The Scream of the Lizard

Bob Veres writes a well-respected newsletter for financial planners. Recently Russ Thornton posted one of Mr. Veres’ articles, The Scream of the Lizard.

I loved this article, because I believe that Veres captures, so perfectly, the fear that is motivating, not just many inexperienced investors, but himself, as well. What’s interesting is that, while he has a very well developed and rational understanding of what investing in the stock market sometimes entails, he is still gripped by the fear of the “roller coaster ride” and the scary (but unrealistic) feeling that we are about to fall into the abyss.

Even though he knows better, he still can’t help the way he feels, because of what he refers to as “the lizard-like part of the back of (the) brain” which screams “against all logic and against many things I (know) to be true.”

If you are extremely fearful and cannot possibly imagine that there is a bottom to the stock market, give yourself a little understanding and possibly a little more TLC. You are not alone; in fact, you are in good company.

I recommend that you read the whole article, but here is the conclusion.

I’m one of those financial media types, and also a pundit on occasion, and I can tell you that I can hear the lizard’s scream echoing across the financial landscape, so loudly that it’s hard to remember that stocks are on a fire sale now and they are certainly a hell of a lot less risky than they were last August, and that these rides are seldom fatal to those who stay in their seats, and they are usually at least harmful to those who panic, unhook their seatbelts and jump over the side toward the distant anthill below.

I can hardly wait to look back on those charts and wonder what the hell we were thinking getting so panicky about a blip, and I know at that time that the lizard will be giving me a different message: that if only I’d had the sense to buy when everybody else was selling…

This too shall pass, and 99% of your brain knows it. The market belongs to the lizard now, and I am ashamed to admit that I, the pundit, the media guru, still feel that sense of panic on the way down, irrational as I know it is. I feel it so much that sometimes I can barely hear the rational part of my mind over the screaming that echoes that are calling up from a deeper part of my consciousness. I would curse the designer of this roller coaster, as I did the fiend who put that damn thing up at Sea World, but I’m afraid this time it is us, collectively, who designed our own fear machine.

Are We Nearer To A Market Bottom?

Milo Benningfield, a fee-only Certified Financial Planner in San Francisco, asks a very good question – Are we closer to the stock market bottom, now that some well-known pundits have turned bearish?

Huh? Market “experts” are worried, so we should get ready to BUY stocks?

To the novice, this may seem perverse, but some stock market observers believe that when “everyone” has become bearish, there is no one left to sell “at any price.” Therefore when “everyone” is fearful, the stock market is likely to go up. So “negative sentiment” is bullish, and vice versa, at least at the extremes (at turning points).

I am obviously delving into the dangerous area of technical analysis by even considering whether stock market sentiment can be an indicator of the future direction of prices. As far as I know, there is no independent academic research showing that this approach results in improved investors’ returns.

For most people, at most times, a buy-and-hold strategy works just fine. And when you think, “this time is different” you are just as likely to be wrong.

On the other hand, I can’t resist.  I simply find this line of thinking fascinating, so here is Benningfield’s post, Pundits Capitulating — Are We Nearer To A Market Bottom?

After months of good-faith efforts to bolster investors’ spirits, several prominent financial journalists threw in the towel this week and turned gloomy. The pundits, at least, are capitulating. Could this mean we’re closer to a market bottom?

Example 1 — Ben Stein
Back in the summer of 2007, after the first wave of the credit crisis hit, New York Times columnist Ben Stein told us the market sell-offs were “nutty,” since “This economy is extremely strong. Profits are superb. The world economy is exploding with growth.”

Over ensuing months, while acknowledging the steady stream of poor economic news, Mr. Stein continued to maintain an upbeat attitude, encouraging investors not to panic and telling them “this big, strong economy will sail on through.” That changed this week. Mr. Stein asks, “What if a slowdown is a never-ending story?” His column raises the specter of a depression, telling us, “This time it’s different . . . The problem now, as in 1929 to 1940, is that the economy is not functioning normally.”

Example 2 — Jason Zweig
Wall Street Journal columnist Jason Zweig has done a valiant job these past several months urging investors to avoid panic and to see the silver lining that has emerged with cheaper stock prices and higher expected returns.

But this week, he, too, turned to the Great Depression in his Wall Street Journal column, “1931 and 2008: Will Market History Repeat Itself?” In the gloomiest terms I’ve ever read from him, Mr. Zweig warned us:

“It is vital to realize that markets are never under some obligation to stop falling merely because they have already fallen by an ungodly amount. It also is vital to explore how bad the worst-case scenario can get and to think about how you would respond if it comes to pass.”

Example 3 — Floyd Norris
The chief financial correspondent for the New York Times, Mr. Norris has done a great job reporting on the credit crisis and, unlike many shyer souls, has been willing to stand up and be counted with his predictions for where a market bottom will likely be found. Not this week. As Mr. Norris put it in his blog, “P.S. I am following the suggestion of several commentators on this blog. I am giving up on trying to identify a market bottom.”

Market bottoms typically require a “capitulation” where the vast majority of investors finally sell most of their assets and walk away in disgust. By many measures, we’re not there yet (and may not be for months). But pundits capitulating is at least a good start.

Nice job, Milo.  I have added your blog Margin of Safety to my list of recommended blogs.

How Bad Is This Bear Market?

“Technically, a bear market is when stocks fall 20% or more from their highs. But there’s a saying that a bear’s true signature is making a fool out of everyone. Based on that, we’re all laughingstocks, because there has been virtually no way to avoid this bear market’s claws.” – Matt Krantz.

An article in today’s edition of USA Today, Bear Market Swipes at More Than Just Stocks by Matt Krantz, spells out just how bad the markets have been this year. Here is a summary:

Following a 445-point slide to 7552 Thursday, the Dow Jones industrial average is down more than 6,600 points from its high. The broad stock market is at it lowest level in 11½ years, with the Standard & Poor’s 500 index off 52% from its high in October 2007 and on pace for its worst year ever, S&P says. Only 13 of its 500 stocks are not down for the year, and more than 100 trade for less than $10 a share.

The pain extends far beyond stocks. Oil has crashed 66% from its record close in early July. Even the so-called safe harbor of gold is down 25.5% from its high in March.

This bear has trashed nearly every investment strategy and asset class. It has humbled some of the most powerful names in the stock market and blown holes through long-held tenets in investing. Market historians strain to think of previous bear markets that have disproved so many investing philosophies at the same time.

“There is nowhere to run and hide,” says Ken Winans of investment management firm Winans International. “You have gotten bludgeoned in every direction.”

The extent of the earth that’s been scorched is breathtaking. Brand-name investors such as Warren Buffett, Carl Icahn and T. Boone Pickens have suffered massive losses. Do-no-wrong mutual fund managers, such as Legg Mason’s Bill Miller, are down big. Hedge funds run by managers once thought to be infallible are having their worst years ever.

Even investors who saw the bear coming have been mauled. Those that rushed into commodities or foreign currencies to sit out problems with the U.S. economy have suffered massive losses.

The pros are struggling

Even investors who’ve sought professional help have been stung. Money poured into mutual funds, hedge funds and private-equity firms run by experts known for out-foxing markets in good times and bad. The bear has proved to be smarter than the fox.

Legg Mason’s Value fund (LMVTX), famous for the longest streak beating the S&P 500 under the leadership of portfolio manager Miller, is struggling. It is down more than 65% this year, the third year in a row that it has lagged behind the market. It now has just a one-star rating, out of a possible five, from Morningstar.

Eddie Lampert, the hedge fund manager for celebrities such as David Geffen and Michael Dell who was routinely compared with Warren Buffett just a few years ago, has seen his investments sour. His personal worth has fallen to $2 billion from $4.5 billion just two years ago, Forbes says. His hedge funds’ biggest investment, Sears Holdings (SHLD), has collapsed 70.5% this year.

Speaking of Buffett, the bear snagged the Oracle of Omaha, too. … Buffett’s personal worth is getting mauled, too. Forbes estimated his net worth at $62 billion in February, but that is based mostly on his large holdings of Berkshire Hathaway stock, which is now down $74,150, or 49%, from its high of $151,650 a share.

Commodities aren’t shelter

Investors who thought they saw the stock crash coming figured they had the answer: commodities. Fears of inflation and economic problems pushed many investors into gold. An ounce of gold soared 53.6% in the year leading up to its peak on March 18 as investors poured in. But investors who piled into gold in March have been dealt a 25.5% loss.

A similar story with oil. The price of crude was soaring earlier this year, and gas prices were a national fixation. At the closing peak of $145.29 a barrel on July 3, crude was up 51% for the year. With predictions of it hitting $200 or more, it seemed like a can’t-lose proposition. Speculators lost and lost big as the price crashed nearly $100 a barrel to about $49 now.

The Reuters/Jefferies CRB index of 19 raw materials dropped more than 4% Thursday, hitting its lowest level since April 29, 2003, according to Bloomberg News.

Global diversification is making things worse

We’ve heard it before. Own both U.S. and foreign stocks, and your portfolio’s ups and downs will be moderated. When domestic stocks zig, foreign stocks are supposed to zag.
But that hasn’t worked either. The iShares MSCI EAFE index fund (EFA), which tracks stocks in developed nations in Europe, Asia and the Far East is down 54.5% this year. That’s worse than U.S. stocks’ decline.

What about emerging markets stocks? Up-and-coming nations such as China, Brazil and India were supposed to be growing fast independent of the U.S. Well, the iShares MSCI Emerging Markets (EEM) index has fared worse, tanking 64%. Every major nation’s stock market is down this year, says S&P’s Capital IQ.

Buy-and-hold investors are getting hurt

Buy-and-hold investors know short-term swings are normal. They hold through tough times, knowing returns come to those who wait. But investors who invested in the S&P 500 10 years ago have seen the value of their stocks decline 35%. Even investors who used dollar-cost averaging and invested $500 a month starting Dec. 31, 1996, and reinvested dividends lost $13,225, or 17%, as of Oct. 31, says Winans.

Bonds are eating away at portfolios

Rather than buffering losses on stocks, corporate bonds are falling apart. The iShares iBoxx Investment Grade Corporate Bond fund (LQD), which invests in bonds with high credit ratings, has a negative return of 14.4% this year. That may not sound that bad, except investors buy bonds because they want very little volatility.

Sam Stovall of S&P says that it’s usually not wise to give up on investing in the depths of a bear market. While it takes five years on average for investors to get their money back after a 40%-plus decline, those who keep investing when stocks are cheaper are made whole faster.

Conclusion

A small point: The article overstates the damage to bond investments. Not all have suffered. In fact, Treasury securities have done quite well this year, as investors have fled to these very safe investments. (As the yield of a bond goes down, the price of the bond goes up.)

But the article is generally correct. Unless the stock market recovers from these low levels, which certainly could still happen, 2008 will go down in history as the worst year ever, as measured by the Standard and Poor’s 500 Index. I believe, though, that this is not the time to get discouraged and abandon your well thought out portfolio. In this instance, doing nothing is preferable to selling everything.

There are some opportunities out there. If you can do it, this is a good time to convert your traditional IRA to a Roth IRA. It might also be a good time to rebalance your portfolio. For more information on these two issues, you should consult your financial advisor.

Going forward, we all must re-examine our actual risk tolerance. When times are good, it’s easy to tell yourself that you can weather the (hopefully) temporary storms of declining stock markets. This year certainly proves that living through a substantial bear market, in real time, is another matter entirely.

Finally, if you are so worried about the stock market that you are having trouble sleeping, consider scaling back your equity allocation. That way you will still maintain some exposure to stocks, rather than making an emotional decision to “sell everything.”

photo credit: lexdennphotography

Investor Capitulation, Part 3

“Bear markets sometimes end with a bang, sometimes with a whimper. You’re more likely to see a unicorn in your backyard or a chimera in your kitchen than you are to spot an indisputable sign of market capitulation.” – Jason Zweig.

Of late, I have been writing about the possibility that the current stock market decline could end with a great big bang, followed shortly thereafter by investor disgust and despondency. It’s more of an intellectual exercise, because I am basically an agnostic on the subject. Frankly, no one really knows whether or not we will have such a “selling climax.”

Jason Zweig’s Intelligent Investor post on October 25 is called Capitulation: When the Market Throws in the Towel. Surprisingly, Bear Markets Don’t Always End With a Bang — Sometimes It’s Just a Whimper. His point of view is worth reading and emphasizes that we just never know what will happen.

There’s a belief that the market can hit bottom only when vast numbers of investors finally capitulate, throwing in the towel and selling off the last of their stock portfolios. In theory, if you could spot this moment, you could make a killing buying at the bottom.

There are two problems here. First, capitulation is almost impossible to define. Second, even if you could get a positive ID on capitulation, that might not do you any good. Market lows aren’t necessarily marked by tidal waves of frantic selling; just as frequently, stocks bottom out in a dull and lonely atmosphere as trading dries up and most investors no longer even care. Bear markets often end not in capitulation but stupefaction.

Oddly, even market pundits who believe in capitulation admit they can’t define it. “Capitulation is a state of mind, without any specific definition,” says Al Goldman, chief market strategist for Wachovia Securities. “You can’t measure it; it’s best identified in hindsight.” Hugh A. Johnson, chief investment officer at Johnson Illington Advisors, says almost wistfully: “I wish I could quantify it for you so I could say, ‘Here, this is capitulation.’ But a lot of this is anecdotal. Talk to enough investors and you get an idea of whether we have capitulation.”

“The most interesting thing about [the 1974 market bottom] was its dullness,” veteran fund manager Ralph Wanger recalled to me. “It wasn’t a crash, it was a mudslide. You came in, watched the market go down a few points and went home. The next day you went through the same thing all over again.” And then, without a moment’s warning, the bull woke up and took off. By Jan. 6, 1975, the market had shot up 10%, and a year after that the Dow had risen 54% from its 1974 low.

In short, bear markets sometimes end with a bang, sometimes with a whimper. You’re more likely to see a unicorn in your backyard or a chimera in your kitchen than you are to spot an indisputable sign of market capitulation.

Conclusion

The obsessive attention so many investors are paying to the huge swings in the Dow suggests that we may not have hit bottom yet; stupefaction seems not to have set in yet. What we can be quite certain of, however, is that stock markets around the world are already on sale. If you have cash to spare, put some to work. If you don’t, save up until you do. But don’t kid yourself into thinking that you will ever get a clear signal out of such an unclear indicator.

I sincerely hope that my posts have not added to the “obsessive attention” to the stock market swings. I believe that when an investor owns, even a single share of stock, he actually owns a share in a business. A share of stock is not like a lottery ticket, and it’s more than just a piece of paper based on numbers that crawl across the bottom of a TV screen.

As providers of capital, investors are entitled to a return. In the short term, returns can vary tremendously. Historically, over the long term, stocks have returned more than safer investments.

As for the short term, i.e. what we are living through now, there are dramatic factors that have been causing stock prices to decline – specifically, margin calls and hedge fund redemptions.

An example of a margin call is a company’s CEO who had earlier borrowed money to exercise company stock options. Because the company’s stock price has since declined in value, the CEO must either put up more capital or sell the stock in the account to meet the broker’s margin requirement.

Hedge funds have been selling stocks, currencies, commodities – basically whatever they could sell – to prepare for imminent redemptions. This is, in effect, “forced selling,” similar to margin calls. And there is just no way to know when this will all end.

Since everyone knows this, it is possible that stock prices already reflect the negative situation. If that’s the case, this could be a great “buying opportunity” for stocks. Unfortunately, we will only know if we were right in retrospect.

photo credit: erin MC hammer

Investor Capitulation, Part 2

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” – Warren Buffet.

In a previous post, I raised the possibility that we might witness a kind of panic selling called capitulation. This was not meant to be a prediction. It was an observation that sometimes a bear market ends in a very sharp decline, and it is generally associated with investors’ extreme discouragement and/or disgust. This is not an exact science, but more like Justice Potter Stewart’s comment on pornography – you’ll know it when you see it.

Well at 7:30 this morning, the futures markets indicate a very weak opening for U.S. stocks. This is happening after markets had steep declines in Asia, with the Japanese stock market falling almost 10%. European stocks have also declined by 7-10%. Right now it looks like we are going to have a “Terrible, Horrible, No Good, Very Bad Day.” (Judith Viorst) Of course, no one knows where the market will close today or what will happen next week.

For more context, Mark Hulbert’s column Anatomy of a Bottom, written for MarketWatch on October 21st, describes the difference between a “Panic” and “Capitulation.”

Capitulation has a number of distinguishing psychological characteristics, such as investor disgust and exhaustion. Having been burned by the market for so long, investors capitulate by resolving never, ever, to trust the market again.

In the wake of capitulation, therefore, interest in the market declines. Apathy rules.

To be sure, this definition cannot be mechanically measured. It is hard to pinpoint when investors become maximally dejected and apathetic. But my hunch is that we have yet to experience capitulation.

One illustration of capitulation that I find particularly instructive, even though it is from a pre-Internet era: During bull markets, as well as during bear markets up until capitulation finally occurs, investors turn to the business sections of their morning newspapers to see how much they made or lost the previous day. At times of capitulation, in contrast, investors don’t even bother to open the business section at all.

From the perspective of this illustration as well, capitulation is yet to occur: Far from being ignored, business news is now splashed all over the front pages of newspapers’ lead sections.

My guess is that, when that low does finally occur, we’ll be witnessing, and experiencing ourselves, a lot more of the psychological traits associated with capitulation: Exhaustion, disgust, lack of interest, even apathy.

Interpretation and Advice

Investors, by definition, are “in it for the long run.” If the recent events on Wall Street, and indeed, across the globe, have you so discouraged that you question whether stocks really do provide higher returns than bank CDs, then you are in the grips of capitulation. How you behave or how you react, at this moment, will be what determines your rate of return for a long time to come.

If you sell when everyone else is selling, you may get some immediate psychological comfort that you have come in out of the storm. My belief, which is based on extensive experience, is that you will do yourself harm in the long run.

What happens to stock prices in the short term is anyone’s guess, but if investors are not rewarded for taking risk by investing in stocks, capitalism cannot function.

photo credit: JdeePanIII

Investor Capitulation, Part 1

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” – Warren Buffett.

I do not believe in the concept of market timing, because no one knows what the short term direction of the stock market will be. An educated guess is about the best anyone can make. That is why a buy and hold strategy, using a well diversified portfolio, works best for most investors.

Given their own, sometimes naïve, perceptions, investors can become either too optimistic or too pessimistic. Unfortunately, it is typically easier to identify these times after the fact.

It is very easy to make predictions that turn out wrong, even if you are very knowledgeable.

For example, former Federal Reserve Chairman Alan Greenspan warned about “irrational exuberance” in 1996. He clearly thought that the high stock prices of 1996 could not be justified. Nevertheless, the stock market went up in 1996, 1997, 1998 and 1999. Eventually, in March of 2000, stock prices began their steep decline. Needless to say, if you had heeded “Financial Guru” Greenspan’s warning in 1996, you would have lost out on 3 – 4 years of profitable gains.

In October 2002, after stock prices had fallen almost 50% from their previous highs, a lot of investors “threw in the towel” and basically gave up on stocks. They sold their holdings and stayed out of the stock market for several years. Many of those investors compounded their mistake by switching from equity mutual funds to variable annuities. (That is a topic for another post.)

Let’s assume that, right now, given the current economic climate, the majority of investors are pretty pessimistic about the future. How can we tell? There have been plenty of indicators. Stock prices have already declined more than 35% from their year-ago highs. Banks have been afraid to lend to each other. Institutional investors (pensions, university endowments) have been pulling massive amounts of money out of hedge funds. Many individual investors have been heavily selling mutual funds. And many people, and institutions, have flocked to short-term Treasury securities,  because they are known to be extremely safe investments, albeit very low yielding ones.

Now, suppose stock prices continue to fall, resulting in investors becoming even more pessimistic than they already are. How could this happen? Well, what if so many investors decided to redeem their accounts that hedge funds needed to sell off even larger amounts of stocks, bonds, and commodities just to fulfill the investors’ demands. What if individual investors continued to sell their stocks and mutual funds, only doing it in greater amounts and with far more urgency?

Panic Versus Capitulation

What is this called? Well, panic is one term. Capitulation would be another. You may be hearing this particular term more often now. What would capitulation look like? Probably like the end of the world. The Dow Jones Industrial Average would fall by 800 – 1,000 points or more in a single day. And just suppose that that the selloff continued for a second day. Imagine the ominous discussion on TV. Investors would feel discouraged, disgusted and positively sick. One reaction might be, “Get me out now, at any price!”

If that happens, and there are certainly no assurances that it won’t, then this may in fact be the best possible time to buy more stock. Of course, it is very difficult to even consider buying when prices are actually plummeting and everyone is afraid. (You should note that it is incorrect to say that there are “more sellers than buyers.” In point of fact, there is a buyer for every seller, or more aptly put, each share to be sold will be bought. It is just that the sellers are willing to accept lower stock prices than previously was the case.)

I do not know if the capitulation phase of the bear market will occur. In Prepare for the Revulsion Stage  Janice Dorn, Chief Global Risk Strategist, Ingenieux Wealth Management, Sydney, Australia predicts that capitulation of investors will probably happen. Here’s how she envisions it.

Now, we are likely to see a washout where just about everyone who has not sold will give up and sell. They will walk away from the markets and vow never to return again. This will be the complete revulsion stage. Only when this happens will the markets be in a position to begin to rebuild the technical damage. This will take time, and it now appears that the highs in the broad indices have been seen for many years to come.

People will have nightmares about the Great Crash of 2008 for years to come. They will lose trust in the entire financial system and in many of their advisors who allowed their accounts to lose somewhere between 25% and 50%. The small retail trader will leave the markets in disgust and distrust.

Dorn’s description is quite graphic. And she is saying that it is likely to happen. Make no mistake, she is predicting a once-in-a-generation change in investor perception. We’ll see if this extreme reaction comes to pass.

But please remember that stock market lows can only be identified in retrospect. Moreover, for people who follow a buy and hold approach, all of this may be of only intellectual interest. On the other hand, knowing that this kind of panic behavior can happen may steel you not to join the herd in selling at what may just be the wrong time.

photo credit: Bitterroot