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

The Cloudy Crystal Ball, Part 6

 

 

“These types of forecasts are wildly off-base. What they’re always about is extrapolation. People are always extrapolating recent trends. And you don’t know how far the trend is going to really run.” – William A. Fleckenstein.

This post is a continuation of articles on how no one can predict the stock market or any other market, for that matter.

Going for the Gold in Gloom and Doom by Michael M. Grynbaum has an analysis of the phenomenon of people who make predcitions that are extreme.  They not only confidently assert their forecasts, but they are frequently wrong.  And they are not held accountable for their mistakes.

“Financial forecasters are in a race to call the bottom to the bear market. And just as on the way up, when analysts competed for attention with their forecasts of bigger and bigger gains, the financial pundit class now seems compelled to out-gloom the next guy.

“To make a crazy forecast today is not crazy,” said Owen Lamont, a former professor at Yale who has studied economic forecasting. “It’s not crazy to predict the Dow is going to 2,000. That’s in the realm of possibility.”

“Even in normal times, forecasters have a strong incentive to make extreme predictions, which is why those “Dow 1,000!” reports persist. “It’s eye-popping. It’s relevant. It seems exciting,” Mr. Lamont said. Such predictions attract publicity, name recognition and a bigger client base in a business where investors pay thousands, if not millions, for stock advice and investment guidance.

And even if a forecast is off-base, there are few repercussions because they are almost always quickly forgotten. “The reason that people do these games is because no one’s really tracking accuracy,” said Mr. Lamont, who now works at DKR Capital, a hedge fund in Greenwich, Conn. “No one is carefully, prudently giving more business to the guy who is 2 percent more accurate than the next guy.”

Some say this is a system that propagates ignorance and poor advice.

“Anyone that invests 10 cents on the basis of someone’s forecast of the Dow is desirous of losing a good portion of their 10 cents,” said William A. Fleckenstein, president of Fleckenstein Capital, a money management firm in Issaquah, Wash. “It is almost the height of arrogance to say this is where the Dow is going to trade.”

“These types of forecasts are wildly off-base,” Mr. Fleckenstein said. “What they’re always about is extrapolation. People are always extrapolating recent trends. And you don’t know how far the trend is going to really run.”

Some financial pundits, however, are all too happy to broadcast their predictions to the public, no matter how apocalyptic.

Peter Schiff, the president of Euro Pacific Capital in Darien, Conn., and a prominent financial Cassandra, has seen some of his most dire forecasts confirmed amid this year’s turmoil. On Friday, he predicted plenty more pain to come.

Forecasters who get too far ahead of themselves would do well to remember an instance of notoriously poor prognostication. One of the few times that a financial strategist has been widely taken to task came in 1999, when Kevin A. Hassett and James K. Glassman published “Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market.”

The book, which arrived just months before the technology bubble burst and stocks plummeted to earth, was actually an argument that bonds and stocks should be considered as equally risky investments. But the title — cartoonish in hindsight and, in its authors’ defense, proposed by the publisher — has since become a popular punch line for jokes about irrational exuberance in turn-of-the-century Wall Street. (The Dow closed on Friday at 8,378.95).

Still, while the reputation of its authors may have taken a hit, “Dow 36,000” has not seemed to hurt their careers.

If you had taken their book seriously, you would be much poorer.  But while their predictions were way off the mark, both authors have done just fine.  One has a prestigious position with the American Enterprise Institute and one with the Bush Administration. 

Conclusion

Wildly optimistic forecasts and wildly pessimistic predictions are often wrong. Frequently the prognosticators are merely extrapolating the recent past. The main thing they accomplish is to gain attention for themselves. If you listen to such predictions and act on them, you do so at your own risk.

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

Is It Different This Time? Part 4

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.
 
Today’s New York Times has two editorials, both of them well worth reading; one was written by Nobel prize-winning economist Paul Krugman and the other by Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, who is touted as one of history’s most successful investors. At first glance, their respective opinions seem to be diametrically opposed, but that is only true if you don’t understand how the stock market works.

In Let’s Get Fiscal, Krugman assesses the outlook for the economy saying that there is “grim news coming in about the real economy.” Summing up the economic situation, he states,

Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long.

Krugman predicts that the unemployment rate, which is already above 6 percent, “will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.”

“And how long will it last? It could be very long indeed.”

Upon reading that, it would be understandable if you decide to sell all of your stocks and put the money from the proceeds “under the mattress,” so to speak. If you’re at all in agreement with Krugman’s analysis, you might want to buy “safe” CDs or, if you are totally freaked out, short-term U.S. Treasury securities, that are paying very close to zero interest.

That understandable inclination of reacting to bad current news, and worse predictions of the future, though perfectly natural, would likely also be entirely wrong. The reason is that the stock market looks forward. What is already known is “priced in the market.” Stock prices have already fallen in anticipation of a worsening economy. If and when the economy declines further, that will only confirm what we think we know now, so stock prices may not decline any more from where they currently stand.

In other words, as an investor, you cannot read the news or even someone’s prediction on where the economy is going and “profitably” act on it. In the stock market, “what everyone knows is not worth knowing.”

Please note, that nowhere does Krugman give any advice on what to do as an investor. That’s not his area of expertise. I am only projecting what a knowledgeable layman might conclude from reading Krugman’s observations.

That brings me to Warren Buffett’s opinion piece. It is an understatement to say that Buffett is a very, very, successful long-term investor. He’s been called, among other things, the Oracle of Omaha and the world’s greatest stock market investor, and an empire builder. His favorite holding period is “forever.” He certainly does not try to time the market, as he believes no one can do that successfully. (There is a lot of academic evidence that people who do try to time the market end up with terrible results.)

In Buffett’s Buy American. I Am, he agrees with Krugman’s basic thesis on the economy.

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

But here is the seeming paradox. What is Buffett doing?

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

Since no one can forecast the short term direction of the stock market, Buffet continues:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

This is typical Buffett — folksy, but right on. He then writes about the Great Depression and World War II, and notes that buying when things look bleakest was the right strategy. He concludes that “bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.

This is my fourth post in the series called Is It Different This Time?  Feel free to read the others, especially if you are ready to hit the panic button and sell your stocks and/or stock mutual funds.

photo credit: notsogoodphotography

The Financial Crisis: Why Were Warnings Ignored?

“Prediction is very difficult, especially about the future” – Niels Bohr

Gary Becker an economist and Richard Posner a judge, both at the University of Chicago, write a joint blog. It is frequently very thoughtful and worth reading, although usually long and a bit academic for some.

Their October 12th post The Financial Crisis: Why Were Warnings Ignored? asks a very important question. Here is a summary of their thoughts.

Richard Posner’s Opinion

Posner thinks the problem was a failure to synthesize all of the warnings. His analogy is the failure to foresee the attack on Pearl Harbor, although there were indications from 1941 on that something like that could happen.

He singles out “a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini who for years had been predicting with uncanny accuracy what has happened.”

In September of 2006–two years ago–he had “announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics.

Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks.

Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble…

The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown.

Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk.

In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.

Becker’s Opinion – Why the Warnings Were Ignored: Too Many False Alarms

Becker has “a somewhat different take than Posner on why warning signals were ignored.”

The period since the early 1980s until the crisis erupted involved both rapid economic growth for most of the world, and unprecedented stability in this growth. Inflation rates were low and fluctuations in real output, as measured by the size and duration of recessions, were modest compared to the past. Economists and central bankers like Greenspan believed that we had learned how to keep inflation low, and also had the capacity to smooth out fluctuations in output and employment.

The second relevant development has been advances in financial instruments, such as derivatives, securitization, credit-backed swaps, and other even more esoteric instruments. These instruments seemed to work quite well in managing, spreading and even reducing the risk of the assets held by banks and other institutions. However, in the process they encouraged greater risk-taking ventures, as reflected by the large increase in the leverage-that is, in the ratio of assets to capital- of banks and financial institutions like Fannie Mae and Freddie Mac. What has been insufficiently understood is that the growing use of these instruments, and the growing leverage of financial institutions, created considerable aggregate risk for the system as a whole that could not be diversified away.

This combination of growing central bank confidence in its ability to iron out various wrinkles in economic performance, and the belief that the new financial instruments would help manage and reduce risk, blinded the vast majority of economists (I include myself), bankers, and government regulators to the vulnerability of the whole system. This vulnerability was especially important for aggregate shocks akin to a classical run on banks. When institutions are highly leveraged, they have great difficulty coping with a massive loss of confidence in the system.

While giving credit to Roubini, Becker lists several disasters during the past several decades that were predicted but never happened:

After the huge one-day stock market collapse in October 1987, Business Week and other magazines and newspapers warned that a Great Depression might soon be coming. These dire forecasts turned out to be completely wrong. Similar highly negative, but wrong economic forecasts, were made during the Asian financial crisis of 1997-98, the internet bubble, and the aftermath of the 9/11 attack.

In an atmosphere where the world economy showed great capacity to withstand difficult shocks, it is not at all surprising that some forecasts of disaster that turned out to be more correct were ignored.

In addition, one should not minimize the great economic achievements of the past 25 years in the form of rapid growth in world GDP, low world inflation, and low unemployment in most countries. Perhaps these achievements will be overshadowed by a deep world recession, but that remains to be seen. If the impact of this financial crisis on the real economy is not both very severe and very prolonged, and time will answer that question, the combination of the past 2 1/2 decades of remarkable achievement, and the economic turbulence that followed, may still look good when placed in full historical perspective.

Conclusion

I appreciate Becker’s perspective that for more than 25 years, the world has seen substantial growth and short recessions. However, this long term success led to overconfidence and excessive risk taking. While everything was working well, investment banks and other financial institutions could achieve large profits. With interest rates so low, borrowing money to increase profits seemed to make sense.

Cassandras are often wrong. The prevailing belief is that markets are usually right in sorting out risks and rewards. (George Soros disagrees with this ideology.)

The problem is that too many people based their decisions on the belief that housing prices could only go up. Unfortunately, too many houses were built and too many people who could not afford the houses were able to get mortgages, often with artificially low “teaser rates.” Now we are dealing with the fallout.

To see how Wall Street took on too much risk, see How Wall Street Became a Giant Hedge Fund.

photo credit: pangalactic gargleblaster

Is It Different This Time? Part 3

“We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.” – Burton G. Malkiel.

Alex Berenson’s October 11th article in The New York Times Those With a Sense of History May Find It’s Time to Invest is well worth reading, especially if you are discouraged enough to be considering selling your equity mutual funds and putting the money in CDs.

The four most dangerous words for investors are: This time is different.

In 1999, technology companies with no earnings or sales were valued at billions of dollars. But this time was different, investors told themselves. The Internet could not be missed at any price.

They were wrong. In 2000 and 2001 technology stocks plunged, erasing trillions of dollars in wealth.

Now investors have again convinced themselves that this time is different, that the credit crisis will push economies worldwide into the deepest recession since the Depression. Fear runs even deeper today than greed did a decade ago.

But in their panic, investors are ignoring 60 years of history. Since the Depression, governments have become far more aggressive about intervening when credit markets seize up or economies struggle. And those interventions have generally succeeded. The recessions since World War II, while hardly easy, have been far less painful than the Depression.

Berenson goes on to quote various investors and economists who believe that the pessimism is overdone and that this is a good time to buy rather than sell stocks.

If there is good and wise policy, and government moves effectively, this need not play itself out in ways like the Great Depression, which is the image that is playing itself out in people’s mind. . Government action typically does not work immediately, and banking crises around the world often require multiple interventions. – Stephen Haber, an economic historian and senior fellow at the Hoover Institution.

“I think in years to come — I wouldn’t say months to come — we will perceive this as being a great value-buying opportunity. Two and three years from now, it will seem very smart.” - David P. Stowell, a finance professor at Northwestern and a former managing director at JPMorgan Chase.

“This is the opportunity of a lifetime. The most important securities are being given away.” – Martin J. Whitman, a professional investor for more than 50 years.

photo credit: Sheffield Tiger

Recession or Depression? Part 3

“In their 1963 book A Monetary History of the United States, 1867-1960, Milton Friedman and Anna Schwartz laid out their case for a different explanation of the Great Depression. … The failure of the Federal Reserve to deal with the Depression was not a sign that monetary policy was impotent, but that the Federal Reserve exercised the wrong policies. They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression.” – Wikipedia.

Definitions: Bear Market or Crash?  from the October 10th Forbes magazine provides useful background information.

Stocks are falling, unemployment is rising and even banks seem to be hiding their money under mattresses. It’s tough to measure how bad things are and impossible to say whether they’ll get worse. With commentators throwing around words usually reserved for the worst of economic times – crash, recession, depression – the one question we can answer is what those words mean.

The economy expands and shrinks in cycles, with times of growth followed by times of contraction.

In an expansion, manufacturers build new factories, retailers open more stores and, most of the time, companies hire additional workers. The 1990s saw a decade of growth, the longest peacetime economic expansion in U.S. history.

In a recession, the economy shrinks for months. Factories produce less, cutting shifts, or laying off workers altogether. Incomes fall. Sales drop. The last recession lasted nine months ending in November 2001.

A depression is a more severe and prolonged version of a recession. In a depression, prices often fall as unemployment rises. Shoppers drastically cut their spending. In the Great Depression, which began in 1927 and lasted for more than a decade, unemployment peaked at nearly 25 percent, and many of those who did work were only able to find part-time jobs. By contrast, the current unemployment rate is 6.1 percent.

Recent talk about depressions has been sparked by worsening economic data and the frightening drop in stock prices, which has been almost as steep as the 1929 crash that began the Great Depression. Most professional investors call a 20 percent decline within a few days a crash.

A 20 percent decline over a longer time is called a bear market. A bear market is a prolonged decline in prices for stocks, bonds, commodities, or all three. While there’s debate about whether the decline of the seven trading days ending Thursday was a crash, there’s no argument that we are in a bear market. The Dow Jones industrial average is nearly 42 percent lower than it was at its highest point last October; marking the largest decline since 1973-1974.

The opposite of a bear market is a bull market, which brings a prolonged increase in the price of stocks, bonds or commodities. Market historians may point to Oct. 9, 2007 as the crest of the most recent bull market – notching a 48 percent rise over five years – and the beginning of a bear market of undetermined length.

photo credit: Lee Jordan

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