Friday, December 31, 2010
Thursday, December 23, 2010
Perspective from Other Respected Advisers
Link to site at Investment News: http://www.investmentnews.com/section/multimedia
Consuelo Mack WealthTrack
Abby Joseph Cohen: The Drought is Over
Consuelo Mack WealthTrack
Abby Joseph Cohen: The Drought is Over
Friday, December 10, 2010
Saturday, November 27, 2010
Market Commentary 11/29/2010
End of Month and End of Year Volatility--International Turmoil
Click on this YouTube link:
http://www.youtube.com/watch?v=et81jKq6Ne8
Please remember that Market Commentary for Friends and Clients is for educational purposes only and is not investment advice for any specific individual. Please contact Wayne for any personal investment advice.
This new "Wayne and Carol" interview has been created using new xtranormal.com software that allows typewritten input to be converted to speech. We hope it is more interesting that just printed text, but just as informative and valuable.
Click on this YouTube link:
http://www.youtube.com/watch?v=et81jKq6Ne8
Please remember that Market Commentary for Friends and Clients is for educational purposes only and is not investment advice for any specific individual. Please contact Wayne for any personal investment advice.
This new "Wayne and Carol" interview has been created using new xtranormal.com software that allows typewritten input to be converted to speech. We hope it is more interesting that just printed text, but just as informative and valuable.
Monday, November 15, 2010
Market Commentary 11/15/2010
A Week with a Great Deal of News!
Click on this private YouTube link:
http://www.youtube.com/watch?v=GeREW-atmAU
Please remember that Market Commentary for Friends and Clients is for educational purposes only and is not investment advice for any specific individual. Please contact Wayne for any personal investment advice.
This new "Wayne and Carol" interview has been created using new xtranormal.com software that allows typewritten input to be converted to speech. We hope it is more interesting that just printed text, but just as informative and valuable.
Click on this private YouTube link:
http://www.youtube.com/watch?v=GeREW-atmAU
Please remember that Market Commentary for Friends and Clients is for educational purposes only and is not investment advice for any specific individual. Please contact Wayne for any personal investment advice.
This new "Wayne and Carol" interview has been created using new xtranormal.com software that allows typewritten input to be converted to speech. We hope it is more interesting that just printed text, but just as informative and valuable.
Saturday, October 9, 2010
The Paradox of Global Recovery
"Originally a paradox was merely a view which contradicted accepted opinion. By round about the middle of the 16th c. the word had acquired the commonly accepted meaning it now has: an apparently self-contradictory statement which, on closer inspection, is found to contain a truth reconciling the conflicting opposites. . . . “ (J.A. Cuddon, A Dictionary of Literary Terms, 3rd ed. Blackwell, 1991)
Even optimistic Americans seem to become a bit uncomfortable when facts and projections about a global “recovery” are discussed. We are used to, since 1945 being the “dominant” economic force in the world and are skeptical when we are told that the world is growing without us being the dominating force for that growth. How can corporate profits be increasing when there is record unemployment in the US and real estate is depressed?
Here’s part of the answer…
The US economy is very big. Even after the recent contraction, it still represents more than $14 trillion per year. (In other words, $14,622 billion.) On an inflation adjusted basis, it is now more than twice as large as it was in 1980. In 1980, a 3.5% annual increase in GDP represented an increase of $227 billion. The US economy in 2010 will probably grow by more than $227 billion. To put this in perspective—the economic output for the entire US will grow more in 2010 than the entire annual economic output of the State of Maryland. In percentage terms, that is slower than in 1980, but in total dollar terms, it is a very big number.
The biggest story however….
Global Trade is now arguably bigger than the total US economy and growing rapidly. Global Trade was in excess of $15 trillion (2009) and forecast to grow by more than 9% in 2010. Companies that are successful and participating in Global Trade are earning profits and the value of their equities (stocks) are rising. But, Global Trade is very competitive and requires a high degree of productivity; It may not contribute to local employment as much as “domestic” business, like residential construction.
The US economy and the economies of some European countries overdosed on residential and retail/commercial real estate during the last 10 years. (Speculation fueled by debt always ends in disaster.) The current difficult part of the US economy in terms of unemployment and declining real estate prices is the “hangover” from that overdosing and binge.
In addition to current Global Trade, consumption outside of the US is growing fast. We used to think of the world economy as three equal parts: the US, Europe, and The Rest of the World. Now, the world economy is four equal parts: the US, Europe, Asia/India, and The Rest of the World. There is now more total wealth in Asia/India than in the US—and therefore, more potential customers for goods and services made by global companies that you can invest in.
Economic activity, estimated to reach nearly $50 trillion for the entire world in 2010 will be the highest in history, having recovered completely from the big drop in 2009—probably exceeding 2008 in real terms by at least 1%. This is despite the fact that the US economy, while “recovering” is still not “recovered”—with GDP for 2010 in the US still slightly below 2007.
Keeping things in perspective: The US has been the world's largest national economy since 1870 and remains the world's largest manufacturer, representing 19% of the world's manufacturing output. Contrary to popular belief, the US was still the largest exporting country in the world for 2009, although Europe as a region, counting only exports outside of Europe exported about 25-30% more. In 2010-2011, China will probably be exporting at levels equal to or higher than the US.
Can the stock market go up and investors prosper, even if the US economy grows slowly?
The answer to that question depends on whether the rest of the world can and will grow without the US in the lead. This has been the debate about what has been termed “economic decoupling”.
My view is that the world will not decouple, but the world economy will become even more inter-dependent. Slow growth in the US will be a drag on global growth. But, the wealth that has been created and accumulated in other parts of the world will no doubt begin to increase demand for US products/services and ultimately bring growth and employment back to historically normal levels. The change is that instead of focusing on producing goods and services for US consumers, our businesses (and their stockholders) will have to shift focus toward satisfying consumers and customers in other countries. The rest of the world will help us to recover from our binge on residential real estate and excess debt.
The paradox of global growth and domestic stagnation is in the truth and simple fact that the huge US economy is having to, and will have to continue to adapt to the reality that for us to prosper, we need to focus not just on selling to and serving ourselves, but the other 95% of the human population living elsewhere as well.
The economy outside the US has recovered and is growing—and the best companies and their stockholders focused on this global economy are prospering accordingly. History teaches us that absent global military conflict, that trend will probably continue.
One caveat is that this global growth could be hurt by ill-advised government actions around the world. Unrestrained real estate speculation and excessive government intervention in China as well as a growing socialist agenda in Brazil are concerns. The growing countries must recognize that continued growth requires an expansion of global trade, which relies on increased imports as well as exports. The US has reached its limit in terms of capacity to absorb the world’s exports without a corresponding increase in reciprocal trade.
Let’s also hope that our government soon wakes up and recognizes that our future leadership in the world lies not in wealth re-distribution and expensive military adventures, but wealth creation in a very competitive world. A competitive, productive workforce, supported by a business friendly government and a superior infrastructure, creates employment and prosperity.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Saturday, September 18, 2010
Is This Time Different?
In a past issue of Forbes Magazine, Gabriel Wisdom wrote an article titled “The Four Phases of Market Cycles”. Phase I: Pessimism and Abject Fear; Phase II: Skepticism; Phase III: Optimism; and Phase IV: Euphoria.
I wrote last month that “Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet.” I think that it can be safely said that for the most part we are in Phase II: Skepticism. Markets have risen dramatically from their lows, but recent declines in June and August had caused some to even fear that we had fallen back into Phase I.
According to Mr. Wisdom, “If you wait for optimism, you missed it.” This is sort of like Warren Buffet’s quote: “If you wait till you see the Robins, Spring has already arrived.”
The important point to remember, is that your investment strategy must ANTICIPATE the movement from one phase to another. If you wait until the markets enter Phase III: Optimism—then you will have missed most of the upside. The time to be fearful is during Phase IV: Euphoria.
Many investors are rightly disturbed by the negative uncertainty of high unemployment, a terrible real estate market, excessive debt, government deficits, and potentially rising tax rates. Even though corporate profits have risen back to pre-crisis levels, the market is skeptical that the numbers are wrong, rigged, or that they are not sustainable. (See graphs in 09/17/2010 weblog entry.) Few investors or pundits can clearly indentify the catalyst that will cause the whole thing to “turn around”.
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| Corporate Profits Recover |
Time for a review of the basics of how equity prices are determined. Let’s start with the question, “How much would you pay for a security that promised to pay you $2500 per year, forever?” The answer for most people is that it would depend on the credibility of the institution making the promise, so let’s assume that probability of the promise being kept is very good. Most people would also need to know the rates of returns being offered by comparable investments.
So, for this example, let’s assume that comparably “safe” investments are currently paying 5% which is comparable to a price equal to 20 times the earnings or a 20 P/E ratio. So, most people would consider paying $50,000 for the security promising to pay $2,500 annually. (Based on current US Treasury Bond rates, buyers are paying more than $60,000 for 30 year bonds with a similar annual return.)
So, for this example, let’s assume that comparably “safe” investments are currently paying 5% which is comparable to a price equal to 20 times the earnings or a 20 P/E ratio. So, most people would consider paying $50,000 for the security promising to pay $2,500 annually. (Based on current US Treasury Bond rates, buyers are paying more than $60,000 for 30 year bonds with a similar annual return.)
Next, how much would you pay for a security where the annual payment is likely to grow or increase over time? Let’s assume that the payment grows by only 3% per year—in 24 years the annual payment would have doubled to $5000. Since the “average” annual return over 24 years would be $3750, most people would be willing to pay 20 times $3750 or $75,000 for this security with a growing return. This would translate to a current 30 P/E ratio.
So, for a security with a stable return, a 20 P/E or price to earnings ratio is acceptable, and for one with a growing rate of return, a 30 P/E might be reasonable. The only reasons the P/E offered would be reduced is fear or belief (hence the risk) that the return or annual payment will be less or less certain in the future. The price of the “market” is clearly Earnings multiplied by Price/Earnings Ratio (P/E). The lower the P/E Ratio, the higher the perceived risk.
During Phase I, both Earnings and P/E Ratios (based on future earnings) fall, causing dramatic market declines. Typically, during the first stage of recovery, Corporate Earnings improve—as has been the case in this recovery. But during Phase II: Skepticism, even though earnings have improved, P/E ratios have not yet risen. Historically, the big market moves have been when earnings become stable (steady gradual growth) and P/E ratios expand dramatically. This will indentify the move to Phase III: Optimism. Essentially the P/E Ratio is a measure of Investor Sentiment.
The problem with trying to predict market movements is that one must predict or “guess”: Average Annual Earnings, Growth Rate and Relative Certainty (Risk). Then the P/E must be determined based on prices for “comparable” investments. When interest rates are low, then P/E Ratios for stocks tend to be higher. Finally, in order to predict market movements one must predict or “guess” likely changes in Sentiment which indicates how others (the market) have processed the same data.
As I wrote last month, “It seems that we are in a bubble of pessimism.” Without a doubt, there are many legitimate reasons for pessimism, but history teaches us that things will get better. As Jeremy Siegel, Wharton Professor and Author has written: “Over the past 200 years, we’ve gone through a Civil War, the Great Depression, two World Wars, and double-digit inflation in the 1970’s. There’s a long list of tragic events, but we always come back to the same trend of long-term stock returns.”
It seems likely that in the long run, Sentiment improves and P/E Ratio’s rise, creating an attractive rise in the market and a move to Phase III: Optimism. When it will happen is unknown. For those who have a long term perspective of 5 years or more—be prudent but start to get ready. “If you wait for optimism, you missed it.” And, “If you wait till you see the Robins, Spring has already arrived.”
In other words, markets will continue to fluctuate, and while one must always consider unknowable geo-political or natural disaster risks, the probability that markets will be significantly UP three to five years from now is significantly higher than the probability that they will be down.
Our economy may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits and sentiment improve are stocks.
Market recoveries are never a straight line up, and at each dip, fear will return. (Remember that September and October tend to be very volatile.) Chicken Little types will yell “Double Dip” and declare bizarre warnings of things like the “Death Cross” and the “Hindenburg Omen”. The media uses this hyperbole to entertain—not to inform.
While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect. We are in the middle of the Skepticism Phase, but Optimism is coming, sooner than later.
I suggest that you review my January 31, 2009 posting: “Early is on time, on time is late, and late is unacceptable”. Since then, the S&P500 is up about 5%, corresponding to a 7.5% annualized return.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Friday, September 17, 2010
Corporate Profits Show "Recovery in Aggregate"
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| Anemic Real Estate is affecting and is affected by Sentiment |
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| Unemployment, like housing is affected by and is affecting Sentiment |
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| Corporate Profits Show "Recovery in Aggregate" Along with sentiment regarding the future, corporate profits are fundamental in determining the value of corporate equities. |
Saturday, August 14, 2010
Are we there yet?
Human beings are not known for being patient. According to the internet Wikipedia article on Patience, we “are inclined to discount future rewards—the present value of delayed rewards is viewed as less than the value of immediate rewards.” On a long trip, our children want to know, “Are we there yet?” and “How much longer?” will it be until the destination is reached.
Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet. During the initial stage of the recovery, it appeared that we were making rapid progress and we hoped that our destination was in site. Over the past few months, it has become clear we are moving slower than we thought and that the journey back to “recovered” will be longer than we hoped.
Data indicates that we have now had 15 straight months of unemployment at 9 percent or higher, 12 months at the current 9.5 percent level or higher. Of the more than 10 million currently unemployed, almost half have been unemployed for more than 6 months. To some, the most impatient and the most pessimistic, it seems that we are moving so slow, that it will take forever to reach our destination of being “recovered” and comfortable. These folks are not only worried about the present headwinds of unemployment and a weak housing market—they are also worried about future headwinds, like higher taxes and bigger government.
It seems that we are in a bubble of pessimism. We can be so focused on the fact that the trip is longer than we hoped, that we fail to recognize that we are still moving toward the destination. As I have written, markets value stocks based on future earnings. Future earnings are unknown, so they are estimated based on present earnings (E) and investor sentiment regarding the future, sometimes measured by the price/earnings ratio (P/E).
Many still estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or almost a 10% increase above the 8/13/2010 close. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)
In addition, when we finally reach “recovery” and return to the S&P500 level reached nearly three years ago in 2007, the market will have risen by 45% from it’s present level !
Corporate profits are clearly recovering. Earnings reported in July have indicated that corporate earnings continue to exceed expectations. Our excessive pessimism tends to discount the importance of these higher earnings with an attitude that the improvement is only temporary.
My prediction is: corporate profits are on the road to recovery. This road may not be straight and it may be uphill, but it’s general direction is toward improvement. We may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits improve are stocks.
While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet. During the initial stage of the recovery, it appeared that we were making rapid progress and we hoped that our destination was in site. Over the past few months, it has become clear we are moving slower than we thought and that the journey back to “recovered” will be longer than we hoped.
Data indicates that we have now had 15 straight months of unemployment at 9 percent or higher, 12 months at the current 9.5 percent level or higher. Of the more than 10 million currently unemployed, almost half have been unemployed for more than 6 months. To some, the most impatient and the most pessimistic, it seems that we are moving so slow, that it will take forever to reach our destination of being “recovered” and comfortable. These folks are not only worried about the present headwinds of unemployment and a weak housing market—they are also worried about future headwinds, like higher taxes and bigger government.
It seems that we are in a bubble of pessimism. We can be so focused on the fact that the trip is longer than we hoped, that we fail to recognize that we are still moving toward the destination. As I have written, markets value stocks based on future earnings. Future earnings are unknown, so they are estimated based on present earnings (E) and investor sentiment regarding the future, sometimes measured by the price/earnings ratio (P/E).
Many still estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or almost a 10% increase above the 8/13/2010 close. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)
In addition, when we finally reach “recovery” and return to the S&P500 level reached nearly three years ago in 2007, the market will have risen by 45% from it’s present level !
Corporate profits are clearly recovering. Earnings reported in July have indicated that corporate earnings continue to exceed expectations. Our excessive pessimism tends to discount the importance of these higher earnings with an attitude that the improvement is only temporary.
My prediction is: corporate profits are on the road to recovery. This road may not be straight and it may be uphill, but it’s general direction is toward improvement. We may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits improve are stocks.
While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Friday, July 2, 2010
Changes in Employment DO NOT predict Future
Market action has been dominated by “traders” who bid up prices and sell quickly. In addition to the traders who sell quickly, driving prices downward, this downward momentum sometimes causes many ill informed individual and institutional “investors” to panic and add to the downward momentum by “getting out before it gets worse”. In addition, many traders not only sell quickly; some also make big “bets” that the market will decline. (I think sometimes these traders actually enjoy and profit from extreme volatility, changing their strategy after they witness those “ill informed individual and institutional investors” finally throwing in the towel.)
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time. Continue to diligently monitor the situation, searching for any such indication.
I would not expect most investors to become macroeconomists, but there are a few good websites that they should visit from time to time: Conference Board—Publisher of Leading Indicators and Consumer Sentiment Data: http://www.conference-board.org/ ; ISM—Publisher of Purchasing Managers Indexes: http://www.ism.ws/ ; Association of American Railroads who publish rail traffic and other economic data: http://www.aar.org/newsandevents/railtimeindicators.aspx ; and Bloomberg.com’s page for the Baltic Dry Index http://www.bloomberg.com/apps/quote?ticker=BDIY:IND . Reviewing the information tells one to be very careful with hyperbole (hype) from the press.
A look at the Baltic Dry Index shows a drop in shipping rates in late May. This might indicate a reduction in global trade, but a look at it over a longer period of time indicates such short term fluctuations are normal and it appears the index is “on trend” to recover to past highs. A look at rail traffic: carloads for the week ending June 26, 2010 “up 11.4 percent compared with the same week in 2009” and intermodal traffic “up 20.5 percent from a year ago and down only 1.1 percent compared with 2008.” JPMorgan Global Manufacturing PMI (Purchasing Managers Index) at 55 for June—“growth remains solid overall and above long-run trend” and June ISM at 56.2—“New Orders, Production and Employment Growing, Supplier Deliveries Slower, Inventories Contracting. Leading Indexes for the US, China are Germany are all UP.
So what is it that so many are worried about? The economy does not appear to be creating jobs fast enough to satisfy some. In 2009, there were 53 million jobs lost and 48 million created. For employment to improve, more jobs need to be created than lost. Well, the latest information, today on July 2, 2010, indicates there were 83,000 net jobs created by private employers in June 2010 and unemployment fell from 9.7% to 9.5%. However at that rate, those nearly five million jobs lost in 2009 will take a very long time to replace.
The momentum of growth has clearly slowed, but most statistics indicate that growth is continuing. Many fear that with chronic long term high unemployment, the economy is doomed to slow growth, no growth or maybe even the terrible “double dip”. And, many do not like to hear that governments around the world may begin to reduce deficits and government payrolls, which many fear will contribute to economic slowing.
My comment regarding fears about reduced government spending: Priming the pump is wise and necessary, but it is only a temporary solution. Once the pump begins to function, continued priming to make the pump put out more and faster is wasteful and foolish. High unemployment is always a sad situation, but unemployment of 9.5% does not necessarily mean a decline in corporate profits and stock prices. The 90.5% of the workforce that are working may be productive enough and spending enough to make the economy quite healthy. Not as healthy as if unemployment were 5% but healthy nonetheless.
Probably the most important economic statistic that is seldom mentioned is the dramatic improvement in productivity that has occurred in the past year or so. It is not so much a bad economy that is keeping unemployment high. It is this improved productivity that is keeping unemployment high. Companies can produce and are producing significant profits with fewer employees. Many believe that the “new normal” for unemployment is much higher than in the past. So, slow increases in employment and continued high unemployment may not justify a reduction in stock prices.
Many still estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or a 16% increase from the end of June level. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)
The recent fears about a slowdown in Europe are probably what started this recent “panic”. Reality is that it probably will cause Europe to buy less from us. The offset of this is that the recent change in China’s currency rate policy will probably cause us to sell more to them. What we lose in Europe may be offset by what we gain from China.
It has been said that markets are only “right” five (5%) percent of the time…and they are “wrong” ninety-five (95%) percent of the time. In the short term--the markets express emotion; they measure corporate profits in the long term. My prediction is: corporate profits are on the road to recovery. This road may not be straight and it may be uphill, but it’s general direction is toward improvement. It is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits improve are stocks.
Employment is not a leading indicator—corporations hire AFTER they are making profits—not before.
The most important thing for investors to consider is not what the S&P500 will be in 2010, but rather, what will it be in 2015. The important questions are: “If markets drop, are they likely to recover within 12-18 months?” and “Are we on track to achieve annualized returns of 8-12% over the next five years?” as well as “How should my portfolio be positioned to achieve my long term financial goals?”
When traders and gamblers are fearful and uncertain, predicting the “bottom” or the lowest point that markets reach is a futile exercise—it is unknowable. And, there are always risks regarding events that are unexpected or that are very unlikely, but possible. That is why the only money that should be invested now is that money that you do not need for at least five years—with a long term strategy, short term fluctuations based on market crowd “emotions” are really of no concern.
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any such indication.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time. Continue to diligently monitor the situation, searching for any such indication.
I would not expect most investors to become macroeconomists, but there are a few good websites that they should visit from time to time: Conference Board—Publisher of Leading Indicators and Consumer Sentiment Data: http://www.conference-board.org/ ; ISM—Publisher of Purchasing Managers Indexes: http://www.ism.ws/ ; Association of American Railroads who publish rail traffic and other economic data: http://www.aar.org/newsandevents/railtimeindicators.aspx ; and Bloomberg.com’s page for the Baltic Dry Index http://www.bloomberg.com/apps/quote?ticker=BDIY:IND . Reviewing the information tells one to be very careful with hyperbole (hype) from the press.
A look at the Baltic Dry Index shows a drop in shipping rates in late May. This might indicate a reduction in global trade, but a look at it over a longer period of time indicates such short term fluctuations are normal and it appears the index is “on trend” to recover to past highs. A look at rail traffic: carloads for the week ending June 26, 2010 “up 11.4 percent compared with the same week in 2009” and intermodal traffic “up 20.5 percent from a year ago and down only 1.1 percent compared with 2008.” JPMorgan Global Manufacturing PMI (Purchasing Managers Index) at 55 for June—“growth remains solid overall and above long-run trend” and June ISM at 56.2—“New Orders, Production and Employment Growing, Supplier Deliveries Slower, Inventories Contracting. Leading Indexes for the US, China are Germany are all UP.
So what is it that so many are worried about? The economy does not appear to be creating jobs fast enough to satisfy some. In 2009, there were 53 million jobs lost and 48 million created. For employment to improve, more jobs need to be created than lost. Well, the latest information, today on July 2, 2010, indicates there were 83,000 net jobs created by private employers in June 2010 and unemployment fell from 9.7% to 9.5%. However at that rate, those nearly five million jobs lost in 2009 will take a very long time to replace.
The momentum of growth has clearly slowed, but most statistics indicate that growth is continuing. Many fear that with chronic long term high unemployment, the economy is doomed to slow growth, no growth or maybe even the terrible “double dip”. And, many do not like to hear that governments around the world may begin to reduce deficits and government payrolls, which many fear will contribute to economic slowing.
My comment regarding fears about reduced government spending: Priming the pump is wise and necessary, but it is only a temporary solution. Once the pump begins to function, continued priming to make the pump put out more and faster is wasteful and foolish. High unemployment is always a sad situation, but unemployment of 9.5% does not necessarily mean a decline in corporate profits and stock prices. The 90.5% of the workforce that are working may be productive enough and spending enough to make the economy quite healthy. Not as healthy as if unemployment were 5% but healthy nonetheless.
Probably the most important economic statistic that is seldom mentioned is the dramatic improvement in productivity that has occurred in the past year or so. It is not so much a bad economy that is keeping unemployment high. It is this improved productivity that is keeping unemployment high. Companies can produce and are producing significant profits with fewer employees. Many believe that the “new normal” for unemployment is much higher than in the past. So, slow increases in employment and continued high unemployment may not justify a reduction in stock prices.
Many still estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or a 16% increase from the end of June level. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)
The recent fears about a slowdown in Europe are probably what started this recent “panic”. Reality is that it probably will cause Europe to buy less from us. The offset of this is that the recent change in China’s currency rate policy will probably cause us to sell more to them. What we lose in Europe may be offset by what we gain from China.
It has been said that markets are only “right” five (5%) percent of the time…and they are “wrong” ninety-five (95%) percent of the time. In the short term--the markets express emotion; they measure corporate profits in the long term. My prediction is: corporate profits are on the road to recovery. This road may not be straight and it may be uphill, but it’s general direction is toward improvement. It is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits improve are stocks.
Employment is not a leading indicator—corporations hire AFTER they are making profits—not before.
The most important thing for investors to consider is not what the S&P500 will be in 2010, but rather, what will it be in 2015. The important questions are: “If markets drop, are they likely to recover within 12-18 months?” and “Are we on track to achieve annualized returns of 8-12% over the next five years?” as well as “How should my portfolio be positioned to achieve my long term financial goals?”
When traders and gamblers are fearful and uncertain, predicting the “bottom” or the lowest point that markets reach is a futile exercise—it is unknowable. And, there are always risks regarding events that are unexpected or that are very unlikely, but possible. That is why the only money that should be invested now is that money that you do not need for at least five years—with a long term strategy, short term fluctuations based on market crowd “emotions” are really of no concern.
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any such indication.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Monday, June 7, 2010
Fear of the Unknown
The March-May quarter first appeared to be a period of growth when suddenly sentiment of professional traders, hedge funds, and institutional investors turned 180 degrees from very optimistic to very negative. This shift fed on itself, leading to the dramatic one month drop of 8.2% in the S&P500 and an 11.8% fall in the MSCI World Index. May produced the worst drop of the DOW JONES Index since 1940. The S&P500 drop was the worst since 1962.
The big question: What comes next?
I have written that “It is important for “investors” to weigh in the balance the opposing risks of being too conservative versus the risk of a possible short term decline.” and “Market action since August has been driven by trading rather than investing---Market action is dominated by “traders” who bid up prices and sell quickly.” as well as “There is still a tremendous amount of cash on the sidelines.” All of these statements still apply.
Nobody knows, with certainty, what markets will do in the short term. Short term movements tend to be based on emotion versus logic. Rather than a certainty that markets are likely to fall, there seems to be general feeling by traders of “let’s wait and see”. In other words this is a period of significant risk for short term investors and a time that requires patience and commitment for longer term investors.
Nothing illustrates this market “nervousness” and the markets moving from fear to greed and back to fear again, better than action during the first week of June. Based on comments from our President that employment was improving, the DOW rose 285 points Wednesday and Thursday, falling back by 323 points on Friday after it was reported that most of the employment “improvement” was temporary government census workers.
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time. Continue to diligently monitor the situation, searching for any such indication.
On the other hand, there are significant indications of a very oversold market situation. Many estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or an 8.8% increase from the end of May level. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)
The most important thing for investors to consider is not what the S&P500 will be in 2010, but rather, what will it be in 2015. The important questions are: “If markets drop, are they likely to recover within 12-18 months?” and “Are we on track to achieve annualized returns of 8-12% over the next five years?” as well as “How should my portfolio be positioned to achieve my long term financial goals?”
A word about Europe..the “worldwide financial crisis” started in 2007-2008 as a result of a fear that high levels of debt would result in defaults and huge losses by lending institutions—leading to a decline in economic activity. This fear subsided in part because of an expansionary monetary and fiscal policy implemented by governments all over the world. Because of the unique structure of Europe’s monetary policy, it became unclear how Europe could sustain the expansionary fiscal policy of government deficits. And, almost simultaneously, because the policy worked so well in the US and China, fears surfaced that these governments might also move to a less expansionary policy in order to alleviate risks of inflation. This caused a nearly perfect storm of fear—not fear of the known, but fear of the unknown.
Is Europe going to reduce fiscal stimulus, perhaps even causing an economic slowdown as they cut government spending and deficits? Will this cause an economic slowdown everywhere, causing the dreaded “double dip”? Well, that is the question that is causing the fear and uncertainty.
First, will a reduction in deficit spending in Europe cause an economic slowdown? By itself, this is probable, but when it is considered that the Euro is likely to have fallen by 15-20%, it is not so probable. Consider that every enterprise in Europe is now 15-20% more competitive—this is a large off-setting stimulus.
Second, will a more competitive Europe mean less economic growth in the US and China? This is probable. On the other hand, with a more competitive Europe, selling to the US for lower prices, it is likely that the US will be able to sustain it’s expansionary monetary policy for a longer period.
When traders and gamblers are fearful and uncertain, predicting the “bottom” or the lowest point that markets reach is a futile exercise—it is unknowable.
The big question: What comes next?
I have written that “It is important for “investors” to weigh in the balance the opposing risks of being too conservative versus the risk of a possible short term decline.” and “Market action since August has been driven by trading rather than investing---Market action is dominated by “traders” who bid up prices and sell quickly.” as well as “There is still a tremendous amount of cash on the sidelines.” All of these statements still apply.
Nobody knows, with certainty, what markets will do in the short term. Short term movements tend to be based on emotion versus logic. Rather than a certainty that markets are likely to fall, there seems to be general feeling by traders of “let’s wait and see”. In other words this is a period of significant risk for short term investors and a time that requires patience and commitment for longer term investors.
Nothing illustrates this market “nervousness” and the markets moving from fear to greed and back to fear again, better than action during the first week of June. Based on comments from our President that employment was improving, the DOW rose 285 points Wednesday and Thursday, falling back by 323 points on Friday after it was reported that most of the employment “improvement” was temporary government census workers.
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time. Continue to diligently monitor the situation, searching for any such indication.
On the other hand, there are significant indications of a very oversold market situation. Many estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or an 8.8% increase from the end of May level. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)
The most important thing for investors to consider is not what the S&P500 will be in 2010, but rather, what will it be in 2015. The important questions are: “If markets drop, are they likely to recover within 12-18 months?” and “Are we on track to achieve annualized returns of 8-12% over the next five years?” as well as “How should my portfolio be positioned to achieve my long term financial goals?”
A word about Europe..the “worldwide financial crisis” started in 2007-2008 as a result of a fear that high levels of debt would result in defaults and huge losses by lending institutions—leading to a decline in economic activity. This fear subsided in part because of an expansionary monetary and fiscal policy implemented by governments all over the world. Because of the unique structure of Europe’s monetary policy, it became unclear how Europe could sustain the expansionary fiscal policy of government deficits. And, almost simultaneously, because the policy worked so well in the US and China, fears surfaced that these governments might also move to a less expansionary policy in order to alleviate risks of inflation. This caused a nearly perfect storm of fear—not fear of the known, but fear of the unknown.
Is Europe going to reduce fiscal stimulus, perhaps even causing an economic slowdown as they cut government spending and deficits? Will this cause an economic slowdown everywhere, causing the dreaded “double dip”? Well, that is the question that is causing the fear and uncertainty.
First, will a reduction in deficit spending in Europe cause an economic slowdown? By itself, this is probable, but when it is considered that the Euro is likely to have fallen by 15-20%, it is not so probable. Consider that every enterprise in Europe is now 15-20% more competitive—this is a large off-setting stimulus.
Second, will a more competitive Europe mean less economic growth in the US and China? This is probable. On the other hand, with a more competitive Europe, selling to the US for lower prices, it is likely that the US will be able to sustain it’s expansionary monetary policy for a longer period.
When traders and gamblers are fearful and uncertain, predicting the “bottom” or the lowest point that markets reach is a futile exercise—it is unknowable.
Prudent portfolio management in periods like this is a bit like sailing a ship in the middle of the North Atlantic during a weather storm. It is seldom wise to return to port and abandon the long term plan of the voyage. It is wise however to be increasingly vigilant to ascertain if any adjustments to the course or rigging may be prudent…and increasingly vigilant for evidence of any new approaching storm.
I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any indication of a deep decline that will last a significantly long period of time.
What comes next?
My best estimate at this time: (subject to change with changing conditions.) In the near term expect very high levels of uncertainty and therefore volatility. Be prepared for 2-3% changes in market levels---daily. Be prepared for short term declines in reaction to bad headlines. Longer term: (barring an unexpected geopolitical event) A) The global economy and corporate profits will rise, albeit at a slower rate than in previous expansions—Market prices will rise accordingly; B) The retirement of debt will be a drag on economic growth; C) Global commerce will increase; and D) Inflation, taxes and interest rates are ALL likely to rise. In my opinion, the best thing to own: a very diversified, income producing portfolio of worldwide stocks and intermediate term bonds issued by “solid” entities/companies that gain from such an environment—with “enough” cash to cover your short term needs.
I continue to advise a cautiously optimistic outlook, being alert and staying prepared for opportunities as well as risks. This means a diversified portfolio consistent with your long term goals and sufficient cash/income to insure that good quality investments do not need to be liquidated at low prices.
Considering that a 44% rise in the market would be required, to get back to the October 2007 “peak” levels, there is a lot of room for markets to rise—moving toward a “fully invested” status between now and September is probably advisable for long term investors with a normal risk tolerance. (Those with a lower tolerance for short term risk and market fluctuation are advised to hold a higher than normal cash level.)
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Thursday, May 20, 2010
Options Expiration Week Anxiety and Uncertainty
We have been hearing a lot about how “derivatives” have increased market volatility. A derivative is a financial instrument or security that can be traded, where the value is “derived” from another security. One of the oldest forms of derivatives is the stock option.
The “basic” stock option is a “right, but not an obligation to buy or sell a stock at a fixed price”. They can be used as a form of insurance, but in most cases they are used by gamblers to increase potential gains as well as potential losses.
One fundamental aspect of most common options is that they “expire” on a given date. In other words, they can become completely valueless on a given day. From the website www.cboe.com (Chicago Board Options Exchange) “The expiration date for equity options is the Saturday following the third Friday of the month. If the third Friday of the month is an Exchange holiday, the last trading day is the Thursday immediately preceding the holiday. After the option's expiration date, the equity option will cease to exist.”
During periods of relative market stability, options expiration does not appear to cause large changes in stock prices. But during periods of extreme fear or greed, it appears that markets sometimes move by large amounts during the week preceding the options expiration date for equity options in the USA. For example, in January and February of 2009, during a period of extreme fear, the S&P500 fell around 10% in the 7 day period preceding options expiration.
On May 12, 2010, the S&P500 closed at 1171. A 10% move down from there would result in an S&P500 level of 1053 or about the same as the 2010 low on February 8. An S&P500 level of 1053 would be a 13.5% “correction” from the 2010 high of 1217. Although such moves down are worrisome, they are not necessarily abnormal nor do they necessarily predict continued decline.
Markets move up because of greed and hope. Markets move down because of fear. In my last blog, I indicated that “As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other.” It is clear that the gamblers or traders have been overcome by fear related to uncertainty. This uncertainty is related to Europe and potential changing of rules in Washington DC.
Markets in the short term are driven by fear and greed. Market movements are exaggerated by the actions of gamblers. It must be remembered that sovereign debt problems, like unemployment tend to be a lagging indicator, not a leading one. Investors know that markets fluctuate, but in the long run, stock markets return to the value determined by corporate profits. Few would argue that corporate profits are not in an upward trend. The debate is really about how fast they will increase. If and when you are confident of the trend, then use the exaggerated market movements caused by fear, greed and the foolish activities of gamblers to your advantage.
There is no way to predict when this current downdraft will reverse. But, you can already hear some of the gamblers beginning to speak about the markets reaching levels where they are comfortable “getting back in”.
Keep in mind that a falling Euro will benefit companies that produce in Europe. It will also cause products made in Europe to be cheaper for American consumers. Keep in mind that falling oil prices tend to stimulate the US economy. Not more than 2 months ago, the headlines were all about the belief that a falling US Dollar was bad. Now, with a stronger US Dollar, there is fear that economic activity will decline. When the headlines seem irrational—they and markets are usually driven by fear and fear in markets tend to create opportunities for buyers—not sellers.
If your money is invested for the long term—five years, ten years or more, and you have income or resources to support yourself in the near term, then stay invested. If you have excess resources, then low prices and fear are an invitation for you to profit—the last two weeks has produced a renewed list of opportunities that seem to become more attractive each day.
The days leading up to options expiration can be so much dominated by options induced volatility, it is seldom a good time to make decisions regarding a change of strategy or a decision to reallocate a larger amount of the portfolio to cash/fixed income. Investors should base their decisions on fundamental principles, not a fear of volatility. Volatility is a normal part of market action, particularly during periods of economic recovery.
Markets sometimes tend to act like a herd of cattle. Sometimes the herd moves toward its expected destination rationally—sometimes it just stampedes off in one direction or another and only stops when the members of the herd get tired.
If you are a gambler, I can’t help you since I do not provide advice or education to gamblers.
If you are an investor, it is probably wise to stay the course until we can see more clearly if the economic environment is truly changing.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
The “basic” stock option is a “right, but not an obligation to buy or sell a stock at a fixed price”. They can be used as a form of insurance, but in most cases they are used by gamblers to increase potential gains as well as potential losses.
One fundamental aspect of most common options is that they “expire” on a given date. In other words, they can become completely valueless on a given day. From the website www.cboe.com (Chicago Board Options Exchange) “The expiration date for equity options is the Saturday following the third Friday of the month. If the third Friday of the month is an Exchange holiday, the last trading day is the Thursday immediately preceding the holiday. After the option's expiration date, the equity option will cease to exist.”
During periods of relative market stability, options expiration does not appear to cause large changes in stock prices. But during periods of extreme fear or greed, it appears that markets sometimes move by large amounts during the week preceding the options expiration date for equity options in the USA. For example, in January and February of 2009, during a period of extreme fear, the S&P500 fell around 10% in the 7 day period preceding options expiration.
On May 12, 2010, the S&P500 closed at 1171. A 10% move down from there would result in an S&P500 level of 1053 or about the same as the 2010 low on February 8. An S&P500 level of 1053 would be a 13.5% “correction” from the 2010 high of 1217. Although such moves down are worrisome, they are not necessarily abnormal nor do they necessarily predict continued decline.
Markets move up because of greed and hope. Markets move down because of fear. In my last blog, I indicated that “As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other.” It is clear that the gamblers or traders have been overcome by fear related to uncertainty. This uncertainty is related to Europe and potential changing of rules in Washington DC.
Markets in the short term are driven by fear and greed. Market movements are exaggerated by the actions of gamblers. It must be remembered that sovereign debt problems, like unemployment tend to be a lagging indicator, not a leading one. Investors know that markets fluctuate, but in the long run, stock markets return to the value determined by corporate profits. Few would argue that corporate profits are not in an upward trend. The debate is really about how fast they will increase. If and when you are confident of the trend, then use the exaggerated market movements caused by fear, greed and the foolish activities of gamblers to your advantage.
There is no way to predict when this current downdraft will reverse. But, you can already hear some of the gamblers beginning to speak about the markets reaching levels where they are comfortable “getting back in”.
Keep in mind that a falling Euro will benefit companies that produce in Europe. It will also cause products made in Europe to be cheaper for American consumers. Keep in mind that falling oil prices tend to stimulate the US economy. Not more than 2 months ago, the headlines were all about the belief that a falling US Dollar was bad. Now, with a stronger US Dollar, there is fear that economic activity will decline. When the headlines seem irrational—they and markets are usually driven by fear and fear in markets tend to create opportunities for buyers—not sellers.
If your money is invested for the long term—five years, ten years or more, and you have income or resources to support yourself in the near term, then stay invested. If you have excess resources, then low prices and fear are an invitation for you to profit—the last two weeks has produced a renewed list of opportunities that seem to become more attractive each day.
The days leading up to options expiration can be so much dominated by options induced volatility, it is seldom a good time to make decisions regarding a change of strategy or a decision to reallocate a larger amount of the portfolio to cash/fixed income. Investors should base their decisions on fundamental principles, not a fear of volatility. Volatility is a normal part of market action, particularly during periods of economic recovery.
Markets sometimes tend to act like a herd of cattle. Sometimes the herd moves toward its expected destination rationally—sometimes it just stampedes off in one direction or another and only stops when the members of the herd get tired.
If you are a gambler, I can’t help you since I do not provide advice or education to gamblers.
If you are an investor, it is probably wise to stay the course until we can see more clearly if the economic environment is truly changing.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
Saturday, May 8, 2010
Chicken Little Should Have Had a Better Memory?
We all remember the fable about Chicken Little who when hit on the head by a falling acorn, decided that the sky was falling—instigating a panic in the community as everyone tried to save themselves from the impending doom. Who would have thought that a possible default in a country the size of Greece would have set off the events of the past week? Particularly since the problems in Greece have been in the news for months.
But, this is how markets work. In the short term, market values are based on perceptions of the future, or in other words, pure psychology. Should we have seen this coming and sold investments? You can’t shoot your herd of cattle just because there is a risk of a stampede! These types of panics can happen at any time.
As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other. Believe it or not, they really do provide a benefit in the form of liquidity and increased market volume. The price we and they pay for this liquidity however is in the form of volatility. What is new is the fact that these gamblers are now armed with increasingly powerful computers driven by computer programs or algorithms designed to exploit minute market movements and to “protect” the gamblers from market falls. If and when these programs all decide, at the same time, that the market is going in the “wrong” direction, they can create awe inspiring market movements like we saw this week.
In response to market volatility in 1987 caused by computer program trading and so called automatic sell programs called “portfolio insurance” the NYSE instituted “circuit breakers” or mandatory pauses in trading. These rules were revised in 1998. The current rules are shown on the website www.nyse.com. Interestingly, no trading halts are set to occur between 2:30PM and 4:00PM ET! It appears that perhaps the new “program trading” algorithms have adapted to this as the “big event” this week occurred after 2:30PM! We may never know exactly what happened, but in an auction market like the stock market—when there are no buyers, prices can get very low, very fast. Especially when computers, not humans are carrying out the bulk of the buys and sells. And, especially with increased potential volume as the result of a dramatically increased activity in derivatives and options. Most likely computer programs began selling and created a vicious cycle as stop loss orders to protect against loss kicked in, creating a tsunami of sell orders with no buy orders until prices fell substantially.
But, this is how markets work. In the short term, market values are based on perceptions of the future, or in other words, pure psychology. Should we have seen this coming and sold investments? You can’t shoot your herd of cattle just because there is a risk of a stampede! These types of panics can happen at any time.
As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other. Believe it or not, they really do provide a benefit in the form of liquidity and increased market volume. The price we and they pay for this liquidity however is in the form of volatility. What is new is the fact that these gamblers are now armed with increasingly powerful computers driven by computer programs or algorithms designed to exploit minute market movements and to “protect” the gamblers from market falls. If and when these programs all decide, at the same time, that the market is going in the “wrong” direction, they can create awe inspiring market movements like we saw this week.
In response to market volatility in 1987 caused by computer program trading and so called automatic sell programs called “portfolio insurance” the NYSE instituted “circuit breakers” or mandatory pauses in trading. These rules were revised in 1998. The current rules are shown on the website www.nyse.com. Interestingly, no trading halts are set to occur between 2:30PM and 4:00PM ET! It appears that perhaps the new “program trading” algorithms have adapted to this as the “big event” this week occurred after 2:30PM! We may never know exactly what happened, but in an auction market like the stock market—when there are no buyers, prices can get very low, very fast. Especially when computers, not humans are carrying out the bulk of the buys and sells. And, especially with increased potential volume as the result of a dramatically increased activity in derivatives and options. Most likely computer programs began selling and created a vicious cycle as stop loss orders to protect against loss kicked in, creating a tsunami of sell orders with no buy orders until prices fell substantially.
Back to the credit crisis concerns about Greece that seemed to light the fuse this week. We have seen this type of thing before. In 1997 we had the Asian Credit Crisis, followed a year later by the Russia’s debt default in 1998. Then in 2001, Argentina defaulted on $132 Billion in sovereign debt—about the same that is at risk in Greece. (Greece’s and Argentina’s economies are about the same. Greece’s economy is only 0.3% of the world’s GDP.)
Let’s put things in a bit of perspective. In early October 1997 the Dow was at 8178. When the Asian Crisis created a reaction, the Dow fell 12.5% to 7161. Eight months later, the Dow had risen 30% to 9328. Reaction to the Russian default in August 1998 caused the Dow to drop 16% to 7827, still 9% higher than the low after the Asian Crisis. The Dow then rose to 11772 by January 2000, falling to 7528 in October 2002. By October 2007, the Dow had risen to 14066. In 10 years from October 1997 to October 2007, the Dow rose from 8178 to 14066, thru three credit crises and a terrible bear market in 2000-2003.
So here we are again with a credit crisis, where fear of contagion causes a bit of panic. The Dow falls 7.4% in days from 11205 on April 26 to 10380 on May 7. Is it over? Probably not yet. The Dow closed at 10325 on the last day of February. Many gamblers may not feel that it is safe to get back into the water until we see a classic 10% “correction”. So, many are probably looking for the Dow to fall at least another 2.3% to 10084. (The Dow was 9908 on 2/8/2010.) Nobody knows for sure when it will change direction. It will change only when the perception of the future changes.
Economic cycles have always more or less been driven by debt. Increased borrowing tends to increase economic growth until the borrowing reaches a point where debtors cannot service it. Then there is a period where debts are restricted or written off and losses are recognized. Decreased borrowing tends to curtail growth.
One big fear is that, even though the US seems to be in a strong economic recovery, that problems in Europe will curtail economic recovery there. And, with a weak Europe, China’s export machine sputters, and the outlook for continued growth in the US is diminished. Another fear is that terrorism is on the rise. Another fear is that governments around the world seem to be taking on too much debt.
It has been said that the most dangerous words related to predicting the future of economies and markets are: “But this time it is different”
The best advice is always to study history and learn from it. Markets in the short term are driven by fear and greed. Market movements are exaggerated by the actions of gamblers. It must be remembered that sovereign debt problems, like unemployment tend to be a lagging indicator, not a leading one. Investors know that markets fluctuate but in the long run, stock markets return to the value determined by corporate profits. Few would argue that corporate profits are not in an upward trend. The debate is really about how fast they will increase. If and when you are confident of the trend, then use the exaggerated market movements caused by fear, greed and the foolish activities of gamblers to your advantage.
If your money is invested for the long term—five years, ten years or more, and you have income or resources to support yourself in the near term, then stay invested. If you have excess resources, then low prices and fear are an invitation for you to profit—the last week has produced a renewed list of opportunities.
If you are a gambler, I can’t help you since I do not provide advice or education to gamblers.
And if you are an investor, when you hear the cries of Chicken Little, tell him he should have a better memory.
This post is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
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