Fundmastery Blog

Kurt Brouwer October 13th, 2008

Burton Malkiel is well-known for his classic investment book, A Random Wall Down Wall Street (W.W. Norton 2007).  He is also a professor of economics at Princeton University.  In this piece, he points to some solid long-term advice on what to do during stock market panics — don’t panic [emphasis added]:

Keep Your Money in the Market (Wall Street Journal, October 13, 2008, Burton G. Malkiel)

…But just because stock markets have panicked, investors should not. The best position for investors today is not “fetal and 100% in cash.” 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.

…Nervous investors convince themselves that every “light at the end of the tunnel” is a train coming in the opposite direction. Panic is just as infectious as blind optimism. During the third quarter of 2002, which turned out to be the bottom of a punishing bear market, investors redeemed their mutual funds in droves. My own calculations show that in the aggregate, investors who moved money in and out of equity mutual-funds underperformed the buy-and-hold investors by almost three percentage points per year during the 1995-2007 period.

Look at history: The market eventually bounded back from the damaging stagflation of the 1970s and the savings-and-loan crisis of the early 1990s, when a whole industry had to be rescued. Stocks also recovered from the Asian crisis of the late 1990s. Similarly, investors who held on after the more than 20% one-day stock-market decline in 1987 were eventually well rewarded.

So what should investors do? By all means, young 401(k) investors, and those in their prime earnings years, who are stashing away funds from every monthly paycheck, should stay the course. If you decide to eschew equities during periods of ubiquitous pessimism, you will lose all of the advantage of “dollar cost” averaging (buying more shares when prices are low than when they are high). Asset allocations should be shifted to safer securities over time as the investor ages, but only gradually and on a set schedule as through a “target maturity fund.”

If you are now approaching retirement and failed to move to a more conservative asset allocation, you should not do so now in response to a time of panic. If anything, well diversified investors should, at the end of each year, consider rebalancing to ensure that your portfolio composition remains consistent with the risk level appropriate for your financial circumstances and tolerance for risk. But this is likely to mean shifting into equities and not out of them.

…No one has consistently made money by selling America short, and I am confident the same lesson is true today.

When stocks are tumbling it is difficult to hold on or even add more to your portfolio.  Yet, we know that during downturns such as this one, we get great buys on high quality companies.  This environment is unusual in that real estate is falling too and even bonds are down.  If you don’t want to buy stocks, then the bond market has very attractive offerings now.  And, savvy investors can look to fallen real estate as well.  So, it is a target rich environment for the patient long-term investor.

• Economy , Mutual Funds , Personal Finance , Retirement
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Kurt Brouwer October 10th, 2008

That’s not a headline I wanted to read.  The Dow Jones Industrials Average dates back 112 years and we just experienced the worst single-week performance in that history.  MSN Money has the story, which is sure to get plenty of attention over the weekend [emphasis in the original]:

Despite rebound, stocks end worst week ever (MSN Money, October 10, 2008, Charley Blaine & Elizabeth Strott)

The stock market finished its worst week ever with a dramatic rebound from even worse lows.

The Dow Jones industrials moved more than 1,000 points during the session — from a low of nearly 700 points to a gain of more than 300 — before falling back again. It was the first 1,000-point swing for the blue-chip index.

The blue chips closed down 128 points, or 1.5%, to 8,451. Twice during the day, the index fell under 8,000 for the first time since April 2003. Twice it bounced back.

The Standard & Poor’s 500 fell 11 points, or 1.2%, to 899. But the Nasdaq Composite Index gained 4 points, or 0.3%, to 1,650. A big engine in the Nasdaq’s gain: a 9.1% gain to $96.80 in Apple (AAPL, news, msgs). The iPod maker had fallen as low as $85 at the open.

For the week, the Dow and S&P 500 were off 18.2%. It was the worst week for the Dow in its 112-year history and the worst week for the S&P 500 since the week of May 21, 1933. The Nasdaq’s 15.3% loss was its worst since the week of April 10, 2000, as the dot-com bust broke…

So, for the Dow we had the worst week ever.  For the S&P 500, we had the worst week since 1933 and the depths of the Great Depression.  What a week.

• Business , Economy , Investing , Mutual Funds , Personal Finance , Retirement
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Kurt Brouwer October 10th, 2008

This headline from a piece in the Washington Post today by one Anthony Faiola gets my award for the most overblown so far.  And, I know reporters do not write the headlines, so we can cut him some slack, but the piece does a good job of laying blame for most of this financial crisis on what the author falsely calls American capitalism:

The End of American Capitalism?

The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism…

In this piece we are given the usual stuff about how America is finally getting its comeuppance.  He blames this crisis on free market failures as though we actually have a free market.  Last time I checked, just before they went under, Fannie Mae and Freddie Mac were government sponsored enterprises, one of which was created in 1938 under Roosevelt and one was created in 1970 under Nixon.  Our banks are regulated by various government agencies as are securities firms and insurance companies.

I would be the first to suggest those regulations did not have the desired effect, in large part because the regulators and those being regulated have for decades had pretty cozy relationships and often switch sides.  Hank Paulson is now Treasury Secretary and previously he was at investment bank — now commercial bank — Goldman Sachs.  But, saying our regulators failed is not the same as saying these companies were operating in a free market capitalist system that failed.

Stay tuned.  No doubt there will be much more of this nonsense ahead.

• Business , Economy , Geopolitics , Money
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Kurt Brouwer October 9th, 2008

Investors are running for the sidelines as the steady drumbeat of negative news pounds on and on.  I could point to the ratings downgrade for GM and to the continued financial crunch, but I suspect it is just as much due to the simple capitulation of investors who feel they cannot take the pain anymore.

From its high point last October 5, 2007, the S&P 500 is now down 40%. The AP has the story [emphasis added]:

Dow Plunges More Than 600 To Go Below 9000 (Associated Press, October 9, 2008, Tim Paradis)

Stocks plunged in the final minutes of trading Thursday, sending the Dow Jones industrials down more than 675 points, or more than 7 percent, to their lowest level in five years after a major credit ratings agency said it was considering cutting its rating on General Motors Corp. The Standard & Poor’s 500 index also fell more than 7 percent.

The sell-off came as Standard & Poor’s Ratings Services put GM and its finance affiliate GMAC LLC under review to see if its rating should be cut. GM has been struggling with weak car sales in North America.

…”The story is getting to be like that movie Groundhog Day,” said Arthur Hogan, chief market analyst at Jefferies & Co. He pointed to the still-frozen credit markets, and Libor, the bank-to-bank lending rate that remains stubbornly high despite the Fed’s recent rate cut.

“Until that starts coming down, you’ll be hard-pressed to find anyone getting excited about stocks,” Hogan said. “Everything we’re seeing his historic. The problem is historic, the solutions are historic, and unfortunately, the sell-off is historic. It’s not the kind of history you want to be making.”

According to preliminary calculations, the Dow fell 678.91, or 7.3 percent, to 8,579.19. The blue chips hadn’t fallen below the 9,000 level since Aug. 6, 2003.

Broader stock indicators also tumbled. The Standard & Poor’s 500 index fell 75.02, or 7.6 percent, to 909.92, while the Nasdaq composite index fell 95.21, or 5.47 percent, to 1,645.12.

I believe this marks the seventh straight down day for stocks.  It certainly feels like a bad version of the movie Groundhog Day. as the commenter mentioned above.

In that movie, a TV newscaster (Bill Murray) keeps waking up at 6AM to sounds of Sonny & Cher singing ‘Put your little hand in mine, there ain’t no mountain we can’t climb.’  Even though he does different things each day, the end result is the same.

The stock and bond markets are giving us the same result day after day too.  This will not last forever, but it certainly feels that way.

• Economy , Geopolitics , Investing , Personal Finance
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Kurt Brouwer October 9th, 2008

Looking back, the bankruptcy of Lehman Brothers was much more disruptive than at first we thought it would be.  Now, finally, the settling up has begun.  Following the successful auction for Fannie and Freddie Mac (see below), comes tomorrow’s session for Lehman Brothers.

In case you were wondering why this matters, it is the uncertainty over who owes what to whom that is at the core of this financial panic.  Events like this auction tend to get overlooked, but this is a fruitful process that has been supported by the government and by the various creditors of Lehman.

The term credit default swaps (CDS) is used a lot and it is at the heart of this crisis.  Without going into any degree of complexity, a CDS allows the holder of some debt (e.g. a portfolio of subprime mortgages) to get insurance on the risk of default of that debt from a third party such as a bank, insurance company or other entity.  In this case, buyers of Lehman Brothers bonds and other debt securities are looking for the payoff of credit default swaps they purchased.

The Wall Street Journal’s MarketBeat Blog reports [emphasis in the original]:

The Looming Lehman CDS Unwind (MarketBeatBlog, October 9, 2008, Geoffrey Rogow)

On the heels of similar auction processes for Fannie Mae, Freddie Mac and Washington Mutual late last month will be the expected Friday settlement for buyers of about $400 billion of protection on Lehman Brothers debt.

For now, traders in the equity market are concerned about the prospects for the settlement, adding that its uncertainty is casting a dark cloud over the most likely holders of the debt — big banks such as Morgan Stanley, Goldman Sachs and J.P. Morgan Chase.

This Lehman credit default swaps settlement auction will likely be one of the most expensive payouts in the history of that market, something the government is certainly keeping an eye on.

The Fed has called a second meeting to discuss the settlement of Lehman CDSs, among other issues, on Friday. “They think there is still counterparty risk out there. But, if we get through that hurdle without too many issues then you will see a more stable market into next week,” said John O’Donoghue, head of equities for Cowen & Co…

Here is a piece from the Financial Times that puts some numbers to this:

Banks Prepare For CDS Payouts (Financial Times, October 7, 2008, Aline van Duyn & Hal Weitzman)

Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and -dealers.

…The Federal Reserve will meet dealers, investors and exchange executives in New York today. Although big dealers had committed to setting up a central counterparty by the end of the year, urgency has increased in light of the collapse of banks around the world and as company bankruptcies loom.

…Credit default swaps, a form of insurance against bond defaults, are the most common type of credit derivative. Yesterday, the default of up to $500bn in derivative contracts linked to Fannie Mae and Freddie Mac was settled, the biggest such exercise ever carried out.

The Fannie and Freddie CDS settled at between 91.5 and 99.9 cents on the dollar, reflecting the fact its underlying debt is not in default after the mortgage groups were seized by the US government. The seizure did trigger defaults on derivatives, however.

The next test will be the unwinding of CDS linked to Lehman, which filed for bankruptcy three weeks ago. Michael Hampden-Turner, a credit strategist at Citi, estimates that there could be $400bn of credit derivatives referenced to Lehman.

These contracts will be settled on Friday, and with the recovery value on Lehman bonds currently estimated at about 10 cents on the dollar, the pay-out by banks and other sellers of credit protection on Lehman could reach a gross $360bn…

This will be a painfully slow process as the deleveraging of so many financial institutions proceeds.  Nonetheless, some progress is being made.  So far though, no one told the stock or bond markets.

• Business , Economy , Geopolitics , Hedge Funds , Investing
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