Friday, November 21, 2008
Taking stock
For those near the end of their patience with the grinding down, water torture phase of this bear market, where the volatility is such that we lose 400 points a day instead of 50 or 75, here are some q and a's to put things into a little clearer perspective.
Q What is causing the prolonged crash?
A There are many factors but the overriding one is that the world became too leveraged with debt, which artificially increased the values of assets, including equities. Once the housing bubble burst, a chain reaction deleveraging was set in motion, that has rotated across several business sectors starting with investment banking. As debt is removed, the asset side of the balance sheet shrinks too, so all kinds of assets (homes, stocks, commodities, etc.) shrink in price. Having made mush of the balance sheets of financial service companies, the damage is now inflicting itself full scale in hedge funds and certain other mutual funds. It is seeping into the retail and commercial real estate areas. This is occurring as layoffs and fears about future employment cause retail customers to pull their horns in on spending.
Q So when do equities finally reflect the real values of the underlying companies?
A Chances are, market prices have already overshot to the downside in most cases. However, that doesn't mean the selling is over or that a bottom has been reached. That's because the hedge funds and certain other market players still have some leverage to unwind. Chances are, that even with all the selling this week, the hedge funds are now only about 2/3 of the way there. The breakdown in prices causes margin calls and forces others to sell, when buyers are scarce. So prices keep plunging without reference to actual corporate value. Since price is set at the margin where the last buyer and seller meet, forced selling in an environment where buyers are scared and scarce drives prices below actual asset value.
Q So why can't we just ignore the stock prices of all these companies? What is the danger?
A For companies with little or no debt, there may, in fact, be little danger. Their earnings will be down for as long as the recession lasts but they probably have the resources to ride it out. However, for those with debt, the situation is perilous. That's because the recession will impact their cash flow and ability to pay down the debt. When the debt becomes due, they may find a bond market and banking system unwilling to refinance their debt or extend it. If rating agencies perceive that this will be the case, they are likely to downgrade the credit ratings of those companies, and those downgrades often trigger collateral or even accelerated repayment requirements in the LOC or bond agreements. If that happens, the company might not survive.
Q So what can be done to break this vicious cycle?
A If we really knew, it would have been done. It has become more and more evident that the very expensive solutions that the Treasury has tried are having little actual impact. Congress seems unable to do anything more than criticize and engage in political posturing. And the Obama people have become very quiet. Given that there are two months still to go in the transition to the new administration, one would think that if they thought they had the right answer, they would have offered it by now. Do they really want to inherit an economy that's flat on its rear end, 1932 style? At least by naming its new Treasury Secretary today, the incoming administration sparked a technical rally.
Q Why do we get these short, one-day rallies of 4% or more?
A Just as in a bull market, we get technical corrections that lurch to the downside, only to have the market reassert the uptrend, in bear markets, the sudden lurch is an unsustained upside move. In a bull market, when margin players get spooked, they rush to sell to protect their positions, but eagerly return to the borrow and buy side once the danger has passed. In a bear market, the short players rush to cover when there is good news or a rally looks like it could take hold. This accelerates the sharp rally, but as soon as the players realize the bear market is not ending, they use the higher prices from the rally to reestablish new short positions.
Q So what is a long term investor to do?
A There's no easy answer. For many stocks, it's too late to sell unless you can use the tax loss. As for buying, you can nibble on debt free companies with credible business plans, but know that even those are likely to retreat until the deleveraging is over. They won't ring a bell when the bear is over, and typically the best part of a bull move is right at the beginning. So it is a little dangerous to be out of the market. Of course, this bear could stay in place for a long time. The looming problems in the retail and commercial mortgage sectors may overwhelm all other factors, leaving the economy in recession for an additional year or three.
---------------------------------------------------------------------------
The recovery, whether it comes in 2010, 2011, 2015, or 2020, is likely to be driven by revival in world trade and employment prospects, reduced taxes on capital (the opposite of what Mr. Obama campaigned on), and technological breakthroughs, which could be in the areas of energy development and distribution, transportation costs, health care costs, communication costs, or global conflict resolution. Obviously, none of these can be guaranteed to occur. But the belief that we can do the right things economically, politically, and/or technologically is what is needed to rebuild confidence and markets.
So far, the Obama team looks mainly to be Clinton era retreads, some capable, some not so capable. In short, the transition is doing too little to breed confidence so far, and with the current administration and congress all but standing down because of lame duck status, the transition period is too long for comfort.
------------------------------------------------------------------------
Wednesday night, I went jazzing for the first time in quite a while, a little reward for a couple of extra hours of office time (and the failure of the weekly card game to occur). For an ad libbed evening, there is nothing like a seat at the bar at the Kitano Hotel, a couple of glasses of really good Oregon Pinot Noir, and some high quality jazz in NYC's most intimate setting (translation - small). On this particular occasion, I was doubly rewarded when the Michelle Walker quartet played a superb set.
Ms. Walker has a very creative and distinctive style of taking a familiar song and providing a fresh cover arrangement. Her strong alto was very solid in covering Lionel Ritchie, Paul Simon and others. Backed by a solid bass and drum, the group took on difficult arrangements but put each song over beautifully, a kind of high wire act set to music.
But the real revelation was Ms. Helen Sung on piano, who performed her own trapeze act (without a net). The 2007 Mary Lou Williams Competition winner (at the Kennedy Center), and obviously classically trained, Ms. Sung attacked each solo with the right combination of touch and speed and all of those swift passages were played as cleanly as a concert pianist. Yet, she swung with the band too, playing the bluesy cracks when called for and causing the audience to whistle and shout during many of her solos (when was the last time you heard that kind of reaction for a piano solo?). In fact, she and Ms. Walker seemed to be having just a fine time all evening, exchanging gleeful laughs and smiles as they explored the intricacies of their daring arrangements.
It's great to be young, fearless and talented. Look for these two on the bandstand when they come to your favorite venue, as surely they will.
------------------------------------------------------------------------------
On Monday, I bought 50 shares of Transocean (RIG) at 70.48, and got shellacked almost immediately. Wednesday, I bought 1000 shares of Books A Million at 2.20, a limit order that saved a penny, which is nothing compared to what I could have saved if I had just waited until the end of the session to put the order in.
I am making the first change in the trading formula in quite some time by reducing the qualifying debt - to - equity ratio for a value buy from 1.0 to 0.7. At 1.0, the capital structure of a company is 50% debt, too much for the current situation certainly, possibly too much for my taste anyway. At 0.7, debt constitutes only 41% of total capital. Note, Jim Cramer has been talking about 0.5 being his ratio break point, but there debt is only one-third of capital, and that may be a little too disciplined in my opinion, especially in normal times. In this environment, it could be that zero debt is the only acceptable level.
The other change to the formula is that regardless of how low the price to book ratio is, a stock having more than a 0.7 debt to equity ratio will not be considered a value play. The current formula has allowed value buys as long as the combination of the two ratios did not exceed 2.5. Where the debt/equity ratio passes, we'll still use 2.5 meaning that book value can exceed two times price as long as the debt ratio is low enough. This recognizes the current urgency around maintaining a low debt ratio.
Q What is causing the prolonged crash?
A There are many factors but the overriding one is that the world became too leveraged with debt, which artificially increased the values of assets, including equities. Once the housing bubble burst, a chain reaction deleveraging was set in motion, that has rotated across several business sectors starting with investment banking. As debt is removed, the asset side of the balance sheet shrinks too, so all kinds of assets (homes, stocks, commodities, etc.) shrink in price. Having made mush of the balance sheets of financial service companies, the damage is now inflicting itself full scale in hedge funds and certain other mutual funds. It is seeping into the retail and commercial real estate areas. This is occurring as layoffs and fears about future employment cause retail customers to pull their horns in on spending.
Q So when do equities finally reflect the real values of the underlying companies?
A Chances are, market prices have already overshot to the downside in most cases. However, that doesn't mean the selling is over or that a bottom has been reached. That's because the hedge funds and certain other market players still have some leverage to unwind. Chances are, that even with all the selling this week, the hedge funds are now only about 2/3 of the way there. The breakdown in prices causes margin calls and forces others to sell, when buyers are scarce. So prices keep plunging without reference to actual corporate value. Since price is set at the margin where the last buyer and seller meet, forced selling in an environment where buyers are scared and scarce drives prices below actual asset value.
Q So why can't we just ignore the stock prices of all these companies? What is the danger?
A For companies with little or no debt, there may, in fact, be little danger. Their earnings will be down for as long as the recession lasts but they probably have the resources to ride it out. However, for those with debt, the situation is perilous. That's because the recession will impact their cash flow and ability to pay down the debt. When the debt becomes due, they may find a bond market and banking system unwilling to refinance their debt or extend it. If rating agencies perceive that this will be the case, they are likely to downgrade the credit ratings of those companies, and those downgrades often trigger collateral or even accelerated repayment requirements in the LOC or bond agreements. If that happens, the company might not survive.
Q So what can be done to break this vicious cycle?
A If we really knew, it would have been done. It has become more and more evident that the very expensive solutions that the Treasury has tried are having little actual impact. Congress seems unable to do anything more than criticize and engage in political posturing. And the Obama people have become very quiet. Given that there are two months still to go in the transition to the new administration, one would think that if they thought they had the right answer, they would have offered it by now. Do they really want to inherit an economy that's flat on its rear end, 1932 style? At least by naming its new Treasury Secretary today, the incoming administration sparked a technical rally.
Q Why do we get these short, one-day rallies of 4% or more?
A Just as in a bull market, we get technical corrections that lurch to the downside, only to have the market reassert the uptrend, in bear markets, the sudden lurch is an unsustained upside move. In a bull market, when margin players get spooked, they rush to sell to protect their positions, but eagerly return to the borrow and buy side once the danger has passed. In a bear market, the short players rush to cover when there is good news or a rally looks like it could take hold. This accelerates the sharp rally, but as soon as the players realize the bear market is not ending, they use the higher prices from the rally to reestablish new short positions.
Q So what is a long term investor to do?
A There's no easy answer. For many stocks, it's too late to sell unless you can use the tax loss. As for buying, you can nibble on debt free companies with credible business plans, but know that even those are likely to retreat until the deleveraging is over. They won't ring a bell when the bear is over, and typically the best part of a bull move is right at the beginning. So it is a little dangerous to be out of the market. Of course, this bear could stay in place for a long time. The looming problems in the retail and commercial mortgage sectors may overwhelm all other factors, leaving the economy in recession for an additional year or three.
---------------------------------------------------------------------------
The recovery, whether it comes in 2010, 2011, 2015, or 2020, is likely to be driven by revival in world trade and employment prospects, reduced taxes on capital (the opposite of what Mr. Obama campaigned on), and technological breakthroughs, which could be in the areas of energy development and distribution, transportation costs, health care costs, communication costs, or global conflict resolution. Obviously, none of these can be guaranteed to occur. But the belief that we can do the right things economically, politically, and/or technologically is what is needed to rebuild confidence and markets.
So far, the Obama team looks mainly to be Clinton era retreads, some capable, some not so capable. In short, the transition is doing too little to breed confidence so far, and with the current administration and congress all but standing down because of lame duck status, the transition period is too long for comfort.
------------------------------------------------------------------------
Wednesday night, I went jazzing for the first time in quite a while, a little reward for a couple of extra hours of office time (and the failure of the weekly card game to occur). For an ad libbed evening, there is nothing like a seat at the bar at the Kitano Hotel, a couple of glasses of really good Oregon Pinot Noir, and some high quality jazz in NYC's most intimate setting (translation - small). On this particular occasion, I was doubly rewarded when the Michelle Walker quartet played a superb set.
Ms. Walker has a very creative and distinctive style of taking a familiar song and providing a fresh cover arrangement. Her strong alto was very solid in covering Lionel Ritchie, Paul Simon and others. Backed by a solid bass and drum, the group took on difficult arrangements but put each song over beautifully, a kind of high wire act set to music.
But the real revelation was Ms. Helen Sung on piano, who performed her own trapeze act (without a net). The 2007 Mary Lou Williams Competition winner (at the Kennedy Center), and obviously classically trained, Ms. Sung attacked each solo with the right combination of touch and speed and all of those swift passages were played as cleanly as a concert pianist. Yet, she swung with the band too, playing the bluesy cracks when called for and causing the audience to whistle and shout during many of her solos (when was the last time you heard that kind of reaction for a piano solo?). In fact, she and Ms. Walker seemed to be having just a fine time all evening, exchanging gleeful laughs and smiles as they explored the intricacies of their daring arrangements.
It's great to be young, fearless and talented. Look for these two on the bandstand when they come to your favorite venue, as surely they will.
------------------------------------------------------------------------------
On Monday, I bought 50 shares of Transocean (RIG) at 70.48, and got shellacked almost immediately. Wednesday, I bought 1000 shares of Books A Million at 2.20, a limit order that saved a penny, which is nothing compared to what I could have saved if I had just waited until the end of the session to put the order in.
I am making the first change in the trading formula in quite some time by reducing the qualifying debt - to - equity ratio for a value buy from 1.0 to 0.7. At 1.0, the capital structure of a company is 50% debt, too much for the current situation certainly, possibly too much for my taste anyway. At 0.7, debt constitutes only 41% of total capital. Note, Jim Cramer has been talking about 0.5 being his ratio break point, but there debt is only one-third of capital, and that may be a little too disciplined in my opinion, especially in normal times. In this environment, it could be that zero debt is the only acceptable level.
The other change to the formula is that regardless of how low the price to book ratio is, a stock having more than a 0.7 debt to equity ratio will not be considered a value play. The current formula has allowed value buys as long as the combination of the two ratios did not exceed 2.5. Where the debt/equity ratio passes, we'll still use 2.5 meaning that book value can exceed two times price as long as the debt ratio is low enough. This recognizes the current urgency around maintaining a low debt ratio.
