I'm Holding On Through this Storm

I am sure that the past weeks have been disastrous for many investors as very few had seen this drop (and its timing) in the stock markets coming. Even those who did saw it coming may not have expected it to be this fierce.

I think I may include myself in that last category. With the lion share of my portfolio invested in American stocks and a long gold position, this week has certainly been one that I do not wish to experience a second time. My long position in gold has been liquidated and I was too early to close my short position on the Dutch AEX index, which generally follows the US indices.

Now is the time to sit and think about what steps to take. Do I sell my shares, waiting for further drops? Do I move extra money into my trading account? Do I sit and wait until the bottom is there, knowing that current valuations are ludicrously low? This is probably a choice that many private investors are now thinking of and their decision partly determines the future course of the markets.

Let's have a look at the signs that we're getting. The move that we've seen since the year-highs was fiercely downward, then sideways, then fiercely downward again. Corrections like these are never ended with a sideways move. They always end after a last fierce sell-off, followed by a quick rise.

The first downward move was mainly caused by financials that were (or were not) affected by the subprime woes. The second downward move, the one that we're in now, was not caused by financials - even though all newspapers, television stations and websites will tell you that investors are selling on subprime fears. And the financial sector is the only one that is going up again!

The main sectors that are now hit are services, basic materials and to a lesser extent, the energy sector. These are the sectors that had not yet had serious sell-offs and investors are now simply taking profits, based on fear or emotions if you like. In addition to that, the carry trade has its effect as well, which has affected precious metals prices as well.

All this means that you're now able to buy dividend cannons like Southern Copper at a p/e below 10; a growth company like Companhia Vale (RIO) at a p/e of 9 and Freeport-McMoran (FCX) at a p/e of 8.4. And these are not companies that have performed badly so far this year! This Thursday's sell-off also means that telecom stocks are reasonably priced again, even though this is not one of my favorite sectors. It means you can buy Apple (AAPL) at $112, where hardly anything's changed since everyone wanted the stock at $140. (I personally continue to think that it's crazy to pay over 30 x earnings for any company, unless it's a junior company with great prospects, but I seem to be the only one.)

All I can say is that today we are one step closer to a turnaround, which doesn't necessarily mean that 12500 was the bottom for the Dow. There may be a further drop, but I am pretty confident that we will not see a drop as fierce as the one we saw this Thursday. Profit has now been taken in the sectors that are fundamentally the strongest sectors, and these best-performing sectors are the last ones to get hit.

From this I can conclude that the bottom is near. I will therefore not sell any of my stocks and wait for better times to come, however painful this may be. The only thing one can do is write some calls or buy some puts, just in case we haven't seen the bottom yet. I still think the precious metals are the sector to be in and especially gold. I will therefore look for a new long position in gold, once again with a stoploss. To all investors who felt the way I felt this week, hold on tight, start shopping again, but whatever you do, don't be the last one selling. After all the economy can't be that bad, because my fiancee's still out there shopping for shoes as if nothing changed this week...

Disclaimer: The author has no position in any of the above-mentioned stocks.

Comments

[David Lentz:]

Sorry Joe -- I really am -- but the bottom is nowhere near. Are you sure that you understand the problem, the reason why the markets are behaving crazy?

Let's go back, back to, oh, say October 1987. The problem then was that program trading and a lack of mechanisms to compensate for those swings had created a situation where the trust in the markets was completely gone, and we could have vertical drops of breathtaking size. The fix was to install better exchange "circuit breakers" to interrupt the downward plunges, and I'm sure that the outfits running leveraged program trades as portfolio insurance (those that survived the wheels coming off the cart) had a stern talking to from their betters, and program trading was no longer as big a factor in market operations from that time forward.

Today, we have a problem in our debt markets. We have a situation wherein some fraction of our mortgages (subprime is a classification that doesn't adequately describe the situation) were issued without adequate (or even actual) value appraisal of the property, or verification of the mortgagees' ability to pay back the loans. On our last refinancing, my own home was appraised via a "drive-by" assessment, where the assessor never got out of the car, never entered the property. I've since read about appraisals being conducted via Google Earth. How many McMansions built by pyramiding profits from flipping home sales are under-capitalized and over-valued? This is not a problem of just the low end of the mortgage market.

Also, following the S&L crisis in the 1980's, we began mining the equity in our homes, and spending it on college tuition, remodeling, new cars, vacations to Hawaii -- you name it. So a lot of the equity in overvalued homes was spent, further eroding the quality of the collateral underlying a lot of the American public's net worth.

And along the way, we learned to commoditize our debt, so it got sold and re-sold and packaged into a zillion different forms and spread all around the planet via the miracle of globalization.

Given that backdrop, the problem is NOT that we have "some bad mortgages" out there -- it's that we are UNABLE TO TELL how many are bad, or which ones they are. Remember, all the records tell us that the underlying asset is worth far more than it is, and that the mortgagees are flush with income to make the payments. The current mortgagor is not the local bank or S&L, but some completely unrelated company or hedge fund or bond fund who bought some kind of packaged debt for the nice yield. Usually, the first hint of trouble comes when the monthly payments no longer arrive. When the home is repo'd and cannot be sold to recover the outstanding debt, the other shoe has fallen.

In this situation, what happens is that any debt not known to be secure -- in this country that's Treasuries, corporate or municipal bonds backed by a transparent source of payments, and that's about it -- is tarred by the subprime brush. EVERYTHING ELSE IS SUSPECT. Money flows away from lesser-quality debt that MIGHT be toxic toward the high-quality, short-term end of the debt pool, and we suddenly have a shortage of credit. Companies that depend on a fluid debt market with a wide variety of risk and rates are suddenly struggling to breathe. Companies that NEED working capital and issue debt (which is, by their own circumstances, of lesser quality and rating) to get that capital are facing oblivion if this isn't resolved in short order. Companies like Ford (and many others). There's just no market for high-yield, low quality debt.

And therein lies the rub. How can this be fixed? In particular, how can this be fixed without allowing half of corporate America to burn to the ground from a severe lack of liquidity? The Fed cannot flood the markets with sufficient credit to compensate for the amount that is now treated as toxic debt, and the ARM time bombs have not even peaked at this point. The peak in the number of mortgages with ARM rate hikes occurs sometime next year. Nobody knows how many of them will push the homeowners into default, and how many more unsold homes will overhang the economy and keep housing with a stake through its heart. And the dead housing market is another albatross around the American economy's neck, something that the rest of the economy has to carry.

So the liquidity crisis is a long way from over, and as the poison spreads through the equity markets, with more and more companies falling victim to a lack of access to the credit markets (at least at prices they can afford), we are going to see big hedge funds, banks, brokerage firms, insurance companies and some companies (like Ford and others) that lie pretty much outside the financial industry, but absolutely REQUIRE vibrant debt markets to survive, those companies are going to have a disease sweeping through their ranks like a plague.

That's why Friday's action from the Fed is a tinkle on a forest fire. I don't see any way to fix this situation without fixing the problem of the unidentifiable bad mortgages in our debt markets.

Got a quick way to do that? I'm sure that Ben Bernanke and Henry Paulson would like to know. There are a lot of things that need fixing, but without being able to neutralize the bad mortgages, the patient cannot be stabilized. In the fullness of time, and without explicit action to identify and recast the bad mortgages, the problem will take care of itself, a painful but highly effective process -- just ask the old-timers who lived during the depression. During this time, the economy will NOT recover.

Historically, recessions and major corrections drop the markets 20%-30% from their highs. That would mean the neighborhood of a bottom for the various indices might be around 10500 on the Dow, 1160 for the S&P, and 2040 for the NASDAQ. If that's the case, we got a ways to go. And I certainly have not seen anything like the panic selling that typically occurs at a selling climax. These tiny 3%-5% moves in the major indices are nothing. Wake me up when the Dow drops a thousand points in an afternoon.

Until things get unbelievable, you won't believe how bad it will seem. Buy THEN.

And holding on is not a bad strategy, at this point, as we're pretty well into the maelstrom -- provided you're not using margin debt to hold on. BTW, have you SEEN the amount of margin debt outstanding?

2007 Aug 18 01:13 PM

[Werlingdervish:]

"Many hedge funds screen their equities based on the same factors of good earnings momentum, valuation etc." such as AAPL has, according to an article by Mark Hines--seekingalpha.com/artic...;u=80141.

Hedge funds with failing mortgage backed securities are forced to sell profitable equities. So this last week was more than profit taking, especially when it occurs with no explanation in the stock's news or fundamentals.

2007 Aug 18 10:03 PM