Market Volatility - A Fast Eddy Redux

 |  Includes: DIA, QQQ, SPY
by: Tyler Mayoras

Back in June, I wrote a piece here that introduced you to an old friend of mine, Fast Eddy. Eddy got his fast moniker because he was always coming up with a "can't miss" get rich scheme. At the time, I wrote about Fast Eddy's past run-ins with "fad stocks" and at the time I told you why I was avoiding fad stocks like Croc's (CROX) and Heely's (HLYS).

Well in hindsight I am very glad I avoided them, in June when I wrote the story, CROX and HLYS were selling at $46 and $29.50, respectively. While CROX did climb briefly up to around $80 a share it has since dropped to $36.50. HLYS is the more cautionary tale as it has been hammered dropping to a recent $6.40 per share.

Now, I rehash that story because I caught up with Fast Eddy last week and our call resulted in another cautionary investment tale. Eddy is a "newspaper investor" -- you know one of those guys that reads several stories in the Wall Street Journal or worse, Time Magazine, about how hot micro-breweries are -- and as a result he rushes out and buys the stock of several micro-breweries. Of course, by the time the story reaches the mass media everybody knows about the industry and the smart money has likely come and gone.

Well Eddy called to catch up last week and I thought I would probe into what he was doing with his money these days. I ask both for the humor in the response and the contrary indicator that it elicits. Turns out Eddy had been affected by all the doom and gloom in the newspapers of late and had decided to sell all his stocks in mid-January. He also wanted to get my opinion on shorting some of the home-building and mortgage stocks as "this is the worst housing recession since the Great Depression".

Hmmm, could this be a good contrarian sign? Given his past experiences, it might be -- but who really knows. One thing I never do is try to time the market. I am not smart enough, nor do I even think it is possible to win consistently in a market timing strategy. And while the economic news has been gloomy, I believe there are some potential signs of relief in the strong headwinds that have been battering the housing and consumer markets over the past 18 months.

First, the steep drop in interest rates over the past 6 months is starting to provide a reprieve to over-leveraged consumers. In the past week, I have talked to 3 friends that are refinancing mortgages. That is a positive sign for both consumer spending and the large number of ARMs repricing this year. This will reduce the monthly expenses for millions of Americans and lessen the risk associated with the large ARM anvil hanging over the heads of millions more.

Second, lawmakers are working diligently on a bill to increase the limit on mortgages that Fannie Mae and Freddie Mac can purchase. Currently that limit is in the $400,000 range but they are discussing increasing it to around $750,000. The implications are very positive for wealthier consumers that have large mortgages. A jumbo mortgage is priced higher than smaller mortgages because of the lack of liquidity in the secondary market. If Fannie and Freddie are let into the jumbo market this should increase liquidity and drive down mortgage rates for this very important consumer demographic.

Lastly, the lower borrowing costs should begin to entice potential home buyers to begin looking again. Given the very slow rate of sales of both existing and new homes over the past 18 months, there is pent up demand that will be released eventually. Many consumers are sitting on the sidelines because of an existing home they cannot sell or because they want to wait for home prices to stabilize. However, at some point interest rates will get low enough that greed will outweigh fear and then home sales should begin to turnaround.

Do I think we have hit the bottom? I don't know, but I do know from past experience that the turning point always occurs during a period of great uncertainty. No one rings a bell at the bottom (or the top for that matter) to signal it is time to buy (or sell). Rather, I choose to remain fully invested at all times because the long-term upward bias of the markets.

I am not happy that my portfolio is down 21% over the past 3 months, but over the past 6 months my portfolio is still up about 5%. I stay fully invested through difficult times, because when the markets turn it will turn quickly and it is easy to miss the first 15% to 20% of the next upturn. I also do not short stocks because I don't like the risk reward ratio associated with shorting (unlimited downside but limited upside).

Rather, I focus my efforts on finding great companies that should continue to grow right through the difficult economic environment. Yes they still go down because of market sentiment as a whole, but they will be posed to increase much faster than average once the market gets moving again.

In the end, I cautioned Eddy to remain invested and that sometime in the future it is going to be very dangerous to be short home builders and mortgage companies. Could the market and those industries drop further -- absolutely. However, at current market levels I think there is much more risk in missing the next market upturn. I am content to suffer some further short term pain in order to position myself to enjoy all of the future upside. Will Eddy listen, probably not, but I hope that others will.

Note: Fast Eddy is a fictional character loosely based upon investment mistakes that I or others I know have made in the past. I use Fast Eddy to illustrate important tenants in my overall investment strategy.