March 2008

March 24, 2008 01:00 p.m. Finally, a Bottom?

There have been several false bottoms in the markets since the mortgage and credit crises began in August 2007. Last week’s holiday-shortened market action looks more positive than the previous bottom attempts. It was accompanied by several prominent forecasts that we had reached a bottom, including a cover story in Barron’s.

Readers of Retirement Watch and my books know that bear market bottoms occur when there is extreme pessimism among investors. At that point prices have been pushed as low as they will go. They might stay at that level for a while, but the only major move left is to reverse course and rise.

Did we reach a point of maximum pessimism and a market bottom recently?

The news reports certainly were gloomy leading up to the failure of Bear Stearns and its takeover by JP Morgan. There also is market folklore that a crisis reaches it nadir when a big name financial institution fails. Of course, that is more anecdote that hard research. Plus, there were a number of failures and humiliations leading up to the collapse of Bear Stearns, and none of them indicated a bottom.

Even so, last week’s stock market action was positive. There were significant gains on Tuesday and Thursday, and the major indexes gained over 3% for the week. Trading volume was high on Thursday, another positive sign. Investor’s Business Daily changed its market outlook from a correction to a confirmed rally.

Yet, it is not time to be a hero yet. There very likely is a lot of deleveraging likely to come. Hedge funds and other institutions will be forced to sell more assets as lenders place new margin calls or refuse to roll over debt. The deleveraging process perpetuated the crises.

I continue to follow our three signs for the end of the crises, and they continue to be negative. Short-term treasury rates remain extremely low, a sign that investors remain seekers of safety. There is little new activity in the mortgage-backed securities markets, and spreads between treasuries and other types of debt continue to expand. The markets have had several rallies since last June, and each sputtered when fresh negative headlines emerged. In fact, the markets have established a pattern of rallying when the Fed takes decisive action, then allowing prices to fizzle after a short time. This is not a time to back up the truck and buy, but it is time to identify prospects and do a little buying, as recommended in our April issue.

March 24, 2008 1:00 p.m. Core Opportunities

One criterion for the mutual funds I select, especially in the Core Portfolios, is that they be shareholder friendly. A problem with this criterion is that shareholder friendly funds close to new investors (and sometimes to new investments from existing investors) when they are too big for the managers to effectively implement their strategies. Over the years, many of my favorite funds either closed to new investors or converted from no load funds to load funds.

In every crisis, however, there are opportunities. One opportunity in the current crisis is that some funds that were closed decided to open to new investors. These long-term value funds see attractively-priced securities throughout the markets. They want to raise new money from investors to purchase these securities for their portfolios. The funds are not calling a market bottom by opening to new investors. They merely are saying that prices are attractive relative to the intrinsic values the funds place on the companies.

Long-term favorites that have re-opened to new investors are: Dodge & Cox Stock; Longleaf Partners; Longleaf Partners International; Third Avenue International Value; Tweedy, Browne Global Value; Oakmark International Small Cap; and Oakmark International. Among these, my very favorite long-term funds are Dodge & Cox Stock, the Longleaf Partners funds, and Tweedy, Browne Global Value.

Investors should purchase at least the minimum amount of each of these funds in their Core Portfolios. The funds are quick to close to new investors when a market opportunity has passed. I cannot list them in my Core Portfolios most of the time, because they are closed to new investors so often. When you can get into these funds, you should do so and hold them for the long term. This is a period of unique opportunity.

March 15, 2008 04:00 p.m. So Much for the Turnaround

On Tuesday investors began to think we might be nearing a bottom in the current crises and the market declines. Monday was a dismal day with bad news across the board. The Federal Reserve’s announcement of a new policy to prop up banks on Tuesday gave new hope to investors. Those hopes were dashed as the week went on, especially today’s announcement that Bear Stearns needed a major bailout and is likely to either be liquidated or sold over the weekend.

Early in the mortgage and credit crises, we identified three signals we would watch for signs of an end to the crises. I want to see short-term treasury rates rise. Those rates fall when investors sell everything else in a flight to safety. I also want to see the volume of asset-backed securities return to a normal level. And I want to see banks making loans. None of those signs is positive. Banks are building assets and increasing lending standards. There isn’t much action in the ABS market, because investors are avoiding anything with risk. For the same reason, short-term treasury yields are extremely low.

The Federal Reserve is doing what it can. Lower interest rates will not reverse the confidence problem among investors. The Fed is serving as buyer of last resort when problems surface.

The Fed needs help from other. There is no movement on fiscal policy. Congress still is planning to let tax rates rise after 2010, and some want to raise them sooner. A good idea would be to set up an entity to buy bad mortgages and other loans, as was done during the savings and loan crisis of the 1980s. Instead, all the talk is of whether or not to freeze mortgage payments or even buy the homes of strapped owners.

Accounting rules also are a problem. When a loan owner decides to unload a loan and is not selective about the price, the mark to market rules require other firms that own similar loans to reduce the values on their books. The lower values on the books can trigger loan defaults or cause lenders to stop lending to them. In a couple of cases there have been allegations that banks seized the portfolios of hedge funds and sold them at lower prices than they could have. All of this creates a spiral of declining prices and rising defaults when there is little or no change in the payments made on the loans.

The mark to market rules are very sensible for normal times. In times like these they make the situation worse. They need to be modified or suspended.

As I said in the latest issue of Retirement Watch this is the longest and most widespread credit crunch in recent times. Because of the amount of leverage involved, it is hard for investors to know which investments can be affected. Some investors believe that a crisis ends about the time that a major institution fails. Perhaps the fate of Bear Stearns indicates the bottom is near. But there is no sign of that yet in either market action or the key financial indicators.

March 14, 2008 04:05 p.m. The Current Crises Explained

I’m going to take a few moments to toot my horn and plug my latest book, Invest Like a Fox…Not Like a Hedgehog.

Many investors are puzzled by how the current crises happened. The book explains that this series of events is normal, occurs all the time, and the various points of the cycle can be identified. Investors swing from extreme optimism to extreme pessimism and back. They do this with all investments. The length of the cycle varies, and the particular events that trigger changes in investors’ outlook change, but there are many points in common.

Because we use this knowledge in our investment recommendations, we were wary of technology stocks in particular and growth stocks in general back in 1998 and 1999. Likewise, we avoided high-yielding income investments the last couple of years. Investors weren’t being paid enough for the risks in those investments. That was a sign of extreme optimism. It took a while, but it became apparent that the optimism was unwarranted. There were risks in investments that investors did not realize. Since last May, income investors have been moving rapidly from extreme optimism to extreme pessimism. This past Monday it seemed that the point of extreme pessimism might be near. All the news was bad, and all the forecasts seemed negative. Yet, at least some things became worse as this week went on.

In the latest issue of Retirement Watch I recommend venturing into a couple of new investments that seem near low points. But it still is not time to take wholesale positions in the markets. I keep looking for signs of extreme pessimism, as I explain in the book. Keeping this cycle of investor psychology in mind helps investors avoid large losses and prevents being surprised by the sudden crises that regularly hit the markets.

March 7, 2008 03:00 p.m. The Great Deleveraging Accelerates

It makes no sense to follow history or the fundamentals when evaluating markets today. Market prices are dominated by the weakest players. Investors who used leverage to buy are being forced to sell, and they are in a spiraling cycle. Asset prices decline because investors are not willing to buy at any price; they are avoiding all risk. Leveraged investors have to sell, because their collateral has declined and they cannot refinance. Lenders today are raising their standards and generally reducing the amount of loans they will make. The forced selling further pushes down prices, triggering forced sales for other investors.

We are reaching a level of high pessimism if not extreme or maximum pessimism. Consider these headlines that appeared at the same time on Bloomberg.com on the morning of Thursday, March 6:

• Stocks in U.S. Drop, Led by Banks on Home Foreclosures, Recession Concern
• U.S. Mortgage Foreclosures Increase to All-Time Hihg as Owners “Give Up”
• Carlyle Mortgage-Bond Fund Gets Default Notice After Missing Margin Calls
• Tricket Dashes Rate-Cut Speculation, Sending Euro to Record Against Dollar
• Treasuries Advance on Speculation That Losses in Credit Market Will Deepen
• Credit Default Swaps Overwhelm Bernanke East as Corporate Debt Costs Surge
• Wal-Mart Sales Climb as Consumer Seek Bargains; J.C. Penny, Gap Decline

That is a load of bad news for one morning, and the news has not improved.

The good news is that we are closer to a bottom than we were before, and investors are indiscriminately selling everything. For some time now we have been very cautious on the markets. Now, we are close to recommending at least a few purchases. There are solid assets being sold at distress prices. Current prices for some of these assets are justified only if a worst-case scenario for the economy and markets is realized. No one can call a bottom, and we are not going to try. But it is time to pay attention when investors such as Warren Buffett, Wilbur Ross, and the sovereign wealth funds are buying. There probably will be a few buy recommendations in the April issue of Retirement Watch.