Juggling Dynamite

Jim Grant of Grant's Interest Rate Observer had a good article in the Wall Street Journal this weekend “The Confidence Game.”:
“In disclosing plans to buy a quarter-trillion dollars of bank stock in the name of the American taxpayer, Treasury Secretary Hank Paulson harped on confidence. “Today, there is a lack of confidence in our financial system, a lack of confidence that must be conquered,” he said on Tuesday.
What Mr. Paulson did not get around to mentioning was the excess of confidence that preceded the shortfall. Under the spell of soaring house prices (and before that, of stock prices), Americans trusted the things they ought to have doubted. But markets are cyclical, and there is always a new day. In compensating fashion, people will eventually doubt the things they ought to have trusted. Investment opportunity follows disillusionment. It's complacency that precedes bear markets.
If the confidence deficit seems so high, it's because the preceding confidence surplus was full to overflowing. People suspended critical judgment. They accepted at face value the pretensions of central bankers and the competence of investment bankers…”
In a world full of politicians, bankers, investment advisors and commentators who did not see this crisis looming and take no responsibility for losses suffered, its nice to read an article that admits it was forseeable and could have been avoided with even a little bit of hisorical study, discipline and common sense. The whole article is worth the read: “The Confidence Game.”

Times are pretty desperate. Investor sentiment is very low. Consumer sentiment and spending have fallen off a cliff. The VIX “Volatility Index” investor fear gauge spiked to 70 Friday. This same indicator was below 10 for much of 2005 to 2007 as the world slumbered in apathy and oblivion. Sadly, idiots fiddled while Rome burned, again. Now that financial pain has struck, people are wide-awake in fear and anxiety.
I attended a fund-raising Gala last night. The attendees were more affluent than the average Canadian and most were commenting with concern about the shocking decline in the economy this year. Since so few people are ever prepared for the downturns, most have been taken unawares.
Net worth is being hit across the board with simultaneous drops in business revenues, real estate, and investment portfolios. People have the feeling that they are literally under siege, they are traumatized and weakened by it. None of this is unusual or unprecedented. These are the common symptoms of every economic downturn. The only aggravating feature this time is that the downturn is across all asset-types and business, as de-levering is taking place all around the world and at once.
The last times this type of broad-based downturn hit was 1973-74 and 1980-82. Few business people or investors that are experiencing this downturn had much to lose during those previous down cycles that long ago. That is why many today feel like present conditions are unprecedented. Most have never seen anything like this recession. But this too shall pass.
Warren Buffett tried to reassure Americans this week in an op-ed article entitled: “Buy American. I am.”:
“The financial world is a mess, both in the United States and abroad. Its problems moreover have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise business activity will falter and headlines will continue to be scary. So…”[and here is the money quote the investment sales crowd will jump on] “I've been buying American stocks.”
Far and wide, buy always investment types will be grabbing Buffett's quote and screaming it from the roof tops in an effort to suave the wounds of those that have bought “buy and hold advice” throughout the past few years to their financial detriment. But here is the part of Buffett's quote that is most crucial of all and yet, will be widely over-looked:
“This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds.”
Buffett is buying now because prices have been pummeled. And because his net worth has not. He has had his entire personal account in cash-like equivalents throughout this downturn. He is in a position of strength now, because he has cash and because he has protected himself from a savage bear market over the past year.
The virtue of cash and is that you then have a position of strength when others are weak and desperate.
This is the point that I have been trying to make for the past couple of years. If you never leave the party of a bull market, you never get to come back and clean up later. If you never see the need to build up cash and pay down leverage in your business, you will never be prepared for an economic downturn.
It is also worth noting that unlike 99.9% of the world, Buffett has no debt, incredible income and billions in savings. And even with his incredible resources he saw the need to go to TBills and defend his personal account from the market downturn. Because of this, now he is ready and able to buy.
Having been out of equities this past year, Buffett [and our clients] are now in a position of strength as we watch for our re-entry points. Remember this the next time someone try’s to tell you that you can't avoid down markets or that Buffett never sells and always holds. It is simply not true.

The question I have been asked most in the past 24 hours, is whether the global market rally of the last 2 days is the start of the next global bull market or just another opportunity to sell equities into strength.
The truth is that neither I, nor anyone else can tell for sure in one day. But one day is no trend change. The market was painfully oversold in recent weeks, a bounce was overdue. Markets had sold so far below their longer-term trend that a rally of even 20% would only retest overhead resistance while maintaining their downward channel.
Based on many factors which we follow, my guess is that we have not yet seen the market bottom this cycle. These dramatic up swings are more typical of on-going bear cycles than bulls. In the midst of all the green yesterday, the Lowry’s Selling Pressure Index still finished at our near its record high. That looked like institutions and levered players selling into strength. Upside volume was only 73% of up and down volume combined.
Meanwhile the Bond Confidence Index this week hit a new low of 64.2 as bond buyers continued to move into the highest-grade bonds for safety over yield. I also note that while American markets roared ahead yesterday, this afternoon that rally is already breaking down. When markets cannot rally for even a few days, it is not very inspiring for the bulls.
Anecdotally, I note that there are still a majority of retail, individual investors who seem to be hanging on with their last nerve to their decimated stock and mutual fund portfolios. Frozen by fear, I have not yet seen evidence of their final capitulation selling. And the poor little guys are sadly always the last to leave. Their final cash out will create the ultimate exhaustion low this cycle. Only then can the next cyclical bull truly start.
For those that did not yet sell their stocks and stock mutual funds any time in the last 2 years, I would still consider the recent rally another opportunity to downsize your risk.
And for those that have been talked into levered loans, manoeuvres or margin loans to buy stocks and mutual funds in the past few years, get out of them. Sell into recent strength and pay off your loan. I know that it is a painful lesson learned. But happily if you learn this lesson now, you will never have to make the “credit is money” mistake again in your lifetime.
We truly have no idea how low these markets can go before they finally turn. Let other people be the sacrificial lambs with their own dough. Remember, it’s the second mouse that gets the cheese.