Economic Ramblings about the Market

So I decided since October to jump headlong into the market. It may be the best time in the next 5-10 years to go running in (assuming we are in a Recession) or I'll lose everything I put in (I hope we aren’t in a depression of depressions). I don't know which it is. With the myriad of voices that seem to purport a thousand different ideas, I don't think anyone really has a clue what is about to happen. Lots of smart people are on both sides of the debate and who knows who will be deemed the prophet of this economic crisis. Most commentators or opinionators have taken us out of the depression range and think that we have a deep recession coming.

So with the uncertainty, why am I investing? I think we are in a recession, stock prices are worth less now than they will be in five years, and dividends though being cut now will resume.

Let me explain:

The first issues is related to an understanding of the market, banks, and the credit crisis happening. Stock prices are directly related to the amount of money being invested in the market. A percentage of the amount of money in the market was due to margin buying by large hedge funds which has decreased along with the amount of credit available. I think in the overall sceme this was a small factor. How do the banks factor in? Banks don't sit on money. They are attempting to make money off every dollar that comes in the door. The reason they pay 2% on savings is that can turn and make 6% on a house loan. It works. In olden times, there should have been little risk on the house loan as every person went through a rigorous test determining their risk on the loan. The rate may increase a little as risk increases but overall the risk is negligible because the underlying asset is stable. In our current environment, house prices aren't stable because too much money was lent to too many people who were too high a risk. The banks got greedy.

Along with making bad loans, banks risk appetite was too great. Try this exercise. Go onto http://finance.yahoo.com/ and get a quote on a company. Let's use BP for example. (I own some.) On the left tab, there is a "Major Holders" link. Look at the Top Institutional Holders. What names do you see? Bank of America, JP Morgan, State Street, etc. These are large banks who put their money to work. T. Rowe Price doesn't count as that is probably all mutual funds. If you do this for a number of companies, you will see lots of banks being named. If you go to the Balance Sheet of these banks, Stocks are either Cash and Cash Equivalents simply based on the liquidity of the market or Short Term Investments. I am not sure which but stocks show up on the balance sheet somewhere. Notice Bank of America owned 16 million shares of BP. If they needed money quickly and couldn't borrow it elsewhere, they could sell these assets to the market for the cash they needed. Stocks were being sold because they could be sold. Other investments were illiquid. Stocks are very liquid.

To support my theory of bank holdings dumps, look at Citigroup and when it had to go back to the Fed. The days leading up to their second Fed offering were horrendous stock days. Why? I think they had to dump their stock assets at any cost. They needed money and quick. I remember reading one analyst who said the stock market is the one market which continues to function properly during this crisis. I think it did to a fault. Banks had to use it to raise capital. This is one reason the Fed's moves have been brilliant and the banks, though accused of sitting on that money, have been doing what was right. They are building cash, which they should. Building cash is losing risk which is best for the economy.

In the end I think time will heal the economy, before it tanks again. It has shown itself to be rather cyclical. Over time, the banks will keep getting checks and rebuilding their capital ratios. Lending will resume but fewer risks will be taken. For further study, did the banks of 2000's commit the same sins as the banks of the 1930's?

The second issue is the recession verses depression issue. I don't think we are going to hit a depression of the magnitude of the Great Depression. Government has not turned a blind eye which is the major difference between then and now. Will there be consequences? Yes! Will they involve 30+% unemployment? I don't think so. I don't think government has made perfect decisions. They have however gotten involved which was the right thing to do. The long term questions is: when the time comes to step away will government do it? Looking at how the government has supported these banks, it is designed to be a 5 year time horizon. Most of the preferred stock has a 5% payout to year 5 and then jumps to 9%. The idea is that the government supports the banks in their time of need, profit some, but give a vehicle for getting out when the time comes. I think the banks as they build liquidity will buy out the government’s shares.

The problem with selling stocks like the banks had to is that the amount of money available through the stock market to companies strinks. So companies can't afford everything they previously could. Companies have been double-whammied as they were losing market share, they also were unable to borrow money from banks. So here again the Fed's moves will work to keep money in the companies.

One will notice in my reasons for investing I mentioned a time horizon of five years. Investors have different time horizons. Warren Buffet has a longer-term view. Day traders have a shorter-term view. You can get rich either way. You can also get hammered either way. If one catches GM's volatility correctly, you can make a killing. If you invested in GM at any point since 1962 and held to today, you would have lost money. Of course, if you bought on 12/31/08 and sold today, you would have a 30% profit. GE held today however bought anytime before 1996 would be a gain. My goal is to get close but not too close to the market. I want a medium (5-10) term view. No company will be profitable forever. Leader's change, technology evolves, and the world changes which all cause problems for anyone who invests for too long a time frame. Too short a time frame is fraught with too much risk. Risks smooth out over time which is another reason I am not too worried about investing in institutions who's stock is as volatile as they are today. If I had to lay out lessons learned thus far here they are:

1) Be patient, days will come when a stock hits a "must buy" or "must sell" price. I was impatient early on and have lost money since investing (both real and paper).
2) Loose as much pride as possible. Mistakes will be made so cutting losses is acceptable. New information will show up and change how one views a company. Perfect companies that will increase in value forever don't exist. So just because a person has a 100% return on a company since investing doesn't mean it will earn another 100%.
3) Don't get too attached to any company. Just because GE was good, doesn't mean it will be good.
4) Be active but not too active. Getting too close to the volatility of the market will take your nose off. Walking away isn't smart either. I think that is my issue with buying mutual funds and never thinking about them again. There were signs that the economy was about to go south. Why did gas spike to $4 a gallon and could the economy effectively handle that spike? I doubt it ever could. If one had put all your mutual fund holdings into bonds or money market, the 401k statement wouldn’t be as scary.
5) Growth and decline are not infinite.
6) Take risk but not too much risk. See point #4 and 7.
7) Diversify. Buy several sectors that you like and buy good companies in those sectors. I also hope to beat buying a mutual fund. Well, to say it another way, as I learn lessons now, I will invest better in the future.

I will publish more lessons as I think about them.

So back to my goals, I didn’t mention one. My goal was to earn a better return than the 3% I was getting on my money market account. Because of that, I have invested in stocks that I think will (in five years) be earning dividends better than 3%. I have invested in a few stocks that I think are low to a quicker (6 month) profit. Those stocks are part of a portfolio of stocks that I am investing in to cover my risk sectors and are companies that I like. I like buying stuff (minerals, oil, natural gas), talent (idea producing companies), and dividends. In five years, I want to swim in dividends. I will take no return today to get a 10+% return in five years.

To sum up, I think this time period is a great time to invest if you can invest. Money has contracted macroeconomicly so any money you can afford to let go of for a few years will, when money is flowing freely again, be worth more.

I plan to keep posting incrementally as I have lots of thoughts in my head. Today’s post was ramblings. Well, they might all be. What do you think?