Back to Normal

Many financial gurus took a swing on the market’s volatility this week.

Because many of these institutions are highly leveraged, the difference between “model” and “market” could deliver a huge whack to shareholders’ equity.
– Warren Buffett

When subprime issues first surfaced this spring, many major institutions said they had none, but recent quarterly write-offs show they did. They weren’t lying; they just didn’t know what they had.
Wilbur Ross

We are unmistakably experiencing volatility in our financial markets… that provides a solid base for financial markets to continue to adjust.
– Secretary of Treasury, Hank Paulson

The markets will eventually normalize.
– John Mack, CEO of Morgan Stanley

These sorts of things are what’s known to the academics as “endogenous to the system” – that is to say, they’re normal.
– Bill Miller

Any overreactions will be areas for people to look for bargains ultimately. But I don’t think we’re anywhere close to that yet.
– Jim Chanos

The selling might accelerate. On the other hand the markets could easily rally. But in the end risk will be repriced. Whether it’s now or in 18 months, risk premiums will be more normal.
– Jeremy Grantham

With all this “marking-to-market” it seems that investors are beginning to realize what “normal” really means; stock prices don’t always rise, earnings don’t always increase, P/E ratios do fall, and that over-performance most definitely ought to be followed by under-performance.

When we say normalize, we don’t say it as a matter of personal opinion (the 200-day average), rather one of historical certainty (the 200-year average).

Logic will dictate that stock prices can only rise as fast as earnings. This equates to an estimated 6% per annum. But fast is the analyst to correct you and shout how equity prices have surged over 11% over the past few years! While this may be true, one must be prune in understanding how stocks prices operate.

“In the short-term the market is a voting machine, but in the long-term it is a weighing machine”. Any speculator has the right to “vote” as to what prices equities may sell for in the future. However, these prices will be determined solely by the economic forces that govern them. If the consumer spends less (due to a credit crunch let’s say), earnings will slow (as they have begun to) and stocks prices will factor this in (enough said). This is why stock prices have always fallen prior to recession.

People keep asking me how much further share prices may fall. My answer: I don’t know (and neither does Warren Buffett!). Sure you can have a guess, but its just as good as anyone else’s. We buy at value and sell at prime, it’s that simple. If we don’t know, we don’t buy. That is the mindset of safety and it will take some time for the market to understand that.

Portfolio Assessment
The following is a quick look at the various asset classes. My personal recommendation in the short-term is to be “long” safety – gold, commodities – and “short” risk – anything derivative with an abbreviated name that you can’t understand (like CDO).

Precious Metals
Gold has fallen is recent days (silver more so) and I am not surprised. I knew my downside and had ample cash on the sidelines for future buying opportunities. This seems like a short-term buying opportunity and nothing we haven’t seen in the past. Funds have been selling all sorts of assets to cover their losses in equity related investments and margin calls. In addition, Friday’s COT report showed an increase in the total short position (850 contracts for the Commercials). This paints an even more bullish picture for the long-term investor.

Stocks may continue to come under serious pressure especially if the retail investor begins to panic. Many small investors I have spoken with who initially felt we were due to see an immediate rebound, are beginning to realize that the decline may be deeper. This, albeit contrary to successful investing philosophy, may lead to further short-term selling.

If you do own stocks on a long-term basis, review your portfolio and be wary of anything that may be debt-related or vulnerable to speculation. As for buying, I believe we’re getting there but not there yet. Until we see a handful of companies with P/E ratios under 10 and higher dividends per share, we have time.

Fixed-income investments have generally been the alternative for the conservative investor, however they are currently vulnerable, as they are a) subject to ratings downgrades by agencies such as S&P and Moody’s, and b) they are Dollar related.

The Dollar
The Dollar finds itself under enormous pressure as prices for goods rise, but interest rates hold steady or may even lower in order to cushion the decline in housing prices. Also, is the worry of recent threats from China to dump reserves if Congress proceeds with its trade sanctions.

My speculation is that the Dollar is now in a counter-rally and should continue to around 83, after which it should once again test its all-time lows of 79.

Other Currencies
This week the carry-trade began to unwind once more. This is important as it exemplifies a) the fleeing from speculative trades, and b) how fast these scenarios can unravel (the Yen surged 7% in a bit over 5 hours). The safest currency in my opinion is the Swiss Franc (currently 1.20 to the US Dollar).

Energy prices have declined somewhat, but are still speculative as Hurricane Dean gathers strength off the shores of Texas. Grains have remained stable, and should continue to do so to meet adequate demand.

Remember, Risk is defined as the differential between perception and reality.


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