A Rally for Andy

My friend Andy used to be completely obsessed with the stock market. He rode the dot-com bubble all the way up and felt the crushing blows on the way down. He found himself right back in the fray until a little over two years ago, when his 40 year old wife died suddenly. Since then Andy admits that he has become a much better investor.

How could such a tragedy transform his financial acumen? The answer lies in the deep emotional current that swirls in every investor’s mind and belly. In the past, Andy would watch each position, tick for tick. He would often experience a kind of euphoria when a trade went well, only to second-guess himself when it went sour. He knew that it was a debilitating cycle, but he could not get out of it.

Then the unimaginable occurred, putting him and his whole family through a nightmare. After his wife’s death, Andy did not have the same passion for investing. He stopped watching CNBC every day and monitoring his accounts on a minute-by-minute basis. Instead, he would call me every quarter or so to discuss the overall economy and asked for advice about general market trends. He no longer purchased individual securities, turning instead to index funds and even began to use bonds and commodities in the portfolio to help diversify some of the risk. Interestingly enough, his performance improved, both on the upside and the downside.

When we met for lunch on Friday, he said that he was not worried about the stock market or even the economy. “Of course it’s terrible for people to lose jobs and for families to suffer, but I am convinced that we’ll get through this period. This country has been through worse—heck, I have been through much worse and you know what I found out? That I can survive the worst and still wake up the next morning to see the sun shining and the world turning. Tell your blog readers, radio listeners and everyone on TV that Andy says that everything is going to be OK.”

It seemed fitting that when Andy and I were having lunch, the stock market was down a touch, but by the end of the day, it reversed course and experienced a powerful rally. The Dow closed 494.13 points higher, up 6.5%, at 8046.42 and the S&P 500 was up 6.3% to 800.03. Yes, it was a terrible week, but for at least one day, Andy was right: everything was OK. It’s not a bad lesson for the rest of us: a little distance might help everyone get through this with more of our wits about us.

1997 All Over Again

Ah 1997…it seems like only yesterday when Jewel was on the Billboard charts, Frasier dominated network television, the movie Titanic swept the Academy Awards and the dot-com bubble had not yet fully inflated. 1997 was also the last time that stocks were at these horrifying low levels. Yesterday investors continued to sell stocks as fears mounted that commercial real estate would be the next shoe to drop as the economic outlook darkens.

The S&P 500 plunged to its lowest level since 1997, sliding 6.7% to 752.44, under the low point of 776.76 reached during the bear market nadir in October, 2002. The index extended its 2008 year to date loss to 49% and is poised for the worst annual decline in its 80-year history. The Dow Jones Industrial Average sank 444.99 points, or 5.6%, to 7,552.29. The Nasdaq Composite decreased 5.1% to 1,316.12. Financial companies led the way again, with Citigroup down another 26% to $4.71 (yes, that’s Citi under a fin!), JPMorgan Chase lost 18% to $23.38, Bank of America tumbled 13.86% to $11.25 and Morgan Stanley was off 10.24% to $9.20.

Yesterday’s catalyst was more of the same—data that indicated that we are in a bruising recession. Weekly jobless claims approached the highest level since 1982; the index of leading economic indicators fell for a third time in four months; and the Federal Reserve said manufacturing in the Philadelphia area shrank at the fastest pace in 18 years. As investors rushed for the exits, they poured money into US Treasuries, driving prices to historic highs. The yield on the two-year note fell below 1% for the first time, while ten year yields fell to 3%...my friends, you can now lend the US government money for ten years and earn a whopping 3% for your troubles!

A client asked me, “How do you know when to just get out?” My answer is that when fear is shaking you to the core and it feels like all confidence is lost is usually when long term investors should be dipping their toes into the water. I am not suggesting that you sell the farm (how much could you actually get anyway?) and jump into stocks, but there are some compelling values out there. It is likely to remain pretty messy in this period, but that does not mean that you should throw in the towel on capitalism. Gather your thoughts, chug a little Pepto Bismol and don’t run for cover just yet.

Slip-Sliding Away

Remember when we thought the financial system was on the precipice of disaster? Well, fears of widespread systemic failure may have passed, but investors are now worried about the economy—big time. It seems that all of the TARPs, EESAs, rate reductions and bailout plans have left us exactly where we were a month ago—at the depths of market lows with little confidence that relief is coming.

Despite massive government interventions, stock prices fell to 5 1/2 year lows yesterday as fears of a deep recession plague the investment horizon. The Dow plummeted 427.47 points, or 5.1%, to 7997.28, the lowest close since March 31, 2003; the S&P fell 6.1% to end at 806.58, well-below this year’s previous low of 840 and on pace for its worst year since 1931; the NASDAQ was tumbled 6.5% at 1386.42; and the small-stock Russell 2000 fell 7.8% to 412.38. I don’t know how many days that I have written “ouch” in response to these types of numbers. Suffice to say that the pain is actually becoming less acute and more chronic, as we all get used to these massive sell-offs.

Some said deflation was the catalyst for the selling—the Consumer Price Index fell by 1% in October, the biggest one-day drop in the 61-year history of the index. I don’t buy the deflation explanation as the reason for the fall. I think that investors are realizing that things will not turn around any time quickly and as a result, many are throwing in the towel and waiting it out. Maybe that’s why Henry Paulson essentially took a mulligan on the TARP and will let the next administration play out the round.

It’s probably a safe bet that the government wishes that it could go back in time and save Lehman Brothers – indeed, it was that company’s failure that sparked the massive slide. Since then, the Dow has plunged 30%. Yesterday, selling in the financial sector once again led the way. Citigroup in particular ran into a brick wall, falling 23.4% to $6.40, a 13-year low, after announcing that it will purchase the final $17.4 billion of assets still in structured investment vehicles; Bank of America dropped $2.13, or 14%, to $13.06; and Goldman Sachs fell $6.85, or 11%, to $55.18, the lowest close since the company's initial public offering in 1999.

Additionally, there was selling pressure in some of the larger insurers, many of which are busy buying banks so that they can tap the TARP. Lincoln National plunged 40%, the steepest decline in the S&P 500, to $7.31, after saying that it expects a charge of as much as $300 million because of declining equity markets last month; Hartford Financial dropped 24%; and good ol’ AIG fell 15%. Adding market woes is the uncertain fate of the automakers -- GM fell 9.7% to its lowest price since the 1940s, while Ford lost 25%.

Here is what I think is going on: everyone is waiting for some good news and it’s just not there. Every time we turn around, there is more disappointing data about housing or retail sales or confidence. At some point, people are going to examine the valuations of companies and realize that not every single one of them should be tossed aside. Until then, we are slip-sliding away.

Bearing Down

As the investor roller coaster ride continues, some are wondering if they can just get off the dizzying ride. For those who can’t deal with the pain any more, no amount of data that is trotted out about going to cash will change their minds. With that said, there are a bunch of investors who are hunkering down and making peace with the bear market.

Let’s start with yesterday’s dismal performance. Now that investors are not consumed with the melt-down of the entire financial system, they are turning their attention to the economy. Given the past year, you can’t blame people for fearing the worst—and the worst would be a lengthy and deep recession accompanied by massive job losses (unemployment rate is projected to reach at least 7.5-8%). As a result, the Dow Jones Industrial Average posted its seventh-biggest point drop in history, plummeting 514.45 points, or 5.7%, to close at 8519.2, a level not seen in nearly five years. The Dow re-tested previous lows, but rallied before the bell. Still, the index has given back 746 points over the last two sessions. The day followed steep losses overseas, as many emerging markets tumbled 10%.

The recession fears spilled into commodities markets, led on the downside by crude oil. The reasoning is simple: if economic growth is going to slow, then the demand for raw commodities will fall. Crude dropped $5.43, or 7.5% a barrel to $66.75, its lowest point since June 2007 and drop of 54% since July 3. Gold futures declined sharply on the back of a strengthening dollar. Gold dropped below important technical chart levels, which accelerated selling pressure. December gold fell $32.80, or 4.2%, to settle at $735.20 an ounce. Other metals that are more sensitive to economic cycles—copper fell to its lowest level since 2005.

So where does that leave those who are still on the investment roller coaster? Well a bit nauseous, but still breathing. This tireless bunch is able to look to the future and recognize that when the government puts massive dollars into the system, it will eventually help out. The two trillion plus dollars (the bailout plus AIG, Bear Stearns and the commercial paper facility) as well as rate cuts should resuscitate the system -- eventually. Once banks are revived from their lending comas, they will actually lend again. Long term investors know that stimulus takes six to 18 months to have its effect on the economy. Additionally, there is a bunch of cash (estimates run over $10 trillion) sitting on the sidelines as investors take comfort in money market funds and T-bills. This money needs to grow and in a zero interest rate environment the money is likely to find itself back into the stock market.

None of this will happen immediately, but as we become more accustomed to the daily gyrations and the Dow Jones Industrial Average firmly ensconced below that 10,000 level, long term investors are bearing down and hunkering down for a long haul. They are likely to be rewarded for their patience.

Buffett Bounce

Just because the stock market rises on any given day does not mean that the bad times are done. In fact, I will be the first to point out that one day does not amount to a trend, but these are trying times, so we’ll take it! Chalk it up to sheer exhaustion, more buyers than sellers or perhaps a “Buffett Bounce,” but stocks actually increased in value yesterday without the government announcing a new zillion dollar rescue plan.

Yes the stock market continues to be oversold on a technical basis, but this article is about Mr. Buffett, a guy who is used to putting his money where his mouth is. In Friday’s New York Times, Buffett wrote an Op-Ed entitled “Buy American. I Am.” Although the title seems patriotic at first glance, country is not what prompted Buffett to pen this article—greed was his motivator. As Buffett likes to say “Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.”

Buffett was not suggesting that buying in this particular moment would amount to instant riches. Indeed, the stock market actually fell on the day that Buffett’s article was published, so my “Buffet Bounce” is a stretch. Additionally, his two recent investments in Goldman Sachs and GE are under water, which may be why he admitted that he “can’t predict the short-term movements of the stock market.” But in his personal account (not Berkshire Hathaway), where he has been parking money in government treasury bonds, he is now selectively adding to his stock position. Buffett anticipates that his non-Berkshire net worth will “soon be 100 percent in United States equities.”

What would prompt someone like Buffett to encourage the masses in such a way? My guess is that he sees himself as a teacher, a market Yoda, if you will. Buffett is a cool head that is prevailing amid panicky investors, both individual and professional. He sees green in a sea of red: “fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.” There is a disclosure that accompanies Buffett’s advice: “I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over…bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price…over the long term, the stock market news will be good.”

OK, so maybe we can’t all be Warren Buffett—we don’t have billions, nor do we have a perpetual time horizon. But he does make valid points about valuation and emotions surrounding the current period. He specifically calls out those who have succumbed to the pressure and bailed out of the market all together. Buffett notes that “Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.” A billionaire who invokes the Great One? It sure is hard to argue with that!

A Superlative Week

It was the best of times, it was the worst of times…it was simply a superlative week. Highs, lows, record moves and of course a healthy dose of hope, fear and dashed expectations were the highlights. It is indeed understandable if you are a bit unnerved by the roller coaster action of the week.

Last Monday, US stocks saw their biggest one-day percentage gain (11-12%, depending on the index) since the Great Depression on the heels of the government’s historic plan to restore confidence and strengthen the US banking system. By Wednesday, the plan lost luster as investors quickly shifted from systemic fear to the problems that exist in the core economy. As a result, stocks had the biggest one-day percentage loss since the Crash of 1987. In between, volatility, as measured by the VIX, reached its highest level EVER. By the end of the week, most were happy that it was just over and some may have noticed that stocks were higher for the first week in five. In fact, it was the Dow’s best weekly gain since March, 2003 and the first weekly gain since Lehman Brothers collapsed, but that is tempered by the fact that it followed the worst week ever for the Dow, which ended the previous Friday (Oct 10) with the lowest close since April 2003.

A Victorian commentator once noted that “Every genuine business panic springs from the same root, which is rank speculation.” Add to that idea that every panic is marked by a sense that the financial system is close to complete collapse and you can guess that the unwinding of speculation becomes super-charged when fear is added to the equation. These are times when loss aversion supplants profit potential as the dominant investor motivator.

In other words, the inverse of a speculative boom is a fear-driven panic, when as Edward Chancellor in the Financial Times, (10/14/08) noted that “excessive confidence is replaced by extreme fearfulness and a nervous distrust takes the place of blind trust.” Or as James Stewart noted in the Wall Street Journal, a panic resembles a bubble: “Just as in a bubble, price/earnings ratios were now irrelevant, because earnings were going to be so much lower than forecast. (In a bubble they're going to be higher.) People were saying confidently that the Dow Jones Industrial Average was going to 6000. (It was 20000 in the bubble.)”

In times of extreme price action, I always come back to the same theme: there are two dominant emotions in this business: fear and greed. For the sane investor, the challenge is to avoid getting caught up in either extreme. On the way up, you need to shut down the cheerleaders, stick to your game plan and not get sucked into buying the speculative top of any asset class. Conversely, on the way down, you need drown out the Cassandras, adhere to your long-term strategy and not get suckered into selling the fear-based lows. This does not mean that you should not adjust your portfolio as conditions change, but not succumbing to extreme emotions is likely to keep you out of trouble, especially during superlative weeks.

It Ain’t Over…

The action of the past two days is more evidence that extreme volatility remains in play for investors. Unfortunately, we have no idea when the fat lady will sing to mark the end of it. In times like these, it is advisable that you try not to make too many big decisions and instead patiently await the return of sanity to infuse the markets.

So what happened over the course of two days? On Wednesday, investors realized that the financial crisis is not the end of the process. People turned their attention to the fundamental economy and the news was a bit spooky, even for October. Evidence is mounting that the downturn could be more significant than the 2001 or 1990-1991 recessions. While we all knew this was coming, it was confirmed by the release of September Retail Sales, which dropped 1.2%--the worst reading in two years. Considering that 70% of the US economy is powered by consumers, a retrenchment in their consumption is going to have a dramatic effect on the economy. Additionally, a more esoteric report underscored the pull-back in global growth. The Baltic Dry Index, which measures the cost of shipping bulk commodities, tumbled to its lowest level in almost six years as recession fears intensified. The index has fallen 49.8% since the end of September and has fallen 86% from May’s all-time high amid weakening demand.

These recession fears were exacerbated in the last hour of trading on Wednesday. Some said it was mutual fund liquidations or hedge fund puking after margin calls. In the end, there were just more sellers than buyers and US stocks saw their worst percentage loss since the crash of October, 1987. The Dow tumbled 733.08 points or 7.9% to close at 8577.91; the NASDAQ dropped 8.5% to 1628.33; and the S&P 500 was down 9% to 907.84. The damage amounted to approximately $1.1 trillion in value in ONE DAY.

Then something neat happened yesterday: investors realized that maybe the world was not ending just yet. The readings on inflation demonstrated that indeed prices are falling—crude oil traded below $70 a barrel for the first time in over a year; interbank lending rates improved; the VIX broke through an intraday record above 80, but finished down 3.2% at 67.06; and stocks partially recovered from Wednesday’s debacle. The Dow swung in an 816-point range, finishing in the black by 401.35 points higher, up 4.7%, at 8979.26, a more than 50% retracement of the previous session's damage.

So what have we learned from the two-day roller coaster? There is now a consensus that we are in a recession on top of significant financial market stresses that have wreaked havoc over the past month. What is less clear is how bad it’s going to get. The best way to think about the massive swings is to translate them into a conversation. On Wednesday, Mr. Market said: “this is going to be a really bad recession and it’s going to last a very long time—maybe forever!” Then yesterday, Mr. Market said: “this is going to be a bad recession, but there are still companies that will make money and maybe they are worth owning.” This will likely be a conversation that continues for some time, so be prepared for more of these wild gyrations.

Nine Survival Tips for the Crash of 2008

The have strange and eerie examples of symmetry in this stock market crash of 2008. On Wednesday, the Dow Jones Industrial Average dropped 508 points—the exact same point drop as the crash of 1987. Then yesterday, on the one year anniversary of the all-time high of the Dow Jones Industrial Average, stocks plunged in the last hour of trading, leaving the blue-chip measure is down 39.4% from its record a year ago.

The day did not start off so bad, despite global big sell-offs that preceded the opening bell. Then at about 2:30 or so, the selling accelerated as hedge funds had to sell holdings to raise collateral and reduce leverage, mutual funds had to execute redemptions as smaller investors reduced exposure or bailed out completely and computerized trading kicked in as stocks traded below specific benchmarks. The damage was severe and intense: the Dow Jones Industrial Average dropped 678.91 points, or 7.3%, to close at 8579.19, the S&P 500 shed 7.6% to end at 909.92; the Nasdaq Composite Index fell 5.5% to 1645.12, the small-stock Russell 2000 tumbled 8.7% to 499.20. No sector was spared in the broad-based selling.

What’s an investor to do in the midst of this mess? Here are nine survival tips for those who want to take action right now to help control their destinies:

1) GET PERSONAL: Sure the market is in turmoil and it is scary, but your personal situation should guide decisions made in this very emotional time. The first step is to figure out where you stand and more specifically, you should understand the status of your "BIG THREE": 1) Emergency cash reserves 2) Current level of debt 3) Current retirement contribution. If you have very little cash on hand, consider stockpiling your reserves so that you have 3-6 months of living expenses--this is especially important if you think that your job is at risk (i.e. EVERYONE). If you have consumer debt, make sure that you pay off higher interest loans first. For some, this may necessitate making some tough decisions--but the exercise will lead you to...

2) DEVELOP A CASH FLOW: This is an empowering part of the process. Considering that everyone feels out of control right now, the simple technique of identifying what is coming in and what is going out can help you come up with a short, intermediate and long term game plans. The process is hard, but well worth the effort and should leave you understanding that which is in your power to control.

3) RETIREMENT: If cash flow can afford it, DO NOT PULL-BACK ON RETIREMENT CONTRIBUTIONS. I know, this is hard one, but you can identify choices within your retirement plan that may have somewhat reduced levels (fixed accounts, bond funds). Your specific time horizon and risk tolerance will help you come to a proper allocation.

4) REVIEW YOUR ASSET ALLOCATION: For some people the process of selecting investments was not well thought out. It's time to see how much money is allocated to stocks, commodities, bonds and cash. If you need your money within two years and all of the investments are in stocks, this is going to hurt...you MUST reduce your exposure and bite the bullet. Unfortunately, if you needed your money within that time horizon, you probably should not have had an allocation that was heavily invested in risk assets. Now that mistake is behind you, so you are going to have to fix it.

5) IDENTIFY YOUR RISK TOLERANCE: During years when the stock market is rising, I have seen clients gloss over the question, "How would you feel if your account dropped by 30% in a given year? Of course now you know exactly how you feel and maybe you aren't so able to assume risk. That said, remember if you shift your allocation, maybe from growth-oriented to more balanced, you can't second-guess yourself and switch back to Growth when things smooth out. This is so hard, because as human beings, we always get greedy at the top and fearful at the bottom. But if you choose a portfolio with a lower risk level, you must assume that when the market recovers, you will not participate as fully in the upside. The idea of sleeping at night is pretty important, so if your accounts are keeping you up, rake action. MOST RETIREMENT PLANS OFFER A RISK ASSESSMENT ON LINE--TAKE IT!!!

6) WHERE TO HIDE NOW: Cash or cash equivalents may seem great (hey, they are not going down, right?) but of course over the long term, staying in cash will not help you grow your money faster than inflation. That said, remember that FDIC insurance recently kicked up to $250K per account and that the government is backing up money market accounts. You can also buy bills, notes and bonds directly from the US government at http://www.treasurydirect.com/

7) BEWARE BIG SALES PITCHES: When we are fearful, we tend not to make the greatest decisions. So if someone (a broker, salesman, etc) is pushing something right now that "guarantees your principal," you should understand that most guarantees come at a cost. Try not to tie up your money for a significant length of time right now.

8) TURN IT OFF SOMETIMES: The current crisis is replete with scary music and graphics. Once you have assessed your personal situation and made some choices, its OK to tune out from the 24/7 coverage.

9) And my personal favorite: Y & A: During tumultuous times, try to find ways to relax...for me, it's yoga and alcohol, but not at the same time!

508…an eerily familiar number

In my office, I have a photo of an old Quotron machine from the eighties. On it, the following jumps out at the trained eye: DJIA -508. The photo was taken on Monday, October 19th, the day that the Dow Jones Industrial Average fell 22.6%. Yesterday, it was déjà vu---another 508 point drop, but this time the point total did not amount to 22%, but 5.1% was plenty, thank you very much!

The selling was not prompted by anything new—same old credit crisis which has now morphed into blind fear. After gains at the start of the session, stocks turned down steadily and the losses accelerated, leaving the Dow down 508.39 points, or 5.1%, at 9447.11, its lowest close since Sept. 30, 2003. The Dow shed nearly 13% in the past 5 trading sessions, the largest drop since September 2001. The 1403.55-point decline was the Dow's biggest 5-day drop ever, and that doesn't include a 778-point drop on Sept. 29. The Dow is now down 33% from its record high reached almost exactly a year ago.

The damage was worse for the S&P 500, which closed yesterday below the psychologically important 1000 level for the first time since Sept. 30, 2003. The S&P fell 60.66 points, or 5.7%, to 996.23. Its 14.6% five-day decline is the biggest since the five days that included the October 1987 stock-market crash and the index stands 21% lower than it was just one month ago. The S&P 500 is now down 36% from its peak a year ago, almost to the day, on October 9, 2007. The NASDAQ fell 108 points or 4.3% to 1862.

If you woke up early this morning, the news did not seem much better. But then at 7:00 am, history was made: in a coordinated global effort, the world’s central banks announced cuts in target interest rates. The US Fed, the European Central Bank (ECB), the Bank of England, the Bank of Canada, Sveriges Riksbank and the Swiss National Bank all reduced their respective policy interest rates by 50 basis points or a half of a percentage point. The Fed's open market committee voted unanimously to cut its target to 1.5%, the ECB to 3.75%, the Bank of England to 4.50% and the Swiss to 2.5%. The dramatic action was intended to help stem a growing global financial crisis. The Fed noted that “The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability."

The unprecedented action is a good step forward, leading me back to October, 1987. At that time, fear gripped investors and everyone bailed out simultaneously. While our crash was not as dramatic because it took place over the course of weeks, not in a single day, this period will likely be seen as what academic Charles Kindleberger called the “revulsion stage” of a crisis---the indiscriminate and contagious selling of distressed assets that leads “banks to stop lending on the collateral of such assets.” When such fear grips the markets, investors (and speculators) are quick to generalize-punishing many for the sins of the few. That’s the most dangerous phase of any crisis—when market implosions start to take on a self-reinforcing life of their own. It is worth noting that sometimes the painful “revulsion” stage sets up the next phase of the process, where investors and markets remember how to breathe.

In 1987, the stock market regained its footing after October 19th and the crash marked the low point for stocks in 1987 and by year-end, the Dow actually showed a gain for the year! Within nine months, stocks recovered all of the losses incurred on October 19th and the US economy never went into a recession as a result of the crash. Given the unwinding that is occurring, it is doubtful that we will avoid recession this time around, but sometimes it is helpful to return to other turbulent periods to help us put our current situation in context a bit more.

Fear and Loathing on Wall Street

To date, yesterday was the maximum point of fear and loathing for investors in this latest market meltdown. Billions of dollars fled securities markets all over the globe, if only to seek respite from the damage that has occurred. Sure TARP may make it better than it could have been, but the view from these folks is clear: “I am willing to miss the next potential leg up in asset prices to avoid further pain on the downside.”

Unfortunately we are living in a time where fundamentals are no longer active. Psychology rules the day and as a result, fear is propelling investors to retrench and go to cash. Maybe you are one of those people who just can’t take it anymore. My advice is that if you can’t sleep, then by all means, make a change. But if you can take a longer view, you may be rewarded for your courage—and courage these days may in fact be the simple action of remaining in your diversified portfolio. (Hopefully you came into September with your money allocated among different asset classes, which has shielded you from the worst of the sell-off.)

Many are wondering how it got so bad so quickly—the answer is clear: the pressures have been building in the credit system for fourteen months and they are now evident for all to see. There has been a growing reluctance among financial institutions to offer basic loans that are the lifeblood of the economic system. Banks don’t want to lend to beleaguered consumers, but worse, they don’t want to lend to another institution if they suspect even the tiniest hint of problems with the counter-party’s balance sheet.

The evidence of this trend can be seen in the Fed’s recent data, which indicated that lenders reduced short-term loans to companies by a record $94.9 billion, bringing the total decline to $208B over the past three weeks. Commercial paper outstanding is down 14% from a year earlier, which is one of the reasons that GE, arguably one of the best companies in the world that continues to operate in the black, could not raise money and had to basically give a piece of the company to Warren Buffett to raise sufficient capital.

As anxiety intensified, so too did fear -- the Chicago Board Options Exchange Volatility Index or VIX, jumped almost 25% percent to a record high of 57.55, before slightly paring gains to trade at 52.05. To put that number in perspective, the last time the VIX was even close to this level was at the height of earlier economic or financial market dislocations, including the 1997 Asian crisis, 1998 Russian financial market crisis, 9-11 terrorist attacks and the economic crisis involving several South American countries in mid-2002. The elevated VIX is just one sign that investors do not trust any asset. Of course the other sign is the stock market, which tumbled to fresh lows on the year.

At its lowest point, the Dow was off 800 points yesterday afternoon, its biggest intraday drop on record. It regained ground at the end of the session to close down 369.88 points, or 3.6%, at 9955.50. The Dow closed below the 10,000 mark for the first time since Oct. 26, 2004. The S&P 500 fell 42 points, or 3.9%, to end at 1,056 and the Nasdaq lost 84 points, or 3.8%, to finish at 1,862. In a bright spot for consumers, crude-oil futures closed at $87.81, down $6.07, or 6.5%, while treasury bonds rallied along with gold as investors sought safe havens from market volatility.

In the end, you can’t be self-delusional about what’s going on – it’s pretty bad out there as investors absorb the structural, sentimental, technical and real economic worries that are plaguing markets and credit investors. Those hurdles aren’t likely to disappear any time soon, and the lack of liquidity clearly isn’t helping. However, by many measures, it appears that we have hit extremes, from sentiment, to performance, to valuation. We are likely to slowly transition away from the fear, loathing and systemic panic that has gripped markets and hopefully emerge with nerves frayed, but the future more secure.

Crash into You

It’s been amazing to read the number of headlines that liken our current problems with the Crash of 1929 and the subsequent Great Depression. It is quite telling of the level of fear and anxiety that plagues the market as we enter the fourth quarter. But how apt a comparison is our situation today to the Crash/Great Depression? I had to revisit the history books to find out.

The first interesting note was that crash of 1929 in and of itself did not create the Great Depression. In fact, as the new decade started, the US economy had not yet retrenched in a major way. But at the end of 1930, a series of bank panics started to spook other banks, as well as consumers. Hundreds of banks eventually closed and by 1932, consumption and investment collapsed, stocks had fallen more than 80% from the top and economic activity cratered by a staggering 30%.

This brings us to the present, where stocks have fallen by over 20% from the October 2007 top, people are starting to worry about bank failures and all of the sudden, the current credit and housing crises are compared to the Crash and the Great Depression. Let’s start by understanding how things are different today.

First of all, one commentator recently noted that the best reason that we should not believe that “the big one” is coming is because we are actually talking about it. Depressions do not often occur when the mainstream media and ordinary people are openly voicing concern about them, as is the case today. Rather these seismic events usually occur when the opposite it true--when no one is worried about them.

Additionally, today we do have the benefit of history upon which to draw. Many economists, including our very own Federal Reserve Chairman Ben Bernanke, have examined the Great Depression and its roots causes. Remember that the Fed was not established until 1913 and after the crash of 1929 the central bank was not as strong as it is today--years passed before the government could flood the economy with cash.

In the 1980’s, Bernanke wrote extensively about the Great Depression and believed that one of the root causes was the fact that as banks closed, loan officers vanished and left nobody to vouch for the borrowers credit quality. Bernanke and many others have studied the causes and solutions to that period and as a result, when the Fed finally woke up and realized what was going on, it acted by implementing creative and unusual liquidity measures.

One big difference between then and now is the existence of the Federal Deposit Insurance Corporation (FDIC). The program was established in 1933 to guarantee the safety of checking and savings deposits. Today, with that insurance in place, the average investor is assured that his or her deposits up to certain amounts are safe. In fact, there is now consensus forming around increasing FDIC insurance from 100K to $250K.

Finally, our economy and the global economy is so different from the world of 1929-1934. The country is far richer today, which means that far fewer people are living on the edge of despair. This does not mean that we do not have poor people, but that the numbers have been reduced. In fact, most households may not have the same net worth that they had two years ago, but the vast majority are in decent shape.

None of the aforementioned historical reference means that all is honky-dory in the US economy. We have serious problems that need addressing and perhaps that is the best lesson of the awful Great Depression—doing nothing would be repeating the past and potentially dooming us for some pretty nasty times ahead. The doing something is not about “bailing out Wall Street,” rather it is about trying to avert a long-term and damaging consequences.

Kiss that Sucker Goodbye

Well the third quarter is done—good riddance! It has been a wildly volatile roller coaster ride these past 90 days. But it was September that really did the bulk of the damage—I guess we shouldn’t be surprised -- 4 of the worst 25 percentage-loss days for the S&P 500 over the last 50 years occurred during September 2008, including Monday’s drop of 8.6%. (source: BTN Research).

Thankfully we ended on a more positive note yesterday, with all of the major stock indexes recovering ground lost on Monday, but still, stock market performance for the three months of July, August and September was rough. The S&P 500 rose 5.3% yesterday to 1164.74, but still finished the quarter with a 9% loss. The Dow got off to a strong start and saw its gains accelerate as the closing bell approached, marking the end of 2008's third period. The 30-stocks index soared 485.21 points, or 4.7%, to close at 10850.66, off 4.4% for the quarter. The Nasdaq Composite Index was up 5% to end at 2082.33, off 9.2% for the quarter.

If those losses did not catch your attention, perhaps the news cycle did. Let’s review what has occurred in the 30 days of September:

1) On September 7th, the US took over the reins at Fannie Mae and Freddie Mac, agreeing to inject up to $100 billion into each company.
2) On September 14th, 158-year-old Lehman Brothers filed for bankruptcy.
3) On September 15th, Bank of America bought Merrill Lynch in a $50 billion emergency acquisition.
4) On September 17th, the US Treasury extended an $85 billion loan to AIG
5) On September 18th, markets were in freefall before news leaked out of potential $700 billion government package to purchase distressed mortgage-backed assets from various financial institutions.
6) On September 25th, Washington Mutual was seized by federal regulators and sold to JP Morgan Chase & Co.
7) On September 29th, Citigroup purchased Wachovia
8) On September 29th, the House of Representatives voted against “TARP” and sent global stock indexes down by 4-9%

Ladies and Gentleman, I do not know about you, but I sure am ready to kiss this month, not to mention the whole quarter, goodbye and to turn over the calendar page to (gasp) October. Yes, I know October can be scary and you may even be tempted to pull the trigger and make a rash decision to sell everything in your portfolio and go to cash, but this very act may be among the most dangerous decisions you could make. Clearly these are trying times that test every investor from Main Street to Wall Street, but remember if you bailed out in at the bottom of the last stock market bottom (October 2002), you may have missed the bounce from 2003-2007, when stocks returned 12.8% annually. It’s hard to stomach, but this is part of the process.

Back in the real world

As lawmakers grill Henry Paulson, Ben Bernanke and Christopher Cox, those of us back here on earth are struggling to keep our heads above the fray. With markets gyrating and the economy teetering, it sure is hard to not bury your head and abandon the financial plan that you created. Like almost every tense issue that you confront in life, you need to take a deep breath and remind yourself what you are trying to accomplish.

For most people, the financial planning and wealth management process allows you to articulate your short and long term goals and then develop strategies to help you achieve them. If you have done this, then you probably were able to shield the short-term money from most of the problems that are plaguing the markets right now. After the government insured money market accounts last week, you likely have very little to worry about. With no reason to panic about immediate needs, you may start to feel anxiety about the longer term money.

One woman recently noted that she was simply “not going to open her retirement statement until this is all over.” That’s not exactly the behavior we would recommend. Besides being a bit irresponsible, you may find that if you have here a diversified portfolio that things are not as bad as you thought. This happened just the other day, when I spoke to a client. He said “the stock market is down more than twenty percent and that makes me crazy!” I responded that his portfolio was down only 9%, which is painful, but not fatal to his long-term plans.

With so much negative news swirling, it’s hard not to think that you are going down with the ship. It is completely understandable that every investor wants to participate on the way up and avoid the pain associated with bear markets. Recent research by Prof. Loewenstein and his colleague Duane Seppi found that investors in Scandinavia looked up the value of their holdings 50% to 80% less often during bad markets. As my mother likes to say, “Who needs absolute confirmation of the bad news?” This is born out by experience--according to Vanguard, mutual-fund holders checked their account values far less often in this year’s market tumbles than they did in mid-to-late 2007, when stocks were setting new highs.

OK, let’s assume that you are going to check the accounts because you are (a) guilt-ridden or (b) responsible. Obviously when the market is in free-fall, you are unlikely to feel good about the entire exercise. But here is an excellent coping mechanism: remind yourself that you are in this for the long-term and take a few moments to go back in market history and see how stocks did after other periods of despondency like 2002, 1998, 1991, 1987, 1982, 1974 and so on. If history is any guide, your inclination to act like an ostrich is a strong indication that the market is about to turn into a phoenix.

Just when you thought it was safe…

Last week ended on a high note—stock markets rallied to virtually unchanged on the week, after the announcement of the proposed $700 billion government bailout of the financial sector. Many were breathing a bit easier over the weekend, but then yesterday, just when you thought it was safe…well, you know the rest. I know you don’t want this to happen—nobody does! We all wish that we never got here, but instead, we are forced to swallow a $700 billion bitter pill and at the same time, deal with the reality that this is likely to be a lengthy and messy process.

Yesterday, as investors slowly recognized this fact, they also had to contend with a sinking dollar and soaring oil prices. Crude oil prices spiked more than $25 at their intraday high and finished with a gain of $16.37, or 16%, at $120.92 a barrel. (Expiration of contracts for October delivery added volatility to the market, but some thought it also could have been hedge fund liquidation.) The less-than-rosy news drove investors to the sidelines. The Dow plummeted 372.75 points, or 3.3%, to 11015.69, down 17% on the year; the Nasdaq Composite Index dropped 4.2% to end at 2178.98, down 18% on the year and the broader based S&P 500 plunged 3.8% at 1207.09, down 18% on the year. The one bright asset class was gold—the December contract jumped $44.30, or 5%, to $909, as investors sought a safe-haven.

Perhaps you thought that the bailout would prevent these kinds of days, but in fact, the plan was a bitter reminder that something this big had to happen to prevent a total seizure of the credit and financial markets. “If we have to live through more of these days, then maybe I think I speak for taxpayers across the country when I say that I would rather not shell out these big bucks,” noted one friend. In the abstract, that might be the case, but we know for certain that doing nothing could have resulted in a financial calamity, so maybe a few 3% swings isn’t the worst thing in the world. In other words, a fence at the top of a cliff is better than an ambulance at the bottom. There will be plenty of time to point fingers and beat our chests about how unfair this whole situation has been, but let’s get things stable before the ambulance arrives.

As Robert Jenkins, the chairman of Investment Management Association said last week, “The crisis arose from the combination of greed, imprudence and leverage. Greed is not new. Reckless lending is not new. Imprudent borrowing is not new. What is new and what distinguishes this credit crunch from past excesses is the unprecedented level of leverage. We will not outlaw greed and cannot legislate against stupidity. But regulators can and must address the issue of leverage.” And indeed we all hope that regulators will refocus and become proactive in the future. But for now, I know that I speak for most investors when I say that all we want is a few days where we can escape history-making headlines or game-changing deals. We just want a few moments of calm, when we can dip our toes in the water without fearing the next massive wave.

President Paulson and VP Bernanke

President Bush didn’t announce it, nor did Congressional leaders. Rather, it was US Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, his intellectual backer, who proposed a vast bailout of financial institutions in the US, requesting unfettered authority to purchase up to $700 billion in distressed mortgage-related assets from private firms, after which it will try to resell them to investors. Given the experience of these two, it is preferable that they run the show amid the escalating financial crisis and become the shadow president and VP of the US economy.

On Friday, Paulson first announced a structural solution for the problem of toxic financial assets in the system. At that time, the concept being floated was along the lines of the Resolution Trust Corp., a key tool to liquidating holdings of failed savings and loans in the late 1980s and early 1990s. The news helped calm investors and pushed stocks to essentially unchanged on the week.

It’s hard to believe that it was just one week ago that we were wrestling with the failure of Lehman Brothers, purchase of Merrill Lynch by Bank of America and the near-implosion of AIG. On Thursday, it was clear that the case-by-case, reactive approach to the crisis was not enough to prevent widespread panic across financial markets. To help stabilize the broader economic and structural problems plaguing the market, Paulson and Bernanke, himself a student of the Great Depression, gathered Congressional leaders and scared them straight. The lawmakers emerged from the meeting visibly shaken, but ready to swallow the bitter pill that Paulson and Bernanke prescribed. By yesterday, it appeared that the US was entering unchartered territory of the credit and housing crisis that would require a new regulatory structure.

Paulson noted that “lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing” and that cancerous mortgage-backed securities had become “frozen on the balance sheet of banks of banks and financial institutions…the inability to determine their net worth has fostered uncertainty about mortgage assets and even about the financial conditions of the institutions that own them.” As Joe Nocera pointed out in the New York Times, “Nobody understands who owes what to whom — or whether they have the ability to pay. Counterparties have become afraid to trade with each other. Sovereign wealth funds are no longer willing to supply badly needed capital because they no longer know what they are investing in. The crisis continues because nobody knows what anything is worth. You simply cannot have a functioning market under such circumstances.”

There are hoots and hollers that we have morphed from capitalism to socialism over the course of a week. To that, one has to wonder whether such free-market adherents were willing to see the entire system seize up and watch idly as the global economy entered what could have been another Great Depression. With a number of terrible choices, Hank Paulson and Ben Bernanke chose the one that seemed the least odious. As Bernanke told colleagues last week, “There are no atheists in foxholes and no ideologues in financial crises.”

The plan is a proactive, systematic approach that attempts to stabilize confidence, which should temper the severe price action and prevent a seizing-up of market liquidity. The action demonstrates that US authorities were unwilling to sit idly and watch the economy slide into a Japanese-like, decade-long malaise. The results of the exceptional government intervention will be written about in history books, but for now, investors are hopeful that with time and this powerful policy response, confidence will be restored and markets and the economy will eventually recover.

Giddy Up

Remember on Seinfeld when Kramer was so excited that he exclaimed, “Giddy Up”? Well markets decided to saddle up yesterday and see what it’s like to trade higher—certainly a novel idea as “the most significant financial crisis since the Great Depression” continues to unfold (Note to the networks—love the new graphics!)

After being down 150 points at 1:00 pm or so, stocks meandered to the unchanged line. Then at approximately 3:00 pm, something happened…all of the sudden, buyers piled into equities, as reports emerged that the federal government was about to take steps to create the mother of all bailouts. While there were few details available, the simple notion that the government was going to do something BIG, allowed investors to breathe a sigh of relief. The surge was lead by financial companies as the Dow Jones Industrial Average swung in a 567-point range from the low of the day to the close, ending 410.03 points higher, up 3.9%, at 11019.69. The S&P 500 Index climbed 4.3%, its biggest daily percentage gain in nearly six years, to end at 1206.33 and the Nasdaq Composite Index leapt 4.8%, its biggest daily move in more than five years, to end at 2199.10 as big technology companies posted solid gains. Gold had closed before the bailout news hit, so it is likely that yesterday’s nearly $50 move up will be erased today.

Markets had been trading higher earlier in the day on Thursday after the Fed authorized a $180 billion expansion of its swap lines with other world central banks. But soon that was not enough, so Henry Paulson and Ben Bernanke, (the President and Vice President of our economy), determined that something bigger was necessary. The plan is to create some sort of government agency that would purchase distressed mortgages at deep discounts from banks and other financial institutions. This is something along the lines of the Resolution Trust Corp. (RTC), which was a key tool to liquidating holdings of failed savings and loans in the late 1980s and early 1990s. Created in 1989, the RTC disposed of bad assets held by hundreds of crippled savings and loans that had been burned in the eighties real estate boom. The RTC closed or reorganized 747 institutions holding assets of nearly $400 billion. By 1995, the S&L crisis had passed and the RTC was folded into the FDIC. The difference is that the 2008 version of the RTC would have the government taking over the distressed assets, not the entire institutions.

Beyond the RTC-like plan, before the opening bell today, the government unveiled a plan to shore up money-market funds, which experienced massive redemptions as one fund “broke the buck” and fear intensified earlier this week. There is likely to be some sort of federal insurance for investors in money market funds (which total $3.4 trillion), akin to the coverage offered by the FDIC for bank accounts. Finally, the SEC (remember them?) is reinstating the temporary ban on short-selling of hundreds of financial stocks. The move comes a day after the UK’s Financial Services Authority (FSA) announced that it was banning short selling on financial stocks until the end of the year. Put all of this together and it looks like another up day for stocks…giddy up!