Sunday, November 9, 2008 2 comments

Biggest threat to investors right now: Themselves

I guess you can say that you are your own worst enemy almost at any point in the investing cycle. After all, psychology is half the question. As intelligent as he is, Warren Buffett is not the best investor due to his mental prowess; rather, it is his ability to block out human emotions.

One of the popular things right now is the tendency for investors to call the bottom. I know it's a problem because even I am tempted to do something on the belief that we are near a 'bottom' and don't want to miss any big rally. The risk is that you will make a sudden, rash, decision rather than thinking it through. This risk isn't that big if you are a value investor that is bottoms-up; but if you are macro-inclined, like I am, making the wrong call is disastrous (because my bottoms-up stock selection is neither great nor my focus.)

From a valuation point of view, I think stocks--this applies to almost the whole world--are attractive but not extremely appealing. This is nothing like 1974. Some markets, and some stocks, are likely worth buying but the whole market is not cheap. I ran across a post by Henry Blodget--yes, who would have thought he would ever be bearish :)--showing a chart of trailing P/E ratio (I believe a 15 year ratio) and interest rates by Robert Shiller (thanks to The Big Picture for original mention):

(source: Robert Shiller)

Two things pop out for me.

The chart shows how out of whack valuations were in the last 25 years. Who knows if history will repeat but if it's anything like the past, it is possible for the bear market to decline further or for it to stay flat for a decade or more. Remember that 1974 was a big bottom (Dow never hit that level since) but the market didn't go anywhere until the early 80's. It is prudent to invest as if that were the case. The implication of this thinking is that one can't rely on the high P/E multiples of the last two decades. It might be lethal to invest in high P/E stocks (without high growth) and expect the market to place a high valuation.

This might also be a time to almost think of stocks as if they were bonds. What I mean is, perhaps one should assume that prices may not rise much and hence returns will be dependent on dividends that you receive. In the last 25 years, investors were always bailed out by high prices--someone would pay higher than you did. That may not be as likely in the future. (Note: this is just a general view and one should change the view based on the circumstance. For instance, if you pick up something at a ridiculously low price with no dividend, that's fine.)

The other thing to note is that it is hard to make a call on interest rates right now--at least compared to history. Rates are sort of at the level where they can move either way. If you look at the chart, you'll see that rates can drop further and end up like the 40's. But it is also possible for rates to rise since they have been declining for two decades. I remember a reader in one of the comments was looking at making a bearish bet on US interest rates. Well, this chart shows how difficult that call is (if you just look at history and don't look at current economic environment.) There is nothing to stop rates from hovering around the 4% level that it is at now, for the next 15 years.


2 Response to Biggest threat to investors right now: Themselves

November 9, 2008 at 11:49 PM

My bet is on deflation. I have participated in the creation of CLOs and synthetic CDOs and know how much was created out of thin air. Debt deflation is required. An economy juiced on credit ultimately can not continue to grow on ever more credit. Currency crisis ala Iceland will ripply across the world.

Be short emerging markets, Tsy bonds, and financials, or just pay off your debts and hold cash.

November 10, 2008 at 10:31 AM

I don't have a strong view when it comes to deflation vs inflation. I used to be in the deflation/disinflation camp but am more neutral right now (because prices have already dropped a lot on nearly all assets.) There are a couple of things to keep in mind.

First of all, there has already been massive deflation already. You are correct in your view that a chunk of the structured finance products were, well, "created out of thin air." However, most of that has already blown up. For example, Ambac has wrote off (reserved) nearly all of the CDOs. Financial institutions have also written off most of it. Furthermore, the big haircuts in commodity prices, real estate prices, stock prices, and so on, pretty much means that deflation has taken hold. But this may mean that prices may not drop much further either.

For deflation to continue, non-real-estate consumer debt or corporate debt has to blow up. The market is pricing in some dire scenarios but I'm not sure if it will be that bad. Apart from real estate and some bubble areas (say Chinese manufacturing or Dubai real estate) I think corporate debt and even non-real-estate consumer debt should perform ok (worse than the last decade and but better than big deflationary periods like the Great Depression.) Corporate balance sheets are also clean (except those over-leveraged LBO buyouts and the like) so downside should be manageable.

Secondly, it's hard for me to see massive deflation when nominal GDP growth is decent. This doesn't prevent a Japanese-style deflation but it does mean that this is nothing like the Great-Depression-style deflation.

Let's also not forget the co-ordinated effort by governments to inject huge amount of liquidity. Who knows how effective this will be but it may smooth the deflationary effects.

I agree with your thinking when you say that holding cash is possibly the best thing to do right now. However, if you are trying to make money, one needs to invest when things look bad. I'm not saying one should buy the market right now (it can drop further and is not extremely cheap) but I do think it's time to research and possibly buy select investments. Jeremy Grantham, a superbear, has remarked recently that if you don't buy when assets are cheap, not only do you look like an idiot, you are an idiot. I'm trying to avoid ending up as an idiot ;)

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