The Iconoclast Investor

I received an email from a reader late on Friday afternoon that I wanted to share with you. Below are the letter and my response.

“I have questions on the bailout–and I don’t know where to find answers.  I would appreciate it if you could help explain to me–or to any reader if you want.

“To start it is only fair to say I do not like the bailout proposals I have seen no matter what the merit, but based on section 8 alone–no one man should have so much absolute authority. I thought AIG was prudent (though I cannot understand why it’s called a loan when 79.9% equity stake is exchanged).

“But it seems to me that a lot of the problem is the mark to market system. Highly levered institutions are seeing their equity positions eroded as the underlying values are falling. While I would normally agree with the soundness of this principal–in this extreme case why not allow mark to historical prices or final payment? This way banks could slowly absorb the inflated mortgages. Equity positions wouldn’t have to take such a huge hit at one time. Some portion of people will default–probably higher than normal, but some portion may be unlucky to have bought a house at the most inopportune time, and it may be worth 20% less today than when they purchased–but they intend(ed) to live in the house for 5-10-20 years–either paying down the full amount or being around until some recovery.

“How are the ‘toxic’ CDOs and MBS going to be valued? Don’t we need to know this before we can get any estimate as to how severe the problem is? IF over-leverage was the cause, is it possible to de-leverage with government support at a reasonable rate? Can the markets support this? What in the plan addresses holders of the CDOs that are not banks–state, local, foreign governments, bond insurers etc.? If we don’t address them, are we not just putting off the next crisis?

“What happens to the bond market and interest rates if we pump another trillion into the market? I’m no economist, but wouldn’t rates rise dramatically? If the goal is to make funds available to companies for the economy–it seems to me that the implied idea is to make ‘reasonable funds’ available. What good is it to have liquidity if you can’t afford to access the funds?

“Sweden went through a similar problem in the 90s and they helped provide liquidity to only the strongest banks and encouraged the weaker banks to merge or go ahead and fail. Is this part of the plan? We still may have a credit crunch–so expand the SBA, even expand its limits–but make reasonable loans. I understand this doesn’t address the Fortune 500–but it would start freeing some capital.

“Why not use a big portion of the money to shore up the FDIC and the SIPC?  If you want to see panic, wait until people are told that their bank failed and that the FDIC ran out of money.

“I’ve not heard anything about what is to be done with the commercial and the derivatives markets. If excessive leverage and a devaluation of the underlying asset caused this problem in the residential mortgage market–what about these other two? What is going to stop players from acting in their own self-interest with a feeling of ‘we are too big to be allowed to fail’–instead of ‘how can we unwind reasonably to avoid collapse”? I don’t understand the derivative markets enough–and that is my next question–what would need to happen to cause the derivative markets to start to panic?

“My last question has to be how can we position ourselves to gain from these actions? I don’t think its time to buy a farm in Idaho and guns to arm a small army. Eventually the markets will stabilize–maybe with a lot of pain–and as John Templeton proved, times like these can lead to real opportunities. I am trying to understand so I can make good bets at the right time.

“I have always tried to do my own research, but there are so many questions that I have which I haven’t seen addressed/asked that I can come to only two possible conclusions: 1) I don’t have the foggiest idea about the implications and inter-workings of our financial system and I need to better educate myself (which is what I am trying to do) or 2) the issue is too huge; no one has any handle on the magnitude of the problem and we are driving blind hoping the road ahead is straight.

“I am sorry this is so long–I did not intend it to be–but one question kept leading to another. If it’s too long to answer directly, I fully understand.

“Thanks,

Larry
Wheeling, West Virginia

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Larry,

Those are great questions.  I believe 1) that you DO have an “idea about the implications and inter-workings of our financial system,” but also 2) that the issue is too huge–there are too many variables–for anyone to know with confidence what the best solution might be.

Nevertheless, I do have two strong opinions.

First, you should spend as much time as you like learning about the intricacies of our financial system, FDIC, SBA, SIBC, CDOs, MBS and more.  Knowledge is power, and if you enjoy the learning all the better.

Second–and much more critical for you as an investor–you should watch the market, and learn to interpret the messages of the market.  When the market’s message agrees with something you “know” fundamentally, you’ll feel confident acting on that knowledge.  More importantly, when the market’s message CONFLICTS with something you “know” fundamentally, you should trust the market and recognize that it is smarter than you (and me).

The issue here, and it’s a big one, is that successful investing is not about being wrong or being right, it’s about making money.  And the best way for a growth stock investor to make money is to watch the market very carefully, to understand what its actions reveal about the thinking of the big institutional investors who move the market, and then to act accordingly.

The sad truth about fundamental knowledge, you see, is that it’s only valuable when someone else doesn’t have it.  As a result, everything that’s in today’s news is fairly useless … because many of the big boys knew it before you.  The last guy to act on today’s information is the sucker.

Contrarily, the actions of the market provide a clue about what the big boys are thinking about the future.  This applies to the actions of the major indexes, which are useful in identifying market trends as well as market bottoms and tops.  And it applies to the action of individual stocks.

Consider the market.  Back on July 15, when the SEC announced its protection plan for Fannie Mae (FNM), Freddie Mac (FRE), and 17 banks and brokerage firms, the Dow plunged to a new low for the year, bottoming at 10,732 before closing at 10,963.  And that was the bottom for a couple months; in fact, the Dow rebounded 11% from that low to its early August high.  But on Wednesday September 17, after many more institutions had fallen into trouble, the government announced it would “solve” the problem with a $700 billion takeover.  And the next morning, the Dow undercut that old low–just barely–by falling to 10,404 before closing at 11,020 (above the July close … a good sign).

Technically, that action was a re-test, which is normal action at market bottoms.  But most investors didn’t notice it.  Most were too focused on the headlines … the bad news.  And since then most investors–like the rest of the country–have been too focused on the stories unfolding in New York and Washington, D.C.–and on the presidential campaign trail–to even think of investing.

But the market continues to tell its story, day by day, trade by trade, and the story we read is this:

The worst of the selling has almost certainly passed.  The professionals have been quietly accumulating positions in the stocks they expect to do well in the next market advance.  Homebuilding stocks, for example, reflect substantial buying power; look at Beacon Roofing (BECN).  Select retail stocks look healthy; look at Urban Outfitters (URBN).  And I see a lot of money going into health care, an observation that supports my fundamental belief that health care might power the next big wave of growth in our economy.  Volcano (VOLC) is promising.

Why are these professionals buying?  Well, many of them have to put the money somewhere; most equity mutual funds, for example are expected to be more than 90% invested most of the time.  But more important is that the buyers are looking forward, attempting to discern which stocks will be the winners and losers in the months ahead once the worst of this great financial turmoil becomes history.  Some buyers–like Warren Buffet who purchased Constellation Energy–are confident that they’re getting good value.  And others, like the folks buying Sequenom (SQNM), which I mentioned here last week, are confident that they’re getting in on a great growth story.  The true professionals are focused on their work, recognizing that major market bottoms are an ideal time to acquire great investments

But not the average investor; virtually everyone else is fixated on the problems of our financial institutions.  And this is typical; at market bottoms, fear runs rampant and the last thing the man on the street is thinking about is investing. But that’s when preparation for the next market advance can pay off big-time.

By contrast, no matter how well you understand the intricacies of the problems our representatives in Washington, D.C., are attempting to resolve, there’s scarce opportunity to profit from that knowledge.

In short, spend all the time you want on analyzing the details of this great financial challenge.  But don’t let that activity detract from the work that can truly contribute to your investment success … the analysis and interpretation of the action of the stock market.