Greece Fire

June 3, 2010

We cut back on riskier stock and bond funds at the end of May, a trade we'd talked about making over the last few months, and a continuation of sales we started a few months after the market rebounded from its March 2009 low, when we made our most recent move into stocks and riskier assets. 

We  want to be in the fund categories other investors avoid. During the market comeback's last hurrah, investors began piling back into junk bonds and foreign, small cap, natural resources, and commodities funds. We prefer investing in these areas when prices are down as investors scramble for safety. Today's investors are worried about inflation, which usually ensures inflation won't be a big problem.

If you examine mutual fund flows over the past year or so, you can see the mistakes investors have made, and why we bought stocks and higher-risk bonds in late 2008 and early 2009 and sold them later in 2009 and now again in 2010. According to data collected from the ICI, the mutual fund trade organization , fund investors removed about $30 billion from stock funds in the first four months of 2009. In the first four months of 2010, they added just over $40 billion. This is called, "Sell low, buy high." 

Of course, it's easy to criticize now, but back in early 2009, it looked like we were on the edge of a depression. That's the trouble with investing. You tend to fare better when things look rocky, and not so well when the waters appear safe again. It will be interesting to see what investors do in the next few months now that the market has again weakened.

U.S. government bond prices have gone up as investors panicked about Greece's economy and backed off of higher-risk bonds. For this reason, we've decided to delay the move into longer-term government bonds that we alluded to last month. We’re still cutting back on high-yield (junk) bonds, however, and plan on making more trades in the next few weeks.

We don’t want to over-analyze the “what went wrong” in the market this month. That’s the job of the mainstream financial press – to come up with a why for every 50-point move in the Dow. When stocks go up for an extended period, they become more prone to a drop. Often, there's a trigger, but perhaps that trigger wouldn't have caused a problem if stocks had been cheaper from the get-go.

In May, the great market rebound that began in March 2009 ended. There were a few minor pullbacks during the big run, but this was the first 10% “correction” – to use Wall Street’s ever-positive spin jargon to describe a market fall of greater than 10%. It's interesting how every time internal emails from investment bankers leak during investigations, their product descriptions begin sounding less optimistic.

This market rebound has attracted more interest from investors as it has progressed. Fund investors fled stock funds for the safety of cash, CDs, and government bonds until April 2009. During the rebound, most of the money that came back into funds went into bond funds, not stock funds. The Great Credit Crisis appeared safely behind us, and stock upside seemed limited. Investors loaded up on anything with a return, albeit limited. The government made super-safe investments tied to short-term rates yield essentially zero in an effort to stimulate the economy and push scared investors back into riskier assets that needed boosting. The only thing worse than an asset bubble is an asset crash, especially with so much asset-backed lending going on in recent years.

In 2010, a half-trillion came out of money market funds as investors sought higher returns in higher-risk debt until growing debt fears reached the point that another global credit crisis seemed possible, no matter how minute the chance. 

During the crash that began in 2007, stocks followed the real problems in the economy downward. Credit markets were already deteriorating as the housing market headed down and took all the bubble-era insanity down with it. This time, it IS different: investors want to sell first and ask questions later.

Of course, what appears to have caused this latest mess was a surprise. It wasn't the U.S. real estate market, or a rise in interest rates. No, it was little old Greece, a country with a GDP of less than 1% of global GDP – approximately that of Virginia. 

No one really cares about Greece's GDP growth or lack thereof. It’s the risk of other Greece’s around the world that are currently in better shape but could be next in line if things get a little worse –– countries that have become very popular to invest in and lend money to. This popularity explains why we largely exited emerging market investing about four years ago (except for a brief foray back into emerging markets in March 2009 –at the bottom of the abyss when prices were once again cheap enough to warrant the risk).

The last time things went awry, the canary in the coalmine was subprime loans fueling the ever-expanding housing market. When those loans began going bad, institutional investors and professional gamblers on Wall Street assured us: <i>what happened in subprime stays in subprime</i>. The problem would certainly not spread to prime mortgages, much less cause the average American home price to decline measurably, or an entire city like Las Vegas to slide – gulp – 50%.

This time, investors will shoot first and ask questions later. It's possible they'll have been wrong both times. Perhaps they should have stepped back from risky assets when the housing market first began to crack, since a bubble that big was sure to drag the entire economy and stock market with it. Perhaps they're also misinterpreting European troubles as the beginnings of the next death slide. 

We know the world is flat, and the global economy can sink when a region tanks, but we’ve been investing more heavily in the U.S. markets in recent years, and expect to slowly move back to foreign markets since they're falling faster than our own. When all the new money that piled into foreign funds starts to return home (and it already has), we’ll be buying.