Rough Seas

August 1, 2008

After several years of smooth sailing on Wall Street, rough seas have made a comeback. Lately it seems like the Dow only moves up or down several hundred points a day. The market fell quite a bit in the first half of July, and then recovered towards the end of the month. For July, the S&P 500 was down just under 1%. Lots of gambling and not much to show for it in the end.

So much for efficient markets, the theory that stocks are always efficiently priced. Such theory doesn’t have much to say for how bank stocks trade these days – up or down over 10% almost every day as speculators simultaneously fear the next IndyMac Bancorp (the aggressive California bank originally named “Countrywide Mortgage Investments” – a name that says it all) but want to get in cheap for the eventual comeback.

On a positive note, some air seems to be coming out of the oil and commodity bubble, though it’s a little early to trade in the hybrid for a heavily discounted Tahoe.

As you know, we used the roughly 20% drop in stocks from the peak last year to increase our stock allocations. We expect some slight performance benefits from our portfolio changes made at the end of June, particularly from the over 20% one month gain in our new commodity short ETF – a speculative short-term pick to hedge major global economic slowdown risk. Junk bonds and telecom stocks have yet to recover, but some of our newly launched stock funds had a fair month.

We bought, but what did other fund investors do in June? This was the million dollar question we didn’t really know the exact answer to when we did the trade: Did fund investors take money out of funds in June? We assumed they did given past trends and behavior during sharp down moves. In May, fund investors added some $16 billion to stock funds – just in time to get walloped by June’s near 10% drop in stocks. As it turns out, fund investors took $4.8 billion out of stock funds in June – not a bad sign for us contrarians, but frankly we were hoping for much bigger numbers. In fact some fund flow estimates were positive for the month.

We’d also like to see more panic buying of money market funds before we increase our stock allocations further. But according to the Investment Company Institute there was $75 billion coming out of money market funds (though for the year a cool quarter trillion went in). We’re not sure where all that money market fund money went, just that it didn't go into stock mutual funds.

Trouble is these days, investors who are not momentum investors are bottom fishers, and there are way too many of both. This is why XLF, the financial services ETF, brought in billions over the last few months. Everybody is trying to make money on the turnaround. While often there will be turnarounds, the truly great deals happen much less frequently and are when other investors feel there is no light at the end of the tunnel. Almost nobody was trying to bottom fish in tech stocks in 2002 when the Nasdaq was close to 1,000. Almost every expert, analyst and TV talking head was talking about the great deals when tech high fliers were down 25% to 50%, only to fall 95% or 100% peak to trough.  

Bottom line, we need to see some more selling by other investors before we get more aggressive in our accounts. Apparently a lending industry that is being held together by increasing government handouts, support, and guarantees isn’t enough to scare investors away. We may need to see more really big bank failures, further drops in real estate, and another 10%-20% hit to stocks for the real deals to appear. Not that we’re terribly scared longer term – no fund investor ever went broke buying into stock funds in months of outflows by other fund investors and sitting tight for the eventual recovery.