2007Aug Been There-Done That

2007Aug Been There-Done That

“Been there, done that.” A ubiquitous statement of life in general, usually found plastered on the T-shirt of a Baby Boomer at leisure. After watching our markets roll back from all time highs on the Dow Jones Industrial Average™ into correction territory, you may feel like someone slapped you on the back and left that statement sticking to your T-shirt.

“Been there” refers to 1998 when the Russians couldn’t pay their obligations and the Asian currency markets collapsed in symphony. In a matter of 40 days the Dow fell off its highs for a 19% correction. We still have the “done that” to go if we repeat what happened in 98’when the Dow took 89 days to climb back to previous highs on its way to all time highs in 2000.

The similarities and dissimilarities between then and now are striking. In 1998 markets were upset when the Russians defaulted, leaving hedge funds holding worthless paper, much of it purchased on margin. The “Hedgies” did what they had to. They sold good securities in which they held long positions to raise cash. But they also had to buy back their short positions in bad securities leaving them critically strapped for cash. Ultimately, the Fed and vulture capitalism bailed them out (as in Long Term Capital), and economic life on planet Earth returned to normal.

This is exactly what is going on now. Substitute sub-prime mortgages for Russian bonds and throw in a large fear factor instead of Asian currencies and the picture looks eerily similar.

There are two major differences. First, in 1998 the economy had been expanding for some time and stocks, according to the Fed Valuation Model, were more than 20% overvalued (based on the IBES Valuation Model and data from Hays Advisory, LLC). Using that same Model today, we began this decline (from all time Dow highs) at nearly 20% undervalued, and are now in the range of 32% undervalued! The Graham valuation model we refer to confirms significant bargains are available. To paraphrase the Sleep Country ads, “These prices won’t last very long.”

Second, quoting Tobin Smith of Fox Bulls& Bears, “the sub-prime ‘crisis’ is not even a speed bump in the global growth miracle, better described as a mosquito bite.” In 1998 and reaching to the bubble in 2000, explosive growth was primarily a U.S. phenomenon. Today, it is global growth. The U.S. is an important, but no longer, the biggest part. According to Smith, the world has added over 2 billion new capitalists who care more about making their own economic situation work than the housing markets in the U.S.

Smith’s views were echoed by John Chambers of Cisco® when he called this global expansion “an expansion like nothing I have ever seen before.”

We may have some additional volatility to wring out of the market. We are likely to hear of more hedge fund failures. However, the Fed has pumped in more than $64 billion of liquidity into the U.S. banking system and has signaled there is more if necessary. The Fed Futures Markets have priced in a strong probability of a rate cut in September which the markets would cheer.

In Europe, the European Central Bank has also added liquidity in the form of some 203.5 billion Euros since last Thursday. The ECB said in a statement that it “notes that money market conditions are normalizing and that the supply of aggregate liquidity is ample.”

Now, I realize I can talk all I want about how strong our economy is, but like a seasick passenger on a boat, you may not care what I say, you just want to feel better quickly. Many investors have been seeking the “safety of Treasuries.” Treasuries are available at premium prices.

The weak stomach reaction is tantamount to returning an item to Costco then walking across the street to buy a similar item from Nieman Marcus. Selling stocks cheap to buy expensive bonds does not help your retirement plan stay on track. There is an illustration of this type of decision process on our website under “Emotions lead us to make mistakes.”

After a review of valuation data from various managers that we rely upon in our work with you, the current market looks much like the opportunities of short-term corrections in 1987, 1990, 1998 and 2003 (which of course was the longest and deepest of the four). Our view remains that the biggest risk in these market conditions is being out of the market, not in the market. When it does snap back, it is likely to be quick, offering little chance to reinvest a portfolio at rare, bargain prices.