Richard Schwartz's

PRINCIPLES OF THE STOCK MARKET

A learning, teaching, always evolving stock market letter and advisory service

Eighteenth Consecutive Year of Publication; Letter #1; September 18^th, 1990

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Monday, December 22^nd, 2008:  So here it is, last letter ‘till Monday, January 5^th, as Lucy & I fly off to the white sand, warm blue waters of the Caribbean, maybe on a last hurrah (if the economy keeps sliding).  I’m taking Cycles of American History & Rethinking the Great Depression books.  Our routine is:  Go to the beach, play backgammon, read & go out to dinner.  Day after day.  Warm our bones & work on new tans. 

THE BIG PICTURE

Friday I saw John Bogle, who has been on Wall Street for 50 years and who created the first index fund, the Vanguard 500 Index Fund back in 1975, say investment bankers and bankers generally owe the country a huge apology (which I doubt we ever get).  Their imprudent speculations and greed for massive fees from too complex speculations led to today’s financial sector problems, problems which have now fed out to the real economy hurting innocent, hard working, everyday Americans.  Mr. Bogle says greed has even spread out to our whole economy, that we’ve morphed into in a “me first” society and it’s something we have to seriously take a look at.  Thus capitalism, allowing markets to work unfettered of regulation and based on trust and trusting, has now been “deeply discredited.”  Even the underpinnings of capitalism have changed radically.  We’re no longer an ownership society whereby individual stockholders used to select and then hold 92% of all common shares; institutions 8%.  Now institutions control 75% of shares through huge sums entrusted to them by others and have not invested prudently.  Again, because of the incredible fees they got for investing.  Mr. Bogle says they sure wouldn’t manage their own monies so recklessly.  These institutions were supposed to be wiser than individuals but, again, it’s not their money.  Supporting Mr. Bogle’s view is the revelation that 29 of the 30 largest losers in the Bernie Madoff Ponzi scheme scandal were institutions whereby just one of these fund of fund companies was paid $160 million in 2007 alone for recommending the Madoff “hedge fund.”  In other words, where was the fiduciary responsibility, the prudency, the probity expected when we entrust institutions to manage 75% of our investments?  Schwartz View:  Regular readers know I’ve been distressed and pounding the table about a number of these societal issues for years.  About capitalism running amuck, culminating its 30-year trend toward widening the gap between it and its counterpart, democracy, with President Bush’s skewed one way Texas twang policy saying the be all and end all is that “bidness is bidness” and thus stifling regulation.  And about society becoming so uncivilized, we ended up booing our own hometown, beloved sports teams!  So while no one wants to live through what may come next in the economy, I have to say America has finally woken up, albeit after the nightmare it usually takes to precipitate major change, and that we are now started down a long and arduous path, but one finally pointed in the right direction again.  As one example, we’ve even started to SAVE once again; amazing!  So, for myself, I guess sort of a contrary indicator in recent years, I’m becoming more optimistic and bullish on our future.  Finally!  “Go America Go!”

THE ECONOMY

It became apparent that the US economy was suddenly falling-off-a-cliff right after Lehman Brothers became the one firm chosen NOT to be bailed out by the Federal Reserve and US Treasury Department.  (Looked back upon as a colossal mistake in strategy I’ve read.)  Lehman’s bankruptcy rippled out far and wide and led directly to losses in some money market funds, a “breaking of the buck,” and thus then to a total loss of confidence.  Now, by all accounts, the economy is in total free fall.  This sudden screeching halt in US business activity has caused the same in our global trading partners and most everywhere I look is now in corresponding economic free fall.  You extrapolate it for yourselves from here.  One view I’m pondering is that many times sharp declines lead to the second leg of a V-move, back up, and we’re overdue.  Maybe stocks, with their recent unwillingness to keep going lower on bad news, means Mr. Market (the consensus of large investors) sees some end out there to the economic free fall.  Still, we’d have to see some economic revival to expect a sustained V snapback in stocks.  For now, I see 2009 providing a steady stream of bad news every time we look up.  Just like in the second year of the last Papa Bear bear market, back in 1974, a continuing stream of bad news back then ultimately overwhelmed all attempts to rally until the final months of that year.  Schwartz View:  The consensus I’m hearing is that this sudden, fall-off-the-cliff global economic contraction is NOT going to lead to a repeat of the depression-spawned 1930s starting with its four-year long period of contraction followed by its anemic recovery, a.k.a. the Great Depression.  I hate to follow any consensus especially when this one’s been so wrong for so long.  But my own history look backs and studies by Federal Reserve Bank Chairman Ben Bernanke, an expert on what went wrong in the 1930s, turning a recession into a depression, show that we raised taxes, cut spending and blocked global trade, just the wrong policies.  So I sure don’t expect any exact repeat of those failed policies.  Leading me to think out of the box and that maybe today’s Fed policy of battling a deflationary depression is also implementing incorrect strategy.  How about worrying against runaway inflation spawning from all the money the US and now the world has and is still throwing at this economic slump?  Just the problems we worried about in the early 1930s but didn’t occur.  You know the old saying, people fight the wrong war, the old war, because that’s what’s still fresh in their minds.  Thus, summing up, maybe we can’t expect much creativeness from the Fed  pointing in the less obvious direction  of battling inflation since they are entrusted with getting us through hard times.  They will naturally, after learning certain lessons from the 1930s well, not break much new ground.  One reason being that if their policies didn’t work, they would be heavily criticized for experimenting.  Thus while everyone pooh-poohs an inflation problem, I still worry about one.  Seems like the consensus, which may be correct, among the minority expecting and talking about an inflation problem, doesn’t expect one until 2010 at the earliest.  Keeps me thinking about that quote I printed here back on Friday, December 5^th, from Sir John Templeton:  “It’s impossible to produce a superior performance unless you do something different from the majority.”

THE STOCK MARKET

Maybe we’ve started off on a new, lasting stock market rally as many now say.  Maybe the November 20^th closing low and November 21^st intraday low did end this bear market or at least this phase of it and start us up and on a new mini bull market.  But I don’t think we can determine that from these final days of stock market trading this year.  This jig jag, saw-tooth modest rally we’ve had in December – the Dow remains down -2.8% this month, but up +13.6% from its closing low on November 20^th – still looks like just a time killer rally to me after stocks fell -6% in September, -14% in October and another -5% in November.  So while I’m off on my annual winter beach vacation, I’m leaving my managed portfolios hedged with a slight long bias, still with my modest overall about 20% or less market exposure which I’ve carried since late last year.  You remember late last year?  At least as a lesson learned for the future, if for no other reason.  After the stock market rallied back from its original car wreck in July, in what amounted to a head fake, false move, dead cat bounce and pretty obvious sucker’s rally, and a  failed break out to new highs by the Dow and S&P (while the rest of the stock market refused to confirm).

Anyway, last week I ended the letter by noting that psychologically we should rally since bad news couldn’t drive prices down in recent days.  Technically we had what could prove to be two months of base building everywhere I looked on the charts (but bases which could easily prove false).  Fundamentally we even finally had low enough market valuations, like P/E ratios, to support a rally as well.  But how about a catalyst?  Well, let me offer up:  (1) much lower gasoline prices which keeps our wallets and purses fuller and healthier, and (2) the good feelings anyone watching our president-elect making non-partisan, non-political, non-ideological selections for his cabinet, should feel.  There may be a wellspring of good feeling, a sort of honeymoon psychological effect on investors, business, consumers and most all of us as we hope our new president can perform miracles.  Schwartz View:  Unfortunately no one man is going to remake America overnight.  So, while keeping an open mind and watching all unfolding developments, for now I’ll back history which says this “worst financial crisis since the Great Depression” has to lead to an extended Papa Bear market, one which lasts at least a couple of years.  Not just for one year, where we stand today.

PORTFOLIO STRATEGY

I hate to follow or even agree with some of what I’m hearing about going forward strategy, especially if such is espoused by those who were so wrong all this year.  I’m speaking specifically about Bob Doll, now at BlackRock as their “Trillion Dollar” fund manager.  I don’t want to pick on anyone but since he’s been leading the charge forward as stock markets collapse and getting all the face time doing such, I guess I have to.  I start off very skeptical because my belief is that these big money managers are not going to get on TV and recommend anything before they and their clients get first crack at their thinking, ideas and recommendations and position themselves accordingly.  I already wrote awhile back many old stock market books talk extensively about how big money always used to try to sucker the little investors.  The age old technical Wall Street term “distribution” implied big guys needed little guys to unload their big positions on to when they foresaw a bear market ahead and thus put on a bullish face.  It took much time to unload huge positions these large investors stockpiled so much frenzied excitement about the stock market had to be built up as big money sold.  What better way today than  Bob Doll coming on CNBC ubiquitously and always saying we are now in a bottoming process.  He said that back in March and those who followed him are much the worst after the October panic crash.  Anyway, that’s all secondary, although supporting, my main point.  My main point is that Mr. Doll now says next year is going to be a good one for those taking on risk, not for those playing it safe.  Again sounds good to me, at least at first blush.  We all know what goes down the most generally can bounce tremendously when psychology changes.  But do we really want to buy really risky investments in just the early part of the second year of a big, bad bear market?  I say no.  Bear markets of this size and scope historically have taken a lot longer than one year to work through. 

Net, net, probably Mr. Doll will be proven correct about taking on risk, if one doesn’t factor in any time period.  I’d guess risky asset classes will move fast when this bear market ultimately does end but do I really believe its going to end soon?  No.  And if we do have a 2009 mini bull market, say because stocks have fallen so much, then I’m not going to count on Bob and other institutional investors to tell me and us exactly when to get back out.  No, starting off next year next week, I’d suggest still playing our cards close to the vest.   Yes, play modestly for a continuing rally but look at it for now as just a bear market rally.

Happy Holidays & Happy New Year!

Richard