What I’ve Learned About the Stock Market

Anyone who has a retirement fund or personal investments has an interest in the stock market. I have an additional interest because I am the fiduciary in charge of trust funds I set up for my nieces and nephews and track at trustfundsforkids.com.

When the stock market started cratering in 2008, I didn’t take immediate action, for the most part (I was going to say didn’t do anything “rash” like sell off, but in hindsight of course probably that would have been under the category of “smart”). I did sell off financials (owned ICICI, an Indian bank, and GE, which is essentially a giant financial conglomerate with a few businesses stuck in there) immediately, and although my exposure to that sector was limited in those funds, those stocks had not done well.

Now I am trying to re-visit the stock market and do some research to consider what to do next. I am starting out with what I’ve learned from this debacle. As always, do your own research, this is just my 2 cents based on my experience and body of knowledge.

1. Watch the level of debt, and the timing of debt – for many years there was an absence of a risk premium, which meant that newly emerging (risky) companies could raise debt very cheaply, such as only a couple of points above the treasury rate. Today, it is unlikely that these types of companies can raise any money AT ALL, and if they did it would be at a rate perhaps 10 percentage points above Treasuries (i.e. if Treasuries are at 4%, they would pay > 14% for financing). Companies are moving into bankruptcy rather than try to refinance at these rates – companies like Charter Communications, for example. Even if bankruptcy is avoided (or deferred) the company would have to be highly profitable to earn enough to cover that level of interest payments – and most companies can’t profit when their cost of capital is that high. I won’t even comment on the 33-1 leverage used by investment banks because we all know how that turned out

2. Guessing the actions of the US Government is important – during the cold war, “Kremlinologists” attempted to divine what was occurring at the top levels of the Soviet government, since it had a direct bearing on our policies. For example, the Feds let Lehman die and saved AIG, although in both cases their equity value evaporated to the point that a 100% equity loss and a 98% equity loss were a toss-up either way. The subtle way in which by saving AIG they benefited Goldman Sachs (since AIG was a major counter-party to Goldman Sachs) would be something worth understanding, for example. The Feds also didn’t bail out Fannie Mae and Freddie Mac preferred shares, which caused whole ranks of smaller institutions to fail. In general, if you are investing in an industry that looks likely to need government help, you should get out now, because whether or not you have a few equity crumbs or go to zero is a Hobson’s choice you don’t want to face

3. Correlation between asset classes is higher than you expect – Basically unless you were 100% in gold or treasuries you were likely hurt badly in this market. Foreign stocks, US stocks, many debt instruments, preferred stocks, real estates and most commodities (excluding gold) all dived together. One of the “core” beliefs of “modern portfolio theory” is that if you spread your investments across classes with lower correlation to one another, you will do better over time. Modern portfolio theory basically didn’t save anyone in the time frame we are talking about here

4. Liquidity can evaporate, and if you depend on liquid markets, you are in trouble – Not only did the risk premium (see #1 above) go up quickly, liquidity in the market evaporated, meaning that if you counted on liquid markets, you were in big trouble. Illiquid markets mean that you can’t “roll over” debt and if you do have to sell, you will receive a distressed price for those assets (a big loss, in real terms). One of the first items to fail were the “auctions” in the municipal area which were a sign of bad tidings to come

5. Real estate is no bulwark – For individuals, there was often an assumption that real estate is a “safe” investment, but real estate values have proven to be anything but. Real estate losses for individuals were semi-spared because the government has set a very low rate for mortgages and nationalized Fannie and Freddie – without that floor mortgages would be illiquid and subject to #1 and #4 below. Now, however, the mortgage market is basically subject to government fiat – see #2 above. If the government decides that condominiums are too risky and pulls back on guaranteeing mortgages on half built condominiums, those investments will fail. For real estate companies that specialize in building new homes, those stocks are basically dead, since demand won’t catch up with supply for years. The government is definitely working to prop up the home market, with tax incentives for the new buyer (and likely no more talk about not making home interest deductible)

6. Complexity is dangerous – Another early warning sign was the fact that Citicorp and others had to bring in “off balance sheet” entities onto their balance sheet when liquidity failed (see #4 above). Those companies were incredibly complex, and their financial statements were incomprehensible even to me, a financial professional. These counter-parties, off balance sheet entities, and WAY too much leverage made a toxic stew. In general, companies that have a very complex “story” will likely have a harder road to travel when trying to show their value to the equity community, since people have been burned by what they don’t understand

7. Dividends provide little shelter – over time a significant portion of the total “return” from stocks is driven by dividends paid to stockholders. Many companies paid dividends at a steadily growing rate for decades, and constantly re-emphasized the importance of dividends to their strategy (giving investors confidence that these dividends would continue in the future). However, virtually everyone gave up on their dividends, from the financial companies that are sliding to the edge of oblivion to GE (who really is a financial company anyways) to many other industrial companies. There are exceptions to the rule (companies that are not facing dire straits) but the fact is that strong companies can pay dividends and weak companies cannot, so betting on a dividend independent of the underlying financial structure is a fools errand. The dividend is nice to have (and starting from a solid one is better), but counting on it in the future has proved to be devastating

8. For the most part, no one (who talks) knows anything – yes you can point to the occasional seer who cried doom and certainly many, many smart and rich (and tight lipped people) made tons of money shorting the entire market all the way down, but for the most part the conventional wisdom was completely and utterly wrong. There are people or firms that understand the market well and can profit in down times, but you aren’t getting their thoughts from Jim Cramer on CNBC or in the WSJ or Barron’s or anywhere else, much less the popular magazines like Time, Money or your local paper columnist. Look at how their stock ratings performed, and generally it was terrible. A lot of this is institutional bias because those magazines and paper can’t just tell you to short everything and get out of the market because those same companies buy advertising and those sorts of negative messages frankly sound un-American when explained out loud.

9. Timing IS important, as is re-investment risk – I resisted timing in favor of “buy and hold” for years but then I moved into selling stocks when I thought that they had peaked on the upside, or they had huge down side risk (financials). Buy and hold really hasn’t done anything for anyone in the last decade or so except rack up huge losses. That doesn’t mean that I have a better strategy, but it is a fact that the central issue is timing. Tied to timing is re-investment risk – which basically hits you in that even though you sell at a gain, you have to re-invest in something else that has increased in price (due to strong correlation) and you don’t mitigate your risk that much by selling one overvalued stock for a gain and trading it for a new one.

10. If it seems too good to be true, it probably is – I am not a seer but I think that all these people piling into municipal bonds for the tax benefits and historically low default rates are in for a rude awakening when bad things start happening to the states. I know that there are many ways to bail out a state including the Federal government but it just seems like the municipal financing is going to fall apart and I don’t want to be holding the bag. This applies to “free lunches” everywhere…

Now with all these “lessons”, what is a forward looking investor to do? The stock prices are down, and this could be an historic time to “buy in” to the market, rather than sitting on the sidelines licking your wounds. I am trying to figure that one out now, but thought it made sense to take stock of what, if anything, I learned so far.

Cross posted at LITGM and Trust Funds for Kids