The Sane Investor

October 9th, 2008
I know a little bit ago that I said that I was going to stop picking stocks, however I just had to write an article in response to trying to protect yourself from the falling market. Let it be known that I don´t make any specific company reccommendations in here, because I just don´t think the market is at a point where I feel comfortable picking specific companies, or even specific sectors. Instead, the stocks listed below allow you to take advantage of certain prices out there (i.e. gold and silver) and some really risk adverse debt (i.e. Treasury Bills). I feel like the prices of commodities like gold and silver are a little bit easier to project, and if nothing else see the suggestions below as my tips to conserve the value of your savings. In addition to this article, you should also check out my post ¨Preparing for the Worst: How I’d Insure Against the Dollar¨.

So back on point, I wanted to address something that´s been floating around the web, stemming from the large concern that things are going to get much worse before they get better in the economy. You´ve probably heard the phrase ¨cash is king¨, and this comes from the fact that in a period of shrinking prices (i.e. commodities, stocks, real estate, etc.), you´re much better served to be holding on to cash rather than having it stuck in some sort of security or hard asset that´s just going to go down in value (gold and silver would be my only exceptions). Thus, especially if you´re someone that´s looking to retire in 5-10 years, I imagine it becomes an issue of whether pulling out now will save you a lot of money.

There´s a really great article in the New York Times today, titled ¨Switching to Cash May Feel Safe, but Risks Remain¨. I think it really addresses the concerns that mount in a bear market (bear means that people have a negative perception of the stock market and prices are expected to go down), but also adequately addresses the fact that inexperienced investors might miss out on pilling their money back in to the market when it has hit its ¨bottom¨.

Since some experts are starting to call bottoms at this point (I´ve been seeing bottom calls by experts on Bloomberg for the past few months now), it will likely be even more difficult for every day investors (like myself) to pick the bottom.

So what do you do? It definitely doesn´t seem logical to keep contributing to retirement accounts when the market seems like it´s just going to continue to keep falling. But like the article points out, to pull out money from retirement accounts also poses problems.

My Prediction

In my personal opinion, things are going to go down, the question is by how much. Typically, when people lose confidence in the banking system, it´s just a matter of time before really bad things start happening. If you want to look for stocks that are going to get hit the hardest, look for those that earn their bread by selling confidence in the firm. This is definitely the case for companies like commercial banks, who in a nutshell make their living taking the deposits of every day folks and then finding places to lend that money to earn higher interest rates. It´s constantly a game of risk analysis, however, since the bank has to ensure that it has just enough money available to give back to people that pull it out of their accounts. This is one of the reasons that the Federal Reserve requires minimum reserve amounts in banks. It´s to help ensure that there won´t be a problem meeting short term demands for deposit returns.

However, when people start to question whether or not the bank will be able to get back their money, that in turn reduces that bank´s ability to sell its credibility, i.e. ensure that people will give them their money. The likely effect of this type of confidence loss you´ll probably start seeing soon, if not already, is like the following:

¨I know the government is insuring everything, but I just don´t trust this system. That´s why I´m pulling out all my money.¨

This effect worsens if said person is in a position of power, or holds considerable sway, because it prompts you to ask yourself that same question:

¨Well if so and so doesn´t trust the banks, should I? I can´t lose that money, I need to pay for ______ (insert college tuition, credit card bill, home mortgage, doctor bills, etc.)¨

A bank run is a bank´s worst nightmare, and that´s one of the reasons that the Federal Government upped the FDIC insurance amount to cover all deposits up to $250,000. Some European banks have gone so far as to insure all deposits in an attempt to shore up confidence. But a bank run is only one of the ways that a lack of confidence in the financial system is visible by everyday people. There´s also the threat that certain parties won´t be able to make good on credit or loans, which prompts some lenders to stop what they´re doing, lest they risk going out of business as well. Like this, the chain of lack of confidence spreads across the system and results in very bad things.

Given That, What I Would Do

Since it´s so hard to know when the bottom is coming, I would not reccommend that you pull money out of your retirement account. You´re definitely not going to lose any money in the next 5 years if you leave it alone. However, that doesn´t mean you have to contribute to a fund that you know will only lose you money in the short term (it´s like trying to catch a falling knife).

If you chose to stop your retirement contributions in favor of cash, you should at least choose to put that money in to a money market account, since you´ll be able to earn a good rate of return while maintaining your liquidity (liquidity refers to how quickly you can access money in a bind. Cash is of course the most liquid, second behind checking accounts. Then you have things like savings accounts and money market funds. That´s finally followed by debt, stocks, and anything else that requires that you sell something). As people have basically shut off lending, the returns on money market funds have rocketed up because no one has liquidity at this point.

You should always have enough money in liquid form (i.e. up to savings deposit level) to pay off your immediate obligations if there were to be an emergency (i.e. 1-2 months bill paying, etc.). You might even go a little bit bigger in liquidity if you know you can´t readily access your other assets (i.e. if all of your other assets are tied up in retirement account and IRAs, there´s a steep penalty to withdrawing on those early. However, if you have a standard brokerage account, you can deposit and withdraw funds as you please).

Step 2

If you´ve already got those obligations met, then you might look at starting a brokerage account for the more short term (brokerage accounts don´t offer you the same amount of tax protection as retirement accounts, however as I mentioned above, they are much more liquid in that you can more readily access funds in a bind). One advantage that I would see to opening up a brokerage account would be to purchase some short and ultrashort market ETFs if you consider yourself a more advanced investor. With these funds, which offer the liquidity advantage of being exchange traded, you can capitalize/protect yourself from falling prices, since the value of these funds go up as the market goes down.

For the general investor, I would not recommend these, since like I mentioned above, the challenge is spotting the bottom. Instead, I would recommend more hard assets, like gold and silver, or you could go with well protected debt like TIPS (treasury inflation protected securities) or simply just Treasury Bills. The reason I reccommend these assets is because they typically perform very well in adverse conditions.

I´ve also been reading a lot of chatter out there about the bullish (i.e. people expect prices to go up) outlook on gold and silver (some great articles: Roger Wiegand: ‘Severe Bull Market’ Ahead for Gold and 700 Billion Reasons to Own Some Gold), and as far as ways to make money in a downturn, gold and silver would be it. For the very least, I have read very little projecting prices to go down, so they should be a good store of value. If you want to read some suggestions of funds that you should invest in to take advantage of gold, check out ¨Precious Metals Stocks to Consider as the Dollar Falls, Banks Fail¨. In general though, I think the two most common funds to look at would be SPDR Gold Shares (NYSEArca: GLD) and Ishares Silver Trust (AMEX: SLV).

I think that moving your money in to funds like these is best, because at the same time they´ll give you a good way to make money (or at least protect your money), they´ll also give you a barometer about what the ¨panic¨ level is out there. I would say that once gold crosses some really crazy thresholds (at least over $1,200 per ounce), you´ll start to know that people truly are depressed with the financial situation out there. At that point, I´d say take the gains on those stocks and move them over in to conventional retirement funds. That way you can make a little bit of money while at the same time ensuring that you won´t miss the upside.

What We´re Reading Today (organized by most relevant and interesting going down):

U.S. May Take Ownership Stake in Banks - New York Times

Why we picked it: it further brings to light the challenges that a full blown bailout can bring. The article talks about the recent talks by the government to directly invest in struggling banks if they ask for help. Since this does not come in the form of debt that has to be paid back, it is probably the most effective way at trying to shore up struggling banks. However, the article also addresses the negative that this could create: ¨Treasury officials worry that aggressive government purchases, if not done properly, could alarm bank shareholders by appearing to be punitive or could be interpreted by the market as a sign that target banks were failing.¨ Either way, it´s an important milestone towards the way our free market system is changing.

Libor Dollar Rate Jumps to Highest in Year; Credit Stays Frozen - Bloomberg

Why we picked it: the London interbank offered rate (Libor) keeps track of the interest rate at which banks lend to each other over night. The fact that an almost universal interest rate slash by central banks around globe did nothing to soothe markets is scaring some, prompting people to wonder whether the system really works to spread liquidity throughout the banking sector.

A.I.G. to Get Additional $37.8 Billion - New York Times

Why we picked it: after the $85 billion loan extended to AIG, the company has been on ¨corruption alert¨ since more people continue to point to the company as a perfect instance of incompetence and corporate greed. Much like the subject of the $440,000 executive conference that the company held was used to fuel the debate rhetoric of Barrack Obama, the recent news that the government needs to extend another $37.8 billion to the company should only fuel the flame. As if to make matters worse, AIG indicated that they had already tapped $61 billion of the loan, causing some to think that the company is worse off than originally thought.

OPEC to Meet Nov. 18, `Likely’ to Cut Oil Production - Bloomberg

Why we picked it: after crude oil prices spiked at $147 a barrel in July, oil has entered in to a downspin, currently holding at $87 a barrel. Because it´s forecast that falling global demand will further reduce prices, member of the oil cartel OPEC are toying with the idea of cutting supply. Altough this will help bring up the price, it probably won´t help stimulate amiable feelings in the devloped world since falling oil prices have come to be one of the few respites in the current credit crisis.

Iceland Takes Over Kaupthing as Biggest Banks Fail - Bloomberg

Why we picked it: I linked one article about the Iceland debacle in my post two days ago, but since then things have only gotten worse for the tiny island country of 320,000. I find the story of Iceland´s practically imminent collapse to be an interesting example of how even modernized nations can succumb to insolvency.

Taking Hard (sic) New Look at a Greenspan Legacy - New York Times

Why we picked it: the article provides a great discussion of the effects that this current downturn could have on the legacy of former Fed Chairmen Alan Greenspan. Although he has recently been criticized for his policy of not stepping up interest rates to curb mortgage markets, which essentially led to the housing bubble, the article also cites how further revelations over financial instruments called derivatives could damage his reputation. Greenspan was a very outspoken defender of not having regulation in the derivatives markets, and it is now being questioned whether that policy helped lead to today´s financial crisis.

IMF readies emergency aid for wounded economies - Reuters

Why we picked it: when people start talking about the IMF having to step in to help countries out, that means that things are really bad. What makes it worse is that they´ve typically only had to help emerging market countries whose flights of capital caused problems throughout the nineties, however the first country that will likely receive their support this time around is the developed nation of Iceland.

Taxpayers, Not Lenders, Would Bear Costs of McCain’s Mortgage Proposal - New York Times

Why we picked it: Although I have nothing against McCain, I do think that after the most recent crash on Wall Street most voters will not be very happy to find they´d be footing the bill for something that most don´t feel responsible for. The article notes that: ¨Wednesday [McCain´s] chief economic adviser, Douglas Holtz-Eakin, acknowledged that the liability [for the proposal] would be borne directly by taxpayers.¨ As the state of the economy continues to develop in to one of the most important aspects of the current election, it will be interesting to see whether this ends up being the undoing of a McCain-Palin ticket.

Three Chemists Win Nobel Prize - New York Times

Why we picked it: if you feeling like reading something really cool about the innovative spirit of America (it makes you feel a little less depressed right about now), check out this article on how the flourescent proteins of jellyfish have been used to trace proteins and cells in different animals. If nothing else, click on it to see the cool picture of a flourescently colored mouse´s brain.

Questions? Comments? E-mail me at thesaneinvestor@yahoo.com

All material copyright

© 2008 Andrew Jarmon

Subscribe in a reader