Tuesday, November 25, 2008

Dodging the Decimation

On Boxing Day 2004 a close friend of a family member watched from his hotel room in Khao Lak as the sea mysteriously receded. He got up and ran down towards the retreating shoreline. Two weeks later came the terrible news that his bloated corpse had been identified. 

What a difference experience - or at least a crucial piece of remembered information - can make to final outcomes. I sometimes wonder whether I would have been one of those people who'd have run in the other direction - to the hills - even lacking specific knowledge about the implications of this apparently portentous event. Some people seem to have an intuitive skill with those critical judgment calls. I don't really know how I would have reacted - I've made some good ones and some bad ones in my life. 

The doomed enthusiasm of the subject of my anecdote is nevertheless more appealing to me than the behaviour of those who just carry on building sandcastles on the beach. This kind of inertia in the face of highly mobile macro conditions unfortunately seems to be strongly ingrained in the citizens of the UK. 

Many of my more outwardly 'dynamic' acquaintances have very possibly had me down as along-term sandcastle builder myself, but I'd say to them now that we are simply different types of evolved animal...and that there's an important difference between moving all the time and moving at the right time. (Time perhaps for a quick aside on Sir Isaiah Berlin (OP)'s theory of hedgehogs and foxes and his interesting notion that Tolstoy was a fox who rather fancied himself as a hedgehog...) 

Leaving London earlier this year certainly felt like heading for the high ground after a worrying breakdown in what the folk up north tend to call normalcy.  The family member who shared an office for many years with the man whose Thai business adventure ended so sadly, told me last week that she'd heard that 1 in 5 people in London will soon be out of work. Even 'half-empty' types such as myself finds that a bit hard to believe - the number is more likely to be something like 1 in 10, though in areas like Canary Wharf, the figure of 1 in 5 may not be so pessimistic after all. 

The PR industry, where I was apparently engaged in sandcastle construction until earlier this year, is indeed likely to be decimated. The last time consumption dropped like this - during the '90/'91 recession - major London agencies like Rowland simply folded. Thanks to the leveraged bet that New Labour placed on the financial services sector, there is every reason to suspect that the contraction this time round will be even worse than 18 years ago and that the communications industry, along with much of the rest of the UK economy, is set for several lean years. 

Back in October I was nevertheless tempted back into some limited hobbeyist investing, having discovered the ease of playing the market short using ETFs. I used DUG for example to successfully track the price of oil down from around $80 a barrel to where it is today, just above $50. TZA on the other hand enabled me to double my gain on every percentage point lost by the Russell 2000 index. (I recently heard a bunch of God-squadies of various persuasions prattling on about how short-sellers are the kind of evil-doers who profit from others' pain but, let's be realistic, stock market investment is mostly a zero-sum game: your gain is nearly always going to be someone else's pain.) 

By the end of the month I had extended my activities to an on-going effort to profit from the see-saw of sell-offs and rallies that then characterised the markets. Day trading, in effect. The trouble was that this turned out to be extremely stressful and was tying me to a desk and computer-screen for several hours a day - precisely the lifestyle I had come here to get away from. 

And then I made a silly mistake. Before setting off for Belize I decided to close a bunch of positions so that I could loll around in a hammock without having to fret about what was happening back in NYC. I sold some bank shares that I had bought at the distressed price of just under one Dollar a share. Then, on my last day in Flores I couldn't resist the temptation to take a peak at Google Finance and found myself chewing on my own liver the instant it became clear that shares in said bank had jumped to $20 before falling back again to around $14. 

I realised that in selling off these assets prematurely I had broken all my own rules of investing and I had done it largely because of the chronic anxiety engendered by riding that roller-coaster every morning for several weeks. Even with thousands of shares at a price of $1 each I could perhaps have afforded to lose this money in the event of that particular bank imploding, but it occurred to me afterwards that, psychologically at least, I could ill afford to part with the hypothetical gain I'd ended up missing out on. I could find no other way of looking at it - I'd just taken one of the the most expensive snorkeling trips in history. 

So, I am out of the day trading business and back into the knowledge accumulation (and sunbathing) business once again. What follows is a rationalisation of my new, healthier, long-term strategy. No more short positions, no more smash and grabs. I'm now in it for the duration of the recession, depression, dark ages...whatever. 

First a few caveats. Historically the US market turns around about 4-6 months before the end of the prevailing recession. By my estimates this means that the bottom could still be some way off - Q3, 2009 at the earliest - and that if the danger of deflation can be avoided. Rarely is there one full and final thump for the market as a whole however, and investors who wait until consumers are feeling good about themselves again before attempting to climb out of the hole are probably going to miss the chance to benefit from any future upswings. 

It would also be a mistake to pretend that the current crisis is entirely the fault of a few coked-up investment bankers and that everything else in the economy was hunky-dory (and appropriately valued) the moment before the credit crunch stole walked off with our collective cheese. The US  economy has been living way beyond its means for some time, with the American ratio of debt to disposable income rising from 70% in the late 90s to around 140% in 2008. Real incomes have meanwhile been fairly stable as housing and equity wealth has begun to decline and levels of savings in America went negative in 2006. Consumption, which represents 71% of US GDP, is going to be hit hard now and may well take considerable time to recover. 

Remember though, that unless you are a resident of Argentina, your GDP generally contracts by around 1-2% a quarter during a downturn, not 40% or even 70% in a few weeks. 

So, here are a few suggestions for those brave and the patient investors who might have squirreled away some funds they don't mind locking up for 3-5 years. 

What these picks have in common is that they generally conform to my old - and mostly successful ploy - of buying at panicky prices and simply waiting for more stable states of mind to kick-in.  It goes without saying too that all remain susceptible to more pain before gain - another banking collapse perhaps, or maybe even an Islamist nutjob atentado in the heart of capitalist proto-optimism.

Let the bottom-fishing begin: 

DIG: Having used its evil twin DUG to slide down the oil and gas index at double-pace, it may now be time to switch to DIG. Fears of a deep global recession have seen a massive collapse in energy prices, but I've always seen $50 as the floor here. That's low even for the Saudis and there will be strong pressure from the likes of Iran, Russia and Venezuela to get things moving upwards once again. DIG costs $30 today. It's been as high as $131 in the 52-week range, so if you do have some cash you are willing to put away for a few years, a bet on energy prices once again rising in response to the diminishing supply seems a relatively safe one. 

GEX - a bit more 'ethical' than DIG, GEX is a fund which tracks global enterprises engaged in the development of alternative, environmentally-friendly energy sources. The New York Times today reported worries that the global downturn will hinder efforts to develop new sources of energy. (For instance, Theolia, one of France's largest alternative energy companies, has recently canceled plans for a subsidiary devoted to emerging markets, and has pulled back on its goals of how much energy it could produce by 2009.) 

There's undoubtedly some scope for renewed faith in global short-termism, yet I suspect that the upcoming Obama Presidency is still likely to stimulate investigation into alternatives to OPEC-dependence and, as I mentioned above, for how many years can energy prices really stay this low?  GEX used to cost $62 before collapsing to $15. It now trades close to $20. 

Las Vegas Sands Corp - LVS: Back on the dark side, this casino company recently looked on the brink when an industry analyst questioned its future as a going concern. Then it raised $2.1bn in new financing. Shares still dropped to an all-time low of $2.19 on Friday but have since rallied to $4. It has traded at $122 within the last 12 months. It won't do your soul any good, but it's a gamble that could pay off...

Citigroup - C:  Felt like a desperately risky venture at $3 last week, but was always going to be too big for the US Government to simply let go. Now trades at $6 and may possibly soon be catching up with the likes of Barclays (BCS) at $10 and Morgan Stanley (MS) at $14, major financial players whose futures now look just a little less secure than Citi's.  The trouble is that Citi has been issuing CDOs like Mexican governments used to print out the pesos and who knows how secure America's prime mortgage debt will prove to be in 2009.  Still looks a bit oversold now though. (The 'do you feel lucky punk?' play in this area has to be FAS though - the triple-leveraged financial bull fund which will give you three times the value of any future banking sector resurrection.) 

DBA - commodities like wheat, soya, sugar and corn have all taken a tumble along with oil. DBA tracks the Deutsche Bank Liquid Commodity Index and has fallen in price from $43 to $23. The fund may not have the potential for massive gains on the back of a future recovery, but it is worth keeping an eye on. 

Valero Energy Corp - VLO: - refiners have been hit hard and perhaps none harder than Valero, which earlier this year traded over $70 only to fall to as low as $13. It's medium term prospects are probably fairly similar to those of DIG above. 

Yahoo - YHOO:  Investors here must be feeling a bit like I did after my Belizean holiday, given that earlier in the year the Yahoo board turned down an offer of over $30 from Miscrosoft. Now trading at $10, this one looked to me a bit like a ride to nowhere a few weeks ago, but I have since looked into the company's cash position and discovered that it owns some tasty little digital businesses in the far east. Microsoft swears it isn't interested any more, but who knows? Rather unlikely to disappear down a hole in the next 18 months, so perhaps it is cheap at the price after all. 

Domino's - DPZ:  The pizza delivery firm has seen its share price sink to $2.5 from around $15 over the past few months without any obvious sign of imminent catastrophe. It has also been reported that board members have been frantically buying up the shares at these discount prices. (If Tacos are more your thing then Rubio's Restaurants - RUBO are looking similarly distressed, but right now also less likely to recover quickly.) 

Chico's FAS - CHK and Guess - GES:  Purveyors of expensive ladies' frocks are feeling the pain. Chico's and Guess stock recently shed 80% of their value. These are still good companies and CHK looks cheap at $2.37 this morning (and Guess not so bad at $12.50). 

EWZ - "Brazil, the country of the future....and always will be" goes the old gag. Less than 12 months ago The Economist rather blithely predicted that this time Brazil had enough local consumer demand not to go down with the lurgies as soon as America sneezed, but as it turned out this country of vast potential, along with the other members of the BRIC club, has become a major casualty of wealth destruction in 2008. The EWZ fund  tracks the performance of the MSCI market in Brazil and is today priced at $32, about 70% off its highs. 

Another developing market that has taken a pummeling is China. FXI tracks the Xinhua China 25 index and has dropped in price from $64 to $24 and remains very close to this low today. Nobody really thinks China is yesterday's news though, do they? 

Alcoa- AA and Steel Dynamics - STLD: The slow down in US (and maybe also global) manufacturing has depressed the values of stocks in companies like Alcoa and Steel Dynamics (aluminium and steel production respectively). STLD fell from $40 to $5 and AA from $44 to $7. Both are likely to remain depressed as long as the US economy struggles, but look like solid longer-term bets.

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