The Stock Market: Sell in May and Go Away?

Now they tell us. While a couple of Federal Reserve governors have recently talked about green shoots in the economy and the like, the Fed staff predicted in April that the economy would get worse than expected earlier this year. It's not as bad as W and the WMDs in Iraq, but you'd think that by now senior federal officials would realize it's not a good idea to say one thing when their staff are saying something contrary. After the release of this information, the Dow Jones Industrial Average abruptly dropped about 100 points, from around up 50 to close down 52.

Now that all of us with market exposure have lost some money, the question is what to do. Those with rose tinted glasses would say we just got a buying opportunity. However, there's an old adage in the stock markets: sell in May and go away. It refers to the fact that the market often is flat to negative during the summer months. September can be volatile (either upwards or downwards). October has the deserved reputation as the worst month--not every or even most years. But almost all the big drops since 1929 have occurred in October. No one knows why (and anyone who claims to know is a liar, a fool or both).

Having said all that, there's no way to predict the current market. Stock values right now pretty much depend on governmental policy--the more government intervention, the higher the market goes. That's why the market rose from March 6 through a couple of weeks ago: the federal government fired up a bunch of programs and the Treasury Dept. and the Fed did so-called "stress tests" of the 19 largest banks. There's no major governmental action in the offing, although some of the federal government's programs will probably intensify in the next six months. The underlying economy is in bad shape and getting worse. Some people think it's getting worse at a slower rate than three months ago, and take heart from that. But getting worse is still getting worse. The credit markets are thawing slightly, but only because the federal government has de facto guaranteed the liabilities of the major banks (which comes very close to nationalizing them, although no one in government wants to admit to that). In short, the U.S. economy and the world economy are in bad shape, with no clear sign of recovery any time soon.

The federal government, for all its programs, still hasn't solved the two baseline problems in the financial system--an extremely ill housing market and trillions of dollars of unbooked losses lingering on the books of the banking system. There is no real cure for these problems that's politically feasible (California's voters just rebelled over a state deficit of some tens of billions of dollars, so there's no way America's taxpayers will pony up the trillions needed to cure these baseline problems).

If you invest now, you might be ahead six or twelve months from now. But no responsible adviser would give you assurances about that. You might also be sitting on top of serious losses (especially if the world economy keeps sliding the way it has so far this year). You should be prepared to wait at least ten years for meaningful returns (net of inflation). One way of looking at things is that you could invest today in U.S. Treasury ten-year notes and get about 3.2% (after commissions) per annum for 10 years. Will the stock market return more than 3.2% per annum for the next ten years? Unclear. It's lost close to that much per year during the preceding ten years. Perhaps after ten years, the market will have had a decent chance to show meaningful gains above 3.2% per annum (although we wouldn't predict that). But if you might need the money some time sooner than ten years, you should think about keeping it out of the market and putting it in something safe like U.S. Treasuries. It could take 20-25 years for the stock market to recover, net of inflation, from the current mess. The last time something like this happened, in the early 1970s, the market didn't recover, net of inflation, until about 1991. And the market didn't recover from the 1929-1932 crash until the mid-1950s.

Some people are predicting the Dow could drop to 4,000. While that may seem far fetched, can it be ruled it out? What's already happened is no more far fetched. If you can't stomach the possibility of serious losses on money you invest today, stay out of the market. It's easy to regret the gains you could have had if you had a little more nerve, but it's really hard to recover from the losses you didn't expect. The best financial planning today is to spend less and save more. That generates an immediate increase in your wealth.

Beware the Herd Behavior of Bulls

Bulls, and other cattle, run around in herds. Participating in herd behavior is risky, because herd animals don't think for themselves. They just follow everyone else. In the stock markets, that meant riding the Dow up to 14,000 and then down to 6,500. The conventional wisdom (read, herd mentality) is that you shouldn't try to time markets. Yet, every contrarian who sold while the Dow was high, or simply stayed out of the market since 1996, outsmarted the herd.

Of course, no one wants to miss out on the market's recovery. That's why the market had such a sharp snapback after the Dow dipped to 6500 a couple of weeks ago. But sharp snapbacks reflect herdlike investing--a lot of people jump in because other people are jumping in. The short sellers add to the buy pressure by covering their shorts whenever they smell a snapback. But if there's one thing that's repeatedly ambushed the herd during the current recession, it's that sharp snapbacks have proven illusory, serving as preludes to new market lows.

That hasn't been for technical reasons. It's that things are bad in the nation's and world's economies. The stock market ultimately reflects the underlying economy. Recently, the government has been putting out positive news about relieving banks of toxic assets, pumping cash into the consumer loan markets, and spending yet more, this time through the federal budget bill. And some recent statistics about durable goods orders and recent home sales haven't been quite as appallingly bad as expected. But you can't have a healthy stock market based on government spending and a couple of very bad, but not horrendous, statistics. If the stock market is to truly recover, the free enterprise part of the free enterprise system has to be doing well. There, however, the news is less glowing.

Commercial real estate is sliding fast, following in the footsteps of residential real estate. This complicates the federal banking regulators' tasks, because commercial real estate loans are a staple of hundreds of medium sized banks. The derivatives-based problems of the major banks could be dealt with through contacts with a handful of formerly very well-paid CEOs. It will take an army of regulatory staff and probably many billions more from taxpayers to cope if the commercial real estate downturn causes banks to collapse.

Trade protectionism is on the rise. Trade barriers of various subtle or not so subtle designs are springing up like dandelions on a well-watered lawn. Things are happening so fast that they may have already slipped out of control. It's unlikely the upcoming G-20 meeting will produce any breakthroughs. In anticipation of the meeting, fingerpointing and recriminations are already in the air. The G-20 meeting is more likely to illuminate differences among the 20 than any unity of policy.

International trade is wilting. Among other things, the Japanese economy's exports have fallen by almost half, compared to a year ago. The Chinese are struggling with millions of newly unemployed, without the unemployment compensation programs that, in the U.S., keep the jobless from becoming immediately desperate. If the major exporters make fewer sales in America and elsewhere, they'll have less money to buy U.S. Treasury debt. Unlike the Federal Reserve, they can't print dollars to fund the Treasury Department's borrowings. If international trade continues to stagnate, we could easily all become poorer.

U.K. Bond Auction Fails. A recent auction of 40-year U.K. government bonds received bids for 93% of the bonds being offered. By contrast, the U.S. Treasury's auctions are routinely oversubscribed. While, by itself, the failure of one U.K. bond auction of a really long term maturity doesn't signal the need to boost one's supplies of freeze-dried food, water and camping equipment, it's rather troubling at a time when government action is the only game in town for reviving the world's major economies. If the U.K. continues to have funding problems, guess who might have to bail it out? (Hint: look in a mirror if you're unsure.) This isn't a theoretical point. The U.S. "loaned" the U.K. an enormous sum of money via the Lend Lease Program during World War II and didn't get repaid. We've bailed out the U.K. in a previous crisis, and it's not inconceivable we might have to do it again.

Cognoscenti skeptical of Geithner's plan. Many, and perhaps most, of the more discerning commentators have expressed concerns about the effectiveness of Secretary Geithner's toxic asset purchase plan. While it's clear that he'll give the ranch away to hedge funds and other institutional investors for participating--which is why they're now signing up--the plan doesn't resolve the devil that's been hidden in the details all along: how do you set the purchase price of the toxic assets? The banks will want the highest price possible, while the private investors will want the lowest price. If the buyers offer too little, the banks may keep the dodgy stuff on their balance sheets, thereby undermining the plan. Banks may resist regulatory pressure to sell at significant losses, since that would require them to recapitalize with current shareholders being diluted. And if the recapitalization is funded by the taxpayers (which is likely to be the case), then executive compensation and a lot of other aspects of banking will be dictated by the government. That's fair from the standpoint of the electorate, but not much to the liking of bankers aspiring to a mansion in the Hamptons.

Put some cash in the market now, if you like. But remember that it could easily become a long term investment if the economic picture follows current trends. Herds can stampede over cliffs if they don't watch where they're going, and there's no certainty that the current rally isn't headed toward thin air. Corporate earnings reports for the first quarter will start coming out next week and the G-20 meeting begins the following weekend. We'll soon know more.

Prediction for the Financial Markets in 2009

If you look at a few financial websites, you'll read that the stock market will dip at the beginning of this year, and then recover, ending the year above its current levels. Or you'll learn that the markets can be expected to rally at first, only to drop off sharply in the second half of the year. Or you'll be told that the markets will rise, drop and then rise again. Or that they will drop, drop some more and then drop even some more.

We would predict that almost all the predictions will be wrong. Of this we are certain. And here's why.

Governmental and political action will have greater impact on the financial markets than anything else in 2009. Consumer demand will stagnate. Business investment will be muted. Bank lending, these days, is almost an oxymoron. The only show in town is the government--or more precisely, the governments of all the world's economic players. And almost nothing is as unpredictable as government action or inaction, and their consequences.

We can expect some sort of big stimulus package from the Obama administration. But will it work? Comparable measures in Japan in the 1990s were ineffective; and there are many similarities between the U.S. today and the Japan of 12-15 years ago. Massive losses were sustained in the real estate and stock markets. The government avoided making the financial sector face up to and write off all its losses. Consequently investors felt constrained not to invest in banks whose balance sheets were opaque (on the accurate assumption that the banks were actually insolvent). Unemployment was rising rapidly even while the social safety net was increasingly strained. Consumers avoided unnecessary spending, and saving became the order of the day. Japan also had a strong export sector. Consumers in other nations, especially America, did much to prevent a collapse of the Japanese economy. The U.S. does not have as strong an export sector today, and the continuing volatility of the dollar and disappearance of trade financing threaten to cripple America's export industries.

The Obama stimulus package should focus on assisting and strengthening the real economy. Between TARP and the Federal Reserve's money printing presses, the financial sector has soaked up enough trillions of taxpayer dollars. The money flooding into the financial sector isn't finding its way into the hands of consumers and businesses. It's time to disintermediate the financial intermediaries and put money directly into the real economy. A large degree of stimulus by the U.S. government shortly after the 9/11 bombings in 2001 did prevent the U.S. economy from nosediving into a major recession, although the Federal Reserve made the horrendous mistake of not withdrawing the extra liquidity it provided quickly enough, producing the real estate and credit bubbles that have now devastated the U.S. financial sector. It's just possible that the Federal Reserve's measures, plus TARP and the Obama stimulus package, might revive the U.S. economy. But we'd predict that the Fed won't have the guts to withdraw the extraordinary levels of liquidity it's now providing, because no one likes to take away the punch bowl just as the party really warms up, even though astronomical hangovers will be the alternative.

Even the best efforts of the U.S. government, though, can be confounded by international developments. Other nations are throwing up trade barriers, by trying to weaken their currencies, raise tariffs, subsidize their industries and slow the movement of imports off their docks. In a time of recession, national protectionism is a game of musical chairs. When the music stops, there won't be enough chairs for everyone. Indeed, in the worst case scenarios, there may not be chairs for anyone. But political pressures within each nation force its government to protect its own citizens, even if the overall worldwide effect is to worsen the recession. Thus, the best efforts of the Obama administration may be undermined by other nations. In the mosh pit that will be the world's economy in 2009, there's no way to predict how things will go for anyone.

So what does an investor do? Stay diversified. Okay, diversification didn't work in 2008, when virtually all asset classes fell in value. But any investment strategy will sometimes fail. Unless you believe in Bernie Madoff, you won't find an investment strategy that doesn't involve losses sometimes. Diversification is like capitalism--it's imperfect, but better than the alternatives. Today, you should think about being more conservative, keeping some dry ammo in the form of extra cash. Use this cash opportunistically when good potential investments pop up. Meanwhile, concentrate on that New Year's resolution to lose the love handles, and you'll have a way to get something positive from 2009.