The Rude Awakening
Wall Street, New York
Wednesday, March 7, 2007 ------------------------- - A distressed sell or a discount buy?
- All's fair (but highly unpredictable) in love and finance,
- To diversify or not to diversify? And plenty more…
------------------------- Eric Fry, reporting from Laguna Beach, California… Stock market selloffs are normal, explains Bill Bonner, founder of Agora Inc., (and issuer of your California editor's paychecks). "But a normal market is like a normal tornado. Both can whip things up and tip over the outhouse." Lesson #1: Don't sit in an outhouse during a tornado. Lesson #2: When the devastating "F5" winds of volatility begin spiraling through the financial markets, don't sit atop steaming piles of speculative securities. Safety is paramount. A benign, upwardly trending stock market may seem normal…and it is. But it is not any more normal than a violently crashing one. "Normal," in other words, includes both the things that go very nicely, as well as the things that go very badly. It includes both reward and risk; good and bad; joy and sorrow. But during a long bull market in stocks, most investors begin to imagine that a "normal" market is as consistently delightful as a young romance. It is not. Both in finance and in love, adversity is sure to arrive. At some point, roses, caresses and glowing fireplaces will become thorns, hostility and ashes…at least temporarily. When adversity arrives, therefore, every investor - and lover - must decide whether to "hit the bid," or to hang on to his long-term investment. Some bids deserve to be hit. (Cutting losses is a virtue, not a vice.) On the other hand, some offers deserve to be lifted. In the midst of adversity, however, the typical investor, or lover, tends to second-guess his intuitions. When he should be selling as fast as he can, he often "averages down." And when he should be "buying on weakness," he usually makes the grave error of unloading his distressed asset to an opportunistic acquirer. So it is that we investors - and some lovers - find ourselves at an important inflexion point. What should we be doing in the midst of the current turmoil? Should we be hitting bids or lifting offers? Should we buy buying the dips or running from the outhouse? Global stock markets are dropping sharply and gyrating wildly. The Dow's 157-point "one-day wonder" yesterday merely added to the confusion. The prudent course of action is not intuitive, but a few timely observations from Dan Denning might help… ---------------------------- Avoid the Rush…Panic Now!
By Dan Denning "Invest for the long-term." "Diversify." "We are in a period of Great Moderation in volatility, so don't panic." You should probably ignore all these soothing platitudes. Our suggestion is to panic now and avoid the rush later. In other words, sell risk. Don't try to diversify your risk away. Sell it! Soothing axioms barely disguise the truth that markets today are more prone to volatility than ever, and that what we have witnessed over the last few trading days may be just a taste of what is to come. "An investor's two best friends," writes American financial guru Ben Stein, "are time and diversification. Get the broadest possible market indexes. Spread yourself out over large and small caps. Have a large dollop of the developed foreign and a goodly chunk of the developing market. Yes, it'll be a rocky ride in China and Brazil, but over long periods you'll do great." Exactly what portion of your portfolio is a dollop? How do you tell a "goodly chunk" from a "badly chunk?" Here's our beef with diversification, as most folks use the term: The idea of diversification relies on the existence of negative correlations between sectors or asset classes. When X zigs, Y tends to zag. And diversification makes sense if some things go up while others go down. But most financial markets have become dangerously correlated. We can no longer count on bonds to go down when inflation goes up, or gold to go up when stocks go down. Inverse correlations like these used to be more more reliable. Pre-Greenspan, there were certain inter-marker relationships that made sense and that you could prove with real performance data. There were also relationships between risk and reward that seemed more logical than what passes for logic today. In the "old days," way back in 2000, risky bonds paid much higher rates of interest than Treasury bonds. But not any more. Perhaps it sounds quaint today, but the high returns that used to be available on Emerging Market bonds were the reward you received for taking a risk with your capital. If you wanted a safe savings account, you weren't going to make much money in it. But if you were willing to buy Brazilian stocks or Icelandic bonds, well that was another matter entirely. You might be crazy. But you might also be right. And you deserved a few hundred extra basis points for being crazy, brave, and correct. But over the last four years, risk premia have nearly vanished. These days, everyone is crazy, no one is brave, and many people are wrong. We say no one is brave because bravery requires some knowledge or appreciation of the nature of the risk you're taking. Yet no one seems to think investing in shares is all that dangerous. "Corporate balance sheets are in good shape. There's been a sustained decline in macro-economic volatility over the past decade, thanks to structural changes that have improved the ability of economies to absorb shocks and better monetary policy. It is, as then-Federal Reserve Governor Ben Bernanke said in 2004, the era of "the Great Moderation. Such an extended period of calm probably explains investor' bold, risk-happy behaviour," writes Corinne Lim in today's Australian Financial Review. Such an extended period of calm usually precedes all hell breaking loose. Stability breeds instability, as economist Hyman Minsky famously pointed out. There has been a ton of instability-breeding going on in the last few years. We saw the first birth-pangs of instability last week. But not the last. All of this happens for a simple reason, there is too much money chasing too few assets. This imbalance causes prices to rise…and to rise…and to rise, creating the impression that risk is not so risky after all. But this phenomenon doesn't mean that risk has vanished from certain types of assets. It just means you are no longer compensated for taking it. Can diversification save you? What does that word even mean in a world flooded with liquidity and cheap money? How is it possible to truly diversify in a market where there's so much money chasing so few assets that everything is going up? If diversification is based on the observation that some asset classes are inversely correlated (that x goes up when y goes down, and that y goes up when x does down), what happens in a liquidity-driven market (say, one where liquidity is expanding massively, while the supply of assets is not)? When all asset classes start moving up because of excess liquidity, negative correlations tend to disappear. X and Y move up along with A, B, C, D, E, and F. With everything rising in lock-step over the last few years, isn't the risk now that everything will fall in lock-step too? So if you'd like to stay ahead of financial fashions, panic now. Joel's Note: You may already know Dan Denning as one of the "original" editorialists with Agora Financial. Back in the day he, Eric, Bill Bonner and Addison stunned friends and foe alike by extolling the virtues of such "crazy" investment philosophies as gold over greenbacks. Presently Dan resides in Melbourne, Australia, where he has launched the Australian Daily Reckoning. As evidenced in yesterday's Rude Awakening column, "The Australian Renaissance," there is a lot going on Down Under these days. In case you're interested, you can catch Dan and the Aussie DR gang here: The Australian Daily Reckoning --- Volatility Trading Special --- Some traders cower in the face of turbulence in the markets…not this man. Reveling in this year's markets chaos, one trader has turned out a stellar erformance,including: 88% on Newmont Mining calls… 130% on The Monsanto puts… 133% on Allstate puts… Learn his secret trading method and capitalize as the volatile markets poise to pay by reading on right here: ---------------------------------- | 
