September 15, 2008
NIRVANA FOR NIBBLING
If it keep on raining, the levee's gonna break.
Some of these people gonna strip you of all they can take.
--Bob Dylan, "The Levee's Gonna Break"
There's a rumor going around that Wall Street's troubles, which have become every investor's troubles, reach back only a year or so. In fact, the genesis of the mess goes back much further. It's true, of course, that most investors have only been paying attention for the last year or so, thus the rumor.
The unwinding of the great bull market is now unwinding faster, and with devastating consequences. But for those who claim that they didn't see it coming, it's obvious that they weren't paying attention in the 21st century. Excess has been building for some time, and the trend must reverse, as all trends eventually do.
There are many lessons one can draw from the downfall that is now in full swing, but the most important one is the same one that every crisis imparts and that too many investors ignore until it's too late: risk management is the only salvation over a full business cycle.
The bankruptcy of Lehman Brothers, the sale of Merrill Lynch and the precarious and perhaps fatal finances of AIG are nothing new in the grand scheme of economics and finance. Businesses have been collapsing and investors have been losing money since the ancients invented the money game. What's changed in relatively recent history is our understanding of how we should play the game, as we've discussed many times, such as here.
Risk management, in short, is the first and last rule in money management. Easy to say, tough to do, but always and forever essential. Unfortunately, learning this lesson is very, very difficult, if not impossible at times--especially for those at the highest levels of the financial industry.
Risk management has been ignored, or at least manipulated and distorted by too many finance heads, and the price tag is now in full view. Identifying the motivation and rationalization for going off the deep end with inane behavior in managing assets is ultimately an exercise in reviewing the flaws of the human mind as it relates to greed and fear.
The policymakers will soon declare X and Y as the evil sources of the problems, and new legislation will no doubt follow to prevent a repeat crisis. Make no mistake: there's much that can and should be done. It's now clear, for instance, that letting large investment banks go to extremes in betting on mortgage-related derivatives is an idea right up there with drinking while driving and taking a bath in an electrical storm.
The only bright spot in all of this relates to the investor with a long run time horizon who has cash to buy securities on the cheap. When we say buy, we're talking, as always, of broad asset classes. Long-term prospective returns are rising. That's a function of falling prices. Of course, that doesn't mean that prospective returns won't rise more, which is to say that falling prices may keep on falling.
The question is how many investors will have the discipline to take advantage of the pain? Our guess is probably the same number of investors who were skeptical about the longevity of the previous bull market in everything.
Rest assured that while the details of the current calamity are unique, this is an age-old process that will one day end. The U.S. economy and indeed the world economy aren't going to collapse, although they'll come out of this a bit lighter in terms of financial institutions and some oother select assets.
Indeed, the center of asset destruction is finance and related industries, which expanded too far based on what could be sustained economically. It's all about trimming the excess, and as our post from last Thursday reminds, the trimming of finance's sails has been unfolding rapidly of late. But just as the excess in finance went higher and lasted longer than reasonable minds expected, the correction in finance will do the same in reverse. Patience, and cash, will come in handy in the months and years ahead.
Today, this week promises to be a watershed in that ongoing correction, perhaps in ways that nobody currently can fathom. But it's all natural and necessary. The only question is how and if strategic-minded investors will benefit. The prudent answer is to continue nibbling at the asset classes that are battered, i.e., equities. Broad-based equity indices, such as the Russell 3000 and MSCI EAFE are hurting, and they'll probably bleed more in the coming weeks and months. No, we don't know where the bottom is, nor does anyone else, but we know it'll arrive eventually. Prudence suggests buying before and after the trough. We'd prefer to buy at the absolute bottom, but we've yet to receive an email alerting us to that glorious moment and so we proceed to plan B.
But there will be clues, albeit vague and obscure but clues nonetheless. Just when the outlook looks darkest, the value is probably at its highest. As such, now may be the time to nibble here, nibble there, if only marginally so. Keep enough cash on hand to nibble again in six months, 12 months, 24 months. But by all means nibble. For those with a long-term view, there's really no other game in town.
Posted by jp at September 15, 2008 9:54 AM