I like using idioms, especially when referring to idiots.
We are coming off a week with market losses of seven and eight percent respectively on the S&P 500 and the NASDAQ. Then Standard and Poor’s downgrades our nations credit rating from AAA to AA+.
Setting the Stage
Our elected officials have had repeated opportunities to serve the best interests of their constituents and have repeatedly betrayed us. In 2008, our elected men and women of honor saddled us with TARP, even though 90% of the voters did not want them to approve it. Do you remember all the lies told to us about how this was going to help get us on track to recovery and promote their marvelous Keynesian beliefs in job growth?
Then we get the failed Quantitative Easing 2 (QE2) administered by a person we didn’t elect. Comrade Bernanke told us in his Washington Post editorial that it would “promote economic growth”. In short, our government has spent over $3 trillion on bailouts to help Wall Street. But where have the politicians been during this wholesale treachery of our trust?
Democrat or Republican, Coke or Pepsi, there is no difference. Have we really become so blinded by corn syrup saturated rhetoric between red or blue that we believe it?
The politicians had an opportunity to right the ship and push for a balanced budget amendment. Instead, they drank their respective hypoglycemic spiked drinks and wet the bed, our bed and our children’s and grandchildren’s.
Imagine your listening to Clark Howard or Dave Ramsey. Someone calls in needing help and advice. The caller has accumulated substantial debt and can no longer make the minimum payments on their credit cards and struggling to keep their mortgage current. The solution offered to the caller is to go get another credit card to help pay the bills. Brilliant strategy right?
The Market Reacts
The result of all this is a flight from risk. What this looks like is exactly what we are seeing and have seen before. When there are more sellers of stock than buyers, the stock prices decline. Moreover, not all stocks are treated equally, as investors see some stocks more risky than others. Naturally this begs the question “what makes one stock more risky than another?”
Stocks with more risk
- A company in the area of discretionary spending. When your dollars become more scarce, are you more likely to buy food staples or high priced cosmetics? Oatmeal or $50 face cream? Even though this is a simplified explanation, I believe it captures the point.
- Companies selling capital equipment. In good economic times, companies will expand their operations by buying new equipment. Conversely, in recessions, companies are reduce or stop capital spending. Most households operate the same way. A new car purchase or home will be put on hold for several years.
- Companies that carry a high debt load is less desirable than a company that has no or little debt and ample cash reserves for operating.
- Companies with negative cash flow carry higher risk than companies with positive cash flow. Negative cash flow drains a companies balance sheet.
- Companies in an industry with many competitors. When sales in the industry declines, everyone becomes more competitive and cuts prices, thus putting more downward pressure on profitability.
- Companies with high valuation multiples. Investors question these companies with high price to earnings (P/E) as to their ability to sustain growth in the economy as well as question the quality of their earnings.
- High beta stocks. Beta is the measure of a stock or mutual fund’s sensitivity to market movements. The beta of the market is 1.00 by definition. If a stock has a beta of 2, then if the market goes up 10%, presumably, the high beta stock would go up 20%. Likewise, if the market goes down 10%, that stock should go down 20%.
While the above characteristics help outline riskier stocks and why some stocks may fall more than others, the larger question you are probably asking is how far the market will fall before we establish a bottom? I wish I had a crystal ball to give you a definitive number. Short of the crystal ball, I can offer my opinion.
I use a term “bloody bottom” to describe when stock prices are trading at or below what a company has in cash on its balance sheet. We’ve seen some of these bottoms in 2002, 2008 and 2009. As of Friday, we are not yet at these levels. Please don’t misunderstand my opinion as a statement of market timing. Market timing does not work. What does work as a long term investment strategy is identifying good companies and buying them at discounted prices.
While nobody can determine where the market is headed in the short term, I’m seeing opportunities starting to arise for accumulating shares of companies and industry groups. The caveat here is the word “short-term” because it will take time, new leadership and economic policies to steer our economy in the right direction. We need wholesale changes in Washington and true supply side economic policies that will attract and keep capital (smart people with their smart companies) in the United States.