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Managing Fear and Uncertainty

It is safe to say that the crisis on Wall Street has reached a fever pitch recently and unfortunately, is causing many investors to succumb to fear. As usual, the media isn't helping the situation as many commentators would have us believe that the sky is about to fall and investors should throw in the towel right this very moment.

Therefore, in this weekend's big picture missive I'd like to (1) pass on what we've learned from previous bear markets, (2) review the key points to this Wall Street crisis, and (3) let you know what we are doing to combat the current market environment.

So let's get started. First, while it may sound trite, I'd like to remind everyone that this is not the first time the markets have become engulfed in panic. And I'm pleased to report that the market has always recovered... it's just a question of how long the comeback has taken.

I have been managing money for clients since the mid 1980's which means that I've survived a difficult market or two. My challenges with big declines have included the Crash of '87, the S&L Crisis, the Emerging Markets crisis, Gulf War I & II, the collapse of LTCM, the attacks of 9/11, and the great Tech Bubble Bear Market of 2000-03. And in all honesty, the single most important thing that I've learned is that, as Abraham Lincoln once said, "This too shall pass."

I have also learned that it is VERY tempting to succumb to emotions and sell everything when things look bleak. However, I can say from experience that selling out after a big decline is actually one of the worst moves investors can make. There is no way to turn back the clock and to take a different course of action now that you have the benefit of 20-20 hindsight. So, give yourself a break and let's deal with what is happening now instead of fretting over what you wished you had done before.

The Cost of Selling Now
I completely understand that it may feel better to just say "I've had enough" and move your accounts to cash after a big decline. But, given that the average bear market lasts a little more than one year (406 days to be exact) and causes losses of -30.8%, does it really make sense to bail out after the Dow has spent most of the past year dropping -25%? So, while it is easy to be swayed by the doom and gloom that is being espoused by the media, it is very important to remember that it usually doesn't pay to heed your emotions when dealing with the markets.

While we're on the topic of looking back in time, there is another important statistic that I would like to share. According to Ned Davis Research, nearly one-half of the gains during a bull market period occur during the first one-third of the new cycle. So, while it may be tempting to give up on your investment strategy and move to cash right now, investors must realize that doing so will likely cause them to miss a fair amount of the next up cycle.

So, if selling now seems like a good idea, just remember that it took the DJIA just 18 months to recover from the 1972 - 74 Bear market, 25 months from the March 1976 - Feb 1978 Bear, 23 months from the Crash of '87, 7 months from the 1990 Bear, and 47 months for the Dow to come all the way back from the Tech Bubble Bear of 2000 - 03. So, unless this recovery is going to be protracted or you have a crystal ball telling you when it's okay to go back into the water, selling everything now could cost you a lot of money in the long run.

A Crisis of Accounting
But enough about investor psychology, let's move on to the causes of the current market crisis. I know that we've covered this a couple of times recently, but it is important to recognize that the current crisis can best be described as a crisis of accounting and is NOT being driven by an economic calamity. It is a shame that just about everywhere you turn; someone on the T.V. can be heard telling you that the economy is in miserable shape. However, this is simply not the case (unless, of course, you happen to work on Wall Street!).

While I won't go as far as some politicians and tell you that everything is peachy keen in the U.S., I think it is worth noting that the US economy is NOT in a recession at the present time and may not technically fall into recession during this cycle. In fact, the Government reported Friday morning that the Gross Domestic Product for the second quarter increased by +2.8%. Sure, this growth rate is down from the readings seen a year ago, but the bottom line is that we have yet to experience even one quarter of negative GDP growth. And remember, it takes two consecutive quarters for the economy to be considered in a recession.

My point is the problem at hand has little to do with the economy and everything to do with the credit markets and the accounting rules by which all banks and brokers must abide if they want to stay in business. Cutting to the chase, the issue here is that the proliferation and the ensuing collapse of mortgage backed securities has wreaked havoc on the balance sheets of banks, insurance companies, and brokers. While I won't bore you with a bunch of accounting rules, the key thing to understand about this crisis is that financial institutions must maintain a certain level of capital on their books. And since the value of mortgage securities and the derivatives thereof have fallen off a cliff - due to the fact that there are NO buyers of these securities - the capital levels of any bank, broker, or insurance company that owned this stuff has taken a massive hit.

Because of the fact that the financial institutions are fighting to find capital to stay in business, banks are no longer lending money - to anyone. Thus, the short-term lending market (which provides liquidity - i.e. the lifeblood of American business) has ceased to function.

So in short, stocks are going down because this situation, if left unattended, could cause the financial system in the U.S. to remain frozen solid. In turn, this could work its way through the economy and create a very serious recession, if not an outright depression. Putting it in real terms, imagine if you couldn't get a loan to finance a new car or furniture, or if students could no longer get a loan to invest in their educations. Imagine if companies like GM could no longer get short-term financing except by paying triple what they are paying now. Yes folks, this would create a BIG problem for the good old U.S.of A.

Turning to the solution, the so-called Paulson Bailout Plan; the public needs to recognize that this plan is NOT about bailing out Wall Street. The brokers that bet big with borrowed money on these toxic securities are now gone and the landscape of Wall Street is forever changed. No, let's be clear about one thing; this bailout is about ensuring that our extremely leveraged financial system continues to function.

And just in case there is any question about the need for or the urgency of the bailout plan being passed, we got a big reminder Thursday afternoon as Washington Mutual (WM) wound up being seized by the FDIC and became the largest bank in history to fail. Yes, JP Morgan Chase (JPM) quickly agreed to buy up the assets of the bank. But, one has to wonder if bank failures aren't going to become the theme of the day if the politicians don't take action soon.

What We're Doing About It
So, what have we been doing to combat this crisis? In short, we are in capital preservation mode. Our goal during this type of environment is to lose the least amount possible. The idea is to try and retain as much of our capital as possible so that we may participate to the greatest extent possible in the next bull market cycle.

Specifically, we have maintained a significant level of cash in our portfolios during this crisis. For example, the majority of our programs currently have between 40% and 60% in cash. Next, we have made every effort to avoid the areas that are being affected the most by this crisis such as banks, brokers, GSE's (think Fannie and Freddie) the leveraged insurance companies, and the consumer discretionary stocks. In addition, we have reduced the position sizes we continue to hold and have taken the less aggressive road when making decisions. In sum, we are being cautious and taking on far less risk than normal.

However, it is also very important to know that, as we have detailed over the past couple of weeks, we DO have a plan to get back in the game. But for now, we're taking up residence in Missouri and asking the market to show us something (a breadth surge) before we commit.

By David D. Moenning
Editor: The Top Gun Trader at StreetAlerts.com