By Bob Wood, MMNS
Mercifully, the month of October is over. It will go into the record books as one of the worst months ever in financial history. The wealth destroyed in world stock markets ran well into the trillions of dollars. But the monthâ€™s last week brought a sharp reversal with the Dow Jones Industrial Average shooting higher by 11%. Investors have come out of their shells in search of bargains that such market lows offer. I hope theyâ€™ve been looking in the same places I did!
Trying to pick a bottom as the stock market falls can be hazardous to your wealth. In looking over the Lipper tables showing mutual fund returns for the year, as of the end of October, I see a truly stunning picture. Not one sector of mutual funds remains in positive territory for the year!
Considering my frequent reminders, I hope this latest proof finally makes evident to the last of you the â€œrealâ€ value of asset allocation theories in bear markets. Diversify all you want in an effort to minimize risk and volatility, but, in bear markets, all asset classes are subject to falling in tandem. So much for the magic of diversification!
A value investor who does his own fundamental research may not really care whether the stock market has hit bottom or not. Warren Buffett often mentions that he doesnâ€™t worry about such things. If he can buy a good business at a fair price, a business that he understands in terms of how it does business and makes money, heâ€™s in.
For the rest of us, market risk matters too much to ignore, especially if we are already nursing losses. So we normally wait until the performance charts turn upward before adding risk in the form of stock exposure. The curse of most value investors is diving back into stocks too early during down cycles. I have done that — more often than I care to recall.
Sometimes, though, the risk just doesnâ€™t seem all that great, regardless of whatâ€™s happening in the overall market. When underlying values become extremely compelling, to avoid buying shares is simply just too hard to do. Actually, I never thought Iâ€™d see again in companies or countries the favorable trends that are now in evidence.
Yet, this is one of those times, with the market reversing its downward trend this past week. And I feel the added comfort of large numbers of other investors who are joining me. I hope this trend lasts more than a few weeks, though I do think this rally, if thatâ€™s what weâ€™re seeing now, will be rather short-lived in the domestic markets.
Since asset prices have been beaten down so far, I am compelled to go nibbling around the edges. Yes, we are seeing prices that I didnâ€™t expect to see again. Apparently, they became possible by the sheer tonnage of mistakes made by hedge fund and mutual fund managers trying to hit massive home runs by using too much margin debt (also known as leverage).
Their loss is someone elseâ€™s gain. For example, consider two of the best known mutual fund managers, Ken Heebner of the CGM Focus Fund and Bill Miller of the Legg Mason Value Trust Fund. Both managers maintained aggressive allocations throughout the past full-year of market decline. Both are now licking their wounds, which happens when fund managers lose half of their customersâ€™ money in such a short period of time.
Besides these losses, they are, no doubt, processing a large volume of redemption requests from fund share holders. With so many investors wanting to get out, fund managers are forced to sell even those shares they consider the very best opportunities for profit. So they sell their favorite holdings to raise cash to pay back investors. And here we are, sitting on cash, waiting to buy. Lucky us!
With such a long list of casualties among funds and individual shares, where do we look first? One option is to do what famed investor Jim Rogers does. He looks for what has been beaten down the most and drawn little interest from the investment crowd.
Rogers says that he looks only in the darker corners of the markets for those buys that are just tossed on the floor, unwanted by others. All he has to do, he adds, is â€˜â€™Walk over and pick them up.â€™â€™ Rogers mentions, too, that he is always looking for the window with the shortest line of buyers.
Now, with so many mutual funds sporting losses of between 40 to 50%, not many buyers are lining up at any window, so, again, we are finding almost too many possibilities to choose from. But, in an effort to keep this process as simple as possible, I will go with Rogersâ€™ basic premise: finding what has been beaten down most and starting there.
Those sectors of mutual funds now showing average losses of more than 50%, year-to-date, are led by emerging markets, China region, gold, international small- and mid-caps and Latin America. So how lucky am I? Those sectors have been my favorite places to shop all along! And if those fund prices have fallen that much, Iâ€™m assuming that some individual shares have dropped even more and are selling at shockingly low prices and earnings multiples.
The best part of this picture is that each of those markets has climbed higher today than at the start of this decade. That cannot be said for our domestic markets, as revealed by charts for the S&P 500 or Dow, which now show losses of about 40%, in nominal terms, since the start of this decade. Doesnâ€™t that fact confirm, again — in stark fashion, that the domestic markets are mired in a long-running bear market cycle?
If you are looking for an obvious opportunity, check the precious metals sector. The gold stock index recently fell to about the same spot where it began at the start of this decade. But then, you could buy gold for about $300/ounce. Today, it goes for well over $700. So gold shares prices now compare with those available when gold and silver sold for approximately half of their current prices.
Sure, production costs for metals have risen, but so has the Federal Reserveâ€™s willingness to print money. And we know that process goes on at alarming rates, thus increasing the metalsâ€™ value.
Secular bull markets in places like Brazil, India and other parts of Asia have been interrupted by the investor herd as it goes about its predictable performance chasing. Before long, many will discover that they were late to the party and sell in disgust — once again. Since many hedge funds did the same thing — with leverage added, they have been forced to sell to stop the pain of taking large losses.
Again, their losses are our potential gains. I believe that the emerging markets and commodity sectors — like metals and energy — will also rebound, based on their underlying fundamentals. This will happen once the last of the big losers leaves the playing field.
This scenario reveals how we investors get the chance to buy low. After all, isnâ€™t that what investing is all about? Of course, if you buy into any of these areas based solely on my recommendation and without doing your own homework, donâ€™t expect an easy ride to profits! Always know what youâ€™re buying — and why. Using the â€œvalueâ€ method to make selections helps you when the going gets tough.
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.