Optimism and Pessimism

By Bob Wood, MMNS

By now it’s pretty clear that the state of the U.S. economy is anything but sound, strong or the envy of the developed world, as we have so often heard. The demise of some of our largest financial institutions like Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual and, potentially, AIG and Citigroup should dispel any optimistic talk coming from Wall Street promoters. Oddly enough, the ramifications of these failures still haven’t hit home for some investors.

I hear weekly, anecdotally, that some investors are eager to cash in by buying what they perceive as bargains in fallen financial shares. I know as well as anyone the temptation of seeing shares selling at steep discounts compared to their prices from just a few months ago. Who doesn’t look at shares of Citigroup selling for under $20/share without thinking “This must be a wonderful opportunity to profit”?

Or how can you sit there, seeing shares of Washington Mutual selling for about $3/share without calling that “worth a gamble”? As a result, almost every week we see a sharp rally in the financial sector based on the optimism that “some entity” will come to the rescue, sending those shares soaring higher on the ‘’good news.’’

Stock market promoters appearing in the financial media, along with some aggressive touting of these shares and their rebound potential coming from brokers and financial advisors, add even more energy to those rallies. They, too, fuel hopes that investors might make a lot of money quickly by assuming that the worst is behind for those companies.

Optimism is wonderful, but it is no substitute for rational analysis. Perhaps those peddling such shares as “great buying opportunities” are the same people who, until recently, dismissed the idea that the financial sector was in any trouble.

Of course, with virtually no sector of mutual funds in positive territory so far this year, opportunities to profit are scarce. So we can almost excuse those tempted to catch distressed shares and play them for a rebound.

But the facts argue too forcefully against even considering such shares now. Take heed: avoidance is the best policy. Many other alternatives exist for investor consideration, rather than relying on hope to carry the day. When some of the biggest, most profitable financial firms in the U.S. are going broke within just a few months, we have to assume that problems in the financial arena are too big to paper over.

When our government commits unknown amounts of money, that it doesn’t even have on hand, to shore up Fannie and Freddie, we should assume that problems are bigger than Wall Street has been admitting. Perhaps the best thing an investor can do right now is simply walk away. We don’t see Warren Buffett jumping into any of those shares, do we? As of today, he has not.

Maybe the most amazing part of this situation is that another bankrupt entity, the Federal Government, is viewed as the most sensible savior to a bankrupt industry! Right now, our government must borrow over $2 billion/day from foreigners as it attempts a bail-out of the mortgage market. Yet the government’s efforts are called by many as “Just the right medicine.”

I’ve seen pyramid schemes that have presented more viable opportunities than what we are seeing now. Maybe we truly have become a nation of corporate failure, shoved into bankruptcy by corrupt and inept leadership, with costs to be borne by taxpayers, many of whom have conducted their own finances responsibly.

You may be inclined toward optimism, but with the way these investment propositions are being sold, shouldn’t we assume that this is the “last ditch” bit of rationale left to the sellers and promoters of those shares?

Pessimism, on the other hand, may well light the way to some truly meaningful investments. With domestic markets in turmoil, some wonderful opportunities are developing in other places and certain sectors.

For example, the commodity bull market has hit a wall, and, with the price of oil falling about 40% in recent weeks, some energy company stocks are selling at big discounts compared to the S&P 500 average multiple. Also, since the gold sector has been hit hard, shares in gold mining stocks are now selling at prices reminiscent of those in late 2004, when gold was going for about $465/ounce.

A stock that has performed well for me in the last several years, Brazilian iron ore miner Vale Do Rio Doce (RIO), has seen its share price cut in half in recent weeks. But the company is experiencing another great year with its Chinese customers agreeing to massive price rises. Yet RIO company shares now sell for about six times this year’s earnings estimates!

Another opportunity might well be found in shares of Anglo American (AAUK), the British producer of platinum, coal and industrial metals. This stock, too, has been hammered, falling from a $36/share high earlier this year to about $20 as I write. The forward P/E on that stock is about five!

Some interesting, though risky, possibilities are also appearing in Asian markets, You may have noticed that China’s stock market is one of the world’s worst performers so far this year. It has fallen from about the 5,000 level to today’s 2,200. That drop has affected other Asian markets, too, and some seem priced much more reasonably than our home market –with less risk, as those markets are better managed and more viable for the long run.

With our domestic promoters desperate to find ways to sell stocks and funds, they have begun bad-mouthing European markets. Since those markets slowed down after ours did, they say, it must follow that the U.S. economy will rebound sooner, making home markets a better play for investors. Don’t believe it for a minute!

Even if what they say were truly the case, it wouldn’t justify our home market’s rich pricing compared to that of many European markets. Selling at about 21 times earnings, isn’t the S&P 500 priced for economic perfection? With about half that valuation metric, Germany’s market appears to be a much safer bet. And look at some of the Northern European markets, which sell for even lower multiples, with a truly pessimistic set of assumptions priced in. Any good news might boost those markets meaningfully.

My advice: sell optimism, and buy pessimism. Remember your best winners from recent years? How were you able to buy those shares at such low prices? You had to be willing to go where most others would not go or simply weren’t aware of. If you aim to buy low, look where pessimism is highest and wait patiently for your opportunity. But be sure to do your research first! If you buy them on my recommendation and lose money, don’t yell at me. I’m probably losing money on them too!

If you like buying high, look where assumptions and sales talk are coated with layers of optimism. Doesn’t this makes a very weak case for investing? If you’d rather buy low, look for where the pessimism is high but the underlying fundamentals are good.

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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