Note: Professor Fleckenstein provides his commentary for educational purposes - his insights are not intended as investment advice. You can find his daily comments at www.fleckensteincapital.com
Lesson About Mr. Market from Mother Nature
The murderous, devastating, epochal tsunami was not a financial event. But--to those of us who make our living in markets--it could not help but provoke thoughts about financial risk. Richard A. Posner, a judge of the U.S. Court of Appeals for the Seventh Circuit, in a fine Wall Street Journal op-ed piece this morning, put his finger on what the new year may hold for our overextended markets: "a disaster that has a very low probability of occurring, but that if it does occur creates enormous losses." The judge was alluding to geological events, but he might as well have been talking about financial ones.
Finding Fault Lines Beneath Wall St.
It seems to me that financial insanity is rampant. Folks are speculating in houses, with many having more than one real-estate investment due to the financing that's available and the belief that real estate is now bullet-proof. Insanity pervades the stock market generically, and Internuts/single-digit midgets (with no real businesses) specifically. The fact that Google could have a $50 billion valuation is a sign of the times.
If one looks at credit spreads, they are also at record lows. And then, I see Fannie Mae at $71, barely flinching after the discovery that the company manipulated their earnings. Whatever people think of their business prospectively, it won't be the same as it's been in the past, So, I just shake my head and say, there's not one pocket of insanity - it's everywhere.
Complacency, vs. Contemplating the Unthinkable
Coming back to the earthquake/tsunami analogy, I continue to believe that our stock market is the financial equivalent of an 8.0-plus earthquake waiting to happen. The fact that it has not happened doesn't mean it won't, any more than the fact that the Indian ocean was earthquake-free for so long didn't mean it was immune to this enormous tragedy. Furthermore, I also believe that the speculation I have detailed over the course of the last couple years has only guaranteed that whatever damage is slated to befall the stock market has only gotten bigger by the month.
So, the question you have to ask yourself is: If you knew that a place was vulnerable in the not-too-distant future to an earthquake and tsunami, would you go there? Most likely, the answer would be: of course not. Similarly, if you knew that a financial market was prone to epic dislocation, would you aggressively allocate money to that market? My guess would be no.
However, the timing of such events is very hard to predict. The longer markets do well (especially in the face of bad news), the more people believe that nothing bad can ever happen. (Of course, sometimes markets "defying" bad news means the news is going to get better. However, when the news doesn't improve after a market has gone up, the stage is set for disaster.)
That is where we find ourselves today, with our stock market and, by extension, our real estate market and the economy. I don't believe that there has been a moment in time in the last 50 years where the stock market has been more lopsidedly tilted toward all risk and no reward. This year, when problems start, they are liable to get out of control very quickly. Given that I believe the stock market is a dislocation waiting to happen, the knock-on effect (i.e., the tsunami that comes after it) will be enormous and far-reaching.
Japanese Food for Thought
It occurs to me that as long as I'm talking about analogies, a potential analogy for our stock market in 2005 might be the Nikkei in 1990. I remember that in the last quarter of 1989, a year when I was short Japan, the fundamentals had started to deteriorate markedly, but the market kept going up. It closed on the high tick in 1989 and opened up 1990 by going straight down, something that was rather unusual for that market - and something that could be occurring right now. Obviously, two days don't make a trend, but it is a parallel worth considering. With all due respect to everyone whose life was affected by the tsunami in the Indian Ocean, I judiciously submit that that is the appropriate stock market analogy for folks to try to get their mind around for 2005.
Red Dawn of a Down Day
Turning to the market action, the early going today was a follow-up of yesterday's poor performance. Should the slide continue this way, pretty soon people's hands will start to be forced. We'll see how quickly 2005 turns to trouble for the bulls, who've had it their way for quite some time, especially in the last four or five months, even as quite a good number of the fundamentals get worse, not better.
The Sox was the lead sled dog to the downside in the early going, as it followed through on yesterday's swoon. For those who care, that is where I continue to have almost all my short exposure. I have maintained a decent short exposure for the last couple months because the specifics of the companies that I follow continue to deteriorate, and I believe the macro environment is getting worse. Rather than try to trade my way around my positions, which I often do, I have chosen to just sit with my shorts as investments, something that I have rarely done in the last five years.
Nevertheless, I think that this year, it might be more possible to be an investor on the short side than the gorilla-fighting trader one often must be, though that will only work if one is in the right names, which is not so easy to know in advance.
Requiem for a Rally
In any case, the early-morning undertow continued all day. Though we saw a small bounce in the last hour, the market went out not far off its lows. While the Sox was the early leader to the downside, it did manage to close down about 3%. Housing stocks were roughed up even more, down about 5% apiece. Large declines were also seen in some of the heretofore speculative favorites like Travelzoo (TZOO), Research in Motion (RIMM), and of course Google (GOOG). In addition, volume was very heavy for the second day in a row, especially on the downside in over-the-counter land. To see huge volume on the downside at the start of the year is pretty rare indeed, and I think indicative of the trouble that lies ahead.
A Dollar-Short on Sabbatical
Away from stocks, the dollar continued the correction it had begun as soon as the new year started, with the euro again getting smoked for over 1% and the dollar index bouncing almost 1.25%. While I was gone, I sold the last of my euros. For the moment, I don't have any FX exposure, except to the Canadian dollar. I absolutely intend to re-add to my dollar short, in the form of currencies.
Yesterday, Justin Mamis penned a brilliant discussion of the dollar and the big picture of currency psychology. It's one of the best all-encompassing pieces I've ever read by a financial market practitioner. In the next couple days, we will post it in its entirety on the site, and I encourage everyone to read it more than once.
I have not reduced my exposure to gold, which has been pummeled in the last few days of the new year. There, too, I will be looking for signs that the correction has run its course, and I intend to buy more. (Today, I bought both gold and silver, but I have no strong conviction about whether this correction is 25% or 75% over.) As for the precious-metal stocks, they have continued to trade poorly. When gold turns around, it will be interesting to see whether they are able to outperform the metal on the upside, which they did in 2003 but not in 2004. In short, I believe that a recipe for profits in 2005 is going to be: short stocks and long the currencies (not advice), but I think that in 2005, the metals will actually outperform the currencies.
Of Dollar Bears and Curve Balls
On the subject of the currencies, I noticed that the last issue Forbes carried a story about Warren Buffett reiterating his long-term bearish view of the dollar. So let me be clear about that: My long-term view has not been shaken one iota. My decision to sell my currencies was simply to reduce my "exposure" a bit while I held onto my metal. Obviously in hindsight, I would have been better off selling the metal and hanging on to the currencies. On the other hand, if I was right all the time, I'd have all the money in the world. VBG.
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