<< Return to Part II
In Part I of this series, I gave a short description of the early press reactions to the emerging subprime problem at the end of 2006 and the beginning of 2007. I then explained my reaction as an investor, which was quite sound-adopting a selling program in May. Unfortunately, as I explained in Part II, either I changed my mind or became undisciplined in my investing. I was a net buyer in June, July and August. Wrong. Wrong. Wrong. As I said.
In this third and final chapter about 2007, I will try to rehabilitate myself somewhat by describing better decision-making in October, after achieving a better understanding of the real estate problems in September.
Word Reaches the White House
By the end of August, word that there might be problem in the real estate market even had reached the White House. And from some quarters, calls were coming for the government to assist homeowners. "It's not the government's job to bail out speculators or those who made the decision to buy a home they knew they could never afford." The President said. Lenders have "a responsibility" to help people keep their homes by renegotiating mortgages, he continued. "There are many American homeowners who can get through this difficult time with a little flexibility from their lenders or a little help from their government, so I strongly urge lenders to work with homeowners to adjust their mortgages." As reported in the FT September 1, 2007.
Super Conduit Nonsense
In September, Secretary of the Treasury Paulson began floating an idea called a "super conduit," subsequently dubbed an "M-LEC," a government-backed fund that would buy up vast amounts of toxic securities from the banks. This proposal really spooked me because it suggested that the Administration was prepared to bail out the banks with a head-fake-that is, purporting to pay market prices for the bonds but actually buying them for significantly inflated prices on the ground that the market was illiquid and therefore not a proper reflection of value. (The Treasury revived the super conduit idea time and again, including making it the original basis for the TARP in September 2008.)
Depth of the Real Estate Problem
In September 2007, I began to look at the real estate issues more closely, and that spooked me more. I saw that unless government did something significant-and probably radical-the U.S. real estate market was going to crash, particularly in the states where price increases had been greatest, such as Nevada, California, Arizona and parts of Florida. It was clear that prices had to go down. But it also was clear that panicky markets overshoot and that gridlock would result, with very bad impacts on the overall U.S. economy. I began to advocate a form of government intervention. But the U.S. Government was set against assisting people. People had to live with their mistakes. Moral hazard etc. Assisting banks was okay.
Selling Stocks, Raising Cash
By mid-October, the stock market was at a new high, and my confidence level was at a new low. Between October 10 and October 22, I executed 35 sell transactions, culminating with 19 on October 22. "Raising cash," "Fear consumer-raising cash," my notes say time after time.
I have been a China investor since the late 1990s. But I sold about half my China holdings, saying "China hi-raising cash" or "China frothy." I also sold some of my Indian mutual funds, again on the ground that the market was too high. These turned out to be good calls because the funds I sold are around half that value today, as I know well because I did not sell my entire holdings.
On October 22, I staggered out of my study, exhausted from the selling spree that had trimmed my equity portfolio by about 25% in one morning. My wife said I looked dazed. But that was the best day I have ever had in the stock market because I, a confirmed long-term bull, had overcome my inertia and emotion and acted bearishly. It was, frankly, an emotional trial even more than an intellectual one.
The market's intraday high, based on the S&P 500, had been October 11. By the time I had finished selling on October 22, it was off only a couple of percent. I had not missed the top by much.
Some Lessons
What should we learn from this process that I went through in 2007?
- First, if we did not know it before, markets do not take good account of macro factors. They have momentum that propels them to unsustainable highs and, as we learned in early 2009, to unsustainable lows. They may be fairly good at evaluating individual companies, but it is macro forces that make the greatest differences in stock and bond prices. Asset allocation therefore must be very flexible if we are outperform over the long term.
- Second, radically changing one's asset allocation based on one's assessment of macro factors is difficult emotionally. Only very seldom are we certain about such things. After all, we are saying that the rest of the market-hundreds of thousands of investors-are wrong. How could we be right in the face of so many contrary opinions? Nevertheless, if we want to buy low and sell high, we have to act on our convictions about the macro factors that will affect the markets in the future. By the time those factors are obvious to everyone, we may have lost our advantage.
- Third, the opportunity to make big adjustments to asset allocations does not come every day. We have to have an everyday philosophy that straddles the possibilities until we see a clear opportunity. Then we must seize the moment, however difficult that may be.
This is the last of Tales of the Buy-Low, Sell High "Summer 2007" series. Another time, I will pick up with my embarrassing 2008 and how I lost my way again because I believed that the markets had factored in the bad news. WRONG again. As I should have learned from 2007, the markets seem not to be as smart about the big picture as they should be. Perhaps that is because there are so many index funds and closet index funds that cannot change their asset allocations. If those funds dominate the market for stocks, then we flexible individuals who seek to buy low and sell high should have a tremendous advantage. We merely need to become more confident in the face of market rigidities.
I hope you have enjoyed and found this series about 2007 useful. I intend to publish additional Tales of the Buy-Low, Sell-High Portfolio, both looking backward at other crucial junctures and forward by analyzing current investment opportunities. Your comments are useful in telling me what you are interested in, as well as in furthering my knowledge and understanding of the complex investment world that we all do our best to navigate. Thank you for them.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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