Value Investing / Main Index / previous / next

August, 2007


On or about 7/19/07, the Dow Jones Industrial Average (DJIA) achieved a new record high, closing above 14,000, considered a psychologically significant figure (for we credit big numbers ending in zeros more than others). At the same time, the S&P 500 Index was at or close to a new record, at 1553, and the Nasdaq Composite Index was near a high for the year, at 2721.

But less than a month later, the DJIA is down, as of the closing level on 8/17/07, to 13,079 and briefly had fallen back below 13,000, the S&P 500 stands at 1446, and the Nasdaq is now 2505. Overall, the major U.S. market indexes have fallen around 7.5% from their highs. (At times recently they have been down about 10%, seeming to essentially wipe out this year's earlier gains.) A loss of 7.5% is not so bad, especially if one does not sell but holds on till things improve. However, we had gotten out of the habit of dealing with any significant downturn at all.

Meanwhile, volatility, long minimal before 2007, is back with a vengeance, single-day triple-digit rises and falls now common. Again as of 8/17, this week for instance the Dow was at one point down about 375. European and Asian markets have been battered as well. A few days ago, Japan's major index had fallen 5% in one day, Singapore's about 7%, and the Indonesian market fell 15% over just a two-day period.

The catalyst for much of this turbulence in the global equity markets seems to be concern over declining liquidity in U.S. real estate, which in turn was a result of reality setting in over the sub-prime mortgage market. Now that we are such an economically interdependent global village, when San Jose or New England housing sneezes, Scandinavia, South Africa, Hong Cong, or Chili financial markets may well catch a cold. Part of the reason for this, in the present circumstance, is that risky mortgages have for some years now been bundled together with hundreds of thousands or millions of similarly higher risk contracts and sold to institutional and other investors seeking somewhat greater interest rates.

So, when the sub-prime market "emperor" was exposed as "having no clothes," there was a sudden awareness that nobody knew the true value of these huge holdings and that actually unqualified borrowers might, instead of paying their rapidly increasing mortgages, be going into foreclosure in record numbers. Thus markets were alarmed 'round the world. The snowball effect continued as credit tightened not just in the sub-prime arena but, overcompensating in pendulum-like fashion, throughout the mortgage market in general. "For Sale" houses were now sitting on the market for longer and in greater numbers than in quite awhile, with would-be sellers' equity meanwhile sliding away all too swiftly. Soon, many could no longer even afford to sell in order to get out from under onerous first, second, or later mortgages.

This general scenario in turn led to a credit crisis affecting the bottom line for major lending companies, large banks, etc. And the credit crunch here in the U.S. exacerbated fears of a melt-down around the globe. People noted too that, at the same time, the dollar was tending to keep falling, bonds were not doing well, equities in general were losing value as large financial companies admitted they could not be certain how much if any profit they really were making, and so on.

People who worried about such matters figured that, if folks could no longer borrow against their homes or buy things on as much credit, they might feel it is time to budget more, eat out less, put off for longer purchasing another car, etc. Since spending by our consumers fuels much of the economy, such issues raised the specter of a recession soon, at the same time that we are experiencing inflation due to high oil, food, health, and other costs. Oh dear, THE SKY IS FALLING!!!!! Can another GREAT DEPRESSION be far behind!!!!!?????

The above is no doubt an oversimplification, but it presents a gist of worries, rational or irrational, behind the recent worldwide sell-off of equities. It may not be an unreasonable reaction to such uncertainties that investors, seeing both their hard-earned real estate and stock market investment dollars evaporating, have been at least selling their liquid assets, which, of course, tends to depress the markets still further, and so on.

Hence my title question, is it time for a panic state or to reallocate? Conservatively allocated investors, with about 10% of their liquid investments in cash reserves such as money market accounts, around 30% in intermediate bonds or bond mutual funds, and roughly 60% in growth and income stocks or stock mutual funds, and who have been rebalancing along the way, say every year or when those allocations are off by 5-10% or so, have probably been doing well over the long-term. Through the nineties and early 2000, when the stock market was first way up and then way down, folks following this approach would probably have seen a ten-year annualized total return on their liquid investments of about 16-17%, despite the sudden drop in stock prices in the first quarter of 2000. Unfortunately, that was then and this is now. Investors are unlikely to see well allocated ten-year total returns like that again for some time, but they can still assure lower risk growth of their assets by putting funds into different type assets and then rebalancing among them after major turns in the market.

And if after the 2000 and 2002 major drops in equities investors had then reallocated again, once those market downturns had provided many new bargains, they no doubt would on average have made out like bandits in the years since, while equities have been back up over 68%, on the Dow for instance, or 76%, on the S&P 500 Index, through 7/19/07.

After the recent sell-off, the Dow is still up 57% since its level at the end of 2002, while the S&P 500 Index remains up 64% in the same period.

And if one had invested in low price to value assets since 2002, one's annualized returns from a well allocated portfolio could have been still better and quite satisfactory.

So, perhaps things are not so bad, despite the near panic in some quarters over the past 3-4 weeks. And, not surprisingly, I would be more inclined to reallocate now rather than joining in the anxious frenzy. I think it improbable that the Federal Reserve's interventions in the last week or so, to ease market and lending stress of late, will by themselves be sufficient to calm worldwide market jitters. Measures by other countries' central banks as well as further action by the Fed may be required. It seems likely to me, then, that the heady volatility will persist for awhile.

Accordingly, I would take a gradual approach to rebalancing a portfolio. Still, over the next several months one might raise or lower (depending on how long it has been since the last rebalancing was done, how one's own portfolio has performed, and so on) reserves, bond holdings, and stocks or stock mutual funds as necessary to return to one's preferred level of risk and growth potential.

In the 10/30/60% allocation example indicated before, if one's current percentages, by way of illustration, are now more like 12% cash reserves, 34% bond assets, and 54% stocks or stock mutual funds, then one might use up to 2% a month of the total funds (taken from cash reserves or bond assets) to buy more equities until the 10/30/60% ratios are reestablished.

Alternatively, rather than selling off any of the bond assets to restore the desired equity level, particularly if they are recently somewhat down as well, the target stocks level might be achieved by increasing stock mutual fund purchases in a regular investment program, for instance through one's 401k plan at work.

If starting from scratch, for a simple, well allocated portfolio that involves little administrative cost, I can recommend such funds as these, from the Vanguard Company:

AssetSymbolToll Free No.
Vanguard Prime Money Market FundVMMXX1-800-662-6273
Vanguard Total Bond Market IndexVBMFX1-800-662-6273
Vanguard 500 Index Fund Investment TrustVFINX1-800-662-6273

And if one likes to invest in individual stocks, those below seem to me to offer worthwhile value for one's money:

Aspreva Pharmaceuticals Corp.ASPV$17.980.005.061.6742.84%
Avici Systems, Inc.AVCI$7.680.004.611.8741.22%
NVR, Inc.NVR$569.000.278.422.4338.60%
RCM Tchnologies, Inc.RCMT$7.480.0012.850.968.52%
Western Digital Corp.WDC$20.450.017.902.6540.44%


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

Value Investing / Main Index / previous / next