The Official Bear Market

The Official Bear Market

So we’re officially in a bear market. For those of you who may not be familiar with it, the official definition is a 20% decline. For the Dow, the year high was 14,280, so anything below 11,424 would be a bear market. Given that the Dow today is at 11,384, that qualifies. As for the S&P, that’s teetering on the edge of an official bear market. The year high was 1,576 for the S&P, and so once the S&P fell below 1,260, the guys wearing the zebra outfits called it. Today the S&P is at 1,273, but it’s already been as low as 1,241.

The real question is, why do we care? It’s not as if we didn’t know it was coming. It’s kinda like inflation: the government is telling you that inflation is not that bad, but all you had to do was walk out the door to know that the price of gas and of everything else we use is way up. With all the trouble in the real estate and finance markets, it’s pretty clear that a big part of the economy is going to be in the repair shop for a long time. Commodities have done well, but it doesn’t take a genius to figure out that that can’t go on forever. Eventually, when the prices get to be too high, people will cut back on commodities too, and that will drive prices down. Once that happens, there aren’t many parts of the economy that will be growing. Think about this – “ once the boom in gas and commodities is over, what’s left? Perhaps medical stocks… but I can’t think of much else.

Once the bear market was official, the press started going to town on bear market statistics. Apparently, once we enter bear territory, the average drop is not 20%, but 34%. And the length, on average, is about 23 months. In other words, the pundits are saying that there’s more to go on the downside, and it’s going to go on for a while. Hopes for a quick recovery are just that – “ hope.

I don’t think the pundits are wrong. If you step back, take a look at the major trends, there’s a pretty strong argument for continued weakness. Before we do that though, let’s take a quick side trip into the Dow Jones chart, below:

Now, I’m not much of a technician. As I’ve said before, I’m a fundamental guy. But sometimes charts are very useful and informative. If you take a look at this Dow Jones chart, you’ll see that in April through December of 2007 it formed what’s known as a “head and shoulders” pattern. This often indicates a market top; basically, investors try to find a new high; exceed that new high, and try a third time before support collapses. Like I said, interesting, huh?

If you look at the recent bottoms, you’ll see resistance around the 12,000 level. Meaning that investors took the DJIA down to this level but failed to break below that level. That is, until this month, when the DJIA broke past and fell into bear market territory.

Looking further back on the chart, just drawing a line through relatively flat trading levels tells us that the next resistance level could be somewhere in the 10,000 to 11,000 level.

So basically, the chartist would say that the trend is downward. Now let’s take a look at some of the trends from the viewpoint of a fundamentalist.

Real Estate and Financials

At this point, you can’t separate one from the other: real estate and financials are intertwined. They’ll be connected, at least for a while. As the banks get into more trouble, credit continues to be a big problem. And that’s a problem for businesses as well as individuals. With loans becoming more expensive and harder to get, demand for real estate will continue to decline. In turn, prices will fall. As that happens, banks will be forced to mark down real-estate related securities that are sitting on their books. That will lead to further losses and write-down from the banks. And so the cycle continues.

And as mentioned in my last article, residential real estate is not the only problem out there. The problems with commercial real estate, consumer credit (credit cards) and auto loans are just beginning. And just to throw a wrench into the equation, to curb inflation, the Fed may have to start raising interest rates sometime in the next year. That will only make a recovery in the financials and in real estate harder.

When does it all end? Real estate will have problems for a long time, I believe. In order for the real estate market to recover, the market will have to work through all the excess inventory, prices must fall to a reasonable level, demand has to re-emerge and credit has to be obtainable. It will be years before all those conditions are met.

The financials will begin their recovery before real estate does. When the size of the write offs taken each quarter actually start to decline, the financials will have bottomed. Of course, no one knows when that will happen. But I do believe this will happen sometime in the next year. Whether the bottom in financials is 3, 6 or 9 months away from now is too hard to predict with any certainty. In a moment, we’ll talk about how to invest in this kind of environment.

Oil and Commodities

Other than real estate, oil has been the bugaboo of the last year. Commodities, too, as worldwide demand drove up prices of pretty much everything you can touch. We all know the story, so the real question is, what will it take to turn things around?

At some point, inflation will start to cut into demand. Prices can only go up for so long before businesses and consumers balk. Many think this so-called demand destruction has already begun. With steel, for example, customers are starting to fight the significant price increases demanded by producers. Around the world, inflation has made food and basic necessities very expensive, and pockets of civil unrest have already appeared. While the US does not subsidize gasoline, many emerging markets do. Those governments are starting to reduce domestic gasoline subsidies and are passing on more of those costs to consumers. As we entered the July 4th holiday, the market reacted by starting a rotation out of commodities and oil. Over the last week, coal, natural gas, steel, agricultural feed products and other commodities-related industries have all sold off. During the last two days, oil has pulled back.

Over the long term, oil and commodities have to fall, but the short term is anybody’s guess. Why? Because to create a sustained decline in oil and commodities prices, I believe inflation and demand destruction are not enough. I think that interest rates have to rise to create a true turnaround in these markets. Basically, low interest rates fuel inflation, just as they fueled the real estate boom. Seal off the flow of money, spending declines, inflation recedes, oil and commodities recede.

Right now, the problem is that raising rates will hurt the banks, and so the Fed is loathe to do that. Still, sometime in the next year, the Fed may be forced to raise rates. Some think they might do that as soon as August. Again, we’re in gray territory; as of today, it’s hard to place a bet on that event.

If you accept this argument, that means the current pullback in oil of the last few days could very well be temporary. Certainly, wisdom dictates that if you’ve earned significant profits in these markets, you should pocket some of that dough. But at this point, I don’t see a catalyst that says oil and commodity prices must come down. There’s not enough demand destruction yet, and customers don’t like the increase in costs but can’t do much about it. And there’s always the possibility of world events – “ whether it be rebels threatening oil supplies or Israeli saber rattling – “ that could cause a spike in oil prices.

A Little Bit of “What If”

In other words, the short term is murky. Now that might seem not very useful, but let’s take all this theorizing and push it a little further. Let’s assume at some point, the bubble in oil and commodities will have to burst. If that’s the case, what industries and sectors would benefit?

Let’s start with the industries that have been most hurt. The list is long and wide – “ airlines, autos, transports (Fedex, UPS), consumer goods and so on. For many of these industries, it would take a significant decline in oil prices to lead to a recovery. For example, a fall in oil prices won’t save the auto companies; the consumer would also have to stage a recovery. Given the continued problems in real estate and credit, that’s not likely any time soon. Same for Fedex, UPS and the airlines. A drop in oil prices would reduce their costs, but not necessarily increase revenue. Business and consumers would have to be healthy enough to spend money on sending packages and plane tickets. Today, I Fedexed a package from LA to San Francisco for a client. Sending a one-ounce disk cost more than $40. A year ago, that same package cost $18 or so. If I’m a small business, I’m avoiding Fedex like the plague.

So you see the problem: a fall in oil and commodities prices helps alleviate the suffering, but doesn’t cure the illness. The customer – “ whether it be a business or the consumer – “ still has to recover.

Consumer Staples

One potential bright spot is consumer staples, or a company such as P&G. Usually such companies do well in a downtown. Not so this time around. Input and transportation costs have cut into P&G’s margins. Today, at $63 or so, it’s 6% off its year low, 15% off its year high. If commodities prices fall, P&G will benefit, since the consumer will need its products regardless. Still, it’s not a completely free lunch. If the Fed raises rates, the dollar will strengthen and the company’s goods will be more expensive overseas. Because P&G is so international, that may cut the benefits it’s been seeing from a weak dollar. So P&G will benefit if the drop in costs exceeds the losses from a stronger dollar. In other words, how well P&G does may very well depend on how fast the dollar rises. If the dollar doesn’t rise quickly, then P&G should do well when oil and commodity prices recede. I am, by the way, long P&G.

Altria / Philip Morris International

Another area that I consider relatively safe in the bear market is tobacco. If you’ve been following this column, you know that I recommended and hold a position in both Altria (MO), the domestic company best know for Marlboro; and Philip Morris International (PMI), the international spin-off of the same company. Both continue to hold up in this tough market, and pay 5.5% and 3.5% dividends, respectively. If you like growth, I’d favor the international arm.

A month or so ago, someone wrote to the editor, objecting to my recommendation of a tobacco stock. I replied to the editor, saying that my job (and the magazine’s) was to recommend a good investment, and that it was for the reader to decide whether he or she was comfortable with the social implications of that investment. I know that some investors do not want to support a tobacco stock, and if so, they should decline to invest. But for others, tobacco stocks can be a very safe place to be in a volatile market, especially if you are looking for a stable, low-risk investment that offers a more than acceptable yield. In times like these, MO and PMI are a perfect place to be, for some.

Citibank and USB, Revisited

On the banking side, I continue to hold and build a position in US Bancorp. The bank is a Buffett stock; it is conservatively managed, has low exposure to subprime, CDOs and the rest. Today, at $28 or so, it offers a 6.1% yield. I see it as a conservatively run bank that is getting hit along with everything else in the banking sector. So for me, dips are a buying opportunity.

Citibank is the more challenging and controversial investment. Again, I hold a position in Citibank, and expect to buy more. I recommended it last month and bought some in the $26 range. I also bought more at the $24 range, and the $20 range. Given the renewed concerns about problems in the banking sector, it’s dropped to the $16-17 range.

So I was clearly early. Still, I won’t claim to be able to catch the bottom. In last month’s article, I argued that you could nibble, and build a position over time. Basically dollar cost average as the stock declines to reduce my average cost. I plan to continue doing exactly that.

Why? Because I believe that my original thesis, that Citibank will do very well if I can hold for say, three (or more) years, remains intact. There are a few key points to remember when investing in a situation like this. The first is, obviously, that you believe your thesis remains accurate (and I do). Secondly, you have to be prepared to follow through and hold for the three years or more. That means playing with money that you don’t need for that time period. Third, and finally, you must not panic. You need to have the stomach to believe in your thesis and hold through the dips. Fourth and finally, if you believe the thesis, you should buy more as the price declines.

So if the volatility in Citibank was not your thing, then I would recommend more stable stocks, such as P&G, MO, PMI or USB. The other option is to wait until Citibank’s balance sheet is more stable, and then invest. You may miss some of the initial upside, but if it will make your mind calmer, then it’s worth it. For me, I don’t mind being aggressive for my own portfolio, but I do realize that’s not for everybody.

A Mea Culpa

Since the last article, I do have one investment recommendation that I wish I had done much better on, and that’s Huntsman (HUN). A year ago, Huntsman agreed to be acquired by Hexion, another chemical company, for $28 a share. I bought shares in the $22-25 range. Last month, the stock fell to the $20-22 range. And then, Hexion announced that it would not proceed with the merger. Within a day, the stock fell to $13 or so, and today stands in the $10-11 range. Ouch. Even more than ouch. Inexpressibly even more than ouch. And for those that invested along with me, I almost don’t know what to say. I was clearly very, very wrong.

I made two major mistakes with this investment. The first is I relied too heavily on management’s actions. After the merger, the Huntsman family (one family member is Chairman, the another is CEO and President) bought more than 682,700 shares at prices higher than $23. This occurred in three separate transactions from August 2007 to November 2007. Then, in February, the CFO bought another 5,000 shares in the $24 range, and in mid-March, CEO Peter Huntsman bought another 20,000 shares for $23.50-23.80.

I believed that if there were a problem with the transaction, management would have some inkling and would not be buying in such significant quantities. I thought it was kinda like dating; if you’re paying attention, you can usually tell if they’re pulling away from you. Obviously, I was very wrong, and it’s now clear that management had no idea that Hexion would try to pull out of the merger. A lesson learned in the most painful way.

My second mistake was not protecting my position as it declined. The irony is, the last time I wrote about Huntsman, I had recommended puts to protect the position if you were concerned about the decline in the stock price. Thing is, I didn’t push that strongly enough, and yes, I didn’t even buy puts for my own position in the stock. So I took the full hit when the stock tanked. Another lesson learned, the very hard way.

At this point, the issue is whether there’s a way to recover. Truth is, I think it’s unlikely that Huntsman stock will reach anywhere near the $28 transaction price. Huntsman is suing Hexion, but the outcome of the suit is, of course, uncertain. The best case is that the transaction occurs at reduced price, probably in the high teens, say $17-18 range. If the transaction doesn’t occur, I believe that at $10, the stock is oversold. However, Hexion, in its merger cancellation announcement alluded to “deteriorating” financial conditions and “increased debt” at Huntsman. The financials upon which the claim is based have not been released to the public, and so it’s difficult to accurately assess the value of the company today. If you were to hold until better economic times – “ that is, when commodities prices aren’t hurting Huntsman’s margins, then you get a valuation in the mid- to high teens. Still, that will take time. So there are no clear, easy wins in this situation.

The outcome of this investment is still to be determined. You may ask, is this different from Citibank? I think it is, because with Citibank, its future is not so dependent on a single event. Citibank will have many, many chances to continue rebuilding the company and its business over the next several years. Huntsman has a bigger hill to climb to get back to my acquisition price.

A Recap

Despite this painful Huntsman lesson, I still believe that the market is a great place to be. And I continue to believe that this time is full of opportunities for the investor. A simple way to look at it: when we look back over every bear market, we always wish we had bought. Now we have a chance to do just that.

My theme, though, for this article is this: invest in stocks that fit your risk profile. I’ve tried to make clear which stocks I think are very stable and safe (such as P&G, MO, PMI, and USB) and which are riskier (C) and require a bit of an investing stomach. There are even riskier plays, without question, and even riskier strategies (e.g. options plays), which we will visit from time to time in this column.

If nothing else, I think this is a great time to learn about investing. And you can do that by simply watching the market, developing your own investing theses and seeing how they play out. Seeing a bear market once will make the next one easier and give you more confidence in your investing skills. Sure as death and taxes, there will be a recovery and another bear market. And if you can spot the opportunities, just imagine what you can do the next time around.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.