Ken Kam's Best Ideas Blog

The threat of a massive credit crunch that could send the economy into a severe recession has been a drag on the market. Almost any negative news sent jittery investors scrambling to sell, oftentimes indiscriminately.

The threat is largely over but the fear remains. This is a good time to look through your portfolio to free up cash to invest in your best ideas.

Fear spreads quickly...

In November, when Goldman Sachs said that sub-prime mortgage losses could cut the banking system's credit capacity and reduce the money supply by a whopping $2 trillion, they said it could trigger a "substantial" recession. Fear spread quickly sending the market tumbling downward.

Fortunately, Goldman Sachs was wrong.

The sub-prime mortgage losses so far have been around $100 billion and according to the Fed could go as high as $200 billion. While this sounds like a lot of money, it is a pretty small part of the $14 trillion U.S. economy. This is a problem the markets and the Fed can manage.

Banks that took too much risk from the sub-prime market, had to raise capital. Citibank, Bear Stearns, Merrill Lynch, and many others got fresh infusions of capital, often from foreign investors, to strengthen their balance sheets.

And the Federal Reserve continued to drop interest rates from 5-1/4 in Sept. to 4-1/4 in Dec. with further cuts expected. Not only did this inject money into the system, more importantly, it helped shore up the balance sheets of banks by increasing the value of ALL their assets.

In stark contrast, European regulators and central bankers seem to be sitting idle. Troubled European banks have not attracted similar infusions of new capital, and neither the Bank of England nor the European Central Bank have cut interest rates. For now it looks like the U.S. and European central banks are not coordinating their efforts as they have in past times of crisis.

When the Federal Reserve cuts interest rates and others do not, the value of the U.S. dollar falls. A weaker U.S. dollar means U.S. products are cheaper and more competitive in a global market. And more importantly, because financial markets are global, companies can borrow money cheaper to fund projects around the world. Lower rates by the Fed will fuel growth globally at a time when the U.S. is more price-competitive.

The threat has past so the biggest risk going forward is fear. Fear can cause consumers to stop buying, investors to start selling, banks to stop lending, and companies to stop investing.

...Restoring confidence takes time

There is little the President, the Federal Reserve, or Congress can do to restore confidence quickly. It is going to take time for investors to realize that things are not as bad as it seems. In the meantime, this is a great time to look for bargains.

After the technology stock bubble burst in 2000 many people exited the market altogether. Others held on to technology stocks, and some even bought more, hoping for a turnaround. Both of these strategies were mistakes. It took nearly three years to reach the bottom, and even today many of these companies are well below where they traded in 1999. Don't make the same mistake with financial and real estate stocks now.

In early 2000, before the technology bubble burst, the S&P 500's weighting for technology stocks was at its peak. Because of this, as tech stocks fell, the S&P 500 also fell, giving the false impression that the whole market was falling apart.

In fact, the Fed dropped interest rates to the lowest levels over the past 50 years, which pushed natural resources, financials, and real estate to the top of the performance rankings. In hindsight, selling technology stocks and investing in these areas was the right thing to do.

Something similar is happening now with financial stocks. After years of out performance, the financials sector is the most heavily weighted sector of the S&P 500. When financials go down, the S&P 500 is dragged down, but that does not mean that the whole market should be avoided.

This time, it looks like financials and real estate stocks will be the "dogs." But the liquidity the Fed is creating is eventually going to find its way into other segments of the market. Once the hysteria subsides, it is likely that market leadership will change and the new leaders will deliver the best returns we'll see for the rest of this decade.

The market's selloff has been so widespread that many stocks are cheap, selling at fire sales. Because it takes time for confidence to return to the market, there is no need to rush to buy stocks, but it is a good time to reevaluate all of our stocks to make sure we still like them in light of current market conditions, and to take another look at the stocks on our watchlist that used to be too expensive, but perhaps now aren't.

Ideally, we want Best Ideas stocks that can grow even if the economy is in recession, are unaffected by the losses in the banking system, and will benefit from lower interest rates.

Posted by Ken Kam at 09:00 PM | Permalink

November was a topsy turvy month. With the subprime meltdown widening, fear and uncertainty causing a credit crunch, the Fed gave in and lowered the Fed Funds rate by 50 basis points (bps) in September. The market was betting that the Fed would lower rates another 50 bps at the end of October so when the Fed surprised the market by lowering the rate by only 25 bps, fears of recession caused the market to fall 9% through Thanksgiving and wipe out almost the entire year's return.

The Best Ideas Portfolio was down 9.3% in November leaving only a 3.7% return for the year.

Making a Course Correction

When you are losing money, do you stay the course or adjust your strategy?

The decision to change your strategy is always a difficult one. It means selling funds or stocks in industries you know well and investing in funds or industries you do not have as much experience in. Add to that the tax consequences of closing out a lot of positions, and it's easy to understand why it is easier to stay the course.

Deciding to stay the course is by far the easier choice. But when the reasons for the poor performance are not short-lived, it is the wrong choice -- whether for yourself or, in my case, for those who've invested in your fund.

Most funds are required by their prospectus to stay the course. If they are a financials fund or ETF and financials are falling - it is your responsibility (the investor) to get out because the fund manager can not or will not. They specialize in financials and even if they could change, you really don't want a financials specialist picking energy stocks for you.

We've organized Marketocracy's research process with a team approach which gives me more flexibility than any other investment firm to adapt to the market's changing opportunities. When necessary, we change the team so that you don't have to.

Prosperity Through Goodwill

With the market falling, it's easy to lose sight of what is going right in the world. Yet its the things going right that create the best investment opportunities.

For example, many people think that economic growth in China and India is bad for us. But, I think the fact that billions of people are now able to improve their standard of living by putting their effort into making things others want to buy is a change for the good in historic proportions.

Throughout history, the most common way for a group of people to improve their lot in life was by taking from others by force. Never before have so many people seen their standard of living improve through peaceful, productive means.

The world would be a more peaceful place if more people came to see that making things others want to buy is a better way to advance their economic self-interests than going to war.

Of course, improving the standard of living for billions of people is putting a tremendous strain on the world's natural resources. As a result, prices for just about every commodity oil, copper, gold, etc. -- are rising. It is no accident that many of the best performing mutual funds of the last 5 years focus on energy, natural resources, and precious metals. (see U.S. Global Investors below)

We are living at an exciting time. The standard of living is improving for more people today than at any other time in history. This single fact is the primary factor driving some of the best investment opportunities most of us will see in our lifetime.

Posted by Ken Kam at 11:00 AM | Permalink

The Federal Reserve cut interest rates last week and the market boomed. I did not foresee this outcome, and I’m still trying to understand the Fed’s thinking.

In the Strategy Lab Open competition, StocksRider pointed out that Wall Street and the media did a masterful job of painting a disaster if the Fed did not reduce rates. The Fed’s decision was not an easy one. I think dishwasher summed it up nicely as a tradeoff of style vs. principles.

But, now that the Fed has acted, it is more important to focus on the consequences of the Fed's action rather than the reasons. As Bobtheinvestor posted, “we have been dealt a deck of cards by the Fed - not exactly what we wanted but that does not mean that the world is over.”

The good news is that the immediate crisis looks to be over. Of course that was the intended effect. But in my experience, it’s the examination of the unintended consequences that often leads to good investment ideas.

For example, if other countries do not lower their interest rates, it is hard to escape the conclusion that the dollar is going to weaken – clearly an unintended consequence. In fact, during the past week, the dollar has set new lows against the euro, the Canadian dollar traded at parity to the U.S. dollar for the first time in over a decade, and the price of gold hit a 27 year high.

Continue reading "Reacting to the Fed" »

Posted by Ken Kam at 10:45 PM | Permalink