Friday, September 19, 2008

“The Only Thing We Have to Fear is Fear Itself”

From the Desk of Joe Rollins

You probably won’t find it surprising to hear that Franklin D. Roosevelt’s famous quote came to my mind on Wednesday after a horrific day of stock market performance. I had always incorrectly assumed that this phrase was used when Roosevelt went before Congress in 1941 to declare our involvement in World War II. However, my research revealed that this well-known quote was actually part of his first inaugural address in 1933. These words mean even more to me now, since FDR was inducted into Presidency in the depth of the greatest depression ever in the United States.

Roosevelt’s popular phrase is actually an abstract of what are, to me, some rather timely and powerful sentences for our current environment:

“This great Nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”

On Wednesday, there was true FEAR in the financial markets. At one point, some investors were actually purchasing Treasury bills with a negative rate of return and three-month Treasuries were selling at a premium. To put this in perspective, some investors were seemingly willing to say, “I will give you my hard-earned money if you promise to give most of it back in three months.” I suppose that sometimes fear just overtakes common sense!

In the middle of Wednesday’s trading day, the interbank lending rate exploded out of control. The rate at which banks normally loan money to one another is 2%, but it had tripled to 6%. Banks began hording money and refusing to loan it to each other, much less to the public. Even though these loans are ostensibly guaranteed by the Federal government, banks did not want to be caught without liquidity on Wednesday.

There was another blatant attack on Wednesday on another financial institution by the people who short stocks for a living. When you short a stock, you sell a security that you do not own. You hope to be able to buy it for less than what you sold it for and make a profit – you’re basically betting that the stock is going down in value.

There’s nothing illegal or wrong with this method; it’s truly a normal and required method of investing. However, when a group of individuals line-up and openly short a company out of business in concert, it’s definitely illegal and immoral. I can tell you without any degree of hesitation that this is exactly what happened to Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG and now, Morgan Stanley and Goldman Sachs.

It was interesting to note that Wednesday morning the Wall Street Journal had a lengthy opinion piece that was eerily similar to my blog on Tuesday (read it here). One of the most successful and financially sound life insurance companies in our history, AIG, was fundamentally destroyed by bad accounting and short-sellers. The sad part is that none of this had anything to do with AIG’s operations or the way they ran their business. As the Federal government liquidates this company, all Americans should be remorseful. This wonderful American institution will now be split up and put in the hands of principally foreign owners going forward. It’s true that the American employee base will remain the same, but the ownership will be foreign.

Wednesday was a grim day from an investing perspective. I heard one commentator say without hesitation that, “There is a lot of volatility of Wall Street these days.” Duh!! How do these experts have such a complete grasp of the obvious?!?! The Dow Jones Industrial Average was down 4.5% on Monday, up 1.5% on Tuesday and down 4% on Wednesday. I don’t think I need anyone’s help in observing that there’s a lot of volatility on Wall Street…

When there’s this much market volatility, people aren’t investing; they’re just trying to survive. Irrational, emotion-driven actions take over and investment logic and intuitive knowledge are ignored. Wednesday was definitely one of those days!

On Tuesday, we started taking money off the table to reduce the volatility in our portfolios. We have raised a significant amount of cash in the hopes that we can get it back to work for our clients once stability sets in. Hopefully that will be sooner rather than later, but it’s impractical to try to make investment decisions when the public is investing with its heart and not its brain.

As difficult as Wednesday was, I strongly believe that the cavalry is on its way. Rest assured that I’m the last person who would ever advocate any governmental intervention in the capitalistic system. However, I’m also a realist and understand that regulation is required. “Unbridled capitalism” is often defined as greed, and that’s what has set in on Wall Street. It was time for the regulators to come down from their ivory tower to end the abuses. Putting companies out of business just because you can isn’t capitalism, it’s greed!

On Thursday morning, there was a worldwide, coordinated injection of capital into the financial markets. One hundred and eight billion dollars hit the money markets of the world simultaneously before the European markets opened up along with another $50 billion when the U.S. market opened. Furthermore, new “naked” short-selling rules went into effect at 12:01 a.m., and large hedge funds are now required to report their short positions on a daily basis. The SEC also issued 50 subpoenas on Wednesday seeking clarification of naked short-selling by hedge funds. You can bet that investors with massive short positions today are looking over their shoulders for Big Brother!

The actions of the Federal Reserve and the Department of Treasury have been spectacular. They’ve broken every rule of stately governmental finance and their actions have prevented a complete financial meltdown in the wake of the attack by the coordinated short-selling against our financial institutions. They should, in fact, be complimented for a job well done.

With the regulators now doing what needs to be done, maybe we can begin focusing on investing rather than on speculation. The financial institutions of this country aren’t in as bad of financial shape as their stock prices would lead you to believe. There will soon be a day where bargain hunting will be the talk of the financial world. At that time, we need to be significantly invested to participate and recover some of our lost ground.

As I correctly predicted, Congress has now been back at work for two weeks and have passed no energy-saving legislation. As I further predicted, the House has approved an offshore drilling bill that they knew would never be debated. It’s a shame that the American public is being deceived by its own Congress and that we’re paying the price in higher fuel costs due to bad legislating. The sole purpose of the masquerade of proposing a bill that we know will not be approved is so one of the candidates running for President will not have to vote against a bill bitterly opposed by his financial backers. How can he say in the political arena that he supports offshore drilling while continuing to accept money from environmentalists? By not having to vote for offshore drilling, he satisfies the public and his benefactors – for the time being.

Much of the blow-up surrounding Fannie Mae and Freddie Mac two weeks ago was due to governmental intervention. Senator Barney Frank basically used these two governmental agencies to buy the votes of the underprivileged. Many loans were made to people who had no right to receive them, but the agencies were mandated by Congress to complete the loans. Unfortunately, the blow-up of these institutions can only be blamed on government itself and not Wall Street. The entire country is now paying the price for that poor judgment exercised by Congress. There were 350 current members of Congress who received campaign money from these agencies.

It’s depressing to me to hear the political rhetoric of both Presidential campaigns. Everyone is blaming everyone else for the upheaval in the financial arena. There’s no question that there’s plenty of blame spread around. In fact, two of the three financial advisors working for one of the candidates each received compensation in the $100 million range working for the two failed governmental agencies that both candidates so regularly criticize.

Whether it’s based on politics, regulation or fear itself, my interest is in the accumulation of wealth for my clients. Today there are stock values represented on Wall Street at unprecedented low levels. A decade from now, we should not be in the position where we are looking back at these prices and wondering why we did not purchase more. There will soon be a day when rational investing overtakes the fear we are currently seeing, and you can rest assured that our clients will be participating when that finally happens.


2 comments:

Atticus Lynch said...

I am reminded of a "Jackass" episode in which they rent a car, take it to a demolition derby, and then return the destroyed car to the rental agency on the following day. When the agency informs the driver that he will have to pay for the damages, he responds with a kind of "What's your problem? I paid the rental fees, so I don't owe you anything more" attitude.

I don't remember anyone asking my permission to loan them my 500 shares of AIG stock so that they could short-sell them. If they had, I would have asked "Why would I want to loan you my shares? What's in it for me?".

Of course, someone short-selling my 500 shares can hardly move the market, but the larger question is why ANYONE who holds a long position would willingly give their shares to someone else only to have the shares returned a few days later damaged (or even destroyed).

In the worst case (as with AIG), the borrower uses my shares to profit from driving down the price. I get back shares that are now worth much less than they were before. This is obviously not to my benefit.

In the "best" case, the person shorting the shares misjudges the market and has to buy them back at a higher price, presumably to my benefit because I now get back shares that are worth more. But the increase in price isn't based on AIG's performance, it is based on speculative return. Such returns can evaporate just as easily as they have been created, and I fail to see how this type of trading adds any stability to market pricing (particularly for fundamental investors such as myself).

Bearish investors and speculators can achieve the same type of short-selling results by purchasing Put options or selling naked Calls. It seems to me that speculators and hedgers should be confined to the derivatives arena where their actions can not be construed as having anything to do with INVESTOR confidence (or lack of confidence) in the underlying equity price.

In my view, only long positions should be allowed for equities; speculators can play in the derivatives sandbox. I further submit that such segregation would make it easier to discern whether prices are being influenced by INVESTORS or by SPECULATORS.

Given the ability to achieve the same results through the use of derivatives, my question is why don't we simply disallow ALL shorting of equities? Given the events of the past few weeks, I doubt that anyone can any longer make the case that shorting is healthy for stable and liquid markets...

Rollins Financial Counseling, Inc. said...

Thank you for your comments. You bring up some very good points.

While shorting may/may not have a place in trading stocks, as you describe, there has been a recent push to if nothing else reinstitute the "uptick rule". This will not stop short sellers, but at lest they will need to wait for the buy side.

Thanks again.