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Lessons Learned From A Dangerous Year

In the beginning of the year, a column I wrote for Real Money discussed some lessons of the past year. It never was moved over to the free site, so here is my belated update.

It is a mix of fundamental, economic, technical and even philosophical lessons that those savvy CEOs, fund managers and individual investors who were paying attention picked up in the recent turmoil.

1) Ignore market rumors:  It seemed every time some firm was in trouble, the same gossip was floated that Warren Buffett was about to buy them. Time and again, these tales proved to be unfounded money-losers. This year's most egregious example was Berkshire's imminent purchase of Bear Stearns (BSC).

That The New York Times Dealbook got suckered into printing this just shows you how pernicious these rumors are. The stock was as high as $123 the day of the rumor.

Anyone who bought homebuilders or Bear Stearns stock on the basis of either of these rumors -- or nearly any other stock that had similar rumors floated throughout the year -- lost boatloads of money.

2) Buy sector strength (and avoid sector weakness): It's a truism of real estate: It's better to own a lousy house in a great neighborhood than a great house in a lousy one. And the same is true for stock sectors: Buying mediocre companies in great sectors generated positive results, while great companies in poor sectors struggled.

The losers are obvious: The homebuilders, financials, monoline insurers and retailers all struggled this year. The winners? Anything related to agriculture, solar energy, oil servicing, industrials, software, exporters, infrastructure plays -- even asset-gatherers thrived.

3) Never blindly follow the "big money": Why? Because professionals make dumb mistakes too.  Many people chased the so-called smart money into these trades. Unfortunately, all of these trades have proven to be jumbo losers.

4) Day-to-day stock action is mostly noise: This is blasphemy to some people, but it's true: Markets eventually get pricing right. But the key to understanding this is the word "eventually." Over the shorter term, markets frequently under- or overprice a stock before settling into the right approximation of value. This process typically occurs over broad lengths of time.

5) P/E matters less than you think: If that sounds like more blasphemy, look at Google (GOOG) , Apple (AAPL) and Mosaic (MOS) -- they all sported high P/Es at the beginning of 2007 before going much higher.  On the other hand, back in January '07, retailers, financials and homebuilders all had reasonably cheap P/Es. (How'd they do over the next 12 months?)

6) Ignore deteriorating fundamentals at your peril: One would think this doesn't need to be said, and yet it does: When the fundamentals of a given market, sector or consumer group are decaying, profit gains are sure to slow.

7) Nothing is more costly than chasing yield: For fixed-income investors, what matters most is not the return on your money, it's the return of your money. Reaching down the risk curve for a few bips of additional yield is one of the dumbest things an investor can ever do.

8) Know what you own: This very basic issue was mostly forgotten in recent years, and it was forgotten by pros and individuals. 

Investment banks like Bear Stearns, Morgan Stanley (MS) and Merrill Lynch (MER) , big banks like Citigroup (C) and Washington Mutual (WM) , and GSEs like Fannie Mae (FNM) and Freddie Mac (FRE) were scooping up assets apparently without doing their homework. The complexity of these pools of mortgages almost guarantees that no one truly knows what's in them (see the next rule). If you don't know what you own, how can you properly manage risk?

9) Simple is better than complex: Start with a few million mortgages of varying credit-worthiness and create a series of residential mortgage-backed securities (RMBS) from them. Then take the RMBS and stratify them. Then leverage them up into collateral debt obligations (CDOs). Once that bundling is complete, make complex bets on which layers might default, via credit default swaps (CDS).

Gee, how could anything possibly go wrong with that?!

10) Stick to your core competency:

E*Trade (ETFC) is an online broker; what was it doing writing subprime mortgages?

Why was Bear Stearns running two hedge funds?

Isn't H&R Block a tax preparer? It was making mortgage loans -- why?

And exactly what was GM's expertise in underwriting mortgages? (The snarkier among you might be wondering exactly what business GM's expertise is in.)

Had these companies stuck to what they did best (or least bad), they wouldn't be in as much trouble today.

11) Fess up! Whenever a company runs into trouble, they seem to take a page from the same PR playbook: First, they say nothing. Second, they deny. Finally, they make a begrudging, pitifully small admission. Eventually, the full truth falls out, and the stock tanks with it.

12) Never forget risk management: Consider what could possibly go wrong, and have a plan in place in the event that unlikely possibility comes to pass. If there is to be upside, then there must also be a corresponding and proportional downside.

13) The trend is your friend: Despite the year's parade of horribles, this market cliché was proven true once again. The Dow, S&P 500 and Nasdaq are all higher this year, as their long-term trends have been tested but remain intact.

The exception, the Russell 2000, broke its trend earlier this year. That made trend traders abandon the small-cap index, which has since fallen even further. This confirms the corollary: "except for the bend at the end." As long as the index trend lines stay intact, investors can sleep easy. But once those trendlines break, well, then you better apply some of the earlier lessons (see numbers 2, 3, 4, 6, 7 and 12!).

Looks even truer 8 months later!

>

Source:
Lessons From 2007: A Baker's Dozen
Barry Ritholtz
RealMoney.com, 1/2/2008 6:54 AM EST
http://www.thestreet.com/p/rmoney/investing/10396497.html

Hey! It did get moved over . . .

13 Things You Wish You'd Known in 2007
Barry Ritholtz
TheStreet.com (01/02/08 - 02:11 PM EST)
http://www.thestreet.com/s/13-things-you-wish-youd-known-in-2007/newsanalysis/investing/10396669.html

Sunday, August 10, 2008 | 08:30 AM | Permalink | Comments (18) | TrackBack (0)
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Comments

Great list of advice. I think some of these can even be turned into lessons for personal investors. I have avoided the financial sector for 2 years owing to my concern about declining fundamentals. Even I had no idea how bad it was going to get. I am still surrounded by cheerleaders who are buying on weakness. To which I reply: "You ain't seen nothin' yet!"

Posted by: kcowan | Aug 10, 2008 10:01:10 AM