Agora Financial’s Rude Awakening

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Baltimore, Maryland

• Snapback! What’s behind the market’s recent rebound?
• Time for the oil bulls: A look at the pendulum swing from greed to fear,
• Why most people invest like Zebras, how to avoid the herd, and plenty more…

Joel Bowman, reporting from Goa, India

Fear will make people do the strangest things. A man might sell a good stock too cheap, for example, fearing that if he doesn’t get out now, he may never have a chance to escape. Or he might decide cancel a trip because a haphazard band of guerillas mount a cowardly attack a few thousand kilometers away from his planned destination.

The attack on Mumbai just a few weeks ago – terrible as it surely was for those effected – was not the mastermind operation of an advanced tactical team of special ops forces. It was not a precision nuclear strike or even the brainchild of a highly-coordinated team of military geniuses. More organization and intellectual rigor goes into building a seesaw than into most acts of terrorism. It takes more courage to have a cup of coffee these days than it does to bomb a café of innocent people; that just takes herd mentality, a moral deficit and a lack of imagination. Mumbai’s attack, like most acts of terrorism, was really just a bunch of halfwit hooligans with machineguns causing as much trouble as they could.

Even so, the whole country is now paying the price. Charter flights to tourist hotspots – even those thousands of kilometers away – have been cancelled until late January. Hotels and beachfront resorts are almost devoid of westerners. Local businesses are suffering during the months when they most depend on their trade.

We hear words like “terrorist” and, immediately and involuntarily, our mind conjures up horrific images of people burning and fireballs ripping through cafés. Before we have the chance to make a calculated decision, our emotional reaction has already taken over and we forget that the chance of being the victim of a terrorist attack is next to nil. There were 20 million people in Mumbai during the siege there. 200 very unlucky people were killed. Do the math. You were probably more at risk being in a taxi in Cairo during those three days than you would have been sipping an herbal tea in one of Mumbai’s umpteen thousand cafés.

The very same emotional drivers are at work everyday in the market. Someone yells “buy” or “sell” and the stampede begins. Invariably the mark is overshot. Then, after a few people have made money and many more lost it, the pendulum swings back the other way.

The market is not an orderly collection of individuals acting rationally, as much as we might hope this to be the case. It is, rather, an amalgamation of irrational investors driven by the emotions of fear and greed. It is always self-correcting but, because it is always in flux, responding to new inputs and variables, it is never actually correct. It is always oversold or underbought.

This makes it virtually impossible to pick an absolute top or, as many investors have learned this year, an absolute bottom. But that doesn’t mean that one can’t drastically increases their chance of success by paying attention to the emotional responses driving the herd.

Dan Amoss, editor of the Strategic Short Report, is a man who knows a thing or two about true contrarian investing. His track record of betting against the crowd this year has delivered his readers some truly stupendous returns in an otherwise bleak market. Please enjoy his insights below…

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Sell High, Buy Low
By Dan Amoss

As a short seller, sharp rallies from oversold conditions can really cut into your returns. Since the panic low on November 20, the market has rallied sharply, with the potential for further gains.

You need to avoid situations in which an emotional crowd can trample you. Right now, the crowd is running back into the stock market. This could change at any moment.

This month’s oversold extremes were unprecedented. The pendulum swung much too far to the bearish camp. The current rally could last several more weeks, but may not carry the major averages much higher.

At the very least, we should examine the market’s reaction to the Nov. 4 elections before entering a new short sale.

Much of the recent stock market collapse can be explained by panicked forced selling, rather than fundamentals. Sure, we’re going to have a long, deep recession – especially in certain sectors of the economy. But you must also keep in mind that stocks are denominated in paper money. Central banks and governments are fighting this credit crunch with the greatest wave of inflation in history. I’m betting they’ll succeed, albeit with many consequences.

During the panic, I read many misleading statements about stock valuation. From day to day, stocks are, obviously, worth whatever the potential buyer is willing to pay. In panics, sellers overwhelm buyers.

But over time – in normally functioning markets – a stock’s price will reflect its ability to deliver free cash flow to shareholders. The next two or three years of earnings are only a small fraction of any stock’s value.

Yet many great companies, including National Oilwell Varco, quickly crashed by 70% or 80%, just because earnings might temporarily slow. NOV’s real value did not fall that much. This was an emotional overreaction, so we took advantage and picked up some cheap call options.
The value of any company depends on factors like future sales growth, profit margins, and capital investments necessary to sustain its business. In short, the value of companies, or stocks, doesn’t really change very quickly from week to week.

But the market can change its expectations very quickly, especially when fear overwhelms rationality.

Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, recently described how fear and stress can impact the stock market:

The whole story of how humans deal with stress is really interesting, but there’s one facet worth emphasizing. When people get stressed, they tend to dramatically shorten their time horizons. If you’re a zebra being pursued by a lion, turning off systems for digestion, reproduction, immunity, and growth makes all the sense in the world because the chase will be done, or you will be done, in short order. But humans, who have many of the same physiological responses, are not dealing with a short-term threat, but rather a long-term system called the stock market. So taking a long-term view is absolutely crucial, although really hard.

Most investors have clearly been acting under dramatically shortened time horizons.
Redemption requests and margin calls have forced many fund managers to sell what they don’t want to sell at ridiculously low prices. But it finally seems we are heading back into a normally functioning market – where investors can make informed decisions without so much fear and stress.

A more orderly stock market will give us plenty of attractive short ideas. I’ll be looking for situations in which the market has already priced in a rosy scenario for a stock. We can all become better investors by honing our abilities to distinguish between the trading noise and the investing signal. In other words: What really matters to the value of this company, and what does not?

It’s amazing how often the market projects the fundamentals of the past year into the infinite future. Those who invested in bank stocks two years ago have discovered the hazard of investing on the assumption that the future will look just like the past. The same goes for traders that chase the latest hot stock up to the stratosphere, to the point where it must keep growing earnings at 30% per year for a decade to justify its valuation. Once there’s a hint that growth will fall short of expectations, formerly “hot” stocks can crash 30% or 40% in a day – especially if earnings were never sustainable to begin with.

There is still plenty of fear in the current investment environment, so it’s difficult to navigate. But if you keep the economy in proper context, many attractive opportunities on both the long and short sides of the stock market can be uncovered.

It makes sense to hold stocks that are:

A) Exposed to sustainable fundamental trends
B) Cheap relative to earnings potential
C) Self-financing in operations
D) In a period of poor sentiment – with small hurdles to clear

Enhance your returns by selling short stocks that are:

A) Rallying on hope (and psychological anchoring to historical fundamentals)
B) Counting on discretionary spending
C) Tangled up with deteriorating balance sheets
D) Enjoying earnings expectations that are still too high
E) Depending on regular access to external financing

In times of panic, the market tends to project the past year’s negative fundamentals into the future. For example, how much does the fact that U.S. gasoline demand is down 4% year over year matter to the value of oil stocks? It matters if gasoline demand keeps falling at a 4% annual rate over the next decade.

But you probably agree that this has little chance of happening, since oil consumption generally doesn’t fall quickly in response to higher prices. Yet most oil stocks now trade at valuations that anticipate an endless spiral in demand and prices.

I think the shortsighted fear about U.S. oil “demand destruction” is noise. It’s distracting investors from an important signal: sustainable worldwide demand and supply constraints that will determine the long-term price of oil. So you have the opportunity to take a contrarian stand, buy cheap oil stocks, and hold them as long as fundamentals stay intact and valuations stay reasonable.

Joel’s Note: If you’re portfolio is in positive territory for the year, chances are you are already playing the short side of the market. Most long-only funds, including those run by many of the world’s best investors, are nursing losses of 20, 30 and 40% YTD…if they’re doing well.

Nobody can tell you precisely where the market is going tomorrow, and we wouldn’t trust anyone who told us they could. Instead, it pays to have a range of strategies at your fingertips, including a short strategy. Dan’s Strategic Short Report is about as good as you’re going to find when it comes to in-depth company research and rock-solid macro analysis. If you’re thinking about adding a short strategy to your arsenal, we suggest you start with Dan’s Bear Market Strategy Report.

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[Rude Endnote: Thanks to all those who wrote in with their nominations for the 2008 Best in Rude series. It has certainly been an interesting year, with much to keep your editors busy. We’ll be taking final votes until Sunday afternoon, so be sure to check out our archives here and tell us what your favorite column was.

Also, congratulations to those readers who were able to snag a position on the mailing list of our new income strategy service. There are still a few complimentary pre-release positions left, but we’re expecting a good deal of them to close over the weekend. When this service is officially released, it’ll go for $1,495 per year. Find out more about how you can get in beforehand for free right here.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com