Agora Financial’s Rude Awakening

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Laguna Beach, California

• Benjamin Graham depression-era investing tools,
• Why crises only end when no one believes they ever will,
• A closer look at the bear market bounce and plenty more…

Eric Fry, reporting from Laguna Beach, California…

The stock market meandered through another directionless trading session yesterday. When the closing bell finally sounded, the Dow Jones Industrial Average had achieved a gain of…drum roll please…almost five points!

Yesterday’s 5-point gain lifted the Dow’s performance for the week to minus 97 points. But that’s not all! Yesterday’s 5-point gain also lifted the Dow’s one-month performance to minus 580 points and its two-month performance to minus 391 points. In other words, the stock market hasn’t been doing all that well lately. And despite the huge early-March-to-mid-June rally, the Dow is still down nearly 7% for the year-to-date.

So what do all these numbers mean? Only that a bear market bounce is just that….a bounce. During bear market rallies, most investors merely recoup a portion of what they already lost. Very few investors actually increase their gains.

Maybe the stock market will begin a new rally phase tomorrow. We have no idea. But we do know a little bit about the history of financial crises. And this little bit of knowledge gives us very little comfort. Simply stated, big financial crises last for a while. They do not end on cue, when the government conducts massive bailouts and declares victory over economic adveristy. Nor do crises end when investors genuinely believe that a government can manipulate markets and fix asset prices for the greater good.

Crises end when no one believes they ever will…and when no one trusts the government to do anything other than confiscate wealth and impede capitalistic enterprise.

The stock market has staged a delightful rally. Too bad the economy hasn’t. Economic activity remains moribund, diseased and crippled. Perhaps the activity, in aggregate, is less bad. But so what?

The economy stinks, pure and simple. Most essential measures of economic vitality are continuing to degrade. Which leads us to wonder, how much higher could the stock market go if the economy refuses to follow along?

The Dow’s springtime rally – 36 percent from low to high – bears a very close resemblance to a rally that occurred 79 years ago. Shortly after the stock market crash of 1929, the Dow produced a dazzling rally. Between mid-November 1929 and mid-April 1930, the Dow jumped 48%.

This was the beginning of the Great Depression. We all know that now. But ironically, the early days of the Depression looked an awful lot like prosperity. Almost everyone knew that that worst was over. And almost everyone knew that the economy was on the mend. But over the ensuing two years, the Dow plummeted more than 80% and GDP tumbled more than 30%.

Most of today’s investors draw comfort from the recent stock market rally, and anticipate that America is already resuming it habitual economic growth.

We are dubious.

In today’s column, Chris Mayer, editor of Capital & Crisis, takes us on an economic tour of 1930 – a year that bears an eerie resemblance to 2009.

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Ahead to the Past
By Chris Mayer

After the crash of 1929, the market had a nice recovery. By April 1930, the market was up 41% from its lows of Nov. 13, 1929. Many believed the worst was over. One of those who did was Benjamin Graham, the father of security analysis, Warren Buffett’s teacher and a great investor in his own right.

In 1930, Graham was 36 years old, a near millionaire who had already enjoyed a lot of success in markets up to that point. So when he met with a successful, retired 93-year-old businessman named John Dix, Graham was full of “smug self-confidence,” as he would admit in his memoir. Graham found Dix “surprisingly alert” as Dix peppered him with all kinds of questions. Then Dix asked him how much money Graham owed to banks. Dix didn’t like what he heard.

That’s because Graham used a lot of debt in his investment fund to finance stock purchases. When Dix heard this, he then offered him a grave warning with “the greatest earnestness.”

Dix said:

Mr. Graham, I want you to do something of the greatest importance to yourself. Get on the train to New York tomorrow; go to your office, sell out your securities; pay off your debts, and return the capital to your partners. I wouldn’t be able to sleep one moment at night if I were in your position in these times, and you shouldn’t be able to sleep either. I’m much older than you, with lots more experience, and you’d better take my advice.

Graham, of course, didn’t take his advice. He even writes in his memoir that he “thanked the old man, a bit condescendingly, no doubt.”

Of course, Dix was right, and the worst was yet to come. “I have often wondered what my life would have been like it if I had followed his advice,” Graham muses. Graham suffered mightily in 1930, his worst year ever.

After 1930, he did unwind the debt he held in his account and he did much better thereafter in what was a mercilessly difficult market. Given that Graham’s partnership had 44% of its assets financed by debt going into 1930, just pacing the market would have wiped him out. Irving Kahn, another great old investor and student of Graham’s, wrote of Graham’s ordeal in the 1930s: “Keeping the fund alive was a great achievement. The small losses of 1931 and 1932 were especially impressive.”

Graham’s big mistake was using too much debt. That’s why Dix told him he shouldn’t be able to sleep at night. Dix appreciated just how dangerous all that leverage was. The inspiration in Graham’s tale, though, is that he fought his way back and went on to earn good returns in the market in later years.

The lesson he learned is a lesson that we have to learn in every cycle, it seems. Fast-forward to today’s calamity and enormous debts once again pose a great danger, despite the market’s recovery.

After the crash of 2008, the market hit bottom on March 9, 2009, when the S&P 500 closed at 676.53. As I write, the market is up nearly 37% from those lows – and a similar view seems to be taking hold that the worst is behind us, just as it did in early 1930. When the market recovered in early 1930, the failure of Creditanstalt, a big bank at the time, sent it lower.

Banking troubles plagued the market for the rest of the year. Today, there is still an enormous amount of debt out there and certainly more bank failures to come.

One of the best pieces I’ve read about our financial crisis recently was “The Death of Kings: Notes From a Meltdown” by Nick Paumgarten in The New Yorker. It is certainly the best written. (It appeared in May and is worth tracking down.) LINK TP IT

Paumgarten talks to a lot of interesting people in his efforts to understand the nature of the crisis. One of my favorites is a man named Colin Negrych, “part market philosopher, part screen savant – a nexus of market intelligence.” Negrych advises some of the most respected investors in the world, who prize his secrecy and distinctive advice. He’s made billions for them, and skimmed off some for himself, too. Negrych seemed to sum up the whole thing rather well:

“There seems to be an unwritten rule that this can’t happen. So much effort is put into sustaining the stock market and home prices. This whole culture has been set up to see stocks and homes as annual riskless investments. They most assuredly are not. Banks are going under because they are undercapitalized… The problem is too much debt… Debt is the story.”

In Negrych’s view, Wall Street churns out believable, but wrong, arguments for why these increasing levels of debt are sustainable. All the financial engineering “fills the gap between people’s desires and their wherewithal.”

So this is the problem. It’s why I’m particularly averse to debt these days. To do well in this market, we’ll need to raise the bar for what is cheap and what is in excellent financial condition.

It’s also why I think it’s especially important that investors stick with cash-rich, debt-light, tangible assets – rich in water rights, oil, natural gas, potash mines, gold mines and the like. We like assets that are inherently useful, even needed – like oil rigs, hydropower assets and methanol plants. Things hard to build, difficult to replace and costly to substitute.

Talented owner-operators with a track record help too.

After all, Graham did quite well in asset-rich names, even in the 1930s, once he kicked the debt habit. As Negrych said, “Debt is the story.” And it will be for some time yet.

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[Rude Endnote: Not much action to speak of from Asia or Europe overnight. In an effort to out-snooze the Dow’s 0.06% gain, Japan’s Nikkei 225 fell 0.04%. Hong Kong’s Hang Seng inched higher by half a percent and the Aussie All Ordinaries also gained a little over 0.8%.

There was a tad more action over in Europe last we checked…but just a tad. London’s FTSE, France’s CAC 40 and Germany’s DAX were all underwater by about half a percent, give or take a few points.

Over in the commodity pits, crude continued its slow selloff. A barrel of the world’s goo slipped beneath $60 overnight and now trades for $59 and change. Gold also continued to fall and now rests at $908 per ounce.

We’ll be back with your usual weekend wrap this time tomorrow.

Until then…

Cheers,

Joel Bowman

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