Agora Financial’s Rude Awakening

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Wall Street, New York

• How to ensure you profit…even in the off chance of an outlier,
• Are we seeing a bottom? Don’t bet your bottom dollar!
• Just another “normal” Victoria’s Secret fashion model and more…

Eric Fry, reporting from the scene of the crimes…

“What is the new ‘normal?’” an attendee at yesterday’s Grant’s Investment Conference in New York City asked one of the speakers, referring to the troubled American credit markets.

“It will look a lot like the ‘old normal,’” the speaker replied. “The lenders might demand a little more collateral or a slightly higher interest rate. But the ‘new normal’ will look a lot like the ‘old normal.’”

Your California editor winced at the response.

“Really?” he wondered to himself. “Wasn’t the ‘old normal’ decidedly abnormal? Didn’t America’s largest lending institutions utilize extraordinary amounts of leverage? And didn’t they load their balance sheets with spectacular quantities of suspect loans and incomprehensible derivatives?

“If America’s uninhibited credit orgy was ‘normal,’” your editor silently reasoned, “it was a very unique kind of normal – like a normal Victoria’s Secret fashion model, or a normal Hall of Fame baseball player or a normal Category-5 hurricane…or a normal once-in-a-lifetime credit bubble.”

Therefore, a normal, once-in-a-lifetime credit bust should result.

The financial markets will certainly return to “normal,” but questions remains. Will the markets return to the “old normal” of 2004 to 2006 or to the “old, old normal” of 1978 to 1980?

Back in those “old, old normal” days, U.S. stocks changed hands for single-digit PE ratios, Treasury bonds offered double-digit yields and the U.S. Treasury tried to support a falling dollar by issuing bonds denominated in Swiss francs and deutschemarks. [The Treasury's Web site provides the scintillating details: Here's a link]

In other words, American financial assets attracted tepid demand. Investors far and wide demanded (and received) a large margin of safety to compensate for the risk of buying and American stocks and bonds.

But times have changed, folks. The risk-averse investors of 1978 have become the risk-indifferent investors of 2008. The CNBC-ization of news flow has created a generation of investors who cannot imagine adverse outcomes. At the same time, the recent American history of mild, short-lived crises has emboldened the current generation of investors to respond to every downtick with “buy” orders, if not leveraged “buy” orders.

But maybe investors should be responding with “sell” orders this time around.

Financial markets ALWAYS fluctuated between extremes of high valuation and low valuation. However, for the better part of two decades, America’s stock, bond and housing markets have fluctuated only between high valuations and higher valuations. Prosperity and robust asset pricing have held sway.

But in the wake of the most severe credit crisis since the 1930s, would it be so surprising if the financial markets revisited extremes of low valuation? A return to even middling valuations would cause widespread weeping and gnashing of teeth.

To hazard a guess, your California editor predicts that the worst of the credit crisis has not YET occurred; the bottom of the housing market has not YET arrived; and the buyers of financial stocks has not YET made brilliant investment decisions.

The Federal Reserve may have succeeded in pulling the financial sector from the flaming wreckage of misguided speculations, but the Fed has not come close to restoring the financial sector to complete health.

The financial sector is still saddled with enormous quantities of illiquid assets, it is still carrying suicidal levels of leverage (debt-to-equity ratios like forty-to-one are still “normal” among America’s leading banks and brokerage companies) and the financial sector is still nowhere close to seeing the business volumes that could produce a growing income stream.

In short, the bottom is NOT in.

That said, not every American company is a Bear Stearns or a Lehman Bros. Some American companies have avoided burdening their balance sheets with hi-tech, toxic waste. And some American companies are operating prudently and profitably. They are earning their dollars the old fashion way: quarter-by-quarter, customer-by-customer.

Far from the drama of CDOs, CDS, billion-dollar writedowns and Federal Reserve bailouts, thousands of American companies continue to prosper in anonymity. Thousands of American companies continue to expand their market shares without fanfare; thousands of American companies continue to increase their profit margins without assistance from the Federal Reserve.

These companies represent the low-profile component of the American economy that rarely attract a front-page headline, but often issue a shareholder-pleasing earnings report. To learn more about these “other” America companies, read on…

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Sell Goliath, Buy David
By Aaron Gentzler

Nice guys get “I like you as a friend” speeches and invites to sit at the “free radicals” table at weddings. Meanwhile, those sporty loudmouth dudes who get all the girls zip about town in tricked out BMWs and never help old ladies cross the street. Likewise, the Dow Jones Industrial Average (DJIA) is a Hall of Fame of gains, while the Russell 2000 burns investment dollars faster than your friend who wanted to start a chinchilla farm.

Gross generalizations like these are not only uncouth and often wrong, they’re bait for another kind of free radicals. I’m talking about statistical outliers. And while staking the farm on outlier philosophy is akin to jumping from an airplane without a parachute, there are lessons ahead for all small-cap investors.

Two examples of outliers — one from the Old Testament, the other from University of Michigan football coach Lloyd Carr’s personal and rapidly manifesting hell: David beat Goliath once. Appalachian State beat Michigan once.

Give David 10 shots at Goliath, you say, and Goliath probably gets the better of David at least seven times. Likewise, if Appalachian State (solid team though they may be) had to play Michigan 10 times, the smart money says the Wolverines win many more games than they lose.

But alas, Goliath and Michigan both ended up dead on the turf. Long live the outliers.

Gross generalizations in sports (and investing) tend to come about via a simple two-step process. In step one, groupthink and/or “conventional wisdom” get the best of those who should know better. Then in step two, the first ailment is exacerbated by a strong dose of outright laziness. People eat what they are fed and fail to do their own work.

Next thing you know, Appalachian State doesn’t have a chance, David is as good as dog meat, nice guys never get the girl and the Russell 2000 is a wasteland compared to the DJIA. I don’t know about you, but I just can’t imagine living in that world.

If you listen to the tout freaks and the balloon-headed commentators, you might think this is the world we live in. So in the hope of cooler heads prevailing both in college football and in the markets, here are some illuminating statistics:

According to a 17-year study conducted by investment firm, Tweedy, Browne, low-valuation small-cap stocks dramatically outperformed their large-cap counterparts between1963 through1980. “One million dollars invested in the smallest fifth of the companies listed on the New York Stock Exchange, which were priced in the bottom fifth in terms of price/earnings ratios, would have increased to $19,500,000 over the 17-year study period,” Tweedy, Browne concludes. “By comparison, $1,000,000 invested in the largest market capitalization stocks with the lowest price/earnings ratios would have
increased to [only] $8,107,000 over the same period. During the period, the annual investment returns for the market capitalization weighted and equal weighted NYSE Indexes were 7.68% and 12.12%, respectively. One million dollars invested in the market capitalization weighted and equal weighted NYSE Indexes would have increased to $3,518,000 and $6,992,000, respectively.”

Overall, that’s not too shabby a result for small cap stocks. But financial media coverage tends to ignore small-caps and focus primarily on large caps. That’s too bad. Investors are missing out.

The Russell 2000 might not be shooting sparks at this very moment, but it is generally keeping pace with the year over year progress of the much bandied-about Dow Jones Industrial Average.

My point is this: Anyone you encounter who exclusively pushes the large-caps doesn’t truly have your best interest in mind.

There are tons of strong deals out there in the small-cap world. Those who hype the large caps to the detriment of all other classes are the groupthink-ers and “conventional wisdom” followers who say Goliath could never lose and that nice guys always finish last.

Dare to be an outlier.

[Joel's Note: Whether you are a small-cap guru or strictly a large-cap enthusiast, having a couple of outliers in the portfolio is a great way to get some exposure to those potentially massive gains. It’s like placing a $20 on the three favorites at the track…and a sneaky $2 on the horse with the longest odds. It won’t win all the time, or even most of the time…but when it does, the drinks are on you for the night.

Grab a couple of outliers on the cheap here and keep things interesting.

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[Joel's Note: As we go to print today, our business partners over at EverBank have JUST announced the release of their NEW World Energy CD. Basically it’s a way you can invest in the booming energy economies of the world, with similar terms to a regular certificate of deposit. The big difference is that the currencies of these countries (Australia, Norway and Canada) are ipso facto backed by their massive energy endowments…not simply the promises of a broke government, as is the case with the US dollar.

All the details can be found here. This is a great offer so we hope you can spare five minutes to learn a little more.

Until tomorrow… 

Cheers,

Joel Bowman
Rude Awakening