The Third Pig: What You Should Do In This Market

Perhaps you have been startled by what has been going on in the stock market this year, and in the last few days in particular. It is understandable if you have been. This is an unusual time. There’s a lot of uncertainty in the financial sector. Bear Stearns and Lehman have failed, Fannie Mae and Freddie Mac have been taken over by the government, AIG had to take accept an $85 billion loan from the government with steep terms, Morgan Stanley and Goldman Sachs converted to conventional banks, the FDIC stepped in to save Wachovia and Washington Mutual, and the Treasury Department is asking Congress to pass a $700 billion bailout of the financial system.

If you watched any news program or read any paper yesterday you know that Congress did not pass the plan proposed by the Treasury. The stock market reacted. Yesterday, the S&P 500 fell 8.9%. As a relative measure, the day the market opened after the tragedy of September 11, 2001, the S&P fell 4.9% on September 17, 2001. It was the biggest one day drop since Black Monday in October of 1987 when the market fell more than 20% in one day.

All of this turmoil is likely to leave most investors in the market biting their nails and pulling their hair out. These folks, not knowing what to do, will do nothing. Others might react by immediately selling all their investments, pulling their money out of their bank, and burying everything they own under the shed in their backyard. I understand both reactions, as both are simply human. But neither is what should be done.

As you have heard (or read) me say time and time again, it is best to act in the way Warren Buffett would. In Berkshire Hathaway’s 2004 Letter to Shareholders, he shares:

“Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.
There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

Recently, Buffett invested $5 billion in Goldman Sachs on very favorable terms. He did so in the midst of all the turmoil in the financial sector of the market. In essence, he followed his own advice.

This method of buying into fear has proven fruitful over time. How does an investor know when others are fearful?

The Chicago Board Options Exchange (CBOE) manages a volatility index called the VIX. The VIX is an excellent indicator of the sentiment, bearish (fearful) or bullish (greedy), in the stock market. It captures the level of uncertainty reflected in option contract premiums. These contracts allow fund managers to insure themselves against sudden share price movements. A high VIX reading indicates investors are fearful and are willing to pay more for this downside protection.

History has shown that when the VIX reaches levels above 25 – 30 (above the red line), it has been a good time to buy. Yesterday the VIX reached nearly 50 and for the last 18 months has regularly reached levels above 25. [Click here for a larger image.]

Additionally, we are in a bear market for stocks. The likelihood of precipitous declines from these levels is somewhat low (though not impossible). Given current valuations, U.S. stocks may be the safest place to put money right now. The S&P 500 now trades at 14x earnings estimates for 2008 EPS. This is well below historical PE levels. Another thing to keep in mind is earnings may be somewhat depressed due to a harsh economy. In other words, when earnings return to normal, prices may prove to be even cheaper than it is currently estimated.

High volatility begets cheaper stocks which begets high returns for those who are greedy when others are fearful.

So what should you do now?

For money you need within 5 years: Keep those funds in an interest bearing account at your bank of choice. Even with all that is going on, the bank is still the best option for your cash funds. If those deposits are below $100,000 ($200,000 in a joint account), they are insured by the FDIC. And the news today is the FDIC is applying to increase those limits. I speculate they will increase them to at least $250,000.

For money you need beyond 5 years: Invest or keep your money in a diversified (at least 20, no more than 30) portfolio of stocks of low leverage (companies that don’t make use of debt), high return on capital companies. If you have cash available, you should consider adding to your portfolio. Years from now, you will wish you did.

Write your congressman: Write your congressman a letter urging him or her to pass the legislation to infuse $700 billion in the banking system.

Disclosure: I and the clients of Brick Financial Management, LLC owned share of Berkshire Hathaway at the time of this writing.