HELPING PHYSICIANS ATTAIN FINANCIAL SECURITY
By Robert M. Doroghazi, M.D., F.A.C.C.
How to Avoid a Wipeout
Part I of II
I saw a long-time subscriber in the doctor’s lounge the other day. He said he loves the newsletters, has made some nice money from my recommendations and general advice. He also said he wished I wasn’t so bearish, yet he shares most of my concerns.
I’m bearish on the economic outlook for good reason. The world is awash in debt. I’m bearish on real estate, and if that has prevented you from losses by not buying back into the market too early, or “sellin’ while the gettin’ was good”, you’re ahead. I am bullish on the precious metals, commodities, collectables, and hard assets in general. That advice has also proved profitable.
The other reason my advice may sometimes “seem” bearish is that I always try to think about what might go wrong. My first concern is not how much I can make, that can cause you to be greedy, but how much I can lose. Everyone is happy when things go well; the wise person is concerned with risk, what might go wrong. This is not “bearish” advice, it is sound common sense.
From my own observations over the years I have drawn my own conclusions. After subsequent reading and study I have often found these are valid, previously documented facts. For example, I noted that if I see something and in 10 seconds say “this is the greatest thing since sliced bread”, these are my winners. Whenever I had to talk myself into anything, these were my losers. In Issue #118 (8/12/10), I quote Blink: The Power of Thinking Without Thinking (Gladwell, Little, Brown and Co., 2005), to show there is a scientific validity to support my personal observation.
I finished All the Devils are Here: The Hidden History of the Financial Crisis (McLean and Nocera, Penguin). In Wall Street’s quest for a formula to quantify risk, in the 1980s the “quants” (quantitative analysts) at JP Morgan (JPM) developed a model called Value at Risk, or VaR. If the VaR was 45, it meant that 95% of the time (19 out of 20 chance), the most the firm could lose in one day was $45M.
Not having any formal financial or economics training has allowed me to come to my own conclusions, unencumbered by standard dogma. I believe Buy and Hold is a myth. I believe the slavish quest for diversification can lead to losses by forcing you to make investments outside your area of expertise. I never understood the “Random Walk”. As soon as I read about VaR, I said “so what happens the other 5% of the time”?
When you think about it; all that really counts is the other 5% of the time. Over the course of a year, the 19 out of 20 cancel out; you make a little money, you lose a little money; it really means nothing. Three to four percent of the time, you make nice money. One to two percent of the time; you get spanked, you can suffer serious losses (In general things go down 5 times faster than they go up). Consider this: if you could avoid just one day, the worst day of the year, you would increase your annual returns by about 6-7%. That would be world-class investing, beating the averages by more than 5% per year.
But even the worst day ever won’t wipe you out. On October 19, 1987, the DJIA was down 22%; the worst day in market history. Very nasty, very scary, and you were certainly much poorer, losing several years of gains in one day. But even the worst day ever didn’t wipe you out.
Wipeouts do occur. In the financial crisis of 2008, Bear Stearns and Lehman Brothers disappeared. Merrill-Lynch, Wachovia, Washington Mutual and Countrywide Credit were absorbed by other firms. General Motors, Chrysler, Citigroup and AIG were effectively nationalized. Millions of people have lost and will lose their homes to foreclosures. Some very bright people feel that many countries in the developed world, including the US, are headed for a financial crisis worse than 2008. If this occurs, there will be more wipeouts.
I believe history shows we are in a secular bear market in financial assets that began in 2000 and still has 5 to 8 years to run. If there is a chance of another financial crisis similar to or worse than 2008; there will be more wipeouts. It is prudent to protect yourself.
So: What can wipe you out? By far the most important common denominator to wipe-outs is debt. For example, on October 19th, if you were leveraged 5 to 1, you were wiped out. The big banks and investment houses were leveraged 20 to 30 to even 40 to 1 going into the crunch of 2008. Fannie Mae and Freddie Mac were leverages 50 to 60 to 1. Those are not typos. With that kind of leverage, even a 5% drop will wipe you out.
You buy a $500K home at the top of the market in 2005/6 in Las Vegas with nothing down (and no documentation, or even lied about everything) and borrow the entire $500K. The home is now down 40-50%. You are wiped out. You put down $200K and borrow $600K to make an investment (such as a restaurant or a vineyard, or you put the money with Bernie Madoff) that eventually goes bust: you are wiped out.
A corollary of this is not having enough cash to cover even (apparently) manageable amounts of debt. Let’s take an extreme example (Extreme examples are useful to show if the system breaks down when stressed, as the Wall Street folks didn’t consider in their elegant computer models). Say you are a farmer with 600 acres of land worth $5K per acre=$3M of farm land. Farm land is the one area of real estate that has performed well and crop prices, in general, are strong. You are flush. In February you borrow $250K to buy a new tractor and a new combine (that’s cheap). Even a relatively poor crop will allow you to pay this note in full after the harvest in November; with plenty left over to get through the winter and have enough for next year’s planting.
But there is a financial crisis. The bank is in trouble and calls your loan (never sign a note that can be called) in July. You are wealthy, yet insolvent because of no liquidity, and could be forced into bankruptcy. Inadequate cash reserves can wipe you out.
In the next newsletter, I will continue the discussion of what can wipe you out, including things out of your control, such as natural disasters or illness, making assumptions, trusting others, and not learning the lessons of history.
RMD
I suggest you check your money market funds. Today’s Barron’s notes than the five largest money market funds in the US have an average of 41% of their assets in the short-term debt of European banks. In general, the higher the yield, the more concerned you should be. I suggest you keep your money in funds that are in 100% US government paper. Remember; your basic strategy with a money market fund is 1) the safety of your money, and 2) instant access, not yield.
Wall Street Journal 6/24/11). “World Oil Reserves Tapped. US, 27 Countries Intervene and Release 60 Million Barrels to Drive Down Prices”.
RMD comment: Sixty million barrels sounds like a lot, but it is only about 2/3 of the world’s daily consumption. This silly grandstanding further highlights that the US has never had a strategic energy policy. We should take the handcuffs off our energy companies and let them develop the resources we have.
This release of oil is like the US government taking out a payday loan.
As recently mentioned, about half the ideas for these letters come from my readings, about half from my personal experience or from talking with people. I was recently talking with a local subscriber, a retired physician and very sophisticated investor (he once won an investing contest), who made a serious amount of money in the precious metals’ bull market of the late 1970s. He said:
1) I am even more concerned about our economy than when Jimmy Carter was President (Inflation hit 15% per year. By 1982, when adjusted for inflation, the stock market had lost more than 80% of its value as compared to the 1966 peak).
2) Gold has replaced municipal bonds as the ultimate safe investment. His mother owned municipal bonds when you still had to clip the coupons on the bond (thus the term “coupon rate”) and send them in to get paid. He said there was never a one default on any bond she owned. As I will discuss in the next letter, gold is the only investment that has no counter-party risk; it stands alone.
I was talking to a local man with financial connections on the national and international level. I relayed the above comment about municipal bonds, and he said he has concerns about the entire muni-bond market. If you have any muni-bonds that are maturing, rather than re-investing the proceeds in more bonds (laddering the maturities), buy some gold.
I was talking with another long-time subscriber. He has a 5% (paper) position in the precious metals, and was thinking about increasing it to 10%. If he felt comfortable with it, I encouraged him to do it, with some of that being physical gold (and a little silver) in his personal possession. He also asked about the miners, as they appear cheap historically in comparison to bullion.
RMD comment: important question. In the end, the price of a commodity, whether it be gold, silver, corn, lumber or oil, is determined by the final demand for the physical product. Silver has been clobbered, but gold has been holding up better. This tells me that people want physical gold, and that the economy may be weakening.
The positives for the miners are 1) they are leveraged to their product. For example, if gold is $1,500 per ounce and their costs are $1,200, a 10% increase in the price of gold represents a 50% increase in profits. Over the long term, the miners out-perform bullion by a ratio of about 3 to 1. 2) Some pay a dividend, usually small, but which should increase with time.
The negatives for the miners are that they represent the stocks of companies traded on the stock exchanges. Issues include 1) general stock market conditions, 2) input costs, such as wages and expenses, 3) political considerations, 4) capital requirements and debt costs, etc. The fact that the miners have recently under-performed bullion, as they did when the broad market collapsed in 2008, is just one more reason I am concerned about general market weakness.
The miners have been crushed; and broke to new recent lows. Since I believe we are in a bull market in the precious metals that has a long way to go, with the presumption that at some time the miners will resume their traditional out-performance, is now the time to buy?
I can’t do it. If you buy on weakness, it should be because you feel the stock is under-priced. Research in Motion (RIMM, see chart, next page) is an example of what can happen when you buy just because the price is lower—because it can go a lot lower. I much prefer to buy on strength. I would rather give up a few points than buy too early and suffer further losses or a long period of dead money.
On Friday, I participated in the ceremony in Jefferson City presenting the Distinguished Eagle Scout Award to Missouri Governor Jay Nixon.
During the meal, someone mentioned one thing everyone remembers is their first phone number. Mine was TR-3719. About the time we moved in 1956 to where my mother still lives, a number was added to make it TR6-3719 (By the way: the limit of our ultra-short-term auditory memory is about 7 digits. Phone numbers won’t get longer because the human mind couldn’t remember it if someone told you a longer number).
The letters at the beginning of the number were exchanges. The exchanges in Granite City were TR(iangle) and GL(enview). Some of the exchanges in St. Louis were Wydown and Chippewa. I’m sorry that has disappeared, as I thought it made things easier to remember, and provided some interesting context.
Some of the other people at the table, older than I and from smaller towns, had 2, 3 or four digit numbers. When one person said their phone ring was “two longs and a short”, friend Diane, from Syracuse, Nebraska (population 1,500), lit up and said “that was ours too”.
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