Catching The Falling Knife

Below is the original version of my latest FT column. Equity markets are as oversold as they have ever been, and the selling momentum has been relentless. There will surely be some sort of rally soon, but it is not one that I am yet ready to trust as marking the end of the bear market.

The metaphor that originally seemed to capture the global financial crisis best was Jeremy Grantham’s “slow motion train crash”, in which a world dominated by unsound monetary policies and reckless bankers headed inevitably towards its eventual demise, unable or unwilling to abandon the course that had led them to this point in the first place. (Some, like the UK Prime Minster Gordon Brown, appear to be still in denial that they were ever driving the train).

However the market action of the first two months of 2009 brings to mind another metaphor, that of the “falling knife” that only the foolhardy will be trying to catch. The speed with which the markets have taken out the lows of November 2008 and headed further south in the last two weeks has been as breathtaking as it has been brutal. For the Dow Jones index to lose 20% of its value in two months is some going.

Clearly, when such powerful market momentum develops, there are dangers in trying to stand in the way. There is no obvious reason why the markets cannot now go on to test further new lows. Valuations, though beginning to look attractive on a medium term view, are not yet anywhere near the level – dividend yields as high as 10%, p/es as low of six – which typically characterise the bottom of history’s worst bear markets.

In a world where the average institutional holding period for equities has fallen to an absurdly low nine months, and relative performance and career risk drive the behaviour of many investment institutions, such downward dynamics could become as lethally self-feeding as portfolio insurance was in 1987. Investors’ emotions are already being tested further by the exceptionally high levels of daily volatility, and if sentiment continues to buckle, the Dow at 5000 or even lower is by no means an impossibility.

By its nature, however, this is the kind of market in which value gets trampled by momentum, and by extension therefore a period in which fantastic returns will be made and lost by those with the liquidity and nerve to identify the worst cases of mispricing. It is also the mechanism by which future generations who have been effectively excluded from the housing and equity markets by overvaluation will eventually be priced back into their normal long term real returns.

As usual Warren Buffett almost certainly has it right when he says that the markets have moved from underpricing to overpricing risk. In his latest Annual Report he confesses to Berkshire Hathaway’s worst annual performance since he first took control more than 44 years ago (this is based, it has to be said, on his chosen performance measure of book value per share, which would not be everyone’s choice, as its effect is to smooth out some of the volatility produced by year-on-year marking to market ).

“In 75% of those [44] years” he writes “the S&P stocks recorded a gain. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall”.

Those who criticise Buffett for his bad timing, as many invariably do in a falling market, take comfort from the fact that the market has fallen since he first started making his comments about equities, inferring (to their own satisfaction, at least) that this makes them smarter than him and that he must therefore have been wrong. All it actually shows however is that their investment horizons are much shorter and that their investment philosophies are radically different.

If he were of the bragging kind, Buffett could easily respond by pointing to his 20% per annum compound return over 40 years, his place at the top of the Fortune list of wealthiest individuals, his high-yielding investments in Goldman Sachs, Wrigley et al, and ask: “where’s your equivalent”? In fact, one of the reasons Buffett has always stood out from the investment herd is precisely because he is often happy to own up to his share of real howlers. What could he have been thinking, for example, when buying Irish bank shares in 2008 and Conoco Phillips when the oil price was above $100 a barrel? It is a useful reminder that even great stockpickers can behave like idiots at times.

Is Buffett right to say that inflation is now the greater risk? It certainly looks that way to this observer. Is he right to say that the U.S. Treasury bond bubble of late 2008 may be regarded by future historians as “almost equally extraordinary” as the Internet bubble and the US housing market bubble? Again, yes. The major difference between the equity markets now and 18 months ago is that further falls from here have a good chance of being reversed relatively quickly, which was not a case that could be made before.

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