The Commemorative Correction

The Dow Jones Industrial Average was down over 360 points today. It hurt to be a shareholder today, but it was a pale shadow of the pain endured by investors 20 years ago to the day on October 19, 1987; a day when the stock market dropped over 20% and so deeply scarred the memories of investors that it is known by not one, but two, nicknames today – “Black Monday”, and “The 87 Crash”.

Of course, the stock market did not drop today because it is the anniversary of Black Monday – traders are not that sentimental. Bad news on many fronts provided ample reasons for traders to dump shares, including:

• Standard and Poor’s downgraded more mortgage-backed securities, creating further doubt about the health of the credit markets.
  
• Oil prices made a new all-time high, crossing above the $90 level for a short time before closing at $88.
  
• Lackluster earnings reports and cautious words about the economy from companies such as Caterpillar, 3M, and Harley Davidson.
  

So, where does that leave us, as individual investors? Relatively calm, if we have been careful to buy “great companies at great prices”; as Warren Buffett would put it. We’re also not overly concerned if we have focused our mutual fund assets in the better managed funds that are available to us, with the right mix of stocks and bonds.

It is hard to tell which direction the stock market will go in the next few days or the next few weeks, but one thing that history teaches us is that the day after a substantial drop in the market indices is not the time to sell your shares indiscriminately. It is a time to calmly assess your financial situation and your risk tolerance, and to make some adjustments to your portfolio if it is out of sync with either of these. And, if you are in the fortunate position of having cash available to invest, it is a time to buy shares in a great company that is selling at a great price because of the drop (or correction) that you have just endured.

Selling all of your stocks on October 20, 1987 would have been a big mistake, and selling all of your stocks on Monday, October 22, 2007 when the US markets next open, will almost certainly prove to be a big mistake if you choose to take that course of action.

After all, the only reason that it is possible to earn higher returns as a stockholder than you can earn in a CD is because stockholders suffer through days like today, (and occasionally, those like Black Monday). This suffering is what accounts for what Jeremy Siegel calls “the equity risk premium” – or, in plain English, the compensation that an investor gets for making a good long-term investment, and then enduring the inevitable bad days that will occur while that investment comes to fruition.

Just remember:

The payment for the pain is the chance to make a gain.

Footnotes and Foreshadowing

I’ll go into more detail about how well-chosen investments reward us for our patience (and our pain) in my next column, where I will discuss my experience owning, managing, and selling a small rental property.

Uncork the Bullish Champagne... But Avoid the Hangover: The Case for General Electric and Johnson and Johnson, Part II

In part I of this column, I discussed how recent market developments will help large companies with strong credit ratings to replace private equity groups as the players best positioned to buy out smaller companies. In this column, I will go into more depth about a few of the characteristics that make Johnson and Johnson (JNJ) and General Electric (GE), two of the many companies that benefit from this trend, such good investments at current prices. These companies share the following outstanding characteristics:

• Exceptional track records of making smart acquisitions (and smart divestitures)
  
• They are well positioned to ride long-term macroeconomic and demographic trends
  
• They have a long history of shareholcder-friendly dividend policies
  

Smart Acquisitions, Smart Divestitures

Both JNJ and GE have a long history of finding good businesses to acquire, and successfully integrating those businesses with existing businesses after each acquisition. As I mentioned in my previous column, GE took advantage of the liquidation of Enron to buy that company's wind power assets, which gives GE a strong position as the demand for green electricty continues to soar in response to forward-looking regulations. GE also made a smart move when it divested its slow-growing plastics business for $11 billion.

Johnson and Johnson recently purchased Pfizer's Consumer Healthcare business, adding an armada of well-known consumer staples brands to its already impressive fleet of products. Have a cut? sterilize it with Neosporin, and then dress it with a Band-Aid. Quitting smoking? Some Nicorette gum will help. Not so successful in your attempt to kick the habit? Then you'll need some Listerine to cover that up from your spouse. With so many staple products in its fleet, you would have to go out of your way to avoid generating sales for Johnson and Johnson on your next visit to the grocery store - never mind the money that they will make on your next trip to the hospital.

A Foot in the Future, A Foot in the Past

But, you say, consumer staples are a boring, old-economy business. What is forward-looking about acquiring consumer staples brands? Quite a bit. In Jeremy Seigel's The Future For Investors, the author examines the long-term returns of companies in the Standard and Poor's 500 index, and draws the following conclusions:

The consumer staples sector has been marked by unusual stability. Most of the largest firms in this sector have been around for fifty years or more, and provided investors with superb returns.

Unusual stability and superb returns are a winning combination in my book. Additionally, if you consider that any healthcare reform legislation that comes out of Washington D.C. in the next few years is much more likely to negatively impact the makers of pharmeceuticals and medical devices, rather than the makers of consumer staples brands such as Listerine and Nicorette, then this acquisition makes even more sense. By adding additional consumer staples brands to the company with this acquisition, Johnson and Johnson has reduced its exposure to the political uncertainty that is a fact of life in its core health care businesses. And regardless of what sort of health care reform comes out of Washington, demographic trends assure that Johnson and Johnson will do well as the United States moves from spending 16% of GDP on healthcare to 20% of GDP on healthcare in the next 20 years.

GE Places Bets on the Future of Energy and Water

Speaking of staples, few things are as essential as energy and water - and GE is no slouch when it comes to looking toward the future and finding ways to align itself with long-term trends in these areas. It is well positioned to benefit from the current (and worsening) energy shortage by selling the world's most fuel efficient locomotive. On the power-generation front, GE will benefit regardless of whether we get more of our electricity from nuclear, coal, or wind energy - after all, they build equipment needed to generate electricity from all of those sources. Even the looming world water shortage will benefit GE as the foremost leader in desalination technology, which converts sea water into drinkable water.

Dividends

So how does all of this smart planning benefit you as a prospective shareholder? Both GE and JNJ sport higher-than-average dividend yeilds of 2.7 and 2.5% respectively, and have a long history of increasing their earnings and dividends over time. It is rare to find such a combination of strong performance, high dividends, and good prospects for the future in one company, much less in two companies at the same time. I own a few shares of each of these companies for the long term, and you could do worse than to buy a few shares for yourself. My 12-month price target on GE is $52, and my 12-month price target on JNJ is $75.

Dow 14000 - The Pros Sustain the Close

Today the Dow Jones Industrial Average closed above the psychologically important 14000 mark. The last time that this number was in the news, it marked the end of a rally in the stock market. This time, it looks like the 14000 level will mark the beginning of a rally, rather than the end of one. As I stated previously in Dow 14000 - The High Water Mark?:

...when a market average such as the Dow passes through 12000, and then 13000, confidence and buying momentum build. And when the next much heralded number, 14000, becomes a barrier that the market can reach, but that the Dow average cannot close above, then that is a worrisome sign for the stock market.

The last time that the Dow average crossed the 14000 line, it closed below that number as traders rejected the new valuation for the 30 Dow stocks. Today, the Dow charged through the 14000 mark on high volume and closed above this number for the first time ever, providing a buying signal as strong as the sell signal that was provided by the rejection of this level last July.

And while we are taking a stroll down the (admittedly short) memory lane of previous columns posted to this blog, I should mention that the "festival of falling knives" that caused so many investors so much pain between the end of July and mid-September appears to be over. Only 40 companies had their shares hit new record low prices for last 52 weeks today, well down from the record of 1,107 new low prices which was set on August 16, 2007.

Certainly, investors have plenty to worry about, from fears of recession to the uncertainty that comes with a prededential election on the horizon, but for the moment we can take solace from a Federal Reserve that is apparently more eager to avoid a recession than to support the dollar or to contain inflation, and from a stock market which is rebounding from a substantial correction. Now is a good time to buy rationally priced assets, using the screen that I described in Avoiding the Pitfalls of Growth Investing, parts I and II, especially if you are investing with a time horizon of a year or more.

In my next column, I will discuss the reasons why you should hold your stocks for over a year, and why the shares of General Electric and Johnson and Johnson look so inviting at the moment.

Uncork the Bullish Champagne... But Avoid the Hangover: The Case for Investing in Safe, Steady Companies like General Electric and Johnson and Johnson

When Ben Bernanke and the other governors of the Federal Reserve lowered the discount rate last Tuesday, it sparked a massive rally. Bankers, hedge fund managers, and individual investors in the stock market and real estate markets alike breathed a collective sigh of relief. Those of us who tend to invest aggressively when good news arises have already started buying stocks again, thinking that the Fed will bail us out if things should go wrong. And yet, even in the wake of a Fed rate cut, it pays to observe how the investing landscape has changed since the giddy heights of Dow 14000 back in July, and to adjust our investment strategies accordingly.

This is especially important when we stop to consider that the Fed would not cut rates by 50 basis points right now, with inflationary risks looming, if they did not believe that we are in danger of entering a recession. In this column, I will provide two recommendations that I believe are poised to outperform the market, over both the short-term (the next 6 months) and the long-term (5+ years), and explain why companies such as GE and JNJ are poised to replace all but the best-run hedge funds as the new kings of the buyout boom.

What has changed?

The first thing that has changed in the investing landscape is that the buyers of debt who helped to keep the leveraged buyout boom going; mostly pension funds and hedge funds; are now asking for (gasp) a significant premium over treasury interest rates to buy the debt that funds these deals. Back in July, the credit spread between junk bonds and treasuries were at historic lows, but they have widened significantly since then, making it more costly to take companies private by issuing junk bonds, so called because of the low credit ratings associated with this debt.

Buyouts of publicly traded companies (and the prospect of buyouts) had provided a significant boost to share prices over the last few years. Buyouts leave fewer companies for investors to purchase shares in, reducing the supply of shares as the demand for shares remains steady. Buyouts have also caused small and medium-sized companies to outperform their large-cap peers as investors scramble to buy shares in the next buyout target before the deal is announced. A slowdown in buyouts by hedge funds changes the market landscape significantly.

Who are the new buyout kings?

OK, you say, enough about the big picture – how does this affect me, and why does this shift make GE and JNJ look more attractive?

Good question. The declining fortunes of hedge funds, the kings of the current buyout boom, benefit the buyers of large companies that pay dividends and have strong credit ratings, due to three important characteristics possessed by these companies:

• Safety: If the current economic slowdown gets worse, buyers of stocks will tend to prefer large companies with strong credit ratings and dividends because these companies have a demonstrated ability to survive recessions, and pay growing dividends to compensate shareholders for the risk of holding stocks in a recession. As Kelly Wright observes, growing dividends are one of the best attributes an investor can seek in an investment.
  
• Value: Large companies (for example, GE and JNJ) have lagged the S&P 500 over the last 5 years, partially because they are too large to be viable targets for buyouts. As a result, GE and JNJ are selling at low PE ratios relative to their historical averages. With the “buyout premium” that was underpinning the share prices of smaller companies fading away along with the mania of the buyout boom, companies like GE and JNJ will no longer be at a disadvantage compared to smaller companies.
  
• Opportunity: With great credit ratings and abundant free cash flow, large companies like GE and JNJ are well positioned to become the kings of the new buyout boom. Both companies have demonstrated skill at buying companies to add to their business. For example, GE entered its strategically important renewable energy business when it purchased Enron’s wind farms during the liquidation of that former high-flyer.
  

Neither of these companies will make you the coolest person in the room when the subject of investing comes up at the cocktail party, but investing isn’t about proving how smart you are, it is about having a comfortable (and preferably early) retirement and being able to meet your own essential needs, as well as those of your family.

In my next column, I plan to dig into what makes JNJ and GE outstanding in terms of their strategies for future growth, and in terms of their valuation.

The Importance of Attitude and Planning In Investing

Many investors believe that their success or failure in the market is solely the result of their skill at choosing investments, or their luck, while forgetting to take another important variable into account: attitude and planning. To better understand this area, we can turn to an emerging field of psychology called behavioral finance, which focuses on why smart people do dumb things with their money. Behavioral finance offers plenty of useful insights for those willing to study, but here are a few of the key points from this field that you should keep in mind when investing:

• If you do not plan for success, you plan for failure: Before you make an investment, you should have a plan for what to do with that investment if it gains value or loses value. For example, in the investment system popularized by Investor’s Business Daily, the rules are pretty simple: if a stock loses more than 8% of the purchase price, you sell and take a loss; if a stock gains over 20% from the purchase price, you sell and take a profit. Conversely, a value investor would generally buy more stock if the price dropped below their purchase price, and would only sell if the underlying business deteriorated or the stock became overvalued. Having a plan is essential, because otherwise you are very likely to sell at a loss when frustrated or afraid, or to fail to take profits when you have them due to greed.

  Remember: your instincts evolved to help you hunt, evade predators, and find food; as such, they are poorly suited to helping you to operate in the stock market. Success requires more than instinct; it requires planning. Your plan can be simple, but it will still be well worth the few minutes that it takes to put it in writing.
  

• Don't fixate on the past: We all have the tendency to give great weight to memorable events when making decisions, in a process that psychologists call "anchoring". Anchoring can cause us to make bad decisions when memorable events are irrelevant to the current situation. For example: the stock that you lost your shirt on in 2000 may be the best one to buy right now, but you will find yourself reluctant to even consider buying it because of the pain that you associate with your previous experience, just as a child is reluctant to touch a stove element after getting burned. Similarly, a great stock that you noticed and considered buying at $10 may still be the best available investment opportunity after it has soared to $20, but you will be reluctant to buy it because your mind is anchored on that lower price, and making the purchase now will mean admitting that you probably should have purchased it when you saw it at $10.
  Pull the anchor: The solution to this predicament is to select your investments using screens or other analytical methods that will help you to make sound decisions without regard to vivid, but irrellevant, memories.
  
• Be tax aware, but don't let the IRS think for you: Many of us have met or heard of investors who had the phenomenal good fortune to hold the right stock at the right time, and to become wealthy, at least on paper. In many cases, these investors failed to take profits in their stock, even when they thought that it was probably going to lose value for one reason or another, because they did not want to pay taxes on their gains. This makes no sense at all, especially now when capital gains taxes are at their lowest levels in years. Ask yourself the following question: Would you refuse a 200% raise because you don't want to get moved into a higher tax bracket? If your answer is no, as I suspect that it is, then why would you choose not to pay capital gains on an investment that has met your price target, and is now overvalued? The key thing to remember is: If you are paying more taxes than last year, it is because you are making more money than you did last year. Deciding not to follow your plan and stick to a rational investment strategy because you fear losing some of your gains to taxation is basically a decision not to make money.
  Don't obsess over the IRS: If you are deathly afraid of paying taxes on your gains, the market will accomodate you by taking those gains away from you and giving them to someone who will pay taxes on them. This also touches on the first point that I made: people who give away fortunes for tax reasons are generally operating without a plan that tells them when to sell. They make excuses for holding a previously winning investment as it loses value, rather than putting a plan in writing before investing and then sticking to that plan. Besides sound planning, another way to keep yourself from falling into this trap is to hold your largest investments inside of an IRA or other tax-sheltered account, where you will be able to make investment choices without regard for capital gains or other tax concequences.
  

I could write endlessly on the pitfalls of investor psychology, but Barry Ritholtz has saved me the trouble with his excellent Lessons for the Apprenticed Investor series. If you are serious about investing or trading and have not already equipped yourself with a winning attitude and plan, these free articles are essential reading.

Festival of Falling Knives, Continued

Apparently, the "festival of falling knives" that I found so impressive two days ago was just the beginning. On July 24, a three-year record was broken on the NYSE when 351 companies listed on that exchange traded at their lowest prices in the last 52 weeks. A day later, 418 companies hit new low prices, even as the Dow Jones Industrial average recovered some of its losses from the day before.

Today, the Dow Jones Industrial Average suffered the biggest one-day loss since February 27, but much more significantly, 780 companies hit new low prices for the last 52 weeks - over twice the number that hit new 52-week lows on any day in the last 3 years. After the incredibly strong stock market performance that we have seen in the first half of this year, and with problems with subprime mortgage lending starting to snowball into what Barry Ritholtz has dubbed "The Great Credit Contraction of 2007", I have to wonder whether this market has further to fall. I also have to wonder whether it will be quite a while before the Dow Jones Industrial Average closes above the DOW 14000 mark that everyone (ok, not everyone) was so excited about just last week.

Does this mean that you should run out and sell all of your stocks and mutual funds? Certainly not. Only a few people are successful at timing the market, even when they have a well-developed system that they apply rigorously. This might be a good time to sell any stocks that have already hit the price targets that you have set for them, though, and to ease off any buying of high-risk shares - remember, high PE stocks tend to fare poorly in a serious market correction.

This is also a great time to buy high quality investments selling at low prices that are poised to benefit from the effect of a falling dollar on overseas sales. Two that come to mind, because I already own shares of them, are Johnson and Johnson and GE. Both have been market laggards over the last few years, but several trends are aligned in their favor, as I plan to detail in my next post.

Until then, I suggest that you remember the immortal words of Douglas Adams, as you keep a cool head during this sell-off:

Don't Panic!

Festival of Falling Knives: NYSE 52-Week Lows

When a company's shares trade at their lowest price in the last 52 weeks, it is a sign of pervasive fear among many of the holders of that company's stock. Because most listed shares trade hands several times a year, it means that most current holders of that stock are sitting on an unrealized loss. Their fear often leads them to more selling as their shares hit new 52-week low prices, which is one of the reasons that buying companies hitting new 52-week lows is often referred to by traders as "Catching a Falling Knife": because you can be badly hurt if you buy such a company and it's shares continue to fall.

Today's trading on the NYSE exchange was, therefore, a sort of "festival of falling knives": 351 companies listed on the NYSE had their share prices hit new 52-week lows - more than at any time in the last 3 years. Unlike the previous "festivals" of 200 or more new 52-week lows, which occurred on October 12, 2005 and June 13, 2006, this festival did not occur after a broad decline had already occurred.

At the top of the chart shown above, I have added a barometer which shows the percent of shares listed on the NYSE that are trading above their average share prices for the last 50 days ($NYA50R). Such 50-day moving averages are widely used by traders and money managers, and are often used as shorthand for the trend of a stock: if a stock is above the 50-day moving average, it is trending up; if it is below the 50-day moving average, it is trending down.

When this barometer shows that only 20 percent of the shares listed on the NYSE are above their 50-day moving average, the market has usually already sold off pretty well (to what is called an oversold condition), and is generally due for a rebound. The previous festivals occurred when this barometer was showing just such an oversold condition, as shown by the green circles in the drawing above. These festivals punctuated long bouts of selling that left most of the companies on the NYSE trending down, and marked the end of the down trends for many of those companies.

Today's festival, in contrast, occurred when 37.27% of the companies listed on the NYSE are above their 50-day moving average - nearly twice the number seen in the previous events. So, if recent history is any guide, the market may have further to fall, and this festival may be just the warm-up for a bigger event in the near future.

To investors with a long time horizon and a hard nose for value, such events provide buying opportunities. But for most investors and traders, a new 52-week low in a stock that they own is a very unwelcome event. And a festival of falling knives, occurring out of the blue, when the NYSE is not oversold, is a very ominous event, indeed.