A year ago when the credit crisis began to erupt in earnest we began to speculate internally about how far the Financials would fall. At the end of May 2007, Financials represented 21.3 per cent of the S&P 500 index. We thought it could drop to as low as 15 per cent. Last Monday during the collapse of Bear Stearns, Financials had fallen all the way to 16.2 per cent of the S&P 500. Close enough. This represents a decline of almost 38 per cent and over $1.1 trillion. These are massive losses. 

Despite all the uncertainty and negative news it is not a stretch to believe the worst is behind the stock market. Oddly enough we think the place to look for bargains now is mostly outside of Financials. All stocks have gotten bruised in the bear market over the last year. Many businesses are doing quite well and have well-defined near- and long-term prospects. Concentrate on these companies and make sure they have strong balance sheets and ample overseas opportunities. The time to be defensive has past.

It’s been a while since I posted a blog and a lot has happened. John Chambers is now officially a great contrary indicator for the economy and stock market. Since Chambers started crowing about how great business was, the economy and stock market have gone straight down and Cisco’s stock is off about 24% – exactly what we feared would happen. 

Nonetheless, Cisco is now an intriguing investment in part due to the company’s change in organizational focus. To his credit Chambers is embracing the tenets of collective wisdom by emphasizing teamwork and innovation instead of relying on his direction only. Specifically, the company set up an internal wiki called I-Zone to generate business ideas. I believe this effort will pay dividends for the company in the future.

Every time I turn on CNBC someone quotes Cisco’s John Chambers who recently opined that the global business environment is the best he has ever seen. Interestingly, he said the same thing in late 2000. About three months later he laid off thousands of workers. 

From 2000 Annual Report, Letter to Shareholders: In our opinion, the radical business transformations taking place around the world will accelerate, making the opportunities ahead of Cisco far greater than ever before. We believe that Cisco has the potential to be the most influential and generous company in history. We are in the fortunate position to be at the center of the Internet economy, and we recognize that although this position gives us confidence, we must balance this confidence with healthy paranoia. 

From 2001 Annual Report, Letter to Shareholders: Having said that, we recognize that fiscal 2001 was different and more difficult than any other year in our history. In fact, in many ways, it was like two different years. The first period, from August through December, started out even more positively than we could have anticipated with year-over-year revenue growth over 60 percent, while the second half became extremely challenging. We obviously would have liked to avoid the challenges we faced in reduced capital spending and the global macroeconomic environment, which resulted in the reduction in our workforce (note: approximately 6,000 regular employees) and inventory charges we announced. However, we are committed to being decisive, addressing issues quickly, and dealing with the world the way it is, not the way we wish it were. Now, as you would expect, we are moving forward with a focus on our customers and areas we can influence and control: market-share gains, growth opportunities in emerging markets, profit contribution, IP technology, and product leadership.

Recent market volatility is a great reminder of why an investor needs a long time horizon. The stock market is risky, uncertain and deceptive in the short term. Prices often jump or fall abruptly, rather than glide up and down smoothly. However, over the long-term stocks consistently provide the highest returns compared to other asset classes. 

As a helpful suggestion rather than focus on the daily price movements, investors should focus on the fundamentals of the company – sales and earnings growth. If the company is growing and the valuation is attractive, the stock price will eventually reflect these fundamentals. 

In fact, it is time such as these that separate good investors from bad investors. Warren Buffett has spoken often about the need for successful investors to have the right temperament: “It requires qualities of temperament way more than it requires qualities of intellect.” (March 9, 2006 Outstanding Investor Digest, from 2005 Berkshire Hathaway investor meeting). 

Like most stock market corrections, the current shake-out if affecting almost all stocks. Many stocks deserve lower valuations but not all. Viewed this way the correction is a blessing for long-term investors because many great companies will be available to purchase at bargain prices.

The message from this quarter’s earning season is that despite a slowdown in the U.S. the worldwide economy is growing at a brisk pace. Many companies reported that strengthen in overseas operations overwhelmed weak domestic results. For example, Caterpillar earnings release highlighted: “Strength outside North America offsets the impact of significant weakness in U.S. housing and on-highway truck engines.” Synchronized global declines have tended to have global causes. Our slowdown is, of course, primarily related to our recession in the housing market. So as long as our housing recession is contained global growth should remain strong. 

These developments, along with a weak dollar, favor multinational companies with significant overseas exposure, and should act as a headwind for smaller companies who derive more profits domestically. Overall, S&P 500 companies obtain about 30% of their sales overseas compared with only 15% for companies in the Russell 2000. 

Importantly, investors should follow the global property market for signs of weakness. There is a chance the forces causing our recession could hit property markets overseas since the property boom was a global phenomenon. Recently the Spanish real estate market experienced a nasty sell-off that got scant attention in the U.S. but could be an important warning sign.

The stock market rallied today with many pundits on CNBC pointing to better than expected housing starts. I doubt that any of these pundits actually looked beyond the headline number. We did and this is what the Commerce Department report said: “Regionally, housing starts fell 6.1% in the Northeast, 2.7% in the South, and 7.7% in the West. Construction surged 44.5% in the Midwest.” 

It appears that something quirky occurred in the Midwest to spike the data. We live in the Midwest and the housing market isn’t on fire as this single data point suggests. In fact, it stinks. Moreover, the giddy analysts failed to mention that housing starts were 23% lower than the level in March 2006. We repeat: Housing is not bottoming and we expect housing to be sluggish for years not quarters. 

The real information in this episode is what it reflects about investors: complacency is an issue in the market because any news is interpreted as good news.

For any investor worried about managing risk there is a must-read March 27th article in the Wall Street Journal by Dennis K. Berman. 

Here is a link for anyone with a paid subscription: Wall Street Journal Article 

This article highlights the frenzy going on in the overheated debt markets. The comment that really caught our eye was from a Princeton economist who studies bubble named Markus K. Brunnermeier. Referring to the banks that make loans and sells them to institutional investors he said, “You try to forecast when the others are getting out. You don’t focus on the fundamentals. You focus on the other players.” 

In other words, “the greater fool theory” is alive and well in the bond market. When market players stop focusing on fundamentals and become dependent on the actions of others, prices are no longer tied to value and can become inflated. 

At some point these fools will stop buying debt with modest returns and high risk. When this occurs asset markets will likely readjust to lower valuation levels.

According to reports today Private Equity juggernaut, Blackstone Group, is planning an IPO in as early as two weeks. This follows the very successful IPO of hedge fund manager Fortress Investment Group. 

Our only comment is that this type of activity happens closer to market tops than it does to market bottoms.

Investors who keep seeing signs of life in the housing market are grasping at straws. The tech bubble in the late 1990s provides some valuable insights. Looking back it is “obvious” technology stocks were in a bubble. Funny, however, how most pundits on CNBC were bullish on tech stocks for most of 2000. The difficulty in recognizing the tech bubble when it was happening was that the fundamentals were fantastic. Venture Capital companies funded every business plan imaginable. These businesses basically bought advertising and computer equipment. Feeling a bit panicky Corporate America felt they were falling behind and did the same thing. Most large-cap tech stocks had tremendous revenue and real earnings growth even in late 2000. The reality that doesn’t get a lot of attention even today is that tech company’s FUNDAMENTALS were in a bubble. Investors placed a high multiple on bubble fundamentals just as the fundamentals collapsed. The result was an 80% decline in the NASDAQ. 

Until recently the fundamentals of the housing industry were in a bubble in part caused by irresponsible financing. Sales of new and existing homes moved far above trend line for several years. Housing fundamentals are now in retreat. Things could really get ugly if interest rates or unemployment start to rise. Regardless, like tech stocks before them, the recovery in the housing market will take years, not months, to work off. There will be many false starts, but don’t be tempted because these will likely be sucker’s rallies.

It is human nature to want to “explain” why the stock market declined by 3% yesterday. There will be many legitimate reasons given by market pundits but a conclusive explanation will prove elusive.

To understand why we can turn to physicist Per Bak who used sand piles to explain about complex adaptive systems found in nature. Fortunately, the analogy is useful when thinking about stock market behavior. If you build a sand pile one grain at a time, at first the pile is stable. As the pile grows and becomes steeper, additional grains will sometimes cause a sand slide. In fact, Bak and his associates did this millions of times through the use of a computer program. They found that most of the time the sand slides were little, but sometimes they were big, and although rare, occasionally the sand slide wiped out the pile. 

In the case of the large sand slide something as inconsequential as a grain of sand caused a disproportionate outcome (the pile was wiped out). The parallel for investors is that many times big moves in the stock market are caused by grains of sand that are impossible to identify. Why did the market decline by 3% instead of 0.5%? Nobody knows for sure; it just happened. 

What we can say with some confidence is that increased volatility if here to stay. The history of the stock market clearly reveals that volatility clusters: so fasten your seatbelts!