One of the most turbulent weeks in financial history has come to a close. The Dow was off 20% for the week and Friday marked the most volatile day in the stock market's 112-year history when the market swung over 1,000 points. Throughout last week and weekend I am sure everyone was fixated to the markets and watching their investments decline. I know I was glued to the news and could not help but think back to Stuart Gabriel's Macro Economics during my first year as an MBA student at the Marshall School of Business at USC. Gabriel, who has since left to be the Director of the Richard S. Ziman Center for Real Estate at UCLA, was among the most clear-headed professors I ever had. Even though he has traded his cardinal and gold for Bruin blue, I still appreciate his wisdom and perspective in these times of turbulence.
I thought it might be helpful to share some of his wisdom from yesteryear which still has meaning for me and hopefully will help you too. One of his most memorable lessons was about markets, how they stalled and how intervention restored their functioning.
In the 1970's, the US experienced a stagflation crisis. Paul Volcker, chairman of the Federal Reserve under Carter, ended the crises by limiting growth of the money supply, abandoning the previous policy of targeting interest rates. He was hugely unpopular at the time because the change contributed to the recession in the early 1980's and the highest unemployment levels since the Great Depression. He suffered strong political attacks and the most wide spread protests in the history of the Fed. Yet, under his leadership, inflation, which peaked at 13.5% in 1981, was successfully lowered to 3.2% by 1983. Volcker restricted the dollars in circulation which was tough medicine for the market and hard to swallow for the country, but ultimately was effective for the ailment.
Our financial markets seem to have stalled due to a lack of liquidity and the government is beginning to intervene to try and get buyers and sellers back to trading. During these times, I have found stepping back and reviewing fundamentals has helped me better understand what is happening and what it could mean for the future. I thought it might helpful to review fundamentals including some definitions of markets.
What is a market?
A market is a structure that allows for one thing traded against something else. It can vary in size, organization, geography, etc. Modern life revolves around markets when we go to work, the grocery store, fill up our gas tanks or trade on E-bay. Buyers and sellers are the participants and play distinct roles with the ultimate goal of consummating a transaction.
How does a market work?
All buyers and sellers of a good or service come together to evaluate it and influence its price. This presumes of course that there is transparency and a reasonable assurance that the value of the good or service will be the same or better after the trade. In economics, a "free" market is one in which the government makes no attempt to intervene through taxes, subsidies, minimum wages or price ceilings etc.
When does a market not work & why?
Markets function properly when both parties are rational and have sufficient information to arrive at a price for the good or service that is mutually acceptable. The buyer must have confidence to part with something of value in exchange for something else. The level of negotiating power held by the buyers affects the function of the market. For example, when there are many buyers (demand) and limited supply of a commodity, a single buyer has less leverage and prices rise. When supply outpaces demand then prices generally fall.
Market can become volatile and even freeze when fear, anxiety, vengeance or other emotions come into play. If a buyer looses confidence he may withdraw from the market or become irrational in his behavior. Sellers on the other hand may still need to sell or chose to because they do not think that the picture will improve. In these instances, prices drop. When many buyers and sellers behave in a similar fashion, a herd mentality can occur and once the selling wave starts, it can be really hard to stop. Yet opportunities abound in all markets. Warren Buffet has long said "Be greedy when others are fearful" and "Be fearful when others are greedy".
Investor Benjamin Graham, Warren Buffet's personal mentor, published "Should Rich but Losing Corporations Be Liquidated?" following the Great Depression. Graham calculated that more than 1 out of every 12 companies on the New York Stock Exchange, were selling for less than the value of the cash and marketable securities on their balance sheets. An investor could theoretically take over, empty out the cash registers and the bank accounts, and own the remaining business for free. Today, nearly 1/3 of all stocks tracked by Standard & Poor's Compustat are now trading at less than eight times their earnings over the past year -- or at levels less than half the long-term average valuation of the stock market as a whole. Nearly 1 in 10 stocks trade below the value of their per-share holdings of cash -- an even greater proportion than Graham found in 1932. This appears to be a great buying opportunity if you have the cash. After sitting on the sidelines with ample cash, Warren Buffet has recently invested $3 billion in Goldman Sachs and another $3 billion in General Electric in spite of market trends.
There could be similar opportunities in the residential real estate market. In the short run, qualified buyers are better positioned that they have been in nearly 10 years to acquire a home where they want at the price they want. Plus with interest rates remaining low, the long-term cost will not be as great either. Another potential long-term advantage, is that home prices tend to rise with commodity prices. Prices of commodities like copper, steel and cement are commanding sky-high prices and the Producer Price Index is up 39% over the last 5 years. Using this logic, one could conclude that the increasing costs of raw materials will eventually push home prices higher. As housing is the ultimate commodity made up of materials like steel, wood and copper that combined with the cost of land and labor become a store of value for every commodity that has gone into a home's construction. This tangible quality makes it a fundamentally different kind of investment than a stock or a bond. It is a great way for you to stay ahead of inflation, plus you have the enjoyment of living in the home and creating lasting memories with your loved ones!
Wishing you all the best during these trying times. Hope this makes some of what is happening a little clearer. Please let me know what you think.
PS - The stock market was up over 900 points today (+11%)
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Posted by: Rhoya | October 14, 2008 at 01:40 AM