HAPPY NEW YEAR... now pay attention

This is no time to be sidelined from the market. And don't try to time an entry. Dollar cost average in so you don't get stuck on the wrong side of the volatility. But Jerry... you always seem bullish, what's different now? (I don't talk to myself often, but sometimes I get lonely)

Here are some very important facts to consider:

1. The high for the Dow Industrials was 14,000 in late 2007. 
   
2. The market gave up 6,500 points through late 2008, approx 46%.
3. Since the lows in late November, the market has recovered 1,500 points, approx 20%!!!
4. "Typical" volatility (as measured by VIX) is under 20 for most cycles.
5. Volatility in November was over 80, but is now under 40!!!
6. Short selling is down across the board (only a few poor performers are exceptions, like GM, go figure).

Summary: a fall in volatility suggests a move toward fundamental investing. A fall in short selling suggests a tendency toward normal equity trading where investors buy and hold companies that represent a good value rather than jumping in and out or flipping positions to ride waves. This summary doesn't mean that the market will be back to 14,000 this year but it does mean two things. First, shorts have to purchase equities to cover positions. A reduction in volatility usually signals a reduction in selling across both long and short positions. Therefore, when the shorts cover while the longs are buying, the stocks move up rapidly and without warning. Thus, you can't time it, so you better be in when the spikes occur. Second, there are trillions on the sidelines waiting to buy into a good position. At a minimum, this usually suggests an end to freefalling prices. Again, when the big pension funds start buying you don't want to be sitting in a money market account. 

Should you get back into the same positions you held before the crash? NO!!! As a rule, I like conservative investors to buy whole market indexes such as SPY or DIA. However, I think the prudent investor will actually look more toward value and income. Eventually a whole market position will cover your losses and then some. But down markets are the time to be opportunistic and make back more than you lost plus the opportunity loss. I think it was Ben Graham that said you don't have to make back your losses the same way you lost them. 

The mark to market FASB rules that hammered the financial segment balance sheets will do the exact reverse as the markets recover. Did you know that your mortgage is probably for sale at something like 60% - 80% of its book value? Would you buy back your mortgage at 60% of the balance you owe if you could? This inversion of value doesn't happen often but it means that financial firms that have the capital to survive the next 6 months will make more with their balance sheet than other segments. 

Let's look at an example: Big Mortgage Bank (BMB) has $100 million in mortgages issued that expect returns in the 6% range (some low risk at around 5%, others higher risk around 8%. BMB's balance sheet of mortgages are now only worth $80 million per FASB but BMB isn't going to sell these loans so the book value is largely unimportant for this example. But BMB is cash healthy and decides to purchase the mortgages of the Risky Business Bank (RBB) across town. RBB over extended their position and a run on the bank caused it to fold (sounds like IndyMac, huh?). Let's say RBB had $100 million in mortgages, too. But BMB has now purchased the mortgages of RBB for $80 million. Since BMB originated the first $100 million in loans their cost was actually $100 million. But the second tranche of loans was purchased, not originated. So now they have another $100 million in loans earning 6% but they only paid $80 million so over 20 years of servicing these loans they will make 7.5% instead of the lower 6%. The same business, doing nothing but keeping an eye open for opportunities will make 25% more profit because the business has a healthy cash position. Sears, or United Airlines won't have the same opportunity. So financials will be a great play. 

So how do you know which financials are healthier? Darwin has taken care of this for us. Only the healthy are surviving, so a purchase of all the surviving players will give you much of the upside without having to research their balance sheets. While the S & P fell over 45% from the highs in late 2007, the financial sector fell over 70%. The market will return smaller than the original so don't expect a 70% recovery soon (or 230% gain). However, the earnings potential is still there for the survivors so expect the financial sector to gain more than the broader markets. XLF is a ticker for the Financial Select Sector of the S & P. It's up 35% since November. Expect more of this.

What else? Income. Some companies are very geared toward benefiting the shareholder. This sort of management team is exactly what the small investor wants. I've always been a Frontline (FRO) fan and expect a dividend of at least 20% in 2009. Their more financial cousin, Ship Finance (SFL), will probably return a similar amount. These shipping companies can be volatile since much of their cargo involves oil. If you prefer a retail play which many believe are the first segment to gain out of a recession, check out Cherokee (CHKE). They don't actually make anything, but you can't leave a Target or major retailer without seeing Cherokee related products in your face. Wouldn't you like to have a company with 20 employees that earned $50 million every year? They get a piece of every shirt and jacket their licensee's sell. Oh yeah, they pay about 11% in dividends, too.  

Happy investing...