Reality Bites

About a year ago I had a really fun argument on Maria Bartiromo's show, on the steps of the Federal Reserve Building with a mutual fund apologist from Kiplinger.  The market was off a rather sudden 500 points at 14,000, and he was pitching the same old "buy & hold" snake oil while I was arguing that there was a significant sell-off in an over-priced market that was going to take your mutual fund down and your retirement with it. 

He basically accused me of wild speculation.  I accused him of willful ignorance in the face of clear evidence that institutions were getting out.  It was like he couldn't hear me.  Like I was speaking English and he was only able to understand Greek. 

The fact is that we were speaking two different languages.  I was speaking the language of value.  He was speaking the language of efficient market theory, or EMT.  In a perfect world like the one Ivy League intellectuals live in, people are stalwart and rational.  In that world, I would agree with him.  But we don't live in that world.  Unfortunately, your fund manager thinks we do.

Efficient Market Theory

Your fund manager was taught EMT at business school.  EMT is a theory about stock market prices that states that since all the information about stocks is widely known to investors, and since investors act rationally in their own interest, the price of any widely traded stock reflects everything that is known about it; and therefore, the current price is the current value of that stock. 

In other words, you get what you pay for. 

Warren Buffett disagrees.

Warren Buffett thinks that you do not necessarily get what you paid for.  He thinks that price is what you paid, but value is what you got.  And that they might be quite different.

Fear Can Create an Irrational Market

The reason that value and price might be quite different is that the real world is quite different than the pretend world. 

EMT is based on a serious error about the real world.  EMT says investors act rationally all the time.  But they obviously don't.  Fear is a powerful emotion that overrides rational thought in the stock market as it does in many situations in life. 

I remember reading about a Roman army defeating, in hand to hand combat, a tribal army that was 10 times as large.  How is that possible?  The Romans were organized and fought as units rather than as individuals.  As these units chopped down the first wave of tribesmen, the next wave saw the apparent Roman invincibility and became afraid.  As defeat and death went from a remote possibility to something that appeared inevitable, fear spread into the ranks, and they panicked and ran.  From that point on it was just 20,000 Romans chopping at the backs of 200,000 terrorized tribesmen until they'd killed them all. 

There is nothing rational about 20,000 defeating 200,000.  But it happens.

Markets are places where fear and panic can, and do, take over and cause irrational outcomes. 

We're seeing panic and irrationality already. A real estate developer in Atlanta went broke a few months ago. He was a smart guy with two great kids and a wonderful wife.  He put a gun in his mouth, pulled the trigger and blew his brains out. 

He was a healthy man with a good education.  He had everything to live for and plenty of resources to go on to a successful financial future.  And yet, he preferred death to living with a business failure. This is not a rational reaction to the situation.  A rational reaction takes everything into account and eliminates emotion from the decision making process.

What Should Rational, Rule #1 Investors Do Now?

A rational reaction in this market meltdown, one that eliminates emotion, would be to see if the value of what you own is significantly higher than its price.  And if it is, then a rational reaction would be to buy more, even if your gut tells you that the price might go lower in the near term. 

If you own something with $10 of value that is selling for $5 now, why not buy more – even if two months from now the price is $4?  You're still buying $10 bills for half off.  And if a panicked investor is selling the $10 bill for $4 in a couple of months, say thank you and buy more of them at that price.  Someday you are going to be able to sell the $10s for $10.  It won't matter a great deal whether you paid $5 or $4.  You made a killing either way.  This is rational investing.

Knowing Value Eliminates Fear of the Unknown

You won't see a lot of rational investing going on anytime real soon.  What you are going to see instead is panic.  Panic comes to markets like it comes to armies – out of fear of the unknown.  In the case of fighting the Romans, the unknown was about tactics.  "How are these guys winning?  They must have a secret weapon.  Time to run away."

In the case of the stock market, the unknown is about the value of the stock.  "Why is my stock going down?  There must be a problem. Time to run away."  This is EMT speaking and, since the theory is b.s., when things start to go down, people panic.

Why Coke Went Up When the Market Went Down

Any stock that has a murky future is going to get pounded in this market, and most stocks have murky futures to fund managers with crystal balls clouded by EMT.  The stocks that will in hang in there, at least in the short term, are stocks like Coke – something that has such a durable market that the long term future is predictable. 

Yesterday, while the stock market got pounded, Coke went up in price. Why?  Because the Big Guys know that Coke is predictable and therefore has some specific value, even if they don't know what it is. 

The irony is that that value is about 60% of the current price.  But isn't that to be expected?  When you are panicking and you need a place to put your money that has some certainty to return, you are willing to take a much smaller return in exchange for removing the fear. 

As Coke's price is bid up by buyers looking for refuge from the storm, the return on investment will go down. 

Right now, the Big Guys are willing to accept an 8% return on your money in exchange for some certainty. That sucks.  But then, it isn't their money.  As long as they do better than the S&P 500 index, they keep their jobs... even if they lose some of your money.

So What Should You Do?

If you have been paying attention here at Rule #1, you've been in cash or trading short term and can get in cash.  You have not lost anything in this tumble. 

What you should do in that case is hope that this thing crashes once and for all.  There is nothing like obvious value to clear the air and lift the panic. 

We need the S&P 500 PE Ratio at about 9 times earnings.  Fortunately, this time, a single digit PE for the index is well within the realm of possibility.  We saw it in 1974 and we saw in it in 1983, but we haven't been there since, and it's about time for some serious fear and loathing about stocks to work its way into the amateur "buy and hold" psychology.  And when that happens – when after 8 years of nowhere and now another big drop, the buy and hold'ers finally can't take the pain and get out – it's going to be time to load up the truck.

Wonder what that Kiplinger guy thinks about his 401(k) being off 40% since we chatted?

Now go play.