Tuesday, October 21, 2008

Investing advice from Uncle Bob

My Uncle Bob* used to work on Wall Street. Twenty-one years ago, he had completely avoided the 1987 stock market crash by pulling completely out of the market months earlier.

Last year, on August 14, 2007, he sent an email to my cousins and me warning about the credit crunch. He warned us to be cautious, conservative, and avoid financials. He rarely sends out investment advice, so his email of warning was a rare and timely event. In retrospect, he wasn't bearish enough.
For the first time since 1987, I've become a bit of a bear, though nowhere near as bearish as I was back then.

The markets continue to be easily rattled, and the Fed has stepped in very significantly because it is worried. So what does one do with one's investment portfolio at a time like this?

Be cautious and conservative. There likely will be a flight to quality: be in large cap, high dividend yielding U.S. and European stocks (but not banks and financial institutions) or mutual funds and money market funds. Bonds and bond funds are a possibility, but at some point interest rates will start going up, at which point the bonds will lose value, so money market funds yielding 4.8% are safer than longer term bonds yielding only slightly more (i.e. 5% to 6%).

I'd ease up on emerging markets, which has been the place to be for the last four and a half years, and small cap stocks or funds (especially small cap with low or no dividends).

Unlike 1987, when I was bearish because of over-valuation in the markets, this time I'm bearish because of an impending credit crunch. So it's okay to remain in the S&P 500 index, which is large cap and will be among the last to fall if things really get ugly. Also, this isn't apt to last a long time, probably only a month or two. As the credit crunch subsides, the markets will strengthen and then one will want to be in equities, which continue to be fairly valued (perhaps even slightly undervalued).

So hang in there, but get rid of the riskier holdings.
A week-and-a-half ago, I got another email from him. Now he is very bullish.
I thought I should let you know that I think we are very near the market bottom. I have been cranking numbers all morning. From the high a year ago, the Dow is off 40.3% and the S&P 500 is off 42.5%. Of the 16 recessions in the last century (since 1920; prior data unreliable), the Dow on average has fallen 31.4%. It has only fallen more than the current 40.3% four times (41.9% after the first World War, 45.1% in the 1973 oil crisis, 49.1% in 1937-8 and 89.2% in the Great Depression), so only once since the second world war.

So, unless we repeat the Great Depression, which seems highly unlikely given the steps the Fed and Treasury are taking in contrast to Hoover's do-nothing policy, we likely are at or very near the bottom for the stock market. I certainly wouldn't sell anything at these low levels, and I very timidly started buying on Friday. The safest move is investing in companies that can finance their own growth without having to access the credit market and are paying a substantial dividend (more than 3% yield).

I'm also a believer in buying TIPs (Treasury Inflation Protected Securities), as the Fed and Treasury actions seem likely to lead to inflation, though not everyone agrees with this. Vanguard has a fund that invests in these.

For you young guys, this is likely the buying opportunity of a lifetime!
* Names have been changed to protect the anonymous.

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