Bubble illusion

University of Oregon economics professor Mark Thoma writes:

A couple of recent conversations have convinced me that many people have "bubble illusion." When they talk about how much they have lost on their houses and in the stock market, and how that has affected their feelings of economic certainty, etc., the losses are almost always expressed relative to the peak bubble value rather than to a realistic assessment of what the house or stock was actually worth during the bubble years.

It does seem to me that whenever asset values are below their peak, people compare them to the peak. When the peak was a bubble, they're not thinking rationally.

Which investments pay the most?

From David Leonhardt, via Greg Mankiw:

The Hamilton Project, a research group in Washington, has just finished a comparison of college with other investments. It found that college tuition in recent decades has delivered an inflation-adjusted annual return of more than 15 percent. For stocks, the historical return is 7 percent. For real estate, it’s less than 1 percent.

LinkedIn's founder got screwed; small investors, too

LinkedIn's founder just got screwed out of millions of dollars and he probably doesn't even know it:

The stock of LinkedIn opened explosively Thursday morning, rising to more than 100 percent of its IPO price.

This means the favorite clients of LinkedIn’s underwriters—Morgan Stanley, Bank of America Merrill Lynch and JPMorgan Chase—are making a fortune. They got to buy in at $45 a share—and have doubled their money instantly.

It also means that LinkedIn’s owners and investors just got swindled. ...

A 100 percent rise is evidence that LinkedIn’s shares were wildly, almost fraudulently, underpriced. The bankers either had no clue about the price people are willing to pay for the shares—or they decided to grant their best institutional investment clients a bonanza at the expense of LinkedIn.

It appears a lot of small investors may have been screwed too. Here's how it happened. LinkedIn only sold a small number of shares. This meant that small investors wanted to buy more stock than was available. If they stupidly placed market orders instead of limit orders, they bought the stock regardless of the price. Ignoring the price is stupid! Whether an investment is a good one or a bad one depends entirely on the price you pay.

Zillow.com filed for an IPO

Want to buy a stake in an unprofitable internet company?

Real estate site Zillow.com filed for a $51.75 million initial public offering Monday. ...

Zillow, founded in 2004, provides a database of more than 100 million U.S. homes for sale or rent, as well as homes not currently on the market.

In March, the site and mobile app together attracted 19.4 million unique users — a year-over-year gain of more than 90%.

Zillow's revenue has grown significantly over the past three years, according to the Securities and Exchange Commission filing. In 2010, Zillow's revenue jumped 74% to $30.5 million.

But the company has also booked net losses during that time, though those losses have been steadily narrowing. Zillow only lost $6.8 million last year, compared with $12.9 million in 2009 and $21.1 million in 2008.

Economic moats

In this video, Morningstar's Pat Dorsey discusses the an important concept in stock investing: long-term competitive advantages.

Warren Buffett's stocks on sale

Warren Buffett—the greatest investor alive—has a simple investing strategy: buy low and hold forever. He prefers companies with long-term competitive advantages. He doesn't time the market. He just buys when the stocks look like a bargain.

A potentially successful investing strategy, then, would be to buy the stocks he owns when they sell near or below his purchase price. As of late February 2011, here are stocks that meet that criteria:

• ConocoPhillips
• Johnson & Johnson
• Kraft Foods
• Munich Re
• Sanofi-Aventis
• U.S. Bancorp
• Wal-Mart Stores
  

Harvard economist: 80% chance of avoiding depression

Robert J. Barro says there is a 20% chance this recession will become a depression, and an 80% chance that it will not:

Central questions these days are how severe will the U.S. economic downturn be and how long will it last?

The most serious concern is that the downturn will become something worse than the largest recession of the post-World War II period — 1982, when real per capita GDP fell by 3% and the unemployment rate peaked at nearly 11%. Could we even experience a depression (defined as a decline in per-person GDP or consumption by 10% or more)? ...

There is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s. ...

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.

The bright side of a 20% depression probability is the 80% chance of avoiding a depression. The U.S. had stock-market crashes in 2000-02 (by 42%) and 1973-74 (49%) and, in each case, experienced only mild recessions. Hence, if we are lucky, the current downturn will also be moderate, though likely worse than the other U.S. post-World War II recessions, including 1982.

In this relatively favorable scenario, we may follow the path recently sketched by Federal Reserve Chairman Ben Bernanke, with the economy recovering by 2010. On the other hand, the 59 nonwar depressions in our sample have an average duration of nearly four years, which, if we have one here, means that it is likely recovery would not be substantial until 2012.

Given our situation, it is right that radical government policies should be considered if they promise to lower the probability and likely size of a depression. However, many governmental actions — including several pursued by Franklin Roosevelt during the Great Depression — can make things worse.

I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.

Update: Professor Barro has recently increased the odds of depression to 30%:

And by examining these patterns [Barro] tells Fast Money there's a 30% chance that the current recession will snowball into an economic decline of 10% or more — the hallmark of depression.

That’s right, there’s at least a 30% chance — not one-in-five — as reported in the Journal. He's become even more bearish since the article published.

A bubble warning from Warren Buffett

From Berkshire Hathaway's newly release shareholder letter:

The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable — in fact, almost smug — in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim "cash is king," even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

I agree that intense fear has caused a high risk premium. This risk premium has caused a bubble in ultra-safe assets (i.e. government bonds) and an incredible long-term investment opportunity in riskier assets (i.e. stocks). Ordinary investors worried about the possibility of being laid off during this recession, however, have no choice but to make sure they have an unusually large emergency fund.

The gradual decline of the housing bubble is causing this recession. Since housing is still overvalued, it will continue declining in the near term, which will continue to weaken the economy as well. When the pace of the housing decline slows, it will probably be time to go full-bore into the stock market even if the economy has not yet recovered. (The stock market typically turns upward six months before the end of a recession, and it typically turns upward rapidly.)

Stocks: the lost decade

The intra-day low on the S&P 500 so far today was 734.52. That's lower than the intra-day low (742.61) on December 5, 1996—the day Alan Greenspan gave his famous irrational exuberance speech. The closing price that day was 744.38. If it doesn't happen today, we will likely close below that level within the next week or so.

Update: The S&P 500 ended the day at 735.09, lower than when Alan Greenspan warned of a possible stock market bubble over 12 years ago.

A lost decade for stocks

Graph: The S&P 500 from the day Alan Greenspan made his famous "irrational exuberance" speech (December 5, 1996), through yesterday:

You would have done better with short-term U.S. Treasury bonds. Of course, you should not make future investment decisions by looking in the rear-view mirror.

Is the stock market undervalued?

Here is Morningstar's stock valuation graph:

Warren Buffett's and Robert Shiller's stock valuation metrics agree

Carol Loomis of Fortune has a new article out saying that Warren Buffett's valuation metric says it's time to buy stocks. I decided to compare Warren Buffett's stock valuation metric with Robert Shiller's. They both compare nicely.

Warren Buffett's stock valuation metric: Total stock market value as a percent of GNP.

Yale economist Robert Shiller's stock valuation metric, based on Benjamin Graham's advice in Security Analysis: S&P 500 10-year price/earnings ratios.

Robert Shiller doesn't compare the S&P 500 only to its current year earnings. Instead, he compares it to the average of the past ten years, adjusted for inflation. This way, he avoids getting fooled when single-year corporate earnings rise and fall with the business cycle.

Although Warren Buffett's and Robert Shiller's valuation methods are entirely different, they both seem to track each other fairly nicely. Knowing what happened in 1929, however, it looks like Robert Shiller's valuation method is slightly better than Warren Buffett's.

100 companies may not qualify for continued inclusion in S&P 500

24/7 Wall Street says 10% of DJIA stocks may get the boot. Even worse:

It looks on the surface like the S&P 500 has some dilemmas of its own. Based upon market caps and prices, something to the tune of almost 100 companies might not qualify. The good news is that there might not be enough replacements for them to get the boot.

With good news like that, who needs bad news?

Hat tip: Tastylunch's CAPS Blog

An FDIC seizure of Citigroup could doom the financial system

Morningstar explains how nationalization of Citigroup could make things very bad for Bank of America and JPMorgan Chase:


And the Bronte Capital blog has this to say:

If Sheila Bair was to confiscate a really big bank and cancel all the parent company liabilities then no other bank in America would be able to raise parent company debt. Indeed I think that has been the case ever since Sheila Bair did the reckless and irresponsible takeover of Washington Mutual… but it would certainly be the case if the parent company liabilities of Citigroup were cancelled.

And that would be a huge decision indeed because then every bank with parent company liabilities (meaning almost every bank in North America) would fail.

Update to the video: It turns out to be a $20 billion dollar check.

More stocks down 85% than up at all this year

Floyd Norris points out how bad the stock market is:

There are only a handful of stocks that are up this year. I just checked the Russell 3,000, which now has 2,938 stocks in it. There are more stocks in it (218) that are down more than 85 percent this year than there are stocks (179) that are up for the year.

He also provides three possible explanations for the huge decline:

There are three reasons that come to mind as possible explanations for such an overwhelming bear market.

1. The world financial system is in deep trouble, and it is integrated, so that the credit crunch is virtually universal.

2. The world recession is hitting everywhere. Even China is now worried, and with good reason, as unemployment rises.

3. In an integrated global financial system, all asset prices were pumped up by excessive leverage, and all are now falling amid urgent deleveraging. The widely feared selling by over-indebted hedge funds is part of this, but not all of it.

I think all of them help to explain what is happening.

If you believe the third one is important, and that we are not entering into Great Depression II, then that should be creating bargains for wide investors who can wait out the recovery without worrying about margin calls.

Hat tip: Tastylunch's CAPS Blog

Don't panic about the stock market...

Paul Krugman says don't panic about the stock market, because there are worse things to panic about—like the bond market!

Buffett stocks on sale

Warren Buffett is widely regarded as the world's greatest investor. His basic strategy is to buy great companies at low prices, and then hold them forever. Many investors try to emulate Buffett's investing method when making their own stock picks, but few can match Buffett's success.

However, one investing strategy available to ordinary investors is buying stocks that Buffett actually owns, when they fall below his original purchase price. Luckily, he lists his major holdings in Berkshire Hathaway's annual letter to shareholders. With a little basic math, you can figure out how much he paid for the stocks he bought.

Today, with the recent stock market sell-off, many of Buffett's holdings are selling for less than what he paid for them. This gives you the opportunity to buy them on sale. I have calculated the purchase price for his major holdings. Here are the ones that are currently on sale.

Stocks currently selling below Buffett's purchase price, and the price Buffett paid:

• ConocoPhillips (COP) — $59.34
• Kraft Foods (KFT) — $33.38
• Johnson & Johnson (JNJ) — $61.35
• Sanofi Aventis (SNY) — $43.21
• US Bancorp (USB) — $32.80
• USG Corporation (USG) — $31.40
• Wells Fargo (WFC) — $34.96

Stocks currently selling slightly above Buffett's purchase price, and the price Buffett paid:

• Burlington Northern Santa Fe (BNI) — $77.78
• Procter & Gamble (PG) — $61.14
• Wal-Mart Stores (WMT) — $47.23

Although this second group is slightly above his purchase price, a single down day in the stock market could push some of them below his purchase price.

Honestly, I don't know what he's doing owning USG. It's a no-growth company, paying no dividends, tied to the housing market. The others, however, would likely serve you well.

While the prices above are what he paid, according to his letters to shareholders, he also just recently bought more BNI at $79.65 per share.

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.

Warren Buffett says buy stocks now

Warren Buffett, the world's greatest investor, has a message for people who have become fearful of today's stock market: Buy stocks now!

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over. ...

Over the long term, the stock market news will be good. ... Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset.... Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. ... Today my money and my mouth both say equities.

WSJ on the history of stock behavior during recessions

The Wall Street Journal has an overview of how the stock market behaves before, during, and after a recession.