Investing myths laid bare by this bear market

Investing myths laid bare by this bear market
TheStar.com - Business -

Foremost is belief that balance sheets reflect true value of assets

October 03, 2008 Bill CarriganSpecial to the Star

The 2007-08 bear market in global stock markets has exposed several investing myths. Let's start with the idea that corporate balance sheets are a fair reflection of the value of a company's assets and liabilities.

Balance-sheet myth

Last Monday's panic liquidation began with shares of Wachovia Corp. plunging to penny-stock status in reaction to the massive devaluation of Washington Mutual's loans.

The problem was WaMu's numbers were much lower than those at which Wachovia was valuing its own portfolio.

Citigroup quickly agreed to buy Wachovia's banking operations for $2.1 billion (U.S.) in a deal arranged by federal regulators.

Mad Money's host Jim Cramer was enraged, claiming Citigroup bought Wachovia "for a pittance."

It was only two weeks ago that Wachovia chief executive Bob Steel told CNBC's Mad Money viewers that out of $500 billion in loans on the bank's books, only $10 billion were bad.
Cramer did not call Steel a liar, but rather believes that Steel believed what he said. Cramer was mad at himself for letting his viewers down. He trusted Steel, who has been known as a solid financier for 25 years, and he urged viewers to do the same.

Cramer went on to say Wachovia's financials "just didn't reflect reality," and "the SEC and multiple bank examiners all signed off on Wachovia's books. Even Steel, a former number two at Treasury, couldn't see how bad his own balance sheet was.

"He just didn't know what was there."

Cramer would end up the session by adding the CEO to the Mad Money Wall of Shame.
The demise of Wall St. shows that balance sheets could not be trusted because large amounts of their assets were based on murky financial engineering.

Complex financial derivatives such as credit-default swaps and collateralized debt obligations were not valued properly because they were not subject to the same visibility as publicly traded securities.

Commodity myth
Remember all that talk about the commodity supercycle and how China's growth would keep commodities prices in the stratosphere forever? Doesn't seem to be working out that way.

The investors who bought into the long-term commodity story have over the past several weeks learned a brutal lesson. Commodities are cyclical. They don't pay dividends and they are not growth companies.

Prices gyrate as leveraged hedge funds push prices every which way with billions of dollars of hot money stampeding in and out of the latest hot commodity.

Global diversification myth

We also learned that global diversification in recent years has been little help to investors. There was a time when markets around the world went in different directions, while economies in different countries did their own thing. But for years now it's been a global economy and markets increasingly move up and down in unison. When it comes to the world bourses, it is monkey see, monkey do.

What you do get by investing abroad, however, is foreign-currency exposure, and that does add diversification.

Currency hedging myth
While investing abroad adds currency diversification, in recent years many investors have curiously moved to hedge out that exposure. The recent weakening of the Canadian dollar has illustrated that currency hedging is an expensive scam. If foreign currency exposure gives you some diversification, why then would you hedge the advantage away? For example, the currency-hedged iShares CDN S&P 500 Index Fund (XSP) is down about 21 per cent year-to-date. An unhedged version would be down about 15 per cent in terms of Canadian dollars. Investment industry pushes helped make hedging popular two years ago.

If you have the time, one strategy that you can employ in sloppy markets is to engage in stock picking. During these volatile markets, the price behaviour of a stock will tell you much more than the current fundamentals because the price leads the fundamentals by weeks and months.
For example, collapsing markets create an opportunity to study the price behaviour of stocks in your portfolio and of the stocks you are thinking of acquiring.

The strategy here is to seek out stocks that performed better or worse than the broader stock indices during a period of fear and panic. That is very bullish

I ran a stock filter and uncovered 48 issuers that displayed the same bullish price action subsequent to the Monday massacre. The selections are relatively liquid and stocks trading under $2.25 (Canadian) were rejected from the scan.

You can view these names on my blog at www.gettingtechnical.com.

Bill Carrigan is an independent stock-market analyst.