Sell, Hedge your Stock Market Investments.. or Be Prepared to Lose!
Stock-Markets / Stocks Bear Market Jun 30, 2008 - 01:02 PM GMT
Martin Weiss writes: The stock market is falling swiftly, and you don't have the luxury of time. So I'll get straight to the point:
If you haven't done so already in response to our many earlier warnings, you'd better sell or hedge your vulnerable investments now . If you don't, be prepared to suffer far deeper losses in the bear market of 2008 and beyond.
But beware: Most brokers will try to talk you out of it. They have a hidden agenda. They want to keep you as a customer; and they know that, once customers sell their stocks, they often close their brokerage accounts.
With this in mind, many brokers have been trained with up to seven sales pitches designed to keep you in the market come hell or high water.
Broker Pitch #1: "Buy more." Their argument goes something like this: "Your stock is now selling at bargain prices. So if you didn't already own 100 shares, you'd probably be thinking about buying — not selling. Instead, why not double down and take advantage of dollar-cost averaging?"
The more likely result in a bear market: Every time your stock falls by another $1 per share, instead of losing just $100, you'll be losing $200.
Broker Pitch #2: "Hold for a recovery!" They argue that the "market will inevitably recover," that the "recovery is always bigger and better than any near-term decline," and that you should therefore "always invest for the long term."
The reality: Bear markets can last for years. It could take still longer for the averages to recover to current levels. During all those years, your money is dead in the water. And don't forget: If the company goes out of business, your stock will be worthless and will never recover.
Broker Pitch #3: "You can't afford to take a loss." If you insist on selling, brokers often come back with this approach: "Your losses are just on paper right now. So if you sell, all you'll be doing is locking them in. You can't afford to do that."
What they don't tell you is that there's no fundamental difference between a paper loss and a realized loss. Nor do they reveal that the Securities & Exchange Commission (SEC) requires brokers themselves to value the securities they hold in their own portfolio at the current market price — to recognize the losses as real whether they've sold the securities or not.
Broker Pitch #4: "You can't afford to take a profit and pay the taxes." If you've got a profit in a stock, they say: "All you'll be doing is writing a fat check to Uncle Sam. You can't afford to do that."
The reality: Although it's not shown on your brokerage statement, the true value of your portfolio is NET of taxes. So whether you or your heirs pay those taxes now or in the future is mostly a difference of timing. And if our next president approves legislation to raise capital gains taxes next year, it could actually cost you more. Besides, which would you prefer — paying some taxes on profits or paying no taxes on losses?
Broker Pitch #5: The "don't-be-a-fool" argument. "Stocks look very cheap now and we're very close to rock bottom," goes the script. "We may even be right at the bottom. If you sell now, three months from now, you'll be kicking yourself. Don't be a fool."
The truth: Brokers don't have the faintest idea where the bottom is. Nor does anyone at their firm. And they know darn well that stocks do not hit bottom just because they look cheap. Worse, for their own accounts, brokers and their affiliates have been — and are likely to continue — liquidating shares, often targeting precisely the same shares they pitch to their customers.
Broker Pitch #6: "The market is turning." If the market enjoys an intermediate bounce, which it certainly will at some point soon, this pitch is invoked. "Look at this big rally!" they say. "Your shares are finally starting to come back. After waiting all this time, are you sure you want to run away now — just when things are starting to turn around in your favor?"
The truth: In a bear market, intermediate rallies actually give you the best opportunity to sell.
Broker Pitch #7: The last ace-in-the hole in the broker's arsenal of pitches is the patriotic approach. "Do you realize," they'll say, "what could happen if everyone does what you're talking about doing? That's when the market would really nosedive. But if you and millions of other investors would just have a bit more faith in our economy — in our country — then the market will recover and everyone will come out ahead."
The truth: Locking up precious capital in sinking enterprises is not exactly good for our country. Better to safeguard the funds and reinvest them in better opportunities at a better time.
Surprise, Surprise: The Wall Street Journal Has Just Made Some of These Same Pitches
Given that the Nasdaq lost more than 75% of its value in the early part of this decade and that bank stocks are now down over 50% since their recent peaks, you'd think Wall Street would have learned to refrain from pitching the same old BS.
But if this weekend's edition of The Wall Street Journal is any indication, little has changed ...
"There's a decent argument to be made for buy and hold," says the Journal . "Aside from the absurdity of liquidating an entire equity portfolio — the tax headaches would be epic — investors ultimately end up better off than if they had tried to sell at the top and buy at the bottom. 'It's hard to time the market, so stay in and benefit from the inevitable turnaround,' says David Dreman, chairman of Dreman Value Management."
In other words, they're telling you to sit it out and watch the value of vulnerable stocks evaporate.
My view: This advice is driven by the same hidden agenda still prevailing in the brokerage industry — to keep you in bad stocks at all costs.
Were you entrapped by similar pitches during the great tech wreck of 2000-2002? If not, great! If so, don't let it happen again. And in either case, use it as a learning experience — to pull out some valuable lessons that could save you a lot of money today ...
Lesson #1
Many Stocks Have Hidden Risks
That No One Tells You About.
Even during the tech bubble, most investors recognized that there was a chance their stocks could go down, at least for a short while. But they never dreamed their tech stocks could go down so far nor so fast. They had no inkling of the multiple, hidden risks that can drive their portfolios into the gutter:
The risk of earnings lies. Let's say a stock is selling for $40. And let's say its earnings are $2 per share. So it's valued at 20 times earnings, and this is considered fair. Suddenly, the news comes out that the earnings are a bold-faced lie. The true earnings of the company is only half what was stated — $1 per share. "Oh, no!" exclaim the investors. "At 20 times earnings, it's really only worth $20 per share." The stock promptly plunges to $20 — an instant 50% loss to shareholders.
In the tech wreck, we saw this kind of outright fraud at big-name companies like Enron, Worldcom, Tyco, and Adelphia. And we saw it repeated hundreds of times with lesser companies. This time around, we see a similar pattern among financial companies that continually understate, cover up or even lie about their true losses.
Case in point: In March 2007, a Bear Stearns hedge fund manager emailed a colleague saying, "The sub-prime market is pretty damn ugly ... I think we should close these funds down." Instead, the company soothed investors with the message that "all was fine." Three months later, the funds failed and investors were left with less than 30 cents on the dollar.
The risk of inflated Wall Street ratings. In the tech bubble, Wall Street's enthusiastic "buy" ratings — often bought and paid for by the rated companies — drove thousands of investors into stocks that weren't worth the paper they were printed on. When it became apparent that the stock ratings were a sham, investor losses were greatly compounded.
Today, little has changed. The SEC and Elliot Spitzer's attempt to encourage independent research on Wall Street has largely failed.
Worse, the ratings issued by Wall Street's leading government-sanctioned agencies — Moody's, S&P and Fitch — are still bought and paid for by the rated companies, often resulting in inflated grades.
Case in point: The rating agencies stalled for months before finally downgrading the nation's giant bond insurers, Ambac and MBIA. And despite the recent downgrades, the ratings still fail to recognize that the bond insurers' entire business model — based on unanimous triple-A ratings — has been destroyed.
The evidence: Credit swaps being traded right now on Ambac and MBIA imply that the probability of default over the next five years is an astounding 90%! And still they're getting "A" or better ratings? It's a joke.
The risk of failure. The company goes out of business and investors suffer a 100% loss. Unusual? Not quite. In the tech wreck, at least 600 Internet companies went under. And between 1990 and 2002, bankruptcy claimed 390 insurance companies, 932 banks and thrifts, plus tens of thousands of business corporations.
The situation today: Although the Federal Reserve was able to ease the credit crunch by dropping interest rates seven times and rescuing the likes of Bear Stearns, analysts are now concerned that the Fed is running out of options. What happens in the wake of the next big meltdown? I don't think you want to hang on to your financial stocks while Wall Street tries to guess at the answer.
My rule number one of investing is: Never underestimate the risk .
Lesson #2
So-Called "Free Advice" Can Cost You a Fortune!
You can get "free advice" from many sources — not just your stockbroker, but also your insurance agent, your financial planner and other professionals. But it isn't really advice. And it certainly isn't free.
In the last bear market, "free advice" — embedded in the hyped-up ratings and research reports issued by major Wall Street firms — cost investors a fortune, luring them into Nasdaq stocks that brought losses averaging more than $75 for every $100 invested near the peak. Plus, free advice in other areas — from bonds to insurance — can be equally expensive.
With "free advice," you can actually get hurt in three different ways:
- You pay significant fees that, despite any assurances to the contrary, inevitably wind up coming out of your pocket.
- You buy investments that are more likely than usual to be underperformers or outright losers.
- You wind up getting locked in to plans or programs that charge various kinds of exit penalties. So when a better, alternative opportunity comes your way, you have to either pass it up or pay through the nose to switch.
In short, taking "free advice" can be like walking into the ring with a professional wrestler. First, he socks it to you with fees. Then, he dumps you into bad investments. And last, he pins you down on the mat and won't let you go.
So my rule number two of investing is: Never act on so-called "free advice."
How can you tell? It's actually quite simple. Everyone you deal with in the financial industry is either a salesperson or an analyst/advisor . It's virtually impossible for anyone to be both at the same time.
The salesperson will tell you he's not charging you for the advice. He'll tell you it "comes with the service" or it's covered by the transaction fees or commissions. That's a dead giveaway.
The analyst (or a true advisor) tells you, up front, what he's going to charge you, he charges the fee, and then he tells you what he charged you. It couldn't be clearer.
The fee could be something in the neighborhood of $100 per year for a subscription to an investment newsletter. Or it could be, say, $100 per hour for a personal consultation. That's cheap insurance that can save you — or make you — a tidy sum.
Still not sure how to distinguish between a salesperson and a true analyst or advisor? Here's what I suggest: No matter whom you encounter in the financial industry — stockbroker, insurance agent, financial planner or banker — ask these questions:
1. Do you (or your company) make more money the more I buy? If the answer is yes, you've got a problem right off the bat. Often, the best investment decision is not to buy. And sometimes an even better decision is to sell . If buying nothing or selling is going to be a negative for his earnings, you don't have an advisor. You've got a salesperson posing as an advisor.
2. Who pays your commissions or fees? If he says it's someone other than you, he's probably lying. Shake his hand, bid him farewell and walk out the door. No financial institution I've ever heard of really pays sales commissions out of its own pocket. If a salesperson is making commissions, it always comes out of your pocket, directly or indirectly.
3. Where are you getting the information or report you're giving me? If the answer is a source that will benefit from your purchase, you can probably throw most of the info into the trashcan.
In the tech wreck, investors got hooked by salespeople repeatedly. And the same is happening right now. But with these three questions, you can discard the salespeople and find the true advisors. They are those who are ...
- Always compensated by you — not by the companies whose financial products you buy.
- Always compensated for their time or their information — not for a sale.
- Always your advocate and defender. Whether it's just a normal, friendly transaction or a heated legal dispute, it's always crystal-clear which side they're on — yours and only yours.
I repeat: "Free advice" is neither free nor advice. Sooner or later, it could cost you a fortune in terms of mediocre performance or, worse, outright losses.
Am I being overly harsh on ethical brokers, sales agents and financial planners? Perhaps. But only in the sense that it's not really their fault. It's the system that's rigged against you.
You see, even the most well-meaning salespeople still have to make a living. But they can't make a good living if they tell their clients to stay out of the most popular stocks ... avoid mutual funds that charge a big fee ... or stick with insurance policies that pay the lowest commissions. Nor can they afford to recommend investments that involve very low fees and commissions, which happen to include some of the best choices you can make today .
If they consistently give you this kind of advice, they can't put food on the table for their families — let alone send their kids to a good college. And they'll never be eligible for the big bonuses and rich rewards that inevitably flow to the top-performing salespeople.
Many salespeople do try to be as ethical as they can be within the limitations of the system. They're friendly and helpful. They bend over backwards to do right for their clients. But they're still salespeople. Work with them to buy the products you want. But get your information and advice elsewhere.
Lesson #3
Wall Street's "Rules of Thumb" Are Often Flawed or Deceptive
The bias revealed in the last bear market went beyond just recommending bad investments. It also was the source of many investing "rules" promulgated by Wall Street pros and blindly accepted by most investors — most of which were myths in disguise.
Some examples ...
Myth: "Always invest in stocks for the long term." You saw this in The Wall Street Journal story I just quoted. And you've probably heard it in many other permutations as well: "Historically, stocks have always moved higher," they say. "Bull markets are longer than bear markets," goes the argument.
The reality: Most of the stats they cite assume you bought stocks after a major decline, when they were at rock bottom. The reality is few people ever buy at those levels. Indeed, most people tend to buy most of their stock after a major rise, when stocks are very pricey. For example:
- If you bought the average Dow Jones Industrial stock before the Crash of '29, you would have lost 89 cents for every dollar invested. And even if you had both the cash and the courage to hold on (few did!), you'd still have to wait 24 years — a full generation — before you could recoup your original investment ... and another 20 years before you could catch up with an investor who just earned a steady 5% yield during that period.
- If you bought the average Dow stock at its peak in 1973, you would have lost 45.1%. The Dow touched an all-time high of 1051 on January 11, and then dropped for two years, hitting 577 in December 1974. It did not cross above 1000 again until eight years later.
- Losses in many so-called "conservative stocks" were just as bad. If you bought the average utility shares, considered safer than most stocks, your losses would have been 88.2% in 1929-32 and 45.3% in 1973-74.
- All the averages understate the true losses and recovery periods. Reason: Bankrupted — or greatly downsized —companies are routinely removed from the averages and replaced with cream-of-the-crop companies. If your portfolio includes some of those companies, your losses will be worse than the averages and your recovery period will be longer.
Myth: "Don't sell in panic. It's probably the bottom." Why is it that when brokers sell, it's supposedly based on reason — but when you or I sell, they say it's based on emotion?
The classic example they like to remind you of is the Crash of '87, which took the Dow down 36% in a big hurry, and then was over almost as quickly as it began. "People who sold at the bottom of the '87 crash missed out on the biggest bull market in history," they say.
The reality: There are two problems with that argument. First of all, even if you sold at the very worst time in 1987, there were many, many opportunities to buy back into the market in subsequent months.
Second, their recommendation not to sell didn't work too well in 2000-2001. The pundits unanimously declared a bottom in April 2000 when the Nasdaq was off 37.1%. Then, they declared another bottom in December 2000, when it was down 55.4%. If you followed their advice, instead of getting hurt just once, you got killed again and again.
Then, ironically, when the Nasdaq did hit a bottom — that's when the majority of "experts" on Wall Street themselves began to panic! Reflecting the nearly unanimous pessimism of Wall Street experts, Business Week advised its readers to dump their shares even if they had already plunged 80% or 90%. Time's front cover featured a mean bear and warned of more big trouble ahead. Nearly all the great "bulls" on Wall Street temporarily abandoned their optimistic bent and "warned" you about events that had already happened.
My rule number three of investing: Sell BEFORE the panic stage. In practice, that means selling just as soon as your stocks fall below a predetermined loss level that you're comfortable with. The actual level will vary, and certain investments, like options, must be treated differently. But generally, a 20% decline in a stock is a key level to consider.
Myth: "Mutual funds have smart managers. They will give you diversification. They will protect you."
The reality: Mutual funds are neither manna from heaven nor the holy grail of investing. In the great stock market years between 1997 and 1999, only 24% outperformed the S&P 500.
In 2000-2001, the smart, sophisticated mutual fund managers running tech funds got scammed just like everyone else. In fact, every single one of 200 tech stock funds lost money, with 72.5% of the funds losing more than the Nasdaq Composite Index. So much for expertise and diversification!
Four More Rules of Investing in Today's Market
My rule number four: Keep a substantial portion of your money in cash or cash-equivalent, including foreign currencies. (For specific instructions, see my two-weeks-ago Money and Markets , Triple Crisis: Your First Defense .)
My rule number five: Hedge with inverse ETFs — special exchange-traded funds designed to go UP in value when the market goes down. (For my step-by-step plan, see last Monday's Money and Markets , The Triple Crisis Strikes Harder .)
My rule number six: Diversify over a broad spectrum of other investment classes, including natural resources like oil and natural gas. (If you want to get Sean's oil report coming out tomorrow, today's your last day to sign up. Click here. And if you invest in oil and gas stocks, be sure to also follow my rule number five for protection.)
My rule number seven: If you work with a money manager, ask him about his programs designed for a bear market. If he doesn't have one, move your assets to one who does.
Good luck and God bless!
Martin
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