Lessons From 2007: A Baker's Dozen - RealMoney

Summary:
Barry Ritholtz with some lessons learned about markets from 2007. Ignore market rumours. Buy sector strength and avoid sector weakness. Never blindly follow the big money. Day-to-day stock action is mostly noise. P/E matters less than you think. Ignore deteriorating fundamentals at your peril. Nothing is more costly than chasing yield. Know what you own. Simple is better than complex. Stick to your core competency. Fess up. Never forget risk management. The trend is your friend. (Published: 01/02/08)

Notes:

1. Ignore market rumors
• Sometimes the big bucks don't even have to make the buy, they need only have to be rumored to be kicking the tires.
  
• That was never truer than in 2007.
  
• It seemed every time some firm was in trouble, the same gossip was floated that Warren Buffett was about to buy them. Time and again, these tales proved to be unfounded money-losers.
2. Buy sector strength (and avoid sector weakness)
• It's a truism of real estate: It's better to own a lousy house in a great neighborhood than a great house in a lousy one.
• The same is true for stock sectors: Buying mediocre companies in great sectors generated positive results, while great companies in poor sectors struggled.
  
• The losers are obvious: The homebuilders, financials, monoline insurers and retailers all struggled this year.
  
• Goldman Sachs (GS ) is a perfect example. Despite record revenue and earnings in 2007, the stock was up less than 15% in 2007. In 2006, on much weaker revenue and profits, shares climbed more than 50%. Great house, bad neighborhood.
• The winners? Anything related to agriculture, solar energy, oil servicing, industrials, software, exporters, infrastructure plays -- even asset-gatherers thrived. Stocks in these groups consistently showed up in the 52-week-high list.
  
3. Never blindly follow the "big money"
• Because professionals make dumb mistakes too.
  
• 2007 saw a number of surprise investments where so-called smart money bought big chunks of troubled companies
• Bank of America (BAC) buying a chunk of Countrywide (CFC) being Exhibit A.
  
• Many people chased the so-called smart money into these trades.
  
• Unfortunately, all of these trades have proven to be jumbo losers. If this keeps up, the "smart money" may need to start looking for a new nickname.
4. Day-to-day stock action is mostly noise
• Markets eventually get pricing right.
  
• But the key to understanding this is the word "eventually."
  
• Over the shorter term, markets frequently under- or overprice a stock before settling into the right approximation of value. This process typically occurs over broad lengths of time.
  
• Unfortunately, that doesn't stop some rather suspect interpretations of what these short-term movements mean. I look at these tea readings as Rorschach tests, revealing more about the speaker than they do about the subject.
  
• Case in point: The homebuilders.
  
• It seemed that every time there was even the slightest uptick in the group, some bozo would declare that the bottom of the real estate cycle was in. Indeed, every dead-cat bounce or short squeeze was trotted out as proof positive that the housing problem was over. Only it wasn't, and the homebuilders cratered some 70% off their highs.
  
• You don't need to be a technician to know this: The little squiggles on the chart mean a whole lot less than the big squiggles do.
5. P/E matters less than you think
• P/E ratios alone tell you very little about a stock's future prospects.
  
• If that sounds like blasphemy, please look at a few examples: Google (GOOG) , Apple (AAPL) and Mosaic (MOS) all sported high P/Es at the beginning of the year. Their stocks have done splendidly. On the other hand, back in January, retailers, financials and homebuilders all had reasonably cheap P/Es. (How'd they do?)
  
• It helps if you think of P/Es not as a photo but as video. The direction matters more than the mere number:
  
• Were P/Es likely to come down as sales ramped up? Or were P/Es modest because they were at the top of a profit cycle, and were likely to fall? The answer to these questions explains the difference between the winners and losers, and that leads us to:
6. Ignore deteriorating fundamentals at your peril
• At various points in 2007, we saw or read recommendations to buy the unholy trinity: retailers, financials and homebuilders.
  
• Each of these buy recommendations came despite the deteriorating economic fundamentals of each sector.
  
• That turned out to be a recipe for big losses.
  
• One would think this doesn't need to be said, and yet it does: When the fundamentals of a given market, sector or consumer group are decaying, profit gains are sure to slow.
7. Nothing is more costly than chasing yield
• For fixed-income investors, what matters most is not the return on your money, it's the return of your money.
  
• Reaching down the risk curve for a few bips of additional yield is one of the dumbest things an investor can ever do.
8. Know what you own
• This very basic issue was mostly forgotten in recent years, and it was forgotten by pros and individuals.
  
• Investment banks like Bear Stearns, Morgan Stanley (MS) and Merrill Lynch (MER), big banks like Citigroup (C) and Washington Mutual (WM) , and GSEs like Fannie Mae (FNM) and Freddie Mac (FRE) were scooping up assets apparently without doing their homework.
  
• The complexity of these pools of mortgages almost guarantees that no one truly knows what's in them (see the next rule). If you don't know what you own, how can you properly manage risk?
9. Simple is better than complex
• Here's why this blindingly obvious observation bears repeating:
• Start with a few million mortgages of varying credit-worthiness and create a series of residential mortgage-backed securities (RMBS) from them. Then take the RMBS and stratify them. Then leverage them up into collateral debt obligations (CDOs). Once that bundling is complete, make complex bets on which layers might default, via credit default swaps (CDS). Gee, how could anything possibly go wrong with that?!
• It turns out plenty can go wrong there. Remember, in the universe of financial engineering, simpler is better than complex.
10. Stick to your core competency
• E*Trade (ETFC) is an online broker; what was it doing writing subprime mortgages?
• Why was Bear Stearns running two hedge funds?
• Isn't H&R Block a tax preparer? It was making mortgage loans why?
• And exactly what was GM's expertise in underwriting mortgages? (The snarkier among you might be wondering exactly what business GM's expertise is in.)
• Had these companies stuck to what they did best (or least bad), they wouldn't be in as much trouble today.
11. Fess up!
    
• Whenever a company runs into trouble, they seem to take a page from the same PR playbook:
  
• First, they say nothing. Second, they deny. Finally, they make a begrudging, pitifully small admission. Eventually, the full truth falls out, and the stock tanks with it.
  
• Companies (and their shareholders) are much better served when the company admits its mistakes, apologizes and tries to make amends.
  
• Promising to do better in the future never hurts either. Even when bad news hits a stock, a quick admission of error makes the pain less severe than it might have otherwise been.
12. Never forget risk management
• This applies to everyone who is involved in anything financial: investors, companies, even the Fed.
  
• Consider what could possibly go wrong, and have a plan in place in the event that unlikely possibility comes to pass.
  
• If there is to be upside, then there must also be a corresponding and proportional downside.
  
• For investors, that may be something as simple as using stop losses and being appropriately diversified.
  
• For others, it means knowing what risk factors face their businesses: the price of oil, interest rates, a hurricane. You may not be able to control these things, but you can anticipate, prepare for, even hedge against all of them.
13. The trend is your friend
    
• Despite the year's parade of horribles, this market cliché was proven true once again.
• The Dow, S&P 500 and Nasdaq are all higher this year, as their long-term trends have been tested but remain intact.
• The exception, the Russell 2000, broke its trend earlier this year. That made trend traders abandon the small-cap index, which has since fallen even further.
  
• This confirms the corollary: "except for the bend at the end."
  
• As long as the index trend lines stay intact, investors can sleep easy. But once those trendlines break, well, then you better apply some of the earlier lessons (see numbers 2, 3, 4, 6, 7 and 12!).
  

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