You'll Need Good Equities... And Balls

Dear Reader,

Vedran here, filling in for David Galland today. Lately, I've been working on an interesting project, looking at stocks which could weather the next market crash. The good news is that there are stocks out there with low betas that fluctuate less with market movements. For example, if a stock's beta is 0.5, one can expect it to lose only 0.5% when market loses 1% on the same day.

In regular market conditions, these low-beta defensive stocks will do their job. However, in my research, I've come across some troubling facts. If the DJIA drops 100 or even 200 points tomorrow, defensive stocks won't get hammered as much as the market. With that said, in a full meltdown, no one is immune. The most defensive stocks will get sold off just as fast as any hot potato on the market. When all hell breaks loose, there will be no place to hide.

If there were some magical stocks out there, which could go down no further than 10% or 15%, I would tell you about them. But unfortunately, even the most defensive stocks sold off 30% or more during height of the crisis. So what's the point of owning defensive stocks? They will still perform better than others in a crash.

If it sounds like I'm contradicting myself, I'm not. Yes, they may tank 30% or more at the height of a crash, but what I kept noticing in case after case of defensive low-beta stocks was a sudden resurgence from the lows. I'm not talking about a period where the stock is doing a little better or where the stock chart has improved but still looks wobbly. I'm talking about stocks which hit a rock bottom, jumped back up, and didn't stop rising for the next four years.

There's good news and bad news here. By choosing some good, defensive equities, you can fare better in the next crash and its aftermath. The bad news is that buying those equities isn't enough to guarantee a better result - you're also going to need some balls, figuratively speaking. When your defensive stocks are down 30% or 40% at the peak of a crash, you will have to resist selling. Unfortunately, many investors in the last crash couldn't fight that temptation to sell and missed the rebound. They had the right idea - just not the nerves to stick through the worst time.

So, how do you know whether a stock will jump right back or not? Your analysis necessarily requires a lot of common sense. For example, right now for our portfolio I'm looking at a prospective company that's in the business of selling a grocery staple most of us regularly purchase. I can't tell you all the specifics, but I'll share some of the key facts about it. In the past five years, this company's revenues have remained flat (this is a defensive play not a growth play). Yet from the company's 2008 peak to its bottom, the stock fell around 45%. That just doesn't make sense. If a company is bringing in the same amount of money during the crisis as it was prior to it, then there's something clearly wrong with the 45% downward valuation.

A lot of investors got spooked and sold the stock, but the firm's fundamentals remained unchanged. Despite the market turmoil, consumers kept purchasing this household grocery staple. The market quickly took notice of this discrepancy, and the stock price quickly began to rise. Within a year of its bottom, the stock had risen over 100% without ever looking back.

Most of us don't have nerves of steel, but understanding your defensive stocks inside and out can help you keep your cool when the market turns chaotic. At Casey Research, we can provide you with the best picks available and the background knowledge for them. However, the emotional and psychological part of trading still rests on your shoulders. The defensive stocks are a necessity for your portfolio; however, they alone can't save you in a deep crash... only you can, by holding them until they bounce back to a rational price.

Re-examining Too Big to Fail

By Vedran Vuk

I've never been a believer in the dangers of "too big to fail," but nonetheless, this is still an idea that captivates many people following the financial news. The concept of "too big to fail" fits conveniently into the media's script and as a result, it simply won't go away. In the past few years, the news-hour theme has been the small taxpayer versus the gargantuan, evil-doer banks. And since the banks are the big bad guys, wouldn't it be great to make them smaller so that their mistakes can't crash the whole economy again? After all, this was all their fault, right?

At first blush, a bank breakup seems like a reasonable solution. But think about what's being assumed here... The assumption is that a few greedy major banks with their poor and sometimes outright foolish decisions are responsible for a multiyear global recession. However, is this how things actually happened? Of course, except for one part: It wasn't just a few banks and they weren't all big.

"Too big to fail" would make sense if the crisis was caused simply by Lehman Brothers or Wachovia, but it wasn't. Every single major US bank was running for cover. Some were in better shape than others, but no one walked out from the mortgage bubble unscathed. Furthermore, Wall Street banks weren't the only ones in trouble. Through not as highly publicized, smaller banks were playing the same dangerous game with real estate. Check out the FDIC's list of failed banks.You'll find very few household names on it. Additionally, there are 772 troubled banks on the FDIC's problem bank list. After subtracting the big boys from that number, you'll still have about 750 small banks on that list.

But there's still more to it. Not only were both big and small banks participants in the bubble, so were banks in Europe and elsewhere around the globe. If the banks weren't making toxic loans themselves, they were knee deep in mortgage-backed securities holding the same debt. And as a result, when things had really hit the fan, no major financial institution anywhere in the world was left blameless. Ultimately, the size of an institution didn't really matter, because the shock was systematic, affecting every bank - big and small, local and international. The 2008 crash simply wasn't the result of a single large bank crashing, but rather a whole system.

When everyone has the same bad incentives, you get bad behavior across the board. In fact, when the problem is systematic, a bank's size has little relevance to the overall crisis. For example, in the 1980s savings and loan crisis, we had the exact opposite of "too big to fail"; many small banks got themselves into trouble, causing a nationwide economic problem.

So how do these problems happen all at once? Unless we look to systematic causes, the explanations can get pretty weird. Maybe there's a black-robed, conspiratorial group of bank presidents and CEOs, ranging from small community bank leaders to major overseas corporations, which is responsible for all of this... but somehow I doubt it. Let's not also forget about the small investors flipping houses and the people taking oversized loans as a part of this story as well. Were these guys also in on the conspiracy? A more likely explanation is that everyone simultaneously faced poor incentives.

What caused these negative systematic incentives?

A ha! It must be the US government, right? Certainly, the federal government does set many incentives and regulations, but that doesn't explain the nature of the global meltdown. Some policies - such as the Community Reinvestment Act - didn't help, but many countries around the world have dumb laws and regulations. However, the effects of poor domestic regulation rarely spill over on such a massive global scale. Perhaps our laws and regulations can explain the slow US recovery, but they can't explain why the entire world went into a meltdown.

We have to look one layer deeper at the problem. Though the US government is huge, the Federal Reserve is the only institution which can truly influence the whole global marketplace. When the Fed brings interest rates down, that affects rates and markets around the world. US Treasuries are considered "risk-free" assets and hence are the benchmark for every other investment in the world. Furthermore, when the Federal Reserve pumps money into the system to keep rates low, some of that money will spill overseas as well. It doesn't stay contained to the US.

So here, finally, we have a possible culprit. The Federal Reserve does have the capability of causing a worldwide crisis. Lehman Brothers was a big investment bank, but at the end of the day, its demise wasn't so huge as to warrant a four-years-long recession. Furthermore, the failure of single financial institutions hardly causes recession. MF Global failed a few months back, and the market has kept on moving.

What really caused worldwide bad incentives was the low-rate policy of the Federal Reserve. With rates held low for an excessively long period of time, cheap money flooded the system. And these funds fueled speculative and riskier investments in search of greater returns. The same thing is going on today with your average investor. People are flooding into junk bonds in search of yield. The Fed with its near-zero-rate policy and cheap money pushes people into riskier and riskier assets. Everyone faces this incentive simultaneously regardless of whether you're Bank of America, the local hometown bank, or just an average guy buying a house.

When a single big institution fails, the whole world can go down in flames as well. However, that institution has to be much bigger than the Lehmans, Wachovias, and AIGs of the world. It is the Federal Reserve. And almost no steps are being made to limit its powers or make it smaller. Unfortunately, this institution will continue to create bad incentives which guide banks - large and small, local and international - right off the cliff.

The Fed's suppression of interest rates is but one example of just how intrusive the government has become in the market. Coupled with gargantuan sovereign debts, ever-increasing business regulations, and escalating taxes, the world economy is so heavily politicized that all the road maps investors have used to guide their portfolios have been altered beyond recognition. To learn more about this dire situation - and how to turn it to your advantage - watch this timely video.

Weighing In on Paul Ryan

By Vedran Vuk

In this presidential election, I lost hope a long time ago. The choice of Paul Ryan as the Republican vice president candidate hasn't restored even a twinkle of that hope. Honestly, I don't think either the Democrats or the Republicans will change a thing for the better. I know that's a fashionable thing to say - for libertarians, especially - but at least in 2008, there might have been some differences between the candidates. McCain likely would not have passed Obamacare, but then again, who knows what else he might have done -especially regarding foreign policy?

Despite my apathy at this point on presidential politics, I am very concerned about Paul Ryan's portrayal by the media. At moment, he is being praised as some sort of free-market intellectual. It's a funny label for the person described in a Politico article, from which these quotations are taken:

"In the fall of 2008, Ryan voted for TARP [the $700 billion bank bailout]. Later that year, he voted for loans to help rescue the auto industry, making him one of just 32 Republicans to do so ....

"All in all, Ryan's congressional voting record reveals a standard, loyal Republican. He has voted at least 90 percent of the time with his party since he came to Capitol Hill in 1999, according to The Washington Post's votes database. ....

"In 2003, Ryan also voted to create the Medicare prescription drug benefit, whose cost - initially estimated at $400 billion over a decade, according to the Los Angeles Times - so rankled conservatives that House Republican leaders had to take extraordinary efforts to pass the legislation by a razor-thin majority.....

"Ryan, like many Republicans, also voted to raise the debt limit at least five times during the Bush administration, when such votes were considered routine and uncontroversial."

Sure, Ryan is good at presenting charts and figures on the budget and Social Security. These charts and figures are cute, but charts do not make one a principled, free-market intellectual. Your voting record does, and Ryan's isn't pretty.

With Romney and Ryan, I'm afraid of the following scenario: The media labels them the "champions of the free market," and then they win the election. After getting into office, the two repeat the same old Republican pattern of spending on wars and their own social pet projects. After four years, the country is in worse shape, and people ask themselves, "Hey, things are even worse now. Whose fault is it? Must be those free-marketeers Romney and Ryan, who've been running the country for the past few years. Let's vote them out for some good old socialism again."

If the average Joe is trained to think that capitalism gets the same result as socialism, why vote for free-market policies? In some ways, I'd rather Obama win another term. That way, the average voter can learn a hard lesson about the policies which don't work. After four more years of Obama, there might be enough political will to actually put some real free-market politicians into office rather than the hypocrites competing for the position now. However, if the average voter becomes confused about what the free market really means, then our chances of ever creating a free market become much slimmer.

I wish Romney and Ryan the best of luck in another entertaining election year, but I also wish that they would stop discussing the free market if they have no intention of supporting it once in office. There's no need to sully the reputation of a good system with their hypocrisies and inconsistencies.

Friday Funnies

While on the subject of Too Big to Fail, let's hear some good ol' banker jokes.

Why don't sharks attack bankers? Professional courtesy.

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A young banker decided to get his first tailor-made suit. As he tried it on, he reached down to put his hands in the pockets, but to his surprise found none.

He mentioned this to the tailor, who asked him, "You're a banker, right?" The young man answered, "Yes, I am."

"Well, whoever heard of a banker who put his hand in his own pocket?"

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A man visits his bank manager and says, "How do I start a small business?" The manager replies, "Start a large one and wait six months."

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If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem.

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Hospitals report that the hearts of bankers are in strong demand by transplant patients, because they've never been used.

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Bankers never die... they just lose interest.

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One night at a bar, a conventioneer sits down next to an attractive women and orders a drink.

The woman, apparently having already downed a few drinks, turns around, faces him, looks him straight in the eye, and says, "Listen here, good looking. I screw anybody, anytime, anywhere, your place, my place, in the car, front door, back door, on the ground, standing up, sitting down, naked or with clothes on; it doesn't matter to me. I just love it!"

Eyes now wide with interest, he responds, "No kidding! I'm in banking too!

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What's the problem with banker jokes? Bankers don't think they're funny; normal people don't think they're jokes.