We can let the mar ket mouthpieces and economists debate whether we are offi cially in a bear market or a recession, but investors don't need labels to know times are tough.
One year ago at this time, the financial world was idyllic Credit was cheap and plentiful. The largest private equity takeover in history was nearing completion, with Sam Zell selling his Equity Office Properties for $40 billion to the Blackstone Group (signaling the market top for real estate investment trusts).
Investment banks eagerly lent billions to finance these deals and were achieving record earnings on the huge fees from LBO loans and mortgage securitizations. Market volatility was at a 20-year low, and default rates on junk bonds were at record lows. The stock market was in the midst of an unbroken six-month run, up 16 percent higher from July 2006. In the parlance of fear and greed, fear was absent and greed was in control.
Of course, the height of this market nirvana was exactly the right time to be thinking about and preparing for the risks lurking in the market. Today, we find the scenario has turned in the opposite direction. The credit crunch has brought a halt to lending, investment banks are taking multibillion-dollar losses on bad LBO loans and subprime mortgage securitizations. Nowadays, distressed investing-investing in securities and loans that are in default-is predicted to be one of the winning investment strategies in 2008. Fear has regained the upper hand.
It has been a while since investors have had to deal with a nasty stock market. And it is understandable that people feel uncomfortable seeing the value of their portfolio decline. However, as difficult as it can be, removing as much of our emotions as possible during these downswings will help an investor think in a more rational manner. Those who let the market's mood dictate their actions tend to make poor short-term decisions.
After all, unless you invest only in index funds, you don't "own the market." Your focus should be on the individual companies that form your portfolio. Are their balance sheets sound? Companies that have large amounts of debt lose flexibility in these periods. What is the longterm earnings power of the companies you own? One simple method would be to add up the past 10 years of earnings and divide by 10. Then compare the 10-year average earnings to the current stock price. If that figure gives you a low priceto-earnings ratio, say 12 or below, and the company has shown a decent growth rate over the past 10 years, you may be getting a bargain price.
Five years from now, stocks likely will be trading at considerably higher levels. Which ones do you own that you should add to as they drop in price, and which new companies do you want to own for the next five years that have excellent long-term potential?
Ignore the high-water mark on your portfolio. It is really easy to go back and say, "My holdings were worth X and now I have 'lost' X-Y." But such thinking is unrealistic because no one sells at the absolute high. And if you are a long-term investor, those levels will be surpassed in time. Instead, adjust your thought process toward the future. And above all, the main thing is to keep your head when everyone around you is losing theirs.
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.