Sunday, February 06, 2005


If you study Greenspan's speech on Friday, what he said was "Come on in! The Water is Fine!" Anytime the Federal Reserve Board is in the mood to increase the discount rate, investors should be careful. When the economy shows signs of weakness, one must guess that the FRB will not raise rates too agressively. The FRB increased rates for the sixth time earlier this week but, Friday, after a less than robust job report, Greenspan stated that the US needs a weaker dollar to solve the trade deficit. In the same speech, he said he was encouraged by the fiscal discipline being demonstrated by the executive branch and the congress.

In effect, he said the economy is doing well, it is not at risk of over-heating and a further decline in the dollar would not hurt. Ergo, there is no need to fear extreme tightening from the FRB. The bond market soared. The long rate is under 4.4%. The President has proposed a plan to fix the underfunding of Social Security which would increase the capital available to go into the stock market. Greenspan assesed the situation for us all and said, "THE WATER IS FINE, COME ON IN"!

I jumped in with both feet! I made aggressive investments on margin and even purchased call options.

Many folks are afraid to buy on margin (borrowing part of the money invested). Margin buying multiplies ones gains or losses. Before the market crash of 1929, investors were allowed to borrow 90% of the amount they invested. When the market crashed, investors on 90% margin and who held portfolios invested 100% in stocks lost 100% of their investments when their stocks declined just 10%. (Diversified accounts saw their bonds go up which offset the losses in stocks.)

After the great crash, the US securities laws were changed. Since then investors are allowed to borrow a maximum of 50% of the amount invested. Should one invest $10,000 and buy $20,000 in stocks and should the stocks go up or down 10% in value, the investors gain or loss would be 10% of $20,000 or $2,000. His percentage return would be $2,000 divided by only $10,000 or 20% (plus any dividends received on the entire $20,000 less the interest paid to borrow the $10,000.)

The right to borrow money is a valuable right and a valuable tool for those who use it prudently. Borrowing money is often a generational transfer of assets. A senior citizen has saved money for retirement and needs income while a young family is willing to pay interest in exchange for being allowed to buy a house. Most home buyers start out on 80% margin. Two important differences between a house and a stock account is that houses are not routinely marked to market. A house can drop in value but, if the monthly payment is made, there is no call for additional sums by the lender. In a stock account, there is typically a call for additonal funds if the equity in the account is 30% or less than the total value.

I am concerned that now-a-days, many folks buy houses with no money down. They buy on 100% margin. The good news is that these buyers typically purchase mortgage insurance that pays off the top 20% of the loan if there is a foreclosure.

Call options are a very different animal. Call options offer the means for aggressive investors to speculate. For example, I paid $55 per hundred for the right to buy several hundred shares of the QQQQ exchange traded fund at $37 per share. This fund is a basket of the top 100 stocks traded on the NASDQ exchange. If I do not act before the third Friday in February and if the QQQQ fund is selling for $37 or less, I will have lost $55 per hundred shares. On the other hand, if the QQQQ were to close at $39, I will have made almost $145 per hundred shares. Note the leverage: the move from $37 to $39 is 5.4% and the move from $55 to $145 is 163%.

I can not and will not recommend margin buying to anyone. The margine tool is a valuable tool but so is a chain saw. Some folks should pay others to cut trees but those who know what they are doing can save money or make money operating a chain saw. One should be very careful should one operate a chain saw or invest on margin.

Options are totally different. If running a chain saw is comparable to buying on margin, then buying options is comparable to paying an entry fee in a contest to cut down the most trees in the next 10 days. The top three in the contest will win prize money and the others will not get back their entry fee. In baseball terms, option investors swing for the fences and strike out many more times than they hit home runs. I recommend that investors stay away from options. They have entertainment value for those who want to "play around". Options should only be bought by those who are comfortable losing 100% of the money invested in this activity.

Back to the real point of this article; the huge rally in the bond market and the words of Greenspan make me believe the stock market will go up in the weeks ahead. The market was very strong on Friday and I believe institutional investors (including investment banks) and speculators are starting to "unwind" leveraged bond positions. I believe the leveraged bond positions will to some extent be reinvested in leveraged stock positions. Note the buy-out of Gillett by P&G. P&G has announced that it will borrow money to buy 60% of the stock tendered. Can you see how the low bond rates make stocks more attractive?

Last night I completed an analysis of an aggressive account I manage. The account uses margin regularly and options occasionally. In the past 32 months, the account has had an average annual return of 75.4%! I plan to check and double check the numbers before posting more information. It took a lot of luck, a willingness to be agressive and a little skill to achieve those kinds of numbers. I am thankful for the insights that allowed me to invest with confidence during these months.

The reason for bringing up the great performance is to help readers understand that the US is enjoying a "bull market". "Bull markets" normally have "two legs". For example, after the recession of 90-91 the market was strong, then it had a tough year in 1994 when interest rates rose. However, in 1995 long rates came down and the market was off to the races from 1995 to 2000. The pattern has been very similar after the 2000-2001 recession. We had two fantastic years, a relatively slow year and tthen a considerable decline in long-term interest rates. I believe the "second leg" to the "bull market" has started.

I agree with Greenspan, "Come on in! The water is fine!"