There are some aggressive steps that investors can take, even in case of recession.
ARROYO GRANDE, Calif. — OK, so you're a perma-bull, a perennial optimist convinced there's always a bull market somewhere. Plus, you've got the time and the smarts to find that bull.
Warning: Stop reading now. You're going to hate what we say today. You'll hear the word "sell" a lot. Why? Because if you don't sell, a lot of you smarties will lose big bucks. Remember: In spite of all the optimistic cheering during the 30-month long 2000-2002 recession, the S&P 500 dropped 43 percent and investors lost $8 trillion in market cap.
But I know how much optimists hate talk of recessions and bears. That's for losers, right? Even when there's a vast consensus forming among economists, Fed watchers and Wall Street insiders. So why the denial? Because you've got a big secret: As Jack Nicholson said in "A Few Good Men," "you can't handle the truth." Behavioral finance experts have a fancy term to describe what happens: Cognitive dissonance.
"People tend to ignore, reject or minimize any information that conflicts with their positive self-image," their preconceived ideas and their ideological convictions, says John Nofsinger, Washington State professor of behavioral finance, in "Investment Madness."
"The avoidance of cognitive dissonance can affect the decision-making processes in two ways. First, you can fail to make important decisions because it's too uncomfortable to contemplate the situation," Nofsinger says.
People hate conflicting data so much they get nervous when their preconceptions are threatened. Their brain freezes, they self-sabotage and do nothing — and their worst fears become a self-fulfilling prophecy.
The second way we handle conflicting information: "Your brain will filter out or reduce negative information and fixate on positive information," Nofsinger says. Unfortunately, "if you ignore negative information, how are you going to realize that an adjustment in your portfolio is necessary?" Plus, you miss lots of opportunities.
The problem is your brain. It insists you're acting rational, even when you're making decisions based on totally irrational beliefs about money, budgeting, savings and investing. No wonder Nofsinger titled his book "Investment Madness."
Even with all our hi-tech online tools, data and programs, the optimist's brain still screws it up.
"Think of the human brain as a personal computer with a very slow processor and a memory system that is small and unreliable," says another behavioral finance guru, University of Chicago Professor Richard Thaler, in "The Winner's Curse."
"I don't know about you, but the PC I carry between my ears has more disk failures than I care to think about," he says.
Thaler warns that the "rational investor" theory is an outdated fantasy. Quoting Nobel Economist Milton Friedman: "Even though people can't make the calculations in the economic model, they act as if they could make the calculations."
Robert Shiller calls it "irrational exuberance, wishful thinking on the part of investors that blinds us to the truth of our situation." We convince ourselves we're rational, yet keep making irrational decisions. Thaler warns: "If you are prepared to do something repeatedly stupid, there are many professionals happy to take your money."
Our ego is trapped in cognitive dissonance, denying the new bear/recession, one that economists say could last until 2010 or 2011, longer than the 2000-2002 meltdown that dropped the Dow 4,436 points, from 11,722 to 7,286.
So what's the solution? The best way to protect your portfolio, retirement nest egg and your family's assets? Let's review the 2008 forecasts from one of America's leading economists, Gary Shilling, Forbes columnist and editor of "Insight," a financial newsletter. Shilling is a contrarian who's been telling it like it is for 45 years. Back in 2004, Shilling predicted: that "subprime loans are probably the greatest financial problem facing the nation in the years ahead." Greenspan, Bernanke, Paulson and Wall Street's greedy, delusional CEOs totally missed that warning until it exploded in their faces last summer.
Every January, Shilling forecasts the upcoming year's major themes. In his latest newsletter he focuses on thirteen recommendations for stock investors facing a long bear/recession. The first five are directly linked to the subprime mortgage meltdown:
Sell short home builder stocks and bonds. If you plan to sell your home, second home or investment houses anytime soon, do so yesterday. Sell short subprime mortgages. Sell short housing-related stocks. Sell short consumer discretionary spending companies."
Like I said, you'll hear the word "sell" a lot. You'll hate it, get angry, and dismiss his advice. Why? Optimists can't handle conflicting data. Remember, as Thaler warns, if you "do something repeatedly stupid there are many professionals happy to take your money." Consider the $8 trillion in losses between 2000 and 2002.
The next five recommendations focus on the out-of-control speculation triggered by years of easy money. "Oceans of liquidity are evaporating into small puddles and the zeal for high yield is being replaced by worries over solvency," Shilling says.
"Leaping volatility in many markets is telling investors, painfully, just how far out the risk spectrum they had climbed. So the de-leveraging of the many areas of intense speculation beyond housing is at hand."
His next five strategies counterattack this rampant speculation:
Sell low-grade fixed-income securities." Junk is junk, so dump! Sell or avoid most commercial real estate." During the 1974-1979 recession, I was at Morgan Stanley helping REITs, banks and developers work out huge problem portfolios. Today smells worse. Short commodities: Long run, we're bullish," Shilling says. But short run "as global demand falters with a global recession, commodity prices will fall." Sell short emerging market equities." If you think foreign stocks will do better than domestic, think again. "Major stock markets tend to move together, particularly on the downside." Plus, China's P/E ratios exceed 50. Sell emerging country bonds.
Also, don't count on Fed cuts rescuing Wall Street. They'll ease the collapse for a few minutes, and then reality sets in again. The recession must run its course. So here are Shilling's final three strategies as he looks deep into America's soul at the rough days ahead:
Sell short U.S. stocks in general. Buy long Treasury bonds." They will "rally as the recession unfolds." Buy the dollar before long," Shilling says. "The buck has been weak recently because the U.S. is the first major economy to slip into recession, the Fed is the first central bank to cut rates, and the U.S. housing bubble is the first to break, all of which make America a relatively unattractive place for investment. ... The recession that we believe is now starting in the U.S. will spread globally in about six months as U.S. imports weaken and the global credit crunch curbs financial activity worldwide. Then the dollar will probably rally as it plays its usual role as a safe haven. Since markets anticipate events, the turn in the buck could be close at hand."
Should you sell or "ride it out?" Shilling asks rhetorically. "Many investors believe they're better off staying with their stocks, even in the face of a major bear market, because timing the market is difficult. That's fine if they stick to their plans, but far too many panic at market bottoms and sell at just the wrong time."
Finally, if your brain is still screaming, "Don't listen! Don't sell!" remember Shilling's formula: "Another reason for selling stocks in anticipation of a bear market is a matter of simple grade-school arithmetic. If you lose 50 percent on a position, you have to double your money to get even."
Get it? Lose 50 percent during a bear, you have to make 100 percent to recover your losses in the next bull. In short, "sitting on the sidelines" may be your best strategy in a bear market. But first, you really have to hear the word, "Sell, SELL!"