FOOL ON THE HILL
Rapid Recovery Unlikely

Back in November, things were finally looking up for the stock markets, as Americans seemed to rally after the grievous September attacks sent stocks plummeting. At the time we warned that there were no real harbingers of an actual recovery. Turns out, things are not looking up at all, but there is a strategy to combat this: dollar cost averaging.

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By Bill Mann (TMF Otter)
February 5, 2002

I hate to say I told you so....

Suddenly, seemingly out of nowhere, we are getting more and more bad news on the economic front. Where people ended last year somewhat hopeful that the economy was turning around as evinced by significant last-quarter gains in the U.S. stock markets, those illusions are quickly turning into delusions.

In November, as stocks galloped higher in an environment of hope and determination following the September attacks on the United States, I put out a piece entitled "Be Very Careful" that described why the market's rapid raise was most likely built on faith and hot air. These are not the kinds of things upon which people should build an investing strategy, to be sure. This piece, and its follow-up offering, "More Words of Caution", stirred up a wee bit of a firestorm, as some felt that I was trying to dampen spirits just when everyone was finally feeling good again after so many months of painful stock-market returns.

You're damn right that's what I was doing.

Not because I enjoy the role of killjoy, mind you. It's not a whole heck of a lot of fun. It's just that the three main legs of the economy (consumer, corporate, and government spending) are so far out of kilter and are so far from healthy that the thought of a rapid recovery seemed ridiculous. Add onto this the fact that the dollar is at an eight-month high against the Euro (at 86 cents per Euro) and the potential collapse of the Japanese economy and the fourth leg, international trade, isn't exactly hopping either.

As we discussed last month, the level of loan-loss reserves held by American banks is at its highest point in years, and yet rose much slower than the actual charge-offs for bad debts. This came prior to the recent spate of bankruptcies, including Enron, Global Crossing, Kmart (NYSE: KM), and others with scores of billions in debt (only part of which is in the form of bank loans and guarantees). What we are witnessing is the culmination of the lowered standards banks were using for loan securitization in the last, most irrational part of the bubble. Rest assured that these banks have already greatly increased the risk requirements for their loans, at the exact same time that the Federal Reserve is trying to encourage them to loan MORE money. While I do believe that things will get better eventually, I think that the thoughts of a rebound in short order are ludicrous.

Banking blues
America's banks are going to feel a LOT of pain in the upcoming months, perhaps even years as the folly of their loan practices in the late '90s comes back to haunt them. Already some of the big money center banks like JPMorgan (NYSE: JPM), Bank of America (NYSE: BAC), and Morgan Stanley (NYSE: MWD) are getting clubbed as investors fear exposure to as of yet undisclosed liabilities to insolvent debtors. Global Crossing is an interesting case in point for what can and will go wrong. It's spent billions to build out this magnificent global fiber network, which will most likely be auctioned off to pay off its debts. But who is left to buy? Telecommunications is a shambles, and only one or two companies have anywhere near the capital position to even bid for Global Crossing's assets at a fire sale price. It's like when Louis Winthorpe III had to pawn his six thousand dollar Roche Vouceau watch in Trading Places. "In Philadelphia it's worth $50."

However, I still continue to believe that the United States banking system is strong. It's just pulled a bit tight. I say without apology that things could get worse in the near term, but it is extremely unlikely that the U.S. would become another Japan, with so many billions of undercapitalization that the banks there have been essentially closed to new loans for the better part of a decade.

The problem is simple: Banks have made loans based upon audited company financials. Now we find out that the Enron scenario is not an isolated event, that there are perhaps dozens of companies for which the working capital amounts listed on statements are grossly misrepresented. Tyco (NYSE: TYC) made $8 billion in acquisitions over the last three years, the details for which were never disclosed. Granted, these acquisitions averaged less than $12 million apiece, but $8 billion in undisclosed acquisitions? That is a massive deployment of capital into which shareowners have zero visibility.

What we're going through (and will continue to go through) is a crisis of confidence. The accounting profession has taken what appears more and more to be a well-deserved beating. The likelihood of Arthur Andersen's survival, in my estimation, is minimal. They have perhaps at most $6 billion in liability insurance, and face the potential of $70 billion in claims. You do the math.

What I hope to see is that investors will cease to entrust their capital with companies that fail to accurately, clearly and lucidly describe their businesses, complete with a frank discussion of liabilities and risk. What I also hope to see is that investors recognize that these troubled times will, in fact, pass.

The whole reason I warned investors in November was I feared that they would be looking for the stock market to predict the recovery. That's just not the case. Investors who plowed money into some of the big movers from September and October such as Juniper (Nasdaq: JNPR) or JDS Uniphase (Nasdaq: JDSU) are now getting mauled.

One solution
Which is not to say that I advocate pulling all your money out of the market. In fact, I think that we have reached a perfect time to practice an old standby strategy: dollar cost averaging. Investors may not have any idea when the market is going to turn around, but that should not force us into sitting completely on the sideline until the market has already moved. Many companies will rebound, eventually. By dollar cost averaging the same amount each month, you will be buying more shares per dollar now when the market is low and less shares when it goes back up. Just make sure you are not buying into a company that has such a poor financial condition or business that it's not coming back. If you question anything, call the company's investor relations department. If the answer you get is unsatisfactory, move along to another stock.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann fancies himself the Vanilla Ice of investment analysts. Ouch, ouch baby. The Motley Fool has a complete disclosure policy.