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Is It Time To Panic?

The past few weeks in the stock market have been harrowing enough to put fear into the most seasoned investor. Another 4% drop yesterday has put the S&P 500 over 16% down since the start of September. Panic begets panic, and the past week has seen an acceleration in sell-offs as more and more people move into perceived safe investments such as treasuries, whose yield has fallen to about half a percent (as more people move into them, interest yield declines). MagicDiligence's Top Buy portfolio has not been immune, falling even faster than the benchmark. What is an investor to do in this environment?

Let's all calm down and take a deep breath. Nearly all bad decisions are emotional ones, and panic and fear are emotional responses to the current situation. We want to look at this situation logically and rationally before deciding to horde our money under the mattress. The basic questions to answer are: what is causing the market to sell off at such alarming rates? Does the rate of decline reasonably reflect the economic problems going forward? And last, as long term investors with at least a 5 year horizon, are these problems likely to be long-lasting or even permanent?

What is causing the market to sell off at such alarming rates?

Clearly the cause is the turmoil in the financial markets. Exposure to bad mortgages has spread like a virus due to derivative securities and threatens a wide variety of firms (detailed MagicDiligence analysis here). A slew of massive financial firms have failed or been bought out, from Lehman Brothers to Merrill Lynch and more recently, traditional banks like Washington Mutual and Wachovia. In this environment, banks are leery about lending out money, especially to each other as it's difficult to know who to trust. Since many businesses rely on short-term loans to meet operating expenses such as inventory or payroll, the inability to secure them can lead to a major slowdown in business activity. It's like having your credit card frozen on you, without you doing anything wrong.

Does the rate of decline reasonably reflect the economic problems going forward?

A 20% selloff in the market should discount about the same reduction in earnings looking forward. So far, the data indicates it is a major overreaction to the actual circumstances. As this article demonstrates, bank lending has far from dried up, even after the collapse of Lehman and AIG. Business, Real Estate, and Consumer loan activity was actually up from August levels in September, and bank-to-bank loans were only marginally lower. The 3-month inter-bank lending rate, or LIBOR, is a shade over 4% today. A year ago it was well over 5% (5.2%, actually). Smaller, well-run regional banks have picked up business by stepping in and providing loans that poorly run larger banks are now shying away from.

In fact, I've heard little first hand data from any stock I follow about having difficulty securing credit. Granted, the majority of MagicDiligence Top Buys do not use debt as a primary financing avenue, but even the ones with a fair amount of debt reliance have not indicated any concerns related to it. Since the Magic Formula systematically avoids banks and insurance companies, it's perplexing to explain why stocks with no direct exposure to mortgage assets are being sold off at a faster rate than the overall market. The rate of this sell-off looks speculative at best.

Are these problems likely to be long-lasting or even permanent?

Wall Street is myopic. This is no secret. A 20% sell-off in September generally means that the Street expects a similar decline in earnings over the next 3-6 months. I think that this may not be so far off. It's reasonable to expect that companies may slow down growth spending as credit becomes more expensive to obtain (if it indeed is). Some adverse conditions may be long lasting. For example, firms that produced big profits by riding the housing boom are unlikely to duplicate those results in the near future.

However, MagicDiligence picks (and many Magic Formula stocks in general) have some counter factors that are not being considered. Many of these companies have large cash balances that they can tap to buy back stock at historically low prices, reducing share counts and propping up earnings per share until growth resumes. Most also have little or no debt, so a macro-economic squeeze on sales presents no long-term danger to financial health. Several truly great companies are selling at price-to-earnings ratios not seen in 2 decades. One of Warren Buffett's most revered quotes is "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful". It may be tough to focus in the future in these kind of times, but the truth is that markets like this is where long-term fortunes are seeded.

In summary, this is a terrible time to sell and an attractive time to buy, especially if you are looking ahead several years. The current sell-off does seem overdone - the fear just is not matching up well with hard lending data. While this data will likely deteriorate some, there is no hard indication of the credit system being in a "freeze" as so many Wall Street blowhards have been saying. Historically, buying during major drops like this have resulted in big gains in relatively short periods of time. Don't forget that the government is stepping in, in a big way, which should soothe any fears of another Great Depression. MagicDiligence Top Buys are all companies with sustainable competitive advantages and strong financial health. They are not going out of business, and many also pay very attractive dividend yields at current prices. So get tough, keep investing, and know that those with courage today will be rewarded in the future.

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