Investing for a Recession (Part I)

One of the key rules of investing at any time is to be flexible in your approach, and not assume that whatever has worked well in the past will necessarily continue to do so in the future.

I am not going to lie: I failed to call the timing of the stock market downturn, but did see it coming. In fact, I called it too early, as after the effective collapse and nationalisation of Bear Stearns in mid-2007, my constant research through economic forecasts was enough to lead me to conclude that storm clouds were gathering and a major correction was coming. So I liquidated all my positions, and sat on mostly cash in my trading account - earning zero interest as I needed it available at short notice in case trading opportunities came up.

Another key investing rule is patience - one that amateur investors all too frequently fail to show as they get excited by a short term fluctuation in a stock price. I was patient for 6 months, as I sat there watching global indicies continue their inexorable rise upwards, and eventually I snapped and made a couple of investments in March 2008. I won't go into details of those as they are not important, but suffice to say that given the unrelenting speed of the market falls from May onwards, I am sitting on losses from those in excess of £50k.

You might whince, but another key to investing is to only invest what you can afford to lose, and while I am not happy about it, it makes no material difference - and I am happy with them both as long holds. More importantly, I have learned a very important lesson for future investing. Learning from your mistakes is the single biggest investing rule of all - and in this case it was that when all the logic points to something happening, it will do.

So by October, when all the fun had kicked off with Lehman Brothers, rather than joining the collective panic gripping many of my peers at the banks, I realised we had reached a wonderful opportunity to start making a large amount of money back from this crisis. Shorting is one, much maligned means of doing this, which is not what I do. On that note, let me say that shorting is needed for valid trading strategies (e.g. hedging), despite the criticism about naked short selling of the banks, which is for nothing other than the pursuit of speculative profit - that is an area more difficult to justify.

Instead I have been much more traditional in my approach - taking long positions (buying) stocks at a lows, and then selling them soon afterwards. The key is that what panic brings to the markets is enormous volatility. I assessed the reality of the fall out by giving it some context. Nothing like this had happened in our lifetimes - it was a cataclysmic shock that would obviously lead to enormous falls in the markets. Therefore key was to not be remotely optimistic and instead look at your worst case scenario expectations on prices and exceed them.

I recall listening on a tedious conference call at work, while idly watching the share prices of all the major banks in freefall. The two of particular interest were Morgan Stanley and Goldman Sachs at that time, due to their status as investment banks. The markets were voting with their wallets in their lack of confidence in this particular business model, and both had fallen a staggering amount in recent days. But no downturn is smooth with stocks, and in this case I had already watched GS hit a floor at $120/share and rally back upwards sharply for a couple of days, before rapidly plunging again.

As such, I watched as GS breached the psychologically important $100 mark and decided it was clearly about to drop off a cliff, despite it already being down 20% on the day. Sure enough, a moment of panic ensued as it moved down below $90/share, and I set a limit order to buy $150,000 of stock at $79/share. The stock suddenly plunged and touched a low of $77/share before spiking upwards above $90/share by the end of the day. I had an unrealised profit of $20,000 in 10 minutes. I also reasoned that based on previous rallies, all those shorting the stock would now be rushing to cover their positions, which creates a short squeeze that drives upward pressure.

Sure enough the next day, GS rose up above $120/share as I had expected, and I immediately sold out. And as I expected, the stock hovered there for a couple of days before plunging and I believe eventually hit a low in the $50/share range - it is somewhere around about $80/share as I type. It is worth noting that as I realised that £40k profit, I liquidated a bad investment from several years ago. Rather than panic or give up on it, I decided to hold and turn a negative into a positive - in this case it became a useful offset against my gains by reducing the amount I will have to pay in capital gains tax. In effect, I had recovered a large percentage of my losses from the market.

I repeated that trade further down with one of the other banks soon afterwards, and then stopped trading in them because I no longer had a strong view on what direction prices were moving and whether or not the downward trend was ending. My considered opinion was that they had further to go when later quarterly results were reported, and so it seems to have panned out as after rallies before Christmas they have plunged again.

However when you cannot decide where you think a stock is going to move, it important to not trade in it. I locked in my gains, and by December had turned £60,000 of spare change into £140,000. Where am I investing now? Two places. Most important was that I had deliberately chosen to trade in US banks throughout the process, because I had known from various research that historically Sterling was overvalued and long-overdue a downward correction.

My analysis concluded that an imminent recession in the UK would eventually fuel a correction in the GBP-USD exchange rate, especially given that the US was ahead in the economic cycle and already in a recession. Sure enough, with money tied up in dollars during the trades, I made considerable sums from the fall in the pound from October to December with so much money held in dollars. I then decided that since I was no longer sure about the direction of banking stocks (or most others), from researching likely directions of currencies in 2009, both sterling and the dollar were likely to continue their falls against other currencies.


As such, with a new policy of 'quantitive easing' on the horizon (aka governments printing money), that meant it was an easy decision to take a large stake in a gold ETF (exchange traded fund) in December 2008. This is effectively like buying shares that are linked to the price of gold in USD. Sure enough, with the pound falling further, I am currently sitting up 35% on my investment to date, and recommend that anybody debating what to do with their money for 2009 use the current minor sterling rally versus the dollar (as I type we are at around $1.43 to £1) and buy into a gold ETF on the London Stock Exchange for 2009.

When governments start printing money in the way they effectively are with all this debt, it will eventually stoke inflation later this year. That should lead to an increase in the price of gold, and makes it a good play until later in the year when it will be worth exiting.

You might be starting to get a taste for what investing is all about from the above outline of my investing activities since October. It is about completing your own analysis, taking into account historical statistics to give perspective, and looking ahead to do your best to assess what is logically going to happen next. If you don't know then do not do anything, but if you do think something is going to happen (such as house prices falling another 20% in the UK) then why sit around holding it?

Next time I will explain what I am doing with the majority of my money in 2009 at present.