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.

"Oh My God, They Killed Kenny!"

As I mentioned in my first post, it amazes me how little financial common sense many people have - in particular my colleagues. After all, these are the supposed 'Masters of the Universe' (where exactly did that ridiculous phrase come from?), who are experts in the many financial products and options for investing our money. Yet it's amazing how many are really just Average Man On The Street when it comes to making those all-important decisions that determine whether you end up with some freedom in life.

On that note, let me be clear that I see money as nothing more than an enabler in life - specifically it gives you personal freedom to decide what you want to do and when. That's why the ultra rich who wander around the shops in Knightsbridge and New Bond Street look so happy and relaxed. You can spot them a mile off, with their designer everything, styled hair, moisturised skin, and most importantly no bags under their eyes from the constant strain of life in the rat race in which we all struggle. Instead they do as they please - it's when they show all the gratitude of Paris Hilton for their position in life that the resentment rightly comes in from the rest of us.

Unlike a lot of people, I have no like or dislike of money. I think those who do are usually scared by it, because it is either a constant problem to meet bills, or they don't know what to do with what they've got. But like all fears, it's facing up to it that helps, not sticking your head in the sand and pretending it isn't important. Money ultimately will decide whether I own that house in a good area in a couple of years time, and whether I can provide for the family that L and I plan to start one day. That's a quick insight into my reasoning, along with why I have no interest in pissing my money away on ego boosts like a flash car, phone or watch.

We all know the type who do that, like a friend of mine, Big H. He's enormously proud of his house, along with his flash company car and likes to be conspicuous with his wealth by showing off various electronic gadgets like his smart phone. In short, he's the kind of overstretched financial idiot of the worst kind: shallow, materialistic, he seems to actually define himself by what he buys. He also thinks he has been clever by racking up £9000 of credit card debt, which he has been flipping every 6mths between company intro deals.

A number of financial websites have advised people to do that in recent years, but as the country is about to find out - it is always a stupid idea to encourage spending beyond your means. Now those deals are drying up fast, so Big H finds himself with an uncertain future regarding his job, and no means to pay that back easily. Anyway back to my colleagues at the bank, as I heard an interesting story on Friday about an investment decision made by one who was an unfortunate lamb to the slaughter in the first big cull back in October.

Kenny's just one of those unfortunate types who was always one of the team comedy characters. We laughed AT him as much as with him, and he hasn't had the best run of luck in recent months. As you'll see though: calling most of it 'luck' is partly to excuse stupidity. Firstly he decided to take a holiday in the summer to Sardinia of all places, and despite the warnings from a colleague who knew the place well to not drive there, he hired a car - and promptly crashed it within 2hrs of arriving, and spent the remainder of his two week holiday in hospital recovering.

Kenny's a good chap, and was well liked around the bank to my knowledge. Unfortunately he was also not politically astute enough to ensure he massaged the ego of the most important person - the Boss. He made the mistake of complaining a little too vehemently about his bonus in December 2007 (that's the last time we expected bonuses). That seems to have been remembered, as he was first on the list our of the door. There's complaining by grumbling and looking like you expected more, and then complaining by making it personal or with veiled threats - and I heard he crossed that line.

Around that time was when all the fun with the banks was really kicking off of course: Lehman Brothers collapsed, and the vice tightening on Goldman Sachs and Morgan Stanley. Overshadowed but still high profile was Iceland, which quickly defaulted on all foreign debts, forcing the UK government to bail out UK savers. Guess who had over £100k stashed away in an Icesave account?

Although Kenny will eventually get that back, meantime he decided to 'invest' his generous redundancy package in a couple of other banks in December - namely RBS and Lloyds TSB. I can only assume his logic was that given they had fallen a lot up to now, it therefore meant now was the time to buy. I should probably point out that Kenny is no trader, but such simplistic reasoning also showed spectacular naivety to assume that more crap was not lurking under the surface at both of those banks. Particularly given that each has swallowed up a terribly run, overexposed competitor in ABN Amro and HBoS respectively. You only have to look at how Bank of America is now suffering from its forced purchase of Merrill Lynch for another example.

Everybody in the City knew both were as contaminated as Lehman Brothers.. or should I say anybody who spent some time doing some research into the matter, which is another key rule of investing.

Since Kenny decided to put in an unspecified amount into those banks, they have tanked an impressive 79% in value, which just goes to prove my point that you should never assume bankers are always competent with their money. Having said that, after the last 6 months I am likely preaching to the converted when it comes to assuming we're all incompetent, overpaid slime.

I must admit, a few of us at the bank couldn't help but laugh when we heard - it was just such a Kenny way to invest. In a post soon, I'll tell you what I have been doing with my own money in the last 6 months, and why I have been making a lot of money out of the downturn.