The Long and the Short of Down-Market Investing

I was going to write about how to give a good job interview, and maybe I will someday soon. But right now I’m moved by the stock market’s continued gyrations downward to say a few deathless words on that subject.

In brief, be of good cheer.

A Bank or a Casino?

Let me explain a few basic things about the stock market. It exists for a variety of reasons. For one thing, it allows entrepreneurs and established companies to raise money for factories and laboratories and mills and mines.

It also allows small and large investors like you and me to purchase stocks to place long-term bets on the economy. We buy into America’s industrial growth, and help it propel us into retirement and prosperity. The stock market allows this.

But the stock market is also a vast casino for the people who work in it. They play feverishly, trying to make a dollar or two (or a million or a billion) via short-term trades. They sell short, buy and sell options, use trades so complex they break computers — all to make a quick buck.

In particular, they can make money by selling short and using “sell programs.” These allow traders to make money as markets fall, just as we long-term investors make money by holding on for the long run.

Take Advantage of the Sale

These trades should be totally irrelevant to us long-term investors, except for one thing: Sometimes, when the traders and gunslingers drive down the price, they give us a chance to buy into long-term growth on the cheap.

As I’ve said before, if the market sells itself down a few percent or more, why not take advantage of the sale the same way you would a sale on paper towels or a washing machine? It’s the same market, and eventually the traders will decide to start their manipulations to make the market go up. And there we’ll be, with our stocks.

Ultimately, when the trading frenzies die down, stocks are priced according to earnings and interest rates, not according to who has the quickest finger on the sell-program trigger. And again, there we’ll be with our stocks. (I learned this from Warren Buffett, so it has to be true… and it is true.)

Now, here’s a key point: When the markets go nuts and traders sell short and trigger sell programs, they don’t ever just say, “Hey, we’re doing this to make a fast buck and profit from fear.” They always have some supposedly legitimate, “statesmanlike” reason.

Barely Blip-worthy

Today, the reason is supposedly terror in the subprime mortgage market. To put this as frankly as possible, this is just nonsense.

Even if subprime delinquencies and defaults are up, they’re a tiny portion of total mortgages. Suppose 13 percent of subprime mortgages are in default. Subprime itself is less than 15 percent of total mortgage debt, so that means that roughly 2 percent of mortgage debt is delinquent or in default.

Yes, that’s more than it used to be, and is a disaster for the subprime mortgage companies.

But when a mortgage defaults, the lender takes back the house or condo, sells it, and usually recovers about 75 percent of the loan value or more. That means the real loss would be about 25 percent of 2 percent, or 1/2 of 1 percent.

In the context of a market as huge as the nation’s mortgage market, that’s not a lot. A few companies will go bankrupt, and someone will make a killing buying their bonds and portfolios at a huge discount as they turn out to be worth a lot more than people thought in March 2007. But it won’t mean a lot to a roughly $14 trillion economy, of which the subprime mortgage market is a tiny blip.

Buy and Hang On

It’s all a fig leaf for unscrupulous traders to spook other traders and try to scalp them. Please don’t let it scare you. Keep holding on, and add to broad indexes like the SPY and the VTI.

There’s also the supposed terror of a tiny rise — .25 percent — in Japanese interest rates. This will make speculators’ easy-money-borrowing in Japan and subsequent re-lending in New York at a much higher rate a tiny little bit more difficult. But you and I have nothing to do with the carry trade, and the carry trade has nothing to do with the long-run level of the stock market.

Meanwhile, the economy is strong. Employment is very, very strong, and corporate profits are great. It’s a good time to buy — especially because traders and speculators have driven prices down.

That’s good news for you, if you’re patient. I know this is counterintuitive; it always feels a lot better to buy when the market is going up. But you make more money buying when the market is going down. Let the traders and gunslingers kill each other. Buy when it’s low and just be happy — and, as always, be patient.

By Ben Stein

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