Treasure of the Sierra Madre

By on August 12, 2006

Originally published in November 1997:

Despite the recent weakness triggered by Asian currency devaluations and fears of more to come, the U.S. market should continue to forge ahead.  It will not be easy to stop this market due to the underlying fundamentals, which should not change precipitously in the coming years. But the stock market is not a risk-free area of investment, and investors should keep this in mind.

The market’s surprising strength over the last few years was easy to foretell if you studied demographics and their effect on the market. “So why not go out and buy as much as you can on margin?,” is a legitimate question. The answer is simply that no one can foretell when and what external shocks are going to surface. Granted, it will take a significant event or events to derail this bull market. A massive sale of bonds by overseas investors (unlikely) or the re-emergence of the united Organization of Petroleum Exporting Countries (OPEC…even more remote) could send the market down. Any number of things could cause a panic to develop…that’s why it is prudent to maintain some cash reserves, especially when the market is so richly valued on a historical basis.

For a better understanding of just how overvalued this market is historically, visit the Mojena Market Timing site at http://members.aol.com/smartlet/upnow.htm. I am not affiliated with Mr. Mojena, but I read his quarterly updates which are particularly well researched. He has also developed a market timing system, which is very different from the one used here.

Flash! I wrote the above prior to the market break on Monday, October 27. The drop of 554 Dow points took me completely by surprise. Despite this fairly severe drop, the market should stabilize and recover fairly quickly. The problems in Asia are similar to the problems experienced by Mexico and Latin America a couple of years ago, which have since recovered and gained much more than they initially lost. There is no reason that the currency problems in Asia will have a lasting effect on our economy. It certainly doesn’t justify this kind of market reaction. However, I’m hoping for a continuation of the selling since the Tactical Timing System is nearing a buy signal.

Deflation may be more of a threat than inflation since the emerging market countries currencies are slipping against the dollar. Their weak currencies should translate into increased exports since their goods will be comparatively cheaper. The competition cheaply priced foreign goods should provide our manufacturing companies may not portend well for earnings, and could make the stocks in certain U.S. industries cheaper.

The Treasure of the Sierra Madre

Early in the 1948 film “The Treasure of the Sierra Madre,” actors Walter Huston (as Howard) and Humphrey Bogart (as Fred C. Dobbs, A.K.A. “Dobbsie”), playing a couple of “down and outers,” are having a conversation in a halfway house. Howard, an old coot, gives his soliloquy on the effect of a love for gold on a man’s judgment, “Gold’s a devilish sort of thing, anyway, you start out you tell yourself you’ll be satisfied with $25,000 and cross my heart, so help me lord….fine resolution….after months of sweating yourself dizzy and growing short on provisions and finding nothing you finely come down to 15,000, then 10 – finely you say, Lord, let me just find $5,000…I’ll never ask you for anything else more the rest of my life.” Dobbsie replies to Howard “$5,000 is a lot of money.” Howard responds, “Yeah, here in this joint it seems like a lot, but I tell you if you was to make a real strike you couldn’t be dragged away. Not even the threat of miserable death would keep you from trying to add 10,000 more….10 you’d want to get 25…25 you’d want to get 50, 50 a hundred. Like roulette…one more turn, always one more.” Dobbsie again, “It wouldn’t be that way with me, I swear it wouldn’t. I’d take only what I set out to get. Even if there was half a million dollars lying around waiting to be picked up.”

Later on in the film, after becoming partners and staking out a major gold claim, Dobbsie changes his tune a little. Howard says to Dobbsie, “$25,000 is plenty as far as I’m concerned. Enough to last me out the rest of my lifetime” Dobbsie replies, “Well sure, you’re old, I’m young…I need dough, and plenty of it.” Howard gives him the “I told you so,” look.

If you’ve ever seen this film, which happens to be one of my favorites, you know how the prospect of unlimited riches transforms Humphrey Bogart’s character Dobbsie into a paranoid schizophrenic. This film is an excellent example of the danger of greed on the judgment of an individual. Now imagine thousands of Dobbsies speculating in the stock market. The greed and fear phenomenon, coupled with crowd psychology, makes the stock market much more inefficient than the proponents of Modern Portfolio Theory would have you believe. This inefficiency creates great opportunities which can be exploited if you can keep your own emotions of fear and greed in check.

Asia Gets Cheaper

The opportunity I wrote about in Asia a couple of issues ago just became too tempting to pass up. After Hong Kong stocks crashed 10 percent on October 23, I shifted a large portion of an IRA into the Fidelity South East Asia Fund. Not that I’m recommending this fund by any means. Fidelity has demonstrated an ineptitude at emerging markets investing that would be difficult to replicate. It was just the most convenient way for me to transfer assets to Asian equities without triggering significant tax liabilities.

Unfortunately, there is no provision in the Tactical Timing System to take advantage of an opportunity like this. Don’t think I haven’t thought of “enhancing” the “rules” to capitalize of situations like this occurring in other parts of the world. I’m not saying that I can call the trough of this bear market, but I believe a major bottom is close at hand in one of the most dynamic regions in the world.

Portfolio Activity

Tricon Global Restaurants (NYSE: YUM; 30 1/2) was spun off from Pepsico (NYSE: PEP; 36 1/4). Tricon is composed of the Pizza Hut, Taco Bell, and Kentucky Fried Chicken chains and will be a minuscule holding of the aggressive portfolio.

Portfolio Updates

Novellus Systems Inc. (NYSE: NVLS; 45 1/8) split two-for-one, then slumped badly, along with the rest of the semiconductor equipment makers due to a couple of negative developments. First, the turmoil going on in Asia will likely affect purchases by the semiconductor manufacturers over there. Second, there’s been a lot of talk recently about semiconductor manufacturing overcapacity with Intel announcing that they were postponing the start of a new manufacturing facility. What a difference a month can make.

LSI Logic (NYSE: LSI; 22 1/16) was a particularly hard hit technology player. They are having problems getting their new chip fabrication plant in Oregon going in this environment of overcapacity. Once DVD and digital cameras go mainstream, prospects should improve.

Recommended Allocations

Aggressive portfolios: 75% equities, 25% cash.

Conservative portfolios: 55% equities, 45% cash.

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