Stock Market: Lessons Learned (Summary)


Lessons Learned

There is to be seven years of great abundance throughout all the state of Egypt. And there will be thereafter seven years of famine; and all the abundance will be forgotten in the state of Egypt as the famine consumes the Egyptian mind. So the abundance will not be remembered because of the following famine, for it will be very grievous. (…)

Let Pharaoh appoint officers over the state of Egypt to conserve one-fifth of the Egyptian national product during the seven abundant years. And let them gather food during the good years that are to come, and store grain under the control of Pharaoh, letting the food be stored in the cities. And the food that will be stored in the land will be available during the seven years of famine that will take place in the state of Egypt, so that the people will not perish during the famine

Genesis 41:29-36

  • By the end of 2007 I was fully invested with the savings of my last 4 years plus the future savings of 2 years more
  • I was invested mainly in banks and a bargain bought in May 2006, Home Depot HD.N. I failed to recognize that Home Depot was highly correlated to the housing downturn and that I would need this money in less than 5 years, to take advantage of the incoming garage sale
  • I used the equivalent of 3 years of savings alone between March and November 2007 to buy US banks, since that the prices had already fallen 20% off. However, the same stocks still had another 30% to go down. I failed to wait for the proper signals before to start shopping


Must control euphoria

Buy fear, sell greed

Paul van Eeden

  • I remember that I felt particularly gratified in January 2007 because the Christmas Rally in December 2006 was much better than usual. I failed to control myself and buy portfolio insurance
  • It was an intense activity in Mergers and Acquisitions (M&A); private capital bought billions in public business: Bell Canada, First Data Corporation, Chrysler. The media repeated over and over again that there was no risk premium asked by investors; too much money looking for home. However, money dried out in just a few hours; for example, the sale of 10% of Home Depot (the HD Supply division that sells to construction contractors) had to be renegotiated

Must control anxiety

  • In February 1987 and 2007 there was an important drop in the markets. Prices fell 15-20%. People saw that the prices were cheap enough compared with recent historical levels and new historical hight were established in July and September
  • During 2007 I went down to over 40% off in non-realized loses, one half of that in November alone. I was receiving approximately 4.8% in dividends from my holdings, which represented 12% of my gross income. The biggest problem was that I did not have money available to use when the prices got really cheap in January, March and July 2008: the margin was already exhausted in my brokerage accounts


Wait for the inevitable events on a market crash

Let the expected events happen

Chronicles of a stock market crash

  • Wait until the retail investors are gone
  • Wait until there is blood in the streets
  • Wait until war spoils are taken over
  • One indicator to follow is the number of IPOs in the last quarter. Must be getting out of the market when the number of new IPOs reach 7-years record highs — even tough the worst thing to do seems to be in cash —, and get into the market when there were zero IPOs in the last quarter: this happened in the quarter ending in June/July 2008 (Antony Ha, Matt Richtel, Joe Duck)

Do not invest unnecessarily during good times — cash will be king

  • All my holdings could have been bought without borrowing any money if I would not spend a dime on the stock market before the 3rd Friday of November 2007, including the last 4 years. I should had kept all savings in Savings or GIC accounts, including the RRSP. I should had wait until all the retail investors were out to start shopping


Dividend Cuts: Time to Sell

Preemptive actions

  • The market crash will last 3 years from the beginning to the end
  • Must sell all common stocks in the first 3 months and stay in cash for 2 years at least

Buy stock insurance (puts) when the crash is expected

  • The puts should have an expiration period at least of 2 years. The first year the market will be just deflating and there will be lots of emotions going on, as the retail investors get out. The second year the market will be incredibly quiet and slow, and still deflating, as there are still no buyers, specially in long week-ends between quarters (like the week containing July 1st and July 4th)

Buy lenders/buyers of last resort before the crash happen

  • I should have moved all my money to Berkshire Hathaway Inc BRK-B.N at the beginning of the year. The financial crisis are usually a liquidity crisis and Berkshire behaves almost like a lender or buyer of last resort. The price of BRK-B.N increased during the crisis in 2007 and 2000-2002

Wait and watch…

The Dow Jones Industrials free fall to 8,000 and lower

  • The Down Jones Industrials' fall is accelerated when the DIA touches 9,000, but slows down when it arrives close to 8,200, where it fluctuates around for weeks
  • Must wait until the DIA goes below 8,000

The USD dollar appreciates fast

  • The world panics and buys T-Bills denominated in USD$ with negative returns, just to maintain principal
  • The Oil drops 50% in a few weeks — speculators are out of the market
  • The CADUSD$ loses 20% in two weeks

The unemployment grows starts growing at a slower pace

  • Must keep close attention to the unemployment grow. Its is an early indicator for the final crash
  • The unemployment rate must start growing at a slower pace before we go back into the market


Diversify: do not concentrate in a few names

  • Buy a basket of stocks of 6 financial companies or more. The final portfolio can consist of around 15 large-cap banks from Canada, USA, UK and Spain. No single holding must be bigger than 15% of the total portfolio. Some banks have to cut dividends 75-50% in a few months for sure. Banks with lower Tier-1 capital ratio will cut dividends first: must weight holdings on the Tier-1 capital ratios, using the FDIC scores before to decide which one to buy (FDIC Statistics on Depository Institutions)
  • Buy the KBW Regional Bank ETF, RKH Regional Bank HOLDRS or KBE SPDR KBW Bank ETF. Regional banks earn the bulk of their profits by borrowing money at low short term interest rates and making loans at higher rates. As the Federal Reserve cuts short-term lending rates, profit margin at regional banks expand. This KBW ETF trade at just over 13 times earnings — and yield over 6% (Steven Halpern, March 2008) RKH and KBE trade just over 11 times earning, and yield over 11% (March 2009)
  • Buy the PFF iShares S&P U.S. Preferred Stock ETF. This was yielding around 11% in October 2008: Sophisticated investors might buy the preferred shares of JPMorgan (JPM), Wells Fargo (WFC), or Bank of America (BAC), all three of which recently yielded between 8% and 9%

Buy highest quality only

  • Do not use margin to buy smaller caps. Smaller cap's value sometimes goes down to $0 — zero, nil, nada —, and for this reason never should be bought on margin (globalstreamer, CanLii)

Dividends must cover interest paid

  • When borrowing money, the dividends must be enough to cover all the interest paid. This is possible with basket of bank shares when they are bought almost at the bottom of the cycle. Only acquire big banks because the other will reduce dividends to switch their business models. The historical average dividend yield for banks is about 3%. For example, on Monday after the 3rd Friday (OptEx) of November 2007 I was paying 8-9% of interest and the dividend yields were:
Name Symbol Dividend Yield (%) Price YTD Return (%)
Bank of America BAC.N 5.4 $42.82 -17.0
BB&T BBT.N 5.3 $33.12 -21.3
Popular BPOP.O 6.8 $9.40 -46.1
Citigroup C.N 6.8 $32.00 -39.9
Comerica CMA.N 5.8 $42.94 -25.1
Commerce Bancorp CBH.N 1.5 $35.17 1.1
Capital One Financial COF.N 0.2 $51.50 -32.9
Fifth Third Bancorp FITB.O 6.0 $27.51 -30.5
J. P. Morgan Chase JPM.N 3.5 $41.37 -11.8
Keycorp KEY.N 5.8 $25.02 -32.2
National City NCC.N 7.9 $20.37 -41.4
Northern Trust NTRS.O 1.3 $75.01 25.1
PNC Financial Services PNC.N 3.5 $69.07 -3.5
Regions Financial RF.N 6.1 $23.77 -34.3
Charles Schwab SCHW.O 0.9 $22.93 25.7
Suntrust Banks STI.N 4.1 $67.62 -17.8
State Street STT.N 1.1 $76.18 13.9
Marshall & Ilsley MI.N 3.9 $30.05 -36.3
M&T Bank MTB.N 2.8 $88.28 -26.5
Union Bank of California UB.N 4.0 $49.45 -17.2
US Bancorp USB.N 5.1 $31.43 -10.0
Wachovia WB.N 6.1 $38.48 -29.0
Wells Fargo WFC.N 3.9 $30.53 -11.1
Washington Mutual WM.N 12.1 $17.04 -63.2
Zions Bancorporation ZION.O 3.4 $50.22 -37.6
  • Even expecting dividend cuts!

While the 10-year Treasury is paying around 3.5%, and a five-year CD is in that neighborhood, bank stocks are yielding an average of around 6%

Here's the problem. Many banks with tantalizing yields have one foot on a dividend cut and the other foot on a banana peel. So, you better be very selective about which banks you buy or hold. Dividends require extra cash that banks increasingly don't have

The past 12 months have set an all-time record for dividend cuts or eliminations by S&P 500 companies; most of these have been financial stocks. Many of the larger banks have high relative dividend payouts and thinning capital cushions

As banks become increasingly strapped for cash, they typically first stop any stock repurchases. Then, they raise cash by issuing preferred stock. After that, they're most likely coming for the dividend

Banks most at risk to cut are banks with high dividend payouts, that undergo large write-offs, and that have already exhausted alternatives by stopping share buy-back programs and issuing preferred stock

Which Banks Will Cut Dividends?


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