Lessons from a mess...

My Dearest Moo Moo Cow,

Take a look at this editorial posted by moneycentral commentator, Bill Fleckenstein (he writes them Contrarian Chronicles on moneycentral) : Warning: This mess will only get worse

• Bubbles have a way of masking what would otherwise be self-evident truths. And, as the credit bubble in real estate dies a dramatic, not-pretty death, a very simple truth has resurfaced: It's not a viable business when you lend money to people you know can't pay it back. If the late, "great" subprime sector had a tombstone, that would be a fitting epitaph for New Century Financial and others.
  
  It's a fact that also eluded those folks who are paid to analyze company fundamentals, i.e., the dead-fish community. Regular readers are aware of my long-standing rant on this topic. Primarily, I focus on the species that follows tech stocks. However, those who follow the financial-stock industry are no less clueless. In particular, they appear not to realize that what they're trying to analyze is the unanalyzable, i.e., a black box.
  
  Who kNEW? Case in point: New Century Financial (NEWC, news, msgs). I have spilled plenty of ink on the subprime industry, including this one-time poster boy for lower-tier lending. But as New Century collapsed, most "analysts" continued to like it until the bitter end. Recently, with the stock poised to go under, Piper Jaffray finally decided to cut it to "underperform," on the heels of a UBS downgrade. Not long before that, Bear Stearns had upgraded its opinion of New Century.
  
  Apparently, dead fish are constantly seduced into buying companies whose fundamentals are clearly deteriorating by two false reference points, both of which revolve around the notion of cheapness.
  
  Sometimes they'll say a stock is cheap because it's "down from" some kind of big price. For instance, they called New Century cheap at $15, since it was down from $50. It closed Friday at $2.34. Obviously, that concept is wrong, but you see it trotted out all the time.

My dearest Moo Moo Cow, leaving the issue of the subprime out, there is a great investing lesson here. The issue of cheapness! See how dangerous it was to consider New Century cheap at $15 just because ot fell from $50? Well what was cheap simply got cheaper. New Century fell to $2.34!!!!

WOW!!

• The other false reference point is that a stock is cheap because its price-earnings ratio is low. The mistake there: People do not understand the caliber of the fundamentals that drive the E part of the P/E -- the price-to-earnings ratio. New Century appeared cheap, but the business that drove the earnings was not viable. So, it's not enough to look at the obvious numbers and state something is cheap. One must look behind the scenes and see what the business dynamics are in order to determine whether the earnings are, in fact, sustainable.

My dearest Moo Moo Cow. That's another fantastic important lesson to learn. Investing is simply much more than looking at the PE. Remember PE simply does not equate to the quality of the company. It merely states that the stock is selling at a cheap valuation in the market versus its earnings. Wouldn't it make sense to understand why is it happening? What's wrong with the stock?

• 'Cheap' is more than skin-deep
  
  Which leads me to the housing stocks. They have been described as cheap because their P/Es look low. When P/Es seem to be reasonable, people feel safe and bottom-calling appears to work, as we saw last fall and during the winter when housing stocks continued to rally on repeated bouts of bad news. However, with the unraveling of the mortgage-finance mechanism, it's hard to see how house sales can do anything but plummet. Therefore, housing stocks really aren't cheap, even though the P/Es recently made them appear that way.
  
  Now the gaping hole in the side of the mortgage market appears to be impacting the price of housing stocks -- just as it will surely impact home sales in the coming months, causing that vast river of denial running through Wall Street to dry up. And, as it does, people will be able to see that there is a gaping hole in the economy, because there's nothing to fill the gap left by an implosion in the housing market.
  
  Tech: Tethered to the economy But for now, bulls cling to the illusion of safety in the tech sector -- which is why those stocks held up pretty well last week, even as everything related to housing and finance was hit. It's almost comical the way they try to hide in semiconductor-equipment stocks, as though they are T-bills with upside, unconnected to the economy.
  
  That's where we are today. The housing market is on the verge of tanking, ditto the economy, but the dead-fish community and bulls at large -- of which there are very many -- are still trying to proclaim that the stock market is at bottom. Just as they did with housing stocks -- until ignoring the obvious stopped working.

How now, my Moo Moo Cow?