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A new post titled "What is Normal" was published on November 3, 2009.

A post titled "It's Not That Random" was published on October 28, 2009.

It’s Just a Number

Here it comes – another grumpy post…

Sure, I’m as happy as anyone that the Dow Jones Industrial Average (DJIA) has once again breached the 10,000 level. Yet all this attention over the attainment of one particular level – we sure love big, round numbers, don’t we? – is, in my view, really beside the point. The fact that the 10,000 level is big news is just another sign that a large percentage of the population looks at the stock market as one thing – the DJIA. These reports fail to note that the DJIA is comprised of only 30 stocks, 30 big stocks. Until recently, it contained former “blue chip” names such as Citigroup (C) and General Motors. Most of the Dow companies are “American” only in that their headquarters are located in the United States. A huge portion of these companies’ revenues and profits come from operations outside this country. Most of them are experiencing solid growth in China, Brazil and other so-called emerging economies. My point is that the DJIA represents just an abstract number, a data point which actually represents the aggregate opinions of thousands of investors regarding each company – its valuation and future prospects.

For me, the bigger celebration should have been August 3rd of this year, when the S&P 500 broke through the 1,000 level, which in addition to being a nice, round number, was an important resistance level, and is now a key support level. Most people who invest in stocks don’t just buy “the market;” they buy Raytheon (RTN), Agrium (AGU), OM Group (OMG), or whatever. The concept of the market being just one thing, one number, probably increases the common misconception that investing is akin to gambling. The market goes up; it goes down. It may seem quite random to many people. This is unfortunate.

Stock prices are higher than they used to be because interest rates are low, earnings are growing and skepticism is still high. These are not random forces – they are powerful, sustaining and sustainable forces. The Fed wants to maintain low interest rates to aid many industries, including autos, finance and housing. Earnings have been growing due to aggressive cost cutting from the early days of the recession and a resumption of spending. Skepticism and cash levels are high because investors have been dealt a gut punch, which may take a while to get over. Oh, and by the way, many of the “gurus” on television told them to sell stocks and hold cash earlier in the year.

Many of the articles “celebrating” the 10,000 level were replete with warnings from traders and strategists suggesting that the party can’t last and that “the market” is ripe for a fall. In my view, this is the real reason to celebrate this level – people are still very worried about a lot of stuff. This concern, this worry will keep sentiment from becoming overly bullish. Overly bullish sentiment is one of the things I really get worried about.

The typical bull market lasts about 4 years and can propel “the market” to a multiple of its bear market trough. For me to predict that we could see Dow 20,000 by 2013 would break all three of my rules of making predictions: 1) if you predict level, don’t predict timeframe, 2) if you predict timeframe, don’t predict level and 3) I don’t make predictions. Yet, if this bull market turns out to be normal, 20,000 by 2013 would not be unexpected. Remember folks, you heard it here first…

Where's the Love?

One sign that we are in a new bull market, in my opinion, is how excited everyone seems to get whenever the market goes down a bit (like it did on October 1st) or when a bit of disappointing economic news is released (like today’s employment report). It is as if people don’t really believe that the stock market rally, which started in March, is real. This has led to an uncomfortable feeling by many investors that hovers awkwardly over the triangle whose corners are marked by “fear”, “hope” and “despair.” Because of the massive hit investor wealth has experienced (although we would note that the market is only down 8% from this time last year!), investors fear that all the recent gains could be somehow wiped out in an instance. They hope things will get better, but so much of the commentary aired in the media focuses on huge, potentially negative imponderables such as the U.S. government budget deficit, the weak U.S. dollar, inflation, etc., that this hope easy turns to despair whenever we hit a patch of bad news.

To me, this bruised and confused investor psyche is actually a positive thing. It suggests that investors have learned from past experiences, and that they are not quickly embracing risk assets just because they might go up. The fact that investors are carefully weighing their feelings about risk and reward is a very healthy development. Part of the whole sub-prime fiasco was due to investors not accurately measuring risk (why is that AAA-rated mortgage bond yielding more than other AAA-rated bonds?), and the consequences which followed taught us all a lot about the risk/reward continuum.

Indeed, this is a rally which is hard to love. But then, most bull markets begin in the detritus of a recession. They are hatched under the cold light of dimmed expectations and loss. They are nurtured by fragile and tottering economies. They appear truly healthy and strong and receive universal adoration by the masses only when they are near the end of their run. Yes, bull markets usually end only when the most conservative investor places his last farthing into that “can’t fail” spec trade or the person so close to retirement “finally” shifts all of her 401k money into small cap growth funds.

Early bull markets aren’t meant to be loved. Because we can’t truly be sure what they are, it is normal to fear them a bit. Those who can accept the risk inherent in the young bull should be rewarded more than those who wait “for the dust to clear.” I believe that focusing on the big picture (the big three positives – growing earnings, low interest rates and bearish sentiment) is really the best way to invest right now. The occasional bad day in the market or disappointing economic data point may be enough to cause a lump in the throat, but not enough to force a course change.

Happy Autumnal Equinox!

Today is the day when people in the Northern Hemisphere celebrate (if that is indeed the right word), the end of summer and the beginning of autumn. This equinox brings a feeling of transition as we move from one season to another; a sense of motion as we move from one place to another. It also brings with it a sense of balance, as we experience on this day the same amount of day and night, dark and light. Many cultures have a strong tradition of a harvest festival, and often these celebrations coincide with the Autumnal Equinox. Even Wiccans and other neo-pagans hold the day in high regard.

As I reflect on this day of transition, this day of balance, this day of harvest, I wonder if all those people telling me to take some profits may be on to something. After all, the market has rallied over 50% since early March, and some people tell me this is the biggest rally in this short period of time since the 1970s. Before that, one would have to look back to the 1930s for this kind of strength. The negative case for the market still carries sizable weight – weak economy, weak U.S. dollar, growing government deficits, high unemployment, unending series of bank failures, fear of rising inflation, financial scandals, key industries on government life support, and so on. Why should the stock market be going up with all this bad news out there?

I think measuring the market’s performance from its crisis low may be misleading. First of all, there’s the math involved. If a stock falls 30%, say from $100 to $70, it needs to rise 42.9% to get back to $100 (do the math). So a rally that simply brings the market back to its starting place will appear “bigger” than the preceding decline. Second, the price of a stock is actually the result of a very complex series of decisions, measurements, and calculations made by a large number of (usually) very smart people. Although it looks like a simple number, it represents so much more. When a stock moves from one price to another, it does so driven by net result of all kinds of investors trading the stock for all kinds of reasons. Although we can simply measure the distance between the two points, this number tells us very little about why the stock moved to where it is and probably tells us nothing about where it is going.

In my experience, three key factors impact stock prices – earnings, interest rates and sentiment. Earnings can be affected by the economy, but excellence in execution and/or good fortune can often be more important. That said, an improving economy is usually good for earnings. The level and direction of interest rates affects valuation and influences investor choices. When rates are high, stock valuations tend to be low and visa versa. Generally, falling interest rates are good for valuations, but rising rates (if accompanied by strong economic growth) does not necessarily hurt the stock market. Sentiment, in my view, is usually a contrarian indicator; that is, when everyone is bullish, the market is near a top and when bearishness reigns, a bottom is at hand (reflect for a moment how bullish you were in early March of this year…)

So where do we stand now on these three factors? The economy is improving – consensus expects positive GDP in the third quarter. A majority of companies are raising expectations for the balance of 2009 and 2010. Earnings = Big positive. Interest rates are very, very low, and although some fear higher rates in the future, I would argue that they would have to rise a lot from here to significantly impact stock valuations. Interest Rates = Positive. Despite the rally, sentiment remains mixed to bearish. We have not yet seen the retail investor plow back into the market. Trillions of dollars still remain on the sidelines in “safe” money market funds. Sentiment = Positive.

I don’t make predictions (I used to do it professionally), but it would be very unusual for the stock market to enter another bear phase now with ALL of the important determinants of share prices so clearly in positive territory. Pauses and corrections are the norm for any near bull market and I would not be surprised to see them sometime down the road. Yet, I think anyone trying to wait for a big pull back to get back into the market might be disappointed.

Instead of looking to harvest some profits here, investors may want to consider the possibility of a new transition – from a bear market rebound into a new, real bull market. Maybe we are only half way into this move upward, the balance of which could take us up another 300 points+ on the S&P 500…

Hurray! The Recession Has Ended! (Old News)

This week we saw a report from Federal Government officials suggesting that they had seen evidence suggesting that the recession might have ended in August. While this is clearly good news for anyone affected by the recession, I would submit that this revelation is really old news. The stock market “knew” about this back in March. This is one of the unusual (some might say “perverse”) aspects of the stock market – it tends to “discount” or “price in” events/developments well in advance of their actual occurrence. Another strange aspect of the stock market’s apparent ability to forecast the future is that it generally does so about six months out. So it is not surprising (looking back with perfect hindsight) that the stock market in March was looking out six months (to September) to assume that the recession would end by then.

Recall, if you can, investor sentiment at that time. As the market found its bottom in early March, investors were extremely worried. By then, the cataclysmic market gyrations of October and November had been replaced with a slow and steady decline, truly notable exactly because it was not being driven by newer and bigger bad news. The market had simply acquired a putrid air about it. It was an undead market slowly shambling to its own ignominious demise. Many investors, like so many B-movie villagers, had fled in droves. Many market strategists and analysts (who perhaps should have known better) were telling investors to sell all stocks and hold cash. So the idea that the recession would end in August or September was not obvious to most observers.

How does the market know about the future? Does it have some kind of magic crystal ball? First of all, there is really no physical entity called the “stock market,” per se. The stock market is simply an abstract concept which incorporates all of the investment opinions, decisions and sentiment of the world’s investors. You can think of it like one of those photo mosaic pictures – it looks like one thing at a distance, but upon closer inspection, is really made up of many small things. There are stock market indices, like the Dow Jones Industrial Average and the S&P 500 Index, but these too are simple aggregates of a bunch of stocks.

It is this composite nature of the market which gives it the ability to “see” into the future. The best and perhaps smartest investors clearly and fully understand the concept of risk, and they are willing to take a few steps into the darkness with the expectation that this assumption of risk will be adequately rewarded over time and in accordance with the laws of probability. This understanding of risk coupled with the ability to measure value allows the professional investor to invest long before the reasons to invest become obvious. Investors who wait for hard, irrefutable evidence before investing will generally be disappointed with the results.

The market can discount the future because the smartest investors out there are anticipating possible future outcomes long before they seem likely.

When Should You Sell?

If someone were to ask me, “what is the most challenging task for an investor to do well,” I would suggest “selling” as the answer. For someone like me who spends the majority of his investment energy in measuring value (as opposed to predicting outcomes), identifying attractive stocks and buying them is an exercise in my comfort zone. I think I understand well the principles of valuation and have enough experience to be confident that when I buy a stock, it probably will make me some money (this, in my opinion, is why value investing is so attractive to me – I generally buy stocks that are kind of “beat up” for some reason or other and usually have limited downside).

So, having bought a stock I consider undervalued, I wait, watch and wonder how high it’s going to go (while constantly monitoring all the important details, of course). Most of the time, I have some idea about the true or “intrinsic” value of a stock, but sometimes I simply feel that the upside could be “very large.” It’s in these cases where the real challenge of selling rears its ugly head.

Early in my career, I worked with some very smart, seasoned equity analysts at Brown, Brothers, Harriman & Co. Bob Dunlop was my first mentor, and he showed me how the value investing principles I had learned in business school could be applied to the real world. We uncovered a small company called Newell & Co. This firm made paint brushes, drapery hardware, bathroom scales and a bunch of other stuff that would basically bore you to death. But the company had a plan – it would acquire small companies that made similar products which were sold into the same retail outlets it sold into and eventually would grow much bigger. The company had a reasonably good track record of doing this to that point, but the company was still very small.

The valuation of the stock was very cheap, and it had totally escaped the attention of Wall Street analysts. We pitched the idea to the head of research and while he did not totally reject the idea, he said that the company would not pay for us to fly down and see the company. Eventually we were able to meet with the Newell’s president in our office and we were very impressed with the story. Shortly thereafter we initiated coverage on the stock with a “buy” rating. I don’t recall what our initial price target on the shares was, but a quick look at the long-term chart of NWL will show that the stock price increased 10-fold in the decade following our report. By the late 1990s, the stock reached the $60 level, a 30-fold increase from when we first discovered it.

So where do you think “taking profits” in Newell would have been a good idea? Up 40%? Up 100%? Up 200%? Granted, not every stock will show the kind of appreciation of a Newell (but this is one reason I really like the mid-cap area – this is where the Newells of the world usually reside), but the fact that some Newells may still be out there should give investors some reason not to pull the “sell” trigger too early. Within the universe of stocks I am closely following right now, I must admit there are none where I expect a 10-fold increase. Yet, there are some I think could more than double from here and there a few more where the upside could be “very large.” I would not want to take profits too early and miss all that sweet potential upside.

John Neff, the famous value investor who ran the Vanguard Windsor fund for over 30 years, had an interesting approach to selling stocks which is somewhat similar to mine. He always tried to sell a stock before it reached its full potential. His idea was that he could always use the proceeds from that sale to buy other undervalued stocks. Regarding his selling discipline he said, "Successful stocks don't tell you when to sell. When you feel like bragging, it's probably time to sell.” That’s probably the best advice anyone could ever give about when best to sell a stock.

Sell All Stocks!

That is what some smart money managers do when they go on vacation. They sell the entire portfolio and let it sit in cash for the 2 weeks they are away. No chance of an unexpectedly bad earnings report tanking a stock. No reason to check into the office. No likelihood that any client will call looking for an update on the portfolio. In other words, a real vacation – totally removed from the daily grind and volatility of the markets. Upon their return, these portfolio managers would review the stocks they had held and would buy back only the ones they really liked. This annual purge would help them from becoming too emotionally attached to any one stock and would reset the cost basis for each stock in the portfolio. Sometimes our cost basis on a stock can cloud our judgment and prevent us from being as objective as we would like to be.

Although I’ve never done this over the course of my career, I did just take a vacation, and I really enjoyed not actively looking at the market for 8 trading days (I did take a peek a couple times). Our active itinerary (four days in Yellowstone National Park, two days visiting family in Billings, Montana and two on a real cattle ranch near La Barge, Wyoming) may not be typical, but was nonetheless relaxing and fun for my family. Upon my return I was able to review all the stocks in my active universe of coverage and, lo and behold, I still liked all of them. I tweaked a few price targets due to higher expected EPS estimates (it turns out that the forecasts companies made earlier in the year amid the worst fears about the economy were too conservative!), but all in all, the list of stock I like remains solid and attractive.

That said, I am still hearing commentary here and there about the market being “overbought” or that a correction is inevitable. In most cases, this commentary comes from people who wanted investors to sell stocks and raise cash in March. As long as $5 trillion of investable funds are sitting on the sidelines and a large portion of the commentary is negative, I find it hard to believe that a major correction is likely to happen. It could, of course, and I never make predictions, but I feel very comfortable owning stocks right now.

So, returning the title of this note – “Sell All Stocks?” Now? Get serious. No way.

Where’s the Good News?

It’s hard to be a stock market bear these days. With the S&P 500 up over 45% since its March lows, I suspect that anyone who has been telling you to sell stocks and hold cash (or gold) is feeling a bit sheepish right now. And yet, many of them are still out there pounding away on the Big Bear Story – the economy has massive structural imbalances, U.S. consumers still have heavy debt loads, the housing market is on life support, toxic assets still abound on bank balance sheets, massive commercial real estate write-offs are coming, people are still losing their jobs, etc. And if that isn’t enough to scare you into selling stocks (or not buying them again), they can dust off the nasty, old hyper-inflation specter (absent seen since the 1970s) and try to convince you that if the recession doesn’t get you, then the massive inflation coming down the road will.

The casual observer may wonder why the stock market has appreciated when all around us we only see bad (at least at face value) news. Take the latest employment report for example. At face value, the report shows that 247,000 people lost their jobs in July. How in the world could that be good news for the stock market? Well, you see, the stock market always cares about data (government releases, corporate earnings, etc.) relative to expectations. The market had been expecting a July job loss of 275,000; by the perverse calculus of the equity market, the July employment report was deemed “good” news.

This idea of the market responding to numbers versus expectations is a key factor as to why the market is up so much since March. At some point earlier this year, the numbers ceased to worsen at an accelerating rate. The numbers (economic data, earnings, etc.) were still bad, but were not getting much worse. Later, the “badness” of the numbers started to improve. About now, the numbers are getting “less bad” at an accelerating pace. For all the talk of the need for structural change in the U.S. economy, the pattern of how the stock market interprets and responds to new information is classically typical. In other words, the stock market since March has responded in an absolutely normal and rational fashion to the new data it has been shown.

Alas, dissecting the past is always easier than predicting the future. I never make predictions (“official” ones anyway), but I do watch those who get paid to do it for a living. Last week the percentage of equity strategists who are bearish declined to be roughly equal in number to those who are bullish. For months, bearish strategists vastly outnumbered the brave, but clearly contrarian, bullish ones by a large margin. To me, this strategist parity suggests that the market can continue to rise. As things continue to get “less bad” and when we eventually begin seeing legitimate “good” news (like the third quarter U.S. GDP figure, which is likely to be positive, from what credible economists are saying), I suspect more of the bearish strategists will change their minds.

This week Abby Joseph Cohen, Goldman Sachs’ equity market strategist, stated that she believes a new bull market has begun and that the S&P 500 could close the year somewhere in the 1,050 to 1,100 range. The first rule of being a Wall Street equity market strategist (I used to be one) is to never make a prediction which features both an exact time and market level. This is why you hear things like, “I think the market will eventually reach the 1,200 level” or “I think the market can be higher by year end,” but rarely, “I think the market will reach 1,200 by year end.” Abby Joseph Cohen, being the seasoned strategist she is, finesses this by providing a range for her year-end forecast. Anyway, I think her comments are significant because I think this is the first time a high-profile strategist has come out and said that the bear market is over.

I tend to agree with her, and given the large amount of skepticism out there, the huge mountain of cash still on the sidelines and the massive amount of pain investors experienced during the bear market (hence their reluctance to jump right back in), I can see the market continuing to climb this wall of worry.

Einstein On Investing

Amidst our nation’s obsession with pop celebrities, reality TV “stars” and those who are famous simply for being famous, we wish to briefly focus on someone truly worthy of the respect, adoration and media attention lavished on others – Albert Einstein. Granted, he left this mortal existence over 50 years ago and to our knowledge never sold a hit record, yet his theories about the nature of energy, light, matter and, indeed, the entire universe continue to profoundly impact our world. For example, the recent discussion between President Obama and Russian President Medvedev about reducing their nations’ stockpiles of nuclear weapons has at its heart a paper Einstein published in 1905. Although we have no hard evidence regarding Albert Einstein’s investment prowess, we suspect that he might have been pretty good at the “big picture” part of the process.


Albert is Smart, He’s a Genius

He is known as a theoretical physicist. Those of us who struggled through high school physics may remember that physics is the study of how things work – from the sub-atomic level up to the interaction among the stars and galaxies which populate the universe. A theoretical physicist would try to explain how things work with theories, formulas and ideas, rather than measurements and observations. This makes this kind of physics even harder for the average person to understand. This suggests that Einstein was not only incredibly smart, but super smart in a very challenging field.


He’ll Be Scribbling Things, Genius Things

Einstein published his first paper in 1902, trying to prove that atoms exist and that they have a finite, non-zero size (something that was still uncertain in the physics world at the time). Although his work did not receive immediate praise, this early work did show the promise which was to blossom in a spectacular fashion within the next few years. For Einstein, 1905 is considered his Annus Mirabilis (extraordinary year) and his work in this year propelled him into the elite circle of great scientific minds where the likes of Newton, Galileo and Aristotle reside. He also won a Nobel Peace Price for his efforts.

In 1905, Einstein published four major papers which revolutionized the physics community and ultimately led to the development of nuclear energy. A brief review of basic findings of these papers can provide some valuable insights into the physics of the investment world.

Photoelectric Effect. – Light, the “stuff” that makes our crops grow, allows us to see colors and most importantly, makes life itself possible on our planet, seems pretty straightforward. Any child can tell you what light is, why it’s good and what it’s good for. But to an early 20th century physicist, light was an enigma. Many thought that light traveled in waves, like sound. Some, like Einstein, thought that light was actually made up of some kind of particles. His paper on the photoelectric effect “proved” (at least in a theoretical way) that light is comprised of discrete packages which he called “quanta.” Modern physicists have refined Einstein’s pioneering work here, and we now know that light is comprised of things called “photons,” but light also continues to display wave-like properties. Einstein was able to prove something that no one could see.

Investment implications. Some things in the investment world are ubiquitous and simple to observe, like stock prices. Anyone, at any time, can measure the price of a stock. But what a stock price really, truly represents; what forces are impacting a stock price at any given time; or why a stock trades as it does are issues much more complicated than the casual observer can truly understand. And understanding these complex forces and their impact on stock prices is the most basic and important step to understanding how to invest. Without this understanding, stock investing becomes nothing less than an exercise in randomness.

Brownian Motion. – Atoms are very small; invisible to the naked eye. Yet, their existence was posited by Indian and Greek philosophers as early as 2,000 years ago. In Einstein’s day, the grand atomic debate centered on whether atoms were real or simply a nice idea, something which helped explain lots of things physicists care about. Einstein was able to prove their existence by postulating what the motion of an atom that had a non-zero finite size would look like and then actually measuring and showing that exact motion. He also devised an experiment whereby one could see this effect (and thus “see” atoms) under a microscope.

Investment Implications. Some important factors which impact our investment decision are hard to see (monetary policy or investor sentiment, for example), but can be measured in one way or another. By accurately measuring and understanding them, one can gain better insight on how the markets operate. Just because something seems small and hard to grasp does not mean it cannot have a big impact on the price of a security or the capital markets at large.

Special Relativity – This theory is a little more complicated, but in simple terms it suggests that all uniform motion is relative and that there is no well-defined state of rest. A simple way to explain this is to consider a person bouncing a tennis ball on a train. To a person in the train, the ball goes down and then comes right back up. To someone watching this from a distance (assuming this person could indeed see the ball), the ball’s trajectory would look like a wide “V” pattern, the horizon movement of the ball being a function of the train’s movement. So what is the “real” motion of the ball? Einstein proved that it would be relative to the point of view of the observer. Another important result of this paper was the notion that the speed of light is constant in all frames of reference.

Investment Implications. Often a person’s point of reference can influence his or her opinion on a security. Consider Person A, who bought stock XYZ at $10, and Person B, who bought the same stock (at a different time of course) at $30. The stock now trades at $20. Person A is feeling pretty good about XYZ, given the 100% gain Person A has in the stock. Person B on the other hand considers XYZ a “dog,” having lost 50% in it. Yet, XYZ has a valuation, outlook and potential irrespective of where one might have bought it. This concept is at the heart of our equity research – we try to assess value and potential regardless of perspective. Not every stock we buy will appreciate. All along the stock’s trajectory, we try to measure its value and potential. Like the speed of light, some investment principles, like valuation and reducing risk by diversification, are fixed, constant, and independent of point of reference.

Matter and Energy Equivalence. E=mc2. This simple little formula was perhaps Einstein’s greatest achievement. He was able to show (theoretically, of course) that the energy of an object at rest (E) is equal to its mass (m) times the speed of light squared (which, by the way, is a really big number = 8.98755 x 1016 m2 s2). The brilliance of this theory was shown (in very dramatic fashion, by the way) at the scene of the first atomic explosion (July 16, 1945), where a very small amount of plutonium (less than 2 pounds) created an explosion with the power equal to 20 kilotons of TNT. Einstein was right; mass can be converted into energy.

Investment Implications. Other than some weak joke about one’s portfolio “blowing up,” we would suggest that sometimes we see an event or a data point that seems small and inconsequential by itself, but can have a profound impact because of the circumstances in which this event occurs. Sometimes we will see a stock move down a large amount simply by missing its earnings expectation by a penny. A specific example would be the Lehman Brothers bankruptcy. Many companies go bankrupt each year without damaging the economy or the capital markets. Lehman’s failure, on the other hand, led to a near total seizing up of the capital markets and led to much of the angst and trauma all investors experienced last year. In the markets, some little things can have a huge impact.

One does not need to be a genius to be a successful investor (not that it wouldn’t hurt to be one); simply following basic, time-testing rules of investing (diversification, value, etc.) can lead to excess returns for the disciplined and patient investor.

The Outlook

While the debate over the length and severity of the recession continues to play out in the media, most thoughtful and credible economists are calling for positive economic growth by the third quarter of this year. The second quarter (just passed) is likely to show negative growth, but a smaller decline than that of the first quarter. The consensus is suggesting that GDP growth in 2010 could be around 3%. Although I would be the first one to suggest that the correlation between the overall economy and the stock market is less than perfect, rising GDP does imply rising corporate earnings, which is a key driver of the stock market. I find it hard to believe that the stock market would go down in the face of a steadily improving economy (something suggested by the consensus economic forecasts). Thus, I would not be surprised to see higher stock prices into 2010.

Another way to look at the current situation may be to recall the stock market’s action in 2003. By early 2003, the bear market was over 2 years old, and large numbers of widely-held stocks were down 50% or more. The economy had also been struggling for a few years, following the tech bubble of the late 1990s. Global tensions were high in the wake of 9/11, and ironically the stock market bottomed in early March, the day US troops invaded Iraq. The market rallied well from there, but by July many were suggesting the market had run out of steam. Because early signs of improvement were just starting to emerge, many suggested to “buy on weakness.” The market never really corrected, but did flatten out for a few months. The rally resumed by autumn and the stock market return for 2003 came in at +28% or so, the best year in a long time.

Every market and cycle is different, but I see important parallels here. This year the market bottomed in the middle of nothing but bad news. As it rallied, many were calling for caution. Now, many are calling for a pull back, something that would allow investors to buy stocks at better prices. And the consensus outlook is for an improving economy. I do not make forecasts, but I we would not be surprised if the market does not pull back as expected. As so often happens in the early stages of a market recovery, those looking to buy at lower prices may be disappointed. Concern and skepticism about the market right now are two factors that could help propel it higher to the end of the year.

Happy Birthday, United States

"Very many and very meritorious were the worthy patriots who assisted in bringing back our government to its republican tack. To preserve it in that will require unremitting vigilance."

--Thomas Jefferson

Celebrity Deaths

This week the entertainment business lost three famous people – Michael Jackson, Farrah Fawcett and Ed McMahon. Someone once told me that celebrity deaths tend to come in threes, and this week is another example of this. I am not going to spend much time discussing their passing, but I do wish to send my condolences to their families. Celebrity deaths affect us so much because we feel like we really know these people; like they are a real part of us. I, for one, have enjoyed the work of all three of these people over the years. But as I read the obituaries, I was struck with one very harsh reality – the entertainment business is extraordinarily competitive and “what have you done for me lately” is a huge part of it. Longevity in the entertainment business is hard to come by (unless you’re Mick Jagger or Christopher Lee).

And this leads to today’s musing about the investment business. Unlike some professions where a person may be engaged in a project that starts, has a middle, and then ends, being a professional investor means your work is never through. Luckily, the markets are not open throughout the weekend, but Barron’s comes every Saturday so we can keep thinking about the key issues which occupy our minds during the working week. I am not complaining at all; this is the life I chose and I love it. It’s just that I am acutely aware (as are all professional investors, I suppose) that I am always thinking about the markets, obsessing on how I can perform better and worrying about what’s going to happen in Tokyo while I am asleep.

There is also a very strong “what have you done for me lately” aspect in this business as well. When a stock I buy goes up, I feel somewhat vindicated that all my hard work in researching, analyzing and actually buying the stock has paid off. Yet, unless I sell that stock and move on, every new day brings the potential for some unforeseen and unexpected event that could drive the stock down. It is not necessarily random, but it is an adventure in probabilities and some things simply cannot be avoided (the Black Swans, if you will). Right or wrong, up or down, I am applying the same level of analysis and dedication to each and every fund and stock I work on. My approach does not change and I clearly do not view my worth as an investor simply by how well my stocks have done in the last few months (last few years, yes).

Client reactions can also follow this “what have you done for me lately” mentality. Some folks who were questioning my judgment, experience and perhaps even sanity back in March, now view me much more favorably. What’s changed? I had the investment equivalent of a hit song or movie. Performance has been very strong lately. Part of this near-term success was due to my making very hard, contrarian and seemingly “crazy” decisions earlier in the year. Part of it was simply sticking to my guns when the consensus was suggesting that all past investment principles had been declared null and void. Part of it was simply the law of the harvest (you reap what you sow) as it applies to the investment process.

I feel a modicum of self-satisfaction as I wave modestly to the crowds, but I know full well that after the applause dies down, I will have to get back in the trenches and dig harder to find those choice nuggets amid all the dirt. It’s a dirty job, but hey, someone’s got to do it…

Are You Being Served?

I am amazed at how much time and effort goes into media reporting about the capital markets. The vast array of Internet, print and broadcasting coverage is truly astounding. We can now enjoy (if that is indeed the right word), 24/7 coverage of all the markets and all the factors that influence them. Every day we can see periodic updates on commodities, bond prices, economic data, government press releases, currency rates, and on and on. An investor might look at all of this coverage and data and reasonably conclude that he or she is pretty well served by all of this. After all, there must be demand for this kind of stuff, otherwise why would they keep churning it out?

But is the investor really being well served?

It seems to me that capital market reporting falls into two basic areas: 1) Here is what happened and 2) Here is what the experts think about this. Whether it’s an earnings release, market trend (higher commodity prices, etc.) or some kind of event (a bankruptcy, for example), the media is all over this “news” with commentary and analysis.

Regarding 1) -- Call me old fashioned, but I thought the stock market was supposed to discount future events and trends. In theory, what is happening right now should have been discounted by the market weeks or even months ago. This is often the reason that when a company reports earnings below (for instance) consensus, the stock can actually rise on that “news.” Sometimes the market is truly surprised by some news and this is probably worthy of the attention it gets. Trouble is, the media seems to struggle with which items are real surprises and which are really already known by the market. The other big issue I have with most of the commentary I hear from the media, is that it rarely puts the event or news item in any kind of investment context. Great, the unemployment number was X – but how does this number fit into the recent trend? Are there details in the other numbers (beside the headline ones) of the report which may provide some insight as to what the numbers are really suggesting? What is the bond market saying about this number? What about the forex market? Why was this number 25% below the lowest estimate from among all the 76 people providing estimates for it (this was true for the May 2009 jobs number)?

Regarding 2) – Where do they get these people? It seems the media can always find some “expert” to ruminate on any given topic, no matter how big or small, arcane or mainstream, controversial or commonplace. More often than not, this “expert” will be the person with an opinion or outlook quite far away from the consensus -- the average is boring, no? At least in the media’s view… So, inevitably, this person’s viewpoint and forecast will often contain a high degree of error attached to it (mathematically, this has to be true, if this person’s opinion is far from the consensus; it could prove to be correct, but statistically, the odds would be lower). Often, the media will line up an investment professional (trader, mutual fund portfolio manager, analyst, etc.) to comment on some trend or stock.

Now let me ask a very direct question – why would someone appear on television and offer, for free, a value-added opinion that could help some make money in the market, when this person has clients who will pay for that opinion? Other than the answer that comes from an old Eagles song (… it’s a certain kind of fool who likes to hear the sound of his own name”), I would argue that NO ONE would do that. In my experienced (and obviously cynical) opinion, these folks are SELLING SOMETHING! It may be that they want you to buy a stock they already own. It may be that they want to you to be impressed with their searing intellect and buy their fund. It may be they are just amassing face time which will help them sell their next book. Whatever the motivation, I think it is safe to say that the interests and needs of the individual investors listening to their story may not be at the top of their priority list.

I have always thought that investment advice is worth what you pay for it. Those offering free advice have no fiduciary responsibility, cannot offer opinions appropriate for the needs of specific investors and are not accountable in any way for their opinions. You certainly would not buy a used car from a person who had this kind of freedom from consequence. Why would you ever buy a stock based on this kind of opinion?

Backs Turned Looking Down the Path

Now that I am no longer operating full time in “crisis management” mode, I thought it might be instructional to look back and reflect on this things I did during the last nine months, which, in case anyone might wonder, has been the most challenging period in my career. This exercise will represent a debriefing, if you will -- an attempt to look back objectively at what happened, how I responded to what happened and what I might have learned from the experience.

Let me start by explaining what I did not do:

1) I did not sell stocks in October 2007, which turned out to be the peak of the market. At that time, the market did not exhibit any of the excesses we generally associate with market peaks. The excesses were located squarely in the housing and credit markets. I had no specific information showing how leveraged the banks and brokers were, nor how this leverage would spill over into the stock market and the general economy. Past bubbles had burst without threatening the entire global financial system. It was not obvious that bursting this one would have that impact.

2) I did not sell stocks to hold cash at any time during this period. I am not a market timer, and I don’t think anyone can do this successfully over time.

3) I did not abandon my long-held personal investment philosophy. It has worked for many decades and I suspect it will work for more decades to come.

4) I did not panic.


Here are a few things I did that I think served me well:

1) By October, I recognized that the situation had quickly deteriorated and that the markets had stopped functioning in a normal fashion. Once the VIX (CBOE Volatility Index) broke the 40 level (which had for years been its peak), I felt that the market could become very volatile. When Lehman Brothers fell and the credit markets seized up, the real trouble began. Still, I had personally experienced the Crash of 1987 and the Long-Term Capital Crisis of 1998, and so I truly felt that we could ride through this one as well. I kept analyzing companies and tried my best to assess the value of stocks – this is my training; this is what I do. Sitting around worrying about what might happen is never a productive activity.

2) By November, I was buying stocks. One of the downsides of being a value investor is that you rarely ever own the stocks everyone loves to talk about – the new and shiny ones with great stories and sex appeal. It’s kind of like driving a Ford Focus when everyone else is driving BMWs. However, starting in November many of the BMWs were going for prices usually associated with Fords. So, compelled by the value I was seeing, I began to nibble at not just the beat-up value stocks, but many of the growth names I had never owned before. The valuations were more compelling that the uncertainty about the future.

3) By early March, I was stubbornly holding my ground. By this time, every single “doom and gloomer” was in full froth mode, telling anyone who would listen (everyone in media, it seems) that the world was truly ending. The January through March decline was very hard for me – the reasons for the decline were even harder for me to understand – the VIX was down and the capital markets were once again working. Why was the market still going down? Was it mostly driven by retail selling? Mutual fund redemptions? Hedge Fund deleveraging? Maybe someday someone will write a book with definitive answers. I did not know that March 9th was the bottom, but I did feel that retail investor panic was peaking that week.

4) I kept working. Go back and read my blogs from February and March. In them you can see that I was closely following the events of the day and trying my hardest to make sense of it all. The best paragraph (in my humble opinion) of the month was this one from my March 9th post:

“Unless ‘this time is different’ (still the four most dangerous words in the investment business, in my view), the stock market will begin climbing the proverbial wall of worry, long before the talking heads will be able to tell us that the recovery has begun.”

Crises, panics and manias are always hard to deal with, but they are absolutely the natural product of open capital markets. No amount of legislation can prevent them. The best way to deal with them, in my opinion, is to 1) understand the risks associated with the markets, 2) understand your investment time horizon and 3) develop a personal investment philosophy that can support and sustain you during the hard times. The last nine months have been a huge challenge, and lots of people have lost a great deal of wealth. But, I firmly believe the only pathway leading to any hope of recovering that wealth will take us directly through the middle of the stock market. Once again.

I Am Not Contrary!

Con-trar-y – adjective. 1) Opposite in nature or character. 2) Opposite in direction or position. 3) Being the opposite one of two: I will make the contrary choice. 4) Unfavorable or adverse. 5) Perverse; stubbornly opposed or willful.

When my boss called me “jaded” after I (once again!) disagreed with the opinion of a well-known and highly intelligent market forecaster, I decided that I need to set the record straight. Although I often take the opposite side in discussions (with just about anyone, it seems) about “big picture” issues such as the economy, currency markets, interest rates or the stock market, I do not do this just because I’m contrary. It’s actually more of a learning style, along the lines of the Socratic Method (“a form of inquiry and debate between individuals with opposing viewpoints based on asking questions and answering questions to stimulate rational thinking and to illuminate ideas.” – Nebraska Department of Education.)

By taking the other side I can actually test the solidity and rigor of an opinion. I may not actually disagree with the opinion, but if the opinion could affect my investment decision-making process, I need to be sure it can stand up to scrutiny and criticism. So, I am not a grumpy old man; I just act like one sometimes.

Con-trar-i-an – noun. A person who takes an opposing view, esp. one who rejects the majority opinion, as in economic matters.

Now we’re getting closer. This really sounds like me. So, why would I appear to be so anti-consensus when it comes to economic and stock market opinions (which really are forecasts)? In part, it is because in the perverse logic of the stock market, the consensus is often either wrong or already discounted in the prices of stocks. Much of the commentary and academic research out there supports the idea of contrarian investing. Some studies suggest that 80% of all investors consider themselves contrarian. Besides being mathematically impossible, I truly doubt that contrarian investing could ever be that popular. Why? Because it’s hard to do.

In many of life’s endeavors, being in the middle of the pack offers great rewards. Listening to popular music or watching popular TV shows can provide a person with a common link to others. The same can be said about going to restaurants, clubs, concerts and other places frequented by a lot of people. The entire fashion industry is based on the premise that a certain style of clothing is “in.” “Keeping up with the Jones” and “being a team player” are just two of many idioms which celebrate the idea of being a part of the crowd.

In equity investing, going against the grain can lead to above-market gains, but it is never easy to do. Imagine resisting the universal euphoria associated with the “paradigm shift” in the late 1990s. Imagine ignoring the huge housing boom of the last few years. Imagine selling oil stocks last summer when all the “experts” were forecasting oil prices to move as high as $250/barrel. Imagine wanting to buy stocks in early March of this year instead of selling them. With 20-20 hindsight, all of these moves may seem obvious now, but in the heat of each particular moment, they would have been very hard to do.

The ultimate downside to contrarian investing comes when the consensus view proves to be correct. This means that the contrarian investor was not only doing something that seemed illogical, misinformed and even a bit crazy, but it turns out to have been obviously the wrong thing to have done. It makes the contrarian look not only wrong, but stupid as well. It takes only a few of these experiences to test the mettle of a contrarian investor.

But in the final analysis, being a contrarian investor may not be a choice, but more of a personality type, or maybe like being left handed. Sure, the contrarian investor can develop and improve technical skills, but at the core, the contrarian needs to be solid and unwavering to the concept and the practice of going against the grain. It may be hard, but in my opinion, it is certainly worth it.

Of Subway Tokens and Stock Market Forecasts

I rode the New York City subway system for many years. Along with many of my fellow “straphangers,” I experienced the unique sights, sounds and smells (!) of Gotham’s underbelly. When I first moved to the City, we could buy subway tokens, metal slugs really, which we could use to enter the turnstiles. I remember as if it were yesterday how some enterprising young men figured out a way to retrieve tokens from the payment slot on the turnstile. One of these underground entrepreneurs would simply place his mouth on the token slot creating a near-perfect vacuum, suck really hard (I am not making this up!) and viola! – he would be the owner of a fresh (hardly), shiny (rarely) NYC subway token worth about $1.50 at the time. I suspect that these clever lads would do this multiple times and either sell these purloined pennies to hurried commuters or cash them in at the token booths.

Anyway, one of my mentors, after a long discourse about his views on this topic or another, would often end the discussion with “well, that (his opinion) and a token will get you on the subway.” It was his somewhat humorous, very self-deprecating way to highlight that sometimes an opinion about the capital markets is not worth very much. I have often wondered why anyone would think this way.

Perhaps it is because there are so many opinions about the markets (oversupply can depress pricing). Perhaps it is because investors would really like someone to tell them what is going to happen and this creates big demand for forecasts and predictions. Again, creating the oversupply of viewpoints we see out there. Perhaps it is because the uncertainty inherent in the capital markets makes a correct opinion such a rare and wonderful thing that people feel richly rewarded for either making a prediction which proves to be correct or for following a successful prediction. Still, I suspect that at some very basic, honest level, most forecasters fully understand the large margin of error attached to their predictions.

So what’s the point of all of this? Despite all the commentary about uncertainty and the difficulty of making accurate predictions, I am still amazed at the sheer number of forecasts which cross my desk on a daily basis. In the newspaper, on TV, in research reports, mutual fund monthlies, webcasts, Internet sites and so forth – I am constantly bombarded by these “experts” and their “expert opinions.” For fun some times, I will try to match up two of these arguments (presented by intelligent, experienced commentators, of course) which are mutually exclusive and exactly opposite from each other. One of these must be wrong…

Many times, these forecasts consist of a series of events. For example, the US Treasury is providing a great deal of liquidity, and this will eventually lead to inflation, and this will depress the value the US dollar, therefore buy Chinese stocks. Regardless of the logic, flow and validity of such a forecast, because it requires so many events or trends to result from the previous ones, its fruition is much like calling a flip of a coin correctly six times in a row. It can happen, but its likelihood goes down with each additional forecast added to the mix. These serial forecasts rarely can accommodate exogenous shocks (Black Swans, if you will) that often determine the trajectory of the markets.

While I am somewhat entertained by all these capital market forecasts, I rarely rely on them for little more than gauging where the consensus is. My efforts are highly focused on measuring value and determining the context of these measurements. I understand that extreme levels in the things I can measure (sentiment, cash levels, volatility, valuation, etc.) can often signal an inflection point. Did I predict the market’s turn in March? No, I don’t make predictions. Am I surprised by the market’s rise since then? Not really, my measurements suggested some huge imbalances in a number of indicators at that time. Will the rally continue? I am not sure (I don’t make predictions). Am I still fully invested? Yes. I can still find a large number of stocks with very attractive valuations. I suspect my enthusiasm for the market will continue until these kinds of bargains become harder to find.

The Car is Parked, But the Motor is Still Running

With the stock market currently standing some 30% above its March low (still a bear market rally, really?), my thoughts turn to those investors who sold their stocks anytime before then and still hold cash. Selling stocks because the market is going down is a classic investment “tactic” driven more by emotion than cogitation. Hey, I’ll admit that I’ve done it, and I suspect a lot of other people have done it too. To be fair, it’s not really our fault, at least according to Jason Zweig in his book, Your Money and Your Brain: How the New Science of Neuroecononics Can Help Make You Rich. It’s our brain’s fault!

His research suggests that when we start losing money in the market, the feral, animalistic and primitive portion of our grey matter grabs the steering wheel and starts driving with somewhat reckless abandon. This response is neurologically similar to what we feel when in real (not just financial) danger. It’s the classic “fight or flight” adrenaline rush. Often in those moments of stress, our ability to think clearly, carefully weigh options and calmly deliberate on possible outcomes goes out the window. We feel we must do something, and selling is the only thing that seems to make sense.

So now here we are, holding on to our cash and watching the market move up. How do we feel about that? On the one hand, maybe we find some comfort knowing that our asset values are no longer going down. On the other hand, perhaps we are wondering if we really missed the boat. This is when the rational part of our brain takes over and starts to make sense of what happened and what to do now. For investors who need their assets to grow in order to achieve long-term financial objectives, stocks and bonds must be an important part of the portfolio.

Ultimately, the decision to raise cash and sit on the sidelines is two decisions; the other one being when to get back into the market. Do you get back in now? Wait until it goes even higher? Or do you wait for a pull back? How much of a pull back is enough? Do you wait for the “other shoe” to drop and buy at a much lower level? What happens if the market never goes back to where you sold? Ah, such are the dilemmas faced by those who try to time the market. The rational part of the brain may understand at some level that timing the market is impossible, but all this good wisdom is forgotten when the feral brain takes over.

I am seeing a large amount of press lately about how “buy and hold” investment strategies no long work. Given the results of this strategy over the last 10 years, some of this press seems reasonable. However, the conclusion that active trading strategies are the only way to make money in the markets going forward seems misguided. Into this debate steps Stephen Mauzy and his excellent article “Trading Paces” (which can be found in the latest issue of CFA Institute Magazine). In this piece, he reminds us that successful traders are as rare as Kansas surfers. One great quote: “You may call one top or one bottom [in your trading] or you might call two. Getting it right requires many excellent decisions in buying and selling. But I don’t know anyone who is able to constantly produce exceptional after-tax results with trading strategies.”

He references another study in which investment professionals were asked to provide 30-day forecasts for 20 stocks and estimate the size of their own errors. It turns out that the professionals were able to make successful predictions only 40% of the time – less than what a simple coin toss could do. This is not to suggest that investment professionals do not provide valuable services, I truly believe that they do. But they may not be all that great at predicting near-term market or stock movements. And, if the professional is not adept at making short-term predictions, what chance does the non-professional really have?

You may be saying to yourself, “That’s all fine and dandy, but what do I do with my cash NOW?” Well, my advice now would be the same as in March, December, September or even last July – buy cheap stocks trading well below their intrinsic value. Over time, cheap stocks (if identified and measured properly) will usually move upward toward their fair value. Nothing is guaranteed, but the time-tested value investment approach, so well explained by Graham and Dodd and so well practiced by Warren Buffett, John Neff and a host of others, is still my favorite way to make money with stocks. There are many great values out there right now, and I am happy to buy and own them.

Mr. Obama’s Big Tax Plans

Yesterday at a mid-day press conference, President Obama unveiled several new tax initiatives aimed at “curbing offshore tax havens and corporate tax breaks.” According to White House estimates, these proposals, if they became law, would raise $210 billion in new tax revenue over the next ten years. I suspect that this number, as is true with many government estimates regarding taxes, is based on a ceteris paribus estimate that assumes rational entities will simply pay higher taxes rather than try to avoid them. And, just for perspective, one-tenth of these new tax revenues (the amount we might expect to see in any given year) represent only 0.6% of this year’s government budget. But hey, at least he’s trying, right?

While the media seems focused on the corporate side of these proposals, what I really want to talk about today is the impact on individuals. Whenever I hear the words “tax haven,” I immediately conjure images of Swiss bank accounts and shady characters in Armani suits. But recent actions by the IRS have convinced me that they are casting a very, very broad net in an attempt to increase tax revenues. Thousands or even tens of thousands of people may be at risk.

Specifically, they are targeting all foreign bank and brokerage accounts held by U.S. citizens and tax residents and even some non-citizens who work in the U.S. The following information comes to me via the international tax experts at The Wolf Group.

Income from foreign bank accounts is taxable and should be reported on a taxpayer’s personal return if that person is a US citizen or resident regardless of where they live. In addition, taxpayers are required to report their ownership interest in a foreign financial account every year to the U.S. Treasury (separate from their income tax return) regardless of whether the accounts generated income that was or was not reported on the income tax return. This report is called the Foreign Bank Account Report (FBAR).

This rule has been on the books for years, but according to The Wolf Group, the penalties associated with failure to file have been levied only 3 times in the last 35 years. This is about to change. The IRS is hiring more agents to discover and research these accounts. They have new and better ways of collecting information about these accounts, aided by new treaties between the U.S. and other nations. Foreign banks are now required to file 1099 forms with the IRS, showing interest income earned offshore. Conservative estimates put the deposits subject to new and intense IRS scrutiny in the hundreds of billions of dollars.

The law states that failure to file these reports on a timely basis carries civil penalties up to 50% of the maximum account value, and the penalty applies to each year the account is not timely reported. Criminal penalties may also be imposed. Each year! That means for an account of say $50,000 that a person held for 6 years without filing the FBAR could be liable for 50% x $50,000 x 6, or $150,000! This kind of draconian penalty is rare but not unprecedented. A person who only held an account open for a short period of time (on a business assignment or to purchase real estate, for example) may still be liable for FBAR filing.

Now the “good” news. In late March, the IRS announced a partial amnesty to encourage voluntary compliance with FBAR rules. Under the initiative, qualified taxpayers who voluntarily file delinquent FBAR reports will only(!) be penalized for one year (the year with the highest aggregate value of foreign accounts among the six prior years) at a rate of 20% (5% in very limited circumstances) of that highest aggregate value. Additionally, the IRS will not seek fraud penalties or criminal charges for tax evasion. Taxes and other civil penalties will apply to any unreported income from the accounts.

So, 20% of the assets or as much as 100%? Sounds like a tough choice, but such are the choices sometimes when dealing with the IRS.

For anyone thinking that this might just be tough talk from IRS, consider the following quotes from IRS Commissioner Doug Shulman:

“We are instructing our agents to fully develop these cases, pursuing both civil and criminal avenues, and consider all available penalties including the maximum penalty for the willful failure to file the FBAR report and the fraud penalty.”

“For taxpayers who continue to hide their head in the sand, the situation will only become more dire.”

I am not a tax expert, but if I knew someone who had foreign bank accounts, I would be sure to let that person know about this new IRS initiative and encourage him or her to consult an international tax expert right away. The amnesty program will end September 23, 2009.

Not About the Swine Flu!

Whew! You can really tell when a story hits the media at a time when nothing else important is going on. With words like “pandemic” and “crisis” being thrown around like cowboys at a rodeo, it’s hard not to panic a little bit. If there is any good news in all of this, it seems that this flu strain is responsive to treatment by existing medicine, which seems to be available in ample supply. We hope for the best for all involved.
What I really wanted to talk about today is the housing market. Remember that problem? Every once and a while, we will hear something about how many homeowners are “upside down” (have mortgages bigger than the value of their house), how many homeowners or behind on their payments or how many foreclosures there were last month, but generally the news flow about the housing market has been rather light lately. When swine flu, automaker bankruptcies and/or banking industries do not dominate the airwaves, we might reasonably expect the media to recycle the apparent bad news about the housing market.

Recall that the baseline problems which led to the current recession and bear market were housing related. Recall that many experts consider the bursting of the housing bubble a key factor in all the economy’s current struggles. Recall that the US government is trying to lower mortgage rates in an attempt to help homeowners keep their houses. Amid of all this, it’s easy to ask “When Will Housing Recover?”
Well, in the latest issue of the Financial Analysts Journal, two finance professors, Eli Beracha and Mark Hirschey, attempt to answer that very question. They point out that in the 25-year period from 1982 to 2007 the annual rate of house price appreciation in the U.S. was 1.65% per year, and that over this period nominal house price never fell. This makes the experience in 2008, where nominal prices fell, so unusual – something not seen since the Great Depression. Yet, they emphasize, that despite stunning declines in several states (California, Nevada, Arizona, Florida and Virginia), the housing market remains moderately strong (or at least not horribly weak) through most of the country. The real trouble exists in those markets which had been the strongest.

This may sound pretty obvious to many of us, but it was a bit of good news to me – that the real estate problem was not the wide-spread “pandemic” we might think it is, just listening to the nightly news. After many pages of data and commentary, the authors were able to offer this conclusion – “…if typical per capita income growth continues for only 1.49 years [note the academic penchant for precision without accuracy! – ed.] with flat housing prices and continued low interest rates… the nationwide housing ‘crisis’ will be on the road to recovery by the second quarter of 2010.” In other words, they can see the housing market recover by the middle of next year, IF incomes rise and housing prices stabilize. Perhaps those two assumptions are overly optimistic, but they are based on reasonably assumptions spelled out in detail in the essay. IF this were true, we could expect the stock market to begin discounting this good news sometime later this year.

I am sometimes accused of being too optimistic. Well, if this is a fault, then label me “guilty.” My optimism is not congenital; is has been acquired through many years of analyzing great companies and seeing how much motivated, creative and hard work goes on behind the scenes. The economy is not one thing. It is not a monolith controlled by some all-knowing entity. Rather, it is the amalgamation of millions of actions by millions of people all trying to make products, provide services and make some money along the way. The fact that this is the driver of our economy makes me optimistic. Better news about the housing market will make me even more so.

The Susan Boyle Rally

By now I suspect that most of the world’s population which is connected to the Internet knows about Susan Boyle. She is the unassuming-looking, late-40s woman from Scotland who amazed the judges (and the world) in her audition for the television talent show “Britain’s Got Talent.” Within a week of being placed on YouTube, her rendition of “I Dreamed a Dream” has been seen and heard by over 12 million people. In an industry that so highly favors looks and image, it’s inspiring to many to see Susan Boyle receive so much praise and notice. As John Rash, an advertising columnist put it, “[her video] encapsulates the power of everyday people becoming overnight sensations.” Bravo, Susan, Bravo.

I think the stock market rally we’ve been experiencing since early March has much in common with Susan Boyle. At the beginning, there was much skepticism. Economic data was clearly drab and uninspiring. Most of the “experts” were not looking at the markets favorably. I suspect many of them expected the market to disappoint or even fall on its face.

Just as Susan’s clear and melodic tones stunned the judges, the market’s rise began to sway sentiment. As the rally progressed, grumpy skeptics, who before only saw gloom and doom, began to see “glimmers” of favorable economic activity. With the market now over 20% above the March low, many more investors are seriously discussing the market’s potential? Is this the big turn? Can it be sustained? Can this market become a “big star?”

We hope the best for Susan Boyle and her budding singing career. We can’t predict whether or not she’ll be a big success, but we hope she will be. Similarly, we hope the current rally will be sustainable and even become the next bull market, but we can’t really predict this. Yet, we are encouraged by the market’s tone and responsiveness to new information (bad or good).

In our view, the fundamentals that matter to the capital markets are always a mix of positives and negatives. The direction of the market is not so much determined by the difference between these two extremes, but rather by which part of the spectrum captures investors’ attention.

Here is a partial list of positive fundamental factors as we see them now:

• High Cash Levels. We see $9 trillion in money market accounts. These funds had been in stocks and bonds and now just sit there waiting for the “all clear” signal to get back in.
• Sentiment. High bearish sentiment (we saw historically high levels in early March) often accompanies the bottom of the market.
• Interest Rates. The Federal Reserve is determined to keep short rates low (which helps a large number of borrowers) and has also begun a tactic aimed at lowering longer-term rates, especially mortgage rates. This could stabilize the housing industry and via refinancing, put more cash into households.
• Lower Energy Prices. The dramatic decline in energy prices from last summer is another stimulus to the American household budget.
• Government Action. The new administration is determined to do as much as it possibly can to jump start the economy and return confidence to the system.

Despite the above, we continue to see significant negatives which may impact the establishment of a new bull market:

• Unemployment. As layoffs continue, many may worry about the impact this has on consumer sentiment, spending and saving. The fact that employment is a lagging indicator may not matter to the average citizen watching the nightly news.
• Earnings. First quarter results have just started to trickle out and despite good news from Wells Fargo, it’s hard to imagine that all companies will report better-than-expected earnings in a quarter where GDP is expected to fall 6%.
• “Expert” Opinions. The handful of economists and academics credited with “predicting” this recession are mostly staying with their pessimistic forecasts. Unless they are particularly nimble (and different from past prophets of doom), they will miss the upside of a new bull market. Yet, the combination of their new-found fame and continued gloomy opinions may sway investor sentiment and stifle the rally.
• Bailouts. Major U.S. industries (banks, real estate, insurance, banking, etc.) may yet require a great deal of government assistance and/or dramatic changes before the “all clear” signal can be sounded. Regardless of the skill of the decision makers involved, these industries’ status is highly uncertain and fraught with risk.
• The Other Shoe. In the back of everyone’s mind seems to lurk the fear that something else, unexpected and dire, is just around the corner, and could bring us right back to the pain and losses seen last year. This fear is particularly worrisome because it’s impossible to prove the absence of something. To the extent that this fear inhibits action, it could dampen the recovery.

Over the last few weeks, the market has clearly been focused on the ““glimmers of hope” and not the “worst economy in 50 years.” Will this continue? Hard to say. I think the time to be defensive is long past. In my view, cash is the most expensive and “risky” asset, especially for those investors with longer time horizons and important financial goals yet unmet. Time will tell.

Happy Birthday Mr. Jefferson

Thomas Jefferson was born on this day 266 years ago. The power of his words still reverberate throughout the nation.

"We, too, shall encounter follies; but if great, they will be short, if long, they will be light; and the vigor of our country will get the better of them." --Thomas Jefferson to Thomas Digges, 1806

Fortune Cookie Investing

After a very satisfying meal at my favorite Asian fusion restaurant, I opened up my fortune cookie with the usual mix of hope and skepticism that dominates my life. Many years on Wall Street has taught me to be skeptical about most things. Being an optimist, so they say, is the key to a long, happy life. Maybe a fortune cookie could bring good luck. Maybe being a hopeful skeptic (oxymoron?), is a good way to cope with the ups and downs of the capital markets.

Despite my penchant for the scientific method and math proofs (I didn’t say I was normal!), I will also occasionally peek at my horoscope in the local newspaper. Generally, I place more weight on things measurable and discernable, but sometimes things just don’t work out like the formulas suggest. I am not suggesting that I ever I select stocks based on fortune cookies, the phase of the moon or tea leaves, but I am willing to consider all reasonable sources for inspiration, motivation and knowledge.

So, what did my fortune cookie say? Thus spake the ancient sage, “The problems of today will be buried by the sand of time.” Is this hopeful or fatalistic? My time in Japan taught me that fatalism is not necessarily negative or hopeless. Often it’s just a broader perspective on the issues at hand.

I think this simple saying contains a grain of important truth. Investors right now are questioning everything they’ve learned over the last few decades. The Wall Street Journal today suggests that many investors are abandoning the “buy and hold” strategy. Many are suggesting that the stock market may never again offer its historical rates of return. According to many, the massive rush into cash marks the end of an era; the stock market will never again attract the average individual investor.

To all this, I say “bah.” Buy and hold never works in a bear market. But it is arguably the best strategy for a bull market. Every time we enter a recession or a bear market, it always 1) feels unique, 2) feels worse the previous one, 3) feels like it will never end and 4) is marked by “experts” telling us that the old ways will never return. I have seen this pattern over and over again in my career.
I recall a research report from the early 1990s by a professional “expert” analyst who stated that the New England commercial real estate market was so over built that no new buildings would be needed for the next 37 years! Of course the late 1990s tech boom made that prediction totally wrong. I suspect that most of the predictions we are hearing now about the U.S. economy and stock market will likely be proven wrong within a few quarters.

What I do know is that there are still many very wonderful companies out there trying to compete and thrive in this challenging environment. The stock prices of many of these wonderful companies appear to be very cheap compared to where they could be in a more normal market and economy. I cannot predict with any accuracy when these stock prices will reflect my measure of intrinsic value, but I truly believe that the potential rewards are well worth the wait. The worse place to be right now is cash. The best place to be (if you have an investment horizon longer than a year or so) is in those stocks I feel are massively undervalued.

And, I don’t think we will have to wait all that long before the sands of time will bury our current batch of problems.

"Have You Ever Owned a Stock?”

This is the question I enjoy the most when speaking to a young person who is looking to enter the investment business. I rarely penalize a person for not having owned a stock, but I am always more interested in those who have. In my opinion, there is no better way to prove one’s passion for something than by actually doing it. I mean if I tell you that I really enjoy fly fishing (I grew up in Montana after all), but then I tell you I’ve only enjoyed by reading about it or watching “A River Runs Through It” a couple of times, are you really going to invite me on your next jaunt to The Bitterroot or Rock Creek?

I think the same thing applies to equity investing. All the “book learning” in the world cannot compete with the education one receives by actually buying a stock. Granted, the more knowledgeable one is about the stock market, the more likely the experience of buying a stock will actually be a positive one.

I remember very clearly the first time I bought a stock as a professional portfolio manager. I had been a sell-side analyst for several years and could tell you everything about how to value a stock, how to write a research report, how to identify an attractive stock and how to convince others that my opinion was the “best” one. Then I landed a job on the buy-side managing the US equity portfolio for a Japanese bank. All of a sudden, I was the decision maker for a large portfolio containing about 50 stocks. I recall thinking to myself, “Wow, this is more complicated than I thought.” This thought came despite my years of Wall Street experience and an advanced degree in finance from a prestigious Ivy League school. Within a few weeks I got up to speed on all the holdings in the portfolio and finally felt I was prepared to take over full responsibility of the portfolio.

Even then I felt a bit anxious as I decided on my first trade as the new portfolio manager. I ended up buying a tiny, incremental position of an electric utility already in the portfolio. I think my trade had absolutely zero probability of impacting the portfolio one way or the other, but the deed was done! I remember my boss (who had no trading experience, but had some “book learning”) saying, as he signed my trade ticket, “Ah, Mike-san, you are bullish on interest rates, no?” I’m sure I nodded and gave some vague answer, but what I was really trying to do was avoid making a big mistake on my first trade.

Since that fateful day, I have made thousands of trades, some great, some not so great, but for each one, I knew 1) what I was buying or selling, 2) why I was buying or selling and 3) how long I needed to wait for the trade to be proven successful or not. Investors who trade or invest in stocks without being able to answer those three questions are more likely than not engaging in an exercise of randomness.

Ultimately, the stock market is not one thing; it’s a collection of many things. Each stock price represents: 1) an entire company and all of its resources trying to successfully compete in its market place and 2) the collective opinion of all shareholders about this company’s prospects. When we hear the media mention the “stock market” it is easy to forget that it’s not some kind of powerful monolith, but the collective and combined effort of thousands of companies, millions of workers and millions of investors, both big and small. The general public may hate Wall Street right now (please see Jeff Korzenik’s blog for more on this topic here) but eventually, we all need to understand that what is good for the stock market (strong economy, rising profits and stable interest rates) is ultimately good for all of us.

Is This the Bottom?

This question seems to be on everyone’s lips. Even though I am an investment professional with many years of experience working on Wall Street, I still sometimes find myself having to stifle a chuckle whenever I hear a question like this. The question is really a series of questions that go something like this:

1) “Should I have put my large cash stash in the market on March 9th?” With the market up over 20% from the recent low, the answer to this one is clearly “yes.” Doing this would led to a quick 20% return, which represents roughly 2 years of “average” stock market returns. As I recall, March 9th kind of felt like the end of the world, capitalism, the stock market and life as we know it. I suspect most people would have found it difficult to throw a bunch of cash into the market that day. I suspect some investors were still in “sell everything now!” mode on that day. But such is the contrary nature of investing in the stock market.

2) “Will the stock market keep going up?” My answer is clearly “yes.” It will go up and then down and then up and then down and so forth. As the equity market strategist at one of my past firms once said so famously (and with a straight face, no less), “I predict that in the future the market will exhibit… volatility.”

3) “Is it safe to get back into the stock market?” No, it’s never “safe” to invest in stocks. One of the immutable dynamics of the investment process is the interplay between risk and reward. For this dynamic to remain in force, the assets which offer the highest potential return must also contain the highest risk. The problem is most of us have a hard time measuring risk, but can easily see returns. When a stock we own goes up, we feel good about that return. When a stock we own goes down, we feel bad about that risk. Truth is that regardless of the near-term returns, every stock possesses an inherent element of risk. By creating a diversified portfolio, investors can offset much of this risk, but never eliminate it. That said, over most long time horizons (the last 10 years notwithstanding), stocks provide the best returns of all asset classes.

4) “If the economy is so bad (everyone is still saying this, no?), why did the stock market go up?” Ah, this is a tricky one. Many people seem to think that the stock market is supposed to reflect what’s going on in the economy. To the extent that economic activity affects corporate earnings, this relationship holds true. However, the stock market is much more than a simple barometer of earnings. Stock valuation is also a function of interest rates, investor sentiment, and supply and demand. Also, the market will respond to the changes in all of the above factors, and most importantly, it will respond to changes in the expectations for all these parameters. The “Economy” is like a supertanker; it does not move nor turn quickly. The stock market, in large part because it is highly affected by changes in expectations and sentiment, is more like a sports car – it can turn quickly and at times move very fast. In the early stages of a new bull market, we will continue to see mixed news about the economy and experience turbulent crosswinds in sentiment.
I suspect that no one can really answer these kinds of questions with the level of certainty the asker ultimately wants. Sure, many (especially those looking for fame in the media) will offer blithe responses with all the confidence and supporting evidence they can muster. Some of them may actually get it right. But no one gets it right all the time. And free advice is rarely worth its price.

The most truthful answer I can give to all of these questions is “I don’t know for sure.” I don’t spend any of my time making predictions. I am fully engaged each day in trying to measure value and trying to find those stocks and funds which offer the best possible return per unit of risk. I am crafting portfolios which are thoroughly diversified and well balanced. I continue to apply the battle-tested investment principles I learned as a younger person to the strange new world in which we find ourselves. In short, I am fully engaged in the investment process every day. It is not a pure science, but not exactly fine art either. It’s not a get rich quick scheme or a hobby. The fact that I love the work makes all the challenges, headaches and heartaches well worth the effort.

It’s Been One Week

Over the last five trading days the S&P 500 has risen just about 10%. Recall that just last Friday, the market had to absorb the bad news of the worst employment report (651,000 jobs lost and an unemployment rate of 8.1%) since 1983. Remember how bad that felt? So what’s the reason for this mini rally?

We’ve been taught to think that the market is always up or down for some good reason. Usually, someone in the media (or the poor fellow who writes the headlines for Yahoo Finance) can link the day’s action in the market to some news story, economic data point or world event. Sometimes there’s just more buyers than sellers.

So what good news could have contributed to the market’s action over the last five trading days? The employment report? No, that was clearly bad news. How about the news that US households lost 18% of their wealth last year? No, that sounds negative too. General Electric’s credit rating was downgraded? Well, the Wall Street Journal did acknowledge this move as a positive because it wasn’t as bad as expected. Ah, there’s something to focus on – the market tends to respond to events, not whether they are positive or negative, but how they are versus expectations. This is the perverse calculus of the equity market that often befuddles the casual observer. This is why bad news (GE’s credit downgrade) can be interpreted by the market as good news (not as bad as expected).

What is clear to me is that the stock market’s recent actions have little to do with the economy. The economy is like the proverbial oil tanker that moves slowly and makes it big, broad turns even more slowly. There was no positive economic news that could account for the market’s recent movement. This is the disconnect many individual investors struggle with – “If the economy is so bad, why did the market go up?”

To be fair over the last week, we did see a sprinkling of good news – Citigroup’s statement about being profitable through January and February; the big pharma mergers are a clear sign that the stocks are cheap and informed decision makers are acting as they should; retail sales for February were not bad, and so forth. Yet, the tone of the news flow remains very negative. Mr. Roubini was featured yet again in the media circus this week, saying now that the recession could now last three (do I hear four?) years! And then they ask him for his stock picks!?

Two items that I think could be helping the market here are 1) a serious discussion at the SEC to reinstate the “uptick” rule and 2) possible changes in mark-to-market accounting. The first item could lead to less downward pressure on stocks from short sellers. The second could ease some of the pain of toxic assets held by banks and insurance companies. Both are technical (not fundamental) in nature, but many have argued that these two factors have contributed both to the credit crunch and bear market. Might be a good idea to keep a keen ear to ground listening for action on either of these issues.

Has the market made its “big turn?” No idea. But I do know that the “big turn” will be marked with just as much uncertainty as we feel right now. Historically, bear market rallies occur frequently and will often take the market up quite a bit (remember the two-week 20%+ rally that started last November?). This could be just another one of those. However, it could be the “big turn.” That’s just the nature of investing in the stock market – it is an exercise in uncertainty. I suppose we cannot know if this is the big turn until the market penetrates some important levels – perhaps 800, 900 or 1,000 on the S&P 500. When the S&P 500 reaches 1,000 level, can we say with certainty that all is well, that it’s safe to jump back into the pool? I suppose so, but I feel sorry for all those investors sitting in cash waiting for some kind of mystical “all clear” signal that will likely emerge (if it does) only after missing 30% appreciation potential (more if they’d been in better stocks). We hold these truths to be self-evident: bear markets and recessions eventually end and the fundamental principles of equity investing are not dead.

No Positive News?

Last week a colleague asked me with a puzzled tone, “Why is the government still talking down the economy?” As I pondered the question, I had to agree with him that much of the commentary we hear from government officials seems to focus on the “half empty” nature of the glass. Perhaps they are still trying to reduce expectations as to what the government can actually accomplish in the short run. Perhaps the newly elected still think that all current problems can be attributed to the newly evicted. Perhaps in order for the average US citizen to fully buy into the significant, fundamental changes embodied by the government’s “stimulus” plan, we all must agree that our nation is broken, and that “… an era of profound irresponsibility that engulfed both the private and public institutions…” (President Obama from “A New Era in Responsibility”) is to blame. Perhaps the hedge fund industry (which has been conspicuous in the media by its absence) has much greater influence over government policy makers than the average citizen can imagine. One thing for certain, those who can short stocks (like the hedge fund guys) are making more money right now than the rest of us who only buy or hold stocks.

Why the excessively negative tone about economy? Not sure. Granted, much of the official data we see coming out of the government reflects an economy in a serious recession, but the commentary I hear from both government spokespersons and the cacophonous talking heads in the media would suggest something “more serious.” I am shocked and amazed at how often and quickly the media and their “experts” will go to the Great Depression for parallels to the current economy. I will concede that the average person may have little or no understanding of what happened during the 1930s, but I would expect that the “experts” so frequently appearing on TV would. In the 1930s, the US had no SEC, no FDIC insurance, no securities laws protecting investors from fraud and market manipulation, no safety nets for the unemployed, no social security for families without breadwinners and so forth. Regardless of how bad the media says things are now, I find it unfortunate that no one seems to be commenting the few positives which I can see, that may be harbingers of better news to come.

For example, mutual fund flows for both stocks and bonds were positive in January (according to Lipper). February retail sales actually rose 0.5%, the first uptick since September of last year. We have seen a healthy number of new bond issuances, suggesting that the credit market is healthier than it was a few months ago. Even the latest employment report showed some deceleration in the pace of employment trends. The prices of many important manufacturing commodities, including copper, iron and oil, have been rising lately, perhaps suggesting some stabilization of demand – something that would precede a recovery. Even China, whose growth has slowed dramatically of late, has reaffirmed its GDP growth target of 8% for 2009. Consolidation in the pharmaceutical industry (Merck buying Schering-Plough and Pfizer buying Wyeth) should be viewed as positive moves, but the media can only view them as further evidence recession fallout.

I am not saying that all is well and that a recovery is just around the corner. What I am saying is that the US public is not getting the whole picture from the traditional sources of news and information. I think individual investors are being particularly ill-served by the media outlets ostensibly created to serve their needs. I feel especially sorry for those who have sold stocks (particularly in retirement accounts) and are holding cash on the recommendation of someone (Cramer, Roubini, etc.) who does not have skin in the game and who does not possess any special insights that will help these investors get back into the market before it goes up.

Unless “this time is different” (still the four most dangerous words in the investment business, in my view), the stock market will begin climbing the proverbial wall of worry, long before the talking heads will be able to tell us that the recovery has begun.

Bigger Guns, More Ammo

Ok, now the “market” has really hit a new low.

I had characterized the November 20th low as the “near collapse of the global financial system” low, and due to the extreme readings of fear and concern at that time (VIX flew to 80, bond spreads widened to historic highs, etc.) I had felt that a retest was unlikely. I was wrong.

This latest new low could be labeled as the “near nationalization of the US banking industry,” but somehow I feel that concern over the banking sector is not the whole story. Even smart people like Barron’s Michael Santoli, who I respect a great deal, find the market’s action so far this year puzzling. In his latest piece he writes, “Rather than a manic and dramatic dive, the drop since early January has been a monotonous and numbing slouch. The selling has been of lower intensity, less inclusiveness, accompanied far less by panic than resignation.” Despite his accurate assessment of the nature of this part of the decline, he fails to discover the root cause for this trip back to the old lows.

Maybe it’s as simple as hedge fund short selling. Short sellers are able to make money as the price of a stock declines. Hedge funds are well-known for their practice of short selling, often as a “hedge” against other assets they own, but in dramatic times like these, where many are fighting for survival, maybe they are simply only investing on the short side. We learned recently that Paulson & Co., a New York City-based hedge fund, made over $200 million from its short position on Royal Bank of Scotland. Multiply this experience by all the bank stocks feeling pressure times all the hedge funds struggling to prosper in these challenging times, and we may find a root cause of the weakness in the market.

I find it somewhat ironic that the heads of US banks receiving government aid can find themselves at the feet of a government panel being berated for alleged mismanagement during the most extraordinary times, while bank stock-shorting hedge funds escape all scrutiny and press coverage. With the traditional buyers of stock (mutual funds, endowments, individual investors) sitting on $9 trillion in money market assets waiting for a “better time” to buy stocks, it is possible that all this short selling is the driving force for the market right now. Consider too the public outrage that might be generated if investors realized that hedge funds were making tons of money as the market declined. And yet, we hear nothing about them…

For all the positive sentiment heroic stories like the Alamo and the Battle for Thermopylae may engender in our hearts, ultimately these brave souls perished because their enemies had bigger guns and more ammo. Maybe “enemy” is too strong a word to characterize the short-selling hedge funds prospering while our portfolios shrink, but it’s easy for me right now to feel more like the Spartans and less like the Persians.