Persuasion Time Has Moved!

Please update your bookmarks as Persuasion Time has a new home: http://blog.thewolfgroup.com/.

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.