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