Persuasion Time

When I was young my house was always full of animals.  Our pets included the traditional cats and dogs, but at times the lineup also featured gerbils, turtles, snakes, frogs, anoles (which we called “chameleons”), fish (including my favorite Siamese Fighting Fish), ducks, iguanas, spiders, owls and for a while even a rabid skunk (it was in our backyard shed until the authorities came to take it away).  At least half of the fun was naming these critters.  I once had three cats at the same time – “Thomas Jefferson Cat” (he was a “tom” cat, natch), “Sy” (a Siamese cat, of course) and “Junior” (the smallest of the three).  Our longest living pet was “Mimi,” a perky little peekapoo, who was really just like one of the kids.  Another favorite dog was “Fida.”  My brother named her by simply (and brilliantly, in my opinion), deriving the feminine version of “Fido,” one of the most common of dog names.

During my college years, a group of my friends and I collectively picked up the moniker “The Dogs.”  The reason for this is really a long story that I will not share at this time, but let it suffice that we were proud of the name and even felt compelled to give each one of us dog names.  I ended up with “Fang” as my nickname, no doubt due to my temperament and biting wit…

In my married years, due to numerous allergies and my wife’s aversion to any kind of critters in the house, our only pet has been a painted box turtle, named “Squirtle,” who lasted about 2 weeks with us.

Sometimes I meet people whose pets have names that to me don’t really sound like pet names.  One friend had a dog named “Chloe.”  Another one’s dog was “Molly.”  At least names that end in the “ee” sound roll off the tongue nicely when you call them.  My boss has two dogs named “Fred” and “Rose.”  I’m sure they’re wonderful, lovely pets, but to my ear, their names sound like they should belong to the neighbors in some TV sitcom.

That brings us to another famous pet with an unusual name, Paul the octopus.  For those who watched any World Cup soccer games this year, you might know about Paul.  Like most cephalopods, he is intelligent (for an invertebrate, anyway), but unlike most of his kind, he can (according to the news reports) predict the outcome of soccer games.  Paul was credited with “predicting” 12 out of 14 World Cup matches, and 8 matches in a row, including the final.  Before each game, Paul would be shown two containers holding his favorite food, each one marked with the national flag of each competitor.  Paul received death threats when he chose his home country (Germany) to lose to Spain in the semi-final game.   Spain won, and Paul became famous.

Anyone with a little statistics under their belt can tell you that calling 8 soccer matches in a row is just like flipping a coin and having it come up “heads” 8 times in a row.  It’s a rare thing, but not a miracle.  In fact, the odds are 1/256 or 0.39%.  Rare?  Yes.  Newsworthy? Perhaps.  Can he really predict games?  Sadly, no.

David Miller, my stats professor at Columbia University, always told us that miracles were things with very low probabilities that actually happened.  He always tried to help us put events into perspective.  Odds of being hit by lightning? 576,000 to 1.  Odds of becoming a pro athlete?  22,000 to 1.  Odds of getting a hole in one?  5,000 to 1.  Odds of being audited by the IRS?  175 to 1.  And so on…

The outcome of any sporting match depends on an incredibly complex series of factors.  Trained professionals spend thousands of man-hours trying to predict of each game.  Yet, the results often mimic that of a coin toss.  Thus anyone, even someone who knows absolutely nothing about a sport, could possibly “predict” correctly the outcome of 8 games in a row.  Does this result make that person a sports guru?  Clearly not.

Yet, sometimes in the stock market (you knew there’d be a tie-in, didn’t you?), we impute virtue and talent to some people who might just be lucky.  Rarely (never?) does some “expert” appear on a broadcast with his or her latest mighty forecast and then discloses all of his or her past predictions and how they fared.  The markets are complex, but most of us want simple answers and solutions.  Many “experts” have appeared to fill this need.  Every decade throws another guru up the pop charts because of an “amazing” prediction that came true.  Rarely (never?) do these one-hit wonders recapture the glow of those peak moments.  The markets are too complicated.  The prediction business is too fraught with uncertainty to rely on the predictions of any one person for long.

This is why I don’t make predictions.  Not that I can’t (I used to get paid to make them), but I don’t think it’s what I’m best at.  I spend my time measuring value, assessing the risk profile of portfolios and matching appropriate investments to clients’ risk tolerances.  Even these activities contain a great deal of uncertainty, but compared to the prediction business, it’s much less random.  And fun, in my opinion.

The stock market is struggling a bit today (down 2.5% as of this writing) following the release of the Consumer Confidence Indicator for June.  This figure fell over ten points month over month to 52.9 vs. the May figure of 62.7.  So consumers are much less confident than they were a month ago.  For anyone who reads the newspaper or listens to television, the reasons for this decline in sentiment would be obvious – economic problems in Europe, too much debt everywhere, high unemployment, falling retail sales, a stalled housing recovery, threats of inflation (or deflation, according to some), the perception that government actions are not helping, soaring budget deficits, the oil leak in the Gulf of Mexico, Courtney Love’s latest horrific concert in DC, and so on.

That said, the glass is never empty just as it is rarely completely full.  Usually, it’s somewhere in the middle (the reality), but how we perceive it (sentiment) can vary wildly and change quickly.  So, if the average person out there (as measured by the Consumer Confidence Indicator) is indeed looking at the glass half empty right now, I must ask, “Is there any good news out there?”

As I often say, the economy is like a big tanker, it does not turn quickly.  For the economy to suddenly stop its recovery now would be highly unusual.  A modest pause in growth, however, is not that strange.  It really boggles my mind when we see a little weakness in the numbers and highly vocal economists and commentators immediately conclude that a “double dip” is coming or “the recovery never happened.”  What’s the upside in such wide-spread negativism?  Who wants us to think that things are worse than they really are?

Last week, I outlined four very big positive factors for the economy.  Believe it or not, they have not changed in the last seven days.

Earlier this month Dennis Kneale (a CNBC editor) penned an excellent piece that got picked up by Yahoo Finance.  It’s entitled, “Are We Psyching Ourselves Out of a Recovery.”  In it, he covers the kind of themes which I often address – the apparent disconnect between economic reality and sentiment.  He noted that U.S. households added $1 trillion to net wealth in the first quarter of this year.  He also mentioned that non-financial companies have generated $380 billion in cash in the past year, the biggest rise in six decades.

He also reported a few details of a recent CEO conference where about 80% of the attendees were confident that a recovery was underway.  One person noted that “travel bookings are booming.”  One Harvard University economist noted that the way the employment statistics are reported may distort the reality underneath the numbers.  He noted that of the 2.7 million jobs created so far this year (sound like a “half full” number, doesn’t it?), 2.6 million of them were private sector ones.

Another CEO put the long-term prospects for the globe into a clear context.  “…three billion extra people will populate the earth by 2050, and most will live in cities, so infrastructure investment will be high”  India itself will be spending $1 trillion on buildings, roads and housing in the next five years.  Even Mark Fields, who runs the Americas business for Ford was pretty optimistic, “Sure, economic data may be contradictory and volatility may be rising… But why fret?  The numbers are just inputs for us.  Our job, as a management team, is to have a point of view and manage those risks.”

Maybe we all should think more like CEOs when it comes to our investment portfolios.  Perhaps less focus on the short-term volatility and more on the long-term opportunities would be a good thing.

Over the weekend, Jason Zweig, one of my favorite financial journalists, wrote an excellent piece in the Wall Street Journal which tries to explain with so many individual investors tend to find comfort going with the crowd.  He cites a scientific study that found “the value you place on something is likely to go up when other people tell you it is worth more than you thought, down when others say it is worth less.”  He places this study’s findings in the context of investing by concluding, “… investors often go with the crowd because – at the most basic biological level – conformity feels good.”

I always find some comfort when I discover that my opinions match up with someone whom I respect (hey, conformity does feel good!), but most of the time, I find myself at the periphery of consensus, toiling away in the dark shadows of non-conformity. In this article, Mr. Zweig praises the notion of contrarian investing, but highlights why most people have trouble doing it — because it usually always feels “wrong.”

At the various Wall Street shops where I worked, I saw this “comfort in conformity” idea played out over and over again.  Whenever an analyst would upgrade a rating on a stock, if several people on the sales desk would get excited about this move, it would take very little time for the entire group to be enthusiastically recommending the stock.  At other times, if a senior person on the desk would have reservations about the ratings change, the reaction from the desk would be likewise tepid.

On the Buy Side too, we see this phenomenon at work.  Quick scans of top holdings of mutual funds which focus on the same investment style will often reveal a certain degree of conformity.  When I was a portfolio manager, I recall hearing my colleagues offer such gems of wisdom such as “no one will ever fault you for owning P&G” (or other big, blue-chip names).  Everyone does it, so it must be good, right??

Even now, I must admit that when I am analyzing a stock, if I find that it is currently owned by Berkowitz or Buffett, I find myself regarding the stock with more confidence than I would have otherwise.  So even the contrarian can find some comfort in conformity from time to time.

Yet, moving with the herd is rarely the best way to invest.  Benjamin Graham, the founder of value investing, noted that “the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities.  The market is a voting machine whereon countless individuals register choices which are the product partly of reason and partly emotion.”

Zweig offers this sage advice to those wanting to dabble in the realms of contrarianism, “…you should note which way the herd is moving – and go the other way. You should get interested in a stock when its price gets trampled flat by investors stampeding out of it.”

Well said.  See you in the shadows…

Last week, I learned that a friend of mine had a heart attack and had to have quadruple-bypass surgery.  This news was particularly surprising to me because this friend has been in excellent shape for as long as I have known him and because he is a martial arts expert.  In fact, he teaches classes in his discipline, and has done so for many years.  Early signs are all encouraging and the doctors think my friend has a good chance of a full recovery.

One part of his wife’s e-mail to me struck a chord. She wrote, “Apparently he has been living with heart disease all these years and didn’t know it because the Kung Fu has kept his heart healthy.”  For some strange reason this fact (his hard work compensating for a serious problem) got me thinking about the investing process.

Imagine yourself a factory worker.  You put in your 8-hour shift making widgets.  At the end of the shift you can see clearly the fruits of your labors – several pallets of widgets all nicely stacked and packaged, ready for shipment.

Now imagine yourself a professional investor.  You put in your 8-hour shift (fantasy!) doing your thing.  At the end of the day, what have you produced?  No widgets stacked in the corner.  Your output is opinions, analysis, and maybe some trading.  Some days you might not have any visible production of any kind.  And you get paid for this?!

Herein lies one fundamental difference between the investment business and nearly everything else – a hard day’s work often produces no visible benefit.  Sometime after a hard day’s work, the market will tank at the day’s end.  On those days, despite your hard work, the only visible output is losses!

I recall one day in late August, talking to a prop trader at the firm where I worked.  He had been working hard every day to make money for his desk.  On that hot August day, he was going home a dejected man – he had lost in one day all of the profits he had made so far that year.  This is the kind of experience that could be replicated in only few other professions (such as farmers, maybe).

I recall working for another firm whose management struggled with understanding the investment business.  This firm’s core business was commercial banking, where the linkage between hard work and output was well understood.  Management concluded that all one needed to do to make money in the stock market was to work hard, in other words, more hours.  In those times when the market was falling, their “logic” suggested that we just needed to work even harder (more hours).  Our attempts to point out the fundamental flaw in this line of reasoning were met with blank stares.

They also held firm the notion that active management meant active trading.  So after I took charge of the portfolio they quickly noticed that the fund’s turnover had gone down (after all, value investors tend to trade less actively than other investor types).  They encouraged me to trade more, ostensibly to help be achieve better returns.  Here too any pushback on my part had no impact on their opinions.  So, every month I would log a sizable number of very small trades that kept them happy without significantly impacting the returns of the portfolio.

So, what’s the point of all of this?  First, the investment process is complicated and perhaps unlike few other human endeavors (except farming, maybe).  This is one reason I feel compelled to write this blog.  The more people truly understand about the investment process, the better.  Second, in the investment process the linkage between hard work and performance is real, but rarely direct or linear.  I believe that my hard work will over time produce above market returns, but day to day it’s hard to measure my value added.  Third, I can invest however you want me to, or I can invest your funds my way and make you more money.  Fourth, stop and smell the roses.  Life is too precious and short not to take time to enjoy the journey.

The market’s recent action is a bit puzzling, but I suspect that the reasons for its movements are not as simple as the media would have one believe.  Friday’s big decline was attributed to the weaker-than-expected jobs numbers and supposedly new bad news from Hungary (did you know that Hungary’s GDP is around $186 billion – just a little big bigger than General Electric’s market cap?!).  Recall that just 3 months ago, the prospects of any job growth seemed unlikely.  I recall Bill Miller (portfolio manager at Legg Mason) at a conference back then suggesting that we’d be seeing job growth of 200k+ per month by the second quarter.  Nearly everyone there thought he was being wildly optimistic.  Sure enough, he was right.  The fact that job growth in this recovery has not been smooth and linear does not necessarily mean that the recovery has failed.  The market seems to think that it has.

This strange connection between the jobs report and the stock market got me thinking about past forecasts that had massive credibility at the time, but proved to be horribly wrong.  Think back to the middle of 2008.  Oil prices were rising rapidly and all the “experts” were forecasting higher and higher prices for the commodity.  I recall one particular report from a credible analyst at a big Wall Street firm forecasting that oil would reach $250/barrel within 6 months.  It didn’t.  The big surge behind oil’s move that year turned out to be massive buying (with leverage) from hedge funds and other traders.  The fundamentals of supply and demand were obscured by this trading, but market observers felt compelled to go with the trend and forecast higher and higher prices.

Think back to early 2009.  As the impact of the global credit crunch reverberated through all the markets, we found ourselves wondering where stocks would bottom out.  I recall clearly credible market observers saying with a straight face that the Dow Jones Industrial Average would fall to 4,000. Many others chimed in similarly woeful predictions, as if everyone was playing some kind of bizarre party game of stock market limbo (how low can you go?).  Happily, the market did not fall to that level.  Rational thinking and investors reacting appropriately to the deep-discount valuations eventually prevailed, and the market stabilized.  As it rose, many of these naysayers held firm their pessimistic notions nearly all the way up to the top.  Something Emerson once said comes to mind, “A foolish consistency is the hobgoblin of little minds.”

Think back to early 2010.  Many credible economists were suggesting that the recovery would be anything but “V-shaped.”  Double dip, “W-shaped,”  “L-shaped” and my favorite “square-root-sign-shaped” were all part of the forecasts.  Some suggested that this would be a “jobless recovery;” that unemployment would remain high or even rise at least to the end of the year.  Lo and behold, we began seeing job growth in March that has continued through May (albeit at a slower pace).  All of this suggests to me that the most dramatic forecasts rarely come to pass.  Often even the consensus is off by a wide mark.  The interplay among the forces of the economy, the markets and investor sentiment are complicated, and are often oversimplified by those seeking quick and easy answers, or newsworthy sound bites.

I make no pretense about knowing what the future holds.  I generally make no predictions.  But the weight of history is surely on the side of recovery.  There is a great deal of good news out there, but as Edward Yardini of Yardini Research commented last week, most of it is old news.  The markets are responding to new news as of late, and most of it appears to be bad.  I suspect that corporate earnings reports, which we will begin to see in July, may provide the shot of new, good news the market needs to resume its upward motion.  Time will tell…

The last few weeks have been rather strange.  It started with a 2% drop in the U.S. stock market on the first trading day of the month.  It picked up more strangeness on the following Thursday when the market fell 10% intraday on reasons still a bit unclear.  The “flash crash” they call it.  It continues today with the market very weak again on, from what I can tell, is no new news.

All the talk of Europe’s problems and the threat of contagion is, in my view, besides the point.  From what I can tell, investors are selling mostly because they want to sell.  It’s as if all the economic progress made from the first part of 2009 was all smoke and mirrors.  Some people may actually believe that – that all the improvement was built on the back of government stimulus that will soon end, spinning us into another recession.

As if on cue, all the doom and gloom gurus, who have been quietly absent from the media’s attention for the last year, are now once again proudly on display, explaining exactly how fragile the situation is, and enumerating all the fun and exciting ways it can become much, much worse.  I know these seem like hard times, but allow me to provide some perspective.

1)      Corporate America is doing fine. U.S. companies have the best balance sheets in decades.  They are sitting on record amounts of cash.  Revenues, profits and cash flow have all surpassed expectations for five consecutive quarters.

2)      Low interest rates are a boon for much of the economy.  The Fed appears committed to keeping rates low for a long time yet.  This helps the car companies, the banks, the housing industry and reduces expenses for every borrower.  It also makes stocks look more attractive relative to bonds.

3)      Stocks are on sale. It’s funny how consumers love anything on sale except stocks.  As the market falls, I begin to see great bargains on many of my favorite companies.  Even if investors have no new cash to invest, these lower prices can allow them to swap into very attractive stocks at cheap levels.

4)      Positives and negatives always co-exist.  Even when the market was rising, the problems the market seems so concerned about right now were there. Never is it the case that only positives or only negatives exist.  Investors are always trying to figure out which forces have the greater influence.  Right now the negatives are winning.  Yet, scores of positive factors exist; they are just being ignored by the market.

5)      The worst case scenario never happens. My worst case view?  North Korean launches nuclear missiles (you doubted they had them??) into Seoul and Tokyo.  Seizing on the mayhem this causes, China invades Russia with 100 million troops.  Responding to this threat, Russia fire off its nukes – unfortunately they are still targeting the U.S.  President Obama, channeling Martin Sheen in “The Dead Zone” fires off our nukes into the heart of Germany, because, well, we’ve beat them twice before.  Anything less than this, I think the market can handle.  Seriously, the stock market has been able to absorb the worst global credit crisis in a generation.  It bounced back from that.  The current fear is unlikely to spread to another crisis of similar magnitude.  Even if it does, it seems logical to me that the market could again rebound from that .

In all reality, I don’t feel fine.  Every day the market shows this kind of volatility affects me in a harsh way.  Yet, I have enough training and experience to know that these days, too, will pass and the market will once again focus on the positives and ignore the negatives.  Until then, I will continue my search for value and seize upon it when I see it.

Well, what I can say?  These are strange times we live in.

The market falls 7.6% in one week (at one point over 9% in one day), and the best the heads of the stock exchanges can say is “we are working on finding a cause for this.”  Last Monday, the market’s actions felt technical – a concerted move by hedge funds and other active traders reacting to a spike in volatility due to concerns in Europe.  I say “technical” because the market went down early in the day and basically stayed at that level to the close.

Thursday’s action was something else entirely.  What exactly, the authorities are still working to discover.  It seems unlikely it was a “fat finger” – someone pushing the “sell a billion” button instead of “sell a million.” The real culprit appears to be the automatic trading systems active traders now use.  High Frequency Traders (HFT) are also being looked at closely to determine what role, if any, this portion of the trading community may have had.

What is HFT?  At the most basic level, it is very short-term trading (measured in milliseconds) driven by sophisticated computer programs which can measure and trade on the slightest inefficiencies in the market.  A few years ago, HFT represented about less than a quarter of the daily trading volume; now that figure is as high as 75%, according to some estimates.  Despite this high volume, HFT traders only represent 2% of the number of traders out there.  HFT proponents argue that their activities make the market more efficient and lower the cost of trading (by narrowing bid/ask spreads).  Critics suggest that they have some kind of “unfair” advantage over other traders.  If last Thursday’s market action was either caused by or exacerbated by HFT, perhaps more scrutiny of this kind of trading may be warranted.

But, all of this is a distraction from what I think is really important now.  Before I comment on the important stuff, let me touch on three important groups of people germane to the discussion of the day:

1)      Journalists.  These folks love to tell stories.  When the market moves up or down, they are supposed to figure out the reasons and the cause and come up with a coherent story which explains the move.  One of my responsibilities at my first job on Wall Street was to write daily market commentary for my colleagues in Tokyo.  Every day I would search the news wires trying to put together the story of the day.  Sometimes “narrowly mixed in light trading” was the best I could do.  Journalists today have tremendous resources available to put together the story of the day, and yet some days, there just may not be a really good reason for why the market does what it does.  However, they still want and need to create and report the story.  My point: the “story” given in the media for any given day’s trading action may not be the whole picture.

2)      Traders. These folks love to make money in the short run.  They measure market trends and will buy and sell in order to capitalize on these trends.  They work for hedge funds, mutual funds, broker-dealers or for themselves.  They use complex computer programs or their “gut feelings.”  The best ones can make money regardless of the direction of the market.  My point: trading is a fine way to make money in the market, but it’s not what I do.  Traders’ opinions about the market are likely to be colored by their time horizon, which can be very short.

3)      Investors. These folks love to make money in the long run.  They measure value and try to buy cheap and sell dear.  Although there are many types of investors, they all share a number of characteristics – they hold investments for a longer time than traders, they usually stay fully invested (as opposed to holding mostly cash), they understand the markets, but may be focused on other things – individual stocks, sectors or countries, and they may care much less about the daily ebb and flow in the markets as do the previous groups. My point: I tend to value the opinions of investors, those folks do what I do and think as I do, over the opinions of other groups.  Part of the challenge of investing these days is sorting through the massive amount of information out there to find the things which really matter.

So, what’s important now?  Fundamentals, that is, those things which ultimately matter to the stock market, do not change quickly.  In my view, Greece is really a digression or distraction from the really important things.  The same goes for the technical glitches from last Thursday.  Corporate earnings, the economy, interest rates and cash on the sidelines are the most important drivers for the market right now and they are all positive.  Amid all the excitement last week, many failed to notice that the US economy added 290,000 jobs in April – something I thought would be a reason to cheer.

Bottom line – I still think that the bull market persists and last week was nothing more than a technical correction and a buying opportunity.  Many smart investors I spoke with last week agree with me and used the weakness to buy stocks.

Or maybe it’s “fear.”  Stock markets around the world took it on the chin today after investors began really worrying about European sovereign debt.  Yes, you might have heard that the European Union had approved a big bailout package for Greece, whose problems are well known, and had concluded (as did I) that Greece and all of its problems was already fully discounted by the markets.  Today’s new twist is the fear of contagion.  This is the “high concept” that one bad apple may indeed spoil the whole bunch.  If Greece can be driven to the brink, this concept muses, why not Spain, Portugal, and others?

Above all else, the stock market fears uncertainty.  Could Greece’s problems spread far, wide and deep?  Maybe.  I am no expert on sovereign debt or the Euro Zone, but I do know that many stocks I really like are now 2—4% cheaper than they were yesterday, without any change in their individual fundamentals.  I also know that corrections within the context of a bull market are normal and actually helpful – they help to prevent the kind of “irrational exuberance” that prevailed in the late 1990s.

This sudden rush of fear reminds me that we are still far away from universal bullishness on the U. S. stock market.  Investor psyches are still tender from the punishment inflicted upon them over the last few years.  Whenever anything negative develops, we tend to move immediately to a “what next?” mentality, as if every negative thing has to be the first of a series of bad events.  In normal times, a correction like we saw today would split opinions somewhere down the middle – half would urge caution and half would view it as a buying opportunity.  The fact that opinions appear to be highly skewed to the caution side this time around tells me that times are not yet “normal” and that much work still needs to be done for investors to fully embrace the new bull market.  That’s one of the key reasons I think it will continue.

My bottom line is that this is a buying opportunity.  I can’t predict that this correction will end in one day; it might last weeks or even months. But I do believe today’s action does not represent anything more than a normal pull back within the context of a bull market.  Time will tell.

Popeye the Sailor

A few years back, I would occasionally be asked to appear on a cable news show to discuss my views on the Asian markets.  Asian specialists were somewhat rare in New York City at the time, and demand for my point of view, especially following dramatic events (earthquakes, currency crises, etc.) ran high.  Once I remember speaking with the young woman who was applying make-up to the guests of the show.  As I surveyed her array of colored powders, brushes, sponges and other paraphernalia, I was interested in how she got this job.  Somewhere during the course of the explanation, she said something memorable, “This is what I do; it’s not who I am.”

I have considered this statement over the years and I think it has profound implications.  First, not everyone “is the job.”  There are a lot people who view their jobs just as something to do to earn money, keep out of trouble, pass the time, etc.  These individuals no doubt maximize their personal utility by doing other things, such as hobbies, forms of entertainment, spending time with friends and family, and so forth.  The stereotypical actor/waiter is a classic example of this.  The person is an actor, but is working as a waiter.

Second, does a person who “is the job” make a better employee?  I suspect that most managers would say “yes.”  Someone who lives (and loves) to work at the job of his/her choice must be a pleasure to have on board.  That level of commitment is the essence behind the “think like an owner” concept.  Still, I wonder if someone that committed can really find the balance, which seems so important in life.  I have seen many sad endings to people who could only find satisfaction in the workplace.

This brings us back to me (it’s my blog, after all…).  One of the nice things about growing older is the feeling of increased self awareness.  I think I know myself much better now than I did 20 years ago.  And as it pertains to this blog and my career, I know that I am a value investor.  I may have been this way my whole life, but working on Wall Street and investing in the stock market has solidified this understanding.  I may lack the skills of Warren Buffett, John Neff, or any of my investment heroes, but I know that deep down we are all cut from the same bolt of cloth.

Throughout my career I have filled many positions, have had many jobs, but each time I approached the tasks at hand as a value investor.  I love buying or recommending stocks at a big discount to their fair value.  It seems so basic and simple to me, but most people I speak to struggle with the concept.  We love to buy “things” on sale – clothes, cars, computers, etc.  But when it comes to stocks, people generally want to buy the  ones that have gone up the most – those that are expensive [by “expensive” I mean highly valued, not those with a high dollar value – a stock trading at $100 is not more “expensive” than one trading at $20 to the value investor].  This tendency makes the concept of “stocks on sale” hard to grasp by the average person.  Many people spend a great deal of time and effort trying to fit in.  The value investor does the exact opposite.  We constantly search for the less-traveled path.

Sometimes it’s a lonely exercise, but in my experience, it’s well worth the effort.  Recently, a junior colleague of mine, obviously puzzled by my lack of apparent enthusiasm for a happy development in my family asked, “Goodson, what do you get excited about?”  With only a split second of thought I answered, “Generating alpha.”  That is, I enjoy beating the market.  Always have.  Hope I always will. That is who I am.

Eyjafjallajökull

Anyone who flew to Europe last week for a short trip was no doubt surprised that a volcano in Iceland would cause their return flight to be cancelled.  After all, the volcano had been dormant since 1823, and besides, when was the last time a volcano interrupted air travel?  Mount St. Helens (1980)?  Mount Pinatubo (1991)?  Granted, “Eyjafjallajökull” doesn’t exactly roll off the tongue, but that mighty mountain’s effect will be remembered by a lot of folks for a long time.

This surprise eruption underscores the uncertainty inherent in our world.  Unexpected things sometimes happen, and often their impact can be widespread and may persist for longer than seems reasonable.  I suspect we will soon be hearing about how this volcano‘s output will be affecting the weather, carbon gases in the atmosphere, global ocean patterns, and so forth for months or even years to come.  One thing can make a big difference.

For the capital markets, the Security Exchange Commission’s (SEC) charging of Goldman Sachs with civil fraud related to mortgage securities is something akin to a volcanic explosion.  The stock market’s decline on Friday seems wholly linked to this one event.  Above all else, the markets fear uncertainty.  This action by the SEC has raised fear in the marketplace.

Not being a lawyer or an expert on SEC regulations, I will not comment on the merits of these charges.  I will note that Goldman Sachs and the other big banks tend to have very good legal teams and every single security they sell and every single research report they publish has been vetted, examined and reviewed by these top-notch legal groups.  So, I would be somewhat surprised if this case has impact as long and deep as the market may fear right now.  Time will tell.

On Thursday I was discussing the market with a junior colleague, who suggested one might want to “go long volatility.”  He noted that the markets’ volatility (as measured by the VIX) was very low and seemed to be cheap, in his opinion.  Buying the VIX seemed like a good trade, in his view.  I, in my role as the know-it-all senior investment guy, pooh-poohed his idea and said something to the effect of “I can’t imagine anything de-railing this recovery or this bull market.”  Well, the very next day his VIX trade (had I not talked him out of it) would have made him 15.5% — not a bad for one day!

I still think that this single event is unlikely to de-rail the recovery; it has nothing to do with corporate earnings, interest rates or cash on the sidelines, but it has raised the risk profile of the markets a bit.  Yet, I learned (or more precisely re-learned) a couple of important lessons from this experience.  First, I don’t know everything.  Yes, that may be obvious to the rest of the entire universe, but after a good run in the market, anyone can get sucked into the illusion of market mastery.  As I often say, humility is a necessary trait for anyone who wants long-term success in the market.  I need to remember it, not just say it.

Second, respect all opinions and sources of information.  This is another fundamental truth of investing which I ignored last week.  My colleague, despite his youth, is very sharp and often sees things that I miss.  So I know this rule (generally), but sometimes the weight of my experience gets in the way of seeing this.  I am not suggesting that all opinions are valid or even useful, but dismissing any because you think you know better is a recipe for missed opportunities.  Balancing one’s own views with the myriad of data out there is ultimately one of the big challenges of being a professional investor.  The market usually rewards independent, contrarian thought, and my colleague’s opinion was a classic example of this.

I continue to think that we have entered a new bull market which will take stock prices much higher from where we are right now.  In bull markets, corrections of up to 10% are normal and actually provide investors the opportunity to test and re-test their ideas and opinions about the market.  I don’t know if this SEC-Goldman Sachs thing will lead to a full-blown correction or not, but I think I would rather be buying stocks now than selling them.