Persuasion Time

In the investment world, certainty is a rare commodity.  Exactly because investing is an exercise in probabilities, we rarely know what’s going to happen.  That’s not to suggest that investors are clueless about the future; indeed we have impressions, feelings, thoughts, concerns and ideas about what may happen, but do we ever really know what’s going to happen?  Rarely.

This is one reason I think Jim Cramer is so popular – he is selling certainty in an uncertain world.  Now, I would never follow any of his investment recommendations, but he certainly exudes confidence and reason about the stocks he recommends.  All the “boo-ya” antics aside, I find him rather entertaining, and I will admit that he has raised awareness among individual investors about the important issues surrounding the investment process.  For more about my feelings regarding those who offer “free” investment advice please refer to this blog.

Because the investment process is encircled by so much uncertainty, investors will often grasp at something that appears to be solid.  The “January Effect” is one example of these “somethings.”  Simply put, the January Effect is the notion that the market usually rises in the month of January and that a good performance by the market in January bodes well for the entire year.  Over the last 60 years, when January logged a positive performance, the market was higher for the full year about 90% of the time.  When the market fell in January, the full year showed a negative return about 55% of the time.

Another similar phenomenon is the “Super Bowl Effect.”  More often than not, the stock market rises in the years when a team from the old National Football League (now the NFC) wins the Super Bowl.  Hence, equity investors may have another reason to cheer for the New Orleans Saints this year.  There are other “somethings” out there like the “Presidential Year Effect,” the “Halloween Indicator,” the “Mark Twain” effect and so forth.  All of these observations are simple attempts to bring more certainty into the stock market.  All of these things are also totally absurd, fun perhaps, but absurd.

They are classic examples of “correlation without causation.” The crowing of the rooster may be highly correlated with the rising sun, but the bird’s cry does not cause the sun to rise.  Every year ice cream sales and accidental drownings show a remarkable correlation.  Does eating ice cream cause drowning?  Clearly not, but they both tend to rise during the summer months.

Just because two effects appear to be correlated does not mean they are related.  Now, I enjoy chatting about the “January Effect” as much as the next person.  In fact, I find all of these observations and anomalies quite entertaining, but I do not use them at all in my investment decision making process.  For that I stick to the things I believe truly matter for the stock market – interest rates, corporate earnings, supply/demand factors, cash levels and sentiment.

And, despite the market’s action in January, I remain encouraged about the outlook for stocks.  This is based on my belief that most of the above factors are supportive and are likely to remain mostly supportive of higher stock prices into the future.

Over the course of my career I have known many equity market strategists.  I found nearly every one of them to be intelligent, insightful, articulate, analytical and creative.  The best of them, in my view, have also shown a tendency for contrarianism.  Regardless of their skill set, they are saddled with the most impossible of tasks – to make predictions about the stock market.  Most of them are required to have annual price targets for the S&P 500 and many of them maintain model portfolios.  Those who work at large firms have access to high-powered analytical tools and databases as well as a bevy of industry analysts who can often help them see the big picture by discussing the particulars of each industry.  We see them quoted often in the media, especially when something dramatic happens in the market.  The best of them can recognize and explain market trends as, or even before, they develop, and the least of them are still very entertaining to listen to.

One strategist whose commentary I find myself enjoying a great deal lately is Liz Ann Sonders, the chief investment strategist at Charles Schwab.  I first heard her speak at a conference a few years back and ever since have tried to keep up with her work.  I find her comments to be very reasonable, quite insightful and easy to understand and appreciate.  In contrast to many of the big Wall Street strategists, she views herself as a “market interpreter” and not a forecaster.  In my eyes, this makes her views and opinions very important for the average individual investor.  She has an uncanny knack for explaining complex issues in a very down-to-earth and approachable fashion.

She was a cool, rational voice in the middle of the bear market and financial crisis and she continues to say and write things which I think are right on.  A couple of examples of her current views:

On the economy: “I think the recession actually ended in the second quarter… We’re starting to see the effect of what I have been calling coiled springs.  There was such a compression in the Fall of 2008 in every metric of the economy that we’re now in the beginning phases of the natural snapback from that.”

On inflation: “Not a near-term risk at all in my opinion.”

Stock prices a year from now: “They’ll probably be higher, but it’s very unlikely that the path on the way to higher will look like it has the past seven months… I expect a choppy path, but that may be the better path.”

Bonds vs. stocks for the long-term: “After a ten-, 20-, 30-year stretch in which bonds have outperformed stocks, the cynic in me can’t help but ask, “Now you’re going to bias your asset allocation dramatically towards fixed income because bonds have outperformed stocks?”  I’m often skeptical about supposed major paradigm shifts, particularly as they relate to how people invest their money based on performance that has already happened…”

With so much noise and hype out there, it is very refreshing to find someone dedicated to helping the individual investor sort it all out.  Bravo!

Here is a link to her bio:  http://www.aboutschwab.com/press/experts/sonders.html

Here is an interview she had with Kiplinger’s Personal Finance magazine:  http://www.kiplinger.com/magazine/archives/listen-to-your-portfolio-.html

Ok, I get it.  Main Street hates Wall Street.  I also realize that anyone who would attempt to defend the bankers’ point of view is likely to risk facing the business end of a pitchfork himself.  Yet, I find it impossible to remain silent in the midst of so much misinformation and confusion.  In the name of full disclosure, I must admit I spent 25 years on Wall Street working for some of the firms which are now once again receiving the full wrath of Washington.  I know that it would be impossible to sway anyone who has already decided that the banking industry is the devil incarnate, but let me provide some perspective to those few souls whose minds are not yet made up on this matter.

Mistakes were made, but few laws were broken. The causes of the financial/credit crises are legion, but now have been simplified for television.  The short version goes something like this – bankers were greedy and made loans to people who they knew would default.  Smarter bankers took these loans and dressed them up (lipstick on a pig?) and sold them as AAA-rated securities to equally greedy, but gullible investors.  Over time there was so much of this sketchy debt that the system was doomed to fail.  Lehman Brothers was the straw that broke the camel’s back.  With the financial system near collapse, the government had to rush in and save the day.  A year later, we find the greedy bankers up to their old nefarious ways, and paying themselves big bonuses while the national unemployment rate remains at 10%.  The real story is quite a bit more complicated, as I tried to explain in this blog.

Regardless of whose fault it was, very few people have been indicted for breaking the law.  All the aforementioned actions taken by the banks and brokers were made within the boundaries of the law.  Congress itself passed the legislation allowing US banks to own brokerage operations and leverage their balance sheets in order to better compete with non-US banks which were taking market share.  The people who smacked those AAA rates on bond bundles which blew up were only doing that which they had been doing for years – getting paid by the issuers of the bonds they rated.  Conflict of interest? You bet.  Illegal?  Not at all.

Bernie Madoff broke the law.  He’s in prison.  Many of the CEOs who made the mistakes surrounding the financial crisis were fired.  It’s odd to me that the banks and bankers continue to be on trial in the court of public opinion for “crimes” atoned for long ago.

Banks which received TARP money got a lot more than they expected. The Troubled Asset Relief Program (TARP) was the program devised and implemented by the Bush administration which allowed banks to sell to the government so-called “toxic assets” which were caused by mortgage defaults.  These toxic assets had become a huge problem for the banks and were an impediment to making new loans or even settling trades.  Something had to be done.  Then-Treasury Secretary Henry Paulson made the TARP loans to a broad number of financial institutions, not just the ones who really needed them, in order to avoid targeting the weakest players in the industry.  Bear Stearns and Lehman Brothers failed in part because they became targeted in the marketplace as being weak.  So the TARP money was distributed and the crisis was averted.  By now, most of the recipients of TARP money have repaid the funds to the government.  In December the government reduced its estimated cost of the program from $341 billion to $141 billion.

Put yourself in the position of one of the bank CEOs who did not need the TARP money, but was forced to take it.  You play along with Paulson for the good of the nation.  You use the money to spiff up your balance sheet a bit.  All of sudden, the rules of the game change and you are being vilified for causing all the problems and taking taxpayer money to enrich yourself (not true, by the way).  “Ah ha,” you think, “I’ll just pay back the money and all will return to normal.”  You pay back the money.  Even-Steven, right?  Wrong.  The government wants to cut your compensation and impose a surtax on your profits because of your past mistakes.  Banks that did not even receive TARP money are being targeted by this surtax.  To me it seems as though the banks are being punished for returning to profitability as much as anything else.  It’s rare to see this much success celebrated so little.

What’s a Wall Street Bonus anyway? To Main Street, the word “bonus” means something entirely different than it does on Wall Street.  The public has somehow gotten the impression that a bonus is some kind of unearned windfall, reward for favors (mostly behind the scenes, of course) rendered and somehow unethical, if not downright illegal.  In reality, the Wall Street bonus program was one of the best examples of a true merit pay system out there.  The basic structure of the Wall Street bonus was this – we will pay you roughly half of what you’re worth in salary.  We will then pay you the rest based on how well you do and how well the firm does.  The firm makes more money, you make more money.  If the firm makes less, you make less.  This tended to encourage all involved to work hard and produce profits.  Most impartial observers would agree that this structure aligns the interests of the shareholder and the employee.  The real issue here I think is the level of compensation.  With the median household income in the US around $46k, I suppose most folks have a hard time figuring out why anyone could do anything that would quality him or her to earn $1 million or more.  If an insurance salesperson receives $100 for every policy he sells and he sells 10,000 of them, would we begrudge his $1 million in compensation?  If an actor can help a motion picture gross $500 million, why not pay him or her $20 million for it?  Professional sports has similar economics.  We don’t mind paying big producers in these areas, why is Wall Street so different?  Because the public really doesn’t understand what they do on Wall Street.

When my children were younger and asked me what I did for a living, I would try hard to explain.  Their blank stares told me they didn’t get it.  Eventually, I just told them to tell people that I was a fireman or a submarine captain (ha!).  Anyway, I can understand how vilifying the bankers now makes some political sense.  They are viewed as pariahs (or worse!) by Main Street and punishing them surely creates some cathartic pleasure by the populace, but it makes very little economic sense to me.  And to the extent that it creates unease and angst in the stock market, I am against it.

Here we are again at the start of a new decade.  As I sit here pondering the future, I can’t help but think back to the year 2000 and the enthusiasm and hope that year brought to the world (after the passing of the Y2K fear, of course).  The stock market was near an all-time high.  The power of the Internet was in full force, and many felt that we had truly experienced a significant “paradigm shift.”  Stock ownership by individuals was at an all-time high, as was employment.  Growth stocks were all the rage and anything even vaguely associated with the Internet was golden.  I recall clearly my younger colleagues thinking that “value stock” was just a euphemism for a stock that didn’t go up.

Little did we know at that time that the next ten years would be so fraught with upheaval and disaster.  The bear market which began in 2000 was bad enough, but the terrorist attack of 9/11/2001 ushered in a new era of fear and conflict which persists even today (just visit an airport for confirmation of this).  Military conflicts in Iraq and Afghanistan, which began in the decade, also persist to the present.  Low interest rates, easy credit and nudging from the government encouraged all Americans to become home owners.  These same forces allowed speculators to make fast money in real estate, which created a sizable bubble in that market.  Massive amounts of new mortgages and clever ways of repackaging them led to another boom and then a bubble in mortgage-backed securities.  New legislation allowed banks to leverage their balance sheets to unprecedented levels. All of this came tumbling down late in 2008.  For the first time since the 1930’s, stock returns were near zero for an entire decade.

This review isn’t meant to create any more despondency or rehash the negative aspects of the past.  Rather, it is meant to be a note of caution to anyone who reads the many forecasts now being published about the future of the economy and stock market.  Nils Bohr, the famous physicist, famously quipped, “Prediction is very difficult, especially if it’s about the future.” Think back to the forecasts which were made in early 2000.  Did any of them contain the possibility of the 9/11 attacks?  Or the US invading Iraq?  Or a three-year bear market?  Think back to the forecasts made in early 2009.  Did any of them suggest that the S&P 500 would be up by 23%?  I recall many forecasts suggesting the S&P 500 would go to 600, 500 or even 400, but no one I remember was predicting 1,100.

I don’t mean to dismiss forecasts entirely; clearly they serve some purpose.  Forecasts satisfy investors’ need for clarity and certainty.  The logic and rationale behind well-reasoned forecasts are often helpful and useful.  Yet, making any significant investment decision based on any given forecast is very dangerous in my opinion.

In my early years on Wall Street, I worked for a firm whose equity market strategist was highly regarded for his ability to accurately assess Fed policy, whether it was accommodative, neutral or restrictive.  His skill in predicting stock market trends, on the other hand, was famously weak.  In fact, one of our clients found his work valuable only because they could usually make money doing exactly the opposite of what he recommended!  I recall that one year his predictions were uncannily accurate and the market did exactly what he thought it would.  After this, the client mentioned above stopped using the firm’s research…

Anyway, I recall one meeting where this strategist was laying out his feelings, impressions and predictions for the upcoming year.  He discussed his views on interest rates, Fed policy, currency factors, the economy, funds flows, investor sentiment, etc.  The list was endless, and for each positive he was able to conjure up a corresponding negative.  Finally (and to the great joy of all in attendance), he began to summarize and offer his final conclusion.  “I think,” he said, “that the stock market this year will…”  Here he paused for a moment, thoughtfully stroking his chin and looking a bit absent-mindedly at the ceiling.  “I think that the market will exhibit… volatility.”  Although no one in the room said it out loud, we were all thinking, “Volatility?  Oh, so you think that stock prices will go up and down?  Thanks a lot for that!”

Now that I’m older (and at least more experienced, if not wiser), I can better see the value of that seemingly useless forecast.  The value is this – complicated forces are impacting stock prices daily, and to reach a simple conclusion (up or down, for instance), grossly misrepresents the complexity of the investment decision making process.

I try to reduce this complexity a bit by not worrying too much about the big picture stuff and focus most of my efforts at the stock level.  It’s a “bottoms-up” approach that is battle-tested and has served me and countless other investors well.  I continue to think we are in a new bull market (a 65% bear market rally is as rare as yeti fur), which is likely to last several years.  I continue to find pockets of undervaluation in many sectors.  The massive amount of cash on the sidelines needs to go somewhere and given the historically low returns offered by bonds right now, I suspect it will eventually find its way into stocks.  Finally, I think sentiment is still very cautious.  We have not seen retail investors plow back into this market yet.  We have heard many stories of investors or their advisors who sold stock in early 2009 and to this day remain in cash or short-term bonds.  Not until I see wide-spread enthusiasm for the stock market will I begin to worry that the bull market is over.

This week the Wall Street Journal ran an interesting story entitled, “What Are You Paying For?”  The gist of the article was that many fund managers invest in so many stocks that their funds begin to look like the market.  The author’s criticism centered on the fact that these managers are charging higher fees for services and performance that could be obtained via an index fund. He said, “’Closet index funds’ have higher fees than true index funds but don’t differ enough to justify the higher costs.”

I am not one to criticize any fund manager – I think their jobs are challenging enough without any kind of grief from me.  If a fund manager can produce consistent above-market returns, I could care less how many stocks are in the portfolio.

But this article did get me thinking about the concept of diversification and made me wonder if one can have too much of it.  Everyone knows the idea of diversification from the old saying “Don’t put all your eggs in one basket.”  Investors should invest in a number of different stocks and asset types.  But how many is enough and how many is too many?

We can attempt to answer this question intuitively.  Everyone would agree that owning just one stock would be the riskiest investment possible.  We can also agree that adding one more stock would reduce the risk a bit.  As would the third, fourth, and so on.  Reducing risk by adding another stock to the pot happens due to something called “correlation.”  Because the price of a given stock is governed by its own fundamentals and investor perception of those fundamentals, it tends to move in a somewhat different pattern than other stocks.  To the extent that two stocks tend to move differently from each other (that is, their correlation with each other is low), holding them both in a portfolio will reduce risk.  Obviously, owning 10 energy stocks (whose correlation with each other will be high) will be more risky than owning 10 stocks from different sectors.

Aside: This may be a good time to talk a bit about risk.  Risk is not the same as losing money in your investments.  Risk, as most professional investors measure it, is the price volatility of the asset in question.  One stock would have the most price volatility imaginable (up or down), and this volatility is reduced as we put more stocks into the portfolio.

The problem with an intuitive solution to this question is that it seems that a portfolio of 100 stocks would be 10 times less risky than a portfolio of 10 stocks.  And a 1000-stock portfolio would be even better – that is, more diversified.  The real solution is mathematical.  The relationship between the number of stocks in a portfolio and its risk is not linear, it’s exponential.  So at some point the addition of another stock to portfolio will reduce the risk only a very small amount.  The chart below illustrates this.

Source: Investopedia

So mathematically speaking, 20 seems to be a good number for optimal diversification.  The problem here is that 20 names will rarely provide the industry sector diversification one may want.  Although the “right” number remains a point of discussion, many fund managers who like to keep the stock count low will agree that something around 30 is a good number.

This has been the guiding principle for diversification my entire career.  While I was thinking about this issue, I did a quick check on my personal portfolio.  Sure enough – it has 28 names in it.  Just about where diversification feels “right” to me.

Much of the commentary out there seems to suggest that many individual investors have too few stocks in their portfolios.  Often these “portfolios” are just a numbers of stocks the individual selected or was recommended by interested parties.  A “real” portfolio, in my opinion, is one which contains enough stocks in different sectors to allow the magic of diversification work.  Investors should also avoid the temptation to own 100 (or some other large number) stocks simply for diversification reasons.  Like many things in life, moderation seems to be the answer to how many stocks truly make one’s portfolio diversified.

Recently I came across a news item that caught my fancy:

“Corporate bond sales hit record. Corporate bond sales surged to a record annual high of $1.171T YTD – more than the $1.167T sold in all of 2007 – as companies take advantage of low interest rates to rebuild their balance sheets. Companies that could not sell debt during the financial crisis are borrowing more aggressively, and being careful to sell debt with longer maturities to avoid being trapped by refinancing risk as they were in 2008, analysts said. The bond sale surge was also supported by the FDIC’s debt-guarantee program – companies issued $200B of debt guaranteed by the FDIC this year before the program ended on Oct. 31.”

The rationale for companies issuing a record amount of bonds this year makes total sense to me – take advantage of the current low interest rates.  But if interest rates are going to rise in the future (it must be true – “everyone” says it going to happen…), why would investors want to buy this record level of bonds at these unusually low rates? Is a puzzlement…

I’ll be the first to admit that I am not an expert on bonds.  Most of my career has focused on the equity market.  To me, the formula for bond investing always seemed a bit simplistic – interest rates up, prices down, and visa versa.  Clearly this view grossly understates the complexity of the marketplace, but it is where I begin with bonds. Fortunately, I know a lot of very smart people who are very good at bonds.

So, I turned to some of my smart friends to answer the puzzling question above.  Through these discussions I learned a number of important things about the world in general and the bond market in specific.

1. The World is a Safer Place Now. With both the credit crisis and recession fading into the past, investors are once again comfortable with owning assets other than cash.  Stocks still may be viewed with some skepticism, but bonds yielding 2-4% are much more attractive than cash yields near zero.  So part of the enthusiasm for bonds is an asset allocation shift from cash to bonds.
2. Stimulus Money Needs a Home. The $3-4 trillion (more or less) in government stimulus money already spent needs to go somewhere.  We have seen the impact of all this liquidity in lots of places – commodities, oil, gold, stocks and bonds. Given the huge size of the bond market, it would not be surprising that it received a majority of this cash injection.  Oh, and the bulk of the approved stimulus spending is yet to come.
3. Inflation vs. Deflation Debate Good for Bonds. Although many expect inflation to eventually pick up sometime in the future, some of the credible bond market commentators are still warning about the threat of deflation.  Deflation is especially pernicious because it’s so hard to fix (consider Japan’s 20-year fight with it) once it takes hold.  Whether or not deflation becomes a problem, the fact that it’s still being mentioned as a threat gives many bondholders comfort that inflation will not be a problem in the near to medium term and that interest rates may remain stable for longer than most expect.
4. Low Interest Rates Benefit Many “Important” Groups. The aggressive monetary easing we are currently experiencing benefits a large portion of the economy, but especially the auto industry, the housing market, the banking industry (have you seen bank profits lately?), and other stressed groups.  Thus, bankers, politicians, unions, and lots of other highly-visible groups really, really like the status quo.  At some point, the Fed may see the need to raise rates, but we can image that Mr. Bernanke is being bombarded by many voices urging him to wait as long as he can.  This delay would be good for bond investors as well as these other groups.
5. The Futures Market is Calm. Although not an exact guide for what may happen in the future, the Fed Funds Futures market can give us a clue what investors are expecting from short-term rates down the road.  Right now this market is looking at a 1.35% Fed Funds rate by the middle of 2011.  This too argues that few expect any kind of aggressive tightening of monetary policy within the next 18 months.

So, what’s not to like about bonds?  Well, low yield for one.  Is the 10-year US Treasury bond a steal at 3.4%?  We are still seeing some deals in the corporate arena, but for the most part bonds look like “everyone” already loves them.  Does this make me bearish on bonds?  Not really.  I can also see the logic of owning them versus cash.

I guess my view on bonds is mixed, but the current enthusiasm for bonds does, at the margin, make me a little more bullish on stocks.  Why so?  The investors who were able to leave the perceived safety of cash for a little more yield in bonds will eventually find bond returns unacceptably low and turn to stocks.  The fact that this hasn’t happened yet gives me comfort that the new bull market has room yet to run.

It may seem a bit cliché to list the things for which I am thankful at this time of year, but Thanksgiving is such a wonderful holiday exactly because it offers us a chance to reflect on the good things in our lives.  Thanksgiving is also the last major U.S. holiday that has yet to succumb to consumerism (some may argue this point given its proximity to “Black Friday” and the consumer feeding frenzy it has become, but I would submit that “Black Friday” has nothing to do with the Thanksgiving holiday itself.  So there!)

So without further ado (and apologies to David Letterman), here are my top ten reasons to be thankful this year:

10. The New Bull Market. Many still cling to the fantasy that a 60%+ market move can be nothing but a bear market rally.  I believe they are wrong.  This new bull market began exactly where one would expect it (in the middle of the recession and at the peak of pessimism) and has climbed the proverbial wall of worry as economic data throughout most of the March to July period continued to show weakness.

9. Low Interest Rates. Not only do they help certain troubled industries (autos, housing, banks, etc.), but they are forcing investors to seek assets which can provide higher returns – like stocks…

8. Tons of Cash on the Sidelines. Many investors still fear the stock market.  Even after this huge rally and the beginning of a new bull market, many folks still hold a huge amount of their wealth in cash or money market funds earning less than 1%.  I view this as dry wood which will eventually be used as fuel to propel the market even higher.

7. Mixed Investor Sentiment. Some people are calling for a “double dip” for the economy.  Some still think that testing the March lows is a possibility.  Some think gold is the only “safe” asset.  Some are seeing new bubbles around every corner.  Some think the government is somehow propping up the markets.  What a fine, grand debate we have here!  The minority opinion still seems to be that stocks can move higher from here.  I guess I’ll have to side with the minority opinion (yet again…)

6. Graham & Dodd. The “fathers” of value investing gave me and others the tools to analyze stocks in our search for excessive returns.  Their work represents the foundation of my career and investment philosophy.  Their work has enabled me to spend my research efforts on measuring and not predicting.

5. Value Investors. The “children” of Graham and Dodd, such as Warren Buffet, John Neff, Christopher Browne, John Templeton, Marty Whitman, Bruce Berkowitz, etc., have provided me excellent role models, showing me that this value investing approach is workable and can be successful.

4. Jim Cramer and CNBC. As long as the media feels the need to provide us with an endless stream of “free” investment advice, I feel that my voice, which I hope is a voice of reason, needs to be heard.

3. The First Amendment. I’m thankful for a country which allows my voice to be heard.

2. Thomas Jefferson. Still my favorite founding father and a major inspiration to me.  “If we can prevent the government from wasting the labors of the people, under the pretense of taking care of them, they must become happy.”  Letter to Thomas Cooper (1802).

1. Opposable Thumbs. Most excellent for holding my grandsons, tossing the football at our annual “Turkey Bowl” and, of course, grasping that big drumstick at the big meal tomorrow surrounded by family and friends.

Bubble, Schmubble

Here we are just 8 months from the stock market’s bottom, a bottom, mind you, that was created by a massive credit crunch and the worst recession in decades, and already we are hearing talk that another bubble may be forming.  Some “experts” are trying to warn us that the government’s easy monetary policy and/or fiscal stimulus will be enough to drive the prices of some “stuff” (gold, commodities, stocks, houses, whatever, etc.) to new bubble levels.  First of all, we still struggle with the definition of a bubble.  It seems to me that we can only truly define a bubble after it has burst.  In the middle of the 1990s Tech Bubble, many were calling it a “bull market,” a “paradigm shift” or the “next big thing,” and not a bubble.  The tech executives, who became billionaires on the back of that bubble, would probably conclude that bubbles are not universally bad.  Some think that all of the world’s economic problems are due to the latest bubble.  I would consider this a topic worthy of a healthy debate.  Others think that new rules are needed to prevent the next bubble.  I would note that the financial services industry is one of the most highly regulated industries out there.  Also, to my knowledge no one has been convicted for breaking any laws in regard to this crisis.

Second, bubbles may be the natural result of rational people searching for irrational returns.  When a person could buy a house for no money down and no credit check and then turn around and sell it within six months for a $50,000 profit, why not do it?  There may have been warning voices at that time of potential negative consequences, but the allure of quick profits is simply too powerful to resist for some folks.  The same thing happened with amateur day traders in the late 1990s.  This part of human behavior has been observed over and over again at least from the South Sea Bubble in 1719.  As long as investors have the opportunity to place their money at risk for the possibility of reward, excesses, or bubbles if you must, are likely to occur.  Charles Kindleberger, in his excellent book, Manias, Panics and Crashes, agrees – “Speculative excess, referred to concisely as a mania, and revulsion from such excess in the form of a crisis, crash, or panic can be shown to be, if not inevitable, at least historically common.”

Third, much of the bubble talk heard these days appears to be centered on one of my big pet peeves – the ceteris paribus (all else held constant) argument.  This line of reasoning goes something like this – “If the current trend (weak dollar, loose monetary policy, rising stock prices, whatever) continues without changing (this is the ceteris paribus part), bad things will happen.”  This argument is cheap and easy to use (probably why we see so much of it in the media) and it has a certain amount of appeal to it.  It’s almost always hard to disagree with the conclusion and it usually seems to make sense.  The fact that things always change rarely surfaces when the ceteris paribus guys are around.  Things always change.  Supply will increase to meet more demand.  Higher prices will eventually lead to lower incremental demand.  Occasionally, a black swan flies in to change all expectations and assumptions.

It seems wise to keep a vigilant eye on the signs and evidence of bubbles, but from my vantage point, I see nothing bubbly about the stock market right now.  Valuations are reasonable, money on the sidelines is plentiful, sentiment is still mixed and earnings are still growing.  Sounds like a recipe for anything but trouble.

“Double, double toil and trouble; Fire burn, and caldron bubble.”

– The Witches from Shakespeare’s Macbeth

On this day of honor and reflection, I wish to pause and add my thanks to the millions of brave men and women who have served and are now serving our country in the military.  I grew up during the Vietnam War, a period of US history where feelings about the military and war where very confused.  However, to the members of the “Greatest Generation” in my family, military service was considered an unequivocal privilege and an honor.  Four of my uncles are veterans.  My mother served in the Women’s Army Corps (WAC) during the Korean War, and my aunt Lilah was a career WAC.  Those of us who have never personally faced the horrors of war can only stand in awe of those who had the fortitude and courage to serve this way.  We salute you!

“History does not long entrust the care of freedom to the weak or the timid.”

— Dwight D. Eisenhower

During the last year we have seen some spectacular (and rare) events. From the credit crisis last Fall which generated enough serious concern to compel the US government to “bail out” a number of large companies, to the nearly-unprecedented rally in the stock market from March, these are strange days, indeed. The biggest problem with these unusual times (aside from losing money, of course) is that they tend to skew our perception of what is normal or usual. In less volatile times, most of us have a clear idea of where the borders of normalcy lie. Occasionally, something happens that makes us think, “Hmm, now that’s unusual,” but most days, time marches on in a steady and familiar beat.

In more volatile times, we tend to assume that anything can happen, no matter how low the chances really are. “If Lehman Brothers can fail,” we muse, “why not ALL the investment banks?” “If AIG can be driven to the brink, why not ALL insurance companies?” “If stocks can fall 40%, why not 100%?” Whereas before one “black swan” would have evoked appreciative “oohs” and “ahhs” of wonderment at its rarity, we now expect flocks of them descending into our turbulent ponds. Much of the commentary I see continues to suggest that the events of the last 12 months are the “new normal.” Some experts still call for stocks to revisit the March lows. Others think that the economy will sink back into recession. Still others predict that the US dollar will continue to fall due to the US government’s massive budget deficit or a permanent lack of confidence that the US economy can ever again maintain sustainable growth. To all this, I say “poppycock.”

I still believe that the four most dangerous words in the investment parlance are “this time is different.” Investing is an exercise in probabilities, and those who are always counting on a highly unlikely outcome generally perform a lot worse than those who operate within the bounds of normal distributions. Let’s take a look at the US dollar for an example of this. The chart below shows the S&P 500 compared to the US dollar over the last few years.

In normal times, we expect the dollar and the stock market to move together – what’s good for stocks is generally good for the currency. This is the normal relationship. As seen in this chart, when the crisis hit last year the dollar became a “safe haven” currency and appreciated vis-à-vis other currencies, and at the same time stock prices fell. In March, the spread between the dollar and the S&P 500 peaked. At this point, anyone who thought that the “normal” relationship between the US dollar and the stock market should return would have shorted the US dollar and bought stocks. The chart shows that since March, indeed the US dollar has weakened and the stock market has risen. The purported reasons for these moves are legion in number, but most commentators will talk about the big, macro factors. Smaller factors like simple reversion to the mean, in other words, returning to normal, seem to be too insignificant to be real. I wonder.

So what do I think “normal” is right now? First, the economy is recovering in a fairly normal fashion from its recessionary trough. The pace may be below past recoveries, but many of usual elements of the recovery are there. The stock market is also responding in a normal fashion to the key drivers of performance – earnings, interest rates and sentiment. The media is also acting as one would suspect – searching out the most sensational stories or highlighting those experts with the most extreme opinions. After all, “normal” is not newsworthy. Finally, I think that many retail investors are acting in line with expectations. Some of them sold near the bottom and continue to hold cash ($4 trillion is still sitting in money market funds), waiting for the “all clear” signal from someone they can trust.

In a “normal” bull market, we should expect stock prices to rise over time with the occasional correction of 10% or so. The next time stocks begin to look a bit weak, we should try to avoid the natural tendency to think that they are somehow destined to go back down to the March lows, and simply accept the correction as a normal part of this new bull market.