Persuasion Time

I received a call last week from a friend who used to actively help me invest my money.  Because our skills were different, but complementary, we were actually able to help out each other quite a bit.  Time moves on, circumstances change and we find ourselves not working together as before.  As he was looking through some old records, he found a list of stocks I had owned when we were working together.  To the best of my recollection, this list comprised of stocks I owned back in 2007.

During our call he noted the prices of these stocks I’d owned then and their prices now:

Stock              Old Price       Now Price    Percent Change

“A”                 $33                 $69                 +109%

“B”                  $20                 $25                 +25%

“C”                 $12                 $9                    -25%

“D”                 $31                 $39                 +26%

“E”                  $47                 $66                 +35%

“F”                  $44                 $57                 +30%

“G”                 $58                 $87                 +50%

The average return for these stocks is around 35%, which sounds great by itself.  The real kicker was when he mentioned the market’s return over the same period:

S&P 500         $1411             $1388             -1.6%

This last bit of information changed the returns from the stocks mentioned from “good” to “exceptional.”  This simple exercise re-enforced a fundamental and critical idea which lies at the heart of all that I do as a professional investor – “You can beat the market!”

Too many people (in my opinion) have bought into the notion that the efficiency of markets precludes ANYONE from doing better than market returns.  Support for this idea usually comes in the guise of aggregate returns for mutual funds.  Yes, according to these data, the “average” return of all mutual funds can lag the market from time to time.  There are a number of reasons for this (which are beyond the scope of today’s note), but nowhere do the data support the conclusion that NO ONE can ever beat the market.  In fact, these studies show that nearly half of the funds measured beat the market in any given year.

“But”, the skeptic may say, “can anyone beat the market consistently?”  Here too, the data seems to lead one to this conclusion.  The trouble is that most studies will look only at annual or quarterly returns.  I will readily admit that it is nigh to impossible to beat the market each and every quarter and year.  If one is suggesting that “beating the market” means only to outperform it each and every year, then, yes, no one can do that.  But, if it means to have above-market returns for a long period of time, then many, many people do this on a regular basis.

Bill Miller, who worked at Legg Mason, had an epic record of beating the S&P 500 for 15 years in a row.  Many other mutual fund managers and hedge fund managers have 5-, 10- and 15-year records well above the markets’ return.  Saying that NO ONE can beat the market because the AVERAGE mutual fund doesn’t, is like saying no one can make it into Harvard, because the average applicant doesn’t.

So why would anyone want to invest in an index fund that is designed to provide market returns?  First of all, it seems easy.  Stock picking is hard work and not everyone has the time, skill or energy to do it.  Buying an index fund allows one market exposure without having to worry about individual stock selection.
Second, it can be a more inexpensive way to invest.  Index funds usually have lower fees than mutual funds.  An actively managed portfolio, whether it’s a mutual fund or a group of individual stocks, may have higher fees and commissions attached to it.

Third, it seems less risky.  Here is where the water gets a bit muddy.  True, owning an index fund is less mathematically risky than owning one or two stocks, but it may not be less risky than owning a mutual fund or a well-diversified portfolio of individual stocks.  This is simple math.  In the case of my stocks from 2007, owning the market was the more “risky” option.

So what’s wrong with index investing?  In my view, it guarantees that you will not beat the market.  It locks one into a return no better than the broad average.  In a decade like the 1990s, this would have been fine.  For the last ten years, much less fine.

Also, the way an index fund is managed assures that it will constantly buy high and sell low.  That is, it will always be buying more of the stocks which do well (and have become a larger part of the index) and selling some of the stocks which underperform.  To the value investor (like me) this seems exactly wrong.

Now a lot of smart people invest in index funds.  And another bunch of smart people spend millions of ad dollars each year trying to convince the public that index investing is the “best” way to do it.  It may be well beyond my power to “prove” that index investing isn’t a good way to invest, but I am pretty sure that it’s not the best way for EVERYONE to invest.

I don’t do it.  My clients don’t do it.  And maybe, just maybe, everyone who is doing it should make sure they’re doing it for all the right reasons.

That is the question.

Because I am a capital markets guy, whenever I speak with somebody, the conversation usually gravitates to the markets, the economy, investment philosophies and so forth.  It’s like the old saying “When you’re holding a hammer, everything looks like a nail.”  All my world views (and most casual conversations) tend to be reflected through the prism of the capital markets.

Not too long ago I spoke with someone about my personal trading discipline.  I buy stocks that I think are undervalued.  I tend to sell only when 1) I think a stock has been overvalued, 2) a stock has appreciated so much so as to represent an uncomfortably large part of my portfolio or 3) the fundamentals of the story change in a meaningful and clearly negative way.  I tend to hold my stock positions for a long time, but may trade around them for the occasional short-term profit.  I don’t think I invented this discipline nor do I dare hold it out as the “best” way to trade.  It simply works for me.

When I explained my method to my friend, he suggested that I must really trade a lot.  I inferred that he thought I traded way too much for what he thought was optimal.  I guess he imagined a “buy and hold” strategy when one never (or rarely) trades as being a better way to invest.  Indeed, many studies exist showing the merits of a “buy and hold” strategy, which appears quite effective, especially over long holding periods.  I tried to defend my approach as best I could, but the sense that I was somehow doing something wrong lingered after our chat.

A few days later I had occasion to speak with another friend and, lo and behold, our conversation drifted into the realm of investment philosophy and trading techniques.  After once again explaining my way, a vague sense of disapproval appeared in the visage of my friend.  “Why don’t you trade more?’ he asked, “You could do much better if you traded more often.”  Here too, he could produce compelling research supporting his notion that more trading is better.  Once again I left the encounter with the sneaking suspicion that I was somehow mistaken in my approach.

As I reflected deeply on these two exchanges, I concluded a number of things: 1) most professional investors are a bit neurotic (in a good way, of course…); we are probably never as certain about anything as we profess, nor as calm as we may appear on the outside.  2) It’s important for me to find “my way” and not “THE way” when it comes to investment style.  There are innumerable ways to invest, all with strengths and weaknesses, but the best way for me is the one I am most comfortable employing.  Whether or not one is a professional or not, understanding and being comfortable with the way one’s portfolio is being managed is critical.  Otherwise, one is apt to be blown around by every popular and “reasonable” investment fad of the moment.  3) I need a new topic of casual conversation.  Maybe politics…  That sounds like a nice, cordial choice…

This week at our Investment Policy Committee meeting, I asked the members of the committee to choose one of the following possible scenarios for the market this year:

1)     The S&P 500 will close roughly where it is right now (1400)

2)     The S&P 500 will close higher than it is now without a meaningful correction.

3)     The S&P 500 will close lower than 1400.

4)     The S&P 500 will experience a sizable correction midyear and then close somewhere around 1400.

Before I share with you our committee’s responses, please take a minute and decide which of these possible scenarios you think is most likely…

Interestingly, all of us decided independently that #2 was most likely in our opinion.  What do you think?

I then asked them which of the scenarios they thought was the consensus expectation of the market.  Here too we were in total agreement on#4.

An old-timer once told me that Mr. Market tends to do that which greatly “discomforts” (not his exact words) the greatest number of people.  So, our conclusions were consistent with that.  If everyone is expecting a correction, then an unabated rally would be discomforting.  If everyone was expecting ever higher prices (like back in the 1990s), then a big correction or new bear market would be surprising.

I don’t make predictions and really don’t have a strong opinion about what the market will do over any short period of time.  I do feel very strongly about the stocks I follow and own for myself and my clients.  I think they will do very well (on average) over time.

But let’s return to our assessment that the consensus is expecting a correction.  For the last two years, “sell in May and go away” would have been a good tactic.  I suspect that many people are thinking of doing this again. But, the market is rarely that predictable.  It’s not some clockwork dummy that responds in simple ways to mundane stimuli.  It’s a very complex system that incorporates the collective opinions and views of thousands of very smart investors and their smartest computers.

Another reason people may be expecting a correction may be still-tender scar tissue from the 2008-2009 global financial crisis.  I still hear people talk about the “volatility” in the market.  The VIX (the standard measure of volatility of the S&P 500) right now is 14.83, near the lowest reading for the year.  The VIX was around 24 in January (the high for the year).  In the worst days of the crisis it was 80.  Last year it peaked in the 40s.  I understand how people could say that last year was volatile or that 2009 was volatile, but to suggest that the market is overall volatile greatly puzzles me.  The current level of volatility matches up very nicely with the calm period of the mid 1990s or even the 2003-2007 period.  Right now the market is not volatile.

The second thing I hear that I really don’t understand is people referring to the “recession” as if it’s still happening.  The U.S. economy is not in recession.  In fact, we are nearly 3 years into the economic expansion which began in June of 2009.  One could argue about the level, pace or pattern of the recovery, but its sustainability should not be an issue or an item of debate, three years on.

Both of these fears – “volatility” and “recession” may be key reasons why retail investors have not fully embraced the equity market, which by the way, just passed the three-year mark of the current bull market run.

To review – volatility is at a five-year low, the economy has been growing for 12 consecutive quarters and the stock market has been rising for three years.

Now for the good news.

Companies are in great shape – profit margins are high, as are cash levels.  The housing market seems to be perking up a bit.  Valuations are reasonable.  The consumer seems to be in better shape than the past.  Expectations have risen but are still far from wildly bullish.  As long as I keep hearing talk of volatility and recession, I will likely continue to be hopefully optimistic about the stock market.  If a correction happens, I will be looking to buy some cheap stocks.  If no correction comes, I will be enjoying the rising tide with everyone else fully invested.  If something else happens, I will adapt and adjust as I always do.

Enjoy the ride.

One of my favorite parts of the movie “My Big Fat Greek Wedding” is the liberal use of Windex as an antiseptic, pain killer and all-around cure-all.  I think it was so funny because its use seemed so far out of my cultural experience, yet was very cute and at some level actually made sense (it contains isopropyl alcohol, after all).

Sometimes I get the feeling that many individual investors approach the investment process with a mélange of clichés, old wives’ tales, fables, and home remedies.

Here are some classic examples:  “Sell in May and go away.”  “Cut your losses, but let your winners run.”  “Real estate is always a good investment – after all they aren’t making any more of it.”  “Things will never be the same again (heard personally by me in 1987, 1991, 1999, 2001, 2008, etc.)”  “This time is different” (heard nearly every time it’s not different).   “Sell to the greedy, buy from the fearful.”  “Buy on the rumor, sell on the fact.”

There are many, many more, but we hear these kinds of statements from the market commentators out there on a regular basis.  In a certain context, each of them makes sense and might actually be helpful, but taken together they form a messy mingle-mangle – clearly not appetizing and potentially hazardous to one’s health.

First of all, it’s important to understand that there are many different types of investors, all of whom have different objectives, styles, tools, and language.  Traders, who care about short-term movements in asset prices, will rely heavily on technical indicators, charts and the day-to-day news flows.  “Cut your losses and let your winners run” makes a lot of sense for these kinds of investors.

For the “average” individual investor, who may be saving for long-term needs such as retirement, the strategies will be very different than for a short-term trader.  A short-term trader’s “neutral state” may be 100% cash.  The trader may only invest when the opportunity arises.  Longer-term investors may hold no or only a little cash, expecting the greatest bulk of their returns to come from the big, broad movement of asset prices, not the daily fluctuations.

The second key element to understanding all this is asset allocation.  Studies have shown that equities provide the highest return of all asset classes over the long run.  Yet, investors with income needs or who simply feel worried about the volatility inherent in stocks will allocate some portion of their portfolio to bonds and/or cash.  I personally approach asset allocation of as a measure of risk tolerance and not as a forecast on which asset class will perform better over some short period of time.  Changes in circumstances, age, family size, etc. may lead to changes in asset allocation, but how we feel about the markets may not be a great reason to change one’s asset mix.

At any point in time, we all have an impression or feeling about how things are going in the economy, in the markets, etc.  Usually the tone of these impressions is strongly colored by the direction of the stock market.  When the market is declining, we tend to be less optimistic about its prospects.  As it rises the opposite occurs.  By simply giving in to these impressions, we could easily sell stocks (or fail to buy them) when we should buy them and conversely, buy them at high levels.  This tendency is why most do-it-yourself individual investors tend to “buy high” and “sell low,” and hence, underperform the market.  We all may feel pretty good about the stock market these days, but the “best” time to have added to stock exposure would have been in the August to October period when the market had dramatically declined and we were in the midst of what was feared could be a major meltdown in Europe.  To the average person, buying more stocks at this time would have been very difficult.  Yet, it would have been the “right” thing to do.

This is where a disciplined asset allocation and rebalancing strategy can help.  Let’s assume we had a 50/50 stock/bond portfolio at the beginning of 2011.

For the year, doing nothing, this portfolio would have returned about 4.5% total return (these returns are index returns – your millage may differ).  Simply by rebalancing twice during the year – once in the April-May period and once again in the August-October period – one could have increased total return by as much as 270 basis points to around 7.2% for the year.

This increased performance does not assume perfect market timing or foreknowledge of what the market was going to do.  That is the beauty of portfolio rebalancing.  At its best it can add to total returns with little effort.    At a minimum, rebalancing encourages one to “buy low and sell high,” one of the investment clichés I really do like.

Today Eastman Kodak (EK), an icon of American capitalism, filed for bankruptcy.   The 100-year-old company had been in trouble for many years as the shift to digital imaging dramatically reduced the demand for its products.  

Early in my Wall Street career, I was a photography analyst.  I was the “guru” for my firm on the photography industry and covered stocks such as EK, Polaroid, Fuji Film and so forth.  I visited Rochester many times and met with EK management on numerous occasions.  EK, in many ways was a victim of its own success.  The silver halide technology which made photography possible also created a very, very profitable product – photographic film.  By all estimates, the gross profit margin on photographic film was around 80%.  EK tried over the decades to use all of its cash flow and profits to fund other businesses.  None were as profitable or stable as the film business.  

After a while it seemed that management was simply trying not to mess up a great business – the goal was not to move on to bigger and better things, but just try to maintain market share and hang on.  By the time the digital threat became serious, EK was already far behind.  It never caught up, and now the reality of the new digital age has caught up to it.

In many ways, EK is a poster child of Schumpeter’s idea of “creative destruction,” which is often used to describe capitalism’s messy way of delivering progress.  Because new, potentially disrupting technology always looms on the horizon, companies must not be afraid to make dramatic changes that may hurt in the short run, but which over the long haul often prove to be a saving grace.  Apple (AAPL) has done this many times over the last decade.  EK did not.

This is one reason predicting the future is so difficult.  The marketplace is constantly changing, and the best companies are prepared to change with it.  Being big or having a dominant market share provides no guarantee for future success. 

I love the idea that some large portion of jobs in the future will come from technologies not yet invented.  Who knew that social media companies would become so big and create so many jobs? 

One of the great pleasures I derive as an investment generalist is researching and analyzing a broad range of companies in many different industries.  Along the way, I learn a great deal about how good management teams run their businesses.  And the dynamism of the markets keeps me ever engaged and looking for the next bunch of really great investments.  So even as formerly great companies like EK fade away, new ones will be born, small ones will get bigger, and investors who can find the gems will be rewarded for their insight, diligence and patience.

To the average citizen, is there any scarier U.S. Government Agency than the Internal Revenue Service (IRS)?  For my entire life I have paid my fair share of taxes, on time, and in accordance with the law (as far as I could figure it out).  Despite a few yellow flags on my returns now and again (high levels of charitable contributions, for example), I have never been audited.  Yet, nothing gets my heart pounding like seeing something in the pile of daily mail from the IRS.  Once they thought I had been a soldier (!) in Iraq (working for the U.S. military, I assume) and was entitled to some kind of combat-related tax break.  It took a few phone calls and letters to convince them they had made a mistake.  One time, they informed me of a mistake I’d made and sent me a check.  I happily cashed it.  Another time, they informed me of a mistake I’d made and demanded more money.  I happily paid them.  In all these cheery exchanges I never really felt threatened or treated harshly by the nice folks at the IRS.

But now, “No More Mr. Nice Guy” appears to be the new theme song of the IRS.

As reported by Bloomberg this morning, the IRS is rolling out a third so-called amnesty program aimed at collecting taxes on foreign accounts held by U.S. citizens and other U.S. residents.  Unlike the first two programs, which by the way were wildly successful (or horribly painful, depending on which side of the deal one was on) – bringing in $4.4 billion in new revenue from 33,000 taxpayers, this one has no stated deadline, but there is no guarantee that the program will be available indefinitely.  The new program does have a higher penalty (27.5% on the highest balance in one’s offshore account) and the ever-consistent threat of criminal penalties for non-compliance.  The IRS has upped the ante in several other ways.  They are also targeting any and all tax-haven banks, bankers and other financial professionals who may have aided taxpayers who failed to disclose information about these accounts.

“Well,” you may be saying, “I have never been a member of an international crime syndicate, a gun runner or drug smuggler.  Surely this program does not and cannot apply to me!”  Much like the big nets tuna fishermen used in the past that would also swoop up dolphins, this program does target anyone who has ever, in the last 8 years  held any kind of undisclosed financial account (saving, brokerage, checking, deposit, etc.) anywhere outside the U.S. or whose name may appear on such account anywhere.  In many countries it is customary for a parent to include the names of children or even grandchildren on bank accounts.  If those children or grandchildren are U.S. citizens or maintain a U.S. address, guess what?  They are potential targets for this program.

Maybe you bought a small piece of real estate outside the U.S. years ago.  When you transferred the money from your U.S. bank to the local foreign bank, did you think to file all the required IRS and U.S. Treasury documents?  If not, you are a target for this program.  If you worked for your U.S.-based company for a few years as an expatriate overseas and opened up a checking account with a local bank for your daily needs, guess what?  You will be targeted by this program, if you failed to file the required paperwork.

“But,” you may be saying, “My company handled all that kind of stuff when I worked overseas.”  Maybe it did, maybe it didn’t, but for certain it will not face criminal penalties for non-compliance. You might.

“Yeah, but,” you may be saying, “I have a tax professional who handles all this stuff.”  I’m no tax expert, but my sense in talking to people who really know this stuff well, is that this program and all of the related regulations reside in the realms of deep esoterica.  Some of the details of the new program are still kind of fuzzy.  The “average” tax preparer may not know this stuff well enough to keep you safe from the growing aggressiveness of the IRS.

The language, tone and scope of this program scare me to death. I sense that many people still feel that somehow, some way it doesn’t really apply to them.  Or they think that the IRS is simply overreaching.  Or that the IRS really doesn’t care about their checking account in the Czech Republic.  I understand these feelings, but they are wrong.  In my view, the program can be summed up this way, “go to them before they come for you.”  If you think that’s hyperbole, consider this quote from Doug Shulman, the IRS Commissioner regarding this new program, “If we catch them [you] involuntarily, it’s going to be much worse for the taxpayer [you].”

Forewarned is forearmed. ‘Nuff said.

To the average citizen, is there any scarier U.S. Government Agency than the Internal Revenue Service (IRS)?  For my entire life I have paid my fair share of taxes, on time, and in accordance with the law (as far as I could figure it out).  Despite a few yellow flags on my returns now and again (high levels of charitable contributions, for example), I have never been audited.  Yet, nothing gets my heart pounding like seeing something in the pile of daily mail from the IRS.  Once they thought I had been a soldier (!) in Iraq (working for the U.S. military, I assume) and was entitled to some kind of combat-related tax break.  It took a few phone calls and letters to convince them they had made a mistake.  One time, they informed me of a mistake I’d made and sent me a check.  I happily cashed it.  Another time, they informed me of a mistake I’d made and demanded more money.  I happily paid them.  In all these cheery exchanges I never really felt threatened or treated harshly by the nice folks at the IRS.

But now, “No More Mr. Nice Guy” appears to be the new theme song of the IRS.

As reported by Bloomberg this morning, the IRS is rolling out a third so-called amnesty program aimed at collecting taxes on foreign accounts held by U.S. citizens and other U.S. residents.  Unlike the first two programs, which by the way were wildly successful (or horribly painful, depending on which side of the deal one was on) – bringing in $4.4 billion in new revenue from 33,000 taxpayers, this one has no stated deadline, but there is no guarantee that the program will be available indefinitely.  The new program does have a higher penalty (27.5% on the highest balance in one’s offshore account) and the ever-consistent threat of criminal penalties for non-compliance.  The IRS has upped the ante in several other ways.  They are also targeting any and all tax-haven banks, bankers and other financial professionals who may have aided taxpayers who failed to disclose information about these accounts.

“Well,” you may be saying, “I have never been a member of an international crime syndicate, a gun runner or drug smuggler.  Surely this program does not and cannot apply to me!”  Much like the big nets tuna fishermen used in the past that would also swoop up dolphins, this program does target anyone who has ever, in the last 8 years  held any kind of undisclosed financial account (saving, brokerage, checking, deposit, etc.) anywhere outside the U.S. or whose name may appear on such account anywhere.  In many countries it is customary for a parent to include the names of children or even grandchildren on bank accounts.  If those children or grandchildren are U.S. citizens or maintain a U.S. address, guess what?  They are potential targets for this program.

Maybe you bought a small piece of real estate outside the U.S. years ago.  When you transferred the money from your U.S. bank to the local foreign bank, did you think to file all the required IRS and U.S. Treasury documents?  If not, you are a target for this program.  If you worked for your U.S.-based company for a few years as an expatriate overseas and opened up a checking account with a local bank for your daily needs, guess what?  You will be targeted by this program, if you failed to file the required paperwork.

“But,” you may be saying, “My company handled all that kind of stuff when I worked overseas.”  Maybe it did, maybe it didn’t, but for certain it will not face criminal penalties for non-compliance. You might.

“Yeah, but,” you may be saying, “I have a tax professional who handles all this stuff.”  I’m no tax expert, but my sense in talking to people who really know this stuff well, is that this program and all of the related regulations reside in the realms of deep esoterica.  Some of the details of the new program are still kind of fuzzy.  The “average” tax preparer may not know this stuff well enough to keep you safe from the growing aggressiveness of the IRS.

The language, tone and scope of this program scare me to death. I sense that many people still feel that somehow, some way it doesn’t really apply to them.  Or they think that the IRS is simply overreaching.  Or that the IRS really doesn’t care about their checking account in the Czech Republic.  I understand these feelings, but they are wrong.  In my view, the program can be summed up this way, “go to them before they come for you.”  If you think that’s hyperbole, consider this quote from Doug Shulman, the IRS Commissioner regarding this new program, “If we catch them [you] involuntarily, it’s going to be much worse for the taxpayer [you].”

Forewarned is forearmed. ‘Nuff said.

Anyone who is a regular reader of this blog will know that I do not make predictions.  I have learned over the years that most predictions are wrong and that the more complex the issue being predicted (the weather, stock market returns or U.S. Presidential elections, for example), the greater the chance the predictions have of being wrong.

Yet, there is something in the human psyche that craves order in the midst of chaos.  Hence, we are all enthralled by any confident “guru” who claims to know where the S&P 500 will be at the end of the year or who the next President will be.  And who am I to not try to satisfy this basic human need?

So, with tongue firmly in cheek, I humbly present my “bold” predictions for 2012.

1)     The World will not end on December 21^st.  I realize that handicapping the Apocalypse is a bit out of my pay grade, but my quick study of the Mayan calendar suggests that they really weren’t predicting the end of the world, just the end of another one of their calendar periods.  It seems that they could not imagine being around after the end of their 13^th big calendar period (which ends on December 21, 2012).  They weren’t.  Despite their prowess at astronomy, they were not able to predict their own demise, much less the end of time.  Feel free to make long-term plans…

2)     The U.S. will either re-elect a Democrat or elect a Republican.  I am not a political “guru,” but I feel pretty confident about this prediction.  The good news here is that according to Ken Fisher, either of these outcomes is good for the stock market.  In fact, his research suggests that the best years for the stock market happen when either one of these things occur.  Feel free to vote for either candidate and buy stocks…

3)     A politician will become embroiled in a scandal.  Feel free to quote me on this one…

4)     The markets will continue to display volatility.  That is, that prices of publicly traded assets will change, fluctuate or otherwise move.  Note that I am not predicting the level of volatility or offering any opinion about the pace or rate of changes in volatility.  And as a nod to my last blog (here), I am not predicting declines in asset prices, just that they are likely to move around.

5)     The S&P 500’s return for 2012 will not be 10%.  Yes, I am aware that 10% is the long-term average for the market, but a quick look at history will show that the market rarely returns its average.  Stock market returns are lumpy and rarely provide the return expected on an annual basis.

6)     Most of the predictions about the S&P 500’s returns this year will be wrong.   It appears that the consensus from the professional forecasters is calling for a 7% return for the S&P 500 this year.  If the collection of forecasts falls into a normal distribution (as it usually does), and if the market tends to surprise the consensus (as it usually does), 7% is also probably not a good guess of the market’s actual return for the year. Consider this, if we only had two predictions, +24% and -10%, the average would be +7%, but this single number would tell us very little about the nature of the estimates from which it is derived.  I much prefer estimates that mention a range or simply a direction rather than a singular, simple number.

7)     Nouriel Roubini will find a compelling reason to be negative.  Okay, this may be a cheap shot, but those who choose to be bearish will always have grist for their mills.  The Utopian “all is well” scenario never exists.  At any point in time, there are significant problems or threats facing any given economy, nation or market.  People tend to believe what they want to believe and disregard any evidence contrary to these beliefs.  One of the most perverse things about the stock market is that pessimism is generally considered a positive.  The market tends to climb the proverbial wall of worry.  The more press coverage Mr. Roubini gets, the more bullish I become…

8)     The Kardashians will completely shun all media and effectively disappear from our view.  This is more of a wish than a forecast =)  Who are these people, and why are they famous?

Here’s to a healthy, prosperous and happy New Year!

Maybe it’s my background as a language major in collage.  Maybe it’s my general penchant for prose.  But, there is something about language that truly fascinates me.  The active math/science part of my brain also seeks for clarity of logic and precision in communication.  So imagine my consternation whenever I begin to hear and read things about the markets that I know is unclear, imprecise and/or just plain wrong.

The latest target of bewilderment is the concept of “volatility.”  Everyone knows [quick aside: whenever you hear anyone say “everyone knows” be on your guard – the words that follow could lead you to a profitable trade – by doing the opposite] that the markets this year have shown unusual volatility.  I have probably heard/read comments along this line hundreds of times (I read a lot) this year.  For most people, hearing something over and over leads them to accept it as true.  To the contrarian, it has the opposite effect – the more I hear something the less I believe it.  In my heart, I believe that the consensus (about most things) is generally wrong.  I can produce reams of research that support this, but I find it nearly impossible to convince anyone of this fact.

So we all (except me, maybe) think that the market has been “extra” volatile this year.  Is there a way to measure this?  Volatility, at its heart, is a measure of the price variation of a financial instrument over time.  Looking at the VIX (which measures the volatility of the S&P 500), we can see that the second half of the year appears more volatile than the first.

Yet, looking at a 2-year chart, we see that even the current volatility is much less than the peak levels of this and last year.  Does anyone remember the worries and “volatility” of last May?  It seems (according to this chart) that last year was as “bad” as this year, and yet no one talks about the increased volatility of 2010.

Looking at the five-year chart of the VIX, we can gain even more perspective on this issue.  The volatility spikes experienced in late 2008 and early 2009 are roughly 3 times the level of the current volatility.  So, one way to say it is that the S&P 500 is 70% less volatile than it was at that time.  While this is true mathematically, this notion seems out of synch with the common knowledge of the day, that the market is somehow “more volatile.”

This is the point where unclear thinking and imprecise language can trip us up.  When I hear “volatility,” I am thinking “variance from the mean.”  I suspect most professional investors would agree.  When others use this word, I sense they take it to mean “the market is down (or a recent variant ’broken’)” or “I am losing money.”  So how much money have investors lost this year, this year marked by this supposed increased volatility?  As of this writing, the S&P 500 is down about 2% for the year, which means the total return (including dividends) is around zero.  Not a great year for stocks to be sure, but not horrible.  Not as bad as one might expect given the “increased volatility.”  Your results may vary.

The key concept here is that volatility affects mostly how we feel about the markets.  Most of us would like the stock market to provide stable, linear returns of 10% or more each year.  But, alas, that is not its nature.  Its nature is to provide an average return of 10% over time with lots of volatility.  The market almost never returns 10% in a calendar year.  To expect this means you almost always will be either surprised or disappointed.  Left to their own devices, the average individual investor tends to sell when things look bad (or “volatile,” if you will) and buy when things have “stabilized” (another imprecise word that usually means “the market has gone up”). I have tons of data to support this premise as well, but well, it’s hard to explain this to anyone who feels bad because the market is “volatile.”

Looking at the performance figures available, this has been a frustrating year for many professional investors.  It’s been a very hard year to “beat the market.” Yet for those investors who thrive on volatility (traders, quants, computers, etc.), it’s been a very good year.  As a long-term investor who does not trade actively, I fit into the former category.  Yet, I am encouraged by the progress individual companies are making.  Economic worries will come and go, but ultimately for stock pickers like me, the fortunes of individual companies will be more important for my returns than the economy, government policy, currency, or even “the market.”  Here’s to a better year in 2012 (historically U.S. Presidential election years are good for the market) and more intelligent commentary (that is to say, commentary that is more intelligent – sorry for being imprecise…) from the “gurus” on television.  Skål!

There is a certain amount of intuitive appeal in the daily chattering of stock market commentary.  We have all been taught from the time we were wee little investors being dandled on our pappy’s knee that there is always a reason for the market’s daily movement.  There are several television channels and countless Internet websites dedicated to explaining the daily “reason” which all seem to have short memories, a limited sense of accountability and a brash confidence that would humble your average high school starting quarterback.

This concept is brilliantly highlighted by the simple daily market commentary headlines on Yahoo Finance.  We often joke around the office that the job of writing these headlines must go to the most junior person on the team, because it is really a thankless job that is nearly impossible to do well.  If the stock market falls 2% at the open, this young go-getter probably calls around to find out why.  The “reason” soon appears front page and center “Stocks Fall on Worries about Italian Debt Plan” (or whatever).  Thirty minutes later the market is up 1% and, lacking a good reason for this turnaround, the hapless intern updates the page with something like, “Stocks Rally Despite Worries about Italian Debt Plan.”  This may seem like an extreme example, but I have seen many headlines like this.

This desperate search for the “reason” would be fine comedy if it weren’t for some poor widow in Minot adjusting her asset allocation based on this kind of chatter.  I realize that I am some times hard on journalists, but I think the real problem for me here is that daily stock movements and journalism are not a good combination.  When everyone was day trading back in the go-go 1990s, it might have made some sense to listen to the market pundits 24/7.  Now, I’m not so sure.

One thing I learned in business school is that companies exist to make profits (profound, eh?).  I suspect that this applies to the media outlets who report exclusively on the markets as well.  As I understand it, these companies are paid by advertisers who will pay based on the size of the audience these outlets can attract.  So, while these outlets may feel obliged to comment on daily market news, they also have a fundamental need to increase viewership.  This may lead to the bad combination I hinted at above.  If one were really dedicated to helping individual investors make money and reach their financial goals, I think they would feature professional money managers who could offer solid, actionable, long-term advice to their listeners.  Instead, we get academics, traders, authors, government officials, economists and a host of other “gurus” who may not be skilled investors and who may not really have our best interests at the top of their priority chain.

Again, I am not a trained journalist, so I may be totally wrong on this, but which headline do you think is “better” for these outlets?  “Roubini: Italy at risk of exiting euro  zone” or “Buffet: Stocks Look Attractive for Patient Investors.”  The problem with the Buffett quote is that he says things like this all the time.  It’s not really newsworthy, but it’s loads more helpful to the individual investor than the other one.  On the other hand, the Roubini quote may lead to a spike in viewership.  Which is better? Hmmm.

The data show (see the work of Dalbar) that the individual investor, in aggregate, is 1) bad at market timing and 2) highly influenced by the sentiment of the moment.  Even a very smart investor with a workable investment philosophy and approach can fall victim to the whipsaw action of sentiment.  Lauren Templeton, a professional money manager (and grand niece of the Sir John Templeton), at a recent conference suggested that there are three ways to “beat the market.”  Better information, better process or better behavior.  These days it is impossible for the individual investor to have better information or a better process vs. the big professional investors.  But, better behavior can still be applied to beat the market.  The problem is most investors behave badly when it comes to the market.  They feel like selling when they should buy and vice versa.

One simple way to improve one’s investing behavior is to not listen to the daily chattering.  If the market is down, maybe it’s because of some Euro problem, or maybe it’s just a lot of people freaking out about the fears they have in their hearts and heads.  The market being down (or up for that matter) may affect how you feel, but it should not change the way you invest, unless of course, you instinctively want to buy when it goes down and sell as it rises.  Ultimately, the stock market cares about three things – earnings, interest rates and sentiment.  Earnings are fine right now, up 12% in the latest quarter (which, by the way, marks the ninth quarter in a row of solid earnings growth) and 2012 should be another good year.  Interest rates remain low and the Fed has promised no tightening before 2013.  Sentiment, which is a contra-indicator, is quite negative now. Thus, from this simple formula, one could conclude that the stock market might be due for a nice rally.  Time will tell.

What I do know for sure is that people who try to trade around their portfolio based on the daily chatter rarely win.