Persuasion Time

Nearly every media outlet is marking the one-year anniversary of the current bull market.  The basic facts are obvious – the market has staged a very impressive rally (+68% for the S&P 500), most economic data have improved and US companies have posted surprisingly good earnings growth over the last four quarters.  What is less obvious is what exactly happened over the past year to bring us to this point.  In trying to answer this apparently simple question, we can also find a very broad range of opinions.  Some would suggest that government intervention – fiscal and monetary stimulus, the TARP program, and other such measures – was the cause of the rally.  Others would suggest that aggressive cost cutting by companies at the cusp of the recession allowed them to post better-than-expected earnings, which reassured investors and helped to turn the market around.  Other more-cynical types call it some kind of conspiracy or shell game, an artifice of smoke and mirrors that any second could collapse revealing nothing of substance behind. Others see it simply as the logical rebound from a market break caused by irrational fears.  Whatever the reality, I would submit that it began just as every other bull market has since 1933 – in the middle of a recession, at a point where pessimism and cash levels were at their peak.  The old saying “the harder the fall, the bigger the bounce” also seems appropriate here.

The tone of the celebration is quite muted, in my view, by lingering doubts expressed by nearly everyone about the sustainability of the current rally.  It is hard to find but a handful of truly bullish portfolio managers or strategists.  Most seem quite cautious, suggesting that problems such as the high unemployment rate, the high valuation of the market, the big move in the market, housing market woes, budget deficits and looming inflation are likely to deflate this new bull market any day now.  In a way it’s quite ironic that we find this kind of sentiment at this point in the cycle.  At the bottom of the market we all had tons of fear and could find really solid reasons to be cautious.  Now that the “worse case scenarios” we could conjure up in those dark days have passed us by, many still feel compelled to be cautious.

In my mind, this is one reason to remain bullish.  Another is earnings growth.  Consensus estimates suggest that the S&P 500 stocks will grow EPS about 14% this year and another 18% in 2011.  Even if interest rates move up a bit (haven’t we been forecasting higher rates for about a year already?), I would think that double digit earnings growth could help stocks move higher.  What about valuation?  There are number of measures people use for this, but in my experience, valuation, as important as it is, is rarely by itself a reason for the market to go up or down.  I can still find good quality stocks trading at substantial discounts to what I consider fair value.  I don’t know about the market, but many stocks are still cheap.  The recent spate of acquisitions may also support this idea.  High cash levels are another reason for optimism, in my view.

But don’t we have problems and worries?  Sure, but we always do.  The stock market does not need utopian fundamentals to perform well; it simply needs incrementally more positive news.  The early stages of the rally were marked with the news being less bad than before.  That was enough to get it started.  Now we will need more good news to keep it going.  The average bull market lasts 51 months.  Because this new bull market began under similar circumstances as every other one before, I think the burden of proof lies with those who think “this time is different” (still the four most dangerous words in the investment world).  For me, I think the weight of history is on my side and I fully expect to ride this young bull for a few more years.  Let ‘er rip!

Long-time readers know that I have a “thing” about people who offer apparently “free” investment advice in the media.  The central tenet of my philosophy about all this free stuff flowing into our homes on a daily basis is this: “Why would anyone give away for free any significant, insightful, accurate and actionable investment advice, when they could get paid for it?”  If your answer to this question is “Because they like us and want to help us make money” then there’s little point in reading any further…

If, on the other hand you share my more cynical view of these articulate ersatz altruists (i.e. they’re selling something), allow me to flesh out a few details.  The media outlets which find the daily fountain of economic data, market chatter and pundit prognostications so endearing and entertaining may not have your best interests in mind.  Instead of helping listeners indentify and implement an investment strategy which would not only make them money but that would fit well with their individual personality and circumstance, they shower the viewers with so much data and commentary, that it would be nearly impossible for the average investor to make any sense of it.

Then, we must also consider the source of this information.  Whenever Warren Buffett or David Einhorn speaks about the market or their investments, we can be assured that they know what they’re talking about.  These are seasoned investors who have a well-defined investment style, which they follow systemically and which has made them lots of money.  So even if one of these seasoned professionals is trying to sell us something, we can be fairly confident that what they say is backed up with serious research and money on the line.

On the other hand, we should find no confidence when other market “observers” (journalists, academics, former hedge-fund managers, etc.) offer their opinions.  Just as you would not seek an airline pilot’s opinion on a medical issue, journalists can probably not help you consistently make money in the market.  All of these people are professional, well intended and likely sincere, but they are not professional investors.  This disconnect between speaking intelligently about the markets and being able to invest intelligently was highlighted by Ron Insana’s hedge fund experience.

Mr. Insana was a highly-regarded CNBC anchor who in 2006 decided to launch his own hedge fund.  He had been covering Wall Street and hedge funds for over a decade.  He seemed to know what he was talking about.  He had great contacts.  The fund closed within two years for a number of reasons, but to me the lesson is clear.  He was an airline pilot trying his hand at medicine!  I suspect that he learned more about the investment business in those two years than he did in all his years as a journalist.  It’s not as easy as it looks.

This brings me to a fellow named Brad Tuttle, who posted a very honest and refreshing article last month about this very topic.  You can read the whole thing here.

Here are a couple of highlights I want to share:

“Journalists are storytellers. They get by excited by new ideas and innovation. But as to how an interesting back story about a CEO or how some new product translates to a company’s long-term profits or stock prices? Most writers don’t go there, and shouldn’t go there. Why? They don’t know what they’re talking about.”

“If following the conventional wisdom led to wealth, then we’d all be rich—which is sorta impossible, because there have to be winners and losers.”

“…Warren Buffett: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”

And the final, perfect quote, “So where should you invest your money? Don’t ask me. I’m a journalist.”

I couldn’t have said it any better…

I’ve never been a huge fan of winter sports (unless you include bowling!).  Despite spending all of my growing up years in the Big Sky Country of Montana, and wading through tons of deep snow, I was never big into skiing, ice skating, hunting, camping, hiking, fishing and the like (misspent youth, I know).  So whenever the Winter Olympic Games rolled around, I met the event with somewhat mixed feelings.  Ski jumping was pretty exciting.  Figure skating had its moments.  But usually the thrill of victory and agony of defeat featured in the Winter Games did not thrill me.

Then I discovered curling.

Wikipedia says it best, “Curling is a team Olympic sport in which stones are slid across a sheet of carefully prepared ice towards a target area.  Two teams of four players take turns sliding heavy, polished blue hone granite stones across the ice towards the house (a circular target marked on the ice). The purpose is to complete each end (delivery of eight or ten stones for each team) with the team’s stones closer to the center of the house than the other team’s stones. Two sweepers with brooms or brushes accompany each stone and use stopwatches and their best judgment, along with direction from their teammates, to help direct the stones to their resting place, but without touching the stones.”

It sounds kind of weird on paper, but watching it is even weirder.  The action (?!) of curling seems like some alternate reality mash up of shuffleboard and sweeping the kitchen floor.  Yelling seems to be a big part of the sport as does looking more like an indie pop singer than an Olympic athlete.  It’s rather difficult to imagine what kind of fitness routine curlers go through to prepare for the games, but I suspect they spend less time in the weight room or on the track than do other Olympians.  I mention none of this to be critical or degrading; I really, truly enjoy watching the sport/game.

For me, there is something elegant in the precision of the game.  It’s clearly a sport which requires more finesse, than flash; more strategy than strength.  The fact that the Norwegians are good at it is also a plus (I’m one-fourth Norwegian).  And the contrarian in me is naturally drawn to off-beat activities such as curling.

As I was watching the match between the US and France, I started thinking that curling is a little like investing.  And as I pondered on this a bit more, I realized that curlers are a lot like professional investors.  I see three points of similarity:

1)      What they do looks easy. If curling were just like shuffleboard, it would not be an Olympic sport.  There is clearly a lot more skill and strategy involved than just sliding a big granite stone down the ice.  Many think that stock picking is also a simple exercise.  Just find a stock with a good story and buy it.  Make money.  The fact the some people with no investment background, training or expertise can make money by buying a stock re-enforces the notion that investing is easy.  It’s not.

2)      They use unusual tools to do their job. Who else brings a broom to an Olympic contest?  What else is on the curler’s equipment check list?  42-pound curling stone? Check.  A pair shoes with different soles (one for sliding, one gripping the ice)? Check. Flashy golf pants?  Check.  The tools for the professional investor may seem as arcane to the average person:  free cash flow analysis, beta, intangibles on the balance sheet, off-balance sheet items, DuPont ROE calculations, earnings yield, insider transactions, sentiment measures, technical analysis, and so forth.  The work behind picking a stock is much more than just finding a good story, but it is work not easily appreciated by the casual observer.

3)      Strategy is paramount. To be successful, curlers need to anticipate the moves their opponents might take a few turns out.  Simply executing the game plan will not be enough to win.  They must be flexible and react to changes in the position of the stones, or modify the plan when they own execution is imperfect.  Likewise, professional investors need to figure out what the market is telling them and what it might do in the future.  Inevitably, the market will make some unexpected moves which require the investor to be flexible, nimble and opportunistic.

I hope that all you curling fans out there will totally enjoy the rest of the Olympic games, and perhaps as you watch a few of the remaining matches, you will take a moment to consider the hard working professional investor who, metaphorically at least, is trying hard to put the stones in the right place in the house.

As the Washington DC area continues to struggle with record snowfall (wither global warming??), the stock market seems to be struggling with its own issues.  At some level, a pause from the dramatic and record-breaking rise from March of last year is needed and even welcomed.  Yet, as the market consolidates a bit, the volume from the bear camp has begun to rise, as it usually does when the market stops going up.  Although we know that corrections and consolidations within the context of a new bull market are normal and expected, when they happen, new concerns inevitably arise. Will the US government budget deficit choke off economic growth?  Will lack of job growth do the same?  Is inflation going to be a huge problem?  Will deflation be a greater threat?  So on and so forth…

One of my recurring themes is the idea that at any point in time there are always positives and negatives to the market outlook.  When the market rises, we tend to de-emphasis the negatives, and in times like these, the positives seem to have less power.  To be brutally logical, nothing in the economy has markedly changed since the S&P 500 hit its recent high on January 19^th.  The US economy is like a big supertanker – it does not make quick turns.  What has changed is sentiment and the appetite for risk.  At the margin, the incremental buyer of stocks has turned less bullish than before. I submit that the reason for this slight shift has more to do with psychology than economics, but since accurately measuring the human psyche is way beyond my skill set, let me reiterate a few of the non-psychological positives as I see them:

1)      Employment. True to my contrarian nature, I put forth the employment situation as my first positive.  Everyone “knows” that the job picture is bad and will probably remain bad forever (!).  The data, however, tells another picture.  The chart below depicts the jobs data from over the last few years.  Although jobs are not yet being created, the improvement in the nonfarm payrolls number from January 2009 and the unemployment rate from July is unmistakable.  Remember that the stock market does not need good news, when less bad news will do.

Nonfarm Payrolls: Monthly and Yearly Change

2)      Interest Rates. Although the consensus seems to think that rates must rise, they haven’t yet and this simple fact can aid stock valuations.  Investors are willing to pay a higher P/E for stocks in a low-rate environment.  To the extent that rates do not rise quickly or by a large amount, stocks stand to benefit even more.

3)      Earnings. Corporations have been posting surprisingly strong earnings since early 2009.  Granted much of the gains have been realized by aggressive cost cutting, but in my view that still counts!  The latest round of results has been tainted in some cases by disappointing revenue growth.  Ultimately, sales will need to grow to maintain earnings growth.  Yet, as we approach the anniversary the Q1 2009 results, we will face extremely easy comparisons.  The April results should make the economy look very, very strong.  I am not sure that investors will be able to view these results as anything other than very, very positive.

4)      Cash. Despite record-low yields on cash and other low-risk assets, investors appear to love the stuff.  According to some sources, investors may have as much as $10 trillion saved up in cash and its cousins.  This is roughly the same amount of money as the entire S&P 500.  Granted, not all of this money will find its way into the stock market, but just some of it would be enough new fodder to move share prices higher.  When does this happen?  No idea.  But I suspect that a resumption of good news on earnings (April?) and/or any improvement in the economic data might be sufficient reason for some of this cash to find a new home in the stock market.  We also learned that, at the same time investors are sitting on a huge pile of cash, corporations are generating record cash themselves.  According to Bloomberg News, US corporations in the four quarters ending September 2009, produced $1.29 trillion in cash.  Companies have a number of options with this cash – they can sit on it like investors are, re-invest in their business (which will lead to higher earnings), or use it to buy other companies.  In my view, the latter two options are very bullish for stock prices.

It may take a while for investors to sort out all the mixed signals and emotions they currently face.  Maybe the market will be stuck in a trading range for a while.  I continue to think that the resolution of these crosswinds will be positive for the market.

Although each year brings new and unique challenges and opportunities, the market sometimes displays familiar patterns.  The stock market’s action in 2009 was similar to 2003, which was another recovery year.  Could 2010 be like 2004, a year of consolidation?  Time will tell.  Note that despite all the backing and filling seen in 2004, the market was able to post a double-digit total return for the year.  Here’s a chart for your reference:

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.