Persuasion Time

I don’t fly very well.  For many years I racked up thousands of frequent flyer miles jetting all over the U.S. and many places in Asia.  I even flew first class a lot back in the go-go 1980s when Wall Street was a sexy place to work.  I once made the mistake of reading Michael Crichton’s “Airframe” (about an airplane disaster) on a 747 bound for Tokyo.  Just as the plane was nearing take off speed, I heard a loud “pop” on the left side of the plane.  One of the engines had blown out.  The pilot immediately slammed on the brakes, and instead of ascending gracefully into the blue, we stopped awkwardly on the JFK tarmac.  Shortly we were surrounded by fire and rescue vehicles.

Ever since then, take offs have become white-knuckle times for me.

So this month when I needed to fly out West to take my son to college, I had to face again another take off.  I have discovered that if I count to myself, slowly and silently, I have very little angst as the plane leaves the ground.  I have also discovered that most large jets reach take off speed about 27 to 33 seconds after they begin to accelerate.  Also, the audible tone designating that it’s OK to use approved portable electronic devices occurs 167 to 210 seconds after the start of the flight.  I can’t help it; I’m a numbers guy…

Once airborne, my nerves settle down quickly and I truly enjoy looking at our fine country from cruising altitude.  Up there the world seems very different.  I am always impressed how big and unpopulated the nation is – something I rarely feel driving on highway 66.  I see farms, towns and forests of all sizes and shapes.  I see lots of open spaces.  The change in perspective is dramatic; and it allows me to see things differently.

Working day to day in the capital markets is sort of like driving on the highway.  It’s easy to get bogged down by the immediate, here-and-now stuff – by the noise, the traffic and the frustration that comes with this daily grind.  And lately, the market seems to be dominated by the latest economic data point, “expert” opinion about this or that, or some new technical fear (the Hindenburg Omen, for example).  But that’s not how long-term investors should view the market.  They really should be looking at the market from 30,000 feet – at the big picture; at things as they really are.

But how can we do this?

Every once and a while, an excellent piece of research crosses my desk that can provide this perspective. The latest one, titled “A Study of Real Real Returns” comes from our good friends at Thornburg Investment Management (http://www.thornburginvestments.com/).  In this report they look at 20- and 30-year returns for all of the major asset classes accounting for the real-life impacts of expenses, taxes and inflation on total returns.  Why these long periods of time?  With advancing longevity, it’s reasonable to assume that investors will not only accumulate saving for 30 years or more while working, but they may also need income from those savings for 30 years after retirement.

So what asset classes did the best in this study?  Stocks and municipal bonds.

Stocks, the capital markets pariah of the moment, have proven to be the best performing asset class over long periods of time.  Critics of stocks point to their performance over the last 10 years to “prove” that stocks will underperform in the “new normal.”  I would note that stocks have underperformed (bonds, cash, whatever, etc.) only twice in the last 100 years: the 1930s and the 2000s.  For the decade of the 1930s, the S&P 500 was down 0.3%.  For the ten years ending December 31, 2009, the market fell 9.1%.  Note that both of these periods begin at a peak of equity prices, valuations and bullish sentiment.  I suppose any numbers series will compare unfavorably when compared to the peak of that series.  Lost on the current audience is that stocks performed well for the six decades in between these two bad ones, with 3 of these decades posting gains of at least 400% for the S&P 500.

Municipal bonds do well due to their ability to avoid taxes.

So despite the current loathing of stocks, the smart folks at Thornburg conclude their report with these wise words, “[our]… study confirms that the highest returns come from the more traditional asset classes – common stocks and municipal bonds.  Asset classes that have traditionally been associated with inflation protection have not generated significant positive real real returns over long periods of time.”

“Over the 20 years that Thornburg has conducted this study, the results have been consistent.  There is no reason to think that they will change significantly going forward.  The two primary unknowns, inflation and tax rates, will remain… A simple asset allocation among the highest real real turn asset classes, accompanied by a reasonable withdrawal rate and spending policy, may provide investors with the best chance of sustaining their portfolios and preserving wealth going forward.”

That’s what I’ve been trying to say…

Certain movies really speak to me.  I like ones with complicated plots, witty dialogue and a surprise ending.  Spike Lee’s 2006 movie, “Inside Man,” is a wonderful example of this.  But perhaps the best example is Bryan Singer’s 1995 movie, “The Usual Suspects.”  This quirky little firm actually won 2 Oscars, but a huge part of its appeal and charm is Kevin Spacey’s tour de force performance as Verbal Kint.  The movie’s complicated plot is nicely summed up by the folks at IMDB: 

“A boat has been destroyed, criminals are dead, and the key to this mystery lies with the only survivor and his twisted, convoluted story beginning with five career crooks in a seemingly random police lineup.”   

At one point during his interrogation, Verbal is asked about Keyser Soze.  He answers, “Who is Keyser Soze? He is supposed to be Turkish. Some say his father was German. Nobody believed he was real. Nobody ever saw him or knew anybody that ever worked directly for him, but to hear Kobayashi [the lawyer] tell it, anybody could have worked for Soze. You never knew. That was his power. The greatest trick the Devil ever pulled was convincing the world he didn’t exist. And like that, poof. He’s gone.” 

Later he adds, “…And like that he was gone. Underground. Nobody has ever seen him since. He becomes a myth, a spook story that criminals tell their kids at night. ‘Rat on your Pop, and Keyser Soze will get you.’ And no one ever really believes.”  So, from this point in the movie, the audience becomes fascinated, even obsessed, with who in the movie might be this criminal specter, Keyser Soze.  Who is this mysterious superman and what can he do?

During our investment policy meeting last week, as we were discussing the prospects for deflation, I said something like “Deflation is the Keyser Soze of the capital markets.”  Why did I say this?  Deflation is something to be greatly feared.  It is rarely seen, but its impact is pernicious and evil.  It really is the boogey-man for economists and central bankers. 

In simple terms, deflation is when the price of things goes down.  More precisely, it occurs when price measures such as CPI or PPI post year-over-year declines.  But one might wonder if lower prices are not a good thing.  After all, who doesn’t like buying things on sale?  The problem with system-wide deflation is that it encourages savings and discourages consumption.  Why is that a problem?  Consider this example:

Let’s say you were interested in buying a $30,000 automobile.  You picked out the one you wanted and were about to buy it.  Then you heard that you could buy the same car for $28,000 at a different lot.  Then right after that, another dealer was offering the same car for $26,000.  At this point maybe you buy the car.  On the other hand, you may choose to wait (thus favoring savings over consumption) to see if the price could move even lower.  If this price behavior becomes rampant, spending falls and the economy stalls. 

Deflation also discourages investment, because there is no reason to risk capital on future profits when the expectation of profits may be negative and the expectation of future prices is lower.

Deflation is scary to economists and policy makers because it is hard to fix.  The normal tools available to central banks are not well equipped to deal with deflation.  It’s like trying to fix a leaky pipe with chop sticks.  In a normal recession, a central bank can lower short-term interest rates to entice banks to lend and borrowers to borrow.  In times of deflation this does not work.  Central bankers understand that it’s much easier to stop deflation from happening than trying to cure it once it emerges. 

The fact that deflation rarely occurs is another reason, I think, there is much confusion about what it is and what it does.  The few examples I could think of were: 1) the Great Depression, 2) Japan from the early 1990s, 3) Hong Kong in 1997, and 4) Ireland last year.  During the Great Depression we found out that the economy was not going to fix itself without fairly aggressive policy intervention.  In Japan, policy makers are still struggling to put that economy on a self-sustaining growth path. 

We have seen deflation-like behavior in one part of our economy already – the housing market.  Prices have come down, borrowing costs have come down, housing affordability is near record levels, and yet, consumers are not buying.  Could it be that the prospect of even lower prices and/or borrowing costs are encouraging postponement of new home purchases?

I am not an economist, and I really don’t have a good handle about the prospects for deflation in the U.S.  The credible economists I listen to tend to think we can avoid it.  Yet, it is something on my “worry list” and something I want to keep a close eye on.  Some things that go “bump” in the night are as scary as we can imagine…

This week someone posted a few pages from my high school yearbook (Go Broncs!) that featured a page on new clubs as of that year.  On that page I saw a picture of the new Science Fiction Club, which included a picture of me!  I will admit it, I like Science Fiction.  In my younger days I spent hours consuming the works of Isaac Asimov, H.G. Wells, Harlan Ellison, Philip Dick, Ray Bradbury, Kurt Vonnegut and others.  Summer days would often find me in the local theaters catching a double feature of Sci-Fi B-movies.  I don’t think I really disliked any of those flicks – as long as they had alien monsters, rocket ships and ray guns, I was a big fan.

One of my favorites from the old days was “War of the Worlds,” a 1953 Byron Haskin film based on H.G. Wells’ novel starring Gene Barry and Ann Robinson.  The story is fairly simple – “meteors” start falling to earth creating large craters which inevitably attract the local folks.  Unfortunately for these curious townsfolk, the “meteors” are actually Martian space craft filled with Martians bent on planetary conquest.  Earthlings are no match for the Martian death rays, and even the best military power on earth (they actually try to nuke them!) has zero impact on the invaders and their futuristic technology.

*Spoiler Alert* Don’t read the next paragraph if you ever want to see the movie and its surprise ending.

So, obviously the Martians don’t win, but with all our weapons ineffective, how is this done?  Microbes.  The Martians are all killed off by invisible germs, which turn out (luckily and conveniently) to be deadly to them.  Whew!

I thought of this movie and its miraculous ending this week when I read about the oil spill in the Gulf of Mexico.  It appears that the big patches of oil that used to be on the surface are mostly gone!  What happened?  Scientists think that oil-eating microbes may be the reason.  It turns out (luckily and conveniently) that certain germs living in the ocean love to eat oil.  Who knew?  All of the human technology applied to the problem (the skimming, the burning, etc.) certainly helped, but a large part of the solution appears to have come from Mother Nature herself.

So now we know that microbes can kill Martians and eat oil; what does this have to do with the stock market?  In discussions about the stock market, a lot of people tend to focus on the “Big Things.”  What are these?   Things like the economy, retail sales, exports, government budget deficits, new regulations, healthcare reform, etc.  They are obviously important and we would all like to know exactly how the big things affect the market.  By the way, the stock market itself is really a big thing.  The trouble with “Big Things” is they tend to be very hard to predict and their impact on the stock market is even less certain.  Yet, many people love to argue about them as they are all that matter.

So what are the “Small Things” pertaining to the stock market?  There are several, but I wish to focus on just one – earnings.  When one company reports its quarterly earnings, it may seem like a small thing.  After all, what are just one firm’s profits in the grand scheme of things?  Well, it could mean a great deal.  For example both UPS and Caterpillar reported very strong earnings in the second quarter. The shipping business and order trends for large equipment are very strong.  Rail freight demand and pricing are near record levels.  Exxon Mobil had revenues of $100 billion in the latest quarter.  All of these small things are supportive of economic strength somewhere out there.

How does this square with the fact with that the majority of people in the U.S. still think the nation is in recession?  Perhaps the media, other commentators and even policy makers are too focused on the “Big Things?”  If investors could connect the dots on the small things, and worry less about the “Big Things,” maybe they could see that the overall situation is nowhere near as bad as some of the commentary we see daily would suggest.

Consider the following under-reported positives:  Ninety percent of those who want to work are working.  Forty percent of homes in the U.S. have no mortgage.  Personal incomes are growing.  Government fiscal stimulus is continuing.  Inventory accumulation is just getting started.  Huge pent-up demand exists in the auto, housing and other big and important industries.  Export demand from Asia continues to be very strong. Monetary policy remains very accommodative.  I consider this list quite impressive and is likely to outweigh the negatives currently being touted.

I am no Pollyanna.  I am not always positive or bullish.  I simply see things a bit differently from the rest of the crowd.  I am not always right; not always confident of my views. But right now, I feel that sentiment has grown way too negative given the mix of positives and negatives I see right now.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Well said.  See you in the shadows…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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