Category Archives: General

Price is Not Value

During one of our recent Investment Policy Committee meetings someone uttered the simple phrase, “Price is not value.”  For professional investors, this comment may seem obvious and even self-evident.  Later, as I pondered a bit on these four simple words, I realized that most people might struggle with this notion. Let me explain.

In the everyday life of the typical consumer, price EQUALS value.  Whenever one buys gasoline, the price one pays represents the value of that gas.  Sure, looking around for the cheapest gas in the area may provide some value for the consumer, but in most consumer transactions “price = value” is probably the correct formula.  If something appears too expensive, the consumer may conclude that the product does not offer sufficient perceived value for the price.  If on the other hand, something is selling well below the norm, the consumer may question the quality of the item.  This is probably as close as the consumer ever gets to understanding the price/value concept.  We tend to feel more comfortable when we perceive the value of something being close to its price.

Applying this idea the stock market, we find that value is much more important than price.  The price of a stock is tangible, certain (at any point in time) and simple.  We can easily see the price of a stock and can chart the history of any stock far into the past.  The value of a stock, which is ultimately more important than its price, is harder to see.  First, there are many ways to measure the value of a stock.  This fact alone may confuse the casual observer who may desire one and only one definite way to measure value (we sure crave simplicity, don’t we?).  Second, stock valuations can change quite dramatically over time.  Why would a stock trading at a price/earnings (P/E – one of the most popular ways to measure value) ratio of 15 times (15x) one day trade at 12x the next? To many this notion of value seems too complex and so they tend to focus solely on price.

Value investing is based on the fact that a stock can, at times, trade at a valuation well below its intrinsic or fair value.  Value investors make money by identifying, analyzing and buying this kind of “cheap” stock, with the expectation that the stock will eventually trade at its fair value. Then they sell it. This works well for individual stocks, but what about the market overall?

It’s easy to calculate the P/E of the market by simply adding up all the earnings of the companies in any given index.  The chart below shows the P/E trend of the S&P 500 over the last 50 years.

This chart clearly shows that although the S&P 500 is now near its all-time high price, its value is in line with the 50-year average.  It also shows how expensive (by value) the market was in 1999 and how cheap it was in 2009. I think it also indicates that value by itself does not give one enough information to trade the market.  Imagine someone in 1995 concluding that because the market’s valuation was above the average, they should sell – thus missing the last 5 years of the great tech rally.  It also helps explain why those voices telling you sell now just because the market is at an all-time high are missing the point.

 

In my experience, valuation by itself is never enough to move the market one way or another. When stocks are expensive, the surprises tend to be negative ones.  When stocks are cheap, the surprises tend to be positive.  When the market is fairly valued, stock selection becomes more important.  Stock pickers should love where we are in the market now.

 

Personally, I am still able to find good value in many stocks in many sectors, giving me confidence that the bull market is more likely to continue than not.

 

Is There Ever One Key to Anything?

I’ll admit it – I’m a Dilbert junkie.  During my career I have worked in large companies which often displayed some of the behaviors Scott Adams skewers in his comics.  In addition to his quick wit and perceptive eye, his pointed (and somewhat twisted) humor keeps me coming back for more.

Whenever I hear “_______ is the key to _______” I immediately think of the above comic.  We all have used this phrase.  You hear it in locker rooms, board rooms, class rooms and everywhere in the media. There is something about us that craves the simple answer, and what could be more simple than the key to something important being just one other thing?

David Freedman adroitly covered this human inclination in his book Wrong: Why Experts Keep Failing Us – and How to Know When Not to Trust Them.  He posits that the more complicated the system at hand (weather, human biology, the stock market, etc.) the greater the desire for a simple answer.  “The key to weight loss is eating grapefruit” is the sort of phrase that would be soothing to a person trying to lose weight. However, the likelihood that one, simple key to weight loss exists is extremely remote.  If one did exist, would anyone be overweight?

Turning to the capital markets, we hear this kind of statement on a daily basis.  In the last few weeks I’ve heard intelligent people say/write the following:

1)   The key to the stock market is Fed policy.

2)   The market is only up because of easy money.

3)   Gold is sending a strong signal about the future direction of stocks.

4)   Because the Dow Jones Industrial Average hit 17,000, the market is poised for a correction or crash.

5)   The slowing Chinese economy will hurt U.S. stocks.

6)   The market is always strong in a year with mid-term elections.

7)   Russia’s actions in the Ukraine will surely bring down the markets.

8)   Higher interest rates will hurt the stock market.

9)   Stocks are overvalued, so they will go down.

10)There has not been a correction for 2 years, so we’re due.

I’m sure that the reader could recall other similar comments.  At their heart, all of these statements contain the idea of “The key to the stock market is ______.” I’m not suggesting that these factors are not important, but rather that any one factor by itself almost never is the reason for the market’s movement.  It’s too dynamic and complex to be driven by just one thing. This is one reason market timing (buying and selling “the market” to make money) is so difficult.  Imagine all the resources a professional investor has at his or her disposal in the attempt to time or beat the market.  Compare that to some “insight” you might have picked up by watching television or reading a newspaper.  Is it logical to assume that this one notion really holds the key to the future of the stock market?

I think not.

Exactly because “the market” is so complex, I spend very little of my research effort on it.  I focus on individual companies and their valuations.  Valuation is not the key to success to investing, but it is one important component of the investment formula.  Also, I can add much more value to the process by looking for undervalued stocks rather than trying to time the market.

So far, this approach has been working for me.

 

 

 

 

 

Looking for an Edge Using Occam’s Razor

Sherlock Holmes and his sidekick Watson go on a camping trip. After sharing a few glasses of chardonnay, they retire for the night.

At about 3 AM, Holmes nudges Watson and says, “Watson, look up into the sky and tell me what you see?”

Watson said, “I see millions of stars.”

Holmes asks, “And, what does that tell you?”

Watson replies, “Astronomically, it tells me there are millions of galaxies and potentially billions of planets. Astrologically, it tells me that Saturn is in Leo. Theologically, it tells me that whatever made all of this is beyond human comprehension. Horologically, it tells me that it’s about 3 AM. Meteorologically, it tells me that we will have a beautiful day tomorrow. What does it tell you, Holmes?”

Holmes retorts, “Watson you idiot, someone stole our tent.” *

This story is a classic example of the principle of Occam’s Razor.  In its simplest form, Occam’s Razor states that when faced with two opposing explanations for the same set of evidence, our minds will naturally prefer the explanation that makes the fewest assumptions.

For decades, pseudo-intellectuals (like me) have been evoking Occam’s Razor whenever discussing (mostly) trivial matters.  In my experience, those who unsheathe this rhetorical construct from their debater’s arms cache, more often than not, do so to show off rather than to defend their point of view.

Today I would like to use Occam’s Razor in two ways: 1) to show that most people seem to prefer the more complicated answer regarding capital markets matters, and 2) to use a simple answer to support my view that we are still in a bull market.

Anyone who follows the daily commentary about the financial markets understands that there are many opinions out there.  Those persons with the most extreme (non-consensus) viewpoints tend to be quoted more frequently than others.  I guess these ideas are considered more newsworthy than less flashy ones.  Recently, I have been bombarded by messages telling me to sell my stocks, buy gold, be prepared for massive inflation, be prepared for even more massive deflation, kiss the American Dream goodbye, feel sorry for my grandkids, expect another global financial crisis worse than the last one, etc.  We hear from Nobel-winning economists that the stock market is overvalued.  We hear that billionaires are selling their stocks.  We hear cautious words from big hedge fund managers.

As outrageous as these viewpoints may seem to me, some people must be seriously considering them.  Each week or so, I receive a forwarded e-mail from a friend, colleague or client stating that the “end is near,” and that the author of the e-mail has the perfect investment product for the apocalypse.  In my view, the vast amount of material like this argues that the general public is looking for a complex answer to the simple question, “Where are stocks going?”  The best simple answer to that question, in my view, is “higher.”  Stock prices, over time, always move upward. In any given year, the markets can experience volatility and price declines, but in the long run, stock investors (who remain invested) always make money. So, the Occam’s Razor answer to the question about the market’s direction could be “higher” (over time).

The current debate about the fragility of the stock market seems to center on 1) the fact that many major indices are at all-time highs and 2) the bull market is old – the “average” bull market lasts about 5 years – right where we are now.  Those calling for a bear market are not content simply citing the above facts; they will buttress their argument with 1) worries about the impact Fed tapering will have on stocks, 2) China’s slowdown, 3) Europe’s on-going problems, 4) wars and rumors of war in divers places, 5) esoteric market technicals (remember the Hindenburg Omen?), etc.

In my view, the bear argument tries to win using a large number of data points much like a lawyer would trying to establish reasonable doubt.  For me, the small amount of my research effort dedicated to macro issues (most of my research effort is spent on individual companies) tries to address the simple question, “Is there a recession likely within in the next 6 months?”  Bear markets usually start in front of a recession. Sure, sometimes a bear market can sneak up on us, but most of the time, they happen because of a looming recession.  If your answer to the simple question posed above is “no” then you (like me) can feel somewhat confident that the bull market is likely to continue.  It’s a good idea to keep a weather eye on the horizon looking for early signs of a recession, but for now “steady as she goes” feels better than doing something dramatically different.  One simple question plus one simple answer equals portfolio peace of mind.  William of Ockham would no doubt be proud…

* Many thanks to Ian Lawton and his website “Soulseeds” (http://www.soulseeds.com/) for sharing this joke with me

What to do in a Bear Market

I have been hearing enough chatter out there about the possibility of a bear market to feel compelled to comment on such nonsense.  First of all, bear markets do not occur when everyone is worrying about them.  The large number of warning articles I have seen lately, if anything, is probably a signal to buy, not sell stocks.

Second, most of the doom and gloom commentary comes from financial theorists, not practitioners.  Why anyone would take serious investment advice from journalists, economists, or academics continues to baffle me.  Assuredly, many of these professionals are highly intelligent, possess keen insights, wield superior analytical skills, have won numerous awards, and may have countless professional successes. However, none of these accomplishments necessarily qualify them to help us make money in the capital markets.

Third, any serious investor knows the tell-tale signs of a bear market, and would have to admit that almost none of the typical harbingers exist right now.  So let’s review what history can tell us about bear markets.

1)   They almost always begin six months before the beginning of a recession.  If someone can produce a credible analysis suggesting a recession by the end of 2014, I’d love to see it.  No credible economist is predicting recession in the foreseeable future.   There have been 14 recessions since 1929 and bear markets occurred in every one of them.  I am not sure how many recessions have been forecasted over this period, but I’m sure it’s much higher than 14…

2)   They occur after a period of considerable tight money policy by the Federal Reserve.  The current forecasts suggest that the Fed may begin raising the Fed Funds rate (the first step to tighter monetary policy) sometime in 2015.  There is a big difference between less easy money and tight money.  When we actually see tight (and not just “tighter”) monetary policy from the Fed is when we should begin to worry about the bear.

3)   Bull markets end (and thus bear markets begin) when the mood of investors is “euphoric.”  Some commentators are trying to paint the current mood as overly enthusiastic (obviously this is a judgment call – there are no infallible metrics for this), but I’m not feeling it.  The large amount of Initial Public Offerings is a yellow flag, as is the large amount of cash flows into equities and equity mutual funds. Yet, many of the sentiment measures are mixed – not suggesting any widespread euphoria.

4)   Bear markets often occur after a binge of borrowing.  Increasing usage of debt can often fuel the final stages of an economic recovery. People who are feeling confident about the future will borrow money to invest, expand their business or simply buy stuff.  This can lead to stretched balance sheets that reduce financial flexibility and can produce cautiousness that often causes, and then exacerbates, an economic slowdown.  Debt levels at the corporate level are far below those seen at normal economic peaks.  Household debt has started to rise again, but remains well below cyclical highs.

5)   Bear markets often begin when corporate profits and margins begin to fall.  It seems that nearly every quarter since 2010, some strategist was out there predicting the end of the current earnings growth cycle.  So far, all of these forecasts have been wrong.  Consensus estimates suggest another record year for corporate profits in 2014.

There may be other factors coincident with bear markets, but I think the items above are sufficient to conclude that a near-term bear market is next to impossible.

So back to the question at hand – what to do in a bear market? For someone possessing perfect foresight the answer is easy – sell all stocks and reinvest when the market bottoms.  For the rest of us, the formula is more problematic.  Selling stocks in times of worry feels very intuitive and doubtless provides the seller with some comfort.  More often than not though, it is exactly the wrong thing to do.  But, let’s suppose one does raise cash in front of a bear market, what then?  Holding cash as the market declines may feel good (offset by the sinking feeling caused by the shrinking paper value of one’s portfolio), but will that same seller have the fortitude to buy back the positions sold near the bottom of the market?  Human nature suggests that this is very unlikely.  We still hear about people who sold in 2008 or early 2009 who are still holding cash.  They were paralyzed by the market’s decline and could not bring themselves to re-invest.  The saddest part of this development is that the market has recovered all that was lost in the 2008-2009 bear market and more.

Ironically, the person who made no changes to their asset allocation during the last bear market likely did much better than anyone who tried to trade in response to it.

Do you recall anyone who told you to sell stocks in October 2007 and then buy them back in March 2009?  Me neither…

So what do I do in a bear market?  Usually, I stay fully invested and do not make changes in my asset allocation.  In the late 1990s, I had actually raised some cash in my portfolio (only time ever) because I thought the euphoria about tech and telecom stocks was way over the top.  I was fully invested in October 2007 and by late 2008 thought that the bear market was over!  As wrong as this opinion was, I did not waver in my resolve to remain fully invested through the bear market and I did.  Although it was more severe than most people expected, it lasted just about as long as the average bear market.  I was greatly rewarded for my discipline and resolve, and my portfolio is much larger than it was in late 2007.  I know a lot of people whose portfolios have likewise prospered by remaining true to their asset allocation and investment discipline.

It’s important to note that most investors with longish investment horizons (five years plus) should be able to easily endure the average bear market.  The last bear market was highly unusual and even more unusual was the flat stock market period from 2000 to 2010.  One must remember that this “lost decade” began with the biggest stock market bubble of this generation.  The last time stocks flat-lined for ten years was in the 1929-1939 period. That seems about right to me.  We can expect a massive bear market like we saw in 2008-2009 about every 80 years or so.

To sum up, I see no bear market on the horizon.  Most investors can endure a typical bear market without any dramatic portfolio changes.  Excessive happiness may be the best predictor of a bear market.

And I Would Walk Five Hundred Miles

Actually, I drove 500 miles this weekend to visit friends in New Jersey.  It was a wonderful experience and a welcome change to my regular routine.  I spent 25 years in the NYC/NJ area, so in many ways, this weekend felt like going home.  I’m not sure I gained any revolutionary investment ideas from the trip, but here are a few observations and conclusions (proclamations, if you will) from the journey:

Driving the “back way” via Pennsylvania is more scenic than driving on I-95.

Parking on the street in Manhattan is actually possible – not just an urban legend.

Hipsters abound in SoHo.

Big beards are de riguer in SoHo.

One can buy a monocle at the Warby Parker store in SoHo.

Everyone looks famous in SoHo (except U.S. tourists – European tourists look pretty fabulous, really).

People are very friendly on Canal Street – they will buy your gold and sell you really shiny watches with brand names on them.

Chinatown has grown geographically.

You can find very good Italian food (and mini cannolis!) in Little Italy (which seems to have become smaller, geographically).

“Baked by Melissa” mini-cupcakes are delicious.  The 100-count box sounds perfect for some occasions.  http://www.bakedbymelissa.com

I know where one can buy a nice collection of stuffed Indonesian bats, framed and suitable for hanging.

The High Line on the West Side is a fun way to see some of the City, and stands as a monument to the persistence of residents who wanted to doing something to make the City better. http://en.wikipedia.org/wiki/High_Line_(New_York_City)

In Washington Square Park you can still:

  • hear bad solo Shakespeare,
  • hear college-age jazz trios (acoustic guitar, double bass and saxophone) playing Beatle songs, and
  • buy an original joke for $1 guaranteed to make you laugh.

NHL hockey games are loud.

Martin Brodeur is still a great goalie.

The U.S. remains a great place for employment opportunities.

Young people can still find many reasons to be optimistic about the future.

Sometimes an orange Jeep may be as cool as a Tesla.

Good friends are more valuable than gold or diamonds.

Smart and disciplined people can easily manage their investments, unless they have jobs, families or hobbies.

Random Thoughts on Passive Investing

I am an active investor.  I am not a passive investor.  A passive investor is one who buys “the market” or some other kind of “index fund.”  The premise behind passive investing assumes that because the “average” mutual fund does not consistently beat the market, one should avoid paying mutual fund fees and simply buy low-expense index funds and exchange-traded funds (ETFs).  Active investors believe that through hard work, discipline, creativity, experience and curiosity, one can beat the market, consistently, over time.

The debate over passive versus active investing has been raging for decades.  The real issue preventing a definitive conclusion is that measuring the performance of the two approaches is nearly impossible.  When I say “nearly impossible” I mean that anyone can use the historical data to convincingly support either side of the debate.

Here is one great example:

 

 

Clearly, the author of this graphic is pro-passive investing.  These numbers are convincing.  One look at these data would be enough to force an investor out of actively managed funds straight into the arms of passive vehicles.  Only when one looks at the source of this data does the bias presented here become clear.  These returns represent a six-month period in 2011, a timeframe when most active investors (including me) struggled mightily to beat the S&P 500.  Is it reasonable to use this extremely short period of time to settle the issue of passive versus active?  I think not.

So how many years of data should one use to tackle this debate?  Five? Ten?  Thirty-eight?  Because the markets are so complex and dynamic, one can find periods, even longish periods, where one approach seems to work better than the other.  Thus, many of the studies I read which attempt to settle this issue can be subject to a timeframe bias.

Another difficulty I see in broaching this issue is defining active investing.  An index fund is designed to track the market and charge a lower fee than the average mutual fund.  Some mutual funds have shown the propensity to “closet index;” that is, they claim active management, but tend to invest much closer to the index than one might expect.  These funds enjoy higher fees than a true index fund, and because they only marginally differ from the index they are unlikely to ever show massive underperformance.  They are equally likely to never show significant, consistent outperformance.  There has been a trend over time for many mutual funds to drift this way.  Herein lies the measurement issue – are these funds “active” or “passive?”  No active mutual fund portfolio manager would ever admit to being a “closet indexer.”  Hence, all of these funds, which have grown as a percentage of the total universe of mutual funds, would be lumped into the “active” bucket for comparative analysis.  The fact that many of the “active managers” in the studies look and act like passive investors can only lead to more confusion about which approach is better.

Into this debate steps Antti Petajisto, who at the time he published his research in the July/August edition of the Financial Analysts Journal was a professor at the NYU Stern School of Business.  He looked at thousands of mutual funds over the 1980 to 2009 period and made the following conclusions:

a) Three broad styles of “active investing,” namely, “closet indexers,” top-down macro investors and concentrated stock pickers – underperformed the market.

b) Diversified stock pickers, who were willing to measurably deviate from the indices against which they were measured, tended to beat the market.  He found that the portfolio managers who focused on stock picking and fundamental research (as a group) did better than the market.

Stock pickers can sell overpriced stocks before they collapse and then buy them back when they become cheaper.  Index funds cannot do this; in fact, they buy more of overvalued stocks and sell the undervalued ones.  Stock pickers can choose to include stocks in their portfolios based on fundamentals and valuation.  Index investors buy stocks as determined by the governing body of the S&P 500 (or other indices), based on factors which may not always be fundamental.  Stock pickers can determine whether or not a company is being smart in its use of its balance sheet and cash flow.  Stock pickers can measure the quality of a company’s management.  Passive investors can do none of these things.

This essay will likely not change anyone’s mind about the merits of passive versus active investing.  Yet, I would hope that my words might have raised some doubts to the notion that the “average” fund managers cannot beat the market.  The average ones may not, but the best ones (diversified stock pickers) can and do.

I am an active investor.  I’ve been doing it my entire career.  It works for me and for those who place their trust in me.

Investing is Like…

FARMING!

One of my favorite jokes is about the farmer who won the lottery.  When asked if he had any special plans for his lottery winnings, he responded, “Nope. Not really.  I’m just gonna keep farming until all the money is gone…”

That joke always gets a few chortles and knowing nods of agreement whenever I tell it at family gatherings (my wife’s family is in the farming business.)  Anyone who knows anything about farming understands that it’s a tough endeavor.  Even if a farmer does everything perfectly, the randomness of weather, disease or other natural disasters can greatly affect the outcome.  Yet, in aggregate farmers produce enough food to feed the nation, satisfy massive export demand and make enough money to buy seeds, fertilizer and equipment to stay in business year after year.  As I pondered on this, I realized that investing (at least the way I do it) is a lot like farming.

This month I made 393 equity and mutual fund trades.  As I executed these trades, I was struck at the wide variety of outcomes among the names I traded.  Some names had been held a long time (over five years); others only a few months.  Some were up a multiple of their purchase prices; others lost money.  Each name told a unique story from the date of purchase to the day I sold it.  As I mused on this notion, I realized that at the time I had bought each and every name, I expected it to make money, probably as much as 30% over some reasonable time frame.  The fact that some lost money and some went up 300%, doesn’t necessarily suggest that I don’t know what I’m doing – it simply underscores the uncertainty inherent in equity investing.

Like the farmer, even when I do all that I can do to assure that a name is likely to produce an attractive, above-market returns, I am always subject to the risks associated with investing.  Sometime, this risk is company specific.  A company can report a disappointing earnings number or be subject to some government inquiry.  Sometimes the risk is macro in nature – the market moves up or down on some big development (Fed action, natural disaster, China slowing down, etc.).  Sometimes there are just more sellers than buyers (or the other way around) affecting the price of a stock.

Taking the farmer analogy even further, some investors only look at “the “market.”  They buy and sell “the market” and talk exclusively about “the market.”  This is kind of like a farmer planting only wheat.  All he cares about is the price of wheat and the many factors that influence this one crop.  A value investor like me who creates well-diversified portfolios using individual stocks, is more like a farmer who plants many different crops, in several locations throughout the world, with varied growing cycles, weather conditions, yield expectations, uses some greenhouses and maybe even tries experimental crops or hydro farming.  Because I am not investing in one thing (“the market”), I get to see each of my names mature, grow and blossom at different times.  Sometimes, the growth is utterly surprising on the upside.  At other times, the fruit withers on the vine or doesn’t even appear.  Sometimes, the harvest season comes early; sometimes it seems to take forever.   Over time, I expect the sum of all my individual names to generate attractive returns for my clients and me.

The bottom line for me is that it always seems to be a good time to be planting and harvesting.  The investor who only owns “the market” is probably worrying about either sellilng or buying – is it time to plant or reap?  My way of investing allows flexibility and yields a bountiful cornucopia of diversified fruits of my labors.  Worries about the emerging markets, Fed policy, retail sales, government actions, and so forth, can and will impact “the market” and my investments.  Yet, taking the longer view and understanding that market declines represent buying opportunities (planting) and that times of euphoria can be selling opportunities (harvesting) makes my job much easier than just buying “the market.”  Or farming for that matter…

Not Another Outlook Report

Tis the Season!  Not just for cheery holiday greetings, warm fires surrounded by families and friends, thoughts of peace on earth, the joy of giving and reflections on the last 12 months, but it’s the season for market forecasts!  As you may recall, I don’t make predictions.  I spend all of my research and analysis effort on trying to measure value, and identifying those stocks trading well below my estimate of their fair value.  This approach has been successful over the years, and is a perfect fit to my temperament and proclivity.

Nonetheless, I sometimes reflect back on my days as an equity market strategist and wonder how it would be to make some predictions again.  Would I be credible?  Could I be “correct” in my prognostications?  Should anyone care what I think about the future?

The good news is that these moments of fancy flee quickly, and I snap back to the reality that almost no one can make accurate predictions consistently enough to make you money.  The best way to make money in investing, in my view, is to find an investment approach that works for you, and stick with it.  In my experience, the people who struggle most with their investments are those who feel the need to “do something” in response to the latest news.  Or forecast…

So, I was reading an outlook report this week that caught my eye.  I read a lot of reports each week, and many of them say the same thing.  I mostly read them to understand what the consensus expectations are.  That way, I can usually assess how each new development fits into this consensus model.  Sometimes things happen that surprise everyone.

This report was entitled, “Top 10 Risks for 2014.”  Now I am not the most “glass is full” guy around, but this title seemed overly pessimistic, even to me.  Are we still carrying deep scars from the 2008-2009 global financial crisis that require constant vitamin E rubdowns from reports like this?  Do investors really think that defining risks is the best way to make money in the coming year?

As a counterpoint to whatever negativity you may find out there as we approach the New Year, let me offer my “Top 5 Opportunities for 2014” (wishes, mind you, not forecasts!).

1)   The U.S. Federal Reserve learns how to reduce bond buying without crashing the market.  This was the big fear earlier in the year:  that the Fed would be tightening monetary policy simply by reducing its monthly bond purchases.  The idea behind this fear is that the stock market has been grossly inflated by easy money, and that reducing this easy money policy would “take away the punch bowl.”  At that time, I argued that tapering was not a move from “easy” to “tight,” but from “super-duper easy” to “super easy.” The stock market’s action this week may be a harbinger of additional good news from the Fed in 2014.

2)   Individual investors will stop worrying about “crashes” and begin to invest in stocks with optimistic long-term expectations.  This does not mean investors become blinded by greed (like in the tech bubble), but it means they will come to understand the true nature of stocks, and embrace the notion that equities still represent the best long-term, easily tradable investment available to all investors.  I understand that some people are still troubled by what happened in 2008-09. I understand that we had a “lost decade” for stock investors.  Despite tons of commentary to the contrary, these events did not alter the true nature of stocks – they always go up over time.

3)   The U.S. Government will address the nation’s entitlement programs and debt level in a mature and forwarding-looking way.  I suspect that most serious investors would applaud any progress on these fronts.  I understand that politics may make progress in these matters difficult, but I think the markets would absolutely cheer thoughtful action here.  You may say I’m a dreamer, but I’m not the only one…

4)    The ingenuity and risk taking of global entrepreneurs will bring forth really cool new products for us to enjoy.  Capitalism works as well as it does exactly because people can take risks and get rewarded for it.  They can also fail; that’s the “risk” element of the formula.  Without venturing out into places unknown, without trying something that no one else has, we can see no progress, no innovation and no fun.

5)   Global economic growth and corporate earnings growth will extend the bull market’s lifespan.  Analysts are expecting about 10% earnings growth for the S&P 500 next year.  Economists see the U.S. growing by roughly 2.5% and the world posting something like 3.5% growth.  One could easily conclude that these growth numbers would be positive for the stock market.  The average bull market lasts about 4 years.  Our current one is approaching its 5th year anniversary.  Unless, one considers the huge “correction” of 2011 as a real “bear market”- the S&P 500 was down over 20% (the classic definition of a bear market), intraday, during August of that year.  If so, one could argue that the current bull market is only 2.5 years old and has longer to run and higher to fly.

Long may you run.  And may you always fly like an eagle.

Here’s to another great year in 2014!

Another Excellent Prediction!

Anyone who has read my blog over the years knows that I don’t make predictions.  Trying to guess where the market might be in a few quarters is about as useful as forecasting the weather out a few months.  I read lots of commentary about the market, and always have to chuckle when I see a truly outrageous forecast.  By the way, if you want to appear on television as a “market guru” be sure to bring a few outrageous forecasts with you.  They are the most “newsworthy” ones.  No one wants to hear your middle of pack predictions…

Anyway, I chuckle at these wild forecasts mostly because the people spouting them usually are not professional investors.  And even if they are, no one is likely to remember their incorrect forecast (most are incorrect, no?), and if by some small chance they are correct, the upside might be huge (I have known people on Wall Street who made a career out of being right once…)

So, let’s go back in time to February 2012.  We had just finished a very volatile year (2011) and people were debating which way the U.S. stock might be headed.  I always think a better question than “Where do you think the market is going?” is “How is your portfolio invested right now?”  To my surprise, Barron’s cover for its February 13, 2012 edition (see above) made the bold prediction that the Dow Jones Industrial Average would reach the 15,000 level by the end of 2013.  At the time, it did seem like a very brash forecast.  The DJIA was about 12,500 at the time.

I had a number of issues with this cover.  First of all, almost no professional investor measures performance against the DJIA.  It’s only 30 stocks, it’s price weighted (that is stock with higher prices have more influence on the index than lower-priced ones) and it’s comprised of only big-cap, blue-chip stocks.  Second, any strategist worth his or her salt does not give both level and time frame for a forecast.  Hence, “The DJIA will reach 15,000” is a “good” forecast.  Equally fine would be “The DJIA will trend higher by next summer.”  To say “The DJIA will be at 15,000 by the end of 2013” is way too specific to be credible.   The third and final issue I had was that the forecast, despite what I thought at first glance, was not really that bold.  It represented only a 20% increase in a period of almost two years. That averages out to be about the long-term average for stocks.  Not exactly swinging for the fence on this one…

Nonetheless, I was somewhat impressed at Barron’s moxie to print such a lead story.  We discussed this idea a bit at our Investment Policy Committee meetings, reaching as we usually do, no meaningful consensus about “the market.”  We spend more time figuring out which undervalued stocks to buy.  For some reason, I cut out the center panel of the cover, and with a black sharpie crossed out the 5 in “15,000” and with a red pen wrote a “6” next to it.  Thus was born a rare forecast from yours truly.  I pinned the modified cover on the big map that adorns my office wall. See photo below.

In the name of full disclosure, this forecast was never mentioned outside our firm.  No bets were made; no consideration ever offered or given.  In true Wall Street fashion, I did not specify the time frame for my “forecast.”  I simply stated that the DJIA will reach 16,000.  Well, miracle of miracles, wonder of wonders, the DJIA hit the 16,000 market last week – near the end of the year.  One could argue that because I used the Barron’s cover, the implied time frame for my forecast was the end of 2013.  One could possibly conclude that I made one of the best calls of the last two years, predicting the level and time frame for the most popular and widely quoted stock index!

 

That said, my “success” with this forecast underscores how useless most predictions are.  No one made any money based on this forecast.  I did not buy more stocks because of this forecast (I was fully invested in stocks at the time anyway).  I was not quoted in the media.  My level of fame has not changed since I nailed this forecast (my Q Score has hovered around zero for about 30 years now…).  None of my IPC colleagues talked about it to anyone else.  They did not adjust their portfolio based on it.  Almost no one knew about it (those who did probably forgot about it a week later…).  Most importantly, had it been wrong, nobody (including myself) would bother even mentioning it. Herein lies the biggest risk of listening and acting on forecasts – the forecasters tend to remember and highlight the correct ones and ignore, rationalize or blithely dismiss the wrong ones.

 

So, where do I think the DJIA is going from here?  I predict that it will display volatility, both now and into the future.   And that is one prediction I can stand behind with confidence…  =)

 

Bullish in Orlando

Last weekend I enjoyed the company of 1,100 retail investors at the biennial conference of the American Association of Individual Investors (AAII) held (this year) in Orlando, Florida.  The non-profit AAII has been around since 1978, and does a great job, in my view, educating individual investors regarding stock market portfolios, financial planning and retirement accounts.  The conference featured some high-profile keynote speakers (Nobel Prize winning economist Robert Shiller, for example), useful advice from professional investors, lots of nuts and bolts presentations, and the latest tools (software, etc.) to help investors get their portfolios and financial houses in order.

The range of expertise of the attendees is incredibly wide – from true neophytes taking their first baby steps into the capital markets to grizzled veterans who clearly knew what they were doing.  As is common with most distributions, the majority of the folks there were somewhere in the middle.  A lot of the people I met seemed to like passive investments (index ETFs, etc.), but most seemed fond of some sort of active management.  The mood was quite positive, and more people were bullish than bearish, but I still sensed a quiet tension about the future in many.  I met a few dizzy day-traders (yes, they’re still out there!), one of whom mentioned that she had lost a ton of money in the late 1990s, a bunch more in 2008, and told me that she’d “better get her act together sometime…”

As colorful and friendly as the attendees were, the presenters were actually quite helpful and user-friendly.  It is beyond the scope of this note to mention all the highlights, but a few quotes and anecdotes may help the reader get a feel for the conference.

One oft-repeated theme was that investors need to find a style that fits them and stick with it.  One person suggested that investors write down how they want to invest during a time when they feel calm and rational.  They then should refer to this document (and follow it) in those times when they are stressed, and especially when they feel “this time is different.”  Do-it-yourself investors are notorious for being bad market timers and prone to “sell low” and “buy high” (I’ve seen tons of data supporting this notion).  Listening to the advice of the AAII presenters could help avoid this tendency.

One person observed that many investors feel a great need to “do something” with their portfolios, especially in times of stress.  One person had some great quotes that I really agreed with:  – “The short-term is absolutely meaningless.” “It is human nature to look at the short term.”  “Focus on the facts.” “A great company is not always a great stock.” “A disciplined, unemotional approach is better than anything else.”

I heard a funny story about how many people pick stocks based on image, brand name or a vague feeling about the company (without doing any real analytical work concerning valuation, earnings, cash flow, etc.).  Imagine that you walk into a doctor’s office. The doctor looks at you and without doing any tests or asking you how you feel, says “I think I will prescribe for you the yellow pill.”  You protest, saying that how in the world does he know the yellow pill will be right for you or how does he even know what’s wrong with you.  He counters with something that we’ve all heard people say about a stock they like:  “I have a good feeling about the yellow pill…”  Classic.

One presenter spoke at great length about Benjamin Graham, arguably the best investor of the 20th century – he was Warren Buffett’s mentor!  Graham suggests that the “intelligent investor” (which is the title of his perhaps most famous book) is one not with a high IQ, perfect SAT scores, or fancy degrees from Ivy League schools, but one who possessed patience, independent thinking, discipline, an eagerness to learn and self-control.  These traits of character were, in his view, more important than smarts.

Overall, it was a very enjoyable experience for me. It’s encouraging that someone is trying to help people be smarter about their money and finances amid all the commercial voices simply trying to sell them something. Bravo, AAII!