Monthly Archives: March 2009

“Have You Ever Owned a Stock?”

This is the question I enjoy the most when speaking to a young person who is looking to enter the investment business. I rarely penalize a person for not having owned a stock, but I am always more interested in those who have. In my opinion, there is no better way to prove one’s passion for something than by actually doing it. I mean if I tell you that I really enjoy fly fishing (I grew up in Montana after all), but then I tell you I’ve only enjoyed by reading about it or watching “A River Runs Through It” a couple of times, are you really going to invite me on your next jaunt to The Bitterroot or Rock Creek?

I think the same thing applies to equity investing. All the “book learning” in the world cannot compete with the education one receives by actually buying a stock. Granted, the more knowledgeable one is about the stock market, the more likely the experience of buying a stock will actually be a positive one.

I remember very clearly the first time I bought a stock as a professional portfolio manager. I had been a sell-side analyst for several years and could tell you everything about how to value a stock, how to write a research report, how to identify an attractive stock and how to convince others that my opinion was the “best” one. Then I landed a job on the buy-side managing the US equity portfolio for a Japanese bank. All of a sudden, I was the decision maker for a large portfolio containing about 50 stocks. I recall thinking to myself, “Wow, this is more complicated than I thought.” This thought came despite my years of Wall Street experience and an advanced degree in finance from a prestigious Ivy League school. Within a few weeks I got up to speed on all the holdings in the portfolio and finally felt I was prepared to take over full responsibility of the portfolio.

Even then I felt a bit anxious as I decided on my first trade as the new portfolio manager. I ended up buying a tiny, incremental position of an electric utility already in the portfolio. I think my trade had absolutely zero probability of impacting the portfolio one way or the other, but the deed was done! I remember my boss (who had no trading experience, but had some “book learning”) saying, as he signed my trade ticket, “Ah, Mike-san, you are bullish on interest rates, no?” I’m sure I nodded and gave some vague answer, but what I was really trying to do was avoid making a big mistake on my first trade.

Since that fateful day, I have made thousands of trades, some great, some not so great, but for each one, I knew 1) what I was buying or selling, 2) why I was buying or selling and 3) how long I needed to wait for the trade to be proven successful or not. Investors who trade or invest in stocks without being able to answer those three questions are more likely than not engaging in an exercise of randomness.

Ultimately, the stock market is not one thing; it’s a collection of many things. Each stock price represents: 1) an entire company and all of its resources trying to successfully compete in its market place and 2) the collective opinion of all shareholders about this company’s prospects. When we hear the media mention the “stock market” it is easy to forget that it’s not some kind of powerful monolith, but the collective and combined effort of thousands of companies, millions of workers and millions of investors, both big and small. The general public may hate Wall Street right now (please see Jeff Korzenik’s blog for more on this topic here) but eventually, we all need to understand that what is good for the stock market (strong economy, rising profits and stable interest rates) is ultimately good for all of us.

Is This the Bottom?

This question seems to be on everyone’s lips. Even though I am an investment professional with many years of experience working on Wall Street, I still sometimes find myself having to stifle a chuckle whenever I hear a question like this. The question is really a series of questions that go something like this:

1) “Should I have put my large cash stash in the market on March 9th?” With the market up over 20% from the recent low, the answer to this one is clearly “yes.” Doing this would led to a quick 20% return, which represents roughly 2 years of “average” stock market returns. As I recall, March 9th kind of felt like the end of the world, capitalism, the stock market and life as we know it. I suspect most people would have found it difficult to throw a bunch of cash into the market that day. I suspect some investors were still in “sell everything now!” mode on that day. But such is the contrary nature of investing in the stock market.

2) “Will the stock market keep going up?” My answer is clearly “yes.” It will go up and then down and then up and then down and so forth. As the equity market strategist at one of my past firms once said so famously (and with a straight face, no less), “I predict that in the future the market will exhibit… volatility.”

3) “Is it safe to get back into the stock market?” No, it’s never “safe” to invest in stocks. One of the immutable dynamics of the investment process is the interplay between risk and reward. For this dynamic to remain in force, the assets which offer the highest potential return must also contain the highest risk. The problem is most of us have a hard time measuring risk, but can easily see returns. When a stock we own goes up, we feel good about that return. When a stock we own goes down, we feel bad about that risk. Truth is that regardless of the near-term returns, every stock possesses an inherent element of risk. By creating a diversified portfolio, investors can offset much of this risk, but never eliminate it. That said, over most long time horizons (the last 10 years notwithstanding), stocks provide the best returns of all asset classes.

4) “If the economy is so bad (everyone is still saying this, no?), why did the stock market go up?” Ah, this is a tricky one. Many people seem to think that the stock market is supposed to reflect what’s going on in the economy. To the extent that economic activity affects corporate earnings, this relationship holds true. However, the stock market is much more than a simple barometer of earnings. Stock valuation is also a function of interest rates, investor sentiment, and supply and demand. Also, the market will respond to the changes in all of the above factors, and most importantly, it will respond to changes in the expectations for all these parameters. The “Economy” is like a supertanker; it does not move nor turn quickly. The stock market, in large part because it is highly affected by changes in expectations and sentiment, is more like a sports car – it can turn quickly and at times move very fast. In the early stages of a new bull market, we will continue to see mixed news about the economy and experience turbulent crosswinds in sentiment.
I suspect that no one can really answer these kinds of questions with the level of certainty the asker ultimately wants. Sure, many (especially those looking for fame in the media) will offer blithe responses with all the confidence and supporting evidence they can muster. Some of them may actually get it right. But no one gets it right all the time. And free advice is rarely worth its price.

The most truthful answer I can give to all of these questions is “I don’t know for sure.” I don’t spend any of my time making predictions. I am fully engaged each day in trying to measure value and trying to find those stocks and funds which offer the best possible return per unit of risk. I am crafting portfolios which are thoroughly diversified and well balanced. I continue to apply the battle-tested investment principles I learned as a younger person to the strange new world in which we find ourselves. In short, I am fully engaged in the investment process every day. It is not a pure science, but not exactly fine art either. It’s not a get rich quick scheme or a hobby. The fact that I love the work makes all the challenges, headaches and heartaches well worth the effort.

It’s Been One Week

Over the last five trading days the S&P 500 has risen just about 10%. Recall that just last Friday, the market had to absorb the bad news of the worst employment report (651,000 jobs lost and an unemployment rate of 8.1%) since 1983. Remember how bad that felt? So what’s the reason for this mini rally?

We’ve been taught to think that the market is always up or down for some good reason. Usually, someone in the media (or the poor fellow who writes the headlines for Yahoo Finance) can link the day’s action in the market to some news story, economic data point or world event. Sometimes there’s just more buyers than sellers.

So what good news could have contributed to the market’s action over the last five trading days? The employment report? No, that was clearly bad news. How about the news that US households lost 18% of their wealth last year? No, that sounds negative too. General Electric’s credit rating was downgraded? Well, the Wall Street Journal did acknowledge this move as a positive because it wasn’t as bad as expected. Ah, there’s something to focus on – the market tends to respond to events, not whether they are positive or negative, but how they are versus expectations. This is the perverse calculus of the equity market that often befuddles the casual observer. This is why bad news (GE’s credit downgrade) can be interpreted by the market as good news (not as bad as expected).

What is clear to me is that the stock market’s recent actions have little to do with the economy. The economy is like the proverbial oil tanker that moves slowly and makes it big, broad turns even more slowly. There was no positive economic news that could account for the market’s recent movement. This is the disconnect many individual investors struggle with – “If the economy is so bad, why did the market go up?”

To be fair over the last week, we did see a sprinkling of good news – Citigroup’s statement about being profitable through January and February; the big pharma mergers are a clear sign that the stocks are cheap and informed decision makers are acting as they should; retail sales for February were not bad, and so forth. Yet, the tone of the news flow remains very negative. Mr. Roubini was featured yet again in the media circus this week, saying now that the recession could now last three (do I hear four?) years! And then they ask him for his stock picks!?

Two items that I think could be helping the market here are 1) a serious discussion at the SEC to reinstate the “uptick” rule and 2) possible changes in mark-to-market accounting. The first item could lead to less downward pressure on stocks from short sellers. The second could ease some of the pain of toxic assets held by banks and insurance companies. Both are technical (not fundamental) in nature, but many have argued that these two factors have contributed both to the credit crunch and bear market. Might be a good idea to keep a keen ear to ground listening for action on either of these issues.

Has the market made its “big turn?” No idea. But I do know that the “big turn” will be marked with just as much uncertainty as we feel right now. Historically, bear market rallies occur frequently and will often take the market up quite a bit (remember the two-week 20%+ rally that started last November?). This could be just another one of those. However, it could be the “big turn.” That’s just the nature of investing in the stock market – it is an exercise in uncertainty. I suppose we cannot know if this is the big turn until the market penetrates some important levels – perhaps 800, 900 or 1,000 on the S&P 500. When the S&P 500 reaches 1,000 level, can we say with certainty that all is well, that it’s safe to jump back into the pool? I suppose so, but I feel sorry for all those investors sitting in cash waiting for some kind of mystical “all clear” signal that will likely emerge (if it does) only after missing 30% appreciation potential (more if they’d been in better stocks). We hold these truths to be self-evident: bear markets and recessions eventually end and the fundamental principles of equity investing are not dead.

No Positive News?

Last week a colleague asked me with a puzzled tone, “Why is the government still talking down the economy?” As I pondered the question, I had to agree with him that much of the commentary we hear from government officials seems to focus on the “half empty” nature of the glass. Perhaps they are still trying to reduce expectations as to what the government can actually accomplish in the short run. Perhaps the newly elected still think that all current problems can be attributed to the newly evicted. Perhaps in order for the average US citizen to fully buy into the significant, fundamental changes embodied by the government’s “stimulus” plan, we all must agree that our nation is broken, and that “… an era of profound irresponsibility that engulfed both the private and public institutions…” (President Obama from “A New Era in Responsibility”) is to blame. Perhaps the hedge fund industry (which has been conspicuous in the media by its absence) has much greater influence over government policy makers than the average citizen can imagine. One thing for certain, those who can short stocks (like the hedge fund guys) are making more money right now than the rest of us who only buy or hold stocks.

Why the excessively negative tone about economy? Not sure. Granted, much of the official data we see coming out of the government reflects an economy in a serious recession, but the commentary I hear from both government spokespersons and the cacophonous talking heads in the media would suggest something “more serious.” I am shocked and amazed at how often and quickly the media and their “experts” will go to the Great Depression for parallels to the current economy. I will concede that the average person may have little or no understanding of what happened during the 1930s, but I would expect that the “experts” so frequently appearing on TV would. In the 1930s, the US had no SEC, no FDIC insurance, no securities laws protecting investors from fraud and market manipulation, no safety nets for the unemployed, no social security for families without breadwinners and so forth. Regardless of how bad the media says things are now, I find it unfortunate that no one seems to be commenting the few positives which I can see, that may be harbingers of better news to come.

For example, mutual fund flows for both stocks and bonds were positive in January (according to Lipper). February retail sales actually rose 0.5%, the first uptick since September of last year. We have seen a healthy number of new bond issuances, suggesting that the credit market is healthier than it was a few months ago. Even the latest employment report showed some deceleration in the pace of employment trends. The prices of many important manufacturing commodities, including copper, iron and oil, have been rising lately, perhaps suggesting some stabilization of demand – something that would precede a recovery. Even China, whose growth has slowed dramatically of late, has reaffirmed its GDP growth target of 8% for 2009. Consolidation in the pharmaceutical industry (Merck buying Schering-Plough and Pfizer buying Wyeth) should be viewed as positive moves, but the media can only view them as further evidence recession fallout.

I am not saying that all is well and that a recovery is just around the corner. What I am saying is that the US public is not getting the whole picture from the traditional sources of news and information. I think individual investors are being particularly ill-served by the media outlets ostensibly created to serve their needs. I feel especially sorry for those who have sold stocks (particularly in retirement accounts) and are holding cash on the recommendation of someone (Cramer, Roubini, etc.) who does not have skin in the game and who does not possess any special insights that will help these investors get back into the market before it goes up.

Unless “this time is different” (still the four most dangerous words in the investment business, in my view), the stock market will begin climbing the proverbial wall of worry, long before the talking heads will be able to tell us that the recovery has begun.