Persuasion Time

It may seem a bit cliché to list the things for which I am thankful at this time of year, but Thanksgiving is such a wonderful holiday exactly because it offers us a chance to reflect on the good things in our lives.  Thanksgiving is also the last major U.S. holiday that has yet to succumb to consumerism (some may argue this point given its proximity to “Black Friday” and the consumer feeding frenzy it has become, but I would submit that “Black Friday” has nothing to do with the Thanksgiving holiday itself.  So there!)

So without further ado (and apologies to David Letterman), here are my top ten reasons to be thankful this year:

10. The New Bull Market. Many still cling to the fantasy that a 60%+ market move can be nothing but a bear market rally.  I believe they are wrong.  This new bull market began exactly where one would expect it (in the middle of the recession and at the peak of pessimism) and has climbed the proverbial wall of worry as economic data throughout most of the March to July period continued to show weakness.

9. Low Interest Rates. Not only do they help certain troubled industries (autos, housing, banks, etc.), but they are forcing investors to seek assets which can provide higher returns – like stocks…

8. Tons of Cash on the Sidelines. Many investors still fear the stock market.  Even after this huge rally and the beginning of a new bull market, many folks still hold a huge amount of their wealth in cash or money market funds earning less than 1%.  I view this as dry wood which will eventually be used as fuel to propel the market even higher.

7. Mixed Investor Sentiment. Some people are calling for a “double dip” for the economy.  Some still think that testing the March lows is a possibility.  Some think gold is the only “safe” asset.  Some are seeing new bubbles around every corner.  Some think the government is somehow propping up the markets.  What a fine, grand debate we have here!  The minority opinion still seems to be that stocks can move higher from here.  I guess I’ll have to side with the minority opinion (yet again…)

6. Graham & Dodd. The “fathers” of value investing gave me and others the tools to analyze stocks in our search for excessive returns.  Their work represents the foundation of my career and investment philosophy.  Their work has enabled me to spend my research efforts on measuring and not predicting.

5. Value Investors. The “children” of Graham and Dodd, such as Warren Buffet, John Neff, Christopher Browne, John Templeton, Marty Whitman, Bruce Berkowitz, etc., have provided me excellent role models, showing me that this value investing approach is workable and can be successful.

4. Jim Cramer and CNBC. As long as the media feels the need to provide us with an endless stream of “free” investment advice, I feel that my voice, which I hope is a voice of reason, needs to be heard.

3. The First Amendment. I’m thankful for a country which allows my voice to be heard.

2. Thomas Jefferson. Still my favorite founding father and a major inspiration to me.  “If we can prevent the government from wasting the labors of the people, under the pretense of taking care of them, they must become happy.”  Letter to Thomas Cooper (1802).

1. Opposable Thumbs. Most excellent for holding my grandsons, tossing the football at our annual “Turkey Bowl” and, of course, grasping that big drumstick at the big meal tomorrow surrounded by family and friends.

Bubble, Schmubble

Here we are just 8 months from the stock market’s bottom, a bottom, mind you, that was created by a massive credit crunch and the worst recession in decades, and already we are hearing talk that another bubble may be forming.  Some “experts” are trying to warn us that the government’s easy monetary policy and/or fiscal stimulus will be enough to drive the prices of some “stuff” (gold, commodities, stocks, houses, whatever, etc.) to new bubble levels.  First of all, we still struggle with the definition of a bubble.  It seems to me that we can only truly define a bubble after it has burst.  In the middle of the 1990s Tech Bubble, many were calling it a “bull market,” a “paradigm shift” or the “next big thing,” and not a bubble.  The tech executives, who became billionaires on the back of that bubble, would probably conclude that bubbles are not universally bad.  Some think that all of the world’s economic problems are due to the latest bubble.  I would consider this a topic worthy of a healthy debate.  Others think that new rules are needed to prevent the next bubble.  I would note that the financial services industry is one of the most highly regulated industries out there.  Also, to my knowledge no one has been convicted for breaking any laws in regard to this crisis.

Second, bubbles may be the natural result of rational people searching for irrational returns.  When a person could buy a house for no money down and no credit check and then turn around and sell it within six months for a $50,000 profit, why not do it?  There may have been warning voices at that time of potential negative consequences, but the allure of quick profits is simply too powerful to resist for some folks.  The same thing happened with amateur day traders in the late 1990s.  This part of human behavior has been observed over and over again at least from the South Sea Bubble in 1719.  As long as investors have the opportunity to place their money at risk for the possibility of reward, excesses, or bubbles if you must, are likely to occur.  Charles Kindleberger, in his excellent book, Manias, Panics and Crashes, agrees – “Speculative excess, referred to concisely as a mania, and revulsion from such excess in the form of a crisis, crash, or panic can be shown to be, if not inevitable, at least historically common.”

Third, much of the bubble talk heard these days appears to be centered on one of my big pet peeves – the ceteris paribus (all else held constant) argument.  This line of reasoning goes something like this – “If the current trend (weak dollar, loose monetary policy, rising stock prices, whatever) continues without changing (this is the ceteris paribus part), bad things will happen.”  This argument is cheap and easy to use (probably why we see so much of it in the media) and it has a certain amount of appeal to it.  It’s almost always hard to disagree with the conclusion and it usually seems to make sense.  The fact that things always change rarely surfaces when the ceteris paribus guys are around.  Things always change.  Supply will increase to meet more demand.  Higher prices will eventually lead to lower incremental demand.  Occasionally, a black swan flies in to change all expectations and assumptions.

It seems wise to keep a vigilant eye on the signs and evidence of bubbles, but from my vantage point, I see nothing bubbly about the stock market right now.  Valuations are reasonable, money on the sidelines is plentiful, sentiment is still mixed and earnings are still growing.  Sounds like a recipe for anything but trouble.

“Double, double toil and trouble; Fire burn, and caldron bubble.”

– The Witches from Shakespeare’s Macbeth

On this day of honor and reflection, I wish to pause and add my thanks to the millions of brave men and women who have served and are now serving our country in the military.  I grew up during the Vietnam War, a period of US history where feelings about the military and war where very confused.  However, to the members of the “Greatest Generation” in my family, military service was considered an unequivocal privilege and an honor.  Four of my uncles are veterans.  My mother served in the Women’s Army Corps (WAC) during the Korean War, and my aunt Lilah was a career WAC.  Those of us who have never personally faced the horrors of war can only stand in awe of those who had the fortitude and courage to serve this way.  We salute you!

“History does not long entrust the care of freedom to the weak or the timid.”

— Dwight D. Eisenhower

During the last year we have seen some spectacular (and rare) events. From the credit crisis last Fall which generated enough serious concern to compel the US government to “bail out” a number of large companies, to the nearly-unprecedented rally in the stock market from March, these are strange days, indeed. The biggest problem with these unusual times (aside from losing money, of course) is that they tend to skew our perception of what is normal or usual. In less volatile times, most of us have a clear idea of where the borders of normalcy lie. Occasionally, something happens that makes us think, “Hmm, now that’s unusual,” but most days, time marches on in a steady and familiar beat.

In more volatile times, we tend to assume that anything can happen, no matter how low the chances really are. “If Lehman Brothers can fail,” we muse, “why not ALL the investment banks?” “If AIG can be driven to the brink, why not ALL insurance companies?” “If stocks can fall 40%, why not 100%?” Whereas before one “black swan” would have evoked appreciative “oohs” and “ahhs” of wonderment at its rarity, we now expect flocks of them descending into our turbulent ponds. Much of the commentary I see continues to suggest that the events of the last 12 months are the “new normal.” Some experts still call for stocks to revisit the March lows. Others think that the economy will sink back into recession. Still others predict that the US dollar will continue to fall due to the US government’s massive budget deficit or a permanent lack of confidence that the US economy can ever again maintain sustainable growth. To all this, I say “poppycock.”

I still believe that the four most dangerous words in the investment parlance are “this time is different.” Investing is an exercise in probabilities, and those who are always counting on a highly unlikely outcome generally perform a lot worse than those who operate within the bounds of normal distributions. Let’s take a look at the US dollar for an example of this. The chart below shows the S&P 500 compared to the US dollar over the last few years.

In normal times, we expect the dollar and the stock market to move together – what’s good for stocks is generally good for the currency. This is the normal relationship. As seen in this chart, when the crisis hit last year the dollar became a “safe haven” currency and appreciated vis-à-vis other currencies, and at the same time stock prices fell. In March, the spread between the dollar and the S&P 500 peaked. At this point, anyone who thought that the “normal” relationship between the US dollar and the stock market should return would have shorted the US dollar and bought stocks. The chart shows that since March, indeed the US dollar has weakened and the stock market has risen. The purported reasons for these moves are legion in number, but most commentators will talk about the big, macro factors. Smaller factors like simple reversion to the mean, in other words, returning to normal, seem to be too insignificant to be real. I wonder.

So what do I think “normal” is right now? First, the economy is recovering in a fairly normal fashion from its recessionary trough. The pace may be below past recoveries, but many of usual elements of the recovery are there. The stock market is also responding in a normal fashion to the key drivers of performance – earnings, interest rates and sentiment. The media is also acting as one would suspect – searching out the most sensational stories or highlighting those experts with the most extreme opinions. After all, “normal” is not newsworthy. Finally, I think that many retail investors are acting in line with expectations. Some of them sold near the bottom and continue to hold cash ($4 trillion is still sitting in money market funds), waiting for the “all clear” signal from someone they can trust.

In a “normal” bull market, we should expect stock prices to rise over time with the occasional correction of 10% or so. The next time stocks begin to look a bit weak, we should try to avoid the natural tendency to think that they are somehow destined to go back down to the March lows, and simply accept the correction as a normal part of this new bull market.