Persuasion Time

Over the course of my career I have known many equity market strategists.  I found nearly every one of them to be intelligent, insightful, articulate, analytical and creative.  The best of them, in my view, have also shown a tendency for contrarianism.  Regardless of their skill set, they are saddled with the most impossible of tasks – to make predictions about the stock market.  Most of them are required to have annual price targets for the S&P 500 and many of them maintain model portfolios.  Those who work at large firms have access to high-powered analytical tools and databases as well as a bevy of industry analysts who can often help them see the big picture by discussing the particulars of each industry.  We see them quoted often in the media, especially when something dramatic happens in the market.  The best of them can recognize and explain market trends as, or even before, they develop, and the least of them are still very entertaining to listen to.

One strategist whose commentary I find myself enjoying a great deal lately is Liz Ann Sonders, the chief investment strategist at Charles Schwab.  I first heard her speak at a conference a few years back and ever since have tried to keep up with her work.  I find her comments to be very reasonable, quite insightful and easy to understand and appreciate.  In contrast to many of the big Wall Street strategists, she views herself as a “market interpreter” and not a forecaster.  In my eyes, this makes her views and opinions very important for the average individual investor.  She has an uncanny knack for explaining complex issues in a very down-to-earth and approachable fashion.

She was a cool, rational voice in the middle of the bear market and financial crisis and she continues to say and write things which I think are right on.  A couple of examples of her current views:

On the economy: “I think the recession actually ended in the second quarter… We’re starting to see the effect of what I have been calling coiled springs.  There was such a compression in the Fall of 2008 in every metric of the economy that we’re now in the beginning phases of the natural snapback from that.”

On inflation: “Not a near-term risk at all in my opinion.”

Stock prices a year from now: “They’ll probably be higher, but it’s very unlikely that the path on the way to higher will look like it has the past seven months… I expect a choppy path, but that may be the better path.”

Bonds vs. stocks for the long-term: “After a ten-, 20-, 30-year stretch in which bonds have outperformed stocks, the cynic in me can’t help but ask, “Now you’re going to bias your asset allocation dramatically towards fixed income because bonds have outperformed stocks?”  I’m often skeptical about supposed major paradigm shifts, particularly as they relate to how people invest their money based on performance that has already happened…”

With so much noise and hype out there, it is very refreshing to find someone dedicated to helping the individual investor sort it all out.  Bravo!

Here is a link to her bio:  http://www.aboutschwab.com/press/experts/sonders.html

Here is an interview she had with Kiplinger’s Personal Finance magazine:  http://www.kiplinger.com/magazine/archives/listen-to-your-portfolio-.html

Ok, I get it.  Main Street hates Wall Street.  I also realize that anyone who would attempt to defend the bankers’ point of view is likely to risk facing the business end of a pitchfork himself.  Yet, I find it impossible to remain silent in the midst of so much misinformation and confusion.  In the name of full disclosure, I must admit I spent 25 years on Wall Street working for some of the firms which are now once again receiving the full wrath of Washington.  I know that it would be impossible to sway anyone who has already decided that the banking industry is the devil incarnate, but let me provide some perspective to those few souls whose minds are not yet made up on this matter.

Mistakes were made, but few laws were broken. The causes of the financial/credit crises are legion, but now have been simplified for television.  The short version goes something like this – bankers were greedy and made loans to people who they knew would default.  Smarter bankers took these loans and dressed them up (lipstick on a pig?) and sold them as AAA-rated securities to equally greedy, but gullible investors.  Over time there was so much of this sketchy debt that the system was doomed to fail.  Lehman Brothers was the straw that broke the camel’s back.  With the financial system near collapse, the government had to rush in and save the day.  A year later, we find the greedy bankers up to their old nefarious ways, and paying themselves big bonuses while the national unemployment rate remains at 10%.  The real story is quite a bit more complicated, as I tried to explain in this blog.

Regardless of whose fault it was, very few people have been indicted for breaking the law.  All the aforementioned actions taken by the banks and brokers were made within the boundaries of the law.  Congress itself passed the legislation allowing US banks to own brokerage operations and leverage their balance sheets in order to better compete with non-US banks which were taking market share.  The people who smacked those AAA rates on bond bundles which blew up were only doing that which they had been doing for years – getting paid by the issuers of the bonds they rated.  Conflict of interest? You bet.  Illegal?  Not at all.

Bernie Madoff broke the law.  He’s in prison.  Many of the CEOs who made the mistakes surrounding the financial crisis were fired.  It’s odd to me that the banks and bankers continue to be on trial in the court of public opinion for “crimes” atoned for long ago.

Banks which received TARP money got a lot more than they expected. The Troubled Asset Relief Program (TARP) was the program devised and implemented by the Bush administration which allowed banks to sell to the government so-called “toxic assets” which were caused by mortgage defaults.  These toxic assets had become a huge problem for the banks and were an impediment to making new loans or even settling trades.  Something had to be done.  Then-Treasury Secretary Henry Paulson made the TARP loans to a broad number of financial institutions, not just the ones who really needed them, in order to avoid targeting the weakest players in the industry.  Bear Stearns and Lehman Brothers failed in part because they became targeted in the marketplace as being weak.  So the TARP money was distributed and the crisis was averted.  By now, most of the recipients of TARP money have repaid the funds to the government.  In December the government reduced its estimated cost of the program from $341 billion to $141 billion.

Put yourself in the position of one of the bank CEOs who did not need the TARP money, but was forced to take it.  You play along with Paulson for the good of the nation.  You use the money to spiff up your balance sheet a bit.  All of sudden, the rules of the game change and you are being vilified for causing all the problems and taking taxpayer money to enrich yourself (not true, by the way).  “Ah ha,” you think, “I’ll just pay back the money and all will return to normal.”  You pay back the money.  Even-Steven, right?  Wrong.  The government wants to cut your compensation and impose a surtax on your profits because of your past mistakes.  Banks that did not even receive TARP money are being targeted by this surtax.  To me it seems as though the banks are being punished for returning to profitability as much as anything else.  It’s rare to see this much success celebrated so little.

What’s a Wall Street Bonus anyway? To Main Street, the word “bonus” means something entirely different than it does on Wall Street.  The public has somehow gotten the impression that a bonus is some kind of unearned windfall, reward for favors (mostly behind the scenes, of course) rendered and somehow unethical, if not downright illegal.  In reality, the Wall Street bonus program was one of the best examples of a true merit pay system out there.  The basic structure of the Wall Street bonus was this – we will pay you roughly half of what you’re worth in salary.  We will then pay you the rest based on how well you do and how well the firm does.  The firm makes more money, you make more money.  If the firm makes less, you make less.  This tended to encourage all involved to work hard and produce profits.  Most impartial observers would agree that this structure aligns the interests of the shareholder and the employee.  The real issue here I think is the level of compensation.  With the median household income in the US around $46k, I suppose most folks have a hard time figuring out why anyone could do anything that would quality him or her to earn $1 million or more.  If an insurance salesperson receives $100 for every policy he sells and he sells 10,000 of them, would we begrudge his $1 million in compensation?  If an actor can help a motion picture gross $500 million, why not pay him or her $20 million for it?  Professional sports has similar economics.  We don’t mind paying big producers in these areas, why is Wall Street so different?  Because the public really doesn’t understand what they do on Wall Street.

When my children were younger and asked me what I did for a living, I would try hard to explain.  Their blank stares told me they didn’t get it.  Eventually, I just told them to tell people that I was a fireman or a submarine captain (ha!).  Anyway, I can understand how vilifying the bankers now makes some political sense.  They are viewed as pariahs (or worse!) by Main Street and punishing them surely creates some cathartic pleasure by the populace, but it makes very little economic sense to me.  And to the extent that it creates unease and angst in the stock market, I am against it.

Here we are again at the start of a new decade.  As I sit here pondering the future, I can’t help but think back to the year 2000 and the enthusiasm and hope that year brought to the world (after the passing of the Y2K fear, of course).  The stock market was near an all-time high.  The power of the Internet was in full force, and many felt that we had truly experienced a significant “paradigm shift.”  Stock ownership by individuals was at an all-time high, as was employment.  Growth stocks were all the rage and anything even vaguely associated with the Internet was golden.  I recall clearly my younger colleagues thinking that “value stock” was just a euphemism for a stock that didn’t go up.

Little did we know at that time that the next ten years would be so fraught with upheaval and disaster.  The bear market which began in 2000 was bad enough, but the terrorist attack of 9/11/2001 ushered in a new era of fear and conflict which persists even today (just visit an airport for confirmation of this).  Military conflicts in Iraq and Afghanistan, which began in the decade, also persist to the present.  Low interest rates, easy credit and nudging from the government encouraged all Americans to become home owners.  These same forces allowed speculators to make fast money in real estate, which created a sizable bubble in that market.  Massive amounts of new mortgages and clever ways of repackaging them led to another boom and then a bubble in mortgage-backed securities.  New legislation allowed banks to leverage their balance sheets to unprecedented levels. All of this came tumbling down late in 2008.  For the first time since the 1930’s, stock returns were near zero for an entire decade.

This review isn’t meant to create any more despondency or rehash the negative aspects of the past.  Rather, it is meant to be a note of caution to anyone who reads the many forecasts now being published about the future of the economy and stock market.  Nils Bohr, the famous physicist, famously quipped, “Prediction is very difficult, especially if it’s about the future.” Think back to the forecasts which were made in early 2000.  Did any of them contain the possibility of the 9/11 attacks?  Or the US invading Iraq?  Or a three-year bear market?  Think back to the forecasts made in early 2009.  Did any of them suggest that the S&P 500 would be up by 23%?  I recall many forecasts suggesting the S&P 500 would go to 600, 500 or even 400, but no one I remember was predicting 1,100.

I don’t mean to dismiss forecasts entirely; clearly they serve some purpose.  Forecasts satisfy investors’ need for clarity and certainty.  The logic and rationale behind well-reasoned forecasts are often helpful and useful.  Yet, making any significant investment decision based on any given forecast is very dangerous in my opinion.

In my early years on Wall Street, I worked for a firm whose equity market strategist was highly regarded for his ability to accurately assess Fed policy, whether it was accommodative, neutral or restrictive.  His skill in predicting stock market trends, on the other hand, was famously weak.  In fact, one of our clients found his work valuable only because they could usually make money doing exactly the opposite of what he recommended!  I recall that one year his predictions were uncannily accurate and the market did exactly what he thought it would.  After this, the client mentioned above stopped using the firm’s research…

Anyway, I recall one meeting where this strategist was laying out his feelings, impressions and predictions for the upcoming year.  He discussed his views on interest rates, Fed policy, currency factors, the economy, funds flows, investor sentiment, etc.  The list was endless, and for each positive he was able to conjure up a corresponding negative.  Finally (and to the great joy of all in attendance), he began to summarize and offer his final conclusion.  “I think,” he said, “that the stock market this year will…”  Here he paused for a moment, thoughtfully stroking his chin and looking a bit absent-mindedly at the ceiling.  “I think that the market will exhibit… volatility.”  Although no one in the room said it out loud, we were all thinking, “Volatility?  Oh, so you think that stock prices will go up and down?  Thanks a lot for that!”

Now that I’m older (and at least more experienced, if not wiser), I can better see the value of that seemingly useless forecast.  The value is this – complicated forces are impacting stock prices daily, and to reach a simple conclusion (up or down, for instance), grossly misrepresents the complexity of the investment decision making process.

I try to reduce this complexity a bit by not worrying too much about the big picture stuff and focus most of my efforts at the stock level.  It’s a “bottoms-up” approach that is battle-tested and has served me and countless other investors well.  I continue to think we are in a new bull market (a 65% bear market rally is as rare as yeti fur), which is likely to last several years.  I continue to find pockets of undervaluation in many sectors.  The massive amount of cash on the sidelines needs to go somewhere and given the historically low returns offered by bonds right now, I suspect it will eventually find its way into stocks.  Finally, I think sentiment is still very cautious.  We have not seen retail investors plow back into this market yet.  We have heard many stories of investors or their advisors who sold stock in early 2009 and to this day remain in cash or short-term bonds.  Not until I see wide-spread enthusiasm for the stock market will I begin to worry that the bull market is over.