Persuasion Time

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…