Monthly Archives: November 2010

The Futile Search for Certainty

I am not good at small talk.

Certain Uncertainty

In social gatherings I find that I compensate for this shortcoming by either talking a lot about things I like (can you spot the boor in the room?) or by wandering around the room trying to avoid eye contact.  In those rare times when I am able to have a more normal conversation with someone, the talk inevitably turns to the economy and/or the stock market.  When someone finds out what I do for a living, they feel compelled to offer me their take on the world.  For the last year or so, the conversation has gone something like this:  

Random Person:  “Financial advisor, huh?  How about that stock market?  I hear things are really dicey now in the market.” [By the way, this has been the opening line from almost any random person I’ve spoken with over the last 2 years or so]

Me:  “Actually, the S&P 500 was up nearly 25% last year and so far in 2010 is up around 6%.  Valuations seem reasonable, corporate earnings are steadily growing, balance sheets are flush with cash and sentiment, which as you know is a contra-indicator, is still quite bearish.”

Random Person:  “Oh, really?  But what about the economy?  I hear that it’s really weak.  Stocks can‘t do well when the economy is weak, right?”

Me: “Consensus estimates for GDP growth for 2010 are around +2.6% and for next year the IMF is estimating growth at around 2.3%.  Not too long ago, U.S. GDP growth around 2.5% was a very good thing.  That’s the economy’s non-inflationary growth average over the long run.  The global economy is growing at around 4.8% this year and is predicted to grow 4.2% next year.  Given that about 50% of U.S. corporate earnings come from outside the country, I suspect that U.S. corporate earnings will continue to grow under the current GDP estimates.”

Random Person:  “But what about _________ ? (This is a fill-in-the-blank statement reflecting the latest “crisis” in the news – today it could be Ireland or China. In the past, it could have been Greece, the Gulf of Mexico oil spill, etc.)  I hear that ______ could lead to another major global crisis.”

Me:  “Possibly.  But consider that the global economy has just been through the worst crisis since the great depression and has recovered.  I suspect that at this point the policy makers have learned a great deal from the events of the last three years and are better prepared to handle any little crisis thrown at them.”     

Random Person:  “But what about the housing situation and unemployment?  How can the stock market go any higher with these two huge problems left still unresolved?  The consumer is totally stressed.  No jobs.  Banks are going to take their homes.  Given that the consumer represents 70% of the economy, how can stocks do well with the consumer in such dire straits?”

Me:  “Ninety percent of people who want jobs have jobs.  Most analysts are now calling for holiday spending to be higher this year than last.  People may be saving a bit more, but consumer spending looks reasonably robust.  Housing was a major growth factor in the middle of last decade and now it has become a drag.  Yet, the economy is still growing despite this drag. At some point, house prices will bottom and may again have a positive impact on the economy.  I don’t think a housing recovery is critical to the success of the stock market.  That was so 2006.  Anyway, about 35% of the foreclosures so far in 2010 were properties owned by investors and not the primary residences of homeowners.  Although things are not rosy yet in the housing industry, the raw numbers reported may overestimate the magnitude of the problem.”

Random Person:  “Well, yeah.  But, I’m still going to wait for more certainty before investing in the stock market.”

Me:  “Please pass the chips…”

Only once in my career has this mythical sense of certainty emerged – in the late 1990s.  At that time, EVERYONE KNEW stocks were going to go up.  I remember new associates at my firm, fresh out of college, using cash advances from their credit cards to day trade stocks.  Everyone was a “genius” back then.  We all know how that period of certainty ended.

The old masters of investing always tell us that the best time to invest in the stock market is when uncertainty is high.  Think back to March 2009, the time when the market bottomed.  How was certainty then?  In the final analysis, this is why investing is not easy.  To be really successful at it one must continually overcome both the “fight or flight” instinct buried deep inside us and the highly reasonable consensus opinion presented daily in the media.

When is the “Right Time” to Sell?

Of all the questions I have tried to answer over the course of my career, this one is the most difficult.  Value investors are pretty good at measuring value and identifying cheap stocks.  A cheap stock (assuming the underlying company has a viable business model) has a tendency to appreciate toward fair value over time.  Selling that stock when it reaches fair value may be one satisfying, simple answer to the question posed by the title.

Yet, many times (and most often in bull markets) the market will award stocks large premiums to their fair values.  So the value investor must face this dilemma when a formerly-cheap stock becomes fairly valued – “Do I sell or hold?”  This is where an assessment of the macro environment may help the value investor decide.  Is the bull market firmly established?  Is the bull market still young?  Is sentiment regarding the market unanimously bullish?  Where are cash levels?  What about technical factors?  And so on.

In those times when the macro environment is positive (obviously this is a judgment call), the value investor may be able to comfortably hold stocks which may appear to be fairly valued.  Why?  If the trend for corporate earnings is supportive and the trajectory of the stock market is generally upward, it is rare for a fairly-valued stock to collapse, or in the vernacular, to become a “torpedo stock” (one that sinks the portfolio).  Thus, in my portfolio at any given moment, one may find cheap stocks as well as fairly valued stocks.  Some purist value investors may point a finger of scorn at this confession, but I have found this approach to be workable and successful.

For me, selling is much more art than science.  Often the best time to sell is when everything looks great for a company and the valuation appears to be rich.  Sometimes these stocks can go up even more after I sell them because I was underestimating the earnings growth potential.  Yet, I never feel bad taking profits.  I am usually able to find some other, cheaper stock which I find attractive.

Sometimes the fundamentals change dramatically and the investment thesis of a stock morphs into something different and unattractive.  Before I buy a stock, I like to consider a number of future scenarios and I usually create an investment thesis – I like to know why I will make money in the stock.  When this thesis is proven wrong, I need to sell – sometimes at a loss.  Still, losing money this way is not really a total loss because it affords me the chance to revisit my thought process as I analyzed the stock.  Where did I make mistakes?  What can I learn from these mistakes?  Do I make the same kind of mistakes over and over again?  This kind of self analysis can be of great value to an investor.

Last week, I was intrigued to learn that Microsoft (MSFT) CEO Steve Ballmer sold $1.3 billion worth of Microsoft shares and plans to unload nearly another billion dollars worth before year end.  Now to be clear – I do not own the shares of Microsoft and I do not have an opinion about the company or its stock price.  The old Wall Street tradition suggests that there may be many reasons for insiders to sell stock (purchasing other assets, diversifying the portfolio, tax planning, etc.), but only one reason for insiders to buy stock – they expect it to go up!  This is why insider buying is often a more reliable signal than insider selling. (Aside – these transactions are totally different than “insider trading,” which is buying or selling based on “non-public, material information.”  “Insider trading” is illegal and insiders cannot do this either.  Most companies have very strict rules governing the buying and selling by corporate officers to avoid any hint of impropriety, and, of course, to comply with the law.)

Mr. Ballmer’s comments about this sale seem consistent with most insider sellers – he said he is selling the stock to “diversify his holdings and to help with tax planning.”  The second part of that statement caught my eye.  Does Mr. Ballmer think capital gains taxes might be going up in the future?

As I understand it, without any action from Congress, the tax rate on long-term capital gains will rise from the current 15% to 20%.  What will happen is anyone’s guess, but perhaps Mr. Ballmer is making a small wager (he still owns $9 billion worth of Microsoft shares) that the rate will rise.  After all, the difference between 15% and 20% on $2 billion is $100 million, and as they say, “that ain’t chump change.”

So what about the rest of us non-billionaires?  I am not a tax expert and am not qualified to give tax advice, but there may be some merit for some investors to realize capital gains this year, just in case the rate goes up next year.  Once the rates move higher, it will be too late to do anything.