Yearly Archives: 2011

What is “Volatility” Anyway?

Maybe it’s my background as a language major in collage.  Maybe it’s my general penchant for prose.  But, there is something about language that truly fascinates me.  The active math/science part of my brain also seeks for clarity of logic and precision in communication.  So imagine my consternation whenever I begin to hear and read things about the markets that I know is unclear, imprecise and/or just plain wrong.

The latest target of bewilderment is the concept of “volatility.”  Everyone knows [quick aside: whenever you hear anyone say “everyone knows” be on your guard – the words that follow could lead you to a profitable trade – by doing the opposite] that the markets this year have shown unusual volatility.  I have probably heard/read comments along this line hundreds of times (I read a lot) this year.  For most people, hearing something over and over leads them to accept it as true.  To the contrarian, it has the opposite effect – the more I hear something the less I believe it.  In my heart, I believe that the consensus (about most things) is generally wrong.  I can produce reams of research that support this, but I find it nearly impossible to convince anyone of this fact.

So we all (except me, maybe) think that the market has been “extra” volatile this year.  Is there a way to measure this?  Volatility, at its heart, is a measure of the price variation of a financial instrument over time.  Looking at the VIX (which measures the volatility of the S&P 500), we can see that the second half of the year appears more volatile than the first.

Yet, looking at a 2-year chart, we see that even the current volatility is much less than the peak levels of this and last year.  Does anyone remember the worries and “volatility” of last May?  It seems (according to this chart) that last year was as “bad” as this year, and yet no one talks about the increased volatility of 2010.

Looking at the five-year chart of the VIX, we can gain even more perspective on this issue.  The volatility spikes experienced in late 2008 and early 2009 are roughly 3 times the level of the current volatility.  So, one way to say it is that the S&P 500 is 70% less volatile than it was at that time.  While this is true mathematically, this notion seems out of synch with the common knowledge of the day, that the market is somehow “more volatile.”

This is the point where unclear thinking and imprecise language can trip us up.  When I hear “volatility,” I am thinking “variance from the mean.”  I suspect most professional investors would agree.  When others use this word, I sense they take it to mean “the market is down (or a recent variant ’broken’)” or “I am losing money.”  So how much money have investors lost this year, this year marked by this supposed increased volatility?  As of this writing, the S&P 500 is down about 2% for the year, which means the total return (including dividends) is around zero.  Not a great year for stocks to be sure, but not horrible.  Not as bad as one might expect given the “increased volatility.”  Your results may vary.

The key concept here is that volatility affects mostly how we feel about the markets.  Most of us would like the stock market to provide stable, linear returns of 10% or more each year.  But, alas, that is not its nature.  Its nature is to provide an average return of 10% over time with lots of volatility.  The market almost never returns 10% in a calendar year.  To expect this means you almost always will be either surprised or disappointed.  Left to their own devices, the average individual investor tends to sell when things look bad (or “volatile,” if you will) and buy when things have “stabilized” (another imprecise word that usually means “the market has gone up”). I have tons of data to support this premise as well, but well, it’s hard to explain this to anyone who feels bad because the market is “volatile.”

Looking at the performance figures available, this has been a frustrating year for many professional investors.  It’s been a very hard year to “beat the market.” Yet for those investors who thrive on volatility (traders, quants, computers, etc.), it’s been a very good year.  As a long-term investor who does not trade actively, I fit into the former category.  Yet, I am encouraged by the progress individual companies are making.  Economic worries will come and go, but ultimately for stock pickers like me, the fortunes of individual companies will be more important for my returns than the economy, government policy, currency, or even “the market.”  Here’s to a better year in 2012 (historically U.S. Presidential election years are good for the market) and more intelligent commentary (that is to say, commentary that is more intelligent – sorry for being imprecise…) from the “gurus” on television.  Skål!

Turn Off the Chatter!

There is a certain amount of intuitive appeal in the daily chattering of stock market commentary.  We have all been taught from the time we were wee little investors being dandled on our pappy’s knee that there is always a reason for the market’s daily movement.  There are several television channels and countless Internet websites dedicated to explaining the daily “reason” which all seem to have short memories, a limited sense of accountability and a brash confidence that would humble your average high school starting quarterback.

This concept is brilliantly highlighted by the simple daily market commentary headlines on Yahoo Finance.  We often joke around the office that the job of writing these headlines must go to the most junior person on the team, because it is really a thankless job that is nearly impossible to do well.  If the stock market falls 2% at the open, this young go-getter probably calls around to find out why.  The “reason” soon appears front page and center “Stocks Fall on Worries about Italian Debt Plan” (or whatever).  Thirty minutes later the market is up 1% and, lacking a good reason for this turnaround, the hapless intern updates the page with something like, “Stocks Rally Despite Worries about Italian Debt Plan.”  This may seem like an extreme example, but I have seen many headlines like this.

This desperate search for the “reason” would be fine comedy if it weren’t for some poor widow in Minot adjusting her asset allocation based on this kind of chatter.  I realize that I am some times hard on journalists, but I think the real problem for me here is that daily stock movements and journalism are not a good combination.  When everyone was day trading back in the go-go 1990s, it might have made some sense to listen to the market pundits 24/7.  Now, I’m not so sure.

One thing I learned in business school is that companies exist to make profits (profound, eh?).  I suspect that this applies to the media outlets who report exclusively on the markets as well.  As I understand it, these companies are paid by advertisers who will pay based on the size of the audience these outlets can attract.  So, while these outlets may feel obliged to comment on daily market news, they also have a fundamental need to increase viewership.  This may lead to the bad combination I hinted at above.  If one were really dedicated to helping individual investors make money and reach their financial goals, I think they would feature professional money managers who could offer solid, actionable, long-term advice to their listeners.  Instead, we get academics, traders, authors, government officials, economists and a host of other “gurus” who may not be skilled investors and who may not really have our best interests at the top of their priority chain.

Again, I am not a trained journalist, so I may be totally wrong on this, but which headline do you think is “better” for these outlets?  “Roubini: Italy at risk of exiting euro  zone” or “Buffet: Stocks Look Attractive for Patient Investors.”  The problem with the Buffett quote is that he says things like this all the time.  It’s not really newsworthy, but it’s loads more helpful to the individual investor than the other one.  On the other hand, the Roubini quote may lead to a spike in viewership.  Which is better? Hmmm.

The data show (see the work of Dalbar) that the individual investor, in aggregate, is 1) bad at market timing and 2) highly influenced by the sentiment of the moment.  Even a very smart investor with a workable investment philosophy and approach can fall victim to the whipsaw action of sentiment.  Lauren Templeton, a professional money manager (and grand niece of the Sir John Templeton), at a recent conference suggested that there are three ways to “beat the market.”  Better information, better process or better behavior.  These days it is impossible for the individual investor to have better information or a better process vs. the big professional investors.  But, better behavior can still be applied to beat the market.  The problem is most investors behave badly when it comes to the market.  They feel like selling when they should buy and vice versa.

One simple way to improve one’s investing behavior is to not listen to the daily chattering.  If the market is down, maybe it’s because of some Euro problem, or maybe it’s just a lot of people freaking out about the fears they have in their hearts and heads.  The market being down (or up for that matter) may affect how you feel, but it should not change the way you invest, unless of course, you instinctively want to buy when it goes down and sell as it rises.  Ultimately, the stock market cares about three things – earnings, interest rates and sentiment.  Earnings are fine right now, up 12% in the latest quarter (which, by the way, marks the ninth quarter in a row of solid earnings growth) and 2012 should be another good year.  Interest rates remain low and the Fed has promised no tightening before 2013.  Sentiment, which is a contra-indicator, is quite negative now. Thus, from this simple formula, one could conclude that the stock market might be due for a nice rally.  Time will tell.

What I do know for sure is that people who try to trade around their portfolio based on the daily chatter rarely win.

The Individual Investor is Alive and Well

Last week I spent several wonderful days attending the biennial conference of the American Association of Individual Investors (AAII).  Despite their frequent depiction of being unsophisticated or, even worse, blind followers of obvious market trends, the individual investors I met were nothing like that.  They were all intelligent, hard working, successful and experienced folks who shared a deep passion for taking charge of their portfolios and financial wellbeing.  That said, their approaches to getting this done was as varied as their home towns or how they had made their money.

I met people who strictly employed the “do-it-yourself” method of investing.  They were assiduous students of the investment process and market mechanics.  They quoted Buffett, Lynch or Paul Tudor Jones as readily as a high school student can recite the latest Katy Perry song.  Others preferred to use professional managers, but held them to a very high standard of above-market returns.  Yet others had found “the secret” of investment (at least for them) and used it (there were many, many of these “secrets” to be found) exclusively and religiously.  There were some folks just starting out, who seemed a bit dazed by all the volatility of the markets over the last few quarters, and others who had been investing for over four decades.  All in all, I found it to be an exhilarating experience.

The professionals at the conference were there to offer their perspectives on the markets or the process of investing, pitch their versions of “the secret,” move a few newly-published books, opine about a wide range of related topics and/or provide encouragement to the group.  Experts in security analysis, trading, hedge funds, value investing, index investing, behavior science and many other areas all vied for the attention of the attendees.  All of the presentations and workshops I attended were excellent.  It was highly reassuring to hear the time-tested investment philosophies I was raised on praised, reiterated and confirmed time and again by many of the experts there.

Space does not allow a comprehensive summary of the things I heard and learned, but let me share with the reader a few of the pithier quotes I was able to capture.  Attribution of the speaker will be shared only off line, if anyone really cares to follow up with me.

“Looking the history of the market, we see that the November to April timeframe usually offers the best returns for any given 12-month period.”

“You pay a hefty price for a cheery consensus” – someone quoting Warren Buffett, who must be the patron saint of the individual investor…

“Value and dividend paying stocks look poised to do well going forward.”

“People are not rational, they are normal.  That is, sometimes we’re smart and sometimes we’re stupid.”

“Intuition is insufficient alone to invest successfully.”

“Hindsight fools us into thinking that we should have known something in foresight as well.”

“The economy tends to grow at irregular rates.  There has never been an economic recovery that is “regular.”

“Bad behavior is always bad.”

“U.S. Presidential elections are always bullish events.”

“Smart investors create their own luck.”

It was very encouraging to see so many people dedicated to helping individuals make better sense out of the complex exercise of investing.  Well done, AAII!

Goodson’s 10 Rules for Investing

Because the world needs more “10” lists…

1)     Never Eat Anything Larger Than Your Head.  OK, it’s not really a rule exactly applicable to investing, but I think it’s a pretty good rule for staying healthy.  The healthier you are, the longer you can enjoy the magic of compounding…

2)     Know the Difference Between a “Trade” and an “Investment.” A “Trade” is a short-term “bet” (for the lack of a more elegant term) that something will happen and the result of that something will be good for the stock you bought.  A reasonable trade always has a trigger event and a deadline.  Buying a stock because you think it will report better-than-expected earnings is a classic example.  An “Investment” is something you tend to hold for a longer time.

3)     Don’t Let “Trades” Become “Investments.” So what do you do when the earnings results are disappointing, and the stock you just bought for a trade goes down?  The temptation is to hold on and try to recoup your losses, but the rule #2 dictates that you sell it.  You were wrong.  Move on.

4)     Limit Your Sources of Information.  This may seem a bit counter intuitive, but I think it works.  Listening to too many outside sources can often lead to confusion.  This is especially true of the more popular media outlets dedicated to capital markets commentary.   In my work, I follow closely two or three equity strategists, a like number of economists, one bond market “guru” and a handful of sell-side analysts.  I note in passing a large number of other sources, but usually pay them no mind.  Some popular sources I actually consider potentially dangerous to one’s portfolio.

5)     Always Know Why You Own Something. At whatever point you are not sure why you own a stock, you should get rid of it.  By the way, merely thinking a stock might go up is not really a sufficiently strong reason to hold something.

6)     Never Get Involved in a Land War in Asia.  Again, not exactly a key principle for investing, but it underscores that fact that much wisdom about life in general can be gleaned by simply watching “The Princess Bride…”

7)     Never Buy a Stock on Another Person’s Recommendation. Actually, that’s a bit strong.  The actual rule is don’t do this unless you have considered how that recommended stock fits into your way of investing or into your portfolio.  Understanding the appropriateness of any investment is critical to portfolio balance and risk management.  Buying a stock just because some famous person on television (or your cousin Ned) recommends it is a recipe for randomness.

8)     Never Buy a Stock on “Gut” Feeling. Intuition may serve us well in many endeavors, but in the investment world, it only helps after we have done all the hard work to truly understand the asset we are considering.  Seasoned Wall Street pros will often talk about the importance of gut feeling in their investment making process, but if you press them, they will admit it’s only about 5% (or less) of the total work required to find, analyze and select a successful investment.

9)     It’s Better to be Disciplined Than Smart. The most successful investors I know have lots of rules that they have crafted over many years of experience.  They also follow them more or less religiously.  Sometimes your particular investment approach will not be rewarded by the markets.  That is no reason to abandon it.  Successful rules will more often lead to outperformance than trying to guess what approach will work next.

10)     Sometimes the “Right” Thing do to is to do Nothing. Many people fall into the trap of feeling they must react to events affecting their stocks or portfolios.  More often than not, simply taking a deep breath and re-evaluating the merits of the investment is a much smarter approach than simply selling (or even buying more).  Understanding whether you are using your emotions or your cognitive abilities when approaching a key investment decision is a critical key to success.

A Treatise for Taylor

Last week my granddaughter, Taylor, was born.  As I reflected on the miracle of birth, I began musing about what kind of life Taylor might expect to have.

Despite all the negative talk about the United States, I suspect that Taylor will be grateful to live in this country.  The U.S. economy is still the world’s largest by a large margin, and per capita GDP is still envied by most of the world. She will likely live in a home most of her life that is warm in the winter and cool in the summer.  Her father sells insurance, a product that will likely be in demand for the entirety of her lifetime.  Her mother has chosen to stay at home and focus her efforts on the rearing of her children.  I suspect that Taylor will benefit from both of her parents’ career choices.

The Greek crisis, which seems to be the key driver for the U.S. stock market these days, will probably be little more than a footnote in some history book Taylor reads in a class someday.   Even the “Great Recession” may become a near non-event in the trajectory of Taylor’s life.   She will likely attend public schools and, if she works hard and gets good grades, may attend a university.  It is likely that her careers choices will include jobs in industries that don’t even exist yet.

If she follows the example of her parents, she will likely fall in love, get married and start her own family, experiencing all the joy, pain and promise that family life can bring.  She will likely cry when her grandfather dies, but will have numerous occasions to remember him fondly, his corny jokes, his dry wit, his unshakable belief in value investing…

During her lifetime, the expansion in innovation and technological gains is hard to imagine.  Consider that when I was born, the world had no knowledge of color television, cable television, 24-hour news programs, MTV, manned space flight, personal computers, CDs, heart transplants, GPS, reality TV shows, Bill Gates, Steve Jobs, moon landings, the Beatles, etc.  Taylor will be able to compile a similar list in her 50s that will likely seem like science fiction to us now.

In spite of the notion of diminished expectations we hear constantly now, I suspect Taylor’s life will be full, rich and fulfilling.  The big picture issues we fret and fuss about now will likely have little impact on her ability to find happiness and contentment.

Taking a longer-term view allows one to see things as they really are, apart from the sometimes myopic view we see through the prism of the present.  Sentiment and the markets will swing around as they will, but truth and true principles (either of investing or other areas of importance) will persist and resist all our attempts to invalidate them.

Precision without Accuracy

As an old Japan expert, I recall chuckling to myself whenever the Japanese government would release its quarterly GDP numbers.  Inevitably, the announcement would include a phase something like, “This quarter the Japanese economy grew at 2.0145%…” suggesting that somehow that last three decimal places were of critical importance for the world’s second largest (at the time) economy.  Someone somewhere in the vast bureaucratic machinery of the government had decided that the public really, really needed to see those last few decimals.

Clearly a case of precision without accuracy.

Lately, I find myself similarly amused as the “gurus” who appear frequently in the media discuss their outlook for the economy.  Most of those featured as of late appear to be in the bearish camp (negativity sells, maybe?) and gravely opine on their chances that the U.S. could slip into recession.  One will say “a 30% probability,” only to be followed by someone the next day upping the odds to 50% (or whatever).  As if these figures were bids in some kind of morbid auction game, the spotlight forecasters begin to move their estimates around trying to underscore the direness of our straits – “It was 35% chance, but now I see 47.398% chance of a U.S. recession…”

Another exercise in precision without accuracy?

In my simple way of thinking, either we will have a recession or we won’t.  The notion of the “odds” of a recession makes sense only if we could run a number of iterations of today’s conditions and see what happens.  Absent a time traveling machine, we can’t do that.  The probability of a recession is either 0% or 100%, not 30%, 50% or 47.398%.  I realize that speaking of the “probability” of a recession is actually a measure of confidence the forecaster is using to color the tone of his or her opinion.  But at the end of the day, everyone who wasn’t forecasting a recession with either 0% or 100% probability will be wrong…

I’m not an economist, but I do follow their work closely.  It’s interesting to note that for all the discussion about the possibility of a recession in the U.S., the consensus for 2011 still shows positive growth for the economy.  The consensus also calls for stronger (albeit still modest) growth for 2012.  So, why all this strum und drang about the economy?  Well, for one, the stock market has fallen from its recent highs.  Whenever that happens the economy tends to get the blame.  We have seen estimates of economic growth falling and we are painfully aware of the current problems in Europe (although drawing a direct line from these troubles to the U.S. is a bit of challenge given the paucity of European exports from the U.S.)  Yet, sequential growth, at a slow pace, is the consensus view.

Also, we are in the middle of an intense political debate within the U.S. about what to do about the economy.  Whether one thinks the government is the solution or the problem, the debate seems to be negatively impacting consumer sentiment.  The key point for me here is that job growth is somewhat different than economic growth.  Clearly there is a link between to the two, but I would submit that politicians care much more about job growth than does the stock market.  So, while 2.0% GDP growth may be “low” for job creation, it may provide adequate earnings growth for the stock market, especially if the so-called emerging economies continue to grow.  Recall that 50% of S&P 500 earnings come from outside the U.S.

In my view, the stock market ultimately cares most about earnings growth.  Nearly every one of the companies I follow closely expects to grow revenues and earnings next year.  We can debate about how much growth might be needed to get the stock market excited enough to return to previous highs, but I would submit that any growth in earnings for next year should be viewed as a reasonable agreement against a recession.  Or said better, the bottom up consensus view about earnings supports the notion that a recession is very unlikely, regardless of what the “experts” on television are saying.

So, what’s to be done now?  I suggest we simply hunker down during this storm of negativity and do nothing dramatic.  In the coming weeks or months the clouds will likely dissipate and we will probably have a clearer vision of what’s to come.

For someone looking for a simple data point that is a clear positive for the equity market consider this:  the dividend yield on the S&P 500 is currently 2.06%.  The current yield on the U.S. Treasury 10-year note is 1.919% (please note my precision here…).  Rarely (if ever), in my career have I seen the yield on stocks higher than on bonds.  This suggests to me that if stock prices were to be flat for the next 10 years, stocks would still outperform treasuries.  Said another way, investors who would sell stocks now and buy treasuries are betting that stocks will be at a same level or lower than they are now.  Does this seem like a “safe” bet to you?

Earthquakes, Hurricanes and Stock Market Rallies

Strange days, indeed.

Last week we here in Virginia experienced the most severe earthquake in recorded history.  And due to the hard underlying rock strata in this part of the country, this quake was felt from Georgia to the Hudson Bay.  Most of us who experienced this shaker were impressed by its loudness; many thought it was a low-flying jet or a large lumbering truck moving through the neighborhood.  Given the general lack of experience many in the region had with earthquakes, their responses were mixed and nearly comical. One family I know, not being sure what to do in the wake of quake, ran down to their basement and huddled in a remote corner, no doubt the worst thing to do. Many ran out of their buildings after the trembling had ceased – again something the earthquake experts tell us not to do.  Luckily the damage was not widespread and in most cases modest.  The stock market rose 3.4% that day.

On Friday of last week, a major hurricane threatened the eastern seaboard and caused what might be considered major panic (perhaps fueled by the media) among the population in the area.  Early estimates suggested that Irene could cause as much as $10 billion in damage.  New York City, for the first time ever, ordered a mandatory evacuation of low-lying areas of the city.  There was concern that the New York Stock Exchange might not be able to open on Monday due to the high water and wind damage.  On Friday, the stock market rose 1.5%.

As luck would have it, Irene did not prove to be as devastating as she might have been.  Serious damage was widespread and flooding was a huge problem in many areas, but it was not quite as bad as people feared it might have been.  On Monday, once the skies were clear and the wind calm, the stock market rose 2.8%.

For someone watching the daily gyrations of the stock market (and I hope the reader is not – you should be out doing fun summer things!), the last few trading days are a bit puzzling.  The recent rally was clearly correlated with the earth quake and hurricane, but was it caused by these events?  Most reasonable people would quickly conclude that a stock market rally should not be caused by earthquakes and hurricanes.  I would agree, and I would also advise caution to anyone trying to make sense out of the tortured logic that may emerge from the commentary about these correlated events.  Despite what one might hear from the “experts” who are supposed to know these things, I would submit that almost no one really has a truly solid understanding as to why the market moves how it does on any given day.  Sure, many are asked to explain what did happen, and I think that their answers (most of the time) appear to be reasonable and might even be part of the reason, but can they really know the daily “why” of the market?  I don’t think so.

This is why I focus on the longer-term and the individual company.  We know that over time the stock market provides the best returns of any asset class.  We also can understand much better the prospects and merits of one company as opposed to “the market.”  We also know that the best time to buy stocks is when everyone else is selling.  Did you hear about Warren Buffett’s latest purchase?  He invested $5 billion in Bank of America (BAC) just at the moment when many thought the company was on the ropes.  One might say, “Yeah, but he’s a billionaire, so he can afford to lose money if the investment goes bad.”  Yet, anyone (regardless of net worth) could have stepped up that day and invested in BAC.  Buffett did, not because he is a billionaire, but because he understands the concept of value and knows how to invest against consensus opinion.

Again, the Sage of Omaha has taught us all a great lesson.  Would that we will listen and learn from it…

Don’t Take My Word for It

Truly, these are the days that try a man’s patience.

The recent market volatility is unprecedented, and surely has caused concern in the minds of many investors.  The reasons for this volatility are legion, but probably not just the simple reasons portrayed in the media.  I cannot profess to know the “real” reasons for the market’s gyrations, but I am feeling that things may not be as bad as the market is suggesting.  Ergo, this may be a buying opportunity for stocks.

Right now, stocks are being valued at an 80-year low versus bonds.  The trailing P/E on the market right now is actually lower than it was in March of 2009.  The most expensive thing out there right now appears to be “comfort.”  We all know that inexpensive valuation by itself is an insufficient reason to buy stocks, but it may provide some comfort to investors that the downside may be somewhat limited or that the rebound (when it comes) may be robust because of this low valuation.  Those of us who focus on investing in individual stocks can find solace in knowing that the companies whose stocks we own will find ways to make money in whatever new environment is presented to them.  Good companies with good management can usually seek new profit vistas no matter what.  We find this thought encouraging.

In the near-term (as always), we (like most investors) have limited clarity of vision. Yet, we are extremely hopeful that the long-term prospects for equities are very positive.  Market bottoms usually come when pessimism peaks.   It certainly feels like negativity is reaching some kind of climax.

But don’t take my word for it.  Here is what some very successful investors say about times like these:

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” – Warren Buffett.

“It’s not always easy to do what’s not popular, but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized.” – John Neff.

“… we continue to believe that investing requires detailed research, independence of thought, and a willingness to act contrary to the lemming-like behavior of most. Boiled down, we have now captured these sentiments in our new tagline: Ignore the crowd.” – Bruce Berkowitz.

“When stocks are attractive, you buy them. Sure, they can go lower. I’ve bought stocks at $12 that went to $2, but then they later went to $30. You just don’t know when you can find the bottom.” – Peter Lynch.

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.” – George Soros.

Mid-Summer Musings

Sometimes I just don’t have much to say…

Not Impressive:  Politicians and fund managers who scare the American public for personal/political gain.

Impressive:  Clear thinking people who tell it like it is and propose workable solutions.

Not Impressive: Talented musicians/songwriters who die at 27.  To wit: Amy Winehouse, et al.

Impressive:  Talented musicians/songwriters who do some of their best work at 27.  To wit:

1)     Paul McCartney – “Let It Be,” “Get Back,” and “The Long and Winding Road.”

2)     John Lennon – “A Day in the Life” and” Lucy in the Sky with Diamonds.”

3)     Pete Townshend – Two massive albums => “Who’s Next” and “Quadrophenia.”

4)     David Bowie – “Rebel, Rebel” from “Diamond Dogs.”

5)     Joni Mitchell – “Chelsea Morning” and “Both Sides Now.”

6)     Jackson Browne – “The Pretender.”

7)     James Taylor – “Mexico” and “How Sweet it is to Loved by You” from “Gorilla.”

8)     Paul Simon – “America,” “Hazy Shade of Winter,” and “Mrs. Robinson.”

9)     Elton John – “Goodbye Yellow Brick Road,” featuring “Candle in the Wind,” “Bennie and the Jets,” “Saturday Night’s Alright for Fighting.”

10)Neil Young – “Heart of Gold” and “Old Man” from “Harvest.”

These are just a few of my favorites, but I’m sure there are many more great artistic accomplishments from folks at this age.

Not Impressive:  Irrational fears about the debt ceiling, Greece, etc.

Impressive:  Even-minded strategists who can describe the current situation and make sensible forecasts without using the words “catastrophic,” “apocalyptic” and/or “end of the world as we know it.”

To wit:

James Swanson, of MFS Mutual funds, continues to think that we are solidly in the middle of an economic expansion (despite the current “slow patch”) and an equity bull market.  He notes that some of the economic data, such as new factory orders, Japanese industrial production, German GDP, etc. are showing quite robust underlying growth.  He also thinks that U.S. profit growth may continue to show strength because unit labor costs (a big part of most companies’ SG&A) continue to show no growth.  He also points out that the strong economies of the 1980s and 1990s, where GDP occasionally grew at 4-5%, were fueled by a massive increase in the use of credit (1980s) and production capacity (1990s – especially in the tech industry).  He opines that an economic expansion absent those factors (which ultimately lead to bubbles and then collapses) may actually be more stable and sustainable.

Time will tell if his predictions prove to be correct, but in my mind I he’s more likely to be right than those who dwell in the realms of hyperbole…

Is it Really the Economy?

With the S&P 500 down about 5% in June, just everyone seems to be freaking out.  One of the unwritten rules of stock market commentary is that there must always be fundamental reason for the market’s movement.  If the market is down, there must be a reason.  If it’s up, there must be a reason.  Around the office here, we often lament the poor person who writes the headlines for the Yahoo Finance website.  That headline must (according to the unwritten rule above) explain what’s going on in the market at that moment in time.  Today I saw one headline that I think underscores the challenge this person faces.  The headline read, “Stocks rise after Dow falls below 12,000.”  Let that sink in for a minute.  Yes, you’re right.  That headline says nothing about why stocks are rising.

Most of the commentary I’ve seen lays the blame for the recent decline on the economy.  The May jobs report was weak and the latest data on manufacturing also suggested some weakness.  These reports were weaker than expected and seemed to be the trigger for near-term concern about the economy and may have been the catalyst for the market’s decline.  But other factors may also be at work here: simple profit taking, a number of aggressive sellers in a low-volume trading environment, forced selling due to margin calls, a strengthening of the U.S. dollar and so forth. I don’t know with certainty that any of these factors are the “real” reason for the market’s softness, but they could be.

Most people crave the simple answer and if the market’s down because the economy is weak, that’s good enough for them.  The trouble with this simple answer is that it becomes a given and others feel the need to pile on with more bad news, which may actually force the market lower.

In my view, there exist both negative and positive influences on the market at all times.  It is as if there is a “balance sheet” of pluses and minuses.  When the market is rising, the commentary tends to focus on the pluses.  The opposite occurs when the market declines.  This is the biggest challenge for investors trying to make money by looking only at the big picture.

So how is the economy doing right now?  We know that Q1 GDP was +1.8% and that seemed to be on the weak side.  Most reports I saw did not comment in detail that a big decline in defense orders (which tend to be lumpy anyway) may have reduced GDP by as much as one full percentage point.  We also know that the tsunami/earthquake in Japan took out a significant amount of products used in manufacturing elsewhere (autos, electronics, etc.) and reduced Japan’s demand for some products.  Higher gasoline prices no doubt dampened consumer spending and sentiment a bit. All of these factors could be reversed in Q2.

Despite a weak Q1 and the recent disappointing data, the credible economists I follow are still forecasting Q2 growth better than Q1.  I suspect that this will make the economy look like it is accelerating when it’s reported later in the summer.  These same economists are also forecasting a stronger second half of 2011.  For the year, I suspect GDP for 2011 will come in at something like 3.2%.  Current estimates also have 2012 growth around 3%.

I understand that the sad housing market and high unemployment rate may make the economy seem weak in eyes of some, but does anyone remember what GDP growth was in 2010?  2.9%.  So, if GDP grows to 3.2%, shouldn’t that be good news?  How fast would GDP have to grow to get people thinking that the economy was good?

I recall a time when 2.5% was the long-term, non-inflationary growth potential for the U.S. economy.  That is, at 2.5%, the economy was growing without any worries about inflation.  That is, 2.5% growth was “good.”  I am not sure what level would seem “good” any more.  A quick look at the last 30 years for the U.S. economy reveals that GDP growth of 4% or more is rather rare.  Only 8 of the last 30 years showed GDP growth this high.  Most of these +4% growth years occurred in the late 1990s when the tech bubble was being created.  Is the tech bubble the model for sustainable economic prosperity?  Do we need to create another bubble in order to feel good about the economy?

So, let’s return to the stock market.  Do you think that knowing exactly what GDP is going to be in the future would help you make money in the stock market?  The chart below show annual GDP and annual S&P 500 returns over the last five years.  Can you see any great correlation here?  Granted the financial crisis no doubt messed up the numbers a bit, but it seems that there’s always something “special,” “unique” or just plain “messed up” about the current situation.  That said, how would you use the foreknowledge of the GDP figure to make money in the stock market?

As I looked at the GDP data, I applied a simple, seemingly-rational rule – if next year’s GDP was going to be better than the current year, I would increase my stock exposure.  If lower, I would reduce my portfolio equity weighting.  This approach helped me to “win” about 62% of the time.  While this is better than a coin toss, it’s no where near where I want to be with my investments.

Alas, perfect GDP foresight does not exist.  And even if one did have it, it would not be a great tool to make money in the market.  No, the stock market is not the economy, and making money in the market cannot be reduced to only one thing.  It’s a complicated process that requires constant attention to many factors, including the economy, but encompassing much more.  People who try to manage their investments in their spare time or as a hobby or only look at headline economic news, in my view, run the risk of hugely underperforming what might be achievable with another approach.  If you find that your portfolio is constantly disappointing you, you may need professional advice.