Monthly Archives: June 2011

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.

What is Investing Anyway?

From time to time, we are all guilty of referring to “investing” as if it were one thing.  Part of the beauty and wonder of investing, in my view, is that it encompasses an amazingly broad range of activities.  And although at times I feel the need to separate “speculation” from “investing,” for the sake of today’s discussion, I will lump all similar endeavors into one grand exercise.

Dogbert Explains Stock Investing

Dogbert Explains Stock Investing

First of all, let us begin to define investing by what it’s not.  It is not gambling.  Although both gambling and investing may be considered exercises in uncertainty, the similarities end there.  There is no “house” in investing.  Also, unlike gambling, where most participants walk away losing money, investing most often leads to gains.  Even an unsophisticated investor can achieve positive returns over time by simply sticking to a few basic guidelines.

So, what then is “investing?”  In my view, investing is simply putting money at risk with the intention and expectation of achieving returns greater than the “risk-free” rate (usually defined as the return on cash-like instruments) with the concomitant understanding that losses may arise from this activity.  As comprehensive as I may think this definition is, it cannot begin to illustrate the vast variety of investment strategies out there.  Let me attempt to list a few of them:

Index Investing. For investors who are convinced that “beating the market” is impossible, simply buying the index is an attractive approach.   The value of their investments will rise and fall with whatever index they are invested in.

Hedge Funds. These investors are seeking absolute return.  Often, they have the ability to “go short” which allows them to make money as asset prices decline.  Hedge fund customers are among the most demanding investors and, as such, pay large fees to invest with the best.  But they are also quick to pull their money away from hedge funds if the returns fall below expectations.

Top-Down Investors. These investors start with a comprehensive view of the world.  From this view, they create a macro forecast of what they think is likely to happen.  Finally, they invest in the assets which they think will prosper as their forecast materializes.  Often they are looking for longer-term, broad trends (such as U.S. dollar weakness) and invest in and around these trends.  New economic data is constantly incorporated into the forecast and allocations are tweaked accordingly.

Bottom-up Investors. These investors largely ignore the macro picture and focus exclusively on what is happening at the individual company/stock level.

Growth Investors. These investors focus on companies which are growing faster than the average one.  Often, these investors are searching for the “next big thing.”  High earnings growth can often drive superior returns for equity investors.

Value Investors. These investors focus on the valuation of stocks.  They can achieve superior returns by finding and buying stocks which are trading at some discount to their intrinsic or “fair” value.

Traders. These investors focus on short-term movements in stock prices.  They are trying to make money every day in the market.

Chartists. These investors ignore all fundamentals and focus solely on the patterns displayed by the price movements of the assets they invest in.  The idea here is that chart patterns tend to repeat themselves and they reflect the collective actions of many kinds of investors.

Astrologers. OK, this may be a bit of a stretch, but I know of at least one successful equity market strategist, who boasts a large and loyal following, and who incorporates an analysis of the cosmos in his work.  The point here is that there are many ways to successfully invest; there is no one “best” way to invest.

Market Timers. However, there is one “worst” way to invest – by trying to time the market.  We know of no one who has successfully timed the market over any meaningful period of time.  Yet, this is the one strategy we often see individual investors attracted to.  Don’t try this at home…

This list is not comprehensive, and even within each of the above groups, there are many subgroups that can be successful in their approach.   As I carefully read Barron’s each weekend, I pay special attention to the articles highlighting some hedge fund or mutual fund portfolio manager or research team.  This is one simple way to gain a better appreciation for the many diverse ways to invest successfully.  The latest edition featured two very different approaches.  One was a value-oriented, event-driven hedge fund with $814 million in assets which never invests in banks, insurance companies, technology or biotech.  They focus on companies with easy to understand fundamentals which have been “smacked by a disruptive event.”  They will often buy these companies shares, bonds, notes or other securities.  Annual returns since 1996 have averaged 17.5%.

The other investor highlighted this week was a $53 billion top-down global asset allocation mutual fund that holds a shifting combination of stocks, bonds and cash.  This fund has logged annual returns of 8.9% since March of 2000 versus the S&P 500’s annual return of 0.62%.  One of the comments made by the portfolio manager of this fund struck me as a really smart thing to do if you are an investor, “…we follow some basic rules: Diversify, buy low, sell high, have a plan.”

I don’t think I could have said it any better.  The most successful investors I know can explain how they invest in a few sentences.  “Simple to explain” does not mean “easy to do.”  The least successful investors I know are those always trying to find the “next big thing.”  They are easily led to highly speculative endeavors because of clever marketing or the simple allure of a track record.  These investors lack a plan and usually cannot explain how their portfolio is positioned with any amount of words.  Their investment philosophy is much like being blown through life sideways.  It is easy to see why they often end up thinking investing is just like gambling, or that the market is rigged, and give up.

It doesn’t have to be this way.  There are many useful resources out there to help the individual investor be smarter.  Ultimately, it takes time, discipline and patience to discover what investment style should be yours.  Another attractive alternative is to seek professional help.  No, not a therapist (although that might be useful for some deeply scarred by the recent global crisis…), but an investment advisor.  There are a lot of great advisors out there.  The best ones can explain their investment approach in a few sentences, and can demonstrate how their services justify the fees they charge.  Many people lack the time, interest or patience to develop their own individual investment philosophy.  For these folks, an investment advisor can be a real benefit.