Persuasion Time

Or maybe it’s “fear.”  Stock markets around the world took it on the chin today after investors began really worrying about European sovereign debt.  Yes, you might have heard that the European Union had approved a big bailout package for Greece, whose problems are well known, and had concluded (as did I) that Greece and all of its problems was already fully discounted by the markets.  Today’s new twist is the fear of contagion.  This is the “high concept” that one bad apple may indeed spoil the whole bunch.  If Greece can be driven to the brink, this concept muses, why not Spain, Portugal, and others?

Above all else, the stock market fears uncertainty.  Could Greece’s problems spread far, wide and deep?  Maybe.  I am no expert on sovereign debt or the Euro Zone, but I do know that many stocks I really like are now 2—4% cheaper than they were yesterday, without any change in their individual fundamentals.  I also know that corrections within the context of a bull market are normal and actually helpful – they help to prevent the kind of “irrational exuberance” that prevailed in the late 1990s.

This sudden rush of fear reminds me that we are still far away from universal bullishness on the U. S. stock market.  Investor psyches are still tender from the punishment inflicted upon them over the last few years.  Whenever anything negative develops, we tend to move immediately to a “what next?” mentality, as if every negative thing has to be the first of a series of bad events.  In normal times, a correction like we saw today would split opinions somewhere down the middle – half would urge caution and half would view it as a buying opportunity.  The fact that opinions appear to be highly skewed to the caution side this time around tells me that times are not yet “normal” and that much work still needs to be done for investors to fully embrace the new bull market.  That’s one of the key reasons I think it will continue.

My bottom line is that this is a buying opportunity.  I can’t predict that this correction will end in one day; it might last weeks or even months. But I do believe today’s action does not represent anything more than a normal pull back within the context of a bull market.  Time will tell.

Popeye the Sailor

A few years back, I would occasionally be asked to appear on a cable news show to discuss my views on the Asian markets.  Asian specialists were somewhat rare in New York City at the time, and demand for my point of view, especially following dramatic events (earthquakes, currency crises, etc.) ran high.  Once I remember speaking with the young woman who was applying make-up to the guests of the show.  As I surveyed her array of colored powders, brushes, sponges and other paraphernalia, I was interested in how she got this job.  Somewhere during the course of the explanation, she said something memorable, “This is what I do; it’s not who I am.”

I have considered this statement over the years and I think it has profound implications.  First, not everyone “is the job.”  There are a lot people who view their jobs just as something to do to earn money, keep out of trouble, pass the time, etc.  These individuals no doubt maximize their personal utility by doing other things, such as hobbies, forms of entertainment, spending time with friends and family, and so forth.  The stereotypical actor/waiter is a classic example of this.  The person is an actor, but is working as a waiter.

Second, does a person who “is the job” make a better employee?  I suspect that most managers would say “yes.”  Someone who lives (and loves) to work at the job of his/her choice must be a pleasure to have on board.  That level of commitment is the essence behind the “think like an owner” concept.  Still, I wonder if someone that committed can really find the balance, which seems so important in life.  I have seen many sad endings to people who could only find satisfaction in the workplace.

This brings us back to me (it’s my blog, after all…).  One of the nice things about growing older is the feeling of increased self awareness.  I think I know myself much better now than I did 20 years ago.  And as it pertains to this blog and my career, I know that I am a value investor.  I may have been this way my whole life, but working on Wall Street and investing in the stock market has solidified this understanding.  I may lack the skills of Warren Buffett, John Neff, or any of my investment heroes, but I know that deep down we are all cut from the same bolt of cloth.

Throughout my career I have filled many positions, have had many jobs, but each time I approached the tasks at hand as a value investor.  I love buying or recommending stocks at a big discount to their fair value.  It seems so basic and simple to me, but most people I speak to struggle with the concept.  We love to buy “things” on sale – clothes, cars, computers, etc.  But when it comes to stocks, people generally want to buy the  ones that have gone up the most – those that are expensive [by “expensive” I mean highly valued, not those with a high dollar value – a stock trading at $100 is not more “expensive” than one trading at $20 to the value investor].  This tendency makes the concept of “stocks on sale” hard to grasp by the average person.  Many people spend a great deal of time and effort trying to fit in.  The value investor does the exact opposite.  We constantly search for the less-traveled path.

Sometimes it’s a lonely exercise, but in my experience, it’s well worth the effort.  Recently, a junior colleague of mine, obviously puzzled by my lack of apparent enthusiasm for a happy development in my family asked, “Goodson, what do you get excited about?”  With only a split second of thought I answered, “Generating alpha.”  That is, I enjoy beating the market.  Always have.  Hope I always will. That is who I am.

Eyjafjallajökull

Anyone who flew to Europe last week for a short trip was no doubt surprised that a volcano in Iceland would cause their return flight to be cancelled.  After all, the volcano had been dormant since 1823, and besides, when was the last time a volcano interrupted air travel?  Mount St. Helens (1980)?  Mount Pinatubo (1991)?  Granted, “Eyjafjallajökull” doesn’t exactly roll off the tongue, but that mighty mountain’s effect will be remembered by a lot of folks for a long time.

This surprise eruption underscores the uncertainty inherent in our world.  Unexpected things sometimes happen, and often their impact can be widespread and may persist for longer than seems reasonable.  I suspect we will soon be hearing about how this volcano‘s output will be affecting the weather, carbon gases in the atmosphere, global ocean patterns, and so forth for months or even years to come.  One thing can make a big difference.

For the capital markets, the Security Exchange Commission’s (SEC) charging of Goldman Sachs with civil fraud related to mortgage securities is something akin to a volcanic explosion.  The stock market’s decline on Friday seems wholly linked to this one event.  Above all else, the markets fear uncertainty.  This action by the SEC has raised fear in the marketplace.

Not being a lawyer or an expert on SEC regulations, I will not comment on the merits of these charges.  I will note that Goldman Sachs and the other big banks tend to have very good legal teams and every single security they sell and every single research report they publish has been vetted, examined and reviewed by these top-notch legal groups.  So, I would be somewhat surprised if this case has impact as long and deep as the market may fear right now.  Time will tell.

On Thursday I was discussing the market with a junior colleague, who suggested one might want to “go long volatility.”  He noted that the markets’ volatility (as measured by the VIX) was very low and seemed to be cheap, in his opinion.  Buying the VIX seemed like a good trade, in his view.  I, in my role as the know-it-all senior investment guy, pooh-poohed his idea and said something to the effect of “I can’t imagine anything de-railing this recovery or this bull market.”  Well, the very next day his VIX trade (had I not talked him out of it) would have made him 15.5% — not a bad for one day!

I still think that this single event is unlikely to de-rail the recovery; it has nothing to do with corporate earnings, interest rates or cash on the sidelines, but it has raised the risk profile of the markets a bit.  Yet, I learned (or more precisely re-learned) a couple of important lessons from this experience.  First, I don’t know everything.  Yes, that may be obvious to the rest of the entire universe, but after a good run in the market, anyone can get sucked into the illusion of market mastery.  As I often say, humility is a necessary trait for anyone who wants long-term success in the market.  I need to remember it, not just say it.

Second, respect all opinions and sources of information.  This is another fundamental truth of investing which I ignored last week.  My colleague, despite his youth, is very sharp and often sees things that I miss.  So I know this rule (generally), but sometimes the weight of my experience gets in the way of seeing this.  I am not suggesting that all opinions are valid or even useful, but dismissing any because you think you know better is a recipe for missed opportunities.  Balancing one’s own views with the myriad of data out there is ultimately one of the big challenges of being a professional investor.  The market usually rewards independent, contrarian thought, and my colleague’s opinion was a classic example of this.

I continue to think that we have entered a new bull market which will take stock prices much higher from where we are right now.  In bull markets, corrections of up to 10% are normal and actually provide investors the opportunity to test and re-test their ideas and opinions about the market.  I don’t know if this SEC-Goldman Sachs thing will lead to a full-blown correction or not, but I think I would rather be buying stocks now than selling them.

The northern part of the Yucatán peninsula is a very interesting place.  I was surprised to find out that the Mayan language is still spoken by over 6 million people in the area.  I would have guessed it would have mostly died out given that the Mayan civilization peaked sometime before 900 AD.  To my ear, it is a very pleasing-sounding language and one that has a very long history.  Geologically speaking, the northern Yucatán is monolithic, that is made of “one rock.” If you like limestone, you will love the place, because that’s all you get there.  The entire area is one huge slab of limestone gently sloping downward into the sea.  No granite, no sandstone, no gneiss, no metal ores – only limestone.

A couple of other notable features follow this unusual bedrock.  First, there are no above ground rivers in the area.  The only water available is underground.  Second, there is almost no soil; our guides suggested that only a few inches of soil is available in most areas.  To think that the Mayans built one of the most sophisticated civilizations in the world to that time, much of it on this harsh slab of rock, boggles the mind.

While at the seacoast ruins of Tulum we learned about a clever adaptation Mayan famers implemented in the shallow soil there.  They would plant in the same patch of land maize (corn), beans and squash.  The corn stalks would provide a natural trellis upon which the bean plants could grow and flourish while the squash would cover the remaining bit of ground with their leaves and fruit.  Thus they could grow and harvest three different and complimentary crops in the same area – all three would grow and thrive in that thin soil.

For some reason, this discussion got me thinking about equity investing. As I pondered the question why three crops in one plot of ground were better than just one, I saw the parallel to an equity portfolio – three stocks are better than one.  Let me explain.  The best performing stock in the Down Jones Industrial Average is Boeing (BA), which is up about 30% so far this year.  Anyone who had Boeing and only Boeing in their portfolio this year would be very happy.  But would that person realize that a portfolio which contains only Boeing represents the riskiest portfolio possible?  Risky?  “Poppycock!” you might say, “there’s no risk, the stock is UP!”

Alas, here is one of the great misunderstandings in the field of investing – risk is not the same as losing money.  Risk is a measure of volatility; losing money is what happens when prices go down.  One can have a diversified portfolio and still lose money.  Yet, the probability of seeing wide fluctuations in returns rises the fewer stocks one has in the portfolio.

The key here is what the pros call “systemic risk” and “non-systemic risk.”  Systemic risk is the risk we all share by the fact that we own stocks.  The market’s movements and volatility impacts our portfolio to a sizable amount. There’s not much we can do to lessen this kind of risk.  Non-systemic risk comes from the stocks we own in our portfolio.  Each stock has a unique risk profile that will affect our portfolio based on its own volatility.  Mathematically, a single stock portfolio has the maximum amount of non-systemic risk (regardless of the return in any holding period).  As if by magic, simply adding another stock (assuming its risk profile is not identical to the first one) will reduce the portfolio’s overall risk profile.  Adding another one will help some more.  Studies have shown that owning about 30 stocks is the optimal way to reduce non-systemic risk to something close to zero.

Perhaps the ancient Mayans would have been astute investors – they seemed to be pretty good at everything else.  I suspect they would have understood the merits of portfolio diversification and invested accordingly…

Last Friday’s employment report contained a very happy surprise – 162,000 jobs were created in the merry month of March.  This was better than expected.  To some the fact that some of these jobs were temporary jobs related to the Census, was enough to take some bloom off the rose, but from my perspective, this is great news.  Almost no one was expecting job growth this early in the cycle.

In a conference I attended last month, a famous portfolio manager suggested that the US economy could be posting 200k per month job growth by the second quarter of this year.  This bold forecast was met with great skepticism from the audience, which was mostly comprised of professional investors and other industry practitioners.  I suspect that everyone may need to brush up (that is, revise upward) their forecasts for job growth in 2010.

Following this employment number, I find myself asking, “What else?”  What else do we need to convince those still on the sidelines, hugging to their zero-percent return cash bundles, that the economic recovery is real, that the new equity bull market is entrenched and sustainable, and that the widely-feared “other shoe” isn’t coming?  Corporate earnings growth and cash generation is great.  Company balance sheets are very strong.  Demand from the emerging markets is helping many US companies generate nice profits.  Monetary and fiscal policies are still quite simulative.  Inflation is benign.  The widely-expected collapse of the US dollar hasn’t happened.  Even housing is looking at turning around.  What else do we need?

From ancient days, many have pursued the ability to transform something common (lead, for example) to something precious (gold).   Although the alchemist’s dream was never realized, people’s interest in the prospect of “a free lunch” continues.  My cynical nature (polished shiny by years on Wall Street) usually keeps me far away from anything which seems too good to be true (the answer is “false” most of the time).  But, when I learned about the details of the ROTH IRA conversion, my skepticism melted.  This might be one of the best things I’ve heard about in a long time.  Read on…

In 1974, the U.S. government established the Individual Retirement Account (IRA).  It was (and is) a great way to save money over the course of one’s working career to supplement retirement income.  One benefit of the IRA is that it could be funded with pre-tax dollars.  Another benefit is that the assets in the account can grow, tax-free, until the assets are taken out.  Anyone with a HP 12-C calculator can tell you the power of compounding – the longer the time-frame, the greater the benefit.

In 1997, the government created the ROTH IRA.  In many ways, the ROTH IRA was a huge improvement over the traditional IRA.  For one thing, contributions are made after tax and distributions, including all investment gains, are tax free.  Also, one can pull money out of the account before retirement as the need might arise (and certain conditions are met).  Unlike the traditional IRA, there are no required distributions – if one doesn’t need the funds in retirement, they can continue to grow, tax free and then be passed on to one’s heirs.  Too good to be true?  Well actually, yes.  Congress limited who could contribute to a ROTH IRA based on income.  So, high income earners (over $100,000) were effectively shut out of this wonderful investment vehicle.

Enter the new decade.  I’m still trying to figure out why this happened, but in 2010 the income limitation has been removed for ROTH IRA conversion.  So now anyone can convert IRA assets into a ROTH IRA.  But, like so many things with the government and retirement accounts, there is a catch.  One must pay taxes upon the taxable amount of the IRA assets rolled over.  In my view, the key factor in the decision to convert or not comes down to whether the tax-free-forever nature of the ROTH IRA is worth the tax payment today.  There are other complications (which frankly make my head hurt a bit to consider), but the choice seems to boil down to short-term payment vs. long-term gain.

One can find ROTH IRA conversion calculators plastered all over the Internet.  I’ve tried to use a few of them, but always got bogged down in the details.  How am I supposed to know what my tax rate will be in 20 years!?  So, happy was I when I found this simple questionnaire.  It doesn’t tell me how to convert, but simply tells me whether or not I would be good candidate for conversion.  Here it is:

Roth IRA Questionnaire

(1) Will you be in a high tax bracket in Retirement?

(a) YES – I expect my tax bracket to be higher in retirement (3 points)

(b) NO – I expect my current tax bracket is higher (0 points)

(2) Are outside assets available to pay tax on conversion income?

(a) YES – I have taxable assets available to pay tax (2 points)

(b) NO – I would need to use IRA assets to pay tax (0 points)

(3) Do you plan to pass IRA assets to heirs?

(a) I do not plan on needing any of my IRA assets in retirement (2 points)

(b) I plan to use some of my IRA assets in retirement but not all (1 point)

(c) My IRA assets will be my main source of income in retirement (0 points)

(4) How long is your investment horizon for IRA assets?

(a) My investment horizon is more than 10 years (2 points)

(b) My investment horizon is between 5 and 10 years (1 point)

(c) My investment horizon is less than 5 years (0 points)

(5) Does your IRA investment strategy seek capital growth?

(a) YES – Long term appreciation is a primary objective (LT Rate of Return > 6%) (1 point)

(b) NO – My investment strategy is very conservative (LT Rate of Return < 6%) (0 points)

(6) Do you have any tax basis in your current IRA?

(a) YES – A portion of my IRA will not be subject to tax upon distribution  (1 point)

(b) NO – all assets in my IRA are tax-deferred (0 points)

Total Score:

0 – 3   :    Roth Conversion may not be a good option
4 – 7   :    Roth Conversion should be considered
8 – 12 :    Roth Conversion should be strongly considered

That’s it – six simple questions, one score.  If you think you might be a good candidate for ROTH IRA conversion, talk to your tax account or financial advisor right away.  If done properly, the Roth IRA conversion can fulfill, in some small measure, the alchemist quest, not turning lead into gold, but turning taxable retirement assets into tax-free retirement assets.  It may not be magic, but in these days of lowered expectations, I will take any good news I can find.

Nearly every media outlet is marking the one-year anniversary of the current bull market.  The basic facts are obvious – the market has staged a very impressive rally (+68% for the S&P 500), most economic data have improved and US companies have posted surprisingly good earnings growth over the last four quarters.  What is less obvious is what exactly happened over the past year to bring us to this point.  In trying to answer this apparently simple question, we can also find a very broad range of opinions.  Some would suggest that government intervention – fiscal and monetary stimulus, the TARP program, and other such measures – was the cause of the rally.  Others would suggest that aggressive cost cutting by companies at the cusp of the recession allowed them to post better-than-expected earnings, which reassured investors and helped to turn the market around.  Other more-cynical types call it some kind of conspiracy or shell game, an artifice of smoke and mirrors that any second could collapse revealing nothing of substance behind. Others see it simply as the logical rebound from a market break caused by irrational fears.  Whatever the reality, I would submit that it began just as every other bull market has since 1933 – in the middle of a recession, at a point where pessimism and cash levels were at their peak.  The old saying “the harder the fall, the bigger the bounce” also seems appropriate here.

The tone of the celebration is quite muted, in my view, by lingering doubts expressed by nearly everyone about the sustainability of the current rally.  It is hard to find but a handful of truly bullish portfolio managers or strategists.  Most seem quite cautious, suggesting that problems such as the high unemployment rate, the high valuation of the market, the big move in the market, housing market woes, budget deficits and looming inflation are likely to deflate this new bull market any day now.  In a way it’s quite ironic that we find this kind of sentiment at this point in the cycle.  At the bottom of the market we all had tons of fear and could find really solid reasons to be cautious.  Now that the “worse case scenarios” we could conjure up in those dark days have passed us by, many still feel compelled to be cautious.

In my mind, this is one reason to remain bullish.  Another is earnings growth.  Consensus estimates suggest that the S&P 500 stocks will grow EPS about 14% this year and another 18% in 2011.  Even if interest rates move up a bit (haven’t we been forecasting higher rates for about a year already?), I would think that double digit earnings growth could help stocks move higher.  What about valuation?  There are number of measures people use for this, but in my experience, valuation, as important as it is, is rarely by itself a reason for the market to go up or down.  I can still find good quality stocks trading at substantial discounts to what I consider fair value.  I don’t know about the market, but many stocks are still cheap.  The recent spate of acquisitions may also support this idea.  High cash levels are another reason for optimism, in my view.

But don’t we have problems and worries?  Sure, but we always do.  The stock market does not need utopian fundamentals to perform well; it simply needs incrementally more positive news.  The early stages of the rally were marked with the news being less bad than before.  That was enough to get it started.  Now we will need more good news to keep it going.  The average bull market lasts 51 months.  Because this new bull market began under similar circumstances as every other one before, I think the burden of proof lies with those who think “this time is different” (still the four most dangerous words in the investment world).  For me, I think the weight of history is on my side and I fully expect to ride this young bull for a few more years.  Let ‘er rip!

Long-time readers know that I have a “thing” about people who offer apparently “free” investment advice in the media.  The central tenet of my philosophy about all this free stuff flowing into our homes on a daily basis is this: “Why would anyone give away for free any significant, insightful, accurate and actionable investment advice, when they could get paid for it?”  If your answer to this question is “Because they like us and want to help us make money” then there’s little point in reading any further…

If, on the other hand you share my more cynical view of these articulate ersatz altruists (i.e. they’re selling something), allow me to flesh out a few details.  The media outlets which find the daily fountain of economic data, market chatter and pundit prognostications so endearing and entertaining may not have your best interests in mind.  Instead of helping listeners indentify and implement an investment strategy which would not only make them money but that would fit well with their individual personality and circumstance, they shower the viewers with so much data and commentary, that it would be nearly impossible for the average investor to make any sense of it.

Then, we must also consider the source of this information.  Whenever Warren Buffett or David Einhorn speaks about the market or their investments, we can be assured that they know what they’re talking about.  These are seasoned investors who have a well-defined investment style, which they follow systemically and which has made them lots of money.  So even if one of these seasoned professionals is trying to sell us something, we can be fairly confident that what they say is backed up with serious research and money on the line.

On the other hand, we should find no confidence when other market “observers” (journalists, academics, former hedge-fund managers, etc.) offer their opinions.  Just as you would not seek an airline pilot’s opinion on a medical issue, journalists can probably not help you consistently make money in the market.  All of these people are professional, well intended and likely sincere, but they are not professional investors.  This disconnect between speaking intelligently about the markets and being able to invest intelligently was highlighted by Ron Insana’s hedge fund experience.

Mr. Insana was a highly-regarded CNBC anchor who in 2006 decided to launch his own hedge fund.  He had been covering Wall Street and hedge funds for over a decade.  He seemed to know what he was talking about.  He had great contacts.  The fund closed within two years for a number of reasons, but to me the lesson is clear.  He was an airline pilot trying his hand at medicine!  I suspect that he learned more about the investment business in those two years than he did in all his years as a journalist.  It’s not as easy as it looks.

This brings me to a fellow named Brad Tuttle, who posted a very honest and refreshing article last month about this very topic.  You can read the whole thing here.

Here are a couple of highlights I want to share:

“Journalists are storytellers. They get by excited by new ideas and innovation. But as to how an interesting back story about a CEO or how some new product translates to a company’s long-term profits or stock prices? Most writers don’t go there, and shouldn’t go there. Why? They don’t know what they’re talking about.”

“If following the conventional wisdom led to wealth, then we’d all be rich—which is sorta impossible, because there have to be winners and losers.”

“…Warren Buffett: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”

And the final, perfect quote, “So where should you invest your money? Don’t ask me. I’m a journalist.”

I couldn’t have said it any better…

I’ve never been a huge fan of winter sports (unless you include bowling!).  Despite spending all of my growing up years in the Big Sky Country of Montana, and wading through tons of deep snow, I was never big into skiing, ice skating, hunting, camping, hiking, fishing and the like (misspent youth, I know).  So whenever the Winter Olympic Games rolled around, I met the event with somewhat mixed feelings.  Ski jumping was pretty exciting.  Figure skating had its moments.  But usually the thrill of victory and agony of defeat featured in the Winter Games did not thrill me.

Then I discovered curling.

Wikipedia says it best, “Curling is a team Olympic sport in which stones are slid across a sheet of carefully prepared ice towards a target area.  Two teams of four players take turns sliding heavy, polished blue hone granite stones across the ice towards the house (a circular target marked on the ice). The purpose is to complete each end (delivery of eight or ten stones for each team) with the team’s stones closer to the center of the house than the other team’s stones. Two sweepers with brooms or brushes accompany each stone and use stopwatches and their best judgment, along with direction from their teammates, to help direct the stones to their resting place, but without touching the stones.”

It sounds kind of weird on paper, but watching it is even weirder.  The action (?!) of curling seems like some alternate reality mash up of shuffleboard and sweeping the kitchen floor.  Yelling seems to be a big part of the sport as does looking more like an indie pop singer than an Olympic athlete.  It’s rather difficult to imagine what kind of fitness routine curlers go through to prepare for the games, but I suspect they spend less time in the weight room or on the track than do other Olympians.  I mention none of this to be critical or degrading; I really, truly enjoy watching the sport/game.

For me, there is something elegant in the precision of the game.  It’s clearly a sport which requires more finesse, than flash; more strategy than strength.  The fact that the Norwegians are good at it is also a plus (I’m one-fourth Norwegian).  And the contrarian in me is naturally drawn to off-beat activities such as curling.

As I was watching the match between the US and France, I started thinking that curling is a little like investing.  And as I pondered on this a bit more, I realized that curlers are a lot like professional investors.  I see three points of similarity:

1)      What they do looks easy. If curling were just like shuffleboard, it would not be an Olympic sport.  There is clearly a lot more skill and strategy involved than just sliding a big granite stone down the ice.  Many think that stock picking is also a simple exercise.  Just find a stock with a good story and buy it.  Make money.  The fact the some people with no investment background, training or expertise can make money by buying a stock re-enforces the notion that investing is easy.  It’s not.

2)      They use unusual tools to do their job. Who else brings a broom to an Olympic contest?  What else is on the curler’s equipment check list?  42-pound curling stone? Check.  A pair shoes with different soles (one for sliding, one gripping the ice)? Check. Flashy golf pants?  Check.  The tools for the professional investor may seem as arcane to the average person:  free cash flow analysis, beta, intangibles on the balance sheet, off-balance sheet items, DuPont ROE calculations, earnings yield, insider transactions, sentiment measures, technical analysis, and so forth.  The work behind picking a stock is much more than just finding a good story, but it is work not easily appreciated by the casual observer.

3)      Strategy is paramount. To be successful, curlers need to anticipate the moves their opponents might take a few turns out.  Simply executing the game plan will not be enough to win.  They must be flexible and react to changes in the position of the stones, or modify the plan when they own execution is imperfect.  Likewise, professional investors need to figure out what the market is telling them and what it might do in the future.  Inevitably, the market will make some unexpected moves which require the investor to be flexible, nimble and opportunistic.

I hope that all you curling fans out there will totally enjoy the rest of the Olympic games, and perhaps as you watch a few of the remaining matches, you will take a moment to consider the hard working professional investor who, metaphorically at least, is trying hard to put the stones in the right place in the house.

As the Washington DC area continues to struggle with record snowfall (wither global warming??), the stock market seems to be struggling with its own issues.  At some level, a pause from the dramatic and record-breaking rise from March of last year is needed and even welcomed.  Yet, as the market consolidates a bit, the volume from the bear camp has begun to rise, as it usually does when the market stops going up.  Although we know that corrections and consolidations within the context of a new bull market are normal and expected, when they happen, new concerns inevitably arise. Will the US government budget deficit choke off economic growth?  Will lack of job growth do the same?  Is inflation going to be a huge problem?  Will deflation be a greater threat?  So on and so forth…

One of my recurring themes is the idea that at any point in time there are always positives and negatives to the market outlook.  When the market rises, we tend to de-emphasis the negatives, and in times like these, the positives seem to have less power.  To be brutally logical, nothing in the economy has markedly changed since the S&P 500 hit its recent high on January 19^th.  The US economy is like a big supertanker – it does not make quick turns.  What has changed is sentiment and the appetite for risk.  At the margin, the incremental buyer of stocks has turned less bullish than before. I submit that the reason for this slight shift has more to do with psychology than economics, but since accurately measuring the human psyche is way beyond my skill set, let me reiterate a few of the non-psychological positives as I see them:

1)      Employment. True to my contrarian nature, I put forth the employment situation as my first positive.  Everyone “knows” that the job picture is bad and will probably remain bad forever (!).  The data, however, tells another picture.  The chart below depicts the jobs data from over the last few years.  Although jobs are not yet being created, the improvement in the nonfarm payrolls number from January 2009 and the unemployment rate from July is unmistakable.  Remember that the stock market does not need good news, when less bad news will do.

Nonfarm Payrolls: Monthly and Yearly Change

2)      Interest Rates. Although the consensus seems to think that rates must rise, they haven’t yet and this simple fact can aid stock valuations.  Investors are willing to pay a higher P/E for stocks in a low-rate environment.  To the extent that rates do not rise quickly or by a large amount, stocks stand to benefit even more.

3)      Earnings. Corporations have been posting surprisingly strong earnings since early 2009.  Granted much of the gains have been realized by aggressive cost cutting, but in my view that still counts!  The latest round of results has been tainted in some cases by disappointing revenue growth.  Ultimately, sales will need to grow to maintain earnings growth.  Yet, as we approach the anniversary the Q1 2009 results, we will face extremely easy comparisons.  The April results should make the economy look very, very strong.  I am not sure that investors will be able to view these results as anything other than very, very positive.

4)      Cash. Despite record-low yields on cash and other low-risk assets, investors appear to love the stuff.  According to some sources, investors may have as much as $10 trillion saved up in cash and its cousins.  This is roughly the same amount of money as the entire S&P 500.  Granted, not all of this money will find its way into the stock market, but just some of it would be enough new fodder to move share prices higher.  When does this happen?  No idea.  But I suspect that a resumption of good news on earnings (April?) and/or any improvement in the economic data might be sufficient reason for some of this cash to find a new home in the stock market.  We also learned that, at the same time investors are sitting on a huge pile of cash, corporations are generating record cash themselves.  According to Bloomberg News, US corporations in the four quarters ending September 2009, produced $1.29 trillion in cash.  Companies have a number of options with this cash – they can sit on it like investors are, re-invest in their business (which will lead to higher earnings), or use it to buy other companies.  In my view, the latter two options are very bullish for stock prices.

It may take a while for investors to sort out all the mixed signals and emotions they currently face.  Maybe the market will be stuck in a trading range for a while.  I continue to think that the resolution of these crosswinds will be positive for the market.

Although each year brings new and unique challenges and opportunities, the market sometimes displays familiar patterns.  The stock market’s action in 2009 was similar to 2003, which was another recovery year.  Could 2010 be like 2004, a year of consolidation?  Time will tell.  Note that despite all the backing and filling seen in 2004, the market was able to post a double-digit total return for the year.  Here’s a chart for your reference: