One of the recurring themes over the last few quarters is the notion that many asset classes, in stark contrast with the past, are moving in tandem with each other. Historically, the price of gold has tended to move in the exact opposition direction of the stock market. Bond and stock prices also used to move mostly out of synch. Other commodities traditionally followed their own unique patterns, again, mostly different from other asset classes. This lack of correlation among asset classes was at the heart of the idea of diversification. By owning both bonds and stocks, one’s portfolio could enjoy better risk-adjusted returns than owning only bonds or only stocks. When the trading patterns of the various asset classes begin to resemble each other, the benefits of diversification diminish. This could lead to unpleasant surprises if portfolios deemed to be diversified fail to act as expected.
One bit of evidence of this idea is the question occasionally asked by knowledgeable market commentators, “Do we all have the same trade on?” That is, are we all doing the exact same thing? Another way professional investors will describe this phenomenon is by pointing out a “crowded trade,” that is an investment tactic which is both widely practiced and frequently promoted as a “good trade.” This tendency to do the same thing at the same time is often called “herd mentality.” As we pondered this phrase, it came to our attention that animal symbols are well represented in the vocabulary of Wall Street as well as other fields of human endeavor. We will explore this theme some more after the review…
Third Quarter Review
The stock market this year, although showing a positive return as of this writing, has been quite volatile. The S&P 500 has lost or gained at least 4% in each of the last five months, something that has only happened once in the last 10 years. The market ended the third quarter on a positive note, with the S&P 500 moving up 8.8% in September, its best September performance in over 70 years! Needless to say, much disagreement remains about the prospects for the market going forward.
Corporate earnings continue to be strong; a V-shaped recovery in earnings has been a reality. What is good for corporate earnings seems to be bad for the jobs picture. Despite some gains for the overall economy, unemployment remains stubbornly above 9%. It’s as if corporate America is back to business as usual (as evidenced by profit growth), but with 8 million fewer workers on board. We are not sure that the stock market cares that much about the unemployment situation – as long as corporate earnings continue to grow, we suspect the path of least resistance for the market will be upward.
The bond market continues to act as if we are still mired in recession and any kind of inflationary pressure remains years away. Many former outspoken bond bulls (Goldman Sachs, for example) are now suggesting that the fixed income market may be in bubble territory. We would note that money flows into bond mutual funds have been positive each of the last nine years, with 2009 being the biggest year with a $307 billion inflow. The bond experts we listen closely to remind us that the bond market can reprice itself very quickly and without a large amount of transactions. Warning signs have been in place for a while now, but investors appear to remain stubbornly attached to their bonds.
Here’s what the third quarter looked like by the numbers:
| Index | 3rd Qtr 2010 | Year to Date | Trailing 12 Months |
|---|---|---|---|
| Dow Jones Industrial Average | 11.0% | 4.3% | 13.6% |
| S&P 500 | 11.2% | 3.0% | 9.9% |
| NASDAQ | 12.3% | 4.4% | 11.6% |
| Russell 2000 | 11.2% | 8.5% | 13.1% |
| MSCI EAFE | 18.8% | 0.3% | 3.1% |
| MSCI EAFE Small Cap | 18.6% | 7.9% | 7.9% |
| MSCI Emerging Markets | 20.3% | 8.4% | 16.6% |
| Barclays Aggregate Bond | 2.2% | 6.5% | 7.2% |
| Barclays Municipal Bond | 3.6% | 5.1% | 5.0% |
| Dow Jones Commodities | 12.3% | 0.0% | 9.6% |
Animal Spirits
“Anthropomorphism” is the attributing of human characteristics to animals or non-living things. We do this all the time. Curious cats, stubborn mules, sly foxes and wily coyotes are all a part of this idea. We find many examples of this in literature: from the talking donkey in the Old Testament (Numbers Chapter 22) to the chatty menagerie found in such books as Alice in Wonderland, The Wind in the Willows and The Chronicles of Narnia.
We also turn this concept around sometimes and use animal adjectives to describe human behavior. Calling someone “chicken” may not be nice, but it surely is descriptive. Would you like to be a guinea pig for someone’s medical school experiment? When you badger someone, do they like it? Would they prefer that you hound them? Do you see any dark horses in the coming election? “Squirrel away”, “rat on” and “wolf down” are all sensible idioms using animals to make a point.
Thanks for all the Fish
Researchers recently finished a ten-year long study of the ocean. The results were amazing. These census takers added 1,200 new species to the list of ocean dwellers and have another 5,000 collected, but not yet identified as new species. Some of the new creatures were particularly surprising: a 21-foot long deep water squid, a lobster weighing over 8 pounds, a new hairy crab which they dubbed “yeti crab,” and an ancient shrimp thought to have been extinct for 50 million years.
This research brings the number of known species living in Earth’s oceans to 250,000. This is what is known. These experts estimate that another 750,000 species still elude human detection. This is the unknown. All of these numbers exclude the millions of microbe species which make up about 90% of the biomass of the oceans. This is the great unknown.
Investment implication: The capital markets run on information. No one is able to obtain (legally, anyway) complete and perfect information before making an investment decision. Operating in this sometimes-fuzzy environment is one of the great challenges of the business. Yet investment professionals march ahead into the gray each day, trying to make sense out of the misty fog and doing their best to identify and capture the most attractive investments out there.
Bulls and Bears
On Wall Street, no more powerful images exist than those of the Bull and the Bear. Bull markets are marked by rising prices. Bear markets are the opposite. Although everyone seems to prefer a bull market, a deeper consideration of this symbol may further our understanding of these market phenomena. First, let’s consider the Bull. Bulls are strong, powerful and virile. They are single minded – they charge, they breed, they graze as they wish, unimpeded in their pastoral kingdoms. No one messes with the Bull.
Bull markets are a lot like that – they move (mostly) in one direction. Investors need to do little but graze on the Wall Street Journal to make money. Some people may make a big deal of “beating the market” in the context of a bull market, but most investors are content to be “fat and happy,” just like the Bull.
The Bear is another type of creature entirely. First of all, bears hibernate. We may not see them for a good part of the season. When they do emerge from their winter slumber, they are hungry. What do bears eat? By definition omnivores, such as bears, eat everything. Unlike the bull, the bear must search, dig, scratch, rummage, snoop, climb, swim, claw, bite and even kill to get a decent meal. Bears are also very fast. Our experts tell us that a bear can run as fast as 35 mph for short distances. Most humans cannot outrun a bear. This is important to know if you ever encounter a bear hiking in the wilderness. We were also told that we did not need to outrun a bear who was chasing us; we just needed to outrun our hiking companion!
Investment implication: Investors need to work harder in a bear market than in a bull market. Our experience has taught us that in a bear market, one can improve performance via more active trading. In a bear market we tend to buy stocks at a discount to fair value and sell them as they approach fair value. In a bull market we tend to buy stocks closer to fair value and sell them at a premium to fair value.
Canada Geese and Crabs
We all know that Canada Geese migrate, and that they fly in a “V” pattern. But why fly this way? It turns out there are many reasons. First, the pattern offers optimal aerodynamics. All but the lead goose benefit from “drafting” behind the others. This reduces air resistance and the amount of energy required to fly. What about the poor guy in front? It turns out that the geese rotate that position, assuring that the group can keep flying even when the leader tires. What if one goose becomes too tired to fly? The tired goose will be accompanied by two other geese (wing men?), who will land and stay with the tired one until he is able to continue. That honking one hears as they fly is, according to our goose expert, encouraging sounds directed at the lead goose, telling him he’s doing a great job and to hang in there.
Crabs, on the other hand, are not good team players. Our crab expert explains that one needs only a shallow bucket to gather crabs from their tidal pools. One crab can easily scamper out of the bucket used to collect them. However, once a second crab is added to the mix, the captured ones lose nearly all chance for escape. It turns out that in its panic to escape captivity, the crab will use all means possible to get out of the bucket, including latching on to any crab above it. This action alone is sufficient to pull any crab above it firmly back to the bottom of the container. The more crabs in the bucket, the less likely any of them will escape.
Investment implication: Teamwork is a good thing. Investing is not necessarily a dogeat-dog proposition, and working with people you can trust makes the endeavor all the more rewarding. For us, our Investment Policy Committee is a classic effort in teamwork. The members of our committee have diverse backgrounds and varying amounts of experience. All members have an equal vote and all decisions the committee makes must have the support of all members. We think that our collegial, co-operative approach works much better than just relying the opinion of one person.
Lemmings and Musk Oxen
“Herd mentality” is generally considered a bad thing. The words conjure up an image of a bunch of unthinking animals following blindly, often into negative consequences. This certainly appears to be the case with lemmings. Lemmings are small mouse-like creatures that live in harsh regions above the Arctic Circle. As their “herd” grows, it can quickly surpass the environment’s ability to sustain it. Thus, they are eventually compelled by instinct to seek greener pastures. This drive is so powerful that it has led to the myth that they will actually commit suicide by running off cliffs and falling into the ocean. In reality, massive changes in the lemming population do occur (fueling the myth), and the experts note that sometimes when the huge herd comes to a body of water, such as a river, they will become temporarily stopped by it. The herd will eventually build up along the shore in a dense mass. Many lemmings at these moments will end up trying swim across and not make it. For lemmings, following the crowd is a deadly proposition.
The musk ox is another Arctic mammal that lives in herds. This bovine creature is noted for its thick, shaggy coat and the strong, musky (hence the name) odor emitted by males during mating season. It would be easy to assume that the musk ox is also guilty of “herd mentality” and all that might imply. One key difference in the musk ox is a unique defensive mechanism made possible only because it dwells in herds. When threatened, musk oxen bulls and cows will face outward to form a stationary ring or semicircle around the calves. Any predator looking for an easy meal will finds itself looking at the business end of a musk ox phalanx, marked by sharp horns and massive heads.
Investment Implication: Blindly following the consensus is usually a recipe for disaster. Ignoring the benefits of working together with like-minded people is also not optimal. Understanding that the investment process is best approached as a collaborative exercise and not something for the lone wolves is probably a good thing.
Acting like an Animal
Jason Zweig, in his great book, “Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich” shows that in times of economic stress, like a bear market, we all tend to use the more primitive, that is animal-like, parts of our brain. When we lose money our brain kicks into an almost instinctive “flight or fight” mode, much like animals who feel threatened do. In bull markets, we can calmly analyze balance sheets and income statements and discuss the relative merits of this asset class versus another. But in times of stress, we want action!
According to Mr. Zweig, we are just hard wired this way. We may try to tell ourselves in those moments of stress that we are being affected more by our emotions than our logic, but we still feel compelled to do something. Many of us have personally experienced these feelings of stress and uncertainty over the last few years. Many may still feel a sense of unease because of the perception that the “new normal” may be stressful for all of us. Yet, we would submit that these stressful times actually create the absolutely best investing environments. Consider when the stock market bottomed in 2009. Most people were not calmly deciding that stocks looked cheap and buying them. The “herd” of consensus was screaming “sell, sell, sell!” Even now that the macro environment has improved dramatically, the consensus still finds fault with the equity market. In our view, this suggests they who hold this view may still be using more emotion than logic.
The Outlook
For the third quarter in a row, we wish to stress that U.S. corporations are in great shape. They hold a near-record level of cash on their balance sheets. Because they are not rewarded for holding cash, it seems likely that they will do some or all of the following: raise dividends, buy back stock, buy each other, increase capital spending, or hire new workers. These things are all positive either for the economy or the stock market.
Earnings have been stronger than expected for five quarters in a row and we see no signs of this slowing down. What about the economic slowness everyone is talking about? Consider that 45% of S&P 500 earnings come from outside the U.S., and one may understand that the link between U.S. corporate earnings and U.S. GDP is not particularly strong. This year the S&P 500 could come close to matching its recent high of earnings (2007). Corporate profit margins, free cash flow generation and even U.S. GDP have recovered to pre-crisis level. The one outstanding laggard in this recovery is the stock market. Given that the stock market was not overvalued in 2007 suggests to us that returning to the highs of 2007 should not be an unreasonable expectation.
Over the last few months, the market has been hit by waves of concern and despair. First it was the Greece Crisis and Euro-Contagion. Now, almost no one talks about that. Then “double dip” was the catch-phrase on everyone’s lips for a while. It too has disappeared as a topic of conversation. The latest worry is “currency war.” Although we are not currency experts, we feel that this concern too, may be a bit overblown or premature. Our focus remains on the micro factors which drive our decisions about individual funds and stocks. A large number of other investors appear to be wholly focused on the big picture, the macro issues. This is a fine way to invest; but we don’t do it. The high degree of correlation we are seeing right now is unusual. Using history as our guide, we expect that this condition is unlikely to persist in the long run. Fundamentals eventually trump all other considerations.
It is very unusual for bond and stock prices to move in the same direction. Using the logic of Occam’s razor, we would submit that one of these markets is “wrong,” and we think it’s probably the bond market. Bonds are very expensive right now (relative to their history and stocks). We rarely make asset allocation shifts based on relative valuation alone (we think that client risk tolerance and time horizon should be the key determinants to asset allocation), but now would be a tempting time to consider shifts from bonds to stocks.
Some have come to wonder if we are always bullish on stocks. The easy answer is “no,” but given the upside we still see in the market, that day when we are much less bullish seems far away.
Sincerely,
Wolf Group Capital Advisors
