A grizzled Wall Street veteran once remarked that the market, at any point in time, tends to “cause discomfort” (or words to that effect) to the greatest number of investors possible. The 2000 tech bubble collapse occurring when equity ownership by individuals was at an all-time high supports this tenet. The steep market declines from September 2008 surprised a lot of investors exactly because many thought the bear market, if it were to be a “normal” one, was nearing its end. Much discomfort ensued. In a similar vein, the strong rally in stocks from March of this year also supports this cynical thesis. The market’s bottom occurred at what felt like a climax of pessimism. A plurality, if not an outright majority, of voices at that time was telling investors to sell stocks and hold cash, “just to be safe.” Granted, the opportunity cost of money not made is always less painful than losing money, yet we suspect that this largely inexplicable rally in stocks has spread its own path of discomfort across a wide swath of the investing public. Which voices do we listen to? Which voices can we trust? Read on…
Third Quarter Review
Only one word can describe the stock market’s performance during the third quarter – “Wow!” For the quarter, the S&P 500 rose 15%, another amazing performance, especially given the market’s strong showing in the prior quarter. In our last letter, we detailed the factors we thought were driving the market from its March lows. Over the last three months, the same factors were at work – less negative economic news, continued cautious sentiment, low interest rates and rising earnings.
In our view, these are really the most important positive propellants the market can ever have. Another important technical factor to consider is the huge amount of un-invested capital out there – some estimates suggest as much as $4 trillion still exists in money market funds, earning next to nothing. Many investors rotated out of stocks some time during the crisis, but many of them have not yet returned to the market. Even now, we hear the many voices suggesting that either now is the “right” time to get back into the market or it’s too late to get back in. Regardless of the merits of either of these points of view, the fact that this debate rages on suggests to us that concern, confusion and big cash positions seem to be the norm. We generally only become worried about the market when there is near universal agreement that the market can only move higher. We sense that we are still far away from this kind of exuberance.
Rarely do we find a good reason to quote from a prior letter, but the following paragraph, from our July 2009 letter, seems particularly insightful (no brag, just fact…) and to be honest, actually described what happened during the quarter. We were discussing the progression of earnings trends from high uncertainty to more certain and suggested that rising expectations could help stocks in the future. We wrote then, “The logical extension of this progression may be seen in the second quarter earnings results where, if indeed the worst of the recession is behind us, companies may begin to raise their outlook for either 2009 and/or 2010. Ultimately, stocks need earnings growth to move higher, and the prospect for higher EPS growth for 2010 could be a key driver for stocks moving forward.” This is what is happening now.
The bond market appears to be nearly back to normal. Fears of a systemic credit crisis have all but disappeared from bond prices. U.S. Treasury rates remain low and, in our view, provide the strongest argument against any near-term resurgence in inflation. While massive monetary stimulus can be an important contributor to inflation, huge slack in the economy, such as high unemployment and low industrial capacity utilization, suggests that inflation may not be an important investment consideration for a few years.
Here’s what the third quarter looked like by the numbers:
|Index||3rd Qtr 2009||Year to Date||Trailing Twelve Months|
|Dow Jones Industrial Average||15.0%||10.7%||-10.5%|
|MSCI EAFE Small Cap||21.0%||42.9%||9.7%|
|MSCI Emerging Markets||20.7%||57.1%||16.4%|
|Barclays Aggregate Bond||3.1%||2.7%||10.3%|
|Barclays Municipal Bond||6.6%||11.3%||17.1%|
|Dow Jones Commodities||4.2%||8.9%||-23.9%|
A Hero for the Ages
Despite being born nearly 600 years ago, Joan of Arc continues to inspire, motivate and command respect from people all over the world. She is a hero to the underdog – an example of a person from indigent beginnings becoming famous and powerful. Military scholars and strategists admire her phenomenal success on the battlefield, despite her youth and lack of experience. French politicians evoke her image and memory often, as a symbol of the best of their nation. Authors ranging from Shakespeare to George Bernard Shaw have written books and plays around her character. Composers have created serious works of music featuring her and her life. Young people find her story compelling because all her success came before her 20th birthday. Even today, her character or aura can be found in film, television, song and dance.
Voices, Visions and Victory
Because her story is complex and multi-faceted (surely worthy of an opera), we will only touch on a few highlights. Her birth occurred near the middle of the “Hundred-Year War” between France and England. When she was 12 years old, she began having “visions” and “hearing voices,” which she claimed were divine in nature. The message was usually the same – “drive out the English and unify France under the King.” She took this message to heart, and over the next few years she was able to obtain an audience with the French court where she made an amazing prediction about an eminent military reversal at Orleans. Fighting there had bogged down and no progress had been made for many months. She convinced the court to not only let her go to Orleans, but to wear the equipment of a knight. Historian Stephen Richey has this to say about this highly improbable development:
“After years of one humiliating defeat after another, both the military and civil leadership of France were demoralized and discredited. When the Dauphin Charles granted Joan’s urgent request to be equipped for war and placed at the head of his army, his decision must have been based in large part on the knowledge that every orthodox, every rational, option had been tried and had failed. Only a regime in the final straits of desperation would pay any heed to an illiterate farm girl who claimed that the voice of God was instructing her to take charge of her country’s army and lead it to victory.”
The French captured the first English outpost in the area on May 4, 1429. Three other castles fell in as many days under Joan’s charismatic leadership. On May 7th she attained full heroine status by leading the main assault on the English stronghold, les Tourelles. Success was followed by more success and by July 16, the French had taken Reims, and the coronation of Charles VII was held the next day. Alas, the story does not have a happy ending. Joan was captured in May of the following year and convicted of heresy, a capital offense at the time. Her death by the executioner’s torch solidified her standing in history as not only a great leader, but a powerful religious symbol. Years after her death, a new ecclesiastical court found her innocent or heresy and declared her a martyr. She was canonized, becoming Saint Joan of Arc in 1920.
In the context of this note, we find impressive her willingness to believe and accept the counsel of a voice which could have been dismissed as being a simple figment of her imagination. Also, we like that this experience led her to actions which required great courage and conviction. We also applaud her success as a military leader, achieved under trying and dangerous conditions.
By now you are no doubt wondering what the point of all this is. As has become our custom, we try to find important (but perhaps less obvious) investment lessons in the lives of famous people (Einstein), semi-famous people (Shane Battier) or in cultural touchstones (Wizard of Oz). Having written many of these “update” reports over the years, and having read even more, we are painfully aware of their uses and limitations. To us, having this letter labeled “boring” would be worse than being burned at the stake (metaphysically speaking, of course). So we try to spice them up a bit.
Our intention is not to be cute or clever, but rather to try to make a point without being dull, stiff or redundant. Any reader who finds our attempt at drollery to be more like drudgery, we would encourage to skip the middle part of the letter and zoom on down to the “Outlook” section.
Making Sense Out of the Cacophony
In the investment industry, we are constantly bombarded by the sounds of many competing voices. In part this is due to the widely diverse nature of investors. Competing for the same mind space, we find day traders, hedge funds, mutual funds, value investors, brokers, strategists, analysts, growth investors, momentum investors, macro investors, quant investors, chartists, penny stock traders, speculators, economists, central bankers, currency traders, journalists, bloggers and so on. It’s no wonder we hear conflicting reports every day about the outlook or even the reasons for each day’s market action. Consider too that for every trade made there is a rational and (potentially) intelligent person buying the security and at the same time another person selling it. So, whose voice can we trust?
In the movie All the President’s Men, Hal Holbrook plays the part of “Deep Throat” – Bob Woodward’s government contact who tries to help him make sense of all the Watergate mess. At one point Woodward is stuck and tells Deep Throat he needs help. Cryptically, he responds with, “Just… follow the money.” I think this advice may help plow through some of the noise we hear in our quest to make sense of the capital market commentary we hear in the media.
In our economy, people provide products and services for a price. The Econ 101 catchphrase “No such thing as a free lunch” still applies. If one wants goods or services, one must pay for them. Yet there seems to be an exception to this rule. We would submit that the most abundant apparently “free” product, broadly available for the taking is… Investment Advice! Every day on television, radio, Internet and printed media we find a never-ending supply of experts and amateurs alike dishing out “free advice.” On any given day, one could hear opinions about interest rates, currencies, stocks and of course, everyone’s favorite – the economy. The massive number of opinions offered each day (we once calculated that Jim Cramer makes over 1,500 stock recommendations each year!) would make it nearly impossible to ever track whose advice was actually worth something.
So why do these apparently rational and (potentially) intelligent people offer “free” investment advice? Using “No such thing as a free lunch” and “Follow the money” as our guides, we would offer the following:
1) To be famous. When a young analyst gets the call to appear on television, it is very flattering. Being able to share your opinions with the viewing public raises visibility, and if your ideas are compelling and your predictions prove correct, you might get invited back. You might be able to get a better job. You could write a book. Become a “guru.” All because you’ve been asked to appear on TV. Helping the listeners to make money might be one motive of the appearance, but it’s not likely the primary one.
2) To sell something. Many of these experts have newsletters, consulting services, books, investment funds, and other goods and services they are selling. Being asked challenging questions by media celebrities is good marketing for these products. Whenever the expert’s company is mentioned during the interview, it’s like free advertising. The things they mention during the interview may be useful for the listener, but here too, it is probably not the prime motive.
3) To entertain. There are some people spouting investment advice who are simply fun to watch. The quirky gestures and catchphrases have become part of our pop culture. Much of the advice is no worse than benign (be diversified, understand the risk, etc.), but some of it is potentially dangerous. We would no sooner buy a stock from one of these entertainers than from David Letterman.
4) Because they already own the stock. This motivation is often couched in a question like “What should investors be buying now?” Do you think it logical for a person, when asked this question in a highly visible forum, to offer up his or her best idea not yet acted on? Just imagine, “Yeah, I was going to buy this stock for my clients who pay me money for my services, but instead I thought that I’d just throw it out to the public for free.” Really? Seriously? Many times the answer to this question will seem reasonable and well-thought out, but when the disclosure statements are mentioned, sure enough, the person already owns that stock, and would no doubt love others to buy and help it move higher.
5) Because they love people. Hey, we’re not always skeptical. There may be some people offering totally free, no strings attached investment advice of some value. The problem is identifying who those people are.
The key here is why would anyone offer something for free in the media that they get paid for elsewhere?
Who Do We Listen To?
Although we will not admit to hearing voices in our heads or seeing visions, we clearly operate within the world of many opinions and perspectives. Some may think we simply pick and choose the best experts and follow them. Others may consider us strictly “middle of the road” investors who find the “average” opinion and follow it.
The truth is we make our own decisions. Our Investment Policy Committee is highly experienced and has personally lived through many bull and bear markets. We listen to many of the voices out there, and we feel some small measure of comfort when theirs match up with ours. But we don’t hearken to any of them. Usually we find ourselves out of synch with a lot of these opinions, including the “consensus” one. Such is the nature of the contrarian investor.
The voices we heed are our own. They tell us to maintain a long-term perspective. They tell us to not get caught up in the daily ebb and flow of sentiment. They tell us to stay diversified. They tell us to maintain adequate international exposure. They tell us be skeptical of anyone who says he or she “knows” what’s going to happen. They tell us to avoid the opinion of anyone who doesn’t have “skin in the game.” They tell us to put our clients’ interests and needs at the top of list of our priorities. We hope that none of this is news to our clients. We have great conviction and confidence in these voices and they move us to action and hopefully on to victory.
Although we tend not to make predictions, we are pretty certain that the bear market is over. This new bull market is, so far, typical in many ways. It began in the middle of a recession. Nearly every single bull market since the 1930s has begun this way. It began at the climax of pessimism. In early March the capitulation was so thick you could cut it with a knife. The gloom and doom guys were permanent fixtures in the media and the only question left to debate at that time was how much worse it could get.
Some commentators are trying to make a big deal out of how much the market has risen in a short period of time. To this we simply would offer an old Wall Street nugget – “The bigger the fall, the bigger the bounce.” Some are trying to say that the market looks expensive. Using trailing earnings this may be true, but looking forward the market looks much less so. Using an earnings trend analysis (something invented by Graham and Dodd), the market is trading at 17x earnings, well below its long-term average of 20x.
What about a big correction? Some have been calling for this since May. In a bull market, corrections of up to 10% are common, natural and actually provide a time for investors to reevaluate their portfolios. We have not seen a correction yet, in our view, because of the huge amount of cash on the sidelines waiting for the “right time” to get back into the market. Every little blip in the market so far has been met with a wave of new buying. It’s hard for the market to decline when more and more people want to buy more stocks.
So where do we go from here? Bull markets generally last about four years. Every one is slightly different and this one will likely have its own peculiarities. Yet, given its “normal” birth, we would be surprised if this one does not fall nicely into the averages (duration and appreciation potential) of past ones. Economic growth may be less than in past recoveries, as nearly everyone seems to expect, but earnings growth could be similar to or better than in the past due to fast and highly effective cost cutting and incremental and powerful demand from emerging economies. Low interest rates, growing earnings, cautious sentiment and tons of cash on the sidelines all combine to make a very attractive recipe for a new sustainable bull market. Time will tell.
As always, your current portfolio holdings are listed in the enclosed Quarterly Portfolio Statement and your portfolio’s rates of return for the most recent quarter, year-to-date and past twelve months can be found in the Portfolio Performance Summary.