Little things mean a lot. This holds true not just in the context of being nice and appreciative to people (although that is very important), but also in the greater systems such as the capital markets. Much of the commentary we see day in and day out seems focused on the big picture stuff: the economy, politics and even “the market” (as if it were somehow just one thing). We believe that small things can have a big impact on the economy, the markets and one’s portfolio. Sometimes a small event or action can have a huge impact on many things, often many degrees of separation from the original event. Often this chain of events seems random or chaotic, but when one understands the linkages, and the limits of predictability, it all seems to make more sense.
Second Quarter Review
For the quarter, the S&P 500 squeezed out a total return of +0.1%. This modest result does not mean the quarter was uneventful. No, in many ways it felt like a replay of the second quarter of 2010. Last year at this time, the markets were extremely worried about a spreading bank crisis triggered by problems in Greece, Spain and Portugal. Also at that time, U.S. employment growth abruptly stalled, and the words “double-dip recession” became the tagline for nearly every economic media report. This year, Greece again proved to be a flash point for the markets, with a much weaker-thanexpected jobs number for May adding fuel to the fire. This year’s version of “doubledip” was called “soft patch,” as economists acknowledged a bit of slow down in certain parts of the economy. On cue, the stock market backed off quite a bit following the string of disappointing economic data releases. Yet the decline in the S&P 500 was only 6.8% (from peak to trough), well in line with normal corrections within the context of a bull market. From the middle of June, sentiment shifted dramatically, and the stock market rallied sharply to leave performance for the quarter unchanged.
The bond market really liked all the bad news on the economy. The bonds indices offered returns well above expectations. Throughout the quarter, the Federal Reserve continued to buy bonds via its QE II program, effectively locking in low rates all along the curve. At the margin, we hear worried voices murmuring about the U.S. budget deficit and coming inflation, but so far, the bond market itself seems unconcerned.
Here’s what the second quarter looked like by the numbers:
|Index||2nd Qtr 2011||Year to Date||Trailing 12 Months|
|Dow Jones Industrial Average||1.4%||8.5%||29.5%|
|MSCI EAFE Small Cap||1.5%||5.1%||37.6%|
|MSCI Emerging Markets||-1.8%||0.8%||29.3%|
|Barclays Aggregate Bond||2.3%||2.6%||2.8%|
|Barclays Municipal Bond||3.8%||6.4%||2.1%|
|Dow Jones Commodities||-8.0%||-3.8%||25.5%|
The Fall of the Roman Empire
Speaking of big things… Everyone has probably studied ad nauseam the main causes for the rapid and hard decline of this amazing ancient empire. Any high school graduate could probably rattle off a fairly comprehensive list of reasons for its demise such as the conflicts between the emperor and the senate, the barbarians learning Rome’s military tactics, overexpansion, a decline in moral values, constant wars and their massive costs, the introduction of Christianity, and so forth. James Dale Davidson and William Rees-Mogg, in their excellent book The Great Reckoning actually make a solid case that throughout all of recorded history ALL empires enter decline when spending on defense and citizen welfare (entitlements) become unsustainably large relative to GDP.
Rome fell hard and we can easily see the many “big” reasons for this. One scientist’s research suggests that a much smaller phenomenon may have had a disproportionately big impact on Rome’s fortunes. Lead. The Romans were famous for their water systems which used both terra cotta and lead pipes. The English word “plumber” can trace its roots back to these times; “lead” in Latin is “plumbum.” The dangers of lead poisoning were known to some extent back then and some records suggest caution when using lead pipes. There was another use for lead that may have caused a significant amount of poisoning among the elite which may have exacerbated the fall.
It seems that wealthy Romans used something called “must” in much of their cooking. It was also used as a preservative. Must started out as simple grape juice, but it was boiled down (removing some of the water content) to create a sweet sauce that could be used in many dishes. The Romans discovered that boiling must in bronze kettles could make it bitter, so lead pots were used. High concentrations of lead consumption by the elite of Rome could have resulted in lead poisoning, the symptoms of which include abdominal pain, confusion, headache, anemia, irritability, and in severe cases can evoke seizures, coma, and even death.
The Butterfly Effect
Well, maybe lead poisoning as a contributor to Rome’s fall may be a bit of a stretch, but it’s a nice starting place for our discussion of how little things may be quite important. This idea is well described in this proverb for antiquity:
For Want of a Nail
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
The idea here is that one small detail, left unattended, led to a massive result. In the New Testament, this notion is further explored by James who writes, “Look at the ships also, though they are so great and are driven by strong winds, are still directed by a very small rudder wherever the inclination of the pilot desires.” His point was that large ships can be moved by something as small as a rudder. He uses this analogy to warn his readers that something else relatively small – the tongue – can have a huge impact on those who say things they might regret later. In Michael Crichton’s novel, The Andromeda Strain, a critical message was not received because a small piece of computer paper became lodged in the bell ringer that was supposed to signal the receipt of a new communiqué. The destruction of life on earth was a potential consequence of this bit of scrap paper stuck in the bell.
All of the above are examples of the “Butterfly Effect.” This term, popularized by Edward Lorenz, an American mathematician and meteorologist, denotes the notion that in a complex system, like the weather, one small change at one place (the butterfly flapping its wings in China) can result in large differences to a later state (a hurricane in the Caribbean). This effect, which can be derived mathematically, works especially well in complex, non-linear systems. Weather forecasting is one excellent example. Any small variance in the initial condition (right now, for example), can lead to end results (say a 5-day forecast) wildly different than expected. The computers used to predict the weather are amazingly complex and the models they use are actually quite accurate within a 5-day or so window. Yet, we often complain about the weather forecasters being so wrong sometimes. These errors are usually caused by very small changes in the model.
Chaos Theory and the Law of Unintended Consequences
Chaos Theory is the field of mathematical study from which the Butterfly Effect spawned. The basic premise of Chaos Theory is that complex, dynamic systems (like the weather) are hard to predict because they are highly sensitive to initial conditions. Any small variance in the initial condition can lead to wildly diverging outcomes.
Chaos Theory was one of the focal themes in Michael Crichton’s book Jurassic Park. In the book, the “perfect” system devised by the brilliant team put together by billionaire John Hammond ultimately fails due to unforeseen problems both in the initial system and how the system evolved over time. In the real world, we see a version of Chaos Theory emerge whenever some unexpected and unintended consequence arises from a new law, program or initiative.
At the time of their creation, Social Security, Medicare and Medicaid all had highminded and arguably noble purposes. Little did their creators realize that just a few decades later they would become such a large part of the U.S. government’s budget and a major campaign issue for the 2012 Presidential-Election. Whether it be the weather, government policies or other complex functions, it’s important to understand that things often turn out in unexpected ways, not because the models were flawed, or that policy makers were acting in bad faith, but simply because certain things are very, very complex and are really beyond the scope of predictability.
This is not to say that all is random and chaotic. The models the experts use to predict the weather or to simulate the growth of budget deficits over time are valuable exactly for what they can offer. The danger sometimes arises when we (the public) place too much faith in policies and models which are very likely to disappoint versus expectations at some point in the future.
Chaos in the Investment World
It’s not hard to imagine that the capital markets are complex enough to render them susceptible to the effects of chaos. A simple look at the global credit crisis of 2008-2009 will quickly prove this point. Of the thousands of market commentators, economists and professional investors carefully monitoring the markets, only a few proved to be correct in their predictions about this crisis. In defense of equity investors, we would submit that the stock market did not look particularly “risky” in late 2008 because: 1) it had already corrected about 20% (the usual amount of decline seen in “typical” bear markets) and 2) stocks looked cheap. Connecting the dots from the overextended housing market to the mortgage securities market to the overleveraged balance sheets of the investment banks was an exercise successfully maneuvered by only a few.
The so-called “Flash Crash” on May 6th 2010 is another example. Here one mutual fund trading desk placed a large number of futures trades that led to an unexpected chain of events that drove the DJIA down almost 1000 points during the day. Most watching the markets that day had no idea what the cause was, and it took several months to get down to the heart of the matter. Again, “unintended consequences” was the reason. Certain automated trading systems, when faced with an imbalance of orders, will automatically transfer pending trades to other smaller regional markets. On that day in May, the volume transferred was overwhelming for these markets and led to all sorts of erroneous price quotes.
One of the recent jobs numbers was another interesting exercise in the nature of chaos. The jobs number reported was actually below the lowest estimate of the 80+ economists posting forecasts. That is to say that ALL of the economists watching this very important economic data point got it wrong. These are smart people with many advanced degrees and years of experience. They are professionals. They do this for a living. And yet, the complexity and non-linear nature of the economy sometimes surprises all of the model builders.
Which Little Things Really Matter?
We are bottom-up investors. That means that we spend most of our time looking at companies and not the markets. We recognize that the economy and “the markets” have an important impact on the general direction of our portfolios, but we really can’t do too much about it. We view ourselves somewhat as the pilot of a sailing ship. We are happy to find a tailwind that makes our work easier, but we realize that how we manage our ship matters more than just the direction of the wind.
At the corporate level this works the same way. In a slow growth economy, we continue to find companies that can grow sales 8-10% on a consistent basis, and earnings at a higher rate than that. How do they do this? They are applying technology to improve productivity. They are capturing market share from less capable competitors. They are expanding their business into new markets. They are cutting costs. They are streamlining their production facilities. The list of “little” things companies can do to better their circumstances is nearly endless. These are the kinds of things we focus on as we monitor our investments.
Sometimes we are surprised by a company we think we know well. Maybe it’s a disappointing quarterly earnings numbers. Sometimes it’s a questionable acquisition. Whatever it is that surprises us, we try to take it in stride. We can’t have perfect foresight; we can’t always be right.
Yet, we have a firm confidence in the way we invest for our clients. It is a philosophy well tested in the real world, by us and countless others. We pride ourselves in our approach and find no small satisfaction in investing in a way that may seem arcane to the Jim Cramers and CNBCs of the world. The most important “small thing” we focus on is “valuation,” which is really a big thing, but one would not know it given how little media coverage it receives. Being able to buy a portion of a corporation at a sizable discount to its fair intrinsic value is a great way to invest. And, that’s a big thing.
The world is often a scary place for those who only dwell on the big picture. At this moment in time, much of the macro focus is on the U.S. Government Debt Ceiling/Budget deficit. Others could be quite worried about the European banking system if Greece defaults. A slow-down in China might top the worry list for someone else. The weak U.S. housing market and employment picture might be atop other lists. Smart people all over the world are constantly finding new areas where another “Black Swan” may land. As always, we are painfully aware of the macro issues and monitor them carefully. Yet, in most instances we see no compelling reason to change our time-tested investment philosophy based on something that might happen. In our experience worst case scenarios rarely occur, whereas the stock market tends to provide the best total returns of any asset class, over time.
We see nothing in the near-future that could change our generally positive views on the U.S. and global economies and the U.S. stock market (absent a U.S. Government default – which we view as a zero probability event). The measurable slowdown in the U.S. economy seen over the last few weeks already appears to be unwinding. We have seen stronger-than-expected manufacturing data in many sectors and geographies (including Japan). The U.S. jobs situation and the U.S. housing market continue to be a drag on growth, but neither of these factors is, by themselves, sufficient to snuff out global economic growth. Most credible economic forecasts are calling for 2011 to be something close to that seen in 2010. We completed a recent internal study looking at quarterly GDP for the last few decades. We were somewhat surprised to note that U.S. GDP growth of over 4% was actually a fairly rare number. The commentary we hear daily would suggest that unless the U.S. economy is growing at close to 5%, something is dreadfully wrong. The data suggest something quite different. It’s important to note that the high growth seen in the 1980s was driven in large part by a massive increase in debt, including aggressive use of home equity borrowing. In the 1990s, the above-average growth was fueled by a large expansion in production capacity in the tech sector. Absent these two big “stimulus” effects, GDP growth for the last 30 years probably would average somewhere around 2.5%.
At the “small things matter” level, U.S. corporations are flush with cash. These cash-rich companies are using this liquidity to raise dividends, buy back stock, and engage in mergers and acquisitions. All of these activities are supportive to the stock market.
With unit labor cost in the U.S. still falling, we suspect that 2011 will be another good year for corporate earnings growth. The consensus for 2011 is for EPS to grow at least 10%. Interest rates appear to be locked at these low levels. Investor sentiment, especially at the retail level, remains cautious. The market’s valuation remains at the low end of historical ranges. All of these elements suggest to us that the bull market in equities could continue. In many ways, this bull market is very typical: it began in the middle of a recession, it bottomed out at the peak of negative sentiment, it rose on the back of skepticism, it has been fueled by fundamentals not “concepts” and it has persisted despite new negative developments. If it continues to display this “normal” behavior, we could see it lasting at another year or two.
Wolf Group Capital Advisors