We began our last quarterly letter with this, “As challenging as the second quarter of 2008 was, it was a walk in the park compared to what followed…” We must again reflect the same sentiment as we consider the events of the last three months. The fourth quarter of 2008 will go down in history as one of the most volatile, turbulent, gut-wrenching, discouraging and frightful periods for capital market investors.
During this time, good and bad stocks fell in tandem – without regard for quality or future prospects. All bonds prices fell (except the mighty US Treasuries) as investors collectively began to shun risk in any form. The threat of bankruptcy hovered over all firms and investors found no solace in the opinions from bond rating agencies. It was they who may have been part of the mortgage securities problem which began this financial avalanche in 2007. During the recent crisis, they seemed unprepared to offer value-added opinions about the prospects of bond issuers. “If Lehman Brothers and AIG can fail, is any company safe?” was the collective fear of many investors.
Hedge Funds and Mutual Funds reeled as they tried to cope with massive redemptions by their investors. Commodities, which had been the one bright spot in an otherwise torpid market for most of 2008, fell hard with everything else. There was no place to hide.
If in the third quarter investors felt they had walked into some kind of otherworldly fantasy land (please refer to our musings on The Wizard of Oz from our last quarterly letter for more on this), then the fourth quarter must have seemed like a horribly vivid descent, arm in arm with Dante, into the nine circles of Hell replete with grotesque illustrations by H.R. Giger. To some investors it might have felt like more than nine levels…
The Black Swan
Nassim Nicholas Taleb’s 2007 best selling book, “The Black Swan – The Impact of Highly Improbable” appears remarkably prescient given the events of the recent months. Mr. Taleb is a bit of an intellectual anarchist. Although he calls himself “part literary essayist, part empiricist, part no-nonsense mathematical trader,” he is, in our view, an expert in uncertainty. One of the main themes of his book is that human history is not defined by the linear, sequential, and normal everyday narrative of daily events or by the highlights of positive planned events (elections, marriages, etc.). Rather, he views history as “the cumulative effect of a handful of significant shocks.” He notes that there is something in the human psyche that wants the flow of life to be planned, calm and linear and our reflections on past events often ignore or reduce the significance of the unexpected, highly improbable and dramatic events.
The fourth quarter of 2008 was clearly a Black Swan. So much of the narrative of this period of time was mostly unexpected and highly improbable – the demise of Lehman Brothers, the failures of AIG, Fannie Mae and Freddie Mac, the nearly total seizing up of the global credit markets, the subsequent crisis of confidence in nearly all financial markets, the massive government response, the reaction to all of these by the equity market (which at the end of September did not look all that bad – valuations were reasonable, corporate profits, apart from financials, had held up well, etc.), and so forth. In our view, Black Swan events are particularly disruptive due to the effects they can have on human psychology and behavior.
Many people, after actually witnessing an unexpected and highly improbable event (like the stock market’s action in Q4), begin immediately to think that: 1) these events will now occur on a regular basis, 2) much worse unexpected and highly improbable events are now MUCH MORE likely to occur and/or 3) life as we knew it before this event will never be the same. This may not be totally rational, but it does seem common.
This mentality became prevalent in Wall Street circles after the 1987 Crash; was prominent during the late 1990’s Tech Bubble (remember the idea of “paradigm shift?”) and found fertile ground in the dark days following the 9/11 attacks. In each of these cases (and in the case of most Black Swans, according to Mr. Taleb), the fears reflected in the previous paragraphs were not realized following these disruptive events. We suspect the same will be true about our latest Black Swan.
Prediction Versus Measurement
Lately, Mr. Taleb has recently captured some media attention due in part to what appears to be a very insightful “prediction” in his Black Swan book. In it he writes, “We have never lived before under the threat of global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks… when one falls, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard… we will have few but more severe crises.1 ”
The grand irony of the media looking to Mr. Taleb as some kind of prediction “guru” is that one of the main themes of his book suggests that making accurate predictions about important events is IMPOSSIBLE, exactly because the most important ones are rare, unexpected and highly improbable!
He writes, “You would expect our record of prediction to be horrible: the world is far, far more complicated than we think, which is not a problem, except when most of us don’t know it. We tend to ‘tunnel’ while looking into the future, making it business as usual, Black Swan-free, when in fact there is nothing usual about the future…. I find it scandalous that in spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude rare events. Prediction is firmly institutionalized in our world.2 ”
In general, we agree with Mr. Taleb’s assessment about predictions. In our way of thinking, prediction is akin to market timing. If one could predict stock market returns with a high degree of accuracy, the best way to invest would be to use a combination of 100% equities when markets rise and 100% cash when markets decline.
We do not know of any professional investor who has been able to do this successfully over any meaningful period of time. The complexities and efficiencies of the capital markets make it impossible to do this. History has shown that someone who professes a special gift or insight into making “highly improbable” returns over the long run may be simply employing an old scam named after one Charles Ponzi. Perhaps now, the “Ponzi Scheme” will be renamed the “Madoff Scheme.”
Given the limited ability we (and all people?) have to make meaningful and accurate predictions, how do we help investors navigate the uncertainty of the capital markets? We focus on what we can measure and what we can know and use this information in the context of our time-tested investment philosophy.
What We Know
For example, we know that the current level of money in safe money market funds is roughly equal to the entire capitalization of the S&P 500. We can measure this. This is the first time this has happened since the introduction of money market funds in the 1980s. This fact suggests to us a great deal of concern about the equity market, but also that the vast majority of selling of stocks may be complete. Throughout history, high levels of cash or cash equivalents has been a reliable contra-indicator for the stock market; the higher the cash level, the more likely stocks were to outperform other asset classes in the future. We view high cash levels as a positive for the stock market.
We know that the current dividend yield for the S&P 500 is 3.8% and that this yield has never been this high relative to interest rates on US Treasury Bonds, money market funds and banks CDs. This too is a simple measurement. This suggests to us that stocks are as cheap as they have ever been compared to so-called “risk-free” assets. Historically, buying stocks when they were cheap has been a good strategy for long-term investors.
We know that in every single recession since 1929, the stock market has bottomed out during the recession, never after. We learned this by looking at charts from history. This suggests to us that, unless the current recession lasts much longer than did the severe recessions in the mid 1970s and early 1980s, the market might be close to bottoming out. Another reason to view stocks more favorably than does the consensus.
We also know that investors’ risk tolerance and asset allocation should not be changed based solely on what the market does. Investors who expected the equity market to generate its historic long-term annual return of 10% were clearly disappointed in 2008. Yet, we know that over time, the equity market has outperformed all other asset classes. Also, the market tends to display periods of dramatic outperformance following very weak years (1988 and 2003, for example). There is a strong temptation for some equity investors to move to cash after a big market decline. They think they are reducing their risk exposure. In truth, they run a much greater risk by missing out of the next upward movement in the stock market.
We know that the valuation of many, high-quality stocks are at levels not seen in many, many years. We recognize that many valuation metrics such as P/E are dependent on earnings, which are expected to be under pressure for the next few quarters as the recession continues, but others such as price-to-book and dividend yield also indicate very attractive valuations. We spend a great deal of our research effort measuring the value of stocks and looking for the best cheap ones. History has shown that buying stocks at cheap valuations most often leads to attractive long-term returns.
Most of what we know comes from things we can measure and requires no precise predictions. We understand that investing in the capital markets is an exercise in probability and uncertainty, but there are many things we can do to find comfort and guidance amid the uncertainty. In our efforts to grow our clients’ portfolios, we are always trying to optimally use what we know. We are always trying to find the best stocks, bonds and funds given what we know. What we don’t do is simply look at the recent past and assume it will be the near future. We don’t look at trends and extrapolate them into the future. We take very seriously the concept of independent thinking. We are not beholden to a larger company to sell any products, to tow the “party line” or to hit benchmarks dictated to us. Our interests are exactly in line with those of our clients.
What We Don’t Know
Time and space constraints prohibit us from detailing all we don’t know. We don’t know where the S&P 500 will be at the end of 2009. We don’t know what the trajectory of the US economy from here to the end of the year will be. We don’t know if housing prices will continue to fall or stabilize. We don’t know whether another Black Swan is waiting in the wings to swoop down into our already turbulent pond. Yet, we suspect that the time-tested investment discipline of buying assets when they are cheap (stocks and corporate bonds), and selling assets when they are expensive (cash and US Treasuries) will yet again prove to be the right thing to do. We suspect that in a long-term distribution of quarterly returns that the -23% that the S&P 500 logged in Q4 2008 will prove to be an extremely rare outlier and not the beginning of some kind of new trend. Mr. Taleb might be pleased that we admit all the things we do not know. Another theme from his book is that recognizing what one doesn’t know is the first step to better understanding the world around us.
The Path Less Traveled
In the December 22, 2008 edition of Barron’s, 12 deeply-experienced, highly-compensated, and well-regarded strategists provided their predictions for 2009. This ritual has been a Wall Street tradition for many years. We could point out that at the end of 2007 a similar group predicted (on average) that the S&P 500 would end 2008 at 1,640, but we won’t. Mr. Taleb’s disdain for prediction feels exactly right when we have just passed through a Black Swan event. In more “normal” times, the Wall Street predictions can be insightful and fun to read, but even then should be used sparingly as a garnish to the investment process. It is important to remember that professional investors who offer “free” advice in the media do so, not out of an altruistic desire to serve the investing public, but to sell something, in most cases their reputation as “experts.”
We will point out that the current 12 are forecasting (median number) a 2009 year-end level for the S&P 500 of 1,022.50 or up 13.23% from 12/31/08. Let us go out on a limb and make a forecast regarding this group of predictions – the actual return on the S&P 500 will be anything but 13.23%! Clearly, we jest, but we do not let predictions about any given year (our investors are looking for long-term results) affect how we approach the markets.
The numerous voices in mid-2008 telling us that oil was going to $250/barrel did not affect our decision to trim energy exposure in July. Oil now trades below $40/barrel. The unanimous feelings about the one-directional nature of commodity prices and commodity stocks (upward ho!) did not impact our decision to sell many of these names in the first half of the year. The overwhelming sense of fear that was palpable in October and November did not stop us from buying good cheap stocks with the cash we had on hand.
To be a contrarian investor means to go against consensus. Sometimes the consensus is right and the contrarian looks very foolish. More often however, the easy, intuitive and “mainstream” thing to do is exactly wrong. We continue to think that the market is in the process of finding a bottom. Whether this takes 31 days or 31 weeks can be placed on the list of things we don’t know. However, we feel very comfortable buying and owning good cheap stocks and bonds at these levels. We think investors who can see beyond the nearterm period (which we have no doubt will be marked with a great deal of dismal news and market volatility) will be richly rewarded by following the time-tested investment principles we use to manage our portfolios.
In a recent interview Bruce Berkowitz, the founder of Fairholme Capital Management, was asked about his outlook for 2009. His answer reflects our sentiments exactly:
“There are two ways to invest – either predicting or reacting. I admit I have no skill at predicting. To predict would be foolish, so we react. We invest based on free cash flow relative to the price of a stock… Prices today are as attractive as I have seen in my career and it will be worth the wait for the market to deliver the true value of these companies.”
Now for the hard stuff. Below you can see just how challenging the fourth quarter and full year were for investors. All asset classes fell dramatically and most markets exhibited a high degree of correlation. In other words, there was no good place to hide.
|Index||4th Quarter 2008||2008|
|Dow Jones Industrial Average||‐19.1%||‐33.8%|
|MSCI EAFE Small Cap||‐23.9%||‐49.6%|
|MSCI Emerging Markets||‐26.9%||‐50.1%|
|Lehman Aggregate Bond||5.7%||3.0%|
|Lehman Municipal Bond||3.8%||‐3.8%|
|Dow Jones Commodities||‐30.1%||‐36.6%|
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.
RDL Financial, L.C.