Happy New Year!
That cheery salutation rings hollow in the ears of some as the nation struggles with a myriad of critical problems. The current list of concerns is long and familiar: slow economic growth, too much debt, government deficits, Greece, housing markets, taxes, banks (either too weak or too powerful, depending on the commentator), political wrangling, high-speed traders, rising government regulation, China, India, PIIGS (!), class warfare, poverty, recession, unemployment, wars, rumors of wars and all kinds of plagues, pestilence and pandemics. To some these days are as bad as the troubled times in late 2008 and early 2009. To many those bad times never ended, despite the equity market having provided positive returns in the each of the last three years. According to the National Bureau of Economic Research, the last recession ended in June 2009. It was a doozey of a recession, coming in deeper and longer than most. But, in the eyes of many economists, the recovery from this recession has been mostly normal. Corporate earnings have been growing rapidly and steadily since the middle of 2009. Monetary policy has been accommodative and supportive of the economy overall and to industries such as banking, housing and autos, in particular. So, as is so often the case, the water level in the glass is very close to its midpoint, and our view of its being “half full” or “half empty” is wholly dependent on our frame of mind and not the glass itself. Can how we feel about things really affect the way we think?
Fourth Quarter Review
For the quarter, the S&P 500 rose nearly 12%, recouping much of the loss suffered in the third quarter. Many of the key indices showed a solid recovery from the broad-based weakness evident in the prior three-month period. During the quarter, the market was able to find support in early October, moved steadily higher from that point, pausing briefly in late November, and then closed at the high for the quarter.
One thing to note was the disparity among the U.S. stock indices’ performance for the year – rarely do we see a 12 percentage point difference between two indices such as the DJIA and the Russell 2000. Clearly 2011 was the year of the big, “safe” stock.
In many ways the performance of the markets in the fourth quarter was as puzzling (and maybe frustrating) as their performance in the third quarter. Europe again dominated the narrative, with a steady flow of news alternating between good and bad which affected the market in predictable ways. The big traders, which at times seemed to dominate the market’s direction, were again employing their “risk off/risk on” trades which have increased volatility, but seem to have (at the end of the day) little longterm impact on the markets. At the end of the quarter, it seems that these two sides (good news and bad news) had reached an uneasy truce, allowing the market to begin again to focus on other more meaningful fundamentals.
Bonds turned in another solid quarter and a great year. We vividly recall cautious comments from bond experts as early as 2007 that the bond market was poised for a sizable downturn, that the gains were unsustainable and that inflation (maybe even “hyper-inflation”) was just around the corner. Four years later, we see bonds logging another year of double-digit gains. All the reasons to expect more modest returns from bonds going forward still exist, but anyone strongly forecasting this now is likely to meet a great deal of skepticism from the holders of bonds and bond funds.
Here’s what the fourth quarter looked like by the numbers:
|Index||4th Qtr 2011||Year to Date||Trailing 12 Months|
|Dow Jones Industrial Average||12.6%||8.0%||8.0%|
|MSCI EAFE Small Cap||0.3%||-14.4%||-14.4%|
|MSCI Emerging Markets||8.6%||-18.2%||-18.2%|
|Barclays Aggregate Bond||0.8%||7.1%||7.1%|
|Barclays Municipal Bond||2.2%||12.7%||12.7%|
|Dow Jones Commodities||1.2%||-14.0%||-14.0%|
Investing as a Behavioral Science
[For those not interested in a discourse on behavioral science, please turn to page 6 for the Outlook section.]
Most people who invest have some idea of what makes the capital markets tick. Although the level of sophistication varies greatly from person to person, most of us understand that the economy, corporate earnings, interest rates and so forth are important factors which affect the markets. Less understood, in our view, is the behavior of investors and its impact on the markets. We sense that a greater percentage of academic research is being directed at the study of investor behavior than ever before. After all, it was the investing legend Benjamin Graham who suggested long ago that the stock market (at least in the short run) is a “voting machine.” In our view, understanding how one feels about the market may be just as important as what one thinks about it.
How we feel about the market can be influenced by many factors – our own biases, the media, expert opinions, intuition and perhaps most importantly, the level and direction of the market. Somewhere in our brains we may think that buying stocks when they are down (thus, cheaper, or a better bargain, if you will) is a good idea (buy low), but as the market declines, it makes us feel bad. And, most people don’t want to invest when they feel bad. Conversely, when the market is higher and rising, we feel better and may be more inclined to invest even though we understand the risk of buying high. Dalbar, a company headquartered in Boston, has measured and quantified this general tendency by individual investors and publishes many studies about this issue. So, although we may think it’s a good idea to buy low and sell high, the way the market moves and how its movements make us feel leads the average person to buy high and sell low. This ought not to be…
Meet Mr. Frankl
Viktor Frankl (1905-1997) was an Austrian psychiatrist who during World War II was imprisoned in a number of concentration camps. His experiences in these horrific places, where he actually provided therapy and medical treatment for prisoners, formed the foundation of his life and work. He concluded that even in the most absurd, painful and dehumanizing circumstances, life still has meaning, and thus, even suffering could be viewed as having meaning. After the war, he published many books addressing the meaning of life and how one could find happiness, or at least meaning despite hardships.
We are not trying to suggest that declining stock prices may lead people to existentialist malaise, but clearly many people seem forever locked into some kind of funk because of the events of the last few years. While it may be difficult to find happiness in a bear market (which we are not in, in our view), we think that one’s attitude can make the investment journey more pleasant and much less stressful. Consider a few of Mr. Frankl’s quotes and how they might apply to the investment process.
“Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom.” Greece (or somebody) is going to default someday. There will be new wars and horrific earthquakes. Another recession cannot be too far away (the average business cycle lasts five years). When confronted with these new surprising events we can choose to join the crowd of panicked sellers, or we can hold firm to our long-term investment horizon and time-tested investment approach. We have the freedom to choose our response.
“When we are no longer able to change a situation – we are challenged to change ourselves.” Most investors want large, steady returns with no risk. What the markets offer is inconsistent, lumpy, volatile returns, with sizable losses thrown in for color. When investors recognize that they cannot attain what they truly want, they must decide to 1) not invest (which will not bring them any closer to their long-term goals), or 2) learn to better deal with market down turns, media negativity and increased volatility.
Meet Mr. James
William James (1842-1910) was a pioneering American psychologist and philosopher who like Mr. Frankl was trained as a physician. For most of his life, however, he taught at Harvard and produced volumes of papers and books. Like many philosophers, Mr. James was deeply concerned about the notion of truth.
In his search for truth, he fell in line with the world view of pragmatism, the philosophical tradition linking practice and theory. His work is so broad and deep it’s hard to pinpoint just one idea that sums up his work, but we will try to focus on his doctrine of truth. Regarding truth he said, “Truths emerge from facts, but they dip forward into facts again and add to them; which facts again create or reveal new truth and so on indefinitely. The ‘facts’ themselves meanwhile are not true. They simply are. Truth is the function of the beliefs that start and terminate among them.“ Let that sink in for a minute. Our interpretation of this idea is that facts by themselves are not truths, and that true things may emerge from facts, but also may be changed by additional facts.
How this plays out regarding the nature of man, free will, religion and so forth is well beyond the scope of this report. We do however see a solid application of this principle in the investment world. So often we see “experts” in the media spouting “facts” as if they are “truths,” to the potential detriment of all. That U.S. government debt is (may be?) 100% of GDP may be a fact (that is, measured one way it looks like that), but it may not be “true” (net of cross-holdings by the government it may be much less than that). More importantly, the implications of this fact may fan out in a wide distribution such that anyone telling us that any one thing will happen is surely likely to be wrong.
We see this idea played out in the market with great frequency. A company may report earnings growth of 20% (the ‘fact’), which sounds like positive news. When the stock trades down on this news, we learn the “truth” that the market was expected 25% growth, so 20% was actually disappointing news. The ability to distinguish the truth from the facts of the capital markets is a necessary first step in better understanding how they operate.
Mr. James also generated a number of famous quotes that apply to the investment process. “A great many people think they are thinking when they are merely rearranging their prejudices.” Looking at the last 10 years of data alone, one might think that stocks are a bad investment, but we think that prejudice, if acted upon now, could lead to serious implications down the road.
“Genius… means little more than the faculty of perceiving in an unhabitual way.” In our view, the best investors in history were able to do this. The average person sees only doom and gloom in a bear market or a recession; the great investor sees only opportunity. This is largely a function of one’s attitude about the current events. This leads to our final quote:
“It is our attitude at the beginning of a difficult task which, more than anything else, will affect its successful outcome.” A person who constantly clings to the perceived safety of cash will likely have a difficult time being an equity investor. Unless that person’s attitude going into the process is positive, any losses in the portfolio early on are likely to send that person back into the arms of no-return cash. One may not lose money holding cash, but holding cash will not help most people achieve their financial goals.
Why do we run away from danger? The easy answer is that we are afraid of what might happen if we don’t. Mr. James used the image of meeting a bear to address this question. He asks “Do we run from the bear because we are afraid or are we afraid because we run?” He suggests that the obvious answer, that we run because we are afraid, was wrong and that we are really afraid because we run. He explains, “Our natural way of thinking… about emotion is that the mental perception of some fact excites the mental affection called emotion, and this latter state of mind gives rise to the bodily expression. My thesis on the contrary is that bodily changes follow directly the PERCEPTION of the exciting fact, and that our feeling of the same changes as they occur is the emotion.”
We all know that some emotions are accompanied by bodily responses (sweaty palms, tight stomach, etc.), and Mr. James suggested that these bodily responses create the emotion and not the other way around. As we run from the bear our heart rate increases, muscles contract, adrenal glands start pumping and these bodily changes create or at least stimulate the idea of fear. We do not cry because we are sad; we are sad because we cry.
Not everyone may agree with Mr. James on this topic, but in the investment world, we see evidence of this. We know, for example, studies have shown that losing money hurts us twice as much as making money makes us happy. That is to say, one needs the “happiness” of a 10% gain to fully offset the “sadness” of a 5% loss. Other research has shown that losing money triggers the “fight or flight” centers of our brains and we tend to react emotionally, rather than use the higher thinking functions.
So why do we fear the bear market? No one likes losing money, but many smart investors love the opportunities bear markets and corrections present. If an investor has cash, investing in the middle of the bear market is the smartest thing to do. It’s also the most difficult. Buying stocks in early 2009 turned out to be a very, very smart thing, but at the time, most “experts” would have discouraged such action. Why? They were afraid that the market could decline further. This was an opinion based on emotion, not thinking. What about those investors who don’t have cash on the sideline waiting for a bear market? In a bear market or correction, investors can still sell the more defensive names and buy the more aggressive names and substantially increase the return potential of their portfolios. We did this for many of our clients in early 2009.
We are not forecasting a bear market (we don’t make forecasts), but we do not fear them. They are a natural part of the ebb and flow of the capital markets. Good times follow bad times much like the spring follows winter. Yet, as Jules Renard so wisely noted, “There are good and bad times, but our mood changes more often than our fortune.” The challenge for all investors is to understand the cyclical nature of things, to not let our moods interfere with the investment decision making process and to act and think accordingly.
The last recession ended in June of 2009. For all the talk that the current recovery is disappointing, in many ways it is quite normal. U.S. GDP has grown every quarter since the end of the recession. One could quibble about the pace and consistency of this growth, but at the end of the day, we have seen growth. Employment, which always lags the recovery, has been disappointing to some, but nearly 2 million new jobs were created in 2011. Our point is that the data suggests something out of line with the attitude and mood of the people. Listening to the media or even knowledgeable people within your community would lead one to assume that things are really bad and getting worse. They’re not. The data does not support this premise.
Cash levels are high at U.S. corporations. This gives them ample flexibility in doing many smart things in the future. Most of the possibilities are positives for either the economy or the stock market. The U.S. consumer appears healthy – year-over-year consumer spending was up 4.5-5% in the fourth quarter of 2011.
Europe is likely in recession. The good news is that only 2% of U.S. GDP is derived from Europe. A “spill over” recession in the U.S. caused by Europe’s slowdown is highly unlikely in our view. Only 10% of S&P 500 profits come from Europe. This suggests that the slowdown is not going to make a sizable dent here either.
Unit labor costs in the U.S. are still very tame, suggesting that U.S. corporate profits are likely to continue growing as they have. Growing profits and low interest rates (something the Federal Reserve has all but guaranteed for the foreseeable future) are a powerful combination for the stock market. 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.
We think that the negative sentiment we sense out there is perhaps the single most compelling reason to consider adding to equity exposure. This negativism is pervasive and born of real pain and fear from the last crisis. But this kind of mood only sows the seeds of great bull markets. We cannot know the timing of such a big rebound, but the dark feeling that seems to be engulfing much of the world tells us that it is only a matter of time.
Wolf Group Capital Advisors