  |
|
||||||||
|
About | Our Team | Services | Investment Strategy | Portfolio Strategy | Contact | Newsroom | |
|
||||||||
|
|
By Howard Aschwald, CFA As the economy recovers in 2009, we will see the end of a deflationary environment and beginning of a more inflationary period starting in 2010. Interest rates will then rise over the next four years. While corporations can adapt to an inflationary period, longer term bonds cannot. The U.S. Treasury 10 year bond currently yields 2.75%. At the beginning of 2000, a 10 year Treasury bond yielded 6.5%. We are conservatively forecasting that interest rates will return to this level within the next four years and then gradually go down. As the chart below illustrates, that makes investing in the current 10 year Treasury bond a risky proposition. For example, if one bought today's 10 year Treasury bond and decided in four years to redeem it when interest rates were higher, it is likely that the investor would get back 84 cents on the dollar. Making matters worse, after taxes and inflation, the investor not only will have lost principal, but the interest received to date would not even cover the nominal amount of loss. The only way that a 10 year market Treasury bond would do well is for the US economy to remain in deflation, an unlikely scenario. There are two primary reasons for our constructive outlook on the stock market: history and valuation. From history there have been twelve recessions in the U.S. The typical pattern is that after a bear market low is reached, the market recovers 16% in the next 7 weeks (like we have seen in November/December) and then the market loses most of this recovery in the next 7 weeks (like we have seen in January, February and early March) and then finally goes on to make 25% in the next twelve months. In the last 100 years, bear markets have lasted 84 weeks on average. At the end of March, we have endured 74 weeks for this bear market. Finally and most compellingly, there have been ten rolling 10 year periods since 1928 when the market returned less than 5% per year. The current ten year period is actually negative. In every case, the 10 years that followed produced satisfactory returns averaging approximately 13% per year and ranged from a low of 7% per year to a high of 18% per year. While history is not an absolute predictor of the future, there is enough repetition to invest with it rather than against it. The case for valuation (i.e., stocks are cheap) is also quite compelling. Various analysts like to use their favorite metrics, but we think the valuation statistic devised by Nobel Laureate James Tobin and used by the U.S. Federal Reserve has the best evidence to support it. The ratio is the market value of all stocks divided by their net equity value. Levels below 1 mean that it is cheaper to buy stocks than to rebuild the companies (just like house prices selling below their replacement costs). As the economy recovers, more economically sensitive sectors will perform better than recession resistant companies. In anticipation of this recovery, we have increased our investments in early stage economically sensitive industries, such as consumer discretionary stocks (like Best Buy) and decreased amounts in defensive companies (like Proctor and Gamble). We also feel that the extraordinary record amounts of money invested in ultra safe CD's and money market instruments will start to flow back into the stock market. Because of the severity of this bear market, most investors will initially choose very safe companies to invest in. By safe we mean companies with strong balance sheets (minimal debt), strong competitive advantages, self-funding to sustain future growth and the ability to pass through cost increases. Generally, these are large companies with global reach. Turning to investment areas beyond U.S. stocks and the investment concept of diversification, our conclusion is that it works 90% of the time. As the chart illustrates, having International stocks and Real Estate in conjunction with U.S. stocks worked quite well for most of the last eight years until mid 2008. Then, everything (except for government bonds and money markets) went down. We expect U.S. Stocks to outperform Real Estate and developed International markets over the next twelve months, but the secret to making diversification work is to be invested. Most of the time, an investor's bottom line results will be better than investing in one class of assets. Investing is a long-term disciplined process with little room for excess emotion. As legendary manager Peter Lynch observed, "The key organ (for investment success) is your stomach. Everyone has the brainpower, but not everyone has the stomach for it." In today's bear market, investors are racing for the exits. Investment cash is going into securities like short-term U.S. Treasuries with virtually no yield. Although such a choice feels good, it is, given expected inflation, likely to prove very costly. Meanwhile, investments in high grade common stocks, which feel like a terrible choice, are likely to prove very profitable and are almost certain to outperform cash over the next decade. Back to TopThe Pendulum Never Stops By Stephen Bradley The pendulum never stops in the middle as used in the context of market valuations and market sentiment is a historical reality. The pendulum inevitably swings from one extreme to another, from periods of outlandishly elevated valuations to ridiculously beaten down levels, and from periods of unquestioned euphoria to absolute pessimism. Look at today's attitude toward risk and leverage, especially as it is portrayed in the media. Companies that were fiscally conservative and didn't borrow to the hilt to boost profits were criticized for failing to maximize shareholder value. Consider investors' attitudes to owning resource stocks. Not long ago loading up on these was all that many investors wanted to talk about, but today they don't even want to hear about owning resources. This is reflected in expectations of oil prices. A year ago the "peak oil" theories held sway and demand from China and India was going to push oil to $200 by year-end. Today we've begun to hear about the "peak demand theory" — the view that demand for oil peaked last year and we'll never, ever see demand at that level again. With the benefit of hindsight, the first forecast is now clearly absurd — and almost certainly the second one will be equally so. Recall all the investment fads and "flavor of the day" investments. The point is that the stock market may be efficient and rational over the mid- and long-term, in the near-term the "swinging of the pendulum creates terrific opportunities for companies and for investors who can maintain their perspective. The pendulum-swinging concept captures two of the most important and widely recognized truths about investing. The first truth is that what really drives markets to their extremes are the twin emotions of greed on the upside and fear on the downside. Both can be hugely costly — and it takes real discipline and resolve to withstand the forces of those emotions as the pendulum moves through its arc. The second truth — the costliest advice for investors — is "it's different this time." Seasoned investors know it's never different. As just one example, those investors who listened to market prophets saying that the historical rules didn't apply to tech stocks in 2000 and resource stocks a year ago ended up paying a huge price. Chances are that those investors who are taking counsel from the most extreme voices of doom today will likely pay a similar price in wrongheaded investment strategies and missed opportunities. It is true that global economy and stock markets are facing formidable challenges. However, open markets, the spirit of innovation and the entrepreneurial ethic have demonstrated remarkable resilience in the past in working through periods that seemed at the time just as dark as the one we're in today. Our role as your financial advisor is to act as your emotional anchor. That is to help you resist the impulse to succumb to the pendulum's extremes. We are somewhere between despondency and depression and worst case we are closer to the bottom than the top of the cycle. We'll look back years from now and recognize that the drastic shift in sentiment has created significant value for those bold enough to look past the swinging of the pendulum. Back to TopGroupthink By Mat Johnson Early in my career as an economist, I worked for a large bank that employed a group of more than twenty forecast economists, most of which held either PhD's or ABD's (all but dissertations) — so relatively smart people, at least on paper. Once a month, we would all convene to develop the group's consensus economic forecast. The first half of the day was devoted to briefings on global economies, major sector events, government policies, etc. The second part of the day was spent formulating the short-term GDP forecast. Each forecasting session started with the announcement of the current consensus estimate. Being young, but mathematically inclined, my task was simple: listen and gather data to input into my long-term forecast model. The official short-term forecast however, was still derived from the figure that was agreed upon at the end of the day. The group was incredibly accurate in its GDP forecasts. We rarely missed the next reported GDP estimate by very much, and as a result we frequently "hit the number." Oddly however, the model that I maintained seemed not to work at all. After inputting the senior economists' estimates for consumer spending, business investment, government spending and net exports, my model produced a forecast that was nowhere near what was actually reported. After a few months I began to notice that the model was good, but the data that was fed into it from the meetings was not. In fact, the forecasts prior to "massaging" the data were very good, often several quarters or a full year in advance of what was ultimately reported. I realized then that the group was really forecasting the current consensus, and the consensus was merely "forecasting" what was known from the data that had already been released — basic addition and subtraction. If the more recent economic numbers were positive, the group became more positive and vice-versa. My model, on the other hand, proved to be long-term accurate, consistently forecasting that if today was really good, tomorrow wouldn't be. If the group's forecast was very negative, the long-term forecast would turn sharply optimistic. In essence, the model was consistently reverting to the mean. What neither the group nor the model did very well was explain how we moved from today to tomorrow, or went from bad economy to good economy. As my career in the industry continued, I came to realize that it is simply human nature to focus intently on today, and in particular on what the consensus is; even if it is widely at odds with rational thinking and longer-term probabilities. Ultimately, my economic peers were practicing what was known as "groupthink" — smart people, when together, making really dumb decisions. John Maynard Keynes described this behavior way back in 1936, in his "beauty contest" analogy to the stock market. Keynes analogy was based on a contest run in a London newspaper, where entrants were asked to choose the "most beautiful" contestant from 100 photographs. Anyone who chose the most popular face was then entered into a raffle. He concluded that there were several strategies, from the "naïve," to the "sophisticated." The naïve strategy was an individual choosing based on who they thought was "most beautiful." A more sophisticated strategy was to choose based on who the majority might choose, and an even more sophisticated strategy was to realize that other contestants might choose based on this latter strategy — in essence trying to "anticipate what the average opinion expects the average opinion to be." In forecasting, contests and investing, groupthink results in the consensus' view being most important. Take for example, the concept of investment risk. As individuals, most of us would define risk as the degree of uncertainty, volatility, or even the risk of permanent investment loss. As a group, however, risk becomes re-defined as deviating from what the consensus thinks. Specific to investing, this can lead average opinion to value equities not based on what they think the value is, but rather on what they think everyone else will predict the consensus price to be. We have seen this in spades in the first three months of 2009, as market pundits toss out random targets for the Dow Jones Industrial Average; predicting the market "must fall" to 7,500 then 6,000 then 5,000, before recovering. As it applies to the recent investing climate, groupthink appears to have resulted in it now being viewed as more risky to buy shares in real businesses at depressed prices, than to hold cash, CDs or Treasury bonds. Even though the latter provides virtually no return, and whose purchasing power is already being destroyed by inflation. Yet everybody else also owns these assets, and investors know they will get their money back, thus these investments are considered to be "safe." What has been lost is the purpose of investing, which is very simple but also easily forgotten. Investing is laying out today's savings in order to receive more money tomorrow. With this in mind, the goal of investing should be to capture as much investment value as possible today, in order to receive a greater share of the future increase in wealth. Unfortunately, investing in stocks is one of the few economic activities where when prices decline quickly, many buyers actually prefer less stocks. In our view, while we respect the impact of investor psychology, and what it is capable of doing to stock prices, to be successful we also need to keep a close eye on the value of equities. On this score, by many metrics, prices have been pushed to historic lows relative to the value available to shareholders. In fact, the true value of equities changes slowly and measurably, though stock prices can obviously change rapidly and dramatically as investor focus shifts from the distant future to the immediate concerns of today. Fortunately, this runs in the opposite direction as well. The Opportunity Emerging From Today's Market While many market pundits have been seeking answers as to how today's economic crisis might develop by looking back to the Great Depression — a comparison of failures — one might also look back to the same period to judge the opportunity that might lie ahead. Measuring the depth of the market decline relative to value, today's market has fallen into historic territory, rivaled only by the 10-year periods that concluded in 1920, 1932 and 1974. Now most will recognize that the subsequent 10-years to the years above, as included some disastrous years for the broader economy. However, they did turn out to be fantastic periods overall for investors. The average 1-year return following the market bottoms in 1920, 1932 and 1974 was +44%. The average 5-year return was +14% per year, and the average 10-year return was +8.5% per year. Notably, the market crash of 1929, the bulk of the Great Depression and the second OPEC oil shock all occurred during the 10-year periods above. Underscoring the potential for a similar long-term period of out performance of equities, is an astounding level of "cash" holdings relative to the size of the U.S. equity market — the proverbial "money on the sidelines." In the past year, the ratio of money market funds (where last year's stock sales wound up) to the value of the U.S. equity market skyrocketed from an already high 20% to a record 45%. A typical ratio has been something on the order of 10%. Our estimation of the prospective long-term return on U.S. equities is now at a lofty 12% a year, versus essentially zero for cash and just 2.8% for 10-year Treasury Bonds. We suspect that in any sort of market recovery, this glut of "safe" money will soon feel the burden of opportunity cost, and begin to flow back to the higher expected return of stocks. Back to Top |
|
|
|||||||||||||||
|
||
|
Home | About | Our Team | Services | Investment Strategies | Portfolio Strategies | Contact | Newsroom © 2008 Quantum Capital Management. All Rights Reserved. |
|
|
||
|
||