What we learn from history is that we do not learn from history.
—Benjamin Disraeli
I have accumulated four decades of investing lessons—most of them are serious but some are less so. Many are presented here.
In this chapter, I explain how playing poker might help us as investors, the significance of the bond market's message, how to right your investing wrongs, the importance of time frames/exposures and risk profiles, how to identify market bubbles, and why price is what you pay but value is what you get.
I even garner some advice from legendary North Carolina State basketball coach Jim Valvano.
During the bull market of the 1990s, research on Wall Street lost much of its integrity and, increasingly, most of its value in helping individual and institutional investors make sensible investment decisions.
Consider that fewer than 1% of all Wall Street research reports are outright Sell recommendations. This is a particularly astonishing figure given that nearly 85% of the stocks listed on the New York Stock Exchange are down year-to-date. It says to me that analysts are simply not doing a good job or are not acting independently.
Indeed, Wall Street research has deteriorated to the point at which its analytical output has been rendered almost useless.
To be sure, there are excellent analysts at many brokerage firms, but unfortunately, they are few and far between. Independent analysis has become nearly nonexistent, replaced instead by hidden agendas (analysts indentured to investment banking clients) and research that is neither thorough nor detailed. Instead of acting as analysts, analysts have been reduced to stenographers and cheerleaders.
Even with stocks so depressed, it is ever important to pay attention to possible indicators of trouble. So, how can the individual investor be on the watch for troubled companies that are candidates for sale or shorting?
Following is a list of 11 early warning signs that often serve as indicators of trouble:
For those investors with larger portfolios who have the resources but not the time to do their own analysis, there are a number of valuable services that provide independent research away from Wall Street. These services specialize in finding companies/industries to avoid or to sell short. The services can be relatively expensive—but you get what you pay for.
While I recognize that capturing a turn in the economy is never an easy task, I once again have to go against the consensus—and this one might be more important than my usual contrarian forays.
From my perch, economic and corporate profit projections are simply too high. And future expectations for the course of intermediate-to-longer-term interest rates (which are generally expected to rise) might also be misplaced.
I had thought that despite a contrarian and negative view of the economy as we move into 2005, a collapse in the price of crude oil (which has occurred) would have been viewed in the very short term as economically stimulative and would hit fixed-income prices and raise yields. So, I shorted the iShares Lehman 20+ Year Treasury Bond Fund (TLT).
I was wrong (despite the renewed and added evidence of inflationary pressures), and I have materially reduced my TLT short as my expectation has been unfulfilled.
This morning I would like to discuss the implications of the current term structure of interest, also known as the yield curve, and why it is signaling slower economic growth.
While the stock market has had a rather mediocre forecasting record, the yield curve is the closest thing to a crystal ball that economic prognosticators have.
One common misperception about monetary policy is that the Fed controls all interest rates. The Fed controls only short-term interest rates, via the federal funds rate; market participants influence all other interest rates.
The shape of the yield curve has served to effectively forecast turning points in both the economy and the capital markets for decades. With the exception of 1966, an inverted yield curve has correctly predicted every economic downturn in the past 45 years.
There are four types of yield curves: normal (example: December 1984), steep (example: April 1992), inverted (example: August 1981), and flat or humped (example: April 1989). Each shape tells us something about prospective economic growth and future stock market performance.
The yield curve (3-month bill up to the 10-year note) has consistently flattened in the last half of this year, and that flattening process is now accelerating.
This is contrary to the expectations of economic bulls and, to this observer, solidifies the argument that economic forecasts (and corporate profits) for next year are pie in the sky.
While I would note that the yield curve is not yet inverted—just flattening—an inversion has presaged a recession and poor stock market outlook in almost every cycle in modern economic history.
When the bond market talks, we should carefully listen.
Today, the general level of interest rates and the flattening of the yield curve are giving unambiguous signs that the economy is slowing.
This weekend I participated in several events at Jack Binion's Gold Strike Casino in Tunica, Mississippi, leading up to the estimated $5 million World Series of Poker, which started Monday.
I did well and managed to pay for my trip, winning a small tournament. But in the end, I decided that my day job should trump playing in the finals (along with about 700 other participants and a first-place prize of about $2 million dollars!), which would have taken most of this week to determine its outcome.
Moreover, after observing Gus Hansen, Phil Ivey, Johnny Chan, Chip Reese, Men “the Master” Nguyen, Sam Farha, and Barry “Robin Hood” Greenstein play on table No. 29 for nearly 40 hours straight (and with average pots in the neighborhood of $300,000), I concluded that I had little chance to survive into the final table this Thursday.
It would be like trying to out-trade Stevie Cohen, Stanley Druckenmiller, George Soros, and Leon Cooperman!
It was an extraordinary weekend on many different levels, but as always, I want to relate my experiences to the stock market.
Poker and trading/investing hold many similarities, and after spending a brief period of time with the greatest poker player of all time, Doyle “Texas Dolly” Brunson, here are some of the parallels between both activities.
Poker, like trading/investing, is a game of people. In both activities, one needs to get inside the head of one's opponent or the collective head of the masses to be able to consistently win. Importantly, in both venues, one has to know what makes your opponent or the market tick. And one has to know the mood of one's opponent or the psychological condition of investors who set share prices.
Neither poker nor the market can be played purely mathematically or statistically. Many computer programmers have tried to game poker and the stock market, but they have failed. A program is unable to understand the perception of the moment, as judgment requires a human mind.
So, after spending 18 hours a day for four days playing poker, here are some of the specific parallels I have observed.
Pay attention, and it will pay you. Concentrate on everything when you are playing/trading. Watch and listen; remember to do both and relate the two.
Understand when to play aggressively. It's the winning way. Don't be a tight or loose player/trader; be a solid one and recognize when it is time to press your bets/positions. To attain superior returns in poker and investing over the long run, grind it out (in stocks until you are up 30% to 40%, and then if you have convictions, go for a 100% year). If you can avoid losing and put together a few 100% years, you can achieve outstanding long-term investment performance.
Tells: Look for them, and you will find them. Poker players and stock markets have tells—giveaway moves that are very revealing. Learn to recognize them. History is your textbook. (For example, improving corporate financials usually presage a rally; conversely, deteriorating financials usually augur poor market performance.)
ESP: It's a jellyroll. In those rare instances when all your card knowledge and market judgment/knowledge leave you in doubt, go with your strong feelings and not against them.
Honor: A gambler/trader's ace in the hole. A good reputation and respect from others will put you in good stead.
Be as competitive as you can be. Go into a poker game and into a trade with the idea of completely destroying your opponent or scoring a major investment coup. If you win a pot or make a successful trade, nearly always play the next pot or make the next trade shortly thereafter—within reason. Although the cards and trades might break even in the long run, rushes do happen, and momentum often feeds upon itself. When you earn the right to be aggressive, you should be aggressive. When you have a tremendous conviction in a poker hand or trade, you have to go for the jugular.
Art and science: It takes both. Both activities are more art than science—that's why they are so difficult to master. Knowing what to do is about 10% of the game. Knowing how to do it is the other 90%.
Money management. The same sound principles of money control apply to the business of tournament/professional poker and to successful investing. The way to build long-term returns or poker winnings is through preservation of capital and home runs.
The important twins of poker/investing—patience and staying power. Come to the poker table or to the markets with enough time to stay and play for a while.
Alertness is key. You must stay alert at all times.
So is discipline.
Never let your mind dwell on personal problems. Never play/trade when you are upset. Make a conscious and constant effort to discover any leaks in your play, and then eliminate them.
Control your emotions. Allowing your confidence to be shaken can turn a simple losing streak into a terrible case of going bad. Keep your emotions in check. When you lose a pot or make a poor investment decision, get up, walk around the chair, or take some deep breaths. Don't lose your poise. If a trade or a poker hand does not work out, walk away from the position/hand. Be confident enough about your ability to win afterwards.
Schedule vacations. It is important to give both your mind and your body a rest.
“You've got to be very careful if you don't know where you are going because you might not get there.”
—Yogi Berra
Arguably, the investment and asset-allocation processes can hold more weight and are more complex than nearly any other business decision. A host of variables, known and unknown, contribute to the investment alchemy. As well, subtle and unconscious influences and personal biases affect the process, as we all seek the market's metaphorical green jacket.
What follows are some basic tenets that form my investment consciousness, which are admittedly simple to write about but more difficult to execute.
I have been concentrating on what an investor should do when he/she is staring into the abyss, and I have deduced that, regardless of market conditions, investors should adhere to the following sound investing practices:
Notwithstanding the attempts by many to marginalize the role of the U.S. economy on worldwide economic growth, most of the world's economies will soon feel our pain.
That bullish cabal will recognize the existence of the downturn only after the fall in equity values (and after digesting the conclusive economic evidence that is forthcoming)—in other words, after it is too late to prepare investors.
The short-term economic outlook is now practically cast in stone, and the sharp downturn in equities will only serve to exacerbate the growing economic weakness and loss of confidence on the part of consumers and businesses.
Expect market assumptions for retail sales, business spending, and, most importantly, corporate profits to be ratcheted down in the weeks ahead.
In order to properly navigate the investment terrain, investors must answer the following five critical questions:
What follows is a summary of my conclusions, and these conclusions will serve as a blueprint for my overall market views and attendant investment strategies.
Most recessions are relatively brief—under a year in duration. The evolving supercycle of credit availability (mainly through securitizations) over the past decade, coupled with its unique profile/character of egregious risk-taking as seen from the eyes of both creditors and borrowers, is unlike any cycle in modern financial history. Problems in the residential real estate category have spread like a wildfire throughout the broader economy, putting a pinch on the banking system and, in a marked reversal, serving to restrict credit to many borrowers.
Corporations of all kinds now face a closed window of credit securitizations, so American industry's ability to grow lies squarely on direct bank lending. Unfortunately, with money market rates at 2.75%, the 10-year Treasury note at 3.55% and the federal funds and discount rates at 4.25% and 4.75%, respectively, banks have little incentive to lend, especially in a questionable economic setting.
The securitization market is broken and will take years to repair. Accordingly (and subject to the magnitude of the negative wealth effect of the eventual stock market hit), the 2008–2009 recession will likely be deeper and lengthier than those of the past. Even more important, the aftermath of the recession will linger, producing a period of inconsistent and uneven growth that will be difficult for corporate managers and investment managers to navigate.
Despite the current appearance of a tardy and timid Fed and a generally unresponsive and unimaginative administration, fiscal and monetary stimulation will be swift in its implementation and will, in the fullness of time, buffer somewhat the magnitude of the falloff in gross domestic product (GDP). More aggressive policy moves could be hastened by the proximity of the presidential election in November 2008.
A profit drop of about 10%, skewed (and deepening) toward the second and third quarters, is about what we should expect in 2008. Mitigating against some of the profit pressure will likely be a reasonably swift decline in commodity prices (especially of an energy kind) and still historically low interest rates. Nevertheless, corporate pricing power will not likely stabilize until well into 2009 (at the earliest), so corporate profits in 2009 will likely be flat to up 5%, well below market expectations.
As we have seen in January, markets see through and quickly reject incessant cheerleading (especially in the media). Most of the fall in the stock market and the rise in the fixed-income market have probably already occurred in an environment that, more than ever, adjusts so rapidly to changing economic conditions.
A possible explanation for this phenomenon is that the dominant investors today (i.e., the world's hedge funds) move more swiftly than the dominant investors of the past (i.e., bank trust departments in the 1970s and mutual funds in the 1980s and 1990s)—and so do individual day traders. Another possible explanation is that the Internet platform and other communication devices provide an almost instantaneous information flow.
As mentioned earlier, the economic choppiness will produce abrupt market moves to the downside and the upside, which will be difficult to navigate but ideal for the opportunistic investor. Perma-bulls, perma-bears, and trend followers will be frustrated, but those who remain market-agnostic and sell the rips and buy the dips could be rewarded.
On the negative side, more worldwide stock market weakness (reinforcing the existing economic vulnerability), tardy and indecisive policy decisions (both monetary and fiscal), another leg down in the housing market, any event that further seizes up the credit markets, and a sharp rise in energy product prices could all prove to have a disruptive effect on the economy and markets.
On the positive side, a decisive move to insure and underwrite counterparty risk by the administration would serve to stabilize the mortgage, bond, and other credit markets and could produce an immediate and immensely positive impact on stocks around the world. As well, a more aggressive easing than is generally anticipated by the Fed could have a salutary impact on equities and business conditions.
The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, our investor protection mission is more compelling than ever.
As our nation's securities exchanges mature into global for-profit competitors, there is even greater need for sound market regulation.
And the common interest of all Americans in a growing economy that produces jobs, improves our standard of living, and protects the value of our savings means that all of the SEC's actions must be taken with an eye toward promoting the capital formation that is necessary to sustain economic growth.
The world of investing is fascinating and complex, and it can be very fruitful. But unlike the banking world, where deposits are guaranteed by the federal government, stocks, bonds and other securities can lose value. There are no guarantees. That's why investing is not a spectator sport. By far the best way for investors to protect the money they put into the securities markets is to do research and ask questions.…
It is the responsibility of the Commission to:
- interpret federal securities laws;
- issue new rules and amend existing rules;
- oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies;
- oversee private regulatory organizations in the securities, accounting, and auditing fields; and
- coordinate U.S. securities regulation with federal, state, and foreign authorities.
The Commission convenes regularly at meetings that are open to the public and the news media unless the discussion pertains to confidential subjects, such as whether to begin an enforcement investigation.…
The Division of Trading and Markets assists the Commission in executing its responsibility for maintaining fair, orderly, and efficient markets. The staff of the Division provide day-to-day oversight of the major securities market participants: the securities exchanges; securities firms; self-regulatory organizations (SROs) including the Financial Industry Regulatory Authority (FInRA), the Municipal Securities Rulemaking Board (MSRB), clearing agencies that help facilitate trade settlement; transfer agents (parties that maintain records of securities owners); securities information processors; and credit rating agencies.…
Common violations that may lead to SEC investigations include:
- misrepresentation or omission of important information about securities;
- manipulating the market prices of securities;
- stealing customers' funds or securities;
- violating broker-dealers' responsibility to treat customers fairly;
- insider trading (violating a trust relationship by trading on material, non-public information about a security); and
- selling unregistered securities.
—SEC mission statement, “The Investor's Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation” (taken from the SEC website)
Most investors (who are long-biased), and indeed the U.S. stock market as a whole, are disadvantaged in a market dominated by momentum-based quant funds and by ultra-bear ETFs, both of which prey on a weakening hedge fund industry riddled by redemptions and by a community of individual investors whose confidence is badly broken.
These quant funds and ultra-bear ETFs, which bypass Federal Reserve Regulation T margin rules governing the extension of credit by securities dealers and brokers in the United States, wreak havoc in a market that needs all the regulatory support it can get.
Today's investors no longer walk tall, as they have seen their portfolios shrivel up. For several years, institutional and individual investors have been competing on an uneven playing field dominated by the powerful quant funds and ultra-bear ETFs that not only have a disproportionate role in total New York Stock Exchange trading but, more importantly, have had an undue influence on pushing stocks lower during the course of the bear market.
Investors are not only facing an unprecedented economic, credit and financial outlook coupled with the uncertainty of public policy but they are also competing against quant funds and ultra-bear exchange-traded funds (ETFs).
As referred to earlier, in the SEC mission statement, our capital markets exist for the benefit of society, and a market dominated by quant funds and ultra-bear ETFs does little to help society.
There has never been a period of time during which the markets had so much money around that could profit from declining prices and invoke economic pain on society. That is what makes the current bear market so much more difficult to navigate than 1930, 1938, 1970 or 1974. Quant funds and ultra-bear ETFs have muddled the ability of the markets to shift assets from weak hands to strong hands.
How do you get people out, if they never run out of firepower (i.e., can short, cover, short, cover all day)?
Under Christopher Cox, the SEC has dropped the ball on a number of key issues over the past several years. The agency's policy (and indifference) almost certainly contributed to our current economic and stock market woes.
It is important that the SEC addresses the dominance and unwieldy influence of quant funds (through the reinstatement of the uptick rule) as well as the circumvention of margin rules by the ultra-bear ETFs in order to “maintain fair, orderly, and efficient markets.” It is also important that the SEC considers regulation of the credit default swap market, a market that the Committee neglected and incorrectly left as materially deregulated in recent years.
Our stock market's playing field is no longer level, and, almost without question, the two players above have contributed to an acceleration of the market's downtrend in 2008 and 2009.
I am hopeful that the SEC will not wait in addressing the role of quant funds and ultra-bear ETFs until it is too late to rescue our stock market. Remember this is the same organization that crippled the markets with Sarbanes-Oxley, though, so I am not going to hold my breath.
One day a hare saw a tortoise walking slowly along and began to laugh and mock him. The hare challenged the tortoise to a race, and the tortoise accepted. They agreed on a route and started off the race. The hare shot ahead and ran briskly for some time. Then seeing that he was far ahead of the tortoise, he thought he'd sit under a tree for some time and relax before continuing the race. He sat under the tree and soon fell asleep. The tortoise, plodding on, overtook him and finished the race. The hare woke up and realized that he had lost the race. The moral, stated at the end of the fable, is, “Slow and steady wins the race.”
—Aesop, “The Tortoise and the Hare” (Wikipedia summation)
In my professional investment career, since graduating the Wharton School in 1972, I have seen multiple bull- and bear-market cycles. And, almost without fail, I have observed that far too many investors worship, trade, and invest at the altar of price momentum, though their investment strategy is framed (publicly and sometimes disingenuously) on fundamental grounds.
While momentum trading has its benefits and can produce superior investment returns, it is not for me.
I am by no means an investment purist, but buying high and selling higher is not in my investment bag. Unlike Jim Cramer, I am no good at it.
Rather, I prefer to stick to the discipline of interpreting fundamentals, valuation, and sentiment through a logically reasoned, objective, and analytical process. This means that I maintain the self-control of sitting on my hands, selling and/or shorting when values are rich and buying (even recklessly sometimes) when values emerge as they did two months ago.
This is, however, easier said (or written) than done. It requires patience and, at times, a variant or contrarian view and strength of analytical conviction. It often also requires one to ignore the business media's staccato repeated sound bites of bullish breathlessness. Their intentions might be honorable, but quite frankly, the media, with few exceptions, have no or little skin in the game. Market participants are often required to ignore the delivery of the media's talking heads, who are too frequently theatrical and shallow in their advice rather than substantive in their analysis.
Today's investment mosaic remains unusually complex, and arguably, it's growing ever more complex, given the proliferation of hedge funds, the instantaneousness of news and the unique economic circumstances (i.e., the great buildup and the consequential unwind of credit)—among other unprecedented conditions.
Regardless of one's style, the preceding factors will contribute to a secular increase in market volatility, and accordingly, that expected heightened market turbulence should lead traders/investors to maintain smaller-than-typical positions and attempt to supplement a buy-and-hold strategy with an opportunistic trading strategy.
For both for individual and institutional investors, erring on the side of conservatism should continue to be the dominant investment mantra.
My Grandma Koufax's words still resonate (as she paraphrased a New York City off-track betting slogan back several decades ago): “Dougie, invest with your kepela (head), not over it.”
Chase value, not price. Be the tortoise and not the hare, given the unusual economic times we face.
Being convicted in a view or in a series of views is important and a key to superior investment performance, but controlling risk at times of strategic misdirection can be equally important. Almost as critical a determinant of portfolio management as making money when your expectations are accurate and your portfolio is properly structured is dealing with how you handle yourself as an investment manager when you are wrong.
While you wouldn't necessarily know it by watching the business media, in which it appears that nearly every talking head missed the 2008 stock equity market collapse and bought the March 2009 generational bottom, over the course of one's investing/trading career, we all get out of sorts. And in a market that for 2008 and 2009 seems to have been a one-way street (down in 2008 and up over the last six months), money management and discipline is critical to surviving the extreme moves in momentum.
Here are six of my strategies to avoid large losses when your tactical view is wrong:
In conclusion, always remember that, by definition, the crowd usually outsmarts the remnants, and staying in the game when you are incorrectly positioned is almost as important as enjoying a period of investment prosperity.
Remember, it's really awful to lose opportunity, but what is even worse is to lose capital.
It can be argued that there are four classical stages in a move from market bottom to market top and then back again.
My position has been that I believe that it is different this time.
From my perch, the prospects for a self-sustaining economic recovery are in doubt in the face of numerous headwinds that are not only consequential in scope but some of which didn't even exist in the last few recoveries out of recessions. Despite the certainty in a smooth and reinforcing recovery that seems to be at the foundation of the bullish cabal, the magnitude of policy (both monetary and fiscal) decisions speaks volumes about how fundamentally different conditions are in October 2009 vis-à-vis past cycles. Moreover, the due bills from those remedies and the timing and response to the withdrawal of the outsized stimulation in 2008–2009 add further to the uncertainty of the slope of future economic growth and poses risks anew.
Whether the stock market is topping out and the economy's 2010 trajectory will disappoint is subject to debate, but what probably can't be debated (and something that truly astonishes me) is the brief period of time in which we have moved from fear to greed.
I have consistently attempted to analyze and strategize about the economy, the capital markets, leading industries, and individual equities.
I try to do this through logic of argument and hard-hitting and independent analysis. Often (maybe sometimes too often), my views are contrarian, as they were when I called for a generational low in March 2009 and again when I pulled in my bullish horns five to six months later, and I will sometimes stay outside of the consensus, even though I recognize that the crowd usually outsmarts the remnants.
One thing I am proud of is that I admit to my mistakes. Frankly, few admit being wrong; after all, it is more natural for all of us to accentuate the positives and our triumphs. No place is this more true than in the business media. If you believe the talking heads' commentary, everyone sold the 2008 high, bought the March 2009 low, and has stayed fully invested since!
I am fully aware that my mistakes over the past few months have been numerous and far-reaching. Above all, I have been steadfastly skeptical regarding the sustainability of the domestic economic recovery and convicted in the view that the foundation for a sustained move in the U.S. stock market was on shakier ground than the consensus believed.
I have been particularly concerned about the still-hobbled American consumer, the tentative recovery in residential real estate and the weight of the phantom housing inventory, the uncertain effect of the withdrawal of government stimulus, the long tail of the last credit cycle and the amount of time it will take the deep scars of the debt overload to heal, a tax-and-spend policy that is aggravating the country's already weak fiscal problems, our reliance on “the kindness of strangers” to fund domestic growth, and the likely onset of numerous nontraditional headwinds (such as rising corporate, individual, and capital gains tax rates as well as the financial disarray at the level of our state and local governments) that are growth- and valuation-deflating. Also, I have often noted the growing schism between the haves (cash-rich, highly profitable large corporations) and the have-nots (small businesses and consumers who face the burden of higher costs emanating from populist tax and regulatory policy), the outgrowth of which has produced an unprecedented disdain against the wealthy that has led to a series of administration-led populist and anticapitalist initiatives. Finally, the necessary austerity measures and consequent need to increase savings and deleverage at so many levels of the private and public sectors in the United States and around the world potentially pose risks to even the conservative forecasters of shallow yet sustainable economic growth.
While there might not be a causality, the consensus seems to have grown emboldened (or at the least very complacent), as share prices around the world have risen over the past 12 months. By contrast, I have opined that the risk/reward of U.S. stocks has turned negative, as it is my view that some of the recent signs of economic growth in many industries represented little more than a statistical expansion from historically depressed levels. To this observer, those signposts of growth are now too readily extrapolated by the bullish cabal. They may be signaling a false sense of prosperity.
All this said, I have been wrong—at least, Mr. Market has been saying so!
I may still prove to be correct in my economic and investment conclusions; as Warren Buffett has written (in paraphrasing Ben Graham), the market is a voting machine over the short run, but it is a weighing machine over the long run. Regardless of the eventual outcome, however, perhaps the single most important ingredient to being a successful money manager or individual investor is to control risk and avoid large losses when one's baseline expectations go awry. An example of when the majority of investors lost their discipline and failed to react in a timely fashion to changing financial and credit conditions that served to sink the equity markets would be 2008. Those who stood pat and didn't sell have only recently, as Jim Cramer writes, “gotten even.”
Ideally, we want to be correct tactically and in composing our portfolios. This means being heavily invested in leading market sectors and in the leading stocks within those sectors during bull phases and being light, or even short, when headwinds arise.
Being wrong tactically and not getting obliterated remain essential ingredients toward delivering superior investment returns over the course of several cycles.
The discipline of recognizing the errors in the timing of one's analysis and, even more important, respecting Mr. Market's price action are integral parts of the investment equation—whether or not the price action is later confirmed or unconfirmed by the fundamentals.
There are many ways to control risk—buying out-of-the-money calls and/or puts is one way—but sucking it up and stopping out losses before they get too unwieldy are the best ways and most straightforward strategies to control risk.
Taking small losses is part of the game; taking large losses can take you out of the game.
“Everyone thinks of changing the world, but no one thinks of changing himself.”
—Leo Tolstoy
The disproportionate influence of high-frequency trading strategies has resulted in an increasingly volatile, trendless, and often random market over the past several months that is difficult for most investors (especially a buy-and-hold kind) to navigate.
Grandma Koufax used to say, “Dougie, take and adapt to what Mr. Market offers you.”
I always listened to Grandma when she was alive, and I remember her investment tenets (and life lessons) since she has passed 15 years ago.
Here are eight ways that I have responded and adapted to the market's changing character:
In summary, in these volatile times, be opportunistic (trade more frequently), stay unlevered, be diversified and err on the side of conservatism.
“It is better to keep your mouth closed and let people think you are a fool than to open it and remove all doubt.”
—Mark Twain
Below are misguided comments made by the Fed Chairman over the past five years on derivatives, the financial crisis, housing and the economy.
Take me out to the ball game
Take me out with the crowd
Buy me some peanuts and Cracker Jack
I don't care if I never get back
Let me root, root, root for the home team
If they don't win it's a shame
For it's one, two, three strikes, you're out
At the old ball game
—Jack Norworth, “Take Me Out to the Ball Game”
I have learned over my career that history is instructive—it rarely repeats itself, but it often rhymes.
That said, we must all recognize that the past is not immutable.
As a cousin to Sandy Koufax, I grew up immersed in the game of baseball. I watched numerous games with my grandfather, Harry Koufax (Grandma Koufax's husband!) at his home in Mount Vernon, New York. I used to watch the peaceful look in Grandpa Koufax's eyes when he sat watching the games in his big cushy chair, cigar in mouth. I have never forgotten that look: He was in baseball heaven. I think I have that same look today when I watch ball games. It's a look of contentment.
It wasn't only the Koufax connection that drew me to baseball; it was the purity of the game. Baseball is an untimed contest. The home run records, perfect games, the tar on the bats, the spit in the mitts all combined to create an almost genteel tradition among today's sports.
And that song. “Take Me Out to the Ball Game” is played during the seventh-inning stretch of every Major League Baseball game, with Harry Caray getting the credit for singing it first at a ball game in 1971. Call me sentimental or old-fashioned, but to this day, every time I am at a baseball game and I hear “Take Me Out to the Ball Game,” I well up in tears.
When I think of baseball, the first thing that comes to my mind is a sense of historical perspective—a respect for Roger Maris's record 61 home runs in one season (1961), Hank Aaron's 755 career home runs, Pete Rose's 4,256 hits, Joe DiMaggio's 56 consecutive games with a hit, and Nolan Ryan's six no-hitters and 5,714 strikeouts.
Back in 2007, I got teary-eyed at the tribute to Willie Mays, the “Say Hey Kid,” at that year's All-Star Game. Perhaps it was that respect for baseball's traditions. Or perhaps it was a sense of a historical perspective, like when Sandy Koufax refused to pitch Game 1 of the 1965 World Series because the game fell on Yom Kippur, the Jewish Day of Atonement.
Where have you gone, Joe DiMaggio?
A nation turns its lonely eyes to you.
—Simon and Garfunkel, “Mrs. Robinson”
It is the same perspective and respect and sense of history that seems to be missing in the analysis of today's stock market by many of its participants—most of whom, in the mounting competitive landscape of hedge funds, invest/trade at the altar of momentum.
Yer blind, ump,
Yer blind, ump,
You must be out of yer mind, ump.
—Damn Yankees, “Six Months Out of Every Year”
To some degree, fear and doubt have been driven from Wall Street today. There is no negativity bubble, but rather a bubble in complacency and in economic and stock market extrapolation.
One would have thought that lessons would have been learned by the unthinking speculation of day traders in the U.S. equity market in the late 1990s, which resulted in a 70%-plus schmeissing of the Nasdaq or in the horrendous stock market during the 2007–2009 period. But nothing has been learned. The same mistakes are being made over and over. Other errata—such as marking to market (collateralized debt obligations), trusting credit agencies (remember Enron, Tyco, etc.?), the use of margin debt, or even the buying of the crap that Wall Street packaged (again, collateralized debt obligations)—will be buried and lost to history, and I guarantee that these mistakes will be repeated in the future.
The availability and price of credit in 2005–2007 facilitated the housing bubble, which in turn followed the technology and Internet bubble of 13 years ago. It was a bubble that fed the private-equity boom and that, for a period of time, created a put under the market that served to reduce fear and produced the aforementioned bubble in optimism (and the concomitant use of leverage, such as the carry trade, by hedge funds and the aggressive use of debt worldwide).
I began writing and warning about the tip of the iceberg of credit on this site—namely, subprime lending—back in 2006, when the ABX BBB was trading at par; it ultimately fell close to zero. Back then, as the deterioration in subprime began to spread, talking heads in the media grew bored of the subject and swept it under the lending rug, dismissing its possible impact on our markets and the domestic economy.
For a while, credit spreads were contained and locked in a narrow range—surprising, considering how levered segments of our economy were, particularly at the consumer level—but the spreads eventually bottomed and, in the fullness of time, widened to levels never thought possible. In turn, the housing market experienced its roughest patch in history, and the residential market's credit contagion grew and was not contained to subprime; it infected all the debt markets. In time, the drop in housing activity accelerated, and there was a pernicious impact on operating results on the entire spectrum of America's companies (especially of a banking kind).
And the Great Recession of 2008–2009 came to pass.
In time, the loose lending of 2000–2006 moved well beyond the subprime mess and into motorcycle, automobile, and credit card securitizations by 2007. And it spread further to every town in the United States (and many abroad) populated by merchants that had encouraged the consumption binge (buy now and pay later).
The crack in the foundation of credit began to gain speed as the lending community grew more circumspect, and, in time, credit grew ever sparser.
The credit crisis was born, and the Great Recession moved speedily toward its height.
For a while in 2007–2008, with the pressure on, the quality of corporate profits and elevated profit margins were dismissed as companies influenced by activist shareholders would mask the evolving headwinds with share buybacks, which, in the fullness of time, served to leverage the one relatively remaining healthy sector: American business's balance sheet. (Look back at the prices that General Electric and Hewlett-Packard paid for their shares in buyback programs back then. It will make you sick! GE and Hewlett-Packard shareholders suffered the hangover effect of the poorly timed buybacks!)
As legendary hedge fund manager Michael Steinhardt said in a 2007 interview with HedgeFolios, “As expected, once companies are faced with having to discuss their quarterly performance, we get a new round of share repurchase announcements.” He pointed to Sears Holdings, which lost more than 7% after it came out with a warning that “almost halves the analyst estimate for earnings and magically a $1 billion increase in its buyback is announced.…Clearly, not every buyback is being used to cover for operational deficiencies, but when a company is struggling to sell products at good margins, that should be more important than a decline in share counts.”
Another legend—this one of a baseball kind—pitcher Satchel Paige once said, “Age is a case of mind over matter. If you don't mind, it don't matter.” For a while, the metamorphosis of the credit cycle was ignored: Investors didn't mind; market participants, however, ultimately got a lesson in history.
Joltin' Joe has left and gone away?
Hey hey hey, hey hey hey.
—Simon and Garfunkel, “Mrs. Robinson”
My advice? Similar to Major League Baseball records, be mindful and respectful of the history of credit and stock market cycles.
This certainly does not mean that anything close to an economic Armageddon or stock market crash lies ahead (similar to what occurred in 2008–2009); it does mean that the economic ride will be increasingly lumpy and that the stock market ride will become increasingly bumpy.
The era of free and easy money is coming to a close at the same time as our recovery is growing increasingly fragile, but it's different this time, with secular challenges that present unique headwinds to a self-sustaining domestic economic recovery.
Consider that today's challenges (fiscal imbalances, structural unemployment, etc.) are more problematic than those that were encountered in the last cycle. Today's challenges suggest a lengthier period of rehabilitation. The solutions to these problems cannot quickly be dispatched, as they are our inheritance from the last cycle and, maybe even, a decade or two of risk and debt accumulation before that.
So, remember for the future, if you don't pay attention to Mr. Market's history, it could be, “one, two, three strikes, you're out, at the old ball game!”
Over the course of the past week and through this upcoming weekend, college and university graduations abound around the country.
Six of my friends either gave commencement speeches last week or are going to give speeches in the next few days.
Several of them asked if I would publish the commencement speech I gave at Alfred University when I received an honorary PhD.
Here it goes. I hope you enjoy reading it. And a warm congratulations to all the 2012 graduates.
Students, parents, grandparents, siblings, teachers, President Edmondson, members of the Administration and of the Board of Trustees, I am honored to be here today.
I want to offer my sincere congratulations to this year's graduates on such an important day in your lives. I especially want to congratulate the parents. And remember that they still need you, and maybe they will now listen to you. If you aren't sure who I am talking to, I am actually talking to both the parents and the students, so congratulations to everybody!
Today, I am going to briefly touch on my journey and then make some observations about what went wrong in our financial system and where we might be going economically in the years ahead.
We live in much different times than when I graduated four decades ago. After all, there was no texting or even cell phones back then. Instead, there was one public telephone on each floor of our dormitories. We ate blackberries; you text, phone, and e-mail with them. We got our news from newspapers; your generation gets the news from blogs and tweets. We wore watches. We took pictures with cameras. We navigated with maps. We listened to transistor radios. Again, you do it all with a cell phone.
We had VCRs that cost $750 each; you use YouTube at no cost, and you can upload 50 hours of YouTube videos in less than a minute. Laptops were nonexistent when I attended Alfred, and the term laptop had an entirely different connotation back then! We bought most of our books at the Alfred Bookstore, not on Amazon. We played pong in the Student Center; you play Wii in your dorm rooms. NASA used mainframe computers to go to the moon; you use an iPod, which is about 500× more powerful, to listen to Lady Gaga on the way to your next class.
We used the word friend as a noun; you use the word friend as a verb. Today, Facebook provides your forum for socializing; in 1970, our social life was centered on campus fraternities and at the only bar nearby, which we called “Down the Road” in Hornell, New York, which, of course, was literally down the road from school! Back then, our idea of search was not Google; it was, again, searching for members of the opposite sex at that bar, Down the Road, 40 years ago.
The fact is that the world we live in today is quite different than the world of 40 years ago.
You will soon search for work in an economy that is emerging from the worst recession since the Great Depression. You live in a world in which change occurs more frequently than at any time in history. You will raise your children with threats of terrorism and climate change—issues we were oblivious to four decades ago.
You will live in a world that is growing more connected. You will work with more people that don't look like you or don't come from where you came from. You will work in an economy that has shifted from manufacturing to information services.
These challenges, these changes might make you worry about the future.
But don't worry.
It is important to recognize that throughout all the challenges of the past two and a half centuries, America has a tradition of thriving through thick and thin. We have always moved toward “a more perfect union” and back toward stability and ultimately growth.
Sometimes, like now, we need the help of our government.
For example, when the markets crashed during the Depression, our government put in new rules and safeguards to ensure that it wouldn't happen again, just like we are doing today.
Two hundred years before I entered Alfred, President Lincoln said that the role for government is to do for people what they can't do better for themselves. His administration set up the first intercontinental railroad system and the first land grant colleges.
Franklin Roosevelt's administration instituted aggressive and unprecedented New Deal programs that left a lasting mark on the American landscape.
President Theodore Roosevelt said that the object of government is the welfare of the people; he broke up monopolies and established a national park system.
In the 1960s the Kennedy administration was responsible for founding the Peace Corps, signing the Nuclear Test Ban Treaty, and helping to end racial discrimination.
When I was at Alfred, the Johnson administration designed the “Great Society,” created the “War on Poverty,” and was instrumental in launching key legislation that protected our environment.
And in reaction to the unique economic times, today's administration is participating in equally profound change.
So while the challenges appear monumental, you will help and in the years ahead be a part of a community that overcomes those headwinds; you will adapt and contribute to these changing times.
The government won't guarantee your future, but the government will give you a good chance to succeed. But in order for our system to work, you must become part of the debate and contribute to the implementation of balanced and effective public policy.
When I was at Alfred, Dr. Timothy Leary developed the counterculture phrase: “Turn on, tune in, and drop out.”
Don't follow his words. Don't be an island. Rather, become part of the process; help choose your leaders and criticize them if they let you down.
Joining in this debate is the responsibility of every graduate today.
I have stressed the dissimilarities of 2010 and 1970, but of course not everything is different today than in the early 1970s. For example, I have been reminded over the last two days that the setting at Alfred remains beautiful. Unfortunately, another similarity is that we are still at war today as we were in Vietnam back then.
Importantly, the University still provides a marvelous liberal arts education, and that education provides a potential springboard to a very successful professional career as it did back then.
I have many recollections of Alfred University as an undergraduate—perhaps the most vivid of which was living in my car for a semester to save money. (Fortunately, my best pal, Sheldon, let me shower in his off-campus apartment a couple of times a week!)
The times were different than today, but, like all of you, my personality and character have been molded by many of my experiences at Alfred.
I would separate those experiences into two categories. First, I recall the close and nurturing relationships I had with some of the faculty at Alfred, with professors like Dr. Gary Horowitz and Dr. Myron Sibley, and the strong bond I had with the then-President of Alfred, Dr. Leland Miles. These relationships led me to the conclusion, popularized in the movie Animal House, that at Alfred, as at Faber College, “knowledge is good.”
Seriously, though, I would strongly recommend that if in the future you are in a position to mentor someone, as the aforementioned Alfred teachers did for me, you will be, again, doing good.
The second category of experiences was a bit more personal and revolved around a remarkably bucolic setting, staged during a remarkable period of time 40 years ago in which I evolved and planned for the future.
- I remember a lot of emotion—the 1960s was a period of feelings.
- I remember my first love—I remember being shot down by my first love.
- I remember the experimentation.
- I remember the music, which seemed at the core of our being. I particularly remember attending the Woodstock Music Festival, and, as Sam Moore of the singing group Sam and Dave shouted out in his song, “Soul Man,” you could say that I was also educated at Woodstock while a junior at Alfred.
- I remember traveling around the country to watch the Grateful Dead perform in 71 separate concerts.
- And I remember the killings at Kent State in Ohio, which made so many of us adopt a philosophy of nonviolence.
I strongly recommend that in the future you, too, hold on to your memories.
I graduated Alfred University in 1970, a bit earlier than most of my classmates, as I was anxious to move forward. My next destination, in keeping with the experience of the times and the turbulence of the 1960s, was a southerly one, to New Jersey, in the graduate program in philosophy at Princeton University.
After majoring in philosophy and religion at Alfred, as a good liberal and as an avid participant in the decade's “make love not war” peace movement, my first job was working with Ralph Nader in the early 1970s. At that time, the consumer movement was in full force, and being a “Nader Raider,” as we were called, was viewed almost as prestigiously as being a partner at Goldman Sachs on Wall Street before the credit crisis hit in early 2008 and certainly before the news of recent weeks. With Nader, I wrote a book entitled Citibank, which presciently argued all the way back in the early 1970s that the banking industry had too much power.
The economy was in a recession in the early 1970s (as it was in 2008–2009), and as much as I enjoyed studying the writings of Søren Kierkegaard, Martin Buber, and Frederick Nietzsche at Princeton, I ultimately succumbed to economic reality: There simply was not a large need for philosophy PhDs at that time! So I continued my trip further south, with my next stop in Philadelphia and business school at the Wharton School at the University of Pennsylvania, where I got my MBA. Three days after graduating, I began my investment career in Lower Manhattan.
By taking that fork in the road to Wall Street, I suppose one may be reminded of something Mae West once said, perhaps relating to my journey, as I made the move from Nader to the business world, “I used to be Snow White, but I drifted.”
So what went wrong with our economic and financial system in the past several years?
Wall Street was at the epicenter of all that went wrong in our economy over the past three years. A small cabal of bankers who created unwieldy, unregulated and unnecessary derivative products, or financial weapons of mass destruction, ended up producing an economic, financial, and credit disequilibrium that affected nearly everyone in the audience today. This was done under the not-so-watchful eyes of regulatory agencies and of our government.
Recklessness abounded. How else to explain investment banks that were leveraged to the tune of 35–1, which seems to be the equivalent of playing Russian roulette with five of the six chambers of the gun loaded. If one added up the off-balance-sheet liabilities to this leverage, you might as well have filled the sixth chamber with a bullet and pulled the trigger.
America rushed headlong into the twenty-first century without a proper understanding of what economic policies and financial tools were going to be required to prosper in a changing world. For more than two decades, the U.S. economy favored financial speculation over production.
The financial crisis impacted nearly everyone in our country, and, with those derivative products imported by the investment banks, AIG and several large money center banks to other financial institutions around the world, a massive credit crisis ensued, which nearly resulted in an unfathomable collapse in the world's banking system and securities markets.
Certainly, everyone in this audience has, to some degree, been impacted. Household net worths were decimated by the unprecedented stock and home price drops, and, to varying degrees, your parents' ability to help you pay for an Alfred education was hurt. The University itself lost money in its endowment and was forced to provide ever more financial assistance to its students. Teachers' head counts were reduced as were other important services curtailed.
We all won't forget the last few years, but I remain hopeful—and you should be, too—that the safeguards now being put in place will protect us in the future. But, again, to be totally effective, you must contribute to the debate that dictates policy.
In discussing this commencement speech with Dr. Edmondson several months ago, Charlie suggested that I offer my view as to where the economy and stock markets are headed. And that is how I would like to end this speech.
But first, I am reminded of a story of a professor at the University of Edinburgh Medical School who asks his class the question: “What part of the human body expands six times its normal size under stimulation?”
The professor points to a woman in the first row and asks, “Ms. Kennedy, can you answer the question?”
Turning beet red, Ms. Kennedy stands up and tells the professor that she can't possibly answer the question.
The professor then turns to a gentleman in the fifth row, Mr. O'Donnell, and asks him the same question. Mr. O'Donnell stands up erect and says, “The pupil of the human eye expands six times its normal size under the stimulation of light.”
The professor congratulates Mr. O'Donnell on the correct answer and readdresses Ms. Kennedy by saying, “I have three responses to you Ms. Kennedy:
- Firstly, you haven't done your homework.
- Secondly, you have a dirty mind.
- Thirdly, you are destined to live a life of unfulfilled expectations!”
In a like manner, if you all think I am about to give you an accurate outlook for the economy and stock markets, you, too, will be living a life of unfulfilled expectations.
But, at least I work cheap, Charlie!
Here is what I see for the U.S. economy.
While it is my view that the U.S. economy faces a healthy near-term outlook, the secular problems put the recovery on a bit shakier ground than usual as a number of nontraditional headwinds and bills from the aggressive government fiscal stimulation are shortly coming due.
I remain particularly concerned about the still-hobbled American consumer, who is burdened by wage deflation and weak income growth, structurally high unemployment, lower housing wealth, elevated debt loads, and still-tight credit. The recovery in residential real estate seems tentative and will weigh on growth as will the uncertain effect of the withdrawal of government stimulus and the long tail of the last credit cycle and the amount of time it will take the deep scars of the debt overload to heal. Other concerns include our reliance on “the kindness of strangers” to fund domestic growth and the likely onset of numerous nontraditional headwinds (such as rising corporate, individual and capital gains tax rates as well as the financial disarray at the level of our state and local governments). Also, the growing schism between the “haves” (cash-rich, highly profitable large corporations) and the “have-nots” (small businesses and consumers who face the burden of higher costs emanating from populist tax and regulatory policy) must be carefully watched as it has produced an unprecedented disdain against the wealthy.
In the current cycle, credit, too, will be a lot less plentiful. Prospectively, China, another uncommon driver to world economic growth, holds some risks in the form of an overheated economy and in a credit and asset boom that includes hidden debt, unproductive real estate, and infrastructure projects.
Finally, the necessary austerity measures and consequent need to increase savings and deleverage at so many levels of the private and public sectors in the United States and around the world (like in Greece) potentially pose additional risks.
Former New York Yankees baseball player, Hall of Famer, and wordsmith, Yogi Berra, might say about the future that it's different this time, but it almost always is!
Let me conclude by mentioning something that Apple's Steve Jobs talked about in his Stanford University commencement speech five years ago, in which he highlighted a very idealistic magazine that many of us read at Alfred back in the late 1960s called The Whole Earth Catalog. In essence it was our Google in magazine form, but it was patched together not by sophisticated desktop publishing systems but by pictures taken from Polaroid cameras and words that poured out of typewriters.
By the time I graduated, The Whole Earth Catalog closed, and on the back cover of the final issue was a photograph of an early-morning country road—the kind you might find here in upstate New York.
Beneath it was a farewell message from the managing editor.
The words were: “Stay hungry. Stay foolish.”
I have always wished that for myself. And now, as you graduate to begin anew, I wish that for you.
Stay hungry. Stay foolish.
Good luck and thank you all for letting me be a part of your commencement.
Managing investment money (as distinguished from trading money) is not taking a black or white position; it is working off a complicated mosaic of fundamentals, sentiment/technicals, and valuation.
While it currently seems as though a risk-on/risk-off market requires one to be spot-on in our decision-making process over every day/week/month time frame, it is not the case. No one is that clairvoyant to accurately predict every wiggle. We can occasionally forecast and position a small portion of a portfolio for a short-term move in an attempt to produce a cash-register effect of locking in gains, but, in the main, we should recognize that the odds of succeeding may be remote.
We should aim for more balance and consistency in our portfolios. This means if, in a normal market environment a 60%/40% stock/bond fix is in line with your investment objectives and risk appetite, then a more uncertain investment backdrop (such as we face today) should have a stock/bond guideline of some lesser amount with a cushion of cash—perhaps 45% stocks, 30% bonds, and 25% cash.
Years ago, John Bogle brilliantly said, “We must base our asset allocation not on the probabilities of choosing the right allocation but on the consequences of choosing the wrong allocation.” In other words, extreme positions of putting on or putting off risk (in cash or stock) are generally unsound and can produce negative consequences. More balance, even in times of uncertainty, represents a more sound investment strategy.
Getting it right is not being all in or all out.
Thoughtful and hard-hitting analysis that generates exceptional information and knowledge of the historic interaction between companies, industries, and asset classes under similar circumstances are some of the basic ingredients for long-term and consistent investment success.
But, as Barton Biggs recently suggested, getting to know yourself will improve your investment behavior and returns:
The investment process is only half the battle. The other weighty component [is] struggling with yourself and immunizing yourself from the psychological effects of the swings of markets, career risk, the pressure of benchmarks, competition and the loneliness of the long distance runner.…
Understanding the effect of emotion on your actions has never been more important than it is now. In the midst of this great financial and economic crisis that grips the world, central banks are printing money in one form or another. This makes our investment world even more prone to bubbles and panics than it has been in the past. Either plague can kill you.
We have been in an environment of crisis since 2008.
It is an emotional setting filled with potential investment opportunity but also terror and potential investment losses.
An unemotional view and a balanced portfolio construction are apt to provide the road to investment success in the period ahead.
A month ago, I was speaking to the legendary Ira Harris (one of the most influential Wall Streeters extant back in the day when he ran Salomon Brothers' Chicago office), who mentioned that he could not remember a time during his investment career when there was so much uncertainty as there is now.
In other words, there exists, as Sir John Mauldin points out in his commentary this week, more than the usual lurking “lions in the grass” (and in the open fields) these days.
In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.
—From “That Which Is Seen and That Which Is Unseen,” an 1850 essay by Frédéric Bastiat (hat tip John Mauldin)
As John wrote over the weekend, most lions are readily seen—they are known, in front of us, and are usually anticipated. The lions in the grass and their distant cousins, the more random black swans, which have been spotted with a frightening frequency over the past decade, however, are not readily foreseen—those are the scariest and the most market upsetting. They spring upon us suddenly, unexpectedly (and some of them even inhabit my annual surprises lists), sometimes taking off an arm or a leg or causing our investment portfolio to plummet in value.
While those lions in the grass are grazing somewhere—one possible grass inhabitant might be the adverse implications of the current U.S. drought—let's review the visible lions that limit the upside and the downside to the U.S. stock market.
“More than at any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly. I speak, by the way, not with any sense of futility, but with a panicky conviction of the absolute meaninglessness of existence that could easily be misinterpreted as pessimism. It is not. It is merely a healthy concern for the predicament of modern man.”
—Woody Allen
“Disaster has a way of not happening.”
—Byron Wien, vice chairman Blackstone Advisory Partners
Many of my most successful hedge fund friends have made their fortunes in buying and holding—namely, by discovering investment acorns that rise into mighty oaks. They contend that, regardless of the environment, there will always be those opportunities.
Many of these hedge-hoggers have prospered by bottoms-up stock picking and have often downplayed the macroeconomic backdrop.
They might be correct—and for many it has paid mighty dividends—but I contend, by contrast, that the unique conditions that exist today make the harvesting of those great investments ever more difficult. Indeed, there are numerous fundamental, valuation, sentiment and technical factors that support the notion that both the upside and downside might be limited.
In his seminal book, Margin of Safety, hedge fund manager Seth Klarman tells an old story about the market craze in sardine trading. One day, the sardines disappear from their traditional habitat off the Monterey, California, shores, so the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, “You don't understand. These are not eating sardines; they are trading sardines!”
The 11 factors discussed above that on one side limit the market's upside and on the other limit the market's downside seem to almost offset each other—ergo, we might be locked in a trading range. These conditions are likely set to deliver what I have termed in the past a trading-sardine market, not an eating-sardine market.
In summary, the U.S. stock market is populated by an unusual amount of visible (fierce and not-so-fierce) lions in the open and likely several lions lurking in the grass.
For now, the pride of lions is holding the markets at bay, and reward vs. risk appears in balance.
As a result, there appears to be no real trend nor is there likely to be one over the short term and into the fall. Instead, as I recently mentioned, a range-bound market confined between 1,300 and 1,420 on the S&P 500 seems to be a reasonable expectation for the balance of the year. (Friday's close of 1,360 is a relatively balanced reward relative to risk.)
My strategy has been to be 20% to 30% (long or short) on either side of market-neutral, depending on my assessment of the near-term outlook.
In the trading-sardine market I envision, I plan to continue to trade the range and rent with a nimble, albeit conservative, short-term view over the next few months, rotating into sectors, as we recently did in the Market Vectors Oil Services ETF, and into individual securities as the opportunities develop.
More serious money is typically made by investing rather than via short-term trading. But, for now, as I look at the investment portion of my portfolio, I plan to be patient while waiting for the right pitch.
Even though there are, no doubt, conspicuous lions and less visible lions in the grass, as we move closer to the election, there will likely be more clarity and a meaningful trend will hopefully fall in place later in the year.
That trend might even produce an eating-sardine market and a good backdrop for investing.
Hopefully, at that point in time, we will have the courage to be the king of the investment jungle.
It's easy to grin
When your ship comes in
And you've got the stock market beat.
But the man worthwhile
Is the man who can smile
When his shorts are too tight in the seat.
—Judge Elihu Smails (Ted Knight), Caddyshack
Here is my checklist when things go differently than I expect in the markets.
Today, I see many traders and investors afflicted with what I call the stock market trading jones. Market participants feel compelled to overtrade. It comes in the form of a near-obsession in overtrading both on news-based dislocations (to the upside and downside) and on nondislocations in the normal course of business, typically through chart gazing. The need to play too many earnings reports and the desire to trade macroeconomic events reside among numerous other catalysts.
There are several obvious influences that contribute to the addiction of too-frequent trading:
All of the above factors contribute to the impatience and heavy trading manifested in the stock market trading jones.
I have believed that by developing a variant view through hard-hitting and investigative research (e.g., contacting company managements, their competition, suppliers or through other means), you will have a much better chance of succeeding with an occasional trade. But, even that fundamental approach (which is time-consuming and doesn't fit in with some who believe that trading gains can be as easy as gazing at a chart) represents a difficult journey toward trading success, especially when it, too, is done with too much frequency.
Regardless of the rationale for action, however, a large portion of traders simply seem to have a trading jones—a need to play, a need for action.
In my investment experience, I have seen many more professional traders armed with every trading system that money can buy (who have been inflicted by the jones of constant trading) blow up rather than succeed over time. Then, why should you, as an individual investor, be more successful?
The answer is that, in all likelihood, you will not be.
So let me be direct and straightforward on this subject—nonstop, excessive trading is a mug's game.
Any market mathematician will tell you that the more trades you make the less successful you will be.
I have written for years that waiting for the right pitch in trading and investing is the way to succeed over the long run in this game.
I believe this now as strongly as ever.
A superior investment will likely trump the jones of too-frequent stock market trading.
Let me demonstrate this observation by looking at the chart of Oaktree Capital Group, a stock I have consistently praised since it went public in spring 2012.
Oaktree is a nonvolatile, low-beta stock. It's an intelligently and conservatively managed company that does not present the thrills and agonies of volatility that are possessed by many favorites of traders such as Apple, Google, or Amazon. Over the past six or seven months, however, the shares have steadily advanced and have provided a great risk-adjusted return.
In theory, a buy-and-hold of Oaktree (just to use one example) will likely have trumped the numerous trades of someone possessed of the stock market trading jones.
Or go to the Securities and Exchange Commission filings of some of the great modern-day investors such as Lee Cooperman's Omega Advisors. What you will find is a remarkably stable and consistent list of the hedge fund's top stock holdings—it's the real pro's proven and time-tested antidote to delivering superior risk-adjusted returns.
The business media is well intentioned and inhabited by a lot of my friends. I am respectful of their contributions, but they too often encourage the stock market jones.
By and large, the media have an agenda that is different from yours. It doesn't make them bad guys—their objectives of a growing audience and higher ratings are inherently dissimilar to your objective of making money.
Moreover, as I have recently chronicled, the media's reaction to events of the day (e.g., the sovereign debt crisis, the presidential election, the fiscal cliff, etc.) is often hyperbolic and simply wrong-footed (from an investment standpoint).
Always remember that they are in the press box and you are on the playing field.
Not surprisingly and understandably (it's in their basic interest), the media too often advance the idea of constant trading and even, at times, (by inference) the dream of instant investor gratification. For every long-term investor queried, it seems as if there are at least 10 traders (maybe more) questioned in the business media.
Maybe it wouldn't sell as well, but I wish there were more forums and time spent on long-term investing in the media.
Unfortunately, many investors watching and listening can't help from being influenced by the media's barrage and sometimes short-term emphasis of time frame. By contrast, long-term price targets (defined in years) are deemphasized, as these are not subject matter seen as capturing ratings and audiences, and typically take a backseat in discussions.
We are often inundated with ways to make fast money. By inference, the pundits and talking heads tell us that this is best accomplished by trading almost every market or individual stock wiggle, often based on technical levels and/or in the knowledge of how to react to certain triggers or events.
In the ultimate level of the absurd, the media conduct contests to guess where the S&P 500 and Dow Jones Industrial Average will close at month's end, what will be the exact jobs number and so on, as if these guesses will provide some sort of magic market elixir to delivering outsized trading gains. The thrust of many of the conversations on CNBC and Bloomberg are too often based on mindless guessing of short-term forecasts, of which few really have any edge whatsoever.
How often does a business show start with the moderator's saying something like this: “The S&P is up by half a percent today, so where is it going to end the day?”
Or the dialogue goes something like this:
You get my point by now—continually going one on one against the trading world by guessing on near-term market and individual stock moves is a difficult (if not impossible) pathway to investment success.
Importantly, I want to emphasize that there is a place for trading, as I believe intelligent trading can be a profitable adjunct to investing.
I am very much an advocate of opportunistic trading, especially when one concludes that the market is range-bound without a clear bias in either direction or, for example, when one can get in front of an earnings report with an informed and variant view or by responding quickly to an earnings quality in an earnings report (among other means).
Done effectively, trading can result in a cash-register effect, contributing to the aggregate returns in your investment account.
But only in moderation and only when the right pitch (read: enhanced reward vs. risk) is offered up.
My definition of a good trading setup is far narrower and more selective than most.
“Millions of people die every year of something they could cure themselves: lack of wisdom and lack of ability to control their impulses.”
—Irving Kahn, chairman, Kahn Brothers Group
My advice is to stop multiple and numerous trades that one justifies by reacting to the media, based on technical analysis or based on any number of other reasons—unless you are very lucky, it will not pay off in the long run.
More likely, you will trade (and churn) your way into investment oblivion.
“If you know the position a person takes on taxes, you can tell their whole philosophy. The tax code embodies all the essence of life: greed, politics, power, goodness, charity.”
—Former IRS commissioner Sheldon Cohen
It is my contention that dealing with our debt and deficits (i.e., the fiscal cliff) is probably easier to resolve than most believe. As a matter of necessity, it must be accomplished by:
As a starting point, there is the U.S. tax code.
There is so much waste and accumulated abuse of our tax code that savings are abundant if our politicians only looked under those rocks.
As Ralph Nader has written, the U.S. tax code (all 7,500 pages of it) “is the victim of severe tampering and perforating by corporate lobbyists and tax attorneys and unattended to by inadequate IRS enforcement.”
One particular abuse that should have bipartisan approval and that seems impossible to defend lies inside an innocent-looking, green-trimmed, white, five-story building in the Cayman Islands: the Ugland House office on South Church Street.
The unassuming but appropriately named Ugland House is currently the home of over 18,500 corporate entities that reside there for the express purpose of avoiding (though some might say evading) U.S. taxes. It houses hedge funds and other partnerships as well as some of the largest U.S. corporations extant—all of which benefit appreciably from the avoidance of current federal income taxes by assuming a Grand Caymans address of incorporation.
Considering that the Cayman Islands have a tax rate of 0.0% and the fact that some of the largest U.S. corporations received billions of dollars from the bailout, one would assume the government would recoup some of this corporate welfare in the form of taxes. Instead, some of these corporations have not paid any federal income taxes for years.
In late 2011, Citizens for Tax Justice analyzed the tax payments of 280 of the Fortune 500's largest companies. Seventy-eight of the 280 companies paid zero or less in federal income taxes during at least one year from 2008 to 2010. Thirty corporations paid less than nothing in aggregate federal income taxes over the entire 2008–2010 period.
How are America's largest corporations avoiding so many taxes? A practice called transfer pricing. This accounting practice lets companies buy and sell products and services with their own offshore subsidiaries and set prices themselves, according to David Evans in the Bloomberg article “The $150 Billion Shell Game” from 2004.
This practice is just as relevant nine years later. Corporations abuse the accounting practice by shifting profits overseas to avoid U.S. taxes. Their prices are set artificially high for imports and low on exports. In the United States, the corporations are allowed to claim the high expenses on the imports and the smaller profits on the exports in their IRS filings.
Profits earned through a foreign subsidiary of a U.S. corporation are not taxed until the cash is repatriated in a dividend back to the U.S. parent company. As a result, while the statutory federal corporate income tax rate stands at 35%, it is estimated that the effective tax rate of the largest publicly traded companies in the United States is closer to 20%.
Regardless of one's party affiliation, the very existence of the Ugland House appears indefensible.
Back to Nader: “Any significant push toward fundamental tax reform has to start by chipping away at the corporatized, commercial Congress which uses tax breaks, deferrals, credits and exemptions as inventory to sell for campaign cash in increasingly costly campaigns.”
If the basic purpose of taxation is to raise revenue needed for public services. Why should hardworking citizens underwrite corporations who skate the tax code? How does filling the coffers of profitable companies who avoid taxes through a labyrinth of skillful tax avoidance—including Bank of America, General Electric, Oracle, Cisco Systems, Microsoft, Apple, Verizon, and so many other companies—and their ridiculously high-paid executives benefit the lives of everyday citizens?
At most large multinational U.S. corporations the tax department is a well-oiled and systematic profit center. In 2010, GE earned $7 billion in the United States but paid no federal taxes to the U.S. government. Verizon and Bank of America didn't pay federal taxes either. Yet all three companies were provided with the resources, public services, and infrastructure to conduct their business.
By most estimates, over $1 trillion of profit earned by U.S. companies sits in offshore cash and short-term investments in offshore holding companies and has never been taxed by the United States. Two conspicuous examples include Microsoft and Apple, which hold $50 billion and $100 billion in cash, respectively, in offshore accounts.
The ever-growing pile of offshore cash has introduced new potential risks to the balance sheets of these corporations at home. Companies are avoiding paying the taxes on the repatriation of their overseas profits but still have to fulfill the obligations to shareholders in the form of dividends, share repurchases, debt repayments, and pension contributions. Given the easy borrowing terms of low interest rates here in the United States, companies are taking on more debt instead of paying Uncle Sam in taxes.
While corporations continue to hoard cash offshore, they are simultaneously improving margins by shipping American jobs and factories abroad. Corporate profits improve but tax revenue is hardly impacted by the process. This has contributed to the loss of more than 5 million U.S. manufacturing jobs and the closure of more than 56,000 factories since 2000, according to Senator Bernie Sanders (I-Vt.).
Sen. Sanders has introduced new legislation with Rep. Jan Schakowsky (D-Ill.) with the Corporate Tax Dodging Prevention Act (S.250) in an effort to stop American banks and corporations from sheltering profits in places such as Ugland House and other tax havens to avoid paying U.S. taxes. The act will also cease rewarding companies that ship jobs overseas with tax breaks. The Joint Committee on Taxation has estimated in the past that the provisions in the bill will raise more than $590 billion in revenue over the next decade.
The legislation will certainly raise some arguments on Capitol Hill. The situation remains that the United States is the only major country that has substantial taxes on the repatriation of profits earned overseas. The GOP argues that the United States needs to move toward a territorial system for international taxation. Under this system, foreign-source income would be taxed only in the country where it was earned and not be taxed at all in the United States. This approach would reduce the tax burden on U.S. companies and eliminate the disincentive for corporations to repatriate their foreign profits, according to the Brookings Institute 2012 article, “A Sensible Plan to Bring U.S. Corporate Profits Home.”
The major point of contention with this system is that certain profits would not be taxed at all in the United States.
The alternative proposition from President Obama is the international minimum tax. Under this proposal, all income of U.S. corporations must be immediately taxed, either by the United States or some foreign country, at a rate greater than or equal to this as yet unspecified international minimum tax rate. If a corporation reported profits in a country that collects no corporate tax, the U.S. would immediately tax those profits at the international minimum tax rate. This would help reduce the appeal of the tax haven, according to Brookings.
Very few people actively support the current system of taxing the foreign profits of U.S. corporations. A combination of the two systems would provide the best compromise: a territorial tax system for the valid tax-collecting nations and the international minimum tax rate for those that collect little or no corporate tax (e.g., the Cayman Islands). At this point in time, however, compromise is a four-letter word in Washington, D.C. Sen. Sanders's new legislation proposition is a good start toward addressing the tax dodging of U.S. companies.
What is the logic of this tax dodge by some of country's largest companies?
Seagate's Brian Ziel's explanation in 2004, which is commonly stated by other corporations as a rationale for overseas subsidiaries that do not pay U.S. federal taxes: “The competitive benefits relate both to taxes saved on certain income earned outside of the United States and the ability to efficiently deploy assets around the globe to remain competitive” (Bloomberg).
Corporations have prospered and have increased their share of GDP at the expense of the middle class, which has seen its wages and salaries stagnate while the cost of the necessities of life has steadily increased. Those large U.S. corporations that have opportunistically reduced their tax bills through Cayman Islands subsidiaries and other schemes are the same companies that have sliced fixed costs (and have recently achieved 57-year highs in profit margins) by paring down payrolls and utilizing temporary employees in place of permanent ones.
Perhaps before considering raising taxes on either the middle or even the upper class of U.S. wage earners, an explosive device should be detonated in order to destroy the rules that form the foundation of the ignominious Ugland House.
Tax what the large corporations burn, not what they earn, by getting rid of the shell game operated in the Ugland House in the Cayman Islands and elsewhere.
Citizens for Tax Justice estimates that tax havens in the Cayman Islands and elsewhere outside of the United States cost our government about $100 billion per year in tax receipts. Many of my hedge fund friends will no doubt push back from the notion of abolishing overseas tax havens, but we are entering a period of shared sacrifice in the four years ahead. Our legislators have hard decisions to make in reducing the country's budget deficit, but this seems one of the easier decisions.
There is an additional concern that is being addressed in Washington, D.C.: the notion of carried interest.
Carried interest is generally treated (preferentially) as capital gains in hedge fund and private-equity partnerships. The taxation of carried interest has been an issue for several years as the compensation earned by investors increased with the size of private-equity funds and hedge funds. Since private-equity firms tend to hold investments long term, the gains qualify as long-term capital gains, which have favorable tax treatment. Managers taking advantage of the maximum 15% tax rate on long-term capital gains have raised concerns. The view that managers are taking advantage of tax loopholes to receive what is comparably a salary without paying the ordinary 35% marginal tax rate is not sitting well with members of Congress nor their constituents. Taxing the gains at the marginal tax rate has drawn ire of several managers on Wall Street, but the move is necessary if Congress is going to close the tax loophole to address our country's budget issues.
After dealing with numerous other tax loopholes, our leaders in Washington, D.C., can begin to seriously address the enormous systemic waste that has been built up over the years in the bulging bureaucracy of our government.
Now there is some serious and heavy lifting.
“If you laugh, you think and you cry, that's a full day. That's a heck of a day. You do that seven days a week, you're going to have something special.”
— Jim Valvano, coach of the 1983 North Carolina State basketball team
Tonight the Michigan Wolverines face the Louisville Cardinals in the NCAA men's basketball tournament final in Atlanta.
March Madness is my favorite sporting event of the year. I have the most precious memories traveling with my youngest son to semifinal weekends and to Monday's finals. Our trips to the NCAA tournament have, in part, defined my relationship with him.
But this morning, my thoughts are on another game and that speech. Both can provide us with important life and investing lessons.
“We were such underdogs that even my mother took the Houston Cougars and gave the points.”
—Jim Valvano
That game took place 34 years ago tomorrow in 1983. In that game (the NCAA finals), a seemingly outmanned North Carolina State Wolfpack faced the Houston Cougars who were led by two future NBA Hall of Famers in Hakeem “the Dream” Olajuwon and Clyde “the Glide” Drexler. Houston finished the regular season as the top team in the country and were collectively known as “Phi Slama Jama,” so named for the fast-paced showmanship of their game. Going into the championship game, Olajuwon boldly predicted “the team with the most dunks will win.”
Though only a No. 6 seed in their regional bracket, the North Carolina State Wolfpack was hardly a team of nobodies at No. 16 in the nation. It took an impressive late-season streak just to get them to that ranking, however, and nobody thought they had a chance against Houston (which had won 26 games going into the game against N.C. State). So it was quite a shock to see Lorenzo Charles dunk the winning two points in the last second of the game, and I will never forget Wolfpack coach Jim Valvano running around like a chicken with its head cut off.
And, oh, that 1993 ESPY Award speech that Jim Valvano gave just eight weeks before he died of cancer—I still cry every time it is repeated on ESPN.
James Thomas Anthony Valvano was the mischievous middle son born to Rocco and Angela. When he was 17 years old he wrote down on an index card his professional aspirations. He would play basketball in high school (he did at Seaford High School in Long Island) and college (he did at Rutgers), become an assistant basketball coach (he did at Connecticut), then a head coach (his first head coach position was at Johns Hopkins, then at Bucknell and Iona), achieve victory in Madison Square Garden (he did while at Rutgers), and finally cut down the nets after winning a National Championship (he did with N.C. State).
Some elements of Valvano's life lessons can be adopted into our investing strategy.
“No matter what business you're in, you can't run in place, or someone will pass you by. It doesn't matter how many games you've won.…How do you go from where you are to where you want to be? I think you have to have an enthusiasm for life. You have to have a dream, a goal, and you have to be willing to work for it.”
—Jim Valvano
The investment mosaic is a complicated one, and no one rule always works. How-to books may sell copies and make money for the authors, but they don't usually make the readers much money. There is no substitute for hard work in delivering superior investment returns. There are 86,400 seconds in a day; it's up to you to decide what to do with them. There is no secret sauce, magical elixir, or special stock chart that provides clarity to our investment decisions—rather, it is a by-product of hard-hitting research.
“Be a dreamer. If you don't know how to dream, you're dead.”
—Jim Valvano
A variant view and second-level thinking are necessary reagents to good investment returns. In The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing, 2013), author Howard Marks addresses these two subjects.
In investing you must find an edge by often thinking of factors/ideas that others haven't thought. Importantly, you must also avoid being too early—especially if your investor base has a different time frame than yours.
Second-level thinking trumps first-level thinking in delivering returns. As Howard puts it, First-level thinking says, “It's a good company: let's buy the stock.” Second-level thinking says, “It's a good company, but everyone thinks it's a great company and it's not. So the stock's overrated and overpriced: let's sell.” First-level thinking says, “The outlook calls for low growth and rising inflation. Let's dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
“I asked a ref if he could give me a technical foul for thinking bad things about him. He said, ‘Of course not.’ I said, ‘Well, I think you stink.’ And he gave me a technical. You can't trust ’em.”
—Jim Valvano
I am often asked why I don't usually listen to company executives or the guidance of their investor relations departments. To me, it is preferable to speak to people in the supply chain or to company competitors, for (to paraphrase Warren Buffett) managements often lie like ministers of finance on the eve of devaluation.
“My father gave me the greatest gift anyone could give another person: he believed in me.”
—Jim Valvano
You gotta believe in yourself. Lehigh's basketball team believed it could beat Duke last year, and, in this year's tournament, No. 14 seeded Harvard upset No. 3 seeded New Mexico.
You gotta know yourself, too. Wall Street is not a great place to “find yourself.” Psychology can be important; it often trumps cause-and-effect relationships that have been in place historically. Above all, have confidence in your own analysis (as long as it is thorough), even if your view is at variance with the consensus.
And, of course, Coach Valvano's most recognized quote: “Don't give up, don't ever give up.”
Learn to survive under adverse market conditions by avoiding large losses, and learn how to prosper during good times. Generally speaking, by maintaining discipline and stopping out your losses, you can live another day in your investing life. It is not batting averages or on-base percentages that count in this game; it is how you control the risk in your portfolio. As an example, short positions can be hedged by owning cheap out-of-the-money calls, and long positions can be hedged by owning cheap out-of-the-money puts—especially in a low-volatility setting.
Laugh, think, and cry—I always do this time of the year, as I will tonight watching the NCAA tournament finals. (I like Michigan in the upset; they are 4-point underdogs.) But it's especially true this year after overcoming my own confrontation with cancer—it's been a shining moment for me.
You, too, can have many shining investment moments by applying some of Coach Valvano's life principles to your investing.
“We are not permitted to choose the frame of our destiny. But what we put into it is ours.”
—Dag Hammarskjöld
Late last week, I mentioned that we are likely to face a lot of volatility in 2013:
Volatility and disorder are likely a more constant state in a global economy that is experiencing a new normal that remains on tenterhooks, still experiencing the deleveraging and tail issues stemming from the last down cycle and, as a result, only experiencing a fragile trajectory of growth.
To me, it's not good volatility; it's the outgrowth of uncertainty regarding economic growth and an unhealthy dependency on the policy of our monetary (Fed) and fiscal (our leaders in Washington, D.C.) authorities.
Regardless of whether volatility is heightened or reduced (or good or bad), among the three most important elements of one's trading and investing should be your time frame, appropriate exposures and risk tolerance/profile.
We all have different quotients of the above factors.
I will deal with two of the three factors: time frames and exposures.
To begin with, I view the market as a continuum in which one's time frame is an essential part of trading and investing.
As a matter of principle, I rarely have a gross exposure (adding my long and short gross exposures together) that exceeds 100%. On average, when I am bullish, I am typically as much as 65% net long (deducting my shorts from my longs as a percentage of the portfolio), and when I am bearish, I am typically as much as 45% net short (deducting my longs from my shorts).
In hedge fund circles, these exposure ratios place me in a conservative minority.
Depending on where we are in the market continuum determines the percentage of my portfolio that is committed to longer-term investments (both long and short) vs. shorter-term trading rentals (again, both long and short).
Under a normally trending (and upwardly sloping) market (and dependent upon my degree of confidence), I would have as much as 67% (when fully invested) of my portfolio in investment holdings (with a majority of longs), and I would have as much as 33% of my portfolio in trading rentals (again, a majority of longs).
But let's add two more market scenarios and characters—namely, a range-bound market and a downwardly sloped market—to the normally trending and upwardly sloping market getting us to three market scenarios.
Again, I change my exposures (investing vs. trading) dependent on the outlook:
Let's now dig deeper into time frames.
To simplify, here are my definitions of time frames (note: yours may be different):
It is important to recognize that sometimes very short-term positioning seems to contradict a market thesis, but adopting a near-term positioning that is at odds with an intermediate-term view may not be that illogical.
Let me explain.
I may do this in response to a number of different stimuli. Maybe the market has temporarily overshot to the downside and has become oversold. Perhaps the reason for the market's slide is not justified or an external shock contributed to the drop, and I expect the conditions to be remedied/addressed.
Or it might simply be my lame attempt to game or react to Mr. Market's volatility.
As I see it, my job is to be transparent in analysis (of markets, sectors, and individual stocks) and also to be transparent in my entry/exit points. Along the way, I try to provide other lessons—for instance, in risk control, as your investment/trading batting average does not necessarily link to superior returns.
But what must be recognized is your risk profile and time frames are likely different than mine (or anyone else's), so when I chronicle my investments and trading rentals, it is important to have the proper perspective so that you can better understand my tactics and strategy (which may or may not be appropriate to you).
Always consider your own time frames and risk profile/tolerance in determining the suitability of exposure and how you weigh your involvement in trading vs. investing.
September 11, 2001, still seems like yesterday to me. It is a day that I will forever remember vividly with clarity and disbelief.
To many of us, 2001 will forever be annus horribilis—the year of horror.
On this day, as has been the case for the past 12 years, my eyes remain full of tears as I write this column in memory of all of those I knew (and those I didn't know) who were lost in the World Trade Center, in Pennsylvania, and in Washington, D.C. It is said that death leaves a heartache that no one can heal but that love leaves a memory no one can steal.
And so it is today Tuesday, September 11, 2013, we observe the twelfth anniversary of the September 11 attacks.
As I have for each of those years, today I want to pass along my thoughts by writing this opening missive as a dedication to some of those who were lost—especially to my best pal, Chuck Zion (a.k.a., Brown Bear).
Chuck worked at Cantor Fitzgerald, the brokerage firm that lost nearly 700 employees 12 years ago. It was the hardest-hit company in the World Trade Center tragedy, accounting for nearly one-quarter of the building's deaths that day. I lost many friends at Cantor on September 11: Eric, Pat, Timmy—too many to count. So did many others. And of course, we all lost one of TheStreet's own, Bill “Budman” Meehan.
In Cantor Fitzgerald's equity division, none had more of a presence (literally and figuratively) than Chuck Zion. He was known to his friends and clients as the Brown Bear, a sensitive, giving, and caring friend; father to Zachary; son to Martin and Jane; and husband to the amazing Carole (“Cheezy”). His love was pure, and there was never any pretense—not wordy, he was on point.
The largest producer over the past decade at Cantor Fitzgerald, Chuck was master of his universe. He was straightforward and clear-cut, a no-nonsense and respected partner who was remarkably generous but never, ever wanted others to know it. He gave often and substantially but always anonymously, without strings attached. Chuck, who also worked at Salomon Brothers and Sanford C. Bernstein, put on some of the largest trades in the history of the equities market. He was the player the “big boys” went to when they wanted anonymity. And I am talking multimillion-share trades, the really big prints. And it was Chuck who introduced me to Bill Meehan—he even had me fill in for Budman on a few occasions in the Cantor Daily News.
I cherished and loved Chuck Zion—he was my confidant and a brother that I never had. When I moved to Florida in the late 1990s Chuck introduced me to his father and mother, asking me to take them out once or twice a year, to look after them a bit. In time, Rabbi Zion and Jane became more than casual dinner mates; they became my mother and father, so Chuck and I really were like brothers (though absent the same blood).
I spoke to Chuck every morning at around 6:15 A.M. If I didn't call him on my direct line to Cantor's trading desk by 6:20, he'd get angry and yell at me in no uncertain terms. Invariably, legendary money managers Neil Weissman, Stanley Shopkorn, Dan Tisch, or Phil Marber (Cantor's former CEO) would interrupt our daily calls. He would take their calls, and then shortly, Chuck would call me back. We rarely talked about the stock market, preferring to talk sports and food (his favorite activity). Sometimes Chuck would tell me to check out Maureen Dowd's editorial piece in the New York Times (“Dougie, she is mandatory reading”), or who was on Imus that morning. I got him to buy a couple of harness horses with me for fun and he got a kick out of them as we followed their losing races. “We'll get him next time,” he would say (his credo)—though we never did.
We played golf together (Chuck wrote the word lost on each of his golf balls because he lost so many of them that he wanted the other players to know they were his), usually with Phil Marber or Andy Smoller. We talked NCAA football and basketball, especially about Syracuse University's teams (his alma mater). But mostly we talked about our children.
The Friday before September 11 was my last day in the office, as I was leaving for Europe for 10 days. That day we spent a lot of time talking about his son Zack, reminiscing about the trip Zack and I had recently taken to New Haven to Yale University, where he watched me lecture at Dr. Robert Shiller's class on short-selling. Chuck was so proud of the way Zack had become a man. And he was nervously awaiting Greenwich High's football season with such anticipation. (They had won the state title the previous year, with Zack playing the offensive line.) Every time he talked about the upcoming season, his voice would rise several decibels. He was the proudest father on the face of the earth.
That Friday morning, the last day I spoke to Chuck, I was playing a Grateful Dead song in the background and I had Chuck on the speaker. Chuck was never what I would call into music. He was certainly not a fan of the Grateful Dead—maybe Motown but not the Grateful Dead. Surprisingly, in our early-morning talk, Chuck remarked how beautiful the song was. The song was “Box of Rain”—and the lyrics captured the concept of how short life can be only days before the disaster.
Chuck's New York Times obituary is still taped to my stock monitor in my office as an ever reminder of his loss. The paper is now aged, yellowed, and torn, but the scars still seem fresh.
Today, after writing this missive, I will again share Chuck's memories with his parents (Rabbi and Jane), his many friends (like Phil Marber), and with numerous longtime subscribers (like Don Gher), who were business associates, recipients of his wise advice or friends with Brown Bear and who, as they have every year, will pass on their day's thoughts to me in e-mails or phone calls, which I eagerly anticipate and will always cherish.
Last night, subscriber Don Gher mailed me a classic story about Brown Bear. Don was thinking about Chuck and relayed that one of his pals, ex-Cantor (Los Angeles) and Dallas trader Eddie Weber, told him that one day he was at Cantor's NYC office, and he and Brown Bear walked out of the World Trade Center to grab lunch. There was a hot dog vendor there, and Chuck asked how many he had left. The guy said 12, and Chuck said, “Sold!” And then they proceeded to eat all of them. That was my brother, Chuck—an original. Don lit a candle for him at Mass on Sunday as he has done in each of the last 11 years. (Thanks, Don.)
I will never forget Mark Haines's report on CNBC of the first, second, third, and fourth incidents that day, as I watched the horror on a television on a cruise ship in the Mediterranean.
TheStreet's headquarters were physically very close to Ground Zero.
And I will never forget the real-time reporting (the confusion and emotion) on TheStreet on that fateful day, the revelation of the extent of the tragedy and the follow-up tributes by our contributors.
Ironically or sadly, Rosh Hashanah (the Jewish New Year) and Yom Kippur (the Day of Atonement) quickly followed on the heels of September 11, 2001. The most poignant recollection on TheStreet was the following post by Jim Cramer, who recalled an incident at his temple—to this day, it brings me to tears:
At our synagogue last night on the eve of the Jewish New Year, our rabbi asked us to shout out the names of friends and family that we'd lost that day. There were so many names, it was frightening and I was glad we had left the kids at home. I felt honored to yell out Bill's name. And I feel honored to have gotten to meet and work with him in his short time on Earth. Oops, wanted to cry as I wrote that. Could feel it coming on. Nope, no can do. Not with that picture of him in my mind wearing that funny floral shirt. He wouldn't want us to remember him in any other way than with laughter. God bless your soul, Bill. God bless the Meehan family.
—Jim Cramer, “Remembering Bill Meehan”
Today, I will also share my fond memories of TheStreet's and Cantor Fitzgerald's Bill “Budman” Meehan with his good pals Jim Cramer, Tony Dwyer, Herb Greenberg, and others, and we will all toast him as so many subscribers did in the fall of 2001.
“All that's necessary for the forces of evil to win in the world is for enough good men to do nothing.”
—Edmund Burke
Fortunately, on May 2, 2011, some very good and courageous men gained revenge for Osama bin Laden's deeds 12 years ago.
I hope that Osama bin Laden rots in hell.
But revenge doesn't reverse the loss of so many.
“Revenge is an act of passion; vengeance of justice. Injuries are revenged; crimes are avenged.”
—Samuel Johnson
I suppose that living and remembering is the best form of revenge.
Thanks for reading this, and thanks for letting me wear my feelings on my sleeve.
Before the market opens and as you watch the annual tribute in downtown New York City, think about our lost loved ones and how lucky we all are.
We all miss you, Chuck.
“Stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.”
—George Soros
The problem with bubbles is that if you sell stocks before the bubble bursts, you look foolish, but you also look foolish if you sell stocks after the bubble bursts.
Yale professor Robert Shiller outlined how to identify bubbles in his seminal book, Irrational Exuberance (Princeton University Press, 2000)—as you will read, there is some overlap in our identification process of bubble finding:
Similar to Dr. Shiller, I have long felt that every bubble has distinguishable conditions leading up to them.
For me, bubbles typically emerge when the following five conditions are all met:
Consider that all these conditions existed during the dot-com stock bubble (1997 to early 2000):
These conditions also existed during the housing bubble (2000–2006):
To my 5 conditions mentioned earlier, I add 5 more (several of these quantify the “degree of bubbliness”) to complete my 10 laws of bubbles:
While some of the above conditions/laws have been met today, many have not.
While debt is cheap and plentiful to some, it is not universally so, as lending standards (especially mortgages and small-business loans) are relatively tight.
While investor sentiment is optimistic (and at multiyear highs), retail investors remain relatively noncommittal to stocks, and there is no new marginal buyer of equities (as was the case in the late 1990s). Nevertheless, the Investors Intelligence gauge of adviser sentiment (at a 55.2% bullish reading and only 15.6% bearish) is not only at the highest difference between the two in 2013 but at the most extreme reading since mid-April, a point in time when stocks experienced the largest correction of the current bull market that began in March 2009.
With over $50 billion of new-issue offerings thus far in 2013 (compared to $63.5 billion in the same period in 2000, the year the dot-com bubble burst) and follow-on offerings at a record $155 billion (year-to-date), conditions on this front are getting bubbly.
While some investors might be thinking that a new era lies ahead, they are in the minority.
In terms of valuations, they are somewhat higher than the average P/E multiple experienced over the last five decades, but they are not excessive.
On the other hand, the S&P multiple has expanded by nearly 20% this year, compared to only a 2.5% average yearly rise in valuation since 1900—that's a bit bubbly.
As to the consensus belief that the Fed can (without the benefit of intelligent fiscal policy) engineer self-sustaining growth, that is arguably a bubble-like notion/condition.
While quantitative easing today might be driving asset prices to potentially unsustainable levels, without stimulating much additional activity, those levels are not that out of the ordinary.
Finally, unlike the exporting of derivatives by our major money center banks that nearly bankrupted the world's financial system in 2007–2009, there is none of that today.
Bottom line: While equity markets might be richly priced relative to fair market value, I would conclude that we are not currently in a stock market bubble.
Yet.
On Sunday, one of the grand sporting events of the year will take place: Super Bowl XLVIII.
Back in January 2000, I created a brand-new stock market Super Bowl indicator as a contrary indicator, very similar to the cover of Time.
My indicator dictates that the more intense the Super Bowl television advertising by a group of companies, particularly in a specific industry, the more likely the stocks of those companies will perform poorly in the year ahead.
Barron's’ Alan Abelson was kind enough to include and highlight my indicator in his “Up and Down Wall Street” during the weekend of the 2000 Super Bowl.
As the late Sir Alan wrote:
As it happens, last week's tech wreck was accurately forecast by a remarkable new stock-market indicator, one we're proud to print for the first time anywhere, the Stock Market Super Bowl Indicator.
Before you start yapping about it being old hat—or old helmet—we respectfully suggest you cool it. Pure and simple, our new indicator has nothing to do with the old Super Bowl indicator. Unlike the latter, its predictive power doesn't depend on the outcome of the Super Bowl or, more specifically, whether the winner represents the National Football League's American Conference or the National Conference.
Our brand-new Stock Market Super Bowl Indicator is a contrary indicator, kind of like the cover of Time. Its critical components are the commercials carried on television coverage of the event and the identity of the companies doing the advertising. Its virtue is not as a forecaster for the market as a whole, but for individual sectors of the market.
The indicator is the handiwork of Doug Kass, a kindly hedge-fund operator who, despite a propensity to short quantum leapers, wound up last year with an improbable performance matching Nasdaq's improbable performance.
Simply put, the more intense the Super Bowl TV advertising by a group of companies, the more likely the stocks of those companies—and others of a kindred ilk—will do poorly in the year ahead. For 2000, we're sorry to report, the indicator is flashing red for the Internet crew.
By Doug's count, roughly 12 of the 30 companies shelling out an average of $2 million for 30-second spots are dotcoms. That's four times the number of 'Net outfits that made their pitch on Super Bowl TV last year and compares with only one in each of the prior two years.
What's more, for the first time, an Internet company, E*Trade, is sponsoring the half-time show. That's known in locker-room lingo as piling on.
If nothing else, the greater the number of look-alike or sound-alike companies doing the shilling, the less the impact of the individual shills. And in fact, there seems to be more than a modicum of evidence that for the viewer, the link between the commercial and the sponsoring Web company barely registers.
Making the auguries all the darker for those dozen dotcoms is the sad history of the sole 'Net TV advertiser during Super Bowls XXXI and XXXII, autobytel.com. A '99 IPO, the stock peaked at $48 and, last we looked, was a hair under $17.
Without Wall Street, Silicon Valley would not have been able to remove the burden of salaries from its operating statements and substitute stock options for cash compensation. Without the lovely boost to earnings afforded by the incredible lightness of labor costs, earnings growth would be considerably less, and so the multiples awarded that growth would be merely ridiculous instead of absurd. There would be only a quarter as many West Coast billionaires and half as many millionaires.
In like manner, since the vast bulk of Internet companies are bereft of even a hint of cash flow, Wall Street has, via stock offerings, endowed them with the means of promoting their wares, not only on TV during the Super Bowl breaks but also in newspapers and magazines, on billboards and in subway cars and every other space known to advertising man.
If, indeed, we are rapidly reaching the point of cognitive congestion where the consumer is under such assault from so many dotcoms that they have begun to merge in his psyche into one big indivisible glob, that spells trouble in capital letters. And not only for the 'Net companies, but also for the media on which that vast flow of lucre has been lavished.
—Alan Abelson, Barron's (January 2000)
Of course, the rest was history, as one of the largest stock market declines (especially of a technology and Internet kind) occurred during the following few years.
Last year, the food and beverage sectors were responsible for an outsized 41% of all Super Bowl advertisements—and, on cue, this defensive group was an underperformer in 2013's sharp U.S. stock market advance.
This year, Super Bowl ad rates are through the roof and are expected to approach $4 million (up from $3.5 million in 2013) for a 30-second commercial compared to about $2 million in 2000, $1.15 million in 1995, $700,000 in 1990, $222,000 in 1980, $78,000 in 1970 and only $42,000 in the first Super Bowl in 1967.
Rates approaching $10 million for a single commercial are going to happen sooner than you might expect!
Significant, again, this year is the preponderance of consumer products companies that have anted up for 30- and 60-second advertisements during the Super Bowl! Auto advertisers are close behind. Combined, they represent the lion's share of Super Bowl ads.
Of the thirty 2014 Super Bowl advertisers, 12 are consumer-products-related, accounting for 11.5 minutes of advertising (or 40% of the total number of advertisers)—and that does not include PepsiCo, the beverage and snack company that is sponsoring the halftime show. Eight advertisers are automobile-related, accounting for 8.5 minutes of advertising (or 27% of the total). Between consumer product and auto companies, the two sectors account for 20 out of 30 advertisers, representing 20 minutes of all Super Bowl commercials (or 67% of the total).
In summary, we might conclude from the historic causality between my indicator and the industry composition of Super Bowl advertisers that headwinds could be facing the shares of both the consumer products (especially food and beverage) and auto manufacturing industries in 2014.