Archive for the ‘View on Market’ Category

How many times in the past few months have we heard the pat answer “the job creators aren’t creating jobs due to uncertainty”. This has become a fine “whine” so to speak. The dictionary defines an entrepreneur as” the owner or manager of a business enterprise who, by risk and initiative, attempts to make profits.” So, now we have entrepreneurs (also known as job creators) who want the profits but none of the risk?

Job creation is slow due to one essential fact-global demand is insufficient right now to cause businesses to hire. Of course, entrepreneurs are using their business acumen and initiative to try to gain an upper hand while h economy is slow. “Lower my taxes permanently, lower my risks, give me certainty”. You don’t get a risk premium on your investment without the risk, entrepreneurs.   It has always worked that way and it always should.

Market volatility is driving investors crazy, everyone seems
unhappy with almost everything (government, Wall Street, you name it). It is
enough to make me think people need to take a deep breath, exhale, and pause
for a moment.

We did not name our business Capstone by random assignment
or dart throwing. A capstone is a crowning achievement, a finishing touch if
you will.  If you
have carved out a meaningful life, our belief was that careful management of
your assets could improve your life (expanding your freedom and allowing you
time to allot to chosen goals).

It seems like people in the U.S. are currently concerned
only about jobs, money, taxes, and real estate. These are not the items which
comprise a meaningful life in and of themselves. The World Database of
Happiness shows the United States ranked 20^th in happiness.  The World Health Organization ranks us 37^th
in health care. We rank 14^th in education, according to a recent
OECD study. We are at best in the middle of the pack for homicide rates around
the world.

Shouldn’t we put some of our focus on improving these areas?
Wouldn’t that help us lead more satisfying and meaningful lives? There is still
a lot of wealth in our country and a pretty decent standard of living compared
to most around the globe. Perhaps a deep breath and a grateful nod to our
abundance could be useful every once in a while?

As many of you may know, Warren Buffet’s first rule of investing is- Don’t lose money! His second rule of investing is- Don’t forget the first rule! This is terrific advice save for one small detail. The detail is that we have never met anyone smart enough to follow these two simple rules. We have never met Mr. Buffet, but we are quite sure that he has not been able to follow these two rules without a few lapses during the past decade.

The third rule of investing is really the only one you need because- you can actually follow it!  Lose money as infrequently as possible and limit the amount of each loss!!

This gives you a plan for investing that you can execute (unlike the far more well known edicts of Mr. Buffet). The process needed to follow this rule will be challenging but you can do it. To lose money as infrequently as possible is to only enter into investments which have a reasonable expectation of being profitable. Buying a tech stock in late 1999  with a price-to-earning ratio of 400 was just not a reasonable concept. Could you have doubled your money as the P/E ration zoomed to 800? Of course, but this was not a likely or reasonable outcome. This investment was more likely to lose money than to make money and should have been avoided. If you did foolishly make this trade (an infrequent loss we hope!), what was your process to keep your loss small? If you allowed your tech stock to fall 90% in value (as most investors did!), you clearly had no process in place that was designed to limit the scope of your losses.

So, make it a mantra and figure out how you are implementing it-

Lose money as infrequently as possible and limit the amount of each loss!!

Americans are a people of faith and belief- that is one of the things that binds us together. Organized religion is an important part of most of our communities and a major social network for many people. Sports have become a second major source of faith and socializing for many. In baseball, who can forget Tug McGraw’s “Ya gotta believe” rallying cry for the New York Mets? How about the hapless New Orleans Saints uniting the hurricane ravaged city of New Orleans on their drive to become Super Bowl champions?  Or the way we root for “Cinderella” during March Madness? Our faith and emotional attachments do much to enrich our lives and are a precious commodity in our lives.

Unfortunately, emotion and faith have little place in our investments. We invest money with a fairly consistent objective- to fund future economic needs through investing our hard earned capital. Implicit in this process is that we invest in order to make a real return (something beyond inflation). Achieving this goal is not a given and usually requires us to take some risk and to carefully weigh that risk in light of potential returns. We refer to that process as Variable Risk Investing^SM.

The traditional world of investment advice is filled with emotion and faith. Primarily, this comes in the form of “experts” who are always of the opinion that now is the time to buy investments. There is never a year in which you are advised not to invest in equity markets. A lot of advisor “guru’s” declare that you should have “abiding faith” in the greatness of free-market democratic capitalism and should therefore fund all future needs by investing in equities. Our contention would be that your “faith” in America is a wholly different issue from the expected returns you have on your investments moving forward. If stocks are way overpriced and the economy is weakening, you are looking at lower than normal returns and higher than normal risk. Is it prudent to invest all of your capital in such a market? It would not be our recommendation and history shows the results can be disastrous.

The flip side of this phenomena are the marketers who make their money by predicting that disaster is lurking immediately ahead (the fear side of fear and greed is their forte). For them, the great reckoning is always upon us. Oddly, they always offer a solution that includes them profiting from you getting out of the way of the impending doom. Bear market funds, gold sellers, equity index annuity sellers and many others await you in this realm of the world. If they can get hold of your fear, they can do pretty well for themselves regardless of your fate.

We believe that realism (not faith or emotion) is the only course to steer to financial success. To participate in up markets and to avoid losses as often as possible is the road to success. To either let your emotions drag you down a dark alley or to always look at your portfolio through rose colored glasses is counter productive. Capital protection and growth is a serious business. Always treat investing as an objective task. It helps you “live long and prosper”.

Near the end of last year, we saw a real gem on the internet. The internet job site Glassdoor.com had published some of the oddest and most difficult questions that job seekers were asked last year. This one caught our attention and we want to respond.

According to the article, a person applying to become an analyst at Goldman Sachs was asked:

“If you were shrunk to the size of a pencil and put in a blender, how would you get out?”

This really caught our attention as we were losing sleep over the very same question!! Really? Really? Your firm was in the mix of those who nearly brought on another great depression and that is what you need to learn about prospective employees? Why bother about fiduciary responsibility, ethics, morality, making sound decisions, or the Golden Rule?

Our mind wandered to the pharmacological state of the questioner? Would somebody grounded on our planet and able to pass a sobriety test really ask this of a prospective candidate? Probably not, but this is Hollywood……no, we meant Wall Street.

Next thing we know news broke of the questions surrounding the deal struck between Goldman Sachs and Facebook, involving Goldman Sachs’ wealthy  private clients. Take these sentences from the Facebook Offering documents:

“There may be conflicts of interest relating to the underlying investments of the fund and Goldman Sachs.” Material in the documents is described as “not guaranteed as to accuracy or completeness.”

Given what we have all gone through in our economic crisis, isn’t it good to affiliate yourselves with people who, if they were reduced to the size of a pencil and placed in a blender, could get out?

We really don’t know where the markets are going from here. We are in a range bound market, where the only certainty seems to be that whichever direction we go for a week or two, we go back in the opposite direction with about the same velocity. Will the next breakout be towards the upside or downside? As market realists, we are totally stumped as to the answer to this crucial question. Will emotions reign? Rational thinking and valuations? Very hard to know at this point. But, what a cottage industry of guessers we are creating.

The Bears are out in force, making predictions that can make them famous. After all, don’t we all want to follow the thinking of the person who “got it right”. Bob Prechter is a well know follower of Elliott Wave Theory. More importantly, he is no dummy. He knows that if you make 10 predictions, you have a better chance of being right once and that people will forget the other nine predictions. So, a couple weeks ago, he predicted Dow 1000!!!! Ouch!!! Is that impossible? No, but neither was the prediction by bulls in 2000 of Dow 36,000. Both are highly unlikely outcomes to a realist, but they cannot be rule out entirely. Now, Prechter predicts a 20% decline in stocks as being on the horizon. This doesn’t negate his Dow 1000 prediction, but certainly gives him another chance to be a “genius”.  It is like the lottery-you want as many tickets as possible to increase your chance of picking a winner!

SoGen’s Albert Edwards is predicting an S&P 500 drop to 450, a drop of about 60%. Gold hawkers are out everywhere with their bear stories-that equities will crash, the dollar will disappear, etc.  These horrors cannot be ruled out by a rational person, but they are highly unlikely outliers in the future’s possible outcomes.

On the flip side, the perma-bears continue to function as always. It is always the right time to invest and they can always show you why. When desperate, they will find non-causal links that are mind bogglingly stupid (i.e. 7 times out of 10 the Dow rises by more than 20% when the New England Patriots lose their opener by more than 7 points)! Stocks are cheap they cry and the rally is just beginning. We rationale folks can’t rule out everything they say either.

Realists need to resist all this noise. Most likely the market is range bound today by one essential truth-the market has it pretty much right and stocks and other assets are pretty fairly valued. If that is the case, we can expect stocks to rise at a fairly slow rate in the coming years, but do it with a great deal of volatility, if that unfolds, we won’t have a new “genius” who made an amazing call on the markets meteoric rise or fall.

As those of you who follow our thinking know, we are hardly in the “perma-bull” category of the financial services world. We remain concerned about the fundamentals and valuations, along with the somewhat limited prospects for growth. We try to be realists, rather than bulls or bears.

Doomsday marketers are everywhere now and they are succeeding in their marketing efforts. One famous doomsday fellow predicts the Dow will fall to 1000! That would mean that stocks would fall by over 90%. If earnings were flat, that would mean that the return on your investment (earnings versus investment) would be over 50% per year when the market is at 1000.

We don’t know about you, but we would gladly put all of money into stocks well before our return would be need to be 50% per year. Alternatively, we might consider that earnings would have to fall 90% from current levels. As current earnings are rebounding from rather low levels, it is hard to imagine that scenario either. Anything can happen, but this is about as likely as being struck by lightning.

But the doomsday crowd is succeeding in frightening people and we are getting calls about how to invest in the likely fall of the market. We don’t say that a market crash is impossible or that a decline will not take place. We do say that profiting from a market decline is the most difficult strategy to employ and that the skill and timing required to do so successfully is daunting.

First, stocks have an upward bias. This is just common sense. A big company makes money every day, so it is literally “worth” more each day. The counter balance to this is that the market has over valued the stock (i.e. investors are paying too high a price in order to own part of the company) and so it will fall even though its worth is increasing daily. So, our common sense means it is relatively harder to make money on stocks falling as opposed to their increasing in value.

Second, let’s go back to the notion that we are market realists. One of our favorite market realists is Jeremy Grantham. He has long produced his 7-year market forecast with astonishing accuracy. He basically normalizes earnings and uses them to figure out likely returns over 7 years given current valuations. His latest forecast shows positive real returns (above the rate of inflation) for all stock classes over the next 7 years.

Many are below normal, but all are positive. These seven years will likely include some big plus and some big minus periods. But, if at the end of the day returns for the period are positive as he predicts, you are once again swimming upstream by trying to invest in a market fall.

We believe we are in a difficult environment and that you need to take more risk when stocks are cheap and rising and less risk when stocks are expensive and falling. To try to make money based on the doomsday scenario,…….., just doesn’t make much sense to us. It is betting on a long shot.

Yes, we have been repeatedly cautious about market valuations this year. We have said that prices have gone too far and too fast and that risks are rising as a result. We have sold some positions and increased our cash positions (because we did not see much that seemed compelling to buy). However, the speed and depth of yesterday’s market collapse was not something we foresaw at all. It was shocking to everyone, including us.

We did not see the market rising as quickly and steeply as it did in 2009 and now we certainly did not expect this rapid a drop. What can we learn from this? First, the market volatility of 2008 is not totally behind us. We still remain in a turbulent market, range bound in the long term but able to climb steeply and then fall sharply. It is a market best suited for hard work and diligent processes rather than passive investing.

The other problem from yesterday was the fact that we seemed to have computers running amuck. Much of the speed of the descent stemmed from computer trading programs, flash trading, etc. The passive investor believes the “market is efficient” and correctly prices stocks at all times. Yesterday afternoon, in that case, all American businesses lost more than five per cent of their total value in less than ten minutes and then regained most of that value over the next hour and a half. I don’t think even the staunchest advocates of efficient markets would like to defend that proposition. So, we had computers and people losing their grasp on reality and nearly causing a calamity worse than the oil spill in the Gulf. It seems to us that we need to replace some of the speed of computers with some more level headed market makers. Flash trades and High Frequency Trades take place on Wall Street in milliseconds. We don’t know about you, but we like to consider our decisions a little longer than a millisecond before we make them. If we don’t want to risk more meltdowns (or melt ups), we need to get some rational people back in front of the market, instead of just the computers that people have programmed to respond quicker that we can poor mortals can think.

We all know the story of the tortoise and the hare. Most of us have seen examples of  this concept in action at times during our lives. Now may be one of the times to see the tortoise beating the hare at investing.

Let take two investors, each of whom has $100,000 to invest. Investor A (the tortoise) gets 20% of market up and 20% of market downs. Investor B (the hare) gets 100% of market ups and 100% of market downs. Now, let’s add some volatile market returns (certainly not beyond the realm of possibility). The market goes up 50% and falls 40% in year 2.

Investor B has a lot more fun at cocktail parties than Investor A. Our hare (B) gets to brag about the huge returns in year one, while the tortoise (A) tries his best not to discuss his portfolio. Arithmetically, our hare ends up with a 5% annual average return (up 50% and down 40%). Our poor tortoise averages only 1% per year (up 10% and down 8%).

The hare, unfortunately, has only $90,000 of his original $100,000 investment left after year 2. Perhaps his excitement was worth $10,000 but we are not that interested in excitement here at Capstone. The tortoise has $101,200 to show for his investment. He averaged less arithmetically, had less excitement, but saw the return of his principal along with a small return on his principal.

When the odds of favorable outcomes are heavily on your side, it may be better to be a hare. When the odds are more neutral or against you, think hard about being a tortoise. The tortoise can make a bit of money in a turbulent environment while the hare loses his.

The debate rages on. The rise in stock this past year has caused the buy and hold folks to peak up from their gopher holes. They are once again touting their strategy (or is it the ultimate lack of strategy?). So, knowing that buying and holding the S&P 500 for the past decade was a very poor strategy, I decided to look back on an even more humorous concept, The Money Magazine list of 10 stocks to “buy and forget” for the last decade that they published in 2000.  A quick look at how we fared by buying and forgetting:

Stock                                       Price in 2000                          Price 12/31/2009

Nokia                                      $54                                          $12.85

Enron                                      $73                                          AARGH!!

Nortel                                      $77                                          $.002 (Wow!)

Oracle                                      $74                                          $24.53

Broadcom                               $237                                        $31.47

Viacom                                    $69                                          $31.50

Univision                                 $113                                        *(36.25)

Charles Schwab                      $36                                          $18.82

Morgan Stanley Dean Witter  $89                                          **$29.60

Genentech                               $150                                        ***(95.00)

• *Purchased by Broadcasting Media Partners in April, 2007 for $36.25 per share
• **Does not include value of Discover spinoff (not enough to avoid losing $$)
• ***Purchased by Roche in March 2009 at $95 per share

So, our version of the old joke- How do you become a millionaire investor? Subscribe to Money Magazine, cling to the buy and hold philosophy through thick and thin, have a 10 year time horizon, and……start with at least $4 million dollars!!!

Maybe take those buy and hold recommendations with a grain of salt???