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Friday, September 24, 2010

Stock picking is dead; long live stock picking!

As human beings, we have a tendency to look backward instead of forward. 

Psychologists have illustrated this tendency with experiments demonstrating hindsight bias and recency bias.  Nowhere does this seem more evident than with respect to economics and, particularly, the stock market.

As support, see the Wall Street Journal's article today: 'Macro' Forces in Market Confound Stock Pickers

The article's point is that stock pickers, with a few exceptions, have not shined brightly in their performance over the last couple of years as macro-economic "forces" have over-whelmed stock picking ability.

Fair point, but only if we drive best by looking through the rear-view mirror instead of the windshield.

It's true, gold, U.S. Treasuries and cash did best over the last two years.  It's true, too, that bonds and cash have beat stocks, as a whole, over the last 12 years. 

But, that's history, not the future.  As Warren Buffett put it, if the past were the best guide to the future investments, librarians would be the billionaires.  They are not.

I couldn't help but chuckle at the title of the article, too.  Confound.  CONFOUND!  The word means overthrow, defeat, ruin according to my Oxford English Dictionary. 

Not a reference to short term under-performance; not a temporary set-back that may reverse; not in contradiction to all financial history; but, confound! 

Isn't this from the same popular press that said Warren Buffett was washed up in 1999 because he didn't "get" the Internet?  Aren't these the same folks that fawned over the housing boom and how home prices could never go down?  Check, and check.

And, now, they've pronounced stock picking is ineffective, done, washed up.  To me, that sounds like an excellent reason to bet that stock picking is about to come back in a major way.

Remember, the popular press called for the Death of Equities in 1979, just 3 years before the greatest, 20-year bull market in history. 

It may not happen tomorrow, or even the day after, but a headline like that leads me to believe that stock picking is about to experience a renaissance.

Stock picking is dead.  Long live stock picking!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 17, 2010

Manic-Depressive Mr. Market

Benjamin Graham, Warren Buffett's mentor, had a wonderful parable for thinking about the stock market.  He called it the parable of Mr. Market:
"Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."
"You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings..." (Graham, The Intelligent Investor, 1973)
The market has been particularly manic-depressive lately, and this has reminded me of the parable of Mr. Market.

One day, the market seems to foresee another recession on the horizon--the market sinks as investor sentiment tanks.  Another day, the market foresees an economic boom on the horizon--the market leaps and investor sentiment soars.

Is the data really that self-contradictory, or is the market just that short-sighted.  I believe the latter.

Much economic data, like unemployment claims, housing market numbers and income growth, indicate an economic slowdown.  Not a recession, mind you, just a slowdown.

Other economic data, like railroad traffic, commodity prices and industrial capacity utilization, indicate an economic expansion.  Not a boom, per se, but an expansion.

Mr. Market, in his manic-depressive way, takes these data points as signs of a collapse or boom.  As a result, market commentators have referred to the stock market's reaction as risk-on/risk-off.  It's either one or the other, and nothing in between.

What is the reality?  Not too surprisingly, given the data and my build-up, something in between.  The slowdown could turn into a recession, but hasn't, yet.  The expansion could turn into a boom, but it isn't at present.

Mr. Market should be more sober-minded and focus on the long term instead of the short term.  There is neither reason to dive for cover nor party like its 1999 (can you tell I'm about to turn 40?).

Given the data and a long term view, it is best to be cautiously optimistic.  The market is mildly over-valued, but nothing like it was in 2000 or 2007.  In fact, long term returns look promising, especially when compared to bonds or speculations like gold. 

Mr. Market needs to take a chill-pill, relax and take a deep breath.  Lucky for sober-minded investors, he probably won't, and this will provide ample opportunities to exploit Mr. Market's manic-depressive tendencies.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Thursday, September 09, 2010

Price paid = returns reaped

Investing has to be one of the worst fields for excess noise.

Currently, most people are focused on the short term versus the long term, inflation versus deflation, macro-economy versus micro-economy, developed versus emerging markets, bonds versus stocks, fiscal versus monetary policy, stimulus versus cost-cutting, etc. 

The list goes on and on. 

But, almost all of that is noise.  As far as your investing and financial future are concerned, what matters is the price you pay today.

In the short or long run, whatever you invest in will be at some price in the future and will have yielded some interim cash payments.  If you pay too much for it now, you'll get a poor return.  If you pay a cheap price, you'll reap a good return.  That's it.

All the factors I highlighted above may influence that outcome, but it's mostly noise, because what you pay for an investment now will determine your return in the future much more than the rest.

This is a simple concept to grasp, but hard to execute.  It's easy to get distracted by the noise.  I get distracted every day by it--sometime several times a day!

Let's take the stock market as an example.  With the S&P 500 at around $1110, you'll get a 6%-like return over the next 5 years.  If you paid the $1023 it was selling for in early July, you could expect at 8%-like return over 5 years.  If you paid the $1217 it traded at in late April, you could expect a 4%-like return over 5 years.

The price you pay now determines your return later.

Emerging markets are growing faster than developed markets.  But, emerging market prices reflect that fact, so the price you pay now determines your return.

Apple is growing like a weed.  But, Apple's price reflects that growth, so the price you pay now will determine your future return.

If you pay too much now, you won't get your desired return.  If you pay a cheap price now, you're return will be satisfactory.

Ignore the noise.  Ignore the crowd.  Focus on price paid relative to value received.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 03, 2010

Is Deflation Really That Bad?

People in the financial world don't have nightmares about werewolves or falling off a cliff, they wake up in a cold sweat crying out one bone-chilling word: "Deflation!"

Ordinary (or should I say normal?) people don't suffer from this affliction.  In fact, I'd dare say most people don't even think of the word deflation, much less dream about it.

However, to those in the financial world, whether investors, economists, accountants, or central bankers, the word deflation conjures up visions of the Great Depression and Japan's Lost Decade (it's been 2 decades, actually, but it's always referred to as 1 for some reason).

Is deflation really that bad?  It all depends on what you mean by the term.  For some odd reason, the term refers to two very different things.

One refers to the end of a credit expansion that ends in debt defaults, bank failures, and tremendous and long-lasting economic collapses.  That's the nightmare one.

The other thing deflation refers to is when money supply doesn't keep up with economic growth.  In my opinion, this one isn't bad at all. 

Can you imagine what life would look like if the cost of goods went down by 3% a year instead of up 3% a year?  Would you really have nightmares if the cost of computers, cars, TV's, food, clothing, etc. went down each year?  I don't think so--everyone loves a sale!

And yet, this is why people get so confused, because deflation refers to two entirely different things.  Can you imagine going to the grocery store and seeing hamburgers labeled "Rat Poison"?  You know hamburgers aren't poisonous, but the label would definitely throw you off.  The same is true with the word "deflation."  It refers to something yummy like a hamburger, and at the same time something terrible like rat poison.  No wonder people fear deflation.

Historically, deflation (the good kind) got a bad name in late 1800's United States.  After the Civil War, the U.S. experienced years of declining prices as the government worked to get its finances back in order and U.S. currency back on the gold standard.

It was great as long as you hadn't borrowed lots of money.  This was a boom time for railroads and manufacturing industry like Carnegie Steel.  If you owned stock in James J. Hill's railroad, the Great Northern, you received 8% dividends that bought more and more stuff each year, plus you benefited from the railroad's growth! 

The cost of things were going down because the U.S. economy was becoming more productive.  It was great unless you owed debt.  Debtholders hate deflation because it means they must pay back loans with dollars worth more each year.

This was especially painful for marginally profitable farmers.  Industrialization had made farming more productive, which meant marginal farmers couldn't break even.  They borrowed to try to keep up with productive farmers, but this just created new problems.  You can't pay back loans or farm profitably if the value of the corn you produce is going down faster than the debt you owe. 

So it is with every technological advance.  I'm sure caveman Ug was put out of the hunting business by caveman Thug who invented a new, more effective spear.  Such is the way of the world.

This industrial/technological/economic shift led to the populist movement and William Jennings Bryant's "cross of gold."  But, none of that helped the poor farmers who needed to find economical work.  Eventually, they went to work in factories and a new boom occurred.

But, the legacy of deflation as a bad thing lived on.  The very vocal minority of unprofitable farmers (and especially their political demagogues) made enough of a ruckus that deflation has a bad name to this day.

Next time you wake up in a cold sweat dreading deflation (not very likely, huh?), just reflect on which type you dreamed about--the hamburger, or the rat poison?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.