Market strategist = diaper

One of my favorite Wall Street jokes: How is a market strategist like a diaper? They both need frequent changing and for the same reason.

So, why are market strategists full of…um…stuff?  Because timing the market is a waste of time. 

Each year prognosticators try to guess where the stock market will go over the next year, and almost every year they are off by a mile.  This is more likely to be the case in 2011 because almost every market strategist is bullish.  The only thing worth less than a market strategist’s prediction is a group of market strategist’s predictions–especially when they all agree.

Why are market predictions so inaccurate?  Because the things that most impact market returns over a given year are also almost impossible to predict: 

  • Will North Korea lob nukes at South Korea? 
  • Will Israel attack Iran’s nuclear facilities? 
  • Will bond markets abandon Japanese, European and U.S. bonds en masse driving up interest rates? 
  • Will the European Union fall apart? 
  • Will the world economy continue to recover at its current pace? 
  • Will China engineer a smooth or crash landing in an attempt to slow inflation and real estate speculation? 
  • Will U.S. unemployment dive from 10% to 5%?
  • Will drug companies discover a cure for cancer?
  • Will accurate prediction cease being an oxymoron?

None of these thing is strictly predictable, but if any of them occur (except that last), they’d have a huge impact on markets.  You’d have better luck trying to predict earthquakes and hurricanes (things entirely deterministic and yet experts almost never get annual predictions right).

So, why do people crave such predictions?  Because we’d all like a sure thing.  Wouldn’t it be great to have next year’s newspaper and know exactly what stock prices would be a year from now?  We’d all love it, and the entertainment factory that is called news sells tons of advertising each year knowing we’d all love those answers.

But, those answers are worth what we pay for them–nothing. 

Instead of reading the horoscope in hopes that we’ll be lucky today, we should get to the daily grind of making things happen for ourselves. 

That’s what I’m going to do: resist the temptation to read or make predictions, and instead do research on good investments at cheap prices.  There’s a new year’s resolution that works.

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.

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Market strategist = diaper

Prudence: pitiful performance persists in 2010

Markets move in mysterious cycles that no one can predict with accuracy.  For several years value beats growth, or large companies beat small, and then the trend reverses.  Markets are one of the most mean reverting data series known to man, so you always know such trends will reverse, but never precisely when.

2010 was a particularly frustrating year to wait for trends to reverse, especially for those who were prudent. 

2009 was an understandably great year for junky versus prudent investments.  Junk had tanked in 2008 and prudence had dropped little, setting up a spectacular rise for junk in 2009 versus a mundane rise for prudence.  Once the government vowed to support any company large and imprudent enough to be in severe trouble, junk’s star was destined to be born.  It was in 2009. 

However, junk’s stardom seldom lasts because investors become understandably nervous as junk’s star gets too high.  I naively expected investors to become nervous in 2010, but was in hindsight much too early.  A quick look at the data (from Bespoke) highlights my naivete.

Companies considered junk by the rating agencies rose 19% in 2010.  Double-A and above rated companies returned a mere 6%.  2010 rewarded this form of imprudence with 3.2x the return.

The most expensive tenth of stocks, as measured by price to earnings ratios, returned 23% in 2010, versus 8% for the cheapest tenth of stocks.  Once again, 2.9x the return for jumping into junk instead of piling into prudence.

Buying the top tenth of stocks most sold short (where short sellers expect to profit from price declines) returned 26% versus the 17% performance earned from the bottom tenth with the least short sellers.  It was a mere 53% better to bet on this particular form of imprudence.

Investing in cyclical companies, those most impacted by economic cycles and thus hardest to predict, returned 25% against 11% for the non-cyclicals that perform regardless of cycles–2.3x better to hope instead of plan.

Finally, small companies (small ships are more easily toppled by storms than large ones) beat large 24% to 11% in 2010, giving those who bet the trend was their friend a 2.2x edge over those who expected trend reversal.

My naivete was on prominent display in 2010, but I’m not bitter.  I find solace in the certainty that markets mean revert.  Plus, I’ve been given the opportunity to buy prudence at even lower prices. 

Will 2011 be my year of redemption.  I don’t know for certain, but in the choice between junk and prudence, I can’t say I’m even remotely tempted to follow the junky crowd of 2010.

Thank you for reading my blog, and may you have the Merriest of Christmases.

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.

Prudence: pitiful performance persists in 2010

Two areas of concern for markets…

When everyone is bullish about the economy and markets (including yours truly), it’s time to look at page 16 news. 

Page 16 news is important, but doesn’t seem important enough–yet–to make it to the front page of the newspaper.  By the time a piece of news hits the front page, it’s already priced into markets.  One should look at page 16 news to know what hasn’t been priced into markets (hat tip to Donald Coxe).

What important news is on page 16 and should be on page 1?  1) Long term bond prices have been dropping hard and 2) oil prices are steadily rising to high levels.

Despite the Fed’s efforts to drive short and intermediate term interest rates lower, long term rates have been rising (yields rise when bond prices fall).  This is important because long rates reflect the market’s assessment of inflation, and because long rates impact meaningful borrowing rates, like mortgages.

The yield on 10 year Treasury bonds have gone from 2.4% to 3.5% over the last 4 months.  That’s a roughly 9% decline in the price of a 10 year bond.  During this same time, the stock market has rallied almost 20%.  As I’ve said in this space before, bond and stock prices should not be moving in opposite directions over the long run.

(Geek’s note: stock prices reflect cash flows discounted over time.  I’m willing to pay $0.91 for $1 of earnings a year from now if I want a 10% return.  That 10% desired return is the discount rate and the $1 I get a year from now is the cash flow.)

Stock prices should reflect long term bond yields.  All things being equal, when long term bond yields rise from 2.4% to 3.5%, this higher discount rate should drive down the price of stocks by over 30%!  Now, as you may have guessed, all things are never equal.

Some believe stock prices are rising and bond prices are tanking because investors are more optimistic about the economy.  I disagree with this position.  Long bond yields rise because of inflation, and inflation is bad for stocks.  Bonds and stocks tanked in the 1970’s as inflation fears rose, and rallied strongly in the 1980’s and 1990’s as inflation fears shrank to nothingness. 

Bond prices do rise and stocks tank when deflation is the fear, as has been the case during the last decade.  But, bond prices tanking and stocks flying because investors are optimistic about the economy?  I can’t think of any historical examples to support that.

Keep in mind, too, that long bond yields also impact mortgage rates.  If long bond yields are going up, so are 30 year mortgage rates.  How exactly is giving an already disastrous housing market an additional headwind of higher priced mortgages supposed to be good for stocks and the economy?  I can’t think of a good reason.

The spike in bond yields may be a temporary phenomenon, and that is my guess about what’s happening.  If bond yields come back down below 3%, that would seem to give the all-clear signal for stocks (at least, for a while).

The other page 16 news is oil prices hovering around $90 a barrel.  The last time this happened, in late 2007 and early 2008, the U.S. economy was entering recession. 

Higher oil prices lead people to consume less.  It tends to act as a natural governor on the economy–when energy prices spike, it tends to slow the economy.  Oil prices impact heating costs, travel costs, grocery costs, pretty much everything.  And, if you have to pay more for those things, you don’t have money left over to buy that new electronic gadget you’ve had your eye on.

Just as long bond yields declining would give the all-clear signal for stocks, so would be declining oil prices (below $80 a barrel). 

But, as long as long bond yields spike and oil prices keep rising, bad news is brewing for the stock market and economy. 

I don’t have any illusions that I can predict such events, but I will be watching with great interest to see what happens.  If long bond yields and oil prices hit the front page, it’ll be too late to do anything but cry in your beer.

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.

Two areas of concern for markets…

The Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I’ve always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed’s mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan’s last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won’t boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That’s because most people haven’t been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won’t create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don’t the people at the Fed possess such common sense?

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.

The Fed wants MORE (?!) inflation

The wall of worry

It should be obvious by now–I’m not much of a short-term market prognosticator.

I can predict 5-10 year returns with a fair bit of accuracy, but I’m terrible over the next day or year.  Fortunately for me, the long run is what matters.

If you’ve read my blog posts over the last 6 to 9 months, you know I’ve been overly pessimistic about both the economy and the stock market.  Whereas I saw trouble brewing in Europe, China, and Japan, and poor U.S. employment and growth, things didn’t turn out that bad.  In fact, things are looking decidedly more upbeat of late.

Which brings me back to my title: “the wall of worry.”  It’s an old Wall Street saying that a bull market climbs a wall of worry.  If everyone is optimistic, big market gains are unlikely because everyone who will buy has bought.  In contrast, when some or many are pessimistic, the market has room to run if and/or when the fundamentals prove the doubters wrong.

I was a doubter, and the market climbed the wall of worry–right over my head, in fact.

But, that was yesterday, and to generate good returns over time we must focus on the future.  Is there currently a wall of worry for the market to climb over?

I think there is.  First, there are still plenty of doubters.  Several very intelligent market mavens with excellent long term records continue to forecast storm clouds ahead.  Perhaps it will be their turn to be stepped over. 

Second, look at the news and you’ll see Korea on the brink of war, China trying to slow down its economy, Europe’s peripheral countries in fiscal shambles, rising unemployment in the U.S., etc.  Bad news is frequently the wall of worry markets must climb. 

There are plenty of worries and worriers to clamber over, still. 

That doesn’t mean the market will necessarily rise, or stay flat, or climb (did I miss any possibilities?).  What it does mean is the market could continue climbing, and part of what can and may fuel that rise is the many concerns and few doubters out there. 

The short term may look okay, but the long term isn’t quite so sunny.  By my estimates, the S&P 500 is likely to return 4.1% annually from its present 1220 price over the next 5 years.  That projected 22.25% cumulative rise may be a steady 4.1% a year, but it’s much more likely to be more volatile.  For instance, the market could rise 20%, then tank 50%, then rise 103.75%.  Any way you slice it, though, 4.1% isn’t a huge annual return, and trying to time the market to sell at the top and buy at the bottom is a fool’s errand.

The short run (next year?) doesn’t look too bad (though my poor short run prediction record should now be scaring you). 

After that, the check will come due.  I don’t know when or how that will happen, but I’m preparing by buying investments that I think can solidly beat that 4.1% annualized return, regardless of how bumpy the path may be.

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.

The wall of worry