All eyes on China

Most investors are focused on Europe, but they should be focused on China instead, because what happens in China is likely to have a greater impact than what happens anywhere else.

There are many candidates for focus next year.  The one that makes all the headlines is, of course, Europe. Its economy, as a whole, is still the largest in the world, after all. If that economy collapsed, or the European Union came apart, or the currency union changed dramatically, then it would, without doubt, impact the global economy. But, a lot of what’s happening in Europe is already discounted in market prices. News on the front page is rarely a big mover of markets because markets anticipate change more than react to it. And, although Europe’s economy is large, it doesn’t contribute much to global growth. There’s a small chance that Europe is the big mover of markets next year, but I doubt it will be.

Japan is a dark horse that may have a big impact on the global economy next year. Its economy is still #4 behind Europe, the U.S. and China, but hasn’t grown in 22 years. The issue from Japan isn’t earthquakes or tsunamis, but debt. Japan is the most indebted country in the world if you compare its overall debt to the size of its economy. The amazing thing is that they pay the lowest interest rates in the world on that debt. The reason rates are so low is that the Japanese are so willing (and compelled) to buy Japanese government debt. When retirees start to outnumber savers, though, Japan will have to start raising debt at much higher interest rates. If markets start to anticipate that inevitable transition next year, Japan could be the big mover of markets. I doubt it will be, though, because I don’t think that crisis will come to a head for another couple of years.

The Middle East is, as always, another dark horse that could greatly impact global markets. Although the Arab Spring is making the headlines, the greater concern involves ancient rivalries between Arabs and Persians, and between Iran and Israel. If Iran succeeds in creating unrest between Shia and Sunni on the Arabian Peninsula, or if Israel becomes increasingly worried about and takes action regarding Iran’s nuclear program, then oil prices will rocket and the global economy will tank. Like Japan’s issues, these are unlikely to come to a head next year. But, unlike Japan’s issues, the Middle East is unlikely to face an inevitable conclusion in the short to intermediate term.

The good old U.S. of A. is another place to focus next year. It’s an election year, so many both inside and outside North America will be curious to see how our political field changes and how that could impact the global economy. The U.S. economy is huge, but is growing so slowly that it has less impact on the global economy than it did five or ten years ago. In my opinion, our political transition is unlikely to change things much, so I doubt it’ll have a big impact on markets. Not only is Congress unlikely to tackle our debt issues during an election year, but the Fed is also running low on monetary ammunition.

China, I think, is the most likely candidate to move markets next year. It is both the world’s 3rd largest economy and the fastest growing. It is also the biggest supplier of goods to Europe and the U.S., the 1st and 2nd largest economies. It has a huge impact on emerging market growth, too, because so many emerging economies supply China with the raw materials and other inputs that fuel their manufacturing powerhouse. In 2013, China is going to go through a major political change (every 5 years, there’s a major changing of the guard) that’s likely to be anticipated by markets in 2012. At the same time, China is trying to tamp down high inflation and an overly-exuberant real estate market. Add all these factors together with a bunch of global investors over-focused on Europe, and you have a high probability that China is the one moving markets next year.

I’m not alone in doing this, but I’m watching with great interest what happens to oil and copper prices and on the Shanghai Stock Exchange. Oil futures (which are high, but not outrageously so) seem to be reflecting concerns in the Middle East more than growth in China or emerging markets. Copper has fallen over 20% since last spring, but has not yet declined to global recessionary levels. Shanghai, like copper, has been falling since spring, and is down at levels last seen in the spring of 2009, when U.S. markets were hitting bottom.  

I don’t really know what will happen in markets next year, but I’m watching China with greater interest than Europe. If China tanks, the world economy will follow; if China thrives, markets are likely to do much better than expected. 

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.

All eyes on China

"Where’s the market going next year?"

Some people love to ask questions they don’t really want an answer to.

When people find out I’m a professional investor, they frequently ask where I think the market is going next year (especially in December). Having no ability to read minds, I assume their question is sincere and I launch into a description of what I do and don’t know. About one-eighth of the way into my overly thorough explanation (I tend to talk too much), I can see their eyes glaze over as they imagine themselves someplace more pleasant…

Having gone through this routine hundreds of times over the last ten years, I’ve learned that most people don’t really want an answer. I don’t know if they are making polite conversation, or if they want me to express a certainty no human possesses, but I get the impression they’d really like to hear me say, “up, Up, UP!!!,” or “sell everything and buy gold!” But, I have the dual problem of being brutally honest (just ask my wife) and overly verbose, so they end up quite disappointed.

If you really don’t want to know what I think, or if you desire precise descriptions about the future, then please feel free to let the mental fog drift in, and imagine yourself on a sunny beach with an adult beverage of your choice…  

If, however, you’d like my opinion, please read on.

Sorry, but I really don’t know if the market will go up or down next year (for a longer term assessment, see below). No one else does, either, so this isn’t a matter of professional negligence on my part, but the nature of the beast. There are no short-cuts to building wealth any more than to getting an education, losing weight for good, pursuing a worth-while career, or building fulfilling relationships.  

Stock market returns include three parts: 1) dividends, 2) earnings growth, and 3) crowd psychology.  Dividends and earnings growth tend to be relatively stable and are easy to predict over the intermediate to long term (3+ years). Crowd psychology, however, isn’t at all predictable and tends to completely overwhelm the impact of dividends and earnings over the short run.  

Anyone who says they can predict crowd psychology a year in advance belongs in a circus side-show, or on Wall Street as a strategist (the latter pays much better than the former, just in case you’re weighing the options). And that’s why no one, not even brilliant people with decades of experience and multiple degrees from esteemed institutions, can tell you where the market is going next year.

Sorry to disappoint you, but it can’t be done.  

If, however, you’d like to know what kinds of returns to expect from the stock market over the long run, then I do have something to say. For, crowd psychology tends to dampen out over time, thus regressing to the mean.  Because this tends to occur over several years, it is possible to make reasonably accurate assessments of long term returns.

On that score, I’m likely to disappoint you, too. I think the S&P 500 will return around 3.5% to 6.5% over the next 5 years.  That includes dividends, earnings growth (including inflation), and a regression in crowd psychology back to the mean (I include 6 year projections each quarter in my client letters, which can be accessed here).

How can I expect such modest returns even though the market has gone nowhere for 11 years? It all comes back to crowd psychology. People tend to go from greed to fear and back again over long periods. There are long cycles of 15 to 20 years with several smaller 3 to 7 year cycles along the way.  

For example, in 2000, people were euphoric. Then their hopes were dashed into 2003, but not completely. They became greedy again in 2007, but not as much as they were in 2000.  Those happy feelings were shredded again into 2009, and this time people became even more depressed than in 2003, but not completely despondent.

Before we get to a long term market bottom, we’re very likely to get to the completely despondent point. That could result in a flat market for the next 5-10 years, or a cataclysmic crash and then gigantic boom over the same time period. I don’t know because of that predictability-of-short-term-crowd-psychology thing. Historically, it’s more likely to be bust then boom, but who knows?

What I do know is that down cycles like the one we’re experiencing end, and are followed by up cycles. Everyone would like to know the timing of such events, because you could make a fortune timing it perfectly, but no one does.  

I will offer a warning that it won’t be fun when the down cycle ends. For starters, the news on the front page will look terrible. No one will want to invest in securities.  Stocks will sell at very low prices relative to historic dividends and earnings. Articles will appear saying that stock investing is dead. At that point in time, when you’ll want to run screaming from the room, is when a new bull cycle will begin.  

That’s also why I’m not trying to time the cycle. I’m almost fully invested and plan to remain that way. Why?

First, its impossible to pick the exact bottom, so anyone trying to do so is likely to miss it and think it’s still in the future. By the time they realize it’s in the past (which can only be demonstrated with hindsight), they’ll have missed a huge part of the up-side.

Second, remaining invested will allow me to generate slightly better returns than the market through the down-cycle. This may sound like a foolish endeavor (like catching a falling knife), but beating the market by even 3% a year over the down-cycle means I’ll start the up-cycle with 65% more money than I otherwise would. That’s a much nicer place to be than guessing about about market bottoms when the world is in total panic (remember 2003 or 2009, when people truly thought there was no bottom in sight?).  

I do have a view on the market, but it’s not for the next year, and it’s dour for years, then very profitable after. The problem is: most people don’t want to hear that.  

That’s okay, I need someone to buy from and sell to over the cycle.  

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.

"Where’s the market going next year?"

Ducking thunder

It’s hard not to feel a bit shell-shocked by current events. Each piece of bad news makes a person want to duck and cover until the storm passes. Although I understand this feeling and can sympathize with it, I don’t think it’s constructive.

When you hear a loud clap of thunder, it’s hard not to duck. The problem is that by the time you’ve heard the loud noise, it’s much too late to do anything about it (not that ducking would help anyway). The danger is long past and you’re just reacting instinctually and uselessly at that point.

The same is true in financial markets. Unless you’re a professional trader working at one of the world’s financial centers, by the time you hear the bad news it has long ago been reflected in security prices. Whether it was Baron von Rothschild 200 years ago or instantaneous computer trading today, you and I are not going to benefit from trading on the news.

That doesn’t mean we can’t interpret the news more intelligently and act on it in the fullness of time, but thinking that we can duck and cover at the sound of thunder is total folly.

This reminds me of my experience in pilot training. Not surprisingly, you don’t want pilots to panic or freak out when an emergency occurs. Our human instincts don’t serve us well in the cockpit, so they train pilots through repetition–in a full-motion simulator–to keep their cool in emergencies and successfully deal with problems.  

We called it “dial-a-death” because the instructor pilot literally had a dial where he chose the emergency you were to handle. The first several times you were given a tough emergency, it was hard not to freak out, but over time you could learn to keep your cool even under the toughest of circumstances. For me, the key was to breath deeply and get very focused on properly diagnosing the problem and then meticulously taking corrective action. If you sat there thinking about the consequences and how worried you were, you were doomed.

I think this analogy is perfect for financial markets, too. We need to be ready for emergencies by preparing ourselves mentally. We need to expect things to go wrong instead of hoping, uselessly, that they won’t. We need to know how to act when things go wrong so our instinctual desire to duck is suppressed and we do what we know we need to do. We need to focus on controlling the things we can control instead of wishing we could control the things we can’t.

How do we prepare for financial emergencies? Go into the situation with your financial house in order: 
  • spend less than you make
  • save the difference (pay your future self, first)
  • invest your savings wisely (by being prepared for both good and bad market conditions that you know will happen, but not when)
  • have enough cash at your disposal to handle life’s inconveniences
  • get enough insurance
  • set up an estate plan  
Also, know what not to do: 
  • panicking won’t help
  • don’t assume see can see bad financial conditions coming (don’t worry, no one can consistently)
  • don’t assume that bad times won’t come
  • don’t believe you can “go to the sidelines” until the storm is over
  • don’t try to time when to get out and get back in (you will almost always do both way too late)
  • don’t inundate yourself with bad news that makes you want jump out a window (good pilots don’t stare at burning engines, they focus instead on putting the fire out)

If you’re more opportunistic (and this is clearly not for everyone, just like flying airplanes), be ready to benefit from others’ panic. Be ready to sell your safest holdings and buy what the panicky sellers are abandoning recklessly. Financial panics are always the best time to invest, and precisely when your instincts most desire to seek cover.  

Just like pilots can learn to handle terrifying emergencies, you can learn to handle and profit from financial panics. Be prepared, have a plan, take deep breaths, and don’t try to duck–it’s already too late.  

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.
Ducking thunder

Why I’m all about value

Investing in glamorous stocks generates lousy returns; investing in out-of-favor, unloved and even hated stocks generates great returns. And, that’s why I’m all about value.

The return from investing in stocks can be roughly broken into two parts: 1) how a company does, which is what almost everyone focuses on, and 2) investors’ general attitude toward a company.

Most investors, whether individual or professional, focus almost exclusively on #1. They look at growth, sales, profit margins, competitive positioning, return on capital, new products, distribution, marketing, etc. Don’t get me wrong, this is vitally important stuff. But, it’s only half the picture.

Just as important is investor perception. When a company is loathed, its price reflects that fact. People sell investments they loath. They don’t want to talk about such investments at cocktail parties. Most of all, they don’t want to try to explain why they’ve bought something unpopular.  

When a company is loved, its price reflects that fact, too. People buy investments they love. They’re excited to talk about such investments at Christmas parties and how they are going to make a fortune. With these investments, people enjoy explaining why they bought it, and how much money they’ve already made (sometimes including all the relevant facts).

But, loved companies aren’t as good investments as those that are loathed. The reason is simple: it’s in the math.

Loved companies sell at a high price relative to underlying fundamentals. All those people who love a company buy it, and that drives its price up. Loathed companies sell at low prices to underlying fundamentals. Everyone who hates it sells it, and its price reflects that.

If all that mattered were the fundamentals, then loved companies would almost always out-perform loathed companies. But the math of returns reflects both fundamentals and the price paid for those fundamentals.

Perhaps a theoretical example will better illustrate my point. Say two companies, Loved and Loathed, both make $1 per share in earnings.  

Loved is growing at 15% per year. Because everyone loves Loved, they pay a high price for it: $30 per share, or 30 times earnings (this is not unusual, Apple sells at 15x, Google at 20x, and Amazon at over 100x!).  

Loathed, on the other hand, isn’t growing at all. Because everyone loathes Loathed, it sells at a very low price, or 5 times earnings (think Merck after Vioxx, or BP after Mecando).  

Now, what happens going forward?  

Even supposing Loved can maintain 15% growth for five years, people eventually become less excited about it. They know such high growth can’t last forever, and a fad eventually becomes boring to those excited about the newest thing. As the saying goes, ardour cools.  Instead of being willing to pay 30 times earnings, investors are only willing to pay 20 times earnings (still a very generous premium). Over five years, earnings per share will have doubled, but stock price will only go up 33% ($2 earnings per share times 20, $40 on a $30 investment is a 33% return).

Loathed, on the other hand, continues to be a dog. It doesn’t grow at all over the following five years. In contrast to Loved, everyone who hates Loathed has already sold it and gets bored with hating it over the following five years. When investors become surprised that Loathed doesn’t go out of business, the price starts to recover. Although Loathed earns the same $1 per share it did 5 years earlier, people are eventually willing to pay 10 times earnings for a no-growth business. Over five years, Loathed returns 100% ($1 earnings per share times 10, $10 on a $5 investment is a 100% return).

My example above may seem contrived, but that’s how things really work out. There are countless research papers from Fama and French, to James Montier, to David Dreman supporting my contention. Or look at the investment records of Warren Buffett, Walter Schloss, Robert Rodriguez, O. Mason Hawkins and Wally Weitz.  

If you think this is a smooth ride, think again. It’s no fun owning Loathed. People will think you’re nuts (believe me, I know). Almost no one will want to talk to you about investing–especially at cocktail or Christmas parties. But, it pays very well.  

Making this approach even tougher, investing in value goes out of favor for long periods of time, too. Value grossly under-performed from 1995 to 2000, before dramatically out-performing from 2000-2005. Value has gain been out of favor over the last six years. C’est la vie!

It may look ugly, be unpopular, and under-perform for long periods, but value investing works by capitalizing on investor perception. That’s why I’m all about value. 

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.

Why I’m all about value