In praise of recessions

Parenting is simple, but not easy.

What I mean by that statement is that it’s not hard to figure out what to do as a parent (simple), but it’s frequently difficult to implement in practice (not easy).

Little Vivian wants a glass of apple juice, but it’s an hour and a half before dinner and she’d prefer to drink apple juice 24/7 rather than eat any solid food–ever! 

I have a choice: I can give her the apple juice she so much desires and worry she won’t eat the food she needs, or I can give her some non-apple-juice options to make sure she’ll be hungry for dinner.

It’s easy to give her the apple juice, right?  But, will it result in the long run outcome I want?  Probably not.  So, I offer her water and tell her she doesn’t want to ruin her appetite for dinner.

The first several times I provide this option, Vivian–like any self-respecting 3-year-old– breaks down in tears.  Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you’ve ever seen (not easy).

I know the right option (simple), but I dread the implementation (not easy). 

After 3 iterations of this process, though, Vivian no longer breaks down and cries.  She expects this outcome and goes about her life quite happily knowing she can’t have what she wants whenever she wants it.

And so it is with the economy, too.  Knowing human nature, it’s easy to see that people take things to excesses at times.  Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren’t necessarily best for their long term well-being.

Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do.  Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.

It’s easy to understand this process is necessary, assuming you understand human tendencies (simple), but it’s unpleasant (not easy) to watch the resulting pain inflicted.

I’m not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears.  But, I must consider the alternative.

If we try to prevent recessions, is the long term outcome better or worse?  Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems.  And, so it is with recessions.

Preventing recessions leads to a build-up of bigger and bigger problems.  Periodic purges prevent major disastrous purges.  If you don’t believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan’s lost decade.

In each case, political intervention was intended to keep the economy on stable footing.  The hope was to prevent short-term pain, but with little regard for long term consequences.

I think an analogy to nature here is useful.  A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan’s Ubiquity for more information).

At first, experts were bewildered at the damage and what could have caused it.  Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable. 

In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn’t have even been possible without preventing small fires.

I believe the same thing is at work in the economy.  Small periodic recessions are good for purging the under-growth of our economic forest.  Without such small recessions, a super-critical state is created.  The attempt to prevent small recessions is the cause of large, disastrous ones. 

And so, I praise small periodic recessions as the necessary prevention for big, terrible ones.  It’s time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary. 

It’s time for the parents to say no to the kids who want something that’s bad for their long term well-being.

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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In praise of recessions

It’s normal to worry, but this is not the time to panic

Below is a slightly altered version of an email I recently sent to clients:

Dear Clients,

As you’ll see next week, my client letter was written at quarter end and doesn’t address recent market volatility. With that in mind and considering the recent market drop, I decided to throw together a quick email to all clients giving my opinion of what is happening and what my response is.

I’ve summarized my thinking in quick bullet points for those short on time or not as interested. Then below, I go into more detail on each point for those who want more info. Finally, my intent is to try to answer your questions as well as I can and to get a dialogue going if you are concerned. Please feel free to contact me at any time if you want to talk to me about what is going on. I will be available or quickly return your calls. This is a stressful time, and I’m here to answer your questions.

1. It’s natural to be worried, but panic selling now will lead to regret in the long run.
2. Historically, this decline is not out of the ordinary.
3. I believe recent government action will work, although it will take some time and it will lead to higher inflation in the long run.
4. It’s not possible to time the market, so trying to sell now and buy at the “bottom” almost always leads to worse results than holding on.
5. The market is throwing the baby out with the bathwater.
6. Our underlying businesses are strong even though their prices are going down.
7. This is a historic time to invest!
8. One of the reasons you hired me is to let me worry about the market for you. That’s what I’m trying to do for you now.

Now, the details.

1. It’s natural to be worried, but panic selling now will lead to regret in the long run.

Being worried is normal–I’m having no fun watching your and my portfolios decline. It’s easy to anchor on recent market tops and expect the highs to continue–there was a lot of media coverage about the Dow hitting 14,000 this time last year. People are panicking because they are scared, but reacting by selling is the worst investment plan and will lead to tremendous regret when the market does rebound. Temporary highs and lows can make you feel better and worse than you want to. The market swings up and down dramatically, so it’s best to focus on longer term averages. A wise person once said that courage is not the lack of fear, it’s the ability to act in the face of fear. Right now, not selling is taking a lot of courage.

2. Historically, this decline is not out of the ordinary.

The stock market tends to decline an average of 40% when recessions hit, which is about every 5-10 years. We’re down around 40%, so this decline is in line with history. As Mark Twain said, history doesn’t repeat, but it sure does rhyme. Sometimes the market goes down by 20%, sometimes it goes down by more. No one knows where this one will bottom, and trying to pick the bottom is a fool’s errand. Our economy and financial sector are facing the worst period since the Great Depression, but that doesn’t mean it will look just like the Great Depression. Comparisons to history are useful, but expecting the same outcomes in the same way is a mistake.

3. I believe recent government action will work, although it will take some time and it will lead to higher inflation in the long run.

Current government plans have flaws, but I believe they will get credit markets and the economy going, eventually. The cost will be higher long term inflation and more regulation, but I do think it will work. The market tends to bottom 6-9 months before the economy does. Economic data comes out months and years after the economic bottom is clearly reached. Waiting for the economy to improve will lead you to miss the huge stock market rebound that will occur. It’s hard to see past our current turmoil, but a long term focus helps.

4. It’s not possible to time the market, so trying to sell now and buy at the “bottom” almost always leads to worse results than holding on.

Like the search for the Holy Grail and a perpetual motion machine, people are always trying to time the market by buying at the bottom and selling at the top. Unfortunately, this isn’t possible, and every attempt to do so ends in tears. I remember buying a company called JLG in 2000 at $8.88 per share, watching it decline to $3.95, and then selling it when it climbed above $17. I had doubled my money when the market was doing terribly, so I felt good about myself. But then JLG climbed to $60. It’s easy, in hindsight, to think I should have known that JLG was worth a lot more than $3.95 at the bottom and buy more. It’s easy to think I should have waited for $60 to sell at the top. Having been through that ride, though, I know very well that it’s not possible to pick the tops and bottoms. Instead, I focus on the underlying value of the business and buy when it goes down and sell when it goes up. I never pick the exact bottom or top, but over the long run, I’ve had very good results.

5. The market is throwing the baby out with the bathwater.

When the market panics, everyone feels so much pain they sell no matter what price they get. This leads people to throw the baby out with the bathwater, and that is what I’ve been seeing since Oct 1st. People are selling good companies and bad ones, small and big, everything. When that happens, it’s very unprofitable to join the crowd and sell, too. This is a sign of how much pain people are in, not the underlying value of businesses. In the long run, the market will recognize underlying business value, even if it takes a while and some pain to get there.

6. Our underlying businesses are strong even though their prices are going down.

When I look at our underlying businesses, I feel very confident. Software companies will continue to sell software and make money, even in a down market. People will still subscribe to cable, even if they don’t pay for HBO anymore. Smart insurance companies will continue to write insurance. Discount retailers are doing better than ever as people look for bargains. Europe’s lowest cost airline is still lowest cost and, and with little debt, can continue doing business and make more money than competitors, smart holding companies have investment money on the sidelines and the inside scoop on the best deals in the market when everyone else has no cash to invest, well capitalized insurers are writing more insurance now that AIG and other insurance companies are in severe trouble, big pharmaceutical companies will continue to sell drugs to people who need the medicine to live longer, happier lives, great banks are expanding by buying competitors at a fire-sale price because most other banks are on the ropes, auto insurers will continue selling car insurance because people have to buy it to drive, smart chemical companies will continue to make vital chemicals and pay lower prices for gas and oil inputs, large integrated oil companies will continue producing and refining fuel for people who will continue to heat their homes and drive their cars, large international banks will continue to grow their international banking franchises and will be able to buy up competitors because they are more conservatively financed than competitors. Many companies are strong and exploiting the downturn–but their prices are going down! Why? Because people are panicking, not because the businesses are going bankrupt.

7. This is a historic time to invest!

If you look back at market history and see 2002, 1998, 1991, 1987, 1982, 1974, 1962, 1953, 1942, 1938, 1932, etc., you will see market bottoms where things were awful. 2002 was the bottom of the tech blowout. 1998 was the bottom of the Asian Contagion. 1991 was the Saving and Loan bailout and recession. In 1987, the market dropped over 20% in one day! 1982 was a sharp recession and the Time magazine article of the “End of Equities.” 1974 was a terrible recession, extremely high inflation, the pullout of Vietnam, etc. And so on and so forth. They were each excellent times to invest and extremely tough moments to do so. What made them great times to invest? Because some people panicked and others didn’t. The people who didn’t panic made out like bandits. If you have extra cash to invest, put it to work now. If you don’t, hold on for now. The roller coaster is on the way down, our stomach is in our throat, we know it will go back up again but can’t think about that because we feel awful. But, holding on is the most profitable route.

8. One of the reasons you hired me is to let me worry about the market for
you. That’s what I’m trying to do for you now.

An important part of my job, in addition to researching and picking investments, is to take the pain for you of watching the market go down. If you can, turn off the TV, get off the Internet, put down the business section of the newspaper. Go out and do something fun. Spend time with loved ones. I remember watching TV for 48 hours after 9/11 and after Hurricane Katrina, and I managed to convince myself that more doom was right around the corner. It wasn’t, and it probably isn’t now. Let me focus on this stuff for you, let me take the pain for you. That’s what you pay me for.

I don’t want to short change current events. These are tough times.

I don’t want to undercut how miserable it is to watch our portfolios decline in value–I’m agonizing because I feel responsible for your money.

If you still have concerns, please call or write me. I’m standing by and waiting to talk to anyone who calls.

Take care and have a great weekend,
Mike

Michael Rivers, CFA
Athena Capital Management Corp.
719-761-3148
www.athenacapital.biz

Visit my blog: www.mikerivers.blogspot.com.

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.

It’s ugly out there

The economy is getting to look downright ugly.

The reason why the U.S. government was working so hard on the bailout is because credit markets are frozen. For those who don’t know, our economy operates mostly on credit. When most companies buy inventory, purchase property, plant and equipment, or pay wages and salaries, it’s frequently done with credit.

So, when credit markets are frozen, businesses (and municipalities) can’t keep operations going, they can’t expand, and they can’t pay their employees.

It’s unclear that the government bailout will unfreeze credit markets. Banks aren’t lending because their balance sheets are either close to or insolvent. They can’t lend. Having the government purchase illiquid securities may facilitate the rebuilding of bank balance sheets, but it won’t rebuild bank balance sheets directly.

The credit freeze has been slowing the economy remarkably over the last two months, and precipitously over the last two weeks. That is why Secretary of Treasury Paulson and Federal Reserve Chairman Bernanke have been running around like chickens with their heads cut off trying to get the bailout going.

Warren Buffett says this is the worst he’s seen in his 50+ years of investing. The situation is being touted as the worse financial crisis since the Great Depression.

It’s going to get worse before it gets better, but, if free markets are left alone to work, it will get better. The U.S. economy is the most dynamic and resilient in the world.

We may be over-leveraged with debt, we may have too much debt, we may not save enough, but we have the best protection of property rights and a relatively sound rule of law. That’s all it takes, and individuals will do the rest.

It’s always darkest before dawn. Things look pretty dark out there now. Believe it or not, that can be a great time to invest. By the time things look better, you will have missed the upswing.

I’m not saying investing at a time like this is easy, but it is smart. In the long run, investments made today will do very well, even if it’s looking ugly out there right now.

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.