Sunday, January 31, 2010

The Price of Lack of Clarity
on Your Investments

Recently I attended a board meeting of a group. (I am not a member of the investment committee of this particular board.) The distinguished chairman of the committee announced that were currently holding over 20% in cash and short term paper because nothing appealed to the committee. In only one of the accounts that we manage, we have a similar out-of-the market position, while we are researching for the right combination of micro and small cap investments. The eventual spending needs of both organizations requires us to become more productively invested. Most institutional investors recognize this need, many individual private investors do not. Until very recently the flows into equity mutual funds have been largely institutional in nature with very little from retail investors except through their automated 401(k) investments.

There are lots of reasons to be uncertain about the future. Globally, the fear of ever-expanding government interference in the private economy, the unprofitability of adding to the workforce, rumblings of sharply increased tariffs, plus over-leveraged governments, companies, and individuals are just a few of the worries. Indicative of these concerns are uncertain tax rates, interest rates, inflation levels, and the value of currencies. Some may share my increasing concern with the ability of the Chinese government to manage population flows. Wouldn’t it be nice if we could divine the answers to some of these challenges?

As investors, the real trick is to get the answers ahead of others and to find prices that reflect the market uncertainty and not our superior knowledge and insight into the future. Dream on.

The plain truth is that prices represent the equilibrium point between buyers and sellers who are driven by their own needs plus some views as to the future. By nature, their views of the future are speculative. However if enough transactions are driven by similar thoughts, a recognized trend is quickly established. Thus, market prices imperfectly discount a series of future scenarios. As views of the future are by nature speculative (because the “knowns” are not known), prices will move ahead of the facts. The best prices will occur before the facts arrive.

Today the general level of stock prices assumes an accelerating recovery in the face of some additional layoffs and small sales increases that are not inventory rebuilding. In order for me to be comfortable with buying and owning equities today, I need to believe in two successive good fortunes. These pieces of good fortune include institutions who have long term spending needs and in addition will invest in their future by buying stocks or their equivalents. These purchases push prices up enough to create a trend that the public buys into in a major way. Will this happen? I have some confidence that it will happen, but I don’t know when the parade that can turn into a stampede will begin.

When I left active duty in the US Marine Corps one of the things I announced to myself is that I would not stand on line again. Foolish thought for anyone who commutes, particularly today at airports! Thus, I have become reconciled to standing on line waiting for something to happen. Therefore, I am willing to be as close to fully invested as my clients need and wait for something to happen. I recognize that some bad things are undoubtedly likely to happen, but I am betting on balance more good for investors than not will occur during this period of low level optimism. (By the way, I think we are well past the period of maximum pessimism which occurred just about a year ago. That was the time to invest.)

Bottom line, at the moment, I prefer to speculate about the future than to wait for the arrival of favorable facts.

For those who must invest to meet future spending needs, how are you investing now?

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