None of us know the future of our investments. Unless human nature is altered we should be prepared for two important losses. According to the Marathon Global Investment Review, the great Ben Graham* (in the Intelligent Investor) warned investors of the probability that most of their holdings will fall by "one third or more from their high points at various periods." I see no reason not to accept his warning today. This is the first investment loss probability ahead of us.
*I feel drawn to any views expressed by Ben Graham. He and my old Professor at Columbia University David Dodd wrote the Bible for our business entitled, Security Analysis. I am particularly susceptible to quotes from them. The New York Society of Securities Analysts which Ben helped to found honored me with the Benjamin Graham award for services to the society.
The second big future loss ahead of us is our reaction to seeing our wealth decline, perhaps materially. After each major market decline some investors in their mind retreat from taking on any more risk and withdraw from investing. Often they blame their loss on what the popular press claims was the culprit. That way it is easy to, in effect, give ownership to the bad people and policies that they think led to their realized loss. Rarely do they examine their own behavior and naiveté as a contributor to the loss of supposed value in their portfolio. Thus, they can transfer all of the responsibility to these external factors. In other words, the government, the leaders, acts of nature, new products, foreigners, etc., were the causes so they have passed the ownership of the calamity to others. Actually, this is a small part of the real long-term loss. The real shortfall is the subsequent loss of opportunity. Fortunately, we live in an equity world that after each serious decline the surviving market prices rise and eventually top all prior peaks and of course valleys. Bottom line: one must be a participant in the game to gain the benefit of the recovery.
For many there is a third risk of loss, a different type of risk: career risk. We are already seeing investment professionals lose their jobs. Often the layoffs start at the bottom of the ladder. Today I know of good analysts, portfolio managers, institutional traders, and various administrative types that have been cut from investment advisors, brokerage firms, hedge funds and some market-making facilities. Hopefully after some difficulty many will survive and quite possibly start or get involved with the new entrepreneurial activities that will become tomorrow's winners.
There is another group who indirectly suffer from the career risks of others, their customers. The current environment, after years of mild investment progress, has had only eight months of slowly accelerating progress except for the last couple of months, when it has been gaining faster. Many careerists have not bought into the current rise, so their portfolios have risen more slowly than the popular markets. This is the final straw that breaks some of their clients’ backs or their investment committees. Many investors can tolerate middling performance when the markets are slow, but when momentum sets in, they want a higher level of participation. Except for race horses that are bred for and trained to come from behind, few come from behind and win in particularly long races.
What To Do Now
Others may disagree with my global belief that we have entered a different phase of the equity markets. Prices are generally rising and have passed out of the comfortable range in terms of average valuations. One clue to this is that most acquisitions are shifting to all or largely stock rather than cash deals. We are seeing proposed deals based on the breakup and sale of the various deal’s parts. Is this a signal that we should withdraw from the global stock markets?
While life is never easy for a conscientious professional investor, a good one can identify the appropriate tool kit for various markets. I believe we have entered the phase where sentiment is more important than published financial information. What is important is not the current facts, but how the market is interpreting the new facts in terms of views as to future stock prices. For example, as is often the case, one can see a lesser risk orientation in the corporate bond market. For the moment forgetting the narrowing spreads for high yield paper versus Treasuries because many of the new buyers are disguised equity buyers, they focus on intermediate credits. Barron’s publishes an index of intermediate grade bond yields. Since the beginning of this year the yields have come down 13 basis points and 100 basis points over the last year, indicating an increased demand for this paper. Similar yields for the highest quality bonds have actually gone up 5 basis points and declined only 21 basis points over the last year. All this arcane algebra is flashing the message that in the most conservative sector of our markets buyers are accepting higher credit risks. They perceive less chance of bankruptcies than a year ago and particularly since the beginning of the year.
Many of the more retail-oriented sentiment indices are slowly beginning to move. One indicator has me particularly interested: BlackRock believes that individuals are replacing trading groups as the main buyers of its Exchange Traded (ETF) index funds. I believe BlackRock’s retail investors are principally going into its Large Cap index funds, just at the same time there is a continuing trend of what I believe are mutual fund investors redeeming their Large Cap funds after reaching their investment goals. Actually I believe the main way BlackRock is seeing flows is from retail-oriented brokerage houses, often discount brokers. I am wondering if the flow is from brokers or investment advisors who are playing catch-up from being behind for a long time? Their clients are outer-directed and easily led. (I see fairly little signs that do-it-yourself, inner-directed investors are moving into Large Cap indices.) The reason for my skepticism is that when all the stocks in an index move together or are highly correlated, the low or no management fee is attractive. Today we are seeing that tight correlations are coming apart. Rank almost any industry in term of stock price performance now and a year or more ago. You will see the performance spread between the best and worst performer growing. If you want to get the best performance one needs to be in the better performing stocks or shorting the worst.
If I am close to being right, the move of the uninformed public being guided by career risk advisors is an important sign of a top.
In addition to sentiment indicators, a good technical market analyst can be useful. One that I follow has been writing about a major top within the next few years. Others have different views and timespans.
Two wise investors from many years ago are worth paying attention to, even though they are very different. The previously mentioned Ben Graham became quite a stoic so he could tolerate the cyclicality of the market and be prepared to buy cheap stocks with good dividends and operating earnings. Jesse Livermore made and lost fortunes as a market trader. (He may have done some of his trading through my Grandfather's firm.) He is quoted as saying, "The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among professionals." Further, he said, "It was not my thinking that made big money for me. It was the sitting."
I have had the privilege to converse with some of the great mutual fund investors over the last fifty years. In terms of the market and their funds during cyclical declines they were stoic and accepted the declines as a normal part of their business even though tension producing. However, one of the reasons that they were so good for so many years was they wanted to chat about their "mistakes" and what they learned from each other, and for the most part they did not repeat. Like all of us they made new mistakes. but they were always learning.
In last week's post I discussed the shareholder letter released last Saturday of Berkshire Hathaway. Since I did not reference the stock, I failed to proclaim that in both my personal and the financial services private fund I manage, that we own some shares. I hope no one was treating the post as a buy recommendation. My attitude is that we can learn a great deal from Warren Buffett and Charley Munger that is worthwhile beyond their stocks.
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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.