Thursday, April 30, 2009

Everyone's Waay Too Bullish (Bearish?)

Investor sentiment is a great indicator.  It pays to be bullish when everyone else is bearish, and vice versa.  The problem is that there are many sentiment measures, and they hardly ever point in the same direction.  At any given time, a bull and a bear could each produce convincing arguments that they had staked out a contrarian position because everyone else was on the other side.  

For example, the current issue of Barron's features a semi-annual poll of professional money managers.  59% describe themselves as bullish or very bullish, a statistic that was quoted by at least one bearish economist to bolster his negative view.  However, he didn't point out that in the same survey, 58% of those same managers said they believe that the stock market has not yet bottomed, despite the Dow's 6469 low in March.  That widespread disbelief in the current rally seems like a very bullish sign.  

I read many blogs every day on my Google Reader (a great invention!).  My sense is that most of the investment blogs favor the bearish side.  Birinyi Associates excellent Ticker Sense blog maintains a weekly sentiment poll of prominent investment bloggers and currently shows bears outnumbering bulls by 39% to 28% (the rest are neutral).  I was particularly struck by one recent blogpost which highlights a bullish report by an economist.  It drew 58 reader comments, 45 of which were negative (and mostly of the "you must be crazy to think that things are getting better" variety).

I don't know whether we've seen the bottom, or which way the market will go in the coming weeks or months.  But I do know that the start of the next bull market will be marked by plenty of initial skepticism.  The most prominent bears, those who gained fame for having correctly forecast the current economic disaster, won't suddenly turn bullish at the bottom.  They'll be fighting the tape all the way up, until they finally fade away.  

And consumer behavior will follow a predictable path, swinging from fear to greed.  Prospective home buyers are currently very cautious because they think that home prices are still declining. However, eventually it will become apparent that the housing market has bottomed and is turning up.  At that point sentiment will shift (and probably rather quickly) from fear of overpaying to fear of missing a great deal.  Similar great deals in airfares, cruises, and consumer durable goods will quickly disappear.

Portfolio update

I've been slowly adding to positions over the past month.  I also added two new stocks to the portfolio:  Nokia and Exxon.  So here's the updated list:  ABB Ltd, Boeing, Caterpillar, Cisco, DuPont, Exxon, General Electric, Google, Goldman Sachs, Intel, New York Times, Nokia, Procter&Gamble, Slumberger, Sysco, and Walgreen.  

My favorite stock right now is probably Sysco Foods.  I'll write about it in detail after they report earnings next week.  Also, the current market advance won't continue forever, so expect to see a reversal at some point.  I'm not smart enough to catch the short-term moves, but I remain confident that the market will be much higher in the next few years.  

Wednesday, April 29, 2009

Buy, Sell, or Hold?

WSJ article today talks about the growing number of investors and investment advisers who have abandoned the "buy and hold" approach.  That's become a very common media theme, particularly among the geniuses on CNBC:  "you've got to trade markets like these.  Buy and Hold has been a disaster for everyone over the past ten years."  Last night I received a cold call from a broker in New York.  He wanted to tell me about his firm's (J.T. Marlin?) successful trading ideas.  He started with the assumption that I knew trading was the only path to success in the current market environment.

Trading your way to profits is largely a myth.  I've been around many professional traders for decades, and I know that it's a very difficult way to make money.   Most people are unsuccessful. I can't do it on a consistent basis, and I'll bet that you can't either.

Sure, buy and hold hasn't worked.  Not in the last ten years, not in the last year.  But that's because if you bought ten years ago you bought near the peak.  If you bought one year ago, you bought near a peak.  Now I'm not smart enough to call tops or bottoms, but I can measure big declines.  If you had bought in March 2003, after the S&P 500 had fallen by nearly half from its 2000 high, you would have almost doubled your investment over the next four years.  And many high quality stocks like ABB, CAT, DD, and BA were up three to six times off the bottom.  

If and when the market sustains a significant advance, I won't be advocating buy and hold.  I'll be taking profits, trimming positions, writing calls, and hoping to move money into munis at more attractive levels.  But after the substantial market decline which brought us to present levels, I'm quite content to buy quality individual stocks and hold with the expectation of significant appreciation.  The fact that many other market participants have abandoned buy and hold only makes me more confident that my strategy is correct.

Tuesday, April 28, 2009

The Ivy Portfolio II

As promised (YAIO April 15), I read The Ivy Portfolio.  I have to say that I started with a negative bias.  Although the Harvard and Yale endowments have produced superior investment returns for the past 23 years (generally a very good period for any equity investor), they lost roughly a quarter of their assets-- $5 to $10 Billion-- in the current bear market.  My first impression of the book is that the authors began the project  well before the debacle of late 2008 and rushed to publish before their conclusions were completely discredited.  It's worth noting that both Harvard and Yale endowments operate with a June fiscal year end, so their 2008 annual reports don't include information about the damage suffered in July to December.  

To be fair, the authors do note in passing that 2008 was a bad year.  However, the book is peppered with statistics based on periods ending before 6/30/08.  For example, consider this: 

 "The worst years for Harvard and Yale were -2.7% and -0.2%, respectively--pedestrian compared to the -17.99% experienced by the S&P 500 in 2002 and the stunning drawdowns of 2008..." 

That's a joke given what we know about their current performance.

However, I did find plenty of value in the book.  Let's cut to the bottom line first.  The fundamental conclusion is that a traditional stocks/bonds/cash portfolio allocation is inferior to one which includes alternative assets such as private equity, venture capital, hedge funds, and commodities.  To simplify things for the individual investor, the book recommends an allocation of equal parts domestic stocks, foreign stocks, bonds, commodities, and real estate, rebalanced regularly.  

On the positive side,   there's a good discussion of some of the behavioral biases that hurt investment performance.  For example, quoting Philip Fisher:

"None of us likes to admit to himself that he has been wrong... More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason."     

Or Warren Buffett on "anchoring":

"When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying , perhaps hoping that it would come back down.  We've missed billions when I've gotten anchored.  It cost us about $10 billion (by not buying enough Wal-Mart)."                                                                                                              
Also some good sections about trend-following and avoiding losses. 

However, I disagree with much of the advice about portfolio diversification through the use of funds.  The outperformance of the Harvard and Yale endowments certainly was due in large measure to timely investments in alternative asset classes like hedge funds, commodities, and private equity.  But that doesn't mean that it will work for you, or even that it could have worked for you.  The authors are quick to acknowledge that the endowments had access to some of the very best funds and partnerships--ones closed to most investors.  The average individual investor risks being put into a basket of very average (or worse) alternatives.  

And finally, here's a more balanced view of Yale's portfolio management from Cash Me If You Can.


Wednesday, April 22, 2009


Based on some recent conversations with readers, I thought that it might be worthwhile to review my thoughts on a few common questions:

I'm sitting on some cash.  When should I buy?

My core belief is that the stock market will be much higher in 5 years-- that's 2014.  I think that the Dow and S&P can double over that time.  If the S&P 500 index, which closed at 850 yesterday, can get to 1700 in 5 years, it will have appreciated at a compound annual rate of about 14.87% .  Add to that any dividends.

That's a pretty good rate of return.  Of course, the market won't go straight up.  Also, you won't get in at the bottom.  It's just not possible to accurately predict the market's short-term moves.
So here's the answer:  First, decide how much of that cash you can truly afford to invest for a five-year horizon.  Then, invest 1/3 of it today.  Look for opportunities to invest the rest over the next few months.  But don't focus on "the market."  Buy very high quality companies with strong balance sheets and truly talented management, and look to add to positions on dips.

I know of some really cheap small cap stocks.  Should I have some of them in my portfolio?

No.  Now is not the time to be buying small cap, or emerging market, or other more risky stocks. It's not that they can't or won't work-- in fact, if the economy and the market improves more quickly than I expect, those stocks will significantly outperform my high quality portfolio.  But that potential of higher reward comes with higher risk.  If the economy continues to weaken, you could see significant losses.  The sweet spot in the risk-reward tradeoff lies in high quality stocks. In my opinion your upside is 15% per year and your downside is fairly small.

What stocks should I be buying now?

My core portfolio consists of ABB Ltd, Boeing, Caterpillar, Cisco Systems, DuPont, General Electric, Google, Goldman Sachs, Intel, New York Times, Procter & Gamble, Slumberger, Sysco Foods, and Walgreen.  I chose them because they are big companies with strong balance sheets and a dominant position in their industries.  I believe that they have minimal risk of being put out of business by a new invention or regulatory change or lawsuit.  These are franchise companies that are rarely available at present valuations.  (please note that New York Times is a special case and an exception; see prior posts for more on NYT).  

I have several names on a watch list, and I'm looking for a chance to add a few if/when prices fall.

Why can't I just buy ETFs or mutual funds?  If the market doubles in five years, won't I do just as well with them?

I want to own individual stocks (and individual bonds when the time comes).  If I lose money on my investments, I want to know that it's because Caterpillar didn't sell enough tractors rather than some failed correlation bet by some fund manager.  And I don't like ETFs because they almost certainly include stocks that I wouldn't want to buy outright.  Take the SPY (S&P 500 index ETF).  It's got lots of financial stocks, and I still think they're too risky at this point.  I want to select my own stocks, not own them simply because they're part of an index or ETF.

As far as mutual funds or other actively managed vehicles, keep in mind that the most managers' objectives are not the same as yours.  You want to grow your net worth with an appropriately limited amount of risk.  The manager wants to beat some benchmark.  That's why, in extreme years like 2008,  your manager can look like a star  while you lose a quarter of your investment.  Forget about benchmarks.

Speaking of 2008, how would your strategy have performed?

Large cap high quality stocks got hit hard last year.  That's why I'm buying them now-- because they're very inexpensive.  I wasn't recommending this portfolio 12 months ago.  It was a much different environment, and much harder to read.  I think that we're now in a unique position that has only come along a few times in my career.  The dramatic recent selloff coupled with ten years of flat-to-down performance has finally put the odds in my favor.  Stocks aren't guaranteed to go up in the next five years, but I'm pretty certain that they won't keep going down.  At some point in the future-- maybe it's two years rather than five-- the valuation disconnect will swing back to a more normal level and the outlook will become less clear.  When that happens I'll likely have a different strategy.

What about bonds?  There are some pretty attractive yields available.

True.  You can buy some high quality bonds with yields around 6 or 7%.  Compared to treasury bonds, spreads are at record highs.  Also, some have pointed out that 6 or 7% isn't much less than the long-term average return in equities, and with much less risk.  

My problem with bonds:
1)  you lock yourself into a maximum return.  DuPont has a 10 year bond that yields about 6%-- that's the most that you'll get.  However, I think that DuPont stock could double, and it pays a dividend yield of 5.84%.  Of course, the stock is riskier, and the dividend could get cut.  But I think that the risk-reward is decidedly in favor of the stock.  
2)  interest rates are unlikely to go down much from here, but there's a pretty good chance that they'll go up due to the massive government stimulus and an improving economy.  I don't want to make an interest rate bet, but that's clearly a negative for those who lock in today's rates with a bond purchase.
3)  although spreads are high, you can't spend spread.  Absolute yield levels of are roughly at the midpoint of where they've been in my career.  

That's not to say that I would not own any bonds.  I wouldn't put all of my eggs in any one basket, including a basket of stocks.  But at current prices, I have a strong preference for stocks. My hope is that my stock portfolio will double as interest rates slowly rise, and I'll then be able to shift a significant part of my portfolio into bonds to lock in a secure income stream for my retirement years.

That's it for now.  If you have any other question, please use the comment function below and I'll respond.  You can comment anonymously if you wish.

and thanks to reader Lisa for some thoughts that prompted this post.

Wednesday, April 15, 2009

The Ivy Portfolio

I happened across a blog called designing better futures by Nick Gogerty.  Smart guy, and he's got a lot of interesting things to say.  

I was particularly interested in his recommendation of a book called The Ivy Portfolio.  "Ivy" refers to Ivy League colleges and in particular the endowment funds of Yale and Harvard, which enjoyed spectacular returns for many years.  I had read another review of this recently published work, and I remember thinking that the authors suffered from poor timing.  Sure, these funds had performed very well leading up to the present Big Bear market, but didn't they get crushed along with everybody else?

So I tried to find current performance info.  Because their fiscal years end on June 30, there's not a lot of hard numbers for 2008-09.  However, several articles suggest that they were down 25% in the second half of 2008, and it's unlikely that Q1 2009 showed much improvement.  

But what surprised me the most came in recalculating the numbers.  The first page of the book trumpets the number 16.62% as the annualized return for Yale's portfolio between 1985 and 2008.  By way of example, it tells us that $100,000 invested in 1985 would be worth $4,000,000 by June 2008.  OK, but what about after June?  I assumed a 25% drop in value (to $3,000,000) and recalculated the annualized return.  To my suprise, the return percentage barely budged:  it fell from 16.62% to 15.33%.  I would have guessed that it would have been a much lower number.

That's an amazing statistic that underscores the power of compounding, which has been called the Eighth Wonder of the World.  It also underscores the awesome performance of the Yale endowment.  

Generally, I'm skeptical of the Ivy plan, which seems to emphasize asset allocation as the most important determinant of investment performance.  There's plenty of academic research to support that theory, but its success is predicated on your ability to identify the right asset classes.  However, I have ordered the book, and I look forward to reading it on my vacation next week.  I'll report back to you soon.

An interesting sidelight:  One of Nick Gogerty's recent posts features a video on (which is an awesome video site-- its tag is "riveting talks by remarkable people" and you should certainly check it out)  with a presentation from the MIT Media Lab.  If you're interested in the next generation of technology, particularly stuff like smartphones and netbooks, this is well worth eight minutes of your time.  Click here.

Thursday, April 9, 2009

Improve Your Diet

As I mentioned yesterday (Clearing the Forest), one of the beneficial results of the current economic crisis will be the clearing of the excesses which built up like plaque in the financial arteries of our markets.

You should want the same thing in your portfolio as you do in your diet:  healthy, high quality, minimally processed, and with few additives.  Avoid sugar, polyunsaturated fat, and hedge funds.

Unfortunately, many of these entities are even now viewed by financial advisors as alpha producing diversification vehicles.  Fund-of-Funds, Private Equity, Managed Futures, etc.  Got some in your portfolio?  I'll bet that diversification into the commodity fund was only diversified to the extent that it gave you an additional source of capital loss in the past year.  

In bear markets, you want to build a portfolio of stocks and bonds. High quality individual stocks and bonds. Not funds.  Not partnerships with names like Pegasus Global Macro Leveraged Opportunities LP.

When we eventually return to a sustained bull market, there will come a time to look at more aggressive investments (e.g., smallcap growth).    But not yet.

Wednesday, April 8, 2009

Clearing The Forest

"These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood."
Clemenza,  The Godfather

Many things in markets and in the economy move along a steady long-term trend, but that doesn't mean they stick closely to the trendline.  Instead, we experience a cycle of overshoot and undershoot.  

Until recently, the top graduates of the top colleges and business schools overwhelmingly pursued jobs on Wall Street.  Overshoot.  When I graduated from business school, the hottest career was consulting. Ten years ago, everyone wanted to work for a dotcom.  Now I hear that law schools are seeing a big increase in applications.

That's a common phenomenon.  An industry, or a career, or a location, or an investment opportunity gets "hot", and people pour in.  Basic economics:  capital, including human capital, flows to the areas of highest returns.  Of course, as more capital flows in, returns get diluted and often turn negative.  Lower returns reduce the capital inflows.  Capital becomes scarce. Lather, rinse, repeat.

For much of modern economic history, the business cycle has oscillated between boom and bust. Periodic recessions served to balance inventories, labor, and other supply-demand factors. However, until recently the US economy had gone for almost twenty years without a recession (the brief 01-02 hiccup doesn't really count).  As a result, a thick underbrush built up in the economic forest.

So as painful as this current recession is, it's part of a healthy and necessary cleansing process. When we eventually emerge from it, we'll find many beneficial effects.  Consumer balance sheets will be significantly better.  Excesses in industries like housing and autos will have been purged. Business bankruptcies, as painful as they are to owners and employees, will allow the survivors to become healthier and more profitable, and will sow the seeds for new entrepreneurs.  Job losses will eventually become job gains, and will provide new opportunities for a new generation of workers.

Investment opportunities follow a similar cycle.  I have previously quoted the aphorism about how bear markets return stocks to their rightful owners.  It's painful to watch the decimation in your 401k.  However, by the time this is over you'll have an opportunity to acquire stock in some truly outstanding businesses at once-in-a-generation prices. 

Buffett and others have often commented on the curious behavior of investors, who collectively seem to prefer to pay high prices and avoid low priced merchandise in the stock market.  Don't obsess over the past.  Be glad that we're heading toward a time of great opportunity-- opportunity for entrepreneurs, businessmen, and investors.  Will you be ready?


Friday, April 3, 2009

Dear Fellow Shareholders

We're just now starting to receive company 2008 annual reports, and this year the CEO Letter to Shareholders is particularly interesting.  A friend called my attention to this one from JP Morgan's Jamie Dimon.  

Dimon offers a balanced assessment of JPM's 2008 performance and outlook for '09 and beyond. However, most valuable is his fairly concise review of the global financial crisis and his recommendations for change.

He's not shy about spreading blame, from banks and brokers to borrowers, hedge funds, regulators, and even pension plans and universities. 

There are many gems here, but I particularly like his comments about how we got here.  It's fashionable today for some to say I-told-you-so and to accuse regulators, risk managers, and others of being "asleep at the switch," but Dimon says: 

"...many of the main causes, in fact, were known and discussed abundantly before the crisis.  However, no one predicted that all of these issues would come together in the way that they did and create the largest financial and economic crisis of our lifetime."

To those who attempt to predict the markets by drawing historical comparisons, he warns:

"Even the most conservative of us, and I consider myself to be among them, looked at the past major crises (the 1974, 1982, and 1990 recessions; the 1987 and 2001 market crashes) or some mix of them as the worst-case events for which we needed to be prepared.  We even knew that the next one would be different--but we missed the ferocity and magnitude that was lurking beneath."

Keep in mind that I have plucked these quotes from a 28 page letter.  I don't mean to imply that Dimon is offering excuses.  But I think that his comment provide good perspective as our elected representatives investigate How Could This Have Happened?

The meat of the letter lies in two sections which address Causes and Solutions.  Here's an outline; I would encourage you to click through to read the details.

Fundamental Causes And Contributions To The Financial Crisis

The burst of a major housing bubble

Excessive leverage pervaded the system

The dramatic growth of structural risks

Regulatory lapses and mistakes

The pro-cyclical nature of virtually all policies

The impact of huge trade and financing imbalances

The Future Of Our System (solutions)

The need for a systematic regulator with much broader authority

The need to simplify our regulatory sustem

The need to regulate the mortgage business in its entirety

The need to fix securitization

The need to fix Basel II

The need to get accounting under control

The need for appropriate counter-cyclical policies

The need for policies in health care, pensions, energy and the environment, infrastructure and education that will serve us well over time 

In all, a very good review from someone who was an active participant in the drama.

Wednesday, April 1, 2009

PPIP and the Cash Cyclone

Have you ever seen a Cash Cyclone?  You can find them at arcades, amusement parks, etc.  You can even rent one for parties.  A contestant stands inside the cylinder to which cash has been added.  A fan is turned on, and the money blows and swirls around.  The contestant tries to grab as much cash as he can before time runs out.

This is how the Treasury's Public-Private Investment Program works.  Only a limited number of institutions are permitted to play, as the WSJ complains in an editorial today Treasury's Very Private Asset Fund

That's why I like my investment in Goldman Sachs stock.  There's nobody better at Cash Cyclone.  I'm trying not to be too cynical, but over the years they've proven to be particularly astute at recognizing when there's money blowing around, and grabbing their share.  The government needs investors for the program to work, and it's offering particularly generous terms.  Watch for Goldman to do its patriotic duty and not incidentally help its share price.