Benchmark Bullsh*t

Q: What do you call an investment manager who substantially outperformed his benchmark in 2008?

A: a big loser.  

In most of the past years, your manager would crow about his performance if he beat his benchmark at all.  And if he exceeded it by 100bp or more, he would beat his chest with pride.

So last year the S&P 500, the most common benchmark, was down by about 40%.  How do you feel if you were down 30%?  Happy?

I recall a conversation with a portfolio manager several years ago:

Me:  What do you think about XYZ?

PM:  We hate it.  It's a lousy company in a poor end market.  Bad management, an overlevered balance sheet, and selling at an unsustainable valuation.

Me:  Well, I notice that you own about a million shares.

PM:  Yes.  But we're underweight relative to our benchmark.

Forget about your benchmark.  Buy stock in high quality companies with good future prospects and attractive current valutions.  Maybe you will underperform next quarter.  But in the long run you'll make an attractive return.

We're All Contrarians

One thing that bothers me quite a bit is the possibility that I'm just one of the sheep blindly believing in a stock market revival.  I read lots of newspapers, blogs, and research reports, and I realize that there's no shortage of bullish talk.  That emboldens the bears, who  say that the market can't possibly go up when so many are predicting it.

There's an old, probably apocryphal story about about a sell-side strategist who was making a speech to a group of buy-siders.  He asked for a show of hands by those who considered themselves to be contrarian investors.  Almost everyone raised his hand. 

The bearish argument is always more elegant, more reasoned, more rational.  If bulls can give you three general reasons for expecting a higher market, bears can offer ten very specific and seemingly irrefutable points to guarantee a fall.  

We're all contrarians now.  We've all learned that the path to profit is the one less traveled.  We all look to fade the consensus.  The problem is that, as everyone fades the consensus, they become the consensus.  

Not Another Year Ahead Piece!

I want to publish my thoughts about 2009- not because I think I can see the future, or because I want to give advice. Rather, I want to have something in print so I can refer to it in coming months and see a snapshot of where I was at the start of the year. That might help me to understand where I made mistakes, and what unanticipated developments caused me to change my thinking.

I think that the stock market made an important bottom on November 20, 2008 at around S&P 750. I allow for an undercut of that bottom. Although every bear market is different, I wouldn't be surprised if we see something like the 2002-03 experience, when the market made its primary low in October (at about 800), rallied to 927 on Jan 10, then fell back to a classic double bottom around 828 on Feb 7 and March 7.

But I do think that the market is presenting us with an extraordinary opportunity over the next 2 or 3 years. I believe that there are many very high quality blue-chip stocks with bulletproof balance sheets and franchise businesses selling at once-in-a-decade valuations. Many offer substantial dividends. I think that these companies could rise 50 to 100% or more in value over the next 2 or 3 years. I'm currently invested in ABB, BA, CSCO, DD, GOOG, INTC, SLB, SYY

If I'm right, I'll almost certainly underperform "the market". In the next bull market, some of the best performers will be high beta names: maybe airlines, or miners, or E&Ps, or beaten-down retailers. But I think that I've found the easy money trade, with very good upside and less risk. If I'm wrong and the market continues down, I'll definitely perform better with these more stable names.

I'm currently about 33% invested in my high-quality portfolio, with the balance in cash. I've been looking for a chance to add to those positions and start a few others, but the market's runup in the past two weeks has taken most of them beyond my target buy points. If the market goes straight up from here, I'll miss an opportunity (although I do have more equity exposure in my retirement accounts). If a new bull market has already begun, I'm willing to take the chance that I'm underinvested. I could easily see more downside, and real losses are more painful than missed gains.

My best guess is that the market trades in a range for at least the next few months. Maybe 750 to 1000 or so, but that range is just a guess. I'll look for a chance to add at the lower end of the range. If it gets up near 1000, I'll consider selling calls on existing positions.

I'm thinking hard about energy stocks. I've only got one (SLB) in the portfolio now. Although I wouldn't expect oil to make a V bottom and charge straight back above 100, I was interested in some recent investor surveys which showed a distinct lack of appetite for energy. The most bullish forecast for oil in 2009 was about $75/barrel , and most expected something around 40 or 50. I'm no expert, but I know that oil is an essential commodity, and recent prices of 40 or lower lots of supply became uneconomical to produce. It wouldn't take much in my opinion to see a slight pickup in demand push prices well above most expectations. It's probably a good "fat tail" trade, buying far out of the money calls. I'll try to play it by adding to SLB and finding one or two more high-quality energy companies that are down 50% or so from recent highs and have great balance sheets.

I'm avoiding beta names. I don't want anything in the portfolio that could get slammed if we find that the drug didn't work, or the hole was dry, or they couldn't roll over their revolving line of credit. No triple short ETFs-- which are really just coinflip bets anyway. No emerging markets, although I wouldn't be surprised if China turns out to put up some great performance in 2009. No small caps, although some very smart smallcap managers with great research will probably have a career year. I don't have great research, so I don't want to own stocks where the smart money sells well before the dumb money (me) discovers a problem. Smart analysts and hedgies can get a great informational edge with many small stocks, but much less so with BA or DD.


I expect that the recession will continue through 2009, and that it will be one of the most severe on record. I think we'll be able to see light at the end of the tunnel by year-end or maybe earlier. I do allow for the possibility--say 10%-- that the current economic malaise extends for much longer than I expect, perhaps 5 years or so. I'll keep some cash around to avoid blowing up, but I certainly will suffer if that happens.

Interest rates and gold should both go up. It's a consensus viewpoint, but I just can't see how all of the government stimulus won't eventually induce significant inflation (although much more dangerous is the possibility that they can't inflate). I don't like bonds. Even with historically wide spreads, higher interest rates will hurt bond prices, and I can get bondlike yields from the dividends on some of my stocks. Munis scare me. I think that many state and local governments are underfunded or worse, and the recession will exacerbate their problems. I don't think that the state of California will default on its debt, but its 6% 30 year paper doesn't interest me.

Finally, a few other names on my stock watch list: CAT, WAG, UNH, PFE, COST, GE, COP, and IBM. I've got some levels in mind if they sell off. No financials. Although I'm certain that the financials will have an absolutely rip-roaring rally at some point, I don't know when. I suspect that they're pretty well washed out, but they don't fit my criteria for bulletproof balance sheet.

So, in summary, there's plenty of money to be made from here in relatively safe stocks. Don't get greedy, and look to add on dips.

Lies, Damn Lies, and Statistics

On Tuesday we learned from the S&P/Case-Shiller Index report that housing prices had declined by 2.2% in the month of October. That was greater than "analysts" had forecast. Hmmmm....

What do you suppose happened to the price of my home in October? Or yours?
I have no idea, because like the overwhelming majority of homes in the country, mine didn't sell last month. It wasn't offered for sale, and I had no intention of selling it. Like most people, I bought my home because I needed a place to live, and it suited my needs and my budget. Some day I'll sell it, and I hope and expect that I'll get a fair price. But why do we need monthly price statistics on something with very low turnover? How does anyone know what the price of my home was in November, or October, or last year? The same is true for art, or wine, or antiques.

We get a myriad of statistics every day. Durable Goods Orders. Producer Price Index. Continuing Unemployment Claims. Merchandise Trade Deficit. Non-Farm Payroll Employment. Sometimes, the reports come from government bureaus, which use them for planning and tracking. But sometimes, they're created by individuals and organizations for publicity purposes (see The Challenger Report of Announced Layoffs) or simply to make a profit. Over a long period, many of the better statistics can help us to understand long-term factors in the economy. But in the short term, they're mostly useless.

However, the media, in its effort to cover the stock market like a sporting event, thrives on statistics. CNBC frequently shows an onscreen bug with the countdown to a report's release (37 minutes to December Retail Sales!). And often a market's move is ascribed to some random event: "Stocks dropped today after traders were disappointed by an unexpectedly large fall in the Empire State Manufacturing Index."

The only statistic that really matters is the one that you see on your stock monitor-- the current quote. A stock, or a barrel of oil, (or your home, for that matter) is worth what someone will pay for it right now. Don't get hung up on statistical analysis; the market price tells you everything you need to know. And if it's an asset that rarely trades and doesn't have a current quote (like your home) don't pay much attention to some theoretical price.

Beware the unknown unknowns

There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.

Donald Rumsfeld, 2/12/2002


A successful investor needs to not only be intelligent and insightful, but also pragmatic. Know what you don't know. But one also needs to allow for events and outcomes that simply can't be anticipated-- the "unknown unknowns."

I thought about this when I read an article in today's Chicago Tribune . It was a "year ahead" piece on the economy and financial markets, with opinions from various experts. Professor Erik Hurst, of the University of Chicago business school, on housing prices:

Housing prices will fall another 15percent to 20 percent in the next couple of years, he predicts. "We've got a long way to go."

His study of market data stretching back decades gives him 100 percent confidence in his prediction, he said. "A big increase in price movements is followed by big declines. Take it to the bank."


Hmmmm.... "100% confidence"? based on his study "stretching back decades"?

I can only hope that he was severely misquoted. If not, I think he's an idiot. Let's think about this. First, what's his data set? "Stretching back decades" could mean as little as 20 or 30 years. But let's assume that he has gone back 190 years (otherwise he would have said centuries, no?). I know that Schiller and others have looked at housing prices back to the 1800s, but how good is that data? Do you really think that they have good records for a broad range of housing transactions dating back that far? Sure, there may be history for some houses on Beacon Hill dating back to the 1600s. But what about the sod huts in Nebraska in the 1870s?
I'd be willing to bet that many home sales went unrecorded or otherwise lack good records at least as recently as the 1930s. And many of the meticulous details that we have today, dutifully reported on CNBC like sports scores, date back to the 1970s or '80s.

But even if we have good data back to the early 1800s, Prof. Hearst is telling us about a study of cycles: a big increase is followed by big declines. How many times has that happened? I can assure you that one of the most basic assumptions about home prices prior to 2007 was that they never go down. This is what got us into the present mess. On a national basis they had virtually never declined. So how many cycles could have been captured in his research? I'll assume that he has looked at regional cycles and other data. Maybe he has captured 20 such events? I'd think that's a generous assumption.

One of the my earliest and best lessons in investing involved my only commodity trade. We were just out of college, and a good friend had taken a job as a commodities broker. He found an investment opportunity in lumber futures: it seemed that there was a seasonal pattern that had worked in 16 of the past 17 years. He put together a group of our friends to open an account and take advantage of this pattern. I think that I invested $2000.

Guess what? By the time that our contract had expired, that lumber trade's record was 16 out of 18. I lost it all. But for $2000, I learned a very valuable lesson about correlation.

One of my favorite quotes from Fooled By Randomness author Nassim Taleb:

My classical metaphor: A Turkey is fed for a 1000 days—every days confirms to its statistical department that the human race cares about its welfare "with increased statistical significance". On the 1001st day, the turkey has a surprise.

Perhaps housing prices will fall 15 to 20 percent in the next couple of years. Or maybe they'll fall 50 percent, or maybe they'll go up. Far too many unknown unknowns here. Wanna bet that if we were to interview the Professor in a few years, and it turns out that his 100% confidence prediction was wrong, he'd cite some unforseen events to explain his error? Unprecedented government intervention, currency crisis, runaway inflation, change in tax laws, etc. etc. The point is that we can rarely if ever be certain about anything. The successful investor attempts to know what he doesn't know, and makes allowances for the unknown unknowns.

Back to Basics

A long time ago, I had a conversation with an investment manager for relatively small firm with a good performance record. There was no secret to his process, he said. "We just buy stock in high-quality companies and hold on to it for a long time."

Bernie Madoff blows up as investors are shocked--SHOCKED-- that a strategy which reported rock steady monthly returns through 20+ years of market volatility was proven to be fraudulent. Newspaper articles go to great lengths to explain the intricacies of "split-strike options."

Today's WSJ notes that a manager who ran a fund which is down 82% this year has "stepped down." STEPPED DOWN? What were they thinking when the fund was down 50%? Why didn't they fire him then?

Hedge funds closing or restricting redemptions in the face of abysmal returns. One of the largest and most prominent is down by 50% this year, and it's got plenty of company. It becomes an accepted tenet of mainstream institutional investment philosophy that common stock investments are shunned in favor of allocations to hedge funds, private equity funds, commodity funds, and other "alternative assets".
Not so many years ago, a large pension fund would invest its assets in three categories: stocks, bonds, and cash. Today, the Harvard university endowment's asset allocation chart shows 11 separate categories of non-cash investments, about three quarters of which are things other than domestic stocks and bonds.

I'm generally a subscriber to the efficient markets theory. I believe that information gets disseminated quickly, and reflected in the market just as quickly. So you think that the economy's gonna be bad for the next six months? No kidding-- so does everyone else. That's why the stock market has fallen 40% or so. But what do you think that everyone else will be thinking next? That's the question! As Keynes said, successful investing lies in anticipating the anticipations of others.

Everyone's looking for an edge. Everybody wants to find the stock, or the asset class, or the manager or strategy that produces outsized returns (and with minimal risk, too). People stood in line, like cattle headed to the slaughterhouse, for a chance to invest with Madoff or some high-profile hedge funds.

There are literally thousands of investment management firms, ranging from esoteric black-box hedge funds to the sleepiest rural bank trust department. They're all looking at generally the same data. Some have vastly superior resources to provide for sophisticated computer analysis or local surveys of Tibet yakherders cellphone purchase intentions. But in the end they all think they can outperform the market. Some do, for a time. But even the most heralded, like Bill Miller or a prominent hedge fund, eventually find that their luck runs out. As Nassim Taleb would say, if you have 1000 monkeys picking stocks over 10 years, one of those monkeys will rank as the #1 stockpicker with the best 10-year average.

So why don't we just buy stock in high-quality companies and hold on to it for a long time? Well, for one thing it's not in the best interests of asset managers, or brokers, or investment committees, or consultants, or fund-of-funds, or most analysts. It probably isn't such a good thing for writers of financial blogs, either. But it probably is a good thing for you.

Wherein I Achieve Peace With The Market

"All financial crises end-- and when they end, they end in ways that create spectacular opportunity" Lawrence Summers




hard to explain.

The Dow was down 680 points today.

Over the past three months, when the market got hit hard like this, I'd get depressed. Didn't want to look at my account value online-- just didn't want to know. I lost a lot of money in the market this year.

But today is very different. I'm actually glad for the selloff. In fact, I hope that the market has a similar decline tomorrow, and the next day. Why? Because the market is presenting me with a spectacular opportunity.

Why now? Why is this better than previous declines? Why couldn't I have said the same thing 2000 Dow points ago? Answer: gut feeling.

I could give a more elegant answer. I could talk about my zero boundary theory (the lower it goes, the closer it is to the bottom) I could refer you to the John Hussman (by way of Henry Blodget) web post http://clusterstock.alleyinsider.com/2008/12/what-the-stock-market-will-be-worth-if-earnings-go-to-zero which argues that the more the market drops, the more attractive it becomes for long-term investors.

But in the end, big stock market returns are made when everyone else is consumed by panic. We all know this ("Buy when there's blood in the streets") but it's incredibly hard to do. It's not just when the dumb money sells. They may have sold long ago, or maybe they'll never sell. Bottoms are made when us smart guys-- the "smart money"-- just can't stand it any more. We buy with both hands down 20%, and we puke down 40% ("this is a disaster-- get me out").

My gut is telling me that we're at the inflection point. That doesn't mean that today was the bottom. But it means that we're not going much lower. Into the 7's on the Dow? Maybe. Probably. But not into the 6s. So how's my gut's historical performance? Pretty good. I'm not exaggerating when I say that I feel very strongly about this: right now, today, right here. No guarantees, but it's a feeling that I don't get very often and that I've learned to trust.

I'm not predicting a near-term rally. Maybe yes, maybe no. What I'm feeling is that investments today in high quality stocks will produce substantial returns-- doubles or triples-- in the next two or three years. This is a once in a generation opportunity to acquire stakes in truly world class corporations at deeply discounted prices. They may well get cheaper, maybe much cheaper, in the next year or so. But in 2011, you'll marvel at the fact that you could have bought these stocks at those prices in December 2008.

So what to buy? It's easy. Buy the blue chips. Buy the companies that are the clear worldwide industry leaders. The ones that have the impregnable balance sheets and the multi-decade records of outsized returns to shareholders. It's truly like shooting fish in a barrel. Forget about relative performance. There will certainly be others that outperform. But names like Intel, Boeing, Microsoft, Caterpillar, Coca-Cola, Cisco, and Pfizer (among others) will give you solid double-digit returns or better plus a good dividend over the next few years. They are franchise companies that are rarely available at today's valuations.

What not to buy? Themes. Tips. ETFs. Anything that represents a guess as to the next market tick. Top down ideas like infrastructure or global decoupling. Anything dependent on interest rates, or commodity prices, or the Baltic Dry Index. Don't buy sum-of-the-parts stories, or discounts to NAV. Don't buy it if you have to look up the symbol, or if you can't immediately describe exactly what business they're in. There are just too many exceptional and truly inexpensive companies with virtually zero risk of accounting fraud, or adverse patent rulings, or competitive threats.

And yes, I know that we're in the worst recession of our lifetime. I know that housing prices haven't bottomed. I know that the payroll employment number on Friday will be a well below pessimistic expectations,that the unemployment rate is going to 10%, and that retail sales this Christmas season will be the worst since the Stone Age.

Bottom line: The market's not going much lower. It may take a while to recover--maybe a long while. But you can become an owner in some unbelievably great companies at incredibly good valuations right now. And they have dividends that compensate you very well while you wait.