The S&P 500 rallied 8 days in a row through March 18th to a 18 month high of 1159.9, still below the level last seen following the bankruptcy of Lehman Brothers on September 15th, 2008.  The daily volatility of the stock market has declined to the levels not seen since the peaceful summer of 2006.  By our calculations, the overall stock market is slightly overvalued.  Whether current levels are sustainable depends on corporate earnings and Federal Reserve policy over the next year, and whether the US can avoid the 'double-dip recession."  We remain cautiously optimistic and fully invested.  Given a breather for first time in two years, we'd like to devote this commentary to:
 
Useful frameworks for investment analysis
Many people have the illusion that our job is easy - anyone can do it!  And we reply, 'Sure!  And anyone can fly a plane, perform root canal, build a house etc."  So much of modern media presents investing as "easy;" Jim Cramer jumping up and down on "Mad Money," the suavely cool investors in the TD Waterhouse commercials (featuring Sam Waterston of "Law & Order," for gravitas) and the E-Trade talking baby (www.etrade.com/baby.)  We think investing is about 1000 times harder than playing poker.  Nonetheless, plenty of amateurs who would never dream of going to Las Vegas to play against professional players think they can beat the market (and do their job and take care of their families all at the same time.)  Good luck!
 
In fact, outside of medicine, we don't know any endeavor more complicated that investing.  Even if you're a particle physicist, the laws of physics have remained the same for the last several billion years.  Becoming a grandmaster chess champion is hard, but at least the rules of chess stay the same from game to game.  Investing has the ability to make smart people look stupid all the time.  We use these frameworks to try to be less stupid than most.
 
Investment gurus are "right" barely 60% of the time
If you search "investing" on Amazon, you'll find 41,459 books ranging from the classic "The Intelligent Investor" by Benjamin Graham to current best seller "Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown."  But any investment expert, if they're honest with themselves, will acknowledge that the percentage of their decisions that are "right" (in the sense of making money) is about 60% of the time.  That does not mean that the experts are charlatans.  In professional baseball, getting a hit 30% of the time is good enough to place you on the top 100 batters of all time.  It does mean that experts need to stay humble (thank goodness investment advisors don't design airplanes - they'd be falling out of the sky.)  The Daily Show compiled this hilarious montage of experts giving disastrous advice www.thedailyshow.com/watch/wed-march-4-2009/cnbc-financial-advice. 
 
We are not immune.  On October 9th, 2008, our president David Edwards appeared on Bloomberg TV http://heroncapital.com/video/bloomberg20081009.rm and gave a sober, reasoned explanation of why he wanted to buy stocks as soon as the post-Lehman tremors had settled down, possibly as soon as the following week.  The interview ended at 2:15PM with the Dow down 100 points.  By the time David got back to his office, the Dow had closed down 683 points.  The next day, the Dow fell another 750 points intra-day (a 16% decline in about 5 trading hours) before starting a monster rally, which took the Dow back above the October 8th close.  From there the Dow slid 2762 points, or 30.3% percent.  The Dow is now 33.1% above the October 10th, 2008 low, and 57.9% above the March 10th, 2009 low, but wouldn't it have been amazing if we could have taken our clients out of the market for those 6 months?
 
The take-way: 
1.      Don't think anyone has a perfect crystal ball into how markets operate.  
2.      Make sure your strategy can survive making a bad call.  We don't use leverage, so we only sell when we want to, not when we have to.  For those clients who rely on their portfolios for retirement or other needs, we make sure that their allowance is paid out of relatively stable fixed income, which we reload when stocks are high. 
3.      Don't invest too much in any one idea.  If you invest 2-5% of capital among 30-50 ideas, inevitable "wrong" ideas won't kill you.
 
The illusion of knowledge
He who knows not and knows not that he knows not is a fool; avoid him.
            Persian apothegm, in Sanskrit, and in the writings of Confucius and Socrates
 
There are known knowns.  These are things we know that we know.  There are known unknowns.  That is to say, there are things that we know we don't know.  But there are also unknown unknowns.  There are things we don't know we don't know. 
           Donald Rumsfeld, US Secretary of Defense, June 2002
 
Few things are more irritating to us than to get cornered at a cocktail party by someone who "knows XYZ" and insists that he or (more rarely she) is absolutely right.  Really?!?  We operate in a state of permanent paranoia about the things we don't know, or worse, the things we thought we knew which have now changed (the entire US tax code, for example, regarding retirement contributions this year and estate taxes next year.)  The people we know who are most prone to being a "fool" are those people who are truly experts in their own field; doctors and university professors are the classic examples. 
 
The rise of the Internet, which has made the world's knowledge no more than a key stroke away, can foster further illusion if the seeker only goes to sources that confirm, rather than challenge, their "knowledge."  These days television "news" caters to their audience's preconceived opinions: Fox if right wing, CNN if left wing, MSNBC if wishy-washy.
 
The most dangerous unknown unknown is a "rule" change in how markets operate.  One of our core assumptions leading into the 2008 Financial Crisis was that "grownups" were in charge at the banks who would take steps to protect the system out of their own economic interests.  Senior management owned tens if not hundreds of millions in the stocks of Bear Stearns, Fannie Mae, Freddie Mac, Citigroup, Lehman Brothers, Merrill Lynch, etc.
 
Wrong!  Not only were the heads of banks completely out of touch with their own firms, but also a whole new generation of market operators were prepared to attack, and if necessary, destroy whole institutions to make a buck (another "rule" change.)  Market regulators at the SEC, Treasury, Federal Reserve, CFTC were no better prepared to limit the damage than FEMA was prepared to protect New Orleans before and after Hurricane Katrina.
 
The take-away: 
1.      Seek out information sources that challenge or contradict previously held opinions. 
2.      Beware the unknown unknowns.
3.      Regulators can't protect you anymore.
 
Investing goes against the natural instincts of 98% of investors
The "Efficient Market Hypothesis" that financial markets operate by sober, intelligent investors making decisions based on rational analysis of all publicly available facts has taken quite a beating over the last decade.  How does EMH explain the "Internet Stock Bubble" of 1999 or the most recent "Real Estate Bubble," which blew apart in 2007?  We believe in the "Mostly Efficient Market Hypothesis," which is to say that markets operate efficiently most of the time, but occasionally go off the rails due the instinctual behavioral mechanisms of people.  10,000 years ago, if you wanted to find food and Caribou tracks led West, then West was the way you went to hunt.  Humans have a tendency to draw a line through a series of data points and project that line to infinity.  So when housing prices rise annually to ever higher values, people just assume higher prices next year even if the underlying valuations (ratio of ownership costs/rental costs) imply problems.  Or last March, with the US stock market down 55% in 18 months, people just assumed it would be zero within a year, even though stock valuations were at the lowest levels in a generation. 
 
Humans are also herd animals.  We told a number of our clients in the 2003-2007 time frame that if they wanted to buy that second home, they should be prepared to own it for at least 10 years, because that's how long we thought it would take them to break even.  That advice did not square with the advice our clients were getting from their real estate broker, mortgage broker, friends and family, so they thought we were idiots. 
 
The take-away: 
1.      We believe that humans are hard-wired to "buy high/sell low."
2.      When our clients disagree with us, we're most likely on the right track.
 
The consensus is often "wrong"
Every January, investment houses across the US and Europe put out forecasts of how the year will develop for stocks, interest rates, commodities, social trends etc.  We like to check back on those forecasts 3, 6, even 12 months later to see how the consensus performs.  The answer, often, is badly.  For example, in a survey of economists and investment managers on 10/19/2009, the biggest concern by far was the potential for a dollar fiscal crisis.  On the day of the survey, the Euro was at 1.4965, peaked at 1.5134 one month later.  From that level, the Euro fell 10.75% to a one year low of 1.3508.  Since then, it has stabilized at 1.3530.  However the US economy looks like it is glacially turning around, while the European economies are stuck in neutral, so we wonder how soon before the downtrend in the Euro resumes.
 
The take-away: 
1.      You can't ignore the consensus, because that view will drive short term price trends. 
2.      But you have to be able to disagree with the consensus from time to time, because that's where excess profits lie.
 
The mosaic theory of investing                                         
A random handful of tiles is neither valuable nor interesting.  Put 30,000 or so up on the wall, and a pretty picture emerges.  Too much of modern investing depends on reacting (or over reacting) to the news of the day.  We think that you need to evaluate the data of the day in the context of at least the last three months worth of data, along with a projection of what might happen in the next three months.  

 

 
For example, at present we are evaluating multiple indicators to understand whether the US will experience a double-dip recession later in 2010, or even in 2011.  "Tiles" in this analysis include:
·         Short interest rates still extremely low at 0-0.25%
·         Federal Reserve shutting down credit market support programs
·         US GDP expanding as US corporations move to rebuild inventories
·         US jobs growth about to resume after 8 million jobs lost
·         Housing prices flat and foreclosures falling
·         Consumer and business credit still in short supply
·         and hundreds of other economic reports
 
We subscribe to dozens of market data services, read over 600 pages of economic forecasts and trade magazines per week.  Our struggle is to limit and filter the data overload to something manageable.  We don't spend much time (OK no time) watching CNBC.  Too many people on that channel have too little time to explain complex issues that could fill whole issues of "The Economist."  The absolutely worst segments are "debates" with 10 heads in little boxes all over the screen.  Four are talking, two are screaming, the rest are trying to get a word in.  At that point, the information is drowned out by the noise.
 
The take-away:
1.      Evaluate the quality (signal/noise ratio) as well as the quantity of data.
2.      Analyzing volumes of investment data is like drinking water from a fire hose; it's easy to get your face ripped off.  Use a "straw" to get just the "sip" that you need.
3.      Overreacting to individual data points will cause "buy high/sell low" behavior.
 
Real companies with real products generate real returns
Investors have focused most of their attention the last two years on the financial system.  We remind our clients that finance is to the rest of the economy (manufacturing, services, education, healthcare, government) what motor oil is to your car's engine.  Yes, you need 5 quarts to keep things running, but ultimately motor oil is an easily replaceable commodity.  Wall Street bankers saw record bonus last year on huge trading profits.  With volatility and the potential for further gains sharply diminished, so also the trading profits that bonuses depend on.
 
We wonder whether the great expansion of financial services, which started with the "Big Bang" end to fixed commissions in 1975, and accelerated dramatically with the application of computer modeling in the 1980's, 1990's and 2000's to create ever more exotic "products" such as Credit Default Swaps, Collateralized Debt Obligations and High Frequency Trading strategies, may shrink relative to the rest of the US economy for a while.  When Wall Street directs the savings of investors to corporations in need of growth capital, everyone gains from the "positive sum" game.  The "innovations" of the last 10 years are more in the category of "zero sum" or even "negative sum" games, where a couple of players make some money, while the rest lose everything. 
 
Meanwhile, unremarked in the mass media, hundreds if not thousands of companies are busy solving the real world problems of the next decade.  To describe just one sector, a dozen companies are working to commercialize routine space travel.  We're not prepared to invest in this sector yet (at this stage, most companies are funded by venture capitalists and not available for public investment.)  Over the next 5-10 years, some will fail, some falter and some succeed.  We'll be looking to invest in the stronger ones.
 
The take-away:
1.      Economic growth comes from manufacturing & service companies developing new products and services.
2.      Many financial "services" companies subtract from economic growth
3.      The upside of lower incomes in financial services will be the migration of clever people back to the real economy.
 
Strategy
The quietest markets in two and a half years gives us more time to spend working with current clients on their evolving needs and bringing in new clients.  We'll be rebalancing accounts through the spring.  Tax season is winding down, but contact us if your accountant is missing any paperwork.