Here we are again in a panic. The financial markets are reeling in response to the coronavirus, oil market disruptions and not least because stock prices were historically high relative to fundamentals. Near zero interest rates give the FED little room to stimulate. Partisan divisions threaten to emasculate fiscal policy.
To navigate this frightening environment Think in the Morning decided to post (unedited) some past writings from the days when our day job was financial advising. The comments and advice holds up pretty well in our opinion. You be the judge. Remember: the writings are from a decade or more ago.
Money Talks
Booms, Busts, and Crises
October 2008
As I print this quarter’s Money Talks some investors think the world is coming to an end. I can’t add much to the numerous reports widely available in the financial press and elsewhere and I am sure some of you are listening to the financial news daily so I won’t repeat what you’ve likely already heard. Besides, not much can be done about that. What I will focus on is what you might expect going forward and how I see the risks and opportunities in today’s investment markets.
There is no way that I know to predict the future. While past performance is not indicative of future results, reviewing the past may be helpful in judging current events. Mark Twain reportedly said “History doesn’t repeat itself but it does rhyme.” The philosopher George Santayana said “Those who do not learn from history are doomed to repeat it,”but he also said “History is a pack of lies about events that never happened told by people who weren’t there.”So, while we may learn from history it is important to be careful interpreting what we learn. One of the worst Bear Markets over the past 50 years occurred in the 1970s. Based on the S&P 500 stock index, stock prices reached a peak around the end of 1972. A year later they were down about 15%. Six months later stock prices had fallen about 30% from their peak. Over the next two months stock prices declined at an accelerated rate and by September 1974 were down over 40% which is about where we are as I write. What investors did not know then was that in spite of the terrible economic news and lack of investor enthusiasm (or perhaps because of them) stock prices had bottomed. Over the next 15 months stock prices climbed back up from their lows rising over 60% and a few months later they were back to the peak levels reached in 1972. There were continued ups and downs but the stock market had recovered from its steep decline and continued to reward patient investors over the next two decades.
We have serious financial problems today. Stock prices have declined over the past year in a way that once again frightens investors. While I cannot reassure you with a prediction that we will eventually see a recovery as dramatic as that which occurred in the 1970s, history indicates at least that it is possible. And, even if the recovery is longer and at a more modest pace, at current levels stocks may already discount most of the bad news.
[Based on S&P 500 index. An index is a hypothetical portfolio of specific securities (common examples are the Dow Jones Industrials and the S&P 500) the performance of which is often used as a benchmark in judging the performance of certain asset classes. Indexes are unmanaged portfolios and should only be compared with securities with similar investment characteristics and criteria. Investors cannot invest directly in an index. Past performance is not indicative of future results. Data throughout this newsletter is based on research from Thompson Financial’s Investment View.]
Pointy Headed Intellectuals
The economist John Maynard Keynes famously said: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas…. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil…”
With that in mind and in the midst of these stressful times my recommendation is that you step back and read a few pointy headed intellectuals on what happened in past financial crises. The monetary economist Charles Kindleberger wrote a classic on the subject Manias, Panics, and Crashes which I like although it may be too scholarly for many people’s tastes. Two very good books by John Kenneth Galbraith for the general reader are The Great Crash and Money, Whence it Came, Where it Went. Professionals prefer Milton Friedman and Anna Schwartz A Monetary History of the United States 1867-1960. If you don’t want to read their long technical book you can buy The Great Contraction which is a reprint of the chapter discussing the Great Depression. I also like John Garraty’s book The Great Depression as well as any general history on the subject.
If you don’t like economics there are some wonderful novels about the fear and greed that are often associated with financial crises. You might try Emile Zola’s Money or Anthony Trollope’s The Way We Live Now.
If you really want to go to the horse’s mouth our own Federal Reserve Chairman Ben Bernanke has published his ideas in Essays on the Great Depression.
At times like this it can actually be an enjoyable stress relief to read a few good books to remind yourself that financial crises have happened before and that we have survived. We will survive this one as well although it may not look like it today.
What The Pros Say
“The only function of economic forecasting is to make astrology look respectable.” John Kenneth Galbraith
Economists don’t have a good record of predicting where the financial markets are headed. Take, for example, Irving Fisher, one of the best monetary economists of his time:
The stock market crash of 1929 and the subsequent Great Depression cost Fisher much of his personal wealth and academic reputation. He famously predicted, a few days before the Stock Market Crash of 1929, “Stock prices have reached what looks like a permanently high plateau.” Irving Fisher stated on October 21st that the market was “only shaking out of the lunatic fringe” and went on to explain why he felt the prices still had not caught up with their real value and should go much higher. On Wednesday, October 23rd, he announced in a banker’s meeting “security values in most instances were not inflated.” For months after the Crash, he continued to assure investors that a recovery was just around the corner. Once the Great Depression was in full force, he did warn that the ongoing drastic deflation was the cause of the disastrous cascading insolvencies then plaguing the American economy because deflation increased the real value of debts fixed in dollar terms. Fisher was so discredited by his 1929 pronouncements and by the failure of a firm he had started that few people took notice of his “debt-deflation” analysis of the Depression. People instead eagerly turned to the ideas of Keynes.
Fisher’s debt-deflation scenario has made something of a comeback since 1980 or so. Even Thorstein Veblen who was a critic of American culture and the American economy and whose classic book The Theory of the Leisure Class is still a best seller was not immune to the euphoria sweeping investors in the 1920s.
“A few years before his death, Thorstein Veblen had done something oddly out of character–he had taken a plunge in the stock market. A friend had recommended an oil stock and Veblen, thinking of the financial problems of old age, has risked a part of his savings. He made a little money on the venture at first, but his inseparable bad luck plagued him–no sooner had the stock gone up than it was cited in the current oil scandals. His investment eventually became worthless… Ironically, his death came less than three months before the momentous crash of the U.S. stock market…” [from The Worldly Philosophers, Robert Heilbronner].
We should be skeptical of the forecasts of economists and of other professionals but we have little else on which to base our own judgments. So, what are the pros saying today? There are several opinions from very pessimistic to mildly optimistic in the long run. [remember, this was written in 2008]
Economist Nouriel Roubini who warned early that we could experience a severe financial crisis said recently in FORBES: “At this point, the U.S., the advanced economies (and now most likely even some emerging market economies) will experience an ugly recession and an ugly financial and banking crisis– regardless of what we do from now on. We are already now in a global recession that is getting worse by the day. What radical policy action can only do is to prevent what will now be an ugly and nasty two-year recession and financial crisis from turning into a decade-long economic depression.”
For the polar opposite view I would refer to economists Lawrence Kotlikoff and Perry Mehrling: “Global markets have not been reassured by the coordinated interest rate cuts of several central banks or by recent congressional action, but they should be. Our bet is that financial markets will return to normal in short order and that the U.S. economy will squeak by with a moderate recession. Recapitalizing the banks and working out mortgages will take time, but the financial system will not collapse — the government won’t let it.”
For the either/or view we have George Mason economist Tyler Cohen: “The best and worst case scenarios–The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, investors keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis. Since Congress doesn’t have to vote for something called “a bailout,” it can give Paulson and Bernanke more operational freedom than they would have otherwise had. The American economy is in recession for two years and unemployment does not rise above eight or nine percent. The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the NYSE shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving. The Paulson plan is seen as a lost paradise. There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.
I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure.
”Nobel economist Gary Becker asks us to put things into perspective: “the magnitude of this financial disturbance should be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25% unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. So far, American GDP has not yet fallen, and unemployment has reached only a little over 6%. Both figures are likely to get quite a bit worse, but they will nowhere approach those of the 1930s.”
Experience has taught me that making emotional decisions and reacting to market volatility with extreme changes to a long term portfolio too often results in regret when more normal circumstances ultimately return. I see no reason to change my thoughts on this in the current crisis. Things could get worse, much worse. For that reason I have always recommended that you hold adequate cash reserves to see you through the tough times, that you make sure you are properly diversified, and that you consider cutting back on unnecessary expenditures and work hard to reduce debt especially today.
The famous investor Warren Buffett sees opportunities in this market—if you can keep a positive attitude. “There are certainly things that are a lot cheaper than they were a few years ago, and the businesses are better. Now, that doesn’t mean they are better today, but they are worth fundamentally more money than they were a couple of years ago, and people are just looking at the glass being half empty rather than half full now.” He’s also a firm believer that the American way of life will continue, unlike some of the bears above. “The genius of the American economy, our emphasis on a meritocracy and a market system and a rule of law has enabled generation after generation tolive better than their parents did…. We unleash human potential and will continue to do that in the future. American ingenuity will tend to surprise on the upside much of the time.”
[Important Disclosure: This information includes original material as well as content that is derived, with permission, from third-party sources. In all cases it reflects my own thinking and opinions. This material is meant for general illustration and/or information only. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. The author is not engaged in rendering legal or accounting advice. The services of an attorney or accountant should be sought in connection with any legal or tax-matters covered herein.]
Do You Need Brains To Invest?
NOTES FROM A FINANCIAL PLANNER
October 1998
Lots of smart people have been poor investors. Recently two Nobel Prize winning economists, Robert Merton and Myron Scholes, and a former Federal Reserve Board vice chairman, David Mullins, and John Meriwether at Long Term Capital Management L.P. managed to rock the financial markets by losing over $4 billion dollars. In essence they were gambling with borrowed money. This “dream team” at Long Term Capital Management is only the most recent in a long line of “smart” investors who have done poorly. As far back as 1720 the brilliant physicist Isaac Newton commenting on the South Sea Bubble said: “I can calculate the motions of the heavenly bodies, but not the madness of people.”” On April 20, 1720 Newton sold his shares in the South Sea Company at a solid 100 percent profit of 7,000 pounds. Unfortunately he had second thoughts perhaps being infected by the mania gripping the world that spring and summer. He reentered the market with a larger amount near the top and ended up losing 20,000 pounds. “In the irrational habit of many of us who experience disaster, he put it out of his mind, and never, for the rest of his life, could he bear to hear the name South Sea.” (see Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises).
100 Minds That Made The Market, a new book by Ken Fisher, Forbes columnist and founder of Fisher Investments, catalogues several examples of investors with brains who did poorly in their investments as well as many, with or without brains, who did quite well. He reserves his most vitriolic prose for economists. Having been trained as an economist, I hate that but I accept it. When writing of the famous economist Irving Fisher (no relation to the author) he says “Clearly, Fisher’s greatest contribution to Wall Street was his own negative example which should stand as a permanent warning to all concerned with financial markets and economics to steer clear of what economists have to say. Since Fisher’s day all kinds of studies have demonstrated that economists are wrong more often than right.” Irving Fisher’s dubious distinction was to have been an optimist throughout the 1929 stock market Crash thereby losing his personal fortune, a loss from which he never recovered.
Financial columnist James Glassman is straightforward with his advice: “Investing is actually simple. The experts – especially when they become convinced of their own genius – get into trouble by making it complicated. The lesson for small investors is to buy good companies at good prices and hold on to them for a long time. That’s it. Stray from this path at your own peril (Washington Post, September 27, 1998).
One of my favorite examples of successful investing without brains is the story of Louie the Loser which was first told to me by a friend at a large mutual fund company. Louie the Loser is one bad luck character. He canceled his dental insurance the day before his root canal flared up. His vacation in the desert was rained out. He misses planes but catches colds. Yet, in spite of his terrible timing, Louie the Loser is able to get better investment results than two Nobel Prize winning economists, an ex-Federal Reserve vice-chairman, Isaac Newton, and Irving Fisher. This is how he does it. Louie decides to invest $1,000 per year into a growth and income mutual fund starting in 1978 and continues to invest $1,000 each year through 1997. Twenty years, twenty thousand dollars invested. Of course, given his terrible luck Louie invests each year on the worst day possible, the day when the Dow Jones Industrial Average peaked. Even with his bad timing Louie’s investment account grows to $115,770 by the end of 1997. This represents an annualized return of 15.7%. Had Louie been smart enough to invest on the best day of the year he would have done better, but not much better. His annualized return would have been 17.2%. The moral: time is more important than timing when investing and complicated strategies aren’t necessary to succeed. [Figures quoted are for illustrative purposes only and are not necessarily indicative of past or future results of any specific investment They do not include consideration of the time value of money, inflation, fluctuation in principal or in many instances, taxes.]
O.K. You don’t need brains to invest and sometimes brains can be a drawback. As Yogi Berra said: “You can’t think and bat at the same time.” Still, there have been some brains and even a few economists who have invested wisely. John Maynard Keynes, the English economist whose theories dominated economic policy from the Second World War until the 1970s explained that investors often act on the basis of what they think other traders will be doing. “… the energies and skills of the professional investor and speculator [are devoted] … to anticipating what average opinion expects the average opinion to be.” (Quoted from Gray Becker, The Economics of Life, p. 299). Keynes put his theories to practical use and speculated successfully throughout his life amassing a fortune for himself and his alma mater, Cambridge. Keynes was a successful investor in spite of his brains because he understood the importance of the psychology of investing. Investors are often pushed by their emotions (fear and greed) to do exactly the wrong thing: sell at the bottom and buy at the top.
There is no tool kit that can make you a successful investor. Brains can be an advantage or a drawback depending on how you use them and on how they affect your own ego. Having a keen understanding of other people is generally a benefit since the financial markets reflect nothing more than the sum total of many individual opinions. Yet, getting too sophisticated with your psychology can easily divorce you from the common sense that successful investing requires. Having a plan can be helpful. A plan is perhaps the best way to overcome inertia. Yet, there are times when deviating from a plan because of unforeseen changes becomes necessary. A simple list of rules may be reassuring but may not be very useful in practice. I have often thought that investment results depend more on personality than brains. Those who are too trusting are easy prey for swindlers and scoundrels. Those who are vain reach too far and fall. Those who are too analytical look for systems which aren’t there while those who avoid detail make unnecessary mistakes. Outgoing types follow the crowd sometimes over the cliff while introverts are often too ahead of or behind the times for their own good.
Investments are not the most important thing. Your life is. When approached from the proper perspective, investing can enhance your life which is all you should expect. Do you need brains to invest? You be the judge.
[IMPORTANT NOTE: Material discussed in this article is meant for general illustration and/or information only. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. The author is not engaged in rendering legal or accounting advice. The services of an attorney or accountant should be sought in connection with any legal or tax matters covered herein. He is a registered representative of and offers securities through Royal Alliance Associates, Inc., an independent registered broker-dealer, member NASD/SIPC.]
Summertime Market Thoughts
NOTES FROM A FINANCIAL PLANNER July/August 2003
They’re back— those articles that list the“Ten Best Investments Today”or“How to Make a Bundle in the Next Bull Market.” Nobel Prize winning physicist Richard Feynman, in his book The Meaning Of It All, writes about how to assess such ideas:
“I would like, therefore, to discuss some of the little tricks of the trade in trying to judge an idea… The first one has to do with whether a man knows what he is talking about, whether what he says has some basis or not. And my trick that I use is very easy. If you ask him intelligent questions— that is, penetrating, interested, honest, frank, direct questions on the subject, and no trick questions— then he quickly gets stuck. It is like a child asking naïve questions. If you ask naïve but relevant questions, then almost immediately the person doesn’t know the answer, if he is an honest man… Now such a man would never get anywhere in this country, I think. It’s never been tried, anyway. This is in the attitude of mind of the populace, that they have to have an answer and that a man who gives an answer is better than a man who gives no answer, when the real fact of the matter is, in most cases, it is the other way around.” [pages 65-66]
It may be that the stock market hit bottom last October. Stock prices have been rising ever since, especially in the second quarter. Investors are happy again and the financial press is capitalizing on this with articles such as “It’s Time to Get Back In.” Of course, few were saying this last October when stock prices were 26% lower. Investors need to be careful where they get their information. No one can consistently and accurately predict the future yet investors are very interested in knowing what is going to happen and what they should do. Because investors want this information, it is provided in abundance and often with a twist that benefits those providing the information.
Investors must make decisions under conditions of uncertainty with the full knowledge that there is a positive probability that things may not turn out as they expect. The Ten Best Investments may turn out to be the Ten Worst Investments if the wrong forces come to bear. The Next Bull Market is unlikely to arise according to any preordained schedule. And, deciding when to get in and when to get out of the market is a tricky business. I know of no one who has done this successfully over a long time. These caveats do not mean that investors should ignore the financial press but that they should read with a critical mind, and perhaps some “intelligent questions”.
Einstein reportedly once said that he studied economics but decided to become a physicist because economics was too difficult. Economics and investing is difficult because it is about people including the emotional and psychological factors which weigh on their judgments. Economist Charles Kindleberger, who died on July 7th at age 92, “was a critic of the growing reliance of the economics profession on mathematics and on what he regarded as over-narrow rational models of human behavior.” Irrational behaviour, which often accompanies broad market swings, makes the financial markets difficult to predict. Prices can and often do swing far beyond what rational models forecast. Legendary investor Warren Buffett describes this process with the analogy that the stock market is a voting machine in the short run but a weighing machine in the long run. Ultimately stock prices seem to move according to the underlying fundamentals but in the short run, which can be a long time, things can be quite erratic.
The investment strategy that I recommend for investors who must deal with the uncertainties of the market, that is for those investors who do not believe they can predict the future, is relatively straight forward. The first point is to understand clearly why you are investing in the first place. Investing is not a game to be won or lost, it is a process to acquire wealth sufficient to meet one’s needs such as providing funding for retirement, college expenses, or other specific financial goals. The first part of the strategy requires sacrifice— in order to invest savings is required. Without savings (or a windfall such as an inheritance) there will not be any money to invest. Nothing plus nothing is nothing as they say. Even the best investment ideas won’t amount to much fit hey are not funded. The second part of the strategy is diversification. This is simply defined as not putting all your eggs in one basket. Now, I know there are those who advise putting all your eggs in one basket and watching it carefully. I am not one of them. I firmly believe that any serious long term wealth accumulation program must include several different types of assets. Real estate, stocks, bonds, and liquid assets are the primary asset classes that form the building blocks of most sound investment programs. How much should you invest in each area? That depends on the time frame, your risk tolerance, your need for return, and market conditions.
Once you have worked out the details and developed an asset allocation that is appropriate for your personal situation, stick with it. Don’t be duped into making large random changes in your investment portfolio based on the daily news or other people’s ideas. If you really think there are some special opportunities that warrant your consideration after a thorough review, don’t overdo it. Allocate perhaps 5% or 10% of your overall portfolio for special situations, if you must, so that if the special situations turn out to be ordinary flops your long term investment plan won’t be devastated. And, remember to re-balance periodically. Most would agree that the way to make money with your investments is to buy low and sell high. Emotionally we often want to do the opposite. That’s why, after stocks have just gone up 26% over the past few months, many investors are now anxious to get into the stock market. One way to keep the emotions out of the picture, at least a little bit, is to have a set asset allocation and to rebalance to that allocation periodically. Suppose you start with an allocation that is 50% in A and 50% in B. Then, over the next six months A goes up by 10% while B falls by 5%. Emotionally many investors would be likely to sell B and buy more of A. But, this would be selling low and buying high. However, the new allocation would now be 54% in A and 46% in B. So, to rebalance would require selling a little of A and buying a little of B which is equivalent to selling high and buying low. There is no guarantee that choosing a fixed asset allocation and periodically rebalancing will always be successful. It may not be the best possible strategy. However, it is a reasonable strategy and one that will help you avoid making emotional decisions that vary with the daily news.
[Of course, if they have the disease of “get-even-itis” they might want to hold B until it recovered, and then sell it, but it is unlikely they would want to buy more even though it is now cheaper. Investors need to be aware that no investment plan/asset allocation can eliminate the risk of fluctuating prices and uncertain returns.]
IMPORTANT NOTE: Material discussed in this article is meant for general illustration and/or information only. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. The author is not engaged in rendering legal or accounting advice. The services of an attorney or accountant should be sought in connection with any legal or tax matters covered herein. Securities offered through David Herstle Jones as Registered Representative of Royal Alliance Associates, Inc., Member NASD/SIPC.
So, those are some thoughts I offered in the past. I would recommend the same right now. Things don’t look peachy today. The coronavirus is an unknown and the possible outcome could be dire. Personally, follow your doctor’s advice and stay abreast of what the reliable professionals have to say. The impact on the economy could also be dire and no one knows how bad the markets might get or how long the might take to recover. But, if the past is any guide at all, the market will eventually recover. As you may know, I recently published a novel Behind The Locked Door. Yes, I talk about it all the time. Getting a novel into the hand of a reader is a long and tortuous process for an ordinary person. I hope many people will read it. There is one piece of advice that might apply to your investments in these difficult times (or might not, I am not making a recommendation here just an observation). An elderly man named Ira (retirement investors will note the irony here: IRA) is suffering from cancer. This is the scene at one point in the middle of a conversation about the disease:
Ira stood up. “I don’t think anybody knows how to stop this damn disease. I could write a book on the doctors I’ve known and the blunders they’ve made about me. I don’t trust any of the bastards. A man comes from the dust and in the dust he will end. Along the way it’s a good thing to take a sip of vodka.” Ira headed for the juice bar, his gray ponytail bouncing along behind him.