A random walk to nowhere
September 30, 2009
Market Summary – 3rd Quarter, 2009
This year, when deaths of icons from Michael Jackson to Ted Kennedy to Walter Cronkite generated significant media coverage, it is ironic that most people missed the passing of another iconic symbol of recent times – the Efficient Market Theory (we’ll refer to it as EMT for simplicity’s sake).
EMT was developed by Professor Eugene Fama at the University of Chicago and popularized by the 1970s bestseller A Random Walk Down Wall Street. It claimed that investors were best served by purchasing the entire market through proxies such as Standard & Poor’s 500 Index funds rather than picking individual securities to outperform the market. The general idea assumes markets account for information so quickly and efficiently that individual investors and even professional money managers are hard pressed to beat the market as a whole.
Author and columnist Justin Fox, in his new book The Myth of the Rational Market, says Professor Eugene Fama and other “freshwater” economists (the name for those not based at coastal colleges) created, promoted and continued to refine their notion of efficient markets. According to Fox, their theories included one stating “that you couldn’t beat the market using any publicly available information” and another suggesting “a market so perfect that even investors with access to private information couldn’t outsmart it.” In other words, there is a level of perfection in the market that investors could not hope to outperform.
These ideas may have merit in theory, but fall short in practice. Steeped in the heat of an 18-year bull market from the early 1980s to 2000, the consensus was that the market knew best. The optimum return any investor could expect was whatever the market offered.
From 1982 through 1999, the Standard & Poor’s 500 stock index returned an average of 18.5% per year. The EMT camp looked to be right on target. Why argue with returns like that? Making money by tracking the index was a no-brainer.
Spreading like an epidemic
EMT became not simply the new conventional wisdom, but the driving force behind product creation on Wall Street. Investment strategies and even federal policy decisions were based on Prof. Fama’s underlying theory. It led to the development and marketing of:
• Index funds
• Exchange traded funds
• Asset allocation models
• Black box trading strategies (used by large institutions and hedge funds) that were focused on finding minute inefficiencies using theoretical models.
Investors’ dollars followed in waves, as investors voted with their feet for the efficient market philosophy by pouring money into those passive Wall Street products. They believed the market would continue to “perfectly” reflect economic reality. Most investors were convinced of the wisdom of the market even when prices became excessive by early 2000. At that point, market returns were significantly out of line from the historical norm. The explanation was that the stock market reflected the new “Great Moderation.” Our economy was said to be under such effective management that business cycles would last longer and severe downturns could be avoided. It had to be true, after all, because the market knows best.
The director of our “Great Moderation” was the man considered the smartest of them all, longtime Federal Reserve Chairman Alan Greenspan (famously dubbed “The Maestro.”) He let his own market ideology, in alignment with the EMT crowd, influence policy decisions in ways that ultimately contributed to the downfall.
Greenspan was content to maintain a loose money policy that some believe contributed to the development of the Internet bubble in the late 1990s. Far more damaging was Greenspan’s willingness to hold down interest rates in the early part of this decade and ignore what seemed to be questionable banking practices. Those decisions enabled an environment that, through “creative” financing strategies crafted by the banking industry, led to the disastrous housing market meltdown that nearly wiped out the world’s financial system. It also destroyed the confidence of many average investors who have lost their trust not just in the markets, but in the power of investing.
When asked by Congress in 2008 whether his ideology pushed him to make decisions he’d wished he would not have made, Greenspan admitted, “Yes, I’ve found a flaw…I’ve been very distressed by that fact.”
Greenspan dismissed critics during his tenure by noting that the nation had never seen housing prices decline in a significant way. In his mind, the market couldn’t go bust, because it never had. In essence, his belief was the market would manage events, and take care of us all. But as with so many other theories over the years, this too proved to be no match for economic reality and the human, social, political and cultural influences that EMT believers always seem anxious to dismiss.
In truth, the markets don’t always reflect reality. A manic-depressive quality can sometimes takes over. Market manias occurred in the past, and surely will again. Excess can also occur on the downside, with the severe downturn following last year’s financial crisis as a case in point.
Overlooking the obvious – Price
While EMT followers removed the human element of judgment, experience and reason from their formulas, they also ignored one of the most important factors – the PRICE paid for an investment. Is it appropriately valued? Has a market anomaly suddenly made the price more attractive? Or has a recent “mania” made it an overpriced asset? Despite claims to the contrary, even the most efficient markets cannot remove the opportunity for mis-priced assets.
The philosophy we adhere to, based on a value-driven approach, has a long and enviable track record. The most notable believer is Warren Buffet, who happens to be the richest investor in the world. We focus on factors overlooked by those using EMT practices, uncovering companies that are priced in a way that minimizes the downside risk and, if the firm achieves its potential, realizes tremendous upside.
Control of downside risk is one of the most important benefits of a focus on price. In times like these, it becomes even more important. While “growth” investors try to predict which companies will generate tremendous earnings growth over the next few years, value investors don’t assume a future they can’t see. The emphasis is on identifying companies that are appropriately priced in conjunction with a variety of measures.
Can the “New Normal” overcome a lost decade?
The first decade of the new millennium, which began with such incredible optimism about the stock market, will likely end with a negative return for broad market indexes. Ironically, the Dow Jones Industrial Average closed a few weeks ago, on the 8th anniversary of the September 11th terrorist attacks, at 9,605 – the exact same place it stood that fateful day in 2001. For index investors, it is as if time has stood still. EMT offered no protection for investors during the most recent market downturns.
So where are we going? Some suggest that we have entered a “new normal.” The definition can vary depending on the source. Those who lived through the latest stock market correction are told to rethink their investment strategy. Several firms changed their asset allocation model assumptions. These models are designed to provide long-term investment guidance. The modifications made reflect an expectation that equities can’t live up to previous return assumptions.
It seems the concept behind the “new normal” thinking would have been more beneficial had somebody come up with it ten years ago. But at that time, the hot catchphrase (along with the “Great Moderation”) was the “new economy,” one that was technology driven, where stocks had unlimited potential to keep growing as they had in the 1980s and 90s. More in line with “new normal” thinking is the August 1979 cover story in Business Week magazine touting “The Death of Equities,” which came just before the start of the two best decades in stock market history. Like then, it would not be surprising if the “new normal” theory proves to be more about hindsight than the future.
“New normal” backers expect slower economic growth in coming years, reflected in reduced stock returns. Proof that stocks offer limited benefits includes a study showing that over the previous 40-year period, an investor rolling over non-callable 20-year U.S. Treasury bonds would have generated slightly superior performance to stocks.
As Professor Jeremy Siegel, Wharton Business School Professor points out, to generate comparable returns over the next 40 years, interest rates on long Treasury bonds would need to decline by 2%. Given that interest rates are near historic lows today, that seems highly unlikely. In fact, bond prices may be close to a peak today. Put another way, when it comes to value, there isn’t much to be found in the today’s bond market.
According to Lipper FMI (Fund Market Information), $350 billion was pulled from low-yielding money market funds in 2009, with 90% of that cash directed into bond mutual funds. In contrast, investors pulled $9 billion out of equity mutual funds in a recent six-week stretch. It strikes us that we should be less concerned about an overheated stock market, and more worried about whether bonds are nearing a peak.
Can stocks turn it around after a depressing decade? Prof. Siegel says if history is a guide, the odds are good. Siegel measured market returns for all 127 ten-year periods going back to 1871. He said each time the ten-year return fell into the bottom quartile (in other words, ranking as one of the 32 worst-performing ten-year periods over that span), the subsequent decade yielded positive after-inflation returns for stock investors. Siegel states the median return for those 32 periods exceeded the long-range average for equities. That appears to verify our thinking that the best time to invest is when price is driven down. History tells us that weakness (whether in the market as a whole or a stock in particular) becomes your ally. Price, not popularity, creates real opportunity for recovery. The numbers in the table below seem to confirm this thought, and that bodes well for the years to come.
Conventional bear wisdom
Since dropping to 6,547 on March 9, the Dow has jumped about 50%, but still far short of its 14,000+ peak reached in October 2007. As the rally progressed, in the face of mixed economic signals, the sentiment has turned decidedly negative. To quote the late William Safire, the “nattering nabobs of negativism” are alive and well.
The market pundits were out in full force just six months ago. In effect, they were pronouncing the investment world as “mostly dead.” But, to quote the memorable movie character “Miracle Max,” (as portrayed by Billy Crystal in the film “The Princess Bride,”) “There’s a big difference between mostly dead and all dead. Mostly dead is slightly alive.”
Fortunately, it turned out the economy and the markets were even more than slightly alive. The old market cliché of “sell in May and go away,” would have been ill-advised springtime advice in 2009. The third quarter was the best single (calendar) quarter for stocks since 1998. The gain of 34% (for the S&P 500) over the past six months is the best run of two consecutive calendar quarters since the January through June period of 1975, when the S&P 500 returned almost 42%.
We point this out as another example of how investors can easily be steered wrong by all of Wall Street’s conventional wisdom. It was wrong six months ago, and we would take with a grain of salt the concerns voiced about the next six months. More importantly, this is a marathon, as they say, and the sprint to the next quarterly return matters less than what we can expect longer term.
In a recent Wall Street Journal column, writer and longtime bear, Jim Grant, suggests that last year’s crisis and the resultant recession created an environment where the markets erred on the side of pessimism. Grant notes “the world is positioned for disappointment. But, in economic and financial matters, the world rarely gets what it expects.”
Using historical analysis as his primary guide, Grant says he is “bullish on prospects for unscripted strength in business activity.” He and others have noted that in a typical case, the deeper the recession, the stronger the economic recovery. As the chart indicates, this has happened time and again.
The pessimists today are convinced it can’t happen this time. But for those who remember the days of high oil prices, double-digit inflation and record high interest rates in the early 1980s, it was one of the bleakest economic periods in our nation’s recent financial history. That downturn laid the groundwork for what became one of the strongest periods of economic expansion in the U.S. It also kicked off a period of unprecedented global economic growth.
What could be the economic trigger today? We noted the most intriguing possibility in our 2nd quarter newsletter – the potential for tremendous economic growth across the globe. Expanding middle classes in overseas markets (China, India and Brazil, for example) will create significant investment potential, both domestically and elsewhere. Investors need to think outside of our borders. Wharton’s Prof. Siegel agrees, says that the “new normal” advocates ignore the bigger picture of global economic growth and its potential impact on the U.S. economy and markets.
There are opinions that can be found on the other side of the argument as well, and plenty of short-term unpredictability. This is nothing new. As Jim Grant points out, “The very best investors don’t even try to forecast the future. Rather, they seize such opportunities as the present affords them.” With a market still down more than 30% from its all-time high, there is additional upside potential that’s been left on the table even after this year’s rally. For those who focus on buying stocks at the right price, the key remains minimizing downside risk while identifying strong potential for long-term reward.
This is the basis of value investing and a focus on long-term economic opportunities. Such factors are difficult to quantify, and there are no accepted algorithms to help calculate the opportunity. Instead, qualitative research, combined with reasoned judgment and an understanding of the human factors affecting the market and individual securities will continue to generate opportunity, regardless of the market’s ups-and-downs.
Meet the new boss – same as the old boss – VALUE!
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.