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Is it a casino or a marketplace?

Market Summary – 4th Quarter, 2007


q407 cartoon2007 will be remembered as the year of “volatility.” While major U.S. equity markets gained only modest ground, it was far from mundane. Economic news was mixed. On the positive side – continued growth in the GDP, slowing but positive corporate profits and low unemployment. On the negative side – the sub-prime mortgage meltdown, a declining housing market and soaring commodity prices raising the risk of higher inflation. There was plenty of news to play on investor emotions, in both directions.

The numbers tell the story. Look at it in two ways:

Day-to-day changes
Significant stock market swings became more common from one day to the next. The closing value of the Dow Jones Industrial Average fluctuated at least 1% on only about one out of ten days in 2006. Last year, the number of times the market’s closing price changed by at least 1% was closer to one in four days. We cannot remember a time when there was so much volatility throughout the entire year.

volatility increased in 2007
Intra-day changes (price movement within the same trading day)
Ever check on the Dow Jones Average in the morning and see it going in one direction only to look again later in the day and see that it has moved dramatically in the opposite direction? It seemed like that happened a lot in 2007, so we checked the numbers. According to our statistical review, the gap between the daily high and low value for the Dow Jones Average was at least 1% (that’s about a 120-130 point change in value) within every single trading day in 2007. What’s more, the gap between intra-day highs and lows was 2% or greater on 68 different trading days. The trend accelerated as the year progressed. Almost all of those days with variability of 2% or greater occurred in the second half of 2007!

What is causing this schizophrenia in the stock market? Can it simply be a reaction to the daily flow of good and bad news?

While traditional investors and their own changing sentiments may be part of the reason for the roller-coaster ride, we think another force is at work.

Patience becomes passé, momentum rules the day
The market is experiencing a significant transition. Short-term traders, including hedge funds and futures trading firms are behind more of the market’s day-to-day movement. Their view is driven by the idea that the best way to generate profits is to use short-term strategies. This mentality involves the use of chart patterns, momentum trends and other data focused far more on psychology then on economic, market or company fundamentals. The age-old axiom of investors everywhere – to buy low and sell high – has been replaced by the desire among these traders to buy high and sell even higher, or sell short and cover their position later at a lower price, hoping to ride the wave of momentum.*

*The SEC revoked the “uptick rule” in July, 2007. The rule only allowedsellers to sell at a price above the last price of a stock, or at the price of the stock’s last trade if it was higher than the previous price. Now, short sellers can “pile on” a tumbling stock and continue selling it short as it goes down in price.

This “instant gratification” approach, basing investment decisions on up-to-the-minute news, mathematical calculation and maybe even a hunch here or there, reflects a casino attitude. It isn’t surprising that the typical factors an investor would consider, like valuation, competitive environment, cash flow and earnings outlook, carry little weight with the new breed of short-term traders.

This mentality is not new to the market. There have always been traders who try to make a profit on small price changes in securities. It is just that it has become much more pervasive. Hedge funds today run close to $2 trillion in assets, a staggering sum in itself. On top of that, those assets are leveraged, sometimes at five to ten times their principal value, attempting to maximize their return (those who leverage ten times are borrowing $10 for every dollar of principal they invest). Of course, this comes at the risk of greatly multiplying their losses if they guess wrong – as many experienced when the subprime crisis struck.

The heavy emphasis on leverage makes it easy to understand why traders would move their money in and out of positions in a hurry. If you are using 10 times leverage, and the market moves 5% in the wrong direction, you suddenly lose half of your money.

The fee structure employed by most hedge funds encourages this type of behavior. For example, some managers charged 20% of gains in addition to their set management fee. That kind of fee structure has the effect of making leverage an even more attractive option for them. But being leveraged requires that they move money quickly in order to try to capture a profit or avoid a sizable loss. In other words, the system virtually demands a short-term focus and instant reaction to market movements.

The result – burgeoning hedge fund assets, heavily leveraged trading and a fee structure that encourages rapid reactions. Hedge funds now account for 50% of stock market volume (that was documented in a recent study by the FBI). They also generate half or more of trading activity in the credit markets, the derivatives markets and emerging markets (according to the consulting firm Greenwich Associates). You can see that the hedge fund tail is now wagging the market dog, at least in the short term.

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So what’s an investor to do?
The market seems to have stopped making sense. Psychologically driven short-term trading may cause individual securities, sectors or the general market to suddenly reach unjustified highs or lows. Can traditional investors survive and thrive in such an environment?

The question brings to mind a famous quote from the classic book “The Money Game,” by Adam Smith – “If you don’t know who you are, the stock market is an expensive place to find out.” Fortunately, we do know who we are. Our answer on how to deal with this market is to keep doing what we have been doing. The record shows that through all of the volatility generated by short selling and algorithmic trading strategies, there is still a place for long-term investors who focus on value.

While the market’s volatility can be maddening, history teaches us this vogue is a short-term phenomenon. Prices of quality stocks can take a temporary beating even as the companies continue to prosper. If one is not overly influenced by the negative psychology of the moment, it is possible to identify an opportunity and take advantage of it. In time, good companies are recognized for the wealth they create. As the proverb goes, “water seeks its own level,” and it truly applies to the investment markets.

Conditions in the present economic and political environment pale in comparison to the major events of the past 50 years. In that time, the Dow has increased 28 times, from 500 to 14,000. This has occurred despite a litany of bad news that has befallen the markets. These include wars in Korea, Vietnam and the Middle East, political assassinations, unrest in the streets, a President resignation, the Arab oil embargo, inflation, stagflation, S&L failures, 9/11, Enron, and the list goes on. The fact that stock markets have enjoyed dramatic growth in spite of it all tells us this – it is expensive to be pessimistic.

industry-market-volatility

What they missed in the casino
Recent history suggests that you see a lot more by looking at the tides rather than the waves. By focusing on the “big picture,” we maintain a better perspective and discover opportunities often overlooked by those who are thinking only of the next ripple in the markets. A good example is where the markets stood at the one-year anniversary of the 9/11 tragedy and in the midst of 2002, a year when the S&P 500 would decline 22%. The psychology of the markets could not have been more negative.

q407 quote buffetBut looking beyond the waves of bad news cascading on investors at that time, it was possible to look out over the horizon and see something bigger going on – a world marketplace that was just starting to kick into gear, and would pave the way for a global economic recovery.

Just 15 years ago, only 55 countries (out of 180) enjoyed economic growth rates (measured by Gross Domestic Product) of 4% or more. In 2007, according to projections by the International Monetary Fund, 123 countries, more than two-thirds of the world, generated GDP growth of at least 4%.

Patience and persistence paid off, as the stock market has gone on a five-year bull run since 2003, a fact that can easily be forgotten as the media continues to focus on waves of bad news rather than tides of progress.

A global economic expansion is underway. For example, India’s middle class has tripled in size in recent years, to 300 million, about equal to the entire population of our country. The middle class is rising in China and many other countries where economic freedom has taken hold. This is the future that creates reason for optimism. The opportunity is available to long-term investors in the marketplace. When you are in the casino, it is a lot more difficult to see the world. We continue to believe that you can benefit most from economic growth through long-term investing in companies that will share their success with you through rising company value.

An additional substantial benefit for those with a long-term approach is that the federal tax system has a lower tax rate on long-term gains. Most of our gains (including dividends) are subject to the most favorable tax rate – a maximum of 15%. By contrast, the tax code, through higher tax rates on short-term capital gains, adds a penalty if you play in the casino looking for quick profits. This should be remembered when comparing results between various short-term strategies and more traditional, long-term investing.

2007 In Review
Looking Through the BIG Rearview Mirror
Here is a quick look back on some of the “big picture” developments that we covered in newsletters you received over the past year:

4th Quarter 2006
A Time to Remember
We paid homage to the late Milton Friedman, and made the point that his free market ideas were clearly taking hold across the world (see the discussion above regarding GDP growth in countries across the globe). The “Friedman effect” of capitalism is driving continued economic expansion (and investment opportunity) worldwide.

1st Quarter 2007
Beyond Corn
We discussed our excitement about new energy alternatives in this newsletter, but specifically pointed out the downsides of corn-based ethanol. The effects were seen in spades in 2007 – corn demand rose, and so did prices for corn and other agricultural commodities. It contributed to a higher inflation rate without stemming the problems of expensive oil. We remain positive on cellulosic alternatives like switchgrass or other biomass material. This developing technology is where the real promise lies.
In addition, we remained optimistic about the prospects for crude oil. While short-termers may have been discouraged when oil reached a low of $50.48 on January 18, 2007, we
held to our long-term belief that the continued demand for oil (spurred on by rapid economic growth outside of the U.S.) combined with a peak in production would push prices higher. By year’s end, oil was nearing $100/barrel.

2nd Quarter 2007
Cicadas have awakened. Will the market’s Sleeping Giants follow suit?
The key point we made is that no matter how big the company or how well known the name, paying too much for the asset can really hurt when a bear market strikes. Our point was that since 2000, a number of the biggest stocks in the market were still in negative territory. This is a critical point. Focusing on major economic forces that can affect industries and stocks is one thing – but it is more important to pay attention to a stock’s price before investing. Only when the price is right do we make a commitment. Fundamental value matters when you invest, even in popular, big name companies. No matter how much the markets change, this basic rule of investing does not change. In this letter, we also warned of the growing market volatility, which accelerated as the year progressed.

3rd Quarter 2007
Intellect with Blinders
We are reminded time and again that the powers of observation are critical for those who want to profit in the marketplace. A lot of great minds, including Nobel prize-winning economists, designed surefire schemes for profits by making casino-like plays that failed (remember Long Term Capital Management in the 1990s?). In recent months, we’ve seen more examples of this, as the subprime crisis has created a financial meltdown for major Wall Street firms and banking houses that, on the face of it, seemed too smart to fall for such a thing. The brain trusts that were busy focusing on instruments like Collateralized Debt Obligations and Credit Default Swaps missed something they should have observed.

Keeping our eyes on the tides
We know that there are short-term traders who do succeed in the markets, though some are more notable successes than others.

Our point is that for the average investor, a patient approach designed to capitalize on solid value in the marketplace has a much greater chance of success. Consistency and a focus on long-term fundamentals will help overcome the day-to-day swings in the markets. While the “talking heads” on CNBC and other stations are good at describing the waves, our experience tells us to ignore the noise and keep watching the tides to discover profitable, long-term opportunities for wealth accumulation.

~MPMG

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.