As we interact with our investment industry contacts, we sense an uncertain numbness which has rendered some of them nearly inoperative. Besieged by waves of bad news and handfuls of “once in a generation” market events, they no doubt feel that their career choice was a lousy one. Yet, we feel just the opposite. Although we were not able to predict the stock market’s decline, we have been fully engaged in dealing with the capital market storms from day one. We have sent out numerous “blast” e-mails giving our clients our best efforts, opinions and perspectives on what was happening at serious inflection points in the markets. Our Chief Investment Officer, Mike Goodson, has begun a blog, “Persuasion Time” (http://persuasiontime.blogspot.com) which represents another means for clients to access our most current views and ideas. We have put fresh money to work for our new clients during these turbulent markets, using our time-tested investment philosophies built on the twin pillars of diversification and bottom-up valuation. Throughout all these challenging times, we have come to the office every day, rolled up our sleeves, and tried to offer our best advice, given the facts as we see them.
First Quarter Review
During the first quarter of 2009, the S&P 500 lost about 11%. This was the sixth consecutive negative quarter for the market. Whereas the declines experienced in the Q4 2008 were marked with dramatic events (failure of Lehman Brothers, bank bailouts, AIG rescue, etc.), the declines seen in January and February were steady and unremarkable. Volatility remained more or less constant and the market did not seem to be reacting to any major news. It just went down.
To some, this was even more worrisome than the declines experienced in October and November. Back then, we learned quickly that something extraordinary was occurring. It was as if the dam had burst, and a huge wall of water had flooded the valley. Then the government intervened and tried to repair the hole and stem the tide. But by January it seemed that new leaks had sprung, and while no massive amount of water was flowing, the valley was again being flooded. The new market lows in February and March were a huge surprise to many and further depressed consumer and investor sentiment. The news over this period consistently indicated that we were experiencing a major global economic slowdown.
We heard many stories about individual investors reaching their breaking point and moving totally out of stocks and bonds and into cash. We heard many high-profile market commentators suggesting that this move was “prudent” and that the market could fall even further from the lows seen in the first quarter. The handful of economists and academics who were credited with “predicting” this crash became not only overnight celebrities, but became the “go to” guys for all matters business or market related. The media is constantly asking these newly-minted “gurus” their opinions not only about the economy (where they may have some high-quality opinions), but about the market, the auto industry, the bank bailout and even their favorite stocks. Many of these otherwise obscure thinkers are truly enjoying their Warhol-esque 15 minutes of fame.
The first quarter was also marked by a minute-by-minute commentary on proposed government intervention and the potential short-term impact of such actions. For longerterm investors, it has been a challenge to maintain the proper perspective on the investment strategy that is likely to succeed in the long term amid the speculation that capitalism is dead, diversification does not work, and that market timing is not only possible, but perhaps necessary. We disagree with all three of these ideas.
Here’s what the quarter looked like by the numbers:
|Index||1st Qtr 2009||Trailing Twelve Months|
|Dow Jones Industrial Average||‐13.3%||‐38.0%|
|MSCI EAFE Small Cap||‐12.0%||‐51.2%|
|MSCI Emerging Markets||‐0.6%||‐44.6%|
|Lehman Aggregate Bond||‐2.6%||‐1.2%|
|Barclays Municipal Bond||3.2%||0.9%|
|Dow Jones Commodities||‐6.4%||‐45.5%|
All the gloom and doom that had been slowly building throughout the first two months of the year, came to a chilling climax on March 9th. That day the S&P 500 closed at 676.53, representing a 55% decline from the October 2007 high and the lowest level for the market in 13 years. Comparisons between these days and the Great Depression were part of the daily fodder on business television programs. The media, ever eager to compound whatever trend appears to be in place, gleefully reported each new negative data point and with a smile told us how many years it had been since things had been so bad.
Then, without fanfare or rational explanation, the stock market began to rise. The U.S. economy surely had not changed its course overnight. But, investor sentiment had clearly reached its nadir, and selling pressure dried up. As of this writing, the market is up about 25% from its March lows, despite weak GDP, bad employment numbers and mixed earnings results.
So what’s happening here? Have investors simply gone mad? Before we attempt to answer these questions, let’s take a short detour and talk about basketball. You will understand why further on in this letter. The NCAA men’s basketball tourney, which occurs every March, is one of the most exciting sports events of the year. Each game sends the loser home and advances the winner closer to becoming the champion, the best team in the sport. Every year at least one team earns the label “Cinderella” by surprising all the experts and defeating a better known and perhaps more skilled team. But usually, the overall winner is the team that has the best talent, the best coaching and the desire to push themselves to the limit every single game.
Who is Shane Battier?
In 2000, Duke won the NCAA championship largely on the back of its versatile 6’ 8” forward Shane Battier. At the college level, he excelled, but some experts were worried that he wasn’t athletic enough to compete in the National Basketball Association (NBA). Now in the ninth year of his pro career, he has become a bit of an outlier. In a sport that glorifies freakish height, leaping ability, quickness and the skill of shooting a ball through a hoop (all sports seem a bit weird when broken down into their elementary parts), Battier is valued for what most do not see and few appreciate. In an excellent New York Times Magazine article1 author Michael Lewis (Moneyball, Liar’s Poker, etc.) describes how Battier, despite mediocre stats and athletic prowess still far below the upper quartile of the league, has become a surprisingly valuable player for his team, the Houston Rockets.
Lewis described the mystery of Shane Battier this way, “Here we have a basketball mystery: a player is widely regarded inside the N.B.A. as, at best, a replaceable cog in a machine driven by superstars. And yet every team he has ever played on has acquired some magical ability to win.” Lewis goes on to explain that many teams are now using the deep statistical data mining techniques which he featured in his book Moneyball. In the past, teams would record just the most obvious stats about the players and the game – points, rebounds, turnovers and the like. With the advent of better computing power and the understanding that all information might be valuable, teams now will track more data in an attempt to find out what non-obvious stats might be important. Coaching staffs can now use this data to help determine defensive match-ups, defensive sets and even the best places for each player to attempt an important shot.
Battier is unique in that he is the only player his team allows total access to this data. He says, “I try to prepare for my opponent as thoroughly as possible. I want to know every angle on the man I am guarding to give me an edge. I read many, many pages and go over strengths and weaknesses many times before a game. ‘Proper preparation prevents poor performance.’ That is a motto I like.”2 Despite his athletic limitations and unremarkable statistics, he has become hugely valuable for a number of reasons, but the one we will focus on is that through a process of study and preparation, he can render the opponents’ best players ineffective. Because he has access to the important data on the players he will guard and he knows how to use it, he can reduce the number of points they score, and this can often influence the outcome of the games.
Near the end of the article, Lewis describes a game where Battier was assigned to cover Kobe Bryant, one of the league’s best players. After holding Bryant to a point total and shooting percentage well below his season average, the game came down to one last shot. Bryant had the ball and Battier was able to stop him from driving to the basket with his right hand (a move Battier knows, through his study of the data, will usually result in points scored) and Bryant was forced to pass the ball to another team member. Shortly thereafter, Bryant was passed the ball again with only a few seconds left in the game.
We will let Lewis tell the rest of the story. “Bryant caught the ball and, 27.4 feet from the basket, the Rockets’ front office would later determine, leapt. Instantly his view of that basket was blocked by Battier’s hand. This was not an original situation. Since the 2002-3 season, Bryant had taken 51 3- pointers at the very end of close games from farther than 26.75 feet from the basket. He had missed 86.3 percent of them… It was a shot Battier could live with, even if it turned out to be good. Battier looked back to see the ball drop through the basket and hit the floor. In that brief moment he was the picture of detachment, less a party to a traffic accident than a curious passer-by. And then he laughed. The process had gone just as he hoped. The outcome he never could control.”
His team lost that game, but Battier felt like he had done his job the best he could. Given the uncertainty and complexity of a game of basketball, he could not ensure the outcome, only try to improve his team’s odds of winning.
Here’s how Mr. Lewis describes Battier’s approach to basketball: “Knowing the odds, Battier can pursue an inherently uncertain strategy with total certainty. He can devote himself to a process and disregard the outcome of any given encounter. This is critical because in basketball, as in everything else, luck plays a role, and Battier cannot afford to let it distract him.”
In short, Battier is a valuable player, not because he does the flashy obvious stuff that everyone usually equates to success on the basketball court, but because he knows how to shift his team’s odds of winning (by thorough and careful study of the important data) and trying to be in the right place at the right time.
Implications for the Investment Process
Why do we mention this story in a quarterly letter about markets, economies and their impact on investment portfolios? Aside from the clear analogy to value investing, we think that we approach the investment process a lot like Battier approaches each game. His careful preparation, using the important data, has a lot in common on how we research our stocks, bonds and funds. Like him, we rely on a process that defines our investment strategy. We concentrate on facts and what is known to provide the basis for our portfolio allocations and security selection.
We understand and accept the uncertainty implicit in the markets, yet we have total confidence in our long-held and time-tested investment philosophy and practices. We spend the bulk of our research efforts on analyzing data and measuring value and very little time on predicting the future. We know we cannot control the direction of the market, but we are confident that our efforts increase our odds of “winning.” Yet, win or lose, we know that we have applied all of our skill, talent and experience to help our clients reach their investment, and ultimately, life goals.
Outlook for 2009
Enough about basketball – let’s get back to the question at hand. What’s going on? Why is the stock market rising as the economic data still suggests recession? Assuming that the market has indeed entered a new bull market (we are not willing to conclude that this is the case; ultimately the real determination of whether or not this is a new bull market will only be made after it has reached much higher levels), the market is doing what it always does at the beginning of a new bull market – climb a wall of worry.
Some investors mistakenly think that the stock market needs good news to recover. Looking at all past recessions and bear markets, it is easy to see that this is not the case. The market simply needs for the news flow to become less bad to begin a new, sustainable rally. Even now, amid what President Obama characterizes as “glimmers of hope,” many so-called pundits and experts continue to predict a longer-than-expected recession and more pain in the stock market.
In our view, the fundamentals that matter to the capital markets are always a mix of positives and negatives. The direction of the market is not so much determined by the difference between these two extremes, but rather by which part of the spectrum captures investors’ attention. Regardless of what positives might have existed in the OctoberNovember period, all investors were focused on the dramatic negatives.
Here is a partial list of positive fundamental factors as we see them now:
- High Cash Levels. We see $9 trillion in money market accounts. These funds had been in stocks and bonds and now just sit there waiting for the “all clear” signal to get back in.
- Sentiment. High bearish sentiment (we saw historically high levels in early March) often accompanies the bottom of the market.
- Interest Rates. The Federal Reserve is determined to keep short rates low (which helps a large number of borrowers) and has also begun a tactic aimed at lowering longer-term rates, especially mortgage rates. This could stabilize the housing industry and via refinancing, put more cash into households.
- Lower Energy Prices. The dramatic decline in energy prices from last summer is another stimulus to the American household budget.
- Government Action. The new administration is determined to do as much as it possibly can to jump start the economy and return confidence to the system.
Despite the above, we continue to see significant negatives which may impact the establishment of a new bull market:
- Unemployment. As layoffs continue, many may worry about the impact this has on consumer sentiment, spending and saving. The fact that employment is a lagging indicator may not matter to the average citizen watching the nightly news.
- Earnings. First quarter results have just started to trickle out and despite good news from Wells Fargo, it’s hard to imagine that all companies will report better-than-expected earnings in a quarter where GDP is expected to fall 6%.
- “Expert” Opinions. The handful of economists and academics credited with “predicting” this recession are mostly staying with their pessimistic forecasts. Unless they are particularly nimble (and different from past prophets of doom), they will miss the upside of a new bull market. Yet, the combination of their new-found fame and continued gloomy opinions may sway investor sentiment and stifle the rally.
- Bailouts. Major U.S. industries (banks, real estate, insurance, banking, etc.) may yet require a great deal of government assistance and/or dramatic changes before the “all clear” signal can be sounded. Regardless of the skill of the decision makers involved, these industries’ status is highly uncertain and fraught with risk.
- The Other Shoe. In the back of everyone’s mind seems to lurk the fear that something else, unexpected and dire, is just around the corner, and could bring us right back to the pain and losses seen last year. This fear is particularly worrisome because it’s impossible to prove the absence of something. To the extent that this fear inhibits action, it could dampen the recovery.
Over the last few weeks, the markets have clearly been focusing on the “glimmers of hope” and not the “worst economy in 50 years.” Will this continue? Hard to say. We generally shun predictions. However, we have positioned our client portfolios to fully benefit from the full economic recovery and new bull market when they come. The time to be defensive is long past. In our view, cash is the most expensive and “risky” asset, especially for those investors with longer time horizons and important financial goals yet unmet. Time will tell.
As always, your current portfolio holdings are listed in the enclosed Quarterly Portfolio Statement and your portfolio’s rates of return for the most recent quarter, year-to-date and past twelve months can be found in the Portfolio Performance Summary.
RDL Financial, L.C.