Just when you thought it was safe to get back in the water, a huge oil rig springs a leak. Just when you thought the economy was finally on the road to a self-sustaining recovery, nearly every expert out there begins talking about a “double dip recession.” Just when the equity market looked like it might just be in bull market mode, we see a bigger-than-normal correction. So what’s going on here?
Lately the amount of negative news flow has been unrelenting. Clearly all this bad news is having an impact on consumer and investor sentiment. We are beginning to see some economic softness which could be the result of consumers feeling less certain about the future. We might be psyching ourselves out of a recovery. On the other hand, we continue to see a great deal of positive news. It just seems less obvious to the casual observer. Job growth in the private sector has been very strong this year. Corporate profits continue to rise. Interest rates are low and seem destined to stay there for a long time to come. Because of all these mixed readings, we sense a feeling of uncertainty on the part of a lot of people. It’s as if many have stopped trying to make sense of it all, perhaps because there is too much information out there or because all they hear is the bickering of so-called experts trying to sway their views. Wouldn’t it be nice to have your own expert to help you out in these tough times?
Second Quarter Review
The stock market struggled in the second quarter, starting off with bad news from Greece in April. By May, many investors were concerned about Greece’s trouble spilling over into other countries. Some were so bold as to suggest that the U. S. would eventually end up like Greece due to its rampant deficit spending. These fears were then met by a spat of economic data hinting that the U.S. economic recovery was not as robust as previously expected.
Corporate earnings for the first quarter (reported from April onward) were strong, and most companies have revised upward expectations for the full year. That was before the bulk of the economic worries hit the market, and we will be watching with great anticipation the results for the second quarter. May was the worst month for the stock market since the dark days of the 2008- 2009 crisis. The S&P 500 fell 8% that month.
Given all these concerns, investors have taken refuge in the fixed income market. The yield on the U.S. long bond, which had moved up to around 4%, has fallen below 3%.
Here’s what the second quarter looked like by the numbers:
| Index | 2nd Qtr 2010 | Year to Date | Trailing 12 Months |
|---|---|---|---|
| Dow Jones Industrial Average | ‐9.3% | ‐4.9% | 18.5% |
| S&P 500 | ‐11.3% | ‐6.5% | 14.2% |
| NASDAQ | ‐11.9% | ‐6.8% | 15.5% |
| Russell 2000 | ‐9.9% | ‐1.9% | 21.2% |
| MSCI EAFE | ‐16.2% | ‐14.4% | 4.5% |
| MSCI EAFE Small Cap | ‐12.4% | ‐8.0% | 10.9% |
| MSCI Emerging Markets | ‐11.0% | ‐9.2% | 17.5% |
| Barclays Aggregate Bond | 3.9% | 5.8% | 8.8% |
| Barclays Municipal Bond | 1.9% | 3.0% | 7.9% |
| Dow Jones Commodities | ‐5.6% | ‐10.9% | 1.3% |
What Kind of Guru Are You, Anyway?
With the advent of mass media we are daily inundated with experts in nearly every field of human endeavor. On any given day watching TV or surfing the Web, one can sample a veritable cornucopia of expert advice on important topics such as health, diet, politics, economics, sports, entertainment, history, and so on. Given the vast number of experts out there, one might begin to wonder what exactly qualifies someone to be an expert.
Science and business journalist, David H. Freedman, in his recent book, Wrong – Why Experts Keep Failing Us – And How to Know When Not to Trust Them, deals with this and many other important questions about experts. The easy answer, according to Mr. Freedman, is that an “expert” is someone “in a position to render opinions or findings that a large number of us might hear about and choose to take into account in making decisions that could affect our lives.” He calls this kind of expert a “mass expert.” This group includes scientists, pop gurus, celebrity advice givers, media pundits, business leaders, sports commentators, etc. What makes a person an expert? Reputation, credentials and style are all part of it, according to Mr. Freedman, but sometimes just being right about something once may be enough.
Who You Gonna Call?
The world is a complex place. It’s nearly impossible to deal with this complexity without the advice of experts. We do this when we go to the doctor, or to the auto mechanic. We read books on how to get our kids to sleep at night or into an Ivy League University. Mr. Freedman calls this the “Wizard of Oz effect.” We have been taught from our youth to trust the advice of our parents, our teachers and eventually the mass experts. “Evolution may well have primed our brains for trusting experts,” he suggests.
Despite the complexity surrounding many of the decisions we need to make on a regular basis, we tend to seek the simple answer. The one-step recipe always seems more interesting or at least more palatable than the 29-part solution. Mr. Freedman offers the following characteristics of expert advice we tend to embrace:
1) Clear-cut. A simple answer, one without qualifications or hedges, always feels better than anything else.
2) Doubt-free. Why listen to an expert who’s not sure?
3) Universal. When they limit the choices, we tend to love it. The one-size-fits-all advice is the easiest to apply and has “the ring of important truth.”
4) Upbeat. We don’t want to hear that our problems can’t be solved easily or that it may take years of struggle to overcome them.
5) Actionable. We don’t want explanations; we want something we can do.
6) Palatable. “If an expert can explain how any of us is sure to make things better via a few simple, pleasant steps, then plenty of people are going to listen.”
7) Dramatic Claims. The bigger the claim, the more likely it is to attract our attention.
8) Stories. When we hear experts’ advice in the context of someone’s actual experience, it tends to resonant more forcefully. A story can put a real face on the advice.
9) Numbers. Experts can add a sense of precision and authority by using numbers. We often refer to this tendency as “precision without accuracy” when the numbers appear dubious or really beside the point.
10) Retroactive fixes. Whenever an expert shows us the obvious solution to some big problem that happened, we tend to listen with great interest. Ironically, the same advice presented before the problem, in most cases, would fall on deaf ears. “A better safety valve would have prevented the oil leak…” We all nod in agreement giving that expert the credibility he or she needs to stay relevant.
Mr. Freedman concludes this discussion with this particularly insightful comment: “We happen to be complex creatures living in a complex world, so why would we expect answers to any interesting questions to be simple? In particular, the problems that lead us to turn to experts – how can we become healthy, wealthy, and fulfilled; how can we get our businesses and nations to flourish – tend to be bound up in extraordinarily high levels of complexity. Experts operate at the very boundary of the unanalyzable, and that’s as it should be; were there simple truths to be had, we would have come across them long ago and might not even need experts.”
Everything You Know is Wrong
Well, not really, but it’s easy to feel like that sometimes. Just when you have mastered the no-carb, all fat and meat diet, some expert on the TV tells you that the newest, best way to lose weight is the cabbage soup diet! Contradictory opinions from experts abound in the media. One reason for this, according to Mr. Freedman is that “There are too many journalists quoting research published in third-rate journals, authored by scientists from the University of Nowhere… It’s these lesser scientists with their sloppy studies, who provide journalists with the health scares and the illusion of controversy that the reporters need to sell papers… If journalists would just say no to these inferior scientists and stick with the real deal, the public would be well informed.”
In our chosen field of endeavor (the capital markets), the variety of views from experts is mind boggling. In recent weeks we have heard well-regarded “experts” suggest the following: 1) the DJIA will go to 1,000 (not a typo), 2) the market will continue to go up for three more years, 3) the chance of a double dip (the economy slipping back into recession is very high, 4) stocks are overvalued, 5) stocks are cheap, 6) gold is the best investment right now, 7) investors should consider selling gold now, and so on.
Heeding all of the advice of these experts would be a disastrous investment philosophy guaranteed to harm not only one’s investment portfolio, but one’s psyche as well. Trying to determine which opinions might be helpful is also a challenge for most people. In our experience, we tend to place more weight on those whose opinions are backed up by their actions. Academics and consultants can have some amazing (good and bad) opinions from time to time, but they rarely face severe consequences being wrong. A portfolio manager or hedge fund manager, on the other hand, can lose his or her livelihood on a really bad call. We tend to listen more closely to this kind of expert, but we also realize that they are not simply offering investment advice for free.
In the name of full disclosure, here is a short list of some investment experts we really like and listen to on a frequent basis:
1) Warren Buffet. Anyone who’s picked up the moniker “Sage” probably has some solid advice. His opinions and actions during the credit crisis were absolutely brilliant – he was buying when nearly everyone else was advising to sell.
2) Bruce Berkowitz. He founded Fairholme Capital Management in 1997, and was named fund manager of the year in 2009. He is a value investor in the Graham and Dodd mold. Quoted often in the press, he loves to offer his opinions about the stocks he holds. We always find his views clear, concise and useful.
3) Liz Ann Sonders. She is the Chief Investment Strategist for Charles Schwab & Co. She refers to herself as a “market observer,” and is not a strategist in the strictest sense of the word – she doesn’t set price targets for the market. But her views on the world are always well-conceived, comprehensive and well expressed. Often her commentary is colored with hints of exactly how complicated this business really is, and we find that bit of humility rare and refreshing. Her call that the recession ended in June of 2009 was one of the first ones out there and will probably be proven to be exactly right.
4) James Swanson. He is the Chief Investment Strategist for MFS Investment Management. His background is economics and fixed income, but now he has responsibility for all capital markets commentary for MFS. We like his commentary because it is always well-researched, backed-up by historical precedent and presented in a no-nonsense fashion.
Occam’s Razor
Maybe the really good answers to life’s big questions are simple. Maybe the “trick” to losing weight is eating less and exercising more. For investing, maybe it’s just following the simple rules of value and diversification. There are a lot of very interesting theories and ideas out there that, in the end, may be just fluff or even simply wrong.
But that still leaves us with the question of who to trust and which experts are worthy of our attention. Mr. Freedman concludes his book with a list of characteristics of more trustworthy expert advice:
1) It doesn’t trip the other alarms. We should give more weight to advice that isn’t too simple to be true and is consistent with what we mostly believe to be true.
2) It’s heavy on qualifying statements. Most research contains these; many news reports using the research will omit them. Read the fine print.
3) It’s candid about refutational evidence. We really like experts who can tell us how and why their opinions might be wrong. Those who can’t imagine being wrong should be avoided.
4) It provides perspective. More trustworthy advice tends to clearly explain the limits of its relevance. We often need help in understanding how we should feel and think about the advice. Knowing how the advice may or not apply to us seems critical.
5) It includes candid, blunt comments. The most reliable experts will often express some doubt about their own opinions. These kinds of comments are rarely displayed in the headlines or on TV, but will emerge in longer articles, letters to journals or in radio interviews. Hearing an expert’s skepticism can aid us in understanding the reliability or significance of that expert’s advice.
Our Role as “Experts”
So, where do we fit into Mr. Freedman’s analysis of experts? Surprise, surprise, we come out looking pretty credible and trustworthy by his standards. We are rarely quoted in the media, so we are not “mass experts.” We rarely employ the simple answer. We may appear confident to some of our clients, but given the uncertain nature of this business, we fully understand the potential fragility of any hard opinion about the markets. We feel that one of our greatest services is to provide our clients with perspective. Exactly because we have a great deal of experience working in the capital markets and in helping people achieve their financial, if not even their life, goals, we are confident that we can guide our clients through these turbulent waters.
We are not pointing this out just to be self serving. In our heart of hearts, we all here at the company truly believe ever single word in our marketing materials. We think that the client does come first. We want to be known as the most honest advisors in the world! We really want to help everyone, not just our clients, to achieve their life dreams. We think we have great tools to help everyone get there. We always cringe when someone lumps us into the huge teeming mass of “financial advisors.” We consider our approach, philosophy and perspective to be unique and special, and wish only that we could better share it with more of the world’s population. And that’s our expert opinion…
The Outlook
We would submit that all that has meaningfully changed in the last three months is sentiment. Sure, the problems in Greece raised investor concerns for the moment. The oil spill in the Gulf of Mexico is certainly ugly to consider and will be costly to clean up. Worries that a potential slowdown in China could also derail the recovery seem a bit misplaced as well. The big drivers of the global economy still appear to be working well. Industrial production is still rising. The U.S. economy created over 1 million jobs in the last four months. Despite some concern about a consumer spending slow down, business-to-business sales are booming. Rail traffic in the U.S. is near an all time high. The only big change we see is that people are worried about what might happen. Perhaps they are listening to the voices of too many experts…
As we mentioned last time, U.S. corporations are in great shape. They hold a near- record level (highest since 1955) of cash on their balance sheets. Because they are not rewarded for holding cash, it seems likely that they will do some or all of the following: raise dividends, buy back stock, buy each other, increase capital spending, or hire new workers. These things are all positive either for the economy or the stock market.
Earnings have been stronger than expected for four quarters in a row now, and revenue growth is even surprising on the upside. James Swanson, one of our favorite experts, thinks that U.S. companies could report 3-4% revenue growth in the second quarter and that as many as 75% of them could log better-than-expected earnings growth.
The chances of a double dip are almost zero. Mr. Swanson points out that it’s only happened three times in the last 150 years – the Great Depression, the U.S. in the early 1980s and Japan in the early 1990s. Each of these periods was marked by massive policy failures which led to the double dip. Conditions now are nothing like any of those times.
The recent concerns have driven Treasury yields back down to levels not seen since early 2009. The most expensive asset classes right now (relative to their history) are bonds and cash. We rarely make asset allocation shifts based on relative valuation alone (we think that client risk tolerance and time horizon should be the key determinants to asset allocation), but now would be a tempting time to consider shifts from bonds to stocks.
We again wish to quote again Sir John Templeton, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We continue to think we are firmly embedded in the skepticism phase of this bull market.
Sincerely,
Wolf Group Capital Advisors
