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of all guest columns written by Dennis C. Butler, CFA
Military metaphors have long been employed when describing the business of Wall Street and the activities of those who ply the securities trade or try their hand at speculation. The Battle for Investment Survival is the title of a still-popular work from the 1930s, and accounts of the challenges faced by individuals in dealing with markets, �manipulators,� and such have often been couched in martial terms. The �fog of war� is in many ways a powerful image of what happens in the securities trading and investment field, especially for those who are unschooled in the ways of that peculiar marketplace. Conditions can change rapidly and unexpectedly, and there is always a great deal of uncertainty. It is not as if an enemy lurks in the bushes waiting to attack, but when markets experience the kind of turmoil we have seen since 2007 in which practically all classes of investments have suffered wrenching declines, it certainly seems that way. As in military crises, during such times the need for flexibility and experienced leadership is paramount. Strategies that look good on paper or computer screens fall by the wayside, necessitating quick thinking and bold, unconventional action.
Financial �preparedness� also borrows terms from military usage. Overwhelming financial �firepower� is a useful thing to have in volatile situations. Stock market pundits often talk of �defensive� selections, although usually after markets are already down significantly. �The generals� is a term sometimes used to refer to the stocks of leading companies, such as those in the Dow Jones average, which typically find their way into those defensive positions. Enterprising market professionals often view themselves as waging battle, with the more aggressive traders and hedge fund managers frequently exhibiting a �take no prisoners� attitude about their exploits.
We personally find one of the great military maxims, attributed to Napoleon, a source of useful insight when observing markets: �Never interrupt your enemy when he is making a mistake.� To us it implies a certain restraint and ability to rise above the fray and see the larger view. Market enthusiasm, the enemy of patience, undermines the instinct for self-protection and the need to preserve one�s resources until conditions are ripe for advantageous moves. A �battle for survival� indeed! Market participants sometimes seem to forget that capital preservation is as important as generating gains. Money and securities are not just pieces of paper or glowing symbols on a monitor; they represent real things to retirees and others dependent on investments. The first duty of the investor is to guard those investment assets against predators and unexpected difficulties, in order to leave capital intact and available for the next skirmish in an ongoing struggle.
Seldom has this duty, and the skills needed for its accomplishment, come into sharper focus than in the last year�s market upheavals. In the quarter just ended the equity markets continued the campaign begun in March to fight back from one of the sharpest and hastiest retreats in decades, permitting shareholders to recover significant lost territory. Whether or not this will turn out to be stalemated trench warfare remains to be seen.
After enjoying the strongest second quarter advance since 1998, some harbored hopes that the worst was over and a period of rising markets was in store, but most of the gains occurred by early May, leaving the averages in a �trading range� for the last two months and dampening enthusiasm for victory celebrations. A renewed interest in risky assets was evident at various times in the quarter; mutual fund buyers opted for more speculative products including emerging market, commodity, and junk bond funds, and the market�s dicier issues attracted a significant part of the ardent buying in March and April. Bonds took a different tack. Interest rates, engineered by the Federal Reserve to the lowest levels in decades, rose dramatically � the ten-year treasury note�s yield rose to nearly 4% from just over 2% late last year � squelching a boomlet in mortgage refinancing and threatening economic recovery. Rates fell back later in the quarter, and even at their recent peaks they remained well below historical norms.
The drop in bond prices was due at least in part to the immense world-wide government stimulus efforts and loose monetary policies that authorities have introduced to wage war against the ongoing economic recession. The fear among fixed-income investors is that such measures will eventually lead to inflation and even downgrades of sovereign debt ratings among the major economic powers. Given the extent of world-wide economic slack and rising unemployment, inflation would seem to be the least of our worries now, but the concern is legitimate and bears watching. Should inflationary pressures build in the future, bond prices will have to adjust accordingly, resulting in significantly higher interest rates. This would not necessarily mean a body-blow to economic activity, as rates currently remain well below even the �normal� levels seen during periods of reasonable economic health, but sectors such as housing that depend on access to credit at a reasonable cost could experience prolonged weakness as previous excesses continued to be shed. This �debt contraction� promises to be with us for some time as the public and business community adjust to more prudent financial management.
Recovery may take a frustratingly long time and the easy access to credit which an entire generation has become accustomed to may not return for the foreseeable future, if ever. With consumer debt as a percentage of disposable income at 128% recently (down slightly, but up from 80-90% in the 1990s), individuals cannot continue to pile on credit card charges. They need to change their spending habits and be more conservative with finances; already, savings rates have climbed from below zero to over 6% of disposable income. This may be beneficial over the long term if the economy operates on a healthier financial foundation, but businesses heavily reliant on consumer spending will be affected.
Banking � the source of all those credit cards � seems especially likely to suffer. Past bank earnings have been proven illusory by subsequent enormous write-offs of bad loans and unwise investments. As financial and economic commentator Nassim Taleb has pointed out, the banking industry in the aggregate has never made money over time, since what it gains in booms is lost and more in busts. Bankers, on the other hand, have gotten rich. This dirty little secret of the lending business illustrates why, from an investment standpoint, banks are seldom valued very highly in the marketplace.
Surprise, Surprise
Problems have a way of sneaking up on you, but in the case of the present dire financial and economic circumstances, we can scarcely add �when you least expect them.� Any well-informed analyst or investor free of the competitive constraints of the financial services industry was well-aware that things simply could not continue as they had for years without a final reckoning, but the tendency was to assume it was far in the future. To paraphrase one prominent banker, as long as the music played you had to keep dancing. Meanwhile, a few cautious investors and businesspeople did know when to leave the dance floor and acted to stay clear of trouble well before the music stopped. While most of their compatriots ignored obvious signs of trouble � burdensome debt loads, flawed incentive arrangements, a mis-pricing of risk, etc � a few cautious souls stood aside, preserving the capital that permitted them to remain standing while others were swept away in the ensuing debacle. For these cautious individuals and their organizations, the present crisis has been full of opportunity.
Following the last market downturn of significant magnitude in 2000-2003, it was the hedge funds that emerged victorious. The contrast between the two successful investment approaches that bookend the decade is telling. Early in the decade, flexibility and the freedom to engage in short selling and complicated trading strategies enabled aggressive hedge funds to post gains at a time when traditional money managers suffered losses. This short-term record of success spurred hedge funds� enormous growth for several years thereafter as institutions and the wealthy sought out those who promised to generate positive results regardless of the market environment. It was ultimately the peculiar nature of the 2000-2003 bear market that made investment �geniuses� out of most hedge fund operators; a small group of stocks (mostly of high technology companies) dragged the market averages down, while most other issues rose, permitting a wide range of successful trading strategies. The almost universal collapse of all securities classes since 2007 has played havoc with virtually all trading schemes, leaving few heroes aside from those who presciently sold mortgage and related securities short and profited from the collapse in housing. In an overcrowded field, the positive experiences of the earlier hedge fund group were, alas, unrepeatable. (Incidentally, prominent among the losers in this down cycle are some big university endowment funds which were leaders in the so-called �alternative� investment craze that includes, prominently, hedge funds.)
Those emerging from the current market cycle with their capital intact are unlikely to attract the attention, dollars, and fees paid to the glamorous hedge fund crowd earlier in the decade. Investors willing and patient enough to take unpopular stances and accept modest results while more aggressive players are winning big returns, accounts, and bonuses don�t tend to excite Wall Street. Perhaps more attention should be directed towards these investment tortoises. Their results tend to be quite good and repeatable. Like the hares, they also did well in 2000-2003, but unlike many of their hastier brethren, they are still moving forward.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. "Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: [email protected]
URL: http://www.businessforum.com/cscc.html
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