Oranjeboom, Espanabust

It has been a great World Cup. Not as once-in-a-lifetime awesome as four years ago, when my two boys and I visited South Africa for a month during the 2010 World Cup. (Thank you again, hosts Gavin and Yvette!) But an exceptional sporting event, with high scoring, dramatic comebacks, and huge upsets. Not to mention a big U.S. victory against the run of play versus World Cup nemesis Ghana, followed by a tie against Portugal and a trip through to the knockout round.

None of the upsets were bigger than the Netherlands victory over holders Spain, in a rematch of the 2010 final with a very different result. (Spain beat Netherlands 1-0 in the last minute of extra time in 2010.) Netherlands dismantled Spain 5-1 in the first week, a demolition completed by Chile when they beat Spain 2-0, guaranteeing an early exit for the former World Cup champions. Three of the last four World Cup champions have failed to escape the group stage.

I’m a fan of the Oranje for two reasons. First, the Dutch are a small nation with a great football tradition. Johan Cruyff, one of the best players ever, pioneered the idea of Total Soccer with Ajax and Barcelona in the 1970s. They play attractive, attacking football, and have enjoyed success on the world stage out of proportion to their small population. Second and more important, I am one-quarter Dutch, and consider that ancestry the source of my congenital stubbornness and love for cheese.

You could say, “What a difference four years makes,” except Spain’s dominance lasted far past the last Cup. In 2012, they beat Italy 4-0 in the Euro 2012 final. Just a year ago, experts were declaring this Spanish side the greatest national team of all time. As of June 7, when FIFA froze its rankings prior to the World Cup, they were the #1 rated team in the world. “How are the mighty fallen.”

There is an interesting cluster of principles here. The first is about our desire to know what will happen. Since human beings dislike uncertainty, our brains impose patterns on data where none exist, to preserve the illusion that we can predict and thus control the future. Philadelphia sports fans suffer from a particularly virulent strain of this defect, alternating between shameless front-running (when the local team wins) and instant despair (at every unanticipated loss).

A second insight from football concerns the pursuit of excellence. In a free economy, or a competitive sports landscape, success spawns imitation, but it can also lead to innovation. When Holland lost to Spain in 2010, they did not go back, disassemble their unique style of soccer, and adopt Spain’s tika-taka passing game. Similarly, Barcelona demonstrated extraordinary dominance of club soccer early this decade, beating their opponents by a cumulative 16-6 in the knockout stages of the 2011 Champions League. They looked literally unbeatable. With the world’s best player, Lionel Messi, supported by Iniesta, Xavi, Dani Alves et al, how would they ever lose?

Yet just two years later, Bayern Munich beat Barca 7-0 in aggregate in the semi-final. And the year after that, Real Madrid in turn beat Bayern in the semis by an aggregate of 5-0.

It is hard indeed to stay on top.

As investors, we can perhaps draw some lessons from soccer. First, what is best practice? Is someone else doing something that confers a durable advantage for their clients? If so, we need to duplicate or clone that strategy. Second, we must always be skeptical of the idea of permanent superiority, whether of individual company, money manager, or investment style. Durable advantages are few and far between in the investment business. What appears to be out-performance is usually style, and no asset class out-performs forever.

We’ll be downing tools here at TGS at 4 p.m. tomorrow, when the U. S. Men’s National Team plays Belgium in the Round of 16. Go Yanks!

Cover-Up 1, Tech Support 0

There may be someone still out there who doubts that the IRS targeting of conservative groups was a deliberate strategy with the intent of suppressing political activity. For the rest of us, the news that Lois Lerner’s hard drive “crashed” in 2011, that her emails could not be recovered by tech support, and that the drive was “recycled,” is as damning at it is unsurprising. Her hard drive was not the only one. As Politico reported, “Earlier this week, Ways and Means Republicans said as many as six IRS employees involved in the scandal also lost email in computer crashes, including the former chief of staff for the acting IRS commissioner.”

So here is what we know:

1) The IRS selectively and comprehensively targeted conservative 501(c)4 groups for elevated scrutiny and denial of approval, for a period of several years including the 2012 election cycle.

2) Individuals associated with new conservative 501(c)4 groups were also targeted by the Department of Labor, the EPA, and other Federal agencies.

3) Since this came to light in early 2013, the IRS has stonewalled Congress and the Department of Justice has failed to investigate with even the appearance of seriousness.

I was a Democrat during the Watergate years. Back then, the fact that Nixon abused the powers of the IRS, on a retail basis, to go after individuals he considered political enemies, was immediately recognized, by observers across the political spectrum, as cause for investigation and ultimately grounds for impeachment.

More than a year after this scandal broke, we have no special prosecutor, and the left-wing and mainstream media are largely silent. I have to ask my many friends on the Left — do we really want to support empowering the explicit use of the taxing authority as a means of political intimidation? Will you be OK with this when and if the Republicans eventually win the Presidency?

My essential anguish on this issue is due to the fact that, unlike back in the 1970s, we have lost a bipartisan understanding of what constitutes an abuse of power, and whether it should be punished. The fact that we can no longer agree on whether the law should be uniformly enforced is one of the most frightening aspects of the current climate of political division. To say that most of the media has been more lapdog than watchdog since Obama took office is to rehearse the obvious. (Not everyone. Ron Fournier, a left-leaning journalist who was once an Obama enthusiast, continues to do solid work on the IRS scandal.)

 

A Tale of Two Kitties

Bill Gross Recently wrote a post about his cat Bob, mourning the loss of a long-time feline companion. Bob followed along wherever Bill went, ever-present, alert and on-guard.

Bandit, one of my two cats, is different. He is a large, black, neutered male. He does not guard anything. Instead, his habit is to lie on the floor right in the middle of the traffic pattern, staring vacantly into space. (Some cats are smart. Not Bandit.)

If you watch Bandit, he seems inactive. Observing his size and girth, you might suspect that his fat has compromised his mobility.

Until he moves. Suddenly, the huge, quiet beast is transformed into a flying ball of fur, a black blur scampering up the stairs chased by the dog, or hurtling around the family room, leaping over furniture and sometimes smashing glassware, in pursuit of our older and smaller cat Millie. (Millicent T. Katt, for those not on a first-name basis.)

Bandit’s apparent inactivity is an illusion. He is simply waiting for his moment, keeping his energy in reserve until some silent alarm goes off in his dim, strange brain, telling him it is time to go. Sometimes I think we should have named him Barkley, after the Round Mound of Rebound who once played for the 76ers. Like Sir Charles, Bandit may look fat, but he has serious hops.

They say pets come to resemble their owners, and vice versa. And maybe not just in appearance.

Bob was quite a lot like his owner Bill Gross, who runs PIMCO, one of the largest bond managers in the world. PIMCO pursues investment advantage within the opportunity set of fixed-income, continuously looking to add a basis point here, two hundredths of a percent there, making the advantages of size, perspective and trade execution gradually accrue returns for their investors.

At our little firm (we run less than one-third of a billion dollars, while PIMCO runs over $2 trillion), we are asset-allocators, like Jeremy Grantham of GMO or Rob Arnott of Research Affiliates. Our advantage is not continuous but episodic. As investors, we spend lots of time sitting and pondering, observing the markets, back-testing different approaches.

But like Bandit, sometimes we move in a hurry. We may react to a threat, when the barking dog of over-valuation chases us partially out of a frothy asset class. (Tech, anyone?) Sometimes we chase the black-and-white cat of investment opportunity, over-loading a cheap asset class in pursuit of gains. Often, we believe our allocation moves may offer both lower risks and higher potential returns.

It is rare when our portfolio adjustments are immediately rewarded. Like the other asset allocators named above, our advantage is usually both delayed and discontinuous. If we buy emerging markets because we think them cheap, it is rare that they begin to out-perform right away. Much more likely is a continued decline.

Sometimes we move quickly, sometimes we wait, and sometimes it is the markets that change fast. But when our results do show up, they are often significant and abrupt. Here is a recent example. For the year ending February 28, U. S. large-cap growth substantially out-performed value, driven in large part by tech stocks:

S&P/Citi Growth: +28.70%

S&P/Citi Value: +21.88%

As you can see, growth had almost a 7% advantage over value. Since we were (as usual) over-weight value, these numbers drove under-performance by the U. S. equity portion of our target portfolio.

But things changed abruptly in March. For the month of March 2014, Large Cap U.S. Growth declined -2.51%, while Large Cap U.S. Value advanced an almost perfectly symmetrical +2.52%, a net swing of 5%. Through last Friday’s close, April saw growth down 3.8% and value down 2.2%. In a bit less than six weeks, a year’s worth of advantage for growth stocks has been reversed.

Of course, any amount of short-term performance surplus or deficit cannot prove a long-term performance advantage or lack thereof. Certainly, I’m not suggesting that these recent numbers demonstrate the likelihood of a continued trend of value out-performance.

What I will observe is that the benefits of asset allocation, when they manifest, often do so significantly and will little prior warning. Let’s enjoy them while they last.

Rumors of War

Back in the 1970s, my college history thesis was on British appeasement of Hitler in the period before the Second World War. At that time, the general outline of the facts of appeasement were known to anyone with a serious interest in European history or international relations. Chamberlain appeased Hitler, sacrificing allies and abandoning treaty commitments along the way, only to end up in the war with Germany he had tried so desperately to avoid, and having to fight from a position of disadvantage and not strength.

Back in the 1970s, most important political figures at the national level had served in the military in some capacity. While the agony of Vietnam cured policy-makers of reflexive military responses to any act of aggression, it did not end the basic understanding, familiar to anyone who had an unpleasant playground interaction in junior high, that plausible deterrence is a necessary component of keeping the peace.

Our political elites are a very different group today. Few individuals at the top ranks of politics, the press, universities, or major corporations have ever served in the military. As I’ve noted before, to an unprecedented degree the Obama administration consists almost entirely of members of the chattering classes, with few individuals who have ever had to make a payroll, construct a building, perform a medical procedure, or fire a weapon in anger. And the teaching of history has largely collapsed. I would not be surprised if neither Obama nor Kerry even recognized the name Anthony Eden, never mind Duff Cooper or Leo Amery.

As I’ve also noted, Obama is careless with words. He fashions his dialogue for immediate advantage, without appreciation for the long-term consequences of an empty promise or threat. Hence his lies about keeping your plan and doctor under Obamacare, and his red line over chemical weapons in Syria, both statements abandoned when they became inconvenient.

In 1938, Hitler commented to Mussolini about Chamberlain and Daladier, the leaders of Great Britain and France. “I saw them at Munich. They are little worms.” The German dictator judged the resolve of the two democracies by his observation of two individuals. A persuasive reading of history suggests that Hitler believed Britain and France would not actually fulfill their treaty obligations to Poland. In that sense, the war he ended up fighting and losing (thank God), was a war that took him by surprise. Churchill called it, “the unnecessary war.”

Putin has clearly made a similar judgment about Obama, whom he sees as lacking in essential courage, as someone whose words are without weight. Putin neither fears nor respects Obama either as man or President. It seems fair to say that his disdain for Obama is part and parcel of his lack of respect for the United States and its European allies.

Vladimir Putin is a man from another time. When the President observes that Putin is acting contrary to international norms, he is making a statement that is accurate, but not dispositive. If Putin can re-make the world to his advantage, because we lack the means and will to resist him, what cause has he to regret the passing of that more peaceful and polite world? One of the lessons of the failure of appeasement is that means and ends cannot be separated. A nation that violates international law to incorporate ethnic minorities is a nation that violates international law, and will do so again any time it perceives such violation to be in its interest.

Obama spent the early part of his time on the international stage apologizing for the United States’ past actions. To paraphrase, he told listeners, “Sorry about that whole Great Power thing. It won’t happen again.” Yet for the entire modern era, until very, very recently, a balance of Great Powers has been essential to preserving peace.

There was a brief period in the early 1990s when it appeared Russia would become a normal nation, a responsible member of the international community, a peaceful democracy and an ally of the West. Unfortunately, that period of international hope for Russia was coincident with a period of chaos and poverty for ordinary Russians. Putin stepped into the vacuum left by Yeltsin, restored order, and rode rising oil prices to a temporary recovery of Russia’s economic fortunes, in turn raising living standards.

For most of the 20th century, the Soviet Union was the center of a slave empire consisting of hundreds of millions of people. Putin calls the disassembly of Soviet tyranny a geopolitical disaster. Today, Putin’s Russia is a gangster state, run without regard for basic human rights. Putin kills journalists by the hundreds, murders opponents of his regime in foreign capitals, arms genocidal dictators.

The response of the President and the NATO allies has actually been encouraging over the last two weeks, but there remains a crucial series of unknowns. What are Putin’s intentions? How does he believe the West will act, given any specific provocation? How will the West act? At the intersection of these judgments, what are the risks of actual armed conflict?

It seems possible that we are entering a new era of geopolitical instability, the dimensions of which are difficult to predict. The costs of restoring a stable balance of power, based as it must be on credible deterrence, once that order has been violated, could be terribly high.

 

What is Money?

A few months ago, I had a conversation with another parent at my son’s school. The gentleman was an enthusiast for Bitcoin, a type of crypto-currency. I had a strong impression his interest was more than theoretical. He exhibited the sort of nervous energy characteristic of speculators hoping a large bet comes good.

Bitcoin’s origins remain obscure. In February, an energetic Newsweek reporter “outed” an unemployed electrical engineer, claiming him to be the source of the computer code that underlies Bitcoin. It appears that identification was wrong, and a lawsuit likely to follow.

Bitcoins create both benefits and problems on multiple levels. One obvious benefit is having access to a virtually untraceable form of buying power, outside the supervision of governments. This has appeal to terrorists, organized crime figures, folks with privacy concerns, and those who fear any government, including our own. (No, I’m not suggesting that Tea Party members are terrorists. I’ve never known any terrorist who walked around with a copy of the U. S. Constitution in his pocket.)

Bitcoin also has appeal for those not members of Al-Qaeda or the Russian Mafia. It is not fiat currency. The algorithm that creates new Bitcoins is designed to strictly limit the number in circulation, in theory preventing the inflation that gradually erodes the purchasing power of paper money in most countries. (Quickly, if you live in Venezuela or Argentina.)

Ironically, the anonymity of Bitcoins, and the lack of regulatory oversight, creates unanticipated risks. In February Mt. Gox in Japan, the largest trading exchange and depository for Bitcoins, sought Japan’s version of bankruptcy protection. Initial reports suggested the firm’s customers might have lost almost $500 million. At the time it went dark, Mt. Gox handled 70% of the world’s traffic in Bitcoins.

Another problem with Bitcoin as money is taxation. The Internal Revenue Service has determined that ‘spending’ a Bitcoin is a capital transaction. If the value is more than you paid, the result is a taxable capital gain.

The very name Bitcoin suggests the intention to create money, also reflected in the term ‘cyber-currency.’ So is Bitcoin money? In more general terms, what is money, and what do we want it to do for us?

The classic purpose of money is to be a medium of exchange. Instead of trading your two sheep for my ten chickens (which would require that you want chickens, and that I have some), you can sell me your sheep, receive cash, and spend that cash on other things you want, including goods that I do not possess. So far, so simple.

An ideal currency would be easy to use, widely accepted, and capable of being used to purchase goods anywhere in the world. By these measures, the U. S. dollar gets high marks. Perfect money should also be a stable store of value. If a sandwich cost $2 in 1980, you should be able to buy that same sandwich for that same $2 in 2014. By that measure, the U. S. dollar falls short. Inflation since 1980 has reduced the dollar’s purchasing power by 84%. (Still much better than the Zimbabwean dollar, which was abandoned in 2009 when inflation hit an annual rate of 6.5 quindecillion novemdecillion percent. You know you are in monetary trouble when you have to use words to save zeroes.)

The appeal of Bitcoin in part reflects dissatisfaction with the money otherwise available to us. The most significant defect of fiat currency like the U. S. dollar is its failure to preserve real purchasing power. Might Bitcoins have avoided that 84% loss in buying power?

Bitcoins weren’t around in 1980, but gold was. Anyone who bought gold in 1980, at the prior inflation-adjusted high, and held through the end of the 20th century, lost 69% of their nominal dollar value and over 90% of real value. Meanwhile, they missed out on a 2,427% bull market in U. S. common stocks.

Buying any asset at a time of euphoria usually works out poorly. How about if you bought gold when it was out of favor? If you had invested $10,000 in gold back in 1968 (illegal at that time in the U.S.), you’d have acquired 286 shiny ounces. Today, 46 years later, you would own the same 286 ounces of the yellow metal. In fiat dollars, the value of your holdings would have grown to $357,000; in real dollars, to $55,000.

So gold can be a successful or unsuccessful speculation, depending on price and sentiment, just like Beanie Babies, baseball cards, or penny stocks. But gold is not useful as money, because it does not reliably preserve real purchasing power, even if held for decades. If you had enough gold to buy a cheesesteak in 1980, by 1999 you might have been able to afford a pack of gum.

Does this mean we must ignore the erosion of wealth caused by long-term inflation? Certainly not. Warren Buffett believes that inflation will gradually confiscate the value of dollars over time. Thus far, he agrees with the goldbugs. But he believes the best hedge against inevitable long-term inflation lies in ownership of growing businesses, not shiny yellow metal. If you invested $10,000 fiat dollars in Warren Buffett’s Berkshire Hathaway in 1968, by the end of last year your shares were worth over $58 million. (Still fiat dollars.)

Would you really be happier to have assets worth $357,000, instead of $58 million, simply because what you held was not a fiat currency?

Saying you want only want physical currency is kind of like saying we should only permit live, not recorded music. Unfortunately, you cannot operate a modern international economy with physical metal, any more than you can carry around fifty symphonies and two thousand popular songs in the form of vinyl LPs. You need those countless trillions of ones and zeroes flying around the world over fiber-optics and copper wire to make the banking system work, just as you need digital data to make your iPod function.

Money is a medium of exchange, useful as a mechanism to make commerce work, hopefully with value that is not ephemeral. It is never an investment. Gold is lousy money in any modern economy, and is never a sensible long-term investment. In fact, gold is not an investment at all, since it produces no economic return. It is, always and forever, simply a speculation on future sentiment. Likewise, Bitcoins are no substitute for actual money, and have no intrinsic economic value. They may retain scarcity value, or they may not. What they most resemble is a kind of Ponzi scheme, since early “miners” of Bitcoins (presumably, those who created the underlying computer code) got lots of them dirt cheap, while later miners extract few coins at great effort.

Bill Gross had a recent comment on this whole issue of money. Conceptually, he suggests we think of all liquidity, including money, simply as diverse forms of credit. I’m not sure this entirely works. With borrowed money, there are two known parties, at least initially. Though once you add in credit-default swaps and securitization, maybe it is no longer possible to differentiate paper assets from real.

An aside — the night I met that other parent, Bitcoin was trading at over $1,000. Yesterday’s close was under $500, a more than 50% loss. Ouch.

 

Against the Wind

“Do you want to know how to get rich in the market? Come closer. Close the door. Be greedy when others are fearful. Be fearful when others are greedy.

                                                                                                     Warren Buffett

I’ve written a few times lately about optimism and pessimism, and passed along the observation of one long-term client that the tone of my recent postings has been too negative, so much so that he no longer passes along our material to potential referrals.

I’d like to share a few data points, offer a bit of mild pushback against the accusations of inappropriate pessimism, and then ruminate a bit on one of the paradoxes of investment management.

First data point: The last month saw a reversal of the public’s recent stock buying, with huge flows from stocks to bonds. It is a cliché, no less true for being so-oft repeated, that individual investors always get it wrong, especially at inflection points. After almost five years of market recovery, with the S&P up more than 175% from the March 2009 low, investors began to buy stocks in late 2013. (In other words, they missed a bull market that more than doubled the price of equities.)

The sharp downdraft in January destroyed that emerging confidence, and individual investors stampeded from stocks back into bonds. But they did not exit at the S&P 500′s intra-day market high of 1847 on January 21. They jumped out in time to catch the intra-day low on February 5, when the market was down almost exactly 6%. And thus missed last week’s rally, during which the market gained 3.4%, erasing most of the prior loss.

Second data point: Investors are fleeing emerging markets stocks in droves. As this article makes clear, the last time the investing public turned similarly bearish on EM stocks, in 2002, the next five years saw annual returns on emerging markets of over 30%.

Which gets back to our recent pessimism. The mass of individual investors are at the mercy of their own dysfunctional psychology, getting in and out of the markets at precisely the wrong times. As stewards of our clients’ portfolios, we have two principal jobs:

1) Make, and implement, good investment decisions.

2) Keep our clients from harming themselves by over-reacting to market events.

If we are doing those jobs as well as we possibly can, we will assist our clients in maintaining an even strain, by letting some steam out of the psychological balloon when the markets are over-priced (during bubbles and late in bull markets), and pumping them up with optimism when they are under-priced (during panics and bear markets). Hence our cautious stance over the last year or so.

Here is the paradox. The way for clients to get rich is to behave against the crowd, as Buffett has often observed. Yet the way for an adviser to best attract new clients is to validate their emotions, not to challenge them, especially when those emotions are most excited.

Paradoxically, by doing what is right for existing clients (counseling prudence at market tops, maintaining optimism at market bottoms), we make it harder for our firm to attract new clients. The answer to the perpetual question, “If you’re so smart, why ain’t you rich?” is that being smart makes us periodically unpopular. My own experience is that challenging a client’s emotions can make me persona non grata. I’ve had a few clients over the years whom I kept from selling out in bad markets, and who never forgave me. They ignored the thousands, tens of thousands, hundreds of thousands, even millions of extra dollars they earned by owning stocks during the recovery, but held onto their bitter resentment over my failure to take counsel from their fears. (As one client said, “You just don’t want me to have any feelings.”)

So here is a statement about what sets TGS Financial Advisors apart from most of our peers in the retail advisory space: We are more committed to your long-term financial security than we are to your short-term psychological comfort.

And if you are a friend of the firm, and don’t think we are telling our story very well to prospective clients, consider saying this to the friend, relative or colleague you’d like to send our way:

“My advisor really beat me up to stay invested during the panic back in 2008-2009. I’ve made a lot of money in the market since then. Now he’s telling me to be careful. Did your advisor keep you invested back then? Is he watching out for you now? Maybe you need a second opinion.”

2014: Risks and Opportunities

“Climate is what you expect, weather is what you get.”

                                                                                               Robert A. Heinlein

We are now a month into 2014, and it has already been an eventful year in the financial markets. Just when a generation of investors, burned badly in the crash of 2008-2009, were beginning to think it was safe to get back in the water, volatility and uncertainty returned with a vengeance. Emerging markets dropped, U. S. equity prices followed, and Treasury bond prices rose in a classic “flight to quality.” Meanwhile, cash yields remain at historic lows.

The best investment opportunities are usually those most out of favor. Despite the sell off, right now that list is pretty short, with emerging markets stocks and commodities the most obviously unloved.

Our portfolios are over-weight cash, under-weight both stocks and bonds. Our core stock mutual funds holdings are defensive, low-beta, and focused on companies of high financial quality.

I’ve commented several times in recent months about optimism, pessimism, and the dangers of sentiment to investment performance. This year’s market action validates those insights. As Warren Buffett has long observed, one key to investment success is, “Be greedy when others are fearful, be fearful when others are greedy.”

At the end of 2013, we were certainly being cautious, though not downright afraid. With markets down about 6% in one month, and market sentiment having swung from Extreme Greed to Extreme Fear, we’re doing some cautious buying in accounts that are under-weight stocks.

Templeton’s Bull

“Bull markets are born in despair, grow amid skepticism, mature in optimism, and die amid euphoria.”

                                                                                                           Sir John Templeton

My son Jack likes to ask people about Theseus’ boat. It is a classic intellectual puzzle, which explores the nature of being. If an object has continuous presence in the world, but every element of it has been replaced, does it remain the same thing? The question might be phrased as, “Does Theseus’ boat still exist?”

Theseus’ boat was in ancient Athens. I’d like to explore the nature, age, and prospects of a very different thing, namely the bull market.

Sir John Templeton was one of the last century’s greatest investors, often considered the father of international value investing. Way back in 1981, when I was a young stockbroker, an article by Templeton convinced me to buy stocks, at a time when Business Week‘s cover had just announced “The Death of Equities.” I found Templeton to be one of the clearest thinkers and writers about investments, in the same must-read category as are Warren Buffett and Jeremy Grantham today. One of John Templeton’s most famous quotes links investor sentiment with the market cycle: “Bull markets are born in despair, grow amid skepticism, mature in optimism, and die amid euphoria.”

I find this specific Templeton quote of greater value than any other single insight about investing I’ve encountered in my thirty-five years of running other people’s money.  His words provide me with the confidence to buy during market panics, at the same time that many of our peers, and even more individual investors, often lose their nerve and sell.

Understand that TGS Financial Advisors does not make discrete buy and sell decisions based on our assessment of market psychology. All of our portfolio allocations are data-driven, and are based on absolute prices, relative prices, or relative yields. Yet at market inflection points, we have consistently found that the fund flows trigged by our portfolio algorithms are confirmed by our seat-of-the-pants observations of investor sentiment. (Understand that this is a negative confirmation, not a positive one. Panicky investors equals buying opportunity, just as greedy investors is grounds for caution.)

Implicit in Templeton’s wisdom is the eternal disconnect between market psychology and market value; sentiment drives price near-term, but value always trumps long-term. Bull markets proceed from a condition of under-valuation (during the despair phase), through fair valuation (at the transition from skepticism to optimism), and eventually all the way to over-valuation (once sentiment reaches euphoria). As Jeremy Grantham notes, most of the time the market deviates from fair value, though the gap is not always large enough to create profitable investment opportunities.

So what about Templeton’s Bull?  Does he still have room to run? This is a variant of the classic road trip question, “Are we there yet?” Or have we already reached the condition of euphoria that marks the end of the bull market?

My gut reaction is, this bull-market cycle is probably not yet over. Since March 9 of 2009, we have had a 175% bull market run against a backdrop of pretty consistent skepticism. As many observers have commented, this might be the most unloved bull market of all time. Recent investor sentiment qualifies as optimism, though not yet as euphoria. (I’m discounting Jim Cramer, who oscillates between euphoria and despair on a short-term cycle, and is useful only as a reverse barometer, if at all.)

If we haven’t yet reached a state of euphoria, doesn’t this prove the bull market isn’t over yet?

I’m not fully convinced. The emotional landscape of the future must always remain an undiscovered country. Anyone who is married knows the entire impossibility of predicting the future emotional state of a single human being, even that human being we know best in all the world. Predicting the future sentiments of millions of investors is impossible.

One of our best measures of market psychology is our communications with our own clients. At market bottoms, a decent number of clients want to sell out. At market tops, quite a few clients want to chase performance. Not every client, surely, but enough at market extremes to provide a robust contrary indicator.

Recently, we have been raising cash in our portfolios. So far, only one client has called to complain that we aren’t fully invested. We haven’t lost a single client who is seeking greener pastures in more-speculative stocks. This does not seem to me enough push-back for this to be a final bull market top.

Every bull market is different. Sometimes bull markets end, not with a bang, but with a whimper. For example, the 2007 market high was less than euphoric. Will the bull market that began in 2009 end like the 2003-2007 recovery, with risk spreads narrow and stock prices high, or like the great bull market of 1982-2000, with spreads narrow and stock prices utterly insane?

We don’t know, and can’t. So we rely on hard numbers on valuation.

Those hard numbers caused us to be overweight stocks months before the market bottom in March of 2009, a posture that was very profitable for our clients as the market recovered. Today, it is just the opposite. T he numbers cause us to be underweight stocks, and overweight cash. Now as then, we are confident our posture is rational, and guardedly optimistic that markets will prove us right—eventually.

2013: Year in Review

It is barely half-past January, and it has been non-stop at our practice since the day after Christmas. Over the next week, I’ll be catching up with several blog posts that never got completed as I was running from conference to conference and dealing with several urgent client situations. 

Last year was great for investors who owned equities, and (like the last six) less than mediocre for those not members of the investor class. U. S. stocks out-performed foreign, small companies beat large, low-quality trumped high quality, and growth narrowly edged out value. Bond prices fell, as the 30-year bull market in bonds finally, and definitively, came to an end. Cash yields remained near zero, punishing savers, but helping big banks coin record profits. Investor sentiment improved dramatically during the year, and was reflected in flow-of-funds data, with the biggest inflows to stocks in years. An interesting footnote – the best-performing asset class over the ten years was the worst-performing over the last twelve months – emerging markets.

There was a continued disconnect between Wall Street and Main Street. Economic growth remained weak and unemployment high. The official unemployment rate is 6.7%, down from a peak of almost 10% in late 2008. Job market participation by adults is the lowest in 35 years, but the number on Social Security disability, like food stamp recipients, reached all-time highs.

The economy showed hopeful signs of sustainable growth, almost five years after the technical end of the recession.

It was a bad year for honesty in government, and for Americans’ faith that big government can deliver on its promises. The initial rollout of Obamacare was a disaster. “If you like your plan, you can keep your plan, period. If you like your doctor, you can keep your doctor, period.” These central promises, offered constantly by the Affordable Care Act’s supporters, both before and after passage, were revealed to be a bold and deliberate lie. Remarkably, over 40% of Americans continue to support the President. (By this point in his Presidency, George Bush was at 40% approval, on his way to a low below 30% in late 2008.)

It was a bad year for the rule of law, and for limited government. The President unilaterally altered, then re-altered the provisions and effective dates of Obamacare, for reasons both political and practical. Senate Democrats ditched the filibuster, a protection of minority rights that dated back to the Founding. Back in 2012, then-candidate Mitt Romney promised to undo Obamare by executive order if elected, a strategy that most pundits agreed at that time was not within the President’s power. Senate Republicans threatened to use “the nuclear option” over judges back in the mid-2000s. In the event, it was the Democrats who pulled the trigger.

“Sauce for the goose is sauce for the gander” is a fundamental principle of reciprocal justice. When and if the Republicans regain the White House and/or the Senate, will they follow the same tactics? How will Barbara Boxer like it when Ted Cruz can appoint to the Appeals Court, and her caucus is frozen out of the process?

The Philadelphia Eagles made the playoffs.

My movie of the year was Pacific Rim. Not the best film, surely, but the most entertaining diversion. Similarly, not the best wine I drank, but the one I enjoyed most, was Effet Papillon, a simple, floral white from the south of France. (The name translates as “Butterfly Effect.”)

It was a good year for our clients, our business and my family, but a tough one for too many decent folks. My greatest wish this year is for a more robust economy, one that provides a decent living for folks young and old who aren’t working now.

Last Bear Standing?

Over the last few weeks, there has been a steady trickle of headlines about formerly-bearish money managers and commentators who have jumped (or slunk quietly) onto the bull-market bandwagon.

One such is Hugh Hendry, a hedge fund manager who shorted financial stocks in 2008, earning a 31% return in a year when most investors lost big. As is all too usual in the hedge fund space, this made him a rock star, got him lots of exposure, and attracted millions to his fund. Which, somewhat predictably, did nothing much for the next five years, as Hendry maintained his prediction that worse was yet to come. Referencing the possibility of a Greek default in 2010, Hendry commented, “I suggest you panic.”

Last month, Hendry announced that he has now become a trend-follower, and is going long stocks. This after a 160% advance in the markets since the March 2009 low, all of which he missed.

Another perma-bear has been Paul Farrell of MarketWatch, who I singled out as an especially worthless analyst in a prior post. After years of advising individual investors that the game is rigged against them, even predicting the collapse of the capitalist world system and suggesting buying a farm in the mountains and stocking it with canned goods, he suddenly turned bullish in late October. A recent headline tells the story of Farrell’s conversion: 12 get-rich sectors for a hot 2014 bull market.

Of course, Farrell is an idiot. But some of the others advertised as new bulls are not. Of particular interest is Jeremy Grantham of GMO, who we at TGS regard as one of the world’s smartest asset allocators.

Grantham has recently been advertised as a bear-turned-bull, with a Barrons headline pretty typical: Jeremy Grantham’s Bullish Two-Year Outlook. (The Barrons article is behind a paywall, but GMO’s quarterly newsletter, from which Barrons and others conclude Grantham is now a bull, is not.)

Given that Grantham is on our very short list of investors too savvy to ignore, this would be a huge change in viewpoint, and would certainly cause us to question our own cautious investment stance. Even a cursory reading of GMO’s recent newsletter, however, suggests Grantham’s opinion has hardly changed.

GMO’s newletter actually starts with Paul Inker’s analysis, titled Breaking News! U.S. Equity Market Overvalued! Hardly bullish. Grantham then discusses the reasons he believes the U. S. stock market is significantly over-valued, but suspects that irrational investors, emboldened by easy money, are likely to drive it higher before the bubble inevitably pops, finishing the three-time cycle of easy money leading to asset bubble leading to market bust (2000, 2008, and perhaps 2015).

We pretty much entirely agree. This is why we have increased our cash position, and tilted our sector choices so heavily toward managers running lower-volatility portfolios and owning higher-quality stocks.

As John Templeton pointed out, bull markets usually “die amidst euphoria.” We’re not there yet, but we are already past the point where further gains will be based primarily on economic fundamentals. As usual, we remain long stocks, but we are no longer over-weight, as we were from October of 2008 through summer of 2013.