"Trees Hidden by the Forest"

Sydney M. Williams

Thought of the Day

“Trees Hidden by the Forest”

September 13, 2011

In the short term, behavior, as much as a company’s fundamentals, influences stock prices. Over the longer term, a company’s earnings, cash flows and balance sheet determine values. Unfortunately for most of us, human nature causes a focus on today, at the expense of tomorrow. We are children of the time in which we live, and for better or for worse ours is the internet age. The ubiquitous nature of the internet and the plethora of information it disperses means that one can find whatever information one chooses to support whatever cause one champions. No human is capable of digesting the superfluity of data we receive, ergo computers designed to ingest the information and produce algorithms to buy and sell stocks with holding periods measured in seconds. It is the forest, not the trees that is of interest to such investors.

This glut of information has been responsible, at least in part, for turning us into a nation committed to the short term. We have become an attention-deficit-disordered society, letting hundreds of data points dictate our daily activity. The concept of thinking about issues seems as old fashioned as hand-cranked car windows.

What prompted this thought was an interview in Monday’s Wall Street Journal with Richard Sylla, financial historian at New York University’s Stern School of Business. For 200 years, Professor Sylla notes, U.S. stocks, adjusted for dividends and inflation, have risen and fallen in surprisingly consistent waves. “When ten-year-average returns dip below 5% and especially when they turn negative, as they did in 2008-2009, markets tend to bottom out and begin a recovery, the figures show.” At other times, when average returns are 15% or above, investors get over confident. His analysis provided a prescient warning in 2000.

Of course when dealing with such time frames there is no precision. At the end of the interview, the professor added: “We may not be able to get enlightened government policies until things get worse than they are now, which isn’t a happy thought, but in the longer run, I think the country is going to recover and go on to prosperity as it always has.”

We weren’t always obsessed with short term price moves. In 1925, Russian economist Nikolai Kondratieff published his major opus, The Major Economic Cycles. He laid out his theory that the economies of capitalist countries rise and fall in 50-60 year cycles, moving from expansion through stagnation to recession. Stock markets follow suit. It has been my experience that an increased attention in Kondratieff is inversely related to economic and market cycles. Unfortunately, his own life ended early. Stalin had Kondratieff arrested in 1930, using his opposition to the total collectivization of agriculture as an excuse. He was executed in 1938 at the age of 46, depriving him the opportunity of living through one of his complete Kondratieff Waves.

A practical manifestation of the benefits of longer term investing is depicted in a recent note to investors from Jim Cullen, (“The Recovery Phase – Update.”) Jim is President of Schafer-Cullen Investment Management based in New York. Depicting five-year rolling investment returns, the study covers the thirty-nine five year periods dating from 1968 through 2010. (For purposes of full disclosure, Schafer-Cullen manages most of my equity assets.) Mr. Cullen, using the bottom twenty percent of the S&P 500 sorted by P/E, demonstrates that in only two five-year periods have compounded annual returns been zero or less – once in 1969-1973, when they were zero and secondly in 2004-2008, when they were a negative 2.3%. However, the five five-year periods that include the 20% stock market crash of October 19th 1987 were all positive. It would, though, be a surprise to me if the returns during the five-year period ending 2011 were positive, as the starting point was near the market highs. Regardless, what should be important for investors are the five-year double digit compounded returns that typically follow the fallow ones.

Market timing is more an art than a science. While there are professional investors who can do so successfully, most people cannot. The reason is behavior. We are elated when things go well, we party too long – greedy to the end. We drink and eat too much, then fail to notice the orchestra has departed until the cleanup crew is mopping the floor. When markets fall into disrepute, as they now have, fear dominates. The Panglossians among us are overwhelmed by the more articulate Doomsayers. The latter’s reasoning is based on fact, while the former can only estimate a misty future. Facts are only available when one looks backward. Forecasts, definitionally, depend on guesswork.

One of the many problems that those of us who take a “longer” view have is that there is no way to predict a turn. Money managers are caught between doing what they believe is in the best interests of their customers, and dealing with the fear our economies and political leaders have created. That fear is generally accentuated by a media more interested in the hyperbole that sells advertising than in offering good guidance. In his book, A Tract on Monetary Reform, Keynes once wrote, “in the long run we are all dead.” He was writing of his belief that controlling inflation was only possible with government intervention. But to many portfolio managers the words are applicable to our current situation. We may know in our hearts that bull markets will return, but how long do we have to wait? Will I have any money or any clients when the turn comes? We can no more predict the return of the orchestra, than we could its leaving. We just know that the orchestra leader will, at some point, again pick up his baton.

Studies have shown that most people are better off toughing it out through these periods, finding stocks at reasonable multiples, ones with dividends capable of growing. It is the argument for indexing and against market timing. It is not exciting and will never provide the most optimum returns, but it will prevent selling at bottoms and buying at tops, unfortunately the fate of most mutual fund investors.

When investors are so focused on massive events, such as the fiscal crisis in Europe or the debt and unemployment picture at home – acts over which we have little control and are not really subject to analysis – individual stocks are left to languish, providing opportunity for patient investors; as long as they have the stomach to withstand the volatility characteristic of markets in disarray. But don’t let the forest prevent you from seeing the trees.