Investors withdrew $6.8 billion from US stock funds in September, $15.5 billion in August and $22.9 billion in July. Makes sense, right? Q3 was the worst quarter for US stocks since the 2008-9 financial crisis. Investors withdrew another $18.2 billion in October, which was the best single month for US stocks in 25 years with a gain of 10.9% in the S&P 500. YTD, US investors sold $53.5 billion of US funds, continuing a pattern of net annual redemptions that has prevailed since 2008.
Warren Buffet, meanwhile, invested $23.9 billion (including $7 billion in stock purchases) in US markets in Q3 - his fastest pace of investment in 15 years. As of March 2011, Buffet was worth about $50 billion, so who do you think is making the correct assessment of the investing climate?
We believe that the current confluence of strong and rising earnings, low stock price valuations and exceptionally low interest rates presents one of the best stock buying opportunities in 50 years. We also believe that most Americans will not take advantage of that opportunity because most invest with their hearts, not with their heads, and right now their hearts are filled with fear! To help our clients invest with their heads, we present:
Behavioral Finance (why watching CNBC won't make you rich)
Since the 1950's, academic researchers postulated the existence of Homo Economicus who coolly and calmly evaluates investment decisions based on a careful measurement of risk and return. The problem is that this model doesn't adequately explain boom and busts, whether in dot.com companies, real estate, emerging market shares, or, as we saw in the 17th century, tulips.
In recent decades, researchers explored why investors often make decisions that are contrary to their long term financial health. The answer, we believe, is that our decision making has not evolved much beyond that of our caveman ancestors, even though the world we live in today is unbelievably complex. Faced with complexity, we take short cuts. For example, if you stood in a hotel lobby and all of a sudden two dozen people ran past you out the door, would you stay put to understand what the danger was, or would you run just as briskly? 15,000 years ago, the caveman who stood around wondering most likely fed a saber tooth tiger.
Warren Buffet buying large when others sell is a classic example of contrarian investing, defined as "an investment style that goes against prevailing market trends by buying assets that are performing poorly and then selling when they perform well." Humans, alas, are herd animals who become distressed when acting contrary to the group. Watch this old Candid Camera prank http://youtu.be/fQI8pZJiMe0 to observe an individual's distress from simply facing the wrong way in an elevator. Now think about the distress you feel when your investment advisor maintains or even adds to your stock allocations, when clearly "a depression is eminent." We track monthly and quarterly cash flows into stock mutual funds because often net flows are inversely correlated with stock market performance. In other words, most investors buy high and sell low.
Lightbulb Press compiled an excellent primer "An Advisor's Guide to Behavioral Finance." We would be happy to provide a complimentary copy to any of our clients. As we also see in the annual "DALBAR Quantitative Analysis of Investor Behavior" investors:
- Experience twice the pain of a dollar loss than pleasure in a dollar gain.
- Focus more on errors of commission than omission (a retirement plan invested only in money markets.)
- Fear making any mistakes even though professional investors make plenty (the best batters in baseball still fail two times in three at bat.)
- Project short-term investment performance, bullish or bearish, to infinity.
- Tend to "fight the last war."
- Focus too much on familiar companies or industries (only company stock in a 401K.)
- Avoid taking loses, but quick to take profits, regardless of the tax consequences.
- Cannot balance risk with reward, often at extremes. (invested on margin, or not invested at all.)
Why CNBC is not your friend
When the stock market collapsed 22% in October 1987, most people read about the crash next day in their newspaper (remember newspapers?) The fledgling "Financial News Network," 6 years old but only available in a few markets, covered the 1987 crash but went bankrupt in March 1991. A two year old rival, CNBC, bought FNN's assets (primarily channel slots on cable systems) and merged the two networks in May 1991. Though figures are not disclosed, it is estimated that CNBC generates an operating profit of $300-400 million per year. Chief rival Bloomberg TV is primarily a loss leader to promote the information service.
CNBC has a state of the art broadcast campus north of Manhattan, while Bloomberg TV makes do with a couple of studios at Bloomberg headquarters on Lexington Avenue. CNBC is available in practically every bar, gym, airport departure lounge, shoe shine stand and elevator in America, while Bloomberg TV is practically invisible in the upper reaches of your cable service.
CNBC's primary editorial line is "what should you trade today?!?!" When markets get particularly hairy, CNBC flags "danger" by putting up to ten talking heads on the screen (don't forget, most people watch the channel with the sound off.) With the sound on, three people are talking, two are shouting and the rest are shaking their heads. The image conveys plenty of emotion, but the informational content is zero.
We believe that most people have no business "trading" because mostly they are chum for the high frequency trading sharks. The producers and on-air talent at CNBC are not maliciously misleading small investors; they truly believe they are delivering a quality service. However, CNBC is in the business of delivering ratings to advertisers who are primarily brokers whose income is trading commissions. Earnest Sam Waterston of "Law & Order" pitches TDAmeritrade's "trading tools" to sexy, skinny clients living in architecturally perfect homes. We have never met anyone like those "traders" in real life!
The biggest offender is Jim Cramer and his edutainment "Mad Money" show. We think Cramer is a very smart, talented person who should have remained at his hedge fund. His thesis is that the average American can do their job, take care of their family, and day-trade their 401K. Perhaps two people in a thousand can achieve that skill after years of practice. The rest should stick to index funds. Like a Pied Piper of investment gurus, Cramer is leading Mr. & Mrs. America off a cliff!
What bugs us the most about CNBC is that their daily focus on whether "the risk trade is off or on," which distracts investors from the really interesting news that not only or S&P 500 earnings at record highs, but also the next several years look pretty good for earnings. As we have said time and again, US companies are an investment in the world economy, not just the US economy. Take a look at this video http://youtu.be/IGQmdoK_ZfY, which shows you what you miss when you concentrate too much on one detail.
Fighting the last war - fears of the "European contagion"
Like the mythological Hydra, as fast as one problem gets solved in Europe, two more spring up in its place. Back in July, we wrote ". If Greece in fact defaults, some European banks will lose some money but will not lose all their capital as we saw in 2008 among Bear Stearns, Lehman Brothers, AIG and certain European banks!" Greek debt was written down by 50%, but a technical default was avoided.
MF Global, which made imprudent bets on European debt, was wiped out. But, as we also commented in July, we don't fear contagion because the system is substantially deleveraged. MF Global went out of business because a.) it was levered 40:1 and b.) there were serious management problems ($600 million of customer funds are not accounted for.) Worriers immediately switched their attention to Italy. Europe's problems have been building for 30 years and will take time and political will to resolve. As long as banks maintain leverage ratios of around 12 and don't exceed 15, European and American banks will take losses but will survive.
US Presidential Election update
The US media is thoroughly bored of the election already. Obama is obviously the Democratic candidate, and, as we said months ago, Romney will be the Republican candidate. To fill the 24 hours news cycle, CNN, MSNBC, Fox and the traditional news channels elevate alternate candidates to Romney, only to drop them as their flaws become evident. Palin, Trump, Bachman, Perry, Cain, and now Gingrich have gone through that process. The chart below from RealClearPolitics.com show Romney holding steady with 20-25% of Republican support for the last year, while the alternate candidates surge and then fall. Perry for example entered the race in August, surged to 30% by September, and now polls around 10% after a series of poor performances in debates.
The actual primaries start in January, but Obama has already won the "money" primary, raising raised $86.2 million, through September 30th, which is $5.3 million more than the 8 Republican candidates have raised in aggregate. Most of that money will be held in reserve for the general election. The Republicans won't confirm Romney the front runner until March or April, and the convention isn't until August, which leaves little time to campaign and raise funds.
Whenever we write about politics, we generally manage to upset BOTH conservative and liberal readers of our commentary. Our job is not to choose sides but to forecast the outcome so that our investments are positioned properly. Based on the last 50 years of presidential elections, we know that a first term incumbent has a huge advantage over their challenger. Americans prefer the status quo, so if the majority think that "the country is on the right track," there's not much that a challenger can do (for example, Dukakis versus Reagan in 1988 or Dole versus Clinton in 1996.) However, if most Americans thing that the country is on the wrong track, then the challenger has an opportunity. In 1980, Reagan crushed Carter with the "It's morning in America!" campaign. In 2004, Bush's deep unpopularity gave Kerry a window of opportunity that he failed to capitalize upon. The electoral college vote was close, and Kerry would have won if he had picked up 60,000 votes out of 5.6 million cast in Ohio.
Obama is deeply unpopular, unemployment is high, economic growth is minimal and 73% of Americans think that the country in on the wrong track. Despite all that, we don't think that the Republican offer a sufficiently compelling alternative in Romney, and Obama will be reelected.
Since the last week of October, US stocks have traded in a tight range on either side of unchanged on the year, but daily swings of over 1.5% are common. Bears say "Europe will crush the banking system again." Bulls say "Stocks are cheap, earnings are strong, interest rates are very low." We are bulls and are fully invested.