Tuesday, April 20, 2010

Are Your Expectations Realistic? ...written by Greg Gann

On several occasions, I have heard realtors say that clients lie. Realtors say this because their clients say that they will only buy a home that specifically meets a variety of stipulations, but then they see a house with none of the required features, and they buy it. This got me thinking about investors and what they say and do.

Investors commonly tell me that they are “conservative”, yet their holdings are the complete opposite. Investors say that they want to incorporate defensive strategies to protect and preserve wealth, yet when the market surges, they question why their assets are not appreciating at the same rate as the “market”. Investors say that they don’t want to invest in stocks when the stock market is down, but then they question why their results are less than the stock market when they are not invested in stocks and the stock market is in the stratosphere. Investors say that they want investments that over time have strategies to make positive returns irrespective whether the market is up or down, but some today can’t fully grasp why their portfolio isn’t keeping pace with a stock market that has surged 75% in just one year.

Since March, 2009, the stock market, as measured through the S & P 500, is up 75%. I do not know of another time in history when this index has surged to this extent, especially in light of the fundamentals in the economy being as tenuous as they are and unemployment hovering around 10%. Dorsey Wright & Associates, a leading investment research organization, on April 14, 2010, recorded more new 52-week highs for stocks in that one trading day than in any single trading session since January 2004.

Based on irrefutable measurements of supply and demand, Dorsey Wright showed that the stock market was very much oversold March 2009. A year later, we are experiencing a market which is very much overbought. Markets can continue trends for periods that defy rationality, but when a market becomes overbought, caution and defense should be the call to action. Warren Buffett admonishes investors to be greedy while others are fearful, and fearful while others are greedy. Many investors become greedy when the market surges and becomes overbought. They develop symptoms of FOMO, an acronym and investment diagnosis known as “Fear of Missing Out”. And when we are in the red zone, as we are as of April 15, 2010, FOMO manifests itself by enticing investors to get back in the game at the absolute worst time. Markets are like rubber bands. They are flexible and can stretch and stretch and stretch. But, eventually they can only stretch so far before there is a snap.

For the decade that ended December 31, 2009, the S&P 500 was down over twenty-four percent. Therefore, $10,000 invested January 1, 1999 was only worth $7600, a full ten years later. The 75% surge in the S&P 500 since March 2009 has been a huge gift. It should be treated as a gift, not only because the fragility of the economy, but also because if an investor’s long-range expectation is to generate growth of say 7% per year, then the returns that have been reached actually in less than one year, should have taken ten years to accumulate. Also of significance is that fact that even after this maybe once in a lifetime 75% one year surge, the S&P 500 is still approximately 22% below its value as of March 2000.

I regularly speak with investors who tell me that their investments took a blood bath in 2008. They also referred affectionately to their 401k’s as “201k’s” in 2001 and 2002 because of the losses in that period. In 2008, the 201k was walloped and became a 101k. These same investors today tell me that they are no longer concerned about the status of the portfolios because they are “back”. When someone tells me that he is back, I know two things immediately. I know that he has tremendous exposure to the stock market and I know that he does not have adequate defenses in place to help secure the net worth from the next correction or “snap”. A year ago, there were serious discussions taking place as to how to prevent a second great depression. Unprecedented government involvement and spending has helped to thwart an imminent crisis. Analysts’ earnings expectations last year were so depressed that in hindsight, it has not required too much for corporate America and beyond to exceed those projections. While it is easy to catch a ride on the euphoria train today, the world still has not presented an exit strategy to unwind government spending and correct unprecedented non-global wartime deficits. Nor is unemployment or housing showing real signs of improvement.

As an asset class, bonds are considered safer than stocks because when we acquire a bond, we become a lender, and in the event of failure, lenders get paid before stockholders, who are the owners. Lehman Brothers was a huge guarantor in world markets. When the government allowed Lehman Brothers to fold in 2008, confidence in the entire financial structure was called into question. If you couldn’t trust Lehman to survive, who could you trust? Because of the uncertainty and fear that this and other failures created in the market last year, bond prices got slashed. Bonds provided stock-like returns, but with significantly less risk. Because of this anomaly, I over weighted clients’ portfolios to individual bonds.

After the stock market has zoomed in one year at a rate at which most of us would be very content if it were realized over a decade, it is easy to forget that a year ago, all of us had real concerns just how deep the recession could go. I believe that stimuli of governments around the globe have significantly helped economies and alleviated panic. I also however believe that they have camouflaged the underlying problems and they have not proposed viable exit strategies or safeguards to prevent the next re-occurrence. For all of these reasons and a variety of others about which I have written in the past, I have exercised with caution over the last twelve months. We have used defensive strategies and a host of safeguards. We have very, very little stock exposure. It is impossible to incorporate these safeguards and defensive investment strategies and expect to earn anywhere near what the stock market does in a year during which the market provides a decade-like return in one tenth of the time. Until the fundamentals of the economy show prolonged and consistent signs of improvement and until unemployment is not near a double digit number, I believe that the prudent investor should remain cautious. Wars, deficits, unemployment, wages, deflation, tax increases, and tremendous regulatory uncertainties, all tell me that while fear and panic are no longer THE sentiments of the day, we are nonetheless not out of the woods. A huge part of increasing net worth is maintaining defenses to minimize losses.

The point is that we can’t have it both ways. The investors with whom I speak who tell me that their portfolios are “back” from the losses of 2008 also tell me that their losses in 2008 were 40% and worse. The S&P 500 gave these investors a gift in the past twelve months. I do not think that it is wise investment policy to only have an offense and to rely on “gifts” to grow wealth. And, one last point, just like car buyers always want to brag about the deal they negotiated on their auto to show off their negotiating prowess, investors at cocktail parties notoriously deflate their losses and significantly exaggerate their gains. So, the next time your friend tells you at the party or on the golf course that he is up 75% this year, take solace in the knowledge that he probably had huge losses in 2001 and in 2002 and in 2008 and probably hasn’t realized growth in over a decade.

I am writing this to give you the perspective that there are always periods during which a particular methodology will surpass another, and time periods can always be conveniently established to make one methodology look particularly beneficial. Offense-only, buy-hold strategies while rewarded with stellar performance in the last twelve months, have resulted in huge losses for more than a decade. Returns are temporary, but strategies are resilient. A fifty percent loss still requires a hundred percent gain just to break even. I rely on a number of both fundamental as well as technical research sources to negotiate the market and deal with whatever curve ball it throws. What all of this tells me is that this is not the time to get caught up in the rapture. It is not the time to take our eyes off the ball. It is however the time to take in the entire picture to set and maintain realistic expectations. For any investor who perceives 2008 as a once in a hundred year flood year, well then so too should they recognize the ensuing twelve months which followed.

The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.