Market Update: April 2012

Spring Is Here and the Birds Are Chirping

This was quite a remarkable quarter: the stock market was up 12.6%, Apple just declared a dividend pushing it above $600 per share, and I hear birds chirping from my window.  Markets around the world are going straight up – what could be wrong in the world?

In my typical dose of caution and concern, there is a lot.  But rather than worry about what might be the issues for us to face – which frankly have not changed a bit since my last Market Update from January 2012 – I’d rather focus on some of the psychology that emerges in these situations.  Unfortunately the history of our “efficient” markets is littered with examples of gross inefficiencies driven by investor psychology.

One simple example is to look at the market volatility from 2011.  The chart below shows the S&P500 for the year of 2011, a chart that I have used in the past.  While the course of the market was remarkable – record setting in fact – the end result was eerily simple.  When looked at from point-to-point (January 1 to December 31), the market was dead flat.

The second chart shows a comparison of January-February on the left side against August-September on the right side.  Two very different charts from the same year – polar opposites in fact.

In the first part of the year there was all the buzz of a strong economic recovery, jobs growth, real estate price stabilization and stock market recovery.  As we now know, most of these claims were either false or premature.  What came to the fore later in the year was the reality of debt overload, sovereign defaults, and a European recession.  When you look at the side-by-side, the impact of psychology leaps from the page.  During Jan/Feb of 2011, the market rise was steady, stable and predictable (low volatility).  During Sept/Oct of the same year, the market was choppy, erratic, and unpredictable.

To put this into context, traditional economic and finance theory relies heavily on the notion of efficient markets and statistical trends based in a lognormal distribution of stock market returns. In that paradigm, the likelihood of the right chart occurring is roughly a 6-sigma event.  In more pedestrian terms, these events are likely to occur once every 5,480 years (roughly since the start of history according to the Jewish calendar).  That should give you a moment of pause.

My point is a simple one.  Conventional theories about the economy and markets are severely limited in describing current events.  In many ways, broken.  Yet, the underlying fundamentals of our world are deeply challenged – American society has been turned inside-out, developed economies are carrying debt loads that are unsustainable, and global conflicts are playing out in ways that can no longer be managed.

A more likely explanation for the first quarter performance is a host of factors that have nothing to do with fundamental strength.  I’ve heard one theory of investor boredom – too much bad news has resulted in a form of indifference.  Another theory is manipulation by the Federal Reserve Bank – with near-zero interest rates and over a trillion dollars flooded into the banking system, money needs a home to generate profits.  You won’t get it in the traditional bond market, with short-term rates near zero.  But you will get it in the form of dividend paying stocks.

To support the second theory, The Wall Street Journal reported that this year $9 billion of investor money flowed into mutual funds and ETFs with stock-dividend strategies.  All other funds had a net outflow of $7.3 billion. (see Jason Zweig article, “The Dividend-Fund Dilemma” on April 7, 2012).  Investors are chasing some sort of return, irrespective of the risks.  While a stable stock could lose half its value in the matter of a few weeks (such as 2008), the prospect of a 3% dividend yield is enticing enough to warrant the risk.  Wow.

To add a bit of punctuation to those thoughts, take a look at the next chart comparison – the start of 2011 and the start of 2012:

Since the collapse of 2008, we have gone through a number of cycles around volatility that repeat.  I never mean to predict where the market goes next, but I do want to point out the irony of the volatility pattern and the interplay with investor euphoria.

Apple and Facebook

Perhaps another sign of psychology gone awry is Apple.  While Apple is by far my favorite company in the history of the planet (and a stock that many of our clients hold and have handsomely profited on), the psychology around Apple is unmistakable.  Based on strong earnings and the resumption of their dividend, the stock was up 48% in Q1.  That gives them the largest market-cap in the world today of  almost $600 billion.  If Apple were a country, it would place them in the top-20 globally, somewhere behind South Korea and ahead of Poland.  Not bad.  And with $100 billion of cash, they can afford to pay a dividend now.

But what happens next?  Other companies of their size trade at roughly 11x earnings and experience growth rates in the single digits.  Never has a company been this large, and never has such a large company doubled in less than several years.  Yet the headlines defy common sense – “Apple to hit $1,001!”  I’m not sure which part of this is more comical.  Perhaps it is the inference that you should put your money into Apple now because it will soon double to become a $1 trillion dollar company (they would start to rival India).  Or perhaps it is the notion that they’re just messing with you, “Hey – let’s come up with a random number that people will love.  Like $1,000. That’s cool!  No, make it $1,001!  That’s cooler!!!.

Don’t get me wrong – there is a day when Apple will likely hit $1,000 per share (and yes, even $1,001).  But that day is more likely to be years away, with many gyrations in between.  You have market volatility, global conflict and product disappointment all standing between now and then.  You even have the potential for scandal and misdeed.  Apple is like any other company in the end, and while they have succeeded in changing the way that people use technology, it is still just a stock with all the failings that stocks hold.

What we cannot predict, or grasp, is the power of market psychology.  We saw it happen in the late 1990s with the dotcom bubble.  Crazy, stupid predictions were levied against company stocks.  And for a long time, those predictions held because of the sheer power of the herd.  When the bubble finally popped, it was a long fall.  The NASDAQ hit 5,100 at the peek.  It then fell 78%.  Today the NASDAQ sits at 3,000.  That is quite a powerful bubble that inflated in the 90s.  It will happen again.

And we didn’t have to wait long.  This morning, Instagram just sold for $1 billion.  They have no profit, no revenue, and thirteen employees.  (The first half of this article was written two days, before the announcement – honestly!).    Back in the height of the dotcom boom, companies were valued at roughly $2 million per employee despite a lack of profits.  Now, it seems that zero revenue can get you around $70 million per employee.  Insane?  Yes… and no.  Allow me to explain.

Facebook is the acquirer.  They have been trading in the private market at roughly a $100 billion valuation, or 150x earnings (at least they have earnings).  Again, a seemingly insane valuation.  Yet, the valuation is justified because the current buyers expect an IPO in May that will allow them an even higher valuation to sell their shares.  Because of the euphoric stock market, Facebook now has a “currency” – their stock – that allows for the type of transaction we saw this morning.  Without the public equity market, Facebook wouldn’t have the currency to make this deal.  Without a bubble, the equity markets wouldn’t place such a ridiculous value on the company.

But why should this matter if the markets are efficient and everyone has a chance to buy or sell at will?  The grim reality is that someone will be left holding the bag, a devious game of musical chairs.  And I can promise you, as we saw twelve years ago, those left with sizable losses are individuals who chase the markets in hopes of gaining a stronger retirement.  They are the ones that inflate the last bit of the bubble, when the institutional traders have started to make for the exits and the employees of Facebook and Instagram have cashed out of their stock.

While I don’t intend to inspire a debate about social injustice, this pattern has played out before.  And the results dragged down the US economy for a decade now, delaying retirement for millions of folks and stripped away jobs from an otherwise healthy economy.  Bubbles create extensive damage, far more than the benefits that are reaped during the inflation.

Investment Direction

As you will see in our current portfolios, we have maintained a conservative posture despite the market rally.  Our equity positions, at roughly a third of portfolios (or less), have done well on the heels of strong individual stock performance (namely Apple, Intel and Weyerhauser).  We don’t expect this range of outperformance again, but I also don’t expect this market rally to continue at this pace.

The balance of the portfolio is in bonds (40-50%) and commodities (10-15%).  Both have been remarkably stable over the past year, and this quarter is no different.  The bonds are geared to provide a stable income stream at above market rates.  We continue to do so with the use of unusual or illiquid pieces and ongoing in-house research to identify opportunities.  The commodities are a hedge against dollar deflation – a very real possibility as the economy stumbles through the next few quarters.  As the government expands the dollar base through Fed action and we pile up debts at the state and Federal level, the pressure on the dollar will increase.

Finally we continue to look at hedges against future volatility.  It is a very real concern, and could be an immediate problem with just a couple of global events.  As we saw in 2011, most hedges were ineffective as volatility reached well beyond historical trends.  We continue to integrate these lessons learned into our strategy while looking for situations in which the markets can challenge us in new ways.

I know that these updates create a certain level of dejection with a few of my fans, and wish that I could be more enthusiastic about the financial situation.  But the realities are tough to ignore, and I’ve always believed that accurate and full information is far more beneficial as we make investment decisions and life choices.

All the best for an enjoyable spring.

Regards,

David B. Matias, CPA

Managing Principal