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HERON CAPITAL
MANAGEMENT
FINANCIAL MARKETS
COMMENTARY
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The S&P
500 rallied 8 days in a row through March 18th to a 18 month high of
1159.9, still below the level last seen following the bankruptcy of
Lehman Brothers on September 15th, 2008. The daily volatility of
the stock market has declined to the levels not seen since the peaceful
summer of 2006. By our calculations, the overall stock market is
slightly overvalued. Whether current levels are sustainable depends
on corporate earnings and Federal Reserve policy over the next year, and
whether the US can avoid the 'double-dip recession." We remain
cautiously optimistic and fully invested. Given a breather for
first time in two years, we'd like to devote this commentary to:
Useful frameworks for investment analysis
Many people have the illusion that our job is easy - anyone can do
it! And we reply, 'Sure! And anyone can fly a plane, perform
root canal, build a house etc." So much of modern media
presents investing as "easy;" Jim Cramer jumping up and down on
"Mad Money," the suavely cool investors in the TD Waterhouse
commercials (featuring Sam Waterston of "Law & Order," for
gravitas) and the E-Trade talking baby (www.etrade.com/baby.) We think
investing is about 1000 times harder than playing poker. Nonetheless,
plenty of amateurs who would never dream of going to Las Vegas to play
against professional players think they can beat the market (and do their
job and take care of their families all at the same time.) Good
luck!
In fact, outside of medicine, we don't know any endeavor more complicated
that investing. Even if you're a particle physicist, the laws of
physics have remained the same for the last several billion years.
Becoming a grandmaster chess champion is hard, but at least the rules of chess
stay the same from game to game. Investing has the ability to make
smart people look stupid all the time. We use these frameworks to
try to be less stupid than most.
Investment gurus are "right" barely 60% of the time
If you search "investing" on Amazon, you'll find 41,459 books
ranging from the classic "The Intelligent Investor" by Benjamin
Graham to current best seller "Aftershock: Protect Yourself and
Profit in the Next Global Financial Meltdown." But any
investment expert, if they're honest with themselves, will acknowledge
that the percentage of their decisions that are "right" (in the
sense of making money) is about 60% of the time. That does not mean
that the experts are charlatans. In professional baseball, getting a
hit 30% of the time is good enough to place you on the top 100 batters of
all time. It does mean that experts need to stay humble (thank
goodness investment advisors don't design airplanes - they'd be falling
out of the sky.) The Daily Show compiled this hilarious montage of
experts giving disastrous advice www.thedailyshow.com/watch/wed-march-4-2009/cnbc-financial-advice.
We are not immune. On October 9th, 2008, our president David
Edwards appeared on Bloomberg TV http://heroncapital.com/video/bloomberg20081009.rm
and gave a sober, reasoned explanation of why he wanted to buy stocks as
soon as the post-Lehman tremors had settled down, possibly as soon as the
following week. The interview ended at 2:15PM with the Dow down 100
points. By the time David got back to his office, the Dow had
closed down 683 points. The next day, the Dow fell another 750
points intra-day (a 16% decline in about 5 trading hours) before starting
a monster rally, which took the Dow back above the October 8th
close. From there the Dow slid 2762 points, or 30.3% percent.
The Dow is now 33.1% above the October 10th, 2008 low, and 57.9% above
the March 10th, 2009 low, but wouldn't it have been amazing if we could
have taken our clients out of the market for those 6 months?
The take-way:
1. Don't think anyone has a perfect crystal
ball into how markets operate.
2. Make sure your strategy can survive
making a bad call. We don't use leverage, so we only sell when we
want to, not when we have to. For those clients who rely on their
portfolios for retirement or other needs, we make sure that their
allowance is paid out of relatively stable fixed income, which we reload
when stocks are high.
3. Don't invest too much in any one
idea. If you invest 2-5% of capital among 30-50 ideas, inevitable
"wrong" ideas won't kill you.
The illusion of knowledge
He who knows not and knows not that he knows not is a fool; avoid him.
Persian apothegm, in
Sanskrit, and in the writings of Confucius and Socrates
There are known knowns. These are things we know that we know.
There are known unknowns. That is to say, there are things
that we know we don't know. But there are also unknown unknowns.
There are things we don't know we don't know.
Donald Rumsfeld, US Secretary of Defense, June 2002
Few things are more irritating to us than to get cornered at a cocktail
party by someone who "knows XYZ" and insists that he or (more
rarely she) is absolutely right. Really?!? We operate in a
state of permanent paranoia about the things we don't know, or worse, the
things we thought we knew which have now changed (the entire US tax code,
for example, regarding retirement contributions this year and estate
taxes next year.) The people we know who are most prone to being a
"fool" are those people who are truly experts in their own
field; doctors and university professors are the classic examples.
The rise of the Internet, which has made the world's knowledge no more
than a key stroke away, can foster further illusion if the seeker only
goes to sources that confirm, rather than challenge, their
"knowledge." These days television "news"
caters to their audience's preconceived opinions: Fox if right wing, CNN
if left wing, MSNBC if wishy-washy.
The most dangerous unknown unknown is a "rule" change in how
markets operate. One of our core assumptions leading into the 2008
Financial Crisis was that "grownups" were in charge at the
banks who would take steps to protect the system out of their own
economic interests. Senior management owned tens if not hundreds of
millions in the stocks of Bear Stearns, Fannie Mae, Freddie Mac,
Citigroup, Lehman Brothers, Merrill Lynch, etc.
Wrong! Not only were the heads of banks completely out of touch
with their own firms, but also a whole new generation of market operators
were prepared to attack, and if necessary, destroy whole institutions to
make a buck (another "rule" change.) Market regulators at
the SEC, Treasury, Federal Reserve, CFTC were no better prepared to limit
the damage than FEMA was prepared to protect New Orleans before and after
Hurricane Katrina.
The take-away:
1. Seek out information sources that
challenge or contradict previously held opinions.
2. Beware the unknown unknowns.
3. Regulators can't protect you anymore.
Investing goes against the natural instincts of 98% of investors
The "Efficient Market Hypothesis" that financial markets
operate by sober, intelligent investors making decisions based on
rational analysis of all publicly available facts has taken quite a
beating over the last decade. How does EMH explain the
"Internet Stock Bubble" of 1999 or the most recent "Real
Estate Bubble," which blew apart in 2007? We believe in the
"Mostly Efficient Market Hypothesis," which is to say that
markets operate efficiently most of the time, but occasionally go off the
rails due the instinctual behavioral mechanisms of people. 10,000
years ago, if you wanted to find food and Caribou tracks led West, then
West was the way you went to hunt. Humans have a tendency to draw a
line through a series of data points and project that line to
infinity. So when housing prices rise annually to ever higher
values, people just assume higher prices next year even if the underlying
valuations (ratio of ownership costs/rental costs) imply problems.
Or last March, with the US stock market down 55% in 18 months, people
just assumed it would be zero within a year, even though stock valuations
were at the lowest levels in a generation.
Humans are also herd animals. We told a number of our clients in
the 2003-2007 time frame that if they wanted to buy that second home,
they should be prepared to own it for at least 10 years, because that's
how long we thought it would take them to break even. That advice
did not square with the advice our clients were getting from their real
estate broker, mortgage broker, friends and family, so they thought we
were idiots.
The take-away:
1. We believe that humans are hard-wired to
"buy high/sell low."
2. When our clients disagree with us, we're
most likely on the right track.
The consensus is often "wrong"
Every January, investment houses across the US and Europe put out
forecasts of how the year will develop for stocks, interest rates,
commodities, social trends etc. We like to check back on those
forecasts 3, 6, even 12 months later to see how the consensus
performs. The answer, often, is badly. For example, in a
survey of economists and investment managers on 10/19/2009, the biggest
concern by far was the potential for a dollar fiscal crisis. On the
day of the survey, the Euro was at 1.4965, peaked at 1.5134 one month
later. From that level, the Euro fell 10.75% to a one year low of
1.3508. Since then, it has stabilized at 1.3530. However the
US economy looks like it is glacially turning around, while the European
economies are stuck in neutral, so we wonder how soon before the
downtrend in the Euro resumes.
The take-away:
1. You can't ignore the consensus, because
that view will drive short term price trends.
2. But you have to be able to disagree with
the consensus from time to time, because that's where excess profits lie.
The mosaic theory of investing
 A random handful of tiles is neither valuable nor
interesting. Put 30,000 or so up on the wall, and a pretty picture
emerges. Too much of modern investing depends on reacting (or over
reacting) to the news of the day. We think that you need to
evaluate the data of the day in the context of at least the last three months
worth of data, along with a projection of what might happen in the next
three months.
For example, at present we are evaluating multiple indicators to
understand whether the US will experience a double-dip recession later in
2010, or even in 2011. "Tiles" in this analysis include:
· Short interest rates
still extremely low at 0-0.25%
· Federal Reserve
shutting down credit market support programs
· US GDP expanding as US
corporations move to rebuild inventories
· US jobs growth about to
resume after 8 million jobs lost
· Housing prices flat and
foreclosures falling
· Consumer and business
credit still in short supply
· and hundreds of other
economic reports
We subscribe to dozens of market data services, read over 600 pages of
economic forecasts and trade magazines per week. Our struggle is to
limit and filter the data overload to something manageable. We
don't spend much time (OK no time) watching CNBC. Too many people
on that channel have too little time to explain complex issues that could
fill whole issues of "The Economist." The absolutely
worst segments are "debates" with 10 heads in little boxes all
over the screen. Four are talking, two are screaming, the rest are
trying to get a word in. At that point, the information is drowned
out by the noise.
The take-away:
1. Evaluate the quality (signal/noise
ratio) as well as the quantity of data.
2. Analyzing volumes of investment data is
like drinking water from a fire hose; it's easy to get your face ripped
off. Use a "straw" to get just the "sip" that
you need.
3. Overreacting to individual data points
will cause "buy high/sell low" behavior.
Real companies with real products generate real returns
Investors have focused most of their attention the last two years on
the financial system. We remind our clients that finance is to the
rest of the economy (manufacturing, services, education, healthcare,
government) what motor oil is to your car's engine. Yes, you need 5
quarts to keep things running, but ultimately motor oil is an easily
replaceable commodity. Wall Street bankers saw record bonus last
year on huge trading profits. With volatility and the potential for
further gains sharply diminished, so also the trading profits that
bonuses depend on.
We wonder whether the great expansion of financial services, which
started with the "Big Bang" end to fixed commissions in 1975,
and accelerated dramatically with the application of computer modeling in
the 1980's, 1990's and 2000's to create ever more exotic
"products" such as Credit Default Swaps, Collateralized Debt
Obligations and High Frequency Trading strategies, may shrink relative to
the rest of the US economy for a while. When Wall Street directs
the savings of investors to corporations in need of growth capital,
everyone gains from the "positive sum" game. The
"innovations" of the last 10 years are more in the category of
"zero sum" or even "negative sum" games, where a
couple of players make some money, while the rest lose everything.
Meanwhile, unremarked in the mass media, hundreds if not thousands of
companies are busy solving the real world problems of the next
decade. To describe just one sector, a dozen companies are working
to commercialize routine space travel. We're not prepared to invest
in this sector yet (at this stage, most companies are funded by venture
capitalists and not available for public investment.) Over the next
5-10 years, some will fail, some falter and some succeed. We'll be
looking to invest in the stronger ones.
The take-away:
1. Economic growth comes from manufacturing
& service companies developing new products and services.
2. Many financial "services"
companies subtract from economic growth
3. The upside of lower incomes in financial
services will be the migration of clever people back to the real economy.
Strategy
The quietest markets in two and a half years gives us more time to
spend working with current clients on their evolving needs and bringing
in new clients. We'll be rebalancing accounts through the
spring. Tax season is winding down, but contact us if your
accountant is missing any paperwork.
As always, please don't hesitate to call with questions
and concerns.
Yours sincerely,
David Edwards
President
The Heron Capital Management client letter is published
immediately following month end and when market conditions require
comment. The views expressed in this letter represent HCMI opinion and
strategy as of the date published and can change at any time upon receipt
of new information. Data quoted in this letter are from sources deemed
reliable, but no guarantee of such data is implied.
Heron Capital
Management, Inc., is affiliated
with Heron Financial
Group, LLC, an SEC registered investment
advisor providing fully managed investment and wealth management services
to individuals, families, trusts, defined benefit plans and
corporations.
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HERON CAPITAL
MANAGEMENT
www.HeronCapital.com
(800) 99-HERON
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