Bulls, Bears and Other Animal Spirits

Last summer, I had the opportunity to visit Yellowstone National Park, with its spectacular geo-thermal displays (including the Old Faithful geyser) and abundant wildlife, including buffalo, elk, deer and – of amusing interest to anyone involved in the markets – real bulls and real bears, all of which freely roam the Park’s forests, plains and roads.

The Park also has abundant signage warning visitors not to approach the wildlife. Why? Because wildlife can be unpredictable and potentially dangerous to humans. No matter how tame the animals might appear, and no matter how serene an image people might have of wildlife through watching television, the fact remains that even the most cuddly looking bear can easily attack a human with devastating consequences.

So it is with the stock market, at least figuratively. No matter how comforting the “long term” statistics and pie charts might look, no matter how consistent the annualized returns appear for a period, the stock market is a wild place of animal spirits that can turn on you without warning and with devastating consequences. As of this writing, the market has dropped roughly 50% in a year and a half. There is no shortage of coverage about the supposed causes of the current mess. Rather than spend time assigning blame, I prefer to ask the following questions:

  • Where are we now?
  • What have we learned?
  • Given what we have learned, how are we choosing to respond?

Where are we now?

  • Just the facts, ma’am. The market is in the tank; the economy is in a deep recession; unemployment is now 8.1% (its highest level in 26 years); housing prices have not yet stabilized; banks have not yet begun to lend in meaningful amounts. The government has taken strong action that should work; nevertheless, gloom and doom prevail.
  • At the same time . . . Stock prices are at attractive levels; economic activity has not completely ceased; and 9 out of 10 people who want to work are in fact working. Recessions are cyclical; we are in what feels to be just about the worst part of this one now. Brighter days are ahead — even if we are not all able to see them now — as the cycle works its way through.

What have we learned?

  • Everything is related. To think otherwise is to miss the nature of our universe. Example number one is the pundits telling us that the sub-prime lending crisis was an isolated issue that would be contained in a small corner of the U.S. housing market. Wrong. The sub-prime fiasco quickly spread into the prime markets and from there into every corner of the global credit markets, bringing lending to a virtual halt and international banks to their knees. The effects of the credit crisis continue to reverberate around the globe. Example number two is the pundits telling us that the so-called BRIC nations (Brazil, Russia, India and China) are growing so rapidly in their own right that a slowing U.S. economy would not have a large impact on the rest of the world. Wrong again. The U.S. recession has affected economies around the world. Put simply, if the American consumer stops buying electronic toys, what are the factories in China going to produce and for whom?
  • Diversification among different stock markets is a bull market myth. In times of economic, political and/or geo-political crisis, all markets drop. So it has been the past year and a half, whether you have been in U.S. stocks, European stocks, emerging market stocks, large cap stocks, small cap stocks, growth stocks or value stocks. In all cases, you are down at least 40% and in some cases much more. Do not diversify one stock market by going into another stock market; diversify away from stocks by owning something other than stocks, e.g., treasury bills, high quality corporate bonds or perhaps gold.
  • It is one thing to discuss your risk tolerance; it is another to live it. That is the secret blessing of this bear market – we are discovering through experience our true tolerance for risk. As mentioned above, we have no control over the market. The current volatility is a reminder of that fact, but can also be a guideline for investors in deciding how much of their portfolios they wish to put at risk.

Given what we have learned, how are we choosing to respond to where we are?

  • And the winner is . . . To survive the epic clash between the desire for control and the unpredictability of the market, investors must accept that the only thing any of us can control is how we choose to show up in every moment. In investing terms, that means choosing how we react to market conditions and how we choose to invest.
  1. First choice: the mix. Assuming you choose to invest, the first decision is choosing the amount to invest in stocks versus cash and/or bonds. Many guidelines exist, including academic studies; rules of thumb; old-fashioned guessing; and the good old standby: the 50/50 split. My advice is to understand the risks and consequences and then listen to your heart. We have learned that the market is uncontrollable, unpredictable. We have experienced the downside for the past year and a half; remember that the market is uncontrollable and unpredictable on the upside as well. Start with a random split between stocks and bonds and see how you feel. Ask yourself, “on the road to future investment gains, if the market drops 50% for a period along the way, will I be able to stick it out?” Your gut will tell you if the split you have started with feels like too much or too little. Go from there.
  2. Second choice: the implementation. The second decision is choosing how to implement your mix of stocks and bonds. For most of us, the answer is to use diversified mutual funds. An important element of becoming a successful investor is to acknowledge our limitations; for most non-professional investors, stock picking is a limitation. The vast majority of mutual funds are managed by professionals with more experience and research resources than we have available to us. (How to pick a mutual fund is a topic for another day!)
  3. Third choice: watch. The third step is to watch, watch and watch. Keep an eye on your holdings, on your split between stocks and bonds and on the constantly evolving investment conditions. Do not be compulsive, but do recognize that it is in your interest to have a least a general idea of how your money is invested. Also, remember that nothing is written in stone. A truly creative investor realizes that at times it is appropriate to make a change in funds and/or a change in your mix between stocks and bonds.

Whatever your choices, be confident and have faith. If you have listened to your heart as well as your mind, you likely will emerge with an investment portfolio that works for you. Happy investing!


Interview with Suzanne Stepan of Utopia Funds

Suzanne Stepan is a portfolio manager at the Utopia family of mutual funds.  The Utopia funds invest globally, seeking absolute return independent of any markets or benchmarks. Richard Bregman, Publisher of Investment CPR, spoke with Suzanne at the Reuters Advice Point conference in New York City earlier this year.

RB: Suzanne, please tell me about the funds.

SS: The Utopia Funds were launched on December 30, 2005. The Utopia Funds were the offspring of an idea to offer our style of investing to any individual that has any range of investable assets. There are four funds within the Utopia family: Utopia Growth, Utopia Core, Utopia Core Conservative; and the Utopia Yield Income. Like our separate account strategies, the family of funds is managed with a goal of global absolute return. Also like our separate accounts,the four funds are managed to match four broad investor suitability profiles with parameters including time horizon, appetite for downside volatility, and withdrawal needs. For example, the Utopia Growth fund is designed for an investor with at least a ten year time horizon, a relatively high threshold for short-term volatility, and minimal withdrawal needs. Utopia Yield Income, on the opposite end of the spectrum is designed for the investor with as little as a three year time horizon, a relatively low threshold for short-term volatility and more regular withdrawal needs. We offer investors absolute return through being able to go anywhere in the market at any given time, being able to look at different geographical sectors, asset classes, types of securities. That complete flexibility allows us to provide value for our clients. We look at risk and reward at all times and that’s the premise with the launch of the funds.

RB: What do you mean when you say your goal is global absolute return?

SS: Absolute return for us is providing a long-term positive return above inflation for our clients independent of what happens in the marketplace. Continue reading

It’s All About Perspective

Last year when I picked up my son from summer camp, we made a side trip to a nearby Six Flags amusement park. Shortly after arriving, my son begged me to go with him on one of the park’s rides, the somewhat innocuously named “Swiss Family Toboggan.”

I am not a big fan of amusement park rides in general and as an investment advisor, I am certainly not a big fan of taking risks for which I do not see adequate reward – and amusement park rides fit squarely into that category for me. Nevertheless, in the spirit of our father/son weekend, I acquiesced. I soon found myself strapped into a “raft” that was essentially a roller coaster in disguise, ascending an incline toward a clearly visible three story vertical drop that would end with a splash through a “pond.” We inched slowly, inexorably forward, getting agonizingly close to the plunge. In my mind, we might as well have been going over the side of the Grand Canyon. The usual panic-driven thoughts started to kick in: what have I gotten myself into? How can I get out of this? I must have been crazy to listen to this kid, etc. Too late – we were going over the edge! But at that exact moment — looking straight down and beginning a free fall — I had a moment of clarity: I was strapped in and could see the bottom! Suddenly, I could let go and enjoy myself – and that is just what I did. What had changed? My perspective. Continue reading

Interview with Wally Weitz

Wally Weitz is the well-known founder and president of Wallace R. Weitz, Inc., and the manager of the Weitz Value fund. He is a deep value investor and, until recently, followed a long-only strategy in his equity funds. In 2007 Mr. Weitz converted a private partnership investment vehicle into an open-end mutual fund, called the Weitz partners Opportunity III Fund (WPOPX). In the Opportunity III Fund, Mr. Weitz runs his version of a long/short fund.

Richard Bregman, publisher of Investment CPR, caught up with Mr. Weitz at the 2007 Morningstar conference in Chicago.

RB: Tell me about the Partners III Opportunity fund. How is it different from your traditional long only funds?

WW: The idea is we almost always have a fair amount of cash in the long only funds, so let’s say 90% invested and 10% cash is a neutral position in most of the funds. In this one [Partners III] instead of being 90% net long that way, we’ve tended to be 105%, 110% long pretty much with that same list of [stocks in our long funds] just more so and then short with whatever seems to be the most expensive part of the market. Continue reading

Bulls, bears and inner peace

A friend came to me today to ask for some off the cuff advice. He is purchasing a second home and wants to know whether he should lock in his current mortgage commitment at 6.5% fixed or should he wait to lock in until after the Federal Reserve meets later this month and (he hopes/fears) lowers rates, presumably lowering the rate on his mortgage. Further, he has the opportunity to buy the rate down to 6% fixed by paying two “points,” i.e., paying the lender an additional two percent of the mortgage amount up front in exchange for lowering the interest rate on the mortgage down to 6%.

In effect, my friend was asking me whether I believe the Fed will lower interest rates later this month. I told him that I do not know. I then laid out different scenarios. Scenario number one is that the current sub-prime fiasco spreads noticeably to other areas of the economy (as of this writing the Fed says that has not been the case), causing a noticeable slowdown economy-wide. That scenario suggests the Fed will lower rates to boost the economy. Scenario number two is that the sub-prime mess is contained and limited only to the residential real estate housing market. Notwithstanding the troubles of those embroiled in the lending problems, the U.S. economy remains strong and the global economic boom goes on with nary a bump. That scenario suggests the Fed will not lower rates. Of course there are other scenarios (including no action by the Fed but a change in language favoring a rate reduction in the future), but these are the two major pro and con arguments regarding the Fed’s decision on September 18th. Continue reading

Control, and lack thereof

One of Investment CPR’s (Investing for Consistent Positive Returns) central tenets is that the future is unknown; we can neither predict nor control it. The future simply arrives in a never ending series of present moments. We can make reasonable guesses and calculate reasonable probabilities about the future, but there is no absolute certainty of an outcome. At the end of the day, we have no control over external events. But we do have control over one thing, and as far as I can tell, one thing only — how we choose to show up in each moment. How we choose to act; how we choose to react to events.

In our case, how we choose to invest. When investing, we believe it is critical to account for the fact that the future is unknown. Traditional investment strategies are designed to take advantage of the belief — whose outcome is unknown — that the markets will go up over time. This has certainly been true in the past. However, it is not a guarantee. And while markets certainly have risen in the past, they are not rising all of the time. So the question for us becomes: what do you do when the markets decline? Most traditional strategies have no answer, except to say “be patient” or “hold on for the long term.” Fair enough, but is that the only choice of action available to us? Are there ways to benefit from declining markets? The answer, of course, is yes, there are investment strategies that enable investors to make gains in down markets. Given that it is impossible to know which way the market will go on any given day or even for any given period of time, we believe it makes sense to utilize strategies that are capable of making money in down markets. In this way, we are using down markets to our advantage as opposed to just hoping they don’t happen.

At the same time, it is always possible that the markets will go up on a given day or during a given peiod. We wish to protect ourselves against missing such a time. As such, we also invest in traditional strategies, i.e., strategies that are largely reliant on a rising market to make their gains. In this way, we capture gains when the market rises. Continue reading

The “R” Word

I saw it yesterday, for the first time since much earlier this decade — the “R” word. Michael Metz, chief investment strategist at Oppenheimer & Co. commenting on today’s reported drop in consumer confidence, said “My guess is we’re heading for a consumer-led recession beginning in a few quarters.” Interesting, how far we have come from the media proclamations several months ago that the sub-prime lending fiasco would not spill over into other parts of the economy. Oops. It is spilling fast, with far-reaching and potentially disastrous consequences. We’ve all read the headlines about failing hedge funds and increasing default rates on mortgages. But now it is starting to sink in: people are going to lose their homes, or come close.

I worked at a large money center bank for six years before going out on my own ten years ago. Though I never worked on the lending side of the business (I was on the investment side), I had plenty of up close experience with lenders and credit standards. Banks and bankers are risk-averse. They do not like to lose money and bankers’ top priority is to not lose money for the bank. When borrowers begin to default on loans, the lenders are rather unforgiving. Their view of risk tightens up and so do the lending standards. The spigot of money that fueled the housing boom and the lending boom for corporate deals is going to dwindle. Deals will slow if not stop; mortgage lending will slow down; home equity lines on heavily leveraged properties will not be given; people who default will not be given second chances. It does not matter that the lenders aggressively sought to make the loans, in many cases to borrowers who should not have gotten them. People will lose homes. The markets and the commentators are beginning to accept this awful reality. Continue reading