Monday, August 14, 2006

On Market Timing and Value Investing

It's no news that the market has been completely tanking over the past couple of months. Institutional investors, fund managers, and retail investors alike are pulling their hair out while watching their the best of ideas and the worst of ideas going down down down. So a few questions regarding this sudden downturn should be posed: what is happening? what is to be done?

We are in a period of a much needed correction on the stock market. In a way, we were still feeling the effects of the economic recovery as a result of Greenspan's relentless easy money policies from 01/02 on--until now. Back when interest rates were eased down to nearly 1%, the hope was the excess amounts of easy capital to business people would be enough to finance capital investments to save the economy from an oncoming doom. The stock market was thus saved, as people got out of fixed income investments because of the low yield and put money into equity investments again. As the stock markets began to rise, investors once again had the confidence that they had lost after the tech bubble, and the stock market became, for a short period of time, the investment vehicle of choice once more. The market gained momentum... and everyone made money, though not anywhere near the amount that people lost in the burst.

So what's happening now? To answer this question, one must first aggregate everything that has happened in the stockmarket the market for the past five years. Before the bubble burst, stocks were allowed to rise to cosmic levels in praise of a "new economy" where financial valuation no longer mattered, and earnings were expected to be able to rise on forever and ever. The over-valuation of equity investments were obvious, but no one really cared. And as the fate of any investment bubble in the financial history of man, it was destined to burst. However, one should be aware of something that often escapes observation. The bubble burst never actually corrected stock market valuations to its historical levels. Meaning, the stock market after the bubble should have crashed lower than it should have before it started to recover during the latter 2002/early 2003. One only needs to look at what happend to interest rates during the crash:

In a way, the Fed saved the markets from an even heavier downfall by decreasing interest rates almost immediately after to historical lows (interest rates that haven't been seen since the late 1950s). By doing so, the Fed has successfully taken the interest out of bond-investments, and thus, naturally--hungry for returns, most investors went back into the equity markets again without the stock market having hit its bottom. It's very important to emphasize the role of the Fed in brining the stock market back up during the past couple of years away from the perceived doom of 2000 - 2001. One can look at the current price investors are willing to pay for the future stream of corporate earnings vs. the historical average level that investors were willing to pay that's been around for many many years:

Taking a look at the end of 2005, it doesn't seem to be too far off from historical highs. Meaning that, in a way, we are still in a period of overvaluation in the market, and that valuation after the bubbles crash can only be considered "relatively low" compared to the heat of the 90's as the tech era boomed. Of course, many could argue that we have reached the highest levels of productivity that mankind has ever seen, with countless number of new innovations that have facilitated efficiency gains beyond anyone's dreams before the advent of the technology boom. However, I fail to grasp how this should affect financial valuation. As much innovation and productivity gains that the American business landscape has seen over the past two decades, the fact that businesses still compete for market share and businesses still compete for capital do not change. And thus, why would financial valuation change? It's not as if a business will be able to make higher returns with less risk than before. If anything, the risk has increased and returns have decreased as a result of a "flatter" business environment.

So, what the Fed right in coming to the rescue back in 2001 when they decreased interest rates to where they were? Yes and no. Yes in that America badly needed an injection of confidence to prevent recession/depression/whatever. No in that the Stock market still needed to go down more.

Anyway, back to present times. Alan Greenspan probably realized that too much money was created in the economy, and started raising interest rates again not too long ago. Bernanke has continued this legacy. But why is too much in the economy bad? I've heard many "average joes" asking very difficult questions such as why "the Federal government is trying to bring down the value of their homes?", or why the government is "trying to create a recession at the expense of the people?". How do you answer these questions? Can you simply tell people that, well, they made too much money with historically low interest rates, and these extra monies went towards intangible investments and bubbles such as (in order of appearance) the tech bubble, the nascent mini-recovery in stocks, and real-estate? No... you probably can't, because chances are, the average joes didn't really make that much money in the tech bubble, and the value of their homes is the only real tangible capital gain that they have seen over the last few years. It's the "smarter" people that got away with real value... like, perhaps the now-famous Andy Kessler who got away just in the nick of time when the bubble burst. So, the average joe got screwed then during the bubble, and they will probably get screwed in the next couple of years that the Fed is tightening to take the extra money (including the gains in home prices) away from the economy (god knows how many people actually went through with taking mortgage-equity out of their homes).

Bernanke is continuing the tightening policy in order to take all the excess liquidity and M2 out of the system. And by tightening, the stock market goes down as returns are discounted at ever increasing risk-free rates and bond markets look more and more attractive to investors that don't want to deal with the risk of capital depreciation. The market has been going down finally for the past few months as rates broke the 5% mark since the lows that it has hit during 2001 - 2002. We can already hear the griping of equity investors begin--and what do you know, they are hammering for a "pause" and an "ease".

Bernanke threw them a bone in the last speech he gave congress--which, by the way, was hilarious because of the congresspeople's insistence that a pause should happen right now (especially the ones with lobbyists from the housing sector and the mortgage financing sector). Bernanke said that the Central Bank would now be more careful in considering many factors that are facing the U.S. economy, including:

1.) The effects of past interest rate hikes in the pipeline that have yet to hit the economy
2.) The possibility of a recession on the horizon and the fallibility of an overhike
3.) The possibility of even more inflation if the previous two scenarios don't play out.

So, anyone dabbling in the equity markets must beg the question... what is to be done?

Will the Fed pause? Or will they keep tightening? Or, everyone's favorite, tighten one more time in August and then ease up?

There is one answer for the value investors--and that is: keep on truckin' :D
As the vagaries of the market and the fed seem to be endlessly unpredictable and volatile, there is almost no certainty and no risk-control in a situation where the average investor is powerless against bigger things than themselves. To rely on the performance of one's portfolio on the effects of the market is akin to taking seriously a young woman's perspective on the "right" kind of man... both are easily swayed by the seasons. So, it is best if serious investors stayed out of the market as a whole, and instead, looked for investments that have "value", not "price".

Of course, even value investors must weather the ups and downs of the market. Any investment in a portfolio lacking immediate catalysts could be subject to heavy correlation with how the market performs. The fact that everyone dabbles in every stock won't change. And since it is indeed everyone that invests, good stocks can face bad returns in down-markets. In a way, I guess I am a hypocrite, in that, I do my best to criticize the market's overvaluation, and yet, I should curse and suffer too if the market corrects itself by falling since I am a part of that everyone.

However, market-risk is one thing, fundamental-risk is another. Market risk is the kind of risk that gives you gains and losses in volatility swings, but fundamental-risk is the kind that gives you a permenant gain/loss of capital. The difference between value investing and investing with an eye on the market is that the former should only care about the permenant loss/gain of capital, and have a strong conviction that so long as the crux of the fundamental investment thesis do not change, value will out despite short-term short comings.

Of course, that kind of thinking is also dangerous in many respects. Unless one completely understands the investment that one makes, it is very difficult to have that level of conviction that is required to stick it through a great many deal of short term losses... and oftentimes, volatility can often be distorted by emotion to become perceived by investors as a permenant gain/loss of capital every time the ticker moves. Loss aversion is there for a good reason, however, when the fundamental value of anything is worth more than the price that the market currently assigns, then value should out, eventually, even if the market thinks otherwise.

That's not to say that the people who correctly make money on market swings are any less intelligent than value investors. On the contrary, many market-timers I know are brilliant in every respect... and most can make money on advanced mathematics and financial derivative trades that most value investors will probably never understand. However, the philosophy is different. Successful market-timers make money on derivatives and hedging, while value investors make money mostly on long-term equity investments. It helps to have a little bit of both, but no strategy is perfect.

And well, I guess my conclusion: as value investors, there is a conviction that so long as discounted equity are correctly assessed, one does not need to worry too much about the vagaries of the market... only fundamental changes that would change one's thesis. As the market goes through a period of much needed correction, the market will be flat at best, and down at worst. Well, value will out no matter what the market does, but personal discipline and constant thesis checking will be the responsibility of every value investor as pride, love, fear, greed (well, maybe a little bit of greed), and soothsaying cannot ever be allowed to affect one's judgement in what is "value" and what is not.

Of course, the trick is to make money on a down market. Oh value, where art thou?

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