Travelling can be anything from a great adventure to a dreadful experience. Of course much of it depends upon one’s perspective and attitude. One of the thorny issues with different cultures is that they are — different. Some people relish these differences, but others are appalled.
A recent tour package to China we saw attempted to assist travellers in getting the most out of the experience. In its “Parting Words of Advice,” the brochure recommended visitors “travel with an open mind and expect the unexpected.” These words of advice can serve today’s investors well too. The volatility wrought by the financial crisis in 2008 and rekindled again recently is a clear indication that we are no longer in the investment environment to which we had grown accustomed during twenty-five years of disinflation. As we “travel”, we should expect the unexpected and it will help to keep an open mind.
At very least, we should always keep in mind that our destination is a very different place. The China brochure reminds people, “Thou shalt not expect to find things as thou has them at home. For thou has left thy home to find things different.”
Indeed, the markets are now clearly in an era of digesting debt loads that in many cases have become excessive. Whether this will involve just moderately slower growth or outright deflation is not so important here (see Market Overview for further discussion), as recognizing that an environment of deleveraging will be different.
Disinflation, as we have seen, fosters stability which makes it easier for businesses, consumers, and all economic agents to plan. Better planning enhances confidence, which increases transactions, which increases overall business activity in a virtuous circle. It is easy to conduct business and for investors to become optimistic about prospects in this environment.
An environment of deleveraging, on the other hand, involves more challenges. Because too many people have too much debt, people become ever-more cautious about spending money for fear of not being able to make their payments. This caution is reflected in purchases being canceled or defered which leads to lower economic activity and gradually erodes business confidence. Since there are many types of businesses and consumers, the adjustment process takes time and is often riddled by
fits and starts with little overall direction.
When people travel to China, they are advised that it, “requires patience and potential delays are to be expected due to [a lower] standard of service.” This too is apt advice for today’s investors. Twenty-five years of disinflation was an amazingly wonderful environment for stocks and bonds alike. It will likely take longer to generate returns from risk assets in a deleveraging environment and investors should “expect delays.”
While travel normally incurs certain costs, that doesn’t mean the journey can’t be enormously enjoyable. Certainly one is likely to be exposed to new things and new ideas which is inevitably stimulating intellectually. Often we learn that certain customs and conditions may seem odd or inefficient at first, but in a different context are perfectly sensible and often charming. A different context can also provide a great deal of fresh perspective on conditions at home. Finally, no one place has a monopoly on excellence and examples can be found around the world. All of these apects of travel can lead to an extremely enriching experience.
In sum, travel abroad provides some useful lessons for today’s investment environment. One lesson is that there will likely be differences from the past. Also, it helps to be flexible in order to facilitate dealing with those differences. Finally, it helps to establish reasonable expectations. We may be away for a while, so we might as well make the best of it.
It seems like the last year has been especially busy. As the market rose late last year and early this year, I found it increasingly difficult to invest cash in new client accounts. I grew even more concerned when market averages were hitting highs at the same time that I saw a number of market risks increasing. An important consequence of becoming incrementally less positive on the market was that I also pulled back on some marketing activities temporarily.
The partial hiatus from a full marketing campaign was driven by Arete’s focus on investing. For example, when I see risks and act accordingly, I say so. I am not going to say one thing, and then do another. I am also not going to quote whatever most-optimistic statistic I can find to try to persuade people to invest. I don’t think it is honest to try to grow assets regardless of circumstances, but I also don’t think it is interesting or rewarding.
What is interesting to me is figuring out the countless puzzles that comprise the market. Certainly these puzzles have become more complicated as conventional equity analysis and economics have become far more intertwined with social and political trends. There is just no easy way to bring so many things together than to read a lot and to think things through — and that takes time.
I also find it rewarding to be able to apply my expertise and efforts to improve the well-being of clients. For example, as I became incrementally less positive on the market, it was very straightforward for me to raise cash for Arete’s mid cap core strategy (to help shield portfolios from losses) and to share my insights with clients.
Importantly, I view the primary output of Arete as far more than just a mid cap core “product,” but rather a unique and valuable investment “service.” One of the reasons I founded Arete is because I saw an opportunity to better serve investors. I had seen and experienced many of the ways in which a lot of resources and education and expertise at investment firms can fail completely to make clients better off.
Although Arete is still relatively small, it offers several compelling advantages. It focuses on mid cap stocks which tend to have far more dynamic growth opportunities than large cap companies. It brings an orientation to research with a long-term time horizon which is extremely difficult for many firms to maintain. Finally, it provides access to me and the insights and ideas I develop from reading and researching every day. Clients can call or email any time.
Every business involves tradeoffs and when push comes to shove, I am happy to have the choice of focusing on investments and serving clients. My research over the past several quarters has revealed an investment environment that has become more fragile, and I have spoken freely about the risks I perceive. Although this approach precludes more aggressive marketing at times, I believe the sacrifice
is more than compensated by the value of efficiently delivering investment expertise.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
The volatility that erupted during the quarter is yet more evidence of how fragile the markets continue to be. In the past, we have outlined several risks which we believe have been contributing to the fragility. As a result, we haven’t been especially surprised, or anxious, about the volatility. While these risks continue to play a large role, the more visible factor has been the sporadic and uneven process by which investors are adjusting their expectations.
As a reminder, expectations comprise a very important element of stock valuation. Fundamentals, in the form of cash flows, are also very important. While near-term cash flows can be measured fairly objectively, any stock valuation involves a long list of assumptions. Just like beauty is in the eye of the beholder, valuation is colored by expectations for companies as well as those for asset classes such as stocks.
Dennis Gartman, a professional trader, author of The Gartman Letter, and market commentator, put this into great perspective when he presented to the Baltimore CFA Society a few weeks ago. He made it very clear that his academic training in economics (which focuses more on fundamentals) was “worthless” to him as a professional trader.
Instead, after thirty-five years of trading, he has come to view trading and investing as the “discovery of the human condition.” In other words, he believes it is much more important to understand the more human elements behind the formation of expectations. As a result, he believes the study of humanities is far more insightful than that of economics, and recommends studies such as philosophy, history and literature.
Gartman’s comments are also deeply consistent with those of the great John Maynard Keynes. One of Keynes’ most famous insights also touched on the human condition: “Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits -a spontaneous urge to action rather than inaction.”
When people run up a lot of debt (as consumers have in the U.S.) and then start realizing the very real possibility they won’t be able to pay off their debts, their behavior normally changes. Gary Shilling provides a great deal of insight to this phenomenon in his book, The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.
Some people, when confronted with economic adversity, lose their “animal spirits,” hunker down, and become prone to inaction. This behavior can be seen indirectly through lower growth and reduced market volume. Other people, however, are more prone to make up any shortfalls at the casino. While speculative behavior results naturally, it is amplified by excessive liquidity and low interest rates. As Shilling describes, “The speculative investment climate spawned by the dot-com nonsense survived. It simply shifted from stocks to commodities, foreign currencies, emerging market equities and debt, hedge funds, private equity — and especially to housing.”
The aftermath according to Shilling, is not likely to be a steady decline, but a process, “reflecting shorter, weaker economic expansions and longer, deeper recessions.” Since, “Speculations never end voluntarily or in orderly fashions,” significant volatility seems an almost inevitable outcome and therefore should not be surprising.
It is also useful to note that it is likely market volatility has been exacerbated by a relatively new development: the emergence of a wide range of exchange traded funds (ETFs). While these vehicles certainly have merits, they also have the consequence of facilitating speculation from a much broader audience across a wide array of assets.
As a result, it has become increasingly difficult to disaggregate the information content in the prices of stocks, gold, copper and other assets from speculative activity. In many cases it may very well be that volatility says more about the desperation of speculators than it does about the fundamentals. This increases uncertainty.
Given the environment of deleveraging and volatility, we believe the overall prospect for stocks and bonds is likely to be muted relative to history. All else equal, lower economic growth means lower profit growth and lower valuations for stocks. It is an important distinction that muted growth just means lower growth, though, justify substantially greater valuations than not vast contraction. what the market discounts.
In addition, in this tumultuous environment of cross-currents, all else is not always equal. Extraordinary monetary policy and government interventions affect all asset classes globally. ETFs can also facilitate speculation which can cause prices of some assets to far exceed their value as hedges or insurance. At very least, this environment demands a flexible approach and a very serious consideration of risks.
There is absolutely good news in all of this though. Without a doubt, volatility creates lots of opportunities. Untempered speculation creates very significant valuation disparities for disciplined, long-term investors. We don’t have problems competing in the marketplace with rabid speculators desperate to sacrifice massive losses tomorrow for a few dollars today. While we are currently seeing some interesting opportunities, we strongly suspect we will see even bigger ones emerge in the not-too-distant future. In the meantime, we remain ready.