In Jeremy Grantham’s latest quarterly letter, he profiled a story about Sir Isaac Newton in which one of the most highly regarded intellects in human history was lucky enough to enter the South Sea stock bubble rather early.  He stayed in long enough to make some money and then, most likely feeling good about himself, sold his holdings at a nice profit.  After the stock continued to rapidly appreciate, his friends began to brag more and more about how rich they were becoming from investing in South Sea stock.  Kicking himself for having made such a foolish mistake by cashing out at such a paltry profit, Sir Isaac dumped much more than he had invested the first time into the stock.  Of course, this time the bubble was perilously close to the top and he made the fateful mistake of riding the bubble burst all the way down before selling out on three separate occasions with hardly anything left to show for his original investment.

Gravity in the Stock Market

There are several lessons in this story.

1. Don’t get carried away no matter what type of circumstances surround an investment.
2. Remember that even smart people get burned by stock bubbles.

For these reasons, we’ve designed our strategy to help fight these feelings.  The stock ranges we establish for each of our clients (and ourselves) act as a discipline, helping to control those visceral responses to booms and busts in the markets.  Making calls of where we should be at a given time within those ranges is a large part of our research process.  So the next time your emotions make you feel like you want to act, remember Mr. Newton’s experience. With a sound and solid investment strategy, you can fight these very human urges that are born out of the fear and greed that dominate the average investor’s decisions.

We spotted a story in the WSJ recently, which described how the Dow’s performance in May was the worst May since 1940.  So we thought it might be helpful to take a trip back to the 1940’s and investigate what the general mood of investors might have looked like during that time.  Most investor’s confidence in the stock market had to be incredibly shaken due to the erratic volatility at that time.  The decade they had just lived through, the 1930’s, saw the Dow register eight calendar months in which it rose or fell by more than 20%. They also had to withstand three stock market drops of 30% or more (with the 1929 crash falling 89%) during that period. Now entering the 1940’s, a pervasive attitude of gloom had spread across our nation.  Many of the messages in the media characterized the build-up of a country preparing for war.

From a 1935 edition of Modern Mechanix

Headlines and News of the 1940’s

• Germans invade Western Europe, France and Great Britain; London suffering bombing attacks daily for almost 2 months
  
• Unemployment drops but is still over 14%; “Union Closes Plant” 200 Men Reported Discharged by Boeing Company; Retaliation Suspected
  
• FDR signs legislation requiring US men Register for Draft
  
• Automobile Production Ceased in 1942 due to need for steel

War on the Horizon

It’s not a far stretch to say that people then were probably even more fearful about economic conditions than they are today.  While fear continued to escalate, U.S. federal debt expanded rapidly, t- bills were near 0% and war savings bonds with a guaranteed 2.9% annual interest rate over 10 years became one of the more popular investments.  However, the investors who were able to put aside their emotions and continue to invest in stocks fared much better.  Dollars invested in the stock market from 1940-1949 averaged more than 9% per year over that decade.  In fact, for the three decades beginning in January of 1941-1943, the annual returns were even stronger averaging in a range from 12% – 15.5%.

That means if you had invested $100K each in stocks, bonds and cash on January 1, 1940 and left it alone through December 31, 1949 your $100k would have grown to the following totals identified by asset class:

What You’ve Seen Often Isn’t What You Get

As the graph clearly shows the price you pay for safety in the short-term could likely be a costly one over the long-term.   By many accounts, at the end of the 1940’s, Americans never had it so good.  The war was over, jobs were plentiful, housing was affordable and the American Dream was in reach for more people than ever before.   How truly valuable this knowledge could have been for an investor at the beginning of 1940.

For many investors in 2010, the strain of watching their investments swing on the roller coaster ride we’ve had since late 2007 has left them fatigued and ready to give up.  However, as much as it goes against our psyche, a negative return for an entire decade is a powerful reason as to why we should be excited about the prospects for the next 10 years.

Reverse Your Emotions

Don't Panic!

Successful investing requires turning emotions on their head.  When most people are nervous is the time to see opportunity, and when most people are fearless is the time to be scared.

The stock market did worse during the 2000’s than it did in the 1930’s! Do you remember how you felt in September of 2002?  Or even last February 2009? These periods are when many people were giving up on the stock market.  Fear had brainwashed their rational decision-making skills. If they would have realized in 2002 that their investments were about to go on a multi-year bull market ride, would their fear have been as pronounced?

On the other hand, people’s attitudes of early 2000 and October 2007 were ripe with optimism and fearlessness.  This is a direct contrast to the fear and pessimism that are now dominant.  Optimism makes people overpay for opportunity, while fear makes them overpay for safety.

It’s important to recognize that we will continue to have economic scares in the future (as we always have in the past).   Economic Cycle Research Institute had a recent write-up about the lag effect in people’s perception after a recession.

Take Inventory of Your Short-Term Holdings

What percentage of your investments are in safe areas?  The basic rule of thumb is to have 3-6 months of your living expenses in a safe place with little risk.  This allows you some breathing room for the money you have invested in the markets.  Knowing that you have a cushion of cash and bonds to access for your everyday expenses gives riskier investments time to ride through the stock market dips.

*Photo Credit: pasukaru76

photo credit - cliff1066™

If you invest in your employer sponsored retirement plan you have probably heard of Target-Date funds.  These funds are characterized as investments that change the allocation of stocks, bonds, and cash according to your specified retirement date.  In theory, these funds should progressively reduce risk exposure as the target date approaches.  However, there are no universal allocation standards, so the returns have varied widely from plan to plan.  This was highlighted by the market downturn in 2008 when funds with a target date of 2010 lost an average of 25%, with some posting losses of over 40%.

While the concept of these funds is great; taking the guesswork out of retirement planning for the average investor; further research, transparency, and likely regulation is required.  To that aim the Senate Special Committee on Aging will be introducing legislation that would require fiduciary responsibility for target-date fund managers. This is a step in the right direction, but there are still many other concerns that warrant attention.  In October 2009 Morningstar’s vice president of research Jon Rekenthaler testified before the Senate Special Committee on Aging.  You can read his testimony here:

“Five Concerns About Target Date Funds”

http://advisor.morningstar.com/articles/article.asp?docId=17632

(1) Countries that went away from the gold standard sooner fared much better during the Great Depression than those that held longer (like the U.S.)

(2) Average inflation, under the gold standard, is determined by the pace at which gold is mined

http://www.j-bradford-delong.net/Politics/whynotthegoldstandard.html

Bill also participated in the Triangle Busniess Journal’s rountables on August 23, 2007 and July 18, 2006.

Please contact our office at (919) 851-8200 for a copy of the full article.

Paid subscribers of the Triangle Business Journal may click here to access the full article through their website.

The following is a good example of the pitfalls of the sales model:

CIT Debt Sold to Widows Has Fine Print Pimco Resists

Notice that FINRA, the self regulatory authority for brokers says:

“….it’s investigating whether the risks associated with the securities were adequately disclosed.”

Well here is an example of so called disclosure:

CIT Group Inc. Prospectus Supplement

It is our opinion that it is ridiculous to expect most Americans to be able to adequately interpret 72 pages of “disclosure” (and this is only the supplement to the initial disclosure document).

Yet the world of FINRA regulation provides the framework for a Prudential spokesman to proclaim:

“As with all bonds, investors choosing to sell the notes before maturity may sell them at market value to other investors and face certain risks, which are fully disclosed at the time of issue…”

In other words, buyer beware.

The inherent problems and conflicts of interest with the sales model is why we choose to operate as Registered Investment Advisors.  Our regulatory framework is the Investment Advisors Act of 1940, which requires that we act in our client’s best interest.  We believe this is the best framework for client relationships.  The SEC is responsible for supervision under the Act, and they have unfortunately been underfunded for the last several years.  We hope that will be corrected as we feel more of the public should be served by Registered Investment Advisors.

http://www.chartoftheday.com

The rest of the story is that the last 12 months of earnings are not
representative of what earnings will be going forward.  Our best estimate is
that at current price levels, the PE ratio is actually around 13 to 17.  Most
definitely not the most expensive market in history.

Much of our research effort involves separating good data from bad data,
which is essential to gain and maintain a competitive edge against other investors.