 November 2008 INTRODUCTION Writing articles for this edition of the Otto & Associates Newsletter has been a bit like trying to hit a moving target. The market is up one day by a lot and down by a greater amount the next. By the time you read this, there may be significant changes from when it was written. But we have attempted to stand back far enough so that what we write has relevance for a longer period. The three main articles are intended to look at the present market crisis from a historical perspective, to reflect on the economy today with an eye toward the future, and to suggest an entirely different context in which to place our daily ruminations. We conclude with a varied collection of shorter thoughts. A LOOK AT HISTORY We at O&A encourage clients to avoid excessive interest in financial news shows or popular investment commentary. But today even the headlines include stories on the markets. When so much news is also opinions of "experts," people are nearly forced to pay attention. We should, though, also listen to what's being said about the historical context around today's investment woes. One major difference between past and present problems was documented on November 1, by The New York Times. While the losses in the stock market during the last year have been major, they have not yet equaled several other past downturns, including the major decline between 2000 and 2002. However, the volatility has been the most dramatic in 100 years. The Times defined a highly volatile day as one where the market ended plus or minus 4% for the day. There were six such days in September and nine in October. According to the same source, "In normal times, the market goes years without having even one such day. There were three such days throughout the 1950s, two in the 1960s, [and] none…from 2003 through 2007." Today's market fluctuations are unprecedented. Another historical difference right now is that the market decline in the past two months has been extremely steep. While the market lost 49% in 36 months beginning in April of 2000, the current decline (through October 31) has been "only" 46%. This downturn started a year ago, but during the first ten months of 2008, the market was up in four of the months, which provided some periodic hope. However, in September and October the market lost more than it had lost in the previous ten months. Such extremes cause concern. It is well known that in times of crisis, people's memory is selective. One way to keep track of the whole picture is to keep a notebook. It need not be complicated or extensive, but simply writing the date, your current thinking, and who said what in a given article that made sense to you (or did not make sense) is sufficient. That way you can more reliably track your thinking and the statements by others that are important to your understanding of the current situation. Another way to get a clearer head in a time of turmoil is to turn to trustworthy books. Here are three to consider:
What is next for the market? This is an inevitable question, even though we all know the immediate future is difficult to forecast. Still, the next article makes an attempt. LOOKING AHEAD Warren Buffet has commented, "In the short run the market is a voting machine (i.e. it listens to popular opinion); in the long run it is a weighing machine (i.e. solid companies that make money come out near the top every time)." In fact, Mr. Buffett wrote an Op Ed in The New York Times on October 17 titled "Buy American. I am." In it he said that he is using all of his private money to invest in U.S. stock companies. He reiterated that he does not know where prices will go in the next year or two, but he is confident that they will rise significantly in the longer term. Why is it that in the short run the market is a voting machine - meaning that a particular mood or idea (hair-brained or not) carries the day so that the market raises or falls? The attached cartoon from The Economist illuminates this question. The depiction is probably more accurate than rational humans want to acknowledge. Because the stock exchanges are auction houses somewhat like places that sell antique furniture, art works, or automobiles, buyers will pay more for a stock if there are competing buyers. You'll get the product for less if there is lots of product for sale and/or relatively few people who want to buy. For many years beginning in 1946, my father had a Pontiac dealership in Mapleton, Iowa. It was a tiny dealership by today's standards, but it provided a modest, satisfactory living for our family. When it became clear that neither I nor my younger brother was interested in taking over the business, Dad sold the agency. The man who bought it already had a garage and equipment, so most of what Dad owned, aside from the building, was to be sold at auction: a car lift, welding equipment, all kinds of tools, showcases, furniture from the showroom, and so on. The auction on November 22, 1963, went fine in the morning and Dad was happy with the prices the items were bringing. Then the auctioneer broke for lunch and it was during that break that word swept through the crowd that President Kennedy had been shot in Dallas. Virtually everyone left the auction to watch the developing news on television. Very few people returned in the afternoon, and things went for a song. The items in the afternoon had the same intrinsic value they had had in the morning, but there was almost no one there to buy them. During the month of October, 2008, there have been a number of days at the stock exchange which had similarities to my father's auction in 1963, days when there was a lot of product (stocks) to sell, but the buyers had gone home to watch the developing news. In the long run most stocks were worth what they had been worth the day before. But when the buyers are not at the auction house, prices go down. The auction at the stock market does have two differences from my father's auction. There is much higher volume at the stock market with exactly the same product (one share of IBM stock is exactly the same as another share, unlike an item such as a showroom display case), and the exact same product is available every day of the week. These differences are significant because it is much easier for investors to act on their anticipation by buying stock that they think is going to go up - or selling stock that they think is going to go down, knowing that they can reverse course with relative ease. That is why we say the market is, in the near term, a voting machine. As rumors sweep through the investor crowd, the direction of the market will change. We are currently in one of those periods where lots of investors are voting. Volume at the auction house is very high. Because the U.S. is now in a recession where, among other things, most companies make less money - or lose money, we might expect the price of stocks to go down further. That may, in fact, happen. But the stock market can also go up in a recession in anticipation of better things to come. It would be surprising if the market were to anticipate the end of the recession when it is just beginning, but that is not impossible. That the market anticipates the future (i.e. casts it "votes" by driving prices higher) is one of the reasons we cannot be sure of the direction of the stock market in the short run. Deborah Maher has been to two conferences recently, both led by mutual fund managers with whom we have invested for many years. The Longleaf group (many clients hold Longleaf Partners) said they have never seen such good values in the companies they are buying. They have an elaborate system of calculating what a company is worth. Their discipline says that they will not normally buy a company unless they can get it at 50% of what they believe to be fair value. They plan to begin to sell a stock when it gets to 80% of what they think it is worth, and they plan to be rid of the company when it gets to fair value. Longleaf believes they are now buying companies at 30% of their fair value. Even if they are wrong by 20%, they still expect those companies to double in value in the next few years. Longleaf has not always been right, of course, but in the past 15 years the fund has outpaced the market by 3% per year - a huge amount. How has Longleaf been able to succeed in this manner? By exercising a very clear and rigid discipline: carefully analyzing a company, looking at what it does and how it does it, examining the leadership of the company, and analyzing the market it sells to and the sustainability of that market. The process continues by determining what the price of the company shares should be worth and then cutting the price in half. When shares are available at that price, they buy the shares, ignoring the market "noise," including what this analyst says about the industry or that analyst says about the company. In buying shares at a 50% discount, Longleaf believes they will make money for investors. Even though Longleaf Partners has lost over 50% this year, we have confidence that they are buying companies that will eventually be recognized by the market as winning enterprises. A question that clients ask frequently is, why not get out of the market now, wait for some signs that the market is going to reverse course and start going up, and then buy back in? It is a very logical question, particularly when there are so many predictions that the worst is still ahead of us. We have two responses: first, no one knows whether tomorrow will be worse or better. In the short run it is anyone's guess, and we put little stock in those who make such predictions. Second, when the market turns around, it can go up very quickly. In October there were two days when the market went up more than 9%. It turned out that the market then went back down. But that will not always be so, and we never know when it is going to turn around and then keep rising. Difficult as it may be to imagine in this environment, it is very hard to buy into a rising stock market. For instance, after the market goes up 15% in a week, many people are reluctant to buy out of fear that it may go back down next week. And, if two weeks later it has gained another 5%, it is equally difficult to buy. And if the market then retreats 10% (for a net gain of about 10%), it may still be difficult to buy because there is a fear that it might retreat still further. While it looks appealing to sit on the sidelines for a while during this turmoil, research shows that most of the time when people sell investments to avoid further losses they eventually buy back into the market at a higher point than when they sold. Investors have reason to be worried. However, we will see portfolios recover. In the meantime, we hope that the explanations and suggestions offered above will provide a bit of insight. A LARGER CONTEXT "If we survive danger, it steels our courage more than anything else," is a comment attributed to the mid-20th century theologian Reinhold Niebuhr, one of two giants associated with Union Theological Seminary in those years. Dr. Niebuhr was still at Union when I arrived as a young divinity student. In a time such as this, when the markets are unpredictable and the economy is unstable, I find myself looking for perspective, in part by reading the financial experts, but also by looking for wisdom that can help direct my thinking and provide a foundation both calming and dependable, and on which I and we at O&A can build. The financial wizards who write for the papers and pontificate on television give conflicting advice. We hear the worst is yet to come; we have reached the bottom and better days are ahead; the market will provide excellent returns in the next few years; and the markets will under perform the historic averages for years to come. So, should we help the economy by spending? Should we sell stocks and buy only bonds and CDs? Should we have less in bonds, keep no cash except for short term needs, and buy more stocks? Should we hold cash and wait for a sign that the market is going up? Should we invest more in Europe and other developed nations? Should we invest less or nothing in those foreign countries? What about emerging markets? It is not surprising that this has been a difficult period for clients of O&A. We have had more calls as a result of the current market turmoil than we have ever had in a similar number of weeks during our 17 years of business. We know that some people are able to simply wait it out. Others have asked for information; some have asked for hand-holding; some have wondered out loud if we should make some modifications; a few have suggested divesting; a couple directed us to immediately sell a portion of their portfolio. We've heard it all before, but never with the frequency of recent contacts. All of these phone and face-to-face conversations have led us to think more about our present situation. Mary Otto said recently, referring to her long career in teaching adolescents and conferring with their parents, "Thank goodness I only had to deal with their children," by which she meant that at times people seem more alarmist about money issues than they are about possible difficulties their children may have. Somehow with children, there is more forgiveness, more chance to redirect one's efforts. Money is so concrete. We measure it to the penny, where other things, such as education, important relationships, and religious beliefs, are more ethereal, more difficult to define, and are often handled in a less frantic manner. There is something different about money and wealth. It is often investors with the most who worry excessively. Decisions begin to seem consuming and there is a fear that being wrong could lead to catastrophe. Such excessive concern is fueled by broader circumstances. For some years now our financial world has been undergoing a reorganization. Take, for example, the huge change brought about by the demise of the defined benefit plans. Corporations in the past often provided retirement income for employees in the form of a pension. The pension may not have been large, but it often allowed the person (or couple), when combined with Social Security, to live in retirement without having to cut back their life style too much. An added benefit was that the retiree had no knowledge of or concern with the investments that were behind his pension check. That was a company matter. All he knew or cared about was that he got his check each month. Today, it is often employees who are responsible for managing their retirement investments. When their investments do well, people can have the equivalent of a monthly pension check. But that too is something that the employee/retiree must manage, and it adds to the worries. Then there is the matter of health insurance, which was previously given to many employees and is now another unsettling question. All of this has led to a heightened awareness among employees and retirees, which rises to the point of hypersensitivity because they are now responsible for more. Understandably, people may fear the worst when markets turn down and they wonder if they have made bad decisions. One of our present clients provides a historical example of a different sort. "Eric," self-employed, never had a defined benefit plan. Rather, he was forced to look to his own best judgment in anticipating his future retirement. I have known his story for a long time, but his retelling it recently was informative. Eric has a wife and family. He worked as a real estate agent and did not have a company retirement plan. Both of his parents had died at a relatively young age, and he had inherited some money, much of which he used to invest in single family homes. He would buy a house, get a long-term mortgage, rent it out, and then sell it in a few years. The rent did not pay for all of the expenses and mortgage, so it was important that he periodically sell a house and use the profit to subsidize the remaining investments. However, in 1986 Congress changed the tax code, one result of which was that investment real estate was much less tax advantageous - something he did not realize at the time. Over the next few years the new tax code put a damper on the real estate market. He was no longer able to sell the houses at a profit - and later he could not sell them for what he paid for them. Though he eventually sold all the properties, by then he had lost all of his inheritance and any other savings the family had accumulated, including his small IRA. Still as he and his wife tell it, after taking two or three years to get rid of the houses and finally having no debt except the mortgage on their home, they started to rebuild. They cut out vacations, rarely ate out, and reduced expenses radically. But they were relatively happy. Their children, their friends, and their families were intact, and that seemed sufficient. They are also clear that for a number of years before the tax act of 1986, they had not been very happy - but not for reasons having to do with money. Their marriage had been in some difficulty. But with professional help, mixed with tenacity, they got through it. When financial issues appeared a few years later, they were not pushed over the edge. Eric's story reminds me of the most well-known quotation that is attributed to Reinhold Niebuhr, the "Serenity Prayer": "Lord, grant me the serenity to accept things I cannot change; the courage to change things I can change; and the wisdom to know the difference." Questions of whether to invest in stocks or bonds, sell bonds to buy more stocks, or hold cash to wait for a sign that the market is going up, become less pressing in this context. Fortitude is required to creatively face today's economic uncertainties. And with it, if we're lucky, comes another benefit, perspective. BRIEF THOUGHTS
OFFICE MATTERS As mentioned previously, Deborah attended a New York City conference sponsored by Southeast Asset Management, the group that manages the Longleaf Mutual Funds. Again this year, Deborah and Judy attended the Baron Conference at Lincoln Center. Baron Asset Management sponsors a number of mutual funds, of which we use three. On a more somber note, Kathy Patton's mother died on October 24 after a brief illness. We extend our sympathy to Kathy, her immediate family, and her siblings. The Ottos have moved - three blocks. David needed a more adequate office, especially since daughter Susan is working in the Vermont office more hours and expects to join her father at least two days a week in the next year or so. |