Managing a portfolio
A frail basis for making investing decisions
Seeing as how June 30 was the end of the first half of 2021, market strategists, chiefs of macro-economic strategy, heads of multi-asset strategies, sell-side chief economists, analysts, pundits and what not, have been busy telling us about all the macro things we should be worrying about and explaining where we are and where we are going and what we should do.
Their discussion might: point out that 10 year U.S. Treasury bond yields have skidded from 1.77 per cent at the end of March 2021 to below 1.3 per cent currently; weave in that the U.S. inflation rate ballooned to a 5 per cent change over a year ago prices; highlight that the U.S. Federal Reserve has changed the anticipated timing of its actions; point to the rise in the industrial commodity price index of 80 per cent change on a year ago; note recent falling commodity prices; remind us that the S&P 500 index is up 20 per cent since early 2020; highlight that the forward estimate P/E ratio of the S&P 500 is now at 22.6; with a nod to the current CAPE ratio of 37; and conclude that investors should exercise caution, trim back stock allocations, practice rotation into different sectors, and so on. Some even go so far as to offer opinions as to where the economy and the stock market will go over the next six months.
What should we make of all this? That’s what this post is about.
Before we get into that, I want to note in passing that this is the second anniversary of my blog. In the spring of 2019 a well-known New York money manager and successful author suggested to me that I put down my thoughts on investing in a blog. Since I started the blog in July 2019 my web site has been visited by investors from 119 countries around the world; yes, that’s one hundred and nineteen countries! I am eternally grateful for the advice I got. By articulating my investing thoughts in a series of posts I have clarified and improved my own investment thinking. And hopefully my readers have also improved their own approach to investment.
One thing we know for sure: The short to medium term outlook for the economy and the stock market is always uncertain. Let me repeat that; it is always uncertain. Economic and stock market analysis of the kind noted in the introduction to this post are a frail basis for making investing decisions.
Let me explain how I got to this point. An experience in 1992 brought home to me the fact that the economy and the stock market are sometimes signaling quite different things for a good reason. This was my personal lightbulb moment. In that fall of 1992 a formal declaration was made that Canada was in a recession. The press was full of gloomy reports. As it turned out, that moment saw the low point in the Toronto S&P TSX Composite Index and would have been a perfect time to buy stocks. This observation does not provide a rule for future stock purchases. It does make clear that macro-economic news is a factor in the confidence investors have in the stock market. What I learned from that experience was that bad news on the economic front does not mean it’s a bad time to invest. And the flip side is also true. Good news on the economic front does not mean it’s a good time to invest. This bears repeating; if you are feeling really good about the outlook for the economy, this is a good time to think twice about putting new money to work in the stock market. Formal recognition of a recession might be a good time to invest.
On the other hand, a strong economic environment might be a good time to invest. It’s just that ones outlook for the economy is not the main factor.
A more recent example comes to mind. During the period 2010 to 2012 the economy in Europe was racked by economic stagnation and Greece was on the verge of collapse and a Grexit or withdrawal from the Euro zone and perhaps even the European Union seemed imminent. And what happened next. German and French stocks substantially outperformed North American markets and the S&P 500 in the next year or so!
All readers will remember the economic malaise that lasted for ten years after the Financial Crisis of 2008. Yet, the stock market soared.
And, more recently, we all remember the stock market falling off a cliff in March 2020. Investors who remained fully invested in common stock from March 2020 to the present, have done very well.
What do we learn from this?
One thing I can say is that trying to predict the course of the economy or the stock market over the next six months or year or even several years is a fool’s game. So, make no investment decisions based on outlook.
As John Templeton says in his Maxim 14: “Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.” For the futility of relying on forecasts see my post here.
In the in the Berkshire Hathaway Chairman’s letter for 1988 Warren Buffett wrote: “As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies. We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.”
Howard Marks writes: “Inefficiencies – mispricings, misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes.” (Marks, H. (2013). The most important thing illuminated: uncommon sense for the thoughtful investor) p97. That is, the ability to exploit market inefficiencies provides us with a behavioral edge.
But, the question I asked at the beginning was: what are we to make of all the economic and stock market commentary?
What to make of it all?
I think that reading this material is useful. It’s just not for the purpose of figuring out what the market is going to do in the next six months or year or even several years.
I do read a fair bit of the material referred to at the beginning of this post. But, I read it for background purposes as I’ll explain.
The investor does not have to be an expert in macro-economic theory. They have to have some understanding of business cycles. I have never studied economics. I believe a reasonably intelligent person can learn enough through sensible reading.
One has to develop a sense that when things are going well in the economy there is the constant risk of the economy overheating. At such times company profit margins and earnings may be deceptively strong. Conversely, in times of recession, company earning may be unduly depressed. We also need to be attuned to cycles of overconfidence and risk aversion in different industries and sectors as well as similar cycles within individual companies.
There are many economic, financial and social long term trends at work that can affect the companies we invest in. We are well advised to read widely about these trends and to keep a questioning mind as to whether they are real or are creatures of misunderstood statistics. The questions to ask are something like the following: Is there a real cycle taking place or is it a trend? Will reversion to the mean take place? Is a trend real and substantial enough for my company of interest to take advantage of? Is the company actually taking advantage of it? Does it have any competitive advantage? Is the company I am interested in able to make a handsome return on invested capital? Is it a superb company? All of the normal questions need to be asked. As well one looks at the downside. What could upset the trend? Are barriers to entry low for companies looking to take advantage of this trend?
There is a difference between understanding the economic consequences of a trend and blindly investing in a trend concept. It is often said that a lot of money has been lost investing based on trends. The trend may be real but the company may be the wrong one to take advantage of it.
Business confidence is an important factor in the economy, both the lack thereof and excess. Investors’ best defense is to develop a keen sense of the level of animal spirits at work. When everyone is optimistic is it best to look at the downside. When all are pessimistic, it is best to see the glass as half full.
The stock market also acts in a cyclical fashion. There is short to medium term volatility. The time from peak to valley or peak to peak is totally variable and unpredictable. Overpricing and underpricing as noted in my Inefficient Market Hypothesis is a feature of this volatility –see posts here.
There are also stock market cycles that are of longer term and what also have been called secular markets or supercycles that may last a decade or longer. Because we don’t try to time the market we do not have to be able to predict these. We simply have to understand they happen.
The stock market and the economy do not go hand in hand. In fact they often make quite contrasting moves. Again, we do not have to forecast these moves.
In practical terms
In the last four weeks I have sold one Canadian stock position completely and replaced it with another. I also sold down part of one U.S. stock position and used the proceeds to initiate another. None of the macro themes mentioned at the beginning of this post had anything to do with those decisions. These are the only changes I have made to the portfolio in the last twelve months. I don’t expect to make any more in the near future. My asset allocation is 100 per cent stocks.
The long term investor does not try to time the market. They buy the shares of superb companies at very attractive prices when others are selling cheap. Stock market cycles will come and go and the long term investor will endure through cyclical bear markets with grace and the sustaining thought that bargains will become available.
To read more on the subject of the reading necessary to monitor a portfolio, take a look at Chapter 44. Monitoring your portfolio of the Motherlode. After an introduction, the chapter continues with these Sections:
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