Wiping the Chalkboard Clean

Phil Diamond, CFA | May 24, 2010

Forget everything you've heard or have learned in the last few weeks and just imagine that naive version of you from just the middle of last month still existed. Then, what if we told you that oil had gone from $80 to $68, interest rates had dropped by 0.60% (or 60 basis points) on 10-year Treasuries, that we had the best monthly employment report in over three years, that corporate earnings were growing like weeds and exceeding almost every analyst's expectations, and while all this was going on the actual prices of the stocks had magically been repriced down 10%. Given that environment, we think you'd have to think this was a great buying opportunity, perhaps the last best chance to get into this bull market before it gets away from you. Well, naive you would be right, while more learned you is sitting there wondering why you are even in this business right now.

How often do we face this same dilemma? When are we going to learn? We have to cast off the short-term worries and hoopla and think and act for the long-term. Get some perspective!

This is not a big crisis that is going to destroy the US financial markets. This won’t even be a footnote to history. At best, this might be useful as a bad example someday. We are all concerned about something that doesn’t really matter all that much. Two years from now, we won’t even remember why the market suddenly dropped by 12% in the middle of a big bull market.

"What we have here is a failure to communicate" to quote the prison guard boss in the movie Cool Hand Luke. Some folks are talking like the world as we know it has been remade; the rules have changed. This isn’t so; the same rules still apply. We’re just not paying attention to the rules, as we often don’t when the rules really ought to be remembered. We had this discussion just a couple of weeks ago about the market of stocks versus the stock market. The stock market people are running amok and selling stuff when it doesn’t make sense.

We will not argue that some areas in the stock market got a bit out of whack with the reality of the economy and the likely future direction of the fundamentals. We won’t argue that industrial or materials names are great bargains anymore. We won’t argue that some of the financials haven’t gotten ahead of themselves. We will argue that stocks in general and growth stocks in particular are still very attractive. The stock market people are selling the stock market. Every market of stocks person we know is looking around and seeing opportunities all over the place.

The big difference between these two groups, as it often is, is the time frame that prevails. If you are a stock market person, then you can trade your stock market -- if you believe the markets are heading lower -- by selling futures, or buying puts or buying an inverse exchange traded fund (ETF) or some other way to get market exposure. But, most of these ways of getting exposure tend to exhaust themselves fairly quickly. Futures and options expire. Leveraged ETFs shouldn’t be viewed as investments but as speculative bets. Betting against stocks has proven unprofitable over longer stretches of time.

Stock market people tend to have a fairly short time frame. Market of stocks people, in other words the good guys in this narrative, have a longer time frame. When you take the time to fashion a portfolio of individual stocks, there is usually a philosophy and process at work. The philosophy could be something as simple as buying stuff that is working right now, but it is still a philosophy. The process should identify ideas that combine solid fundamentals with a rationale why those fundamentals ought to improve over time. That is how you get stocks that compound your investments over time. Even a well thought out process won’t necessarily succeed, but most such processes, if applied in a disciplined manner, will succeed because the successes will overcome the losses.

Once you have spent the time and energy putting your portfolio together, you’d be loathe to tear it apart. Especially if it is just because some politicians in Greece cheated on their Euro-commitments, when that has nothing to do with your process and philosophy. Even if some Spanish and Portuguese politicians did the same thing. You will rely on your philosophy and process to get you through this, and it will.

We would like to thank our colleagues and business partners at FocusPoint Solutions for their contribution to our Commentary. Particular thanks go to Phil Diamond, CFA; Ryan Long, CFA and all within their research staff. We look forward to their on-going Commentary contributions.

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