Saturday, February 26, 2011

Climbing the Wall of Worry-Managing Risk

In our last “post” we shared a video with an interview of Goldman Sach’s, Abby Joseph Cohen, titled “The Drought is Over”. Stock market performance in January and February sure seems consistent with that assessment! The S&P500 has risen 4.95% and the MSCI World Index is up 3.52% for January-February. On the other hand, fixed income did not provide very good returns, with the DJ CBOT Weighted Treasury Index actually declining 0.15%.

Reversing an eight month trend of outflows totaling more than $61 billion, money started returning to US Stock Mutual and Exchange Traded Funds with $26 billion inflows in January. Optimism on the part of many has returned, BUT many worries remain.

While paper earnings appear solid, many believe that banks are hiding skeletons in their closets. House prices continue to fall. Federal stimulus designed to reverse this fall in housing prices has resulted in higher prices in other areas. Inflation, particularly in food prices seems to be one spark, among many causes for uprisings in the Arab world where the average family spends more than 40% of their income on food. Unemployment is still a problem in the US. Sovereign debt in Europe is still a great concern. And, high energy prices threaten to choke off the fragile recovery. Finally, no one is sure of the long term effects of US debt and deficits; and no one is sure of the short term effects of austerity measures to reduce this debt and deficit. To a great extent, the stock market in the US is underestimating these risks.

Investors always have three choices: Buy, Sell or Hold. Clear “Sell” signals were present in 2007. By mid to late 2009, we saw clear “Buy” signals. Since November 2010, our cautious view has been somewhere in between Buy and Hold. Global markets appear fairly valued and the US stock market as a whole appears a bit overvalued. One caution is that markets can continue to be overvalued for quite some time.

For the long term we are bullish and, we like what Warren Buffet had to say in his recent letter to shareholders of Berkshire Hathaway….
“Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of “great uncertainty.” But think back, for example, to December 6,1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective. We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.”
“It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone (to replace Mr. Buffett over time) with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.”
                      …Warren E. Buffett, February 26, 2011
                       (BERKSHIRE HATHAWAY INC. 2010 ANNUAL REPORT)

In the short term however, we advise caution and draw your attention to Mr. Buffet’s comments about investment managers needing an “understanding of – and sensitivity to – risk” and “the ability to anticipate the effects of economic scenarios not previously observed”.

I believe that in the short term, there is considerable risk of a correction. Not a 100% probability, but higher than 50%. So, particularly for new money, continued caution is advised. For existing investments, particular attention to quality is important. Attention to individual securities that are possibly overvalued is appropriate.

In addition, I am always careful when the statement “this time is different” is made. This statement is often very dangerous, particularly when it breeds overconfidence. However, I believe that we are presently in one of those “economic scenarios not previously observed” that Mr. Buffett writes about. This is a time when an “understanding of – and sensitivity to – risk” is even more important than it is normally.

Managing risk in the short term may result in a conservative position with higher than average cash positions---and to the average investor, may appear to result in missed opportunity as the “market” rises more than their portfolio does.

In an upward moving market, it is important to recognize “the trend is your friend”. But the trend is a fair-weather friend and can turn at any given time. The trend doesn't announce its intention to change direction. It switches back and worth as it pleases without your permission.

It is important to remember that bull markets climb a “wall of worry” and as Mr. Buffett has said, “Be Greedy when others are fearful when others are greedy”. Perhaps today, too many are greedy and not enough are fearful. As soon as that situation reverses, great opportunity for long term gains returns.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.