Exceeding Expectations..

In past commentary, I’ve shared the proverbial description of the manic-depressive “Mr. Market”.  There are times when Mr. Market is depressed and he fears that things are not only bad, but they probably will get even worse. These are times when market prices are well below “fair value”.  Then there are times when Mr. Market is euphoric and is convinced that things are not only good, but likely to improve a lot.  These are times when market prices are well above “fair value”.

I warned back in May that it looked like Mr. Market was hopelessly euphoric and over optimistic in 2013. After a brief period in the summer and before the government shutdown, Mr. Market became a little less optimistic, but by the end of the year he again was back in that “Happy Days are Here Again” mood.

Let’s say from a “average” market index point of view, the market certainly exceeded expectations in 2013. This is not a bad thing.  But it is a bad thing if you catch Mr. Market’s disease.

Do not judge the value of your investments by one or two stock only market indexes like the S&P500 or the Dow Jones Industrial Average. The true value of your investments is based on the future income from interest or dividends and long term capital appreciation that your investments produce because of that future income. And, for stocks, that future income is all about how much profit the company can achieve. And here’s where it gets confusing…the value from long term capital appreciation has little to do with the stock market index daily quotations or fortune telling future predictions from market pundits on TV. In fact, one could argue that the long term future appreciation of your investments is actually negatively affected by markets that exceed expectations because of Mr. Market’s manic euphoria.  Risk is actually higher as prices rise.

You can always tell when Mr. Market is crazy on the optimistic side.  In the daily flood of news, there is always good news and bad news.  You can tell when Mr. Market is crazy on the optimistic side because the headlines tend to ignore the bad news and overemphasize the good news.

For example.  Recent news tells us that the economy grew faster than expected in the third quarter of 2013.  What few focused on was that most of the unexpected growth came because of increasing inventories and decreasing imports.  You see, business activity can increase if companies produce more than they sell---but only for a short period of time. Then they have to cut back. And, the way that GDP is calculated causes GDP to rise if imports go down relative to exports. But if exports stay the same and imports decline, it means that demand is actually declining. The media and pundits took the report to mean that the “economy is recovering”.  My take on the GDP report indicates caution in regards to future business activity and profits.

Another example.  Even though home sales are down, new building permits are up. The media and pundits took the report to mean the housing market is recovering. My take is declining sales is always an indication that caution is advised.

Another caution.  A great deal of the market’s rise for “hot” stocks is fueled with borrowed money. As I wrote in past commentary, Margin Loan activity is near record highs. That is always an indication that caution is advised.

Another caution. Markets are a pure auction. Around 50% of the participants think the market price will rise, so they are buyers.  Around 50% of the participants think the market price will fall, so they are sellers.  All it takes is for a very small percentage change toward buyers and prices rise.  These short term movements have little to do with known changes in future income—they are mostly based on “hunches” and “sentiment”.  Sadly, this “sentiment” is almost always wrong—history teaches that going against it tends to be more profitable that joining in with the crowd.

Another caution. Normally there is a lot of “tax selling” at the end of the year. Investors tend to sell their losers and offset the losses by selling some of their winners.  There has been a lower level of that activity this year because there has been fewer than normal “losers”. There is a significant risk that sellers engaged in “profit taking” after the beginning of the year may cause a stock market drop.

There are those that will tell you that the market always predicts the future rationally. My take is that statement is wrong.  The stock market does focus on the future, but it is seldom rational.  Mr. Market has a bad case of Manic-Depressive Syndrome. Mr. Market tends to see the future as he would like it to be. And, a rising market simply makes him think he is “smart” until he wakes up some day and becomes afraid that he has been wrong.

I am not being a pessimist. My opinion is that the economy seems to be recovering, albeit slowly and I’m quite optimistic about stocks—in the long run.  For those who already own a diversified portfolio, it is probably a good time to “hold”.  But most of the popular indexes are significantly overvalued—highly skewed by a few stocks that are ridiculously overvalued.  (Amazon for example has a Price/Earnings Ratio of 1360!)  And, for those with “new” money, I would recommend extreme caution. (If the market fell by 15%, I would probably be recommending a lot of buying.)

One way to explain my point is to think of investing as an ocean voyage.  At sea, one can always expect bad weather and big waves. A good ship is designed to take it.  So, think of a diversified portfolio of good quality investments as a super tanker in deep water, far from shore—properly captained, even bad storms are not too much of a risk.  But think of a portfolio with a lot of “new” money—coming out of a CD for example---as that same ship in harbor. Going to sea, leaving the relatively shallow harbor and attempting to navigate narrow channels can be risky. A wise captain will be cautious and will be reluctant to go to sea if the weather looks dangerous.

One can never be 100% sure about the weather or short term movements in the market.  Enjoy the relatively pleasant “voyage” in 2013.  But, be aware that we are overdue for bad weather.

Examples 2013 Capital Gain (UP) or Loss (DOWN) YTD:

10 year US Treasuries                DOWN 7.7%

Boeing                                      UP        80%

IBM                                          DOWN  2.7%

ATT                                          UP        4.4%

Caterpillar                                 UP        1.4%

McDonalds                               UP        10%

It has been many years since we last saw a substantial decline in the value of 10 year US Treasuries. These are supposed to be one of the lowest risk investments there is. One should always be careful when stocks are rising at the same time that US Treasuries are falling.  The drop in value of US Treasuries has also ‘exceeded expectations.