The correction we had been waiting for finally arrived, taking the S&P 500 down roughly 20%, enough to be qualified (theoretically) as a bear market.
Who would have thought a tiny, economically insignificant country like Greece could generate such a headache for Europe and through contagion, the USA? The reality is that Europe, as a whole, has been as guilty as any other developed country in terms of social spending and entitlements. The difference between Greece and Germany or France is that the latter two have a better tax collection system.
The consensus thinking right now is that we are in a prolonged economic stagnation because governments will have to increase taxes in order to pay all these entitlements. We happen to think that this is not the path the government will follow. We are inclined to believe that part of the entitlement payments will be renegotiated to help cut government deficits. In return, the tax system will have to change in order to be more broad-based and less geared towards special interests groups. Higher tax rates do not always bring higher revenues for governments but higher economic growth surely does.
There are essentially 3 ways for governments to diminish their debts:
- Cut expenses, i.e. reduce the size of government, cut services, extend the retirement age and the right to collect pensions, stop indexing pensions etc.
- Increase revenues, i.e. increase tax rates, make the tax system more broad-based by removing some exemptions and loopholes etc.
- Print money, i.e. repay debt with freshly minted paper.
Realistically, the solution will be a combination of these 3 choices. The preferred choice of the “left” would be to increase tax rates, or in other words, make the “haves” pay while the “right” would prefer to cut expenses and lower tax rates to encourage investment and let the private sector create jobs, thereby growing the economy. We are hopeful that there will be a compromise some time after the US election. In the meantime, the Fed will stay accommodative with the monetary policy.
We are continually puzzled by the fact that US politicians seem to be ignorant about economic policies. Economics 101 teaches us that while monetary policies can be used to stabilize a currency and provide liquidity for the banking system, it is fiscal policies that can encourage the private sector to generate growth. Today, the same politicians wonder why Corporate America is sitting on so much cash and refuses to invest in long term projects and thus hire more workers. They are either totally self serving (blaming all the economic ills on corporations) or have no clue how businesses operate: if business owners do not know how future social costs and regulations will impact their company, why would they invest for the long term? Moreover, if all these tax cuts are only temporary (subject to congress renewing them when and if they feel like it), would it not be a smart idea to treat them as one-time events, hoard the cash savings and not commit them to anything for the longer term?
We know most clients would like us to give them a quarterly market outlook. If we had to give one, we would say the following: the world is a mess. Yet we continue to hold stocks and even look to buy more of them. Here lies the distinction between an investment philosophy and a market outlook. Whereas a market outlook is basically a wild guess of what speculators en masse will do over the next several months, an investment philosophy is like a tool kit that we can use to assess the potential return of each investment at any given time.
Owning shares is akin to owning a piece, albeit small, of a particular business. In assessing the value of the shares, it always helps to think about whether we would want to own the whole business if we could afford it. In a nutshell, our investment strategy is based on assessing the economics of a business, its competitive advantage and its intrinsic value. The market is then merely a place where we can observe the buying and selling prices of the business in question at any given time. It will allow us to judge whether the potential return (the difference between the intrinsic value derived from our analysis and the market price) is worth our while. At current prices, we believe that many stocks offer quite attractive returns over the long term, especially relative to fixed-income instruments such as bonds (and this is not to say that they could not move lower in the short run).
In our experience, it is always tempting to guess the market lows so one can profit from market timing strategies. The famous economist John Maynard Keynes compared the stock market to a beauty contest, where 100 photographs were displayed, and the contestants were asked to choose the six prettiest. The winner would be the entrant whose list of six came closest to the most popular of the combined list of contestants.
Obviously, the best strategy, Keynes noted, is not to pick the faces that are your personal favorites. It is to select those that you think others will think prettiest. Better yet, he said, move to the “3rd degree”, i.e. pick the faces you think others think still others think are prettiest. In speculative markets, you win by picking not the soundest investment, but the one you think others will bid higher. Or better yet, you try to pick the one that others think still others will bid higher…..
As you can guess, we don’t see how we can excel in this game. In fact, we don’t see how anyone can. Unfortunately, today’s 24-hour news cycle does not help. Behavioral finance also teaches us that people love predictions and forecasts, especially by some market “gurus” or “experts”. Sometimes (not to say most of the time), they internalize these readings and spit them out as their own predictions. For those who falls prey to this behavioral deficiency, we suggest you use the Ulysses method in the Odyssey (you being Ulysses, your manager being your crew and the market being the sirens):
The Sirenuse Islands off the southwest coast of Italy were famous for being home to the Sirens, whose songs were so irresistibly seductive that seamen felt impelled to fling themselves into the water in an attempt to reach them. No seaman ever survived, so no living human knew the nature of the Sirens’ song.
Ulysses wanted to be the first human to hear the songs and survive. He instructed his crew to fill their ears with beeswax to block out the sound, then tie him securely to the mast and ignore his pleas to be released, should he do so. The plan worked.
The Claret Team