Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
Sometimes we feel like legal pad operators in an iPad world. We seldom use cell phones and feel no pressing need to be reachable anytime, anywhere. We find computers to be useful mostly for information, communication, and word processing, not algorithmic trading. Nor do we see any sense in being located next door to the stock exchange lest the limits imposed by the speed of light interfere with our investment strategies, as is the case with the cutting-edge “flash trading” outfits.
We are by no means Luddites, but we find that the older, slower, and less technologically sophisticated ways of conducting our business suit our purposes quite well. Furthermore, recent news from the field of cognitive science supports our own wholly intuitive views on the subject. The clickable world is changing the way the human brain operates, narrowing its focus to on-the-fly decision making, and “damaging the long-term memory consolidation that is the basis for true intelligence,” according to a recent piece in The Economist. Besides, we have long felt that sophistication in the use of instrumentalities garners unwarranted attention and impresses people far more than its contribution to investment outcomes justifies. More valuable is sophistication of purpose. Scientists have devices of incredible complexity at their disposal, but subtlety in the setting up of experiments and their interpretation is what counts. Computing power in the investment field probably rivals that of any other endeavor, but we would argue that it is in the ability to wait patiently, refrain from unnecessary action, and ignore short-term fluctuations where true sophistication lies.
As far as we can tell, the evolution of technological capability has done little to improve the ability to meet the fundamental goal of investment, which is to protect capital and make it grow at a reasonable rate. There is no doubt that trade and data processing power have been enhanced and that purveyors of investment products have profited handsomely from being able to create complex new financial devices that entrance those with money and enable the extraction of fat fees. Investors now have a greater variety of places to put their capital, but as the recent crisis has shown, some of those places are none too safe. In the end, despite the technological and financial wizardry, investment results are no better than they were decades ago when choices were simpler. The power to process data, transactions, and information flow that comes with modern technological sophistication in finance leaves unaffected the judgement entailed in using the information wisely and directing the transactions in an intelligent manner. Judgement will always be subject to the limitations of our noodles; technology simply provides more and greater ways to make the same old kinds of mistakes, and bigger and faster ones, too. Technology evolves; human beings remain the same.
The oil spill in the Gulf of Mexico exposed the dangers technology can pose when it interacts with the human traits of arrogance and gullibility. BP claimed it had employed oil exploration systems whose sophistication rivaled what was used to put a man on the moon. Such equipment has pushed the search for oil into more inhospitable regions, with apparent safety. Disaster struck when judgement in the use of the equipment failed. Now we realize just how risky a business deep-sea oil exploration really is. Similarly, in the financial world, limits were pushed with complex and untested products until pressure from poorly-understood risks exploded.
Sensitized by the economic crisis, the market’s concerns about risk rebounded during the second quarter after stock market gains of 70-80% from the depths in March 2009 led to complacency and undue optimism over near-term economic growth and investment rewards. Even retail investors got into the act, putting money into equity mutual funds for the first time in months. Unfortunately, they were rewarded with the worst May for the market indexes in fifty years. June saw further weakness. At quarter’s end the major averages were down 10% to 12% for the period, and 7% to 8% for the year to date.
“Gold gains nearly 1% on flight-to-safety buying,” read a recent headline. Gold is becoming even more precious as it is one of the few winners so far in 2010. When market chatter starts referring to the metal as a “safe haven,” however, it’s time to watch out. Gold prices have been on the rise for most of the last decade and now trade near their record high (at least on a “nominal basis” — not adjusted for inflation). Gold long ago lost its appeal as a form of insurance against calamity and entered the realm of speculation. Forecasts are now calling for even higher prices — as much as $5,000 per ounce. Anything is possible.
The other winning asset — treasury securities — continued its march into the rarefied regions of speculation as well. The two-year note’s yield fell to the lowest ever (around 0.6%), and the returns being offered on longer maturities declined towards levels last seen in 2008 at the height of the crisis. There are some logical reasons for this, including flight to safety over concerns about debt problems in Europe, and a lack of realistic alternatives. But buyers at current prices are expecting to sell at even higher prices, making the treasury market a potential source of big trouble. In the past when yields have been very low, change came dramatically and unexpectedly. Given the size of the current bubble and the breadth of the market for U.S. debt worldwide, the ramifications of an eventual bursting could be far-ranging.
The Old Normal
The view that we are in a “new normal” economic era has gained notable attention in financial commentary. Promoted by a prominent bond management firm, this thesis maintains that we have entered an extended period in which economic activity, and market returns for investors, will be below average as we work off excessive debt loads, deal with a more robust regulatory environment, and enjoy fewer benefits from international trade. The strength of the authors’ credentials probably accounts for the seriousness with which this view is being discussed, and the somber tone of the forecast also seems to fit the mood of the times.
We habitually take broad market pronouncements such as this one with a grain of salt, while freely admitting that it could very well come to pass; we may indeed be looking at only 3% annual returns on stock investments going forward. Nevertheless, we are skeptical.
First, it might be helpful to ask what is “normal” in the first place. Between 1966 and 1982 the stock indexes were flat, producing no returns beyond dividends. By the time the bull market began in 1982, investors were expecting nothing from stocks even though their long-term record was superior to other asset classes. The 17% plus annualized returns enjoyed in the 1980s and 1990s were far from the norm, but by the end of the latter decade a majority of investors had come to view them as such. Also abnormal was the 100% appreciation in property values in some areas during the real estate boom years; belief in the continuation of strong property markets lay at the heart of the real estate and credit crises. Likewise, the 37% plunge in stocks in 2008 was very unusual, as was the 70% plus rise from the lows of the following year, and in each instance the usual fear and greed responses followed. As good a definition as any for “normal” in terms of the stock market is the 9-10% annualized returns seen over the very long run.
In the above examples, we point out the changes in investor attitudes to illustrate the danger in extrapolating from trends and assuming they represent a permanent state of affairs. Perhaps the current “new normal” advocates are doing just that. Stock investors have already experienced a long period of disappointing returns — negative since 1999 (so even a 3% return would be a considerable improvement). In 1999 very few analysts were predicting low future returns, although high security prices at the time virtually guaranteed poor results, as the “lost decade” of the 2000s subsequently bore out. Security valuations are currently much lower that in those years, perhaps discounting a significant portion of the debt pain before us. Our economy has struggled through challenges greater that this before, and eventually investors have been rewarded. A return to average, non-bubble-like conditions could conceivably permit investors to enjoy “old normal” results.
Volatility, the bugbear of the financial chattering classes, is also expected to remain elevated during the “new normal” era — perhaps meaning more “flash crashes” to come. While attention-getting, price variability is, in fact, not new with stocks. Equity investments returning 9-10% on average over time will see those returns vary in a plus or minus 20% band around the average most of the time, with occasional spikes one way or the other. More importantly, in our view, volatility has no bearing on the attractiveness of equities as investments — quite the opposite, in fact; it enhances it. Nevertheless, volatility is a factor that needs to be addressed and protected against. If you enjoy the climate in southern Florida, you’d best live in a sturdy house, well fortified against the occasional hurricane.
In short, investors always face a “new normal” in that we can never be certain what the future holds, and it is that very future which will determine the ultimate results of our efforts. That fact does not stop us from taking advantage of opportunity whenever it arises. And that can happen even when people look wistfully back to the “old normal” as a thing of the past.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2010 Dennis C. Butler, All Rights Reserved
Revised: July 9, 2010 TAF
© Copyright 2010 Dennis C. Butler, All Rights Reserved