Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
In a sign of the times, 2011 saw Brazil overtake Old Europe’s United Kingdom as the world’s sixth largest economy. Rapid growth and increasing wealth in China and some of its Far Eastern neighbors is trickling down to countries such as the South American dynamo, which benefit from exports to the Eastern regions. In all likelihood Brazil represents just the beginning of a shift in relative economic power; the prognosis for the other big European Union industrial nations is not promising. France and even export powerhouse Germany stand to lose their international rankings to upcomers China, India, and Russia, whose export-led economies seem positively dynamic in comparison with those in the West. As (ironically) one Chinese official so impolitely phrased it, the European Union is a “worn out welfare society.” Europe is not alone in having to face new economic realities. Much as North America loomed over Europe a century ago, the growing powers of South America and the East will eventually challenge even the U.S. Japan also will not escape the fate of relative decline. The whole world is changing, and peoples and politicians who for so long have been accustomed to being the top economic dogs will have to undergo a psychological adjustment.
Be that as it may, Old World economies are and will remain massive, and their vigor — or lack thereof — continues to impact world growth, including that enjoyed by their new rivals. Ineffectual attempts to deal with a debt crisis in the Euro Zone have created endless frustration among financial operators and politicians worldwide who fear that a “contagion” effect could negatively impact financial markets and thwart economic recovery in their countries. For the last several months markets have reacted violently to disappointing European Central Bank pronouncements and news from meetings in Brussels, Paris, and Berlin. There is no mistaking the linkages; an economic breakdown in Europe, or dissolution of the Euro Zone, would hurt everyone, whether through problems such events could trigger at major international banks, or a general slowdown in economic activity. In a world economy plagued by excess capacity and unemployment, more economic shocks would be decidedly unwelcome.
Here in the U.S. an agonizingly slow recovery seems to be underway. The unemployment situation shows some modest signs of stabilization if very little real improvement, and data from the housing sector has been a bit less bad than it was. A weak economy remains vulnerable to any number of potential external threats that could involve Korea, the Middle East, Europe, and Russia, to name a few. But external triggers are unnecessary when internal political paralysis and discord — and the resulting inability to deal with long-term problems in a long-term fashion — is creating a great deal of uncertainty among economic actors, as the debt ceiling fiasco last summer demonstrated. Fortunately, our central bank has been able to deal more forcibly with the challenges, and its low interest-rate policies and liquidity measures have undoubtedly kept the system afloat these past few years. Although it is small comfort to those who have been unemployed for a year or more during this unusually deep recession, the central bank has made economic activity less weak than it would have been otherwise.
As we have been saying since the financial crisis began a few years ago, the fundamental problem is one of too much debt — often taken on to finance purchases, such as houses, at prices that were too high — which will take time to solve. Three years further along in that process and people despair of ever seeing an end to the financial pressures, but as with all things in the future, improvement could come suddenly and unexpectedly. Signs of an easing of conditions could appear where they are least expected, in the stock market. Stocks do the darndest things.
It is generally believed that Fed policies such as “quantitative easing” served to support our financial markets last year. Although the equity averages were only flat to modestly positive, they compared favorably to losses in some foreign markets that were as much as 15-20%. The seeming calm indicated by a level market from the year’s beginning to its end belied a great deal of variability in stock prices in the in-between. Sharp day-to-day fluctuations shocked and frightened the investing public, causing money to flee stock mutual funds all year long. (Much of that money went to bond funds — in all likelihood setting up the next big disappointment for investors.) It was a bad year for the vaunted hedge funds as “correlation” (the tendency for prices of various assets to move together) rose, reducing trading opportunities for the wizzes of Wall Street, but statistical anomalies were not responsible for some notable blow-ups among prominent hedge fund managers; funds that had made a killing from wagers related to the housing debacle lost their “Midas touch” and suffered from the failure of subsequent bets on gold and financial companies. A popular image of the wealthy individuals who invest with hedge funds is of people bragging about “their” fund managers at cocktail parties; a 50% loss would certainly make for interesting party chatter.
Tune in to any business news program nowadays and inevitability the subject of “market volatility” is discussed, usually in serious, foreboding tones suggesting that great mysterious forces are afoot, ready to crush the unwary investor. In fact, stock prices always fluctuate a lot; annual returns bounce around a long-term average by about twenty percentage points, so on that basis, 2011 was pretty tame.
The real focus of the media’s attention was on the extreme daily variability in the markets. Much of the hype was probably due to the media’s inherent need to excite viewers, however, Barron’s reported that through December 16 there were 67 “all or nothing” trading days in 2011 (days when most stocks either rose or fell) — the same as the total count of such days from 1990 through 2004. Clearly something unusual has been happening. Additionally, given the fact that many of those days saw the popular averages move by 3-4% or more, it is understandable why so much attention was paid to day-to-day variations, and why many find them unsettling. The exact causes of this market behavior are uncertain, but we suspect the fact that the majority of stock trading volume is now controlled by computers overseen by humans whose investment horizons do not extend beyond their noses is probably a major factor. But beyond the fact that sharp moves in asset prices are disconcerting, their lasting impact on the financial system remains uncertain, and what, if anything, can or should be done about them, is still a question.
Some believe that extreme volatility — “flash crashes” and huge up-and-down moves in prices — are harmful to the capital markets because they cause participants to question the fairness of financial transactions, making it more difficult and costly for issuers to raise funds. On the other hand, there are corporations that are well-known for their ability to raise funds cheaply when demand for securities is high — for their ability to take advantage of volatility to the upside, in other words. Another group that can be hurt by a volatile and, especially, directionless market are short-term traders who have to be nimble indeed to avoid getting whipsawed. Traders and other speculators should understand the risks they run and be prepared to pay the price. For institutional “money managers” who fret over short-term “performance,” volatility is the bain of their existence, but trying to change attitudes and practices in this business is a tilting-at-windmills endeavor not worth taking on.
Periods of volatility or trendless markets inevitably spawn a new group of snake-oil salesmen peddling “solutions” to a credulous investing public who fear falling short of their financial goals. These schemes typically take the form of some variety of “tactical asset allocation,” which promises to move money among asset classes (stocks, bonds, commodities, etc.) to take advantage of those expected to gain and avoid those the promoters think will decline. Such strategies attract the most attention after big market upheavals — times when people are susceptible to believing that they, too, could have gained from owning some favored asset, or at least avoided losses. In reality asset allocation is nothing more than another name for market timing, which has a dubious history and little promise of lasting success. Other methods of avoiding volatility, often using insurance products, entail costs that offset any benefit over the long run; the cost of compelling publicly traded investment vehicles to act in a manner inconsistent with the nature of public markets tends to be high.
For the genuine investor, volatility is nothing more than an entertaining market spectacle that is occasionally useful for creating good investment opportunities, just as it useful for those corporations which know how to raise capital cheaply. The only difference is that investors take advantage of volatility to the downside, when sellers abound and prices are low. Volatility is not something that can be avoided. Our usual advice in such matters is to think like an investor: take a long-term view, position yourself so you can be indifferent to market fluctuations, do sensible things, hold cash if necessary while you wait for good ideas. Don’t expect to enjoy outstanding “relative performance” all of the time. Invest at opportunity regardless of how fearsome the financial environment may seem. By the time markets calm down and the way forward becomes clearer, attractive situations offering the best returns will be far fewer in number and heavily sought-after.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 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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Revised: January 9, 2012 TAF
© Copyright 2012 Dennis C. Butler, All Rights Reserved