Theme Music

By Bob Wood

If you are in that long line of investors confused about what to do next, after apparently facing a resumption of the secular bear market that began in early 2000, I offer you a little island of mental certainty to visit from time to time — whenever needed. Let me offer a bit of theme music, something to play in your heads — while those around you are losing theirs.

To begin, let’s start with the basics, the same that I’ve written about before. Revisit basic investment ideas like paying attention to valuations, secular trends and risk management, which play central roles. They provide the fundamental principles of investing that have never changed — and never will.

Following analysts’ recommendations about what you should buy and what should outperform the market — or whatever other jargon they use — is obviously not an option for the rational investor. To a large degree, you are responsible for what happens to the value of your holdings. Relying on conflicted advice — and we know that is what modern brokers offer — is an obvious trap.

That opinion was seconded this past week by Graham Copley, global head of equity research at HSBC, an international banking and financial services organization. In a widely circulated e-mail, he scolded his own internal team of analysts, saying that their work had ‘’become predominantly worthless flashnotes.’’ He added that, in his view, ‘’many of our analysts and team leaders do not deserve to be paid this year.’’

This harshly worded message was circulated outside of HSBC and featured in a short piece in a recent issue of Financial Times. A subsequent letter to the editor sarcastically remarked that Copley’s comment should not exactly be news to anyone who follows the equity markets. The letter writer suggested re-reading Chapter 12 of Keynes’ General Theory of Employment, Interest and Money as a refresher course for prudent investing.

As I read that comment, I leapt to my feet and raced to my office bookshelves with all the speed and agility that my aging knees would allow. (Yes, it does take me a little longer these days, but that’s what time does to our knees!) But as I re-read Chapter 12, I realized that some things, unlike my knees, never change, especially when they involve the markets.

Keynes’ 1953 classic on economic theory delved into what moved markets and why so many investors seemed frustrated with their results – not much different than common occurrences today. Many of the book’s passages serve the modern day investor well; in fact, maybe they should be taped to the foreheads of stock market participants who forget what the markets are for and how they really work.

Considering recent volatility in stock markets and bear market beatings taken by so many investors during the first phase of the current secular bear market, beginning with the 2000-2002 drop in stock prices, several of Keynes’ passages resonate even more than others. One of my favorites includes:

“A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield since there will be no strong conviction to hold it steady.”

In other words, a person buying a stock based on what someone else said or based on past performance will be among the first to change direction when that price moves against him. A couple weeks ago, I mentioned this type of occurrence in a column referring to the Dalbar studies on investor returns vs. the overall markets.

Keynes also wrote that, in his time, the markets weren’t dominated by value conscious investors in the mode of Warren Buffett. Instead, “the actual, private object of the most skilled investment today is ‘to beat the gun,’ as Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating half-crown to the other fellow.”

Also noted for comparing the actions of investors to those of judges at a beauty contest, Keynes wrote: “It is not a case of choosing those which, to the best of one’s judgment are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

What he seems to say is that investors aren’t so concerned about investing as about playing a derivative game, which, in a way, is gambling, and Keynes even went so far as to call modern investing “a game to be played.”

While those times surely had some long-term, value-oriented investors who performed up to their expectations, Keynes noted, “investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave…”

I’m supposing that this is where trading systems and technical analysis entered the investment picture. Keynes went on to describe the kind of behavior that tends to deprive investors of acceptable risk-adjusted returns, which was confirmed more recently by the Dalbar work. It seems that investor behavior is more important than the general direction of the markets in which they invest.

“Finally, for the long term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness, and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

For those of you wondering why your portfolio is still full of domestic blue chips while the domestic markets have gone no higher than they were seven years ago, you are failing conventionally. And that is also the safest thing for most investment advisors to do. They seem to know instinctively that beating the market seldom happens yet need to promote the illusion of value in their services.

So there you sit with a portfolio full of the best known names while raging bull markets in gold, emerging markets, commodities and real estate have richly rewarded the investor who dared to think differently, who dared to look irrational to his peers. And the pain of being wrong for so long could have been avoided if you had applied a more modern investment theme in selecting your holdings.

My basic theme for investing involves finding secular bull markets — wherever they may be. Paying strict attention to market history and valuations should have sent investors away from an S&P 500 index selling at 20 times earnings and into the better-valued international markets. And erosion of the dollar’s value, which continues to gain speed, further enhances the performance potential of hard assets like gold and energy.

Investing really is just about that simple! And since none of the basic parameters have changed in the past few years, my theme music sounds much like it did four or five years ago. And since Keynes’ concept about the game playing mentality of market promoters still appears to be much the norm, separating yourself from the crowd still makes sense – and has made sense for a very long time. Perhaps you should adjust your own theme music accordingly.

Have a great week,

Bob

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