Weekly Market Commentary – September 9th, 2008
Confirmation bias is a tendency to interpret new information in such a way that it confirms our beliefs and to avoid or ignore information that contradicts our beliefs. A clear example of this tendency is how nearly every investor reacts to their portfolio value. Most people when asked will say that market timing is impossible and that they have adopted a long term view. However, these same people will look at their account value each day and attempt to discern some insight from the change in value. If the portfolio increases in value, investors consider themselves smart and savvy. Sustained declines in value are treated with an explanation that daily fluctuations don’t matter to a long term investor. Subconsciously, these investors are practicing confirmation bias when positive moves are attributed to smarts and negative moves reinforce an extended timeframe.
As an investor who stares at computer screens all day, I understand the need to take a long-term perspective. Many price swings represent investor emotions, incorrect news flow and other forms of noise. While the daily moves in the markets provide opportunities, the daily movements often obscure what is truly occurring. Considering that the important movements in our economy and markets often occur over decades, not days, those who fight for each daily trade often run the risk of missing long-term trends that offer the chance to compound gains that will often exceed what can be earned from a daily trading strategy.
Consider the bull market from 1982 – 2000 as an example. When Ronald Reagan first took office in 1981, the United States had suffered many years of high inflation, high taxes and high nominal interest rates. Reagan began a process of deregulating the economy and reducing taxes. Paul Volker, the head of the Federal Reserve (Fed), crushed inflation. The end result was an 18 year period of economic growth accompanied by falling inflation, falling interest rates and expanding P/E multiples. The Dow Jones Industrial Average (DJIA) trades at 777 in August 1982. By the end of the bull market, increasing profits, low interest rates and a deregulated economy allowed the DJIA to peak at 11,722 – a gain of 1,400% in an 18 year span.
During the great bull market, there were plenty of tough spots. Market timing may have captured most of the gains, but opportunity existed to get scared from the market and miss the next leg higher. Instead of focusing on the daily moves, one would have been better served to assess the protracted trend of less regulation and free market principles and thus positioned accordingly. Doing so would have allowed you to compound great wealth with lower transaction costs and tax costs than an active trader.
When the great bull market ended, we began to see many unseemly events that occurred in happier days. Accounting fraud at Enron and WorldCom raised the question of whether free market principles had gone too far. Wall Street scandals surrounding biased research and late trading in mutual funds called into question whether self-regulation was truly efficient.
Most people will acknowledge that the enormous stock market gains from 1982-2000 would lead to a period of subpar results. Since bust often follows the boom, the bear market exposed investors to sharp losses. Looking back, we now see that overvalued stocks needed to return to a more reasonable valuation level. That could be accomplished in one of two ways. Either profits needed to grow sharply or share prices must drop. As we know, share prices dropped sharply. As the market was heading lower, investors began looking for scapegoats. Unable to admit that shares were purchased at absurd valuations; investors looked at the examples of corporate fraud and blamed these events for their mounting losses. With public outrage increasing, many turned to our politicians in Washington, DC to address the situation. This ended our 18 year process of deregulation and began a process of government intrusion.
As government decided they could better legislate the free markets, we saw reams of legislation to encourage ethical behavior. What started with Sarbanes-Oxley morphed into increased regulation of the financial markets. When you consider that the average Wall Street research report has more pages devoted to legal disclaimers than analytic content, is it surprising that research coverage has been reduced and many companies now look to foreign markets to list their shares?
While creeping regulation led to lower competitive advantage in some markets, regulation was absent in other places. The mortgage market had no true oversight. Banks making home loans had different regulators depending upon how they were registered. Non bank mortgage companies were often regulated by state laws and armies of wholesale brokers often escaped all regulation. As the housing market imploded and lending abuses uncovered, we now see the same scramble to increase regulation.
All of these changes have occurred in a relatively short time period. Over the past 6 years we have seen the desire to regulate away bad behavior and imprudent practices. While the intent of this action is worthy, we must ask what the true benefits will be. Does anyone really believe that the frauds at Enron would have been avoided if the CEO and CFO had to verify the financial statements? People who are determined to act unethically will do so. Excessive regulation increases the cost of doing business and lowers future returns on capital. It does not prevent dishonest people from acting unethically.
Unfortunately, the trend toward increased regulation has taken a quick turn in the wrong direction. With the decision by the US Treasury to seize Fannie Mae and Freddie Mac this weekend, I believe we are starting down a slippery path toward economic socialism. Over the past 6 months, the government has stepped into the market to support a failing investment bank, organize a short squeeze on financial company share prices and nationalize two key components of the housing market. With the auto industry in trouble and Michigan a swing state in this election, is there any doubt that a large loan is coming to General Motors and Ford? One can easily envision other industries with large workforces in battleground states receiving similar government assistance. Where do we stop?
When I step away from my computer screens and think long-term, I do not like what I see. Market dynamics play out over long periods of time. I can easily imagine the current environment lasting 10 years longer. At every turn we will see increased government intervention, increased bureaucracy and less innovation. The United States will begin losing its competitive advantage, experience lower returns on capital and lower asset valuation. Within an environment that shows no sign of economic growth, investor expectations must b reviewed. I continue to believe a well executed investment strategy can provide strong returns while a reliance on index funds will disappoint. Investors should search for new ideas, deploy capital to those ideas that offer above average return and always look to hedge. A combination of strong fundamental valuation, creative use of options and opportunistic short sales will be needed to prosper in the years ahead.
Fantastic read Sean!
Great read Sean, another enjoyable post as usual