First Quarter Letter
“We all know it’s going to end badly, but in the meantime we can make some money…”
–Jim Cramer, CNBC
Hard to believe, but Jim Cramer –bubble cheerleader extraordinaire – has probably best summarized popular sentiment about the current market environment. Of course, we also think that most of his advice is dangerous to one’s financial health. Nonetheless, the stock market is priced as if the United States economic recovery is in total expansion mode. What we see is the fourth year of a subpar recovery with more reasons to be worried than excited.
Market Advancement Versus Fundamentals
When the Dow Jones Industrial Average (DJIA) hit its old record high back in October 2007, the unemployment rate was 4.7%. In January of this year, the unemployment rate was 7.9%. While total wages and salaries nationwide are up 6.7% since October 2007, the consumer price index has risen more than 10% during the same time frame, essentially negating any wage gain by the average worker. Gross domestic product grew 3% in the third quarter of 2007. Revised figures from the government claim that GDP in the fourth quarter of 2012 increased by a mere 0.1%.
To download a PDF of this report, click here.
In other words, the stock market has achieved a new record high despite the economy’s performance, not because of it. We have no idea what the market knows — but we clearly do not see what the market sees. Granted, the stock market has reached a record high, when measured in dollars, but the index is not even close to a record high when measured in gold. The fact that the gold-priced stock market remains anemic suggests that Chairman Bernanke has played a critical role in the market’s record-setting climb. In other words, by devaluing the dollar, Bernanke has “inflated” the stock market price.
S&P 500 Priced in gold
As equity markets are approaching a level not seen since 2007, the individual investor is starting to become interested in stocks once again. Rachel Fox is a 16-year old stock picking celebrity with her very own website: “Fox on Stocks” (http://foxonstocks.com/). Fox is perhaps best known for playing Kayla Huntington on the television series Desperate Housewives a few years ago. Today, Fox is a day-trader who uses technical analysis to create her trades. In a recent interview on CNBC’s “Squawk on the Street”, Fox said that what makes her a good trader is that her Zodiac sign is Leo. “So, I’m as fearless as I come. When I get an idea in my head that something is going to happen, I just go do it — nobody can tell me otherwise. That’s a really good thing to have.”
Fox continued, “I should be a better reader of books, but I am just not. I read a lot of scripts, blog posts, and stuff on Yahoo Finance. But I definitely think there are lots of books I’d like to read, especially to get a psychological perspective on trading. But at the same time I try not to intake too much information. If you intake too much of the wrong information it could clog your head with the wrong stuff. It’s better to keep a clear vision and go with your gut.”
This mentality is not just limited to individual investors. Todd Harrison, a former hedge fund manager and current CEO of Minyanville.com, recently commented that “It sure can continue…the question is ‘how long is it going to continue?’” Harrison also noted that the NASDAQ 100 broke out of a “cup and handle” formation yesterday. “That’s bullish,” Harrison says. Looking forward, “I think it’s not going to end well,” he says. “But I’m not going to be against the rally on a daily, intraday basis. I’m going to trade risk both ways and let the market dictate” his actions.
To summarize Fox and Harrison: “Cup and handle” formations are bullish. Investment horizons beyond several hours can be excessive. “Keep a clear vision and go with your gut.” Be fearless. To use Cramer’s words, this is going to end badly but in the meantime, Rachel Fox and Todd Harrison are going to “make some money”.
In the book What I Learned Losing a Million Dollars, authors Jim Paul and Brendan Moynihan point out the emotional traps that lead to stock market losses. While individuals rarely feel invincible by themselves, people feel powerful when they become part of a crowd. In the market, this means a crowd of opinion, while participation is typically enjoyed by sitting in front of a computer screen. Paul and Moynihan write that “an individual is in the hands of the price changes on the screen, the words and suggestions of whoever got him into the market in the first place or anyone else from whom he seeks opinions.” Becoming part of the crowd is dangerous when prices go against the investor. “One of the most incomprehensible features of a crowd is the tenacity with which the members adhere to erroneous assumptions despite mounting evidence to challenge them,” write Moynihan and Paul.
This phenomenon is played out as investors express opinions about the market. Repeating those opinions further cements the idea in the investors’ psychological profile. If the market goes your way, you are smart. “Emotionalism overwhelms you. You’re hypnotized,” write Paul and Moynihan. For losing trades, your ego keeps you in it. You’re courageous for sticking it out. “The market is wrong and will turn around. You take pride in your courage to go against the crowd because according to market lore, the crowd is supposed to be wrong.” The emotional disconnect is that the market participant is speculating on price rather than investing on fundamentals. As a result, one is neither smart nor courageous, just speculating. And, as the current market drifts higher, investors feel smarter and grow more confident.
In reality, equity bull markets are driven by the combination of two simple factors: rising earnings and a rising average P/E ratio. To put it another way, equity bull markets occur because earnings increase and investors collectively decide to assign a higher value to those earnings. The extent by which a bull market is driven by earnings reflects the magnitude of improving fundamentals. In contrast, a bull market driven by the multiple of earnings indicates the level of increasingly optimistic sentiment.
The current U.S. equity bull market that began in 2009 is one of the more sentimental driven bull markets. Based on the change in the Shiller P/E ratio, only 11.8% of the price increase from the March 2009 market bottom has been due to improving fundamentals. The remaining 88.2% can be attributed to investors’ willingness to pay a higher price multiple on company earnings.
The significance of this information is that bull markets with a relatively high sentiment component tend to be followed by relatively severe bear markets. In the meantime, prolonged bullish market sentiment eventually causes bears to capitulate and turn bullish. For example, Adam Parker, Morgan Stanley’s chief equity strategist, recently flipped bullish after fighting the rally the whole way off the March 2009 bottom. We sympathize with his predicament as the most difficult part of forecasting is predicting crowd psychology. The sentiment of crowds is what determines the earnings multiple investors willingly assign a dollar of earnings. Our contention remains that this market is being driven by sentiment created by our central bankers at the Federal Reserve rather than by fundamentals.
Fundamentally driven bull markets typically rely more on cyclically adjusted earnings growth and less on the willingness of market participants to pay ever increasing multiples on those earnings. We recently came across an interesting table posted on a blog (www.wallstreetrant.com) that focused on bull markets of 100% or more. The author employed a starting and ending Shiller P/E ratio pulled from Professor Robert Shiller’s online dataset to determine performance attribution from sentiment.
When one compares the 1974-1980 bull market to the current bull market, the investor clearly sees the contrast between fundamentals and sentiment. Although the magnitude of the advance is similar between the two bull markets, the 1974-1980 advance only experienced a P/E multiple expansion of 2.2 (from 7.8 to 10.0) versus the current 11.1 (from 11.9 to 23.0). Further, bull markets that relied least on P/E multiple expansions on average experienced smaller subsequent bear market drawdowns. For example, the top five fundamentally-driven bull markets averaged a bear market drawdown of 30.4%, whereas the four least fundamentally-driven bull markets averaged a 48.5% drawdown. While history may not exactly repeat itself, investors should not be surprised if the next bear market drawdown proves deeper than average — sentiment rather than fundamentals are driving the current bull market.
To better understand how sentiment guides a market higher, economist Marc Faber recently employed a quote from philosopher Bertrand Russell to explain how Wall Street willingly accepts the premise behind the Federal Reserve’s money printing efforts:
“Bertrand Russell said: ‘If a man is offered a fact which goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence.’
“It should be clear that people in the financial sector will accept bailouts and money printing ‘even on the slightest evidence’ that these policies work, because they ‘afford a reason for acting’ in accordance with ‘their instincts,’ which will always support any economic policies that boost asset values, performance fees and their personal wealth. How these monetary policies will eventually play out remains to be seen. The optimists will contend that the world is healing…”
This distorted view is pervasive in the stock market today. Faith in the central bankers at the Federal Reserve has rarely been higher — including faith that the Federal Reserve can implement a graceful exit from its current addiction to quantitative easing (QE). In recent testimony before Congress, Federal Reserve Chairman Ben Bernanke admitted that there is no historical precedent for exiting QE with the exception of Japan, the only nation to use large-scale QE before the United States.
The release of the transcripts from FOMC meetings in 2007 provides some embarrassing insight into the Federal Reserve and certainly calls into questions the market’s misplaced faith in our central bankers. Top policymakers at the Federal Reserve believed that during most of 2007 the problems in housing and banking were isolated and unlikely to damage the economy. Obviously we know today that housing and banking crushed the economy in 2008.
Of note, Timothy Geithner said “We have no indication that the major, more diversified institutions are facing any funding pressure. In fact, some of them report what we classically see in a context like this, which is that money is flowing to them.” Federal Reserve Chairman Ben Bernanke clearly underestimated the risks as well. “I do not expect insolvency or near insolvency among major financial institutions,” he said in December 2007. “I think the odds are that the market will stabilize. Most credits are pretty strong except for parts of the mortgage market.” One wonders how committee members of the Federal Reserve could be so myopic. In terms of behavioral economics, our country’s monetary policymakers were victim to “representative heuristic”— the tendency to assume that the future will look like the past.
One of the most famous studies in the field of attention research is the Invisible Gorilla (www.theinvisiblegorilla.com) experiment conducted by Christopher Chabris and Daniel Simons. In the study, research subjects are shown a video of two teams of kids — one team wears white; the other wears black — passing two basketballs back and forth between players as they dodge and weave around each other. Before it begins, viewers are told their responsibility is to do one thing and one thing only: count how many times the players wearing white shirts pass the ball to each other. The assigned task is not easy, because the players are constantly moving around and viewers really have to concentrate to count the throws.
Approximately a half-minute into the video, a large man in a gorilla suit walks on screen, directly to the middle of the circle of kids. He stops momentarily in the center of the circle, looks straight ahead, beats his chest, and then casually strolls off the screen. The kids keep playing, and then the video ends and a series of questions appear, including: “Did you see the gorilla?” Sounds ridiculous, right? There is a gorilla on the screen — of course you are going to see it — but in fact 50% of people miss the gorilla. This is because when you ask someone to perform a challenging task, without realizing it, their attention narrows and blocks out other things — like a huge, hairy gorilla that appears directly in front of them. The effect is called “inattentional blindness”, as our brains focus so strongly on the task at hand we filter the world around us. In other words, our brains shape what we want to see.
Investors today want to see a market that consistently climbs higher. As participants are so focused on market price action, perhaps they have chosen to filter out a strong reason for the market’s 131% advance off the March 2009 lows – an extremely active Federal Reserve that operates with the explicitly stated goal of pushing stock prices higher. For years, the Federal Reserve has herded investors away from cash and bonds and into stocks. The Federal Reserve has plainly stated that it wants to keep investors confident on stocks, hoping higher stock prices will create a wealth effect.
The market’s positive price action is reinforcing the optimist’s viewpoint that markets are healing. Maybe they are ignoring the gorilla in the middle of the stock market – the actions of the Federal Reserve. The last twenty years have shown that the Federal Reserve has a knack for creating investment bubbles, yet this same institution remains questionable at controlling conditions when bubbles pop. At the end of this current mission to create a wealth effect, the Federal Reserve may see stocks at higher levels, but we believe that our underlying economy will remain weak.
As value investors, we rely on fundamental analysis of a company’s balance sheet, income and cash flow statements. Naturally, we view ourselves as long-term investors because the logical time horizon needed for a company to improve its financial performance spans several quarters, if not years, in order to cope with changing economic cycles and management’s implementation of strategic plans. And therein lies the natural paradox when investing in publicly-traded equities – over short periods of time company fundamentals do not change materially; however, stock prices can move violently up or down.
Although Warren Buffett’s quote that “the best time to sell a stock is never” holds tremendous appeal to us as value investors, we find it difficult to implement. Our investment discipline dictates that we sell a stock once its price exceeds our fair value estimate of the company’s worth. Obviously this investment process is complicated over short periods of time by a stock market that operates under the influence of crowd psychology rather than company fundamentals. Because crowd psychology vacillates between the emotions of greed and fear, stocks do not simply rise from undervalued to fair value. Greed takes hold and can moves prices far beyond any fundamental justification of fair value. By selling too soon, the value investor misses those speculative gains where price action now drives the decision making process.
Investors who adhere to a value investment philosophy will often buy stocks on the way down, as stocks tend to suffer additional declines before recovering (fear). If we continue to be comfortable with the business fundamentals, we view additional price declines as an opportunity to add to our initial positions at lower prices. Eighteen short months ago, there were a number of attractively-valued companies operating in the consumer staples and healthcare sectors. Many of those same stocks today are trading at or above our estimates of fair value. We still like many of these companies and remain attracted to their business models. However, we invest with our eyes wide open and realize today that greed has taken hold of many market participants. We believe that today’s higher valuations have removed any margin of safety when investing in these very same companies that we found so attractive a short time ago.
American financier Bernard Baruch (1870-1965) is quoted as saying, “Don’t try to buy at the bottom and sell at the top. It can’t be done except by liars.” The discipline of St. James will by default always lead us to sell too early. Then again, Baruch also said, “I made my money by selling too soon.”
Robert J. Mark
The opinions expressed are those of the Fund’s portfolio manager and are not a recommendation for the purchase or sale of any security.
The Castle Focus Fund’s prospectus contains important information about the Fund’s investment objectives, potential risks, management fees, charges and expenses, and other information and should be read and considered carefully before investing. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. You may obtain a current copy of the Fund’s prospectus by calling 1-877-743-7820. Distributed by Rafferty Capital Markets, LLC-Garden City, NY 11530, Member FINRA.
The risks associated with the Fund, detailed in the Prospectus, include the risks of investing in small and medium sized companies and foreign securities which may result in additional risks such as the possibility of greater price volatility and reduced liquidity, fluctuations in currency exchange rates, and political, diplomatic and economic conditions as well as regulatory requirements in foreign countries. There also may be risks associated with the Fund’s investments in exchange traded funds, real estate investment trusts (“REITs”), significant investment in a specific sector, and non-diversification.