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The Quarterly Report

  • The Quarterly Report
  • Third Quarter 2006
  • Chuck Osborne

Fitting In

THE OTHER DAY I came home from playing golf, and my wife came home from the mall. She asked if I wanted to see what she got, and not being stupid, I said, “Of course Honey.” Then she showed me a pair of blue jeans, which she was very excited about because she had found a great deal. It was at this point that I made my crucial mistake: I asked what she paid for the jeans. Yes, I do know better than to do this, but she was so excited about her savings that I figured this couldn’t be so bad. She excitedly told me that she got these wonderfully cool jeans for the bargain price of $98.00.

After recovering consciousness, I responded with, “You paid what for a pair of blue jeans?” She calmly told me, “Only $98.00.” Then she started to educate me on designer jeans in the Year of Our Lord 2006. Evidently I’m lucky, because other people actually spend as much as $300.00 or more for a pair of jeans. They actually cost more if they come with holes already in them. I always thought you were supposed to earn the holes in your jeans by working or playing football, etc., but in our pampered society, why should you get all sweaty breaking in a pair of jeans when you can pay someone else to do it for you?

I do understand paying up for fine clothing. I understand paying a premium for craftsmanship or fine fabrics, but my wife just paid $98.00 for $10.00 worth of blue denim. The fact that people are actually willing to pay more did not help me. Then I realized something. My wife did not pay $98.00 for a pair of jeans. She paid $20.00 maximum for the jeans, and she paid $78.00 to fit in with her fashionable friends. Don’t misunderstand, I’m not being judgmental, I am merely stating a fact. My wife is human and she wants to fit in with her peers.

I do the same thing. Not with blue jeans, I am immune to that particular strain, but we all have something that we do that may not seem completely logical, but we do it in order to fit in with our peers. It may be the kind of golf clubs we play with, the rifle we hunt with, the car we drive, where we eat, the way we wear our hair. One could go on forever. The fact is that humans are social creatures and we all have the desire to fit in with our peer groups.

So what does all this have to do with investing? Everything. Don’t get me wrong, it is important to understand how to read financial statements and economic indicators. It is important to understand correlation, asset allocation and portfolio construction. In other words, it is important to understand the science of investing. However, it is equally important to understand the psychology of investors, or, shall we say, the art of investing. As one of my mentors used to say, “To understand the market you simply have to understand the human emotions of fear and greed.” Greed drives the market up as the masses see their friends making money and start buying in order to fit in, forcing the market even higher. Then some of the smart people will start to sell to take profits, making the market drop, and the crowd, afraid of losing their gains, or perhaps more importantly no longer fitting in, starts selling in mass, driving the market down. Fear and Greed are more powerful in investing than any economic indicator or fundamental valuation.

Last month I was having a discussion with some analysts from Legg Mason Value Trust. This is the fund managed by Bill Miller, who has beaten the S&P 500 Index 15 years in a row. They have been spending a lot of time trying to understand the human side of investing, or what many now call ‘behavioral finance.’ They have discovered that the average investor has a psychological need to own whatever has done best over the last five years. They don’t merely desire to own these assets, they need them. That is strong stuff.

There is an industry group called DALBAR that has published a study on the returns of mutual fund investors vs. the mutual fund in which they invest. They have been publishing this study for years with little change, the most recent results out last year with data through 2003. According to DALBAR, the average mutual fund investor received an average annual rate of return of 3.51% from 1984 through 2003. The market as measured by the S&P 500 Index for the same period had an average annual return of 12.98% and the average large cap mutual fund had an average annual return of 11.33%. How do investors get only 3.51% while the funds themselves returned 11.33%? Simple: according to our friends at Legg Mason, investors have a physiological need to invest in what has done best over the last five years. That means they buy these funds when they are at their high.

Unfortunately for our average investors, that is only the beginning of their downfall. Then other psychological needs start to surface. John Nofsinger, Ph.D., Professor of Finance at Washington State University and author of the Psychology of Investing, calls this next emotional trap, ‘the disposition effect.’ Basically human beings fear regret, which often follows the purchase of stocks (as well as blue jeans), and seek out pride. So how does this manifest itself in investing? The average investor tends to hold onto losers far longer than the professional would. The average investor also sells winners far sooner than they should. When I first read this I did not believe the good professor. In fact I was sitting at the bar of a restaurant in Chicago’s O’Hare airport when I read this, and just then, two guys sat down next to me. One of them saw that I was reading a book on investing and decided for me that I would rather talk to him than continue to quietly read my book. He explained to me (I’m not making this up) that he had a fail-proof strategy for winning on Wall Street. When he buys a stock, if it goes down he holds it until it gets back to even and then he sells, but if it goes up he sells immediately, thereby locking in his gains.

On the surface this strategy may make sense to you. After all, if he holds onto the losers until they come back he hasn’t “lost” any money, and if he locks in the gain then he has “made” money. However, what he has done is created a portfolio of losers, selling all the winners and holding onto the losers. This follows what DALBAR found. They saw that investors bought the funds that had done best, and therefore were destined to fall out of favor and do poorly. Then investors held on to those losers for a long time, until they finally gave up and again invested in what had done best over five years.

So how do you avoid this trap? Having a disciplined investment process is the greatest defense against these emotional traps. In the words of my Financial Markets professor, geeks rule the world! Geeks, like me, don’t try to fit in with the crowd. We stick to what is logical and what actually makes money. Remember that it is okay to pay for cool blue jeans, but when it comes to investing, being cool usually leads to being broke.

Your friendly neighborhood investment geek,


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

The three keys to the conomy this quarter were housing, housing and housing. Yes the bubble has burst and housing is down in almost every way you can measure it. Sales of new and existing homes are down and there has been a sharp decline in home construction. There is also 4.5 million un-sold units (including single family homes and condominiums) sitting on the market. That is a record. Real estate is of course driven mostly by local factors and the market could be better or worse for you depending on where you live. However, nationwide housing is bad and that means home owners have less wealth and therefore they will spend less, or so the theory goes. This is why most economists are saying that GDP growth will slow to 2.5% in the 3rd quarter, down from 2.6% in the 2nd quarter and nearly 4% in the 1st quarter.

The only problem with this theory is that the economist forgot to explain it to the consumer. Retail sales have grown at a brisk pace. Wal-Mart reported same store sales up 6% in September. Nordstrom reported sales up 13% and the teen retailer American Eagle Outfitters saw sales rise 19%. Overall retail sales were up 3.8%. How does the consumer do this while housing prices are going down? By going back to work, that’s how. Unemployment is down to 4.6% and while the jobs report for September showed only 51,000 new jobs what was lost in this was the fact that the previous good jobs reports from earlier this year are all being revised upward. For example, the Labor Department now says that there were 60,000 more jobs created in August than previously stated. Going back further, they now say that 70,000 more jobs were created each month for the twelve months ending in March. On top of this solid job growth wages are now increasing at roughly 4% a year. Housing may not kill this economy after all.

The global economy still looks much stronger than the US alone. India grew at 8.9% in the last quarter as they quietly take their place as the “next China”. Europe expects to match the US with overall growth of 2.5%.

Review of Market

Markets were up across the boardfor the quarter. The S&P 500 was up 5.67% for the quarter which leaves it up 8.53% for the year. Small stocks fared the worse, coming in flat. The Russell 2000 index was up 0.44% for the quarter and remained up 8.69% for the year. Value outperformed Growth with the Russell 1000 Value index, which represents large cap value stocks, being up 6.22% vs. the Russell 1000 Growth index which was up 3.94%.

The fed finally paused their interest rate hikes leaving the fed funds rate at 5.25% and long-term rates fell from 5.13% to 4.63%. The Yield curve remains downward sloping, indicating that the market expects short term rates to be lower in the future. The declining rates caused the Lehman Brothers US Aggregate Bond Index to rally going up 3.81% for the quarter. High Yield bonds remained strong with the Merrill Lynch High Yield Master Index up 4.03% for the quarter and up 7.22 % for the year.

International stocks remained strong during the quarter. The MSCI EAFE index, a proxy for developed international equity markets, rose 3.93%, and is up 14.49% for the year. European stocks climbed 5.63% while Japanese stocks were down -0.72%. Foreign emerging markets were up 4.10% for the quarter and remain up 10.15% for the year.

Market Forecast

With the S&P 500 up 8.53% year-to-date, our prediction of 7-9% growth is looking conservative. It looks like the S&P will end the year up approximately 10%. Equities remain more attractive than fixed income with interest rates still being very low by historical standards.

Our faith in large caps started to pay off this past quarter. Mega cap stocks are still selling at a discount to the rest of the market based on trailing and expected P/E and Price/Cash Flow ratios. Small and mid-cap stocks have significantly outperformed for the last 5 years and are becoming less attractive from a fundamental standpoint and are now under short-term selling pressure. Growth stocks look especially attractive right now, although the market momentum is still favoring Value.

Our outlook on foreign equities has not changed. Based on traditional portfolio characteristics such as P/E, P/CF, Price/Book Value ratios, foreign developed markets appear attractively priced. Valuations on domestic companies already reflect the competitive nature of U.S. firms. Foreign valuations reflect the regulatory and institutional challenges faced by firms domiciled in less business friendly countries. As many of these foreign countries become more free-market oriented, the productivity and profit growth potential could be substantial. In addition, rising interest rates in Japan and Europe, along with the large U.S. balance of payment deficit, are likely to put downward pressure on the dollar, which should enhance the dollar returns on foreign investments. We believe developed markets are more attractive than emerging markets for the intermediate term.

We were right about the Fed pausing and this did bring some relief to the bond markets. However, we do not see interest rates actually dropping anytime soon, with real rates still being historically low. In fact, we would not be surprised if the fed had to raise rates again before finally easing. We continue to expect a current yield return from fixed income with little capital gain or loss from interest rate movement.