HUMMONEY - The Falacy of Market Timing (Perspective)

- by Greg Lewin

There was a study done in the 1990’s which examined the stock market performance of the 1980’s. It looked at the 2528 trading days of the decade which produced a 17.5% annualized return for the S&P 500, and then subtracted the 40 best days. As amazing as this will sound, subtracting the 40 best days reduced the annualized returns on the S&P to 3.9%. To state simply, less than 2% of the days accounted for over 75% of the annualized performance of the decade.

Now I have not seen a similar study of other decades and we all know the character of markets have changed considerably, but I will assert that a decade is a meaningful sample size and if this study is not entirely sustaining in merit it certainly warrants considerable attention. If we are to gain wisdom from this information, what is it?

Simply, the exercise of market timing is a poor use of your time as an investor. For any task which demands that you correctly locate 2% of the possible choices is a poor game to play, let alone invest time and money in. To me this is a great observation because it clearly eliminates an investment strategy from consideration, further narrowing the choices to which you allocate your time and resources. It may also help you avoid the mistake of market timing if you find yourself drifting toward this behavior.

Remember market timing is the constant buying and selling of stocks with your view of the market’s short term direction as the determining factor. This does not preclude market views. It simply advises against changing them frequently in order to capture short term gains.  

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.  

HUMMONEY - Disappointing Realities (Perspective)

I want to bring to your attention some important findings from a recently updated report released by McKinsey & Co. regarding the accuracy of Wall Street analysts’ earnings forecasts. The following remarks should prove instructive:

• “Only in years such as 2003 and 2006 where strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark.”
• “When economic growth accelerates the size of the forecast error declines; when economic growth slows, it increases.”
• “Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”
• “… long-term earnings growth for the market as a whole is unlikely to differ significantly from growth in GDP, as prior McKinsey research has shown.”

So what should we learn from these points?

• Analysts’ forecasts are highly inaccurate. An additional caution that can be deduced is the questionable accuracy of company forecasts, which are the primary source of analysts’ information.
• The accuracy of forecasts declines as GDP slows. It’s a lot easier to be right when things are not so tough. 
• Corporate earnings highly correlate with GDP.

To incorporate this information for today’s world, we know that in the recent economic cycle GDP peaked in 4Q09 at 5.6% then declined to an estimated 2.5% in Q3 2010. Economic statistics thus far reported for the fourth quarter point to another quarter of deceleration. If this is the case, investors should be wary of earnings forecasts which paint a cheery picture. Realities may prove to be quite disappointing.   

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.  

HUMMONEY - The Risk of Interesting Investing (Perspective)

-- BY GREG LEWIN               

Research recently produced by Munich Re (a reinsurance company whose job it is to study risk) and reported in BusinessWeek reveals that traffic fatalities have dropped sharply with the introduction of safer vehicles with modern safety features.  However, the rate of serious accidents has not dropped. Their conclusion was that “We introduce risk-mitigation devices that are supposed to make life safer and then we change our behavior to make life more interesting.”   

Well, in investing risk is not interesting and seeking it without a meaningful change in reward is insane. The business of investing is very straightforward:  the goal is to acquire as much reward with as little risk as possible, and when you have unearthed the great anomaly in these two factors, place a meaningful amount of capital in this investment because these opportunities are rare. Investing is very cold.  It is simply about this ratio of risk and reward.  But the subtlety which will determine success and failure is all about the confidence you have in your assessment of this ratio and the probability of the outcomes of each factor.

In the extreme, confidence and capital commitment can be more important than being right or wrong. As an example, let’s say you make 100 investment decisions in which you are right the first 99 times, but each time you only invest $1. You only are wrong regarding the 100^th investment but you invest $100.  You lose. I understand this is an extreme example, but my experience has shown me that conviction plus capital commitment have consistently been more important decisions than wrong or right. However, it is also my experience that judging risk is infinitely more complex than evaluating reward. Let’s be honest - reward is all about the fun parts.  This is the path of fantasy and fiction where all your dreams come true, products sell, research succeeds, the economy grows and management plays it all perfectly. Risk, however, is the salt on the wound, competition, management mistakes, closing capital markets and business and consumers retrench.  All of this should change our behavior and not because it is interesting.

Finding a very attractive risk/reward ratio is important, but again my experience has shown me that only when the risk is low will you find an investment worth serious capital commitment and that is where the real money is made.  Now if you consider that the financial industry of any country is populated with reasonably bright, overly aggressive and hardworking people, it is reasonable to assume that when your assessment of risk and reward is very attractive, something is probably wrong because everyone is looking for this same anomaly and by definition have crowded out this exceptional return. There are exceptions, of course, but when you find them make sure you examine them extra carefully. As a rule, if you can find an investment that offers 3 times the reward of the estimated risk and can realize that result in the next 2 years, this may be worth your investment of time and energy. I share these proportions and timeframes for specific reasons derived from my experience because inevitably investors are overly optimistic in assessing the parameters that create reward and not adequately pessimistic about those which form the basis of judging risk.  To ensure a margin of safety it is good to start with a disproportion of risk to reward. Secondly, the further out in the future you are forced to forecast the less likely it is that your accuracy will remain true. Therefore, it is best to create a series of shorter term plans with embedded risk and reward parameters rather than longer term which may provide for a loose examination of performance leading to unmanageable losses.

The game is simple and sterile:  risk, reward and capital commitment. But the important nuance is managing behavioral disposition toward risk because investing shouldn’t be about making life more interesting, but rather about possibly facilitating a more interesting life.

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.  

HUMMONEY - Innovation = Empolyment (Perspective)

--- By Greg Lewin

A wonderful interview with Andy Grove, former CEO of Intel, appeared in the July 1st edition of BusinessWeek. In this piece Mr. Grove strings together the following logic:

- Today, manufacturing employment in the US computer industry is lower than when the first PC was put together in 1975.

- For each US computer manufacturing employee there exists 10 in China.

- Not surprisingly, when looking at other emerging/important industries such as alternative energy and batteries the numbers are roughly the same.

- Why does this happen? In part because the US is willing to trade high value-added jobs in design and development for manufacturing. More importantly, the US undervalues manufacturing.

- Mr. Grove contends that without manufacturing experience we break the chain that is so important in technological evolution. Abandoning today’s “commodity” manufacturing can lock you out of tomorrow’s emerging industry. Important linkages between innovation and manufacturing, customers and suppliers, and scaling are effectively lost. As a result, we fall further behind the innovation cycle.

- And of course, any policies which promote a highly paid knowledge class and a large unemployed group are fundamentally unstable.    

Mr. Grove’s insights are incredibly important at this juncture in our world economy, and therefore, our country. In my opinion, one of the core virtue’s of the US has been its ability to foster a climate and culture of innovation. I always believed it stemmed from our beginnings as a young nation of immigrants less attached to the cultural anchors of a long history. It promoted a culture of “what’s next” and from that spawned an avalanche of creative spirit that could be found everywhere from the arts to the sciences. This is why talent always wanted to come here first.  Now Mr. Grove postulates that in the sciences we could be permanently impairing our ability to innovate, our creative spirit. And if that were to happen I fear that could spread.

As an investor I have obsessed about the long term impact of debt and unemployment. But as a technologist, I always felt that one way out might be through our ability to innovate, to create new platforms for productivity, employment and economic leadership. If Mr. Grove is right, the path may be increasingly less clear. As the US celebrates Thanksgiving this past weekend and the world begins the traditional holiday season over the next month, we may want to pay careful attention to his warnings if we want to keep our collective spirit vibrant.   

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.  

HUMMONEY - A Brief History of Speculation (Perspective)

--- By Greg Lewin 

The best way to know where we are going is to look at where we have been. In an effort to be somewhat brief and to the point, I will assert that although over the past 40 years we have lived through several periods of high profile speculation such as the Drexel Burnham led LBO craze of the 80’s or the collapse of long term capital in the 90’s, I would suggest that the speculative bubble that began with the IPO of Netscape in 1995 and ended with the collapse of Enron and WorldCom around the year 2000 was the period that fundamentally reshaped our cultural acceptance of risk taking. For in that period when the NASDAQ rose 500% in value is when the general public became personally attached to the stock market. Prior to this event financial markets were a more unfamiliar beast best left to trusted advisors and brokers to help with our investing. Then came the internet and all of a sudden everyone was on the front line together. The question was no longer about earnings, interest rates and inflation, but rather who knew what, when, where and for how long. All of a sudden everyone was an expert, everyone was perceived to be on equal ground, everyone could play (with leverage) and everyone was winning until they weren’t. The money train came and went almost as fast but the taste remained. Investors liked speculating, investors liked margin and they definitely liked the markets.

As the dust cleared and many of the world’s governments wanted to help pick up the pieces, they called to action one of their favorite tools - lower interest rates - to get things moving again.  As the general public wanted to stay in the game and stay with something they could still claim expertise in they turned to housing. Heck, most everyone owns one.  Just as Wall Street and the bankers were happy to oblige the investing public in the 90’s with a steady stream of IPOs and inflated research, here they were again with new  products, new terms, and the same lousy research to encourage and justify behavior. But this time they were not alone, as opposed to prior risky periods when the government was more of a silent partner, occasionally offering up a sweet tax incentive or such. Now they were all partners using institutions like Fannie Mae and Freddie Mac, promoting leverage and, under the guise of deregulation, being careful not to supervise too much. Now the culture of speculation and leverage had spread from the private sector to the public sector and everyone was all in, wanting desperately to avoid any and all pain which could be easily sidestepped with easier money, more debt and a heavy dose of benign neglect.

So where are we going?  If one wanted to intelligently address the root of our problems you would have to alter leverage, risk tolerance and behavior. That is if you really wanted to promote change. Now let’s check out the landscape. The consumer’s debt level remains historically high and house values remain in retreat, so he or she is still effectively on the sidelines. The government’s debt level is way beyond historic highs, if you remotely count honestly. Government policy is viewed as a failure and all politicians are held in the lowest regard, so they too are without either weapons or the political authority to use them. We know corporate America has stayed clearly on the sidelines, hoarding cash and laying off employees so they seem to be somewhat of a nonfactor. So that leaves the Fed and Mr. Bernanke. He seems to be quite willing to act, which is interesting, because fortunately he is not accountable to anyone. So let’s see what he’s up to. Well, Plan A was QE1 and lower interest rates. The intention was to get money to the banks to promote business lending and reduce interest rates on mortgages to support housing prices and put more money in people’s pockets to promote spending. We know the results of Plan A: banks didn’t lend, housing prices kept falling and people didn’t really spend. So now he has put Plan B in action, QE2. With interest rates at 0, the only thing left to do is send more money to the banks by buying their low yielding Treasury securities in return for 0 yielding cash from the Fed, thereby encouraging the banks to buy stocks (the only place left to possibly get returns on cash) in the hope of creating wealth which will then trickle down to the rest of our economy.

So let’s think for a moment: the one man left with policy making ability has come up with the master stroke of more leverage and more speculation to cure our problems of leverage and speculation. When this fails who are we to blame? Have we changed risk tolerance, leverage or behavior? Have we tried to do anything remotely hard? When this emperor stops parading down this last street do you think there is any chance that he is still wearing any clothes?

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.