“Well, It’s Not Really As Bad As It Sounds…”

Saturday, February 4th, 2012

Mark Twain made the above remark in 1888 after visiting Germany and first hearing Richard Wagner’s music.  As with many of Twain’s humorous observations, his assessment of Wagner embodies an idea that has much wider application to many areas and is a useful way to view what took place in the financial markets in 2011.

In 2011 the S&P 500 behaved like a schizophrenic yo-yo, making double digit moves in both directions and ending the year essentially where it started. Much of the market turmoil was linked to the debt crisis in Europe, the downgrade of US Government obligations from Triple A and the lack of constructive actions both in Europe and the US Congress to address the growth of deficits and the lack of growth in the economy.  In the middle of the summer it looked as if Euro-zone might implode as the sixteen constituent countries, especially the two wealthiest, Germany and France, could not agree on a way to restructure Greek sovereign debt and avoid a disorderly default with Italy, Portugal and Spain possibly waiting in the wings.  At the same time the US Congress could not agree on a constructive agreement to manage our own debt ceiling and growing deficit.  These problems and trends are not going to change simply because the calendar has added a digit.  Yet now we stand at the end of January 2012 with the sense that implosion in Europe is  probably off the table and that some green shoots which had appeared in the US during the past year with respect to job creation and perhaps even residential housing are heading in the right direction.  The deficit still grows but if there is little confidence in Congress, there is a consensus that the financing of the deficit is in the more competent hands of Ben Bernanke and the FRB.  So after much turmoil or as Angela Merkel might say “Sturm und Drang,” the US equity market recovered in the final quarter to end the past year flat and has begun 2012 with a strong opening month.  This is far different outcome than in past traumatic years.  Moreover in 2011, Richard Wagner’s The Ring of the Niebelungen enjoyed new and inventive productions playing to sold out houses first at the San Francisco Opera and currently at the Met.  So not surprisingly Mark Twain had it right on a few fronts at once.

Despite the equity market ending the year flat, a survey of investment returns reflects the difficulties of navigating through the volatility.  Some high profile mutual fund managers such as Steve Leuthold whose Core Fund has consistently beaten the S&P and returned 8% annually over the past 10 years  dropped over -5% and fared less well than the aggregate actively managed fund average return in 2011 which was down -3.3% .  The place to be in 2011 was the Treasury market, but even Bill Gross at PIMCO, the most influential fixed income manager on the planet, sold his Treasury holdings before their big rally occurred in response to the chaos in the Euro-zone.  A year such as 2011 often brings out the index and closed-end fund advocates such as John Bogle the founder of Vanguard, who created the first S&P 500 Index Fund in 1975 and Princeton Economist Burton Malkiel, author of A Random Walk Down Wall Street. Not unexpectedly we usually hear  them leading the table  pounding against active management.  Yet Bogle and the other index asset allocators have been rather quiet and Professor Malkiel has published some Wall Street Journal Opinion Pieces advocating investing specifically in cash flow generating dividend stocks and for long term upside allocating some money to emerging markets.  The word “closed end fund,” which was at the heart of the gospel according to Burt in his well known random walk theory does not even appear.

As for the best strategy for investing in 2012, we would combine Professor Malkiel with Shakespeare.  Specifically the line repeated several times by Iago in his scene with the wealthy Venetian Rodrigo in the first act of Othello: “Put money in thy purse.”  Now of course Iago, one of Shakespeare’s truly maniacal villains is hardly offering investment advice, rather he wants Rodrigo to sell his lands to get more liquid and then Iago will separate Rodrigo from his money.  But let us not shoot the messenger.  The advice to generate cash flow from your portfolio is an excellent idea.  According to a white paper from the Investment Institute in 2010, historically 44% of stock returns over time frames of five or ten years and longer have come from dividends rather than appreciation, and in 2011 the number was higher.  Further Shakespearean wisdom on navigating a tumultuous investment environment comes from Rosalind, the heroine of As You Like It.   Rosalind spends most the play disguised as a boy in order to evade detection after her father has been deposed.  She finds this a problem since some young women fall in love with her, one of these being a shepherdess named Audrey who is spurning the attention of her own diligent suitor.  Rosalind’s advice to her is quite simple—the fellow in front of you is as good as it will get:  “Sell when you can, you are not for all markets.”    This sage investment advice  along with a cash flow oriented strategy is something we do our best to implement at JMR Capital through a variety of investment vehicles.  Although some of the “it might be 2008 all over again” fears are currently on the back burner, we are not completely out of the woods and it would be a mistake to expect stock returns to derive from significant price gains through multiple expansion.  Stocks are cheap according to the historic S&P multiple of sixteen times earnings (they are currently between  twelve and thirteen) but they more than likely could stay that way unless the global economy picks up significant steam.  As Professor Malkiel points out in his WSJ article of January 5, 2012, good quality stocks are the best house in a bad neighborhood. He notes that if you buy 10 year Treasury bonds now with a 2% yield to maturity, you know exactly what you will earn, and that is hardly a satisfactory return.  So there is a good possibility that cash on the sidelines at the end of 2011 could find its way into dividend paying high quality stocks, and our strategy will be to “put money in thy purse” through those kind of investments including high yield bonds, but to the chagrin of the buy-and-hold advocates, it is a good idea to listen to Rosalind be aware that not everything is for all markets and know that adjustments to even the best ideas and strategies will serve us all well in the long run.

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