Third Quarter 2013 Letter to Clients

There is a TV commercial in heavy rotation on the networks right now from one of the major financial products giants, and every time we see it, it makes us cringe. Not so much for the message, mind you, but for the reality it conveys.

The ad features a succession of polished, middle-aged couples sitting in offices across from their annuity salesmen – er, we mean “financial advisors” – and saying the following:

“We felt better holding onto our money. But we shouldn’t wait anymore. So here we are. We need to invest again!”

To which we find ourselves fairly shouting at the TV in response:

“What, you mean now that the stock market has gained 150%? Now you’re ready?”

It isn’t that these fictional couples shouldn’t be investing in the market, of course: History shows that long-term investors are always better off investing today than waiting for some far-off point in the future because stocks, over the long term, have always climbed. By that measure, all waiting does is cost you money.

Nor is it the content of the ad that sticks in our craw; in fairness, the financial products giant that produced it is merely shaping the message in a way that the investing public can relate to.

And that is the part about this ad that causes us to cringe every time we see it, because it reflects the reality that most investors have been sitting on the sidelines in bonds and cash while the stock market has soared the past four-and-a-half years. As a result, they have missed one of history’s great bull markets after having bailed out and locked in their losses during the steep market plunge in 2008-09. According to mutual fund industry statistics, it is only just now that they are dipping a toe back in the stock market.

This ad acutely underscores what we have always said is the hardest part about trying to time the market: It’s a lot easier to get out than it is to get back in. Even an investor who bailed out of the market at, say, Dow 10,000 before things got really bad in the fall of 2008 but failed to get back in has missed out on a 50% gain he should have enjoyed. If that investor had a portfolio of $500,000 at the time he bailed out of stocks, that’s about what he would have today given the meager returns of bonds and cash. Had he stayed invested in stocks he’d be sitting on about $750,000 instead, even though he rode the Dow down to its low point of 6,500 in March 2009.

This is a broad-brushed illustration, but it has happened in a very real way to hundreds of thousands of investors all over the country the past five years, and it has cost them real returns they’ll never get back. This is how we get to statistics like the one we see in the chart below:
Every year Dalbar Inc. updates this chart, and every year the so-called “Behavior Gap” between what the stock market earns and what the average stock-fund investor earns persists. It illustrates the perverse reality in investing that investors who attempt to limit the damage to their portfolio by moving in and out of the market almost always cause damage instead.

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One of our favorite bits from the Seinfeld television series is the scene in which Jerry is lambasting the reservation clerk at the car rental company for not actually having a car for him despite the fact that he had a reservation. “Anyone can say they take reservations,” he lectures the clerk. “But it’s the holding of the reservation that matters.”

We thought of that recently in another context when an analyst on a cable news show described this as a “stock picker’s market.” It is an old canard that gets kicked around whenever there are a growing number of stocks in the market that are hitting either 52-week highs or 52-week lows. It is an assertion that not just any Average Joe can make money in such a market; rather, it is only the (ahem) pros who know how to deftly identify the “good” stocks and avoid the “bad” stocks the unwashed masses won’t be savvy enough to discern.

Like the reservation clerk in the Seinfeld episode, it’s easy to say it’s a stock picker’s market. But how do stock pickers actually do?

It seems logical to assume that mutual-fund managers should be among this country’s best stock pickers; it is, after all, what their entire career is dedicated to, and they are handsomely rewarded for their efforts. So we should be able to look at the number of mutual funds that are beating the market over time and see how stock pickers, as a group, are faring.

And here we find they are not faring very well at all, as evidenced in the following table that shows the percentage of mutual funds underperforming their benchmarks (Source: S&P Spiva Scorecard):

If ever there was a time for stock pickers to demonstrate their prowess, it was in the past five years, when we ran the gamut of just about every conceivable market environment imaginable. And yet what we find is that somewhere between 68% and 90% of actively managed funds have failed to beat their respective benchmarks during that time.

So while the active management crowd can use the “stock picker’s market” phrase all they like, they clearly aren’t walking the talk!

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“Move over, Russia: U.S. is Now World’s Biggest Oil Producer”
- Headline from CBS MarketWatch article, October 4, 2013

It is a stunning thing to consider how fast the conventional wisdom about our country has gone from “running out of oil” to “world’s largest oil producer”.

All through the latter half of the 20th century, the data told us that our oil reserves were dwindling and our energy fate would be increasingly chained to countries that, to put it mildly, did not always have our best interests at heart. It did not take an expert to chart the line between our increasing energy needs and our dwindling supplies and realize that, sooner rather than later, we would run out of oil and have to import everything we used, everyday.

But then a funny thing happened on the road to energy ruin. New technology, unforeseen and unimaginable only a few years earlier, suddenly emerged and unlocked vast new quantities of oil and natural gas right under our feet. All of a sudden our oil and gas resources went through the roof:

As a result, the U.S. has now accomplished something that was unthinkable only a few years ago – out paced Russia and Saudi Arabia as the world’s largest petroleum and natural gas producer: 

There is a lesson here for investors. It is easy to be dismayed by the doom-and-gloom of today’s headlines, which always point to a long list of problems we presently face. But when those problems seem insurmountable, it’s helpful to remember mankind’s long history of overcoming challenges with new technologies that come along seemingly out of nowhere and completely transform the landscape as we knew it.