November 10, 2007

Client Question:  I’m confused by the 2 articles dated 11/6.  The one article is optimistic that no recession is in sight.  The other article on third level accounting hints at a recession with a potential 20% drop in the stock market.  Can you clarify?

Answer:  The short answer to your question is that there are, as always, both positive and negative indicators/news/forces for the stock market and the economy at any time.   But there are two broader answers.

Answer #1:

From a marketing/client service standpoint it is very common in this industry for advisors to select a mantra ("the market will go up in the long term, stay the course" or, "the stock market is a dangerous place, buy gold", or whatever) and stick to it.  I believe that the news/data flow is more fluid, and that flow is never entirely upstream or entirely downstream.  As such, I tend to write about what I feel is important as opposed to paying attention to only the data that supports my mantra.

As a corollary to the notion of paying attention to only one side of the data flow, psychologically humans tend to only pay attention to and/or weight as more important data that supports their beliefs/assumptions.  There have been several studies on this phenomenon.  For example, one study that reviewed the resources used for Ph.D. student dissertations found that researchers 1) ignored data that did not support their theories or assumptions and/or 2) weighted as more important the data that did support their theories or assumptions. 

I learned about these types of studies before I got into the professional investment business some fifteen+ years ago.  And I have always kept this knowledge in the forefront of my mind when was performing research on a certain investment, sector, asset class, or theme.  It does me no good to search out only information that supports my assumptions.  I must also challenge my assumptions and seek data to disprove my theories. 

The end result of researching ideas is the purchase of an investment for a client account.  It is unfair to the client if at that time I only spend time trying to validate my action by finding compelling information to support a purchase.  What I need to do is balance my buying disciplines with selling disciplines.  There are typically two different types of sales, neither of which come quickly enough if I only work on finding supportive data.

One type of sale is to increase proceeds to make cash available for another, hopefully better purchase – that may come from the result of research that focused on finding something new to buy.  The other type of sale may come from cutting losses if a mistake was made in the research or the timing.  And those “cutting losses” sales never come from advisers that neglect to look at the other side of the trade.

These “cutting losses” sales typically do not come from two types of professional investors.  The first type focuses on an inflexible mantra (ex. “invest for the long-term; don’t worry about volatility in the short/intermediate-term”).  The second type is just an ego-maniac. 

The first type is not as dangerous because generally speaking it makes sense to invest for the long-term.  Just look at the S&P 500 or the Dow Jones Industrials today versus 1999.  While there was a lot of destruction and distress in the intervening years, over eight years investors did O.K. and will probably end up making a lot more money in the next eight years.  However, sometimes you have to be flexible enough to change allocations in the face of a market crash or a recession, or even if fundamentals favor an asset class so much that allocations should simply be adjusted.

The other type, the ego maniac, will not admit to mistakes and will hope (emphasis on “hope”) that time will heal all portfolio wounds and that they will look smart in the end.  In short, they refuse to admit when they are wrong (like focusing on the long-term when 2000-2002 could have been sidestepped, although most mistakes are, thankfully, materially smaller). 

Here is my two cents on this and how it affects my line of thinking (and why I may post positive and negative commentary on the same day and sometimes even in the same report).   Within the context of an exact science, mistakes are statistically inevitable.  They are going to occur and there is no getting around it.  Unfortunately, investing is an art, not an exact science.  As such mistakes are going to be much, much more prevalent.  Because of the likelihood of many mistakes I believe that investors must be flexible (adjust asset allocation to more favored areas, don’t be afraid of cash positions when you need to figure things out, use non-standard investments, etc), and investors must, must admit when they are wrong.  There is no shame in being wrong, but there is shame for holding onto a wrong assumption when the data flow changes.

To sum, answer #1, I look at both the good news and the bad news because it is important to pay attention to both.

Answer #2:  I envision www.BerkshireMM.com to be not only a venue for me to make market prognostications (ultimately your portfolio is the venue for that), but more so to share with you the things I take into consideration when managing your portfolio.  I wouldn’t consider it an educational too, per se, but since clients are paying me to manage their portfolios I use the website as an opportunity to explain my strategies.

Within the context of your question, please also allow me to address recent market activity.  I have lost count of the number of times in the last month or so that I argued that the market could very likely re-test its August lows (admittedly and curiously, as unexpected as recent volatility was it seemed to not make it any less stressful).  I also explained many times that this is a pretty regular market occurrence (about once every fourteen months).  I won’t repeat the rationale behind the forecasts, but the bottom line was that it made sense to hold investment positions through any re-test (or attempted re-test) because the follow through rebound and rally would be sustainable and of good magnitude.

However, if it appears as if that strategy/theory/assumption is wrong (either that the downturn would be materially more severe or that the rebound was not of the stuff that looked sustainable), then I will be flexible and change my strategy (raise cash, change allocations, etc.).  And you just can’t be flexible unless you take your ego out of the question and admit that you are wrong.  And that is why I look at and report both positive and negative news.  (To be clear, I am still of the idea that the best trade is to hold through any current volatility and ride positions upward through the end of the year.

Thanks again for your question.

Respectfully,

Allen Harris

President