“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
— Sir John Templeton
Sir John Templeton died last week at the age of 95. He came from a poor background, attended Yale on scholarship, earned a degree in economics and became one of the most successful investors of all time. He got his start in 1939 when he bought $100 of every stock trading below $1 on the NYSE and AMEX. I don’t know if he considered 1939 to be the point of maximum pessimism, but it proved to be a great investment; he made roughly 4 times his money in the next 4 years. His career spanned buying stocks during the Great Depression and selling stocks during the internet boom.
If bull markets are born on pessimism as Sir John pointed out, then right now we are in the throes of a long and painful labor. I’ve been investing for over 25 years and have never witnessed the level of pessimism that permeates the financial markets right now. It is small comfort that the economic reality of the current situation is not nearly as dire as the mood suggests. Phil Gramm, an economic advisor to the McCain campaign, said last week that the US is filled with whiners and that the economy is in a “mental recession”. Regardless of the grain of truth in those statements, speaking them aloud got Gramm a one way ticket back to private practice.
What Phil Gramm fails to recognize is that for the majority of Americans, this is a real recession, no matter what story the economic statistics tell. Rising gas and food prices may not affect the government’s calculation of “core” inflation, but it affects the pocketbooks of average Americans. Inflation is a perniciously regressive tax and it affects the lives of poor and middle class Americans much more than it does the wealthy. They may be whining but their pain is real and relieving that pain will require time and good economic policy. Providing a little anesthetic will probably prolong the recovery, but that doesn’t mean it shouldn’t be applied. We just need to ensure that the anesthetic is not mistaken for the cure.
Unfortunately, the palliatives being offered by our government institutions will do little to soothe the anxieties of the middle class because they don’t address the root cause of our current troubles. Almost everyone, with the possible exception of Alan Greenspan, now acknowledges that the Federal Reserve was a significant contributor to the real estate bubble, the bursting of which is now at the center of the credit crisis. And yet Congress has done nothing to address the source of the problem, preferring instead to search for scapegoats outside the realm of government. Lenders and commodity speculators are demonized while the Federal Reserve accumulates more regulatory powers to complement the ones they failed to utilize during the bubble. Government institutions are the only organizations for which failure is seen as an opportunity to expand the scope of their activities.
Just as the Fed was at the center of the real estate bubble, it is also the source of the commodity bubble that is causing so much pain for the middle class. Bankers line up at the discount window for a bailout, while average Americans pay the price through higher gas and food prices. Interest rate cuts are of no use to Americans who can’t get a loan, but they are good for banks that can borrow from the Fed at 2 ¼% (using suspect loans as collateral) , buy 10 year Treasury notes at 4% and pocket the difference. Interest rates held below the rate of inflation are also a boon to commodity speculators and producers who are able to finance the storage of scarce commodities that are rising in price rather than sell them at today’s prices.
Politicians call for increased regulation of commodity markets and the financial industry while ignoring their own role in creating this mess. The CRA (Community Reinvestment Act) threatens banks if they don’t lend to the underprivileged and politicians blame the lenders when borrowers can’t meet their obligations. Ethanol subsidies divert land from food production to inefficient energy production and the resulting food shortages are fobbed off on “speculators”. For thirty years, Congress prevents the exploration for and production of known energy sources in the US; oil companies and the aforementioned commodity futures speculators are the bad guys. The Federal Reserve keeps interest rates artificially low for years and lenders get branded as predatory as if they were tackling people on the sidewalk begging them to take loans at those artificially low rates.
It is not capitalism that has failed. It is government intervention in the market which has produced these predictable but unintended consequences.
At least some portion of the stock market June swoon can be traced to policies that haven’t even been enacted yet. Barack Obama has been very public about his desire to raise capital gains taxes and now that he is the front runner, investors are taking him seriously. Sellers this year will pay a long term capital gains tax of 15% while those who wait may face a higher number yet to be determined. It shouldn’t surprise anyone that sellers are taking advantage of the lower rate while they can. To be fair to Mr. Obama, I don’t think the effect is that great or that his opponent and self proclaimed economic illiterate, Senator McCain, is much better on economic policy.
Since politicians and their ilk are the source of most of our economic problems the solution will not be found in their campaign documents. By the time they do anything, I suspect the market will have already disposed of the problems that plague us now. Any actions they take are more likely to cause future problems than solve current ones. The market is already cleaning up the current mess. The real estate bust is nearing its final death throes as housing starts have fallen to levels that will allow the excess inventory to be liquidated. Banks are raising capital to replace what they destroyed and those that can’t, will, or soon will, be liquidated by the FDIC. Banks with stronger balance sheets will take over weaker ones that are worth saving. It just takes time and we are well into the healing process.
In the meantime, the economy is not doing nearly as badly as the pessimists would have us believe. Growth in the first quarter was weak, but the second quarter is looking significantly better than initially thought. The latest Wall Street Journal poll of economic forecasters shows an average estimate of 1.4% growth in the second quarter. Based on the latest trade report, I think the number will come in above the consensus and possibly as high as 3%. We’ll find out July 31st. The point is that even with the body blows the economy has received since last summer; it continues to show a resilience that is nothing short of amazing.
For investors, the question is whether this will turn into something much worse than we see today. The economic situation today is far from perfect, but neither is it as ugly as the pessimistic scenario. Even if the situation continues to deteriorate, how much lower do stocks have to go before it is fully discounted? I suspect that the stock market, as it often does, has overshot, this time to the downside. In the past, the stock market has bottomed long before the economic statistics sound the all clear and I see no reason to believe this time will prove any different.
Keeping to an investment plan is difficult in the best of times. It is almost impossible when things are at their worst, but we’ve stuck to our strategy and I believe it has proven its worth during this bear market. Our commodity exposure has softened the blow of the losses on the stock side of the ledger. Without the positive returns from commodities, we would be facing the daunting task of recovering from a 20% + decline. Instead we have suffered a mid single digit loss from which it will be much easier to recover. I am starting to shift assets from the commodity indices to the stock indices. I may not catch the exact top or bottom, but by taking advantage of the wisdom of Sir John Templeton, I am doing what common sense dictates. Have we reached the point of maximum optimism about commodities? Have we reached the point of maximum pessimism about stocks? We will only know the answer to those questions in hindsight, but it seems a good time to start considering the possibility.
Joseph Y. Calhoun III is Chief Investment Officer of Alhambra Investments.