Does Santa Still Deliver?

These last few workdays before the Market goes holiday-somnolent find us puzzling over what seems like a departure from normal year-end Market action, and, not surprisingly, wondering about what the New Year will bring for investors. As is fitting for such a way-too-interesting year, the home stretch of 2009 seems to be disregarding the normal, seasonal cue cards. That would be a wave of abnormal selling pressure as yearend approaches, attributable in the main to the need or desire of many investors to generate losses for tax purposes. The eventual abatement of this tends to be followed by a decent rally in the indices, which has been called the “Santa Claus Rally” or more prosaically, the January effect. This has gone on for many decades, though in recent years the “January-ness” of it has diminished. As more investors, no doubt trying to get a jump on others, have done their tax loss selling in November if not October, the rally which follows has shifted into December.

Last year, the Panic which started in earnest in September marked out a bottom of sorts on November 21 and pretty much did away with the need for anyone to deliberately generate a tax loss for the purpose of offsetting gains (not that 2008 had been rife with opportunities to book gains in the first place). The unpleasantness that dominated the early months of 2009 has blotted out the memory of a DJIA that rose some 24% from its 11/21 nadir to its intraday high on 1/6/09. This time around, the effect of tax loss selling seems hardly to have registered. Most of us can find the answer to why this is by reviewing our accounts. If there is not a lot of tax loss selling going on, it is because most investors have enough of those cussed things already, booked early in the year if not carried over from last year. To the extent they also have gains, they are probably still of a short-term variety, and probably only a few months before they go long term. This dearth of what is normally seasonal selling pressure is in my estimation being met with unusually strong demand from money managers who underestimated the power of the post 3/9/09 recovery (We all underestimated it, but some of us at least recognized the turn in the tide and found the courage to act). This “better late than never” buying is no doubt motivated by the fear of being taken to task for missing out on what has come to feel like the rally of a lifetime. We should not be surprised if once 2009 is passed, this upward pressure abates, and so allows the Market to sell off to a degree that would be considered a meaningful correction.

In reviewing the tape, so to speak, of that way too interesting time that was the last leg of that historic Bear Market, I could not help but notice that for many stocks, 11/21 really was the Bottom. There were lots of stocks you could have bought 100+ days ahead of what we all hope is the Generational Low of 3/9/09 and you did alright, certainly better than if you had waited until March and then been so balled up full of dread that you did nothing (a real possibility considering just how scary it was as we stumbled along what felt like the edge of an abyss). November was the bottom for many of the stocks that had fallen from favor clear back when the Market got its first whiff of impending recession. That last leg down after 1/6/09 was much tougher on the stuff that investors thought was somehow immune, as if the Market was making a point about “no place to hide”. There might have been more bargains on 3/9 than on 11/21, and there were no doubt some even more extreme bargains, but my point is that while an investor who went “all in” 100 days too early would have paid a great price in terms of visceral wear and tear over the next three months (unless they had the good sense to go on a sabbatical in Patagonia or something like that), a year later he still would been sitting pretty indeed. It’s not about timing the Market, but it is a lot about being there when it hurts.

So what should we expect in 2010? Viewed through the lens of that bag of tools that is securities analysis, the Market is by any measure ahead of itself and poised for some kind of meaningful correction. In terms of what I call Commercial reality, I get a very bifurcated view. If the business is based on truly global demand (e.g., components for electronic devices that facilitate connectedness on one’s own terms, aviation equipment) growth and/or cyclical improvement if not downright excitement is clearly in the picture for 2010. If it is strictly domestic and at all discretionary (e.g., housing related), the road ahead looks steep and slippery for as far as the eye can see. It is going to be trickier to make money in the Market in 2010 than most of 2009 turned out to be. I would expect to be a net seller over the course of the year until a convincing correction (15% decline in major indices) manages to take place. My sense is that while there will certainly be numerous days when the Market swoons, such a meaningful and sustained pullback is far from inevitable. Absent the sort of development that registers in the history books, we are looking at a Price Reality that probably keeps the Market on an upward skew for most of the year ahead. This is because equities, especially US equities, seem to be setting up to become the proverbial, albeit short-lived, “only game in town”.

Such momentary madness (where residential real estate was just a few years ago) generally happens by default. Money is restless, and sometimes flocks to the least ugliest candidate in the beauty contest. The world is awash with capital looking to earn a return. Where can it go? As I survey the options, and consider the degree to which so many investors cannot or will not accept mere nominal returns, it is hard not to see a net flow into equities. Money rates are practically nil. Bonds (a.k.a., certificates of confiscation) have just done the seemingly impossible, outperforming equities over the course of a full decade. A year ago, there were once in a generation opportunities in corporate and municipal bonds, but that cow has since been milked. Look for a regression to normal and then some. Commodities, especially gold, have just gone through that classic, 10 +/- years procession from dead money to a near-mandatory category of asset allocation. As with any other asset whose price has gone hyperbolic over the course of a decade, gold could easily double again, or already have started a multi-decade slump back into sterile oblivion. (You pay’s your money, you take your chances.) Real estate abounds with opportunity, distressed priced assets in the hands of those who did not intend to be owners, but only for the truly astute who can afford to be patient. (The demise of the popular notion that it is the rule rather than the exception that home ownership will be a primary generator of, as opposed to a mere store of, personal net worth, will be the subject of a Musings in the not too distant future.) And however important it is to have a global orientation to one’s investments (i.e., exposure to companies that are not strictly domestic), Dubai World and now the sovereign state of Greece are reminding us that there are risks and uncertainties of a whole different order when one ventures beyond our shores. Indeed, investors are likely taking heart from the recent political developments here in the U.S., where the system has proven remarkably resilient against what earlier this year looked like an unstoppable takeover of productive assets by the non-productive. Damage is indeed being done, but nowhere near as badly as we were tempted to expect only six months ago, and the ugliness of the struggle seems to be setting the stage for a vintage 1980-like revival.

The debate among analysts as to what stocks are worth can (and does) go on ad nauseum. The reason Bull Markets of every sort last longer than those of us who “know better” can make sense of is that a big popular market is one place where wishing really can make it so, if only for a season. The data of valuation is inherently debatable and ambiguous at best. What seems to tip the balance in a direction accommodative to price appreciation most of the time (i.e., except during periodic Bear Markets, when all this accrued unreality gets flushed out and then some) is a heartfelt need on the part of investors at the margin to be able to earn “acceptable” returns. “Acceptable” got up around 20% during the late Nineties. It is not that high now, but it is a lot higher than fixed income can presently deliver. Marginal investors and their enablers will see the data in a light that will continue to bid up stock prices. A resumption of M&A activity will produce “metrics” which confirm bullish valuations.

This will to believe in the “everything’s going to be alright” that comes with plump 401ks that don’t need a lot in the way of cash contributions is why the Bull can be durable and powerful beyond all we can make sense of. So as we approach 2010, I remain “constructively fully invested”, which is to say with a modest amount of “dry powder” in the event we hit an air pocket early on in the New Year. Barring a downturn at least as spirited and durable as what marked June of this past year, though, I would look to be much more a seller than a buyer as the year goes by, making sure I have the flexibility to take advantage of any kind of “bump in the road” as well as whatever other needs for cash might come along. If you can’t afford (i.e., are yield dependent) to keep upwards of 20% of your investable net worth “at the ready” (in cash) a good deal of the time, you will be operating at a significant disadvantage to those who can.

Systemic Inscrutability Reaction Syndrome

This week’s research workload saw us more engaged than usual with inscrutably complex systems and the tendency of experts to bluster past their mysterious aspects. No, I am not referring to the oh, so, au courant question of Climate Change, though it is a mystery indeed how when all those generators of hot air and bad gas congregate in the Nordic regions, so much of North America is visited by record breaking cold. (Could it be a somehow endothermic extinguishment of the celebrity star power of a certain professional golfer/lothario?) This week has been very much about trying to get to the bottom of what drives demand for a promising new medical device that has been developed by one of my companies, which has meant trying to learn all I can about how the body responds to trauma. It is truly amazing how, via what is called the sympathetic nervous system, our bodies somehow “know” to respond to threats. We understand this in terms of “stress”, which triggers responses (adrenaline, endorphins, faster pulse, being “in the zone”, etc.) that facilitate fighting back and otherwise coping (“eustress”), but past a certain threshold render us less effective (muscle tension, excessive perspiration, “choking”). When the body experiences trauma that it somehow deems life threatening, this same sub-system starts down a pathway that is initially manifested by what we call shock. This mechanism seems to start out as a way of enhancing survival. For example, blood is restricted from the extremities so that it might concentrate on the brain and heart, which are most susceptible to damage in the event of oxygen deficit. However, if this chain of events persists long enough, it cascades into things like S.I.R.S (systemic inflammatory response syndrome), sepsis (S.I.R.S + a pathogen) and multiple organ dysfunction syndrome (MODS), hallmarks all of what despite all of our progress remains pretty much a path of no return. I cannot help but wonder, when I consider the lot of that vast sweep of humanity that did not exist on this apex of technologically-rendered ease and comfort that we think of as normal, if perhaps this is a system seemingly designed to hasten death and make it less difficult (akin to how shock can shut down the pain response to the sudden loss of a limb) once a certain point has been passed.

In the process of learning not only about this marvelous system and how our understanding of it has evolved in recent years, but also how clinicians and other practitioners respond to evolving knowledge, I could not help but see the similarities that arise in any field of inquiry where there is complexity shrouded in mystery. (Perhaps we should define mystery as a way of describing that part of a field of study for which our tools of inquiry remain inadequate, or perhaps do not exist at all.) The ways we go about trying to understand the system that is human physiology are not unlike how we address similarly complex and mysterious systems like climate, the economy, or the enterprises which comprise the productive portion of an economy (or the government entities which comprise the non-productive portions). In any case, we have lots of data derived from observable phenomena and subject to timely verification, but much of what we like and need to know is shrouded in mystery. In these cases, we rely on indicators where the connection between the observed phenomena and the functioning of the organism is plausible but not assured. Sometimes we find indicators that seem to have predictive value (“leading”). More typically, we get lagging indicators, which obviously are not much help in dealing with contemporaneous threats to the system, but do help us learn and so be better prepared for the future.

With this in mind, the old joke about the drunk looking for his keys under the lamp post (“because the light is better”) comes to mind. This joke is a classic because it connects with something very real in the human condition. We go where the light is, with the indicators we have and are used to. The passage of time invariably brings up new ways of looking at things, but the uptake is way slower than an idealized understanding of ‘the pursuit of knowledge” would expect. Medical practitioners understand the mysteries of physiology which they face each day with the accepted wisdom they “grew up with”. Experts in all fields find themselves similarly stuck. To the degree that reputations, academic sinecures and other forms of financial security are tied to a certain interpretation of a field of inquiry whose understanding is hindered (if not foreclosed) by mystery, resistance to reinterpretation is all the more likely to occur.

I would like to think that my experiences as an investor have provided something of an antidote to this. It is, after all, about acting on the courage of one’s convictions with respect to an ultimately inscrutable future. The Market is pretty good at instilling humility, at teaching us, if we are willing to absorb the lesson, the consequences of being dogmatic about mere data, especially when we have confected some elegant hypothesis that ends up almost but not quite bullet-proof. Spare me the pride of authorship if it psychologically locks me into an eventual capital loss! (In the aftermath of that avalanche of humility that was the Market a year ago, it was a real treat to read Mr. Buffett’s interview with the WSJ about his experience, to be reminded that we weren’t the only ones experiencing stress bordering on shock!)

Such humility seems to be lacking in fields where there is nothing like the Market doling out its corrective feedback. Indeed, any subject that relies heavily on indirect measures of what happened before there was anyone measuring is probably going to end up overrun by reckless speculation. I suspect this is a problem in any number of disciplines (paleontology, cosmology, etc.) but is especially in play in what we call climate sciences. Here, with the Climategate scandal, we have been treated to an illustration of exactly why “appeal to authority” is one of the classic logical fallacies. Scientists are human (though not all “scientists” are really scientists in the sense that they actually use that methodological set of tools that is science as classically understood). We should not be surprised to learn that there are scientists (even in the real sense) who are pretentiously and yet falsely “objective” in much the same manner that we find clergy whose facade of “holiness” turns out to be an instrument of deceit. (For some reason, something in us tends to want to hold the clergyman to a higher standard. Mysterious, no?)

Back to where my research goes on, the path that took me into the mysteries of physiology is pointing in the direction of what just could be, from the perspective of picking stocks, my biggest winner ever. The device in question appears likely to be able to replace lagging and difficult-to-do indicators of shock with something of a leading indicator (i.e., hypoperfusion of oxygen in the microcirculation as opposed to arterial or venous) of shock, or at least early enough to prompt a more timely intervention aimed at keeping the patient’s system from starting down the aforementioned path of no return. It has also been found to be useful in cutting down the likelihood of over-resuscitation, which is both expensive and damaging. In a venue where each hour of delay in recognizing the onset of sepsis (the #2 killer of the elderly) increases the likelihood of mortality by 7%, a simple to operate, noninvasive early warning would seem to be a real game changer. The financial implications of this are staggering, and will be the subject of much work by High Road Value Research in the year ahead. Stay tuned.

Put Another Log on the Fire

This week finds us wondering about something we thought we had gotten away from when we exited Upstate New York: the prospect of running out of firewood!  An early start to winter way down here at Latitude 30.32 has our wood stove working a lot harder than recent experience had led us to expect. A blast of snow and hard frost has it is starting to look like our not inconsiderable wood pile might not get us through winter. Now the consequences of this are not as bad as in one of our “favorite” memories of life in the Taconic Hills (i.e., stumbling around in the snowdrifts looking for deadwood that might be burnable) but it certainly helps to set my frame of mind as I consider the scandal that has engulfed the “science” of anthropogenic global warming (AGW). 

This recent uproar, wherein a coterie of scientists got caught red-handed perpetrating an array of dirty tricks in order to protect their carefully orchestrated “consensus”, does not offer much as to the substance of the debate over AGW. To argue that it somehow settles the matter as to whether the “A” belongs next to the observable phenomenon that is “GW” would be to stoop to the same tainted logic that its promoters have used in imploring that “the discussion is over”. A wobbly case just got a whole lot more so, but it is the authority upon which so much of it rested that took the real hit. At issue is a matter even larger than what the Gasbag from Tennessee or that weird man who is in line to be the next King of England have told us is at stake. Our worst suspicions about collaboration between corrupt journalism and corrupt science have been confirmed. Like the proverbial pair of sticks, portions of those two institutions were rubbed together under a pretense of producing illumination, but after years of generating nothing but blinding smoke have suddenly burst into a pyre that threatens to immolate both of them.  

Now to say that an enabling if not morbidly incurious Establishment media has lost yet another shard of credibility is not unlike describing the Titanic settling a bit deeper into the sea bottom as “sinking”. Corruption in the press has been with us for about as long as there has been printing, though the fatalism that has accompanied the technology driven splintering of media seems to have hastened the rate of putrification. The true heart of the matter is what this scandal has to say about the enterprise that calls itself Science. We should not be surprised that people who choose this path are any less corruptible than those who choose others. The proportion who succumb to, say, greed might not be as high as what we observe on Wall Street, but that does not mean that at least a few “scientists” will not sell out for money. The temptation to celebrity,  to prideful repute as a top “expert”, or that urge to be a part of some “inner circle”, and of course the impulse to exert control over others; has not Science grown to be a sufficiently capacious tent to provide cover for legions who are susceptible to these? Thoughtful observers will not be surprised to find that Big Science has its bad apples, too. But as others have already observed, AGW has over the past few decades become the face of Science as popularly understood. It has not helped that like so many other words, “science” has gotten so squishy, to degree that what we once called the “hard” sciences have been buried under all kinds of activities that employ a lot of “scientists” in what amounts to mere speculative (i.e., not subject to that empirical verification that once defined the heart of science) activity. With AGW having hogged the spotlight for so long and now having been rendered suspect by the exceedingly unscientific actions of its perpetrators, we have to wonder how much damage will be done to the credibility of science as a whole. 

This is not an altogether worrisome development. One wonders how hard anyone anywhere thinks about the science underlying the technology which enmeshed so much of their lives. How awful would it be if it got harder for charlatans to wrap themselves in that mantle of authority that so many people ascribe to science? I am thinking of someone I once did a bit of business with whose arguments are riddled with condescension rooted in his status as a “scientist”. The man rescues squirrels and cats for a living (okay, endangered snow leopards.), a kind of globe trotting dog-catcher if you will. A bunch of biology courses 25 years ago somehow makes him more of an authority on any matter encompassed by “science” than the rest of us. Not surprisingly, a lot of people fall for this. It has been said that Nathan’s of NY hot dog fame got its first leg up by hiring earnest looking young men wearing white lab jackets to hang around eating at their stand. It created the impression that if doctors ate there, it must be good for you. The bull case here, if you will, is that spurious “science” might lose some of its ability to bamboozle, that it will become harder for charlatans to extract money, political power or influence by invoking the priest caste that so much of the “scientific community” has become. 

I think we can expect this scandal to slow the advance of Green Tech and forestall some of its more damaging aspects, but there are good reasons to expect the body politic to proceed with some kind of Energy bill. The need for some kind of driver of economic growth will trump the shoddiness of the science. Recovery from a recession requires some kind of economic locomotive. Last time it was housing, the time before that, the emergence of the Internet economy. Neither of these look powerful enough to move the needle on 10% unemployment. A re-tooling of energy production and distribution, worldwide, certainly has that potential. Just because the issue of what the energy sector will look like in the future has been co-opted by jackasses does not mean that there are not bona fide investments to be made in safer, cleaner more efficient power. For example, the US seems to be dragging its feet while the rest of the world, down to the likes of Viet Nam and Bulgaria, are jumping on the nuclear power band wagon. Opponents have been reduced to making insinuations about “cost”, but considering our lack of focus here for the last 35 years, what do we know about what the actual costs might be? It is specious to say that its too expensive because we haven’t really treated it with the kind of priority that in the past have  yielded surprisingly good results. It is an engineering problem, the kind Americans are unusually good at. Make it a priority like the Space Race, and we just might surprise ourselves with just how cost effective a solution our engineers come up with.  

There are also ways that our electrical grid can be made a lot smarter, at least if politics can be kept at bay. There are certainly more places where siting wind turbines makes sense, though probably not as many as the industry’s advocates would have us believe. Likewise, if there really is a path forward for solar cell efficiency akin to what was done with previous nano-structures like microprocessors and LCDs (I suspect we will eventually find out why Moore’s Law is less applicable here than purported, but am willing to go along until more evidence is in.) moderate subsidies might prove to be a good policy investment. All this would be easier to implement if AGW was a credible, palpable threat its perpetrators have labored to trump it up to, but less so now that the credibility of Big Science has gone up in smoke. Expect a lot of Wizard-of-Oz-like “pay no attention to that man behind the curtain” from the political class and their enablers, a greatly diminished likelihood of severe damage-by-legislation, but also a continuation of investment that improves the lives of millions, though perhaps with not quite the financial returns that a few friends-of-Al have been dreaming about. In the mean time, I’ve got to go and put another log on the fire.