The Natural Disaster “Playbook”

Last week I found myself discussing the Natural Disaster Playbook with several clients. This “playbook” is followed by institutional investors with little variation and is employed during unexpected or exogenous events like earthquakes, floods, tsunamis, pandemics, etc. It is also often used for non-natural disasters such as terrorist attacks, assassinations, and any other event that is unexpected and not already discounted by the market. The playbook goes like this: When a natural disaster occurs the reaction of the general public is fear and panic. In such a situation the media is often an enabler of emotional reactions to the event as video is played throughout the 24 hour news cycle. “Experts” are interviewed with dire predictions. In such situations, markets attempt to instantly discount the impact of the tragedy and inevitably panic selling ensues. By definition, the selling overshoots the true fundamental impact of the event creating a buying opportunity for steely-eyed institutional dip buyers. As the smoke clears and the panic subside, it becomes clear that the world isn’t coming to an end and although the event is tragic, in almost every case the global economy continues with little pause. In fact, the odds are that subsequent government spending to recover from the disaster causes GDP to grow faster in the future. Does anyone remember the anthrax scare? How about bird flu, swine flue, and hoof and mouth disease? They all are covered in the playbook.

Buying when there is “blood in the streets” is a proven and time honored method of making money. Institutional investors who buy into disasters are considered to be expert value investors who rise above the panic of the crowd in order to do what they are paid to do, which is to exhibit the counterintuitive behavior of buying when everyone else is selling. The “playbook” includes the unwritten rule that buying a disaster is a low risk strategy from the perspective that clients understand that they wouldn’t do it, so even if it turns out that buying the dip was “wrong,” there is little career risk associated with the strategy as long as it is done in moderation.

There is one hitch to following the playbook, which is the notion of a “black swan” event. These events, by definition, happen very rarely, can’t be discounted in advance by the market, and actually do have dire consequences for investors. Because by definition these events are extremely unlikely to happen, it’s hard to know just what to do about them. The nuclear situation in Japan is a perfect example. The playbook says buy the tsunami and the earthquake, and I suppose we should buy the nuclear meltdown as well. However, if nuclear disasters don’t warrant just a little bit (heaven forbid…not panic) of extra concern, then what does? Until the reactors are under control, I will be in favor of cautiously applying the playbook in the context of unleveraged portfolios that are properly diversified and are positioned close to benchmark risk. Playbook or no playbook, sometimes it is wise to be patient.

A Bullish Contrarian Bonanza

Lately I’ve been considering that fact that “informed intuition” about investment markets, the very stuff we hope to warehouse in large quantities at Pinnacle, can be tainted by any one analyst’s appetite for risk. We train ourselves to see bullish and bearish investment opportunities when they appear, and with training our goal is to see the world differently from the consensus. As someone who is not a big personal risk taker, I have to go out of my way to not let my personal predisposition to avoid risk color my ability to see bullish opportunities in the risk markets when they appear. And since one of the most tried and true methods of identifying risk taking opportunities is to be a contrarian and recognize that investment opportunity is often born of despair, I’m wondering if this isn’t the most bullish investment opportunity of all time. It looks pretty dark out there to me.

For example: We don’t manufacture things in the U.S. anymore. The profits remain here for large corporations but the jobs go overseas. Does anyone believe that we are better off? We have deficits everywhere, from fiscal deficits to trade deficits and now the Federal Reserve is running a “print up some dollars and buy all kinds of stuff” deficit of their own. It seems obvious to me that we can’t afford the social contracts that we’ve made in terms of pensions, social security, and health care, but no one has the courage or political will to do anything about it. I suppose we can blame our politicians but we really have the political system that we deserve. Most Americans don’t vote, and many of those that do are frighteningly uninformed about difficult and nuanced issues that defy “sound bite” explanations suitable for the evening news. Nowadays we pay attention to some kid writing a blog at 3PM at his parent’s house where he lives because he can’t get a job. We have 10% unemployment where the percentage of Americans who want to work but who can’t find jobs is frightening. Corporate earnings are up on the back of cost cutting (meaning layoffs) and government stimulus plans that we can’t afford. It appears that we are throwing the dice that all of these programs designed to thwart the next Great Depression by manufacturing either asset inflation or price inflation will work out well. Everyone knows we are on a high risk path for curing our national malaise but we all seem to be shouting at each other at such a volume that if there is a reasonable solution to be had, we just can’t seem to hear it.

We have a national foreclosure problem that is a disgrace and could lead to hundreds of billions of bank write-offs as well as another 10-20% decline in real estate prices. At the moment there ain’t no one interested in insuring titles to homes anymore because with the originate and distribute model for mortgages no one knows who actually owns the note on your home. The dollar is falling on the back of our unofficial national economic policy of debasing the currency, and “beggar thy neighbor” fiscal and monetary policies are breaking out around the globe. They say that every generation in U.S. history had a better standard of living than the one that preceded it, and every parent along the way worried that their kids wouldn’t do as well as they did. Well, I’m wondering about my kids and their kids. I’m afraid we are messing this up so bad that they won’t be able to continue the streak. So….the obvious conclusion is to back up the truck and buy stocks. If you are a contrarian, it’s hard to see how it can get much better (or worse) than this.

Double Dip Fears

I saw this chart a few weeks ago, although I cannot remember where, and brushed it aside. But I felt compelled to recreate it today after sifting through some sentiment indicators. Sentiment Indicators are used in technical analysis to gauge investor attitudes toward the market. They allow a market observer to quantify the level of optimism or pessimism in the market. The chart below is not a typical sentiment indicator; however, I think it accurately conveys the level of pessimism that is present in most retail investors today.

The chart is called a Google Insight, which is basically their label for searching searches. You can type in any word or phrase you want to see how many times it’s been searched using Google. In this case, I put in the phrase “Double Dip Recession.” You can see on the chart that the popularity of that search has skyrocketed over the last month, and in fact, it was the most searched phrase by the end of June. (To read the numbers, you divide the searches for your word by the searches for the most searched word. That percent is then graphed.)

The fear in the market was extremely high at the end of June based on these results. “Double dip recession” was used repeatedly by pundits in the financial media, and even we used it on a recent conference call with clients. And when the public ran with this fear, it proved to be a good opportunity to purchase stocks. The near term bottom in the stock market was July 1st, and since then the market has gained roughly 10%. This is a great example of how contrarian investing works.

Contrarian Thinking

“Nevertheless, clearly there have been periods when the crowd and the consensus is right, particularly in extended bull markets, contrary opinion seems to be of greatest value at market extremes (lows and peaks).” - Steve Leuthold, View from the North Country, November 2009

Steve Leuthold is one of our favorite analysts and we also happen to own his fund, the Leuthold Core Investment Fund, in many of our managed accounts. I believe that his views on the consensus are right on the button. Value investors are always looking to invest differently from the consensus, but sometimes doing so results in missing out on large investment gains easily available through momentum investing, the very definition of investing with the consensus. I thought it would be an interesting exercise to list out a few of the consensus views of today’s investors:

• The economy moved from recession to expansion sometime in June or July.

• The dollar is in a secular (long-term) downtrend.

• Economic growth in the developed world will be subject to “the new normal,” meaning that it will be significantly lower than the historical averages for some time to come.

• Economic growth will be led by emerging markets, especially China, as opposed to developed countries like the U.S. and Japan, England, or the Euro zone.

• U.S. consumers will spend less and save more as they repair their personal balance sheets over a period of years.

• The Federal Reserve will not raise interest rates for the foreseeable future.

Because these are consensus views, investors have presumably priced them into today’s security prices. We happen to subscribe to the consensus view at the moment, but we are also on the lookout for those opportunities that occur when the consensus is wrong. As Leuthold says, contrary opinions have the greatest value at market extremes, but I don’t think we are there quite yet. Even so, we are currently hedging the consensus view with a variety of securities in the portfolio. The hedges won’t make us money while the consensus reigns, but they are essential ingredients of sound risk management when markets are trending as they are today.

Are Contrarian Signals Flashing?

Behavioral studies in finance are a fascinating subject that attempt to prove how irrational we as humans can be, and how those traits carry over to the world of investing. At Pinnacle we try to use this valuable information to be contrarian investors at times. A contrarian by definition is a person who invests contrary, or opposite, to popular opinion when crowd behavior moves market prices to extremes, either too high or too low. As investors stampede into or out of different “hot” investments, the market often catches the masses off guard by making sudden, violent moves in the opposite direction (Tech stocks in 2000 are the most glaring example). This week, we have picked up on a few signals that have raised our contrary antenna.

Barron’s Magazine is a respectable journal in the finance community, but nevertheless they are still a part of the media and are subject to over exuberance at times. On October 12th, the magazine ran a story about the salvation of Bill Miller, the famous mutual fund manager who struggled mightily the past few years, titled “It’s Miller Time.” The article explains that the Legg Mason Value Trust Fund managed by Mr. Miller is “up a whopping 37.52% so far this year, putting it in the fifth percentile of all large blended-fund returns.” First, congratulations to him on the big rebound, but come on, “It’s Miller Time?” His fund cratered by -72% from the top of the market in October 2007 to the bottom in March, which was much worse than the S&P 500’s frightening -55% plunge. That means his fund is still down 45% from the market top! If that’s “Miller Time,” then I’ll be reaching for the Silver Bullet.

We switched TV stations in our office from CNBC (disparagingly referred to as “Bubblevision” by some critics) to Bloomberg, coincidently right at the March lows. However, yesterday even Bloomberg surprisingly paraded the Dow 10,000 hats normally reserved for Bubblevision. We hear the argument that 10,000 is a very important psychological level, but more and more people seem to be partying like it’s 1999. CNN has an article this morning titled “Stocks look beyond Dow 10,000.” With bullish excitement building, it would not be surprising to see a short-term market peak sometime soon. And then it will be time to see if the fundamentals justify this run, or if it is time to become a contrarian and head for the exits in the face of the rapidly growing enthusiasm.