Fed Phrenology

July 7, 2000

Dear Investor:

An economic slowdown is at hand. If you’re nine years old, this is the first such event you’ve ever witnessed; for the rest of us, it’s business as usual.

The economy does appear to be disengaging from nine years of solid expansion. Home sales have started to soften and unemployment has ticked up, establishing 3.9% as the bottom threshold. Anecdotally, there are further signs of slowdown. But anecdotes don’t make for good investment decisions. And there are some hard yet quirky figures that conversely point to continued strength: in May, factory orders rose 4.1%, the largest gain in almost eight years, showing increasing demand for many goods, including chemicals and electronics. This figure confounded many economists because similar orders had fallen 3.8% in April.

But the bottom line is that six Fed interest rate cuts do appear to be gaining traction. For all those who declared the Fed impotent, this is a wake-up call. Our opinion is that that the Fed has lost control in a traditional monetary sense, but that its actions now act more like psychotropic drugs, swinging investor mood from mania to depression and back again with good success. The Fed will persistently deny they try to target investor psychology. That may be true, but it is what they nevertheless accomplish.

The implications for investors are at once profound and uneventful. The slowdown in growth must be put in perspective. Domestic GDP is set to slow to something above 3%, hardly a recession (which technically would be defined as two consecutive quarters of GDP contraction). And worldwide GDP is set to exceed 3.5%. Again, more like a world in “drive” as opposed to overdrive–a far cry from reverse, or even neutral. Such moderated growth means that corporate earnings will not fall off a cliff, however much they might slow. Recent high-profile earnings warnings such as those from IBM and Unisys will continue to grab media headlines, but we would hear far more mea culpas if the economy were truly toast.

A slowdown does, however, mean a flat to sloppy stockmarket. As of the end of the second quarter, all major indices are negative year-to-date: the S&P 500 Index is down 0.4%, just holding onto a flat year. Meanwhile the Dow is down 9.1% and the Nasdaq off 2.5%. The only asset class in the black is bonds, which perform well in a slowing economy and are benefiting our conservative accounts.

A bear market, or even a flat market, will try the patience of many investors who are used to consistent gains. What is important to remember is that the stockmarket rarely goes straight up, and the only investors who are truly rewarded over the long-term are those who stay the course, acting as investors instead of gamblers. Despite the lip service paid to this idea, people are human: many throw in the towel when the excitement wanes. The Fed has successfully removed the positive stimulus of a parabolic stockmarket because they had to. If they hadn’t, markets and mania would have overheated the economy. In doing so, the Fed has altered the moods of many people, especially daytraders who have had their addiction yanked right out from under them. Many daytraders were wiped out clean in the Nasdaq collapse, but even the rest stopped describing their days as “fun.” This is a good thing for most investors who were being subjected to unhealthy price distortions by the lunatics running the asylum. But now that the doctors have regained control, the orgy is over.

Do not be dissuaded by this environment. Historically, many investors lose faith in an asset class once it passes out of favor. If the bear market worsens, you will see many articles proclaiming the “death of equities” like the famous Business Week cover in the seventies. Those who threw in the towel after reading that issue have been kicking themselves ever since. Most often, such supposed death knells are preludes to massive rallies.

Speaking of daytraders, let us take just a few out-of-place paragraphs to explain why investing is better than trading and why all traders are actually gamblers (this is a controversial statement, but one we are prepared to defend at anytime to anyone):

For one, traders must rely entirely in a belief on the trader’s own worth, whereas investors must rely somewhat on the investor’s own worth but more so on the underlying investment’s intrinsic worth. The first is psychologically appealing to many egomaniacs but dangerous. The first is exciting, the other boring. The first gambling, the other work. The first allows you to hang out with gangsters and molls amidst the garish casino glow, the other puts you on the phone with accountants under a green banker’s light. I think you can begin to see why most people prefer trading to investing and why casinos are more popular than classes in securities analysis.

Here is an analytical example of why investing is better than trading:

Let’s assume that Company X has Y net cash on its books and is selling at Y – 20. The Investor makes a realistic assumption that, in time, Company X will trade at Y. This is based on hard logic, not whim: if Company X does not trade at Y, someone will eventually (even if it takes years) acquire the company, publicly or privately, and realize the cash value.

In contrast, the Trader assumes that Company X will trade at some imaginary variable Z at some future hour, where Z is usually some multiple of Y. The trader arrives at Z by guessing what other traders will eventually also pay for X. But the trader sees no intrinsic value in Z. Rather Z is just a temporary marker. The success of the trader’s game is predicated on being able to sell X at Z at some point, which is in turn predicated on Sucker S paying Z for X and then passing off X at Z plus some imaginary number we’ll call Q.

The overwhelming advantage to the Investor’s strategy is that (as stated above) if no one comes along to buy X in the passive market and thus value X fairly at Y, then the private market (through an LBO, M&A or other transaction) will eventually deliver Y to the investor. And if that never happens, then company X could be liquidated at Y or at some small premium to Y. This is why value investing nearly always works over time. As Marty Whitman is fond of explaining, the investor does not have to rely on the public market for an exit strategy.

The overwhelming disadvantage to the Trader’s strategy is that if no one (i.e. Sucker S) comes along to buy X at Z, then X will fall in value (perhaps to Z minus 90%, like Dr. Koop.com) with no possibility of a private bailout at Z as described above.

But there is a disadvantage to the Investor’s strategy. It’s slow and boring. And thus requires that most precious of all commodities: patience.

It is our contention that trading is only good for:

1. Traditional brokers who make money on transactions, not results (this is why it’s so deeply ingrained in market culture).

2. Gamblers who must satisfy a psychological need.

3. Those who believe they can always predict Sucker S’s psychology and thus always know when Sucker S will pay Z for X—a difficult and dangerous pursuit. We have never come across someone so smart that they could do this consistently. George Soros was probably the most successful member of this group, but even his star has now fallen.

To appreciate how difficult #3 is to accomplish, examine the classic probability question: if a roulette wheel lands on red six times in a row, what is the likelihood that next time it will land on black? If you understand this quandary and its psychological temptations, you understand why investors have long careers, while traders come and go.