July 3, 2014

Dear Investor:

The Dow is at new highs near 17,000. It’s hard to imagine that the Dow was at 6,500 only five years ago. Lest anyone think this type of rally after collapse is atypical, it helps to recall that the Dow rallied from 41 to 194 (a virtual quintupling) from 1932 to 1937–the five year period that followed the Great Crash.

History should give anyone pause as they consider what happens next. We’ve gone without a large correction for over two years. That’s as rare as the endangered green sea turtle. A downturn will come eventually. What will cause it? Nobody knows. By definition, a big fall in markets is caused by something that’s not yet even a blip on the radar screen. If it were now visible, it would already be priced into the market.

The most common comment I get is: “If you think a market correction is coming, why don’t you just get out of stocks?”

It’s a reasonable question with a sometimes hard-to-swallow answer: I know that one will come. It always does. But we don’t know when.

This is not a flip response. A year ago I would have guessed a correction was imminent, but I didn’t act on my mere guess. Thankfully, because the market is up approximately 30% since then. Even when the market is flat, it returns a 2% dividend yield, so the potential opportunity cost of being out of markets can be huge or small, but never nothing. That’s why timing the market is mere speculation, not investing.

Many people will try to predict the when. If they were being honest, they would tell the bitter truth: the answer cannot be foretold. Predicting the market’s next move is no more scientific, logical or professional than playing roulette and betting red. If the wheel lands on red, we call the gambler lucky. If the market collapses just after someone “predicts” it, we call them a genius—forgetting that they’ve likely been predicting it every month for the past few years. Even a broken clock is right twice a day, as they say.

People often have hunches the market will go this way or that. I have them too, but I won’t invest your money (or my own) based on hunches, yours or mine. In any other profession, the idea of using hunches in place of proven analytics would be laughable. Imagine the surgeon who removed your left kidney on the hunch it was diseased. Or the pilot who took off on a hunch the plane had enough fuel.

Hunches are no substitute for analysis. Unfortunately, no aspect of market timing is analytical. That’s why it’s so treacherous. No great investor that I’m aware of has made their fortune by timing markets (unless it was on the fees they charged for this so-called advice). Of course, just like the roulette wheel, you will always hear of someone making a big bet on market direction and winning. But sustainability’s the key. Ask them to repeat their success this year or next and see what happens.

Instead, the only way to make investment decisions is based on value: assessing whether the underlying assets are expensive or cheap relative to their cash flows—and resigning yourself to the temporary but unfortunate vagaries of market declines. Stocks are still priced low enough to be more attractive than bonds or cash. With free cash flow yields exceeding 6%, it’s unlikely that bonds will beat stocks over the coming five years, even if a brutal correction takes place sometime in the meantime.

My strategy will always be the same: to swap out of what’s overvalued into what’s cheap. That has meant moving some client money out of cash, bonds, consumer staples, tech and/or domestic stocks and into emerging markets, steel, and Japanese equities—all areas I would still describe as deeply undervalued. If there’s a correction of sufficient magnitude (5%-10%), I will move more cash into those sectors. We always keep some cash position just so we can take advantage of downturns. So we are positioned to take advantage of bad market declines, with the percentage of cash on hand depending on the particular risk profile and investment plan of the portfolio.

When the correction does come—whether tomorrow or next year—we’ll be able to take advantage of it, even as we suffer through it, and even though we can’t predict it.