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Investor Resources Inc, Investment Advisory Service, Port Orchard, WA

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2011Apr18 Recovery - But Still Feeling Sick

2011Apr18 Recovery - But Still Feeling Sick

 "My best guess is that we'll have continued recovery, but it won't feel terrific. Even though technically we'll be in recover and the economy will be growing, unemployment will still be high for awhile and that means that a lot of people will be under financial stress." - Benjamin Bernanke, Chairman of the Federal Reserve in a Q&A at the Woodrow Wilson International Center for Scholars.

ECONOMY:

Worry seems to be an easy response for homo sapiens. No less so for the respondents to Morgan Stanley's monthly Business Consumer survey. Fears persist for the economy with concerns about the impact of Japan's disasters and the Mid-East uprisings.
 
While sentiment declined somewhat in recent weeks, core data was little changed from March. The conflict between the sentiment and the data is similar to last spring when we were facing the European debt crisis and the Gulf oil rig disaster. Underlying data proved to be a better indicator of what the year would eventually become. Morgan Stanley remains upbeat about the market's direction for 2011.
 
Having published different data, Goldman Sachs has reached a similar conclusion. Their analysts' forecast of earnings for the S&P-500 rises from the current $84 to $96 by year end which is higher than the peaks of 2000 and 2007. Higher earnings push their S&P forecast to 1500 commensurate with the two prior peaks. They do caution for disruption due to oil prices and more Mid-East unrest.

Our pricing data continues to support a long-term bullish trend subject to volatility in the short-term.

STRATEGY:
Carl Richards from the brilliant BehaviorGap.com has an apt illustration of a common, and disappointing, occurrence for many investors. It's kind of funny because it's true, but the disillusionment can turn a lot of people off to the markets:  

 

The outcome is unpleasant and the outcome is what most investors focus on. But focusing on the outcome masks two common problems that investors don't realize they have.
 
1) Despite the implication of the cool graphic, the cause of the investment problem is not buying what is hot. The actual problem is the lack of an appropriate investment process-what to do when the asset is no longer hot, for example.
 
2) The second common confusion centers around holding an asset with current lousy performance and holding a strategy with current lousy performance. Those two things are worlds apart.
Because many investors do not distinguish between these problems, they wind up avoiding situations and strategies that could be quite profitable, if only they knew how to handle them correctly. In effect, they end up like the cat in Mark Twain's parable:
 
The cat, having sat upon a hot stove lid, will not sit upon a hot stove lid again. But he won't sit upon a cold stove lid, either.
 
Learning from mistakes is important, no doubt about it. But if you learn the wrong thing from that mistake, you'll make that same mistake again-because you won't recognize it as the same mistake. It's the difference between having 25 years of experience or one year of experience 25 times.
 
Investment process is much, much more important than most investors realize. If you look primarily at past performance, you're just seeing what happened. The important thing is to dig in to the investment process to understand why it happened. Was it luck or was there a consistent process at work? Can the success be replicated, or was it dependent on the current (and perhaps unusual) market environment. Is the investment process designed to get maximum benefit from a given return factor?
 
There's also a world of difference between an asset and a strategy. Let's say you have found a successful investment strategy and that you understand how it works. If you look back at how it has performed historically, you will notice that it will perform better in some environments than others. All strategies will go through periods of outperformance and underperformance. For example, sometimes value managers do very well against the market; their performance can be miserable at other times. Yet regardless of their current performance, they are still buying stocks that rank highly on their value metric. They are engaged in the exact same process year-in and year-out. It's only their end results that vary from period to period. Understanding the difference is critical.
 
If you can learn to focus on process rather than current results, and can differentiate between an asset and a strategy, you are likely to have an enormous improvement in your investment results.
 
GURUS:
 
"There are many methods for predicting the future. For example, you can read horoscopes, tea leaves, tarot cards, or crystal balls. Collectively, these methods are known as "nutty methods."Or you can put well-researched facts into sophisticated computer models, more commonly referred to as "a complete waste of time." ~ Scott Adams (American Cartoonist)
 
In Future Babble, Dan Gardner acknowledges his debt to political scientist Phililp Tetlock, who set up a 20-year experiment in which he enrolled nearly 300 experts in politics. Tetlock then solicited thousands of predictions about the fates of scores of countries and later checked how well they did. Not so well. Tetlock concluded that most of his experts would have been beaten by "a dart-throwing chimpanzee." Tetlock found that the experts wearing rose-tinted glasses "assigned probabilities of 65 percent to rosy scenarios that materialized only 15 percent of the time." Doomsters did even worse: "They assigned probabilities of 70 percent to bleak scenarios that materialized only 12 percent of the time."
 
Why, then, do people even listen?
 
"Whether sunny or bleak, convictions about the future satisfy the hunger for certainty," writes Gardner. "We want to believe. And so we do."
 
It's fine, I suppose, if you listen to forecasts for entertainment. But knowing the track record of forecasters, why in the heck would you ever base your investment policy on a forecast? I'm not talking about just extreme forecasts like the rosy scenario or gloom-and-doom. A pie chart that allocates assets based on a forecast of expected returns and expected correlations is no less a forecast-and no more likely to be accurate.
 
Just because we hunger for certainty doesn't mean it is available. The only thing I can forecast with any certainty is that things will continue to change in unpredictable ways. Price represents a market's best guess about what might happen down the road, rightly or wrongly. Price is an informed guess; people are putting real money on the line. Research shows that prediction markets are often more accurate than experts. Relative strength is just a handy way to measure price and gauge what market participants are doing.
 
Staying with strong relative strength trends and departing when they weaken is the simplest way to stay in synch with the changing flow of information in the market.