“I can predict the movement of heavenly bodies, but not the madness of crowds.”
Sir Isaac Newton, after losing £20,000 ($3-million in current value) investing in shares of the South Sea Trading Company.
“Money, again, has often been a cause of the delusion of the multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper.”
Charles Mckay, Extraordinary Popular Delusions and the Madness of Crowds (1847)
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August is supposed to be a quiet, relaxing month where everyone is on vacation and you can’t get service anywhere. The etymology of August is “great” or “magnificent,” but clearly someone forgot to tell the markets to remain calm and perform well in the middle of summer.
In many ways, what we are experiencing is, as they say, a bit of history repeating. Before we go on to explain how we’ve seen this before and how our investment philosophy has been specifically designed to protect client portfolios in environments such as this, let’s examine what’s happening to the markets.
Technically, one can argue we are in a bear market for almost all equity markets across the globe (a drop of 20% or more from the last high point). Yet it is a market full of contradictions:
- U.S. politicians put together a very lame budget compromise and agreed to raise the debt ceiling. S&P, in its wisdom, viewed this weak effort for what it was and reduced the credit rating of the U.S. to AA+ (less than France, England and Canada to name but a few). Almost immediately, the world reacted by buying as much U.S. Treasury Bonds as they could find, at one point driving the yield down to just over 2% (perhaps they believed S&P’s due diligence was the same as it was back in 2007 when they rated dozens of tranches of sub-prime mortgage bond packages as AAA).
- Market volatility exploded and the bear market that slowly started back in May continued. This is occurring as major companies globally are making record profits and have huge amounts of excess cash (well over $1-trillion for U.S. Non-Financials alone). As one writer noted, Apple has more cash ($75-billion) than the U.S. government (however my Aunt Midge has more than the U.S. government as well).
- Dividend yields on the S&P 500 are now the same or slightly higher than 10-year bonds. The last time this occurred was at the market bottom in March 2009, and before that in the late 1950’s. Yet investors seek the comfort of guaranteed bonds that have no inflation protection and no chance of higher income distributions for ten years.
A couple of weeks ago we wrote about how bond markets would eventually force governments to take disciplined approaches to their fiscal situation. This week France is feeling their wrath, and eventually the U.S. will as well unless Congress comes up with credible solutions for reducing both debts and deficits.
The market challenge of course is that government and consumer deleveraging is likely to be deflationary even in the face of very loose monetary policy. Interest rates will remain low for longer than we might imagine (subject only to the bond vigilantes disciplining profligate governments from time to time).
As investors, that leaves us to search for yield without incurring unreasonable risk. Before we consider those investments that provide good income, let’s revisit one of the themes we have been writing about for more than ten years now. In February of 2000 (about three weeks before the NASDAQ peaked at just over 5000), we wrote a newsletter entitled “The Madness of Crowds” describing the folly of “market timers” jumping from one technology stock to another, while the value investor appeared destined to be left behind.
Two months later, after the Dot Com Bubble burst, we followed up with another letter to clients and had this to say:
“It is the day after the largest single-day drop that North American markets have ever experienced (although it is nowhere near as large in percentage terms as 1929 and 1987).
On February 17th of this year we sent a letter to all of our clients called The Madness of Crowds, expressing our real concerns with the bubble-like state of technology stocks. The NASDAQ index had reached a record 4400(on its way to its ultimate peak of 5138 on March 10th). Meanwhile, value investors were being left behind as if they were yesterday’s forgotten man.
Where are these markets today and, more importantly, how have some of the major funds and other investments that you own fared during this turbulence?
Lastly, what should one do now?”
In that letter, we compared client investments to the state of the market (our portfolios did quite well) and it was our way of reemphasizing that value investing, diversification and owning assets that generate cash flow dramatically reduces volatility and provides sufficient resources to take advantage of assets with distressed prices.
That brings us to today and a similar comparison. The table below shows Nicola Wealth Management’s estimated client year-to-date return in 2011 versus various world equity indices as of August 12th, 2011:
* average based on client portfolios above $1-million
To reiterate a point from earlier, since the peak of this latest bull market, most of these indices have dropped more than 20%.
At this stage, it is critical to remember a fascinating statistic: we have been in a long-term secular bear market since 2000. While we have seen significant cyclical bull markets since 2000, most indices are at the same or lower price levels than their peaks over 11 years ago. Without dividends (and in our case, cash flow from covered writing of “calls” and “puts”), there has been very little, if any financial gain from stocks.
If you consider that since 2000 most prices are the same or lower, there is an even stronger case for cash flow and extensive diversification since our average client return over that span has been just under 7%.
This secular bear market environment could easily last another 4-6 years, especially given the need for long-term government and personal deleveraging in developed countries.
The two graphs below illustrate well how long these cycles can last and why it is so hard to make long-term capital gains from equities in this environment.
So let’s come back to our yield question: Where can one reliably generate cash flow in today’s tumultuous environment? Below are a few of our time-tested investment strategies:
- Buying companies with sustainable dividend yields well above the average of 2.2% for North American equities and enhancing those yields with the use of options such as “cash-covered puts” and “covered calls.”
- Selecting quality REITs (Real Estate Income Trusts) that generate stable cash flow with the associated tax advantages. Our NWM REIT Fund has a current yield of 6.5% and a YTD return of 9.5% and – this Fund has weathered this storm very well.
- We also feel strongly about direct ownership of hard asset real estate through our real estate LPs, SPIRE and SPIRE US; both distribute cash flow (7.7% and 5% respectively) and both have a strong ability to provide long-term inflation protection.
- There are several debt instruments such as high yield bonds, preferred shares, mortgages and prescribed annuities that provide significantly better yields than government bonds with reasonable additional risk. In the case of preferred shares and prescribed annuities, as much as 75% of the income received is tax free.
There is a lot being said in the media about the World’s fiscal shape and we understand that it is only natural to feel concern over your investments.
This short piece is meant as a friendly reminder that irrational or fearful markets are where investment opportunities are created. I am not at all sure that this “event” in its entirety is over, but our job is not to predict markets – it is to acquire good assets at attractive prices.
If we get that right, then returns will look after themselves.