The Independent Market Observer

5/5/14 – Uncertainty and Investing

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 5, 2014 1:00:00 PM

and tagged Commentary, Politics and the Economy

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This will be a short post, as I arrived home at 7:30 this morning after flying and laying over for the past 18 hours or so, so I am a little tired. That said, it was all worthwhile when Jackson came running out of the house to hug me as I pulled up in a cab, then tried to drag my bag—which weighed more than he does—into the house. We did it together—teamwork!

Back to the post. As I watched the news this morning and reflected on some of my conversations at the Presidents Club conference, I realize that there are a few points well worth sharing.

Fred DeBaets, our fixed income portfolio manager, sent out an e-mail this morning noting that the 10-year Treasury was at 2.56 percent, the lowest point since last November, and dropped out of the typical trading range for the first time since January. This means that—despite the almost universal expectation for rates to rise this year—they have, in fact, have fallen.

The year is not yet over, of course, but here we are in May and the general expectations are not playing out. Expectations were wrong, and anyone who bet heavily on them is now losing money. Does this mean we should now change those bets?

This question—which deals directly with expectations and how we invest around them—plays into discussions I had with advisors over the past week. I was asked about how I changed my views over time, why, and what that meant for my investing recommendations. I think this is a very fair and interesting question, as it includes where I was right, where I was wrong, and what I learned from both of those cases.

Let’s deal with what I got right first, since what I got wrong is more interesting. I was right about the economy and markets in 2007, as I was very bearish. I have been right for the past couple of years about the economy, and I was much quicker than most in calling the recovery.

Where I went wrong was in staying bearish on the equity markets for too long. Exactly how I was wrong, and why, though, is an interesting discussion on its own.

The simplest version is that I should have said, “Don’t fight the Fed,” prior to 2012 and 2013, and there is quite a bit of truth to this. When the Fed decides to pump money in, get out of the way. Quite frankly, this is a lesson learned.

2013, though, was not just about the Fed. No one—and I mean no one—saw the 2013 stock market melt-up coming. Expectations were for a pretty normal, 8 percent to 10 percent year. Instead, of course, we got a 30-plus-percent year, due largely to multiple expansion rather than earnings growth, even as profit margins continued to increase to record levels.

This is a harder event to learn from. Had we experienced a 10-percent year, rather than a 30-plus-percent year, current discussions with advisors, clients, and investors would be very different than they are right now. One exceptional year made a minor mistake into what could be perceived as a major one, as 2013 has changed the equation for many people. On a longer-term basis, though, was the decision to emphasize caution, rather than upside, wrong?

I don’t believe so. One lesson I did take away from 2013 is that, while fundamentals tell you where you are going, technicals can help tell you when you are leaving. Had l paid more attention to technical factors in 2012 and 2013, I would have been more constructive on the market earlier. The other lesson I take from this is that, while I had a plan to get out in 2007, I did not have a plan to get back in. While this defensive tactic made sense, and was certainly defensible, I could and should have been more open to the actual action of the market.

I have, I hope, learned these and other lessons in the past several years. My current research and personal investments take all of these lessons and factors into account. I believe I am better because of this and believe that our advisors benefit as well. Now, I am busily trying to figure out what new mistakes I will make in the next cycle, so I can avoid them. An impossible task, but necessary.

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