ELF
Capital Management, LLC
(Endowment
Like Fund Management)
November
1, 2008
This is the ELF Capital Management,
LLC Market Letter for the month ended October 2008. If you do not wish to be included in our
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Testing the Small Investor Theory
Not only
was October a gut wrenching month in the markets, it was also a very
interesting study case for financial theory.
The most notable of which, being the Small Investor Theory. After a month when almost every class of
investment, except for government bonds, drops quite dramatically to new lows
and trades like distressed securities, this topic needs to be dusted off and
looked at anew. October seemed to
precipitate from an overwhelming expectation that the sky was falling. For some, it may have felt that way; and for
others, there existed only the fear that the sky might fall. I’m sure the next generation will learn much
from it and, yet, I suspect that many important observations may never make it
into the history books.
As the theory goes, a “small investor” buys – purchases
investment assets – when prices are high and sells when prices are low. This was generally thought to be a result of
“small investor” being more likely to follow the crowd rather than follow a
disciplined approach. They invest when
they hear of the successful experiences of friends and neighbors – usually
after a significant run up in the market – and sell when they hear that market
prices are falling. This is the
parenthetical opposite of what investors need do to create wealth – to do so,
one should buy low and sell high.
From the
dynamics of this month, I think we saw the small investor theory undergoing
great testing and few seemed to be excluded from it. This time, both professionals and novices couldn’t
keep themselves from the small investor mentality. Only history will tell. And optimists like
myself, need realize that we are more than likely experiencing a time that is
both extreme and short-lived. At the
same time, I am also aware that the market can remain irrational longer than
one can remain solvent. However, most of
the invested money I oversee, including my own family’s, is either long term
retirement money or taxable accounts that represent long term money. Most of these accounts are approximately a
third in cash and none are borrowing
on margin. So, there is a high
probability all can remain solvent.
How Bad Did It Get in October?
As far as October’s
market return numbers reveal, we experienced a market capitulation. Investopedia.com describes a market
capitulation as: “the point in time when investors have decided to give up on
trying to recapture lost gains as a result of falling stock prices… Many market
professionals consider it to be a sign of a bottom in prices and consequently a
good time to buy stocks.”
Why do
people capitulate? Fear. From recent events, what seems to bring the
most fear causing “small investors” to capitulate? Job losses and rising unemployment concerns. That’s perhaps how the “Small Investor
Theory” came to be. Some “Small
Investors” may feel that they need their savings to help them through the
potential of experiencing a job loss, while seeing their investments go down in
value. On the other hand, those who feel
more secure with their financial situation can keep a long-term prospective on
their invested assets and see opportunity when the “small investor” reacts with
a capitulation.
To give you
an idea why I think we saw a capitulation, the following reflects some of the
market lows that we saw in October:
The Dow
Jones Industrial Average fell 25.5% during the month; the S&P500 fell
27.9%; Russell 2000 fell 35%; using EAFE (non-US developed country stocks) fell
33.4% and the emerging markets index fell 39.7%. These are for October; and not the lows for
the year! Yet, on a positive note, crude
oil also fell to 39.6% low during the month.
If these
numbers don’t reflect capitulation, I don’t know what does. And, in my mind, a capitulation is a validation
of the Small Investor Theory. Yet, if
this theory was generally thought to be a result of “small investor” being
more likely to follow the crowd rather than follow a disciplined approach, now
we can add the concept of selling due to job loss fears to that list.
How did the
capitulation manifest itself in October?
Well, if you believe the media, the selling stemmed from mutual fund and
hedge fund selling to meet redemption requests.
Yes, even though hedge fund investors are supposed to be sophisticated,
high net worth persons not among the mental image of the typical “small
investor’, it is apparently hard for these people to not follow the crowd as
well. When fear is rampant, it is very
hard to be a contrarian.
Is History a Reliable Guide?
You know,
following long standing theories is usually profitable. It has also proved worthwhile to look back
over the statistics of history to give us guidance on how to invest in the
markets. These methods have good records
of success over long periods of time. However
when the market has dealt a big loss, as we have seen this year, seemingly
sound theories and analytical work can fall on deaf ears. This is because emotions cloud rational or disciplined
thought and play a more dominant role in the behavioral side of investing. When emotions take over, even the hardest
working professional can appear to be wrong – especially when investor behavior
is driven by fear and uncertainty. Nevertheless,
history can give us some clues as to how highly emotional investor behavior
finally plays out also. In fact, in
every major downturn, history has shown to repeat itself in one way or another. And, the nuances can be described in terms of
how the government responds.
In this
downturn, the government is throwing a great deal of stimulus at the problem;
much more so than in any instance since 1929.
It will take a little time for this stimulus to work through the system,
and I suspect that it may create much more impact than we need. If this belief proves accurate, the economy
should be humming before a year passes.
Then, they will need to figure out how to slow things down again. This is what history tells me.
More
notable observations came from the NYSE floor traders – courtesy of CNBC
coverage. Hasn’t everybody been watching
CNBC these days? When the market was
going down, trading volumes were fairly light; and when US markets staged their
biggest one-day rally on October 28th, the volume was light
again. For me, the floor trader comments
were valuable as they represented spontaneous reactions to what was happening
at the time; as opposed to the various speculative and self serving opinions we
have been hearing lately. The comments
reflected that while the markets were selling off, very few investors were willing
to step up and buy; and, when the market staged its huge rally, days before the
end of the month, few investors were willing to sell into it. This leads me to believe that emotions are
guiding the markets more than anything else right now. And that the stocks are downright cheap as a
result. I also believe we have overshot
the downside and the market is offering us opportunity. Yes, I know it is very easy to doubt my
reaction given all of the events we’ve experienced since last October.
Add to
this, that in looking over historical stock market charts since the 1929 crash,
and considering the economic factors we are facing now, these charts suggest
that prices have reached an extreme and that the trend is setting up to change. This is supported by how the October 28th
stock market rally played out. At the
same time we have tested market lows for a third time and while we penetrated
the prior two lows, this one came with my sense of capitulation having finally
occurred. In studying these historic
charts, the only time prices went dramatically lower afterwards, was subsequent
to the 1929 crash. At that time, factors
that drove the markets and the economy lower were significantly different than
now. Specifically, the
If you believe, as I do, that this capitulation downturn is
ebbing, this is a time for opportunity.
Why I
think it is Time to Become Greedy
I’ve said this
before and generally receive criticism for it by my colleagues in the
investment industry: markets are always
driven solely by supply and demand dynamics.
At the end of the day market prices go up because there are more buyers
than sellers and prices go down when there are more sellers than buyers. Everything else is just a reason why buyers
or sellers, as the case may be, should react in a certain way.
Those in
the investment management business who make their living from short-term
trading strategies tend to study the momentum of investor behavior; and those
who make their living from pursuing longer term investment strategies spend
their energies studying why investors should behave in a certain fashion. My style falls in the latter category as, over
time, longer term investment themes have proven more reliable. Yet, there are a few trading firms that are
very good at beating the odds and ply their strategy with great success. And, something can be learned from
considering behavioral momentum and when that behavior might be overdone.
In the
words of Warren Buffet: “Be fearful when others are greedy and greedy when
others are fearful”.
First, we
were frightened by the sub-prime crisis; then, we were frightened by that
crisis causing a broader financial crisis; then, we were frightened because oil
prices went to almost $150 per barrel; then, we were frightened by the
financial crisis momentum causing real damage.
Now, we are being frightened by potential job losses exacerbated by
seeing a stock market capitulation; all this while the
With fear
growing more intensely from summer though October, many have reacted by
capitulating and others are perhaps exhausted by the fear and are looking
towards the future. High levels of fear
just do not seem to be sustainable and at some point, optimism will kick
in. From my past conversations with
clients and acquaintances, most people are already turning there focus more
optimistically towards the future.
Playing the odds, optimists are not only more fun, but they are the
people that take the appropriate risks that make them more successful. In fact, the optimism I have been seeing in
others has helped me through penning this letter. And, I’m now sharing that optimism with my
gentle readers.
As I’m
starting to see more positive pricing action in the stock markets, I’m sensing
that we should be turning the corner.
That’s not to say, that I don’t still see selling come into the markets
in the last 5 minutes of the trading day.
However, early buyers seem to be coming back into the markets. This may not be a “maven” buying signal, but
my young sons can to me this month and asked to be able to cash in their
savings bonds that we have been holding for them since their births. When asked why, they commented that their friends
have been discussing that the stock market is very low and they wanted to
invest in stocks. We did it for them.
No one
knows how long it will take for the markets and economy to recover, but I
certainly believe we are near bottom and believe that we will begin to see the
market creep upwards from here. We have
seen the most volatile prices that I can remember in my lifetime and those
swings have lost their newness for most investors. So, I can’t guaranty that we’ve seen the last
of volatility. In fact, I expect continued
volatility until things become clearer that we’re headed towards greater
prosperity. By that time, the market
will have already reacted upwards. I’m
remembering the October 28th rally and when the sellers didn’t want
to play, the market rapidly rose 10% that day on light volume. Does that give you any hint about how fast the
stock market recovery could be? It
should.
One Last Note Involving the Election
My
financial publisher, InvestorsObserver.com (www.iotogo.com)
had asked me to participate as a weekly contributor to their paid subscribers. Previously, I had only supplied them my monthly
newsletter to publish on their Home Page open to the public. Each week, they supply a topic and in my second
article I was asked to write about how the Presidential Election would impact
your taxes. In these articles, they desire
me to put on my CPA hat for them. Researching
the article to write, I came across some interesting information about each
candidates tax proposals and wanted to share it with you. If not for the article, I would have not
known myself. Here’s an excerpt:
We’ve heard a lot that Obama is
proposing to reduce taxes for households earning less than $250,000 per year
and increasing taxes for those above that amount. And, if McCain was able to be more
articulate, we’d learn that he was proposing to reduce taxes across all income
levels as well. To get an idea of the
scale of these changes, the TPC’s recent executive summary states: “Compared to
current law, TCP estimates the Obama plan would cut taxes by $2.9 trillion over
the 2009-2018 period. McCain would
reduce taxes by nearly $4.2 trillion.”
What is clear is that the Obama plan relies on a redistribution of
wealth and the McCain plan does not. All
we are hearing is that the Obama plan favors the middle class and that McCain
favors the wealthy. Isn’t it all about
how these issues are being spun?
Note: TPC
stands for the
Each candidate’s tax proposals go
beyond individual income tax returns; they also include estate taxes and
corporate income taxes. These other
taxes do have a significant impact on the economy. Yet, I get the impression that most people
are concerned with the individual income tax impacts. So, rather than go through each and every
proposed detail, I’m going to cut to the chase and use data from the TCP study
to quantify both positions:
While the Obama plan may be more
material for those households earning less than $50,000 per year, it seems
fairly immaterial to most of the middle class and very important to those
households earning over $200,000 per year.
In fact, I expect that the over $200K crowd will be pretty angry. To understand this anger, here is an email
from a friend of mine who recently tried an experiment. He wrote me this:
“Today, on my way to lunch, I
passed a homeless guy with a sign that read: [Vote Obama, I need the
money]. I laughed. Once in the restaurant my server had on an
[Obama 08] tie. Again I laughed as he
had exhibited his political preference.
Just imagine the coincidence.
When the bill came I decided not to tip the server and
explained to him that I was exploring the Obama redistribution of wealth
concept. He stood there in disbelief
while I told him that I was going to redistribute his tip to someone who I
deemed more in need - the homeless guy outside. The server angrily stormed from my sight. I went outside, gave the homeless guy $10 and
told him to thank the server inside as I've decided he could use the money
more. The homeless guy was grateful. At the end of my rather unscientific
redistribution experiment I realized the homeless guy was grateful for the
money he did not earn, but the waiter was pretty angry that I gave away
the money he did earn even though the actual recipient deserved money
more. I guess redistribution of wealth
is an easier thing to swallow in concept than in practical application.”
My friend works in sales and
produces great results for his employer.
His efforts bring profits to the company and those profits enable the
company to hire other people. To me, it
seems that creating resentment and promoting a class war, especially among
those who help create jobs, just doesn’t seem to be worth the difference in proposed
tax plan payments. At the same time,
McCain’s proposals seem to be more tax friendly to business as well. And, business creates jobs also.
Under poor economic conditions, as
we are experiencing now, McCain’s proposal is more attractive to someone like
me. Yet, there is more to the
President’s job than just taxes. I’ll
not go into the other platforms of both candidates as I’ve promised a brief
article and was asked to only focus on taxes – thank goodness!