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First and Second Level Thinking

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Regular readers know I often express myself in tones of varied skepticism. While I admit this tendency comes naturally to me, you should know it serves a deeper purpose. Let me briefly explain.

There is something inherently comforting when things sit in a state of balance. In investment markets, however, things are constantly in a state of flux, to one degree or another. Given this, an intelligent investment management process is often lonely and rarely involves broadly following the crowd. Skeptical investors love to ask questions and test the consensus view.

Influential investor and market thinker, Howard Marks of Oaktree, recently wrote about what he refers to as first-level and second-level thinking. His memo did a nice job of highlighting a concept that helps to explain why I feel a healthy sense of skepticism is beneficial as an investor.

First-level thinking tends to reflect the obvious facts already in the news. China’s slowing, commodity prices are down, sell oil stocks, avoid multinational companies and own the US dollar. With gas prices so much lower now and with interest rates still so low, buy consumer-oriented stocks that cater to domestic shoppers.

Now, a second level thinker, in reaction to a first-level thought, might sound very different. Yes, energy and commodity prices are down a ton and it does look like China is headed toward a rough slowdown. But, US oil and gas producers are busy lowering their costs and are finding ways to innovate. With their stock prices down so much and – as long as their balance sheets can hold up – I think they’ll make it through this down cycle. These companies might now be trading at bargain levels.

First level thinkers tend to feel more confident with validating information. It creates a comfortable emotional feedback loop as it follows a seemingly, logical, straight-line relationship. As their confidence builds, they seek safety in the crowd. Soon, ever larger numbers of investors adopt the same comforting view. And, over time, it becomes the consensus view of far too many investors.

The second-level thinker can appear allergic to the consensus view of the day. As uncomfortable as it can feel, second-level thinkers know that following the consensus is not how money is made or how losses are avoided in investment markets. Actually, just the opposite tends to be true over time.

Second-level thinking can appear counterintuitive and can come across as skeptical or stubborn and can be viewed as somewhat pessimistic. Instead, I’d argue that second level thinking is inherently optimistic about the fact that – because things are always changing and are never in balance – great opportunities are always around the bend.

So, the next time you look at your portfolio or begin to make an investment decision, ask yourself if you are making a first- or second-level decision. And, if the decision feels a bit tough or uncertain, you’ll very likely have a good idea.

 

Is the Bull Market Still Alive?

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The stock market has recently delivered quite a ride for many investors. The word I hear most to describe the volatility is, roller coaster. However, the most common advice I hear in my industry is, don’t be emotional, don’t panic, the bull market is still alive.

Before addressing the common refrain that this recent market blip is/was just a correction in the midst of a continuing bull market, I too agree that panic is not wise behavior. Panic often leads to poor decisions, unless you really are being chased by a wild animal.

It is often cited that China is the reason for the recent market volatility. We all like to find a proximate cause for any change in our surroundings. Yes, the Chinese stock market is down nearly 40% in three short months. But, this has only erased a 60% gain during the three months prior to that.

Rather than pin the market downturn on China alone, I view it as a symptom of a larger, global economic ailment; one rooted in the very prescription used to quell the ‘08 credit crisis and subsequently slow global economic recovery.

I remember back to the ‘80s when my “little brother” – who now towers over me – used to play a simple computer game, SimEarth. In this game, the goal was to tweak the elemental makeup of the environment in order to spur the sustainable development of plant-life and the animal kingdom in a simulated world.

I had no interest in SimEarth back then and, voila, my brother became a scientist and I became a money manager! Who knew that SimEarth would now indirectly apply to my life’s work?

Since late 2007, central bankers around the world have been playing their own version of SimEarth. Their prescription was no less than a change in the basic rules of capitalism; zero interest rates for almost a decade.

Like the basic makeup of our natural atmosphere, interest rates act as the driving force behind all asset prices. The world of financial markets operates in a constant state of comparative analysis. Every investment choice is measured against an alternative with interest rates sitting at the center of the analysis. For at least the past decade, central banks have manipulated capitalism’s atmosphere.

Viewed in this context, the frantic chase for global riches in China, along with large amounts of capital rushing into other developing markets, is simply an outgrowth of the desperate reach for investment returns in a world of suppressed interest rates. The likely effects are artificially high asset prices and greater volatility near the end of the experiment.

With the US stock market, as measured by the Shiller P/E ratio, still valued at levels only seen in 1929, 1966 and during the tech and housing bubbles, it might not be such great advice to bank on the resumption of six-year old bull market. Panic, never. Plan and prepare, always.

Markets: Where and When, What and Why?

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As an investor, it’s important to ask the right kind of questions. Especially during periods of markets in stress, forget the “where and when” questions and try to focus on those that begin with “what and why.”

Over the span of four successive days from last Wednesday through Monday, the US stock market dropped 1%, 2%, 3% and 4%. The total decline was fast and furious and resulted in a long-awaited 11% drop.

It’s about time. I’ve been expecting this. You should expect more ups and downs along the way. If this quick drop has left you a bit shocked, there is always time to reevaluate your overall risk in your portfolio.

I’ve personally seen a number of people who are far too invested in the stock market. When I pointed it out, they largely appeared unaware. I suspect it was due to a lack of asking the right type of questions.

At times like these, the questions I get most begin with where and when. They also tend to be formed by fear and greed and often focused on fortune telling.

Where is the market headed? When is the selling going to stop? Where is the bottom in oil? When is China’s government going to stop the contagion? Where’s the Fed now?

The reality is most investors – including professional advisors – don’t know much about where markets will be tomorrow, next week, next month or even next year. Honestly, many don’t have a clue about much at all.

While questions of when and where tend to lead to emotion-based decisions, I’ve found the best action-leading questions start with the words what and why. These are the questions that tend to drive deeper thoughts and fact-based decisions.

What’s trading at bargain levels now? Why not own more energy stocks after such huge declines? What dividend does this company pay based on today’s stock price? Why not sell that stock with it now priced for such good news? What’s management going do with that huge pile of cash? Why shouldn’t I buy more with it down over 20%? What level of exposure to China does this company really have?

Over the years, my view is, people have distanced themselves from an understanding of the investments in their portfolios. I cannot entirely blame them for this. The cloud of complexity can get pretty thick in the financial industry. The cynic in me wonders if the pile of acronyms and flurry of buzzwords are secretly designed to intimidate the public.

In moments like these, my advice is to take note of the types of questions you’re asking yourself and others. What exactly do you have to lose by doing that?  

 

Beware of IRS Impersonation Scam

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jasonheadshotQ: A friend of mine recently received a very disturbing phone call from a person identifying themselves as an IRS agent. On the call, this supposed IRS agent threatened to arrest my friend if she didn’t immediately pay her back taxes. She followed his very detailed directions to send a MoneyGram for over $2,000. Is her money long gone? Is this a scam? If so, can you please warn others?

A: Your friend is not alone. According to government reports, to date about 5,000 people have now lost over $15 million to this IRS agent impersonation scam. They have already received close to a half million complaints from citizens. Clearly, this scam fools enough vulnerable people.

Rather than paraphrase the definitive source, the IRS has addressed this particular scam on their website. Here’s what they say;

“Note that the IRS will never: 1) call to demand immediate payment, nor will the agency call about taxes owed without first having mailed you a bill; 2) demand that you pay taxes without giving you the opportunity to question or appeal the amount they say you owe; 3) require you to use a specific payment method for your taxes, such as a prepaid debit card; 4) ask for credit or debit card numbers over the phone; or 5) threaten to bring in local police or other law-enforcement groups to have you arrested for not paying.”

The victims of this fraud do see the red flags, yet their common sense still fails them. For example, I’ve heard of cases where the victim knew to call their financial adviser or a relative before sending any money. However, the fraudster countered with intensified threats of imminent arrest if they hung up their phone. The perpetrators always have a well-rehearsed response.

I have personal experience with another fraud that involved my wife’s now-deceased grandmother. In her 90’s and amazingly on Facebook, she was contacted by a man impersonating her seriously-injured grandson stuck in a foreign hospital. Unable to reach other relatives – deftly name dropping some of her Facebook contacts – this fraudster convinced her to send over $1,000 to pay for his medical bills and a plane ticket home. Her own bank obliged, with far too few questions asked.

These predators need to be stopped, or at the very least, slowed. With our aging society and with technology that enables crooks to hide in plain sight, these scams will continue to grow. I call on regulators and our legislators to introduce additional “speed bumps” into the financial system. It’s a very small price to pay to protect the most vulnerable among us.

Until then – and I know it might be a long, long wait – I ask all readers who know of someone who might fall for such scams, particularly those with memory impairment, to pass along this column to both them and to their loved ones.

August 4, 2015 | Jason P. Tank, CFA

 

Revisions, Revisions, Revisions.

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The recently released GDP report came out today, along with the revisions to their previous calculations stretching back over the past four years. I always find these revisions interesting, in the sense that it highlights the futility of reading too deeply into the markets’ reaction to current-day, real-time economic releases.

Overall, the stretch of 2011, 2012, 2013 and 2014 showed an even slower economic recovery than previously estimated. And, it wasn’t fast to begin with.

GDP Chart Revisions
Overall, it’s safe to say the we’ve seen about 2% growth per year over this entire recovery since the summer of 2009. And, we’ve even seen two years of sub-2% growth, in 2011 and 2013.

It’s quite amazing the companies have done as well as they have, unless one looks at anemic wage growth and the tepid business investments made over this period. Those moves, coupled with large share buybacks, has upheld earnings per share growth that investors like to see.

These decisions do have longer term ramifications on economic growth, however. I think we’re seeing these ramifications in the picture above.
For 2015, so far, we’ve now seen a 0.6% first quarter and a 2.3% second quarter. Together, the first half has shown growth of about 1.5%. If the second half accelerates – as most expect – for whatever reason – another 2% full year is in the cards.

This is certainly an odd recovery, to say the least – especially in the face of such low rates and robust stock market performance (especially 2013). Disconnect is a reasonable adjective to use.