IceCap Asset Management: "The Queen"

From IceCap Asset Management, January 2013

The Queen

She adores hats. She is always very polite and respectful of others. She waves to everyone, and consistently avoids conflict. She is a lady; she is The Queen.

Without a doubt, Queen Elizabeth lives a life quite unlike everyone else in the World – after all, royalty does have its privileges. Yet, when it comes to investing, the Queen is swimming in the same pool of stock market sharks as us common people.

Like everyone else, she pours through her quarterly statements to see how she’s fared. And like everyone else, she loves to make money and simply deplores negative returns.

It was rumored that the 2008 crisis hit her particularly hard – over USD 40 million in stock market losses. This experience must have jilted something, as when The Queen was visiting the esteemed London School of Economics she asked the professor a rather “un-queen” like question – why did economists fail to predict the biggest global recession since the Great Depression?

Speaking on behalf of economists, investment managers and mutual fund sales people everywhere, the professor responded that “at every stage, someone was relying on somebody else and everyone thought they were doing the right thing.“ In short, no one could have predicted the 2008 crash.

Meanwhile, in the parallel universe called America, Ben Bernanke was selling everyone the exact same story.

February 15, 2006. “Our expectation is that the decline in activity or the slowing in activity will be moderate; that house prices will probably continue to rise but not at the same pace that they had been rising.”

– America housing prices would eventually decline by up to 50%.

March 28, 2007. “At this juncture, however,” he testified, “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

- The subprime housing market wasn’t contained, in fact it collapsed. January 10, 2008. “The Federal Reserve is not currently forecasting a recession,” - The 2008-09 recession was so severe, it was called the Great Recession.

If the famed London School of Economics and the Chairman and full committee of the US Federal Reserve were unable to predict the crisis, what hope does the World have with predicting future crisis's?

In actual truth, and despite claims by the US Federal Reserve and the London School of Economics, many people accurately predicted the collapse of the US housing market and the subsequent collapse of the stock market.

In fact, using the exact same data points as the US Federal Reserve, these brave people concluded that nothing good would come out of the misguided policies at the time and actually put their money where their mouth was.

One such famed investor was Michael Burry of Scion Capital. Featured by author Michael Lewis in his book “The Big Short,” Mr. Burry spoke how despite being 100% correct about the market crash and making millions in profits for his clients – they actually despised him.

Now, we’ve never met Mr. Burry, but he seems like a nice enough fella. His educational achievements are certainly top notch, and his penchant for removing subjectiveness from his analysis should be the goal for every investment manager. Yet, just as Shakespeare burdened his protagonists as tragic heroes, so too had Mr. Burry’s clients.

His crime: he wasn’t an optimist. This lack of bullish thinking certainly had no place in the investment World. After all, from 1982 to 1999 the stock market always increased by double-digits. Yes, stock markets did experience a mild case of an upset stomach from 2000 to 2002, but this was merely an exception.

Bullish thinking was so prevalent during that time that the once-mighty Merrill Lynch splashed the airwaves with their ever un-prescient “be bullish” mantra every chance they could.

Today of course, the mighty Merrill Lynch is no longer mighty – yet the inherent bullish bias still lives in the investment industry.

Big banks are once again hypnotizing their clients to buy the dip, while universities continue to shape their student’s heads to nicely fit the round holes offered by the industry at graduation time.

Fortunately, it doesn’t have to be that way. Accepting, understanding, and embracing the fact that today there are plenty of investment professionals who are willing to view the World objectively should be comforting.

At the same time, those dark days of 2008 seem like a lifetime ago. Perhaps it was a bad dream. Perhaps it never did happen. And perhaps the fuss about Europe’s debt, Britain’s triple dip recession, America’s debt ceiling and Japan’s 20 year recession is just that – a fuss.

Most investors today do not realize that many investment firms are simply not structured to:

a) anticipate a significant market decline, and

b) position client portfolios in anticipation of a significant stock market decline.

One would think that both options would be an integral component of any investment management process – yet it isn’t. Instead, most firms are built to do two entirely different things:

a) gather new assets ie. new clients

b) remain invested at all times ie. never anticipate anything

There are many things you are not told about the investment business. For starters, it is a billion dollar fee bonanza – it is well known that stock brokers and advisors routinely pay more attention to their compensation grid and trailer fees than client performance.

Next, there are many untruths bouncing around – all with the sole objective to sell you more investments. One such untruth, is that if you miss the 10 best days of the year, your return will be significantly less – therefore do not try to time the market and stay invested at all times.

Well, the corollary is also true – if you miss out on the worst 10 days of the year, you’ll be considerably better off as well. When was the last time your advisor mentioned this?

Our favourite axiom is that according to the nice fellas at Ibbotson Research, since 1926, the long-term stock market return is about 10%. Therefore stay invested long-term and the bounces will flatten out – enjoy the ride.

What the Ibbotson folks didn’t mention, was that if their little calculation started a few years earlier or later – the average return is reduced to about 7%.

At first glance, the relative difference between 7% and 10% may not appear to be that significant. However, to see the real difference, just ask your financial planner to show you the hypothetical growth of your investments with these two different returns. The difference is significant.

How can such a difference in long-term return expectations exist? We’re still viewing 80-100 years of stock market returns which is easily long enough to meet anyone’s definition of long-term. Yet the difference is startling and the difference likely hasn’t been explained in your quarterly mutual fund statement.

The answer? It just so happens that the key driver of stock market returns is the PE ratio. Yes, IceCap has droned on about stock market returns and PE ratios before. The reason we mention it again is due to the message falling on deaf ears. This is important stuff here. Investment professionals, media and the investing public all want to desperately believe that all you need for stocks to rise is earnings growth. We tell you that is simply not true.

Dividends, interest rates and inflation combined are way more important than precious earnings growth. In general, a rising stock market has declining dividend yields, declining interest rates, and a steady improvement in inflation.

Today, dividend yields can’t go much lower, interest rates can’t go any lower, and inflation is in a nirvana-like state. All of these factors directly influence the oft-misunderstood PE ratio. Ignoring the mathematical computations, all one needs to know is that when the PE ratio is increasing – stocks are sure to follow. And, as one would expect, the opposite is true as well.

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More in the full report (pdf):

Ice Cap The Queen by zerohedge