Short-Termism
and Other Radical Belief Systems That are Reeking Havoc With Our Way of Life.
“Can’t you see what is happening? Potter isn’t selling, Potter is buying and all because we are panicking and he isn’t.” – George Bailey (Jimmy Stewart), It’s a Wonderful Life.
This is one of my favorite quotes from one of my favorite Christmas movies. George Bailey and his new bride are on the way out of town for their honeymoon when they see a run on the bank. They give up their honeymoon budget to save the Bailey Building and Loan during the depression.
Fear and Greed: these are the emotions of the marketplace. Fear gripped the nation during the Great Depression and the runs on the bank that were illustrated in the classic film were commonplace. Franklin D. Roosevelt, in his first inaugural address on March 4, 1933, uttered these famous words, “So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning unjustified terror which paralyzes needed efforts to convert retreat into advance.” I would guess that most of you recognize that quote. I would also guess that most of you did not know that this was given in a speech in 1933, long before the onset of World War II, and FDR was not talking about facing Nazis or the Japanese. Later in the same speech he goes on to say, “In such a spirit on my part and on yours, we face our common difficulties. They concern, thank God, only material things.”
FDR was talking about economic fear. He was talking about the kind of fear we see today on Wall Street. Irrational, short-sighted fear. There is of course a difference between now and then. Now, we are just a few short months from all-time record highs on Wall Street, then we were suffering through the worst bear market of all time. Now we have 5% unemployment which is incredibly low on historic basis, then unemployment was rampant. Now we have had just a few mortgage companies go out of business, then more than 4000 banks went under in the first two months of 1933 alone. In other words, they actually had cause for fear; we do not.
The problem with fear and its evil twin greed for that matter is that it is almost always short-sighted. Wall Street has always suffered from this disease, but in recent years it has gotten much worse. The CFA Institute has even given it a name, Short-Termism. Short-termism results in the permanent destruction of wealth, or at least the permanent transfer of wealth. This was the conclusion drawn by Jack Gray, investment strategist at the firm of Grantham, Mayo, Van Otterloo and Company in Sydney, Australia. Gray presented his findings at the CFA Institute’s 2006 annual conference.
Gray points out that from 1945 to 2005 the average turnover of US equity mutual funds has gone from just over 20% to over 100%. In 2005 the average mutual fund held a stock for no more than 9 months. The results speak for themselves. Jack Bogle, founder of Vanguard, points out in his research that from 1983 to 2003 the average mutual fund had an average annual return of 10%, while the S&P 500 had an average annual return of 13%. The actual investor did even worse, with a 6% return according to Bogle. Not only are the mutual fund managers short-term focused with 9 month holding periods, but the mutual fund investor was also short-term focused holding their investment for only 2 years. Let me put this in perspective for you. If you invested $100,000 in a tax free account in 1983 and got the 13% return from the S&P 500, in 2003 you would have accumulated $1,152,309. If you got the 10% return from an average mutual fund you would have accumulated $672,750, and the 6% return of the average investor would net only $320,714. Those differences in percentage returns may not seem that great, but the difference in resulting wealth is huge.
Much of that wealth destruction can be blamed on shorttermism. Gray conducted a poll to determine who was responsible for short-termism and 89% of respondents selected the media. Mutual fund managers know they can get on the cover of Money magazine, or one of the other financial tabloids, only if they post huge short-term returns. You as an investor may have a time horizon of 10, 20 or even 30 years but no one in the financial system shares that view. Starting with government regulators, who are either political appointees whose time may be short, or are young attorneys padding the resume to make the big move to a Wall Street firm. Their time horizon may be 3 years if you are lucky. Investment managers are judged monthly by their institutional clients. The media may have a time horizon as short as hourly. The good people at CNBC want to know what is going to happen in the next 15 minutes. Finally, traders and hedge fund managers have the shortest time horizons of all. The system is heavily biased towards the short-term which causes what Gray refers to as a substantial principal-agency horizon misfit.
This leads us to the newly popular momentum investing fad, which is the quintessential form of short-termism. Momentum investors buy what has gone up and sell what has gone down. Momentum investing can be a self-fulfilling process as prices go up or down not because they should but because momentum carries them in that direction. This private gain comes at a public loss as the market ceases to be a mechanism to allocate capital efficiently in order to maximize total economic output, and becomes instead a ponzi scheme leading to bubble after bubble.
Review of Economy
President Bush's approval ratings continue to decline, which will not help his party in the upcoming election. The country is in the midst of a housing slump and there is a crisis in the banking sector. Most Americans believe we are in a recession, eve though we are not, by the true definition. The Federal government is trying to bail out homeowners and the banks that made these risky loans and no-one seems happy about it. This is the state of the world at the end of 200… wait a second, am I describing 2007 or am I describing 1991? If you sit back and look carefully, it seems as if we have been here before.
GDP growth for the 3rd quarter was an incredible 4.9%, but growth slowed in the 4th quarter to an estimated 1%. The job market took a turn for the worse with unemployment moving up from 4.7% to 5%.
The Fed lowered the fed funds rate by 1.25% to 3.5%, as the credit crunch in the financial markets overshadowed the risk of inflation. The problems that started in subprime home loans spread throughout the credit market and created a true panic.
Housing remains the biggest negative on the economy, and the continued bad news has created a fear of a recession. Fear of a recession usually causes a recession. Fortunately for us, we know how this story ends.
Review of Market
Fear ruled in the 4th quarter with the S&P dropping 3.3% for the quarter and ending the year up 5.49%. The bear is starting to raise his head on Wall Street as all the major indices were down for the quarter. For the year International was still the place to be especially emerging markets as the MSCI Emerging Market Index finished the year up 39.78% and the MSCI EAFE Index finished the year up 11.63%. Domestically large caps outperformed and growth stocks did better than value stocks. The Russell 1000 Growth Index, which represents large growth stocks, was up 11.81% while the Russell 2000 Value Index, which represents small value stocks, was down 9.78%.
It was also a good year for bonds as the Fed began to lower interest rates in the second half. The Lehman Aggregate Bond Index finished the year up 6.96%.
In the end 2007 was a wild ride. The story of the market this year was negative forecast followed by better than expected actual results, over and over again. At the end, the negative forecast seemed to win out. It reminds me of the old saying, “If you say it enough it will eventually be true.”
