Archive for March, 2012

Our macro thesis for investing in financial institutions was laid out earlier on in the following posts:

Tea with a macro-investor, thoughts on the financial sector

Tay Fund Commentary 2011

, and more specifically, our investment thesis for Bank of America,

The Compelling Case for Bank of America – Research Report

I feel somewhat vindicated that our scenario has played out as it has been thus far. However, let us not get too far ahead of ourselves as the recent run-up in banks has in large been due to

(1) the apparent orderly restructuring of Greek debt,
(2) the success hence far of the ECB’s LTRO refinancing operation, and its consequent effect of driving down the yields of sovereign debt,
(3) the latest results of the Federal Reserve’s bank stress test.

Indeed, it is this slew of good news that has led to a dramatic advance of the major indices since its October 2011 low, to achieving new highs in both the S & P 500 (1400 points), and the DJIA (13,000 points) not seen in years. Whether investor optimism is misplaced remains open to question. I however, continue to ignore economic forecasts as part of my investment framework, and have little faith but much distrust in the predictions of those who proclaim to know the future.

What I feel that investors should take heed of is the tendency of the markets to swing from a state to unwarranted pessimism, to one of unjustified optimism, and the short time frame in which it occurs. There are few certainties that exist in the market. However, the inclination of the masses to swing from extreme states of emotion is one that existed for centuries,  and is certainly in my view, one that can be counted upon reliably to repeat itself in the future, lest human nature changes (highly improbable).

With the markets assuming a “risk-on” position, it is perhaps prudent to take a moment to reflect whether the situation has improved to such an extent to justify such a dramatic increase in price levels. Unemployment has been slowly edging downwards, the housing market in the US is showing some signs of recovery after what was mostly certainly a depression (just the property market and its associated industries), and the European Union appears outwardly at any rate, to be getting its act together. However, on a note of caution, we are not out of the woods yet and there remains many headwinds that can derail the recovery.

My own personal view is that high quality equities in the US are priced at reasonable levels to give a satisfactory, if not unspectacular rate of return in the coming years. However, the recent run up in prices of financial institutions have made them far less attractive than they were 6 months ago. In the long run, I expect them to outpace the average return of the market. However, investors should bear in mind that  returns will be volatile, and further irrational advances in prices will skew the risk/reward ratio against the favor of the investor. If that happens sooner than later, will take appropriate steps to close our positions.

What I find more disconcerting are the price levels of lower quality companies, and more specifically, recent stock offerings of social media companies which trade in great multiples of what little earnings they generate. Paying for the promise of future earnings, especially one that is projected to grow generously is reminisce of the dot – com bubble. This investment strategy has worked out poorly over the years for the vast majority of the public, which has shown itself inclined to enter the market in droves at the very worst possible of times.

I would caution investors that investing in such issues would in no way qualify as an investment operation by Graham’s definition – “An investment operation is one which, upon thorough analysis promises safety of principal, and an adequate return.”

Admittedly, areas such as real estate, commodities such as gold and silver and common stock offerings are not my area of expertise. All I can say is “Be sure it’s yours before you go into it.”

I would like to end the letter cautiously optimistic. By a conservative standard, the S & P 500 is moderately valued. However, it’s encouraging to see that high quality companies paying a reasonable dividend yield can be purchased at some of their lowest price/earnings ratio in years, providing the chance of reasonable return over the next decade.

On the same thread of thought, I would caution investors against locking in their capital in long term bonds at record low rates. Although there may appear to exist a safety of principal, such investments offer little protection against inflation which I suspect that many people are underestimating. This will most certainly lead to a substantial loss in purchasing power over a protracted period of time. Ultimately, I do not believe that investors are being compensated adequately for the risk that they are tasked with assuming.

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