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The Sandy Spring Way

July Observations

July 3rd, 2014 | By Beau Mercer

FredericBurke“I’m back in the USSR, You don’t know how lucky you are, boy back in the US, back in the US, Back in the USSR.” 

—Beatles 1968.

The tradition of the July 4 celebrations goes back to the American Revolution when representatives of the colonies fighting against Great Britain declared their independence.  The declaration stated that the right to life, liberty and property were inherent human rights and that the then existing monarchy (and many governments in place today) would not guarantee such rights.  Emotion and a willingness to accept risk are the spirit while independence is the soul of the United States.

The World Cup is the most widely viewed and followed sporting event in the world, exceeding even the Olympic Games.  The current format of the tournament involves 32 teams competing at host country venues over a period of about a month.  In four years, the tournament will be held in the USSR. Yesterday the United States took on the vaunted Les Diables Rouges (the Red Devils) or the Belgium national soccer team in the World Cup.  According to some experienced soccer aficionados, Belgium possessed the experience and superior talent of a tested athletic machine but would be challenged by a determined United States goalie.  Against Belgium, the United States team coached by a German who emphasized defense turned to a team personality built upon offense.  Prior to the start, the United States team acknowledged their underdog status but their hope and enthusiasm persisted.  The media broadcast the consensus that the United States did not have the talent to compete against Belgium, Germany or Argentina but forgot that emotions and spirit blind the odds.  Can hope and persistence improve probabilities or should the laws of probability be amended?

Sometimes hands-on professional investors entertain dreams like winning the World Cup that ignore the laws of probability and the values of analysis.  In the late 1990’s institutional portfolio managers became so enamored with technology stocks, that they paid exorbitant prices for the newest untested technology stock.  They incorrectly redefined risk, not as the risk of overpaying, but as the risk of not owning the security.  Since 2007 market decline, there has been a ‘drum beat’ for alternative investments that is reminiscent of the late 1990’s.  The pitch for alternative investments has been that they generate high returns with lower correlation to the broader market.  Alternative investments have higher, multi-layer fees and leverage, are difficult to value and generate mediocre returns. There is also a sense that the best returns from alternative investments have already been generated.  Since the evolution of capital deployment, there has never been an investment that over time combines high returns and low risk.  Depending on the then prevalent market psychology, investors seek unrealistic returns and ignore tested prescriptions …they are counting on luck or maybe an investment product salesman.  Markets, like soccer competition, are driven in large part by emotions and sentiment, and at times by an ability to suspend disbelief.  The investor, like the undermanned United States soccer team in their battle against the Red Devils, at times, may need the assistance of an advisor with the talents of Pele or George Washington.

Growth of the Gross Domestic Product or GDP typically sets the direction of the stock market. The GDP measures everything produced by the citizens and the country.  In late June GDP was revised substantially lower, down -2.9%.  Most of the revision was attributable to the weather. (Economic data released thus far for April, May, and June indicates that the economic growth has started to reaccelerate.)  Contrary to the negative signal of the GDP, the S&P 500 is hitting new highs. The S&P 500 has remained above the 200-day moving average for 402 days-a record.  The famous Wall of Worry has been broken into pieces.  In 2014 there has been no remarkable surge in earnings growth, investor sentiment or dividend growth.  Historically the market went up if earnings came in stronger than expected but that has not taken place.  Market returns are now being driven by low interest rates.  Not only is the Federal Reserve Board printing money but also every major bank in the world is joining the party.  Market expectations, therefore, rest on global banking policy and to a significantly lesser extent on GDP growth or the fundamentals of equity participants.

“O beautiful for patriot dreams that sees beyond the years…America the Beautiful.”

Kathleen Bates – America the Beautiful

—Fred