Market Musings Blog

After the credit crisis of ’08/’09, Americans decided they didn’t like banks. Ever willing to oblige, politicians highjacked the populist uproar and created a behemoth of a regulatory morass, called Dodd Frank. If your community bank has closed its branch near you or completely merged out of existence, you can blame Dodd Frank. If your community bank still exists, just wait a while, and very possibly, it won’t.

Community banks had nothing to do with the credit crisis. They are less leveraged than big banks. They are less profitable than big banks – except during the crisis itself when big banks collapsed and small banks sailed through relatively well. They serve small populations – towns with farmers for instance – where often there is no other choice. They will make loans because they know you; large banks make loans that fit in their numerical parameters. They don’t know anything about you, except what their computer profiles tell them you should look like.

Community banks have tight underwriting standards, and in many categories, lower loan charge offs than big banks. Even though community banks make up a smaller share of the overall banking market than other banks, they make over 50% of small business loans, and over 50% of agricultural loans.

Before the credit crisis, small banks were losing market share, albeit slowly. After Dodd Frank passed, in just a few years, community banks’ share of banking assets has shrunk by 12%, a huge decline in a short time. Consolidation – which means mergers – has ramped up. While you thought bank failures ended shortly after the crisis, that hasn’t been true for small banks. From 2010 through 2014, 338 community banks have failed.

The beneficiaries of these market share losses are, of course, big banks. In the effort to ‘punish’ the banks for the credit crisis we have effectively hollowed out the best of the banking business, and made the perpetrators even more successful.

Dodd Frank is over 2200 pages long. Its regulations were set to evolve over years, serving up an incredibly complicated, ever-changing banking environment. When JP Morgan needs to hire 5000 compliance personnel, it is annoying, but JP Morgan will survive. When Bank of Anytown must hire even one compliance attorney – if it can even attract one – the cost can be enough to put it under. Furthermore, compliance personnel do not make loans or get to know borrowers.

The aftermath of the credit crisis has caused a big chill, not just in banking. What we have set forth here can be multiplied over many other industries, as regulations have skyrocketed in the last few years. Some are simply impossible to comply with. All fall hard on small business. We reap what we sow, and that has been a very slow recovery in employment, and virtually no income growth. Perhaps America has decided she wants the ‘bigger is better’ approach, because that’s certainly the trend.

At some point in every market cycle, investors forget the last cycle and get too frisky. We can tell when this happens because it usually coincides with so-so performance for value managers, and great performance for growth managers. Value managers toil in the leaky basement, sifting numbers and history, tripping over stuff that didn’t sell at the last garage sale. Growth managers sail around in the sun, grinning and telling wonderful stories about what is going to happen next to their favorite stock.
While value managers fret about the one thing investors can control – risk – growth managers are creating spreadsheets out forevermore, showing how earnings and revenue will double! triple! And their stocks rise and rise and rise, shaming those of us who are saddled with dopey telecom stocks or plunging energy stocks, and have no interesting stories to tell.
Disappointment sets in. You might be making a little money in your value portfolio, but everyone else is making a LOT! TONS!
Eventually growth gets whacked when the market decides it’s had it with going up and needs to go down for a while. All those stories vanish, and there’s no safety net. No high dividends, no solid cash flow.
That’s where the devastation comes in. When growth gets whacked, it doesn’t do it by half measure. Instead, it does the same thing it did while going up: with vigor, it seeks the bottom of the barrel.
Sometimes, even, a former darling falls into the leaky basement, and hits the value guy on the head. But that’s another story.
Value stocks will fall, make no mistake about it. In a bear market everything will fall. But the degree will be less, and sometimes just holding on to most of your money is the best you can expect.
We vote for disappointment, rather than devastation. Devastation from your investment program is pretty rough when you’re just trying to live your life.

After Good Friday’s not-so-good jobs report, we expect a continuation of the rocky road stocks are traveling this year. Like last year, a rough winter has sideswiped the economy. But new factors are in place – the fall in oil prices and the big rise in the dollar. Last year, when the economy shrank in Q1, corporate earnings still looked pretty good. Now, low oil prices are not giving the boost to spending that everyone expected, while hitting certain segments of the construction industry, many states’ oil producing industries, and other niches of the economy. The rising dollar has hurt exports across the board.

Stocks are not wildly expensive, but if we have a poor earnings season this quarter or next, that will be new and negative. So far in this bull market, earnings have come through well, quarter after quarter, year after year, pretty much since late 2009. Worse performance on that score will lead to a rough patch for stocks.

Buckle up, but keep an eye out for bargains, too.

No, not me, in fact I don’t really know what this means. But a friend who wanted advice about retiring lately said this to me and it made me wonder, because actually I hear this fairly often. So this is a muse about what it means to ‘not trust’ the market.

Bill, my friend, likes real estate, and plenty of RE investors don’t ‘trust’ the market. They like assets they can touch, and they feel like they can control physical assets. This, of course, is an illusion. Many also think they’ve made money in real estate, but they tend to recall purchase prices, and not the myriad other expenses such as property taxes, interest on the mortgage, refi fees, transaction fees, yard care, repairs, expansions, remodels, etc. Most non-professionals don’t make money on real estate; they only think they do. But real estate has a special relationship with its owner, who is always doing something on its behalf, and thus … feels in control.

Other folks don’t ‘trust’ the market because its price can crater, for seemingly unfathomable reasons. Because they don’t understand the reasons for price movements, they don’t trust it. These folks actually don’t trust themselves, because the market defies their logic. Usually they haven’t followed markets for decades, don’t know a thing about market history, can’t understand the math around internal returns and compounding, and let emotions rule their decision making. Further, real estate prices DO change, but RE is not transparent about price changes. It’s hard to figure out how much your property is worth. Even if you sell it, you are not sure you got the best price.

Weirdly, while stock quotes are far more granular (down to the hundredth), and far more frequent, this constitutes a reason not to ‘trust’ them. It’s as though better information is not desirable.

There’s also a suspicion around price manipulation, and a sense that the market is only for high rollers, or gamblers. We can concede on price manipulation. We see it happen. But, why not take advantage of it, instead of mistrusting it? One of our stocks, Digital Realty, was the target of short sellers who relentlessly hammered the stock. We kept buying it, since the shorts only made it cheaper. Once the shorts went off to play somewhere else, the stock recovered dramatically.

But we can’t understand the ‘high rollers/gambling’ bit. Plenty of ordinary folks have made lots of money in stocks by holding them forever. Stocks represent bits of businesses; okay, some businesses do gamble, and many stocks represent a gamble, but you don’t have to buy those businesses.

The other public relations problem that stocks have is that understanding returns, and what might give you a good return, requires more than a vague facility with math. Many people don’t understand compounding, or internal returns such as return on capital or equity and what those mean over the long haul. They don’t understand the difference between principal and dividends.

All this said, we haven’t seen many folks who don’t trust the market flip, and begin trusting the market. Or if they do, it happens at the top of the market, and getting in then is a great way to reinforce your lack of trust!

Giving to charity can be – like many things in life – fraught with pitfalls. It should be simple, and most folks think of it in that way – write a check or hit the ‘paypal’ button and off goes your money, supposedly to do good. How would you feel if you discovered that a high percentage of your gift went not to the end user who really needs the funds, but to administration or marketing? Or that the endowment that you are flowing cash to has a terrible long term return? Or that your favorite charity is competing with other charities to save the Tiger, in a way that actually deters the desired result?

We think of giving to charity as an investment, similar to picking the next well-performing stock or bond. Steps you can take to begin viewing giving in this light are:

1. Check your charity at charitynavigator.org for how much of every dollar you give actually makes its way to the end user. Keep in mind that new charities, and even some older ones may not show up or may show poorly on charitynavigator for various reasons. When you see a poor result, pick up the phone and call the charity to ask for an explanation.
2. Try to resist giving tiny amounts to lots of charities. Instead, put them in competition for your money by choosing the best amongst them, and plying those few with more cash.
3. Apropos of #2, ask the charity how they know they have been effective, and how they’ve used money more efficiently over the years. Did $100 feed 10 people 10 years ago and now they’ve figured out a way to feed 12 for the same money? If you are making contributions to an endowment, ask for the endowment’s return history and investment policy. If it’s not at least as good as your own investment program, you are better off skipping endowment contributions to that particular organization; instead, given to their general fund.
4. When you apply #2, you may be given a phone number for a contact person at your charity of choice. Having that person’s ear can help you track what’s really going on with your favorite causes.
5. Inspect the premises if you can. We visited World Wildlife Fund in D.C. and interviewed the scientist in charge of endangered species – a great experience that only made us more likely to contribute.

A final thought for those investors who prefer socially responsible investing and are sometimes frustrated in the search for good performers in that space: one alternative to hewing to socially responsible investing is to compromise to some extent on those criteria, then make up for your transgressions by increasing your charitable giving, focusing on needs that matter to you.