Market Cycles

I LOVE THE PROCESS OF INVESTING — all the thinking about the craft itself and the fun of rummaging around looking for interesting stuff to buy. So naturally, when I get a chance to hear successful investors chat, I go out of my way to grab a seat. You never stop learning.

I headed up to Manhattan recently with Dan Amoss, who writes the new (and red-hot) Strategic Short Report. We met in Baltimore and caught a train north to attend the 2008 Columbia Investment Management Conference. There, an all-star cast of successful investors assembled to speak about this crazy craft we all find irresistible — and to offer some ideas.

Richard Pzena’s opening talk was the most interesting to me. In part, because what he had to say was timely, yet full of timeless wisdom. His title: “Surviving the Cycles of Investing.”

Good topic, considering the nasty spill the market took to open 2008. And with the cloud of recession thick in the air, investors seem awfully full of worry. Pzena had some soothing words.

Pzena says there were only eight years in the last 40 when you would’ve been down 20 percent using a simple value approach. (For purposes of his discussion, he used a simple value strategy of buying stocks only in the lowest quartile of the market ranked by price to book. But the point applies to all us cost-conscious investors.) We just suffered through one of them — with the S&P 500 and Dow Jones industrial average dropping 20 percent from top to trough.

One obvious conclusion from looking at the data, if you are a value-minded sort like me, is to shrug off the bad times and say, “Who cares?” It’s no accident that most people can name the big bottoms (1974, 1982, 1990…). It’s because they are relatively infrequent. Plus, the long-term return on value stocks over the full 40 years more than made up for them.

“The problem is,” as Pzena says, “when you’re losing 20 percent, it doesn’t feel very good.” You start to question what you’re doing. You start to wonder, “Can I avoid those 20 percent down periods? Should I avoid them?”

To the first, Pzena rolls out the shopworn, but tested wisdom that trying to predict exactly when these downdrafts will happen is impossible. And selling after the market has already taken its tumble is a sure loser.

Therefore, “riding through them is the smarter thing to do,” he advises. “The quest to get the timing right is what trips up most investors,” Pzena says. The best investors buy value when it’s offered and don’t worry about timing the market or fretting about recessions.

Many investors think that with a recession looming, or already here, it may be best to sit on the sidelines. One problem with this is that economic health is extremely difficult to gauge. It’s not as if you can slap on a pair of latex gloves and say to the economy, “Turn left and cough.” It’s possible we won’t know we were in a recession for sure until it’s over.

But even so, recessions tend to be good times for investors who buy value. Pzena had examples. From January-December 1969, we had a momentum market. A momentum market is one in which people focus on getting the next piece of information. Quarterly earnings reports and recent price action dominate. This kind of market can be difficult for value guys, who think longer term.

However, Pzena points out that a recession began in December 1969 and lasted through January 1971. Stocks flipped to a value market from January 1971to August 1977. The timing of that flip coincided with the beginning of a recession. The same holds true for all recession cycles of the last 40 years, according to Pzena.

How do you explain it? Pzena asks: “As people worry about a recession, what do they do? They put their money in what’s working.” That means momentum stocks, or stocks that have gone up. They worry about what the recession will impact. This is where we are now.

The thing is, as Pzena discussed, recessions bode well for investors looking to pick up bargains. As you get into the recession, though, people start to think about valuation again. Momentum stuff starts to not make sense.

Are we in a recession now? Pzena didn’t hesitate to make a guess. “Anecdotally, yes,” opined Pzena. “Toward the end of 2007, we had, at least, a major slowdown.” The market is, once again, offering attractive bargains.

Pzena points to price-to-book indicators. Right before 2007, there was a narrow gap between the lowest quartile by price to book and the S&P 500. Meaning, the cheapest price-to-book stocks were trading at a small discount compared with the rest of the market. Now that gap has reversed. The gap is now wide, Pzena says.

So parts of the market look attractive again. But what about those ugly headlines, you say? “This is why value works,” Pzena says. “Because when you see your list, you want to throw up.” It’s what gets you the pricing you want.

The savvy group at the conference was excited about the opportunities the market has given them. They are not alone. Several great funds long closed to investors are now open again for new investors. They’re open because they have more ideas than they have money. They want to buy.

The opening of these funds, captained by investors with long track records of success, is also an indicator that the smart money is buying.

Chris Mayer
March 27, 2008