Muhlenkamp: The Investment Climate
02/28/2003 12:00 am EST
Over the last three bear market years, the Muhlenkamp Fund has maintained a positive return. Though modest, the fund's 2.8% average annual return has far outpaced the S&P 500's negative 14.5% average annual loss over the same period. In a fascinating speech, manager Ron Muhlenkamp creates an analogy between investing and farming, providing an easy way for investors to understand some important investment basics.
"It occured to me that investing in the stock and bond markets isn't much different from farming - but without the benefit of a calendar. Indeed, the longer I manage money, the more it looks like farming. A few years ago, in mid-February, we had 70-degree weather in Pittsburgh. While looking at the calendar one day, I started to ponder how a farmer without a calendar would know whether it was February, normally a poor time to plan crops, or April, normally a good time to plant. Of course, this very problem resulted in the invention of the calendar in the first place. It then occurred to me that investing in the stock and bond markets isn't much different from farming - but without the benefit of a calendar.
"In either endeavor, the first thing you need to know is the climate in which you live. When my parents moved from Ohio to Albuquerque, they planted a lawn that soon turned to sand. The next time they built a house there, they knew to landscape with sand. In Albuquerque, brown, not green, is beautiful. The climate for investing is heavily influenced by the levels of inflation and interest rates, and it can change fairly rapidly. In the 1970s, the investing climate in the US was determined by inflation levels well above interest rates. You could not offset inflation by lending money. The climate favored borrowing - and buying 'hard' assets like gold, oil, and real estate, which held their real value versus the depreciating (deflating) dollar.
"Since 1981, interest rates have been well above inflation, reversing the investment climate of the 1970s. Back then it then paid to lend money. Savings accounts, bonds, and stocks were big money makers. Owning gold or oil and mortgaged real estate was very expensive - sort of like trying to grow cotton in Ohio, or grass in New Mexico. The fundamental difference between farming and investing is that we, in the aggregate, determine the climate for investing. Inflation is determined by government action in response to our demands. Interest rates are determined directly by the levels that people are willing to pay or receive. But even within a given climate, the seasonal and daily weather patterns have great variability. In Ohio, planting that is done in April is less likely to suffer frost than planting done in February, but a late frost cannot be ruled out. The hot, humid weather of July and August, which is ideal for growing a corn crop also makes the ideal conditions for hailstorms, which can destroy a corn crop.
"The emotional swings of the investing public, which affect the daily prices of securities, are at least as variable as the daily weather. These swings are part and parcel of all investing climates. The key is not to confuse the daily changes with seasonal changes in the climate. I've often compared the October 1987 stock market crash, where prices dropped 25% in two days, to a hailstorm that wiped out one year's crop. But the storm (crash) changed neither the climate nor the fertility of the soil (the strength of the real economy). So the appropriate response was to plant a new crop, and the following year indeed produced a bumper crop. We saw a similar situation in 1990 when talk of war scared the public (bad weather in our analogy) and postponed the end of the recession (delaying spring). But it also set the stage for a bumper crop the next year.
"We are now in a similar situation, recovering from recession, implying springtime in our analogy. But this economic springtime is complicated by an unusually large number of factors with major psychological impact. The hangover from the "fad" stocks of 1999, terrorism, the threat of war with Iraq, corporate malfeasance, a drought in the US farm belt, the dock strike, etc. The combined effect has been to drive stock prices lower and to delay the expected springtime in the market. In fact, last year had been the first time in ten recessions since 1945 that the stock market didn't do well despite the economy recovering from a recession. Our best description of the current market is a drought. But just as the two-day drop in October 1987, was similar to a hailstorm (short and quick, but destructive) the decline we have been experiencing is similar to a drought - a long, drawn-out combination of adverse weather (psychology) that destroys the crop.
"As farmers and investors, you and I know that droughts are part of the business - and we're likely to face them in our lifetime. But it's very hard to predict when. So our only recourse is to allow for drought and to make sure we survive it when it comes. But it doesn't change the climate, or the seasons. So the proper response is to plant a new crop. The psychological factors overhanging the market appear to be peaking, and we believe that the combination of economic recovery and current stock prices now favor planting that crop."