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Quarterly Newsletter - July 2008
The stock markets of the world continue to fall. We are now officially in a bear market, with both the S&P 500
and the Dow down more than 20% since last October. Some markets are down much more. We have seen the
sub-prime crisis, the rescue of Bear Sterns, rising foreclosures and unemployment and a doubling of oil prices.
The stress is showing. The markets exploded upward starting in 2003. Now they are taking some of those big
gains back. As ever, we do not believe that there is anything that an investor can do about these things as or
after they happen. Investors need to be prepared in advance. Prepared with a properly diversified portfolio, and
prepared with proper expectations. We have worked hard to prepare you for this kind of market. We hope we
have succeeded. There is a concept in economics called equilibrium. Equilibrium is achieved when two or
more opposing forces just exactly counter-balance one another. Supply and demand is such an equilibrium
concept. There is an abstraction called a demand curve, the quantity of a given product demanded at each
given price. There is also an abstraction called a supply curve, the quantity of a product that firms can
profitably produce at each given price. Where these two curves cross is called the equilibrium price. It is the
price that clears the market. Reality gropes toward that price, never actually arriving there. Market competition
forces an airline to offer airfares at unprofitable prices. It goes bankrupt. The supply of airline seats then falls
and market prices rise toward the equilibrium price. Starbucks offers coffee at very profitable prices. New
companies seeking some of that profit build their own coffee houses, increase the supply and drop the price.
Starbucks has to adjust and drop their prices as well. Economies are, in other words, very special kinds of
systems. They equilibrate. They self-heal. For every force going in one direction there is another that balances
it. And economic equilibrium does not just happen by magic. It is caused to happen, by people and their
actions. The market for equities is an economic market and it also equilibrates. As investor perception of risk
falls, as the world of the future seems to be a safer and more secure place than had been previously thought, the
price investors are willing to pay for equities rises. Their willingness to pay higher prices is equilibrated,
balanced, by the very fact of higher prices. As equity prices rise the price/earning multiple of the market rises.
The market becomes more expensive. Investors are paying more and more for each dollar of expected
earnings. The expected return to equities is falling. Higher prices means lower expected returns, not higher
ones. Then some event happens, such as the sub-prime debacle, and expectations change. The future looks less
rosy. The price of equities now has to fall; they have to become cheaper, to compensate investors for the
increased perceived risk. The big difference between the equity market and goods markets is that in the equity
market the clearing price is reached instantaneously – every minute. Prices make gigantic moves. Panicked
investors yank their money out. A buyers' strike emerges, and the (often desperate and frightened) sellers have
to accept lower prices if they wish to transact. We all have seen this in the real estate market. When the future
looks rosy and wonderful sellers rule. They demand only cash and lots of it. Then the perceived risk for real
estate rises. The market goes cold and buyers get their revenge. Now it's the sellers who are desperate. The
seller has to reduce the price to a level that compensates the new owner for the increased perceived risk. No cut
in the price – no sale. There is always another house down the block. I will go look there. It's the same with
stocks. Real estate is a goods market so it equilibrates more slowly. Equities are fast as lightening. But the
logic is exactly the same. And please don't imagine you can time the market by your knowledge that the world
is riskier today than it was yesterday. Everyone in the market already knows that. Cheapness compensates for
risk, not uncertain opinions about an unknowable future. Real estate and stocks are both a lot cheaper than they
were nine months ago. A lot of disaster is already priced in. What matters are expectations. The mounting
disasters only have to come in less badly than expected. That will be enough. Oil prices might rise less rapidly
than expected. Banks might prove to be less weak than expected. Inflation and/or unemployment might be less
bad than expected. Equities will then recover. We have no idea when. They might well go a lot lower first. It's
exactly the same as the real estate market. Would you sell a property now? Not unless you had to. The sellers
are desperate – especially those with big mortgages and reduced income (think leveraged hedge funds). “Let's
find a truly desperate seller and make a low-ball offer. Maybe we will get lucky.” The logic is exactly the same
with stocks. The only difference is that you are more familiar with how to value real estate. It's the posted
price. But equities also have value metrics. With equities cheapness is not measured simply by posted price but
by the ratio we mentioned above. The current perception of risk is already embodied in current prices. Weak
handed sellers and ruthless buyers make sure of that. The world is riskier and stocks are cheaper. If perceived
risk rises, equities will get cheaper still. And the cheaper they are the higher expected returns will be. Lower
prices mean higher expected returns. Again, you know that in property but it's just the same in stocks. Our
method has not changed, but something else has. Fidelity has re-written the basic plan documents for most of
the big 403(b) plans they custody – including those of Harvard and MIT – in a way that allows investment
advisors to manage those accounts. We think this is a big deal. The money stays at Fidelity but we can see it
and manage it. If you have money in these plans we could combine it with your other accounts in a single asset
allocation and rebalancing structure. This should allow us to establish a more tax efficient overall portfolio for
you. We could apply our method, discipline and performance reporting to these accounts as well. We will need
a minimum aggregate dollar amount at Fidelity to make this venture financially feasible. Jim & Dean
Excerpt: The stock markets of the world continue to fall. We are now officially in a bear market, with both the S&P
500 and the Dow down more than 20% since last October. Some markets are down much more.
Post date: 2008-07-15 23:23:34
Post date GMT: 2008-07-16 03:23:34
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