Predicting versus Preparing for the Future

Memo to: Vailshire Clients

From: Jeffrey W. Ross, MD

Date: October 1, 2014

Predicting versus Preparing for the Future

Predicting the direction of markets is futile.

Those who are willing to place their hopes and dreams of “becoming rich” on the backs of unproven penny stocks and other speculations frequently learn the painful lesson of distinguishing investing from gambling.

While the future can never be known, investing in great and growing companies will reward their co-business owners—the shareholders—who persevere through the emotional mood swings of the market.

What the Professionals (Don’t) Know

I frequently watch the talking heads on cable business channels… it’s fascinating, really. Unlike the average viewer, I don’t watch it for the hot stock tips or market predictions, as black pearls seem to be at least as common as the shiny white ones. Rather, I use CNBC and Bloomberg television to gauge the emotions of the market.

Emotions are a funny thing—and powerful, too. Fear, greed and complacency constantly dance on the market floor to create drops and subsequent surges in nominal stock prices, while the underlying business itself changes little from day to day. Meanwhile, the wise investor analyzes and understands the underlying value of the business (or bond, or commodity, or whatever), and waits patiently for price to come to him, on his terms.

In light of this, I get a kick out of watching the high profile fund managers and academics get constantly prodded for their predictions:

“Where is the market going?”

“Are we headed towards inflation or deflation?”

“What will low interest rates do to bonds?

“Are emerging markets headed higher?”

To these and many more questions, the highly paid “experts” spew their answers as the watching world “oohs” and “ahhs.” Some are humble, most look a bit conceited, all are just guessing.

What’s amazing is not that they are often wrong in retrospect, but that viewers believe that they must be right, for they are the experts! Meanwhile, the market swoons and/or soars as it attempts to digest the fear and/or confidence instilled by the said expert’s testimony.

Well, If You’re so Smart…
What will happen?
Where are the markets headed?

In short, I don’t know. Here’s what I do know:

The Federal Reserve’s latest round of Quantitative Easing (QE) is set to end this month.

Without the massive amounts of “easy money” being injected into the financial system—which have greatly benefitted the U.S. equities market and its participants for several years—deflationary pressures will return to the forefront of the economy.

It is entirely possible that the U.S. economy, which remains weak, will slip back into a recession.

Parts of Europe remain in a recession, prompting the head of the European Central Bank (Mario Draghi) to continue similar easy monetary policies.

Ironically (or not), Draghi has stated that additional Eurozone QE could begin as early as this month.  Was this timed to coincide with the end of the Fed’s QE?  Of course it was.

Finally, not unlike Ben Bernanke and Alan Greenspan before her, Janet Yellen almost certainly won’t tolerate a drop in the markets and increased volatility that are certain to follow any signs of deflation.  In light of this, she will feel much pressure to “fight deflation” with a new round of QE, subsequently launching yet another surge in stock prices.

How Vailshire is Preparing for the Unpredictable, Yet Inevitable, Future

Market volatility (a measure of fear) has been at record lows over the past couple of years.  With the latest round of QE nearly complete, I expect investor uncertainty and fear to return.  U.S. stock prices will likely be choppy, moving in a zig-zag sideways (or downward) pattern.  Vailshire takes advantage of the increased volatility and therefore, increased options prices, by selling naked puts and covered calls on safe, solid companies.  This generates current income even if the price of the underlying equity “goes nowhere” for a long period of time.

Second, Vailshire has begun accruing positions in Eurozone companies and ETFs.  We know that QE and forced low interest rates generally leave equities as the best option for wealth generation.  Mario Draghi has made his intentions quite clear, and Vailshire will be there to capitalize on the (nearly inevitable) rise in the Eurozone markets.

Third, we won’t panic.  This sounds humorous at first blush, but I mean it sincerely.  I expect our clients’ portfolios to be more tumultuous in the coming quarters than we are used to.  With the lion’s share of our holdings in fantastic companies, we will forget about day-to-day price fluctuations and invest wisely for the long-haul.  With Warren Buffett-like apathy to the TV and newspaper headlines, we will trust that a great business today will become an even greater business tomorrow.

Fourth, we plan on a final big leg up in the U.S. stock market before a larger downfall ensues.  Since this is all conjecture based on what the Fed, the economy, the politicians, and the world may do (all of which is unknowable)… we will invest for this anticipated move up, while simultaneously starting to hedge against (and profit from) an inevitable future move down.

Fifth, we will avoid most bonds, especially high-yield (aka, “junk”) bonds for the foreseeable future.  Junk bond yields are at historical lows.  This means that buyers are receiving little compensation for relatively high risk in these less desirable companies.  If the market does falter—and it will—look for junk bonds to lead the way.

Finally, Vailshire will continue to invest in long-term trends that we believe will lead to large profits over the next several decades.  These include:

immune-therapy, genetic testing/applications, and other up-and-coming biotech treatments that are truly changing the face of cancer and a myriad of chronic illnesses

hydraulic fracturing and the shale revolution, which are rapidly changing macroeconomics and the world’s political relationships

the “Internet of Things,” which will soon be a part of everyone’s daily routine, as machines, computers, the cloud and humans will all learn to interact

the aging of America’s huge Baby Boomer generation, and its impact on the economy and the massive health care industry

While Vailshire (or anyone) cannot predict the future itself or the direction of the markets, we can wisely gird our emotions and prepare our portfolios to minimize losses while maximizing profits. 

Thanks for investing with us.

Vailshire:  Live well.  Invest wisely.