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Quarterly Letter to Clients 

July, 2011

Indices at quarter-end (June 30, 2011):

    Dow Jones Industrials:             12,414.34       2Q'11        +0.77%          YTD      +7.23%

    Standard & Poor's 500:             1,320.64        2Q'11        -0.39%         YTD      +5.01%

 

The second quarter of the year started strong, and the year’s highs were set during the first few weeks of the period.  But ultimately it proved to be a quarter for the markets to "rest".  This is a euphemism generally meaning “go down”.  And it did go down for much of the quarter.  A rally in the final week of the quarter made up the deficit.  It felt much more wrenching than it actually was.

The Dow, which was up 6.4% in the first quarter, managed to tack on an additional  0.77%, bringing its year-to-date gain to 7.23%.  The S&P 500 has trailed the DJIA this year; a negative 0.39% showing for the quarter resulted in a YTD gain of 5.01% for that index. 

How do you approach a prospective investment?  The question was posed:  are you better off buying gold or a house?  Putting aside the matter of where you might live should you choose the former, the point is to highlight the investment differences in the two markets.  Gold, of course, has been soaring of late, while housing--well, you know what has happened there.

As I see it, it is a classic market question:  do you buy the asset that is trading up, hitting new highs, or the one that has tumbled, and which is now at multi-year lows?  In this exercise we are plumbing one facet of investor psychology:  momentum versus value.

Ignore the fact that typically you buy a house on margin (the mortgage), and therefore have leverage working for (or against) you.  Ignore also the utility of a house, and ignore gold’s lack of  any utility.  Simply focus on the investment potential of the two asset classes.  Which asset will yield you the greatest reward?

If your timeframe is measured in weeks or months, it is anyone’s guess.  But if you have a long-term outlook, as I do, the attractive choice in this case is the cheaper one, the one that has been declining.  This is an over-simplification, of course.  With any investment there is an array of factors to be considered.  But when investing for the long run, all else being equal, I would generally prefer to buy something at a low price rather than at it's high. 

There are many other people who might choose the "momentum" play.  There is nothing really wrong with either mindset.  You can make money either way.  But the real question is how you handle losses.  How much can you lose before your judgment becomes impaired?  Therein lies the real poser:  investment involves risk.  How much risk can your individual personality handle?  And with which asset--gold or real estate--are you exposed to the greater risk?

To put this thought process into a real-life stock market example, recently a company named LinkedIn went public, soaring on its first day of trading to more than double the offering price.  At that lofty level the company was being valued at $8.5 billion, or some 40 times it's sales ($243 million in 2010).  Earnings for the year 2010 were less than $3.5 million, so the enthusiastic buyers were paying something on the order of 2400 times earnings--and that is for last year’s earnings; the company expects a loss for 2011.

Now ask yourself:  at those prices would you rather be a buyer or a seller?  I know where I stand in that calculation.  The game is one of risk versus reward, and the game is won by controlling risk.

This is the type of thinking that I bring to my investment work.  In comparing stock versus stock, bond versus bond, stocks versus bonds, I am constantly weighing the risks against the possible rewards.  My approach is to look for value, value that will be realized over time, through dividends, interest, and growth.  I play to hit consistent singles and doubles, and if, once in a while, the ball goes over the fence, well, that is wonderful, and it helps to make up for the inevitable errors that all market participants experience. 

In all investments, even in just holding cash, there is some level of risk.  The main thing is to not purposely put yourself in harm's way.  Seek the rewards, but manage the risk.

Jim Pappas

copyright © 2011 JPIC