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The Best Offense is a Good Defense
For old-school football fans, coaches and players who look to game
fundamentals and the importance of a strong defense, this article may bring
back your “bye-gone” days. For old-school investors, the following message
is important, as well. In the investment world, the best offense is a good
defense. This is the mantra, which American Asset Management Group, Inc. (AAMG)
has stressed since our inception 20 years ago. It has kept our clients on
the right side of secular bull and bear markets over the years.
The best offense is a good defense; we must protect our capital. Good
fundamentals are important in sports and investing. The “run and gun
offenses” of recent market cycles were similar to the “go-go years” of the
1960’s, 1970’s and the “new paradigm” years of the 1990’s. These cycles may
be good for a year or two, but, if you are in for the long term, discipline
and defense will give you the Hall of Fame career. Consequently, our
investment style reflects discipline and defense at all times. Our
equity-income style focuses on equity selections of mid to large capitalized
companies with good fundamentals that pay dividends. Paying dividends keeps
a company “honest,” a word that has lost some of its significance in
American business over the past decade; dividends are a benchmark of
accountability.
We invite you to click on our “Market Views” found on our website at
www.aamg.com. Each
article reflects an opinion and a strategy based on what was happening in
the market place at that time and how we assess market conditions based on a
defensive posture. At the beginning of this year (see Past Market Views;
2004 and Beyond…Will The Good Times Continue?), we stressed, “defense” at a
time when the television news and Wall Street experts were screaming
“offense.” So far this year, market performance has been negative, not
positive. It has been a time for defense, and it continues to be so. We try
not to predict, rather we assess the present and apply common sense based,
in part, on investment behavior. Interpreting human behavior is a definitive
way to assess price behavior. Money moves markets, people move money and
behavior moves people; therefore, behavior moves money. One component of our
market model quantifies this assessment through money flow and business
fundamentals. This selection process aids in assessing the current
environment and leads us down a logical path as we continue to position
client assets.
Let us review the missive we posted on our website this past January, grade
ourselves relative to the first seven months of this year and see what we
need to do to have another year in which we outperform the major indexes.
Growth seemed to have been on everyone’s mind early in 2004. After posting
large Gross Domestic Product (GDP) numbers in late 2003 and early 2004, it
appeared the market would continue to head higher in 2004. Although the
“street” is anticipating a higher market this year, it is presently down
between 2-3%. The market is a discounting mechanism. It knows all that has
happened in the past and is a crystal ball forecasting the future. Yes, the
market is that smart, only it is not going to advertise this on CNN prior to
its run up or down in price. A good manager must ”read” the market’s
language and understand its meaning.
In our January posting we defined the Money Multiplier for you and suggested
that the creation of additional dollars by the Fed over the past 3 years
would be a drag on GDP, not a stimulus for the stock markets, as the news
was reporting. As the August 2, 2004 headline of a prominent business daily
shouts, “ GDP Growth of 3% in Q2…Is Well Below Views,” we hearken back to
our Money Multiplier. Defensive measures were correct again. Visit the
Economic Cycle Research Institute’s web site (www.businesscycle.com)
for a preview of what may be in store for our economy in the
quarters ahead. Another remark concerning defense would be the rising raw
material prices we spoke about in January. This would lead to higher
consumer prices because higher finished goods’ prices would lead to higher
prices and squeeze consumer spending. This was not a recipe for higher stock
prices, we said. As a contrarian, we were concerned about inflation while
the news reports worried about deflation. We moved out of technology and
into a higher allocation of defensive issues. This move has paid off. The
July 29, 2004 headline in Investors Business Daily (IBD) now supports our
concerns voiced in January: “Oil Breaches $43 Level…,” the highest price for
a barrel of oil ever recorded. This is not the deflationary trend that was
supposed to happen. In fact, rising prices now become a weekly tax on the
American consumer at the gas pump.
The “D” words, debt, the dollar and deficits also are keeping us defensive.
To quote from a recent weekly column by Paul Van Eeden (www.paulvaneeden.com)
, “Now enters the Budget Deficit – it has to be financed, somehow.
Since only 1% of all taxpayers pay almost 30% of all taxes, and 5% of all
taxpayers pay a full 50% of all taxes, the logical conclusion is that we can
expect an increase in taxes in addition to any and all other means of
financing the government’s unrestrained spending habits.”
“If spending by the “rich” is the only thing keeping the economy growing,
will higher taxes finally kill the last vestiges of this consumer-driven
economic expansion?”
Consumer credit card debt is out of control, so we stay defensive. AAMG
anticipated a rise in interest rates by the Fed. In our Market View we cited
Greenspan’s testimony leading to this move. This was not a prediction. It
was a view based on Fed testimony. The average American is heavily in debt.
If rates continue to rise, then the debt payments for consumers will also
rise and spending will be stifled. The August 4, 2004 headlines in IBD read,
“Consumers Pulled Back on Spending in June…” The tracks in the sand we spoke
of in January are showing up in the news headlines now and they are not
pretty.
Our response to these sobering assessments has been to position our clients
in vehicles that are defensive: real companies that pay real dividends, not
promises. We are trying to protect our client’s downside risk by investing
in companies that have good balance sheets, market share and a real business
plan.
Experience has taught us that we cannot fight the bear with the same tool we
used to ride the bull. AAMG focuses on fundamentally strong companies and we
examine industry groups that are also solid. During the year, we continue to
analyze each of the 207 Industry Groups in our universe and apply
quantitative values to each group. Our focus is on strong companies in
strong industry groups. Computers make the research process a bit easier. An
investment must not only have a compelling value but must be put into the
perspective of the market. Studies show that 3 out of every 4 stocks will
fall in a bear market, regardless of good company fundamentals. Therefore,
being in the market during this part of the cycle is riskier. If one chooses
to participate in equities, one must know which industry groups offer the
best chance for success. This is a defensive measure, since we are
protecting against downside risk, while avoiding industry groups that are
under performing in the market. AAMG has this methodology in place.
We are still in a bear market. What we have seen since March of 2003 is a
bull market move (up move) in a secular (long-term) bear market. The July 5,
2004 issue of Barron’s magazine notes on page 5, “We’re still of a mind that
the healing process takes longer than a year or two for a post-bubble
economy.” We happen to agree with this assessment. In fact, we have
supported this view since 2001 in past articles found on our website. We
have stressed the high probability of a trendless market in which many
mini-bull and mini-bear moves will occur within a flat to down period of
price action. This type of price action occurred in a period from 1966-1981.
The Dow, in January of 1966, traded for the first time in history at over
1000 (intraday) and closed at a record high of 993.20. Over fifteen years
later, on June 22, 1981, the Dow again closed at that precise figure. But
during the intervening years the Dow Industrials had, in four major
advances, gained over 1350 Dow points. A policy of entry and exit from the
market at exact points would have been immensely profitable. A “hold through
the long-run” philosophy, as measured by the Dow, would have netted a zero
gain. We would note a fact regarding our equity selection in dividend paying
stocks relative to this historical fact: the compounding of reinvested
dividends resulted in an average of 4.1% per annum during this period. A
startling fact is that from 1802 to 1992, 80% of the total real return of
stocks was generated by the reinvestment of dividend income. That is the
reason we choose to invest in income issues. Even during trendless times in
the market, we get paid for waiting.
The recent move up from the March 2003 low has retraced approximately 50% to
the upside since its demise in March of 2000, the beginning of the current
secular bear market. A 50% retracement is an average move up, and a very
profitable one at that, before another down move occurs. It is in all
likelihood where we stand at this time. If the market was to go back down
between 8,000-9,000 on the Dow, we would still be in a 1966-1981 scenario.
An interesting and recent study from Crestmont Research
(www.CrestmontResearch.com)
entitled, “The Stock Market is Not Highly Correlated to Economic Growth”
supports our current view. An argument for a return to all-time highs
because of the recent spat of good earnings news over the past two quarters
DOES NOT CORRELATE. According to the August 5 issue of IBD, “The market is
poised to deliver its best string of S&P500 profit growth in 30 years. So
where’s the rally?” Earnings and profits have not mattered thus far this
year. With price action flat the article repeats our view that “ the market
may be looking ahead to Q3 and Q4, when profit growth is seen cooling …”
Hence, we have seen a mini-bull move starting in March of 2003, within a
longer term bear market starting in March of 2000. If earnings cannot make
the market go up from here, what will? The continuing $6 Billion monthly
bill for our Middle East visit, rising interest rates, high business,
personal and government debt and the back-end of a real estate boom are not
the ingredients for higher stock prices. We remain DEFENSIVE.
Is it still possible to make money in the stock market? Yes. What counts is
stock selection, not timing or “buy and hold.” As mentioned earlier, a
selection methodology is the primary methodology in our model. Finding the
high quality equity and bond issues in the top sectors and industry groups
have given most of our clients a positive gain in the aggregate, during our
current bear market cycle. The market, as measured by the SP500 index, is
down during this period.
We remain defensive. We see more downside risk than upside potential at this
point in the game. The uncertainty level is Code Orange. With all the good
news from Wall Street relative to earnings and profits over the past year,
yet, no rise in equity prices, we continue to see dark clouds on the
horizon. Historically, the first year in a Presidential Cycle (2005) is
always the worst performing market year of the four years a President is in
office. This historical precedent stands true for Republicans and Democrats,
alike. We are still in a time of economic healing from the Bubble Years.
While we try to overcome the massive liquidity given to us by the Federal
Reserve to stem recession since the market crash, we must also face higher
interest rates, higher government deficits and global bills. The picture is
not pretty. America will survive, as it has in the past. However, the “easy
money years” are over. Through good defense and good stock selection AAMG
will continue to practice the discipline and fundamentals needed during
another tough season. We intend to have another winning season. That is why
we play the game.
AAMG Management Team
August 5, 2004
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