Model Portfolio timbo56:SSOF1

I see no contradiction between the concept that the stock market is efficient and the idea that a person could outsmart the market on a long term basis, although I think that many other observers do see a contradiction there. I believe that market efficiency is largely a matter of perspective. Let us take the perspective of "Joe Investor." Joe investor has an IRA of $200,000 and he would like to get the maximum return on this budding nest egg. He has above average intelligence and is quite interested in the stock market. He reads a few different publications on this subject and is considering using the advice given in these publications to make investment decisions. He has some of his money invested in individual stocks and another portion in mutual funds. From Joe's perspective, unfortunately, the market is efficient, for the following reasons:

1. With respect to stocks:
a. Anything he reads will have been read by hundreds of thousands of other investors.
b. Whatever the article writer has gotten right will have had its value diluted by a movement of the stock in the recommended direction.
c. Whatever the article writer has gotten wrong will mislead Joe.
d. The mutual fund managers, capital managers and big-money investors who are trading in Joe’s stocks will have much deeper and more complete knowledge of the issuing companies, and their business environments, than Joe has.

2. With respect to mutual funds: Any mutual fund that has performed well enough, long enough, to really show that it is being managed with skill, and has not just been the beneficiary of good luck, will either:
a. Have so much money to manage that it will have a very difficult time meeting previous performance levels, achieved while managing much less money; or
b. Be closed to new money, so that Joe will not be able to invest in that fund.
Moreover, there is no way to tell, for most funds, when there is an actual change in management.

So, for Joe Investor, the market is efficient. He might as well, indeed, invest in a passive instrument, such as an index fund.

Does this mean that it is not possible to beat the market on a regular basis? Of course it does not. Joe is working on the assumption that standard sources of information, interpreted in a straightforward manner (i.e. accepting the advice they give) can work. Nothing, of course, is that simple. In order to beat the market one must disagree with the current, most widely accepted (by the big money players, that is) market wisdom. One must free him or her self from commonly accepted images of industries and question every societal bias. One must be broadly informed, think independently, and have very strong analytic skills that one trusts as a guide.

Take, for example, my bet on the steel industry in 2003, when it had the worst imaginable image as a rust belt, sunset industry. I challenged that image, by asking why the domestic steel industry had that image. The conclusion I reached was that it was at least in part due to a dollar that had been very strong in the eighties (Reagan era supply side economics) briefly dipped in the early nineties, but then came roaring back and given an extra boost by the Asian currency crises of 1998. No wonder the domestic steel industry had suffered such a string of painful reversals. The strong dollar, the low price of fuel and comparatively low wages abroad had encouraged a flood of imports. But the dollar had already begun to fall at that point and any thinking person had to realize that the trade deficit of that time was unsustainable (although it continued to grow, even after that). Moreover, the increasing price of fuel would make it more expensive to import steel from distant countries. Now the domestic steel industry is doing great. The price of stock of AK Steel has risen from a low of about 2 and 1/2 in 2003 to 65 today (it was recently over 70 before dropping back a bit).

By questioning the accepted wisdom (and industry image) of the time, that the domestic steel industry was a rust belt, sunset industry, and by looking at the bigger international and historical picture behind that image, I was able to make a lot of money, both virtually and actually. What stunned me, and continues to puzzle me, was the power of that imagery in the minds of people that I would talk to, who simply could not accept the idea that the domestic steel industry would stage a comeback. The poor image, of course, made the deal so much sweeter, because it made it possible to purchase shares at what, in retrospect, was a ridiculously low price.

So for someone who examines the broad historical trends, who understands that just because things are a certain way right now does not mean that it is normal for things to be that way, who challenges industry images and looks deeper for the underlying causes of growth or decline, and who enjoys doing this and is good at it, the market is not efficient at all. It veers crazily in one direction, sending stocks of companies with no earnings up to dizzying heights one year, only for them to come crashing down and out of business the next. That is not efficient. Right now the stock prices of companies that own Las Vegas casinos are at high levels that makes no sense whatsoever. After all, their earnings were down with $100/barrel petroleum in the first quarter, what will $130/barrel-and-up petroleum do to them this quarter and next? Also, there is a crazy lack of recognition for the growing tidal wave of inflation that will sweep over our society, changing everything. There was an article in the New York Times business section yesterday advising how to manage one's bond portfolio with the threat of inflation in the air. I know how a bond portfolio should be managed: LIQUIDATE.

I would never say that beating the market is easy. The market is not logical, but rather a chaotic, illogical beast. But if one is patient and insightful, those reckless swings can become very profitable.