Wealth Management for the Long Run

You can now read our blog through our website!

2011-02-08T12:05:00.001-08:00

All future blog posts can be found on the Kenfield Capital Strategies website:

http://www.kenfieldcapital.com/blog/

Please continue to give us feedback, make comments, and suggest topics for future blog posts that you would like to know more about.

Avoiding Fraud by Investment Managers

2010-12-02T16:27:00.000-08:00

I came across an interesting article today on the financial blog Acrimoney.com. The piece is from March 2009, but the author's advice is still as true as it was then. The topic is how to avoid being the victim of Ponzi schemes and other investment scams.

Excerpt:

After fifteen years in wealth management—with both investment boutiques and brokerage houses—I know only one foolproof way to beat fraud: separate money management from reporting. You can hire that lights-out investment manager. But keep all your assets with a custodial bank like State Street or Pershing. They report your account value, not the money manager. It’s like separating church and state.

Custodians don’t make investment decisions. They hold securities, process trades, and provide independent statements showing your portfolio’s value. They collect dividends and bond payments. They receive wire transfers into your account or send them with your instructions. Their job is to watch your money. In the timeless words of Ronald Reagan, custodians enable you to “trust but verify” what your money managers claim.

Full article

New Financial Regulations

2010-06-28T12:56:00.000-07:00

After months of intense debate and extensive media coverage, Capitol Hill and the White House have finally agreed upon a plan to overhaul financial regulations in the US. The bill still must pass through both chambers of Congress before it becomes law, but this is all but assured as President Obama and Democrats from the House and Senate are on board. Major last-minute concessions, such as allowing banks to trade swaps and derivatives to hedge against their own risk, had to be made to gain support of the bill from moderate and conservative Democrats so that the proposed bill could be finalized in time for Obama to present it to the G-20 meeting in Toronto. The provisions of the 2,000-page bill can be broken down into four categories: expanding the power of the government, tightening regulations for financial companies, protecting consumers from institutional banks and protecting investors from bad deals.

Regulations on financial companies are greatly increased in the financial reform bill. The provision that will likely have the most significant impact on how banks do business is the Volcker Rule, which prevents financial institutions from making risky trades with their own funds. This rule, similar to the Glass–Steagall Act of 1932, protects taxpayers from having to bail out institutions that risk (and lose) funds that are protected by the FDIC. It should be noted, however, that the ban on proprietary trading is not total: banks can still invest up to 3% of their funds in hedge funds and similar vehicles. Swaps will now have to be done through affiliates of banks, with the exception of trades that are tied into the banks’ business and necessary for hedging risk (interest-rate swaps, foreign-exchange swaps, gold and silver). Swaps relating to agriculture, uncleared commodities, most metals and energy will have to be traded by affiliates, since these trades do not directly pertain to banks’ business. Banks will also be required to meet more stringent capital standards, and will no longer be allowed to include trust-preferred securities in their calculations of capital. Also, financial institutions and hedge funds with more than $50 billion and $10 billion in assets, respectively, will be assessed fees over the next five years that will total $19 billion (to offset the cost of the bill). These fees will be collected by the FDIC, with any leftover funds going towards paying down the national debt.

The other goal of the bill is to protect investors and consumers from being taken advantage of by financial institutions and related businesses. Under the Federal Reserve, the new Consumer Financial Protection Bureau will oversee banks and other non-bank financial firms (including mortgage-related businesses and credit unions) and enforce regulations as needed. Mortgage lenders will now have to verify a borrower’s income, credit history and job status before giving them a loan. Banks will have to keep 5% of the credit risk from packaged loans on their own balance sheets, which should incentivize them to issue loans only to worthy borrowers. Also, the bill established a Financial Stability Council, which will monitor large financial firms and advise the Fed of any potential threats to these companies and their business. If necessary, the council, along with the FDIC, would have the authority to wind down failing firms, and the bill addresses this liquidation procedure. The bill also gives states the power to impose additional consumer protection laws against banks if they feel it necessary. For investors, the bill gives the SEC the authority to hold broker-dealers to a fiduciary standard similar to the one that investment advisers, including KCS, are currently held to. Hedge funds and private-equity firms will now have to register with the SEC as investment advisers and provide more information on their trades than currently required.

If signed into law, the financial reform bill would be the most dramatic financial regulatory overhaul in the US since the 1930s. But at this point, given that it is still just a bill and there are a number of details to be dealt with yet, it is hard to say at this point how it would affect our financial system and the way we do business in the long term. And while it seems like a lock that the bill (now being referred to as Dodd-Frank) will pass through the House and Senate, even after the death of Senator Robert Byrd (D-WV) over the weekend, we know how quickly things can change.

Today’s Market Reflects Tomorrow’s News

2010-06-18T17:07:00.000-07:00

So far in June, the stock market has continued to be volatile, but has gone nowhere since the end of May. Usually a stagnant period in the middle of a recovery would be disappointing, but in this case is more of a relief after a crummy May that saw a –8.3% drop in the S&P 500. In any case, mediocre market performance over the last month should not come as a surprise, given the amount of apparently bad news we have been receiving over the last few months about the progress of the recovery.

Investors often make the mistake of attributing current market performance to recent news. In reality, the stock market acts as a leading indicator for the economy. (For an explanation of economic indicators, see my last entry about the Volatility Index). News we hear on any given day is nearly always already reflected in current stock prices. (This concept is often called the “efficient market hypothesis.”) Exceptions include unforeseeable occurrences, such as the BP oil rig explosion, and events about which advance information is privy to only a select few individuals, such as the announcement of civil charges against Goldman Sachs. In nearly all other cases, so-called “current” information has already been considered by millions of investors, particularly professionals with huge amounts of capital, whose decisions move stock prices. On average, the stock market reflects information about five months in advance, so that today’s news is already 5 months old as far as the stock market is concerned.

Investment banks pay huge salaries and bonuses to analysts because they depend on them for recommendations that they use when making enormous bets on the market. Analysts are human like the rest of us, which means they can make mistakes and lack clairvoyance. But the combination of intelligence, experience, training and the resources at their disposal allows them, as a whole, to develop hypotheses about the future with a significant collectivedegree of success. This success comes from the sum of the incredible amount of manpower and money that professional investment firms devote to research.

Analysts are usually assigned to a specific sector or industry; some operate in the even narrower scope of analyzing a single security, or a select few. Many firms have multiple analysts working in each sector, which illustrates the amazing amount of resources dedicated to analyzing each area of the market (especially when you consider the inhuman hours that many analysts work). So it should come as no surprise that the European debt situation was being considered and accounted for months ago by large institutions—weeks or months before it was mentioned by the media. The same goes for financial reform, the anticipated slowdown in corporate earnings growth, and other economic issues that have recently induced fear (and selling) by day traders and non-professional investors.

Given their level of compensation and resources at their disposal, you can understand why analysts and their firms are expected to remain ahead of the curve and be right more often than not. However, this informational “edge” is not, by itself, enough to ensure outsized success for Wall Street, and it also does not mean that non-institutional investors can’t compete. Rather, it tends to create a marketplace that rewards contrarian investors who don’t blindly follow the crowd. The best investors do not act on information as it becomes public, because they know this information is already priced into the market. They take the information a step further and figure out what sort of opportunities it might create in the future.

The Volatility/Fear Index

2010-05-19T15:57:00.000-07:00

Over the past few weeks equity markets have been shaky—to say the least—owing to rising uncertainty over the global economy. Lately it seems as if every development in the European debt situation (some call it a crisis) leads to a massive market selloff, both here and abroad, as investors weigh the effects of global problems on the US economy and fear the worst for the future. The Chicago Board Options Exchange Volatility Index (Chicago Options: ^VIX) is often called the “fear index” because it measures the implied volatility of S&P 500 index options over the next 30-days. Its price corresponds to the expected change, so the recent VIX price of 32 indicates an anticipated annualized change of 32% in the S&P 500 price over the subsequent 30 days. In stable markets, the VIX typically stays in the 10–20 range; in very unstable markets, such as September 2008 – May 2009, when the price broke 80 on two occasions, we saw short-term averages in the 50s and 60s.

The VIX price is generally (and, as we will see, erroneously) accepted as a leading market indicator, meaning its movement precedes changes in stock prices. More specifically, a sharp rise in the VIX is thought to indicate an imminent drop in the market. This idea makes logical sense—heightened fear among investors triggers a rise in option premiums (implied volatility), which in turn triggers a stock market selloff. But after comparing VIX and S&P 500 prices over time, it is apparent that the VIX price has acted as a concurrent, or even lagging, indicator during higher levels of volatility, and no indicator at all during other times. If the VIX price were a leading indicator, the highest levels of volatility would indicate that the worst is soon to come; in reality, it indicates that the worst is already here, or in some cases, has already passed.

As you can see in Figure 1.1 below, the highest levels of the VIX usually coincide with cyclical lows in the S&P 500. The relationship is much more evident in declining markets, which makes sense, since the VIX price stays relatively consistent when the market is doing well. In Figure 1.2 I have included markers to show cyclical lows of the S&P 500 and the corresponding peaks in the VIX price. Perhaps even more helpful is Figure 1.3, which shows the S&P 500 vs. 1/VIX (the reciprocal of the VIX). You can see how the two measures move in tandem, since stock prices and volatility generally move inversely. This relationship is shown in greater detail in Figure 1.4, which tracks S&P 500 prices and 1/VIX from 2007 – 2009. Again, the relationship is stronger during this bear market, where volatility plays a greater role in investor decision-making.

One specific situation that helps illustrate this point, and has a number of parallels to the current situation in Greece, is Russia’s debt crisis of 1998 (Figure 1.5). The country was dealing with excessive inflation, and appeared susceptible to defaulting on its debt, much like Greece today. The ensuing panic (in the US) led to a -11.7% drop in the S&P 500 over a period of just 3 trading days, beginning on August 27, 1998. But as you can see from the graph, the VIX did not top out until approximately two weeks later, illustrating once again that the VIX typically coincides with or lags market movements. The fallout from the Russian debt crisis also led to a “double-bottom” the next month (shown by the green circles), where the market fell again soon after rebounding from a collapse. Once again, the VIX’s high came shortly after the market bottomed out for the second time.

It is no surprise that the volatility caused by the Flash Crash (May 6), combined with the situation in Europe, gave way to the S&P’s lowest close since February. But given what we have learned from the VIX (which hit 42.15, a 52-week high, on May 7), we know this increase in volatility was indicative of a current low, not an impending one. While this doesn’t mean that stocks can’t go somewhat lower before rebounding, perhaps accompanied by an even higher VIX, the May 7 peak in the VIX is useless in predicting whether or not this will happen.

The BP Oil Spill

2010-04-30T18:13:00.000-07:00

Last week the Deepwater Horizon, a Transocean Ltd. (NYSE: RIG) oil rig leased to British Petroleum (NYSE: BP), exploded and sank in the Gulf of Mexico, costing at least eleven lives, hundreds of millions of dollars in damages and great harm to the environment as its well leaks oil at a rapid rate. As I write this entry, the well is leaking 5,000 barrels (155,000 pounds) of oil per day into the Gulf. Even more frightening is the fact that if the well cannot be closed, the total leakage could amount to over 100,000 barrels (4.2 million pounds) of oil.

Many Americans are wondering why more safety precautions were not taken in anticipation of such an event, given the potentially catastrophic damage we are seeing now. Every oil well has a shut off valve, known as a blowout preventer, which cuts the flow of oil from a well when closed. Crew members of the rig were either unable to close the valve, or they tried and the shut-off process simply did not work. Still, the shut-off process should have happened automatically through the “dead man” switch, whose purpose is to sense catastrophe and close the valve. The Deepwater Horizon did have a dead man switch, but for unknown reasons it failed to close the valve. The last line of defense in this situation would be an acoustic trigger, a device that sends acoustic impulses through the water that can trigger a valve to shut down the well; however the Deepwater Horizon did not have one. Interestingly enough, BP was the main opponent of regulations proposed by the US that would have required acoustic triggers on deep sea rigs, citing unproven effectiveness and cost issues as their reasons for opposition. If it fails it fails, but it looks like it would have been worth the $500,000 (the cost of an acoustic trigger) to try – this incident alone is costing BP $6 million a day, not to mention the $560 million cost of replacing the rig.

The issue now is trying to stop the leak at its source, and then deciding how to move forward if that effort fails, which is very possible. Remote-controlled robots were dispatched to activate the blowout preventer, but so far those efforts have not proven effective. On Wednesday, BP conducted a “test burn” to measure the effectiveness of setting fire to the oil-filled water. While the test was successful, weather conditions deteriorated soon after, preventing any further burning from taking place. Other ideas for containing the leak include building a massive dome to be placed over the well, as well as drilling a second well at an angle to relieve the pressure of the leaking well, and intercept its contents. BP’s stock price has already fallen 13.8% since April 20th, the day of the explosion. But even more damaging to BP is that it is on the hook for the total cost of containment and cleanup, which is an unknown at this point but exceed $1 billion. Luckily for Transocean, it is insured for the total cost of the rig, $560 million, as well as $950 million in third-party liability coverage, but is responsible for any losses exceeding that figure.

It’s safe to say that we will see major changes in safety regulations for deep sea oil rigs, and eventually BP will be faced with fines and lawsuits related to the incident, but at this point the main concern is containing this massive leak and minimizing further damage. It also remains to be seen whether or not the government will scale back offshore drilling in general, mainly in the Gulf and off of the Atlantic.

Financial Reform Bill

2010-04-23T16:26:00.000-07:00

All the focus this week is on two issues surrounding the financial industry – Obama’s efforts to push his financial regulatory reform bill through Congress, and the fraud lawsuit brought against Goldman Sachs by the SEC. While these two issues should be unrelated, it’s hard to overlook the convenient timing of the SEC’s accusation against Goldman. But since our President has assured us that he found out about the accusations from the news media, and that the SEC is an independent agency that does not report to the White House (and we know politicians always tell the whole truth), we can chalk it up to “coincidence.” And since I already discussed at length the charges being brought against Goldman and the likely effect on the company and stock market, I will spend more time focusing on the impending financial reform bill.

The financial regulatory debate has parallels with the recent healthcare issue. While most people understand why Washington is trying to implement these reforms, much like the healthcare reform bill, few people understand what reforms they are advocating, and how these reforms will affect Wall Street or anyone else. Additionally, both parties are taking such a strong stance on this issue that the facts have become secondary to partisan jabbing, leaving the American people clueless.

The goal of all the proposed reforms fall under four major categories: protecting individuals from banks and other large financial institutions, protecting these institutions from themselves, increasing the power of shareholders, and requiring more disclosure by financial institutions. The strongest opposition from Wall Street has been in response to the idea of a tax that would affect bank, thrift and insurance companies with more than $50 billion in assets, in order for the government to recoup its losses from the bailout. While this would generate more cash flow for the government, it would almost certainly lead to increased fees for these institutions’ clients. The law also seeks to heavily regulate the trading of derivatives, financial instruments whose value is dependent upon the price of an underlying asset. But too much regulation of derivatives could impede the ability of financial institutions and others to hedge against major losses (the intended purpose of derivatives trading). Other proposals include increased shareholder powers, a consumer protection agency, and the Volcker Rule which would require banks to be separate entities from hedge funds or private equity funds, and would also ban proprietary trading by banks except in certain cases.

Any future changes to our country’s financial industry will undoubtedly come with one major caveat – people will find a way around them. Congress needs to limit changes to things that have a high likelihood of achieving the above four goals without unpleasant side effects. Delaying full commissions for mortgage brokers until the loans have been refinanced or shown to be performing, and requiring banks to retain a stake in loans they securitize so that they remain on the hook for some of the losses, are both ideas that would provide positive incentives to do good while increasing accountability by financial institutions. These are the types of changes that might actually prevent another financial crisis. We could do without regulations that just create loopholes, encourage gaming the system and cause more distress to the American taxpayer.

Government Bond Yields Reflect More Than Just Default Risk

2010-04-13T15:12:00.000-07:00

I’ve said it before and I’ll say it again – we (investors and non-investors alike) need something to worry about. So it shouldn’t come as too much of a surprise that members of the media are questioning the safety of US debt after three Treasury auctions were met with poor demand a couple of weeks ago, mainly from foreign investors. There are a lot of things we should worry about as investors, but the safety of US Treasury debt is not one of them. In the Wall Street Journal article entitled “Debt Fears Send Rates Up,” the reporter points out that during the prior week, U.S. Treasuries were yielding slightly more than U.S. corporate bonds, which is surprising but not unheard of. But her source, an economist at BNP Paribas, brazenly goes on to say that maybe investors are more comfortable with the risks of owning bonds backed by U.S. corporations than the government. This seems far-fetched considering our government just bailed out a number of our country’s most prominent banks and automakers to the tune of nearly a trillion dollars, and given the fact that the US has never even come close to defaulting on our debt. While it is a worst-case scenario, we could simply print more money, unlike many European governments—such as Greece—which depend on the European Central Bank to control the money supply in the Eurozone.

A rising yield for Treasuries, or any developed country’s debt issues, is only occasionally reflective of increased default risk, which is not the main determinant of bond yields and prices. Expected growth, inflation and changes in currency exchange rates are the major determinants of government bond prices; in many cases, they are more important than default risk in pricing a bond. Let’s look at current bond yields to illustrate this point. 10-year U.S. Treasuries and U.K. Gilts currently yield 3.63% and 3.75% respectively, while Japanese government bonds yield only 1.40%. However, according to the S&P, Japan’s credit rating is “AA” while the U.S. and U.K. both have the most secure rating of “AAA.” Whether this is caused by expected appreciation of the Yen against other currencies or assumptions about growth rates or inflation in Japan, it is clear that investors are willing to take a much lower interest rate on Japanese bonds despite their supposed higher default risk.

The decrease in Treasury prices and subsequent increase in yields (since prices and yields move inversely to one another) isn’t something to completely overlook. This could be problematic for the housing market, as it could lead to increased mortgage rates, or could be indicative of other impending problems for the U.S, such as higher inflation down the road. But it certainly does not mean U.S. debt is any less secure than it always has been for many decades.

Gambling, Losing, and Complaining About It

2010-03-12T17:46:00.000-08:00

There has been a recent uproar from citizens and politicians, in Los Angeles and a number of other cities and counties in the U.S., over municipal interest rate swaps that are now costing local governments millions of dollars a year. An interest rate swap is essentially a legal bet between two entities, one of which is trying to hedge its interest rate exposure. In Los Angeles’ case, the swap was made with Bank of New York (BNY) Mellon, who in 2006 exchanged $443 million worth of fixed-rate debt for an equivalent amount of variable-rate debt issued by the city.

Los Angeles made the deal to protect itself against the possibility of rising interest rates, which would have increased the interest owed on its variable-rate municipal bonds. However, in agreeing to this exchange, the city exposed itself to the risk that interest rates would fall, which they of course did—dramatically. The payoff in a swap is determined each quarter by the spread (difference) between the variable and fixed rate. Thus, the fixed-rate buyer stands to gain if interest rates rise, or lose if they fall.

Four years and one economic crisis later, the City of Los Angeles finds itself on the hook for $19 million a year (at today’s interest rates). But rather than accept the consequences of its gamble, or opt to refinance the floating rate debt with fixed-rate bonds, the city is demanding a renegotiation of the deal and threatening to never do business with BNY again if it does not comply. The most vocal cry baby of this effort is city councilman Richard Alarcon, who according to the LA Times described the deals as “tantamount to gouging” and likened the bank to merchants who sold water for $20 per gallon after the 1994 Northridge earthquake.

Conveniently, Mr. Alarcon doesn’t bother to mention that the City of LA, arguably a sophisticated investor, agreed to the deal, in which BNY also assumed risk. This is very different from the price-gouging merchants, who were taking advantage of increased demand owing to a natural disaster. “The bank is taking an unconscionable profit,” said Alarcon according to the Wall Street Journal. “We want to bring it down to a simple customer-to-vendor relationship. When a customer is not satisfied, they go to a different vendor.”

Yes, Mr. Alarcon, LA is welcome to use a different swap vendor in the future, but the city still owes the money on the legal contract signed by consenting adults. We feel that there is even less substance to these claims than to those of a gambler who asks for his losses back from the casino.

Taxpayers in LA and other municipalities where interest-rate swaps have gone awry (such as Jefferson County, AL which owes $3.2 billion on sewer bonds) are probably all wondering the same thing: Why gamble? Swaps are typically used as a hedging instrument. For example, if you have exposed yourself to the risk of rising interest rates from issuing floating-rate bonds, you can mitigate that risk (and any reward if interest rates drop) with a swap. So the city either made a cold bet on the future of interest rates, or it has succeeded in hedging another risk and still wants to recoup its losses on these swaps. What we are seeing here is nothing more than a case of buyer’s remorse at the municipal level.

Currencies and Purchasing Power

2010-03-05T18:07:00.000-08:00

This week we are looking at the fluctuation of currency exchange rates, as well as the effects of exchange rates on investors and consumers. The exchange rate between two currencies indicates the relative worth of one currency against the other. As I write this article, the Euro-to-US dollar (EUR/USD) exchange rate is 1.36 – one Euro has the equivalent value to $1.36 USD. The American dollar-to-British Pound (USD/GBP) exchange rate is 0.66, so an American dollar in England can purchase £0.66 worth of goods. In efficient markets, equivalent items should cost the same in all countries; this is known as “the law of one price.” But since prices cannot adjust to rapidly fluctuating exchange rates, the purchasing power of one currency against another is constantly changing.

Purchasing power parity (PPP), based on the law of one price, attempts to find the appropriate exchange rate so that an identical good in two different countries has the same price in terms of purchasing power. In theory, PPP should determine exchange rates; in the real world, currencies fluctuate for all sorts of other reasons, while the prices of goods and services remain constant over short periods of time. (A notable exception is The Trader Bar in Melbourne, Australia, where the price of each drink fluctuates based on the current demand. A lighthearted, though effective, illustration of PPP is The Economist’s Big Mac Index, which compares the price of a McDonald’s Big Mac in different countries against the country’s exchange rate to show how relatively expensive or cheap each currency is.

The market exchange rate determines the purchasing power of one currency relative to another, but what determines market exchange rates? Let’s look at the recent situation in Europe and how it has affected the purchasing power of the Euro. Currencies fluctuate similarly to bonds in that a rise in interest rates results in a decrease in the currency value, which happened recently as a Greece, Spain and other European nations issued a large amount of debt. Uncertainty over these governments’ ability to repay loans to their investors forced them to issue debt at a higher interest rate than previously; as expected, the Euro declined sharply. For example, relative to the US dollar, Australian dollar and Yen, the Euro has fallen -4.90%, -5.63% and -7.66% respectively since January 1, 2010. These are drastic declines over such a short period.

Investing in the foreign exchange market is unique in that it operates 24/7 and produces small profit margins in comparison to other markets. As a rule, I do not attempt to use currencies as long-term investments. I do, however, occasionally hedge against large fluctuations in exchange rates that may affect my foreign investments by using various techniques. Currency fluctuations don’t usually affect investment returns that much over the long term, but exchange rates can be highly volatile over short periods of time.

In the long run, purchasing power parity should determine the relative value of currencies. But in the short term, currencies can be substantially over or undervalued, such as the Yuan which the Big Mac Index estimated to be almost 50% cheaper than the US dollar. So if you are looking for the best price on Big Mac’s, look no further than Beijing!

GDP: Fourth Quarter 2009

2010-02-26T18:38:00.000-08:00

This morning the Bureau of Economic Analysis (BEA) released its second estimate for 2009 4th quarter gross domestic product (GDP), which they estimated at just under $14.5 trillion. GDP measures the output of domestically-produced goods and services. The real (inflation-adjusted) GDP increased at an annualized +5.9% from the third quarter, a jump from the previous quarter’s +2.2% increase. And while annual GDP decreased -2.4% from 2008 to 2009, last quarter’s GDP was +0.1% higher than the 4th quarter of 2008. The current report indicates positive shifts in a number of important areas, and is consistent with a country beginning to claw its way out of recession.

GDP is divided into four broad categories: personal consumption, private investment, government spending and net exports (the difference between exports and imports). The largest increase from the prior quarter came from private investment, which increased an astounding +48.9%, thanks in part to improvement in private inventories (after a -23.1% decrease over all of 2009). The change in private inventories accounted for 64% of the total change in real GDP. Both this change and the +2.8% increase in consumption of goods reflect the improved consumer spending as well as anticipated spending. They also demonstrate what I discussed yesterday in my email article – that both recessions and recoveries are driven by business spending, not consumers. Consumers buy after Corporate America: if Wal-Mart is re-stocking their inventory, they do so because they are expecting us to buy more of their products.

As for government expenditures, which include federal and state/local spending, you may be surprised to learn that they decreased by -1.2% from the prior quarter. State and local governments decreased spending by -2.0% while the federal government increased spending by +0.1%. Federal government spending is broken down into defense and non-defense spending, which dropped -3.5% and increased +8.3%, respectively. The fact that a small decrease in defense spending and a large increase in non-defense spending effectively negate one another shows how much of our discretionary spending (64%) is devoted to national security.

Another favorable economic indicator from the recent GDP estimates is the increase in both exports and imports. While we are still running a trade deficit of -$347 billion, we can take some solace in the fact that exports increased +22.4% from the previous quarter while imports rose +15.3% over the same time period. This capped off a 2009 that saw a +$138.9 billion increase in net exports (a decrease in the trade deficit) from the previous year and a fourth quarter increase of +$10.3 billion. Historically, a substantial increase in both imports and exports is a strong indicator of economic recovery.

While it is promising to finally see significant growth in consumer spending, private investment, exports and other important areas, it only means things are headed in the right direction. Last year’s real GDP is still a -2.4% decrease from 2008. We are definitely on the road to recovery, but we still have a ways to travel to get there.

Treasuries

2010-02-19T18:28:00.000-08:00

Last week we looked at historical returns on gold and showed that, despite widely-held beliefs about the commodity, it’s a risky investment that barely keeps up with inflation. We showed that over time, gold has proven itself to be significantly riskier and far less profitable than stocks.

This week we look at treasuries, which by their nature are not as risky as stocks or commodities, but are still perceived to be far safer than they truly are when you look at real (inflation-adjusted) return. Treasuries are unique in being fully guaranteed by the US government. If you buy a $1,000 10-year treasury bond with a 6.8% coupon, you will undoubtedly receive $34 semi-annually until the bond matures, at which point you get your $1,000 back. The total interest earned over this period (before reinvestment) is $680. But even with the ultra-safe, guaranteed return, you could still lose money!

You may be wondering how it’s possible for an investment with guaranteed returns to lose value. The answer is inflation. For example, $1,000 in 1970 had spending power equivalent to over $2,160 in 1980. If you collected any less than $1,160 in interest payments over the life of the bond, your real (inflation-adjusted) return was negative. In the example above, you would actually have lost $480 over the 10-year period.

Let’s compare treasury bills, which mature in one year or less, treasury bonds, which mature between 20 and 30 years, and common stocks. Since 1871, stocks have returned +6.3% annually after inflation, compared to +1.9% for treasury bills and +2.4% for treasury bonds. So stocks provided far better returns over the long term.

Now let’s look at risk. Over the past 110 years, the worst decades for stocks were the 2000s, when they returned –2.2% annually, and the 1910s (–2.1% annually). Treasury bills, on the other hand, returned –4.5% per year during the 1940s, while treasury bonds dropped –4.8% per year in the 1910s and –3.2% in the 1940s. Not so safe after all it seems.

So while treasuries fluctuate less than stocks in the short term, their worst-case performance over a decade is lower than for stocks. And stocks’ best-case performance is far better: +15.7% in the 1990s vs. +8.1 for treasury bonds and +3.7% for bills in the 1980s. So while bonds are an important part of a diversified portfolio, and usually yield a positive real return, it is important to understand that risk is inherent in any potentially profitable endeavor. US treasuries are no exception.

Gold – Not So Safe after All

2010-02-12T17:15:00.000-08:00

Following a disastrous 2008 for equities, stocks have come to be perceived as risky, volatile investments, especially for investors funding retirement accounts and other conservative portfolios. Instead of trying to find the next Google, investors have become more interested in finding safe places for their money – low-volatility, minimal-risk investments that hopefully protect against inflation. Gold has recently developed a reputation for being one of these “safe” investments after posting a comparatively fantastic +11.28% annualized return from 2000-2009, a decade during which stocks actually declined for the first time since the 1930s. Seems like gold is the place to be!

But wait one second. An historical analysis of gold returns against the S&P 500 shows that not only has gold been less profitable than stocks over the long-run – it has also been more volatile. You may be surprised to learn that gold has only outperformed stocks in three of the eleven decades since 1900, and has barely posted a positive return since 1871, with less than +0.8% annual growth, while stocks have grown +6.3% annually over the same period (both of these figures are after inflation). To get an idea of the significance of this difference, over 30 years at the above rates of return, $1,000 worth of gold would have grown to $1,266, vs. $6,252 for stocks (again, after inflation).

Until 1968, the price of gold fluctuated little owing to fixed prices and the Bretton Woods System, which held gold to a fixed price relative to the value of the US dollar, the system’s anchor currency. The system was enacted partly because the US government had nearly $26 billion in gold reserves, and by controlling the price of the commodity it virtually ensured the value of its gold would not substantially decrease. Bretton Woods eventually became unsustainable and was ended in 1968, at which point the price of gold was free to fluctuate. But in comparing returns on stocks and gold since the 1970s, a decade where gold returned an average of +16% annually after inflation, we still see a greater annualized return for stocks (+5.2%) than for gold (+4.2%) in the 40 years since 1970. The 80s and 90s saw a massive disparity between the two investments: stocks posted annualized after-inflation returns of +9.9% and +15.7% respectively over each of the two decades, while gold lost value at annualized rates of -8.2% and -5.3%. So much for hedging against inflation!

My point is not that one should only own stocks and never own gold. Nor do I necessarily disagree with analysts who project that gold will be a profitable investment over the near term. I am just using historical analysis to show that gold has been a relatively poor investment and ineffective inflation hedge over the long term, and is even more volatile and unpredictable than stocks. Its recent reputation as the perfect inflation hedge or as a “safe” investment is not deserved.

This is an illustration of how $100 would have grown over the last thirty years (click to enlarge):

Looking for Bad News in Greece and China

2010-02-02T14:53:00.000-08:00

There are times when investors want to find reasons to see the glass as half-empty—looking for some issue or problem to confirm our fears and justify scaling back our positions or becoming more conservative in our investing. Last week was one of those times. It should have been a good week for stocks, between Bernanke’s reconfirmation, better-than-expected corporate earnings and a +5.7% jump in GDP for the 4th quarter, the most in six years. Instead, we saw sharp declines in stocks around the world from Tuesday through Friday. The two most obvious scapegoats are Greece, with the possibility of its national government defaulting on its debts, and China, which intends to curtail its own economic growth over fears of future inflation.

Analysts and stock market reporters can write much better stories by looking at what happened (stocks fell) and trying to explain why it happened (people were scared about Greece and China) rather than addressing the real issue—investors are still scared of being burned, and are looking for every reason not to invest, even if they are not good reasons.

We haven’t seen a national government default since Argentina in 2002. Before that we saw Russia and Ecuador in 1998 and North Korea in 1987 (that last one must have been a real shocker!). And though there is a slim possibility that Greece could default on its debt, I find it hard to believe, especially in view of recent statements, that the other EU nations will let this happen and endanger their monetary union. It is hard to say what effect an EU bailout of Greece would have on the US stock market, but the distant possibility of a foreign default is not reason enough for investors to shy away from investing when conditions are otherwise as promising as they were last week.

With China, why is it such a big problem if the government there wants to ease growth from too fast to just fast enough? Might they overshoot and slow the economy more than they would like? Of course they could, but their recent actions to rein in lending were triggered by data showing that the Chinese economy has been growing much faster than expected. Even investors in “China-sensitive” stocks, such as energy and materials, must have been surprised by 2009’s upwardly revised GDP figure of +8.2%. China’s economic growth rate had actually been accelerating throughout last year. The rest of the world should be so lucky.

Make no mistake, I am not saying that the possibility of Greece defaulting or China’s future economic growth slowing a little too much should not be considered in our decisions today, because they could affect our global economy and equity markets. I just question the sudden and indiscriminate selling of securities amidst the reality of better than expected economic news and corporate earnings reports on the basis of “what-if” scenarios that probably won’t ever happen.

No Healthcare Bill -- What Now?

2010-01-22T16:08:00.000-08:00

Healthcare stocks rallied Tuesday morning when it was all but confirmed that Massachusetts Republican Scott Brown would be Ted Kennedy’s replacement in the Senate, likely dooming Obama’s healthcare initiative. Reports from Wall Street indicated a sense of relief among healthcare investors, in large part because we would not have to deal with the uncertainty of a restructured health insurance system. Famed stock trader Jesse Livermore said that “all through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope.” Aside from investors’ aversion to change of any kind, the situation surrounding the healthcare bill can be attributed to two of these emotions – fear and ignorance.

How many people can say they understand the intricacies of Obama’s healthcare plan? Not very many – and even for those who do, there are too many factors to take into account to predict its long-term effect on the healthcare industry or the overall economy. Nonetheless, due to the uncertainty of the proposed plan, stocks of managed care companies and pharmaceutical firms performed poorly in 2009 relative to the market. But as it became less probable that we would see a dramatic restructuring of the healthcare system, these firms’ stocks started to rally strongly.

This is a clear example of how fear and ignorance drive investment decisions. We fear the proposed change, and we are too ignorant to embrace the possibility of the change producing a good outcome. Obviously there are political and selfish motivations for opposition to the plan, but for all we know Obamacare could be a good thing for the healthcare industry. (Medicare was fought bitterly in the 1960’s, yet it drove tremendous growth and innovation in healthcare.) For example, millions of uninsured Americans would become policyholders, potentially increasing the revenues of health insurers, along with doctors, hospitals and pharmaceutical companies. Or it could cause a nightmare for healthcare companies and their investors, as many believe. Nobody can know for certain, but one thing we do know is that we’re scared to death to find out.

In any case, the battle over Obamacare has certainly confirmed Jesse Livermore’s assertion – at least the part about fear and ignorance.

Roth Conversion—Much Ado about Anything?

2010-01-15T15:12:00.000-08:00

This year, everyone seems so excited about the new guidelines for converting your traditional IRA to a Roth IRA. For those of you living in a cave, the new rule that took effect at the beginning of the year allows anyone to convert a traditional IRA to a Roth. Before 2010, you could only convert if your modified adjusted gross income was less than $100,000/year. Also, a “one-time special offer” allows the tax burden from the conversion to be spread over the next two years. While the new guidelines provide a potentially money-saving opportunity for some people, it’s far from the “no-brainer” that many financial columnists would lead you to believe.

A traditional IRA is typically funded by pre-tax dollars, providing a tax write-off when you make the contribution, but the withdrawals are taxed as ordinary income. They also require investors to begin withdrawing money at age 70 ½ in the form of required minimum distributions (RMD). To make matters worse, your withdrawals could push you into a higher tax bracket and force you to pay more taxes than necessary. On the other hand, a Roth IRA taxes the funds contributed at the time of contribution, with the promise of tax-free withdrawals in the future and no distribution requirements. It sounds like a slam dunk to convert, but everyone’s situation is different, making the answer to the question fuzzy and in need of case-by-case analysis.

Lifting the income restrictions for Roth conversions, and incentivizing the move even more with drawn out taxation, certainly makes sense for the government. During the next two years, the Federal and state governments will realize tax dollars they would not have seen for years from people who take advantage of the new laws. If enough previously excluded investors decide to make the move, it could mean a big near-term payoff for government, especially since far more money is tied up in traditional IRAs than in Roths ($3.7 trillion vs. $178 billion in 2006).

For the individual investor who can comfortably afford the immediate tax burden of conversion, and who is confident that those tax dollars are unlikely to serve a better, more efficient purpose, making the conversion seems like the logical move. But consider the uncertainty of the world we live in, and the nature of financial markets. Also consider a scenario a decade or two down the road where the government, in a similar situation to today, needs to generate revenue. They might not find it hard to justify taking money from rich people who are withdrawing massive amounts of tax-free money from their retirement accounts. Although an unlikely scenario, it forces you to look at the big picture and ask, “Why pay tax now if I can delay it?” Perhaps, 401(k) expert David Loeper said it best in a recent article: “With a highly uncertain future, basic option theory and common sense dictates that we should not pay additional tax now with certainty if we can avoid it, unless there is a clearly compelling advantage to doing so.” Don’t just go blindly and convert; do a thorough analysis and convince yourself that it really makes sense.

For most people, the analysis is too tedious and convoluted to spend time on, and most of the online tools are far too simplistic. If you have a financial advisor that you trust, he or she should do the analysis for you. If you are seriously considering conversion but don’t have a trusted financial advisor, it may be worth the cost to hire one just for this purpose. The fee may justify the wisdom of conversion, or it may save you from paying a lot of income tax today unnecessarily.

The Chips Fall Down

2009-11-20T09:22:00.000-08:00

Today was the first real down day we’ve had in a couple of weeks. There was no specific reason for it, which is usually a good sign. After several big up days (the S&P 500 had jumped over +6% in just 11 trading days), it was time for a little selling (the pros call it “profit taking”). The financial press blamed it on a Bank of America analyst who downgraded 10 computer chip companies, including Intel, because of a potential “inventory overshoot” next year. But European markets were falling before this analyst opened his mouth, so investors were already in a selling mood prior to the opening bell in New York.

What about this feared “inventory overshoot?” Well, chip companies, along with just about everyone else, have pared their inventories to the bone during the recession. Now they’re finally starting to restock in anticipation of future demand. The concern is that they’ll overshoot, and have too much inventory by sometime next year. This would cause them to reduce production in order to work off the excess inventory. Could this happen? Of course; no one can predict demand precisely enough to always have the right amount of inventory. Will it matter? Probably not. Temporary mismatches between inventory and sales are common in business. Besides, the semiconductor industry is anticipated to grow 18% in 2010; I expect it could be more than this.

I bring up this rather arcane story because of something that happened to me recently, and which reminded me how low inventories have become. I ordered some additional memory for my Power Mac at home: 2 GB DIMMs, direct from the manufacturer (Micron Technology). That was several days ago, and the order hasn’t yet shipped. Why? The manufacturer is out of stock! We’re in the deepest recession since WWII and Micron can’t keep up with demand for its memory chips. So we already have at least one mismatch between sales and inventory: too little inventory. With demand increasing, manufacturers are going to have to ramp up big time to replenish their meager stocks. Also, I wouldn’t be surprised to see a lot of the more popular items sell out over the holidays. (You might want to finish your holiday gift shopping early this year.)

Most economic data and corporate earnings continue to exceed expectations. Earlier this week, Japan’s GDP report showed annualized growth of +4.8% in the 3rd quarter, more than twice what was forecast. And just a few minutes ago, the Bank of Japan upgraded its view of the country’s economic outlook, while leaving interest rates at historical lows. The global economy is clearly on the mend, but hardly anyone seems to notice, focusing as they do on lagging indicators like employment.

Except the stock market, that is. Global equities (as measured by the MSCI ACWI) are up over +70% since their March low. That’s a very impressive move in less than 9 months. Yet there are more than a few who think this huge up move is a head fake—a “countertrend” rally in a longer-term bear market. They think that we’re in the 1970’s all over again. Back then, stocks made little headway for the 16 years from 1966 to 1982. If they’re right, so the story goes, that could mean little upward progress until 2016. Not a pleasant thought.

But even if we’re “back to the ‘70s,” the stock market’s future could still be quite bright. Because what you don’t hear about those 16 years of stagflation is that the low point occurred in 1974, just under 9 years after the prior peak. Between December 1974 and the August 1982 “bottom,” which marked the beginning of an 18-year bull market, the S&P 500 had a total return of about +125%. Not bad for a bear market!

Coincidentally, the March 2009 low of this bear is exactly 9 years from the March 2000 peak. So even if 2009 is like 1974, there could still be a lot of appreciation before the next “official” bull market begins, as stocks have so far only risen about half as much from their lows as they did from 1974 to 1982. So even the worst-case scenario doesn’t sound so bad.

Also, if this is a “counter-trend” rally, it would be the longest and most powerful in history. The previous record is held by the initial rally after the crash of 1929, when the Dow Jones Industrial Average (there was no S&P 500 back then) rose +48% in 4 months before beginning its dizzying 3-year drop. The current rally is already significantly stronger and more than twice as long. The chances that the bear market of 2007–2009 is not yet over are, in my view, incredibly small. (And if this really is the first rally of a new bull market, as I believe, there’s a LOT more upside ahead.)

Too bad for the average investor, as mutual fund data indicate that a great many have been sitting out this rally, waiting (perhaps hoping is a better word) for a big decline that will allow them to get back in at much better prices. They are likely to have a very long wait. I said it in March and I’ll say it now: I don’t think we will ever again see the S&P 500 at 666 or the Dow at 6,500. Not just in our lifetimes. Ever. So stop waiting for the other shoe to drop. Yes, there are lots of problems, and yes, there will be more economic crises and bear markets in future years. But there will be no more falling footwear in 2010.

Day of the Dead?

2009-11-02T09:52:00.000-08:00

I wasn’t planning to write 3 daily emails in a row, but after today’s stock market reversal, I thought it would be a good idea going into the weekend.

As you probably know, stocks took back yesterday’s gains and a bit more today. So in 3 days, we’ve had 3 big moves: down—up—down. So should Monday be up? Who knows; investors have all weekend to stew about it.

Yesterday, it seemed pretty clear that the rally was driven by the better-than-expected GDP report. So what drove today’s drop? Whatever it was, I don’t think it was news. The only significant report to come out today was consumer spending, which was down –0.5% for September after several months in a row of increases. But this was exactly the number that economists expected, and was largely the result of a decline in car purchases after the expiration of the “cash for clunkers” program (see yesterday’s email for a discussion of this). Outside of motor vehicles, most areas of consumer spending actually increased.

Today was the last trading day of the month, and the last day of the fiscal year for many mutual funds. So “portfolio window dressing” could have had an impact on today’s trading. Also, volatility has been increasing rapidly over the past few days, which often scares people out of stocks. Volatility tends to peak at inflection points in the market, particularly at bottoms. Currently, we’re at about the same level of volatility as we were at the market’s July low, which was the end of a –7% correction; as of today, the S&P 500 is down about –6% from it’s October peak.

It thus seems that we’re in the process of forming a base from which another significant rally can start. Whether it begins as soon as next week or later is impossible to guess, but I doubt it will take more than a few weeks for the market—and investor sentiment—to turn around again. Interestingly, investor sentiment is also at about the same level as it was at the July bottom, yet the S&P 500 is nearly +18% higher than it was then. The wall of worry that typically drives bull markets remains solid.

Yes, this has been a disappointing week, and scary, too, owing to big daily price swings. But the S&P 500 is down barely –2% for the month, which is only 1/10th of its drop of last October. And this came after 7 consecutive months of gains. A pause in the upward momentum shouldn’t be a surprise. I think this pause will be one that refreshes, similar to the one in July. You may not remember, but back then the stock market made no headway at all for 2 full months, and was actually –5.4% lower in early July than it had been in early May. But those who stayed put and didn’t panic have already been rewarded with a double-digit gain.

From frightened to fearless

2009-10-30T10:37:00.000-07:00

What a difference a day makes!

Yesterday I opined that a better-than-expected GDP reading today could turn the market around and send stocks up again. That’s just what happened: 3rd-quarter GDP came out at +3.5%, better than the +3.3% “consensus” estimate. Stocks shot up right out of the gate and did not look back. By the time the closing bell sounded, the Dow was up 200 points (+2.1%) and the S&P 500 had jumped 23.5 points (+2.3%). Today also represents the biggest one-day rise since July 23.

So is the correction over already? It could be, as the length and depth of the drop has been similar to the several we have seen since March. Also, we are entering a seasonally strong period (November through May), which typically sees the best gains of the year. On the other hand, the market is much pricier now than it was just a few months ago, meaning that the bar is moving higher for good news to have a positive impact. Though I personally believe that we will see more positive surprises than negative ones over the next few quarters, that doesn’t mean we won’t have periodic setbacks.

You may have heard in the news that a lot of the growth in GDP last quarter came from government programs, such as “cash for clunkers” and the home buyers’ credit. One article said that “stripping out auto output, the economy would have expanded at only a 1.9 percent rate in the third quarter.” There are at least two problems with these statements. One is that it doesn’t matter why people buy something: a purchase is a purchase. Government incentives may be driving some sales now, but once they fade, other reasons could take over. The argument that consumption will suddenly stagnate without government incentives is specious.

The second problem with these statements is that they are just plain wrong. My own calculations from actual government data show that if one stripped out all auto sales directly attributable to the cash for clunkers program (670,557 vehicles at an average price of $28,400 = $19 billion), the economy still would have expanded by $93.5 billion last quarter, or 3.0% annualized. This is still a respectable advance, and well above the 1.9% claimed above. (You could calculate a growth of just over 2% if you stripped out all durable goods sales, including not just cars and trucks, but washing machines, furniture, heavy equipment, iPhones, etc.) On top of this, a large percentage of people who bought cars under the government’s program said they would have done so anyway.

What about the homebuyer’s credit? This is harder to calculate, because only new home construction and real estate commissions affect GDP; sales of existing homes or new homes sitting vacant since the prior quarter are not counted. It’s difficult to discern whether the home buyer credit caused an increase in the construction of new homes, and by how much, but I’m going to try. A study by Goldman-Sachs estimates that the tax credit has enticed about 200,000 more homebuyers to enter the market. About 1.5 million homes sold in the 3rd quarter. Let’s assume that all 200,000 of those first-time homebuyers bought a home last quarter; this would mean that 13% of sales were from these government-incentivized buyers. Let’s further assume that home construction increased proportionately.

According to the government GDP release, new home construction added 0.53% to GDP last quarter. (This is, by the way, the first time that residential construction was a positive contributor to the economy, rather than a drag, since 4th quarter 2005, when it added a whopping 0.1%!) If 13% of that was caused by the home buyer credit, then this government program added all of 0.07% to GDP. So without the credit, GDP growth last quarter would “only” have been +3.43%.

Take out both programs, and GDP would still have risen by about +2.9%, considerably better than economists were estimating just a month ago. What about direct government expenditures, or the rest of the stimulus program? Non-defense federal expenditures and investment added all of 0.17% to GDP last quarter, about the same as 2nd quarter; this is actually less than it contributed during several quarters in 2003 to 2006, when the economy was doing well. So direct government expenditures are not driving our economy, either. (As a comparison, during WWII military expenditures added a whopping 29% to GDP in 1942 and 19.5% in 1943; today they add between 0 and 0.4%.)

So those who say that government stimulus is primarily supporting our economy are misreading the data. Interestingly, these are often the same people who say that government stimulus programs don’t work. Now I’m not going to get into the economics nor the politics of this hot potato. I’m just going to conclude that the recession is over, the economy has started growing again—with or without government help—and good times will eventually follow.

Why is Wall Street spooked?

2009-10-28T11:36:00.000-07:00

Judging by the talking heads in the news media, you’d think the nascent recovery has come to a grinding halt. Despite over 80% of S&P 500 companies beating their earnings estimates, with many also showing higher sales than expected, gloom is everywhere. Consumer confidence has fallen for 2 months in a row. Forecasters are starting to ratchet down their 3rd-quarter GDP growth estimates. And the equity markets have taken back their October gains, putting us about flat for the month. This many be disappointing, but after last October, when global markets plunged –20%, a merely flat month should be something to cheer about. After all, even in a roaring bull market, stocks never go up every month. But why is this happening in the context of mostly positive news?

The obvious answer is that stock prices already incorporate the good news, while the few pieces of unexpected bad news (an earnings miss here, a surprise drop in new home sales there) are drawing everyone’s attention. During periods of economic growth, there are times when growth stalls or even backtracks. This has been the case in every recovery. Stocks tend to follow a similar pattern, with an overall uptrend punctuated by periodic setbacks. A drop in stock prices tends to reinforce the pessimism that triggered the drop in the first place. Eventually, pessimism peaks and the markets hit a near-term bottom. At this point, the uptrend can start again.

There’s clearly no way to know exactly when this will occur. If I did, I’d buy only on the days when each downtrend reversed and do all my selling just before each drop started. So although I claim no special clairvoyance (never have, never will), I sense that we’re close to a reversal back toward the upside, which could start as early as Thursday or Friday. A lot will depend on how the “flash” GDP number looks tomorrow. It it’s much better than expected, stocks could soar; if worse, they could fall some more before turning up again.

This GDP number is particularly important because it will likely represent the first quarter of economic growth in well over a year. Investors and economists are anxiously awaiting the “official” number, even though this initial estimate will be revised 2 or 3 times over the next several months, and “flash” reports are notoriously inaccurate. Even so, people will parse the details behind the aggregate number looking for clues to the future trajectory of economic growth in the US (despite the well-known fact that predicting the future by examining the past is futile).

On top of anxiety of tomorrow’s GDP report, and ongoing fears regarding bank solvency and the commercial real estate market (universally described as “the next shoe to drop”), we’ve had a couple of well-regarded investors call a near-term top to the current bull market. These include Bill Gross, chairman of PIMCO and one of the best bond managers in the word, and Jeremy Grantham, a well-known equity investor who supposedly predicted the 2008 downturn. Not surprisingly, many people take these pronouncements seriously, even though the smartest person is as likely to be wrong as right when predicting the future. And by the way, Bill Gross, despite his expertise in bonds, has a terrible track record in predicting the stock market (good thing he sticks to bonds when investing). And Jeremy Grantham not only predicted a bear market in 2008, but also in 2003, 2004, 2005, 2006 and 2007. (Nothing like being 5 years too early!) And by the way, despite being an avowed bear, Grantham still has 62% of his clients’ funds in equities. Go figure.

In sum, nothing that has happened recently has convinced me to change my intermediate- and long-term view that the economy, and along with it, risky assets such as stocks, bonds and commodities, will continue their general uptrend for quite a while. Until pervasive fear is eventually replaced by pervasive greed (something we are not likely to see for several years), every brief downturn and setback will scare the daylights out of most investors. But this sudden increase in the underlying level of fear only serves to form a base for the next leg upward, which these frightened investors will likely miss.

One last note: Americans continue to focus on their own country to the relative exclusion of the rest of the world. This is even more of a mistake today than it was in years past. The US stock market now represents only 42% of world market capitalization, and our GDP is just 25% of world production. And much of the world is growing far faster than the US. South Korea, for example, just reported a surprise 2.9% increase in GDP last quarter (equivalent to 15.4% annual growth). US economists would be giddy if we could produce an annual growth rate of just 6% in a single quarter. Thus, much of the opportunity in investing lies outside the US. This is why over 55% of our clients’ equity investments, and more than 20% of their bonds, are in non-US countries. Why not take advantage of the relative rise of the rest of the world?

Halloween should spook you; Wall Street should not.

Third quarter, 2009: Best in 11 years

2009-10-06T10:36:00.000-07:00

Stocks keep going up, with only minor setbacks, despite all the well-advertised problems with the global economy. The quarter just ended was the best one for the Dow Jones Industrial Average since 4th quarter 1998, and the best third quarter since 1939. For those who like numbers, the MSCI ACWI rose +17.9% during the 3 months ended September 30. The best performers were those very stocks that fell the most in 2008: financials, materials and consumer discretionary companies. This is typical of the early stages of a bull market: those stocks that are hit hardest rebound the fastest.

Why are stocks doing so well? For that matter, why are bonds on a tear as well? We all know that the economy is on the skids, the financial system is still shaky, the real estate market is moribund and unemployment is nearing post-Depression highs. Banks are failing on a weekly basis owing to continuing loan defaults, particularly residential mortgages. Everyone knows that commercial real estate loans are next. US consumers remain stretched, and instead of borrowing more against their homes, are paying down debt and cutting back, both voluntarily and in response to tight credit. Massive layoffs, and fears of being laid off, are naturally exacerbating consumer cutbacks.

Yet through it all, stock prices continue skyward. Even the pullbacks have been relatively short and mild. The deepest drop since the March bottom was about –8%; the current one has only been about –4% so far. This, again, is typical of early bull markets: the first real correction of –10% or greater doesn’t usually occur for 12 to 18 months or more. By now you know that the stock market doesn’t react to the economy; rather, it anticipates it. Thus, the sharp rise in equity prices over the past 7 months points to an improving economy, and recent data confirm this view. So a rising market at this point should be no surprise.

Many people, however, worry that stocks have come too far, too fast. After all, a +69% jump in just a few months seems overdone. Surely, we must be due for a substantial drop, even if the economy continues to recover. And if we have a “double dip” recession, then a drop must certainly be in the cards.

The problem with this logic is that all of these risks are well known. Stock prices don’t react to known information, but only to surprises. And by definition, a surprise cannot be anticipated. Thus, the only thing that should cause a major change in the direction of the market is something bad that happens out of the blue. A major war with Iran could be in this category, although even that risk is starting to be discounted by the market. Continuing loan defaults and home foreclosures, lousy corporate earnings, sluggish consumer spending and rising unemployment are widely known problems that no longer have market-moving power.

Moreover, most of the surprises over the past several months have been of the positive variety. Corporate earnings are mostly better than predicted. GDP growth worldwide is coming in higher than expected. And the status of the banking industry is no longer dire. In fact, the European Union recently completed a “stress test” of its 22 largest banks (accounting for 60% of deposits in the EU) and found that they are in surprisingly good shape. None are likely to need additional capital even if the economy does much worse than expected (and yet, many are raising additional capital anyway, and successfully at that).

The other thing to keep in mind when looking at stock prices is that using the March 9 low as an anchor can be very misleading. Yes, stocks are up hugely since then, but the global bear market that took them to those lows was more severe than any since 1721 (and worse in the US than any since 1932). At the levels of this March, stock prices were pricing in a total meltdown of the financial system that never occurred. At their present levels, they are predicting a gradual recovery from a severe recession, yet remain –31% below their highs of 2007. Just to get back to those levels, the MSCI ACWI needs to rise +45% from here. This return trip will probably take another 3 years, which means the economy won’t be back to early 2008 levels until 2013. This may seem painfully slow, but it represents an annual return of over +15% including dividends—far more than you’re likely to receive from most other investments.

Over the past week or so, people have been focusing on the lousy employment numbers and what the very slow recovery of the job market might mean to the economy. The reasoning goes that we can’t see meaningful GDP growth while unemployment continues to rise and the consumer holds back. But history shows the fallacy of this reasoning: employment is one of the last indicators to turn positive, well after GDP has started growing again and the stock market recovered. During the past 4 recessions, employment didn’t start growing again until an average of 8 months after the stock market bottomed.

But job recovery keeps taking longer, for a variety of reasons. After the 1990 recession induced by the S&L crisis, for example, unemployment didn’t peak until 16 months after the market started to rebound, by which time it was already up +40% (and this after a relatively mild –20% bear market). Job recovery this time will likely take at least that long, meaning that we’re not likely to see a peak in unemployment until next July. And by then, stocks could well be significantly higher than today.

So while the gains in all asset classes have been impressive over the past several months, most investors missed it. They opted for “safe” investments such as CD’s, US Treasuries and money market funds, happy to earn 1% or even less. On top of this, most investors that were willing to take some risk did so with bonds rather than stocks: from March through mid-September, mutual fund investors put 20 times as much into bond funds as stock funds. (In contrast, during the preceding bull market, stock mutual funds received 2.5 times more money than bond funds.) One has to wonder what stock prices will do when individual investors finally switch into the stock market, given how well it’s already done without much of their money.

So now we’re entering a new phase of the bull market. That the global economy is improving is now common knowledge (Australia raised interest rates in a surprise move today because the economy there is really heating up). This time around, the US is likely to be pulled up by other countries rather than leading the rebound. Where you invest, and what kinds of investments you choose, will become progressively more important. Just being bold and buying any beaten-down security is not likely to be so remunerative as it has been. And that’s a major reason behind the portfolio rebalancing that I’ve been doing lately, and will continue to do until I’ve positioned everyone as well as I can.

As always, somehow the world has made it through yet another financial crisis. Things should be a lot better for a while, until the next crisis, which likely will be far less severe than the one we just survived. But no amount of regulation will prevent bear markets, or financial panics, or recessions. You just can’t regulate human behavior, especially when ruled by emotion.

Maybe we should put Prozac in the drinking water instead of fluoride (just kidding).

September Song

2009-09-05T12:45:00.000-07:00

Happy Labor Day! The summer’s nearly over, which means that Wall St. traders will be returning from their Hampton summer homes and getting back to work. Trading volumes should be much higher starting next week. And despite fears that September is the cruelest month for stocks (I don’t know about you, but I’m sick of hearing about it in the news), I see no reason for a big drop anytime soon. Minor pullbacks of –5% or so will continue to occur throughout the early phases of this new bull market, but a big drop of up to –20% seems highly unlikely.

I’ve given you many reasons over the past few months why I think the bear market is over and we’re in a new bull market that will not only reclaim the highs of 2007, but should surpass them. The former drivers of the bull market continue today: extremely low interest rates, low inflation, and rapidly normalizing credit spreads (3 month LIBOR is now 0.31%, the lowest in history). The bond yield curve continues to be very steep, with long-term interest rates far higher than short-term rates, which is great for banks, corporations and the economy, and of course for the stock market.

And don’t forget that there are still trillions of dollars in cash, money markets, CD’s and short-term Treasuries earning next to nothing. Money market balances alone are currently $3.58 trillion, which is equal to 34% of the entire stock market’s capitalization. Even after a +50% jump in equity prices from the March lows, this percentage is still higher than the 29% we saw near the market’s bottom in 2002. There’s also $3.5 trillion in bank checking and savings accounts, $trillions more in short-term Treasuries earning less than 1%, and $trillions in corporate bank accounts just itching to buy other companies. Thus there’s more than enough fuel to heat up the market for some time to come.

I remember back in the winter, people were arguing that stocks had to become as cheap on an absolute basis as they were in 1982 before we’d see a market bottom (although if you recall my March 10 article, they did become as cheap on a relative basis as in 1982 and 1932). Only then would investors be enticed to buy risky stocks in favor of safer investments. But this ignores an extremely important difference between 2009 and 1982: back then, you could earn 15% in totally safe short-term CD’s and US Treasuries. Why buy risky stocks with this kind of return from safe investments? Today, safe short-term investments earn 1% or less, making the long-term return from stocks that much more attractive.

On top of all the good news we’ve been hearing since the spring, including an apparent bottoming of the housing market and lots of corporations beating earnings estimates, another bull market driver arrived recently: the recession not only appears to be over, but the rebound is starting to look like the “V” everyone said couldn’t happen. What?! Could the terror of the last 2 years actually have been just a particularly long and deep recession rather than the end of the world or Great Depression II? And could the recovery and associated bull market be pretty normal, too, but perhaps even longer and stronger than average? Boy, wouldn’t this piss off the doomsayers! Only time will tell, but I wouldn’t be surprised to see economic growth of +4% or more for several quarters.

So during the Labor Day weekend, if you have to think about investments or the economy, look at the bright side. Forget about rising unemployment or an overleveraged consumer. As I’ve said recently, these are far less important to a recovery than the factors mentioned above. And by the time unemployment has fallen back to more normal levels and the consumer starts spending like crazy again, the bull market will be mostly over. When everybody’s happy and can’t see any clouds on the horizon is when I start to worry. But that’s obviously a long way off.

Party hearty (but healthfully)!

How long should you keep financial records?

2009-07-27T10:40:00.000-07:00

One of you asked how long one should keep tax returns, bank and brokerage statements, etc. Since I think this information will be of general interest to all of you, I decided to put it in one of my client emails. This information comes from a variety of sources, including my CPA wife, the IRS, the SEC and FINRA, the CFA Society and the AICPA, we well as KCS’s own practices. This is meant as a guide only and not the final word on the topic, as experts will often disagree (as they do in most things).

First, tax records. Backup for your tax returns, such as receipts, canceled checks for charitable contributions, bank and brokerage statements, 1099’s, W-2’s, etc. should be kept for 4 years after your return was filed (or the due date for the return if later). Thus, if you filed your 2008 taxes on April 15, 2009, you should keep all these records until April 14, 2013, at which point it is generally safe to shred them. If you had an extension and filed on Oct. 15, then you should keep your records until Oct. 14, 2013.

There are two exceptions to these guidelines: It’s usually a good idea to save the tax returns themselves forever, partly as proof of filing, and also for useful data in filing future returns. If this seems too long, then 10 years is a reasonable compromise. The second exception is evidence of the cost basis for investment property (stocks, bonds, real estate, etc.). These should be kept as long as you own the asset, then filed with the tax records for the year in which the asset was sold (and thus kept an additional 4 years). This can be a LONG time: I only recently sold shares of stock my father had bought in the 1950’s!

Evidence of the purchase cost of a financial asset can typically be found on your brokerage statement, as well as on the trade confirmation. The latter is usually easier to keep for a long period.

Insurance records, including policies and appraisals or purchase receipts for insured property, should obviously be kept at least as long as the policy is in force; it’s probably best to keep the policies themselves for at least 3 or 4 years after they’re canceled, along with the last year or so of policy statements. Purchase receipts should be kept at least as long as you intend to insure the property (if it’s also an investment asset, see above). Some say that old appraisals can be discarded once you have new ones, but others suggest keeping appraisals forever. The latter approach provides a history of the property’s value.

Lastly, there are things you should keep forever: copies of all versions of your living trust, other trust documents, wills, durable powers of attorney, healthcare advance directives, birth certificates, citizenship papers, medical records, diplomas and transcripts, marriage and adoption papers, divorce and separation agreements, and other really important papers. Note that regarding documents that are periodically updated (especially wills and living trusts), make sure that the latest version is always clearly indicated and readily available. You don’t want your executor mistakenly using an outdated document!

At this point, you’re probably thinking, “That a LOT of paper to keep!” And some of it should be stored in a safe place, such as in a safe deposit box. But for many documents, especially financial records and tax returns, there’s another option: electronic storage. That’s how we keep just about everything at KCS, including many of our clients’ records. As we look at expanding the kinds of client records we keep for your convenience, as well as how to make them readily available to you (such as over the Internet), here’s a rundown of what we currently keep on file and for how long:

Financial statements: For all accounts to which we have direct access, most obviously your Fidelity brokerage accounts, but also certain other types of investment accounts, we keep electronic versions of the statements for 7 years (as per SEC and CFA guidelines). Fidelity keeps 18 months accessible online through Fidelity.com (they also keep older statements, but we typically have faster access to them). We keep cost basis information as long as you own the asset, plus 7 years after you sell it.

In addition, we have transaction information in our portfolio management system back to when you first became a client of KCS. For those of you who were previously clients of Gay Abarbanell, we often have transaction information going back many more years. Access to this information can be surprisingly quick.

Any document that you have provided to us, either in electronic or paper form, is kept electronically for at least 7 years, and longer if it’s one of those “forever” documents listed above. Thus, if we don’t have the most recent copies of your living trusts, wills, insurance policies and other important papers, as well as tax returns going back several years, please don’t hesitate to send them to us for storage.

To get them to us, it’s obviously easiest if you have them in electronic format (PDF’s or TIFF’s are preferred). Some people are concerned that regular email could be intercepted, and we are looking into an easy and convenient means for you to email us encrypted documents. However, we host our own email server here, so that a hacker would have to grab an email during the brief time it’s in cyberspace, as our emails are not stored on any outside server that might be prone to hacking. So the odds of your email falling into the wrong hands, while not zero, are extremely low.

For paper documents, it’s best for you to send us a clean copy of the document that we can scan and then shred. We don’t recommend sending originals of important documents through the mail, but if you must do so, registered mail is best (we will return the documents by registered mail as well). Another option is to physically bring the documents to us, such as during one of your scheduled meetings; we can scan them and return the originals to you before you leave our offices.

Note that we’re not really a document storage service, so I’m not recommending that you discard originals of important records and documents just because we have them here. While we make frequent and multiple backups of all your data, I see having your documents at KCS more as an added failsafe and convenience to also keeping them yourself. On the other hand, if you have the ability to store electronic copies of documents that don’t necessitate keeping hard copy originals, we can provide you with PDF’s so that you can save storage space at home. (As always, back up your hard drives regularly, and also keep important documents on archival CDs or DVDs.)

So there you have it: more information than you probably ever wanted on record retention. But boring as it is, I’ll be this info will come in handy someday, perhaps when the IRS comes a-knocking.

Oh, by the way, the S&P 500 hit another new high for the year today. It’s now up about +6.5% so far in 2009. Not terrific, but a welcome change from 2008! Meanwhile, our benchmark, the MSCI ACWI [All-Country World Index], is up a much more impressive +17.2% so far this year, and a whopping +54% above its March 9 low. Yet despite these big recent returns, many are still denying that the bear market is over. What’s your opinion?

The time seems right‹Finally!

2009-07-14T17:12:00.000-07:00

After a ferocious run through most of March, April and May, global equity markets stagnated for a while and then fell for about 5 weeks. The MSCI ACWI (All-Country World Index) peaked on June 2 at +48.6% above its March 9 low. It then spent most of the next 5 weeks drifting down, for a net loss of –7.6% from its recent peak as of last Friday. Investors became progressively more nervous during this period, with some measures of investor sentiment falling to levels not seen since mid-March, even though market indexes were at least 25% higher. Green shoots became brown weeds, and people again fretted over the speed and timing of an economic recovery. Several downbeat economic reports contributed to this feeling, and worries over earnings season, which began last week, added to the malaise.

Make up whatever reasons you want, the market just doesn't go up (or down) in a straight line. After a nearly +50% jump in just 12 weeks, stocks were due for a breather. A decline of 5–10% should have been expected. And that is the main reason I have been holding off investing cash and rebalancing portfolios recently, waiting for the correction to end, as I feel confident it will. And although it’s too early to know for sure, I suspect the end came yesterday, when the S&P 500 rose over +2% and erased its losses from the prior week.

Today, stocks edged up again, and after-hours action suggests another positive day tomorrow. The NASDAQ 100, for example, is up nearly +1.5% this evening, largely because of Intel’s positive earnings surprise. After the market closed today, the tech bellwether reported earnings and sales well above expectations; in fact, sales for the quarter were over $700 million more than analysts anticipated, and the company expects continued improvement in the third quarter. Intel stock is, not surprisingly, up over +7% after hours.

Yesterday’s powerful rally was ostensibly driven by the comments of Meredith Whitney, a prominent bank analyst who made a name last year by predicting hard times for banks. Far from her usual doom and gloom, yesterday she said that banks’ and other financials’ earnings in the second quarter would likely be much stronger than expected; Goldman Sachs’ announcement this morning that their earnings were +42% above expectations certainly added support to that view. Maybe the shoots are green after all.

Not surprisingly, the recently-ended second quarter of 2009 was one of the strongest for stocks in history, with the MSCI ACWI up +22.3% during those 3 months. Large numbers of investors who sold out of stocks in fear and disgust during February and early March ended up missing a history-making rally. These recent results are all the more impressive when you realize that the last time we had a positive quarter for stocks was way back in the third quarter of 2007 (when the MSCI ACWI was up only +3.5%)! It’s certainly been a long and horrific bear market!

But today I’m going to make three heretical statements, the kind I’ve been loath to make for well over a year now. Here are two predictions for the stock market and one for the economy:
1. The bear market that began on November 1, 2007 ended on March 9, 2009. Furthermore, the lows of that day will never be seen again (ever).
2. Stocks will continue to rise (in their usual irregular fashion) throughout this year and next. The MSCI ACWI will end 2009 at least +26% higher than today. 2010 should see another increase of +20% or more.
3. The recession that began in December 2007 is already over (at least as measured by changes in GDP). US GDP bottomed no later than June 2009. (We won’t know this “officially” until at least September.)

Many people will undoubtedly argue with me on these predictions, as well they should. But rather than giving me reasons why I might be wrong (or right), let’s just put these away until December 31 and see how I did.

Given the state of the markets and the economy right now, I think it’s finally time to buy stocks again. Those of you who have received your updated portfolios will start seeing trades in your accounts very shortly. Those who have not yet received your rebalanced portfolios will get them very soon. I wish I could do them all at once by computer, but because every client portfolio is a little different, and because I use a unique industry and country weighting approach, there is no software available that will do the trick (including those costing $100,000 or more). At some point, I hope to develop custom software to handle rebalancing; in the meantime, I will continue to use Excel and a lot of time and sweat!

You know we're in a bull market when....

2009-06-05T14:39:00.000-07:00

You know we're in a bull market when....

General Motors, once the world’s largest corporation, files for bankruptcy protection, yet global markets rise 2.5%. That’s exactly what happened yesterday. At the same time, GM was kicked out of the Dow Jones Industrial Average after an 83-year stay, replaced by the much younger Cisco Systems. Perhaps even more a sign of the times, Citigroup is also getting the boot, to be replaced by Travelers Cos., its former subsidiary. (How’s that for poetic justice?)

That stocks rose strongly on such news continues to suggest that investors are looking forward rather than back. The demise of once mighty GM is being taken as a sign of progress, as old industries mature and downsize, while newer ones (as embodied by network router maker Cisco) continue to blossom. “Creative destruction” is necessary for economic progress, and it tends to accelerate during times of economic turmoil.

So in the midst of the worst recession since 1982, and perhaps since 1932, stocks continue to rally. Even after the strongest March and April in memory, stocks maintained their upward march in May, with the MSCI ACWI (All-Country World Index) adding another +10.0%. Stocks’ rise from their March bottom has been nothing short of impressive: the MSCI ACWI has surged +45.8% in the 59 trading days from March 9 through yesterday, and it’s actually up +9.5% for the year. Quite a turnaround from being down -24.9% year to date on March 9!

The skeptics abound, and that is good for stocks. Many investors still think the worst is ahead of us, and are waiting for this rally to fizzle and take stocks down a lot before committing their money. They are likely to have a very long wait. Even many of those who believe we’ve seen the lows for this cycle (as I do; in fact, I believe we’ve seen the lows for this century!) don’t expect stocks to rise much from here. They’ve got plenty of good reasons, too, from the slowing economy and the fragile financial system to the overleveraged consumer and surging unemployment. Many of their arguments are sound, yet stocks just keep going up. What gives?

I think that the current surge in stock prices comes from the realization that the Armageddon scenario, in which the world financial system melts down and we enter Great Depression II, is now off the table. 2009 is likely to be characterized by “just” a very severe recession and credit crunch, but nothing of the magnitude of the 1930’s or what many were imagining just a couple of months ago. And in that context, the current rapid rise in the stock market makes sense.

We’ve come down so far from the highs of 2007 that they now seem like meaningless numbers: investors have “anchored” to the recent lows rather than the more remote highs. In fact, just to bring stock prices back to where they were before the collapse of Lehman Bros. and AIG, before the Armageddon scenario first started to be priced into stocks, the MSCI ACWI would need to rise another +29% from here. At that level, stocks would again be pricing a severe recession, which is what we’re experiencing today.

So absent any new and unexpected economic shocks, it looks to me that stocks could rise another 30% or so before being fully priced. No real improvement in the economy or financial system is necessary; just the gradual adjustment of investors expectations to the current reality. Once we make it back to that level (perhaps by the end of this year), further progress will depend on the economy actually improving. Most agree that this will happen next year, and the pace of improvement will help determine the rate at which stocks continue to rise.

The biggest risk to a persistently rising stock market over the next year or so is a “double dip” recession, in which the economy improves for a few months but then starts to contract again. This has happened before and it could happen again. While such an an occurrence would almost certainly cause stocks to fall, history suggests that they will remain well above their recession lows (as they did in 1933, for example.)

I’m not expecting the double-dip scenario, but one must be prepared just in case. Such preparation does NOT mean getting out of stocks now, because that risks missing what could be a roaring bull market. Rather, it means being watchful and doing one’s best to spot a double dip early. But most important, it means not panicking should one occur and abandoning stocks just before the best part of the bull market. Those who did so in 1933 missed out on four of the best years in stock market history, and a real return of +436% over that period. I’m sure they felt pretty stupid in retrospect!

Let’s be smart and realize we can’t predict the future. But we can learn from the past, both recent and more distant. I’ve certainly learned a lot recently, and have adapted my investment style in response. Not huge changes, but incremental ones, because successful investing is an endurance contest, not a sprint.

The bull keeps on running....

2009-05-20T13:59:00.001-07:00

After last week’s –5% drop in the S&P 500, many were already calling an end to this rally. But I don’t think it’s over yet: far from it. This move up is likely to continue—with inevitable pauses such as the one last week—for many more months and even years. I suspect that before the new bull market is finally over, and stocks again suffer a –20% or greater decline, we’ll not only have reclaimed the highs of October 2007, but should be well beyond them. With very rare exceptions, bull markets are much bigger than the bears that precede them. The main risk to I see now isn’t losing money, but missing out on big profits.

Of course, I could be wrong. But I’m not seeing any economic or financial signs that disturb me. Most of the latter are hugely positive; for example, 3-month LIBOR (the rate at which many banks lend to each other) is now 0.78%. This is the lowest level ever, and it has fallen from 1.10% only one month ago. If LIBOR were to drop to about 0.50%, that would mean the inter-bank lending market was back to normal. It’s possible we could see this in just a couple of months.

Investor sentiment, while way better than it was in early March, remains tepid. And last week’s market drop was enough to convince many that the bear market is not yet over. As recently as last night, few expected a rally today. Tokyo was down –2.4%, as were several other Asian markets. But India changed all that when it rocketed +17% shortly after the open, apparently giving strong approval to the winning party in the just-completed election. Almost immediately, other Asian markets that were still open (Tokyo was closed) turned strongly positive, and the bull was reinvigorated. All this shows that markets can shift suddenly for little apparent reason.

Some of you are still waiting to see your re-allocated portfolios; most who have received them so far have had no comment (either you think they’re terrific or I’ve totally confused you). To all of you: don’t worry about missing the bull, we’ve got plenty of upside ahead of us. Just returning to the old highs on the S&P 500 would give us a +73% rise from here, and that’s without dividends. Allocating wisely among countries, industries and individual securities could provide even better results: non-US developed markets need to rise +87% (without dividends) to reclaim their 2007 highs, for example, and many individual stocks (such as GE) need to triple (that’s +200%) just to reach their old highs.

What’s driving the rally? There’s just too much cash out there, and cash isn’t earning squat. After inflation and taxes, nearly all so-called “risk free” investments are earning negative returns. If investors want to make a reasonable return in this environment, they simply have to take some risk. And in a nearly perfect reversal of the bear market, since their recent lows, riskier investments have provided higher returns than less risky ones. The risk-return relationship is again positive, as it has typically been over the long term.

Here’s a note from STIR Research on how institutional investors are dealing with their mounds of cash (written just before today’s big jump):

“According to this week’s Barron’s, growth stock managers have been left behind the last two months. Only 33% beat the benchmarks in March and only 25% in April. They want to catch up, and with high levels of cash, they are looking to buy on any dip.

“But the market has not been very accommodative. Last week we had 4 down days for the S&P 500, NASDAQ, the Russell 2000 and others. But on three of those down days volume was below normal. Even with Friday’s option expiration, which normally leads to a spike in volume, it was below average.

“We are interpreting that to mean, that even when the buyers pull back, sellers are not panicking and dumping stocks. Instead the selling has been drying up. Therefore, institutional investors wanting to deploy some of their excess cash, have to bid stocks higher to find willing sellers: a formula for a market moving higher.

“In a bullish report sent out Friday by Goldman Sachs, they noted that following the 18 largest bear markets in history, the initial rally lifts stocks 43% and lasts 180 days. And that is just the average.”

The last point is interesting. Given that the recent bear market was at least 50% worse than average, one could expect the initial rally to be roughly 50% stronger than average. This would imply that 6 months after its low, the S&P 500 would rise +65%, which translates into a level of 1,100 (compared to 910 today, or another +21% gain over the next 3 1/2 months). I’m not saying that this is what will happen, but it wouldn’t be out of line historically. Of course, if the global economy and credit markets are in decent shape by September, stocks should continue to move upward.

Remember that stocks are not the only “risky” asset. Corporate and municipal bonds, commodities, and real estate all fall into the risky asset category, and should also do well as the financial markets improve. They, too, deserve a place in most portfolios (and my model portfolios do include them). The only assets I would avoid right now are US Treasuries, CD’s and other “risk-free” assets. They should lag severely, and could even provide negative returns going forward.

Don't moor yourself to the wrong anchor

2009-05-15T16:31:00.001-07:00

For a while there, it looked liked the market would continue to go straight up without pause. Last week, stocks—especially the beleaguered financials—were on a tear. This week, they’ve dropped back significantly (although they did rise +1% today). The market never goes straight up, and I’m actually pleased that we’re taking a breather, because investors were getting ahead of themselves. Think about it: in only 2 months, the S&P 500 had risen nearly +40%. It was time for a rest. As of today, the S&P 500 is “merely” up +34% from its March 9 low.

Whether this is a bear market rally or a nascent bull is beside the point; predicting short-term market moves is impossible anyway. The bears say the recovery will be too weak to justify a continued rise in stock prices. The bulls say that the market had priced in a depression, and we’re ending up with “just” a severe recession, meaning prices got too low and need to rise. Who knows and who really cares? Prices of nearly everything—not just stocks—dropped to depression-like levels. But now the global credit markets are clearly in recovery, and the economy will eventually follow. Already, it’s clear the economic cliff-dive that began last September has abated, the rate of decline has slowed dramatically, and some areas are already in an early uptrend. The world hasn’t come to an end (sorry, Dr. Doom).

It’s about now in the market cycle that investors again start making irrational decisions. Panic is just a memory, and despair is fading. Indecision is the order of the day. “Do I buy or do I sell? Do I take my money and run or do I put more to work now that the coast seems clear?” In trying to make these difficult decisions, many investors look to “anchors”: prices of individual assets and market indices that seem to have special significance. Problem is, these anchors are almost always meaningless and thus misleading.

For example, in early March the S&P 500 was at a bear market low of 666. Today it is at 893, a +34% gain in only 2 months. Many people say: “Too far, too fast. Must be a bear market rally.” These people have “anchored” that 666 value, giving it special meaning and significance. The unspoken assumption is that 666 was an accurate measure of the stock market’s value, and that the current level of 893 is thus too high because stocks shouldn’t rise so fast. But what real significance does 666 have, other than the level of the S&P on a particular day? Maybe 893 is closer to the market’s intrinsic value, or maybe the correct number is 1,000. We just don’t know, and of course, both current prices and intrinsic value change continuously.

The key point is that the market low of 666 is just an arbitrary, and basically meaningless, number. But people will be anchored to it and reference it for months and years to come. This “anchoring bias” is compounded by another cognitive error that investors typically make, called “recency bias.” This is the natural tendency to remember recent events more clearly and to weight them more heavily than more distant events. Remember when all the market pundits were referencing current prices to the bull market high of 1576 from October 2007? But today you don’t routinely hear that “stocks are cheap because they’re 43% below their highs.” Rather, they’re expensive “because stocks are 34% above their lows.” We anchor to the more recent number and tend to forget the older one. But in reality, both the high and low values are just arbitrary numbers of no significance except to statisticians and market historians.

We do the same thing with individual stocks, anchoring their highs and lows (emphasizing whichever of these is more recent). Take, for example, BHP Billiton, the world’s largest mining company. Many investors think it is becoming expensive because at a recent $50 per share, it’s doubled from a low of $25 in only 6 months. You don’t hear anyone saying it’s cheap because the stock is down 48% from a high of $96; that anchor is too far in the past. Again, these numbers should have no significance to the methodical investor, because there are only 2 prices of any importance: today’s, and what you think the stock will be worth in several years. Everything else is noise.

Another common anchor, perhaps the most often used (and abused), is the most meaningless of all: the price you paid for a stock. How often have you heard (or said), “I’ll sell the stock when it recovers to my purchase price” or “I’ll sell it after it doubles” or “I’ll sell it if it falls 20% below my purchase price.” If Mr. Market doesn’t care about high and low prices, how indifferent must he be to the price you paid? Basing a sell decision for a stock in relation to your purchase price makes no more sense than selling your house solely because it’s now worth twice what you paid. You should sell your house when you need to move, no matter what its current value. Similarly, the only reason to sell a particular stock is because you believe that the money would be better deployed elsewhere: in a different stock, in a different type of asset, or in consumption. The current price of the stock, whether in comparison to its recent high or low, or to your purchase price, is completely irrelevant. (It is relevant, however, in comparison to your assessment of the stock’s intrinsic value).

So don’t get too anchored; go with the flow, because prices and values are fluid. And don’t make the mistake of assuming that recent price movements have any impact on future prices. If a stock has recently doubled, it’s not necessarily expensive, but could potentially double again. Similarly, if it’s just fallen in half, it’s not necessarily cheap and worthy of purchase. It might halve again. In other words, random prices are just that: random. And “past performance does not predict future results” is totally true with individual stocks and the market as a whole. The future cares not a whit about the past, nor does Mr. Market, and neither should you.

March was nice, but April was nicer

2009-05-01T16:08:00.000-07:00

I wanted to quickly recap April’s market performance. For the month, the MSCI ACWI (All-Country World Index) rose +11.8%, one of the best monthly performances in history. Tacking on March’s +8.2% rise, we now have a 2-month rally that’s totaled +21.0%. And since its March 9 low, the MSCI ACWI has soared +31.1%.

Despite this stellar performance (or perhaps because of it), many investors are worried. Are stocks moving up too fast? Could this just be another of those bear market “head fake” rallies that will give up the ghost as did several prior ones? These fears are not unfounded, as there’s been a lot of bad news recently, and much more still to come. Add to that the recent outbreak of Mexican swine flu, and there’s plenty to worry about.

But as I’ve said so many times before, bear markets climb a wall of worry. The time for successful investors to be brave is when most others are scared. And the data continue to suggest that the majority remain bearish and afraid:

“In this week’s latest survey of Investment Advisors, according to Investors Intelligence, more advisors are bearish than bullish. In fact, for the past 4 weeks the number of bullish advisors has been falling as the market has moved forward. Basically the market continues to climb a wall of worry. While earnings have been poor as everyone was expecting, the surprise has been that in many key places, they haven’t been as bad as expected....

“With the majority of advisors not believing in the rally, probably means it still has more room to move on the upside over the coming weeks.”

(The above is from STIR Research, whom I’ve quoted before.)

If my recent conversations are any indication, most of you feel the same way, much more afraid of another drop than of missing the new bull market. All this pessimism is good, and adds to my confidence that the lows are finally behind us. Much data, moreover, are suggesting an end to this recession sooner than most had thought. It looks like we won’t have to wait until the end of 2009 for the economy to start growing again; that could happen as soon as next quarter. No, the stock market isn’t crazy, it’s just doing its job, which is to discount the future.

A note on swine flu: Even if we do see a global pandemic, the social and economic toll are likely to be significantly less than in prior ones, and certainly nothing like what we saw with Spanish flu in 1918. And even during that horrific period, when over 20 million people died worldwide, the Dow Jones Industrial Average gained +26.4% in the year following the month during which the pandemic first started to mushroom. Strange as it may seem, pandemics are not necessarily bad for stocks.

But today’s situation is far different from 1918, and even from the other, smaller, flu pandemics of the 20th century. First, the new virus was identified early, and public health measures have been quickly put in place worldwide. Second, the current swine flu virus doesn’t appear to be any more virulent than normal flu, in sharp contrast to the 1918 Spanish flu or the recent avian flu. Third, we have the ability to make vaccines today, though it will be several months before one is available. Fourth, we have 2 antiviral drugs in ample supply that are highly effective in reducing symptoms of the virus. Fifth, new research indicates that the majority of deaths from Spanish flu were from bacterial pneumonia superimposed on the original virus, for which we have safe and effective antibiotic treatment today.

Most of the people who die or become seriously ill from flu virus are the elderly and the infirm; most children who succumb have ongoing medical problems. Healthy children and adults typically come through the illness unscathed, even without antiviral drug treatment. And the bulk of the economic effects of a pandemic come not from the illness itself, but from attempts to reduce the spread of the virus. Quarantines (both voluntary and imposed), work absences, reduced travel and shopping, can all contribute to an economic slowdown. The key is to protect yourself without becoming a drag on the economy.

The real thing?

2009-04-24T14:06:00.000-07:00

No, I don’t mean Coke. I’m referring to the stock market rally, now 45 days old and not falling apart, despite considerable bad news and a pretty crummy earnings season. Could we finally be in the early stages of a new bull market, rather than one of those head-fake rallies that we most recently saw in late November to early January?

One of the characteristics of a new bull market is that most investors don’t recognize it until it is well underway. After a “normal” bear market, it typically takes an up move of 25–35% before the majority of investors realize that the lows are history. After this record-setting global collapse, one might expect investors to be even more cynical, requiring a 35–50% rally before most of them become believers. By then, of course, the easy money will have been made.

As this rally ages, and the lows and panic of early March fade further into the past, I continue to see signs that this one will stick. Little by little, several professional investors with excellent track records, and whose opinions I value, are saying that it’s becoming safer to buy stocks, and are putting their remaining cash to work. Some who were extremely bearish in March are turning bullish. At the same time, the vast majority of investors, both professionals and amateurs, are doubting the rally, keeping their funds in cash or bonds, and waiting for the market to drop 20% or more. They may have a very long wait.

Investor sentiment surveys are especially revealing. Two I follow are Investor’s Intelligence (a survey of investment newsletter writers) and the AAII Investment Survey (of individual investors). Both were extremely bearish in early March, with the AAII survey hitting a low not seen for at least 18 years. Since then, sentiment has understandably improved, but is still only slightly better than it was last fall, when the world seemed certain to end. In other words, most investors remain bearish despite a 25% jump in stock prices over just 6 weeks. This suggests that the “wall of worry” remains solid, which is a bullish sign.

The overall market is acting well, with virtually every sector participating in the recovery. More importantly, economically sensitive sectors, including technology, materials, industrials and consumer discretionary stocks, have been outperforming defensive sectors such as utilities, healthcare and consumer staples. This is an indication that some investors are looking forward to the economic recovery and are becoming more willing to take on risk. All of this bodes well for a continued financial and economic recovery.

This week was the first in 7 that stocks lost ground, but only a little. In fact, there has not been a drop of more than –5% since the rally began. This is typical of early bull markets, as investors with lots of cash wait in vain for that big pullback so that they can invest near the lows. But that big pullback rarely comes. Here’s an explanation from SITR Research:

“... at the start of a new bull market move, rarely will the market accommodate those investors [who are waiting for a big drop]. Our good friends at Ned Davis Research did a historical study of market pull backs at the start of new bull markets. The conclusion: the pull backs are small, typically way under double digits.

“The logic is simple; investors have hordes of cash by the end of a bear market cycle. Unfortunately most of that was raised right near the end of the bear market, which has to happen to make it the end—investor panic.... So, we have investors sitting with cash, saw the market rally, and wishing that they had invested some of their money near the low several weeks ago.

“They are now hoping for a pullback to put some of that cash to work. So when the pullback starts, there are always just a few who get anxious, and start nibbling and buying before the pullback gets very large. That little bit of buying attracts other buyers who had been sitting on the sidelines also, and the combination keeps the pullbacks small and shallow.”

Currently, we appear to be in a period of “consolidation,” when the major averages start trading in a relatively narrow range as individual stocks gyrate more wildly. Such periods can last several weeks or more, and are great times to put money into stocks and other “risky” investments. The market doesn’t run away from you, but at the same time, the movements of individual stocks relative to each other can enable one to take advantage of temporary pricing anomalies. The goal is to sell those stocks that become temporarily overvalued and buy those that are temporarily undervalued: an ideal time to rebalance portfolios. (I can’t promise the market won’t continue to rise strongly during the rebalancing process, but that’s still OK.)

Some of you have already received your new portfolio proposals, and the rest of you will over the next week or so. (Each portfolio is customized, so I can’t do them all at once.) I invite questions, both general and specific. I can’t know where you’re confused or disagree with me unless you tell me.

One additional point that I can’t emphasize enough: the financial markets always recover well before the economy. And the general public doesn’t start feeling good until many months, or even years, after the economy has bottomed. By the time Joe and Jane Main Street realize the recession is over, and the press prints mostly good news, half or even two-thirds of the bull market is already behind us. The prices of stocks and other assets are not rising now because things are good or even improving, but because the “smart money” can finally conceive of an end to this recession and financial crisis.

A New World Record

2009-04-10T09:51:00.000-07:00

As a brief aside before resuming the portfolio email series, I would like to answer a query I’ve received from more than a few people. In the midst of the most powerful stock market rally since 1933, many are still wondering, “How low can it go?” In other words, if March 9 was not the ultimate low for this bear market, what’s the worst that could happen if the bottom is ahead of us rather than behind?

As you know, I’ve often used history as a guide. In that context, I’ve said that 2008–2009 has been the second worst bear market ever, exceeded only by the one in 1929–1932. Using that massive decline as the model, if the economy today were to become as awful as it was in 1932 (highly unlikely), we could be looking at another drop of more than –50%. Scary, yes. But there are two big problems with this comparison.

The first is that the 1929–1932 bear market was unique in taking stocks from extremely overvalued to extremely undervalued in a single 3-year decline. Normally, this process takes 10 years or more. For example, during the “lost decade” prior to this one, stock valuations peaked in 1968 and did not bottom until 1982, a period of 14 years.

The most recent valuation peak was in March 2000. If March 2009 marked the valuation low for this cycle, then the process took a total of 9 years, faster than average but far less than in the 1930s. The 1929–1932 debacle was really 2 powerful bear markets combined into one, and thus should have been roughly twice as severe as this one or the recent 2000–2003 decline. On the basis of this analysis, the current decline could already be over.

There’s yet a second flaw in using the US market decline in 1929–1932 as a model. Like today, the financial and economic crisis of the 1930s was worldwide, starting in the US and subsequently spreading overseas. But the US suffered disproportionately back then, both in the scale of its stock market decline and in the depth of its depression. This time, the pain is spread relatively evenly, with economic and market declines of roughly similar magnitude in a large number of countries. Thus, a better comparison to today’s market would be a global stock index, specifically the MSCI World index of 23 developed countries.

A global comparison also makes sense because the US represents a much smaller proportion of worldwide GDP and stock market capitalization today than in the 1930s (even without counting the emerging markets that aren’t included in the MSCI World index). So on a global basis, how does today’s bear market compare with others?

Until February 27 of this year, the 1929–1932 bear market was still the worst in world history, with a –54% decline in the MSCI World index after inflation. But on that day, the world record was officially broken. By the time the decline hit bottom on March 9, 2009, the MSCI World index had dropped a stunning –57.8% from its peak on October 31, 2007. Those of us alive today can now say that we’ve lived through the most severe bear market in world history!

Based on this analysis, what does history tell us about the ultimate low? It at least suggests that we’ve already been there, having exceeded the previous record drop. There is no reason (at least on the basis of history) to believe that global stock markets need drop any more from here. The knowledge that we made market history in 2009 is simultaneously sobering and encouraging.

In sum, history supports the notion that we have seen the lows. Valuation analysis comes to the same conclusion (see my email of March 10, “Are stocks cheap yet?”), as does investor sentiment. So even though the bad news is far from over, and the market will continue to behave badly from time to time, the worst may finally be behind us. I’m actually starting to think 2009 will be the best year for stocks since 2003. We’ll know for sure in less than 9 months.

Great March, Crummy Quarter, but better times ahead

2009-04-02T14:36:00.001-07:00

True to it’s name, March came in like a lion and went out like a lamb. After continuing its recent tumble that began in early January, the MSCI ACWI (All-Country World Index) hit a bear market low on March 9 that was –58.4% below the all-time high set on Oct. 31, 2007. The magnitude of the drop makes this the most severe bear market since 1932. At its low, stocks were as cheap by most measures as they have ever been (as I discussed in a prior email). If the March 9 level holds (and it’s looking increasingly likely to me that it will), then it could well mark the low point for stocks in the 21st century.

Then, on March 10, global stock markets embarked on their most powerful rally since 1938, rising +22.6% in only 12 trading days before settling back a bit (although as of today’s close, we’re back up to the March highs). For the month of March, the MSCI ACWI rose +8.2%, reducing its loss for the first quarter to –10.7%. This was clearly crummy, but still better than the stunning loss of –22.4% during the 4th quarter of 2008.

So where do we go from here? Have stocks really hit their lows for this cycle? Is it finally time to start buying again? Obviously, I wish I knew for sure. And although I don’t, the character of this rally makes me feel like it is finally the real thing, a rally that will eventually (over 4 or 5 years) take stocks to new highs. My reasons are many, and include: 1) fundamental factors, such as the extremely low valuations seen on March 9; 2) technical factors, such as the divergence between the level of stock indexes during the decline and the number of stocks hitting new lows, and decreasing volume on down days with increasing volume on up days; 3) sentiment, which is still very low despite the rally, with most investors doubting its staying power and believing that even lower lows lay ahead; and 4) economic factors, which suggest that the rate of economic decline is slowing, and that an end to this recession may finally be in sight.

This rally, if I am right, is likely to humble both the bulls and the bears. The bulls will be humbled because real bull market rallies move upward in fits and starts, with many scary drops (such as the one we saw on Monday) that make one question the rally and potentially sell out prematurely. Countertrend rallies, on the other hand, tend to move almost straight up, rekindling a false optimism among investors. Bears will be humbled because in waiting in vain for those lower lows, they will miss out on a big portion of the rise, not investing until it’s clear that the prior lows are but a distant memory. Most investors will not, as they mistakenly believe, get back in at a level lower than that at which they sold. More likely, they won’t reinvest until stocks are some 20% to 40% higher than their exit points.

For those who might be concerned, I definitely don’t think it’s too late to load up on stocks. Based on yesterday’s close, and a historical average of 5 years for stocks to return to prior highs, one could reasonably expect an average annual return of around 17% per year through 2014. Certainly not bad, and significantly better than most competing investments. (Obviously, this is a projection, not a guarantee.)

Thus, if we’re really past the worst of this epoch-making bear market, and it’s not too late to fully invest in equities, it makes sense to re-allocate portfolios. Toward this end, I now plan to start re-allocating portfolios to prepare for the next phase of the economic cycle. This process should take about 2 months. During that time, I will be writing a series of emails explaining: 1) my portfolio construction process; 2) my short-term and long-term expectations for the global economy, corporate earnings and asset valuations; 3) my specific rationale for stock, bond, country and industry allocations; and 4) my choice of specific securities and the reasons for those choices.

I will also be contacting each of you individually to discuss your personal portfolio recommendations, which will be customized within the broader parameters to be outlined in the emails. More than ever before, it’s crucial that we’re each on the same page going forward, as the future is even more unknowable than usual.

Here’s to a brighter future

The Fed gets serious

2009-03-18T16:50:00.000-07:00

Anyone who has doubted the Federal Reserve’s resolve to get the credit markets and the economy moving again need only read today’s statement to become a believer. While some will question how quickly these efforts will jumpstart the economy, there should be little doubt that they will eventually bear fruit. The Fed’s moves today were stimulated by ongoing tightness in the credit markets, economic weakness, job losses and falling home and stock prices.

As expected, the Fed left short-term interest rates at historic lows near 0%. What was unexpected, however, and which galvanized both the stock and bond markets today, was their announcement that they would buy up to $300 billion of longer-term US Treasuries, and more than double their purchases of mortgage-backed securities up to $1.45 trillion. This “quantitative easing,” which the Fed last employed in the 1940’s, is designed to lower long-term interest rates, particularly mortgage rates. The Bank of England recently began a similar program with their own government bonds, and have succeeded in lowering long-term rates in the UK by 0.75%.

So we know from the Fed’s last foray into quantitative easing, and today’s experience in the UK, that it can work, and work quickly. In the 1940’s, the Fed targeted a 10-year yield of 2.5%, and these rates never went above that level for a decade. They were able to do so by holding only about 7% of outstanding Treasury notes and bonds, which today would amount to about $280 billion. So despite what some economists are saying, $300 billion should be sufficient, at least initially, to keep rates down. And today’s market reaction supports that: 10-year Treasury yields plummeted from 2.95% to 2.53%, the biggest 1-day drop in 47 years. Although the Fed has not stated a target interest rate, 2.5% seems to be what the market is betting on.

Lower long-term Treasury rates will translate into lower borrowing costs across the board, from corporations to municipalities to individuals. Even the US government will save money on interest expense. Lower rates, provided borrowers can obtain credit in the first place (a problem which other Fed and Treasury programs are targeting), provide an obvious benefit to the economy.

But the Fed did not stop there. It is simultaneously buying up to $1.45 trillion in mortgage-backed securities, in an attempt to further lower mortgage rates relative to other long-term debt. This represents about 12% of all outstanding mortgage debt in the US, and over 25% of debt guaranteed by Fannie and Freddie. I think there’s little question that taking this much debt off the market will substantially lower mortgage rates, and I suspect that 4% mortgages will become relatively common within the next few months.

Those of you contemplating a home purchase or refinancing should therefore wait a bit until making the plunge. I’ll be keeping a close eye on mortgage rates as well, and will let you know when I think they have bottomed. Note that in the past, the Fed was able to keep interest rates low for more than 10-years; thus I don’t expect rates to rise much until the economy is clearly on the mend.

The path to recovery will not be smooth, and there will be more pain and bad news to come. The current stock market rally, while it may continue for some time and potentially be very powerful, will undoubtedly be interrupted by some scary drops. And although March 9 may have set the final lows for this bear market, it is possible that they will be revisited or even violated somewhat before the new bull market is finally underway.

Fortunately, in addition to the Fed’s obvious resolve, there have been indications that the rate of financial and economic decline may be abating, which would likely precede a definitive turn upward. Housing starts were better than expected, as were retail sales. Commodity prices are rising (copper is up 22% in the past 30 days, oil up 31%). Oracle’s earnings came out better than anticipated, and they instituted a dividend for the first time (in contrast to many other companies that are reducing or eliminating theirs).

But perhaps most significantly, mergers and acquisitions (M&A) are seriously heating up. In the past few days alone, we’ve had several multi-billion dollar acquisition announcements: Pfizer buying Wyeth, Roche buying the rest of Genentech, and today, IBM buying Sun Computer. Big corporations have many $billions in cash looking for a higher-return home, and credit is again flowing to investment-grade companies. Many companies are selling at prices not seen for decades, and cash-rich firms are increasingly deciding that it’s safe to jump into the M&A fray.

Expect many more deals over the coming months and years. And keep in mind that much of the bull market of the 1980’s was driven by merger activity, at a time when companies had less cash and interest rates were far higher. Paradoxically, it is possible we will see a higher stock market in the face of a prolonged recession as stronger companies gobble up weaker ones. It will be fascinating to see how all this plays out; we certainly do live in interesting, if painful, times.

In future emails, I will expand further on how the Federal Reserve’s actions are likely to stimulate the economy. And I will give some detail on how I plan to position portfolios going forward, given all that’s happened and is likely to happen. We are clearly at an inflection point in economic history, one that will be written about for decades. It’s obviously crucial to prepare for the future based on the best information and reasoning one can muster, even if, in the end, the future is unknowable.

Can we trust the rally?

2009-03-16T16:52:00.000-07:00

In the past few days, global stock markets have rallied about +10% from decade-plus lows. Today, the US market was again in rally mode, only to lose steam during the infamous final hour to close slightly down. The question on investors’ minds is, “Is this rally for real?” Will we see a significant rise in stock prices from here, or is this just another brief respite before yet lower lows?

It’s obviously too early to tell, but several signs suggest that this rally may have “legs.” Even if it is a countertrend rally rather than the first of a new bull market, it may last for a while and generate a welcome partial recovery in stock prices. My reasons for thinking this are several:
1. Volume has been higher recently on up moves than on down moves.
2. The number of stocks hitting new lows was declining even as the major averages took out their October and November bottoms.
3. The bulk of sellers recently appear to be individuals (“dumb” money) rather than hedge funds and institutions (“smart” money).
4. A lot of news lately has been better than expected:
• Several big banks announced that they’re actually making money so far this year.
• GE’s downgrade was less than expected and the company now has a stable credit outlook.
• Retail sales were higher than expected.
• Home sales were up in California.

Calling the end of this grueling bear market is still premature, but we’re overdue for a significant rally. Hopefully we’re in it now.

And regardless of the short term picture, the longer-term outlook for stocks remains bright. Sometime soon we will set generational lows for stock prices that we may never see again. Perhaps we already established these lows last week at an S&P 500 of 666 (a good omen?). Wherever and whenever that elusive bottom comes, we will look back on it years from now as an historic long-term opportunity that most people will have missed out of short-term fear.

Are stocks cheap yet?

2009-03-12T10:57:00.001-07:00

Today the stock market showed us that it is capable of going up as well as down, rising over +6%, which is obviously a nice change. Now we have to see if it can put in a few up days in a row, which it has had trouble doing for most of this year.

The impetus for today’s big jump seemed to come from Citigroup, of all places. Their CEO said that they’ve been profitable for the first 2 months of 2009, and that they expect this quarter to be their best since Q3-2007. If even Citigroup can make money in this environment, maybe the banking sector is finally on the mend after receiving $billions in bailout funds. Time will tell.

Whatever the reason for today’s move, it seems that the market “wants” to go up, as evidenced by several recent days that started with strong gains, only to be pared or turned into a loss during the final hour. In the fall, much of that final hour selling came from hedge funds; this year, it has been mostly individuals liquidating their mutual fund holdings. At some point, buyers will overwhelm sellers for more than one day, and the market will start to recover. Maybe today was the beginning of a longer trend; maybe not. We’ll know soon enough.

Regardless of what happens over the next few weeks or months, we need to feel confident that stocks really are cheap enough to buy. My last email talked about the long-term trend of stock returns and how far below trend we’ve recently fallen. As stocks gradually return to trend, they should provide above-average returns. Today, I’ll talk about stock valuations, looking at whether or not stocks today are historically cheap. I’ll do this by comparing today’s valuations with those during two major buying opportunities of the past century: 1982 and 1932.

The attached article contains the long version for those who want all the details. The Reader’s Digest version is below:

I wrote the article in part to respond to a New York Times piece entitled “Why Stocks Still Aren’t Cheap,” published on February 20, when the S&P 500 was nearly 10% higher than today. It proposed that because the 10-year average price-earnings (P/E) ratio of the S&P 500 was 14.5, below average but still well above the lows of 6 to 7 reached in 1932 and 1982, stock prices still had a ways to fall. I went on to point out the flaws in the author’s approach, and to do my own comparison of stock valuations today compared with those two prior periods.

I identified 4 shortcomings in the authors analysis: 1) 10-year periods, while they do smooth out the highs and lows of corporate earnings, are arbitrary; 2) the author didn’t account for inflation; 3) the proper or “justified” P/E ratio varies at different points in time owing to changes in interest rates, required return on stocks, payout ratios and expected earnings growth rates; and 4) accounting rules have recently changed, making comparisons with prior period earnings somewhat problematic.

To address these problems, I did the following: 1) calculated 5-, 10- and 20-year average P/E ratios at each time period (2009, 1982 and 1932) and averaged those; 2) adjusted earnings and prices for inflation; 3) calculated justified P/E ratios for each period based on interest rates and other data from the respective time period; 4) added an adjustment for recent accounting changes. I found that the last of these made little difference, so I eliminated it from the comparison.

The results indicated that stocks at 2009’s low for the S&P 500 were undervalued by about 12%, compared with a 14% undervaluation in 1932 and a 29% overvaluation in 1982. This analysis suggests that stocks today are compelling values, in line with the great buying opportunities of the past century.

I then went on to use several other valuation methods to compare stocks today with 1982 and 1932: price/sales (P/S) ratio, price/book value (P/B), price to replacement value (P/Q) and residual value. In all 4 cases, the actual measure today was below the justified measure, while in 1982 and 1932, at least one of these measures was higher than the justified value. The conclusion again was that stock valuations today compare very favorably with 1982 and 1932.

Lastly, I looked at 1974, which was a bear market bottom that did not precede a decade-plus bull market (the 1982 bear market was still to come). Valuations at that time appear to have been even lower than today, 1982 or 1932. Warren Buffett was a big buyer at that time; his superior results suggest that, if you buy stocks cheaply enough, you can make good money even if another major bear market will soon follow.

My conclusions were as follows: Putting all of these valuation measures together, we find that stocks today appear about as cheap as they did during two of the great buying opportunities of the past century, 1982 and 1932 (although perhaps not quite as cheap as in 1974). This doesn’t mean they can’t go lower still over the next few weeks or months. But their historically low valuations, based on my analysis of market history over the past 138 years, suggests that stocks should provide returns far above their historical average over the next 10 to 30 years.

I know I can’t time the bottom, but stock returns’ current distance below their trend line, plus the extremely low valuations suggested by my analysis, make me comfortable that buying stocks (or continuing to hold them) around these prices will eventually prove to be a very lucrative move.

It's lonely at the bottom

2009-03-10T11:26:00.000-07:00

Now that the major global market indices are all near or below their November lows, we’re hearing the pundits predicting ever lower market bottoms. Calls for “Dow 5,000” have become common, and there was even an article in today’s Wall St. Journal talking about this possibility. Jim Cramer, the chair-throwing investment guru on CNBC, did his own calculation and estimated that a “worst-case scenario” could bring the Dow down to 5320 (got to admire his precision).

Obviously, all of these numbers are total guesses, as there’s just no way to know where the market will go in the near term. But investors continue to sell nonetheless, concerned that stocks may still be far away from a bottom. The bulk of these sellers during the current downturn, as opposed to last fall, appear to be individual investors, who redeemed $71.2 billion from mutual funds in the 4 weeks ended March 4. While this is down from the record $137.9 billion withdrawn last October, it represents an historically huge number and a marked increase from December and January.

Meanwhile, institutional investors, including hedge funds, have dramatically curtailed their selling of equities since the fall. And many institutions and professional investors are buying stocks. Warren Buffett, the wealthiest man in the world (earned entirely through a lifetime of investing) went “all-in” to stocks with his personal fortune last October, and has been putting Berkshire Hathaway’s huge cash hoard to work recently. Peter Lynch, legendary manager of the Magellan Fund during its heyday, remains fully invested in equities. Marty Whitman of Third Avenue Value Fund is buying the deep value stocks that he loves (and that have been getting especially creamed recently). Even George Soros, one of the granddaddies of hedge fund management who publicly remains quite negative, has been seen recently buying $billions in stocks for his Quantum Fund.

All the the investors mentioned above have stellar track records going back 30 years or more. Why would these people, and others like them, be buying, while the general public is selling? Do they know something the average investor does not? History tells us that they do, as the bottom of every prior bear market has been accompanied by heavy individual selling, while insiders and pros start buying or at least stand pat. I know that this one will be no different, but knowing this does not help me identify the date or the level of the market’s bottom.

At the risk of wasting my time and yours, I will take my own stab at where the bottom of this bear might be. Although many analysts have tried to use valuations to do so, bear markets at this stage are driven primarily by sentiment (i.e., fear) and the need (or desire) for cash, not by a cold analysis of stocks’ value. Valuation analysis is, however, useful in determining whether one is at a propitious long-term entry point; we will examine this in a subsequent email.

One might, however, be able to look at prior bear markets to get an idea of where the bottom might be. At its current level, the Dow Jones Industrial average is 13.8% below its low of the previous bear market in 2002. It turns out there have been only 2 prior bear markets in the past 120 years when this has happened, that a bear market low is below the level set in the previous bear market: 1974 and 1932. In 1974, after that brutal 2-year bear market, the Dow was 8.5% below the price reached at the bottom of the bear market in 1970. At the market’s historic bottom in 1932, the Dow was 35% below the low reached in the prior bear market in 1921.

Using this particular metric, the Dow could bottom during the current bear market anywhere between 4,935 and 6,628. The index is now slightly below the higher number. So on a very simplistic level, if you think things now are about as bad as they were during the darkest days of the 1970’s, then the bottom should be right around here. If you think the economy will get as bad as it did during the Great Depression, then we’re talking about another 24.6% drop. Or maybe somewhere in between.

But the above analysis is actually severely lacking in at least one respect, as it looks at price only, and does not take dividends or inflation into account. Including both of these factors, and going beyond the Dow to the more inclusive S&P 500 index, the US stock market actually returned 57.6% from June 1921 until June 1932 (11 years). This is obviously very different from a –35% drop. In the 4.3 years from June 1970 to October 1974, stocks actually lost –22.8%, showing the effects of high and rising inflation. Today, on this basis, stocks have returned –16.9% since October 2002. Using this approach, then, it seems that the worst-case bottom should be another 7.1% below today’s close.

In reality, the numbers above are just guesses as well, and not supported by financial theory. But it’s interesting that very different approaches yield a fairly narrow range of results. Either the bottom is right around where we are, or it’s between 7% and 24% lower. Either way, with the S&P 500 already –57.1% below its 2007 high, the lion’s share of the drop certainly seems to be behind us.

I don’t know whether the above is encouraging or discouraging. But either way, it’s really the wrong question to ask (after all that, you say!). The near-term market bottom is not only unknowable, it’s irrelevant to a long-term investor (at least from a rational point of view; emotions are an entirely different thing). What counts is where stocks will be in 5, 10, 20, even 30 years. That’s because stocks are a long-term investment by definition. Even an 85-year-old couple has a joint life expectancy of over 10 years, and a 65-year-old retired couple could easily see one spouse live for over 30 years. So don’t say you’re too old to look that far into the future.

So let’s look into the future by looking at the past. Review the graph below, which shows total return after inflation for the S&P 500 from 1871 through today. (Don’t worry about reading the dates.)

The squiggly blue line is the actual return from stocks, while the straight black one is a trend line that shows the average return over a period of nearly 140 years, including the recent bear market. Note that while actual stock returns have strayed both above and below the trend line at various times, they never stray that far before “reverting to the mean.” The greatest drops below the line were in 1920 and 1932. Stock returns remained moderately below the line from 1974 to 1987, as well as for most of the period from 1932 until 1954. But the reversion to the mean during these periods resulted in some fabulous bull markets.

Note where we are today: about the same distance below the line as we were in 1982. Unlike 1982, it took only months, not years, to get there. In 2000, we were well above the line, but the 2000–2003 bear market took us back to trend. The current bear market started with stocks only a little above trend, far less so than in 2000, the 1960’s or 1929.

Could we go further below the line, either in the short term or sometime down the road? Of course we could, and there’s no way to know. But the more important point is that sometime in the next decade or so, we should get back to trend, and possibly rise above it again, at least temporarily. This would result in abnormally high returns for stocks during that period.

To get an idea of what that future return might actually be, I extended the trend line for 13 years past June 2008, when the market most recently dipped below trend. I used 13 years because that’s how long it took the market to recover to trend after first falling below it at the end of 1973. If the market recovers more quickly that that, returns will be higher; if more slowly, returns would be lower.

The trend line return, by the way, is +6.61% per year (remember, this is after inflation). Real purchasing power doubles in about 11 years at this rate. Now, if we return to trend from here over the next 12 1/4 years, that implies an average annual return, after inflation, of +12.23%. At this rate, real purchasing power doubles in less than 7 years; after 12 1/4 years, your purchasing power would have increased over 4 times.

Could such an optimistic scenario come true? We obviously won’t know for sure until more than 12 years have passed. But total real returns of this magnitude are not out of line with prior bear market bottoms: comparable period returns were +12.31% after 1932, and +9.72% after 1974. As you can see, inflation was a great drag on returns during the latter period, even though during and after the Depression it took much longer (22 years vs. 13) for stock returns to revert to trend.

Although I don’t know for sure whether +12.23% will be close to the actual return experienced over the next decade or so, I am sure that the path will be anything but smooth. There will be great rallies and bull markets, as well as scary corrections and probably at least one bear market during this period. But the overall trend should be decisively up, and at a rate that is both historically high and better than most other investments (cash, bonds, commodities, real estate, etc.). The price one pays for this higher rate of return is more volatility, which on rare occasions reaches the crisis proportions we see today. But no crisis lasts forever.

One other thing I know by looking at the graph above is that the bear market of 2007–2009 will go down in history alongside the great bear market of 1929–1932 as one of the 2 worst ones in US history. We’ve had other severe bear markets, but none as sharp and brisk (or as scary) as these two. But a further examination of the graph might give one hope: the sharpest bear markets have historically been followed by the strongest rallies. This one should, too. Now if only I knew exactly when it will start!

The daughter of all bear markets?

2009-03-03T16:33:00.000-08:00

The bear market of 2007–2009 is now officially the second worst in US history, exceeded only by the mother of all bear markets, the one from 1929–1932 that coincided with the initial years of the Great Depression. Thus, we have no viable model to use in estimating the trajectory of the current bear market, except for the “big one.” It’s for that reason we see more and more pundits throwing out numbers where they guess this one will bottom: Dow 6000, Dow 5000, etc. But these are really no more than wild guesses, and have no basis in either history or current reality. There’s just no way to know when or where the bottom will finally occur.

As much as I loathe to do it, however, I will draw some comparisons between today and those fateful years in the early 1930’s. First, I’ll model what would happen should things actually get that bad again. Then I’ll give a bunch of reasons why they almost certainly won’t.

The S&P 500 is now -55.8% below its all-time high from October 2007, and the Dow is down -52.9%. These are both greater falls than in any prior bear market other than 1929–1932. Overseas markets are down even more: the Nikkei average of Japanese stocks, for example, is down -61% from its high. These are big numbers by any measure.

If this were 1930, though, we’d be only about halfway done. The US market would have another -63% to fall before hitting bottom in mid-1932. That’s a frightening prospect! Certainly, few people held on during this period, with many of them selling out near the bottom in 1932 (most of the rest were forced out earlier because of margin calls and the need for cash to live on).

But suppose you had held on, not expecting the market to continue to plummet, and knowing that it would eventually recover. How long would you have had to wait to make your losses back?

Not as long as you might think. You would have recovered your money from that second sickening drop and be back to your 1930 balance by March 1934, or about 20 months after that final bottom. By February 1937, about 3 more years, you would have recovered 81% of your money from the 1929 peak. This, of course, assumes you stayed 100% passively invested in stocks the entire time, not trying to own the better stocks, countries or industries. (These numbers include dividends, which remain an important part of stock returns.)

In real terms, the numbers look even better, because the 1930’s were a time of significant deflation, which itself contributed both to the drop in the stock market and the downturn in the economy. That’s why governments are so intent on avoiding deflation today. So, after inflation, you would only have had to wait until May 1933, or 11 months, to earn back that second drop. And by February 1937, you would have earned back 99.5% of what you had in August 1929, before the “Crash.” So in the greatest bear market in world history, it took less than 5 years from the bottom to earn back everything you’d lost. Bad, but not the end of the world. (Not only that, but US GDP had actually reached 1929 levels by 1936.)

So now you know what the worst case looks like. Now I’ll tell you why, as bad as things seem, they are not even close to the 1930’s, and extremely unlikely to approach that level of economic or financial decline.
1. The economic decline is not even in the ballpark of the 1930’s: Even the worst-case scenario sees a 5% drop in GDP during this recession (it was -3.4% in 1973–75 during the oil embargo). From 1929–1932, real GDP dropped nearly 30%. Unemployment may well reach double digits this time (as it did in 1982); in the 1930’s, it exceeded 25%.
2. As bad as things are with the banking system, it’s in better shape than in the 1930’s: Remember, mark to market accounting makes banks’ financial status appear much worse than they would under 1930’s accounting rules. And in the 1930’s, there was no deposit insurance, so runs on banks made some sense. When a bank went under, depositors lost most or all of their money. Thousands of banks failed in the 1930’s because of bank runs, which obviously severely reduced the amount of cash the banking system had to lend. This fed on itself, until the banking system was near collapse. It was only stopped by FDR’s bank holiday, shutting all banks for a week and then gradually reopening only the solvent ones. Also, today we have all sorts of government guarantees on bank liabilities, along with government programs to replace some of the lost lending.
3. US government responses were either inadequate or counterproductive until 1933: They actually raised some taxes and increased trade tariffs, as well as cutting government spending. Today, we’re seeing tax cuts and massive spending increases relatively early on.
4. The Federal Reserve didn’t have a clue in the early years of the Depression: They kept credit tight, allowing the money supply to plummet. This caused deflation to embed itself in the economy, leading to a downward spiral in economic growth that was difficult to reverse. Today, the Federal Reserve has not only reduced interest rates to near 0 and greatly expanded the money supply, it’s also working to lower long-term interest rates such as mortgages and implementing several new programs to provide liquidity and increase lending.
5. The US was on a gold standard until 1933: The gold standard was a big reason the Federal Reserve had such trouble increasing the money supply. When a country is on the gold standard, the amount of cash in circulation is limited by Federal gold reserves. And when people start trading in their dollars for gold (which was permitted then), this further reduces the cash in circulation. When other countries went off the gold standard before the US, this further drained our gold reserves. One of FDR’s very first actions, along with the bank holiday, was to take us off the gold standard. The economy then started growing almost immediately.
6. Protectionism and trade wars made the Great Depression even worse: This time, as I’ve said, protectionism is minimal. Governments around the world have dramatically loosened monetary policy and put large stimulus programs in place. In addition, there is a fair amount of coordination and cooperation between countries. In the 1930’s, we had a massive trade war with punitive tariffs, along with the rise of fascism in Europe that eventually led to WWII, something that we thankfully don’t have to contend with today.

Thus, while this recession is turning out to be the worst since 1982, and perhaps even become the worst since 1932, stock declines have already discounted something very severe, having been greater than any bear market since the Great Depression. I’ve listed above several reasons why it’s highly unlikely that the economy will sink anywhere near as much as it did in the 1930’s, and thus neither should the stock market. But given all that, it may be somewhat comforting to know that even during the economic Armageddon of the 1930’s, investors made virtually all their money back in less than 5 years by just sitting tight.

So given that neither I nor anyone else can predict the future, and given how far stocks have already fallen, and given the history of past bear markets, it seems to me that the bigger risk now is missing the rebound, rather than suffering a further big fall. I may be wrong this time (as I have been for many months now), but the longer this bear market goes, the closer we must be to the end. And the end will come when no one expects it, seemingly out of the blue, as has the end of every other bear market. I’m sure even I will be surprised when stocks finally decide that they can go up as well as down. And believe me, no one is more anxious to see this bear market end than I am!

In future emails, I’ll look more closely at the question of valuation (are stocks really cheap now, or do they just appear to be?), and finally explain mv=py and how it governs many of the Feds actions.

In like a lion....

2009-03-02T18:35:00.000-08:00

March certainly started off with a bang, as worldwide equity indexes plunged over –4%. We now appear to be watching “Panic, The Sequel.” But unlike the panic selling that occurred in October and November, which was justified to some degree because of fear that the entire global financial system could collapse, no such risk exists today. Governments worldwide have gone to extraordinary lengths to rescue the banking system and restart lending, as well as stimulate the economy. There’s no longer any question that we’ll come out of this crisis; the only issue remains exactly when, and how much more pain we might have to bear in the interim.

Concerns about bank nationalization should not be an issue, either, as the stocks of banks most at risk of being nationalized (here or abroad) already trade at prices reflecting this. And if nationalization of one or more US banks were to occur, the experience of Sweden in the 1990’s with their banking crisis should provide solace that such an outcome does not portend disaster.

Yes, AIG reported a huge $60 billion loss, but this has been expected for several days. And HSBC (one of the world’s largest banks) said it plans to raise $17.7 billion in equity—but this will be private money, not from the government. It’s actually impressive that a bank feels it can raise private funds without a government backstop. Moreover, most of the economic news today was better than expected. The ISM manufacturing index came in higher than anticipated. Personal income and spending both rose in January, while most people were expecting it to fall.

Oil prices dropped 10% today after rising strongly last week. But paradoxically, copper prices (as I’ve mentioned before, one of the early indicators of economic recovery) fell less than 1%, and copper remains well above its December lows. Even stranger, gold prices fell slightly as well, which you wouldn’t expect if investors were preparing for Armageddon.

So we’re seeing panic selling when the economic environment does not justify panic, and when trading in other markets suggests the opposite. What’s going on here? Why the panic selling? And when might it end?

Interestingly, the last 2 bear markets (1990–91 and 2000–2003) also had a secondary panic phase. Not only that, but both primary panics occurred in October, with the secondary panics ending 3 to 5 months later. We’re now just under 5 months from the October panic and 3 1/2 months from the November one. Seems we’re right on schedule.

Why has this pattern repeated itself? I suspect it has to do with the rise of hedge funds. These highly-leveraged investors sell heavily during the primary panic to rapidly reduce their leverage and meet anticipated redemptions. Other investors, such as mutual fund owners, follow the hedge funds’ lead as they see stock prices tumble. The primary panic burns itself out when the hedge funds stop selling.

The secondary panic starts with a more orderly decline in prices, driven largely by individual investors (including owners of mutual funds) and less nimble institutions such as pension funds, with hedge funds largely sitting it out. This is because they’ve already raised a large amount of cash and no longer have an urgent need to sell. Finally, having endured a couple of months of steadily falling prices, an ever greater number of investors throw in the towel and head for the exits. While all kinds of investors participate in this final market “blow off,” the driving force is the individual investor, who is typically the last one out, both at market bottoms and at market tops.

Trading data from the past several months support this scenario. Individuals have been big sellers since mid-January, while hedge funds have backed away from selling. This is also in keeping with the adage that the individual investor has the worst possible timing, selling at the bottom and buying at the top. Why should this time be any different?

Selling during a panic such as the current one can be very dangerous, because reversals tend to be rapid and powerful, as well as unexpected. And panics tend to be short: the rapid declines of last October and November each lasted only 5 trading days. During these brief stretches, stocks fell 22% in October and 18% in November. The current panic is now 3 days old, and the S&P 500 has dropped about 10% during that time. Obviously, I can’t say exactly how many days this one will last nor how much stocks will fall, but 5 days and 15% is as good a guess as any. In any case, it’s likely to be over very quickly.

Recoveries after panics can be impressive. In October, the S&P 500 soared 23% in only 2 1/2 trading days. In November, the surge was 21% in 5 trading days. In other words, the losses can be recovered almost as quickly as they occurred. One has to be extremely nimble to take advantage of such rapid price movements as they occur.

Because of the rapidity and unpredictability of panics, I tend to sit them out, neither buying nor selling. Sometimes, I’ll make purchases on day 4 or 5, but one has to be very brave to do so. It’s usually safer, and certainly less nerve wracking, to do so after the first definitive up day.

Bear markets are always unpleasant. This one has been the most severe since 1932, so it’s certainly normal to feel worried (or even a little panicked along with other investors) during these rapid down moves. But they all do end and give way to new bull markets. Even the one in 1932 did so, and provided investors with some of the most impressive returns in US stock market history. Investors who stayed the course from the high in 1929 to the recovery in 1937 made back 99.5% of their money after inflation. This is pretty impressive after the mother of all bear markets. 2007–2009 has been bad, but not nearly as bad as 1929–1932. And the recovery, when it finally comes, should be very profitable.

I know the temptation to sell now may be very strong. Obviously, lots of people are giving in to that temptation, which is exactly what is driving prices lower. But it will be a long-term mistake to do so, and perhaps a short-term mistake as well. And I’m not recommending anything different from what I’m doing with my own money, as my personal accounts remain heavily in equities. I feel the pain of loss just as much as you, but I also know that acting on that pain can make for very bad decisions. Sometimes doing nothing is the best course of action. Now may be one of those times.

The US government and Citigroup

2009-02-27T19:36:00.000-08:00

I’ve been getting some good questions from clients lately that I will answer for everyone, since if one person is asking it, many more are probably thinking it. Today, someone asked what the US government’s new deal with Citigroup means, and whether it makes the stock a “buy” now.

Today, the government announced that it is converting some of the preferred shares that it acquired in 2 prior investments into common stock. As you should know, common stock (or “equity”) represents a “residual claim” on a company. This means that if the company goes under, everyone else gets paid ahead of the common shareholders. If the company grows, the common shareholders get most or all of the benefit.

Preferred stock, despite its name, functions more like debt: the holders are paid a fixed rate of interest and do not get additional financial rewards if the company grows. The difference between preferred stock and more conventional debt (such as bonds) is that preferred stock comes next in line in case of a bankruptcy, but still ahead of common stock. It also is typically “perpetual,” meaning it never matures (unlike a bond, which has a fixed term of years).

When the government initially invested in Citigroup and other banks, it bought preferred stock that paid a fairly high dividend (8% in the case of Citigroup). It has now agreed to convert up to $25 billion of those shares into common stock, provided that private investors who also own preferred shares agree to convert a similar amount. As of today, it looks like $27.2 billion of privately-held preferred shares will be converted, thus exchanging a total of $52.2 billion of preferred stock for common equity.

What this means for Citigroup: First, the company will save about $4 billion per year in preferred dividends (its annual common stock dividend is only $.04 per share). Second, Citigroup’s balance sheet now looks considerably different, with $52.2 billion more in common equity and that much less debt, giving it much more headroom to sustain losses in the future without putting its survival in peril. This has happened without any additional investment of cash by the government or private investors, and represents yet another move by the government to keep Citigroup from going under.

What it means to the US taxpayer: The government (and thus all of us) will now own a total of 36% of Citigroup. Our $25 billion investment will now bear the same risk as all the other common shareholders: if Citigroup goes under, that $25 billion will disappear. This obviously gives the government even more incentive to keep Citigroup afloat. On the flipside, if the company eventually recovers, taxpayers stand to make a lot of money.

What it means to current Citigroup common shareholders: They will be “diluted” by the issuance of a lot of new shares, reducing their stake in the company from 100% to only 26%. This is probably the main reason that Citigroup’s stock fell so much today, as the existing shares now represent roughly 1/4 as much ownership as before. On the other hand, 1/4 of a company that survives and may eventually thrive is worth more than 100% of a company that goes under.

What this means for the financial system and other big banks: For the financial system as a whole, this is a good thing because letting a bank the size of Citigroup fail would make a bad situation even worse. It also sends a clear message that the government intends to rescue all the big banks, but will avoid fully nationalizing them.

On the other hand, there are 3 real concerns here:
1. Will the government need to put in more money later, after Citigroup’s “stress test,” and potentially gain even more ownership, further diluting existing shareholders? (I suspect that any additional funds will be invested via preferred shares that don’t convert.)
2. Will the government need to convert preferred shares in other big banks, such as Bank of America, and thus end up with significant ownership in several big banks?
3. Will Citigroup have an unfair competitive advantage over other banks as a result of its actual or implied government guarantee?

Until these questions are more fully answered, expect the market, and bank stocks in particular, to continue to be volatile.

So does all this make Citigroup a “buy” or a “sell?” It’s pretty clear to me that the bank is not going to fail, but it could be broken up by the government, and existing shareholders could be further diluted. This makes its shares, even at their current price of $1.50, very risky. On the other hand, if things eventually work out for Citigroup, they could easily soar 10 or 20 times. So they make an attractive speculation, but no more than a speculation. As of today, I’m still staying away from these shares with so many other juicy, but safer, opportunities.

Next up: Is the stock market’s price/earnings ratio high or low? Are stocks really cheap or do they just appear to be?

Enjoy your weekend

Why it's risky to sell now

2009-02-24T12:37:00.000-08:00

It sounds counterintuitive, but it may actually be riskier to sell now than to stay fully invested. This would be true even if the bear market still has many months to go. Why? Because of bear market (or “countertrend”) rallies, which tend to be both rapid and powerful. They also tend to be unexpected, seemingly coming out of nowhere when both news and sentiment are terrible. Kind of like now.

How powerful are these rallies? Very. Look at Japan since 1989, when its stock market last peaked. Since then, it’s been in a secular downtrend that’s lasted 19 years so far. There have been 7 countertrend rallies during that time, ranging from +21% to +135%, with a median gain of +48%. On average, 1/5 of that gain came in the first 5 days, so its pretty hard to just jump in when it starts. Each one lasted several weeks to a many months.

The picture in the US is similar. During the secular bear markets of 1929–1938, 1966–1980 and 2000–today, there have been 8 countertrend rallies. They median gain was +67%, even better than in Japan, with 1/5 of the rise coming in the first 13 days.

So big rallies do happen during extended bear markets, and we have yet to have one since the current downtrend began in late 2007. When it finally arrives, suddenly and without warning, it should be impressive. The question at that point will be: Is this a countertrend rally or a new bull market?

Unfortunately, it’s usually almost impossible to tell until well after the fact. But fortunately, it really doesn’t matter for most investors. If you are invested for the long term, you should stay that way during and after the rally. If you need to reduce the risk level of your portfolio, you’ll want to cut back on your equity holdings after they’ve recovered somewhat regardless of what you think the future holds. This is good, since the future is ultimately unknowable. The only thing I know for sure is that it won’t look like the past.

Can investor sentiment get any worse?

2008-10-15T15:16:00.000-07:00

Another day, another big drop. When will the market finally turn around for real?

If anyone could accurately predict the exact date, he or she would already be a trillionaire. I don’t know any trillionaires.

But whatever the short term brings, the longer turn is looking much brighter, regardless of recession, credit crisis or bank failures. Why? Because the biggest bull markets spring from extreme pessimism. Investors were down in the dumps in 1982. I’m sure they were depressed in 1932 (we don’t have any good investor sentiment data from back then). Today, they’re as negative as they’ve ever been, far more so than in 1990 or 2003. On top of that, stock valuations are, by many measures, the cheapest they’ve been in decades, maybe ever. Cheap stocks and extreme bearishness—what could be a more bullish combination?

Merrill Lynch just completed one of their investor surveys. This firm's outlook is often cited as one of the best contrarian indicators: When Merrill is buying, you should sell; when Merrill sells, you should be buying. (I wonder if we’ll still be able to use the Merrill indicator once they’re absorbed into Bank of America?)

Currently, Merrill—and the fund managers they survey—are selling... everything. “Right now they hate almost everything except cash.” Even hedge funds are moving to cash. (One hedge fund manager says the best position to be in right now is CASH and FETAL.) Individuals are going so far as to take money out of banks and put the cash in safes (apparently, safe sales are up 50% this month). No one wants a whiff of risk. And no one seems to think anything will change anytime soon.

Which probably means it will.

Someone asked me today, “When will individual investors put their money back into stocks?” My answer: when they usually do, well after the market has recovered, and after the “smart money” has already made 30% or more by being invested when the rebound began. Since you don’t know when that will be, you’ve got to be prepared ahead of time, even if that means withstanding some huge price swings.

Stocks are historically cheap. Investors are terrified. Everyone thinks we’re on the cusp of another Great Depression. They buying opportunity of a lifetime? I think so.

Volatility works both ways

2008-10-13T16:55:00.000-07:00

Today was another one for the record books, and thankfully it was on the upside! The Dow Jones average had a record point gain (though not a record percentage rise) of +936 points. That’s bigger by nearly 200 points than any of the large one-day drops we’ve had recently. The percentage gains were impressive as well: +11.1% for the Dow, +11.6% for the S&P 500 (now up +19.5% from it’s low last Friday), +15.9% for the EAFE (developed foreign markets), and +22.8% for emerging markets. Some individual stock gains were enormous: Morgan Stanley was up +87%. Today’s huge one-day move illustrates that volatility can work going up as well as going down. Expect to see a lot more big moves over the next few weeks, both up and down.

What propelled today’s jump, and will the rally continue? In other words, have we finally seen the bottom of this ferocious bear?

Answering either question requires some speculation, but it seems clear that worldwide government action over the weekend contributed to the turnaround. I won’t go into detail here on everything that transpired, but the message sent by governments everywhere was that they are committed to real action, and proved it by putting some unprecedented programs into place. One positive that didn’t involve direct government intervention was that the deal by Mitsubishi UFJ Bank to buy 21% of Morgan Stanley went through, albeit on somewhat less generous terms than initially proposed 2 weeks ago.

Since this is a market dominated by fear, anything that calms investors down and/or reduces uncertainty is likely to spur buying. But there are other factors at play that may conspire to create a very rapid recovery of the recent large losses. These include the cessation of margin calls, a massive short squeeze, and the settlement of the Lehman Bros. credit default swaps. All three of these are powerful, though arcane, influences on market prices.

I was going to explain each of these, but this post was getting too long. For now, suffice it to say that in addition to fear and the desire by many investors to own only the safest assets, internal market forces that contributed to the big drops of the last 2 weeks are now in decline. And they may continue to wane over the coming weeks, which is obviously a good thing.

So are we out of the woods yet? One day does not a bull market make, and we’ll almost certainly have some more chilling drops over the next few weeks as fear periodically resurfaces. Yet while it’s still too early to say with conviction that last Friday’s panic lows represent the ultimate bottom for this bear market, a number of factors are finally coming together that make this more likely than not. I also think it’s again safe to start buying stocks; even if you don’t catch the lows, you’re getting in at incredibly cheap prices.

As painful as the past year—and especially the past 2 weeks—has been, I believe that we’ll look back on October 2008 as one of the great buying opportunities of the 21st century. Those who purchased stocks this month—or didn’t throw in the towel on their existing stockholdings as so many other investors did—should enjoy returns well above average over the next decade or more.

Now more than ever, it’s crucial to focus on the long term. Today’s wild swings seem huge in comparison to what we’re used to, but in the long run, they’ll be just blips on a chart.

Mr. Market's Wildest Ride

2008-10-10T16:35:00.000-07:00

Today’s violent mood swings capped one of the worst weeks in stock market history. (It’s not always fun to be part of history in the making.) Fortunately, stocks recovered sharply in the late afternoon, so that the averages were down 1% or less today (a few were even positive). At one point, the Dow Jones average soared over 1,000 points from its low in just 30 minutes. Talk about volatility!

This weekend, the G-7 ministers are meeting in DC, and all eyes are on them. I suggest you forget about this. Also forget about whether or note the economy will suffer a long and deep recession. Forget about the credit crisis. None of these have anything to do with stock prices any longer. At this point, it’s all about perception.

Over the past couple of weeks, as the averages tumbled at rates rarely seen, there have been 2 primary types of sellers:

1. Those selling because the want to, mainly out of abject fear (usually accompanied by some seemingly rational explanation, which is just cover for the underlying panic); and

2. Those selling because they have to, mainly hedge funds and other leveraged institutions that have been receiving margin calls (demands for cash) at a rapid rate.

Virtually none of the selling has come from a cold analysis of the facts. Because if you take a step back (and a big breath), you’ll see that stocks are cheaper by almost any measure than they have been in our lifetimes. Cheaper than 2002. Cheaper than 1990. Cheaper than 1982. We’re talking 1949 and 1932 cheap. It all makes no sense.

Here’s something to keep in mind: During the Great Depression, US stocks bottomed in July 1932, just after FDR was nominated. Over the next 18 months, they rallied +187%, starting a full 9 months before the economy began to grow again (after shrinking 30% over the prior 3 years). By the end of 1936, stocks had risen +368% (that’s 4.7 times) from their lows.

There’s only one question you need to ask yourself when deciding whether to stick with stocks (or even buy more): Is the world about to end? If the answer is “Yes,” sell everything (not just your stocks), buy gold and diamonds, lots of canned food and ammunition, and hole up in a bunker. If the answer is “No,” then stocks are now the best place to be.