What could go wrong?

The economy seems to be getting back on its feet. New unemployment claims seem to be turning the corner. Manufacturing seems to be turning up. The housing market even seems to be stabilizing.

There are very good reasons to believe the U.S. economy may be growing again before year end.

That's the good news.

But, what could go wrong? When things look rosy, I begin to wonder what would happen if most people are wrong. There are good reasons to worry.

This is not a normal post World War II recession. This is a credit induced recession, and credit induced recessions take longer to work out. It's possible we are out of the woods, but I don't think it's likely.

For starters, the thing that got us into this recession, a credit induced binge to buy real estate, doesn't seem to have worked its way out, yet. Housing may be stabilizing, but option ARM, jumbo, Alt A and prime loans will be reseting to higher rates over the next couple of years. That could put us right back into a 2007-2008 scenario.

On the other hand, the governments of the world have done everything they can, both monetary and fiscal stimulus, to get the world economy going again. There's no such thing as a free lunch, so such stimulus will have consequences. Those consequences could include much higher inflation and perhaps even a dollar crisis.

More credit defaults would be deflationary. If the economy improves, then government stimulus will be highly inflationary. We are stuck between a rock and a hard place. If everything happens perfectly, then we'll be okay and we won't experience inflation or deflation. But, that doesn't seem to be the odds-on bet.

More likely than not, investors will want to be prepared for both contingencies. If deflation happens, then you'll want to be in solid companies with strong balance sheets and earnings power. If inflation happens, you'll want to be invested in companies that benefit disproportionally from inflation, like resource companies or companies with strong pricing power.

It's possible for us to reach a Goldilocks economy again with low inflation and good growth, but it doesn't seem likely considering the dynamics currently at play.

Be prepared for either inflation or deflation. Keep some dry powder in case great opportunities come up. Don't invest in marginal or junky companies--this is not the time to gamble.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Investing in the unloved

The highest returning investments are also the most unloved.

This may sound counter-intuitive at first, but it makes sense when you stand back and think about it.

Great companies, like Google and Apple, that are firing on all cylinders, almost always have share prices that reflects that fact. The very obviousness that such companies are doing well causes investors to flock to those stocks, and hence bid up their shares to very high prices relative to underlying fundamentals. As Warren Buffett puts it, you pay a high price for a cheery consensus. Once everyone loves a stock and has bought it, who is left to buy more?

The companies that are seemingly on the ropes, like Microsoft and Dell (full disclosure: my clients and I both own shares of Microsoft and Dell), on the other hand, have share prices that reflect their tough competitive landscape. Everyone knows that Google is going to crush Microsoft and that Apple is going to crush Dell, so Microsoft and Dell have low share prices relative to their fundamentals. Once everyone who hates a stock has sold it, who is left to sell more?

But, what if what everyone knows to be true isn't true? What if Microsoft and Dell aren't completely doomed? What if they do even slightly better than everyone thinks? Then their share prices may perform better than consensus. Actually, once everyone who is going to sell Microsoft and Dell to buy Google and Apple have done so, then there is only one direction share prices can go, and its the opposite of what most people expect.

In my experience, the more hated the company, the more potential for great upside. This isn't always the case (think: Worldcom, Enron, AIG, Citigroup), but it happens much more frequently than most think.

In fact, I tend to get excited when the consensus comes to such a conclusion. When I tell people I own Comcast (full disclosure: my clients and I own Comcast) and their reaction is, "they are toast, everyone will be watching TV and movies for free over the Internet!", I just smile and nod. I know that Comcast's share price reflects this consensus opinion, and that it's price probably has a lot of upside.

Investing in what is hated is tough. No one will pat you on the back at cocktail parties. But, what would you rather have? Pats on the back, or long run market out-performance? Not everyone agrees with me on this, but it's an easy choice for me (and I think my clients are happy that I take on that burden for them).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Don't invest with your heart, invest with your head

Emotions make us lousy investors. People, as humans, tend to act in emotional ways during tough or exciting times. When people give in to emotions--investing with their hearts instead of their heads--they get lousy results.

If you've refused to sell a losing investment, bought because everyone else was, sold because a stock's price went down, picked investments because they seemed safe, or sold because the economy looked dreadful, then you've invested with your emotions. Don't feel bad, everyone fights and succumbs to this at some point.

The field of behavioral finance has clearly shown that we humans suffer from several biases that lead us to make unwise investment decisions.

For example, there's anchoring bias. If you hold an investment waiting for it to get back to the price you paid, you're suffering from anchoring bias. If you wait to buy an investment until it declines back to the price you could have bought it at (and regret not having done so), that's anchoring bias again.

Another bias is called recency bias. This is the tendency to think that recent events are more likely than they are (and that distant events are less likely). Someone who buys hurricane insurance because a bunch of hurricanes seem to have hit recently is suffering from recency bias. Someone who drops earthquake coverage because an earthquake hasn't happened in a while has been hit with recency bias.

Loss aversion is one of the most common biases. It happens when people refuse to sell an investment because they don't want to "book the loss." People feel losses more keenly than gains, and they usually need twice the gain to make up for a given loss. This can lead people to make bad investment decisions by holding on to something they should sell.

Then, there's the endowment or halo effect. This happens when one particular good attribute overwhelms all other attributes. Many people still see GM as a great company because it was in the past, even though there's a lot of evidence it isn't anymore. It can also happen the other way around, when one particular bad attribute overwhelms all good attributes. Many assume a company whose stock has gone down a lot must be bad, even though it may have many excellent characteristics. The price drop seems to overwhelm everything else.

Finally, there's overconfidence. When asked, we all claim to be above average drivers, kissers, and investors, but this isn't Lake Wobegon and everyone can't be above average. It's hard for us view ourselves objectively, and so we make unwise investments when we feel more confident than the facts suggest.

The way to fight these biases is simple, but not easy: discipline. If you use strict criteria to buy and sell investments and act on that criteria, you can fight these emotional biases and win. This will greatly improve your results. Even better, If you'd prefer to let someone else be disciplined for you (I'm not unbiased on this suggestion), then unemotionally select an advisor that can act with discipline on your behalf.

Invest with your head instead of your heart, and you'll get dramatically better investment results over the long term.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Can investors trust their money managers?

A recent article in the Wall Street Journal, "Taking Control," by Jennifer Levitz highlights how investors feel they can no longer trust money managers. Multi-billion dollar Ponzi schemes by the likes of Bernie Madoff, prominent financial companies being accused of cheating clients, and terrible recent performance have all conspired to make investors feel shell-shocked.

This is quiet understandable. After being re-assured that regulators were looking out for their interests and by money managers who have conflicts of interest, no wonder people feel scared.

The article goes on to spell out some of the things investors can do to take back control, so they don't feel as scared.

1) Do your homework when picking a financial advisor. Every investment advisor must provide a Form ADV Part II to prospective clients. This form spells out an adviser's structure, methodology, criminal record, compensation, etc. If you advisor won't disclose this basic information, then don't consider them. I gladly provide this form to all my prospective clients.

2) Ask tough questions to identify potential conflicts of interest. Some advisers are salespeople in disguise. They are compensated by commissions and they only have to judge a potential investment as "suitable" for clients. A tougher standard, which all registered investment advisers must meet, is a "fiduciary" standard. A fiduciary must put the client's interests first. A commission-based broker only has to ensure an investment is "suitable," which has a lot of wiggle room. Make sure your advisor holds themselves out to the fiduciary standard. I do.

3) Find out how an advisor is compensated. If they are compensated by commission, then your interests and theirs are not aligned. Their commissioned-based structure may not be obvious to you, so ask a lot of questions. If an advisor gives you a financial plan for $500, and they recommend you put $100,000 with a mutual fund they get a 5% commission ($5,000) for recommending, they have 10 times the reason to get you to buy their fund than to provide you with an objective financial plan. If they work for a flat fee and don't receive kick-backs for recommending investments, then their interests and yours are aligned. If they work for a fee based on assets under management, then their interests are aligned with yours except when you ask them how much of your money they should manage. Find out how your advisor is compensated and you'll find out if their interests are aligned with yours. I'm compensated by a fee based on assets under management, so my interests are aligned with clients, and I disclose my conflict of interest when they ask me how much money they should stick with me.

4) Ask tough questions about risk factors. Most advisers try to paper over risk factors. They stick clients with a hundred page prospectus (feeling certain no one except accountants and engineers will read it), or they try to understate risk considerations. Make sure your advisor can clearly articulate the risk factors of their particular approach. I have a brutally honest web page that explains the risk factors of equity investing (which is what I do), and I tend to over-emphasize risk to my clients. My first client letter, in the summer of 2005, said the market was over-valued and that clients should lower their return expectations. Fortune favors the prepared mind.

5) Don't expect a free lunch. When someone gives you a free steak dinner, you have to question their motivation and objectivity. When someone says something is "cash-like," doubt their statement. Cash is cash-like; structured products, bonds, even CDs all carry risks that are distinctly not cash-like. I invest in equities, and they are not cash-like. Don't be fooled by someone trying to pitch a product that anything other than cash is truly cash-like.

6) Does a manger invest his own money the same way he's recommending you invest your money? Does he or she eat their own cooking? If your advisor doesn't or won't invest where he is recommending you invest, be very worried. If they earn $100,000 a year selling variable annuities and have $20,000 of their own money in a variable annuities, be very worried (they make so much more from selling annuities that they'll never care about the mere $20,000 they might lose). If an advisor believes in what they do, then they'll have all, or almost all, of their money invested there. I have over 90% of my money invested in the same securities I recommend for clients. My other 10% is in a bank account in case an emergency happens.

7) Does your adviser's firm have interests aligned with yours? Firms make more money when they advise more people. But, the more people they advise, the less time they have for you. Such is the conflict of interest of money management. Added to this, large firms cannot move as quickly as small firms to exploit market opportunities, nor can they deploy their money in smaller situations like small firms can. The benefit of large firms is the possibility of lower costs. With Vanguard, that's the case. Most firms that are 100x my size still charge more than I do, when all costs are considered. Many large firms charge their clients to help them market to new clients, that's what 12b-1 fees are at mutual funds. What a rip-off. My firm is small and nimble, allowing me to provide excellent, personalized customer service to a limited number of unique clients.

Yes, Virginia, some money managers can be trusted, but you have to do your homework to find that out. Get full disclosure, ask about advisor conflicts of interest, find out how they're compensated, get clear information about risk, don't expect a free lunch, ask lots of questions and expect understandable answers. It's hard work, but very much worth the effort.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Higher saving rates are a GOOD thing!

The U.S. saving rate recently hit 5.7%, and all types of commentators have been saying this is bad for the economy. I think this is a load of hooey!

One of the most famous economists of the last century, John Maynard Keynes, made this fallacy main stream with his "Paradox of Thrift."

I'll spare you the details, but the gist is that savings aren't spent in the economy, and therefore prevent growth, employment, all good things.

This fallacy has all kinds of people, including economists and commentators with IQs that are much higher than mine, saying that more savings will crush the economy.

But, I think they are full of baloney. Saving stuffed under a mattress, as they were during Keynes time, aren't spent in the economy. But who puts their savings under a mattress nowadays?

No, most people put their saving into the bank, bonds or stocks.

If savings go to the bank, they are lent out again and used for consumption or investment in productive capacity. I call that spending.

If the money goes into bonds, then whoever sold the bond will either spend the money, which is consumption, or invest the money elsewhere, which will turn into an investment in productive capacity.

If the money goes into stocks, you get the same thing as with bonds.

If people save their money (and don't stick it under the mattress), it gets invested. Investment is where higher productivity, new jobs, and growth come from.

We shouldn't be encouraging people to spend, we should be encouraging them to save and invest. Consumption, especially consumption paid for with debt, is what got us into this economic mess to begin with!

What we need is more, not less savings. That will create new jobs, higher productivity and higher growth. This will not prevent growth, but is the necessary precursor to growth.

Okay, I'll get off my soap-box now...

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bond market in focus

Most stock investors, myself included, tend to focus solely on how the stock market is doing. I own almost entirely stocks and so do my clients, so why focus on bond markets?

For starters, bonds are alternatives to stocks. If bond yields rise high enough, some people will sell stocks to buy bonds. If bond yields are climbing, like they have been lately, then it may lead investors to sell stocks and buy bonds.

Bonds are also a strong indicator of inflation. If bond yields are climbing, it means bond investors are probably worried about inflation. With governments around the world printing money to get the world economy going again, this worry is not unjustified. Inflation is bad for stocks in the short run, so increasing bond yields are a bad sign for stocks in the short run. If you remember the 20% stock market crash that happened in one day in 1987, you might also like to know that bond yields had been rising and the dollar sinking for months beforehand. Sounds like today in some ways...

Bond markets are good indicators of financial stress, too. When investors become worried about credit issues, they frequently flood into U.S. Treasuries, which leads to declining interest rates. Lately, interest rates have been going the other direction, indicating that worries about credit issues are declining and the economy may be recovering. This could be signaling the end of the credit crisis, and/or the beginning of a dollar crisis.

Bond markets are as vital to understanding the economy and investing as stock markets. They frequently signal economic, credit, and inflation changes long before stock markets do. It's important to pay attention to bond markets for this reason.

As I've highlighted above, interest rates have been climbing recently. Interest rates climb when bond prices go down, and are an indication that stock markets may decline because of competition with bonds or worries about inflation. Increasing interest rates can also mean the credit crisis may be ending, the economy may be improving, and investors may becoming increasingly concerned about the value of the U.S. dollar.

These are important things to consider.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Selling low and buying high

Sometimes the stock market seems like a machine designed to produce regret.

When the market goes down, most people hang on until they reach a point of maximum pain and they sell. That's when the market starts to climb back up again.

When the market goes back up, most people wait for the market to pull back (so they can "buy back in"). When the pull back doesn't occur and the market continues to climb, they reach a point of maximum regret and buy back in. That's when the market starts to tank again.

And so the story goes on and on over time. People end up buying at the top and selling at the bottom, en masse, because they invest using their psychological inclinations instead of their heads. That's what allows calmer minds to make money over time.

The financial press is full of articles about those who sold at the bottom and are now regretting it and buying back in at the top. Why don't people learn that trying to time the market doesn't work?

This fear and regret cycle has repeated twice over the last 6 months. As the market tanked in October and November of last year, people sold at the bottom. As the market climbed out of those lows, the same people bought back in only to see the market tank again in March. Guess what happened from March to May? Rinse and repeat.

Why don't people just accept that their psychological inclinations are almost always wrong when it comes to investing in the stock market? I don't know. Tons of studies have shown that people make bad investing decisions using their psychological reactions. And yet they continue to do so.

The stock market will go up and down, I guarantee it. When it feels awful to hold on, you should be buying. When it feels wonderful because things are going up, you should be selling. Do almost the exact opposite of what you feel, and you'll be a better, more successful investor.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A little extra cash is not a bad thing

I must admit, I used the recent stock market rally to sell some of my clients' and my holdings, and I didn't re-invest the money into something else right away.

This may sound like a prudent thing to do, but many take issue with such an approach.

They believe not being fully invested means timing the market. But I disagree with the approach that always being fully invested is the smartest way to go. I also disagree that not being fully invested--holding cash--means timing the market.

In the history of free enterprise, the most successful businesses almost always operate more conservatively than they need to. By doing so, they have the ability to be aggressive in difficult times.

During the Great Depression, companies with extra cash were able to boost advertising at low rates, purchase competitors at cheap prices, expand into new markets, etc., while their competitors were simply attempting to survive the crisis. Having extra cash on hand during tough times allows great businesses to buy at super-cheap prices exactly when competitors are hamstrung.

The same is true for investing. By operating a bit more conservatively--holding extra cash in principle--an investor can purchase during those rare times when prices are once-in-a-lifetime cheap. Those who are fully invested cannot. Those with extra cash may under-perform during boom times, but they tend to out-perform over the long run.

Holding extra cash is not the same as timing the market, either.

Timing the market is the attempt to sell at the top and buy at the bottom. That's not my approach, nor do I think timing the market is a successful strategy.

Instead, I assess the value of businesses. With such an assessment, I attempt to purchase businesses (that's what buying stock is: purchasing part-ownership in businesses) when they are cheap and sell them when they're dear. The buying and selling occurs because of the relationship of price to value, not because of my opinion about the market's top or bottom.

Carrying extra cash can be a competitive advantage, both in business and investing. I'm happy to sit on a little extra cash and wait for stock prices to move to cheaper valuations. If it happens sooner, great. If later, that'll work, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It looks like a slow economic recovery is on the way! (but that doesn't necessarily mean we're out of the woods)

At long last, there are some pretty solid signs the economy may recover soon.

This week, both the weekly initial jobless claims report and the monthly unemployment report showed improvement. Initial jobless claims have been high, but declining, which usually happens several months before the economy starts growing again. The monthly unemployment report showed high and growing unemployment, but with much fewer jobs being cut by employers.

These reports aren't saying the employment situation is getting better, just that it's getting bad less quickly. But, that's always the first necessary step to an economic recovery.

You see, unemployment almost always peaks long after the economy starts growing again, so it's normal for the employment situation to be getting less bad when the economy turns.

Not surprisingly, the stock market anticipated this situation. The market has been rallying since March, showing once again its predictive ability. But keep in mind, the stock market has forecast 9 of the last 5 recessions and 9 of the last 5 recoveries.

That's not a typo, the stock market frequently tanks or moves up falsely, indicating things are getting worse or improving when that isn't the case. In other words, it's not a great indicator by itself, but it is a good indicator in concert with others.

Adding to information from employment and the stock market, the Chinese government is working hard to stimulate its economy, and it looks like those efforts have been successful so far. Unlike the U.S. government, the Chinese government actually has money to stimulate their economy instead of simply borrowing from others to stimulate. This doesn't mean the Chinese government's efforts are efficient or even sustainable over the long run, but for now it's working, and they have a lot of money they can spend to get things going.

Putting these data points together, along with retail sales, copper prices, industrial activity, inventory levels, and so forth, it looks like an economic recovery is on the way.

How will this impact investors? Good question. As usual, I don't really know what will happen in the short run.

This could be a V recovery, a sharp economic rebound, a U recovery, a long slow period followed by faster growth, a W recovery, a sharp rebound followed by another slowdown followed by a sustainable recovery, or an L "recovery," where we don't really recover so much as things don't continue getting worse. An L recover is really a U recovery where the base of the U is very, very wide. Think Japan over the last...well...20 years.

If a V recovery is in the works, the stock market could just keep going up. It won't move straight up, because conflicting information will cause temporary setbacks, but on the whole it will not reach new bottoms and will trend upward over time. That would be the most fun, but I believe it's the least likely scenario. It's possible, though.

A U or L recovery would mean the stock market has gotten ahead of itself, and if companies start pre-announcing that things don't look that great for the 3rd and 4th quarter, the market would probably tank. The market's recent move indicates V or W with strong growth and earnings beginning late this year or early next. If that doesn't happen, market participants will be very disappointed and prices will decline, perhaps significantly.

If a W recovery is in the works, the market could go up for the next year or more, only to crash again as the current nascent recovery turns out to be a false dawn followed by another recession. Unfortunately, I see this scenario as quite likely. Government stimulus may lead to higher inflation and high commodity prices, which could send the economy right back into recession.

My guess, and I'll admit its no better than that, is that we are in a W recovery. That means enjoy the rally for the time being, but be prepared for another downdraft in a year or two. This may sound unpleasant, but it will produce many opportunities to make money both on the up and the downside. That's what happened in the late 1970's and early 1980's. There was a lot of money to be made on commodities during the turmoil, and then the greatest bull market of all time began in 1982.

The next most likely scenario, in my opinion, is a U/L recovery. This would be no fun for most investors, but work out fine--over the long run--for the prepared. It would provide a lot of false dawn rallies and several exploitable downdrafts. That's what the 1930's and 1970's looked like, as well as Japan over the last 20 years.

The V recovery, which I consider least likely, would, I believe, look like the recoveries we saw after the late 1990-91 recession and the 2001 recession. In both cases, the market didn't really take off until a couple of years after the economy left recession. In both cases, they were referred to as "job-less" recoveries, with economic growth and very slow employment improvement.

As you may have noticed, I didn't include any scenario where the market just takes off into a 20 year bull market with annualized returns of 20%. That's because I consider such a scenario so unlikely as to be hardly worth mentioning. It's possible, but I wouldn't bet on it.

It feels a lot better to be talking about recovery than it did talking about how bad things were last November or March. However, I believe the market may be getting ahead of itself in predicting robust growth by year end. It might be a good time to take some profits and sit on a little bit extra cash.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The peril of bonds

Long term bonds have beaten stocks for decades.

As reported by Rob Arnott (chairman of Research Affiliates), 20 year bonds have provided better returns than the S&P 500 starting any time from the 1979 through 2008.

That's a startling fact to many investors who've been told, ad nauseam, that stocks always do better than bonds over the long run.

This out-performance by bonds has not gone unnoticed by investors, who are selling stock mutual funds and buying bond funds.

Is it time to abandon stocks and buy bonds?

No.

You shouldn't drive your car by looking in the rear view mirror, and you shouldn't invest your money that way, either. The past can be a wonderful guide to the future, if and only if situations are sufficiently similar.

But, the situation over the next 30 years is highly unlikely to be the same as it was over the last 30 years.

For starters, inflation was in double digits 30 years ago. When inflation is high, bonds sell at super-cheap prices. When high inflation is tackled, as it was by Paul Volcker in the 1980's, and continues to decline for another 20 years, as it did, then bonds have remarkable performance.

That is not the situation today. In fact, reported inflation is at an all time low, showing its first annual decline since the mid 1950's. Bond yields reflect this low inflation with record low yields.

Bonds will not perform as they did over the last 30 years because inflation isn't starting high and going to record lows. Count on it.

In addition, the threat of growing inflation is as high now as it was the last time bond rates were this low, in the 1960's.

At that point in time, government spending was going through the roof to fund new social programs like Medicare and to fight an on-going war in Vietnam. If that sounds familiar to you, it should.

The U.S. government is running record high deficits as a percentage of the economy in an attempt to jump start an economic recovery, fight on-going wars in Iraq and Afghanistan, fund social programs like universal health care, and reduce carbon emissions to prevent global warming. If you think that won't sooner or later lead to high inflation, I've got a few bridges I'd like to sell you.

Just because long bonds have done well in the past doesn't mean they will do well in the future. If deflation continues for some time, as many smart people think it will, long bonds will do well. But, I believe that situation will only be temporary.

When inflation kicks up, as I think it will, long bonds will be gutted.

Stocks may not do well in the short run, but they offer excellent long term protection against inflation. Stocks are also selling at historically low prices relative to bonds. Bonds are now priced for perfection (low or declining inflation) whereas stocks are priced for a sustained recession.

Stocks may under-perform bonds over the short run, but over the long run, I don't think its even a contest--stocks will almost certainly out-perform over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Less bad than expected

This is the time of year when companies report how they did last quarter. It's referred to as "earnings season."

There's nothing magical that happens in a single quarter to business in general, but Wall Street pays a lot of attention to quarterly reports.

Its amusing to watch.

Wall Street analysts try to guess (and I use that term intentionally) what companies will earn in a quarter. There is a lot of focus on these estimates because most people trade securities every 6 months.

If a company beats Wall Street "expectations," the stock price tends to jump. If a company misses "expectations," its price usually tanks.

Keep in mind that the fundamental value of a business changes very little over a single quarter. A company is worth it's earnings into the infinite future. What it does this quarter is, at best, meaningful to less than 5% of a company's value.

But, if you hold a stock for only 6 months, like most market participants do, then those quarterly estimates and price moves become vitally important. Why play that game?

I don't. I pay attention to long term business value. I tend to hold companies for 3 to 5 years on average. The reason I buy is because a company seems to be selling far below its mathematically assessed value. I sell because someone is willing to pay much more than think it's worth.

I don't guess what will happen in one quarter. I don't hold for 6 months. I don't play that game.

This quarter has been particularly amusing to watch because companies are reporting earnings that are less bad than Wall Street expects.

That wording is also intentional. The companies aren't doing a lot better, they are just doing a lot less bad than Wall Street expects.

These are meaningful moves. When USG (full disclosure: my clients and I own shares of USG) reported earnings on Tuesday, its price jumped 25.4% in one day. When Mohawk (full disclosure: my clients and I own shares of Mohawk) reported earnings today, its price jumped over 33% (as of 1:51 Mountain Standard Time).

Did these companies report record earnings? No, they reported big losses. Did they forecast huge sales and earnings increases in the short term future? No, they both said the economy looks terrible and they don't know when end demand will pick up.

Did these two companies become 25-30% more valuable simply by reporting losses and dire outlooks? No, of course they didn't. They just reported less bad earnings and expectations than expected.

If you ever think markets are rational and that most market participants thoughtfully consider the prices they buy and sell securities, just remember these examples of how short term and silly Wall Street and most market participants can be.

I must admit, its amusing to watch....

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Retirement prospects look poor

An article in the Wall Street Journal today highlighted that those in or preparing for retirement are less confident than ever.

Only 13% of workers say they are very confident about having enough money to retire comfortably. That's a record low.

This is not a surprise considering that 49% of people 55 and older have saved less than $50,000. That's so far short of what's needed as to be outrageous. That could pay out around $4,400 a year over 30 years assuming an 8% return. Nowhere near enough money.

Those retired or going to retire over the next decade or two may at least have the benefit of social security and perhaps a pension. Younger folks should know that social security will be so far insolvent as to be unavailable to everyone.

Hope is not a strategy.

Only 25% of workers are highly optimistic about covering food and housing costs in retirement. That means 75% of people know--absolutely KNOW--they can't take care of themselves in retirement. Stunning!

For those currently retired, only 20% are confident about being able to afford a secure retirement. Only 25% say they have enough for medical expenses. Only 34% are optimistic about covering basic expenses. That means two-thirds of retirees believe they can't pay for the basics. Unbelievable!

On the bright side, workers are doing something to change their situation. They are cutting spending, working more hours, saving more, and talking to a financial professional. I hope they get good advice.

One major problem is that so many believe they can work longer to postpone retirement. But, 50% of current retirees left the workforce sooner than they expected because of health problems, downsizings or obsolete skills. Counting on working longer is not a solution.

Also, two-thirds of workers planned to work after retiring, but less than 35% actually ended up being able to work. Hoping to work more is not necessarily a viable option.

What do people need to do? They need to save more. They need to invest that money wisely. They need to think hard and independently about the amount of money they will need and why. They need to plan to take care of themselves, not hope that things "work out." Hope is not a strategy. Hope for the best, plan for the worst.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

New Bull Market, Or False Dawn?

Has the stock market finally turned the corner? Is the economy really recovering? Is it time to throw all your money at the market?

Everyone would love to know the answer to these questions--including me--but no one does. Someone may guess (like I will below) and be right, but that will be luck, not skill (that's why market strategists are like diapers, they require frequent changing, and for the same reason).

Why can't anyone know if the market and economy are finally recovering? Because it's too complex. Why can't I gather enough data to figure out precisely how many inches of rain will land in a square foot in my back yard this month? Same reason: it's too complex. Knowing all the inputs doesn't tell you the outcome. Markets are even more difficult to precisely predict than rain, because the weather doesn't possess freewill, but investors do!

There are strong psychological reasons for wanting to know what the market and economy will do. No one wants the regret of investing and then watching the market tank by 50%. For that matter, no one wants the regret of NOT investing and then watching the market double, either.

The fear of regret drives people to look for all kinds of clues, but such searching and wishing won't bring the answers. You can't reap the benefit of market returns if you sit on the sidelines. You have to put your money at risk and then either win soon, or win later. Not a bad bargain, when you think about it.

Okay, enough rambling, what do I think about the market and economy? I believe there are faint glimmers that the economy may be starting to turn. Those signs come in lower claims for unemployment, a slight rebound in factory activity, a pickup in activity in China, better than expected retail sales, and stronger than expected exports.

Do those glimmers mean the economy definitely will recover? No (please reread above if you expected the answer to be yes). There is still plenty of bad news out there, like higher credit defaults, higher foreclosures, more bankruptcies, higher unemployment, weak car sales, etc.

What about markets? Does a market recovery require an economic recovery, first? Probably not. Markets anticipate improving fundamentals and tend to turn up first, usually 3 - 9 months before the economy does. The stock market's rebound is one of the main reasons many believe the economy may be starting to recover.

I tend to think that the market and economy have yet to turn up, but that's just a guess. The problems that got us into this situation--housing and credit markets--are still in serious pain. Just because housing starts and prices are declining at slower rates doesn't mean happy days are here again. The economy and markets will probably recover before housing and credit do, but I think there is still a lot of downside there before things turn up.

Also, the stock market has only been going down for 1 1/2 years. This is the worst economic downturn since the Great Depression, so markets will probably be down longer than usual. The 2001 recession was one of the mildest on record, yet the stock market took 3 years to hit bottom. Granted, valuations were higher in 2000 than in 2007, but that doesn't account for everything.

Also, the consensus of leading economists think the economy will recover late this year or early next. Those folks are almost always wrong! Guess how many of them predicted this severe recession even with over-extended credit markets and declining housing prices staring them in the face? Zero, zilch, nada, not a one. If those folks didn't see this coming, then why should I believe they correctly see the recovery? I don't.

It's possible the economy could start to recover toward the end of this year or early next year, and that would indicate an increasing stock market now, this summer or this fall. But, the stock market could also go down much further into this fall (2009), spring of 2010 or fall of 2010. Who knows? I don't, and I don't know anyone else who does or can, either.

It's also possible the economy starts to recover only to enter another recession in 2011 or 2012. That's referred to as a double dip recession, and it happened in the late 1970's and early 1980's. That was the worst recession we had had since the Great Depression, until this one of course. A Double dip recession could easily be caused by the Federal Reserve raising interest rates too soon, or by raising them too slowly and causing enough inflation to send us back into a scenario like the stagflationary 1970's. Let's hope not (but, hope is NOT a strategy).

The best thing to do is invest wisely in sound, low valuation companies and prepare for the market to be bumpy. No predictions will prevent the market from going up and down. Sitting on the sidelines through it all is a sure-fire way to miss the upswing when it does come--whenever that will be. . .

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Don't listen to a word I have to say

When you listen to a financial expert's advice, your brain turns off.

This revelation came through Jason Zweig, who writes for the Wall Street Journal. In Zweig's blog, he highlighted a recent study by Dr. Gregory Berns of Emory University.

In Dr. Berns study, he watched how people's brain responded to inputs using a functional magnetic resonance imaging (fMRI) scanner. Specifically, he monitored blood flow to different parts of the brain of test subjects.

When subjects thought for themselves, two parts of their brain activated: one for determining the payoff of a sure win in the scenario presented, and one for calculating the possible gain from such a gamble.

Then, they did the same experiment, but with an "expert" with impressive sounding credentials. When that happened, the subject's brain activity faded. In other words, once the expert started suggesting, the subject's brain when into resting mode, "off-loading" the task of making the decision to the supposed "expert."

It seems obvious to me that not everyone falls for this gag, but, it's good to be aware of it.

I know I've paid for car maintenance I didn't need because I tried to make a decision too quickly in the presence of an "expert," so I feel keenly how easy it is to fall for such a trap.

How do you avoid "off-loading?"

Zweig suggests speaking to "experts" with a list of your concerns or the direction you'd like to go thought out and written down ahead of time. This will give you something to refer to when you're talking to an "expert."

Another thing he suggests is to make the decision later, after you've had a chance to think about it on your own. This lets you regain independence and get that blood flowing to the payout and gain portions of your brain.

There's nothing wrong with listening to investing advice, but doing so without the right approach may lead you to do something you'll regret.

So, listen to my advice, but turn it over in your mind on your own, think about what you thought beforehand, and give yourself some time before acting or deciding.

I always recommend this to my clients, too, because I've found I'd rather have happy clients for the long run than tricked clients that soon figure they aren't happy with my approach. In the long run, the truth will out.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds aren't as safe as they may seem

When stock markets tank, most people think, "boy do I wish I owned bonds."

Let me make this clear--bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn't mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you'd have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward--but those are profits you can't eat.

So, what are the risks for bonds. The first risk is the same as for stocks--what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business's assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what's left, but that doesn't mean they will get paid back in full, and it doesn't mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn't have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can't go down like stocks, think again!

The price declines I referred to above would happen quickly, but you'd still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That's true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you'd receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970's, and they'll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business's assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren't riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it's a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Short term madness

The average holding period of a stock on the stock market is only 7 months.

7 MONTHS!!!

Using some back-of-the-envelope math, that means that if a mere 2.4% of trading is done by long term holders (who hold an average of 4 years), then the average holding period of the other 97.6% of people is under 6 months!

That means that when you see the price of something you've bought go up or down, it is because the vast majority of traders--not investors--are only looking at how a stock will "perform" over the next 6 months.

But, what happens over the next 6 months is almost entirely random. How a company will perform over the next 3 to 5 years is based on underlying data. But, focusing on how stock will "move" in the next 6 months is not investing--it's just guessing at "price action."

Many investors have been shaken by recent price movements, and I have been, too. But, when I consider the fact that almost all trading is done by people with a focus on the next 6 months, I start to relax and focus on the long term.

When you aren't buying for the next 6 months--when you're truly a long term investor--you can focus on underlying businesses, and how they will perform over the next 3, 5, 10, even 20 years.

This is the way to invest.

Don't focus on short term price movements. Focus on the underlying business and how it will perform over the long term.

This won't prevent short term anxiety, but it may very well allow you to focus on the phenomenal growth prospects that await investors over the next 3 to 5 years.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What is smart money doing right now?

Investors frequently wonder what the "smart money" is doing. Who or what is smart money?

Smart money usually refers to big investors who got that way by generating high investing returns over a long period of time. That doesn't necessarily mean big money.

A lot of money is managed by large organizations that didn't necessarily get that way from smart investing. Think about a large pension fund or insurance company. Those organizations have a lot of money because a lot of money has been contributed to them (pension contributions and insurance premiums), not necessarily because they've managed it well. Big money is not the same as smart money.

Smart money has a lot of money because they've compounded initial investments at high rates for a sustained amount of time. Smart money moves into and out of markets before they move, not after or as they are moving. Smart money includes the "lead bulls" that the rest of the herd follows. Knowing what the smart money is doing can help build wealth because you can buy before things move.

This last reason is why everyone, including me, wonders what the smart money is doing.

So, what is the smart money doing now? I don't know exactly, but I have an idea.

For example, a lot of smart money is still on the sidelines--in cash. It's not there because they sold at the top or because they were timing the market. It was in cash because the smart money has been waiting for opportunities, waiting for years most likely.

Why haven't they started buying? They have, but very selectively. Remember, smart money buys before things move, so you can't look at price movements to see what they are doing. They are buying things on the cheap, at prices they can only get once every two or three decades, but they are taking their time.

Why are they taking their time? That's the most important question, and I think I have an answer. They're taking their time because the rules have changed. When the rules change, you have to wait for new rules before you can act.

What new rules am I talking about? Let me use banking as an example. It used to be that bad banks went out of business and good banks thrived. But recently, bad banks have been deemed "too big to fail," and so they have been kept alive. Keeping them alive hurts good banks, and so the smart money is waiting for the new rules to invest. They don't want to invest in good banks only to find out the new rules will hurt the good for the benefit of the bad.

The same could be said for distressed debt investing. Whether a company survives or not has less to do with assets, liabilities, cash flows and business model, currently. Instead, it has as much to do with number of employees and perception. Look at U.S. car companies. No one cried when Circuit City or Pilgrims Pride declared bankruptcy, but if a U.S. car company is in trouble, it doesn't need to go bankrupt. The rules have changed, and the smart money doesn't want to invest until they know those news rules.

I think the key reason markets haven't been improving is because the rules have changed, and the smart money is waiting to learn those new rules. When those rules are made clear, then the smart money and, eventually, everyone else, will jump back into the pool. Market values are cheap enough, whether equity, debt or real estate. I don't believe the smart money is waiting for markets to get cheaper, they are waiting to discover the new rules of the game.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The investing world's Holy Grail

Archimedes once said that he could move the world with a large enough lever and a place to stand. Like Archimedes, I think I could "move the world" by dramatically improving investors' returns--if I could just eliminate their desire to time the market.

I don't believe there is anything that destroys long term investment returns as much as the desire to time the market. It is the investing world's Holy Grail--it doesn't exist, but people keep trying to find it anyway.

Every investor seems to wish he could sell at "the top" and buy at "the bottom." Very few consider whether this feat is possible with anything other than hindsight. If investors would consider this seriously, perhaps their returns would improve dramatically.

The stories investors hear about someone who supposedly sold at "the top" and bought back at "the bottom" seems to egg them on. Like feats of ESP, this supposed achievement is frequently sited but infrequently submitted to rigorous study.

Remember, even a broken clock is right twice a day. So, if someone repeats over and over again that the market is going to drop, at some point they will be right. Same with the market rallying. This is not a demonstration of skill, but that a broken clock can be right.

Have you ever examined the Forbes 400 list of richest people? Check it out some time, and look for the market timers. You won't find a single one. In fact, the guy topping the list, Warren Buffett, says timing the market is not possible. Take his advice, seek not the Holy Grail.

The investors who build wealth over the long run do it by PRICING, not TIMING. They figure out something is cheap and they buy it. They don't panic when it becomes cheaper, because they know what it's worth. They usually buy more.

Those who try to time the market end up guessing about market tops and bottoms, because such things can only be seen clearly in hindsight. They almost always end up buying high and selling low.

Look at the statistics on investor versus mutual fund returns. Mutual fund returns are anywhere from 4% to 8% higher than the returns investors get. Why? Because most investors, in their search for the Holy Grail, sell what's not "working" and buy what is "working." They almost always sell something that is about to take off and buy something that's about to tank.

I'm not saying people don't get lucky every once in a while and sell at the top or buy at the bottom. What I'm saying is such luck should be associated with winning the lottery or getting struck by lightning, not with a sound approach to reaching your financial goals.

Don't seek the Holy Grail. Buy when things are cheap and accept that they will almost certainly get cheaper. Buy more if it gets cheaper. Rinse and repeat. In 5 to 10 years, you'll be very happy you didn't pursue the investing world's Holy Grail.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Lessons from the Panic of 1907

Few remember that the Federal Reserve was created in 1913 because of the panic of 1907. This panic was caused by the failure of several banks that were overly indebted and had made a lot of bad loans. If this sounds familiar to you, you're not alone.

The lessons of 1907 were that when a banking panic occurs, the smart bankers of the world need to get together, examine the books of questionable banks, draw a line in the sand on which banks are solvent and should be supported, and let the rest go into bankruptcy to be sold off piecemeal to solvent institutions and investors.

Back in 1907, the leader of the smart bankers was J.P. Morgan. Although vilified for the power he displayed in this role, Morgan managed to save the economy from complete collapse because he understood banking better than most and had the knowledge, experience, and iron will to make things happen.

The Federal Reserve was originally created to serve this purpose (so that some would-be J.P. Morgan would not have so much power), but its mandate has drifted significantly. Instead of drawing a line in the sand between solvent and insolvent bankers, it now tries to set monetary policy to provide full employment and manage inflation at reasonable levels.

Note how markets have reacted to the Federal Reserve's policies over the last 2 years. At first, markets were assured (early 2007 to mid 2008). Now, markets are tanking because of the Fed's actions. If you believe markets are tanking because of conditions beyond our control, you're not alone, but I don't think you're right. Markets are tanking in reaction to inept policy, not because of economic circumstances, per se.

Instead of allowing bad banks to go under and supporting good banks, the Fed is doing the opposite. Its supporting the bad banks, thus punishing good banks for their prudence. Markets are tanking for good reason.

Letting bad banks go under would hammer the bond and equity holders of such institutions, but their customers need not suffer. In almost every bail-out so far, banking customers were safe. What was threatened were the bond and equity holders, including the stupid banks who had invested in such bonds and equities.

Bailing out the ineffectual at the expense of the effective is a recipe for disaster, and markets will continue to tank as long as such a policy is followed.

In the long run, the truth will out. The bad banks will go under anyway, and the day of reckoning will merely be delayed at great expense, pain and frustration.

If, instead, the government would draw a line in the sand and let the insolvent go under by effecting an orderly liquidation while supporting the solvent, the impact would be painful but over quickly.

Regardless of how the Fed and U.S. government try to solve this problem, the hardworking people of this country will provide the bailout. That bailout will come in the form of hardworking entrepreneurs, prudent businessmen, diligent workers, and rational consumers.

Inept policy will only delay recovery, it will not prevent it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Sticking to the basics

For the last 5 months, markets have been nuts. The price swings have been awful and painful to watch.

During times like this, it's hard to focus on the fundamentals because watching your portfolio get diced every day is very distracting.

But, getting distracted, especially when great value are to be had, will lead you to poor returns over time.

How am I avoiding distraction? I'm sticking to the basics: looking at businesses I understand, evaluating underlying business economics, evaluating management, and examining valuation versus price.

First off, I can't get good returns by looking at businesses I really can't understand. No amount of research will allow me to understand a biotech firm, so I don't try to. Sometimes, I can educate myself enough to understand a firm, but it doesn't make sense to. Why figure out how to pick ripe fruit high on a tree when the same fruit can be picked off the low-hanging branches? If I can understand the firm without having to learn particle physics, I have a good candidate for further evaluation.

Second, I evaluate a business's underlying economics. What kind of returns will it generate over time? What competitive advantages does it have? Are those advantages stable, or does technological innovation and industry shifts make predicting the future almost impossible. Businesses with good economics are great candidates for potential investment.

Third, I evaluate management. Are they honest? Do they speak plainly and describe their business and its dynamics well? Are they compensated rationally? Do they own a chunk of the business themselves with shares purchased on their own (not options or restricted stock grants)? Do they do what they say over the years? Do they measure the business's performance rationally? A business I understand with good economics and management is an excellent candidate for potential investment.

Last, I examine price versus value. What is the company worth to a rational, long-term investor? What are the discretionary cash flows relative to the price of the business? What kind of growth rate and return on equity can be generated in a normal environment? Does the business carry too much debt making it susceptible to insolvency during difficult times (boy is this important)? If value is significantly above price, then the business is a very good candidate for purchase.

When the economy is in the tank and stock market prices are gyrating wildly, it's best to focus on the fundamentals. Right now, I'm focusing on businesses I understand with good economics and good management selling at cheap prices. There are a lot out there right now, so I have a lot of work to do. And, that's a nice "problem" to have.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

In praise of idleness

When the economy is in the tank and the stock market is down 40% and going nowhere, there is a great temptation to do something--anything--to improve short-term results. This is almost always folly.

In almost any field, action is the mark of progress. An architect waiting for inspiration to hit is a slacker. A manager waiting for problems to solve is a buffoon.

But, an investor who doesn't trade frequently is an enigma. He's seen as being a slacker buffoon, but in reality may be doing a lot of thinking and research, and deciding that acting is a poor choice.

You see, stock market prices move much more than underlying values. Any attempt to chase these almost random price movements leads to poorer returns than doing nothing.

Because the common paradigm is that activity equals progress, most people are confused by an investor who isn't trading. When things aren't happening, progress doesn't seem to be achieved. Right?

That's why idleness in an investor is virtue. Doing research, comparing alternatives, watching underlying fundamentals of current investments, but infrequently trading denotes a capable investor.

Frequent trading is like chasing fog: a lot may seem to happen, but little is achieved.

Patience is truly a virtue in investing. If you've invested in the right businesses at the right prices, the best thing to do is not to trade.

Research alternatives? Yes. Study more deeply current holdings? Yes. But, don't mistake such work, and lack of trading, for lack of progress. In this case, idleness is praiseworthy.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Diversification works great...until it doesn't

Many financial advisers tout the benefits of diversification. They reason that spreading your eggs among many baskets can protect your aggregate egg count in case one basket drops.

But, what if there is some underlying reason that causes all baskets to drop all at once? Then, of course, all your eggs drop.

Most people didn't think this was possible, and yet it happened in 2008. Almost every asset class dropped as the market panicked. The one major exception was U.S. Treasury Bonds.

As John Authers put it in his "The Short View" column in the Financial Times, "...last year's sell-off was so extreme that diversification would not have helped one whit."

But, isn't it at times like this, when everyone is panicking, that diversification is supposed to provide benefits? Yes, it is supposed to. But, that doesn't mean it does.

The reason why is that all financial markets are linked. Just because everyone is running from one investment does not mean another "historically uncorrelated" asset is necessarily doing well. This was very clear in 2008.

Diversification seems to work best when you don't need it. People don't get excited about diversification during normal times. It just gives you average instead of slightly better or slightly worse returns.

If you have half your money in U.S. stocks that provide a 5% return and half your money in foreign stocks that provide a 15% return, you get 10% returns. All you manage to do is lock in mediocre returns all the time. Getting 5% returns versus 10% or 15% returns in a single year won't ruin someones retirement. Losing 40% the year after retiring almost certainly will.

When markets really panic, everything goes down together. Even a brief glance at economic history confirms this. Diversification fails when people want it most. Like...well, like in 2008.

There is a very real benefit to be gained from this situation, though. Not all investments have bad underlying characteristics. The very fact that a panic has occurred means both good and bad investments were sold off. So, you can currently buy excellent investments for the same price as the poor ones.

But, if you diversify you'll get both the bad and the good returns going forward. Someone down 40% will see a world of difference between getting a 67% return (being in the good investments and returning to starting principal value) and getting a 33% return (being diversified in half the good investments that go up 67% and half the bad investments that go nowhere, thus still being down 20% from starting principal value).

Or, as John Authers put it, "If there is any consolation, it is that the sell-off was so indiscriminate. The odds are overwhelming that some stocks and asset classes will now begin to outperform."

I don't know when, exactly, those good stocks and asset classes will take off, but I'm quite comfortable I have identified them and believe very strongly my clients and I will benefit going forward.

This may very well be a case where not being too diversified will reap great benefits.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Economists are like diapers

Economists love to make forecasts. The problem is: most economists are like diapers, they require frequent changing and for the same reason (i.e. they are full of crap). Don't spend too much time thinking or worrying about economic forecasts, they are seldom if ever right.

This may seem like an overly harsh judgment, but I cannot think of any profession that has a worse track record (even politicians seem to do better, and from me that's quite a concession).

Most economists are either from or in academia. Their focus is on an other-worldly fantasy that has few similarities to the world we live in. Not surprisingly, this ivory tower approach leads to terrible forecasts.

You would think this would bug economists, but it doesn't. Most seem quite happy to profess theories based on assumptions they will gladly admit are false. They are more concerned with theoretical elegance and mathematical precision than with accurately predicting reality.

One school of thought is that markets are always efficient--they are always rational in the sense of an unemotional investor with all the facts at their disposal. I don't know any unemotional investors, and any experience with markets would quickly convince any honest person that markets are not rational in the short term (though they definitely are over the long term).

Another school of thought is that markets are irrational and thus require government intervention. But, if the human beings in the market are irrational, what prevents government employees--also human beings as far as I know--from not also make irrational decisions in their intervention? No answer is given.

Another school of thought is that the government printing money can solve bad lending. But, if printing money fixes problems, then why not just print it all the time and make everyone happy always. Sounds like a perpetual motion machine to me (more accurately: hyper-inflation).

Another school of thought is that the government can cut taxes while continuing to spend recklessly. But, if it's dumb for an individual to spend beyond his means forever, why would it be smart for a government to do so? Because the government exists on another plane of reality?

Another school of thought refuses to make precise predictions because it acknowledges the impossibility in the realm of human endeavors. Paradoxically, this seems to be the only school that correctly foresaw the Great Depression, the inflation of the 1970's, the Internet Bubble, and the Housing/Credit Bubble. No one listens to this school, it's considered fringe by many, and is taught in only a handful of colleges (Auburn is one).

Next time you hear or see an economist make a prediction--on the radio, in print, on TV--keep in mind the field's lousy record. Remember they are mostly academics with little success in predicting real world events.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The perils of leverage

One of the biggest lessons of the current financial crisis is: don't take on too much debt.

This may sound like common sense advice, but it's amazing how often people forget it.

If you buy a house with cash and its value increases 20%, you've gotten a 20% return. If, however, you borrow 80%, put 20% down, and its value increases by 20%, you've just doubled your money. There's a big upside to using leverage.

But, debt is a double-edged sword. It doesn't just give you bigger returns if things go well, it also gives you bigger losses if they don't go well.

Using the same example above, someone who pays cash for a house that decreases 20% in value losses 20%. Someone who only puts down 20%, though, has lost everything.

Archimedes said he could move the world with a large enough lever. The lever multiplies the impact of your input. But, such leverage works both positively and negatively.

When banks were as free as they've been, in the late 19th century (1800's), they carried 40% equity and borrowed 60% (levered 2.5 to 1). Banks operated that way could generally survive the inevitable economic storms that come along with economic cycles.

But, banks nowadays are regulated to be levered 10 to 1: they borrow 10 dollars and only contribute 1 of their own (or shareholders'). Such leverage is a double-edged sword, too. If a bank levered 10 to 1 makes loans and 9.1% of them go bad, the bank is basically insolvent. That's what's been happening recently.

Investment banks were levered 30 to 1. The top 5 investment banks are all gone or have been forced to become levered 10 to 1. Mortgage insurers and bond insurers were levered as highly as 140 to 1, they are now almost all insolvent. Many other insurers were levered up too much, such as AIG, and they didn't understand the leverage they had taken on. That lack of understanding didn't save them (or taxpayers).

Our current crisis is a perfect illustration of the perils of leverage. Companies like GM and GE are in trouble because they financed their companies with too much debt. It is difficult for almost any but the least levered companies to borrow money, now. As a result, almost any company with too much leverage has had their stock price massacred.

Everyone seems to understand that too much leverage is bad. But many businesses and individuals took on too much leverage and they blew up. Those are the folks getting bailed out now, and they are being bailed out by those who didn't take on too much leverage. That just doesn't seem right.

It seems like taking on too much leverage is a lesson that must be learned periodically. Those who survived the Great Depression were terrified of borrowing money.

Unfortunately, our country is currently trying to fix our leverage problems by levering up our government. It's hard to understand how you can solve the problem of leverage with more leverage.

When a government gets too levered, the resulting problem is almost always inflation. Inflation solves the government's problem with leverage, but not its citizens'.

Beware leverage. Beware inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

After a financial crisis, recessions are worse than average

Not all recessions are the same. Most recessions are a manifestation of the business cycle. But, when a recession is the result of a crisis in the financial sector, things get much worse.

What does that mean for investors? It means this is a once or twice in a lifetime opportunity to buy equities at very low prices. This opportunity may exist for some time, but trying to predict when markets will recover is a losing proposition. Get invested now and keep some cash on hand in case things get significantly worse.

A recent paper by Carmen Reinhart and Kenneth Rogoff, called "The Aftermath of Financial Crises," provides support for the view that recessions following a financial crisis are worse than average.

In their paper, they show that asset markets collapse more deeply and for a longer time period. Real (after inflation) housing prices collapse an average of 35% over 6 years. Equity prices collapse by 55% over 3 1/2 years. Unemployment rises an average of 7% over 4 years. Output falls 9% over 2 years. The real value of government debt explodes.

The average recession lasts 10 months. Using that average, we would have come out of this recession last October because we entered it in December of 2007. As I'm sure you know by now, that didn't happen. In fact, the recession hit high gear around that time.

Averages are not a proper expectation for what will happen. If you stuck your head in an oven and your feet in a freezer, your average temperature would be comfortable, but I guarantee you'd be miserable. Averages can be deceiving and misused.

But, averages can be useful for gauging what could happen. My intention here is to prepare you for the downside and how rough this ride will be, not to predict what will happen or when.

Asset markets have been down around 40%, so getting to down 55% would require another 25% decline from the down 40% level. I wouldn't be surprised to see markets go significantly lower, but that's impossible to predict. A decline to the 55% level, or even the 90% level like the Great Depression, is likely to be very short lived. The best thing to do is be prepared for the downside while acknowledging that the upside for equities from here is extraordinarily good. Try to pick the bottom is a fool's errand.

We're only a year and a half into the housing price decline, but this market was unusually over-valued at the top, so I expect it to end up more than 35% down. I also wouldn't be surprised to see this last shorter than it has historically because of how rapidly it declined and how actively the government is intervening.

Unemployment bottomed around 4.4%, so it would have to get over 11% to reach historical average. The rate is around 7.2% currently, so we are well on our way there. Remember, unemployment is a lagging indicator. It will almost certainly hit its peak long after the markets and economy are recovering.

Output has only started to fall, and getting to the down 9% level will be painful. Like with employment, this will be a lagging indicator. By the time we see it recovering, markets will almost certainly be up significantly.

Government debt is already ballooning and will continue to do so. Government officials are already calling for a $1.2 trillion deficit this year, and that is only the tip of the iceberg. When an institution issues a lot of debt, even the U.S. government, their cost of debt will go up. Be prepared for higher interest rates and inflation. This may take years to develop, but when it does it will be truly life-changing.

Recessions following financial crises are deeper and longer lasting than average. It looks like we're in such a situation. Be prepared for the downside. Be prepared for a lot of negative news going forward. But, most importantly, get invested to take advantage of the recovery and be prepared for even lower prices--in case they happen--in the future.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Happy New Year!

I enter 2009 as enthusiastic as I've ever been about future returns.

That's not a forecast for returns this year. I don't know what returns the market will generate over the next week, month or year, and anyone who tells you they do know is lying.

What I do know is that stock prices are as low as they've been relative to fundamental business values since the early to mid 1980's.

Does that mean the stock market won't go lower? No.

If the stock market bottoms where it did in the 1970's, it would be 33% lower than it was at year end.

If the market bottoms where it did in the early 1950's, it would be 40% lower than it was at year end.

If the market bottoms where it did during the early 1930's--at its worst during the Great Depression--it would have to go down another 60% or more.

Those aren't forecasts, that's just a report of how bad things could get based on historical information.

But, as Mark Twain said, history doesn't repeat, but it sure does rhyme. No one knows what precisely will happen, even if they get lucky and their prediction turns out to be right.

All a prudent investor can do is invest based on the facts, and the facts say that stocks are cheap. If they get cheaper, then even better bargains will be had. If they get dearer, investors will see their portfolio values climb.

Based on fundamentals, it's reasonable to expect the S&P 500 to be up 10% - 15%, annualized, over the next 5 years. That's unlikely to be a smooth path upward, but it's a very likely outcome.

Even better, carefully selected stocks are likely to do much better than that.

And, that's why I'm as optimistic as I've ever been in my 13 years of investing.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

At some point, inflation

Sometimes it's useful to look beyond the current headlines to what may be coming over the next 3 to 5 years.

From my vantage point, what I see coming is inflation.

Currently, the news is filled with signs of deflation. Asset prices are collapsing. Housing prices are down significantly. Almost anything, other than U.S. Treasury securities, seems to be down over the last year.

Commodities have been particularly hard hit. It wasn't that long ago that oil was at $147 per barrel and people were talking about it going over $200. Now, it's below $40.

But, what has changed? Mostly, demand has dropped dramatically. As Economics 101 will tell you, when the demand curve shifts down and the supply curve stays the same, you get lower prices. I think I can safely say that has happened.

So, why had demand been crushed. In a word, deleveraging. The economy as a whole--businesses and consumers, at least--have been paying back debts to keep from going bankrupt. Not everyone is succeeding.

This reduction in debt has led to a tremendous fall-off in demand for goods and services of all sorts. You can see that clearly in the GDP and employment numbers. For those those who thought only Wall Street was in trouble, take another look.

But, the biggest debtor out there--the U.S. government--has been borrowing and printing money like it's going out of style.

Eventually, such borrowing and printing will get credit markets going. And, when they do, we'll all owe a lot more debt and have a lot more dollars chasing the same number of goods. In other words, inflation.

I don't think it will happen soon. Although the Fed is printing money and Congress is finding all kinds of ways to spend it, economic activity has slowed down so much that all it's doing is making deflation happen less quickly. Eventually, and over the next several years, economic activity will pick back up again and this will be visible in the so-called velocity of money.

When that happens, the demand curve will shift back up and prices will recover. But--and there's always a but--the government will be in a lot more debt and there will be a lot more dollars chasing the same amount of demand.

In 3 to 5 years, and perhaps sooner, the news won't be about deflation, but inflation. And, that inflation will be a lot higher than in the 80's, 90's or 00's. In fact, it wouldn't surprise me to see $300 a barrel oil and double digit inflation rates (not the core rate, but including food and energy).

With that in mind, you may want to consider inflation-proofing your portfolio over the coming years. Think about companies that can jack up their prices and customers will still pay. Think about commodity producing companies. Be wary of bonds with low payouts or higher risk of default.

It may not happen right away, but over the next several years, get prepared for inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Keeping your head in trying times

The hardest part of watching the stock market recently has been keeping things in the right context.

The stock market is not a crystal ball that reveals a company's true worth. It merely shows what people are willing to buy and sell partial ownership of companies at any point in time.

But who is buying and who is selling?

Are sellers under pressure because they bought with borrowed money? Are they professional investors who are selling because their customers are cashing out in a panic?

Are buyers carefully considering the value of companies? Are they waiting to see what the government or other buyers and sellers will do next?

Markets do not reveal underlying worth, they simply reveal what people are willing to pay at a point in time. But, those assessments change over time--sometimes dramatically.

The way I'm keeping my head in these difficult times is to look past stock prices at the underlying businesses I own. Such businesses are in good shape and have bright futures.

Focusing on the underlying business is key to keeping your head. It allows the market to be your servant instead of your master.

Right now, and for some time to come I think, that servant will provide wonderful bargains on great companies.

As long as you look past the price at the underlying business, you too can keep your head and benefit from trying times.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Things are looking up

I'm not a market timer, but when market sentiment is as negative as it is now, it's not a bad idea to look for the silver lining which may mean things are improving.

Today, new unemployment claims came in at over 500,000, the worst report since the brutal 1974 recession. After these figures are fully adjusted over the next several years, it would not surprise me to see this number close to 1,000,000.

How is that good news? Because the market is up today!

When extremely negative numbers come out about the economy and the stock market doesn't go down by much or even goes up, it means people have fully grasped how negative things are and are starting to look for a future recovery.

That doesn't mean the market has bottomed or that all the bad news has been announced. But, it does mean that market participants are recognizing how bad things are and are perhaps seeing that things won't be so bad in the future.

Added to this, employment figures are a lagging indicator. That means that employment figures tend to look worst near stock market bottoms. Employment is a reaction to economic conditions, not a forecaster of them. Employment figures look bad when employers are throwing in the towel and laying people off. This is usually when the stock market begins to recover.

Why? Because the stock market is a forecasting mechanism. The price of a stock should be equal to all future cash flows. Prices shouldn't reflect current conditions, or even conditions over the near term, but should reflect all future possibilities of a company.

That's why the stock market tends to recover long before the economy, and why waiting for economic figures to improve is a sure fire way to miss out on huge market rallies.

I don't know if the stock market will go up next week, month or year, but I do know that many companies are trading at depression levels even though they have bright futures.

In other words, the best bargains in 25 years can be found right now, if you can see the silver lining.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Market prices are only relevant if you have to sell

Andy Kessler wrote an excellent opinion piece that appeared in the Wall Street Journal yesterday. His article was titled "Ignore the Stock Market Until February."

His basic point is that a lot of selling in the stock market over the last 2 months has been due to reasons other than a rational assessment of investment merit.

He goes on to list the reasons why many people have been selling:
- tax loss selling - selling to book losses, thus reducing taxes
- mutual fund redemptions - people selling mutual funds cause the effected money manager to have to sell something, and such managers tend to chose things that have gone down the least
- mutual fund cap-gain distributions - investors are selling to pay their capital gains taxes
- hedge fund redemptions - just like mutual fund managers, hedge funds facing redemptions have to sell something, and they are choosing to sell things that have gone down the least
- margin calls - people, both individual and institutional investors, who bought stocks on margin are selling to cover margin calls as stocks go down--the so-called process of de-leveraging

I'll add another thing to that list--stop loss orders. People who think that putting in stop loss orders will save them from losses are having their stop loss orders triggered over and over again as the market goes down. This tends to be sell-reinforcing on the way down.

The result is a bunch of forced selling that is causing the stock market to go down more than it otherwise would. This may seem bad, but it's actually a good thing. (If there were a self-reinforcing cycle that made flat screen TVs go down in price, we'd be tickled pink because the value of the TV to us doesn't go down as the price does--how are stocks different?)

Why are declining stock prices good? Because that means the stocks being sold are getting pushed down to lows they would not otherwise hit. The underlying value of the business isn't changing, just the quoted price other people want to buy/sell it. If you hold a company whose price has gone down, you are free to disagree with the market by not selling, or even buying.

As long as you don't have to sell, the current market quote isn't relevant.

Only when you have to sell are market prices relevant. If you don't have to sell, you don't have to book losses. And, if you don't have to book losses, then you haven't really lost anything, yet.

Benjamin Graham once said the market should serve you, not be your master. Right now, the market is serving up unbelievable discounts on some of the best companies around. This is a great time to buy, or a great chance to sell things that haven't gone down and buy great companies that have gone down significantly.

Kessler makes the point that the market will continue to go down in December as tax loss harvesting continues and leverage is unwound. In January, a bunch of money managers will get fired for lousy performance, and the new managers will be selling in January to get rid of the previous manager's mistakes. That means market prices are likely to be far off underlying values until at least February.

That means you have 2 months--2 glorious, happy months--to buy into the best bargains seen in almost 25 years. I've never been so excited about future returns.

When February comes, I'll be well positioned to benefit, and so will my clients.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.