In praise of recessions

Parenting is simple, but not easy.

What I mean by that statement is that it's not hard to figure out what to do as a parent (simple), but it's frequently difficult to implement in practice (not easy).

Little Vivian wants a glass of apple juice, but it's an hour and a half before dinner and she'd prefer to drink apple juice 24/7 rather than eat any solid food--ever! 

I have a choice: I can give her the apple juice she so much desires and worry she won't eat the food she needs, or I can give her some non-apple-juice options to make sure she'll be hungry for dinner.

It's easy to give her the apple juice, right?  But, will it result in the long run outcome I want?  Probably not.  So, I offer her water and tell her she doesn't want to ruin her appetite for dinner.

The first several times I provide this option, Vivian--like any self-respecting 3-year-old-- breaks down in tears.  Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you've ever seen (not easy).

I know the right option (simple), but I dread the implementation (not easy). 

After 3 iterations of this process, though, Vivian no longer breaks down and cries.  She expects this outcome and goes about her life quite happily knowing she can't have what she wants whenever she wants it.

And so it is with the economy, too.  Knowing human nature, it's easy to see that people take things to excesses at times.  Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren't necessarily best for their long term well-being.

Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do.  Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.

It's easy to understand this process is necessary, assuming you understand human tendencies (simple), but it's unpleasant (not easy) to watch the resulting pain inflicted.

I'm not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears.  But, I must consider the alternative.

If we try to prevent recessions, is the long term outcome better or worse?  Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems.  And, so it is with recessions.

Preventing recessions leads to a build-up of bigger and bigger problems.  Periodic purges prevent major disastrous purges.  If you don't believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan's lost decade.

In each case, political intervention was intended to keep the economy on stable footing.  The hope was to prevent short-term pain, but with little regard for long term consequences.

I think an analogy to nature here is useful.  A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan's Ubiquity for more information).

At first, experts were bewildered at the damage and what could have caused it.  Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable. 

In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn't have even been possible without preventing small fires.

I believe the same thing is at work in the economy.  Small periodic recessions are good for purging the under-growth of our economic forest.  Without such small recessions, a super-critical state is created.  The attempt to prevent small recessions is the cause of large, disastrous ones. 

And so, I praise small periodic recessions as the necessary prevention for big, terrible ones.  It's time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary. 

It's time for the parents to say no to the kids who want something that's bad for their long term well-being.

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.

All returns are not created equal

In my last two blogs, I wrote about 1) measuring what matters most: after-fee, after-tax returns and 2) capital preservation: maintaining purchasing power as the prime directive of investing.

Now, I want to bring those two thoughts together with a third: all returns are not created equal. 

Just as investors place undo emphasis on 1) tax avoidance and low fees instead of actual returns, and 2) volatility and "safe" securities instead of the risk of permanent loss and after-inflation purchasing power, I believe investors also commit a third sin: 3) undo emphasis on returns earned over some arbitrary period instead of the process by which those returns were generated.

A quick example here should illustrate my point.

Suppose you were given the choice to invest for the next 10 years with two money managers: Firm C or Firm M.  Suppose, too, that you were presented with their 5 year investing records: Firm C: -6% loss over 5 years; Firm M: +6% gain over 5 years.

For most people (and for me in the past), this is an easy choice.  Over 5 years Firm M has earned a positive 6% return and Firm C has lost 6%, so go with Firm M, right?

But, wait!  How were those returns achieved?  Let's examine each firm's annual returns over the last 5 years:

• $100,000 invest with Firm C
• Year 1: -4.5%, $95,500
• Year 2: +1.0%, $96,500
• Year 3: +1.0%, $97,500
• Year 4: +1.0%, $98,500
• Year 5: -4.6%, $94,000
• $100,000 invested in Firm M
• Year 1: +4.5%, $104,500
• Year 2: -1.0%, $103,500
• Year 3: -1.0%, $102,500
• Year 4: -1.0%, $101,500
• Year 5: +4.4%, 106,000

See anything funny, yet?  Don't worry, I wouldn't have, either.  Let me explain how those returns were achieved.

As a thought experiment, I put these two investing firms against each other.  Each year, one bets $1,000 that a 6-sided die will land on 1 and get paid $4,500, and the other takes that bet (hoping the die lands on 2 through 6).  In my example, Firm M is making the bet and Firm C is taking the bet.

Now, perhaps, you're not so sure you want to invest with Firm M!  Sounds more like gambling than investing?  Yes, precisely. 

Each year, Firm M has a 1-in-6 chance of gaining $4,500 and a 5-in-6 chance of losing $1,000.  Although Firm M's investing record looked pretty good over the last 5 years (because the way the die just happened to roll those 5 times), you may not feel too comfortable now that you know how the return was generated. 

In fact, the next 10 years have a very high likelihood of Firm M losing 4.2% a year and Firm C gaining 4.2% a year.  That's where the firm names came from: M is for Madoff and C is for Casino.  The odds were on the casino's side all along, even though the record looked bad over those five years, and the odds were always against Madoff.

And, that's the point I'd like to make.  Most investors look at an investing record and believe past is prologue.  But, the past is rarely the best judge of the future.  Instead, the right way to judge returns is by examining the method used. 

Two investing firms can have the exact same investing record, but one can generate returns by taking bad bets (and getting lucky) and the other by taking good bets.  You need to figure out which firm is taking good bets to generate satisfactory returns in the future.

This is particularly the case today.  Some firms have deceivingly weak records over the last several years because they've taken smart bets and the die has rolled against them.  Other firms have brilliant-looking records although they've taken bad bets and the die has rolled in their favor. 

Only by looking behind the curtain will you see if there is a real wizard or a blathering fake.  It may seem trivial or time-consuming, but understanding how returns are generated is much more important than the return record itself--future returns will depend on it (as Madoff so ably illustrated).

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.

Capital preservation

Investing is not as complex as most in the field like to make it out to be.  Economists, financial planners, market strategists, professors of finance and economics, etc. like to make the field seem more difficult to grasp than it is.  Not surprisingly, this serves their interests.

In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine.  If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church.  This served the church's interests well.

And, so it is now with investing.  Today's clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms.  Their efforts are not to clarify, but to obfuscate; for, if you're completely confused, then you'll need their help! 

(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn't writing in a sufficiently high-minded way.  He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level.  When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!) 

So, why do I claim that investing is simple?  I read a description of investing 16 years ago that made perfect sense and was simple, and I've used it ever since.  This description, from Benjamin Graham and David Dodd's Security Analysis, 1934:

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative."

No mention of alpha, beta, standard deviation, diversification, macro-economic forecasting, the efficient frontier, small cap blend, negative correlation, optimized portfolios.  You're investing if you 1) do thorough analysis, and 2) invest in securities that promise a) safety of principal and b) a satisfactory return. 

If you don't do thorough analysis or hire someone who doesn't, it's not investing, it's speculation.  No stock tips, no hunches, no astrology, no gut feel, no "I just know...", no buying lots of everything--just thorough analysis.

If you invest in securities that don't promise--first--safety of principal and--second--a  satisfactory return, then you're not investing, you're speculating.  A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).

Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs.  This lip service to capital preservation is frequently waved away with the magic of diversification.  If you put your eggs in many baskets, they say, then there's no way all your eggs will break at once.

2008, or any other financial crisis in history for that matter, should put that notion to rest.  Unfortunately, it hasn't.  Putting your eggs in poorly built baskets, no matter how many of them, is unwise.

Capital preservation is also framed in terms of volatility.  If the basket goes up and down a lot, they say, you'll get scared.  Fear is a relevant issue, but it's not the same as capital preservation.  Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.

Capital preservation means you get back what you put in.  Not volatility, not fear, but whether you get back what you put in.  The price of an investment may go up and down and all over, but it's still capital preservation if you get back what you put in. 

Risk, as Graham defined it, is the permanent loss of capital.  Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital.  Not eggs jostled or raised and lowered, but eggs BROKEN.

If your investment returns the capital you put in, then capital has been preserved.  If not, or if the safety of that capital, upon thorough analysis, is suspect, then it's not investing.

This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital.  Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital.  If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it's not capital preservation. 

Many incorrectly think of cash or bonds as being the soundest means of capital preservation.  In most cases it is, but not if inflation occurs.  If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection.  Cash and bonds, by themselves, don't cut it.

Most investing experts focus too much on secondary, tertiary, etc., issues.  They focus on diversification, statistical "guarantees," unexamined impressions, recent history.  But, investing just isn't that complex. 

You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you'd like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in). 

It's not rocket science or brain surgery--it's quite simple.

But, as Warren Buffett put it, investing is simple, but not easy.  Which means: knowing how to invest is not complex, but doing it well is difficult.  Losing weight requires you to consumer more calories than you put in--that's simple.  But doing it isn't easy--it's very difficult (especially around Christmas!).

Perhaps Buffett's investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.

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.

Measure what matters

Measuring what matters is one of the hardest things to do in life.

Take happiness.  Everyone wants it, but few get it.  Why?  Because most pursue short term pleasures, becoming hedonists, and chase their tail instead of becoming happy.  You have to think long term, and focus on virtue to become happy.  Short term pleasure is the wrong thing to measure; long term virtue is the right thing to measure.

Or, take weight loss.  Almost everyone wishes they weighed less.  But, most fail to lose weight because they try some crash diet they couldn't possibly stay on over the long term.  The result: they lose a little weight, but put it all back on again because they focused on the wrong measurement--short term scale measurements.  To keep the weight off, you need a long term change of lifestyle--usually less food and more exercise.  You need to measure less food and more exercise over the long term.

But, it's not easy to measure what matters most.  It's hard to do and doesn't give instant results.  C'est la vie!

I run into this all the time with investing.  People want to build long-term wealth, but they try a quick fix instead of measuring what matters most. 

Take, for example. investing in fads.  Many think investing in the latest thing or making a big lottery-style bet is the way to build wealth.  It isn't, so the vast majority of those who try this approach don't build wealth.

Or, take index investing.  People hear or read that you can't beat the market, that low fees matter most, so they jump on the index investing bandwagon (usually after several years where it has worked--too bad we can't drive by looking in the rear view mirror).  But, paying low fees doesn't do you any good if the index goes no where for a decade. 

Which brings me to the measure that matter most for investing: after-tax, after-fee returns. 

There's no benefit to avoiding taxes if you get lousy returns, can invest very limited amounts of money, and pay all kinds of extra fees.  Many 401k and 529 plans exhibit this "benefit."

Avoiding taxes is not the measure that matters most.  If you can get 10% returns in a tax deferred plan and 10.91% returns in a taxable plan (assuming 33% turnover and 25% marginal tax rate), you end up with the same after-tax money.  That's right, just find someone who can beat the market by 0.91% over the long run and you might as well save in a taxable account.

This matters because most 401k and 529 plans stove-pipe investors into a few limited options--options that are heavily marketed to make sure lousy money managers can get lots of assets under management.  And that's before we even get into all the wonderful fees and restrictions that come with such plans. 

There's no benefit to paying low fees if you get lousy returns, either.  Many investors over-focus on fees.  If you are looking at two options that will generate the same returns, then fees are what matter.  But, that's a big IF--IF THEY WILL GENERATE THE SAME RETURNS!

If manager A beats the market by 0.5% after fees and index B only charges you 0.25%, you should go with manager A, because your after fee returns are 0.75% better. 

The measure that matters most in investing is after-tax, after-fee returns, not fees by themselves, not tax deferral, not anything else.  Anyone who tries to convince you otherwise is probably selling you something.

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.

Not so great expectations

If I've said it once, I've said it a million times: for most investors long term returns are what count most--not what the stock market will do this year or next.

And yet, most investors over-focus on short term prospects.  That's probably why they get lousy investment results over the long run and brilliantly high (and then low) returns over the short.

It's not the returns you could have gotten that count, it's the returns you actually get.

But, long term prospects don't look that great right now.  By my reckoning, the S&P 500 is set to deliver slightly more than 3% annualized returns over the next 5 years.  With inflation of 1-2%, that's a real return of only 1-2%. 

Do investors have great expectation when they should have realistic expectations?  I believe so, and they very much want to believe the market commentators who promise 10% returns this year.

Don't get me wrong, we may see 10% - 20% returns over the next couple of years.  It's not just possible, it may even be likely! 

But, those returns will be given right back over time.  The market will regress to the mean, as it always does, and investors will once again be right back where they started, or lower.

The way off this treadmill-to-nowhere is to start with realistic expectations and then pick investments that can solidly beat them.  But, this takes time and effort, so most investors prefer the strategy of hope.

Hope, let me be clear, is NOT a strategy (a mantra I learned to repeat from my time in the Air Force).

Can you find investments right now that will beat 1-2% inflation-adjusted returns?  Yes.  Will bonds that yield 3% do it?  Most likely not.  Will stocks of companies with solid franchises, strong balance sheets, reliable cash flow, meaningful dividends, selling at low prices to fundamentals do it?  Most likely.

Will such investments beat the market every month, quarter, or year?  Almost certainly not.  That's why most people don't own them!  But, after the market goes up and then down, or down and then up, or sideways for years, or whatever else could happen, such investments will almost certainly win.

Just look for investments in companies that have pricing power--the ability to raise prices with inflation.  That will take care of that nasty 1-2% (or likely more) inflation. 

Then look for businesses that grow with the economy--they sell products or services that people can't do without.  That will likely give you 3% real returns. 

Then look for businesses that aren't financed with tons of debt--they are the ones that could go bankrupt in tough times. 

Then, look for businesses that can and do pay out a portion of their earnings in dividends, and make sure they can continue to pay even if business conditions become poor--they are the one's whose dividends are covered easily by earnings in good times and bad.  That should give you a 2-4% return while you wait for the market to regress to the mean.

Then, make sure you don't pay too much.  If you pay a high price to fundamentals, you're doing the same thing as buying the S&P 500 and locking in 1-2% real returns.  If you pay a low price to fundamentals, you're protected against the downside and likely to benefit from the 1-2% inflation, 3% underlying growth, and 3% dividend specified above. 

If you do all that, you should lock in 6% real returns instead of 1-2%.  That may not blow your hair back, but it's a lot better than riding the roller coaster up and then down again for the 3rd time in 15 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.

Shifting tides

The stock market is frequently looked at as one amorphous whole.  It's not.

Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance.  Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc. 

What seems to surprise investors is how long these trends can last--years, not months.  Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue.  Just the opposite is the case.

Mean reversion--the tendency of a prices to move back to average--is one of the most powerful forces in finance.  That which has performed best is likely to reverse over the long run.  Just when investors think the tide has gone out, it comes back in.

I believe this is especially the case today.  Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed...well...almost everything.  But, that which can't go on forever, won't.

In particular, I've been surprised at how well small has done versus large.  From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year!  If that doesn't sound like much, let me rephrase: it's the difference between no return over 12 years and doubling your money!

Let me clarify: small usually beats large.  Small companies can grow faster and are more nimble, so it's normal for small to beat large over the long run.  But, the margin is usually a little over 1% a year, not more than 6%.  It's the difference between having 12% extra money and having over 100% extra. 

Now, this can not last.  And, it won't.  Regression to the mean will cause large to out-perform small for several years until historical relationships are restored.  I can't guarantee that, but it's as close to a sure thing as you can get with investing.

When will the tide come back in?  I don't know.  I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out.  From 2004 until now, I've been shifting more and more from small to large in anticipation of the sea change.  What has surprised me is that I expected the tide to come in sooner (as it has historically).

Just because the tide seems to be going out more than I thought doesn't mean I should try to ride it to the last.  Quite the opposite.  The smart thing to do is switch when it becomes prudent and wait for the inevitable.  I'm patiently waiting, and expect to be riding back in to shore soon enough.

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 strategist = diaper

One of my favorite Wall Street jokes: How is a market strategist like a diaper? They both need frequent changing and for the same reason.

So, why are market strategists full of...um...stuff?  Because timing the market is a waste of time. 

Each year prognosticators try to guess where the stock market will go over the next year, and almost every year they are off by a mile.  This is more likely to be the case in 2011 because almost every market strategist is bullish.  The only thing worth less than a market strategist's prediction is a group of market strategist's predictions--especially when they all agree.

Why are market predictions so inaccurate?  Because the things that most impact market returns over a given year are also almost impossible to predict: 

• Will North Korea lob nukes at South Korea? 
• Will Israel attack Iran's nuclear facilities? 
• Will bond markets abandon Japanese, European and U.S. bonds en masse driving up interest rates? 
• Will the European Union fall apart? 
• Will the world economy continue to recover at its current pace? 
• Will China engineer a smooth or crash landing in an attempt to slow inflation and real estate speculation? 
• Will U.S. unemployment dive from 10% to 5%?
• Will drug companies discover a cure for cancer?
• Will accurate prediction cease being an oxymoron?

None of these thing is strictly predictable, but if any of them occur (except that last), they'd have a huge impact on markets.  You'd have better luck trying to predict earthquakes and hurricanes (things entirely deterministic and yet experts almost never get annual predictions right).

So, why do people crave such predictions?  Because we'd all like a sure thing.  Wouldn't it be great to have next year's newspaper and know exactly what stock prices would be a year from now?  We'd all love it, and the entertainment factory that is called news sells tons of advertising each year knowing we'd all love those answers.

But, those answers are worth what we pay for them--nothing. 

Instead of reading the horoscope in hopes that we'll be lucky today, we should get to the daily grind of making things happen for ourselves. 

That's what I'm going to do: resist the temptation to read or make predictions, and instead do research on good investments at cheap prices.  There's a new year's resolution that works.

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.

Prudence: pitiful performance persists in 2010

Markets move in mysterious cycles that no one can predict with accuracy.  For several years value beats growth, or large companies beat small, and then the trend reverses.  Markets are one of the most mean reverting data series known to man, so you always know such trends will reverse, but never precisely when.

2010 was a particularly frustrating year to wait for trends to reverse, especially for those who were prudent. 

2009 was an understandably great year for junky versus prudent investments.  Junk had tanked in 2008 and prudence had dropped little, setting up a spectacular rise for junk in 2009 versus a mundane rise for prudence.  Once the government vowed to support any company large and imprudent enough to be in severe trouble, junk's star was destined to be born.  It was in 2009. 

However, junk's stardom seldom lasts because investors become understandably nervous as junk's star gets too high.  I naively expected investors to become nervous in 2010, but was in hindsight much too early.  A quick look at the data (from Bespoke) highlights my naivete.

Companies considered junk by the rating agencies rose 19% in 2010.  Double-A and above rated companies returned a mere 6%.  2010 rewarded this form of imprudence with 3.2x the return.

The most expensive tenth of stocks, as measured by price to earnings ratios, returned 23% in 2010, versus 8% for the cheapest tenth of stocks.  Once again, 2.9x the return for jumping into junk instead of piling into prudence.

Buying the top tenth of stocks most sold short (where short sellers expect to profit from price declines) returned 26% versus the 17% performance earned from the bottom tenth with the least short sellers.  It was a mere 53% better to bet on this particular form of imprudence.

Investing in cyclical companies, those most impacted by economic cycles and thus hardest to predict, returned 25% against 11% for the non-cyclicals that perform regardless of cycles--2.3x better to hope instead of plan.

Finally, small companies (small ships are more easily toppled by storms than large ones) beat large 24% to 11% in 2010, giving those who bet the trend was their friend a 2.2x edge over those who expected trend reversal.

My naivete was on prominent display in 2010, but I'm not bitter.  I find solace in the certainty that markets mean revert.  Plus, I've been given the opportunity to buy prudence at even lower prices. 

Will 2011 be my year of redemption.  I don't know for certain, but in the choice between junk and prudence, I can't say I'm even remotely tempted to follow the junky crowd of 2010.

Thank you for reading my blog, and may you have the Merriest of Christmases.

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.

Two areas of concern for markets...

When everyone is bullish about the economy and markets (including yours truly), it's time to look at page 16 news. 

Page 16 news is important, but doesn't seem important enough--yet--to make it to the front page of the newspaper.  By the time a piece of news hits the front page, it's already priced into markets.  One should look at page 16 news to know what hasn't been priced into markets (hat tip to Donald Coxe).

What important news is on page 16 and should be on page 1?  1) Long term bond prices have been dropping hard and 2) oil prices are steadily rising to high levels.

Despite the Fed's efforts to drive short and intermediate term interest rates lower, long term rates have been rising (yields rise when bond prices fall).  This is important because long rates reflect the market's assessment of inflation, and because long rates impact meaningful borrowing rates, like mortgages.

The yield on 10 year Treasury bonds have gone from 2.4% to 3.5% over the last 4 months.  That's a roughly 9% decline in the price of a 10 year bond.  During this same time, the stock market has rallied almost 20%.  As I've said in this space before, bond and stock prices should not be moving in opposite directions over the long run.

(Geek's note: stock prices reflect cash flows discounted over time.  I'm willing to pay $0.91 for $1 of earnings a year from now if I want a 10% return.  That 10% desired return is the discount rate and the $1 I get a year from now is the cash flow.)

Stock prices should reflect long term bond yields.  All things being equal, when long term bond yields rise from 2.4% to 3.5%, this higher discount rate should drive down the price of stocks by over 30%!  Now, as you may have guessed, all things are never equal.

Some believe stock prices are rising and bond prices are tanking because investors are more optimistic about the economy.  I disagree with this position.  Long bond yields rise because of inflation, and inflation is bad for stocks.  Bonds and stocks tanked in the 1970's as inflation fears rose, and rallied strongly in the 1980's and 1990's as inflation fears shrank to nothingness. 

Bond prices do rise and stocks tank when deflation is the fear, as has been the case during the last decade.  But, bond prices tanking and stocks flying because investors are optimistic about the economy?  I can't think of any historical examples to support that.

Keep in mind, too, that long bond yields also impact mortgage rates.  If long bond yields are going up, so are 30 year mortgage rates.  How exactly is giving an already disastrous housing market an additional headwind of higher priced mortgages supposed to be good for stocks and the economy?  I can't think of a good reason.

The spike in bond yields may be a temporary phenomenon, and that is my guess about what's happening.  If bond yields come back down below 3%, that would seem to give the all-clear signal for stocks (at least, for a while).

The other page 16 news is oil prices hovering around $90 a barrel.  The last time this happened, in late 2007 and early 2008, the U.S. economy was entering recession. 

Higher oil prices lead people to consume less.  It tends to act as a natural governor on the economy--when energy prices spike, it tends to slow the economy.  Oil prices impact heating costs, travel costs, grocery costs, pretty much everything.  And, if you have to pay more for those things, you don't have money left over to buy that new electronic gadget you've had your eye on.

Just as long bond yields declining would give the all-clear signal for stocks, so would be declining oil prices (below $80 a barrel). 

But, as long as long bond yields spike and oil prices keep rising, bad news is brewing for the stock market and economy. 

I don't have any illusions that I can predict such events, but I will be watching with great interest to see what happens.  If long bond yields and oil prices hit the front page, it'll be too late to do anything but cry in your beer.

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 Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I've always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed's mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan's last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won't boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That's because most people haven't been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won't create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don't the people at the Fed possess such common sense?

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 wall of worry

It should be obvious by now--I'm not much of a short-term market prognosticator.

I can predict 5-10 year returns with a fair bit of accuracy, but I'm terrible over the next day or year.  Fortunately for me, the long run is what matters.

If you've read my blog posts over the last 6 to 9 months, you know I've been overly pessimistic about both the economy and the stock market.  Whereas I saw trouble brewing in Europe, China, and Japan, and poor U.S. employment and growth, things didn't turn out that bad.  In fact, things are looking decidedly more upbeat of late.

Which brings me back to my title: "the wall of worry."  It's an old Wall Street saying that a bull market climbs a wall of worry.  If everyone is optimistic, big market gains are unlikely because everyone who will buy has bought.  In contrast, when some or many are pessimistic, the market has room to run if and/or when the fundamentals prove the doubters wrong.

I was a doubter, and the market climbed the wall of worry--right over my head, in fact.

But, that was yesterday, and to generate good returns over time we must focus on the future.  Is there currently a wall of worry for the market to climb over?

I think there is.  First, there are still plenty of doubters.  Several very intelligent market mavens with excellent long term records continue to forecast storm clouds ahead.  Perhaps it will be their turn to be stepped over. 

Second, look at the news and you'll see Korea on the brink of war, China trying to slow down its economy, Europe's peripheral countries in fiscal shambles, rising unemployment in the U.S., etc.  Bad news is frequently the wall of worry markets must climb. 

There are plenty of worries and worriers to clamber over, still. 

That doesn't mean the market will necessarily rise, or stay flat, or climb (did I miss any possibilities?).  What it does mean is the market could continue climbing, and part of what can and may fuel that rise is the many concerns and few doubters out there. 

The short term may look okay, but the long term isn't quite so sunny.  By my estimates, the S&P 500 is likely to return 4.1% annually from its present 1220 price over the next 5 years.  That projected 22.25% cumulative rise may be a steady 4.1% a year, but it's much more likely to be more volatile.  For instance, the market could rise 20%, then tank 50%, then rise 103.75%.  Any way you slice it, though, 4.1% isn't a huge annual return, and trying to time the market to sell at the top and buy at the bottom is a fool's errand.

The short run (next year?) doesn't look too bad (though my poor short run prediction record should now be scaring you). 

After that, the check will come due.  I don't know when or how that will happen, but I'm preparing by buying investments that I think can solidly beat that 4.1% annualized return, regardless of how bumpy the path may 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.

The week that was...

Most weeks, I choose one topic on which to spout my thoughts and opinions.  But, this week, there were just too many interesting things to ponder, so here are 8 brief points of interest.

1)  Earnings season is over and the results were better than expected.  Revenues didn't dazzle, meaning that end demand is slow, but cost cuts more than made up the difference.  This just goes to show that companies and the stock market can do well even in a slow economy.

2)  Economic numbers continue to improve.  Unemployment claims improved, railroad loadings are up, leading economic indicators surprised on the upside as did the Philly Fed's survey.  The economy is improving ever so slowly, but it is improving.

3)  There's been a lot of speculation that the Fed's quantitative easing program is merely an attempt to puff up the stock market to get rich people to spend, thus improving the overall economy.  Andy Kessler and Don Coxe made convincing arguments that the Fed is really worried about real estate and the financial institutions that depend on real estate values, and thus quantitative easying may be an attempt to support bank balance sheets.  Why did the economy roll over in 2008?  Oh, that's right, real estate values tanked and financial institutions froze up.

4)  The mortgage documentation mess promises to have much more lasting impacts than most realize.  This issue goes to the heart of real estate titles and ownership, and the dinosaurs are going toe to toe to find out who will eat losses.  If the banks end up losing this fight, like they should, then we could be right back into a 2008 crisis again.  See 3) above.

5)  Ireland will likely take a bailout from the European Union (EU).  If you think this means Ireland is in a weak position, think again.  When you owe the bank $10,000, it's your problem; when you owe it $10 billion, it's the bank's problem.  The EU is more worried about Greece, Portugal, Spain and Italy than Ireland, so they are hoping to draw a line in the sand at Ireland (after Greece).  Ireland has the stronger hand in this game.  Oh, and by the way, why is another bailout in Europe good news for markets?

6)  China is working hard to slow down their economy, mostly by slowing bank lending, because food inflation is making the natives restless.  China may succeed more than world markets anticipate.  Initially, markets will probably take that hard.  But, over time, this will lower the prices of input commodities, thus improving developing economies.  This may be a case where slowing for them is good news for us.

7)  Many state and local governments in the U.S. look like Portugal, Ireland, Italy, Greece and Spain in terms of fiscal health.  When these issues hit the front page, likely next year or the year after, it will rattle markets and lead to huge bailouts by the federal government.  This will be good in the long run (because budgets are out of touch with reality), but I don't think many people, especially investors, are paying attention to the short term impacts.

8)  Long term bond yields spiked over the last couple of weeks.  An almost 5% decline in the 10 year U.S. Treasury bond over a couple of weeks should be a wake up call for investors who think bonds are risk free.  It should also give pause to equity investors who should know that stocks should go down when long term bond yields spike.  But, why worry about that, the market is rallying!

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.

Pension pain

You've got to be a bit of a geek to love investing.  One reason is the math--there's lots of it.  Another reason is that you should enjoy digging through obscure footnotes to financial statements.  Most people would rather get a root canal than read such arcana.

I, however, am a big fan. 

An area that will soon get big attention is pension accounting.  You must dig into footnotes to see this information, and it's not a pretty picture.

When organizations, whether governments or companies, report their financial situation, they must disclose how much they owe employees through pensions.  Like all accounting information, this is based on assumptions.  One key assumption--that's way off base--is return on assets.

An organization that owes money to employee pensions must estimate how much they need to pay out and how much return they'll get on assets to make those payments.  If they assume lower future payments or high returns on assets, then their pension liability magically shrinks!  And you thought Santa was good...

Not surprisingly, most companies and public pensions are making flattering assumptions to make their financial statements look better.

As a simple example, most companies I research (with pensions) assume they'll get 8% returns on assets.  That may not sound ambitious to you, but it is.  Bonds will probably provide 4% returns from here and stocks will return around 6%.  Assume a pension has a standard 60% equity/40% bond allocation, and you get a whopping 5.2% return. 

So, most companies and governments are under-reporting pension liabilities by around 33%.  This will be difficult for many companies, but they will get by (although shareholders will be less sanguine).  Public pensions, however, will be a nightmare.

Another fact unknown to most is that governments have a different set of accounting rules than companies.  Whereas companies have strict rules about accounting for and allocating assets to pensions, government bodies are much more lax (pay as you go, easier assumptions).

I was reminded of this recently when talking to a lobbyist who works for our local power company.  I asked him if the utility would be bought by a company or taken private, and he said he didn't think anyone would buy it because they would have to account for pensions differently, and that would wipe out the value of the utility company.  Wow!

Now, picture that occurring all across America.  Most public pensions are grossly under-reporting pension liabilities, and they are in trouble even before reporting that huge liability accurately!

This will make big news at some point, probably within the next 2 to 3 years.  The cause will be interest rates rising (thus decimating bond values) or a big decline in equity prices (hitting pension assets from the other side). 

Mark my words: pensions will cause real pain to shareholders and major pain to state and local governments (which means taxpayers). 

Just when you thought it was safe to go back in the water...

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.

QE2 launched to much fanfare

This was no buy the rumor, sell the news week.  This week, it was buy the rumor, buy the news...whatever you do, just buy, buy, BUY!

The Federal Reserve will create dollars out of thin air and use them to buy debt issued by our Treasury Department, and this was good news to markets.  Everything, except the U.S. dollar, rallied. 

Happy days are here again.  A chicken in every pot, a car in every garage, prosperity for all.  Print away, dear Fed!

Okay, I'm just bitter because I thought  more than 3 people might see election outcomes, quantitative easing part 2, and 9.6% unemployment as less than good news.  I was wrong.

But, the little voice of reason in my head is screaming in protest, "How can printing money with no backing create prosperity?!  I know, for a fact, it can't!!!" 

A lower dollar means a little extra business for a couple of U.S. exporters.  But, the U.S. imports vastly more than it exports, so it means higher costs for the majority of us. 

If you don't believe me, look at commodity prices--they're up 19% since August.  The rocketing price of cotton is jacking up clothing costs.  Oil at over $86 a barrel will translate into high gasoline and heating oil prices.  Copper closing in on $4 means higher prices for electronics.  Et cetera, et cetera, et cetera.

Soon, this will translate into higher costs and lower profits for U.S. companies.  It will also mean higher prices for all U.S. consumers.

Quantitative easing will not create jobs in the U.S. or increase lending to U.S. businesses (although both of those things are occurring completely separate from and despite federal action).  The Fed's printed dollars are going to find their way into emerging markets, commodities and government bonds.  In the short run, it means "party on, Wayne"; in the long run, it means more inflation.

Oh, by the way, the last 2 times the Fed tried to create prosperity with the printing press (and the economy was not on the brink of financial collapse) ended in the dot-com crash and the housing crash. 

While the party is going, it will seem great, just like the NASDAQ and housing bubbles back in 1999 and 2006.  But, when it ends, and few will see it coming or be prepared, it's going to hurt like no hangover we've ever experienced.

In the meantime, the markets will rally and the prudent will look foolish.  And, yes, I'm looking like a fool.

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.

Expectations...fulfilled?

There's a lot of news coming out next week, both mid-term elections and the Federal Reserve meeting to announce the much-anticipated launch of QE2 (quantitative easing, round 2). 

The key question for markets is: how much of the news is already factored into prices?

This points to one of the most difficult concepts for investors to grasp--prices do not reflect current or past information, but investor expectations.

Many investors are surprised when good news comes out--"company earnings grew 50%"--only to see a stock's price tank.  Why?  Because market price already reflected greater than 50% growth. 

Or, they're surprised to see bad news--"the economy shrank by 2%"--lead to a jump in the stock market.  Why?  Prices reflected a more than 2% economic decline. 

Prices, whether for bonds, stocks, commodities or currencies, reflect investor expectations.  Prices move up when actual news is better than expectations and down when it's worse than expectations.

Which raises the question in my title: will news next week exceed, fulfill or disappoint expectations?  If fulfilled, prices won't move much; if exceeded, prices will jump; if disappointing, prices are likely to fall.

Right now, investors clearly expect the Federal Reserve to announce a quantitative easing package that is favorable to bonds, stocks and commodities and bad for the dollar.  Will that announcement fulfill, exceed or disappoint?  Markets seem too optimistic to me, but as the old Wall Street saying goes: "don't fight the Fed."  On the other hand, is the Federal Reserve printing dollars really a cause for stocks and bonds to appreciate?  Something to think about.

Investors currently expect Republicans to take back the House of Representatives and make gains, if not restore a majority, in the Senate.  Do market prices already reflect that expectation, or will they be disappointed?  For that matter, are market participants correctly reflecting what will actually happen if their expectations are fulfilled?  Will Republicans cutting spending be good or bad for stock prices in the short run?  Something to ponder.

The S&P 500 is selling for around $1180 right now, reflecting an expectation of 14% per share earnings growth over the next year.  With the economy likely to grow at around 2% and profit margins at cyclical highs, is overly optimistic earnings growth expected?  What will happen to stock prices if those expectations go unfulfilled?

In the long run, investing success is all about paying the right price for an asset.  In the short run (which is what Wall Street does with less than 6 month holding periods), investing success is all about guessing investor expectations.  For those focused on the long run, next week is a non-issue.  For those focused on the short run, next week will be a nail-biter.

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.

Buy the rumor, sell the news

An old saying on Wall Street is "buy the rumor, sell the news."  It means that markets tend to react to rumors by bidding up prices and then selling (pushing prices back down) when the news actually hits.

Unless you've never read my blog before, you know that I don't tend to pay much attention so this short-term, trader-oriented approach.  However, I am sometimes so completely baffled by the way markets react to news and rumors that I can't help but remember the old saying.

Since late August, the stock market has rallied strongly, as have commodities and gold.  Over the same period, the dollar has tanked.  Since spring, the bond market has rallied strongly, too.  What's going on?

In my opinion, bonds have rallied strongly because economic numbers have been weak.  Unemployment remains high, GDP growth has slowed, the ECRI weekly leading index has tanked (but is recovering), and new unemployment claims have stayed stubbornly over 450,000.  I think bond holders are forecasting a sustained slowdown or recession and continued deflation.  This should not be good news for stocks, commodities and gold, and should be good for the dollar.  So, why is the opposite happening?

In short, the answer is that Federal Reserve board members, since late August, have been strongly hinting that the economy is so weak it may need another round of "quantitative easing."  For those of you blissfully ignorant of what the heck quantitative easing is, it's economic jargon for central bankers printing money (without physical backing).  In this case, they will print dollars, creating money from nothing, and use those dollars to purchase government bonds on the open market.

Why is that good for every market except the dollar?  Good question.  It's good for bonds, because the government will buy bonds in large amounts.  It's good for stocks because this will supposedly goose the economy.  It's good for commodities and gold but bad for the dollar because it means inflation.  If you're confused now, good for you.

Let me summarize: the U.S. economy is doing so badly that the Federal Reserve is going to try to intentionally create inflation.  Somehow that's good for stocks, bonds, commodities and gold, but not the dollar?  That can't be so.  Inflation may be good for commodities and gold and bad for the dollar, but it's definitely not good for stocks and bonds.  Something's amiss.

Which brings me back to: buy the rumor, sell the news.  The Fed has not officially announced its second round (the first was in 2008) of quantitative easing (colorfully dubbed QE2 by market watchers).  That is most likely to occur in early November.

I think that markets are buying the rumor of QE2 and may very well sell the news come early November.  Markets may be particularly unhappy if the news of QE2 doesn't meet its grand expectations. 

In the long run, bad economic news can't be good for stocks and commodities.  If the Fed does manage to create inflation with QE2 (which is not a given), it won't be good for bonds, stocks or the dollar. 

How can bad news about the economy be good news for markets?  In the long run, it can't be.

My ability to time the market is somewhere around zero, so take what I have to say with a big grain of salt.  I'm not buying this rumor, nor selling the news, but caution is highly recommended.

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.

Mixed up markets

When most people think of "the market," they think of the stock market.  But, there are other markets that are equally or more important to pay attention to.

For example, bond and currency markets are bigger than stock markets.  Commodity markets are important, too, but most people ignore them.

Why are other markets important, you may ask?  Because they frequently bring warnings of contradictory premises held by different participants in each specific market.

In a normal state of affairs, currencies and gold should move in opposite directions.  That's what's happening right now, especially with gold flying high and the U.S. dollar crashing.  All good there.

Normally, commodities move opposite the dollar.  Commodities have been soaring and the U.S. dollar is tanking, so everything looks as it should there, too.

Next, we come to bonds.  Bonds and commodities normally move opposite each other, and here we run into our first contradiction.  Commodities are soaring and bonds are climbing, too.  The first indicates inflation and fast economic growth and the second indicates deflation and slow or declining economic growth.  Both markets can't be right.

Furthermore, commodities and stocks usually move opposite each other, which is just another way of saying bonds and stocks tend to move together.  Climbing commodities indicates inflation and high interest rates (lower bond prices) which both tend to be bad for stocks.

Don't get me wrong, I'm not saying these relationships exist at all times and all places.  But, when I see markets seeming to indicate different opinions, I take notice.  It means markets are mixed up and one will turn out to be right and the other wrong.

Things are pretty mixed up right now.  The dollar is sinking, commodities are climbing, as are stocks and bonds. 

The dollar is sinking because the Fed is going to print money to try to further revive our flagging U.S. economy.  That means a lower U.S. dollar, higher inflation, and rising commodities and gold.  So far, so good.

But, a lower dollar, higher inflation and rising commodities is inconsistent with high bond and stock prices.  High inflation is bad for bonds and stocks.  That contradiction must be resolved.

To further muddy the waters, rising bond prices usually correspond with higher stock prices, but not super high bond prices.  Super high bond prices means very low bond yields, which tends to indicate low growth, deflation and economic stagnation.  And, that's usually NOT a recipe for higher stock prices.  As illustration, Japan's bond prices have gone up for 20 years while its stock market has lost 75% of its value. 

Bonds are indicating slow or negative growth and stocks are rallying, and that doesn't make sense.  Bond markets are right more often that stock markets, so the on-going stock rally might be in danger. 

High gold and commodity prices and a falling U.S. dollar should mean lower bond prices and high bond yields (a.k.a. inflation).  Once again, this contradiction must be resolved.

Over time, all markets will sync back up again.  Either bonds and stocks will tank and the dollar will continue to fall; or, commodities and gold will tank, the dollar will rally, and stocks and bonds will continue to rise.  It may take time, but markets will re-achieve consistentency.

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.

Competitive Devaluation

The issue I fear most from an economic, political and geo-political standpoint is the huge debt overhang of the largest developed economies of the world: U.S., Europe, U.K. and Japan.

Solving this nightmare is not just an issue for the developed world, either, because it also greatly impacts the developing world (especially Brazil, Russia, China and India).

In order for the developed economies to pay off their debt, they must either grow their way out of debt or print money to inflate away the debt they owe. 

Growth would be the best and most honorable way to solve the problem, but growth in developed economies is inhibited by high debt loads (which lead to slower growth) and huge social programs (Medicare, Medicaid, Social Security and their equivalents in the other developed economies).

I'm sorry to admit it, but democracies have never successfully voted away social programs, and I don't think they will this time, either.

That leaves inflation.

But, inflation is a nasty solution to debt problems. 

From an economic standpoint inflation is tough to put back in the bottle once you let it out.  If you think the Federal Reserve or any other central bank has a dial they can turn to 3%, 5%, or any other specific level of inflation, I'm sorry to let you know that smurfs aren't real, either.

Inflation crimps a whole economy as everyone--from employees to employers, from government bureaucrats to private companies--becomes bogged down in trying to figure out wages, salaries, costs, prices, tax rates, etc.  No high inflation economy runs smoothly and efficiently.

The political and geo-political stage started to ripple this week as the U.S. Congress is trying to pressure China into revaluing their currency and Brazil's Finance Minister remarked that an "international currency war" is taking place as governments manipulate their currencies to improve their export effectiveness.  Japan recently announced they will be active in currency markets to prevent the price of the yen from rising too much and becoming uncompetitive in global markets.  These trends will result in the beggar thy neighbor problem I highlighted in a previous blog.

This competitive devaluation process is a race to the bottom and has an ugly history.  In the past it's led to world war and economic collapse.  I wish I could say these were idle fears, but they are not.

The U.S. economy currently has low inflation, and that looks set to last until the private market works down its bad debt problem (which I think will happen over the next 3 - 5 years).  Some believe the U.S. economy will experience the low inflation, deflation and low interest rates of Japan over the last 20 years.  In that environment, cash and bonds will do very well.

Never say never, but I doubt we'll experience what Japan did.  In that case, inflation is the more likely threat, and that's not a good scenario for owning a lot of bonds or cash.

The competitive devaluation that's occurring does not need to continue, so my fears may be unjustified.  Even if they are justified, the end-game is unlikely to play out soon, but over the next decade.  Hope is not a strategy, so I'm hoping for the best while preparing 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.

Stock picking is dead; long live stock picking!

As human beings, we have a tendency to look backward instead of forward. 

Psychologists have illustrated this tendency with experiments demonstrating hindsight bias and recency bias.  Nowhere does this seem more evident than with respect to economics and, particularly, the stock market.

As support, see the Wall Street Journal's article today: 'Macro' Forces in Market Confound Stock Pickers. 

The article's point is that stock pickers, with a few exceptions, have not shined brightly in their performance over the last couple of years as macro-economic "forces" have over-whelmed stock picking ability.

Fair point, but only if we drive best by looking through the rear-view mirror instead of the windshield.

It's true, gold, U.S. Treasuries and cash did best over the last two years.  It's true, too, that bonds and cash have beat stocks, as a whole, over the last 12 years. 

But, that's history, not the future.  As Warren Buffett put it, if the past were the best guide to the future investments, librarians would be the billionaires.  They are not.

I couldn't help but chuckle at the title of the article, too.  Confound.  CONFOUND!  The word means overthrow, defeat, ruin according to my Oxford English Dictionary. 

Not a reference to short term under-performance; not a temporary set-back that may reverse; not in contradiction to all financial history; but, confound! 

Isn't this from the same popular press that said Warren Buffett was washed up in 1999 because he didn't "get" the Internet?  Aren't these the same folks that fawned over the housing boom and how home prices could never go down?  Check, and check.

And, now, they've pronounced stock picking is ineffective, done, washed up.  To me, that sounds like an excellent reason to bet that stock picking is about to come back in a major way.

Remember, the popular press called for the Death of Equities in 1979, just 3 years before the greatest, 20-year bull market in history. 

It may not happen tomorrow, or even the day after, but a headline like that leads me to believe that stock picking is about to experience a renaissance.

Stock picking is dead.  Long live stock picking!

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.

Manic-Depressive Mr. Market

Benjamin Graham, Warren Buffett's mentor, had a wonderful parable for thinking about the stock market.  He called it the parable of Mr. Market:

"Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."

"You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings..." (Graham, The Intelligent Investor, 1973)

The market has been particularly manic-depressive lately, and this has reminded me of the parable of Mr. Market.

One day, the market seems to foresee another recession on the horizon--the market sinks as investor sentiment tanks.  Another day, the market foresees an economic boom on the horizon--the market leaps and investor sentiment soars.

Is the data really that self-contradictory, or is the market just that short-sighted.  I believe the latter.

Much economic data, like unemployment claims, housing market numbers and income growth, indicate an economic slowdown.  Not a recession, mind you, just a slowdown.

Other economic data, like railroad traffic, commodity prices and industrial capacity utilization, indicate an economic expansion.  Not a boom, per se, but an expansion.

Mr. Market, in his manic-depressive way, takes these data points as signs of a collapse or boom.  As a result, market commentators have referred to the stock market's reaction as risk-on/risk-off.  It's either one or the other, and nothing in between.

What is the reality?  Not too surprisingly, given the data and my build-up, something in between.  The slowdown could turn into a recession, but hasn't, yet.  The expansion could turn into a boom, but it isn't at present.

Mr. Market should be more sober-minded and focus on the long term instead of the short term.  There is neither reason to dive for cover nor party like its 1999 (can you tell I'm about to turn 40?).

Given the data and a long term view, it is best to be cautiously optimistic.  The market is mildly over-valued, but nothing like it was in 2000 or 2007.  In fact, long term returns look promising, especially when compared to bonds or speculations like gold. 

Mr. Market needs to take a chill-pill, relax and take a deep breath.  Lucky for sober-minded investors, he probably won't, and this will provide ample opportunities to exploit Mr. Market's manic-depressive tendencies.

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.

Price paid = returns reaped

Investing has to be one of the worst fields for excess noise.

Currently, most people are focused on the short term versus the long term, inflation versus deflation, macro-economy versus micro-economy, developed versus emerging markets, bonds versus stocks, fiscal versus monetary policy, stimulus versus cost-cutting, etc. 

The list goes on and on. 

But, almost all of that is noise.  As far as your investing and financial future are concerned, what matters is the price you pay today.

In the short or long run, whatever you invest in will be at some price in the future and will have yielded some interim cash payments.  If you pay too much for it now, you'll get a poor return.  If you pay a cheap price, you'll reap a good return.  That's it.

All the factors I highlighted above may influence that outcome, but it's mostly noise, because what you pay for an investment now will determine your return in the future much more than the rest.

This is a simple concept to grasp, but hard to execute.  It's easy to get distracted by the noise.  I get distracted every day by it--sometime several times a day!

Let's take the stock market as an example.  With the S&P 500 at around $1110, you'll get a 6%-like return over the next 5 years.  If you paid the $1023 it was selling for in early July, you could expect at 8%-like return over 5 years.  If you paid the $1217 it traded at in late April, you could expect a 4%-like return over 5 years.

The price you pay now determines your return later.

Emerging markets are growing faster than developed markets.  But, emerging market prices reflect that fact, so the price you pay now determines your return.

Apple is growing like a weed.  But, Apple's price reflects that growth, so the price you pay now will determine your future return.

If you pay too much now, you won't get your desired return.  If you pay a cheap price now, you're return will be satisfactory.

Ignore the noise.  Ignore the crowd.  Focus on price paid relative to value received.

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.

Is Deflation Really That Bad?

People in the financial world don't have nightmares about werewolves or falling off a cliff, they wake up in a cold sweat crying out one bone-chilling word: "Deflation!"

Ordinary (or should I say normal?) people don't suffer from this affliction.  In fact, I'd dare say most people don't even think of the word deflation, much less dream about it.

However, to those in the financial world, whether investors, economists, accountants, or central bankers, the word deflation conjures up visions of the Great Depression and Japan's Lost Decade (it's been 2 decades, actually, but it's always referred to as 1 for some reason).

Is deflation really that bad?  It all depends on what you mean by the term.  For some odd reason, the term refers to two very different things.

One refers to the end of a credit expansion that ends in debt defaults, bank failures, and tremendous and long-lasting economic collapses.  That's the nightmare one.

The other thing deflation refers to is when money supply doesn't keep up with economic growth.  In my opinion, this one isn't bad at all. 

Can you imagine what life would look like if the cost of goods went down by 3% a year instead of up 3% a year?  Would you really have nightmares if the cost of computers, cars, TV's, food, clothing, etc. went down each year?  I don't think so--everyone loves a sale!

And yet, this is why people get so confused, because deflation refers to two entirely different things.  Can you imagine going to the grocery store and seeing hamburgers labeled "Rat Poison"?  You know hamburgers aren't poisonous, but the label would definitely throw you off.  The same is true with the word "deflation."  It refers to something yummy like a hamburger, and at the same time something terrible like rat poison.  No wonder people fear deflation.

Historically, deflation (the good kind) got a bad name in late 1800's United States.  After the Civil War, the U.S. experienced years of declining prices as the government worked to get its finances back in order and U.S. currency back on the gold standard.

It was great as long as you hadn't borrowed lots of money.  This was a boom time for railroads and manufacturing industry like Carnegie Steel.  If you owned stock in James J. Hill's railroad, the Great Northern, you received 8% dividends that bought more and more stuff each year, plus you benefited from the railroad's growth! 

The cost of things were going down because the U.S. economy was becoming more productive.  It was great unless you owed debt.  Debtholders hate deflation because it means they must pay back loans with dollars worth more each year.

This was especially painful for marginally profitable farmers.  Industrialization had made farming more productive, which meant marginal farmers couldn't break even.  They borrowed to try to keep up with productive farmers, but this just created new problems.  You can't pay back loans or farm profitably if the value of the corn you produce is going down faster than the debt you owe. 

So it is with every technological advance.  I'm sure caveman Ug was put out of the hunting business by caveman Thug who invented a new, more effective spear.  Such is the way of the world.

This industrial/technological/economic shift led to the populist movement and William Jennings Bryant's "cross of gold."  But, none of that helped the poor farmers who needed to find economical work.  Eventually, they went to work in factories and a new boom occurred.

But, the legacy of deflation as a bad thing lived on.  The very vocal minority of unprofitable farmers (and especially their political demagogues) made enough of a ruckus that deflation has a bad name to this day.

Next time you wake up in a cold sweat dreading deflation (not very likely, huh?), just reflect on which type you dreamed about--the hamburger, or the rat poison?

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.