Nobody really knows exactly what is going to happen

Despite my forecasts, I don't know exactly what's going to happen. And, neither does anyone else.

When I make forecasts about the future, they are mere probabilities--usually what I consider to be the highest probability outcome.

But, a probability is not the same as certainty.

In fact, a low probability event, like 9/11, can potentially blow all high probability outcomes out of the water!

It's important to acknowledge what I don't know, and the degree of uncertainty in any situation.

When I make investments, I don't know with certainty the outcome. In fact, the best I can do is assign probabilities to several outcomes and then take action based on such assessments.

But, investing is fraught with uncertainty. The economy is too complex for any one person to know exactly what will happen.

The way to make money over time is to formulate probabilities and outcomes with enough accuracy to get things generally right. That's all it takes, but it's not easy.

The economy appears to be entering a recession. I think that is a high probability at this point, but that doesn't mean it's certain.

I think that if we enter a recession, there is a high probability the stock market will end up down much further than it is now. Once again, my high probability assessment--not certainty.

I acknowledge that I don't know what will happen, and have invested accordingly. My goal is to make good returns regardless of whether or not we enter a recession. I've picked investments that I have assessed to be good for the long run. That's the best anyone can do.

Those who just guess and bet big don't remain in the game for long, unless they get blind lucky.

Stick to long term thinking, prepare for the worst and hope for the best, invest so that you'll do well regardless of short term outcomes, and you'll do just fine.

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 triumph of hope over experience

The Fed bailed out Bear Stearns and now everything is okay. Right? RIGHT???

Wrong.

The Fed bailed out Bear Stearns in a forced marriage to J.P. Morgan because they feared (and still fear) a collapse of our financial system. That isn't good news.

The Fed cut interest rates another 75 basis points, down to 2.25%, because it's trying to re-ignite economic growth. They are more worried about growth than inflation despite surging commodity prices and a tanking US dollar.

Economic reports this week showed worse employment data, worse leading economic indicators, worse business outlook, worse housing starts, worse producer price inflation, worse capacity utilization, worse industrial production, and worse forecast auto sales.

So why did the market rally this week?

The triumph of hope over experience.

The stock market is simply not reflecting economic reality or previous experience with economic slowdowns. Those who believe we'll ride this out without an even 20% decline in the major indexes need to prepare themselves for a bumpy ride.

I'm not moving into a fallout shelter, but I'm also not ignoring a long and vivid stock market history, either. I'm ready for a rough couple of years that will, eventually, be followed by another economic and stock market boom.

This is not the time to think the Fed and Treasury can solve all economic problems (have they ever really succeeded in the past?). This is not a time to expect a mid-cycle slowdown or light stock market downturn. This is the time to prepare for tough sledding.

I'm ready for a downturn, and I'm finding good things to buy. But, I'm not expecting this to be a pleasant or smooth ride!

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 the stock market projecting a recession?

With the terrible jobs report last weekend and poor retail sales report this week, I would have thought the market would be projecting a recession.

But, the Dow Jones Industrial Average is down only 16.3%, the S&P 500 is down only 18.3%, and the Russell 2000 (the most grossly over-valued of the three) is down only 22.6% from their most recent highs.

These may sound like significant falls, but it's normal for the stock market to be down 30-40% during a recession.

In other words, the stock market still seems to be projecting a mid-cycle slowdown despite a lot of data suggesting otherwise.

How should one react to such a situation? This is a great time to be buying!

I can't forecast the top or bottom of the market. And, I'll let you in on a little secret: no one else can, either.

When there's blood running in the streets, you should be buying. That doesn't mean things won't go down further--they almost certainly will. But, knowing that you can't pick the bottom of the market means you should be greedy when others are fearful and fearful when others are greedy. I'm feeling pretty greedy right now.

This is the time to buy cheaply priced businesses with good economics and management. If you take this path, either yourself or with the help of an advisor, your results will be quite satisfactory over the next several years.

I'm finding value in specific companies whose industries are feeling a lot of pain now. Think retail, real estate, building construction and airlines. I still think it's too early for financial services (except some select insurance companies), but that time will come in the not-too-distant future, too.

I think this is a great time to invest, so if you're looking for someone to manage your money and are curious about my services, contact me soon.

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.

My RSS feed is finally fixed

Thanks to help from my friend, Sean Cayton (Cayton Photography), my RSS feed is back up and running again.

If you already signed up for my RSS feed, or if you have been baffled at why it wasn't working, please sign up again and it should work.

Many thanks to Sean.

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.

Mid-cycle slowdown...or recession?

This question has occurred to me over and over again recently, because some very smart people are coming down on both sides of the argument.

To some, this may not seem very important. In a mid-cycle slowdown, the stock market goes down. In a recession, it goes down even more. If the market goes down either way, who cares?

But, the magnitude and period of decline make this difference very important to people with short term time frames. I'm not one of those people.

The yield curve, retail sales, the housing market, and credit markets all seem to be signaling a recession. The stock market seems to be indicating a mid-cycle slowdown. Employment data and factory activity are near recession levels, but not quite there, yet.

I'm guessing (with the emphasis on guessing) that we're entering a recession. My guess is based on my analysis of past credit cycle declines. Our economy has been increasingly levering itself since the mid-1980's. If deleveraging is occurring--and I believe it is--then a recession seems much more likely.

How does this alter my investment approach? Not much. I know I'm not smart enough to time the market, and especially not to time the economy!

So, how do I invest? Simply put, for the long term. I don't think our economy will go into a 10 year depression. If that were the case, then I'd be building a fallout shelter.

Instead, I'm investing for the eventual recovery that will happen either sooner, or later. Whether sooner or later is less important to me than having selecting good companies--those with good economics, honest and competent managers, that are selling at large discounts to what the company will be worth over full economic cycles.

That's a lot easier to do than trying to figure out what the economy will do in the short term. And, just between you, me and the fencepost...it's also a lot more profitable!

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's the most wonderful time of the year!

Usually this phrase is attributed to Christmas. Not for me.

Today, Berkshire Hathaway's annual report, written by Warren Buffett, will be published! (Full disclosure: I own Berkshire Hathaway both for clients and myself)

I know what you must be thinking, "here's five dollars, go out and buy yourself a life!"

But really, I look forward to this time of year like no other. Every year at this time, I get to sit at the feet of the master and find out what he's thinking. Every year, he explains things in a way that greatly improves my understanding of business, economics, people and investing.

I am quite literally giddy with anticipation, like I am every year. In fact, I'm writing this blog much like a child tries to focus on something other than Christmas morning and all the presents that brings--I'm trying to distract myself.

At 2:30 Mountain Standard time it will be available...what will I do until then...

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 investments are looking interesting?

I am not a top-down investor. What does that mean? It means I don't think about the macro-economy and investment sectors first, trying to determine what will happen from a big picture perspective, and then picking individual investments that fit my big picture themes.

I am a bottom-up investor. What does that mean? It means I look at individual companies, one at a time. I try to understand the economics of each business: what are its competitive advantages, does the company generate good returns on capital employed. I try to understand management: how are they compensated, how competent are they, how honest are they, how much of the company have they bought with their own money. Finally, I try to understand what the business is worth: I assess what the business would fetch to an outside investor thinking about buying the whole thing. Only when I can find satisfactory economics, management and valuation do I buy.

Although I am not a top-down investor, I've realized over the years that my bottom-up approach tends to uncover interesting investments areas. All the sudden, I start finding a bunch of cheap ideas in one sector.

In 1998, I found a ton of technology companies selling at dirt-cheap prices because of the Asian contagion and Long Term Capital Management fallout. I didn't go looking for technology companies, I just realized after looking at several cheap technology companies that there was a theme.

In 2000, I found a ton of small cap value companies selling at dirt-cheap prices because everyone was selling small cap value to buy large cap growth and technology. Once again, I didn't decide to look at small cap value companies, it was just where I was finding value.

Where am I finding value now? Not surprisingly, I'm finding value in financial, real estate, retail and building materials companies.

It's probably too early to bite on financial companies. More write-downs are coming and it must be crystal-clear that the business you're buying will survive and thrive in this credit crisis environment.

Some real estate investment trusts are selling very cheaply. I think some babies are being thrown out with the bath water, but you must be very selective to avoid buying dirty water.

Some outstanding retail companies are selling at dirt-cheap prices. Why? Everyone is worried about the consumer and whether they will be able to spend. In the short term, the consumer will be crimped. But, in the long run, the strongest retailers will gobble up market share and emerge stronger during the next up cycle. It may take patience, but it'll work. Once again, avoid anyone with too much debt or poor competitive positioning.

Some building materials companies are looking dirt-cheap. The housing market is getting pummeled, so such companies are scrambling to scale back capacity to avoid losing too much money. Like with retail, the strong companies will emerge stronger and with more market share and greater pricing power. More patience on this, too, but what did you expect, a free lunch?

History has shown that great times to invest are tough times to put money to work. But, that's when the bargains can be found. I'm finding more bargains than I have in years, so I'm happily buying some great companies and waiting for others to come to me as this volatile market unfolds.

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 a double dip recession possible?

Two reports today seemed to confirm that we are probably entering a recession.

The first was the University of Michigan's Consumer Sentiment Index that plunged to lows not seen since the early 1980's and early 1990's recessions.

The second showed that capacity utilization dropped below 80% at US factories. This, too, is usually an early indicator of recession.

Added to this, import prices are showing a continuous upward trend at the same time. Can you say "stagflation" boys and girls?

This got me to thinking about our last recession in 2001, and how I dramatically under-estimated the impact of government stimuli.

Back then, the Federal government provided huge fiscal stimulus in the form of government spending and tax cuts.

At the same time, the Federal Reserve provided huge monetary stimulus by cutting short term interest rates down to 1% (thus spawning the housing and credit boom, and now, bust).

Will the US government be able to repeat these stimuli? I believe they may succeed in goosing the economy in the short term, probably in the second half of 2008 and first half of 2009, but I don't think sending out checks and cutting interest rates will fully fix our current economic problems.

This led me to wonder: could a double dip recession like the one that occurred in the early 1980's happen again now? It's certainly possible.

Our economy, unfortunately, follows the four year election cycle pretty reliably. It's very unusual for the stock market to tank in an election year because politicians are promising and delivering all kinds of goodies to get re-elected.

But, such politicians tend to buckle down after the election is over and this slows things down fairly consistently.

My guess, and it is only a guess, is that fiscal and monetary stimuli will work this year to get the economy going again. But, in 2009 and 2010, things will get ugly.

So, in the mean time, it's probably reasonable to expect a recovering economy toward the end of this year, which will probably mean a stock market rally in the spring to summer time frame.

But, look out for 2009 and 2010, when we just may enter a second leg down of a double dip recession. And, this time, the US government will be out of the ammunition they used to bail things out this time.

I'm not personally betting on this scenario, or any other macro-economic scenario for that matter. I invest for the long term and try to look through boom and bust cycles.

The best protection against market and economic cycles like this is to buy great companies at good prices, and that's what I'm doing for my clients 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.

January was quite a month

Every once in a while, the stars align and you get outstanding performance relative to the market in a brief period of time. January was one of those months for my clients and me.

I didn't do it my day trading. I didn't do it by forecasting the economy or market direction.

I bought businesses over the last 3 years that looked cheap relative to my assessment of their value. That's it.

It takes a while for the market to recognize long term value. The average holding period on the exchanges is 9 months. 9 MONTHS!!!

In other words, most institutional and individual investors, as a whole, are trying to forecast what will happen over the next 9 months. I, on the other hand, have a time horizon of 5 years or more.

This investing style takes a lot of patience. But, it pays off.

In January alone, my growth clients beat the S&P 500 by 4.6% and the Wilshire 5000 by 4.7%.

Over the last year, my growth clients have beaten the S&P 500 by 13.3% and the Wilshire 5000 by 13.7%.

Over the last two years, my growth clients have beaten the S&P 500 by 12.4% and the Wilshire 5000 by 13.2%.

Since inception (4/30/05), my growth clients have beaten the S&P 500 by 7.1% and the Wilshire 5000 by 4.4%. (for full disclosure of my performance, please go to my website)

It pays to be patient, and it pays to assess the value of the businesses you buy.

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 the Fed easing interest rates because it thinks we AREN'T entering a recession???

Surprisingly, the market did well this week.

This is surprising, to me at least, because the Fed cut interest rates another 0.5% and the jobs report came in looking pretty bad.

The Fed did not cut interest rates this week because it thinks the economy is doing well. It especially wouldn't have done so after dropping rates between meetings by 0.75% just last week.

The Fed is clearly signaling the economy is in serious trouble. So why is the market rallying on news the Fed thinks the economy is in serious trouble?

In addition, the job report today was simply awful. It showed the first monthly decline in jobs since the economy was slowly coming out of the last recession. Cause for celebration? Apparently so.

In my opinion, market participants are still digesting the market's significant drop during January. They are also digesting recent economic news, government actions and election results.

The reality is that much more deck-clearing is required in the financial sector, credit markets and housing sector before the next bull market can really take off.

In the meantime, some excellent bargains can be found in select places in the market. Troubling times like this are a big opportunity to prepare for the next upswing, regardless of when or how it comes.

I'm seeing some of the best opportunities I've seen since 2003, and I think those opportunities will grow in number and size in the not-too-distant 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.

"Hey, the market didn't do too badly this week...maybe the worst is over..."

You keep telling yourself that if it makes you feel better.

The market moves in fits and starts.

During a bull market, as prices go up, there are periodic sell-offs as some people take profits. Then, the market resumes its upward path.

The same is true during bear markets. As prices go down, there are periodic run-ups as bargain hunters buy and short sellers cover their shorts. When the bargain hunters--who are a small minority--and short sellers are done, the market resumes its downward path.

In my opinion, that's all that happened this week. The Fed's reaction (more accurately: people's reaction to the Fed), bargain hunters (all 12 of us) and short covering led the market to remain roughly flat this week.

But, that's just a temporary reprieve. The fundamentals behind the market haven't changed. The housing market is still going downhill fast, with no end in sight. Credit markets are still tight. Banks are still struggling to rebuild their balance sheets. Bond insurers are still in trouble. Employment still looks weak. Retail sales are still poor. Industrial activity is still slowing. The fundamentals haven't changed one iota.

In my opinion, after this "clearing rally" is over, the market will resume its downward path. And, I think it will take years to hit bottom. In the meantime, there are a few great bargains to be had out there, and I've been selectively shopping and buying.

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.

"Are we there, yet, Dad?"

The stock market seems to be finally reflecting economic weakness. The bond market reflected it some time ago, but the stock market only now seems to be coming around.

The question now is: how much farther do we have to go?

I'll be the first to admit, I don't know. But, I do have an opinion on whether we've reached bottom, yet, or not.

It seems hard to imagine that the fallout from a steeply declining housing market and the seizure of credit markets will wash out in less than a year.

Remember the wash-out that resulted from the dot.com bubble? It took from 2000 until 2003 to really hit bottom and turn back up.

Does it seem reasonable to expect the stock market to hit bottom so soon and with so little damage when housing and credit markets are much bigger pieces of the economy than technology? I don't think so.

No, I think we still have some way to go.

First, the subprime mess will continue to spread. A lot of floating interest rate mortgages will reset, and a lot more people will punt their homes to lenders. Credit card debt, auto loans, etc. will also fall apart as credit markets further reflect housing turmoil. That, by itself, will take another year or more to work out.

Next, credit markets will have to absorb all those losses and downwardly spiraling asset prices. That will take another year or so.

Then, a bunch of politicians and lawyers will ride to the rescue, further highlighting the misdeeds of the housing and credit markets. That will take another year or so, too.

In my opinion, we still have at least a couple of years to go on this.

That doesn't mean stock prices won't hit bottom beforehand. They usually do.

That also doesn't mean there aren't good investments to be found. I'm finding some outstanding bargains now and expect that list to grow over the next year or two.

My goal is to be greedy when others are fearful and fearful when others are greedy. The latter kept me out of the housing and credit down-spiral. The former is what I'm looking forward to, but I don't think others are quite fearful enough, yet, to call the bottom.

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.

Recession seems imminent

More troubling economic news this week.

First, the Institute for Supply Management reported that it's manufacturing survey index showed a contracting industrial sector. Any reading below 50 means contraction. The reading was 47.7 last month. The last time it was this low was in April 2003, coming out of the last recession. Readings below 45 usually indicate a recession is occurring. We're not there, yet, but we seem to be on the way.

Next, residential construction spending showed a 2.5% decline in November. The housing market is dropping, that's no surprise. But, it's impact on the economy as a whole still seems under-acknowledged.

Then, initial jobless claims fell 21,000, but the 4-week moving average, which better indicates labor market trends, was up to 343,750. This number is usually up around 400,000 in a recession, meaning we may not be there, yet. The last time the 4-week moving average was this high was in the summer of 2004, during the slow recovery from the previous recession.

Next, shipments of factory goods excluding petroleum and coal showed its fourth decline in 6 months. This indicates that, other than higher energy costs, shipments of factory goods is in a downward trend.

Today, payroll employment came out at +18,000 jobs. That may sound good, but a large part of that number is based on assumptions about jobs being created by small companies. Large revisions in this number are normal, especially at turning points in the economic cycle.

The payroll employment report was accompanied by a report of the civilian unemployment rate at 5.0%. Unemployment hit a cycle low of 4.4% just last March. When the civilian unemployment rate rises from its cycle low to 0.4% above that rate, a recession is usually imminent. 5.0% is 0.6% above 4.4%.

The stock market finally seems to be noticing with the S&P 500 down over 10% from the recent all-time high it hit last October. Although a 10% drop may not seem bad, recessions frequently cause 40% declines in the stock market.

It's not all doom and gloom, though. Although the economy may be rolling over into a recession, this is a normal part of the business cycle. As long as our government doesn't do stupid things to try to "solve" this "problem," we will soon see an upswing in the market and economy.

Usually, the stock market drops long before the economy does. This time, it seems a little behind schedule. Despite this, the stock market also tends to lead the economy as we come out of a recession. Considering that most recessions don't last more than a few quarters, this could very well mean the stock market could end up for the year.

That means this year could very well be an excellent year for bargain hunting!

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.

2007 Year in Review

2007 was a very satisfactory year for me.

I generated significant market out-performance, and that came mostly by avoiding the things that did badly this year.

After waiting since 2004, this was finally the year when the mortgage bankers, mortgage insurers, bond insurers and other financial institutions reaped the consequences of their poor business practices. Although I did not short these investments, I was able to generate significant out-performance simply by avoiding the group.

Unfortunately, several of the Real Estate Investment Trusts (REITs) I invested in were also taken to the woodshed this year. In each case, I think the REITs I've chosen are the babies getting thrown out with the bathwater, and will almost certainly be market out-performers in the years to come.

I look forward eagerly to 2008 and beyond, when I think my out-performance will be generated not just by avoiding bad investments, but also because I've chosen great investments.

I believe 2008 will be another volatile year, as uncertainty about the economy and slowing corporate profits will lead to significant market moves both up and down. It should be a good year to be a bottom-up stock picker.

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.

Recession storm-clouds gathering

Although the latest GDP report showed the US economy grew at a blazing 4.9% in the 3rd quarter, the data looking forward is looking increasingly weak.

The Index of Leading Economic Indicators (LEI) has gone into negative territory. Our economy has gone into a recession every time the LEI has gone negative, except for once in the late 1960's.

The credit crunch, brought on by lax lending standards to subprime borrowers, is spreading to every credit market. Banks are taking HUGE write-offs, and being forced to make fewer loans as they rebuild their balance sheets.

The employment market looks to be rolling over. The four-week moving average of initial jobless claims has risen to 343,000, the highest since June 2004 (except for the spike due to Hurricane Katrina). In June 2004, it was on the way down after the 2001 recession. It's currently on the way up.

Retail sales are looking to be worse Christmas season since the last recession.

Volatility in the bond and stock market has risen dramatically.

Copper prices have been falling.

UPS and Fedex have announced disappointing results looking forward, and the Dow Jones Transportation Average has been diving.

Financial indexes have been tanking, and in a finance-based economy like ours, that's a bad sign.

The one big thing that hasn't confirmed all these dark clouds is the stock market. Either stock investors are more prescient and no recession will occur, or they are deluding themselves into believing things will be okay or the recession won't last long.

My guess is that most stock investors are being overly optimistic, and aren't looking at coming earnings shortfalls.

When companies begin to report earnings next January, I think investors will get an initial shock. Over time, more information will pour out that the economy is in a recession. By the time this evidence is conclusive, the economy will probably be recovering.

Most investors will be scared when they should be greedy. In other words, by the time investors are scared about a recession, stock prices will be low, and it will be a great time to invest.

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.

You can't get something for nothing

The market seems to be absolutely focused on the Fed.

Everyone seems to think the Fed has the power to make or break the economy, get lending moving again, support the dollar, etc.

The fact is, the Fed doesn't have that much power. If you don't believe me, go read John Hussman's article on the subject, or read any of his recent weekly commentaries that address the issue.

The thing that surprises me is how many people believe the Fed can take action with no seeming repercussions. As if the Fed could move interest rates, or lend money to banks without any adverse reaction.

The reality is that the Fed can only take action with consequences, just like the rest of us mortals.

When the Fed offers liquidity, they are printing money and creating inflation.

In the long run, the Fed doesn't matter much, although they do have a short term psychological impact on the market.

Even worse than that, the Fed's actions almost always come with some downside, and that long term impact can be profited from by smart investors.

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.

Concentrated money managers beat everyone else

Money managers who concentrate on a few well-researched ideas beat indexers and money managers who are closet indexers (those who mirror the index closely and try to tilt their portfolios in one direction or another).

Although I've long known this, it was nice to see this confirmed in a recent academic article.

The authors of the article created a unique measure for finding out how actively a money manager differs from an index.

Their research results indicated that money managers who differed significantly from an index in their holdings had a significantly higher chance of out-performing the index.

This may seem obvious to you, but many managers try to avoid risk by hugging an index. Such managers do this because they lack the skill to pick the best companies to invest in. Unfortunately, these managers still charge active management fees. Not surprisingly, their lack of conviction leads their investor to under-perform the index after fees.

This just goes to show what I always tell people: you should either index to match the market at minimum fees or find an investor who can beat the market after fees. Such managers are rare, but, if they can out-perform an index over the long term, they not only pay their fees, but lead their clients to reach significantly higher levels of wealth.

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.

Catching falling knives

One of the most difficult tasks in investing is to buy things as they go down. Psychologically, its no fun.

Hence, some investors refer to this as catching falling knives: you may do it right, but you may also get cut.

The payoff in investing can be huge. Buying companies that most people think will go bankrupt can be very profitable--if they don't go bankrupt. There's the rub, as Shakespeare put it.

How do you know the company in question won't go bankrupt? There are very smart people out there who know enough about certain businesses, bankruptcy, etc., who can pull this off. But it's not for the faint of heart any more than catching literal falling knives.

This question occured to me because a lot of very smart value investors are looking hard at mortgage and bond insurance companies (which I wrote about here and here).

Mortgage guarantee companies like Triad and Radian and bond insurers like Ambac and MBIA have been taken out to the woodshed recently, in terms of their stock prices. This seems justified considering they seem to insure a lot more than they could pay out.

Such investments were great as long as you assumed a housing recession or deep economic recession never hit. That doesn't seem like a very wise bet, now, nor did it beforehand.

The question is how will these investments do going forward? It seems hard to imagine the government will let the rating agencies downgrade their insurance ratings, for this would surely put them out of business and leave the financial markets in one heck of a mess (tons of investors have their money insured by these entities and would lead to a major dislocation).

But, do you want bet on that? That's the question. Will the government save these entities? Should their shareholders get off scott-free instead of bearing the risk they took? Will this encourage moral hazard (I can answer that last one--YES)?

Although I believe a ton of money could be made by investing in bond and mortgage insurers at these prices, I'm not expert enough to catch these falling knives. Do I know enough about the risks they've assumed and the capital they can use to support claims and the cozy relationship between rating agencies/the government/such insurers?

I don't. And not many do.

Perhaps that's why it might be best to leave catching falling knives to the experts.

As Warren Buffett put it, I don't try to find 7 foot fences to jump, I look for 1 foot fences to step over. Bond and mortgage insurers look like a 7 foot fence to me.

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.

Will the Fed cut rates?

The market certainly seems to think so.

Just look at interest rate futures and you'll see investors are expecting a 25 to 50 basis point cut in the Fed Funds Rate.

Or, more meaningfully, look at the gold market. Gold prices spiked to over $785 an ounce, today.

That's up 17% over the last month and 31% over the last year.

Why does the gold market indicate a cut in the Fed Funds Rate?

Because the Fed does not create growth--they do not possess some magical fairy dust that makes the economy run faster.

The Fed prints money to decrease interest rates. And, when the Fed prints money more quickly than the economy grows, they create inflation.

Gold prices are going up because gold investors believe the Fed will print money, also known as cutting the Fed Funds rate, thus creating inflation.

Gold is going up because investors are guessing the Fed will create inflation by cutting rates.

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.

Comparing apples and oranges

What would you say if I told you the market was over-valued by 30%? Would you think I was full of it?

What if I told you that this over-valuation were based solely on market commentators comparing apples and oranges?

When someone says the market is fairly valued or over-valued, what do they mean by that? What standard are they comparing it to? This may seem like a pie-in-the-sky question, but it's very important.

Why? Because market commentators are frequently saying the market is fairly valued by comparing apples and oranges! And, the two are off by 30%.

You see, many say the S&P 500 is fairly valued because they are comparing the S&P 500's forecast, operating earnings to the S&P 500's actual, reporting earnings. But that's comparing apples and oranges.

This may seem like technical minutia, but it makes a big difference. In fact, operating earnings of the S&P 500 have been 20% higher than reported earnings over the last 5 years. And, forecast earnings for the S&P 500 have been 10% higher than actual earnings.

In other words, when commentators say that the S&P 500 is trading at its historical average, they are comparing apples (forecast, operating earnings) to oranges (actual, reported earnings). And, those apples are 30% overstated compared to the oranges.

Next time you hear someone say the market is fairly valued, ask them if they are comparing apples to oranges. Are they comparing forecast, operating earnings to the historical average of actual, reported earnings? If so, tell them to adjust their numbers and get back to you when their figures are fairly comparing apples to apples.

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.