Market history...simplified

Though I disagree with George Santayana's pragmatist philosophy, I couldn't agree more with his remark that "Those who cannot remember the past are condemned to repeat it."  I have thus endeavored to become a student of stock market history to avoid the condemned thing.

Market history is boring and frustrating to think about for most, but I will try here to simplify it for you.  Tell me how I do.

Stocks are priced, over time, relative to the earnings of underlying companies.  Sometimes market participants are optimistic and willing to pay a lot for underlying earnings, sometimes they are pessimistic and willing to pay little, and most of the time they are somewhere in between.

• 20% of the time they are optimistic: happily accepting  less than 4% annualized returns to buy stocks
• 15% of the time they are pessimistic: demanding 16% or greater returns to buy stocks
• 65% of the time they are in between: expecting something between 4% and 16% returns from stocks

Briefly, in March 2009, investors were pessimistic enough to demand 16% returns.  At present, they are happily accepting less than 4% returns. 

With that very brief and simplified market history, let me be bold now and predict the future.  Please wait a second while I gaze into my crystal ball...

...I see people getting less than 4% returns in the future, I see them getting very pessimistic at times, very optimistic at others, and spending the majority of the time in between. 

Okay, I don't really have a crystal ball, but that's what will happen if you invest in the market today.  The past will repeat and those who haven't learned will being doing the condemned thing.

Oh, and by the way, you don't have to invest in the market.  Instead, you can--right now--buy pessimistically priced companies and sell optimistically priced ones.  That's another lesson of market history, but it's not as simple.

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.

Invert, always invert

I'm very proud of my investing record over the last 6 years as a professional (beating roughly 80% of my competitors) and the last 15 years as an individual (beating the S&P 500 by over 4.5% annualized), but it could always use improvement.  For, as Goethe put it, "he who moves not forward, goes backward." 

With that in mind, I've spent a lot of the last few months reviewing my investment process and looking for ways to improve.  One of the most important lessons I have derived is the importance of not investing in things that go down a lot.

Now, this may seem perfectly obvious to you, but it's hard when one is busy with day to day research and portfolio management to focus on the downside instead of the upside.

In fact, I'd go so far as to say that most people focus too much on the upside--myself included.  Most people seem to believe that hitting the ball out of the park is the way to win baseball games, when in fact it has more to do with not striking out and getting base hits.

So it is with investing.  I'm a devoted fan of Warren Buffett, so this thinking should be more implicit in what I do.  Buffett describes his two investing rules quite simply:

• Rule #1: don't lose money
• Rule #2: don't forget rule #1

Or, as Alice Schroeder, Buffett's authorized biographer, described it in a presentation at the University of Virginia: Buffett's first step is to look for catastrophic risk.  If he sees any possibility of catastrophic risk, he just stops right there and moves on to other ideas.

I was struck recently with how little I've devoted to this side of the process.  How do you not lose money?  Don't invest in things that go down a lot.  If you avoid blow-ups, then the upside will take care of itself.

Charlie Munger, Buffett's business partner, likes to quote famed German mathematician, Carl Gustav Jacob Jacobi, on this issue.  Jacobi told his students to "invert, always invert" (the quote on Wikipedia is "man muss immer umkehren," which I translate as "one must always invert").  What Jacobi meant was that many problems can be solved backwards by inverting the problem.

For example, do you want to know how to be happy?  Instead of trying to figure out how to be happy by examining happiness or looking at what happy people do, look for what you absolutely know will make you unhappy and then don't do that.  See the subtle difference?

If I study business successes, I may find out what common characteristics business successes possess, but that's not the whole picture.  I must also look to see if business failures share those same characteristics to avoid hasty generalization.  Perhaps 5 businesses were successful by selling widgets and 95 were failures, so looking only at the 5 successes may lead me to falsely conclude that selling widgets is the way to success.  I must also study the failures to see the full truth. 

With that in mind, I can invert the problem as Jacobi suggests.  What causes businesses to fail?  If I know the answer well, and that business successes don't do it, then I can avoid blow-ups by avoiding businesses with failure characteristics.  Invert, always invert, indeed.

So, not surprisingly, I've decided to become a student on what makes businesses fail.  By inverting the problem to avoid failures, I will ensure greater success in my investing results. 

Thank you Buffett, Munger and Jacobi.

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.

China Rising?

So much ink has been spilled--especially over the last several years--about the rise of China that I wanted to devote a blog to the subject.

I won't bury the lead: I believe China is more likely another Japan than another United States on the rise.  My goal is not so much to tell the future--I don't know what will happen--as much as it is to cast doubt on the overwhelming consensus of China's inevitable rise to supremacy.

What consensus you might ask?  That China's economy will inevitably surpass the U.S.'s in the next 10, 20, or 30 years; that China will surpass the U.S. in technological superiority; that China will surpass the U.S. militarily; that China will surpass the U.S. in every way possible, it seems.

All of these things very well may come to pass.  But, it is not written in the stars, and the consensus view is almost entirely built on an extrapolation of current trends--a technique of forecasting which is almost never accurate.

As an interesting illustration of forecasting difficulty, I'd like exhibit #1 to be Paul Kennedy's excellent book, The Rise and Fall of the Great Powers.  Now, granted, this book came out in 1987, when Japan's ascendancy was widely accepted as given, but it's a wonderful example of how someone extremely knowledgeable in a specific field can suffer from the biases of extrapolation. 

In his book, he speaks of the 5 centers of power at the time: the U.S., the U.S.S.R., Japan, China and the European Economic Community.  He spells out how clearly Japan is surpassing or going to surpass the U.S. in computers, robotics, telecommunications, automobiles, trucks, ships, biotechnology and aerospace. 

Please understand, he was writing in 1987, when Japan Inc. was thought to be unbeatable, buying up property all over the world, technologically unstoppable.  He didn't know Japan would fall into an economic funk a mere two years later where Japan's economy wouldn't grow for the next 22 years (nor did he see the fall of the U.S.S.R. coming, and even seems to poo-poo the idea).  So much for Japan Inc. and extrapolation of the past.

But, really, how could anyone really think that Japan would surpass the U.S. in computers and software?  Or biotechnology and aerospace?  Yes, Japan has definitely done better in robotics, automobiles and ships, but to provide such a long and overwhelming list as a historian?  A bit naive, I think.

The consensus view on China reminds me in many ways of the view 20 years ago of Japan.  Don't get me wrong, Japan and China are very different stories, but people's perception seems to be similar. 

Just as China's centrally planned economy and "state capitalism" (an oxymoron if there ever was one) is seen as the wave of the future and a better way to govern, so Japan's Ministry for International Trade and Industry (MITI) and it's coordination of economic activity was seen as a huge advantage over the U.S.'s capitalism. 

Just as China's production of engineers and scientists is seen as an unstoppable force, so was Japan's.  Just as China's high research and development budget is seen as superior, so was Japan's.

Just as China's high national savings rate is seen as an advantage over the U.S.'s consumption, so was Japan's.  Just as China's superiority in aptitude tests is seen as intellectually over-powering the U.S.'s poor scores, so was Japan's.

I believe people make these extrapolations because they don't really understand the sources of growth.  They simply expect the recent past to keep going, but it almost never does.

Just as Japan's extraordinary growth came from adopting western technology and industry and having huge western markets to sell to, so does China's.  If either Japan or China had had to create these industries from scratch, as the U.K. and U.S. had done, the growth would never have materialized.  And, just as Japan's economy has demonstrated over the last 20 years, if China ever has to rely on it's own consumers and businessmen for innovation and growth, you'll see growth fall off a cliff.

Neither Japan nor China invented the Bessemer process, or assembly lines, or transistors, or binary computer logic, or almost any of the other major innovations which allowed them to grow.  They got it all from the west. 

And, this brings me back to my blog of two weeks ago, where I said that return on capital is the most important concept in finance.  You see, neither Japan nor China view return on capital as a primary concept.  Japanese businessmen are frequently on record saying that the U.S.'s focus on shareholder returns is ridiculous.  China is a communist state that sees returns on investment as a mere means to other ends.

The U.S. and U.K., at least during periods of innovation, let returns on capital as determined by individuals allocate resources, instead of some central planning bureaucracy.  The U.S. and U.K., thanks to intellectual greats like Adam Smith (a moral philosopher, not economist), recognized that human potential was unlocked when individuals were able to pursue their self-interest, as long as there was a rule of law and, specifically, protection of property rights.

Good luck finding that intellectual framework in Japan or China. 

In forecasting the future, this return on capital concept is vital to accuracy. 

If the U.S. abandons its focus on return on capital (as the U.K. has in most ways done), good-bye growth and innovation, good-bye technological and military superiority, good-bye world leadership. 

If Japan adopts a focus on return on capital at the individual level, which I believe is possible over time (perhaps in the next decade) welcome back growth and innovation. 

If China adopts a focus on return on capital at the level of the individual--an unlikely route, in my opinion--it can become a leading state.  Without that focus, growth will eventually crash and burn as it did in Japan (China is witnessing a boom in real estate, just as Japan did before its crash--coincidence?).

Forecasting China or U.S. over the next 30 years seems a bit silly without a focus on return on capital, but the consensus opinion is that it's a done deal--China will be supreme. 

I beg to differ because I don't believe large population, numbers of engineers, test scores or central planning are the lifeblood of growth, but the innovation of individuals who produce high returns on capital for their own benefit.

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.

An investment advisor's most important job

Before deciding to have a child, my wife and I did a tremendous amount of research on how best to parent.  It occurred to us both, early on, that one of our jobs would be to comfort her when she was cast down, and challenge her when she was feeling too self-satisfied.

This reminds me, in a lot of ways, of what an investment advisor must do for clients.

Too many investment advisors are eager to give clients what they want, not what they need (we all know how that parenting style works).  In such a relationship, the advisor benefits at the expense of clients.  Not good.

Most investors get overly excited about market prospects after investments have made big gains, then become overly despondent when investments tank.  This is not some great sin on the part of investors--it's a well tested and documented human tendency.

Investors who don't exhibit this tendency, and there are quite a few, don't really need an investment advisor.  If they tend to zig when others are zagging, their investment results are likely to be very good without the help and expertise of an advisor.

Investors who exhibit the all-too-human tendency referenced above, however, do need the help of an adivsor.  In fact, I would argue it's the advisor's most important job to prevent clients from buying at market tops and selling at market bottoms.

I've made this focus the centerpiece of client communications.  When markets look frothy, I write client letters and blogs that express concern and cautious action.  When markets look abandoned, I express enthusiasm and a need for bold action.

This is vitally important, because most investors won't get anywhere close to meeting their retirement goals if they buy at tops and sell at bottoms.  If you need concrete examples, please see any of the multitude of studies showing how unprepared baby boomers are for retirement.

So, it was with great distress that I read an article in SmartMoney today highlighting that 1/3 of advisors moved client dollars out of the stock market and into conservative investments (cash and bonds, mostly) in 2009 and early 2010. 

In other words, those advisors were doing just the opposite of their most important job.  Instead of talking clients off the ledge, they were facilitating their jump. 

Even if you could argue that those clients needed to get out of the market for psychological reasons (can't sleep at night), I would further suggest they didn't belong in the market to begin with, and that their advisor should have been the one to figure that out before the market tanked.

Any advisor worth their salt should have been able to see that in early March 2009, the stock market looked likely to provide 20% annualized returns in the future (10% earnings yield, plus 6% economic growth, plus 4% dividend yield).  This is not rocket science, but many investment advisors panicked just like their clients.

It's like a pilot running up and down the isles of an airplane with an engine fire instead of soberly resolving the problem.  Such a pilot is clearly not doing their job, and neither is such a panicky investment advisor.

Can you imagine if 1/3 of pilots panicked like passengers when problems occurred?  No one would be willing to fly on an airplane!

And, yet, investors have and will continue to pick investment advisors based on their community involvement and winning personality, instead of their sober-minded expertise and an ability to deal successfully with psychological stress.

Perhaps investors will learn their lesson this time, and turn to advisors who give them what they need, not what they want.

After all, isn't that a parent's job, too?

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

The most important concept in finance

I was going to write a blog about why I think China looks more like developing Japan (with the same dreadful destination) than developing America, but realized I just couldn't get there without an intermediate step. 

That intervening step may seem like a minor point, but I believe it's the most important concept in finance and one of the most important in economics: return on capital.

Okay, of the 10 people reading this blog, I just lost 80% with that last sentence, so thanks for sticking around remaining 2!

Return on capital probably seems like either a very mundane or overly abstract concept.  Everyone knows that for any financing to work, the financier must get his capital back and then some.  Otherwise, why bother, right?

But, it seems like people frequently drop this context when they discuss broader issues.

Take college loans for example.  If you lend someone more money than they could possibly repay to go to college, it's not economic.  But, you've got to do the math to really grasp this concept. 

If you lend someone $100,000 to go to college, and they earn a degree that pays $20,000 a year, then it would take 20% of their pay ($4,000) for the rest of their life just to service a 4% interest rate--and that's without paying any of the principal!

No intelligent financier would ever make such a loan, yet most people think the financier is being mean.  What they should recognize is that such a loan is bad for the borrower and society just as much as for the financier--such a loan saddles the borrower for life and reduces the productive capacity and standard of living for the whole economy.  It's not mean, it's just a plain stupid.

In 2006, I would have been laughed at for suggesting that many home loans were being done under the same uneconomic conditions.  I hope that 2007-2009 has convinced most people of the soundness of this logic.  If you can't get a positive return on capital, it screws up the whole economy and wrecks the lives of those involved.  If you can't get a positive return on capital, it's not financial or economic, it's charity.

Society does not grow and prosper by charity, it requires a positive return on capital.  For those who wish we were ants or that reality was other than it is, this may be a real downer, but that's the way it is.

In order to meet our current and growing needs, we need to produce more this year than last, and the only way to do that is to get a positive return on capital.

What, exactly, does that term mean, anyway?  It means if you borrow $10 from someone, you need to be able to pay them back the $10 plus whatever makes it worth their time.  Or, more importantly, it means that you need to do something with that $10 that will generate $10 plus interest. 

Or, more fundamentally, it means that if you buy 10 pieces of wood for $10, you better be able to turn those 10 pieces of wood into something worth more than $10, or you're wasting your time and someone else's money.

Or, even more fundamentally, if you don't produce something worth more than $10, then you've reduced the productive capital available and thus lowered everyone's standard of living (please see Peter Schiff's How an Economy Grows and Why It Crashes for an excellent, very readable, and more thorough illustration).

This is not a minor point, I hope you can see.  If you lend someone $10 and they can only pay back $9, it's not just bad for you, it's bad for them and for the rest of society.  Those 10 dollars were earned by your time, effort and resources, which you can never get back.  That $1 is done, gone, kaput!

Perhaps dollars is an inadequately concrete way to describe this point.  Suppose you had 10 pieces of wood and you destroyed one by fire without producing any product or service.  Nothing you can do will bring that piece of wood back.  That wood can't be used for fuel, or be turned into furniture, or anything else ever again.  Time and effort would have to be expended to gain a new piece of wood--time and effort could have been used productively instead of simply bringing things back to the way they were before.

Return on capital isn't just nice to have, it is a very concrete description of what is necessary to maintain and grow our standard of living.  We must use our resources wisely such that they produce more and more each year. 

It's the bedrock upon which our world is built, and if taken too lightly, our foundation and prosperity will suffer.

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

Investing records and political handicapping

The investors with the best records over the last decade have proven themselves more adept than others at navigating the shifting investment landscape. 

Is it because they're better at valuing businesses, digging into financial statements, analyzing competitive advantages, assessing the ability of management, forecasting economic outcomes?  No. 

Great investing records over the last 10 years have been generated by correctly assessing how, when and where the government will intervene.

Betting on AIG, Citigroup, Bank of America, General Motors, General Electric, and so on, before or shortly after the government bailed them out has made fortunes for a handful of hedge and mutual fund managers.  AIG, et al., should have gone bankrupt, and their share prices properly reflected that reality.  But, when Uncle Sam intervened, lumps of useless coal were transformed into valuable diamonds.  No one investing more prudently could beat such out-size returns.

Investors who have correctly forecast the Federal Reserve's frequent and haphazard interventions have rung up major dollars, too.  If they had been wrong, they would have lost their fortunes.  But, they were right.

I'm not drawing attention to conspiracy, here, because I don't believe a conspiracy exists.  Those investors with the best records have simply better realized that the investing landscape has changed, and that correctly guessing Uncle Sam's intervention is the new way to make big dollars.

Am I envious of such results?  In a way, yes.  I wish I had been more perceptive that the game had changed.  But, in another way, I'm not at all envious.

First, guessing Uncle Sam's next move may win for a while, but it will eventually fail.  Even Uncle Sam's pockets aren't infinitely full of economic stimulus. 

Second, correctly guessing Uncle Sam's next move is as much a matter of luck as skill.  Just because someone wins the lottery or makes $10,000 in Vegas doesn't mean that's the way to plan for retirement.  Lady Luck will eventually come to collect the bill.

No, I'm quite satisfied to invest prudently, if unspectacularly, and slowly build wealth over time.  Just because the new game is popular and seems more profitable (remember the dot-com craze of 1999 or flipping houses in 2005?) doesn't mean the old rules no longer apply.  They do.

Eisenhower warned of the military-industrial complex in his 1961 Presidential farewell address.  Did he know it would become the military-real estate-banking-automobile-pharmaceutical-tobacco-airline-firefighter-teacher-investment banking-college funding-steel manufacturing-etc.-industrial complex?

If he had, I think he, too, would have looked at Roman and British history and said such complexes are nothing new, and always end poorly.

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 say you want a revolution?

We in the United States of America romanticize revolution.  After all, our revolution ended in the greatest country in the world, so it must be good for others, right?

Well, not always. 

Take, for example, the French Revolution of 1789.  It occurred 13 years after our Declaration of Independence, but ended in the Reign of Terror and Napoleon steamrolling Europe and Russia.  France is now on their 5th Republic and still trying to get it right.  You say you want a revolution?

Or, take the Russian Revolution of 1917.  It was supposed to free the oppressed people of Russia from the yoke of the Czar (isn't it mind-boggling that we now use this term to denote our government figures: Auto Czar, Drug Czar, Energy Czar, etc.?).  Instead of a worker's paradise, they got Stalin, purges, millions dead by murder and famine, and Nazi slaughter.

Or, for instance, the Chinese Revolution of 1949.  Chairman Mao, millions dead of murder and famine, Cultural Revolution (there's that word again!), etc.  You say you want a revolution?  Okay this story is, currently, going better than France and Russia, but that came about without a revolution. 

For those who think potential revolutions in the Middle East are necessarily a good thing, it's time to review the history of revolutions.  They don't all end happily.

The western press was quick to assume the 1979 Iranian Revolution was a good thing, too.  It wasn't (unless you're one of the goons in charge, I suppose).  The press thought the English speaking people they interviewed represented the revolution, but Islamic clerics were pulling the strings and ended up in charge.  You say you want a revolution?

I'm not saying all revolutions end badly, but enough of them do that they shouldn't all be greeted gladly.  Things in the Middle East may get better through revolution, but don't count on it. 

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

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.