You choose: short term "reward" and long term risk, or short term "risk" and long term reward

 

Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won't. To reach your financial destination, you can either:

• get lower returns and save more money over time (thus having less to spend )
• get higher returns and save less money over time (thus having more to spend)

There's no option to save less and get low returns--that won't work.

The difficulty investors face is that they want to take little or no "risk"--avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn't your destination, then it's the wrong route. You can make valid choices among routes that will get you where you want to go, but you can't successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro's and con's of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 

• cash (including checking, savings, CDs, etc.)
• bonds
• commodities
• stocks
• real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980's to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term--or their wished-for ability to time the market--to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term "reward" with significant long term risk, and stocks and real estate provide short term "risk" with real long term reward. If you want to reach your goals, and don't suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns--and the vast majority of people do--then stocks are the best option.  Choose wisely.

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.

Investor, know thyself

 

From a psychological perspective, being a part of the herd feels comfortable.  Going against the herd, in contrast, feels almost unbearably miserable.  

Believe it or not, investment success is mostly about understanding this psychology, making a conscious choice to be in or out of step with the herd, and then acting accordingly over time.

Let me describe this in more detail.  If the market is hitting new highs and your portfolio is going nowhere, it feels almost unbearably painful.  If the market is hitting new highs and your portfolio is fully invested, it feels great to be "participating" in the run-up.

This is called herd psychology for good reason.  When running with the herd, animals are least likely to become a predator's meal.  When running against or away from the herd, you're quite likely to become lunch.  Our general psychology reflects this herd bias because it worked oh-so-well during human evolution.  Being away from the herd is painful.

This carries implications for investing.  If you prefer running with the herd, or know yourself well enough to acknowledge you'll feel miserable standing apart from the herd, then invest in an index fund.  The benefit is you won't feel the psychological pain of being out of step and thus make big investing mistakes at just the wrong time.  The downside is you'll generate mediocre results and thus have to save more money over time.  

They key is objectively understanding your temperament, and then making a choice that you can actually--not hypothetically--stick with.  You must know yourself, first.

If (and that's a BIG if) you have the temperament or will-power to run apart from the herd, the benefit is you can achieve above average results, and thus have a bigger retirement or reach your retirement goals with less required savings over the years.  But, you must be able to tolerate the psychological pain of being out of step.  This is no trivial matter.

Most people say they would prefer to do better than the herd, but very few actually have the stomach to do so.  They believe they can stick relatively close to the herd and generate better results, but they simply can't.  They say they can tolerate being out of step, but when their portfolio is going nowhere and the market is moving up, they get cold feet and decide to jump back into the herd.

This is why they do worse than both the herd follower and the out-of-stepper who can stay the course: flipping from out-of-stepper to herd follower and back again--at the time of maximum psychological pain--over and over again, generates terrible results (Dalbar publishes results each year supporting my position).

The important point isn't which method works best by itself, but which method you can stick to from a psychological standpoint.

Beating the herd is not impossible, but it requires a willingness and ability to go against the herd through the psychological pain of being out of step.  Fewer can do it than are willing to admit it to themselves, but that's also why it 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.

Americans generally not prepared for retirement

The latest Employee Benefit Research Institute survey is out, and it's not pretty (and hasn't been since I started following it).

Only 14% of Americans are very confident they will have enough money to live comfortably in retirement.

Employment insecurity is the most pressing financial issue facing most Americans.

60% of workers have less than $25,000 in savings and investments (!) outside their home and defined-benefit plans (pensions).

Half of retirees said they left the workforce unexpectedly (due to health problems, disability, layoffs, or their employer closing)--meaning that most of those expecting to work longer won't really have that option.

I don't know if retirement just seems too far in the future, or if the virtue of thrift has gone by the wayside, but most Americans aren't doing what it takes to prepare for their future.  

They may heartily blame someone else, but "truth be told, if you are looking for the guilty, you need only look into a mirror." 

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.

Know what you're getting yourself into

Suppose I gave you 3 investment options:

• Investment A charges 0.05% in fees per year
• Investment B charges 0.20% in fees per year
• Investment C charges 1.5% in fees per year

Which would you choose?  

A lot of investors, and their advisers, would blindly choose Investment A because they believe lowest fees always win. To which I would ask: lowest fees for what? The goal of investing is not to minimize fees, but to preserve and grow capital.

Suppose I gave you 3 new investment options:

• Investment A has 0% standard deviation over 5 years
• Investment B has 18%  standard deviation over 5 years
• Investment C has 68%  standard deviation over 5 years

Now, which one would you choose?

Most finance professors, investors and their advisers would chose Investment A because they believe lowest volatility wins. Risk equals volatility, they'd say, so reduce risk by investing with lowest volatility. To which I would ask: is the goal of investing to avoid volatility, or generate returns?

Suppose I gave you 3 new investment options:

• Investment A has returns of 5% a year for 5 years
• Investment B has returns of -8%, +20%, -8%, +32%, and +20% over 5 years
• Investment C has returns of -5% a year for 4 years, then jumps 146% in year 5

Now, which investment would you choose?

Most investors would choose A because B would be "too much of a roller coaster ride" and C would "go nowhere" for too long. To this situation, I'd ask: is the goal of investing the avoidance of "roller coasters" or "going nowhere," or to generate returns?  

Suppose I gave you 3 final investment options:

• Investment A generates a 5% annualized return over 5 years
• Investment B generates a 10% annualized return over 5 years
• Investment C generates a 15% annualized return over 5 years

Which would you choose this time?

Most investors and advisers would chose Investment C because it produces the best return.  On this one, I'd agree.

If you recognized that Investments A, B and C were consistent throughout my examples, then excellent observation on your part.  

Investment A is basically a saving account or Certificate of Deposit (not that you can find that kind of yield now). There is no daily market quote for the instrument so it appears not to fluctuate at all (which means the volatility appears to be zero), the fees are very low, the returns are steady, but the result is low compared to other alternatives.

Investment B is basically an index fund invested in the stock market. The fees are low, but not as low as at the bank, the returns are unpleasantly volatile--hence the roller coaster comment--but generate a very respectable return of 10% per year (assuming the market is at average value).

Investment C is basically a value-style investment. The fees are high, the standard deviation of returns is quite volatile, the investment goes nowhere for 4 years before taking off (meaning that it doesn't track with the overall stock market--which vexes professors, investors and advisers to no end!), but the returns are truly outstanding.

My attempt here is not to say that investment C is the right choice for everyone--it most certainly is not--but to illustrate the choices investors are faced with and some of the inherent trade-0ff's they must make.

If you believe that low fees are the most important criteria, then I'll quote Oscar Wilde: "The cynic knows the price of everything and the value of nothing." Price is what you pay, value is what you get. It's a mistake to look at price and not what you get for that price.

If you can't stand volatility of any kind, like watching your investment double one year and plunge 50% the next, then you should probably avoid the stock market. If 5% returns aren't enough to allow you to reach your financials goals, you have a true dilemma on your hands. If 5% returns will get you where you want or need to go, then why bother with more volatile options?

If you invest in stocks, don't expect 10% returns each and every year, but 10% returns over time assuming you invest when the market is at fair value. If you invest when the market is high, you won't get 10% returns; if you invest when the market is low, you'll do better than 10%.  In either case, don't expect a smooth ride. There is no such thing as a free lunch, so don't expect to invest in the stock market and get bond-like or savings-account-like returns.

If you want better returns than a saving account or the stock market offers, then don't expect steady returns or returns that track the market. To do better than the market, you may have to be willing to "go nowhere" for quite some time.  Better returns will very likely be more volatile, look very different than the market, and test your patience. Conversely, an investment that is steady or mirrors the market is extremely unlikely to generate above average returns.

Successful investing is less about fees and volatility and more about knowing what you're getting yourself into. If you buy C and expect A or B, you'll be disappointed and bail out before good results accrue. If you buy A and expect B or C, you'll be disappointed with low returns. If you buy B and expect A, you'll be scared out by volatility. If you buy B and expect C, you'll wonder why you're not tracking to the market.

Most financial plans fall apart not because things go awry, but because people don't know what they are getting themselves into and bail out at just the wrong time. Successful financial planning begins with a clear understanding of the options, the likely outcomes, and the probable path to the destination. People leave a restaurant when they expect steak and potatoes and get foie gras and escargot.  

My wife has a saying, "you knew it was a snake when you picked it up." Know what kind of snake you're picking up, and don't judge it by nonessential characteristics.

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.

Counter-intuition

To most people, good investing seems frustratingly counter-intuitive.

When the economy is on its back, looking like it will never recover, and the stock market is hitting new lows--that's the best time to invest. When the economy is breaking growth records and the stock market is hitting new highs--that's the absolute wrong time to pile in.

Or, as Warren Buffett more succinctly put it: "be greedy when others are fearful and fearful when others are greedy." (He should know, you don't become one of the richest people in the world and the most successful investor over the last 60 years if your approach is fundamentally flawed.)

But, most people can never really get their brain around this paradigm. They easily accept that they know nothing of particle physics, brain surgery and rocket science, but they just can't accept the notion that investing and economics are similarly complex.

To most, investing is counter-intuitive.

But, to me, this counter-intuitiveness makes perfect sense. Investing is not like physics, surgery, rockets, home building, plumbing or most other things people do. In most fields, man is competing with nature.  

A physicist is trying to understand the rules of nature with mathematical precision such that it can be harnessed. The surgeon wants to understand disease and human physiology such that he can operate to restore health. A rocket scientist uses the rules discovered by physicists to harness nature's power to propel and guide a payload into space. A home builder seeks to erect a structure that will keep out the elements and provide a comfortable and convenient abode for its dwellers. A plumber desires to harness water to serve man's needs within buildings. All of these fields are concerned primarily with overcoming nature.

Investing is different. It's more like sports or warfare in that it is inherently a competition of man against man. And that, I believe, is why it seems counter-intuitive to most.  

With investing, you are not just trying to figure out which company will survive and thrive, but how other people perceive that company. The price you pay is not based solely on a company's underlying fundamentals, but on how investors in general understand and interpret those fundamentals (or just plain feel about a company).  

When people are excited about an investment, like Apple, they tend to bid the price up above underlying fundamentals. When they hate a company or think it is going the way of the dodo, they bid its price down below fundamentals.

When they think the economy will go ever higher, they want to be fully invested. When they think it will never improve, they want to pull all their money from the market--right now!

But, this herd-like behavior is almost always reflected in prices before such people buy and sell. The price they pay or receive is for the perception of a company or the economy, not just the underlying fundamentals.

In the long term, however, the fundamentals win out. As Benjamin Graham put it, "in the short run, the stock market is a voting machine, in the long run, it's a weighing machine." In other words, stock prices reflect human emotion in the short run and underlying fundamentals in the long run.

Which is why successful investing seems counter-intuitive. When everyone is selling and it seems like things can never get better (2009), you want to be buying. When everyone is buying and it seems like a new era of non-stop growth has dawned (2000), you probably want to be selling.

Because most people will never get their brain around this, counter-intuitive investing will continue to work for those who can harness other people's short-term emotions. 

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 article

Despite its all-too-common use of the ridiculous term, "state capitalism," this article outstandingly spells out the case for China to experience an economic crisis in the next 5-10 years: Time Magazine, Why China Will Have an Economic Crisis.  

China can and might change course, but it's current path is one we've seen before and will end in tears.

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.

Lucky, or good?

One of the hardest things to do well, especially as an investor, is to learn from our mistakes.

When we pick an investment that does well, it's easy to think about it, analyze it, dwell on how smart we are. But, when an investment goes against us, it can be very tempting to put those losses into our mental dustbin and try to forget them.

This temptation really should be resisted, because learning from our mistakes is more important than celebrating our victories.

Just as important, and more often overlooked, is that we should examine critically our successes, too. Sometimes good outcomes are due to luck and not skill. We need to understand which occurred to improve our results over time.

I like to look just as hard at my failures and my successes, because learning from both can reveal powerful lessons that can be applied in the future. I've found this can lead to much better investment results over time.

There are several questions I ask myself with both successes and mistakes:

1. What happened at the underlying business in terms of fundamentals?
2. What happened to the market price and valuation with respect to those fundamentals?
3. Was I lucky, or good?

(I ask more questions than this, but these are the most important ones.)

When I invest, I do it based on certain assumptions about underlying growth in sales or book value and underlying margins or returns on equity. My first question is to figure out how far off I was in evaluating those underlying fundamentals. Did the company grow faster or slower than I expected? Were the margins higher or lower? What led to those outcomes and how was that different than my expectation?

My first question is about the underlying company separate from the market's reaction to it. The second question is about how the market reacted to those fundamentals. Sometimes a company does worse than you think it will, but the market's opinion becomes more favorable than you thought it would. Sometimes a company does better than expected, but the market's opinion about the business becomes worse.  

The answers to the first two questions helps me answer the third question: was I lucky or good? When a company does much worse than I expect, but the market's opinion about the company improves, that's more lucky than good. When a company does much better than expected, but the market's opinion sours, that's unlucky.  

It's very important to differentiate between luck and skill with investing. If you've been lucky and don't identify it as such, you're likely to repeat that process and see your luck run out. I had a lot of success buying technology companies from 1996-2000 each time prices pulled back temporarily.  That success was more luck than skill, and I ended up paying the price later when that strategy no longer worked.  

It's also important to differentiate between bad luck and bad skill. If you pick a company that does well, but sell it because the market's opinion of the company worsens over time, you will likely miss large future gains. A good process may lead to bad results occasionally, but that's a bad reason to give up on the good process.

Learning from mistakes can be very time consuming, and that puts many people off. You have to go back and look at historical fundamentals over time, you have to look at how the market reacts to those fundamentals, you have to adjust for temporary changes like recessions or transitional industry dynamics, you have to keep track of your initial expectations and how they changed over time. It's not simply a matter of looking at your returns in a vacuum, but of evaluating your results relative to your expectations, market reactions and alternative options.

I believe the effort is well worth it, though. When you realize you had good luck instead of good skill, you can prevent that process from happening in the future. If you realize you've been unlucky and not unskillful, you can keep that process in place to profit when the odds turn your way. 

No one relishes examining bone-head mistakes in detail, or realizing one's brilliant outcome was luck instead of skill. But if you like improving results over time, the effort is well worth 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.

Extraordinarily average

Regression to the mean is a well documented phenomenon in investing, as it is in many other areas of life. 

It refers to the basic tendency of a statistical series to move toward average over time. Just as trees don't grow to the sky and average IQ's don't double in a generation, returns on equity investments tend to move toward average, too.  

As I described in my January blog, this phenomenon can be used to profitable advantage, and now seems to be one of those times.  

Why do I think that? Because group performance of some stocks seem to be far out of line from long term history, and if those relationships are restored--as they always seem to be--then money can be made investing in a way that supports a regression to the mean.

To flesh this out, let me describe one way of looking at historic returns: by assessing them relative to company size and valuation. For example, you can group large companies together and small companies together, or look at companies with high price to earnings (growth) or low price to earnings (value).  

One popular way to look at this, used commercially by Morningstar and described academically in a famous study by Fama and French, is to break companies by size and valuation in to four groups: 1) small value, 2) small growth, 3) large value and 4) large growth.

I like to look at this data over 5 year periods to observe whether one group is moving further from average and may snap back.

Over the very long term, from 1927 to 2011, small value has been the best performing group, followed by large value, large growth and small growth. In fact, over 84 years of data, small value did 3.7% better than average, large value did 0.5% better than average, large growth did -1.7% worse than average, and small growth did -2.4% worse than average.  

If you've ever heard someone say buy small companies or value companies, they were referring to this long term data set.

But, there is a problem with just buying small value without further thought, because your particular returns depend on how far from average the data is at the time you purchase. If small value has done much better than average when you buy, it won't generate historically average results for you. And, if small value usually does best but has been worst recently, you'll probably do much better than historic average.

Knowing the long term average and recent performance can lead to profitable discoveries, in other words.

With this in mind, how has recent performance looked? Instead of small value leading the pack over the last 5 years, small growth has. The 84 year historic worst group--small growth--has been best over the last 5 years (+4.9% better than historic average). In my opinion, this seems like a terrible time to buy small growth.

Large growth, usually the second worst group, has been the second best group with 3% better returns than usual. Small value, usually the best group, has been the second worst, -2.5% worse than historic average. Large value, historically the second best group, has under-performed by -5.4%!

Does this mean something fundamental has changed, or will regression to the mean bring things back to average. Both analysis and experience leads me to believe that regression to the mean will occur like it always has, making small growth a poor place to invest and large growth the belle of the ball over the next 5 years.

Will this smooth transition begin the minute I publish this blog? Almost certainly not. And, that's the rub: regression to the mean happens over the long term, not the short term. We don't know when things will regress, only that they almost certainly will.

Will large value greatly out-perform small growth? I don't know how soon or by how much, but I am very comfortable betting it will over time. As always, I've put my money where my mouth (blog?) is.

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.

Better than zero

This seems like a bad time to be an index investor.

The market's impressive return since November is getting investors excited again, so it's time to dampen that euphoria with a realistic look at future returns.

By my estimates, the S&P 500 looks likely to provide a poor return of 3% over the next five years. After inflation, taxes and fees, I think someone investing in or holding an S&P 500 index fund or ETF will be lucky to break even. I doubt many investors expect or want such returns.

I base my estimate on normalized earnings per share of the S&P 500 since 1948, which have grown at a remarkably steady rate of 6% per year over that time.

Add a 2% dividend to that growth, and it seems like you'd get an 8% return. But, you have to keep in mind the price you pay for those earnings and dividends.

Currently, the S&P 500 is trading at around 19 times normalized earnings per share, but the historic average since 1948 is closer to 15 times. Going from 19 to 15 times earnings over the next 5 years would subtract 5% from returns each year, leaving you with the 3% I mentioned above.

Inflation since 1948 was a bit over 3%, not to mention the dent from fees (even low fees of 0.2% will hurt). The end result is a 0% or less annualized, after-inflation return over the next 5 years--not very enticing.

Like all estimates, mine, too, may turn out wrong. The economy may grow less than 6%, especially with the debt and entitlement burdens the U.S. faces (see the work of Reinhart and Rogoff for their take on why GDP growth is likely to slow).  

Inflation may be more or less than I forecast. Dividends could be higher, too. But growth, inflation and dividends are unlikely to be far different than my estimates, meaning the actual result may be a bit higher or lower, but essentially the same.

The multiple to earnings may go much higher or lower on it's way to 15, too. In 2000, it topped out at 37. In 2007, it topped out at 26. Assuming that will happen again and that you can time getting out at that top seems a bit foolish, though.  

On the low end, the earnings multiple could drop below 10, like it did in the late 1940's and mid 1970's to early 1980's. Such lows would mean significantly negative after-inflation returns (which would almost certainly be temporary in nature).  

Like I said above, you can play with the numbers a bit and come out with slightly different outcomes, but the underlying math won't move the meter much. Index investing looks like a poor option from here.

What are the alternatives? Bond yields are dismally low, and a spike in inflation would quickly eliminate that yield. Commodities (including gold) may continue to soar, but a hard landing in China's economy seems a distinct possibility, and could easily gut that return overnight. Real estate may be coming back, but the high returns seen from the 1970's to mid 2000's will not return.

What's left?  For me, stock picking seems to provide the best answer (not surprisingly, I'm talking my own book, here). Some of the companies in the S&P 500 will thrive and some will dive, and successfully picking the thrivers could generate acceptable, though not outstanding, returns over the next five years.  

Buying companies at 10 times earnings that, on average, grow at 6% a year and pay dividends of 3% provides a return of 9%, even with no multiple expansion to the 15 average seen historically (which would obviously increase returns). Taking away 3% inflation and management fees of 1.5% gives a 4.5% pretax return. This may not make you salivate with greed, but it would mean your money would grow by 25% in real value over the next 5 years instead of shrinking.  

There are no guarantees such an outcome will occur, but I feel quite comfortable putting my money into situations with that type of underlying math.  

Index investing may have low fees, but low fees on no return seems like a poor deal 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.

Stock picking: not dead, yet

In my most recent client letter, I had a section about the death of stock picking.

I highlighted that correlations between stocks within the S&P 500 have been very high with the index itself, particularly since late 2007.  

This means it's been very hard to pick stocks that beat the index, because if almost all the individual stocks in an index march in lock-step, it's going to be very hard to beat the index.

There's been a lot of speculation about why high correlations occurred. One theory is that Exchange Traded Funds (ETFs) have taken over for individual stocks as the investment vehicle of choice. Another theory is that high-frequency traders have caused all stocks to trade together. Still another is that markets have been moving in sync because everyone is scared out of their wits since markets and economies started tanking in 2008.

None of these explanations seem satisfactory.  

If ETFs were the cause, then wouldn't stocks have marched in lock-step with the advent of the index fund, or highly diversified mutual funds? No, that didn't really happen.

How about high-frequency traders? If that were ultimate cause, then each advent of new, faster trading technology or smaller decimal trading would coincide with higher correlations. Again, not so much.

As for the fact that everyone is scared? Is that really new? Does anyone really think that recent events are scarier than World War I, Spanish Flu, a world-wide Great Depression, World War II, the threat of nuclear annihilation, or Boy George?  

If markets didn't become and stay correlated at those points, why would we expect them to have done so now?

And, that was the point I tried to make in my client letter: that high correlations are not that unusual, and they have always ended as abruptly as they've begun.  

Lo and behold, correlations of stocks within the S&P 500 tanked in January and my clients beat the market by 4% (on an absolute, not annualized, basis) that month.

Did something suddenly change? Did Europe's problems go away? Did the U.S. fix its government debt? Did Japan's economy recover? Has China avoided a hard landing? No, no, no, and no.

Were ETFs eliminated? Did high-frequency traders all go on vacation? Are people no longer scared? No, no and no.

So, why the change? I don't know, and I don't really care.  

Successful investing isn't about reading tea-leaves and guessing future turns in the market, it's about investing in individual businesses that you understand at low prices and then holding until short-term-oriented investors recognize underlying value.

The attempt to explain and predict crowd psychology has been--and always will be--a dead-end.

Will correlations stay low? I have no idea about the short term, but I'm certain high correlations will come and go over time. Will my clients and I retain our gains?  Again, I don't really know.

But, that's no barrier to long term investment success.

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.

Avoiding Blow-Ups

Everyone loves a big winner. The problem is: most don't focus enough on the odds of winning big.  

In baseball, a batter who swings from his heels and knocks it out of the park is considered a hero. In football, a 50 yard Hail-Mary pass that ends in a touchdown is called miraculous.  In basketball, a wild three-point shot that wins the game is considered stellar. But, what are the odds of those outcomes? Sport statisticians know the numbers, and most complain about the show-boats who pull such stunts. Why? Because they know that the odds are terrible, and that it doesn't consistently win games.

Why do people dwell on big wins? Because huge victories are vivid--everyone can imagine themselves as the star. And, big wins seem much easier than hard work over many years.  Who wants to slog away in obscurity for years hitting singles? Most people don't--they want home-runs!

When it comes to investing, this attitude is extremely unproductive. Instead of trying to get steady returns over time, investors eagerly gamble their hard-earned savings hoping they can score a big win. 

With investing, as with many other things, this just doesn't work. If you don't beleive me, examine the record of Warren Buffett, or almost any other billionaire. You won't find that they "invested" in a lottery ticket or bought Apple stock.  

Most investors, unfortunately, seem to think that swinging from their heels is how you win, and they invest accordingly. Their results illustrate the failure of such an approach.

As contrast, look at Buffett's two rules of investing:

• Rule #1: don't lose money
• Rule #2: never forget rule #1

Anything in there about making a big gamble and aiming for a big score? Nope.

Why the boring approach of avoiding losses? Because it works. Show-boating doesn't win in sports, buying lottery tickets doesn't lead to happiness, and investing in "winners" that are "certain" to go up a lot doesn't generate enviable investment results.

Why not pick winners? Because that's what tons of other people are trying to do, and companies perceived as winners have stock prices that reflect investors' generally high opinion. The high competition in picking winners makes it a losers game.

There's not a lot of competition, however, in picking companies that are considered losers. Not surprisingly, this means the odds of good outcomes from investing in supposed "losers" are much better. There is a risk, of course, of investing in the unloved: they may turn out to really be losers.  

And that is why Buffett and so many other value investors focus on avoiding blow-ups. If you buy something that tanks, it will pull you down more than your winners will pull you up. If you can do everything in your power to avoid such blow-ups, your returns will be good--perhaps very good.

How can you minimize the risk of blow-ups? I've found there are two keys:

1. Avoid blow-up situations
2. Don't pay too much for a company

Blow-up situations can be due to financial problems. If a company finances its operations with too much debt, it can go bankrupt and its stock can get wiped out. If a company needs funding and it can't get it--even temporarily--lenders may end up owning the company and you'll own a worthless stock. This means avoid companies that may have leverage or liquidity problems.

Blow-ups situations also occur for business reasons. Most buggy whip makers were toast as soon as Ford's cars were a success.  Technological obsolescence can kill a business seemingly overnight. A major change in end markets, like people getting their information from the Internet instead of newspapers, can kill a business, too. Supply can dry up. Regulations can alter the landscape forever. Competition can steam-roll weak players. Business risk is the hardest to assess, but one of the most frequent causes of blow-ups. You have to do a lot of research to assess this risk.

Management is another cause of blow-ups. They can do it with fraud, like Enron or Worldcom; or they can do it with incompetence, like Kodak; or they can do it with bad capital allocation, like Tyco. Management risk may seem harder to judge than business risk, but I find it's much easier to detect. Evasive management is one thing to look for. Another is inconsistency in measuring their own performance: one quarter it's sales, then next its market share, the next its customer satisfaction.

Doing everything you can to avoid blow-ups is crucial, but not enough. Sometimes, unpredictable things happen: hurricanes hit, earthquakes occur, sound businesses turn out to be unsound because of new technology that no one saw coming.  If you invest assuming you know everything, you'll get burned. Acknowledge, from the get-go, that you're not omniscient, and pay a low price for your investments.

Paying a low price protects you in two ways. First, if a company turns out to be a blow up, you'll do less damage if you paid a low price. Second, you'll earn much better returns on the companies that don't blow up--because you paid a lower price--and that will allow your winners to make up for your infrequent and low-loss losers.

Investing success comes from putting the odds in your favor, and using the right approach. Don't try to swing for the fences. Instead, avoid picking losers and don't pay too high a price.

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's in a name?

Quick quiz. Would you prefer to work with a: 1) financial planner, 2) investment planner, 3) money manager, or 4) wealth manager?

If you feel like I just asked if you like: 1) pizza, 2) pizza, 3) pizza or 4) pizza, you are not alone. The financial intermediaries who claim to be these things can't keep it straight, so no one should expect clients to, either.

In a recent study by Cerulli Associates, Inc., 1,500 financial intermediaries were found to mis-identify themselves as something they weren't, frequently exaggerating the services they offer.

According to the study, 59% of financial intermediaries identified themselves as financial planners--certified to work with clients in building comprehensive plans that include insurance and estate planning. Cerulli's study, however, found that only 30% of those 59% actually fit that description.

22% of financial intermediaries called themselves investment planners, who focus on asset management, retirement and college savings plans. 56% of the survey's respondents actually fit that description, which makes it sound like a lot of investment planners try to pull themselves off as financial planners.

11% described themselves as wealth managers, who do comprehensive planning for wealthier clients, but only 6% actually fit the description. Once again, it sounds like an inflated title is used in hopes of generating business.

It turns out that money managers, who manage and build investment portfolios (that's what I am), were the only group that accurately described what they do. Apparently, they knew what they were and weren't afraid to describe themselves as such.

I must admit, I've run into this confusion a lot with clients, prospective clients, and even friends and family. Someone asks what I do, and I describe that I manage money for people.  Then, they say, "So, you're a financial planner," or "So, you're a stock broker." I don't blame them for the confusion, but I do blame my industry.

There are a lot of honest people in the financial services business, but it doesn't seem like a large majority. Specifically, a culture exists that focuses on commission-based sales, and convincing people to purchase "products." An old industry adage is that insurance products aren't bought, they're sold. Looking at how most financial intermediaries are compensated, you'll see that the adage is all too true.

I'm highlighting this not just to pat myself and other money managers on the back (whoopee, I'm on Team Honest!), but to illustrate how the financial services industry seems to thrive while confusing clients.  

A helpful term to look for is fiduciary.  A fiduciary "must act for the benefit of their clients and place their clients' interests before their own" (CFA Standards of Practice Handbook).  

When you go to a Ford dealership, you don't expect a commission-based salesperson to recommend a Toyota, but when you are talking to a doctor, lawyer or another professional, you should expect them to treat you fairly.

When dealing with a professional, you are placing yourself in a position of trust with someone who is an expert in a field where you aren't.  It would be unfair, and frequently illegal, if the professional used that position of trust to benefit themselves at your expense.  That is why so many legitimate professional organizations require members to adhere to a code of ethics (and will boot you if you don't!).

When a so-called financial planner earns a 5% commission (yes, on the gross amount of the dollars you invest) because you invest in the mutual fund they recommend, that's not adhering to a fiduciary standard.  When an insurance agent earns a 10% commission selling you a whole life insurance policy or variable annuity, it should be clear their supposed advice is tainted by a big conflict of interest.

The best way to protect yourself, whether you're dealing with someone who claims to be fiduciary or not, is to ask how they are compensated.  That should make it clear whether they are serving themselves first, or you.

What's in a name?  It turns out, a lot.  

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.

Caveman brain and variable cycles

Almost everyone claims to be a long term investor, but few truly are.

A person's real attitude toward investing only becomes obvious with time.  One person initiates an investment approach and sticks to it for 20 years, while another switches after it doesn't "work" over three.  The result is almost always good performance for the person who sticks to one approach, and terrible results for the person who changes course every three years.

In my opinion, the cause of this short-term-orientation is twofold.  

First, human psychology really does a number on us.  Our caveman brain evolved to handle different problems.  You don't need more than three years of data to decide whether you should run from a hungry lion or a pack of wolves.  But, hunter-gatherers and farmers need to think longer-range to survive.  Unusually bad winters and poor rainy seasons don't happen every year, but when they do, you'd better have enough food and clothing stored, or you won't survive.  On an evolutionary time-scale, this thinking is pretty new to us.  As a result, we make lots of mistakes when our caveman emotions take over from our long-range, reasoning mind.

I'm as prone to this difficulty as everyone else, much to my distaste.  My biggest investing mistakes are seldom a refusal to sell something bad, but impatiently selling something too soon.  I, too, have suffered from short-term-orientation with investments that weren't "working," only to see them take off shortly after selling.  

I sold Berkshire Hathaway in November 2009 (having held it for 3 1/2 years) shortly after Buffett bought the Burlington Northern Santa Fe railroad.  Buffett was clearly signaling that his company would never grow like it had in the past.  The stock then jumped 21% in four months.  I was right about underlying growth, but wrong to have sold at a low price to fundamentals.

I sold UnitedHealth in November 2010 (3 1/2 year holding, also) after company management had repeatedly described how new health care legislation could rapidly change their business model.  The stock proceeded to climb 44% in the eight months after I sold.  Once again, I was right on the fundamentals of the business, but wrong on the decision to sell when price to fundamentals were still too low.

My purpose in giving these examples is not to highlight what a moron I am (I've actually gotten many more right than wrong--no really!), but to illustrate that even someone aware of the psychological traps of investing can still fall into them.  The solution is better process, which is fertilized with a thorough, rational analysis of past mistakes.

The second reason I think short-term-orientation sets in has to do with the fundamental nature of investing and business cycles, which are wildly variable in amplitude and duration.  Just as you can't decide the quality of farmland without considering weather cycles, so you can't decide what's going on with an investment without considering investing and business cycles--and that makes analyses more difficult.  

Investing cycles are caused by the boom and bust mentality of investors.  One year investors eagerly pay 20x earnings for an investment, and another year they won't pay 5x.  This boom-bust cycle is caused by the psychology of investors as a herd.  They go from euphoria to terror and back again over time, and no one can predict how long the cycle takes or when it will reach its zenith or nadir.

Business cycles, which are less psychological than investing cycles, are caused by a variety of things (including government policy, fads and fashions, competitive dynamics, just to name a few).  Like investing cycles, business cycles follow unpredictable paths that can distort the information investors need to make good decisions.  A rational analysis of long-term sales and margins over the full cycle is required, as is an in-depth analysis of industry and company dynamics.  Is a downward cycle permanent, or temporary?  Has a paradigm shift occurred that makes the business model defunct?  Only time will tell.

Investors generally have a hard time handling investing and business cycles.  Its easy to panic and "throw in the towel" when the future is unknown, but it rarely generates good investment returns.  People would love to know if their investment approach is working by seeing results right away, but the world is too complicated to say one, three or even five years of data are enough.  It depends, and each cycle is different than the last.  It's more constructive to look at long data samples, but few have the patience or desire for such work.

Given that, what's the solution?  

First, you'll only stick to an approach over the long run if you really--deep down--know it works.  If you've looked at the long term data, you'll know that value investing crushes growth investing over the long term.  If you spend enough time picking the right approach (or the right manager), it's possible to ride through periods of under-performance that can last as long as a decade.  If not, you'll panic and abandon ship at just the wrong time.

Second, you'll have to do battle with your psychology.  You will feel emotions when your investments tank.  You will want to throw in the towel when something isn't working for several years.  Be ready to fight your emotions with reason, data, analysis, or whatever else helps you.  I've found temporary distraction works, as does exercise, deep breathing, meditation, reading.  Do what you must to hold emotion at bay and focus on the facts.  Only then will you stick to your approach.

Our caveman brain and variable cycles make sticking to an investment approach very difficult, but not impossible.  The rewards, however, are truly extraordinary and well worth the time, effort and intermittent anxiety.  

Find the right approach, and stick to 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.

Big bad banks?

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years.  Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn't together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

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.

Five year snap-back

Each quarter, Barron's publishes how mutual funds performed by sector.  Sectors in this case refers to how mutual funds are categorized, like funds invested in large, mid-size or small companies, growth or value, bonds, international, gold, real estate, science and technology, etc.

I find this information interesting not because I think quarterly or annual performance is meaningful--it's not.  You have to look at much longer periods, like five or ten years, to get meaningful information, and Barron's publishes that as well.

And, here's where things get interesting.  If a particular sector has done well over the last five years, does that mean it is likely to continue to do so going forward?  Not at all.  In fact, a good case can be made that the sectors that do best over the last five years are seldom if ever the one's that do best over the following five years.

And, that's what I look for in Barron's tables.  I look for the sectors that have done best and worst over the last five years because the best will likely become worst and the worst will likely become best.

The analysis isn't quite that simple, of course (nothing worthwhile in life is that easy), but some interesting data points can be gathered that might prove useful in guessing about the future.

For instance, the best performing sector over the last five years was precious metals (8.09% annualized).  That's not at all surprising given that gold and silver have been on a tear over the last decade.  Will it be best going forward?  I doubt it.  I'd guess precious metals will continue to do well for a few more years and then tank.  Good luck trying to jump off the elevator before it plummets.

What else has done well?  If you guessed U.S. Treasuries, good for you.  They were the second best performing sector out of 103 sectors(!) with an annualized five year return of 6.99%.  If you think that one will be the best performing over the next five or ten years, please don't operate heavy machinery.

The absolute worst sector was short bias funds with a -16.61% annualized return.  It's almost impossible to make money, long term, by going short all the time.  If the world falls apart, short bias funds will perform best over the next five years.  But, then again, you have to wonder whether property rights will be enforced or if the dollars you withdraw will be worth anything.

The Japanese stock market was the next worst sector, with a -13.27% return.  I'd guess that Japan is a very good candidate for a turn-around, but they culturally seem to scorn shareholders so I personally hesitate.  Unlike short-bias funds, I think this one has a good chance of looking brilliant in five or ten years.

The third worst was financial services (-11.09% annualized).  The crash and recovery from 2008 to 2009 makes that unsurprising, and a very likely candidate to out-perform over the next five years.  Like Japan, it has the clear ability to turn around, and everyone hates it, so it's a great contrarian bet.

After looking at the best and worst stand-outs, I look at small versus large and value versus growth.  Anyone who has studied finance knows that, over the long run, small beats large and value beats growth.  The support and records behind that, both theoretically and empirically, are so strong and long that there is very little reason to believe it will change going forward.

However, the long term record also shows that small doesn't--each and every year--beat large, and value doesn't always beat growth.  In fact, long periods of time go by where just the opposite happens.  Such periods are usually followed by a snap-back to historic averages--and profit-making opportunities.

The last five years are very interesting along this dimension, because growth has crushed value and small has beaten large by a much larger margin than is historically usual.  This leads me to believe (and has for several frustrating years now) that value will greatly out-perform growth over the next five years and large will greatly out-perform small.

I'll admit that I don't invest with this approach as my starting point: I don't examine the Barron's tables and then go do research accordingly.  Quite the opposite, the Barron's tables simply verify what I've been seeing in my bottom-up (security by security) research--that precious metals and U.S. Treasuries look very expensive, and that Japan and financials look very cheap.  It also confirms my experience that large companies seem to have much better return prospects than small, and that value looks much better than growth.

Barron's report of five year performance isn't a magic crystal ball, but it does provide some interesting information.  I think we're likely to see a five year snap-back, and my fundamental research confirms that assessment.

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

A bird in the hand is worth two in the bush

Generally, investors are an optimistic lot. They tend to expect next year will be better than the last one. They tend to over-estimate their abilities. They tend to mistake luck for skill.

Investors are people, after all, and people tend to be over-confident. For proof, simply look at the success of lotteries. The odds are terrible, but the potential payout is huge, so people generally love to play.  

If you ask a lottery player what chance others have of winning, and what chance they themselves have of winning, you'll almost always get two different answers. "I am special," they seem to say, "and I will prevail over the odds."

As far as evolution goes, this is a great attitude to have. Pessimists make lousy leaders, are chronically unhappy, and don't tend to do what is necessary to succeed. Optimists, in contrast, tend to be better leaders, happier, and more confident in doing what they need to succeed.

When it comes to investing, though, the evolutionary program doesn't work very well.  

Investing is basically a contest with other people--not a contest with nature. The goal is not just to pick winners, but to pick winners before other people do. Seeing that Apple has succeeded doesn't do you any good, you have to have seen it before others and acted on that conviction to benefit.

This is why optimists tend to make lousy investors. They invest boldly because they are so sure of themselves. Unfortunately, they are not alone, and investment prices reflect the over-confidence of so many optimists investing boldly.

Optimists assume that high growth will continue. They assume they know more than others. They assume the distant future will look like the recent past. Unfortunately for them, it seldom does.

This attitude isn't just reflected in the actions of individuals, but in their investment advisers, too. People tend to choose optimistic advisers. They want someone who confidently and boldly predicts good things will happen. They don't really want a straight-shooter, they want a leader who they believe will take them to new heights. 

This compounds the problem, because even pessimists tend to prefer optimists as advisers. That leaves even fewer pessimists doing the actual investing, thus causing prices to over-reflect the optimistic attitude.

So, why do pessimists make better investors? Because, unlike optimists, pessimists tend to under-estimate their abilities, they tend to think things will get worse, they tend to mistake skill for luck. Instead of investing in "high potential growth," they tend to invest in actual performance.

A bird in the hand is worth two in the bush. The performance that has actually occurred is worth more than the potential that hasn't. High growth always slows over time, and low or negative growth almost always improves more than expected.

The pessimist invests in the bird in the hand instead of hoping for two in the bush. It rarely turns out there are two in the bush, and even when there are, they are almost impossible to catch.

The pessimist tends to generate better investment results because he isn't over-confident.  He doesn't invest in potential, but in the actual. Being unsure of his ability to predict the future, he doesn't try. The pessimist ends up selecting investments that optimists hate, and thus pays a very low price for it. 

What happens going forward? The optimist ends up paying a high price and finds out the future isn't quite as good as he confidently predicted. The pessimist ends up paying a low price and finds out the future isn't quite as bad as he worried. The optimist's investment tanks on disappointment; the pessimist's investment rallies when things turn out less bad than most predicted.

This process is so counter-intuitive that few follow it. Who brags they invested in a near-dead company? Who loves to brag that they invested in Apple? It's human nature, right?  

To get better results, though, you need to be a bit more skeptical. You need to worry that potential growth will falter, to question your confidence, or to find someone more paranoid than you to do the worrying for you.

It may sound counter-intuitive, but it works. When it comes to investing, hope is foul language. 

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 eyes on China

Most investors are focused on Europe, but they should be focused on China instead, because what happens in China is likely to have a greater impact than what happens anywhere else.

There are many candidates for focus next year.  The one that makes all the headlines is, of course, Europe. Its economy, as a whole, is still the largest in the world, after all. If that economy collapsed, or the European Union came apart, or the currency union changed dramatically, then it would, without doubt, impact the global economy. But, a lot of what's happening in Europe is already discounted in market prices. News on the front page is rarely a big mover of markets because markets anticipate change more than react to it. And, although Europe's economy is large, it doesn't contribute much to global growth. There's a small chance that Europe is the big mover of markets next year, but I doubt it will be.

Japan is a dark horse that may have a big impact on the global economy next year. Its economy is still #4 behind Europe, the U.S. and China, but hasn't grown in 22 years. The issue from Japan isn't earthquakes or tsunamis, but debt. Japan is the most indebted country in the world if you compare its overall debt to the size of its economy. The amazing thing is that they pay the lowest interest rates in the world on that debt. The reason rates are so low is that the Japanese are so willing (and compelled) to buy Japanese government debt. When retirees start to outnumber savers, though, Japan will have to start raising debt at much higher interest rates. If markets start to anticipate that inevitable transition next year, Japan could be the big mover of markets. I doubt it will be, though, because I don't think that crisis will come to a head for another couple of years.

The Middle East is, as always, another dark horse that could greatly impact global markets. Although the Arab Spring is making the headlines, the greater concern involves ancient rivalries between Arabs and Persians, and between Iran and Israel. If Iran succeeds in creating unrest between Shia and Sunni on the Arabian Peninsula, or if Israel becomes increasingly worried about and takes action regarding Iran's nuclear program, then oil prices will rocket and the global economy will tank. Like Japan's issues, these are unlikely to come to a head next year. But, unlike Japan's issues, the Middle East is unlikely to face an inevitable conclusion in the short to intermediate term.

The good old U.S. of A. is another place to focus next year. It's an election year, so many both inside and outside North America will be curious to see how our political field changes and how that could impact the global economy. The U.S. economy is huge, but is growing so slowly that it has less impact on the global economy than it did five or ten years ago. In my opinion, our political transition is unlikely to change things much, so I doubt it'll have a big impact on markets. Not only is Congress unlikely to tackle our debt issues during an election year, but the Fed is also running low on monetary ammunition.

China, I think, is the most likely candidate to move markets next year. It is both the world's 3rd largest economy and the fastest growing. It is also the biggest supplier of goods to Europe and the U.S., the 1st and 2nd largest economies. It has a huge impact on emerging market growth, too, because so many emerging economies supply China with the raw materials and other inputs that fuel their manufacturing powerhouse. In 2013, China is going to go through a major political change (every 5 years, there's a major changing of the guard) that's likely to be anticipated by markets in 2012. At the same time, China is trying to tamp down high inflation and an overly-exuberant real estate market. Add all these factors together with a bunch of global investors over-focused on Europe, and you have a high probability that China is the one moving markets next year.

I'm not alone in doing this, but I'm watching with great interest what happens to oil and copper prices and on the Shanghai Stock Exchange. Oil futures (which are high, but not outrageously so) seem to be reflecting concerns in the Middle East more than growth in China or emerging markets. Copper has fallen over 20% since last spring, but has not yet declined to global recessionary levels. Shanghai, like copper, has been falling since spring, and is down at levels last seen in the spring of 2009, when U.S. markets were hitting bottom.  

I don't really know what will happen in markets next year, but I'm watching China with greater interest than Europe. If China tanks, the world economy will follow; if China thrives, markets are likely to do much better than expected. 

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.