Monday, December 30, 2013

Exceeding Expectations..

In past commentary, I’ve shared the proverbial description of the manic-depressive “Mr. Market”.  There are times when Mr. Market is depressed and he fears that things are not only bad, but they probably will get even worse. These are times when market prices are well below “fair value”.  Then there are times when Mr. Market is euphoric and is convinced that things are not only good, but likely to improve a lot.  These are times when market prices are well above “fair value”.

I warned back in May that it looked like Mr. Market was hopelessly euphoric and over optimistic in 2013. After a brief period in the summer and before the government shutdown, Mr. Market became a little less optimistic, but by the end of the year he again was back in that “Happy Days are Here Again” mood.

Let’s say from a “average” market index point of view, the market certainly exceeded expectations in 2013. This is not a bad thing.  But it is a bad thing if you catch Mr. Market’s disease.

Do not judge the value of your investments by one or two stock only market indexes like the S&P500 or the Dow Jones Industrial Average. The true value of your investments is based on the future income from interest or dividends and long term capital appreciation that your investments produce because of that future income. And, for stocks, that future income is all about how much profit the company can achieve. And here’s where it gets confusing…the value from long term capital appreciation has little to do with the stock market index daily quotations or fortune telling future predictions from market pundits on TV. In fact, one could argue that the long term future appreciation of your investments is actually negatively affected by markets that exceed expectations because of Mr. Market’s manic euphoria.  Risk is actually higher as prices rise.

You can always tell when Mr. Market is crazy on the optimistic side.  In the daily flood of news, there is always good news and bad news.  You can tell when Mr. Market is crazy on the optimistic side because the headlines tend to ignore the bad news and overemphasize the good news.

For example.  Recent news tells us that the economy grew faster than expected in the third quarter of 2013.  What few focused on was that most of the unexpected growth came because of increasing inventories and decreasing imports.  You see, business activity can increase if companies produce more than they sell---but only for a short period of time. Then they have to cut back. And, the way that GDP is calculated causes GDP to rise if imports go down relative to exports. But if exports stay the same and imports decline, it means that demand is actually declining. The media and pundits took the report to mean that the “economy is recovering”.  My take on the GDP report indicates caution in regards to future business activity and profits.

Another example.  Even though home sales are down, new building permits are up. The media and pundits took the report to mean the housing market is recovering. My take is declining sales is always an indication that caution is advised.

Another caution.  A great deal of the market’s rise for “hot” stocks is fueled with borrowed money. As I wrote in past commentary, Margin Loan activity is near record highs. That is always an indication that caution is advised.

Another caution. Markets are a pure auction. Around 50% of the participants think the market price will rise, so they are buyers.  Around 50% of the participants think the market price will fall, so they are sellers.  All it takes is for a very small percentage change toward buyers and prices rise.  These short term movements have little to do with known changes in future income—they are mostly based on “hunches” and “sentiment”.  Sadly, this “sentiment” is almost always wrong—history teaches that going against it tends to be more profitable that joining in with the crowd.

Another caution. Normally there is a lot of “tax selling” at the end of the year. Investors tend to sell their losers and offset the losses by selling some of their winners.  There has been a lower level of that activity this year because there has been fewer than normal “losers”. There is a significant risk that sellers engaged in “profit taking” after the beginning of the year may cause a stock market drop.

There are those that will tell you that the market always predicts the future rationally. My take is that statement is wrong.  The stock market does focus on the future, but it is seldom rational.  Mr. Market has a bad case of Manic-Depressive Syndrome. Mr. Market tends to see the future as he would like it to be. And, a rising market simply makes him think he is “smart” until he wakes up some day and becomes afraid that he has been wrong.

I am not being a pessimist. My opinion is that the economy seems to be recovering, albeit slowly and I’m quite optimistic about stocks—in the long run.  For those who already own a diversified portfolio, it is probably a good time to “hold”.  But most of the popular indexes are significantly overvalued—highly skewed by a few stocks that are ridiculously overvalued.  (Amazon for example has a Price/Earnings Ratio of 1360!)  And, for those with “new” money, I would recommend extreme caution. (If the market fell by 15%, I would probably be recommending a lot of buying.)

One way to explain my point is to think of investing as an ocean voyage.  At sea, one can always expect bad weather and big waves. A good ship is designed to take it.  So, think of a diversified portfolio of good quality investments as a super tanker in deep water, far from shore—properly captained, even bad storms are not too much of a risk.  But think of a portfolio with a lot of “new” money—coming out of a CD for example---as that same ship in harbor. Going to sea, leaving the relatively shallow harbor and attempting to navigate narrow channels can be risky. A wise captain will be cautious and will be reluctant to go to sea if the weather looks dangerous.

One can never be 100% sure about the weather or short term movements in the market.  Enjoy the relatively pleasant “voyage” in 2013.  But, be aware that we are overdue for bad weather.

Examples 2013 Capital Gain (UP) or Loss (DOWN) YTD:

10 year US Treasuries                DOWN 7.7%

Boeing                                      UP        80%

IBM                                          DOWN  2.7%

ATT                                          UP        4.4%

Caterpillar                                 UP        1.4%

McDonalds                               UP        10%

It has been many years since we last saw a substantial decline in the value of 10 year US Treasuries. These are supposed to be one of the lowest risk investments there is. One should always be careful when stocks are rising at the same time that US Treasuries are falling.  The drop in value of US Treasuries has also ‘exceeded expectations.

Monday, October 28, 2013

Making Sense of Employment Data

Lot's of information is reported regarding "employment".  Data comes from the government's BLS and some private firms like ADP.  There's the "unemployment rate" or the % of people looking for work that can't find it--a figure that can really be misleading as the number of people "looking" for work can change depending on economic conditions and outlook.  To make more sense of the unemployment rate, one must also look at the "labor participation rate" which gives the % of "potentially available" that are actually working. Again, it can be misleading as people retire at different ages.  In addition, people "drop out" when employment conditions are difficult and "return" when finding jobs becomes easier.

Perhaps the most meaningful data is from the BLS and shows the total number of full time jobs. See chart below:

The "take-away" here is that employment is improving, but is still significantly below the 122 million in 2007.   Almost 5 million fewer full time jobs now than in 2007, despite a growing workforce and trillions of dollars spent to "stimulate" the economy.

How this affects markets is that it creates "slack" in the labor market
and depresses labor costs---resulting in higher corporate profits but lower corporate revenues.  This is exactly what were are seeing during this and previous earnings seasons.  My take is that people are having increasing difficulty dealing with existing prices of many products and services, causing demand to be restrained, but because of low costs, corporations are able to increase profits, even with lower than expected sales.

This is not a trend that is sustainable in the long term and is one more reason why I recommend being very selective in what segments and companies to own in your portfolio. I tend to prefer companies that provide "essential" and "necessary" products and services that are less "price sensitive".  Every product and service is subject to declining demand with higher prices or slower economic growth; but some are more sensitive than others. 

Part of the market sees a continuation of corporate earnings growth, primarily because they believe that demand will soon accelerate as we get back to and rise above 2007 levels of employment.
Others see that with present rates of employment growth, those levels will not be seen until 2016 and that this slow rate of growth does not justify current stocks prices for many "hot" segment and stocks.

My "take" is that we should expect growth, but that continued stock price increases will increasingly require corporate profits that grow along with increasing revenue.

Friday, October 25, 2013

Danger Signals—Yellow Light

I am an admirer of Alan Greenspan. But, I am also a bit skeptical of comments by anyone who survives a lifetime career working in the political environment of Washington DC.  Alan has written a new book telling us what he has “learned” during his period of reflection after retirement.  In a recent interview, he made this statement about bubbles: “But a bubble in and of itself doesn't give you a crisis. It's turning out to be bubbles with (debt) leverage." He also said, "If you're looking at the distribution of outcomes, fear is hugely more important than euphoria or greed," Greenspan told CNBC. "Bubbles go up very slowing and then they go bang."

 Admittedly, my career as an economist is not as long or as storied as Alan’s, but I guess Alan and I disagree about the definition of a “bubble”. It is my strong belief that a “bubble” is caused by (debt) leverage.  And, it is the spending of money that people don’t have that creates the fear that ultimately causes the bubble to pop.

Without excessive debt, asset prices can rise significantly, but they seldom crash. Think of a rocket versus an airplane.  Rockets rise rapidly until they run out of fuel—then they crash. Airplanes rise too, but even when they run out of fuel, they can still glide back to the surface.  Bubbles are like rockets and the required rocket fuel is excessive debt.

Everyone pretty well understands that the 2008 crisis was caused by excess debt related to housing. Less well understood is that there are people who speculate in the stock market using borrowed money. It’s called “margin”.

Many people believe the stock market crash of 1929 was caused by excessive margin debt with some borrowing as much as 90% of the stock’s price.  After the crash, the Fed has limited margin to a maximum of 50% of the stock’s price—still a very risky investment strategy.

You will see from the figure that high margin debt rises and falls with the rise and fall of stock markets.  Is it a leading or trailing indicator?   I think it is a leading indicator---people using increasing amounts of money they don’t have to buy stocks causes stock prices to rise beyond the “reasonable” price that a “cash” buyer would pay based on the investment value of the stock. 

Speculators use margin to increase their short term profits—it is leverage—more “lift” with less effort.  But, they know it is risky.  At the slightest sign that prices are falling---they ALL run for the door at the same time, trying to sell and protect their gains or to avoid huge losses.

 Rising margin debt in 2013, fueled by Fed Quantitative Easing pretty much explains the exceptional performance of the S&P500 this year. Prices have now risen beyond the “reasonable” price that a “cash” buyer would pay based on the investment value of the stock for many stocks.   

If you are a “cash” buyer/investor, then it is not necessarily a time to sell, but it is certainly a time where prudence calls for caution when it comes to buying most stocks. (Sort of like 2007 when home prices had risen to a high level because of excess borrowing by buyers spending money that they did not have and could not pay back—not necessarily a time to sell your home, but not a very good time to be buying a new one!) We are currently at record levels of margin debt--every major correction in the past (1929, 2001, 2008)  has been preceded by record levels of margin debt. This time might be different because interest rates are so low, but although history does not repeat itself--it does tend to rhyme. High margin debt is a warning signal to pay attention--there is a potentially dangerous situation forming.

Keep in mind that investors don’t typically own the “market” but rather a unique collection of specific securities. Bubbles tend to cause all stocks to rise, but most of the “froth” shows up in only certain stocks and “hot” sectors.  e.g. Google and Amazon.  Many “solid” companies are still not significantly overvalued and it is likely that quality stocks are still very good long term investments.  (For example, home prices in Las Vegas rose to ridiculous levels and crashed in 2009, but home prices in like York, PA, Texas and Tennessee did not rise or fall as much.)

We do advise clients to hold a higher than average “cash=short term fixed income” balance in anticipation of buying opportunities that present during future market downturns.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Thursday, October 17, 2013

Long Range Strategy Given Present Political Scenario..

With the government shutdown averted, pretty much as expected, with only a short term “truce”, it looks like the “war” in Washington DC is likely to continue for a very long time.  Even if Republicans win the Senate in 2014 by gaining several seats, no faction will have the 60-75% majority needed to make major changes.  Gridlock and continued “drama” is likely until the next Presidential election in 2016. (Elections do have consequences!)

Everybody knows that deficits and our long term debt levels, along with ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) by the Fed are not sustainable in the long run. So far, because of unemployment and a slow growth economy allowing low interest rates, deficits and debt have been easy to bear. The question is: How long will this last?  And, what comes next?

This link will take you to the governments records of revenue, spending and deficits since 1930.  It is a remarkable picture and provides little hope that deficits will ever end.  It simply appears that the American system of government does not encourage a balanced budget.  Also, there are way too many so called Economists who foolishly argue that Federal Debt as a % of GDP is the only thing that matters—not the total debt per see. Hence, it is likely that the debt will continue to grow. You should know that the White House now predicts that the debt will “level off” at around an enormous 105% of GDP.

Now to put that into perspective, some think that would be like a family with $100,000 of annual income maintaining a debt level of $105,000. So if that family was able to increase their income by 3% to $103,000, using the “maintain the debt level” concept, they would increase their debt by $3,000—spending $3,000 more than their income.   But wait!  GDP is the income of the entire economy and debt is only the Federal Government’s.  If government income is now 20% of GDP, then the National Debt is really 525% of the Federal Government’s income.  So in reality, it’s more like a family with $100,000 of annual income having a debt of $525,000. Using the argument that it is only important to maintain debt as a % of GDP, that 3% increase in debt caused by the $3,000 “deficit” goes entirely to the Federal Government that would then have an a spending rate of 22% of GDP. This is the argument put forth by some Democrats including Austan Goolsbee, former Chief Economist for the Obama Administration--he regularly reinforces this with appearances on CNBC.  Republicans argue that the Federal Government’s share of GDP should remain the same 20%, meaning that over time the debt as a % of GDP actually decreases. The “deficit” in this example would be no more than $600=20% of the GDP increase. And debt as a % of GDP would go down to 102.5% in the one year of the example given here—decreasing each year over time.

This is really what the struggle regarding the debt ceiling was and is all about. No matter what the media says about polls regarding approval ratings and public opinion, those that just want to “get along and go along” are really not doing the country any service. Democrats want the Federal Budget to go up and are comfortable with a lot of debt. They are convinced that higher taxes will solve the problem. Moderate/Traditional Republicans, even those who call themselves "Fiscally Conservative" are OK with the Federal Budget and Debt rising albeit at a slightly slower rate. They are against higher taxes.  Conservatives are demanding that the Federal Budget be restrained with spending AND taxes at somewhere around 18-20% of GDP--This would actually result in taxes  slightly higher than they are today. The present stalemate with big deficits and rapidly rising debt is a very serious threat to our future prosperity. The argument supporting high debt levels (100% of GDP) is like the assumption made by borrowers and lenders that led to the 2008 Financial Crisis—that nothing bad would happen unexpectedly and that incomes would rise steadily. (The assumption that a person with $100,000 income could carry a $525,000 mortgage----Certainly possible as long as they don’t lose their job or get sick and as long as their income rises over time---and as long as interest rates don't rise too much.)

As an investor, you should hope that the Conservatives continue to argue their position as they at least restrain the other groups to some degree. History teaches that US prosperity requires a Federal Debt as a % of GDP in the range of 30-60%--a substantial reduction from present levels.  Failure to move in this direction will surely lead to slower economic growth due to inflation, substantially increased taxes, or both. Since it is unlikely that this substantial reduction in debt will occur before 2016, it seems wise to prepare your investment portfolio for a slow growth economy with both rising inflation and rising taxes expected--sooner or later. This calls for a conservative strategy of owning a portfolio of high quality stocks—highly diversified by industry and geography, but with a focus on profitable companies that increase their dividends regularly.

We have been focused on risk of recession with resulting deflation for several years. I humbly submit that the risk of slow growth with inflation and rising interest rates along with much higher taxes is the most likely future scenario to prepare for at this time. (Think 1970’s and Jimmy Carter--sort of.)


Wednesday, October 16, 2013

The Real Source of Argument

Important to understand why so much fuss about spending and debt..

This graph is alarming to some....especially since the federal government is still spending 20-25% more than it takes in each year.

At what point does DEBT AS % OF GDP reach crisis levels where interest rates rise causing deficits to increase significantly faster than revenue?  Nobody is quite sure.

Even if budgets were balanced with no more deficits, at an economic GDP growth rate of 3% per year, it would take 24 years of fiscal discipline for the debt to return to "normal" historical levels!

What to do as Shutdown lingers..10/16/2013

Just want to assure our clients that I am paying close attention to the unfolding budget/debt drama and am ready to recommend and take action as necessary and appropriate to manage your investments according our clients’ goals and objectives.   As always, I stand ready to answer questions, process transactions, and put forth best efforts to manage portfolios with the same dedication, diligence, skill and judgment demonstrated over the past several years.

You will recall my repeated observation that investors always have one of three choices in response to external factors—buy, sell or hold. Hold is another word for “do nothing” or “stay the course”.  Since 2011 you will note that I have advised the best course of action is “be cautious” and for the most part “stay the course” during this period of “stormy weather”.  So far, that has proved to be good advice. I firmly believe it is still the right advice today.

Despite the media “hype” and “public despair” and predicted doom from a government “default”, today (10/16/2013) the S&P500 reached a near all time high on “hope” of an uncertain “deal” to end the current crisis. Why is the market up during all this? 

First, markets expect a “kick the can down the road” temporary truce---i.e. more of the same. US Treasuries are still expected to be the most safe and liquid investments in the world—for the most part, competing securities are still seen as more risky. China, Japan, and Germany all need a place to invest the money they earn from exporting to the US—either US Treasuries, US Corporate Bonds, US Real Estate—or US Equities. Actions that make US Treasuries look less attractive may actually make US Equities rise in value.

Second, markets expect that the Fed will “do what it takes” to continue the stimulus needed to inflate stock and real estate prices—i.e. more of the same.

As strange as it may seem, markets like “more of the same”---change or a fear of change is what causes markets to fall.

So what to do?

Since you are a long term investor and not a gambler---no action is recommended to anticipate any deal or lack of a deal. Predicting an uncertain outcome is like picking the winner of a horse race—it is gambling.  Markets could suffer a brief panic and a significant decline (maybe back to early 2013 levels) over an unexpected delay in reaching an “deal” but history teaches they will recover quickly.  In this case, our recommended reaction to a down market would probably be to increase ownership of equities—but let’s wait and see.

P.S. About the politics of all this….

The Media reports that Republicans have lost a lot of support because of this shutdown. Yet, it is doubtful that this will change the outcome of House elections in 2014.  Few regular voters are unhappy with their own representative despite some “throw them all out” polls. The most recent Gallup poll shows the leader of the House (Republican Boehner) and the leader of the Senate (Democrat Reid) tied with a low 27% “favorable” rating. The President seems to have done better, maintaining a 49% “favorable” rating.  There is a philosophical war going on in Washington. It used to be a just a struggle about how Big Government would spend our money along with whether deficits would be funded with increasing taxes or increasing borrowing.  There is now a strong and growing group who want the federal government to get smaller—a lot smaller. (The Tea Party is only a small part of the "we want smaller government" group. The larger and underestimated group is probably the Evangelical Christians that are less vocal but still irritated by the actions of a large "secularized" central government.) They really don't like the traditional Republican program any more than they like the Democrat's program. This group sees the present course of deficit spending leading to a catastrophe and they believe that raising taxes to cut the deficit would also end in catastrophe. (An analogy would be the actions of the passengers on the Titanic if 20% of them had been absolutely sure that the ship was headed for an iceberg.)  I don’t see this group “surrendering” so I would predict continued and perhaps even increasing turmoil in Washington----and I predict that markets will adapt to this new uncertain environment. Perhaps they already have. I also predict that the most likely future is that bond markets will force government spending to be cut and taxes to be raised—this will occur when interest rates rise significantly from present low levels.

Monday, October 7, 2013

Historical Perspective of Washington Dramas

Please keep in mind, that although I do have strong political views about the proper role of the federal government in our lives, my commentary about clients’ investments focus NOT on how politics “should” be, but rather the best strategies for dealing with current political realities.

The present political reality is that we have a government influenced by sharp political differences. And, the electorate has allowed one side to have “veto” power over the other.

One only needs to read the biographies of Alexander Hamilton and George Washington as well as other historical writings to learn that our present situation is not much different from that in 1790 and most of our history as a nation.

Our founding fathers “compromised” to create the system where a 55% majority (53% in the 2012 presidential election.) vote does not give the “winners” the right to force the “losers” to submit.  (Only once in our history did our leaders fail to compromise—when the minority decided to secede and the majority sent an invading army to subdue and conquer them.)  As evidenced by the US Constitution that requires 75% approval for an Constitutional Amendment to pass, generally unless one side controls 66-75% of the electorate—some form of “negotiation” is required for anything of any importance to get done. (Many believe that this protection of the minority from the will of the "mere" majority is what makes us a great country.)

Unfortunately, some negotiators choose confrontation rather than consultation as a strategy. One side makes a demand, and the other states “I will not negotiate”.  In Game Theory, this is called “Chicken” where the loser is the one who gives in first.  It is a proven fact that most mature and rational people hate to “deadlock” or “fail” in a negotiation. But, for some reason, our centralized federal government has always been full of people who believe that when playing Chicken, even if there is a “crash” because of a deadlock, they can still win…in the NEXT ELECTION. (Perhaps we should elect people who are great negotiators rather than great orators and campaigners.)

Both sides of the present argument believe that they can gain control of BOTH the House and Senate in the next election in 2014 if they can paint the other side as “Bad” or the “Most Worse”. Since control of BOTH the House and Senate is a big deal—especially with a lame duck President, expect a very serious fight.  I think the probability is that it will be as big as 2011. Our massive debt and deficits magnify what is at stake.

So let’s see how the threat of default and a “historic” downgrade of US Credit has affected investors:

In June 2011, the S&P500 was at 1345. It fell 18% to 1099 after the deadlock on raising the debt ceiling. It recovered back to 1345 by February of 2012.  Basically, a seven month long headache.  For those that did nothing from June 2011 to February 2012, nothing really changed. 

The negotiation and “settlement” in 2011, set up another confrontation in late 2012---the Fiscal Cliff and Sequestration. The S&P500 peaked at 1465 in September 2012 (falling 8% by December)  but quickly recovered to 1465 by January 2013. The S&P500 reached 1700 in September 2013.  In two years of almost never ending Washington drama, the S&P500 rose 26%.

Trying to profit by selling before the crises and buying at the bottom is not an investment strategy—it is a gambling strategy. Nobody knows exactly what will happen and when. Most of my clients are not gamblers—so other than being conservative and patiently waiting and looking for buying opportunities with surplus cash—my general advice is to simply watch the drama play out.

It is impossible to predict the exact outcome. But, history teaches that markets USUALLY recover remarkably quickly and those that continue to hold a diversified portfolio of good quality investments get wealthier over time.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Thursday, October 3, 2013

When the Press warns of all the bad that MIGHT happen...

My advice is to avoid any anxiety related to the political comedy in Washington DC.  Short term market reactions to the recent “2011 Debt Downgrade” crisis and “2012-2013 Fiscal Cliff and Sequestration” crisis have proven to be overdone—essentially buying opportunities WHEN looking back from a long term perspective. It is impossible to predict the market reaction to the present shutdown and debt ceiling controversy, but the end result is probably that we simply return to the market realities of a long term slow but steady growing economy where inflation begins to become more of a problem.

My greatest fear STILL continues to be real inflation over the longer term and a diversified portfolio of good quality assets is one of the best strategies to address that risk.
Just look at the rising cost of groceries, medicine, health insurance, college tuition; and government reports of low 2% inflation seem laughable. I think fixed income markets are still underestimating inflation risks and bonds continue to look potentially dangerous—an environment that is very different than what we have been used to for twenty plus years.

On the Government Shutdown…

As investors, we should be thankful for politicians who stand by their convictions and struggle against actions they believe result in our sacrificing freedom for security—even when the “majority” condemn them for “causing trouble”.   
Here is some wisdom about the subject spoken nearly 50 years ago during a time of similar struggles regarding the expansion of central government and welfare programs.
“You and I are told we must choose between a left or right, but I suggest there is no such thing as a left or right. There is only an up or down. Up to man's age-old dream--the maximum of individual freedom consistent with order -- or down to the ant heap of totalitarianism. Regardless of their sincerity, their humanitarian motives, those who would sacrifice freedom for security have embarked on this downward path. Plutarch warned, "The real destroyer of the liberties of the people is he who spreads among them bounties, donations and benefits."”
Ronald Reagan  1964 “A Time for Choosing” speech
No matter what your politics…if you are an "investor"....
For those that rely on income from savings, through wise investment and free markets, it is important to remember that success of such investment requires a society that values and protects individual freedom/s and free markets.  Without the ability to earn an income from savings accumulated from past labors, we would ALL become wards of the centralized government, dependent on that government and those who run it for our welfare. other words, no longer “free”.
Being reminded of the importance of “the maximum of individual freedom consistent with order” and the dangers of too many “government bounties, donations and benefits” is the value of having a “loyal opposition” to those who claim to represent the “majority” currently in power. It is necessary protection against excess power--however well meaning.

Friday, August 23, 2013

Mixed Signals

Good news on Thursday 08/22/2013:
European Manufacturing PMI up to 51.7 from 50.5.

Chinese Manufacturing PMI up above 50 for the first time in four months.

US Manufacturing up to 53.9 from 53.5. New Orders now up to 56.5.

Bad News:

Clearly some parts of the economy are doing well while at the same time other parts are doing lousy.   Most retailers are reporting weak sales--except Home Depot and Lowes. Seems like people are spending money for "home improvement" but not much for new clothes and other "stuff".

Rapidly rising interest rates are causing bond portfolios to fall in value. They are causing concerns about less buying of dividend paying stocks. Also, since emerging market economies rely a lot on borrowed money, rising interest rates create a lot of concerns for stocks in emerging market countries--like India and Brazil. Finally the nascent "housing recovery" has stalled with a 13.4% drop in sales of new single family homes in July after mortgage rates reached 4.58%.  Low interest rates have made new housing more affordable, but the pool of buyers get's smaller when interest rates rise and mortgage payments rise by more than $150 per month (on a $200,000 mortgage) because of the recent rise in interest rates.

Take heart---markets always send mixed signals. And, interest rates are still quite low by historical standards.  Growth is never a straight line and is seldom homogeneous across segments. 

It certainly looks like we have a slowly recovering global economy. People may hope and expect that "it's safe now"  (almost like an on-off switch) but reality is always a bit more complicated.  Markets have blown off a bit of their "froth" recently--and may do more of that as fear of rising interest rates becomes more widespread, and as our government argues over fiscal polity, so the "market" still appears to be overpriced. But, opportunities in some segments are starting to present themselves.

Stay focused on the long term, always seek quality in your investments, and don't fall into the trap of the fear/greed "risk on/risk off" foolishness.

Thursday, August 8, 2013

CNBC Article--Quotes from Cramer

I must admit that I'm not a fan of Cramer.  I think he is a wonderful entertainer and a master self-promoter, but I seldom agree with his short term investment advice...however when he begins to talk about real long term investment strategy in retirement accounts, he sometimes spouts genuine wisdom.... Here's an excerpt from a recent article (link to complete article above.)

What should you buy in your IRA?

 "Your best bet here is to own high yielding dividend stocks that provide protection and generate income. The goal here is to be able to reinvest your dividends and let them compound year after year after year without paying any taxes until you withdraw your money at the very end, a terrific recipe for producing huge long-term returns."

Thursday, July 18, 2013

Earnings Season Update

Using a baseball analogy, this critical Q2 earnings season is only in the second inning.  From my point of view, earnings have been disappointing, but the "market" has taken a different view so far...

Here is a link to an article by Sheraz Mian, Director of Research at Zacks:
Q2 Earnings Season Update from Zacks

This is an excerpt:

"There is not much growth outside of Finance, with the composite Q2 earnings growth rate for the S&P 500 (combining the 76 reports that have come out with the 424 still to come) currently at +1.6%. Excluding Finance, the composite Q2 earnings growth for the S&P 500 drops to a decline -3.5%. The Technology sector is a big drag on earnings growth, with total earnings for the sector expected to be down -7.8%."

So in essence, reporting so far has been dominated by the Finance Sector, who not unexpectedly reported good earnings. (A lot of their earnings has to do with estimates of the value of loan portfolios and financial transactions that may be completely independent of corporate profits in other sectors.)  I still think Financials are overpriced and Financials (Banks) is my least favorite sector. Excluding Finance, things have not been so good and several "bellwether" companies have warned of upcoming "headwinds".

Rail traffic growth looks anemic and the AAII Sentiment Index, as well as many other indicators tells me that the North American economy is worse than what the market is indicating.  The global economy is much worse. I am still recommending caution when investing new funds. 

While I think that generally, many people are overvaluing the effect of FED stimulus, the economy seems to be steadily improving--albeit much slower than people would like and much slower than many on Wall Street are currently assuming.  Most companies are struggling to improve top line sales. Companies are running out of cost cutting programs--good for employment, but not as good for the stock market in the medium term.

Of the three possible strategies in the short run---buy, sell or hold...I definitely recommend the "hold" strategy at least for a little while longer as this earning seasons progresses.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Friday, June 21, 2013

Put Things in Perspective

Last month I wrote:  “When it seems too good to be true”.   In that article I explained the reason why I was skeptical of the market’s rise this year, and warned that May 22 and June 20 (options expiration dates) would likely be days with extreme volatility and probable market declines.  May 21 seems to be the peak this year so far (S&P500 at 1669 on 5/21) and June 20 had a very large (2.5%) one day decline (S&P500 at 1588).

The most bewildering part of May-June for many is the fact that fixed income investments declined significantly.  7-10 year US Treasuries actually declined in value by almost 6%.  Those that thought Gold, Silver and Bonds were “safe” have learned otherwise. (Gold is now down more than 30% from it’s peak.)

It should now be apparent why I have been recommending to investors that they overweight their cash holdings. Sometimes there are times when everything except short term money market/cash holdings decline in value. (And, when inflation if considered, there are times when everything, including cash declines in value.)

While all of this up/down can make the average investor a bit nervous, and listening to the financial TV talking heads creates anxiety; It is always important to put things in perspective and realize that this type of market action is really “normal” and beneficial for investors with a long term focus. Even after the 6/20 decline, global stocks are still up more than 15% YOY.

Stock prices rose too high, too fast and interest rates fell too low—Stocks AND Bonds have been overdue for a correction. Couple this with markets finally realizing that the Fed never intended for stimulus to last forever and you get what you’ve seen the last couple of months.

Is this volatility over?  Maybe, but Probably Not.   The S&P500 is only down 5%--normally corrections are bigger.  But, some segments are down more: World Stocks down almost 8%, Utility Stocks down close to 10%.

While the global economy seems to be in a long term slow recovery, short term uncertainty still looms large.  Earning season begins again on July 9 with Alcoa and continues throughout July.  Reported earnings and forward looking “guidance” more than anything else will affect markets.  It always pays to be cautious—so a conservative stance and a modified dollar cost averaging strategy when deploying cash always makes sense in uncertain times.

I am still long term bullish and short term cautious. I think earnings and guidance may disappoint in July and that may turn out to be a very attractive buying opportunity.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk.  Most investing involves costs. A complete analysis of these costs should be undertaken before making any choice. Costs, risks and expected results should all be weighed in the balance.

Tuesday, May 28, 2013

Capital Gains Tax 2013

As you can see, rates vary a lot depending on income. Some investors with less than $72K (married) income pay no capital gains tax. Most investors with income in the $72-$223K range pay 15%.  Over that rates get higher, but in all cases capital gains tax rates are lower than marginal rates on ordinary income.

Source: IRS. Chart provided courtesy of Lord Abbett

Monday, May 20, 2013

Financial Advisor (Broker) or Investment Adviser (Manager) ???? One Insider’s View

Advisor with an “o” or Adviser with an “e”. Is there a difference that matters? One way to evaluate or compare competing models of service is to see how the participants spend their time. The below analysis is based on my personal experience of nine years as a Broker (ending April 2013) and five years as a Investment Adviser. 

Customer Service includes meeting and/or talking and communicating with clients about their investments, opening accounts, processing deposits and withdrawals, etc.  Administration and Compliance includes general administration of running the practice, actions to insure compliance with regulations, and the maintenance of appropriate records.

Sales includes activities related to new client acquisition and solicitations of clients to buy investments.  Investment Review, Selection and Management is time spent evaluating present and potential investments and investment portfolios, macro-economic  circumstances considered,  in order to achieve clients’ goals and objectives.   Here is an estimate of time spent:

                                                 Broker     Investment Adviser

Sales                                         50%             5%

Investment Management          10%             60%

Service                                      20%             20%

Admin                                        20%            15%

Notice the dramatic difference between the two models of financial services. 30% of total time attending to client investments versus 80%!  A Broker generally spends at least 50% of his time selling—most of which (70%) is finding new clients.  (20 sales calls per day is the norm.)   Only 10% of the Broker’s time is normally spent analyzing investments and clients’ investment portfolios. Annual reviews, Seminars, and other client communications are often nothing more than an additional sales opportunity. (One major brokerage firm’s training program stipulates that the Broker should spend even more than 50% of his time selling—urging him to delegate the Service activities to a “Sales Assistant”.)  Usually investments sold are either recommended by the home office or are mutual funds recommended by the fund’s sales force known as a “wholesaler”.  An Investment Manager on the other hand spends only about 5% of his time selling with the bulk of his time analyzing clients’ portfolios and evaluating potential investments that might improve portfolio performance.

The Broker’s income depends primarily on the buying and selling of investments, primarily from new clients. His skill set is persuasion and the ability to accept personal rejection. The Investment Adviser’s income in the long run depends primarily on clients’ satisfaction with the performance of their investment portfolios. Most of his business comes from referrals and sales related activities are therefore minimal. His skill set is research, analysis and problem solving.  

Is one model more "expensive" than the other.  In my opinion, the cost over the long term is not much different.  One difference is that by regulation, the costs dealing with an Investment Adviser are more visible and transparent--there is that fee documented by an invoice each quarter.  Dealing with a Broker, the transaction "confirmation" shows the commission that is sometimes quickly forgotten. And, costs associated with mutual funds are buried inside a prospectus and annual report.  
My experience is the successful Broker and the successful Investment Adviser enjoy about the same amount of income for the same amount of time spent.  I do believe however that it is the client’s best interest to deal with Investment Advisers rather than Brokers. Like children and flowers, investment portfolios usually develop better with more individual attention---this belief and opinion is strong enough that I stopped being a Broker and work solely now as an Investment Adviser/Manager.
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk.  Most investing involves costs. A complete analysis of these costs should be undertaken before making any choice. Costs, risks and expected results should all be weighed in the balance.

Thursday, May 9, 2013

When it seems too good to be true…

The general sense one gets by paying attention to the mainstream and financial media recently is that “Happy Days are Here Again”.  (BTW..The song is probably best remembered as the campaign song for Franklin Delano Roosevelt's successful 1932 presidential campaign. Even though stocks had risen in the summer of 1932, stocks did quite poorly after the 1932 election-- so his emotional appeal was a bit early.) There is no shortage of pundits telling us that “stocks are cheap” and “we are in a bull market”.  Despite bad news about the economy—since it’s not getting worse, according to some it seems to make sense that “it must be getting better”.  And as long as the Fed is pushing QE, markets “have to” go up. (Not true!) It is claimed that based on P/E or price earning ratio’s, stocks are cheap compared to historical averages.  It is claimed that we are a special situation where TINA (There is no other alternative) to stocks because interest rates are so low. Kind of makes one wonder if we are being left behind and the “train is about to leave the station”.

All of these pundits might be right—there is a possibility. But, I am very skeptical. Based on my observations and experience, there is a better than 80% probability they are very wrong. Bull markets do in fact “climb a wall of worry” as new, previously skeptical, buyers enter the market over time. So mixed opinions are normal and healthy. And, although you don’t hear many skeptics on CNBC, just pay attention to the bond markets and cash on the sidelines.  Interest rates are not rising like you would expect in a bull market. The bond market tells us there is a lot of very negative sentiment.

Bull markets are the result of a re-pricing of assets based on expectations of an expanding economy. Rising stock prices almost always are accompanied by rising interest rates caused by an expanding economy. Expanding economies also tend to cause commodity prices to rise—not fall like they have since the first of the year.
In the current situation, we have a slowly recovering economy, but nothing to justify the dramatic rise in stock prices since the first of the year while interest rates continue to be low, taxes have risen, and government spending is falling.   A slowly rising economy should result in a slowly rising stock market.
So what is going on? 
Markets are affected by fundamentals in addition to greed and fear.  While fundamentals are slowly recovering, justifying a steady rise in stock prices over time since 2009, markets have fluctuated significantly based on swings in psychology from extremes of fear and greed.   I believe that there is a high probability that we are at the extreme on the greed scale.

Most people realize that markets today are strongly influenced by institutions and their money managers who use very complicated derivatives that affect markets in ways that are counter-intuitive. (Warren Buffet has said that derivatives are weapons of potential mass destruction.) When traders expect markets to rise (because of QE for example) they buy call options—an option to buy stock later at a fixed price. The seller of the option is now at risk---if stocks rise more than the premium he charged for the option.  To hedge that risk, many option sellers will buy the underlying stock—an action by itself that drives the price up—especially if market volumes are relatively low.  The rising price attracts more gamblers and can sometimes cause prices to rise significantly--until the options expire.  As soon as the options expire, there are no more buyers—only sellers and prices can drop significantly.    

While the gamblers are playing, the rising market can sometimes attract the unsuspecting individual long term investor who history shows tends to buy late and too high.  

Sometimes old fashioned advice is quite valuable. “When others seem greedy—be fearful”…and “When it seems too good to be true—it probably is” should be remembered. I’m currently fearful and skeptical.

BTW—options expire May 17-22 and again June 19-28.  One or both times may turn out to be buying opportunities for the long term investor.  
This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Saturday, April 27, 2013

Alpha, Beta, Sharpe and the Value of Advice and Supervision

When one is considering investment options, it is sometimes difficult to see through the clutter of sometimes conflicting information.  In many financial publications, a buy/hold “passive” approach to investing is promoted. The advice is “Buy an Index Fund—Active Managers never beat the market over the long term”. Or alternatively, “Seek out investments with the lowest fees—fees always reduce your potential return.”

The problem with such advice is that it is wrong—but not completely.  Fees can reduce potential returns—UNLESS the benefits from the activities of the Active Manager exceed the costs. There are many Active Managers who try but never do beat the market—but there are also many “better than average” Active Managers who do in fact provide performance that beats the chosen benchmark, risk management considered.

When choosing investment options, the “right” choice depends on many factors.  Benefits and costs should both be carefully considered and weighed in the balance.

What many people that write for financial publications fail to tell you is that investing needs to consider returns AND risk.

For example, many Active Managers intentionally hold cash in reserve and “trail the market” during a rising market because they are “managing risk” to avoid or reduce the effects of market declines.  And, what people fail to realize is that index funds are a bit like flying on auto pilot—OK when markets are rising—but a bit scary during a stormy market decline.

Generally, the discussion about Active Managers and Index Funds relates to mutual funds—the favored investment for the mass market. But a similar analysis would apply to the more customized approach of a fee-based Investment Adviser managing your own “customized” investment portfolio.  Benefits and costs should both be carefully considered and weighed in the balance.

The tools needed to evaluate the benefits provided by a fee-based Investment Adviser are both quantitative and qualitative:  Is he trustworthy and diligent?  Is he skilled and experienced?  Does he possess the required educational credentials?   The quantitative metrics should be expanded to include measures of performance and risk together rather than just performance. 

The “Big Three” risk/reward or metrics I think are the most useful are: Alpha, Beta and Sharpe Ratio.

Alpha is a measure of performance on a risk-adjusted basis. The excess return of the investment relative to the return of the benchmark index is a fund's alpha.  A positive alpha of 1.0 means portfolio has outperformed its benchmark index by 1%.

Beta is a measure of the volatility. Generally the lower the beta, the lower the risk associated with market fluctuation as compared to the benchmark.

Sharpe Ratio is a measure of return for a given level of risk as compared to the benchmark. When comparing two assets versus a common benchmark, the one with a higher Sharpe ratio provides better return for the same risk (or, equivalently, the same return for lower risk).

Lets do some comparisons:

Vanguard’s unmanaged 500 Index Fund: 124% 10 year return (All stocks); Alpha=0; Beta=1.0; Sharpe Ratio= 0.52   (Worst one year decline was 43%!)

American Funds popular Capital Income Builder (25-40% fixed income):  125% 10 year return (116% with max commission); Alpha=0; Beta=0.67; Sharpe Ratio=0.68. (Less volatility than the index fund, better return vs risk ratio. Worst one year decline was 34%.)

Legg Mason Value: 43% 10 year return (All stocks); Alpha=Negative 5; Beta=1.28; Sharpe Ratio=0.2 (Worst one year decline was 59%!)

So, Capital Income Builder was a good value in that the return was close to the benchmark index with much less risk. Legg Mason’s Value fund was a poor performer—better to have bought the index.

Now, lets look as some “Custom Managed” Portfolio’s:

Highly diversified $1 million + account “conventional” program, composite with “value” orientation (30-35% fixed income): 126% 10 year hypothetical return (116% after fees)  Alpha=0; Beta=0.55; Sharpe Ratio: 0.78. (Less volatility than Capital Income Builder, better return vs risk ratio. Worst one year decline was 27%.)

Highly diversified, actively managed with high intensity, composite with “value” orientation (15-20% fixed income incl cash):  250%+ 10 year hypothetical return after fees; Alpha=6; Beta=0.8; Sharpe Ratio=0.78.  (Less volatility than benchmark index, very high return vs risk ratio. Worst one year decline was 27%.)

So, the Investment Adviser in this case provided his clients with the choice of a lower risk portfolio with returns close to the benchmark index. (Risk management for essentially little or no net cost) Or, at the other end of the spectrum, with higher risk (but still lower than the benchmark index) with returns far in excess of the benchmark.  In this example, the actively managed with high intensity portfolio would have hypothetically grown from $100,000 in 2003 to $350,000 (after fees) in 2013 compared to only $225,000 if invested in the unmanaged index fund or the “better than average” managed mutual fund.   

The value of advice with continuous and regular supervision by an experienced manager?    Certainly more than the cost of the fees in most cases… It depends on who you choose.

Choose your Investment Adviser based on his diligence, investment style and philosophy, education, experience, and judgment. Keep in mind that it’s difficult to judge past performance without looking at more than five year periods of time—and judging probable future performance is more important. Look out the windshield, not the rear view mirror. Choose wisely and you will be well rewarded with good long run returns and peace of mind.