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. 

Cash in your Portfolio-It has a Purpose

Cash, defined as holdings of Money Market Mutual Funds, or short term US Treasuries can be an important part of your investment portfolio, particularly in times of uncertainty.  Unfortunately, the value of this asset class is often misunderstood and underappreciated by the non-professional investor.  Cash is not “lazy money” and the correct understanding of it’s strategic purpose and value is a major part of wealth management.

An investment portfolio is a collection of assets held in an account or group of accounts with the goal of achieving a certain targeted, long term rate of return, with a corresponding level of acceptable risk.  The management of the portfolio involves the selection of an appropriate asset allocation and the selection of individual securities fitting that allocation. Another name for asset allocation is the identification and selection of the appropriate investment categories, classifications, and/or types.

Most people understand simple  types of asset allocation, for example one popular “conservative” allocation is referred to as 60% stocks and 40% fixed income.  However, effective asset allocation involves the assignment of allocations to a much larger list of investment categories.  In other words, even in a simple portfolio, the allocation of stocks involves assignment to domestic, global and international as well as various business sectors, size or capitalization, investment categories like growth and/or value as well as geographical areas. The allocation of fixed income involves assignment to domestic, global, and international, categories like government and corporate as well as maturity dates and credit ratings. It is much more complex than just a certain % of stocks and % of bonds. (Cash is a part of the fixed income allocation with high credit rating and short maturity.) Picking the correct asset allocation has proven to be more important than the actual selection of individual securities in most cases. Academics vary in their opinions with some saying 90% of the return is determined by asset allocation; others claim that securities selection and asset allocation are equally important. In any case, asset allocation, including how much is allocated to Cash at any one time is very important.

Cash is the only asset in the investment portfolio that does not fluctuate in value. (It can decline in value over time if the interest earned does not exceed the rate of inflation.)  Generally, all forms of fixed income investments are thought to be “stable” in value.  However there are periods (like now) when fixed income investments are subject to significant fluctuations in value. An appropriate amount of Cash during these periods becomes even more important.

In addition to its role of providing a stable component of the fixed income part of a portfolio, Cash also is a tool to be used to increase expected returns by buying during periods when markets are undervalued.  The more volatile the market and the more uncertainty there is—generally the more appropriate it is for a higher level of cash.

Rather than getting too deep in the weeds with an academic discussion, let’s examine the use of cash by arguably one of the most successful investors of all time: Warren Buffet.  During the period from 2010 thru 2012, the average amount of “cash” held by Buffet’s Berkshire Hathaway in their “investment portfolio”  has been reported to have ranged from 19-23% of the total portfolio.

The decision to use cash for purchases of securities is particularly critical when new funds are added to the portfolio—now the decision of when to buy in the short term becomes essential and critical to achieving the investment goals for the long term.  Hence,  portfolios with “new” cash will tend to have a higher level of cash for a time.  And, generally,  more mature “fully invested” portfolio’s will tend to have a relatively lower level.  Managing a portfolio is always a matter of making the judgment of Buy, Sell or Hold.  Sometimes in uncertain environments, the status quo or “HOLD” is the best course of action.

It is sometimes difficult to create a truly useful analogy in order to illustrate a point, but in this case I like to remind investors that professionally managing an investment portfolio is very much like being the Captain of an ocean liner.  The sea can be a dangerous place, but reaching the ultimate destination is generally worth the risks.  Sometimes, when he senses danger or uncertainty, a wise Captain decides to run at less than full throttle—maybe a speed of 10 knots instead of 22.  Despite a series of warnings from other ships of drifting ice in the area, the unwise Captain of the infamous Titanic was sailing at maximum speed of 22 knots, in the dark at night, just before hitting the iceberg and sinking. (The Captain of the Titanic was managing performance and was neglecting the important aspect of also managing risk and uncertainty.) Keeping some Cash in the portfolio is a little like running the ship at less than full throttle during periods when the Captain senses there is risk and uncertainty—perhaps that is when he produces the greatest value to the passengers (investors).  

The ocean liner analogy also helps illustrate the value of a higher level of cash being held for a period just after “new” cash is added from a rollover or transfer.  It is well known that ships can handle big waves once “out to sea” but exiting the harbor during a big storm can be particularly dangerous. So, a wise Captain runs the ship a bit slower while in shallow waters near the shore and typically does not run the ship at top speed until it is well out to sea. 

Hopefully we are soon approaching a period of less uncertainty and perhaps lower risk. But we are not there yet.  Be cautious but not too cautious.

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.

It’s not Over ‘til it’s Over

When the dust settled, turns out worries about the Fiscal Cliff and the Mayan 2012 End of the World prediction turned out to be a waste of emotional energy.  Sort of like the Shakespeare play, Much Ado about Nothing.  

At least, so far…..

As expected, Congress and the White House procrastinated and pushed out resolution of many problems into the future.  On the other hand, many issues relating to taxes where resolved with somewhat surprising clarity.

Unless your annual income is higher than $400,000, your incremental income tax rate did not change.  In fact the Bush-era tax rates were permanently extended for everybody making less than $400,000. ($450,000 for married filing jointly)  Taxes due on dividends and capital gains did not change for those making less than $400,000. If you were in the 15% (or lower) income tax bracket, your tax on dividends is still ZERO.  For everybody making less than $400,000, taxes on dividends and long term capital gains remains at the low rate of 15%.  For high income earners (above $400,000/$450,000) the tax rate on dividend and capital gains goes up to a still low 20%. 

Dividend paying stocks still look like a very good deal from an after-tax income point of view---for almost everybody. Look for them to return to popularity after lagging the market in 2012.

Generous 50% bonus depreciation and Sec 179 expensing for equipment was extended thru 2013—still a big incentive for small business to make investments this year.

Estate tax limits were raised to a $5 million exclusion, with the rate increased to 40%. Most folks won’t have to sell the family farm to pay the estate tax.  This exclusion makes the estate tax irrelevant for all but the truly wealthy. It also means that the net amount that people expect to inherit is up---many people will feel more wealthy and hence spend more.

All in all, not a bad “temporary” outcome—and the markets reacted by rising rapidly.

But, as they say,  “Don’t Count your Chicks before they Hatch”— government spending all over the world continues to far exceed tax revenues and the government continues to borrow huge sums, creating an alarmingly high government debt.  Sooner or later this will be resolved by actions that slow the economy or raise inflation—or both. Everybody knows we have a problem—but there is a big argument regarding the solution. Like Yogi Berra said, “It’s ain’t over til it’s over”.  And, the press is likely to hype every event as the process and political fight moves along.  Emotions of fear and greed will alternate back and forth as usual.

Markets were oversold in December and moved quickly to perhaps an overbought condition today. (With many notable exceptions for individual securities and some sectors.) At some point, expect a correction, but it impossible to predict when.

Be prepared for continued volatility.  Stay focused on the long term as everyone else seems to be focused on the short term.   Be cautious, but not too cautious.

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.

As a service to my clients, links to articles that go with the headlines are available at my “with permission only” Twitter site: @waynestrout https://twitter.com/waynestrout When encountering any comments there thought to be political, please consider I am a politically conservative Independent. I believe in small government strong enough to protect individual liberty and active enough to promote general prosperity; personal responsibility and personal liberty; a strong defense but with a reluctance to make war; and a compassionate Christian based (Love thy Neighbor) charity toward the disadvantaged.

Ignoring the Good News?

When headlines and commentary from main stream media seems obsessed with the negative and sensational---“falling off the fiscal cliff” and “collapse of Europe” for example, a careful review of all sources of NEWS gives a different picture with headlines from different sources:

11/9 “Wholesale sales up in USA more than 4.4% YOY”

11/21 “HSBC China PMI at 13-month high of 50.4 in Nov”

11/21 “Housing starts in America rose by 3.6% to 894,000 in October, the highest in over four years”

11/22 “Mark Hulbert: Insider behavior points to imminent rally”

11/29 “World Economy in Best Shape for 18 Months, Poll Shows”

11/30 “Corporate Profits highest in History”

Link to FRED

As I’ve indicated previously, be prepared for markets to move up and down a lot as headlines focus on comments from political figures prognosticating about the Fiscal Cliff and the European Economy.  But also as I’ve mentioned previously, stock markets are ultimately driven by corporate profits and as can be seen in the chart above---the trend is UP, UP, and UP.  Certainly that trend will reverse at some point—that is what is behind the fear of the Fiscal Cliff and the situation in Europe—the fear that this upward trend will turn downward.  But considering that profits are up 300% over the past 10 years and the S&P500 is up only 50%, it is highly probable that markets are presently undervalued and that we have a ways to go before we see a major drop in markets.

We all know that sooner or later, taxes are going up and the growth of government spending will be restrained.  Government deficits cannot go on forever. The situation in Europe and political struggles in the US are all about this process.  While in the short term, the implementation of actions to reduce those deficits may restrain economic growth—in the long run, these actions are positive. The size of the Fiscal Cliff and European Austerity do not make me fearful--they only bring attention to the enormity of the real problem--continuing large government deficits that cannot be sustained. Big Government is scary, but Big Government running on borrowed money is terrifying.

The real potential economic pain over the long term will not come from actions that reduce government deficits, but rather from political inaction that allows these deficits to continue unabated. I pray for the wisdom and courage of our elected leaders.

For now, I'm still indicating that for long term investors, staying the course for now is probably the best course of action.

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.

As a service to my clients, links to articles that go with the headlines are available at my “with permission only” Twitter site:  @waynestrout  https://twitter.com/waynestrout  When encountering any comments there thought to be political, please consider I am a politically conservative Independent. I believe in small government strong enough to protect individual liberty and active enough to promote general prosperity; personal responsibility and personal liberty; a strong defense but with a reluctance to make war; and a compassionate Christian based (Love thy Neighbor) charity toward the disadvantaged.

Deja Vu All Over Again?

As I write this today, I’m looking at my computer telling me that from 11:30 AM to 12:30PM, the S&P500 has risen almost 1.5%, from 1340 to 1360 (Dow up 126 points) in one hour! All because of a statement from John Boehner, that his meeting today with President Obama and others was “constructive”.  

One should keep in mind that the Fiscal Cliff is not 2008 all over again---it is more like 2011 all over again.  A review of events last year leading up to the deadlock regarding the debt ceiling and resulting credit downgrade provides some possible insight into the present situation.  Remarkably it involves all the same players—the major difference being that today, we are not in a pre-election year. Keep in mind, the uncertainty regarding Europe’s economic problems remains about the same now as it was last year. Between May and the end of June in 2011, the S&P500 fell about 7% as it appeared that there was major disagreement between the House and the President. Then, once it was clear that negotiations had failed and the unexpected worst case (credit downgrade) in fact occurred, the S&P500 fell another 11% to 1123.  Seven months later, it had risen 25% to 1408.

Between September 2012 and now, the S&P500 has fallen about 7% as it became clear there was a possibility that the Fiscal Cliff would not be resolved---especially after Obama’s unproductive “dig in his heels” speech/press conference on Wednesday of this week. Most probably, worst case is the remote possibility of another 11% drop, like in August-October 2011. Some investors will attempt to avoid this drop and time the market by selling good investments. This is a very dangerous strategy because they would likely be caught flat footed when/if a settlement is reached with markets rising rapidly. Wharton’s Jeremy Siegel has predicted the possibility of a 1000 point gain in the DOW in one day!

Another major difference between 2011 and now, is that the VIX index, a proxy for “fear” in the markets was an elevated 40+ last year and has remained a relatively low 18 or so over the past few weeks.  Importantly, the another difference is that last year, no significant fiscal tightening occurred--fears about the Fiscal Cliff have to do with substantial fiscal tightening. What history teaches us is that the “players” in this drama, have probably learned that deadlock is not a good outcome for them.  Also, they have never shown a willingness to allow higher taxes on lower income citizens or to knowingly allow circumstances to increase unemployment in the short term. For this reason, the likelihood of some form of negotiated settlement is high. (They are not prone to committing political suicide.)

The reality is that the settlement most probably will involve significantly higher taxes on higher income investors.  Hence, we have seen selling of even good quality stocks over the past two weeks—mostly to harvest capital gains but with some foolish attempts to avoid paying higher taxes on dividends.  Polls indicate that more than 74% of investors plan on buying in the dip or holding. Still the small percentage that have been selling into a market with few buyers has caused the market to fall. When sellers outnumber buyers, markets fall—and few, even the most optimistic investors, have been buying recently.  The “stay the course” strategy is what the vast majority of investors are following.

As I mentioned in my last post—long term investors should focus on the long term, and in this case, other than some “temporary” risk in the short term—the most likely outcome 6 months out is a substantial rise from here. Best guess—an S&P500 level likely above 1500 before March 30.

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.

Afraid of the Fiscal Cliff ?

Go to Turner Classic Movies--click on this link.

The phrase "FISCAL CLIFF" was coined in early 2012 by Fed Chairman Ben Bernanke.  One would not have expected an economist to be so artful in his presentation, but it shows just how masterful Mr. Bernanke is as a politician.

The video clip above is from the classic 1951 film, African Queen. Specifically the scene as the boat is approaching and navigating the first set of rapids.  It is a useful metaphor as the true risks of the fiscal cliff are more like shooting river rapids than falling off a cliff. (Video courtesy of TCM for non-commercial use. (http://www.tcm.turner.com/mediaroom/) Plays well on your smart phone.)

For the record, although the explanation wasn’t reported or repeated as much as the catchphrase itself, Bernanke actually said the fiscal cliff was about the large spending cuts and tax increases already scheduled to occur being far too big for the current U.S. economy to handle at one time. “I hope that Congress will look at [the spending cuts and revenue increases] and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date,” he told the committee.

Bernanke indicated that all of the upcoming taxes and spending cuts were probably good for the country and the economy (i.e. "long-run fiscal improvement") in the long run, but he was concerned about the changes all happening "at one date".

There is in fact many moving parts of this issue.  Politicians have procrastinated and put off decisions for so long, the list has become quite long.  Changes to Federal Estate Taxes could have big effects on those with estates greater than $1 million.  Changes to Alternative Income Tax rules could subject a surprisingly large number of people to much higher income tax rates.  Going back to the 2010 payroll tax rates would reduce take home pay of nearly the entire population and probably would reduce consumer spending.  Expiration of the Bush Tax Rates could significantly raise taxes on dividends and capital gains.  And, then the new taxes related to Obamacare take effect.  On the spending side, there are big cuts in Defense Spending--large enough that a lot of people employed by government contractors will lose their jobs.

If Congress does nothing and everything scheduled to change, does in fact change all at once, the effect on the economy would be large and potentially dangerous--sort of like shooting the rapids.   Nobody and I mean NOBODY knows the actual effects or outcome, for sure.  So this is an event made for the media. Who needs the Mayan 2012 end of the world story when we have the Fiscal Cliff to scare everyone who shakes at the thought of potential danger!  What you are hearing on TV and reading about now is like the movie trailer for African Queen---intentionally sensational to get your attention.

I use the term potentially dangerous in that even though it would definitely cause a short term slowdown, it would definitely move us toward the dramatic "long-run fiscal improvement" that we all know must happen, sooner or later.  So don't be surprised if some very intelligent people seem to be quite nonchalant about the possibility of complete deadlock in Washington.  It is the "long-run fiscal improvement" that is the most important to our future economic prosperity.  Sort of like going on a diet to lose weight---the benefits of the weight loss are known---the discomfort from being hungry and doing without will simply determine the length of time it takes to achieve the goal.

Having lived through many election and economic cycles, I've learned that usually the actual outcome is never as bad as feared by the pessimists and never as good as hoped by the optimists.  I've also learned that politicians seldom will intentionally approve an action that is generally feared and unpopular with their "constituents".  So, the most prudent expectation is that some sort of compromise will be found and the Fiscal Cliff will be more like a Fiscal Step.

On the other hand, this is a very divided country. President Obama was re-elected by only a 51% majority and he LOST 24 of the 50 states. Despite claims of great victory and a "mandate", this one was a very close election and the politicians' "constituents" still have very different opinions about tax and spending policy.  A "deadlock" like the 2011 debt ceiling debacle is unlikely, but possible.

Then, one must remember that even though January 1 is a "deadline", there is a long history of tax policy being changed "retroactively".  So a "deadlock" might be followed by a "compromise".

As markets wrestle with that possibility of "deadlock" and "compromise", they will fluctuate significantly.  Hence, the next 60-90 days is full of short term risk and opportunity. 

One example is the discussion about changes in taxes on dividends--a very large portion of stocks are held in IRA's and 401K's where a change in the tax rate on dividends will have not effect at all.  And, the "alternative" to dividends is interest that is already taxed at a high rate.  Any drop in prices because of people selling dividend paying stocks should be seen as a buying opportunity. Another example is the effect of changes in Capital Gains and Health Care Excise tax rates. For the most part, this change will most effect those with incomes over $250,000 and securities like Apple where capital gains have been and are likely to be a large part of the total return.  Prices on these stocks may fall more than others.

Should one be a buyer or a seller in this environment?   I think gambling and trying to predict the outcome and timing of complex political negotiations in the short run is unwise for a true long term investor.

On the other hand, there is almost universal agreement that whatever the outcome, economic growth and prosperity at some higher level than now is coming--sooner or later. Higher taxes will slow down consumer and business spending--but a lower deficit may make the climate for long term investment more attractive.  Keeping taxes low may force lower levels of government spending,  but will encourage higher levels of consumer and business spending and may also reduce the deficit, making the climate for long term investment more attractive.  One should remember that while consumer spending is 70% of the economy, much that is spent drives up imports without really improving our economic long term welfare and domestic employment.

The worst possible outcome--not expected by many--would be some sort of compromise where the deficit does not get smaller any time in the near future.  A bad outcome for investors would be where taxes don't go up and spending does not go down over time.  This would make the general public happy in the short term, but the likelihood of high levels of inflation would be almost inevitable.

We can argue about whether we would be better off with one outcome than another.  I have personal convictions that big government will generally make most investors less wealthy. So for my own sake and the sake of my investor clients, I am an advocate for government being as "small" as possible. (Sort of "A government big enough to do things for you is big enough to take things from you" philosophy.)  But, I also have strong convictions that wise, patient and prudent people can do well over the long run, even in less than optimum situations.  Good quality investments, chosen because of their ability to prosper in a given environment will do well. Wherever there is risk, there is opportunity, and whenever a trend is identified, you can make it your friend. Because of the election, government over the next two years will get bigger. But do not forget that we still have a divided government, so government growth will be constrained.

So for long term investors already invested--staying the course makes sense. For long term investors with new funds--entering the market as a buyer when the market dips may be wise.  When the outcome is known with certainty in January or February, it may then be wise to make adjustments to be sure your investment strategy is optimum given the known landscape--not exiting the market but rather a consideration toward changing the allocation. All of this of course depends on your tolerance for risk---investing is never an activity whose outcome can be predicted with 100% certainty.

Be sure you have sufficient liquidity to ride out these storms and stay focused on investing for the long term. Be diversified.

Most likely, like in the movie, we'll make it thru the rapids just fine---I'm sure that for most of us, unlike Rose (Katherine Hepburn in the movie), we will not find the experience and drama to be "invigorating".  Times like these are very difficult for investors and I for one am looking forward to less drama.

This paper is for non-commercial 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.

Don't Oversimplify

Reading the headlines one could conclude that markets are “plummeting” as a reaction to the election last night.   That conclusion would be an oversimplification and generally wrong.

Without taking sides in the political discourse, in my professional role as an “investment economist” I can tell you that today’s market action probably has more to do with Europe than the election in the US.  

After being fixated on our election for the past few days, this morning, traders focused attention on Europe and did not like what they heard---the head of the ECB indicating that inflation was not a risk because the economy in Europe was so bad and likely to be bad for a long time!   Yes, the Dow fell more than 2.5% in the morning, but dollars flowed from Europe and the stock market into US Treasuries. If you don’t have confidence in the leadership of the US government—it is not logical to buy IOU’s from the US government.  At about 11 AM, the DOW began rising steadily.

No doubt, a certain portion of the nearly half of the electorate who voted against the incumbent have sold stocks this morning—sort of a vote of “no-confidence”.   But, in fact, the election has essentially changed nothing—we have the same political situation that we had a week ago, and I would argue, the markets have essentially expected this very outcome. (With one exception—namely that coal and energy stocks had risen in anticipation or hope of a Republican victory and they have fallen back considerably today.)  As I write this, the DOW is essentially close to the August 30, 2012 level. 

Framing (many times influenced by media headlines) is a nasty behavioral bias that pre-disposes humans to certain behaviors—a desire to simplify a very complicated world using certain pre-conceived notions.  Oversimplification is dangerous. Concluding that all rich investors are unhappy with the outcome of the election and are selling their stocks would be wrong.  Data shows that the 10 richest counties in the US voted overwhelmingly for the incumbent—more than 60%!  (My take is that the election results are not related to a struggle of haves against have nots, but rather “traditional” values against secularism.)   

As I have stated, we are in a period of great uncertainty about Europe, China, Middle East Geopolitics, and US Monetary/Fiscal/Tax Policy.  Any of these could and probably will affect markets in the short term. But it is precisely because of this short term uncertainty, stock prices are depressed—providing very good long term opportunity in many cases, for specific investments. In addition, history teaches (since 1950-13 out of 15 quarters following a presidential election) that there is an 86% probability that markets will be higher on 12/31/2012 than they are today.

While there seems to be a lot of risks affecting short term global growth---there is growing evidence, barring any unexpected global shock, that robust global growth is on the longer term horizon. Beware, when robust global growth returns, it will probably bring along it’s pesky friend—inflation.

The only thing that I see that is more dangerous than oversimplifying is paying too much attention to media sources whose main goal is to entertain and to sell advertising rather than to inform.

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.