"I'm up 25% on the year! Isn't that great? Who needs a professional money manager anyway? Heck, I was talking with a fee-only financial advisor the other day, asking him what he charged and how his clients were doing and he wouldn't even give me a straight answer! Guy probably can't walk and chew bubble gum at the same time let alone beat my investing returns this year!" (Individual investor speaking gives himself an air high-five and chest bumps the wall). "Baby I am hot!"
Or is he?
Academic research shows that most individual investors don't accurately track their investment returns from year to year and, on average, substantially over-estimate their returns. One study done a few years back concluded that individual investor returns were actually less than half of what individual investors thought they were - seems most folks don't actually tote up the numbers, instead relying on memory. It also seems that most folks have a very selective memory, remembering their winning investments and conveniently forgetting their losers. Or they just plain forget to back out current year contributions to their portfolio, lumping them in with their returns.
But what about the chest bumping, high-fiving dude who did do the math and was up 25% in 2009? He's kicking butt right? Well, maybe...
It turns out that measuring returns is different from measuring performance. Performance isn't just about accurately capturing a portfolio's return (although that can be difficult enough to do). It is also about measuring the amount of risk in the portfolio and making an apples to apples comparison with an unmanaged benchmark. In fact, the prestigious CFA Institute now offers The Certificate in Investment Performance Measurement (CIPM) program, which is the industry’s only designation dedicated solely to the specialized field of investment performance evaluation and presentation. The CIPM curriculum emphasizes the application of investment principles and is based on a body of knowledge defined by global best practices in investment performance evaluation and presentation. The coursework includes: Rate of Return Calculations; Benchmark Selection; Attribution Analysis; Ex Post Risk Measures; Performance Evaluation; and The GIPS Standards (don't ask, they are boringly extensive).
Okay, so on the one hand you have many individual investors shooting from the hip on their returns, with really only the vaguest notion of how their portfolio's performance compares to a comparable benchmark, and, on the other hand, you have those CIPM weenies who will put you to sleep explaining your performance and how it REALLY measures up. The individual investor and the CIPM geek might both be speaking English, but I can assure you that they are almost certainly not communicating!
And we aren't even talking about the tidal wave of emotions that pour forth when investors are talking about their nest eggs. I've gotta tell you folks that trying to have a performance discussion with an individual investor can get pretty dicey sometimes! You don't want to offend them when they proudly trot out that big return number, but you do want to find out whether that big number represents good performance or not. After all, if you made your 25% putting all of your money into a single stock, then your risk-adjusted return is gonna suck, considering that the unmanaged S&P 500 index was up about 25% on the year! (a lot less risky to buy the entire index than invest in just one stock). Conversely, making 25% in a bunch of low-beta defensive stocks means you knocked the cover off the ball in 2009. Why? Because a low-beta portfolio should lag the S&P 500 return, not match it. Here's how that works...
Any unmanaged index has a beta of one with itself, by definition. The S&P 500 goes up 10% when the S&P 500 goes up 10%. An S&P 500 stock that tends to go up only 8% when the S&P 500 goes up 10% will have a beta of 0.80. Likewise, a stock that tends to go up 12% when the S&P 500 goes up 10% has a beta of 1.2. The second stock is 50% more volatile than the first stock. Build a low-beta stock portfolio and still keep up with the S&P 500 return and you are adding value! Conversely, build a high-beta stock portfolio and merely perform in-line with the S&P 500 and, well, you are destroying value (even if you are making money) because you aren't making as much as you should. As well, you are going to lose more money than the index on the way back down with the higher beta stocks!
Bottom line here is that accurately measuring performance can be complicated. And if you can't measure your performance then it's tough to know whether you need to makes changes to your investing process.
A couple of real life examples to make the point. I recently exchanged e-mails with a friend who was initially interested in getting my thoughts on how to best hedge against the risk of inflation. I e-mailed him my two cents worth, but then encouraged him to let me buy him a cup of coffee so that we could talk more fully about the subject. I didn't want him making investment decisions based on my brief reply to his inflation concerns. He shot me back an e-mail wanting to know my fees. He also let me know that his portfolio was up 22% year-to-date (about the same as the S&P 500 at the time). Uh-oh, a tricky performance conversation looming! What to do what to do?
I mean, do I tell him that my personal all-stock portfolio is up well north of 50% on the year? Do I tell him that Biechele Royce's stock and bond portfolios are up on average 24.58% on the year, 230 basis points ahead of his (likely) all stock portfolio? Do I put him on the spot by asking him if he realizes that his return was merely in-line with the S&P 500 return and, boy, I sure hoped he wasn't loaded up with a bunch of high-beta dogs when he would've done just as well with a lot less effort (and risk) by owning an S&P 500 index fund? Tricky situation, very tricky!
Well, guess what I did do...
None of the above, because this turnip didn't fall off the truck yesterday, and I know from past experience that all three courses of action are non-starters when trying to help an individual investor understand investing results. So I ignored the performance thingy and simply reiterated that my advice was free - in fact I was going to buy HIM the coffee - and that he should give me a holler when he had some time. Epilogue: Apparently he didn't believe I was really free because I didn't hear back from him. Or maybe he didn't get back to me because I ducked the whole performance issue and he mistook my bobbing and weaving for an implicit admission that he'd outperformed us and didn't really need any advice from me...
The second real-life example involved a family member. She apparently is subscribing to a newsletter of some sort and thinks the guy is pretty good. One of his investment ideas in the first half of 2009 was a sector ETF (I think that's what she said - I was reading up on my fantasy football team and only half listening) which was up 20% since she'd bought it. Without thinking (my focus was on my fantasy football team, which was really floundering) I shot back "And how does that compare to the S&P (500)?"
Blank look from Sis as in "What the heck are you babbling about?"
So I reluctantly pulled myself away from my fantasy football team (which had sunk into second on less than spectacular play and a HUGE run by my brother's steroid using players) and made an effort to explain. Modern portfolio management is a very logical sequencing of decisions. First you decide on a strategic (long-term) asset allocation based on the clients strategic (long-term) financial goals and risk tolerance. Once the allocation decision between stocks, bonds, real estate, commodities, and cash is made (along with allocations to sub-classes such as international, emerging market, investment grade, and high-yield), the institutional investor must implement the plan. As part of the implementation process, each investment within an asset class must be benchmarked to an unmanaged index in order to determine whether active management is adding value and the active managers are earning their fees. Clearly you shouldn't be paying a manager (or newsletter author) if they aren't able to add value by outperforming an appropriate benchmark on a risk-adjusted basis. Which means in my sister-in-laws case...
Her 20% return in the sector ETF was likely top-notch if it was a utility ETF and pretty much a bust if it was a semiconductor ETF (like I said, I was distracted when she started talking so I can't honestly tell you what she had bought). But I can tell you that she didn't have the foggiest notion of how to evaluate her performance in order to evaluate her newsletter writer (they count on that by the way - make enough suggestions and a few are bound to pan out big. Point to the winners and ignore the losers and you can make most people think you're doing quite well for them!).
The bottom line here is that returns are not the same as performance and measuring performance is a complicated, yet necessary, step in deciding whether your investing strategies are really working.... or not.
Oh, and by the way, I finished second behind my big brother in my fantasy football league (having also finished second to him in 2009 in fantasy baseball!). Which means I definitely underperformed in 2009....
Tuesday, December 29, 2009
Saturday, December 26, 2009
The Retirement
The old man lay quietly beneath the heavy blankets, listening in the dark to the hushed sounds of the small apartment. Somewhere overhead the heating unit hummed as warm air attempted to breach the barrier of cold that had settled heavily in the small bedroom. The old man could feel cold's nip on his sunken cheeks and crag of a nose; he had taken to wearing a nightcap to protect his balding head. Wisps of white peaked out from underneath. He wore his hair long these days, what little he had left. No longer an executive, the other workers at the plant could've cared less that the straggly wisps worked their way down almost to his shoulders. Barber's were a luxury and his wife's hands shook so much from the palsy that he would no longer let her near him with anything sharp.
Colder than normal, he thought, and that was saying something. He and is wife, whose labored breathing was muffled, but still audible, even buried as she was under the heavy, woollen blankets, kept the thermostat turned down as far as they could tolerate during the cold winter months. What with electricity rates having climbed steadily over the years, it was just too big a hit to their budget to keep the apartment heated to more than the bare minimum. He felt the cold gnawing away at his joints and settling into his bones, despite the extra blankets.
He could just make out the muted rush of winter's cold breath on the nearby window as gusts pushed against the concrete and brick complex. It was going to be another windy, cold day by the sound of it, he thought, already dreading the walk to the nearby bus stop. It would take him perhaps ten minutes to shuffle the six blocks to the metro stop. He didn't move very fast anymore. Both hips had been replaced a while back, along with his left knee. He'd been fortunate that his employer still provided medical coverage, not many did anymore since the government had entered the business. His employer's coverage was more expensive, took a bigger bite out of his meager salary, but at least he could get into see a doctor without a six month wait. Medicare wasn't an option since he still worked; the government had dropped coverage for seniors who were still working as part of the 2030 "austerity" initiative, designed to save America from having to declare a formal bankruptcy.
A soft, steady tick tick tick brought him back to the apartment. The alarm clock hadn't gone off yet, it wasn't quite 5:30, but he'd awakened a few minutes early. The ticking came not from the alarm clock, but from what many would consider an antique these days, an old-fashion wind up grandfather's clock that stood in the corner of the small bedroom, next to the single wooden dresser. The grandfather's clock was really the only thing the old couple owned of any interest. The rest of the furniture was cheaply made from pressed wood. It was merely functional at best. The old man knew his wife desperately wanted to replace the worn out furniture. Many of the wooden pieces were scratched and even splintered, but who could afford new furniture these days? Still, the furniture served its purpose, and they'd gotten it years ago before prices had risen sharply, the result of the rest of the world outbidding Americans for lumber... and for everything else for that matter. The U.S. dollar just could not compete, which meant everything cost more in dollars.
It wasn't a big apartment building, perhaps a hundred units in all, populated by those who couldn't afford more spacious quarters uptown. The apartments were efficiency units, kitchen, small dining area, a living room and a bedroom, no more than 750 square feet all in. Still, it was a roof over their head and only cost a couple week's wages, and it was definitely better than the barracks that'd been built a few years back to hold the indigent - baby boomers who weren't even able to afford a place of their own, all 35 million of them.
He exhaled as he shifted in bed, making sure not to let the covers slip from him, not yet. He might have a couple more minutes before the alarm went off. He didn't want to look at it, didn't want to see that it was time. A few more minutes to rest before getting ready, in the cold and dark, for another day at the plant. The irony of working at a coaling station did not escape him. After all, he'd spent most of his career as an economist working for Big Oil, much of his time taken up trying to figure out an economically viable solution to transitioning the energy industry to a successor energy source, one that would satisfy the Green movement, proving to them that Big Oil was serious about developing clean alternate energy sources. It was actually true of course. The energy industry quite understood that oil was a finite and diminishing resource that would need to be replaced with something else. The problem was how to economically make the transition to whatever that something else was while staying in business. Of course the lack of a strategic energy policy and the sharp drop in the value of the U.S. dollar had forced the U.S. to abandon most environmental goals. It had turned out that much of the Green movement was a luxury for the rich.
Coal had come back in a big way in the United States after the dollar's slow motion collapse sent the price of oil to $200 a barrel. The environmentalists howled their outrage when Congress passed the legislation lifting all bans on the use of coal by utilities and what few manufacturing plants remained in the country. The politicians had even cleared the way for the return of coal fired heating units in multi-unit housing, recognizing that 79 million baby boomers and countless younger voters would turn them out of office if they didn't let Americans keep their electricity. After all, America was the Saudi Arabia of coal, and it only made sense to use those natural resources that the country still controlled, regardless of the environmental impact.
The inflation that had swept the country over the last decade had wiped out many retirement nest eggs besides his own. He recalled having read years earlier that 50% of all baby boomers would run out of money before they died, an estimate based on a mere 3% inflation rate, below the historical 4.5%, and well below the high single digits that had prevailed for much of the last twenty years. He'd been confident he wouldn't be one of them though. He'd already saved close to $2 million by the time he'd turned fifty, a retirement portfolio capable of throwing off $80,000 in income per annum while still lasting at least 30-years, or so he'd been taught. His defined benefit plan would pay him an additional $950,000 lump sum when he turned 59-years old, and he was still saving in his 401(k). No, he'd been downright smug at the time! He simply hadn't realized what high-single digit inflation could do to an investment portfolio. Hadn't realized that the dollar was losing 37% of its value every 10-years at the historical 4.5% inflation rate that had prevailed post World War II and had lost 97% of its value since the Federal Reserve's creation in 1913.
The old man let his mind wander back over the decades to a time when he'd just turned fifty, a time when both the Republican and Democratic parties had lost their senses and were spending money they didn't have on initiatives that provided no long-term benefits to America, saddling generations of Americans with debt they couldn't possibly pay back. The politicians had recklessly created credit, encouraging asset bubble after asset bubble in an attempt to jump start the economy and, in so doing, buy votes for themselves. The madness had continued right up until the riots. The high unemployment rates and rising inflation had led to millions struggling simply to survive. Some of those millions eventually took to the streets to protest $8 bread and $10 gas. The price controls hadn't worked, nor had the government's attempts to run the country's farms through a combination of price controls and tax incentives.
The old man shifted once again under the heavy blankets. The cold was still gnawing at his face, his wife was still sleeping heavily at his side, but he knew it was almost time. He rolled onto his side and silenced the alarm before it went off. His wife worked nights at a meatpacking plant and had only come in a few hours ago. He knew she was bone-weary and arthritic pain made it hard for her to sleep. He didn't want to wake her unnecessarily. Slowly he slid from under the covers, shivering as the cold air enveloped him in its icy embrace. He sat momentarily on the side of the bed, taking a mental inventory of his aches and pains, wiggling his toes and ankles to make sure he'd be able to stand up without losing his balance and falling. He couldn't afford anymore broken bones. Damn lucky they even had jobs!
Satisfied that he could stand, he rose slowly and shuffled to the closet. Getting dressed before the cold invaded his very core was important he'd found, otherwise he tended to stay cold all day. Reaching the closet, he slid open the door and hurriedly reached for one of his two heavy woollen shirts. Thank god his wife had been able to mend it, he thought as he slipped it on, a new shirt was definitely not in their budget this year! As he reached for his blue jeans another thought struck him and he grunted in mild surprise. Eighty years old today, he thought, as he slipped into the jeans...
Colder than normal, he thought, and that was saying something. He and is wife, whose labored breathing was muffled, but still audible, even buried as she was under the heavy, woollen blankets, kept the thermostat turned down as far as they could tolerate during the cold winter months. What with electricity rates having climbed steadily over the years, it was just too big a hit to their budget to keep the apartment heated to more than the bare minimum. He felt the cold gnawing away at his joints and settling into his bones, despite the extra blankets.
He could just make out the muted rush of winter's cold breath on the nearby window as gusts pushed against the concrete and brick complex. It was going to be another windy, cold day by the sound of it, he thought, already dreading the walk to the nearby bus stop. It would take him perhaps ten minutes to shuffle the six blocks to the metro stop. He didn't move very fast anymore. Both hips had been replaced a while back, along with his left knee. He'd been fortunate that his employer still provided medical coverage, not many did anymore since the government had entered the business. His employer's coverage was more expensive, took a bigger bite out of his meager salary, but at least he could get into see a doctor without a six month wait. Medicare wasn't an option since he still worked; the government had dropped coverage for seniors who were still working as part of the 2030 "austerity" initiative, designed to save America from having to declare a formal bankruptcy.
A soft, steady tick tick tick brought him back to the apartment. The alarm clock hadn't gone off yet, it wasn't quite 5:30, but he'd awakened a few minutes early. The ticking came not from the alarm clock, but from what many would consider an antique these days, an old-fashion wind up grandfather's clock that stood in the corner of the small bedroom, next to the single wooden dresser. The grandfather's clock was really the only thing the old couple owned of any interest. The rest of the furniture was cheaply made from pressed wood. It was merely functional at best. The old man knew his wife desperately wanted to replace the worn out furniture. Many of the wooden pieces were scratched and even splintered, but who could afford new furniture these days? Still, the furniture served its purpose, and they'd gotten it years ago before prices had risen sharply, the result of the rest of the world outbidding Americans for lumber... and for everything else for that matter. The U.S. dollar just could not compete, which meant everything cost more in dollars.
It wasn't a big apartment building, perhaps a hundred units in all, populated by those who couldn't afford more spacious quarters uptown. The apartments were efficiency units, kitchen, small dining area, a living room and a bedroom, no more than 750 square feet all in. Still, it was a roof over their head and only cost a couple week's wages, and it was definitely better than the barracks that'd been built a few years back to hold the indigent - baby boomers who weren't even able to afford a place of their own, all 35 million of them.
He exhaled as he shifted in bed, making sure not to let the covers slip from him, not yet. He might have a couple more minutes before the alarm went off. He didn't want to look at it, didn't want to see that it was time. A few more minutes to rest before getting ready, in the cold and dark, for another day at the plant. The irony of working at a coaling station did not escape him. After all, he'd spent most of his career as an economist working for Big Oil, much of his time taken up trying to figure out an economically viable solution to transitioning the energy industry to a successor energy source, one that would satisfy the Green movement, proving to them that Big Oil was serious about developing clean alternate energy sources. It was actually true of course. The energy industry quite understood that oil was a finite and diminishing resource that would need to be replaced with something else. The problem was how to economically make the transition to whatever that something else was while staying in business. Of course the lack of a strategic energy policy and the sharp drop in the value of the U.S. dollar had forced the U.S. to abandon most environmental goals. It had turned out that much of the Green movement was a luxury for the rich.
Coal had come back in a big way in the United States after the dollar's slow motion collapse sent the price of oil to $200 a barrel. The environmentalists howled their outrage when Congress passed the legislation lifting all bans on the use of coal by utilities and what few manufacturing plants remained in the country. The politicians had even cleared the way for the return of coal fired heating units in multi-unit housing, recognizing that 79 million baby boomers and countless younger voters would turn them out of office if they didn't let Americans keep their electricity. After all, America was the Saudi Arabia of coal, and it only made sense to use those natural resources that the country still controlled, regardless of the environmental impact.
The inflation that had swept the country over the last decade had wiped out many retirement nest eggs besides his own. He recalled having read years earlier that 50% of all baby boomers would run out of money before they died, an estimate based on a mere 3% inflation rate, below the historical 4.5%, and well below the high single digits that had prevailed for much of the last twenty years. He'd been confident he wouldn't be one of them though. He'd already saved close to $2 million by the time he'd turned fifty, a retirement portfolio capable of throwing off $80,000 in income per annum while still lasting at least 30-years, or so he'd been taught. His defined benefit plan would pay him an additional $950,000 lump sum when he turned 59-years old, and he was still saving in his 401(k). No, he'd been downright smug at the time! He simply hadn't realized what high-single digit inflation could do to an investment portfolio. Hadn't realized that the dollar was losing 37% of its value every 10-years at the historical 4.5% inflation rate that had prevailed post World War II and had lost 97% of its value since the Federal Reserve's creation in 1913.
The old man let his mind wander back over the decades to a time when he'd just turned fifty, a time when both the Republican and Democratic parties had lost their senses and were spending money they didn't have on initiatives that provided no long-term benefits to America, saddling generations of Americans with debt they couldn't possibly pay back. The politicians had recklessly created credit, encouraging asset bubble after asset bubble in an attempt to jump start the economy and, in so doing, buy votes for themselves. The madness had continued right up until the riots. The high unemployment rates and rising inflation had led to millions struggling simply to survive. Some of those millions eventually took to the streets to protest $8 bread and $10 gas. The price controls hadn't worked, nor had the government's attempts to run the country's farms through a combination of price controls and tax incentives.
The old man shifted once again under the heavy blankets. The cold was still gnawing at his face, his wife was still sleeping heavily at his side, but he knew it was almost time. He rolled onto his side and silenced the alarm before it went off. His wife worked nights at a meatpacking plant and had only come in a few hours ago. He knew she was bone-weary and arthritic pain made it hard for her to sleep. He didn't want to wake her unnecessarily. Slowly he slid from under the covers, shivering as the cold air enveloped him in its icy embrace. He sat momentarily on the side of the bed, taking a mental inventory of his aches and pains, wiggling his toes and ankles to make sure he'd be able to stand up without losing his balance and falling. He couldn't afford anymore broken bones. Damn lucky they even had jobs!
Satisfied that he could stand, he rose slowly and shuffled to the closet. Getting dressed before the cold invaded his very core was important he'd found, otherwise he tended to stay cold all day. Reaching the closet, he slid open the door and hurriedly reached for one of his two heavy woollen shirts. Thank god his wife had been able to mend it, he thought as he slipped it on, a new shirt was definitely not in their budget this year! As he reached for his blue jeans another thought struck him and he grunted in mild surprise. Eighty years old today, he thought, as he slipped into the jeans...
Most Individual Investors Still Wrong!
The investing year isn't quite over but the returns are in for Treasury bonds in 2009 - and it ain't pretty. We wrote last week that individual investors fled in droves to supposedly risk free Treasuries in 2009, dumping $357 billion into bond mutual funds (much of it going into Treasuries) through the first 11 months of the year, while actually pulling money out of stock mutual funds. The S&P 500 is up over 20% on the year while Treasury bonds have lost almost 15% because of the (inevitable) backup in interest rates from record lows in 2008. No straight lines in nature or the markets, but rising interest rates are waiting for all of us over the next few decades as we pay the piper for our bumbling Federal Government's complete mismanagement of fiscal and monetary policy over the last 20-years. Of course, forecasting rising interest rates is the same as forecasting rising inflation, since real interest rates (interest adjusted for inflation) are fairly constant at between 1% and 2%.
Wednesday, December 23, 2009
Using Market Forecasts
A quick note on how we use our market forecasts. We are big believers in the KISS principal. Complicated strategies are hard to execute and prone to major failures. Knowing that the stock market is likely to sell off 20% or so sometime in 2010 is not the same as having the ability to capture the profit, either through short selling, or a timely exit (and subsequent re-entry). Rather, we use our forecasts to help with the valuation process and with risk management. Stock selection for us starts with basic business valuation; it is impossible to value a business in a vacuum. Consumer discretionary businesses are worth less currently given the likelihood that it will be years before consumers have the wherewithal to spend robustly once again. Consequently, we require a larger discount than previously before buying retailers, restaurants, and other consumer discretionary businesses. Likewise, we would like a bigger margin of safety in general before purchasing a share of a business right now, given our view that the market is overbought, and some 25% over valued. Conversely, we are also likely to sell a successful investment more quickly than otherwise in order to prevent price risk from building in the portfolio in a higher risk market.
We urge individual investors to always stay properly diversified and to avoid allowing certainty to rise too high in a very uncertain world!
Happy Holidays!
We urge individual investors to always stay properly diversified and to avoid allowing certainty to rise too high in a very uncertain world!
Happy Holidays!
Saturday, December 19, 2009
2010 Market Forecast
"Why Are Most Investors Mostly Wrong Most of the Time?" was the title of Dr. Marc Faber's October Market Commentary. It's a great question and one that deserves at least an attempt at answering. But perhaps you disagree with the basic assumption of the question? Are most investors mostly wrong most of the time? The data would strongly tend to support that belief. Take a study by Dalbar, a Boston research firm, that was released a few years ago. Dalbar found that individual stock mutual fund investors earned an average return of 5.23% per annum from 1984 to 2000 - a period during which the unmanaged S&P 500 returned 16.3% per annum on average. The average fixed income (bond) investor earned 6% per annum on average during that period while the Lehman Brothers Long-term Bond index returned 11.83%. Mind boggling isn't it? Anyone care to calculate how much wealth individual stock mutual fund investors managed to leave on the table during one of the greatest secular bull markets of all time? I'll save you the trouble - $1,060,000 in foregone profit on a $100,000 initial investment. Incredible! A $100,000 investment in the S&P 500 index in 1984 would have grown to $1,301,000 by the end of 2000. Meanwhile, the typical individual investor's $100,000 would have grown to a whopping $241,000. Yikes!
Okay then, most individual investors are mostly wrong most of the time, just as Dr. Faber contends - but why? Well, the field of behavioral finance offers us some clues. Behavioral Finance is the study of how human psychology effects decision making in the investment arena, and it has produced some very intriguing findings over the years. One commonly observed tendency is for individual investors to place a much higher probability on an investment outcome than is warranted. High levels of (undeserved) certainty lead many investors to pursue concentrated investment portfolios lacking sufficient diversification. Certainty also leads investors to dive into and exit markets at the wrong time. For instance, investors seem to gain confidence the longer a trend is in place, leading them to load up on an investment at just the wrong time. Individual investors were fully invested in stocks and real estate in 2007, seemingly convinced that stocks and home prices had nowhere to go but up, despite strong evidence that prices had disconnected from the real economy. Likewise, many investors bailed out of the stock market in the spring of 2009 at a time when the S&P 500 was demonstrably undervalued and likely to deliver well above average returns going forward.
Currently, investors seem to be buying into the notion that deflation is the greatest risk out there - how else to explain the huge demand for bond mutual funds in 2009? Well, perhaps it is simply the fear of owning stocks that is forcing people into bonds by default, rather than a conscious fear of deflation. Regardless of what is driving investors to load up on bond funds in 2009 and ignore stock funds, it is likely that most individual investors will be mostly wrong once again. Year to date U.S. bond funds have attracted net inflows of $357 billion while stock mutual funds had outflows of $11 billion, according to Barrons (stock mutual funds currently hold about $4.5 trillion in assets while bond funds hold about $2 trillion). Furthermore, according to Morningstar, nine of the year's ten best selling mutual funds invest in bonds. A disconcerting development for all of those folks who chose to buy bond funds in 2009, thus missing a $4 trillion dollar increase in the value of the S&P 500 from the March lows (to put that number in perspective the U.S. economy currently produces $14 trillion in goods and services annually). Put another way, individual investors chose to buy bonds, which have a superb 10 and 20-year trailing track record, apparently on the assumption that the long-running trend will continue. They bought bonds despite the fact that every time the 1-year rate of return of the Ryan index of 30-year Treasury bonds was above 30% the subsequent return was negative - the return in 2008 was 41%! They bought bonds near record low yields even while stocks were available at a sharp discount to any reasonable estimate of fair value (the S&P 500 companies probably have the ability to earn $60 per share in "normalized" earnings, which means the index was available for 11x earnings in March at the 666 low). They chose to buy bonds despite huge government borrowing needs, and despite a U.S. dollar that is likely to continue to fall in value over the long run (circumstances which will normally lead to rising yields and inflation, and falling bond prices), instead of buying stocks at a time when the 10-year compound annual total return is the worst ever - by a HUGE amount. In fact, except for a brief period of time in the late 1930s, trailing 10-year compound returns had never been negative, going all the way back to 1827. As of February 11 2009, the 10-year compound annual total return was minus 4%!
Acting on our belief that most individual investors are mostly wrong most of the time, I would maintain that stocks are a better buy right now than bonds in the United States. However, the S&P 500 returned more in a shorter period of time between March and October of 2009 than at any other time since the Dow's humongous recover rally in 1933! Furthermore, fair value for the S&P 500 is likely somewhere between 800 and 900 based on that $60 per share earnings estimate, making the index over valued by around 25%. Finally, stock mutual fund investing inflows hit their second highest level of the year in the week ending October 23, after net outflows in August and September (five months after the bottom), indicating that individual investors may finally be ready to embrace a rising stock market (the S&P 500 has essentially moved sideways since October and may be in the process of putting in an intermediate top).
Add it all up and it is more than a little likely then that the stock market will correct, giving up at least some of it's heady 2009 gains. Of course the $64,000 dollar question is when and by how much!
Uncertainty is a fact of life and a fact of investing. Capital preservation should be any investor's first priority. Losing money is an investing sin due to simple mathematics. A 20% decline in one's portfolio requires a 25% gain simply to get back to even. There is a reason that Warren Buffet's first rule of investing is don't lose money and his second is: refer to rule one! Proper diversification is an essential tool in any investor's tool box. We are already on record as liking stocks more than bonds for 2010, but what about cash, given that we will likely see a pullback in the stock market sometime in 2010 (likely beginning in the next few months) that could breach 20% (a common definition of a bear market). Cash is an asset class after all, although one that currently yields a negative real rate of return ( return adjusted for inflation).
The Federal Reserve has increased the monetary base (currency in circulation plus reserves) from approximately $850 billion to around $2.1 trillion since the financial crisis began. Furthermore the Fed has continued to grow the monetary base at an almost 100% per annum rate, indicating that it does not see a quick end to the financial crisis. Our government is basically flooding the economy with paper money and hoping that it will start to circulate sooner rather than later. In very simple terms, the more paper money circulating the more everything will cost in that paper money - inflation is coming! In fact, it is likely that inflation is already here. Actual inflation is currently closer to 6% than the 1% reported by the government (perhaps we'll blog on the government's systematic under reporting of inflation next). Cash then is a wasting asset! It is not holding its value now and is likely to be worth substantially less 10 years from now. Most Americans don't truly understand the pernicious nature of inflation. Inflation has averaged 4.5% post world war II (using the government's own highly distorted metrics). At a 4.5% rate of inflation, a $20,000 car will cost $31,000 ten years from now! We like cash even less than bonds, except in the very short term.
To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters. It is likely however that the market will not make fresh bear market lows and that the Federal Reserve and government will support the market, pushing it back toward current levels by year end. Bonds are a disaster waiting to happen, particularly if the Fed ends quantitative easing on schedule in March, leaving the corporate bond market and foreign central banks to absorb some $2 trillion in Federal debt in 2010. Finally, we like cash even less, given the huge increase in the monetary base over the last 18 months and the likelihood of continued irresponsible government spending. It is more than possible, however, that the dollar rallies for a few quarters as it works off its currently oversold state. Any non-dollar assets are preferable once the current dollar rally sputters and dies, including gold.
Our 10-year forecast is for rising inflation, rising taxes, rising interest rates, and rising commodity prices. We do not see stocks advancing much in real terms over the next 10-years, but they might manage to hold their own against inflation, thus preserving your purchasing power. Our favorite investing assets remain commodities, international stocks and international bonds. Our favorite area to invest remains Asia. Our favorite sectors remain Asian consumers, U.S. multinationals, and world infrastructure. We would avoid the U.S. consumer discretionary sector (for example retail and restaurants) unless the purchase price is literally a steal.
However, the future is always uncertain and no one should feel so certain of it that they load up on any one asset class, sector, or theme.
Most individual investors are mostly wrong most of the time. We do not condone market timing or concentrated investing for individuals. Rather we recommend that you build a properly diversified portfolio that makes sense given your individual circumstances and financial goals. Your strategic allocation should change only as your individual big-pictures circumstances change. As far as executing your investing plan... well, we advocate contrarian investing in all asset classes all of the time, and by now you can probably guess why!
Okay then, most individual investors are mostly wrong most of the time, just as Dr. Faber contends - but why? Well, the field of behavioral finance offers us some clues. Behavioral Finance is the study of how human psychology effects decision making in the investment arena, and it has produced some very intriguing findings over the years. One commonly observed tendency is for individual investors to place a much higher probability on an investment outcome than is warranted. High levels of (undeserved) certainty lead many investors to pursue concentrated investment portfolios lacking sufficient diversification. Certainty also leads investors to dive into and exit markets at the wrong time. For instance, investors seem to gain confidence the longer a trend is in place, leading them to load up on an investment at just the wrong time. Individual investors were fully invested in stocks and real estate in 2007, seemingly convinced that stocks and home prices had nowhere to go but up, despite strong evidence that prices had disconnected from the real economy. Likewise, many investors bailed out of the stock market in the spring of 2009 at a time when the S&P 500 was demonstrably undervalued and likely to deliver well above average returns going forward.
Currently, investors seem to be buying into the notion that deflation is the greatest risk out there - how else to explain the huge demand for bond mutual funds in 2009? Well, perhaps it is simply the fear of owning stocks that is forcing people into bonds by default, rather than a conscious fear of deflation. Regardless of what is driving investors to load up on bond funds in 2009 and ignore stock funds, it is likely that most individual investors will be mostly wrong once again. Year to date U.S. bond funds have attracted net inflows of $357 billion while stock mutual funds had outflows of $11 billion, according to Barrons (stock mutual funds currently hold about $4.5 trillion in assets while bond funds hold about $2 trillion). Furthermore, according to Morningstar, nine of the year's ten best selling mutual funds invest in bonds. A disconcerting development for all of those folks who chose to buy bond funds in 2009, thus missing a $4 trillion dollar increase in the value of the S&P 500 from the March lows (to put that number in perspective the U.S. economy currently produces $14 trillion in goods and services annually). Put another way, individual investors chose to buy bonds, which have a superb 10 and 20-year trailing track record, apparently on the assumption that the long-running trend will continue. They bought bonds despite the fact that every time the 1-year rate of return of the Ryan index of 30-year Treasury bonds was above 30% the subsequent return was negative - the return in 2008 was 41%! They bought bonds near record low yields even while stocks were available at a sharp discount to any reasonable estimate of fair value (the S&P 500 companies probably have the ability to earn $60 per share in "normalized" earnings, which means the index was available for 11x earnings in March at the 666 low). They chose to buy bonds despite huge government borrowing needs, and despite a U.S. dollar that is likely to continue to fall in value over the long run (circumstances which will normally lead to rising yields and inflation, and falling bond prices), instead of buying stocks at a time when the 10-year compound annual total return is the worst ever - by a HUGE amount. In fact, except for a brief period of time in the late 1930s, trailing 10-year compound returns had never been negative, going all the way back to 1827. As of February 11 2009, the 10-year compound annual total return was minus 4%!
Acting on our belief that most individual investors are mostly wrong most of the time, I would maintain that stocks are a better buy right now than bonds in the United States. However, the S&P 500 returned more in a shorter period of time between March and October of 2009 than at any other time since the Dow's humongous recover rally in 1933! Furthermore, fair value for the S&P 500 is likely somewhere between 800 and 900 based on that $60 per share earnings estimate, making the index over valued by around 25%. Finally, stock mutual fund investing inflows hit their second highest level of the year in the week ending October 23, after net outflows in August and September (five months after the bottom), indicating that individual investors may finally be ready to embrace a rising stock market (the S&P 500 has essentially moved sideways since October and may be in the process of putting in an intermediate top).
Add it all up and it is more than a little likely then that the stock market will correct, giving up at least some of it's heady 2009 gains. Of course the $64,000 dollar question is when and by how much!
Uncertainty is a fact of life and a fact of investing. Capital preservation should be any investor's first priority. Losing money is an investing sin due to simple mathematics. A 20% decline in one's portfolio requires a 25% gain simply to get back to even. There is a reason that Warren Buffet's first rule of investing is don't lose money and his second is: refer to rule one! Proper diversification is an essential tool in any investor's tool box. We are already on record as liking stocks more than bonds for 2010, but what about cash, given that we will likely see a pullback in the stock market sometime in 2010 (likely beginning in the next few months) that could breach 20% (a common definition of a bear market). Cash is an asset class after all, although one that currently yields a negative real rate of return ( return adjusted for inflation).
The Federal Reserve has increased the monetary base (currency in circulation plus reserves) from approximately $850 billion to around $2.1 trillion since the financial crisis began. Furthermore the Fed has continued to grow the monetary base at an almost 100% per annum rate, indicating that it does not see a quick end to the financial crisis. Our government is basically flooding the economy with paper money and hoping that it will start to circulate sooner rather than later. In very simple terms, the more paper money circulating the more everything will cost in that paper money - inflation is coming! In fact, it is likely that inflation is already here. Actual inflation is currently closer to 6% than the 1% reported by the government (perhaps we'll blog on the government's systematic under reporting of inflation next). Cash then is a wasting asset! It is not holding its value now and is likely to be worth substantially less 10 years from now. Most Americans don't truly understand the pernicious nature of inflation. Inflation has averaged 4.5% post world war II (using the government's own highly distorted metrics). At a 4.5% rate of inflation, a $20,000 car will cost $31,000 ten years from now! We like cash even less than bonds, except in the very short term.
To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters. It is likely however that the market will not make fresh bear market lows and that the Federal Reserve and government will support the market, pushing it back toward current levels by year end. Bonds are a disaster waiting to happen, particularly if the Fed ends quantitative easing on schedule in March, leaving the corporate bond market and foreign central banks to absorb some $2 trillion in Federal debt in 2010. Finally, we like cash even less, given the huge increase in the monetary base over the last 18 months and the likelihood of continued irresponsible government spending. It is more than possible, however, that the dollar rallies for a few quarters as it works off its currently oversold state. Any non-dollar assets are preferable once the current dollar rally sputters and dies, including gold.
Our 10-year forecast is for rising inflation, rising taxes, rising interest rates, and rising commodity prices. We do not see stocks advancing much in real terms over the next 10-years, but they might manage to hold their own against inflation, thus preserving your purchasing power. Our favorite investing assets remain commodities, international stocks and international bonds. Our favorite area to invest remains Asia. Our favorite sectors remain Asian consumers, U.S. multinationals, and world infrastructure. We would avoid the U.S. consumer discretionary sector (for example retail and restaurants) unless the purchase price is literally a steal.
However, the future is always uncertain and no one should feel so certain of it that they load up on any one asset class, sector, or theme.
Most individual investors are mostly wrong most of the time. We do not condone market timing or concentrated investing for individuals. Rather we recommend that you build a properly diversified portfolio that makes sense given your individual circumstances and financial goals. Your strategic allocation should change only as your individual big-pictures circumstances change. As far as executing your investing plan... well, we advocate contrarian investing in all asset classes all of the time, and by now you can probably guess why!
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