TheKnowledgeableInvestor

China is Bad for Bonds

2011-09-15T08:43:00.000-07:00

Our main export over the last 20-plus years has been the U.S. dollar. We've run up huge trade deficits, sending dollars over seas to China, Japan, Korea, the EU, the Middle East, and to anyone else who would take them in exchange for their goods. The virtuous cycle has worked until now because the giant vendor financing scheme suited every one's interest. U.S. consumers got cheap goods from overseas and were allowed to spend beyond their means by borrowing cheaply. Export led foreign economies were able to sell into one of the largest consumer economies in the world, keeping their labor forces employed and running up huge surpluses in the process (reserves are a wonderful thing when hard times hit, since you have to pay back international debt regardless of whether you're earning sufficient currency or not).

But what to do with the tsunami of dollars flooding their shores? How to avoid the Renminbi, Yen, Won, Baht, Peso, and Real, among others, from strengthening and thus decreasing the competitiveness of their goods in the world market? Why, recycle all of those excess dollars back into the U.S. by purchasing the (until now) safest investment in the world - U.S. Treasuries. Buying U.S. Treasuries with surplus dollars had the beneficial side effect of keeping U.S. interest rates far lower than they would otherwise have been, in turn stimulating the U.S. consumer to take on even more cheap debt with which to buy more foreign goods.

Clearly though the trend was unsustainable and had to come to an end eventually. At some point the foreign vendors financing our purchases would want to get something tangible in exchange for their store of paper money. Now it increasingly appears that the end is near as America's policy of dollar debasement is obviously vexing the foreign holders of U.S. debt.

China, in particular, appears to be signaling that it is serious about ending the trend. The Chinese have accumulated some $2.2 trillion in U.S. debt, primarily U.S. Treasuries. but lately they have been signaling an end to unlimited Treasury accumulation. Instead they have been diversifying away from US Treasuries by using the roughly $200 billion accumulated each quarter to buy other currencies and assets. More ominously for the U.S. Treasury market, the Chinese are now indicating a desire to actively sell Treasuries in order to buy U.S. strategic assets, according to Chinese official Li Daokui in a statement made at the World Economic Forum.

"We would like to buy stakes in Boeing, Intel, and Apple, and maybe we should invest in these types of companies in a proactive way," Li said at the Forum. "Once the US Treasury market stabilizes we can liquidate more of our holdings of Treasuries," he went on to say. HELLO?

The Chinese liquidating their Treasury holdings isn't a dollar negative if they use the proceeds to buy American assets, but it could send the bond market reeling, driving up interest rates and throwing the United States into recession in the process. The Federal Reserve is already financing the entire budget deficit (and has been for almost two years now). Is the Fed ready to prostitute its balance sheet further by stepping into the breach to buy China's Treasuries if they follow through with their plans to swap out T-bonds for hard assets? Perhaps. But will the rest of the world allow the Fed to get away with it for long? Not likely....

Dollar dumping by the major holders of our debt is a growing possibility, with serious consequences likely, not the least of which are rising interest rates and an economy in recession. Neither bonds nor stocks will weather that particular storm very well.....

Recession All But Certain

2011-09-12T10:35:00.000-07:00

The government likes to spin the numbers as does Wall Street. Politicians seek re-election and Wall Street seeks transactions. You will almost never hear a fee-based Advisor, insurance agent, or product selling financial planner (all distributors of Wall Street's products) tell you that now is NOT a good time to buy, because they make most of their money from the commissions they get when they sell you something. The positive spin coming from Wall Street economists is often nothing more than cover for their product selling compatriots.

But the data now strongly suggest that we are either already in or will soon be in another recession. The deterioration in financial and economic measures that provides a unique signature that always and only is observed during or immediately prior to U.S. recessions is in place. These include a widening of credit spreads on corporate debt versus six-months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total non-farm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. The evidence has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions), according to Dr. John Hussman

We have been forecasting a bear market (20%-40% decline) since late last year with the most likely starting period the spring of 2012 and the second most likely starting period the fall of 2011. The S&P 500 is at 1137 as we write, having peaked in April at 1370.58. A 20% to 40% decline would put the S&P 500 in a range of 822 - 1096. We are mindful of the fact that average valuation for the S&P 500 over the very long term, based on average 10-year trailing earnings, replacement cost analysis, and the dividend growth model is in the 900 range. Our conclusion is that we will likely see 900 or thereabouts in the coming bear market if the European sovereign and banking situation is contained. We could quite possibly see 500 on the S&P 500 if it is not (although 500 might seem like a mind-boggling number to many investors, it should be remembered that we hit 666 intra-day in March of 2009). It's probably also worth pointing out the 500 on the S&P 500 would be about right as a starting point for the next great secular BULL market based on past valuations in 1919, 1946, and 1982. For the record, we are not anticipating a decline to 500, believing that 800-1000 is the more likely floor. But we do feel it's a number worth mentioning since the European banking and sovereign debt crisis could very easily spin out of control, sucking the U.S. (courtesy of our hyperactive Central Bank) into the maelstrom.

Biechele Royce Advisors is continuing to buy good companies when we can find them on sale. We are emphasizing dividend paying blue chip stocks with defensive characteristics. We are watching high-yield bonds with interest and believe a buying opportunity will present itself within the next year. We are still overweight non-dollar assets as we continue to believe that the wildly inappropriate monetary policy currently being conducted in the U.S. has a high probability of sparking strong inflationary pressures before all is said and done. Finally we are waiting to put excess cash to work should we be fortunate enough to experience a market cleansing decline into the 800-1000 area. We have a long and growing list of good companies that we'd love to own at the right price!

Common Mistakes with Wills

2011-08-23T11:20:00.000-07:00

Your Will can have a major impact on your family (including your spouse), friends, and favorite causes after you're gone. It is all too common for someone to die without a will, ensuring that their wishes aren't honored in death. Wills allow individuals to specify how they want their assets divided up after they are gone and can greatly impact the individual's legacy - assets distributed smoothly and in accordance with the individual's wishes, or squabbling and legal challenges that can cause hurt feelings and ill-will among your loved ones.

A second common mistake is making surprise decisions on who gets what, which can also lead to hurt feelings and family conflicts. Most people do not want spouses, children and other relatives fighting over their assets when they are gone, but that is exactly what can happen if they don't take the time to explain to their heirs what they plan.

Cutting out a spouse is surprisingly common, but unless you have a prenuptial agreement, your spouse is entitled to receive up to one-half of your estate, whether you write it into your will or not. Have your spouse sign a waiver before your death or expect your estate to face claims afterwards.

At the other end of the spectrum are those individuals who are in a second marriage and leave everything to their spouse. The children from the individual's first marriage can end up with nothing after the spouse dies if he/she has remarried in the interim. One solution is to set up a marital trust within your Will that holds assets for your spouse and then transfers them to your children after your spouse's death, ensuring that your assets stay in the family rather than going elsewhere.

Another common error is forgetting about Insurance/IRA designations. Separate beneficiary designation forms control the distribution of retirement accounts, annuities and life insurance after death. It is critical to complete beneficiary forms for these assets if you wish to avoid probate court, and the costs and publicity that goes with the probate process. Assets titled in your name, as opposed to jointly held with rights of survivorship, without designated beneficiaries will be distributed according to the general instructions in your Will, possibly triggering taxes much sooner than otherwise would be the case.

Please feel free to call or email with questions!

Market Update

2011-08-05T07:17:00.000-07:00

The market topping process we wrote about Tuesday is now complete. The stock jockeys bounced the market hard on Wednesday in an effort to avoid a close below the March 16th low (1249), which would have put the top in place and brought in more short term selling. Unfortunately the Wednesday bounce was short lived and itchy trading fingers started pushing buttons on Thursday, pounding the market lower. The S&P 500 basically opened at its high and closed at its low on big volume - just about as negative as you can get from a technical stand point. We will likely get an oversold rally starting either late today or more likely early next week as the speculators (which is almost everyone these days) try to jam the market back into its six month trading range (1249-1370). The rally is likely to fail and further downside testing (perhaps all the way to the low 1100s) is likely by the fall. We continue to think the market will likely rally into year end, following this sell off, with the onset of the real bear market not occurring until sometime next spring. Our best-guess scenario is predicated on the Federal Reserve and/or the Administration coming up with yet another ill-conceived, short term program to support the market, delaying, but not preventing, the inevitable bear market that lurks out there in our future.

Our longer term forecast is unchanged - a bear market within the next 12-18 months that takes the S&P 500 down 20%-40% from its 1370 high. The bear market's underlying causes will include the simple fact that S&P 500 fair value is only about 900, making it an expensive investment currently. Additionally, record net profit margins will revert to their long run mean at some point as the economy continues its slide back into recession, resulting in disappointing earnings from the S&P 500's constituents.

Biechele Royce Advisors continues to buy good companies at great prices as we find them, but has been carrying extra cash in client portfolios and favoring more defensive investments in anticipation of the selling we are now experiencing.

Recession and the Bear

2011-08-02T10:22:00.000-07:00

Last week was a big down week for equities, with most major averages down around 4%. DJIA lost 4.24%, S&P500 down 3.92%, and NASDAQ fell 3.58%. The S&P 500 was down 2.2% for July. Treasuries rallied for the week, with the 10-yr. yield lower at 2.79%. Some of the economic highlights to go with the weak stock market action were:

Q2 GDP disappoints…Q1 revised lower.
U.S. economy grew by only 1.3% in Q2, and Q1 was revised down to a mere 0.4% growth rate.
(Weakness in consumer spending suggests that higher prices for certain food / energy items have played a role in restraining spending.)
0.1% increase in personal spending was the lowest since Q2 2009 in the midst of the recession.
Budget cuts in state/local government contributed to a 3.4% drop in government spending.
It appears that sub-par growth continues to be the path of the economy for the second half.

GDP growth has now decelerated to a level below the 2% threshold that has been a predictor of recession in the past. Jobs and housing are closely linked and both remain a drag on the economy. New home sales fell in June as potential buyers pulled back from the market amid job uncertainty and tough lending standards. Canceled home transactions in June jumped to 16%, way above the 4% level seen in May and the 9-10% range of the last year. Tight appraisals and tough loan underwriting scrutiny are to blame, according to the media. Most of the activity in the housing market are distressed sales.

Technically, the market has broken the uptrend begun on 7 July 2010 and continues the topping process begun 18 February 2011. A drop below the 16 March low of 1249 would put the top in place and sharply increase the likelihood that the secular bear market is resuming. We continue to think it more likely that a retest of the 1 July 2010 low at 1011 won't occur until sometime next spring but a fall retest is a possibility. Regardless, we continue to maintain a defensive posture in client portfolios given that S&P 500 fair value is around 900 and that the economy is clearly slowing.

Laddered Bond Portfolios

2011-06-22T06:54:00.000-07:00

I received a call from a Dow Jones newspaper reporter yesterday asking me my thoughts on laddered bond portfolios as a strategy for income in retirement. She was under the impression that I was not in favor of them - possibly from something I'd written in the past (although she wasn't able to quite recall what she'd read and I wasn't able to quite recall what I might have written). Anyway, we had a very pleasant half hour conversation about laddered portfolios, fee-only versus fee-based (brokers) advisors, variable annuities, and properly diversified multi-asset portfolios...among other investment topics.

But I thought I ought to pass on my thoughts on laddered bond portfolios to my readers, since it was the primary reason she called.

I think a laddered bond strategy makes quite a bit of sense for retirees, but only as a part of a properly diversified multi-asset portfolio. I am not in favor of single asset portfolios for anyone, let alone a retiree. Putting your eggs all in one basket is never a good idea, even if it is in the supposedly safe basket of Treasury bonds, which I personally believe carry quite a bit of risk currently. (Bill Gross of Pimco is on the same page by the way as his firm - the largest bond investor in the world - is currently completely out of Treasury bonds according to statements the bond king has made in recent months).

Bonds were known as certificates of confiscation back in the early 1980s, before the great bond bull market kicked off in 1982. Bond investors had lost their shirts over the prior 15 years or so as interest rates had risen steadily along with inflation. Negative real rates eroded bond wealth steadily for better than a decade. However, Paul Volcker's Federal Reserve changed all of that by committing to sound monetary policy designed to bring down inflation and restore the stability of the dollar as a store of value. Bonds have proven a splendid investment ever since... until now.

It is highly likely that inflation will continue to rise and, with it, interest rates over the next decade. We may have another year or two to wait before the trend really gathers steam, but without drastic changes in U.S. monetary and fiscal policy, the odds of a long bond bear market are high. A laddered dollar bond portfolio is not where you want all of your assets in such an environment. Yes bonds will mature yearly and can be reinvested at higher rates, but the bonds in you portfolio will lose value. Any sales necessitated by unexpected cash needs will result in losses. And generating capital losses in bond investing is a cardinal sin. Even more dangerous is the strategy of attempting to "ladder" a bond mutual fund portfolio, given that bond mutual funds have a perpetual duration - duration is a measure of bond price sensitivity to changes in interest rates. The longer the duration the bigger the price moves in a bond, and perpetual is as long as you can get.

Far better to build a properly diversified multi-asset portfolio for our retiree that might include a laddered bond portfolio to go with the high-quality dividend paying blue chip stocks, the dollar diversifying international assets, and the inflation hedging tangible assets (real estate and commodities primarily).

The S&P 500 is rallying short term after moving into oversold territory, but is likely to at least retest the recent low at 1256. It is still too early to tell if the correction is merely the pause that refreshes on the start of a topping process that will ultimately lead to the next downleg in the ongoing secular bear market. We reiterate that fair value for the S&P 500 is in the 900 area and that the economy is now showing clear signs of slowing - a combination that would suggest prudence is the better part of valor at the moment.

Correction

2011-06-13T11:33:00.000-07:00

The market is finally starting a correction that could eventually turn into a full fledged bear market, depending on what policy decisions the administration, the Federal Reserve, the ECB, and the Chinese make in response to a slowing economy in the U.S. and rising inflation overseas. The S&P 500 has lost 7.7% since its 2 May peak of 1370.58 (5.3% of that loss coming in June). The next key support is 1249 - the 16 March low. Selling pressures sufficient to take out the 1249 support level would sharply increase the likely of further significant downside testing. There is strong support for the S&P 500 from 1150 down to 1000 however, making the onset of a full blown bear market unlikely in the next few quarters. Tops take time to form and it is more likely that a bounce off of 1249, or perhaps off of 1220 support (10.9% pullback) will see the S&P 500 rally into year end and finish somewhere near the May 2 high of 1370.

Nevertheless, a renewal of the secular bear market this year can't be ruled out. S&P 500 fair value is in the 900 area, net profit margins are at record levels (and will certainly fall going forward), and the U.S. economy is showing signs of slowing. As well, the Chinese are tightening monetary policy and the ECB is talking about tightening monetary policy - both entities would like to deflect inflation away from their shores.

On the other side of the ledger is the President's desire to win re-election. It is very likely that Obama will take steps to bolster the economy short term (and by extension the stock market) in order to win re-election. No post WWII incumbent has won re-election with unemployment above 7.2%, which means Obama must do something fairly quickly to light a fire under the jobs market if he hopes to serve a second term.

Likewise, Ben Bernanke continues to send signals that QE2 will not be the end of his monetary largess. He apparently remains determined to use every monetary policy tool in his tool box to keep the stock market afloat while the banks continue to repair their shattered balance sheets. Bernanke is likely to trot out another initiative immediately on the heels of QE2's end on 30 June. Our forecast is still for a resumption of the bear market sometime in the next 12 to 18 months, but we continue to believe that we are more likely to feel the Bear's bite in 2012 than 2011.

We continue to look for high-quality dividend paying blue chips to buy. We also continue to invest in shorter duration fixed income investments, given the likelihood of rising interest rates in coming years. Finally we continue to invest in nondollar assets that will provide a hedge against purchasing power loss as the shortsighted policies pursued by politicians (on both sides of the aisle) and the Federal Reserve all but ensure rising inflation over the next decade.

Stocks For The Long Run?

2011-05-27T07:11:00.000-07:00

There are at least a few academics who argue that stocks are too risky for retirement portfolios and that an all bond portfolio is more appropriate for retirement portfolios, given the much more predictable return streams of bonds versus stocks. Bond portfolios can be constructed to ensure that cash flows match known cash needs throughout a retirement plan. Unfortunately, bonds are not particularly good at preserving purchasing power when inflation unexpectedly makes an appearance (Biechele Royce is forecasting rising inflation over the next 10 plus years). Stocks, then, are a necessary evil for investors who fail to save enough during their accumulation years - the vast majority - to make it possible to survive in retirement on an all bond portfolio.

Okay, okay time out.... You are puzzled because I'm dissing stocks for the long run aren't you? I mean, the baby boomers grew up in the stock friendly world of the 1980s and 1990s. We were told that stocks always deliver a superior return over the long run and that most of us should just forget about bonds and pile into stocks as long as we were looking at a 10-year plus time horizon. We were told that we'd end up with far more wealth in retirement by sticking with the superior long run returns of stocks. Well.... we weren't really getting the whole story when it comes to stock returns versus bond returns as it turns out.

The fact is that bonds have far outperformed stocks over the last 10 years, to the tune of 5.23% per annum, and have kept up with stocks over the last 20 and 30 year periods with far less volatility. The fact is that investors over the last 30 years would've been far better off sticking with bonds ONLY. But that must be a very unusual occurrence right? Not really. It turns out that there have been a number of very long periods during which bonds were superior to stocks. The period 1803-1857 comes to mind - bonds trounced stocks handily and it wasn't until 1871 that stock investors managed to break even. Stocks failed to match bonds once again from 1929 -1949 and stocks didn't manage to break even until the early 1960s. We've had a huge bull market in bonds since 1982 and it may not be quite over yet.

But it is probably coming to an end, given that nominal interest rates aren't likely to fall much further absence outright deflation - something that Federal Reserve Chairman Ben Bernanke says isn't possible if a central bank is willing to keep printing money, as ours clearly is. So back to stocks for the long run then? We don't think so given the tremendous over valuation that currently exists. It is hard to get excited about loading up on stocks when they are trading some 45% above fair value.

And that leaves us with a conundrum - neither stocks nor bonds are particularly attractive for the long run right now, making it a difficult time to be an investor. I am holding cash and gold stocks personally, along with a position in a single stock. I have a list of companies I intend to buy when the next big sell off hits, likely sometime in the next 12-18 months.

Biechele Royce Advisors builds properly diversified portfolios (mine is not) and is currently overweighting nondollar assets, tangible assets, and big blue chip dividending paying U.S. companies. We continue to buy good companies at great prices as we find them.

Presidential Cycle

2011-05-16T07:40:00.000-07:00

The S&P 500 sold off two weeks ago, losing 1.72%. Energy was the hardest hit, declining close to 7%, followed by materials, which was down 3.77%. Defensive sectors such as Staples and Telecom were flat or only down slightly. The overall market traded basically flat last week until a Friday sell off closed it out near its recent lows.

So much for the very short term action. Longer term the S&P 500 is trading 45% above fair value, according to Jeremy Grantham of GMO ($108 billion under management), who pegs fair value at 920 for the S&P 500. Grantham’s estimate of fair value gibes with both Tobin’s Q and Shiller’s P/E (very good long term measures of stock market fair value). All of which means equity investors are still playing with fire. Hide out in bonds? Not Treasury bonds, at least not according to Bill Gross of Pimco fame. Bill has informed the world that Pimco has sold all of its Treasury holdings ahead of the end of QE2 (set to finish up at the end of June).

Grantham had thought that the combination of QE2 and the third year of the presidential cycle could push the S&P 500 back to between 1400 and 1600 by October of this year – putting it back into bubble territory. (Grantham is a student of bubbles in various asset classes throughout history and measures them against average valuations. He uses a two standard deviation divergence from long-term fair value to mark a bubble – what is supposed to be a once in 44 year event). Grantham now thinks it much less likely that the S&P 500 will reach the 1400-1600 level by fall, given its failure to advance farther by now. Historically, the market has advance 20% in the first seven months of the third year of the Presidential cycle (started last October). The entire return, on average, for the 48 month cycle is only 21%, meaning investors can expect a whopping 1% return from the S&P 500 over the next 41 months based solely on the Presidential cycle. Of course, these are only averages for the Presidential cycle and don’t take into account things like the current overvalued state of the market or the current jobless recovery (negatives for likely future returns.)

Bottom line for investors (and yep I know I’m starting to sound like a broken record) is that the market remains very overpriced and a dangerous place to be right now. Healthy levels of cash will ensure that any 20% to 30% decline from current levels in the next few years will make it possible to buy cheap assets that will provide above market rates of return going forward.

Biechele Royce Advisors continues to buy good companies at great prices as we find them. We are holding extra cash in clients’ portfolios for the inevitable rainy day that is coming, likely in the next 12 to 24 months.

Real Asset Allocation

2011-04-12T08:00:00.000-07:00

"The market tends to be priced in a way that if you want to try to outperform, you have to take the risk of looking like an idiot," according to Ben Inker, the head of asset allocation at Boston-based global money manager Grantham, Mayo, van Otterloo & Co. (GMO has approximately $107 billion under management). And looking like an idiot can get you fired in the money management business, which means the markets are not efficient, since money manager behavior is predictable. Career risk is real and money managers do make decisions to avoid taking on career risk. It is far better to lose money together than make money alone. Likewise, it is important to stay up with the Jones when the market is rising. Falling behind the pack in a bull market can get you fired as well. Mutual funds are currently fully invested, with cash levels back to the 2007 lows. Its a curious decision mutual fund managers have made to go "all in" right now given the demonstrably overvalued market and the obvious catalysts for a correction/bear market, unless you understand that it is career risk that is driving the train, not investment risk. Inker's quote bears repeating because it is the alpha and omega of money manager behavior. "The market tends to be priced in a way that if you want to try to outperform, you have to take a risk of looking like and idiot." Inker goes on to explain that to outperform you have to deviate from your benchmark, and that increases the risk of under performance and, in the extreme, looking like and idiot and getting fired. It is no coincidence that fully 75% of the so-called actively managed funds are actually closet indexers according to academics (closet indexers claim to actively manage their funds but actually mimic their benchmark, leaving investors to pay high fees for something they could get for a fraction of the cost by simply investing in index funds). And what is the impact on the market as a result of the career-risk factor? Markets exhibit herd-like behavior, which leads to momentum, and money flowing into whatever strategy is doing best, according to Inker. Valuations rise to extremes within the better performing asset classes and sectors until the gravitational pull of replacement cost exerts itself. Replacement cost (Tobin's Q is a very good long term measure of the relationship between the market and replacement cost) eventually always brings the market back to fair value, but typically with an overshoot to the downside first (as the herd exits in mass, ignoring valuations on the way down just as it did on the way up). Biechele Royce Advisor (like GMO) increases allocations to assets and sectors AFTER they have dropped and decreases allocations to assets and sectors AFTER they have risen, in order to take advantage of a HUGE inefficiency in the markets created by career risk. However, we primarily let individual securities lead us to our over and under weights, using big picture considerations to provide a context for our valuation decisions. In other words, rather than making a broad call on an asset class, we instead do basic business valuation in order to buy good companies at great prices. Likewise we let basic business valuation drive our sell decision, making sure we exit a position once the company has returned to fair value.

Variable Annuities - the New Snake Oil

2011-03-25T07:49:00.000-07:00

The cliche of the snake oil salesman is deeply embedded in American cultural in the form of frequent depictions in the movies of those fast talking salesmen touting their wares to a crowd of curious onlookers. Most of you probably have seen a scene from a western in which the smooth talking dandy pitches his wonderful elixir as "good for whatever ails you!" Variable annuities with a guaranteed minimum wealth benefit (GMWB) are increasingly sold in much the same manner. Insurance agents and fee-based "advisors" increasingly push variable annuities on anyone and everyone, regardless of their age, income, and wealth. Frequently these salesmen don't even understand what they are selling, only that they get BIG commissions for selling them. Are you a 78 year-old single woman with Alzheimer, but with $1.3 million in the bank? No problem! You NEED a variable annuity with a GMWB rider. A couple in your mid-60s with two defined benefit plans between you? No problem! You need TWO variable annuities and you definitely need to replace the ones you were already sold in your Roth IRAs with two brand new ones that are waaaaay better! Why are they better? Because they are NEW and generate another commission for ME! The truth is that variable annuities are one of the most oversold products out there because of their big commissions, not because of their actual performance. Now here's a dose of reality courtesy of Dr. Michael Edesess (advanced mathematics and economics), Louis Mittel of Advisor Perspectives, and Robert Huebscher. Variable annuities under perform a passively managed fixed income portfolio by almost 1.60% annually on average based on modeling 100,000 trials using random date-of-death Monte Carlo simulations. In fact, a passive fixed income strategy has a higher internal rate of return (IRR) for all life spans through 113 years of age. The variable annuity returns just can't make up for their higher fees and the cost of the longevity insurance embedded in the product over shorter periods of time. Of course, insurance industry sponsored research "shows" that variable annuities are superior to passively managed fixed income portfolios. However insurance industry studies are flawed to say the least. For instance, industry studies assume that an investor will live to be 90 years of age 100 percent of the time even though the actual probability is only 19%. As well, insurance industry studies "show" that variable annuity income will keep pace with inflation even though inflation has averaged 3% over the last century and the actual nominal median average income increase for variable annuities is only 0.5% per year (far below insurance industry claims). So the next time the snake oil salesman comes a calling, "JUST SAY NO!" Biechele Royce Advisors could sell you variable annuities and make those big commissions, but instead chooses to do the right thing by building you properly diversified stock and bond (fixed income) portfolios to help you achieve a successful retirement. Best Regards, Chris Christopher Royce Norwood, CFA Biechele Royce Advisors, Inc.

Valuations Matter

2011-03-15T08:55:00.000-07:00

The table below summarizes very nicely why we continue to view the U.S. stock market as high risk and low return. We have been projecting since the beginning of the year that a 10% to 20% pullback was likely sometime in the first two quarters of 2010 . We think the events in Japan are now serving as a catalyst and believe the correction has begun. The S&P 500 is down 6.2% peak to trough currently and we expect it to fall to at least 1200 before the current pullback is over. A correction to the 200-day moving average would result in a decline of about 12% and is the minimum we expect at the moment. A deeper correction back to 1100 is certainly possible. Biechele Royce will continue to buy good companies at great prices as they come available.

TABLE

10-year S&P 500 total returns by P/E level

***Shiller P/E is currently 24***

Shiller Avg Annual Return

Below 12 16.0%

12 to 16 14.3%

16 to 20 10.3%

20 to 24 6.6%

Above 24 3.5%

5-year S&P 500 total returns by P/E level

***Shiller P/E is currently 24***

Shiller Avg Annual Return

Below 12 16.5%

12 to 16 12.4%

16 to 20 9.3%

20 to 24 11.6%

Above 24 3.2%

(Note the jump in five-year returns for valuations in the 20 to 24 range: it is the result of short-term momentum in bubble markets. The S&P 500 hasn't seen Shiller P/Es at or above 24 except for a very brief period in 1929, and then during the current bubble years encompassing 1999 to the present.)

Please feel free to call or e-mail with questions about the current investing environment...

Regards,

Christopher Royce Norwood, CFA

Biechele Royce Advisors, Inc.

Dividend Paying Stocks Are Superior

2011-02-09T09:37:00.000-08:00

Dividend paying stocks outperform with lower volatility. Put another way... non-dividend paying so-called growth stocks are inferior investments. Now that might come as a surprise to many of you who've been suckered into buying growth stocks by your fee-based (stockbroker) advisors (either directly or via growth mutual funds), but the empirical evidence is irrefutable. You are better off buying "stodgy" dividend paying stocks because you will make more MONEY with less RISK.

The latest in a string of studies done by the academic world has once again verified that dividend-paying stocks are better investments than the zero dividend crew. Specifically, a study done by Dr. C. Thomas Howard (Reiman School of Finance) for the period January 1973-September 2010, shows that companies which grew their dividend out performed dividend cutting stocks by more than 10% annually. Companies that merely maintained their dividend outperformed companies with no dividend by 5.29% annually. Let's do some Q&A...

Would you rather have $24,267 or $9,285? Would you rather have $21,288 or $11,977? The first number is what you'd accumulate from 1973 thru September of 2010 if you stuck to dividend growing stocks and made an initial $10,000 investment. The second number represents dividend cutting stocks while the third amount is a portfolio of no change dividend paying stocks and the final number are the GROWTH companies that pay no dividend. Kinda makes you wonder why the brokers are always pushing growth stock mutual funds on you doesn't it?

But it gets even better! You can have the $24,285 portfolio with less risk - as measured by volatility. Dividend growing stocks had a standard deviation of 17.6% versus a standard deviation of 26.6% for zero dividend paying stocks. Standard deviation is a measure of volatility which means lower is better.

Now some of you might point out that there is a tax penalty associated with dividends in non-qualified accounts (qualified accounts such as IRAs, 401(k)s and 403(b)s don't pay taxes and aren't impacted). And you'd be right. However, the out performance of dividend paying stocks more than compensates you for holding them - EVEN IN A TAXABLE
ACCOUNT.

The bottomline (once again) is that investors are far better off buying dividend paying stocks (directly if possible to cut out the mutual fund fees) rather than the high-flying, zero dividend paying growth stocks that are typically pushed by the commissioned based salesmen passing themselves off as investment advisors.

Biechele Royce Advisors buys good companies at great prices. We are currently focusing even more than normal on high-quality dividend paying stocks in our equity portfolios. Fair value for the S&P 500 is between 800-900 and we expect the market to exhibit increased volatility over the next few years as the current cyclical bull market ends and the secular bear market resumes.

The Current Rally

2011-01-12T07:01:00.000-08:00

So there I was rereading my last blog and I could sorta kinda understand why some of my readers e-mailed me to sarcastically thank me for my gloomy outlook. To those readers and everyone else let me proclaim...

The world is NOT coming to an end! (and no that's not a change of mind on my part.) My intention in my last blog was to make sure everyone is aware that the economy is sick and likely to stay that way for a long time given the crushing debt load - both public and private. As well, I wanted to make sure you folks understood that the market risk level is extremely high. However...

You can invest prudently, even in today's overvalued stock market, and earn a positive return over the next 10-year period. But chasing momentum, volatility, or credit risk will likely lead to losses over the long-term unless you happen to be a very good speculator. Fair value for the S&P 500 is somewhere around 800-850 based on a number of very good long-term valuation metrics (which are not widely followed by Wall Street because they have limited use for speculators focusing on short term returns). For instance, investors using Tobin's Q, price to trailing 10-year average earnings, and the long-term dividend growth rate as guidelines would have anticipated the 10-year period of negative stock market returns that began in 2000. Currently those valuation metrics are forecasting a return of 3.5% to 4% during the next 10-year period - a big step up but still well below the long-term historical return of 10%.

The current rally is not based on attractive valuations but rather speculative forces chasing higher risk, lower quality assets, egged on by the Federal Reserve's blatant promises of more money printing. Examining return factors makes it painfully obvious that speculators are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk, and volatility while avoiding stocks with reasonable valuations, stability, high-quality earnings, and attractive dividend yields. In fact, looking at thirteen week factor returns tells a compelling story of speculation that, when coupled with an overpriced market, makes it almost inevitable that bad things will eventually happen to those investors choosing to play the risk game.

Return sources for the 13-weeks leading into year-end 2010 from high to low were: Market Beta (Risk) - 17.8%; Raw Materials Beta (Commodity sensitivity) - 17.5%; Credit Spread Beta (Macro Economic Sensitivity) - 14.7%; Small v Large Beta (Style sensitivity) - 12.5%; Silver Beta (Commodity Sensitivity) - 10.9%; Sigma Risk (Volatility) - 10.7%; Operating Cash Flow Yield (Valuation) - (- 4%); EPS Stability (Quality) - (-5.6%); Value v Growth Beta (Style Sensitivity) - (-5.9%); Return on Invested Capital (Profitability) - (-6.6%); Dividend Yield (Valuation) - (-9.3%); 10-Year T-Note Beta (Macro Economic Sensitivity) - (-9.6%); High v Low Quality Beta (Style Sensitivity) - (-15.7%)

Clearly the high risk, low-quality garbage stocks have dominated the rally into year end while lower risk, high-quality stocks have trailed sharply. Tellingly, Operating Cash Flow, Sales/Price, Market Cap, and EBIT/Enterprise value lead all other return factors over the last 10-years, meaning valuation does eventually win out! More specifically, those investors who focus their attention on the underlying value of the businesses in which they are investing will do just fine over the long run as price (eventually) always follows value. Buying good businesses at great prices only adds to both the margin of safety and the ultimate returns. Businesses that are steadily growing cash flows over time create a situation where it is nearly impossible for an investor to lose money - as long as the investor is willing to wait for market prices to reflect underlying values. Which brings us back to current valuation levels....

Given that fair-value for the S&P 500 stands around 800 to 850, it would seem prudent for investors to set aside at least some cash now in order to take advantage of better valuations sometime in the (near?) future. And for those of you reluctant to raise some cash because you're worried about missing the next great bull market? Relax! The gains we are currently experiencing in the market will almost certainly reverse sometime in the next few years and quite possibly in the next few quarters. The fact that net profit margins are currently 50% above their long-term mean (and it is a strongly mean reverting series) all but ensures that corporate profits will begin to disappoint sometime in the next few years (few quarters?) and cause a market sell off back toward fair value. Capital preservation is still the priority of the day and cash is not a dirty four letter word!

Biechele Royce Advisors is holding more cash than normal for its clients. We don't buy stocks unless we can invest in good companies at great prices. We are focused on high-quality, dividend paying stocks in our domestic portfolios and expect to have an opportunity sometime this year to add to our holdings at lower prices.

America Bankrupt/Dangerous Market

2010-12-27T09:06:00.000-08:00

We have maintained since late 2007 that both the U.S. and European banking systems are insolvent. Were they required to mark assets to market they would have insufficient assets to cover their liabilities - a basic definition of insolvency. Fortunately for the banks on both continents, central banks have waived the requirement to mark assets to market while the banks attempt to earn enough profits to (eventually) write down bad assets sufficiently to return to solvency. Meanwhile the Federal Reserve has been stuffing its own balance sheet with toxic assets purchased from U.S. banks in an effort to expedite the process. Unfortunately for U.S. taxpayers, the Fed is paying top dollar for toxic assets, ensuring that taxpayers will suffer billions in losses. One example should suffice to make the point. The Fed's Maiden Lane LLC purchased $30 billion from Bear Stearns in order to facilitate Bear's sale to JP Morgan Chase - Jamie Dimon refused to go through with the purchase unless the toxic assets were first removed from Bear Stearn's balance sheet. Outrageously, the Fed allowed Bear to value the assets sold it without so much as a cursory inspection.

The U.S. government is insolvent as well. The number's don't lie! Well, okay they do, but only because government bureaucrats keep changing the accounting treatment to hide the true extent of the situation from the public. The government uses a quasi-cash basis to produce its yearly deficit totals - 2010 is expected to run around $1.3 trillion (almost 10% of GDP!!!) when the numbers are finalized. However on a GAAP basis (using generally accepted accounting principles), the 2010 number is $2.1 trillion - more than 50% higher than the official number. Broader GAAP-based federal deficits that include the unfunded liabilities represented by Social Security and Medicare have been running between $4 and $5 trillion over the last three fiscal years (2010's deficit is approaching $5 trillion).

Now here's the really important part...

The U.S. government can't make up the annual shortfalls through higher taxes as, "there are not enough untaxed wages and salaries or corporate profits to do so," according to Dr. John Williams, a noted private economist. Nor can the government cut spending sufficiently without touching Social Security and Medicare. To wit; the government could cut all other spending and still not eliminate the deficit! The United States will default on some of its liabilities. It is simply a question of when and how. The most likely scenario for default is through a combination of inflation (paying debt off with less valuable dollars) and a reduction in social security and medicare benefits (reneging on promises already made). The public should plan for retirement accordingly...

Meanwhile, the U.S. market is very overbought on a short-term basis and expensive longer term. It is highly likely that we will experience a painful pullback at some point in the next two to four quarters. It is also increasingly likely that the 2011-2013 investing period will result in a loss for the U.S. market and that the next ten years will see returns of only 5% to 6% versus a long run average of between 10% and 11%. Consider the following:

1) S&P 500 more than 8% above its 52 week (exponential) average 2) S&P 500 more than 50% above its 4-year low 3) *Shiller P/E greater than 18 4) 10-year Treasury yield higher than 6 months earlier 5) Advisory bullishness greater than 47% with bearishness less than 27%. (Investor's Intelligence)

“The historical instances corresponding to these conditions are as follows:

1) December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)
2) August - September 1987 (followed by a 34% plunge over the following 3 months) 3) July 1998 (followed abruptly by an 18% loss over the following 3 months) 4) July 1999 (followed by a 12% market loss over the next 3 months) 5) January 2000 (followed by a spike 10% loss over the next 6 weeks) 6) March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002) 7) July 2007 (followed by a 57% market plunge over the following 21 months)
8) January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks) 9) April 2010 (followed by a 17% market loss over the following 3 months)

10) December 2010 ….?????”

*The U.S. stock market has experienced losses over the following three-year period one-third of the time when Shiller's PE is above 19.5 - the ratio is currently 22.7!

Biechele Royce Advisors is currently overweight cash in its models and is maintaining a strict sell discipline in order to limit price risk in its clients' portfolios. We continue to favor blue-chip, dividend paying stocks in the U.S.

Currency War!

2010-11-12T06:55:00.000-08:00

On 11 October we wrote, "The Federal Reserve is going to print more paper dollars, likely beginning shortly after the November elections. The estimates from the folks in the know is a minimum of $500 billion to $1 trillion. The U.S. economy is currently around $14 trillion and public debt is around $12 trillion - so a trillion in freshly printed greenbacks is not small potatoes. Recent comments from the likes of Federal Reserve Vice Chairman Dudley and the recently released FOMC meeting minutes all but assure that the Federal Reserve will act soon and in size. The September/October stock market rally is telling us as much."

NAILED IT!

The Federal Reserve announced on 4 November that they would be buying $600 billion in government bonds beginning immediately and running through the middle of next year. The stated intention is to drive interest rates even lower in an effort to stimulate spending and job creation in order to fight the deflationary threat which the Federal Reserve governers insist is looming. Well, most of the Federal Reserve governers anyway.

In a rare public disagreement with the consensus, FED Governer Warsh announced that he isn't concerned about deflation, citing Dr. Allan Meltzer's position that there is no deflationary threat. Dr. Meltzer, the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, issued a scathing critique of the Fed just last week saying, "All this is not relevant now, since there is no sign of deflation in the United States. The Fed's claim that there is a risk of deflation should embarrass it." Meltzer's views carry weight since he is considered one of the world's foremost experts on the development and applications of monetary policy. It's time to take notice when Meltzer derides Federal Reserve policy in such strong terms.

So what is the Federal Reserve up to if it isn't slaying the deflationary dragon?

Well, it is almost a certainty that its real goal is to debase the U.S. dollar, making it easier for the United States to pay back the trillions it owes to its citizens, to the Chinese and other sovereign nations, and also making our exports more competitive in world markets. Of course the U.S. can't publicly admit it is following a classic "beggar thy neighbor" policy. Fed Chairman Bernanke isn't about to own up, nor is Treasury Secretary Geithner. On the contrary, Geithner just appeared on CNBC and said (with a straight face) that, "“THE U.S. WILL NEVER DO THAT. WE WILL NEVER SEEK TO WEAKEN OUR CURRENCY AS A TOOL TO GAIN COMPETITIVE ADVANTAGE OR TO GROW THE ECONOMY.” …

So is the rest of the world buying the baloney? Not hardly...

China's Dagong Global Credit Rating Co. just cut its credit rating on the U.S. to A+ from AA because of the Fed's plan to purchase bonds to spur growth and inflation. Dagong Global wrote, "The credit outlook for the U.S. is negative amid deteriorating debt repayment capability and a "drastic" drop in the government's intention to repay debt. The Fed's quantitative easing policy will erode the value of the dollar and is against the interests of creditors." Ouch!

And here is what German Finance Minister Schaeuble had to say about QE2 in an interview with Spiegel magazine last week, "I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don't recognize the economic argument behind this measure." He went on to say that, "It's inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money."

It would appear that the rest of the world understands very well what is going on. But why should the U.S. consumer care if the rest of the world is getting hosed (with dollars)?

INFLATION!!!!!!

Gold is saying the inflationary threat is real, reaching more than $1400 per ounce before pulling back (temporarily most likely). Although it is always difficult to forecast price levels, it is quite possible that gold will reach $2500 per ounce within a few years if the Federal Reserve continues in its madness. The bottom line though is that inflation is bad for savers and good for debtors and U.S. savers will suffer right along with the Chinese, Germans, and Japanese. Inflation erodes wealth. Inflation destroys middle classes. U.S. citizens will suffer greatly in coming years as their purchasing power is dramatically eroded by the inflationary genie that the Federal Reserve appears determined to let out of its bottle.

Biechele Royce Advisors builds properly diversified portfolios using individual stocks and bonds whenever possible to reduce costs. We are currently overweight tangible assets such as real estate, precious metals, and commodities as well as non dollar assets, including international stocks and bonds. It is our belief that Inflation is coming and it could get pretty ugly if Bernanke and his lunatics continue to run the asylum.

Quantitative Easing a.k.a Money Printing

2010-10-11T11:46:00.000-07:00

The Federal Reserve is going to print more paper dollars, likely beginning shortly after the November elections. The estimates from the folks in the know is a minimum of $500 billion to $1 trillion. The U.S. economy is currently around $14 trillion and public debt is around $12 trillion - so a trillion in freshly printed greenbacks is not small potatoes. Recent comments from the likes of Federal Reserve Vice Chairman Dudley and the recently released FOMC meeting minutes all but assure that the Federal Reserve will act soon and in size. The September/October stock market rally is telling us as much.

Will quantitative easing(QE2) more effectively stimulate consumption the second time around? After all, the Federal Reserve is estimated to have bought $1.5 trillion in bonds and mortgages between 2008-2010 during the first money printing exercise. Nevertheless, and despite $860 billion in fiscal stimulus thrown in by Congress, final demand grew at only a 1.3% rate in the first four quarters of recovery.

Although the public might not fully appreciate it, the Federal Reserve is boldly going where no central bank has gone before - and the unintended consequences could be disastrous. But what exactly is the Fed trying to accomplish with its radical departure from orthodox central banking? According to a Goldman Sachs report covering a Q&A session with Vice Chairman Dudley, successfully pushing interest rates down will allow those who are able to borrow to do so at lower rates, freeing up some of the income now being spent on debt service. Perhaps more importantly, QE2 will work on other elements of financial conditions, including equity prices and the exchange rate.

And there you have it. QE2 is intended to push the U.S. stock market higher and the dollar lower. The Federal Reserve is targeting the stock market and the dollar... and the smart money knows it, which goes a long way in explaining the recent stock, gold, and commodities rallies. Furthermore, Wall Street investors are also front running the Federal Reserve in the bond market, pushing rates lower without help from the Fed, but with the understanding that the Fed has their backs. (Not coincidently, the Federal Reserve began to signal its intention of carrying out another dollar debasement campaign in early September, just as the S&P 500 looked ready to test the early July low at 1003.)

But what could go wrong? Well first, it is possible that the Federal Reserve QE2 program will be smaller than expected, which would likely result in a bond market sell off. Rising rates could quickly end the stock and commodities market rallies as an already sluggish (contractionary?) economy reacts poorly to a higher interest rate environment. Conversely, the Fed may move HUGE and actually succeed in pushing interest rates down to the point where a falling dollar begins to generate significant inflation. In the latter case, you can expect interest rates to once again start to rise as inflation takes hold. Private bond investors will run for the exits, once again front running the Federal Reserve (with its now even bigger inventory of government bonds).

Who will the Federal Reserve sell to in order to reverse its successful inflation generating policy? What private investor is foolish enough to step in front of that kind of supply? Not the Chinese, who've let Washington know in no uncertain terms that they are opposed to another round of dollar debasement. Yet, unless the Federal Reserve can find a willing buyer for its trillions in bonds, it can not start to drain money from the economy and prevent inflation from ripping out of control. Unfortunately for stock investors, the second scenario will also likely lead to a stock market sell off due to the negative impact rising inflation and interest rates will have on the economy.

All in all it seems to us that investors would do well to sell into the current stock, bond, and commodities market rallies, locking in profits and preparing for a better buying opportunity down the road. Biechele Royce Advisors continues to hold higher levels of cash than normal in its client accounts because we continue to struggle to find good businesses available at great prices.

(Fun Fact: The U.S. stock market has now lost about 80% of its value in gold since the secular bear market began in March of 2000. We see the trend continuing.)

Debt, Inflation, and Governments

2010-09-13T11:23:00.000-07:00

The S&P 500 may motor higher if the Federal Reserve implements an aggressive Quantitative Easing program as is increasingly likely. The July bottom may hold and the S&P 500 may take another run at the April 1219 high. Or perhaps the Federal Reserve will wait too long and the combination of a weakening economy and (still) overpriced market will lead to further selling, taking the S&P 500 back to a three digit number in coming months. Predicting short term market movements is a difficult task at best, in part because policy decisions yet to be made can greatly influence the market's path. For the record: we are of the opinion that the probabilities favor a sell off back below 1000 as the market digests the implications of a weakening economy and weaker than expected corporate profits. However, we are far more confident about our prediction of rising inflation in the years to come...

Next year the Federal Government is expected to spend approximately $3.8 trillion, exactly twice as much as the 2001 budget of $1.9 trillion. Amazingly, the federal government has managed to double its size in just one decade. Further, the U.S. has almost doubled its national debt in just the past 7 years. It now totals almost $120,000 per taxpayer. Unfunded liabilities, such as social security and medicare, equate to approximately $355,400 per U.S. citizen. Clearly the United States will default on some of its obligations because there isn't any way that every man, women and child in the United States of America can generate that amount of cash in time to meet all of those obligations as they come due!

But the form of default is critical because it determines who bears the burden, since not all defaults are created equally. For instance, the U.S. government could choose to default on its public debt, leaving foreign governments and U.S. bond investors holding the bag while John Q. Public escapes unscathed. Another option is for the government to renege on some of its social security and medicare promises by curtailing benefits, which means the elderly and poor would bear the brunt of the default. Or the government could decide to let inflation run wild, thus devaluing ALL of the debt it owes to everyone. Savers bear the brunt of this defacto default while debtors cheer (paying debt back with cheaper dollars is much easier to do).

It should be obvious which option is easiest politically. And in fact, inflation has always been the choice of every government everywhere throughout recorded history when too much debt was accumulated. The Federal Reserve has ballooned its balance sheet from $850 billion to $2.3 trillion in the last year or so and will likely explode it again to around $4 trillion over the next year if QE2 is implemented, as is increasingly likely. What is highly unlikely is that the same Fed who failed to see the tech and housing bubbles form, will successfully pull off what amounts to a high wire artist performing without a safety net... blindfolded... as it attempts to siphon all of that extra cash back out of circulation once it deems the economy rescued....

Biechele Royce Advisors continues to overweight non dollar and real assets and under weight fixed income and financial assets. We also continue to strongly prefer dividend paying stocks, which make up the bulk of a stock investor's return in secular bear markets....

Increasing Weakness

2010-08-31T08:42:00.000-07:00

The S&P 500 is down almost 4% since we last blogged about the increasing likelihood of renewed recession and market weakness. Unable to retake the flattening 200-day moving average a second time, the market sold off and is now 2.5% below the 50-day moving average. Further, the 20-day moving average is set to fall below the 50-day, which would put the four main moving averages (200, 100, 50, and 20) in bear market order. The Japanese Nikkei is already in a bear market. The S&P 500 was down almost 18% at its low in early July and looks increasingly likely to retest it - and fall below 1000 on a failed retest. Our forecast is based on our outlook for the economy, which continues to show every sign of falling back into recession.

Our December 2009 forecast of at least a 20% pullback in the S&P 500 sometime in 2010 looks increasingly like another solid win for the home team. We had written that the spring of 2010 was the most likely time (missed it slightly as the pullback stopped at 18%) and that the fall was next most likely. Our belief in a 2010 bear market stemmed from a few basic observations. First, the 2009 market recovery went further and faster than any bear market recovery since 1933, leaving the S&P 500 about 35% overvalued based on a number of long term valuation metrics (metrics Wall Street doesn't like to acknowledge because it gets in the way of them selling product to the unsuspecting public). Second, the economic recovery touted by the Fed and the Obama administration just wasn't supported by the numbers. Inventory swings were the main factor in the positive GDP numbers in Q4 of 2009 and Q1 of 2010. Final demand remained punk, as you would expect given the huge debt load born by the consumer, the lack of credit formation, and unbalanced make up of GDP (the consumers' share had grown to a record 72% during the spending orgy and is likely to fall back to a more sustainable 66% or so in the coming years).

Pair an overvalued, overbought market with an under performing economy and you are likely looking at poor market action going forward - which was our call in December 2009 and remains our call today. Market performance in 2010 has more than justified our cautious stance coming into the year. And unless the Federal Reserve gets busy printing more paper, the S&P 500 looks increasingly like it will sink to new lows for the year. The market is unlikely to test new lows for the secular bear market that began in March of 2000 however, because the Fed is clearly targeting the stock market now as a source of wealth and will eventually get around to supporting it. The Fed is likely to act sooner rather than later with renewed quantitative easing - given Bernanke's latest statements - and that just might give the market a lift into year end, but perhaps starting from the 850-900 level....

Biechele Royce Advisors continues to advocate proper diversification among all major asset classes with emphasis on blue-chip dividend paying stocks in the U.S., tangible assets, and nondollar assets. We continue to believe that inflation will pose a major threat to wealth preservation over the next ten years. Finally, we offer another reminder that secular bear markets require a focus on capital preservation first and capital appreciation second…

Posted by Chris Norwood, CFA(R) at 8:42 AM

Recession Looming

2010-08-18T07:33:00.000-07:00

We did get the short term pullback predicted in our 14 July blog. We referenced the 20-day moving average sitting at about 1075 as a likely destination. The actual decline bottomed on 20 July at about 1060 before the S&P 500 motored higher once again, retaking the 200-day moving average in the process. Unfortunately, the S&P 500 was unable to maintain above that long term trend line, peaking at 1130ish in early August, before sliding back below the 200-day (We had written about strong resistance in the 1100-1130 area likely putting a lid on the stock market for the foreseeable future).

The stock market has essentially gone nowhere since last October, validating our concerns about an overpriced market that had climbed too far and too fast after the March 2009 bear market bottom. We have stated repeatedly since last October that it is a high risk market and investors should proceed cautiously. We are even more concerned today because the market has now put in a ten month top and a broad decline is increasingly likely in the fall, or next spring at the latest. It increasingly appears as if distribution is occurring whereby professional investors distribute shares to the public, leaving the public holding the bag when the market decline starts in earnest. One indication of distribution is On-Balance-Volume (OBV), which is showing a negative divergence over the last few months, portending coming weakness.

But what is the fundamental case for a broad stock market decline? Well, how about a return to recession? The probability of another recession (or continuation of the one which started in early 2007) is quite high. Real M-3 (the broadest measure of money supply) is still contracting strongly year-over-year. Recession has followed 100% of the time when real money supply contracts on an annualized basis, typically with a six to nine month lag. As well, the ECRI is now contracting sharply and, again, recession has followed 100% of the time when the contraction is as sharp as now. Likewise, real retail sales are weakening with July real retail sales growth essentially zero - opening up the possibility that Q3 real retail sales will turn negative. Furthermore, a surprisingly bad June trade deficit number will result in a reduction in reported Q2 GDP. The deteriorating trade balance also increases the likelihood of a negative Q3 GDP number. Finally, a developing contraction in housing starts, along with deterioration in a slew of other housing numbers, adds further pressure to an economy already under siege.

Expect a retest of the recent 1010 low on the S&P 500 with a likely decline into the 800 to 900 area within the next six months. Investors should continue to proceed with extreme caution in a very high risk market.

(A major caveat: the Fed appears likely to initiate a new quantitative easing program sooner rather than later, which would provide major support to the stock market, at least in nominal terms.)

Short Term Top

2010-07-14T09:54:00.000-07:00

The S&P 500 continued to fall until finding support just above 1000 (big round number), which we suggested might happen in our 30 June blog. The S&P 500 then rallied furiously over the next nine days, gaining 9% before running smack into the leading edge of resistance yesterday. (Also noted in our last blog - 1100 to 1130). The S&P tested 1100 yesterday and again today but has been unable to punch through. A couple of positive earnings reports from Alcoa and Intel have probably helped hold the index aloft, but it certainly looks as if the market is getting ready to move lower very short term - likely back to the 20-day moving average sitting around 1075.

More broadly speaking, the S&P 500 is now firmly entrenched in a downtrend and would need to break above about 1130 to renew any semblance of short term upside momentum. To the downside, the recent low of 1010 is likely to be tested in the coming months as increasing weakness in the economy translates into disappointing earnings. We are maintaining our price discipline, selling stocks as they approach fair value and buying stocks only when we believe we have a sufficient margin of safety to warrant taking the risk of adding new positions in what remains a high risk market.

Market Top

2010-06-30T10:35:00.001-07:00

We warned in our 1 June blog that the market was likely to test 1000 (big round number) and then 950 (top of the bear market base) by the fall. We think the evidence, both fundamentally and technically, has grown stronger for more downside testing since our warning. Real money supply, as measured by M-3, is still contracting sharply (May annual real contraction 7.9%). Real retail sales are softening, falling in May by 1.0%. There are indications that the housing market is softening once again and that home prices are likely to turn lower. For instance, May's existing home sales according to the National Association of Realtors (NAR) showed a monthly contraction of 2.2% when a strong upside gain had been expected. The Federal Reserve has taken note of the softening economy by inserting language in its most recent communique that, "Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad."

Rumors are already surfacing that the Fed is preparing to reinstate quantitative easing (QE), which would continue to sow the seeds of future strong inflation, but also put a floor under the stock market once again...

Quantitative easing is the process of buying our own debt in order to force more paper money into the economy. The Treasury issues bonds and the Fed buys them with money it prints expressly for that purpose. It is a sure fire way to create inflation.

Technically the market continues to weaken, with a breach of the 1042 level occurring Monday, 29 June. Tops take more time to form than bottoms typically, and the topping action is now about six months old, sufficient time to build up overhead supply to the point where the market is no longer capable of pushing higher without first selling off more substantively. Specifically, there is now stiff resistance in place in the 1100 to 1125 area that isn't likely to give way anytime soon. Meanwhile, downside risk is 800-900 at some point either later this year or by early next year, assuming our forecast of another recession is accurate AND the Fed doesn't go back into full blown QE mode. (Normally, I would acknowledge the likelihood of the S&P 500 moving below fair value - 850ish - as the secular bear market finally plays itself out completely and the market hits its ultimate low, but our activist Fed makes that scenario a remote one)

Investors should continue to proceed with caution in what continues to be a high risk market....

Picking Stocks Revisited

2010-06-23T17:36:00.000-07:00

A friend suggested that I write about how to pick stocks in which to invest. Regular readers are aware that I frequently write about the economy and the markets (and have correctly forecast the current market turmoil in 2010). The reason that I shy away from writing about individual stocks is because I don't want my readers going out and purchasing them on their own. Knowing when to buy a stock is only half the investing equation. It is also important to know when to sell, and I can't be there to make that call for you - unless you are already a client of course. Nevertheless, I will update you on a stock I wrote about back in October of 2008 in order to better illustrate the art of stock picking, but first an update on the market.

Our most likely scenario for the remainder of the year is the continuation of an oversold bounce that takes the S&P 500 back to the 1150-1175 area before renewed selling takes us lower into the fall. Of course, it is also possible that the bounce is over already and we are headed lower now. Regardless of the eventual path, it is quite likely that the S&P 500 will test 1000 (big round number) and then 950 (top of the bear market base) before the year is over. Why? Well because it is quite likely that we are headed back into recession as the effect of the fiscal stimulus runs its course and the tremendous burden of U.S. debt reasserts itself. The stock market is merely a reflection of the underlying economy. A weak economy will eventually lead to a weak stock market - absent additional stimulus from the government (which can't be ruled out). Okay, now on to individual stock picking...

Below is an analysis I wrote of Intel in October of 2008. It well illustrates the thought process involved in seeking out good businesses at great prices. (Please skip down to the last couple of paragraphs of the blog for a summary if you aren't into the nitty gritty of analysis).

INTC $14.28 Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams, often choose to buy back shares with excess cash. We think it unfortunate, because managements tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.

Whew! So what did Intel do in the 20 months since I wrote that analysis? Well, it bottomed at around $12 per share
in November of 2008 and retested that low in March of 2009, before marching to a 52-week high of $24.36 in April of 2010. Investors who bought INTC on my recommendation in October of 2008 would have made a pretty penny, earning over 50% on their investment (including the dividend) during the 20-month holding period (assuming they still owned the stock, which currently trades at $20.81). Had they sold the stock last fall when the return hit 50%, they would have earned approximately 55% annualized on their Intel investment. (My personal investment hurdle is the likelihood of earning 50% within two years. I regularly take my profits when I hit my target because business valuations simply don't change that quickly, making it highly likely that my initially undervalued business is no longer cheap enough to hold for the long-term without taking on too much price risk).

One other thing about investing in individual stocks....

You don't find good businesses at great prices among stocks hitting 52-week highs. You do find them among stocks hitting 52-week lows. I'm currently building a rather large position in a big blue chip S&P 500 company that recently lost over half its value due to a short term (in my opinion) problem with its business. My math tells me that I have a high likelihood of earning my 50% hurdle over the next few years.....

Bear Market?

2010-06-01T09:35:00.000-07:00

We warned in December of 2009 of a likely correction in 2010 that could reach 20%, writing that it was most likely to occur in the first couple of quarters of 2010. "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." (December 19th 2009). The S&P 500 has fallen just shy of 15% so far at its May 25th low.

We wrote about the high risk nature of the current U.S. stock market, first in February of 2010 and then again in March. On February 18th we wrote, "Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline." Finally, we wrote on May 19th that, "Prudent investors would do well to heed the warning shot that was fired on 6 May 2010, it quite likely presages more trouble to come...." (Six days later the S&P 500 hit a new low for the correction of 1040 inter-day, after falling almost 7% in just four trading days).

The wise guy traders (which includes just about everyone these days it seems like) bounced the market hard off the 1040 level on 25 May, making the 1040 area a line in the sand, a breach of which is likely to trigger a further round of selling. The bad news is that the S&P 500 recently failed to take back the 200-day moving average during last week's three day bounce and is setting up for another test of the now critical 1040 area. A close below 1040 opens the way for further declines, first to the big round number (1,000) and then to support at 950. It is possible that the market will rally out of its current very oversold condition first, which would delay any sell off to the 950-1000 level likely until the fall. (Even if an oversold rally does materialize, taking the S&P 500 back to the 1200 level, it is likely that the market will eventually test 1000 and perhaps 950 in the fall as the stalling economy pressures stocks.)

Now, the technical mumbo jumbo is a useful guide primarily because so many professional money managers utilize it. Mutual funds are speculative vehicles these days, turning their portfolios over 80% per year on average. The short term focus puts pressure on managers to track the technicals, making them a self fulfilling prophecy to some extent. It was no coincidence that the market bounced hard from the 1040 level. Everyone can read a chart and everyone could see that the February 1042 low was sitting out there as support. Likewise, it is no coincidence that the S&P 500 recently traded back to the 200-day and failed. Mutual fund managers see the 200-day there and place sell orders accordingly, creating resistance.

Fair value for the S&P 500 is still in the 850-900 area. A return to that level by the fall is still a real possibility and a decline to 950-1000 a fairly high probability event. Hopefully your advisors haven't ignored the high risk market and kept you fully invested over the last few months. Hopefully they too recognized, by late last year, that risk levels were building and prudent risk management was in order. Wouldn't it be nice if you had some cash built up already with which to buy good companies at great prices? Biechele Royce Advisors values price discipline above all else, knowing that the only sure way to outperform is by consistently buying assets for less than they are actually worth. Cash builds up on our clients balance sheets when we can't find undervalued assets to buy - that cash is available to put to work when assets sell off and good companies can be had again for great prices.... perhaps by this fall.

A Thousand Point Warning Shot

2010-05-19T07:05:00.000-07:00

Many of you have probably heard that the Dow took a thousand point dive a few weeks ago. You might have also heard that a fat fingered trader might have been responsible for pushing the wrong button and setting the mini-crash in motion. Hopefully you aren't buying the urban legend...

First of all, real life trading doesn't work that way. It is not possible for a single, inadvertent keystroke to set off a market meltdown. Wall Street knows it and the political weenies likely know it as well. However, it does make for a good cover story to distract the masses from a far more worrisome reality - that the market is running on vapors and is increasingly exposed to the reality of an impending worldwide economic slowdown.

The government's search for a fat-fingered trader is a comical and ironic distraction. Of course, it is serving a purpose - keeping the masses entertained while also keeping the public from wondering if perhaps there is a fundamental reason for the market's brief crash. After all, it is far less worrisome to many to pin the meltdown on an "accident" than it is having to acknowledge that perhaps there is a pervasive, deep-seated rot setting in.

But where's the irony? Well, try this on for size. The government's witch hunt is focused on who might have pushed the wrong button to send the Dow careening 600 points lower in a matter of minutes (it was already down 400 points or so as a result of the steady, heavy selling that led up to the meltdown) rather than on who might have ridden to the rescue with heavy blasts of futures buying. Profit seeking traders are not known for a willingness to catch a falling knife, nor are they likely to willing place themselves in the way of a massive market meltdown. Who, then, stepped up and turned the tide with relentless, massive futures buying, even as the Dow's decline accelerated to four-digits? Perhaps the government should look into who jacked the market up 600 points in a matter of minutes? Perhaps the government already knows....

No, Fat-fingered Freddie didn't cause the market to plunge. What did do it was steady, heavy selling from nervous money managers who are beginning to see the writing on the wall. Tops take time to form and we may have started doing just that over the last few months. Sure the S&P 500 exceeded it's January high in April, but it has already retraced that gain and is currently trading below the January high and just above a flattening 200-day moving average. Furthermore, the 20-day has recently dropped below the 50-day moving average, portending continued market weakness, at least for a few more weeks. The 200-day lies in the vicinity of 1100, a big round number in its own right, making that level very important to traders (and that's most everyone these days). Finally, we've had ten days of well above average down volume since the middle of April, a sign that smart money is exiting. All in all the weight of the evidence suggests a very cautious stance is warranted from a technical point of view.

Fundamentally, the picture is even more worrisome. Europe is in trouble and contractionary forces there are likely to intensify in the coming quarters. The effects of the EU's self described Bazooka (the pledge of a 750 billion Euro backstop to Europe's banks) are already fading as the Euro is weakening again and approaching four-year lows, even as sovereign risk spreads have started to widen, despite intervention from the European Central Bank (ECB). The massive rescue package is as ill-conceived as the U.S. TARP effort (which led to a short term bounce in the stock market but saw an eventual 50% additional decline in the S&P 500 after the short-covering rally faded).

The ECB's proposed 750 billion Euro bomb is a declaration that they stand ready to buy almost $1 trillion dollars worth of distressed Euro-area debt in order to preserve the Euro. Of course, they are also on record as stating that they will sterilize the transactions to prevent the Euro from debasement (750 billion Euros let loose in the EU could create inflation on a massive scale if the transactions were left unsterilized). But that means the ECB is planning to, "debase the quality of its balance sheet by exchanging higher quality Euro-area debt with lower-quality debt of countries that are ultimately likely to default," according to Dr. John Hussman.

Now if that M.O. sounds familiar, well it should, since that is exactly what the Federal Reserve has done over the last couple years in the U.S. The Fed has exchanged U.S. Treasuries for the toxic assets residing on U.S. bank balance sheets, prostituting its own balance sheet in the process and setting the U.S. dollar up for a massive decline in value going forward.

But the worldwide debasement of paper currencies and the ultimate high inflation rates that will follow is for later. For now, it is likely that the EU economy will slow and eventually fall back into recession. Likewise, China is showing early warning signs of an impending slowdown. Finally, the U.S. economy is very likely to return to recession within the next quarter or two, based on the ongoing contraction in real money supply that began last December. Which gets us back to a much more reasonable explaination of what caused the Dow's thousand point drop. Rather than pointing to Fat-Fingered Freddie, we should instead be acknowledging that the professional money managers, who have composed the bulk of the historic rally off of the March 2009 lows, are beginning to edge toward the exit, and that their selling temporarily overwhelmed buying from the public. It's well known among traders that when an overcrowded trade reverses it often does so violently and to excess. Prudent investors would do well to heed the warning shot that was fired on 6 May 2010, it quite likely presages more trouble to come....

Beware Bonds!

2010-04-12T07:44:00.000-07:00

Most individual investors are mostly wrong most of the time... It's a phrase I borrowed from well-known economist Dr. Marc Faber. The available evidence is pretty damning - for instance, individual investors captured only about one-third of the gains during the great secular bull market of the 80's and 90's, according to Dalbar, a Boston research firm, returning a mere 5.23% per annum from 1984 through 2000 even as the S&P 500 returned 16.3%. Behavioral finance explains much of what's wrong with the decision making among individual investors. The heuristics used by people to get through life - stereotypes, intuition, rules of thumb, just don't work well when investing. For instance, it turns out that good companies often make bad investments and that bad ones often make very good investments!

But we wrote about all of this in the 4th quarter of last year; why bring it up again so soon? Because individual investors piled into bond funds at a record clip last year and anecdotal evidence suggests that they are still at it even though the bond market is likely to get hammered hard here starting sometime this year if the economic recovery is for real. The 10-year Treasury has already risen steadily from its intra-day low of 2.06% set on 31 December 2008 to a current level of 3.74%. It will likely challenge it's 2008 high of 4.25% in short order. A move above 4.25% opens the way for a run into the high- 4s, a decidedly unappealing development for bond investors and home buyers alike.

What is the fundamental argument for higher interest rates though? Well, it centers around basic supply and demand dynamics. The U.S. government is likely to run a $1.4 trillion deficit this fiscal year (10% of GDP) and foreign investors can only be expected to absorb about $300 billion, leaving a monstrous $1.1 trillion of debt for domestic investors to finance. There aren't enough domestic savings to absorb that much new supply, which means interest rates will rise as demand fails to meet supply. Last year the Federal Reserve bought most of a similar amount of supply, but Bernanke is on record as saying the Fed is done with its quantitative easing and is out of the market.

A second fundamental argument for rising rates centers on the expected economic recovery. An expanding economy requires an increase in the velocity of money, assuming a constant money supply. Inflation will rise (and with it interest rates) as the velocity of money accelerates unless the Federal Reserve successfully reduces the money supply in a timely fashion, which will require them to raise short term rates aggressively. The combination of huge new supply and an expanding economy will likely prove a toxic mix for bond investors.

A second possibility, of course, is a failure of the economy to maintain a strong growth trajectory as the existing heavy debt load remains too onerous to allow any economic momentum to persist. A slide back into recession late this year or early next (our forecast) will result in continued huge deficit spending by the U.S. government and even more supply hitting the Treasury bond market as result. The Federal Reserve is highly likely to re-enter the bond market either directly or indirectly (with an assist from Treasury - courtesy of taxpayer money - through Fannie Mae and Freddie Mac for example ). The result of the latter scenario would be continued low rates (although not necessarily falling rates) for another year or two. The one major fly in the ointment in the second scenario hinges on whether foreigners will continue to support the dollar in the foreign exchange market. There is increasing evidence that foreign central banks are slowly edging away from the dollar as a reserve currency. A run on the dollar would likely cause interest rates to sky rocket as the U.S. is forced to beg for bond investors to take debt off its hands at any price.

Either way, interest rates are set to rise sharply over the next five to ten years; it's only a question of whether that climb begins now, on the back of a sustained economic recover, or in a few years, after another round of heavy fiscal and monetary stimulus. Bond investors will need to decide when to lighten up on bonds because those who stay in the Treasury bond market overly long will almost certainly get flattened by the approaching runaway train.

Individual investors, who increasingly seem to believe that Treasury bonds are a risk free investment, will wake up one day to the awful realization that they can lose large amounts of money in the bond market too....

The Importance of Estate Planning

2010-03-30T10:21:00.000-07:00

Accumulating wealth for retirement is a basic goal of every investor. For many people, the vast majority of their retirement wealth is contained in a tax deferred or tax free investment vehicle. In fact, it is not at all uncommon to run across a couple with 80 to 90% of their entire networth in either 401(k)s, IRAs, Roth IRAs, or some combination of the three. Furthermore, many of these diligent savers go to great lengths to ensure that they maximize their tax-deferred contributions and invest those assets as prudently as possible to maximize wealth in retirement. Why then do so many investors fail to fill out even a few of the most basic estate planning documents to ensure that their nest eggs are used as intended in life, and make it intact to their loved ones upon the investor's death?

One quick example of the latter instance (passing assets along to the next generation) should suffice to show the importance of making sure you do the paperwork. The beneficiary form is easily the single most important estate planning document when dealing with IRAs and Roth IRAs. The beneficiary form controls who will get the investment portfolio and how long they will be able to keep it. What a shame if your loved ones don't get assets intended for them or can't take full advantage of the tax deferred feature of an IRA, or tax free feature of a Roth. Yet it happens all of the time because people fail to fill out a simple beneficiary form, instead relying on their will to take care of the distribution of assets after their death. Here's the problem though!

An individual who inherits an IRA without being named on the beneficiary form will not be considered a designated beneficiary, and that makes a HUGE difference. (An estate has no life expectancy and is never a designated beneficiary even when it is named as the default beneficiary, which is common in plan documents) Inherited IRAs and Roth IRAs must be emptied within 5 years of the death of the owner if the owner dies before the Required Beginning Distribution (RBD) date (always the case in a Roth since there is no RBD). Think about what that little oversight - not filling out a beneficiary form - just cost your heir! Rather than being able to allow assets to continue to grow tax-deferred for decades longer, your heir will be forced to empty the IRA - AND PAY INCOME TAX - no later than 31 December of the fifth year following your death. It's even worse when dealing with a Roth IRA since assets in a Roth can be held tax free and allowed to compound for decades as the beneficiary stretches out tax-free distributions over their lifetime, making for a considerably larger ultimate transfer of wealth between generations.

Failure to fill out a simple beneficiary form for your IRA or Roth IRA is just one example of an estate planning oversight that can cost your family dearly. Take a few minutes to review your beneficiary forms to make sure it doesn't happen to you. And then take some time to review your other estate planning documents as well....

High Risk Market STILL

2010-03-23T10:44:00.000-07:00

The S&P 500 is overvalued by about 25%, but you wouldn't necessarily know it if you listened to the mass financial media. Fair value for the S&P 500 is around 900, based on how the market has been valued historically using 10-year trailing earnings as a measure. Again, you might be lulled into thinking the market is undervalued if you spend too much time listening to CNBC (Heehaw), or reading the likes of Barron's or the Wall Street Journal. Likewise, many of the brokerage firms are busy talking to clients and telling them now is the time to buy, buy, buy!

The only problem with that self-serving assessment is that it probably isn't true. Again, the S&P 500 is about 25% overvalued if history means anything at all. One of the best long-term measures of stock market valuation is the Price-to-Earnings (P/E) ratio, based on trailing 10-year average earnings (commonly known as Shiller's P/E). The current Shiller's P/E is about 20, well above the long run average of 15x - 16x, putting the current market in the top quartile in terms of EXPENSIVE. But why should you care if you are a long-term investor? Isn't it conventional wisdom to buy and hold your investments rather than "time" the market? And doesn't the Efficient Market Hypothesis tell us that no one can outperform the market by timing the market anyway? (since the market is always "correctly" priced given the known information), and therefore everyone should always be invested all of the time if they have a long-term time horizon?

In fact, you should care, because likely three year investing returns change drastically when buying into an expensive market - and your typical friendly neighborhood stockbroker (a.k.a. fee-based advisor) won't necessarily tell you that since they operate under the convenient assumption that stock market returns are unpredictable and, "oh what the heck, let's just always stay invested". Reality is somewhat different from that party line, however, and can lead to LOOONNGGG periods of time needed to recoup market losses for those investors who stay aggressively invested during high risk markets.

First the return assumptions typically used by advisors...

The standard return assumptions based on 125 years of data are: a normally distributed set of returns for a 3-year holding period averaging 9.5%, including dividends; a 15% probability of investors losing money over the 3-year period, a slight possibility of tripling their money and a slight possibility of losing around 80% over three years. The standard return assumptions in fact are merely past history projected into the future. But what if those return assumptions are wrong? What if the actual returns for a 3-year holding period where only 7% annually on average with a 28% probability of losing money during the 3-year holding period? Would you be quite so eager to own stocks then?

Probably not. And, as it turns out, the current Shiller P/E of 20 does create a return distribution in line with the second scenario. Shiller P/Es of 19.2 or higher produce return results averaging a mere 7% per annualized 3-year holding period with a likelihood of losses 28% of the time, according to Keith C. Goddard, CFA (Goddard used Professor Shiller's work on stock market price-to-earnings as his base data). Would individual investors make the same allocation decisions if they knew they had a 28% probability of losing money over a 3-year period rather than only a 15% probability of losing money? Again, probably not, if our experience with investors is representative.

Now, throw in the fact that the broad money supply is still in contraction (real M3 contracting is a 100% accurate indicator of recession 6 months down the road) and the already expensive market becomes an exceedingly dangerous one. Investors should plan accordingly....

(Biechele Royce Advisors will continue to buy good companies at great prices when we can find them, but continues to currently see very little of interest, which also indicates an expensive market.)

Roth IRA Conversions

2010-03-12T07:46:00.000-08:00

"Roth conversions can trigger unintended tax traps and financial problems that are not being addressed in the mounds of 2010 Roth conversion information that currently dominates the media, " Ed Slott wrote recently in his newsletter, "Ed Slott's IRA Advisor."

Biechele Royce Advisors is fielding an increasing number of inquiries from clients and the public regarding Roth conversions. Roth conversions are a hot topic because the income cap for conversions was removed permanently starting in 2010 and the IRS is allowing investors to defer taxes on converted IRAs in 2010 only, until 2011 and 2012 (You can choose to pay 100% of the taxes owed in 2010 or pay tax on half the converted amount in 2011 and on the other half in 2012). A quick review of the main differences between a Roth and a regular IRA might help frame the conversion discussion.

IRAs are funded with pre-tax dollars, reducing an investor's tax bill in the year of the contribution. IRA investments grow tax deferred, but an investor is required to pay income tax on all distributions, which are allowed without penalty when the investor turns 59 1/2 years-old. Required minimum distributions (RMD) kick in once the investor turns 70 1/2. The Roth IRA is funded with after-tax dollars, which means no reduction in your current tax bill. However, you will never pay tax again on your Roth investments and there are no required distributions, making the Roth a very attractive option for anyone who meets the income requirements.

Investors have had an option to convert from an IRA to a Roth for years, but only if they made less than $100,000 annually. All investors are eligible to convert staring in 2010 however, and many investors are weighing the pros and cons as a result. Unfortunately, there is no simple answer to the conversion question and each situation must be reviewed individually. There are, however, a couple of basics to keep in mind when deciding whether a conversion makes sense. Roth conversions are most appealing to clients who have significant IRAs and wouldn't touch them if it weren't for the required minimum distributions (RMD). Roth IRAs are a much better estate planning vehicle since investors aren't required to take RMDs and can therefore leave more assets in a tax free investment vehicle for future generations. And unlike an IRA, which requires beneficiaries to pay income tax on inherited IRAs when taking distributions, Roth IRA distributions are tax free! As well, conversions are attractive to those investors who would owe very little additional income tax on conversion. Future expected income tax rates figure promonently into your calculations here. Income taxes are expected to rise sharply in coming years, which means many of us might be in a higher income tax bracket in retirement, making a conversion now more appealing. On the other hand, you may have less income in retirement, putting you into a lower tax bracket. One last piece of advice on conversion: it is almost never a good idea to pay the taxes generated from a conversion from the IRA since you want as much of your money to grow tax free as possible. Consequently, conversion becomes much less attractive if you don't have money set aside to pay the taxes. The bottom line on the conversion question? Consult with a trained investment professional (CFA) or a CPA for guidance.

Now that you've decided to convert, making sure to avoid the numerous tax traps and pitfalls takes some planning.

First, investors who choose to split the tax bill must understand that it is highly unlikely that the tax bill will be the same in 2011 and 2012. The total tax bill will depend on various factors including tax rates (which could well go higher) and overall income. Also, beware paying the conversion tax with IRA money if you are under 59 1/2 - you will unwittingly trigger the 10 percent penalty. You will also trigger the 10% penalty if you withdraw converted money within 5 years of conversion if you are under 59 1/2. Simple IRAs have a two-year holding period and can not be converted sooner; the IRS will treat it as a taxable distribution! Non-spouse beneficiaries can't convert an inherited IRA but can convert an inherited plan. Don't roll the inherited plan into an IRA and then try to convert or you will have a problem. As well, rolling a plan mid-year into an IRA after converting your IRA to a Roth will lead to a bigger tax bill than anticipated given how the pro rata rule is calculated (only applies if you have basis in your 401(k). Also, for those of you who are already taking required minimum distributions (RMD), you can't roll your entire IRA into a Roth without first taking the required distribution - you will owe taxes one last time! Oh, and for those of you hoping your child will qualify for tuition assistance... remember that tuition assistance is based on income not retirement assets. Converting your IRA to a Roth may disqualify your child from receiving assistance!

There are a number of other tax traps and gotchas that you must carefully consider before making your conversion. Please consult a knowledgeable investment professional before converting willynilly and inadvertently triggering unnecessary taxes and penalties. Qualified professionals include CPAs, CFAs, and CFPs.

A Market of Stocks - The Art of Stockpicking

2010-03-05T05:13:00.000-08:00

(Excerpt from my October 2008 "From The Bleachers" Newsletter)

Perhaps this is a good time to shift to the topic indicated by the title up above, before readers decide we’re just a bit off the mark with it. Our fervent hope is to both entertain and educate our readers on the art of stock picking for – as the title declares – it is a market of stocks not a stock market in which we invest. To be fair, we are contrarian by nature, and a bit old fashion to boot. We recognize that index funds exist, that exchange traded funds are available with which to place your bets on red, black, or even green, but we prefer to build a portfolio the old fashion way, one well researched stock at a time. We hesitate to declare that we’re looking for an undervalued business in which to invest since we will almost assuredly be (mis)labeled as a value investor. So we will avoid the claim. Rather, we simply recognize that a share of stock means a share of ownership in a corporation which entitles the stock holder to a share of the profits, should there be any.

Now oddly enough, we have found over the years that companies that make increasing amounts of money are deemed more valuable (eventually) to investors than those who don’t, and the stock price of said company invariably rises over time as a result of the increasing stream of cash finding its way into the shareholders’ pocket, a truly wonderful outcome for those of us who enjoy turning a profit with our investing. It is our belief that we are buying ownership in a business that guides our search. Not for us the pursuit of a stock, simply because it is rising – that game belongs to the many speculators who invest with a six to twelve month time horizon. Speculators they are because they invariably buy a stock in the hope that it will trade higher in the coming quarters, allowing them to sell at a tidy profit and move on to the next piece of paper. The many mutual fund managers, institutional asset managers, and individuals who choose to rent a stock (and we are now fairly describing upward of 90% of the investors out there) are not interested in the value of the underlying business. They care only whether the stock price will rise in the short run, and turn to such devices as earnings revisions, upside surprises, relative strength indicators and insider buying to divine the short term future of a company’s stock price. We, on the other hand, care very much what price we pay for a company. Just as we choose not to overpay for a car, house, vacation, or that big flat panel TV that makes Peyton Manning’s flapping and stomping prior to the snap looking even more like a blue heron dancing in the shallows (Of course we are fans, season ticket holders as a matter of fact).

Don’t misunderstand however. We have owned all manner of stocks in our 20 years of investing. Technology stocks, drug companies (back when big pharma was considered a growth industry), the King of Beers, and the royalty of soda pop (Coke) have all found their way into our portfolios. We will buy anything in any industry if the price is right, and we are very patient in waiting for that happy event to occur. For instance, Coke was the poster child of expensive back in the late 1990’s, peaking in the vicinity of 55 times earnings if we remember correctly. We even used it as a marvelous example of a great company that was no longer a great investment. But we didn’t hesitate to pay some 20 times earnings in 2005, with the stock in the low 40s, nor did we hesitate to sell it some two years later in the high 50s when the price-to-earnings multiple no longer matched the company’s growth prospects. A market of stocks, not a stock market, and stocks as certificates of ownership in an ongoing business – two of the guiding principles of our investment philosophy.

INTC $14.28

Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.

In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.

In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams often choose to buy back shares with excess cash. We think it unfortunate, because managers tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.

Yet another way to do the math without the distortion of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.

A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.

The company is currently the world’s largest semiconductor chip maker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.

For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).

Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.

Stock Picking

2010-03-01T07:18:00.000-08:00

"So is there a reasonable expectation that a reasonably intelligent consumer can pick stocks?" was the question put to me by a friend. "That would be a challenge to blog on without it sounding like a sales pitch," he went on to write.

Indeed it will be, but I LIKE a challenge! Before I answer the question however, I need to tell you a little bit about myself so that you will better understand my world view...

The CFA Institute awards the Chartered Financial Analyst (CFA) designation to individuals who complete a three-year post MBA graduate program in finance, economics, accounting, statistics, and investing, and who have worked in the industry for at least three years. CFAs are trained as institutional investors and are hired by mutual fund companies, banks, insurance companies, and pension plans, among others, to invest assets on their behalf. My own background includes a 12-year run as a hedge fund manager ($55 million in assets and a tout in 2001 by Barrons as a top fund manager). As well, I've spent over 15 years dealing with individual investors and have learned quite a bit that the CFA textbooks don't teach an aspiring candidate. With all of that out on the table... here's my answer to stock picking for the masses.

Absolutely it is reasonable to expect that a reasonably intelligent consumer can (successfully) pick stocks! In fact, I could teach a person with average intelligence how to outperform the stock market by a wide margin over multi-year periods of time in just a few hours of instruction. Intellectually it just isn't that hard! Wanna beat the U.S. stock market over five-year periods? Piece of cake! Simply focus on companies with solid balance sheets, free cash flow, and which are trading in the bottom quintile of all stocks based on price to sales and/or price to book. You will outperform magnificently over 5 and 10 year periods. Now you won't necessarily outperform over one or two year periods. And you might not outperform after adjusting for volatility. But you will outperform in the metric that counts most - total return!

Okay, if it is so easy then why doesn't everyone simply eschew mutual funds and build their own portfolio of stocks? Because it takes patience and discipline, and a willingness to go against the crowd. John Maynard Keynes' edict that, "it is better for reputation to fail conventionally, than to succeed unconventionally." is spot on. It is well known in professional money management circles that losing money with the crowd is not a career risk, while losing money alone most certainly is! Individual investors share the same behavioral traits as the professionals. They would rather be wrong together than risk being embarassed alone.

Buying beaten down, out-of-favor stocks takes a level of courage and contrarianism that is uncommon to say the least. I have always found it amazing that more people don't focus on buying cheap assets, which can lead to highly profitable outcomes. Instead they are filled with the gambling lust, determined to find that needle in a haystack that might become Microsoft, or Google, or Cisco. The pot of gold at the end of the rainbow leads them to speculate, for instance, in small biotech companies, instead of buying historically profitable companies when they are demonstrably cheap. And speculating is exactly what most investors are doing these days. The average holding period for a stock on the New York stock exchange has fallen to 6 months, down from 6 years 40 years ago. Now, for those of you who would like to actually invest in good companies at great prices, here's all you need to do...

Buy companies with little or no debt. The current ratio should be 1.5x or better and long term debt should not exceed equity. Buy companies with low fixed costs and profitable histories, and which throw off plenty of free cash (what's left over after all the bills are paid, including salaries). Buy companies trading close to book value with a return on equity close to 15%, and buy them when they are trading cheaply based on their own history and relative to the stock market. Read the last few annual reports and the most recent 10K and 10Q to make sure that no long term negative changes to fundamentals have occurred. Finally, don't expect to make money in these stocks over night; it might be a few years before they kick up their heels and take you to the promised land of outperformance. Do all of those things and the academic data overwhelmingly points toward a serious case of studly performance in your future. About the only thing that could ruin it for you is faint heartedness, since you will be going against the crowd, forced to justify your choices to your friends who will sneeringly tell you what a fool you are to bet on boring stuff while they are getting ready to strike it rich in Nanobiotechno Industries Incorporated! Ignore them for they are the fools chasing a pipe dream and you are the true investor buying companies on the cheap!

High Risk Market

2010-02-18T09:08:00.000-08:00

The S&P 500 fell almost 10% from its January 19th high to its February low. We wrote about the overbought market in our 2010 forecast and the likelihood of a 20% plus pullback sometime in 2010; the question is, has the expected decline already begun or is the market working off its overbought state by trading sideways for a few months (markets can correct in time instead of price, chopping sideways until earnings catch up with price). There is no question that the up trend from the March 2009 low is broken. Furthermore, with the 20-day moving average now below both the 50 and 100-day moving average, additional market weakness is a distinct possibility. Add in half a dozen distribution days (down days on heavy volume) since the January 19 high, and the case builds that the rally is on wobbly legs and will need to regain momentum in fairly short order if further profit taking is to be avoided (many institutional investors rely on charts to trigger buy and sell decisions, which is why charts are useful in the first place - circular reasoning I know, but very much a reality in the casino that passes for today's stock market). Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline.

As well, it is easy to build a fundamental case for further declines in the market. The S&P 500 is still about 20% over valued using $60 for earnings and 15x for a trailing multiple. (The S&P 500 has traded on average at 14 to 15x trailing reported earnings historically). Also, reported economic growth is mostly smoke and mirrors at the moment. The reported 5.7% Q4 GDP growth is likely to give way to Q2 and Q3 2010 growth in the 1% to 2% range, given the weak final demand components of the Q4 number. As you will recall, Q4 GDP got a huge assist from inventories declining at a slower rate, adding an estimated 4.4% to the final number. History indicates that subsequent quarters show punk growth when over half of GDP growth is coming from inventories.

In fact, there have been 9 quarters since 1970 in which GDP grew by at least 3 percent and at least half of the growth was due to inventories. While inventory spikes make for big growth numbers (average growth in the 9 quarters was 6.6%), average growth in the subsequent quarter averaged only 0.9% and only 1.6% in the second quarter following the blowout number. Weak growth numbers in the next few quarters will likely make current earnings forecasts overly optimistic, which will, in turn, pressure the stock market (It is possible that Q1 will come in fairly strong if the inventory swing hasn't quite played out).

One last indicator that the market is due for a further decline, or at least a relatively long period of sideways chop - the "we-can't-find-many-good-companies-at-great-prices" indicator is flashing at us. As many of you know by now, we do not do market timing. Rather, we look at risk levels in the market as context for our bottoms up, one-company-at-a-time, portfolio construction. It is currently taking us quite a bit longer to put new money to work in our client portfolios because we are just not finding that many good companies at great prices at the moment. Our price discipline held us in good stead in 2000-2001 and again in 2007-2008; we would expect it to prove beneficial once again in 2010. Meanwhile, we recommend continuing to treat the market as high risk, and plan accordingly...

Bogus GDP Report Revision

2010-02-10T14:10:00.000-08:00

We wrote recently about the bogus Q4 GDP number which was reported initially at 5.7% last month. We believe the final number will come in somewhere between 2.0% and 3.0% when all is said and done - although we won't likely see that admission from our clever government bean counters for a year or so. Meanwhile, it looks as if there could actually be an upward revision in the GDP number as the December inventory number was likely flat, while the BEA assumed a sharp inventory liquidation in December. It is possible that the GDP number might temporarily be revised as high as 6.7% for Q4 2009, leading people to assume that a strong economic recovery is in place. Given that over 4% of the Q4 number would be due to a decline in the rate of decline of inventory liquidation and that personal income took a bigger hit than previously thought (based on Friday's downward revision in payrolls and hours worked) we are unable to get on board with the idea that the U.S. economy is powering strongly ahead. Rather, given continued weak end demand, we see an economy poised to decelerate back into recession sometime in 2010 - likely in the third quarter. Our confidence in that forecast is only increased by the continued and increasing contraction in real M3 (the broadest measure of money supply). As previously mentioned, contraction in real M3 is historically a 100% predictor of economic contraction in the following two to three quarters. We think it unlikely that it will be different this time.

And, of course, a renewal of the recession means a continuing rise in unemployment and decline in home prices among other (bad) things. A double dip recession is also unlikely to be a positive for the U.S. stock market....

Diversification Revisited

2010-02-08T11:53:00.000-08:00

Proper diversification is one of the single most important tools for any investor. Properly diversified investment portfolios are the best means of protecting and growing wealth. There are two main levels of diversification, at the asset level, and at the individual security level. Most people ought to own both stocks and bonds, as well as real estate, commodities, and cash. As well, folks ought to own some international stocks and bonds since a good portion of the world economy is outside the U.S. and investors can miss out on quite a few attractive investment opportunities by limiting themselves primarily to home country investments. (Home bias is a well known investor mistake that leads investors to put too much of their money in domestic assets and not enough elsewhere). And well-diversified portfolios should also have diversification within asset classes. Too much exposure to any one company, through its stock or bonds, is an unnecessary risk that is unjustified in most cases. A couple of real life examples can help investors to understand how risky it can be to invest too much in one single asset class or one security.

The first example is a case in which an individual sold his business and retired. His fee-based advisor (stockbroker) built a portfolio consisting of $2 million in stock mutual funds and $400k in private real estate investment trusts. The $2 million in stock mutual funds consisted of a large cap growth fund, large cap value fund, small cap fund, and an international fund (a pretty common allocation for the many sales guys passing themselves off as qualified investment advisors). Of course, all of the funds were front loaded and paid the sales guy a hefty 5.75% commission along with a 0.30% yearly trailing commission, and of course our poor investor was also paying 0.60% annually to the mutual fund to actually do the investing. The $400k in private REITs was split into two investments with the same company, with basically the same commercial real estate exposure in both.

So what kind of diversification did our poor investor get for all those commissions paid? Very little is the answer. The three U.S. stock mutual funds all performed equally badly during the 2007-2009 bear market and the international fund did even worse. The illiquid private REITS can't really be valued since our investor can't get out of those particular roach motels at the moment - the REITs are husbanding their capital and have suspended redemptions for the time being. The bottom line is our retired investor is busily looking to unretire now that his portfolio has dropped from $2.4 million to $1.2 million. Oh, and in case you are wondering why the sales guy put our investor in illiquid private rather than liquid public REITS the answer is.... BIGGER COMMISSIONS!

Our second case study highlights both types of unwarranted concentration. The fee-based advisor had put an older couple 100% in bonds (at the older couple's request), using both mutual funds and individual bonds. Additionally, the advisor had placed the majority of the money allocated to individual bonds in GE Capital bonds and California muni bonds. In fact, the GE capital bonds alone made up approximately 50% of the entire portfolio. Yikes!

There are a few observations worth making here. First, commission based advisors must sell something in order to make money. Like any good salesman they will keep trying until they find something their customer likes. Don't want mutual fund A? How about mutual fund B? Don't really want to own stocks? No problem, I'll sell you bonds (and take a juicy slice of the mark up). The moral of this story is that commission based advisors often sell what's easiest to sell rather than providing actual investment advice to the client (and risk losing the sale). There is no way a couple in their mid-60s with a 25 to 30 year planning horizon should be allowed to put 100% of their money in bonds - unless they have so much wealth that purchasing power risk (inflation) isn't going to bite them in the budget in the out years. And after Enron, WorldCom, Bear Stearns, Lehman Brothers, AIG, GM, Fannie Mae, and Freddie Mac, do I even need to talk about the incredible risk assumed by having some 50% of your bond portfolio in just one company? The fact is that our couple did dodge a bullet as the Federal Government did have to (quietly) bail out GE last year when the commercial paper market seized up.

Building properly diversified, low-cost, portfolios that will both preserve and grow an investor's wealth is a critical step in planning for retirement. Appropriate portfolios are not static in nature as they must change as an investor's needs change. Unfortunately, most financial advisors are paid to sell products and do not actually make their money from giving advice or investing on a client's behalf. Consequently, their motivation to sell frequently gets in the way of sound investment advice. It is no coincidence that both of our poorly constructed portfolios were put together by fee-based advisors. The fact is that it is a huge conflict of interest, which investors would be well advised to take into consideration when dealing with "the sales guy".

The Bogus Q4 GDP Number!

2010-02-01T06:37:00.000-08:00

Whoopee! The economy is in a strong recovery and all is well with the world. The huge stock market advance of last year is justified after all and it's clear sailing from here on out! Or is it?

The short answer is that we aren't buying what the numbers are selling. Q4 GDP was reported at 5.7% but that number is much less than meets the eye. Inventory build accounted for about 3.7% of that growth and will likely reverse in subsequent quarters given the weak consumption component (the consumer spending growth rate actually declined in the quarter from 2.3% in Q3 to 1.7% in Q4). Approximately 90% of the preliminary GDP number is composed of guesstimates since most of the inputs aren't finalized yet; the government has had a tendency to report overly optimistic initial numbers and then revise down those initial estimates in later quarters... when people aren't paying as much attention. One likely source of a coming downward revision is the trade deficit, which worsened in October and November (December hasn't been reported yet), but, nevertheless, is credited with adding 0.5% to the GDP number in Q4. Other problems with the GDP number were falling imports and declining aggregate private hours worked, which contracted at a 0.5% annual rate. Neither number indicates any kind of strong recovery taking place. All in all, we think the GDP data point toward a slow growth to no growth economy in coming quarters and quite likely an outright resumption of the recession sometime in 2010.

Further evidence that we are heading back into recession in the next few quarters lies with the money supply data. Money supply growth is currently negative as M2 and M3 continue to contract. We have never had an outright contraction in M3 (the broadest measure of money supply) without an accompanying recession! The bottom line for the public is to take the currently reported economic numbers with a HUGE grain of salt, and to act appropriately in positioning their investment portfolios.

Performance Measurement

2009-12-29T11:07:00.000-08:00

"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....

The Retirement

2009-12-26T08:49:00.000-08:00

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...

Most Individual Investors Still Wrong!

2009-12-26T08:32:00.000-08:00

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%.

Using Market Forecasts

2009-12-23T13:22:00.000-08:00

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!

2010 Market Forecast

2009-12-19T11:52:00.000-08:00

"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!

Create Your Own Income Stream!

2009-11-24T12:17:00.000-08:00

Once again I'm electing to postpone my annual forecast for the economy and capital markets due to a more pressing issue - the need to debunk the slick variable annuity sales pitches making the rounds. Annuity salesmen from insurance companies such as The Hartford, Prudential and Mass Mutual, and stock brokers from the likes of E. D. Jones, Wachovia, and Morgan Keegan (Regions Financial) are preying on peoples' fear of running out of money before they die to sell them variable annuities. Variable annuities are expensive, restrictive, and usually poorly performing investment vehicles that were designed to shelter high-income earners from paying more taxes than absolutely necessary; they've morphed into guaranteed income investments for the elderly. However, they are wildly inappropriate for most individuals who are simply looking to ensure a certain level of income in retirement. At least one retired couple has learned to just say NO to variable annuities after getting a complete explanation of what these expensive insurance contracts actually could and couldn't do for them. The husband related how the E.D Jones broker was "pushy" when told that the insurance contract was about to be cancelled (during the free look period); clearly Mr. Broker didn't like the idea of losing his big, fat commission. Fortunately, the husband and wife had had a change of heart once they'd read the prospectus (which they finally received) and realized how much they were paying and how little they were actually getting once the boilerplate was boiled down to reality.

Nevertheless, the retired couple's basic problem still remains - how to earn a sufficient return on their savings to meet their retirement needs? (in a perpetually low interest rate environment that continues to punish savers and reward borrowers - thank you for nothing Federal Reserve!). Fortunately there is an answer that is far less expensive and far less restrictive than the Variable Annuity. It's called a diversified stock and bond portfolio!

A properly constructed, diversified portfolio will contain assets (stocks, commodities, real estate) that hedge against inflation in order to preserve purchasing power over the long run. The portfolio will also contain sufficient fixed income assets to generate a minimum level of current income to meet current liabilities. The wonderful thing about bonds is that they throw off a well defined stream of cash that can be used to meet liabilities as they come due! You don't even have to take credit risk if you stick with Treasuries and investment grade corporates and municipals. It is relatively easy for a qualified investment advisor (as opposed to a broker-dealer representative aka fee-based advisor) to construct a diversified bond portfolio that will yield 4% or so without taking any meaningful credit risk. As well, it is fairly easy currently to build a diversified portfolio of blue chip, dividend paying stocks with an average yield of 3.5%. The 4% rule tells us that a 60/40 stock/bond portfolio will last a minimum of 30 years, which gives us a starting point, at least, for positioning a portfolio for the decumulation phase of an investor's life cycle. The math: a bond portfolio yielding 4% and comprising 40% of the overall portfolio yields 1.6% to the investor, while a stock portfolio yielding 3.5% and comprising 60% of the overall portfolio yields 2.1% to the investor. Total yield of the 60/40 stock/bond portfolio is 3.7%.

Let's take a $1,000,000 portfolio as a case study to see what kind of current income we could generate while still positioning ourselves for a 30 year retirement. We would allocate $400,000 to bonds and currently could construct a portfolio of investment grade corporates and municipals that would give us an average yield of at least 4% with a duration of between 5 and 10 years. Interest produced would run at least $16,000 per year. We would allocate $600,000 to a diversified portfolio of blue chip stocks and could currently easily get a 3.5% average dividend yield, which would throw off at least an additional $21,000 in dividends. Total income generated by the entire $1,000,000 portfolio is at least $37,000, or approximately 3.7% per annum (almost meeting our 4% rule). Careful stock selection focusing on high-quality companies with well-covered dividends will provide an additional benefit in that the dividend income will rise over time as the companies raise dividends. Companies like Proctor and Gamble, Johnson and Johnson, Coke, and Microsoft can provide an annual and growing annuity unencumbered by the strait jacket restrictions placed on Variable Annuities sold by insurance companies.

And there you have it: a portfolio of stocks and bonds becomes that low-cost variable annuity that can provide a payout of (in this example) 3.7% per annum without touching principal - something you aren't allowed to do anyway in most variable annuities for between 5 and 10 years if you wish to qualify for the minimum income guarantee. The portfolio's overall yield will rise over time as the dividend paying stocks in the stock portion raise dividends regularly. Additionally, the 3% plus per year in average variable annuity expenses stays in your pocket rather than going to the insurance company. And finally, should your situation change and you need access to your money because of an unforeseen emergency... well, you have access without having to pay any of the penalties or forgo any of the guarantees.

One last thought:

Individuals with a shorter time horizon (less than 30 years) could construct portfolios with a greater allocation to bonds and reduced allocation to stocks, thus increasing the overall portfolio yield. Likewise, investors with excess wealth can reduce their allocation to stocks, if they wish to reduce variability in cash flows, since purchasing power risk isn't as much of a concern. After all, someone with $5 million of assets and a time horizon of only 15 years is likely to be able to survive on a 3% draw ($150,000) or even a 2% draw ($100,000) to meet everyday basic needs.

Our retired couple made a good call cancelling the annuity contract. They were looking at paying an up front commission of 3.5% and better than 3% annually in costs for a contract that was unlikely to benefit their income needs in any meaningful way. Now they need to construct a properly diversified stock and bond portfolio that will throw off sufficient income to meet their everyday needs while still protecting them from the long-term risk of inflation. By saying no to high-cost, restrictive and poorly-performing variable annuities and YES to low cost, flexible, diversified portfolios of blue chip stocks and bonds, our retired couple will get an acceptable level of income and still retain control of their assets!

The New Variable Annuities

2009-11-13T08:31:00.000-08:00

I had planned on updating our macroeconomic view and laying out a likely course for the stock market over the next year, but have decided to put that blog on hold for a week in order to write once again about variable annuities. The catalyst for my change of mind? A seeming rash of variable annuity sales to folks who have no need for the expensive, restrictive, and even punitive insurance contracts (yes they are heavily regulated insurance contracts). The insurance sales representatives and the insurance companies themselves have stepped up their game and are preying on peoples' fear of running out of money before they die like never before. The seemingly too-good-to-be-true contracts are exactly that - too good to be true. Yet like the snake-oil salesmen of yesteryear, the variable annuity peddlers of today promise that these almost impossible to understand insurance products are the panacea for all that ails you.

Are you worried that you might end up in a long-term care facility? No problem! Your variable annuity will double the amount of your money you are allowed to take out if you do (if you pay extra for the privilege). Worried that you will run out of money before you die? No problem! Your handy dandy variable annuity will guarantee you a monthly payout for life (if you pay extra). Worried about dying early with your annuity investment under water? No problem! Your variable annuity will reimburse your beneficiary your original investment (if you pay extra and - in many cases - aren't 75 or older). Of course all of these guarantees come with a heavy price - most variable annuities will charge you more than 3% each and every year that you own the contract, although the fees are difficult to tease out of the offering documents and most people are blissfully unaware that they are paying so much for so little (an assertion that I will back up here shortly). Additionally, the investment choices given are usually extremely limited relative to the broad investment universe available to IRA owners, and typically are mutual funds that the insurance company manages in-house (more fees for them) or are managed by a "preferred provider" who kicks back fees to the insurance company (isn't that a cozy relationship?). And did we mention that these insurance contracts take a PhD in nuclear physics to understand?

There are now more than 1,100 different annuities on the market according to SmartMoney Magazine, up from 295 a decade ago. Variable annuities are suppose to be sold by prospectus because of their complexity and heavily regulated status, but the truth is many people aren't even aware that they are buying a variable annuity, or have only the vaguest idea of what they are buying. Russell Schellenberger was a successful business man who "didn't even know he'd bought one (variable annuity), according to Janet Paskin of SmartMoney. The word "annuity" hadn't even been mentioned during the sales process. It is a safe bet that Mr. Schellenberger wasn't given a prospectus, not that the highly legalized boilerplate would have necessarily enlightened him much. I'm a Chartered Financial Analyst (CFA)r with twenty years of forensic financial statement analysis under my belt. Nevertheless, I was recently put to the test on behalf of a nice, older couple who handed me their prospectus in the hope of getting an explanation of what they'd just purchased (They weren't given the prospectus before they signed on the dotted line, but instead received it after I explained to them that they were suppose to have gotten one and that the prospectus would explain the investment to them). After wading through the legal document I can honestly claim that I was only half right... they were suppose to have gotten a prospectus.

It's important to understand that the new-age variable annuity is an expensive, yet untested product. Traditional insurance works by using large numbers of people to spread risk out; the insurance company keeps the difference between the premiums collected and the insurance paid out. Variable annuities concentrate risk in the stock market. There is more than a little concern within the industry that insurance companies will not be able to meet their obligations if the stock market continues to under perform expectations. York University professor Moshe Milevsky has studied annuities for decades and believes that the new products are under priced to cover the cost of protecting investors in a crash. Moody's has raised red flags recently over concerns that insurance companies will not be able to meet their promises to investors under plausible worst case scenarios. And annuities do fail. Exhibit A is U.K. Equitable, a major British insurance company. U.K. Equitable was forced to sharply reduce the minimum guaranteed payout to annuity holders in the late 1990's because interest rates didn't do what actuaries had predicted.

Turns out then that the minimum income guarantee that is available (for an extra cost) is only as good as the financial strength of the insurance company selling the annuity. But what about the basic product itself (assuming that the insurance companies will survive the next big downturn in the stock market) - is the minimum income guarantee really a panacea for investors who have under saved and are now worried that they will outlive their assets? The answer is not really. Here's how the typical product works these days:

An investor buys a variable annuity, placing the money into an investment account that then disburses the money to sub accounts composed of typically high cost mutual funds (remember that cozy relationship between the insurance company and the either captive mutual funds or "preferred providers"?) The mortality and expense fees for the variable annuity usually run around 1.65% per year while the underlying funds usually suck out another 1.5% to 2.0% of the investors money every year. A 3.0% plus per annum expense ratio is a high hurdle to overcome and almost guarantees under performance of the contract relative to owning individual stocks and bonds or low cost, no-load mutual funds. Your broker is often receiving the 12b-1 trailers on the funds in which you invest inside the variable annuity by the way.

Your investment account is left to grow, and the insurance company hopes it grows sufficiently to cover the guaranteed income payments once you start to take them down the road. One product I recently reviewed for an investor had been bought when the investor was 60 years of age. He was guaranteed a minimum income benefit of $30,000 per year if he left the money in place for at least 10 years. He bought a $300,000 variable annuity which was placed into stock mutual funds. The insurance company moved the bulk of the money into a fixed account earning 2% per annum when the bottom fell out of the market in 2008 - it will remain their for the rest of the contract life in order to protect the insurance company. The investor will be allowed to take $30,000 of his own money out of the contract every year until he dies, starting when he turns 70. Of course, the average life expectancy for a man of his socioeconomic background and health is around 78. It is still barely possible that his investment account will make it back close to the original $300,000 level before he turns 70, since he does still have $29,000 invested in stock mutual funds within the annuity - perhaps it will double in the next 8 years, although that is unlikely.

Regardless, this investor has taken $300,000 from his tax deferred IRA (in which he had absolute freedom to invest in any number of low cost mutual funds or directly in a portfolio of blue chip stocks) and put the money into a restrictive, condition-filled insurance product that might actually return all of his original investment to him by the time he turns 80 (if he lives that long and the insurance company is still solvent). Should he manage to make it to 85-years of age he will have hit the jackpot! By 85 he will have been allowed to withdraw $450,000 over a 15-year period (some of the money likely the insurance company's). Whoop dee do!

Why the facetious celebration? Do the math! Our investor will have taken out $450,000 from an original investment of $300,000 made 25-years earlier. A fifty percent gain over 25- years comes to exactly 2% per annum compounded (and that's before paying income tax on the withdrawals). You can better than double that return right now in 20-year tax-free Treasuries, and easily construct a bond portfolio that allows you a substantially higher guaranteed income stream than the annuity, without the onerous restrictions placed on you by the insurance companies - who might not even be in business in 25-years!

Yep! Ya really gotta love those variable annuities and the snake-oil salesmen who peddle them!

Stock Brokers and Dictatorships

2009-10-22T08:15:00.000-07:00

It's a twofer today for those of you willing to indulge me by reading on...

The securities and exchange commission (SEC) found that 76% of main street investors (the public) don't know the difference between a representative of a broker-dealer and a registered investment adviser. Score one for the stockbrokers who have successfully managed to fool the public into thinking they are investment advisers. These guys (and gals) are good at what they do, which is trick the public into thinking they get paid for giving advice when, in fact, they do not. In plain English from a recent article in the Investment News: "The broker-dealer rep does not get paid to give advice and is not licensed to provide advice, and hence is not an "adviser". Such reps get paid when they sell a product: thus they are salespeople."

It would appear obvious that when Broker-Dealers (Wachovia/Wells Fargo, E.D. Jones, A.G. Edwards, Morgan Keegan, Merrill Lynch/Bank of America, Morgan Stanley and numerous others) refer to their salespeople as financial advisers, financial counselors, financial planners, and financial consultants that they are intentionally trying to mislead the public. (My own personal favorite is the guy I met recently who referred to himself as a "financial health coach". Sometimes you just have to laugh at the snake oil salesmen and the lengths they will go to hide behind pithy self-made descriptions!) Personally, I think their titles ought to reflect what they really do so that the public isn't misled. How about "financial services sales representative"? Or perhaps "vice president of mutual fund and variable annuity sales"? After all, when is the last time a "vacuum cleaner adviser" knocked on your door looking to advise you on your need for a new vaccuum?

Of course Wall Street owns the regulators (it's called regulatory capture by the academics) and is able to twist and turn them however they choose. Which is why Big B-Ds are now allowed to also register as RIAs and dual register their brokers. The problem, of course, is that the public has no way of knowing when the stockbroker has his registered adviser hat on and is giving actual objective advice (is that even possible with a juicy commission at stake?) as opposed to trying to sell product. Just ask yourself, when is the last time your broker representative put you into a no-load mutual fund that paid him nothing for doing so? Exactly! After all, there is a reason why fewer than 5% of all financial advisers are fee-only! Fee-only advisors are required to provide sound advice over a period of years before they will make what a broker can make in a single transaction.

Dictatorships confiscate property from individuals as a matter of course. The dictator takes what he wants when he wants it. The American constitution specifically protects property rights, or at least it did until recently. One recent and particularly egregious example (but certainly not the only one) involves the shameful manner in which the current administration stole from hospitals, pension funds, and nonprofit endowments - among others - in order to enrich its political supporters. Sound like a wild, inflammatory accusation? I'll walk you through it and you be the judge.

The Chrysler near-bankruptcy provides a very telling case in point of what can happen when a tyrannical government acts for the "good of (some of) the people". The Chrysler auto bank-debt restructuring committee consisted of four big banks and Elliott Associates. The committee proposed that collateralized senior debt holders should be paid in full (since the debt was collateralized by all of Chrysler's assets). Four hundred years of contract law (going back well into English history) and the American Constitution stood behind the committee's proposal. (There is a well-defined pecking order in bankruptcies and restructurings with senior, secured creditors getting paid before unsecured creditors and unsecured creditors getting paid before stockholders. It is that well-defined pecking order that allows lenders to calculate the risk they assume when lending money to companies which need capital to grow or restructure.)

Unfortunately for the senior lenders to Chrysler (whom were investing on behalf of pension funds - including Indiana's PERF, hospitals, and non-profit endowments among others), the Obama administration decided to reward its political supporters by leapfrogging the unsecured creditors to the front of the line. The unsecured creditors represented the UAW's pension fund and post-retirement health-care-related claims.

It was widely reported that the Obama administration gave the creditors an ultimatum, telling them to accept 32 cents on the dollar for their bonds or be named and blamed by the president of the United States as the cause of Chrysler's bankruptcy. Meanwhile, the administration was offering unsecured creditors (the unions) 60 cents on the dollar for their pension and health care claims, standing hundreds of years of contract law on its head and shredding the U.S. Constitution's protection of property rights in the process. Resisting debt holders, who are required by law as fiduciaries to the hospitals, pension funds and non-profits whom they represented, to do their utmost to act in their investors best interests, received threatening phone calls from governors, senators, and congressional representatives to apply additional pressure. It has also been reported that lenders received threats of SEC and IRS investigations, according to Grant's Interest Rate Observer, if they resisted accepting the government's "generous" offer. (Anyone else picturing Chavez seizing private assets down in Venezuela and strong arming private industry into submission? Anyone else remembering the history of the "Worker's Revolution", in the darkest days of the rise of the Soviet Union, as private industry was wiped out by centralized government planning?)

You, my dear reader, are sadly mistaken if you don't think any of this will eventually impact you more than it already has (remember, it was our "Big-Brother" government that got us into this mess in the first place with more than 50 years of fiscal and monetary mismanagement accompanied by a pernicious mission creep that threatens to completely destroy a once vibrant free-market economy). One of the most obvious unintended consequences of the theft is that the cost of money will rise as lenders require higher interest rates to compensate them for government's capricious "taking" of their property. Credit is the life blood of our economy; there is no economic growth, or only very slow economic growth without abundant credit. A lack of economic growth means a lack of job creation, and that means millions of Americans will remain unemployed due to Big Government's oppressive actions, which are creating a chilling effect in the credit markets even as the Federal Reserve attempts to stimulate lending through its irresponsible spending of taxpayer's money. The bill for the great rape of the American Constitution and American contract law has not yet even begun to be calculated.

Bonds For The Long Run?

2009-09-29T08:28:00.000-07:00

Wharton professor Jeremy Siegel wrote a very popular book in the 1990s called Stocks for the Long Run, in which he made a case for building equity-centric portfolios. Professor Siegal's thesis is that stocks beat bonds over long periods of time by so much that investors must have meaningful exposure to stocks in order to accumulate sufficient wealth for retirement. The fact that stocks have beaten bonds on average by more than 3% per year from 1871 through 2008 would seem to support Siegal's point of view. Further, Siegal maintains that the recent horrendous performance of stocks is exceedingly rare and that investors need to maintain substantial buy-and-hold exposure to equities.

However, not everyone agrees that investors should heavily weight their portfolios toward equities. Boston University professor Zvi Bodie believes that equities are simply too risky over the long run and the core of a retirement portfolio should be Treasury Inflation Protected Securities (TIPS). He contends that a portfolio of stocks doesn't become less risky the longer you hold it because, historically, there have been multi-decadal periods in which bonds have beaten equities (periods long enough to encompass an individual investors entire investment life). Furthermore, Bodie claims that stocks are a poor way to hedge against an investor's future income needs - which is, after all, the main reason for investing in the first place. Bodie believes that inflation-indexed bonds are the best asset for matching future liabilities.

Now facts are facts and the S&P 500 has outperformed bonds by about 3% over the last 137 years. Why on earth would anyone not want maximum exposure to the stock market if they had a sufficiently long time horizon? Well, that turns out to be the rub - the time horizon. As pointed out by Bodie, bonds have outperformed stocks for long periods of time in the past. In fact, bonds beat stocks over the 68 year period ending in 1871. Bonds outperformed stocks from 1929 to 1949 - a 20-year stretch that saw the stock market lose some 89% of its value at its nadir. Currently bonds have outperformed stocks over a 41-year period going back all the way to 1968! And now comes the $64,000 question: Do you really care that stocks are likely to outperform bonds by about 3% over the very long run if you happen to be the poor slob investing in them during one of those horrible, multi-decade long stock market debacles? After all, average returns are all well and good, but you only get to live your life once! There are no redo opportunities!

But how likely is it that you will be one of those unfortunate investors living through a down period in the stock market? Well, there is a 1-in-20 chance that the S&P 500 will underperform a broad U.S. bond index by 130% over a ten-year period. There is a 1-in-5 chance that stocks will underperform bonds by 50% cumulatively over a ten-year-period. Knowing that, on average, the S&P 500 will outperform a broad bond index by 50% over a 10-year period is of small comfort to those investors who don't happen to get the average stock market return during the period that THEY are invested in the stock market. The fact that the shortfalls in stocks vs bonds over 10-year periods are much greater than the shortfalls generated over a single year is also exactly why Bodie argues that stocks are not less risky over longer periods of time. His point made another way is simply that looking at average returns does not address the question of the magnitude of a shortfall when one does occur. In Bodie's own words from his original 1995 paper, "But as has been shown in the literature, the probability of a shortfall is a flawed measure of risk because it completely ignores how large the potential shortfall might be."

What then to do with your investment portfolio. The reality is that most of us do not have an investment portfolio big enough to stick 100% into bonds - we need the extra capital appreciation kick that will come to us from stocks over 10 and 20 year periods... on average. Yet it seems apparent that heavily overweighting stocks is far too risky as well. Put another way, meaningful exposure to assets other than bonds increases investors chances of successfully funding their retirement by reducing longevity risk - the probability of outliving your assets. Building a diversified portfolio of stocks, bonds, commodities, and real estate increases the likelihood of creating a sufficient, sustainable income stream during retirement while still being able to withstand a worst-case scenario in the stock market - a worst-case scenario that seems to come along all too frequently!

One last comment: we are writing from the point of view of buy-and-hold investing, which is the same point of view that Professor Siegel has in his book. Biechele Royce Advisors is not a buy and hold investor on behalf of its clients. We add value and control stock market risk by refusing to overpay for a business. We buy good companies at great prices and great companies at good prices. We sell those same companies when they return to fair value. Our price discipline and focus on stockpicking gives us a big advantage over buy-and-hold investors during secular bear markets!

It's the Government Stupid!

2009-09-01T12:15:00.000-07:00

Public opinion appears to blame the free market system for the current state of affairs in which we find ourselves. Voters have turned overwhelmingly to the federal government for answers to the economic malaise that exists throughout the 50 States. The Obama administration has spent hundred of billions of dollars already and pledged trillions more in an effort to get consumers spending and the economy expanding once again - to the applause of a majority of U.S. citizens. Yet, it is the misguided fiscal and monetary policies of the last 50 years (with the exception of a brief period in the 1980s) that have culminated in the worst recession since the Great Depression. It is the continued application of those policies that will almost certainly lead to more economic pain in the coming decades. Americans must get a clue! It is the Federal Government which bears overwhelming responsibility for the current mess. It is the Federal Monster that must be reigned in and subjugated to the will of the free people of the United States of America, or most of us will die poor.

Not interested in politics? You should be. Politics is the process by which groups of people make decisions, among the most important of which are how to allocate scarce economic resources. Politics, when left to run amok, can ruin an economy, as has happened in Zimbabwe, where inflation is running at 11,200 percent per annum. The United States is not immune to hyperinflation and, in fact, may be barreling head on into just such an environment. Highly inflationary environments are not typically good investing environments. Wealth preservation becomes problematic to say the least, never mind wealth creation.

Right now the markets are running nicely and many economists and political pundits are declaring victory over the recession that has been with us now since sometime in 2007 (the precise start of the economic contraction is still open to debate and will likely be moved back closer to 2006 (once the government is finished massaging the data for political purposes and the academics move in to correct the record). The folks at ECRI say that their leading indicators are pointing toward a very strong recovery in the economy; they are far less sanguine about the chances of a sustainable recovery.

The problem is that the Obama Administration is not addressing the underlying structural problems with our economy, choosing instead to simply stimulate the economy with additional credit, which may have positive short term consequences, but is unlikely to provide a lasting source of economic expansion. We have too much debt; the government is loading more debt on at a furious rate. We have too little manufacturing; the government is doing nothing to address the hollowing out of American industry, which has occurred over the last 30 years. We are fighting two wars, but do not have the money to pay for either. The cold war is over. We need to pull out of most parts of the world. We are not the world's policeman; there is no money in our Treasury for it and the world does not reward us for it.

Get the Federal Government out of state and local affairs. Shut down the giant spending machine that is increasingly sapping our national vitality and robbing us of our individual initiative. Get government out of business so that businessman can compete against one another, rather than having to compete against a government that can change and manipulate the rules at will to ensure supremacy. Let American ingenuity have free reign once again. Let small businesses grow unfettered by government interference! Job growth will follow. Real income growth will follow (Real income is currently below 1973-1975 recession levels.)

The stock market isn't likely to keep its gains. The consumer is 70% of the economy and the consumer has no money to spend other than what the federal government is handing out. The economy is highly likely to slip back into recession more or less as soon as the federal government stops giving people money to spend. The profit recovery implied by the stock market rally from the March lows is unlikely to materialize. We are entering silly season in the stock market - that period where the boys on Wall Street underpin the market in an effort to maximize year-end bonuses. The most likely outcome of this secular bear market rally is a nasty sell-off sometime early next year, perhaps around the March time-frame.

We are maintaining our price discipline by refusing to pay up for businesses that are no longer undervalued, and by taking profits on companies that are up 40% or more since the March lows (business valuations do not change so rapidly as that in the real world). We are acknowledging the lunacy of our federal government's (this isn't a Democrat/Republican thing by the way - both parties are responsible) fiscal and monetary policy by favoring tangible assets over financial, and international assets over domestic.

We strongly urge investors to tread with extreme caution over the next six months as the government's massive spending winds down and the underlying structural problems reassert themselves. The piper has not yet been paid for 30 years of over consumption, over spending, and easy credit.

Investing in Stocks

2009-08-06T13:11:00.000-07:00

We wrote about portfolio diversification a while ago - we related how a 15 - 25 stock portfolio can give you 90% of the benefits of diversification and how a 40 stock portfolio can give you 99% of the benefits. (Diversifying away non-systemic - company specific - risk is important in achieving the highest possible return for the amount of risk taken). We work hard educating our clients on the importance of building properly diversified and appropriate portfolios consisting of stocks and bonds. Properly diversified to us means eliminating all unnecessary risk while appropriate means putting our clients at a risk (and return) level that works for their financial situation and temperament.

But what about individual stock selection? If strategic asset allocation (the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and cash) accounts for most of the variation in returns over the long run (and it does), why even bother with individual security selection?

A very good question indeed!

Because we can add to returns with careful security selection and reduce taxes through tax loss harvesting. The empirical evidence overwhelmingly shows that we can outperform the market using a common sense approach to investing - buying businesses when they are trading for less than a knowledgeable buyer would pay for the entire company in an arms length transaction. In other words, buying companies when they are trading cheaply. It only makes sense! An investor should outperform the market over the long run by purchasing undervalued businesses and avoiding overvalued businesses - and the academic data supports that view.

How is it possible that the market is inefficient enough to give value investors a known edge over other types of investors? Economics 101 teaches us that excess profits in a capitalistic system are eventually competed away. Why don't the majority of investors recognize that value investing brings superior returns and join the gravy train?

The answer lies with some well-known investor biases that endure, despite wide recognition that they exist. People will be people! It is estimated that only about 10% of investors are value investors while the other 90% chase growth and momentum. Value investors are able to take advantage of investor biases which create excess profit opportunities for them. For instance, investors routinely associate good companies with good investments and are willing to pay a premium for them in the stock market. The Behavioral Finance term is "representativeness". Good companies are usually widely recognized as such and are highly priced as a result - and on average they under perform the market going forward. Likewise, investors routinely associate low growth (bad) companies with poor investments and shun them, creating a profit opportunity for the savvy value investor.

As well, a majority of investors expect stocks with poor liquidity (thinly traded) to have lower returns, yet the empirical evidence shows otherwise. Also, investors expect lower returns from stocks that are not widely followed by the financial analyst community, yet the evidence contradicts that expectation. Less widely followed stocks actually tend to outperform.

It really isn't rocket science. Rather, it is having the patience and discipline to buy a good company at a great price (or a great company at a good price) and waiting for the herd to recognize that it was overly pessimistic. It is also about having the discipline NOT to buy a stock just because the entire stock market it rising. We will not pay up for an investment - ever! Price discipline makes for successful investing and we never forget it at Biechele Royce Advisors. Although we aren't willing to market time per se, we are willing to let cash build up in our client accounts if we can not find good businesses at great prices or great businesses at good prices. Price discipline is risk management and risk management is a must during a secular bear market.

Mutual Funds and Benchmarks

2009-07-10T09:21:00.000-07:00

Many people are invested in mutual funds. Most people have no clue how to tell if their mutual funds are better or worse than average. Many people allow their financial advisor, planner, accountant, or fee-based advisor (broker) to put them into mutual funds but must take their advisors word for the "best-in-breed" claim. Unfortunately the reality is that actively managed mutual funds do not out perform their unmanaged benchmarks on a risk-adjusted basis after taking fees into account. Furthermore, the mutual funds that do outperform their benchmarks on a risk-adjusted basis over trailing five and ten year periods are unlikely to outperform going forward. In other words, the top ten performing mutual funds in a market segment - say large cap - over the trailing ten year period are unlikely to be the same funds that out perform over the following ten year period. Bottom Line? There is no way to know in advance which funds will outperform their benchmarks on a risk-adjusted basis, net of fees, over five and ten year periods.

Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!

Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!

But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.

To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!

Diversified Portfolios

2009-06-29T10:45:00.000-07:00

Many people believe they have too little money in their investment portfolio to own individual stocks. They feel that mutual funds give them the "safety" of diversification. I often review portfolios for prospects and find that they are invested in five, six, ten different mutual funds. The prospects believe they are adequately diversified; after all, they own multiple mutual funds which hold one hundred plus stocks each on average. They are often surprised when I tell them that they are not very well diversified at all. They are down right disbelieving when I tell them they could get almost the same diversification with a portfolio of 25 carefully chosen stocks. The reality is that 15 to 25 well chosen stocks provide 90% of the benefits of diversification and that a 40 stock portfolio can provide 99% of the benefits of diversification. The hundreds of additional stocks owned by the mutual funds in which our prospects are invested provide almost no additional diversification benefits. Have $100,000 allocated to equities? More than enough to build a 25 stock portfolio that will adequately diversify away your non-systemic (company-specific) risk. However, you aren't properly diversified just because you own a properly diversified stock portfolio.

A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).

The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).

Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)

Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!

Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).

The Really Big Picture

2009-05-18T09:51:00.000-07:00

I had a prospective client ask me the other day how we were handling the current stock market rally. He wanted to know if we planned on raising cash as the rally progressed or whether we thought this was the start of a new bull market. My prospect's question certainly isn't unusual. In fact, CNBC and the other popular media outlets spend hours debating those same questions. Speculating on where the stock market is going, what interest rates will do, whether commodity prices will rise once again this year - these are the questions to which people want answers. And, Wall Street provides those answers in abundance, although many of the answers contradict one another and most of the answers turn out to be wrong - predictable once you realize that it is all just speculation about an unknowable future.

Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.

I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.

Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.

We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.

We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.

Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.

And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.

Medicare Supplements

2009-05-05T10:25:00.000-07:00

Medicare isn't the end all and be all of medical care for seniors. The truth is that most seniors need supplemental insurance if they can't afford to reach into their pockets repeatedly as they grow older and require increasing amounts of medical attention. In fact, practically everyone needs a Medigap or Medicare Supplement policy. The only folks who probably don’t need a supplement are those who qualify for Medicaid or another government assistance program. It is important to sign up during the 6-month window provided by law after turning 65 to avoid having to qualify medically. The six month window allows you to enroll in any plan you like; you may lose that freedom of choice if you miss the window and your health is questionable.

You need to understand what Medicare is and isn't to understand the value of a supplemental policy. Medicare is a federally funded health insurance plan for citizens of the US who are age 65 and above. Medicare Part A is an automatic enrollment and costs nothing. This is the “Hospital” coverage portion of Medicare. Individuals must enroll in Medicare Part B which covers out of hospital charges; doctor’s visits, lab work, outpatient surgeries and the like. Part B coverage is paid out of your social security benefit and currently costs $98.00 per month.

One of the most misunderstood things about Medicare is how it pays benefits. Many seniors think that it will pay for all their medical expenses and that can be a costly error. The reality is that Medicare comes in two parts. The 2009 Part A Deductible is $1068.00 annually and is for hospital stays. The 2009 Part B Deductible is $ 135.00 annually and is for non hospital expenses. Now here is the IMPORTANT part. Medicare does not pay 100% after the deductible is met, instead paying only 80% of the costs. And that is very important to understand because if an individual with Medicare parts A & B goes into the hospital and generates a $100,000.00 bill from their stay, then that individual would owe approximately $20,000.00 to the provider. Yikes!

But that is where Medigap policies enter the picture as they are designed to pay one or both deductibles and the 20% remaining balance that Medicare does not pay. Remember that $20,000 bill we generated with our single hospital stay, even after Medicare had paid its portion? Your bill would drop to $0.00 with a Medigap policy.

Now you do have choices to make regarding which plan is right for you. There are 10 STANDARD Medicare supplement plans (standardized by the federal government a few years back). Pricing and the actual plan details are the key as every insurance company must provide an identical standardized plan by law. Of course, the financial strength of the insurance company is also a front and center issue. One important attribute of the standardized plans is that they allow policyholders to go to any doctor/hospital that accepts Medicare assignment. It is critical that prospective buyers understand that Medicare Select policies and some of the newer policies such as the "Advantage Plans" severely restrict your access to doctors and hospitals and also require you to make co-payments for services, as well as limit some benefits. Non-standardized plans are not necessarily wrong for you, but you do need to make sure you understand what you are and aren't getting for your money.

Seniors who currently have a plan can shop for another, cheaper one as long as they qualify by answering a few health questions. There are no lengthy exams and the underwriting decision is usually made within a few hours. Premiums for Standard plans are determined by age, take into account whether you are a smoker, and sometimes are adjusted based on medicines prescribed. You should expect to pay around $100.00 per month for age 65 up to around $240.00 per month for a 90 year old depending on the plan you choose.

It is worth while talking to an agent when shopping around for a plan. Agents are paid a commission from the insurance company so no direct fees to the client are involved. Of course, the insurance company will seek to recoup those commissions with a portion of the premiums paid. A knowledgeable agent should be able to help a senior with the choice of a supplemental plan that makes sense for the senior while also advising on an Rx plan under Medicare Part D (the prescription drug portion of Medicare that currently offers 75 different options). Another service that an agent can provide is accessing a clients qualifications to see if they are eligible for free or discounted medications. Any agent you choose should have some experience in the insurance industry, the ability to review part D for you, have an understanding of low cost Rx plans, and also be able to advise the client on other senior products, such as long term care planning.

In summary: Medicare Standard plans allow the owner the most flexibility and best coverage. They are a commodity product though so shop price. While Select and “Advantage” plans may be less expensive, you are restricted in choice of providers and may have poorly disclosed co-pays for each service. It is important that you understand exactly what you are and aren't getting in these non-standard plans. And don't forget that you may replace your current plan for less benefits, more benefits, or a lower price.

(I'd like to thank Bob Dorman of Dorman Benefit Consultants for providing invaluable help with researching the article.)

Fiduciary Standard

2009-04-27T03:51:00.000-07:00

Fee-only is different from fee-based... period, and don't let your fee-based advisor tell you any differently (and they'll try). I recently talked with a stock broker from Raymond James Financial (of course he called himself an advisor) who wanted to split hairs in an effort to get me on board with the idea that someone such as himself was really the same as a fee-only advisor. Baloney!

I politely explained to him that only a firm that gets paid solely by the client, and not by a third-party, can legally claim to be a fee-only advisor. He looked a bit puzzled and asked me what I meant. I said it was really quite simple. A fee-only advisor doesn't accept money from anyone other than their client. A fee-only advisor works for their client and their client only. When I asked him if the many mutual funds he sells his clients pay him a sales commission (a loaded fund) he reluctantly admitted that they did. Bingo! Major conflict of interest since the advisor now has a vested interest in selling you products that will make him money, paid to him by a third-party, rather than products that are in your best interest.

Fee-only, independent advisors registered with the SEC can claim fiduciary status; the manufacturers and sellers of financial products (mutual funds, variable annuities etc.) can not. In the words of Evan Cooper of InvestmentNews, "the providers of products and advice (whether known as brokers, representatives, financial consultants, financial advisors or any other title that connotes investment advice-giving) must recommend only those products that are suitable for a client," (a much looser standard that does not require the client's best interests to be placed first.) Mr. Cooper goes on to write that, "Wall Street wants to keep the suitability standard as long as it can, because it permits principal trades. If a brokerage firm can sell a bond from its inventory when a client comes in to buy, it's a lot more profitable for the firm than having to shop the order among other dealers to get the best price. There's a lot of money to be made by the brokerage business by putting the broker-dealer ahead of the investor."

Not a problem you say to yourself? You don't buy bonds from your fee-based advisor? How about stocks? Your boy gets a commission every time you buy one of his recommendations, incentivizing him to sell you stocks, whether it is in your best interest or not. And how about those front-loaded, high operating cost, 12b-1 mutual funds that are still so prevalent in the industry? Your boy gets paid every time you pony up your hard earned money to make an investment in an average performing fund that almost certainly has a no-load, lower operating cost alternative. I mean for crying out loud! There are something like 10,000 mutual funds out there now, more funds even than stocks.

Want to know the saddest part? The academic evidence overwhelming shows that no one can pick a mutual fund that will outperform its peer group a priori (in advance), which means that everyone should be focusing on costs and tax efficiency when it comes to mutual fund selection. That's right, all of those so-called advisors out there who tout their ability to put you into the best performing mutuals funds are full of you know what. The fact is (and it is a fact) that the top twenty performing mutual funds from the prior five-year investing period will not be the same top twenty who outperform over the coming five-year period. In fact, few if any names will repeat.

Oh, and one last pearl of wisdom from Mr Cooper of InvestmentNews that I couldn't agree with more, "The rules should be crystal clear. If you are licensed to give financial advice in any way, shape or form, you must put clients' interest first. If brokerage firms (and fee-based advisors) can't comply, let them reorganize themselves, or label their advice as sales promotion."

Amen!

Retirement Planning Requires Goals And Balance

2009-04-13T06:40:00.000-07:00

The talking heads on TV spend a majority of their time agonizing over the question of stock market direction. When they aren't talking stock market direction, they're talking economic trends - hoping that will help them predict stock market direction. Less often they will focus on individual stocks and try to predict their near-term direction. It is well understood within the industry that most "marks" (read individual investors) don't have the patience to actually buy a stock for the long-term (three to five years) and instead want their investments to start appreciating right away. Stock brokers get that, which is why they tout growth and momentum strategies, despite the mountain of evidence showing that those strategies under perform over the long run. Brokers know that most investors are all too happy to buy a sexy growth story, rather than buy a company selling for less than its intrinsic value.

Speaking of stock brokers, I want to be very clear what they actually do for a living. Stock brokers are out on point, selling whatever new hot products Wall Street wants sold. Oh, they've taken to calling themselves financial advisors, financial planners and "financial health coaches" (no kidding, I actually had a broker tell me recently that he tells his meal-tickets he's a financial health coach. I guess he's hoping the meal-ticket will view him like a personal trainer instead of as the commissioned based salesman that he actually is). But at the end of the day, stock brokers are exactly what they've always been, Wall Streets hit men, compensated handsomely for pushing product through the pipeline and into the hands of the unsuspecting public. John Bogle, founder of Vanguard, is on record as stating that most of Wall Street's innovations are designed to benefit Wall Street, not investors. Ya think! Legendary value investor Jean-Marie Eveillard told Consuelo Mack recently in an interview that, "When I’m in a good mood, I say Wall Street is a vast promotional machine,” Eveillard said. “When I’m in a bad mood, they are a den of thieves.” Amen! And don't forget that the "financial health coaches" aka stockbrokers, are the den-of-thieves' agents (think Mr. Smith from the Matrix)!

Okay, enough of the broker bashing (for now). Let's get to the retirement planning.

You can't know how to get there if you don't know where you're going. Sounds straight forward enough right? But you'd be surprised how many individuals really haven't sat down to figure out where they are going. For example, most individuals I talk with have actually spent very little time thinking about how big their investment portfolio should be in order to throw off enough cash in retirement to meet their desired lifestyle. One million? Two million? Three million?

How's 4 percent grab you?

William Bengen developed the 4% rule in 1994, arguing that investors could safely withdraw 4% from their balanced stock/bond portfolio in the first year, and then adjust that dollar amount upward for inflation each year. Bengen recommended an allocation as close to 75% stocks as possible, with the remainder in bonds. Subsequent research suggested a mix closer to 60/40 stocks and bonds was better. The consensus now seems to be somewhere in the 40% to 75% stock range. Cooley, Hubbard, and Waltz quantified Bengen's rule in 1998, determining that "safe" represented a 95% success rate with a 50/50 portfolio.

And success is defined as making your retirement portfolio last 30 years without running down to zero. Bengen's original findings were that the 4% rule allowed a retiree to live off his investment portfolio in every 30-year period on record from 1926 through 1994, some periods with only a few bucks to spare and some periods with millions left over. The 4% rule has maintained its success rate since 1994, despite the last eight years of horrible stock market returns.

Investors who are sophisticated enough to correctly gauge market valuations can fine tune the 4% rule based on current market valuations when they retire. It turns out (as common sense would suggest) that investors can increase their withdrawal rate when market valuations are depressed at the start of their retirement. Michael Kitces, publisher of The Kitces Report, showed in a 2008 study that safe withdrawal rates in a balanced portfolio depend on market levels. Withdrawal rates in excess of 4% are possible when valuations are depressed, based on Shiller's P/E (a 10-year trailing average). Conversely, of course, withdrawal rates should be reduced when market levels are high, as they were in 2000 and again in 2007. In fact, the greatest risk to a retiree's portfolio is severe market under performance at the beginning of the retirement period, a risk that many recent retirees are unfortunately experiencing first hand right now. The problem with stock exposure is that severe under performance at the beginning of the retirement period will leave the retiree with a depleted portfolio balance that will result in a smaller annual distribution, at least until the portfolio recovers - which can be a very long time depending on the investing period.

There are some retirement experts who believe that stocks should be avoided entirely, precisely because of the risk of early-year under performance. Robert Huebscher has written (Advisor Perspectives, March 24, 2009) that an all bond portfolio is preferable to a stock/bond portfolio. His main contention is that an all-bond portfolio offers far more certainty of success because cash flows are much more certain and total real return depends only on correctly forecasting inflation rates. He further maintains that "inflation is far more predictable than equity market returns and can be efficiently hedged using TIPS." His last main point is that, "the all-bond portfolio is insulated from the risk of historically unprecedented adverse-market conditions near the beginning of the retirement period." Although he admits that there is a risk to the all-bond portfolio - underestimating inflation.

I think Mr Huebscher makes some interesting points, but his over-all argument for an all-bond portfolio is dependent on not underestimating inflation, and that is, in my humble opinion, exactly where we stand today. I also take issue with his contention that TIPS provide an efficient means of hedging inflation. The U.S. government has a huge vested interest in under reporting inflation, since all of the cost of living adjustments for social security and federal employees and retirees are tied to the CPI. It is extremely naive to believe that our government is accurately reporting inflation. In fact, economist Dr. John Williams, of Shadowstats fame, estimates that inflation is currently running about 8% higher than the official number.

More importantly, we are at the cusp of a long period of rising inflation and rising interest rates, brought on intentionally by a government determined to debase our currency in order to make it easier to meet the $65 trillion in unfunded liabilities it has taken on over the last twenty years of unprecedented spending. Governments everywhere and always have chosen the least politically painful option of currency debasement, once they've recognized their inability to make debt payments. The process has just begun in the United States and is likely to culminate, as in the 70's, in double digit inflation rates and double digit interest rates. Now, I am making no guarantees. It is barely possible that our elected officials will do the right thing, sharply curtail spending, raise short-term rates to encourage savings, and defend the dollar at every turn in an effort to keep it front and center as the world's reserve currency. But I doubt it.

The main point, however, is that an all bond portfolio will leave retirees eating dog food in 10-years or so if my inflation scenario comes to pass (and I give it better than a 50% chance of doing so). A prudent investor would do well to maintain a balanced portfolio of stocks and bonds in order to balance the risk of a near term short fall in stocks at the beginning of retirement against a longer-term risk of loss of purchasing power with an all-bond portfolio. It is exactly the uncertainty surrounding both stock market returns AND inflation rates that demands using both asset classes to increase the likelihood of a successful retirement using the 4% rule. (And no I do not think that stocks are cheap enough yet to raise the withdrawal rate to 5%, but that is for a different blog).

Oh, and the average inflation rate since 1966 has been 4.6%, yet many financial advisors use the 2.5% to 3.0% default rates prevalent in the investment planning software used by many of them when projecting real, long-term portfolio returns for their clients. You might want to ask them why next time you speak with them...

Consumers Beware!

2009-04-06T07:34:00.001-07:00

Fidelity Investment long ago made a name for itself in the mutual fund industry by providing a wide range of open-ended mutual funds that, at one time, were consistently ranked in the upper end of the mutual fund universe. Peter Lynch made Fidelity a household name back in the 70's and 80's with his stellar performance as manager of Fidelity Magellan, a fund that has fallen on hard times in recent years.

But what many investors don't know about Fidelity is that the firm is no longer a pure mutual fund company, having strayed from its roots as a producer and passive distributor of product to an active distributor of product back in the 1990s. The company currently runs a hybrid operation that now not only offers mutual funds directly to the public, but also pushes managed-money programs and other proprietary products through a broker network of its own. Now, since we're all educated consumers of financial products, we know that anytime a company is selling its own products to consumers through brokers that we have entered the "Conflict of Interest Zone!!!!!"

Apparently, many of Fidelity's own brokers are acutely aware of the conflict as well, given that dozens recently jumped ship, claiming that they were forced to leave because Fidelity was requiring them to obtain their certified financial planner certification. Now why would that cause a problem for the brokers? After all, obtaining a CFP certificate sounds like a step in the right direction for these sales people. It can't possibly hurt to require a stockbroker to actually get an education in investing before going out and peddling stocks to individuals can it?

Of course not, but the problem (as is usually the case) centered on compensation and disclosure. Apparently Fidelity wanted the brokers to get educated, but was continuing to prohibit them from disclosing to clients and prospects that a substantial portion of their compensation was commissioned based. Unfortunately for Fidelity, a CFP holder or candidate must disclose material conflicts of interest to clients and prospects, including compensation arrangements. So what was Fidelity's response to the dilemma? Did it choose to continue to require its brokers to obtain a CFP certificate in order to better serve clients, and then also begin disclosing compensation arrangements to clients?

Hah! Not a chance. Fidelity has decided to rescind the mandate to get educated and is instead no longer requiring its brokers to obtain the CFP certificate, thus preserving the commissioned based part of their compensation scheme (albeit back in the shadows once again) and allowing brokers to continue to profit handsomely from client transactions.

Caveat Emptor!

The Variable Annuity Con

2009-04-01T09:47:00.000-07:00

It makes me both sad and mad to see how many individuals get conned into putting IRA and 401(k) money into a variable annuity. Variable annuities are a tax-deferred investment vehicle that come with an insurance contract, typically designed to protect you from a loss of principal. The earnings inside the annuity are allowed to grow tax-deferred and there are no annual contribution limits as there are with other tax-deferred investment vehicles such as IRAs and 401(k)s.

Wait, back up a moment... did I just write "as there are with other tax-deferred investment vehicles such as IRAs and 401(k)s"? Well, by golly I did didn't I. Well then why in the world would an insurance salesman want you to take your already tax-deferred money and put it into another tax-deferred investment vehicle? Is there some kind of double deferment thing happening here? NO

What's happening is the snake-oil (ahem) I mean variable annuity salesman is looking for a big pay day, anywhere from 5%-10% of the total amount of the money you put into the annuity. It's a bad deal for the investor, make no mistake. You gain nothing in improved tax treatment, yet variable annuities are expensive, running 2.44% per annum in annual expenses versus 1.32% for the average open-ended mutual fund, according to Morningstar. And that 2.44% doesn't take into account the additional commissions that are often paid out as ongoing fees. Oh, and there is the pesky little surrender fee designed to lock you into the variable annuity long enough for the insurance company to pay-off the guy who sold you on the idea in the first place. The typical surrender fee in the first year of a contract is a whopping 6%, dropping to a mere 1% in the seventh year.

And what's the big benefit of using a high-commission, high-expense variable annuity? Well the smooth talking salesman is going to point to the minimum guaranteed return, the so-called death benefit. The death benefit guarantees that your account will maintain a certain minimum value - usually the amount that has been invested. Sometimes the minimum guarantee will be some positive rate of return, but you can rest assure it will be a very low hurdle indeed, one that the profit-seeking insurance company expects to clear with ease. As well, the death benefit usually expires at around age 75, making it no real death benefit at all. In fact, given that stocks have returned approximately 11% annually from 1926 through 2007, it isn't surprising that the death benefit is triggered very rarely, perhaps for less than 2% of all annuities sold - almost sounds like a lottery ticket set up doesn't it?

Bottom line here folks is you gain zilch by putting your IRA and 401(k) money into a variable annuity, but you give up plenty in the form of commissions, extra fees and investing flexibility.

Okay, okay you say, no more putting already tax-deferred money into an expensive, inflexible variable annuity. But surely these things are worthwhile for non-qualified chunks of money right? In most cases no. Why?

Because gains are taxed as ordinary income, which can run as high as 35% versus the current 15% on long-term capital gains. Remember, gains are tax-deferred not tax free, meaning you will eventually pay taxes on the high-commission, high-expense investment vehicle's earnings. And the different tax rate makes a huge difference in your after-tax returns. It may take 15 to 20 years for the benefits of the tax-deferred variable annuity to make up for the more onerous tax treatment. Of course, it will take even longer to come out break even when you factor in the higher expenses.

Still want an annuity for your non-qualified money? Fine, at least cut out the snake-oil salesman and go direct to a low-fee, variable annuity provider. You can buy a low-cost variable annuity from many mutual fund and insurance companies such as Jefferson National, Vanguard or T. Rowe Price. Already own a high cost variable annuity? No problem. Make a tax-free transfer (1035 exchange) to a low-fee annuity (but don't forget to check on your surrender charge first).

Even Congress "Gets It"

2009-03-30T08:23:00.000-07:00

I'm not a big fan of the current Congress. Too many of its members seem far more concerned about political posturing designed to garner votes than they do about doing what is best for our country. Nevertheless, it seems even Congress, or at least one member, "gets it" when it comes to financial service providers who both sell products AND give advice to their clients.

Rep. Robert Andrews, D-N.J. said at a hearing last week that advisors who provide advice on IRAs should be independent of companies that sell investments. "I don't think somebody should be giving advice on your retirement money if they serve two masters, whether it's your 401(k), your IRA or your defined contribution account," said Rep. Andrews.

Now to me this is a "Duuuuhhhh" issue, as in "Well of course!" Why on earth would anyone think that they are getting objective advice from an advisor associated with a mutual fund company, brokerage firm, insurance company or other seller of financial products, especially when that advisor is compensated, often handsomely, for selling those products to their clients.

Now, 20-years ago I would have stated firmly and with profound conviction that legislation just isn't necessary because the absolute superiority of a fee-only, independent advisor model over a commissioned based model was so self evident that it would be only a matter of time before stockbrokers and annuity salesmen went the way of the dodo bird. Investors would just stop using them. Hah! Shows you what I knew back then - not much when it came to human behavior as it turned out.

The reality of the modern financial services business is that it has changed very little over the last 20 years regarding the issue of compensation. Fee-only, independent advisors still make up only a small percentage of the total number of advisors. Why? Likely, because most advisors just can't resist selling lucrative investment products to their clients, and most clients just don't seem to understand or care that the advice they receive is tainted by those juicy commissions.

Chasing Performance

2009-03-30T08:13:00.000-07:00

The average stock fund investor has far underperformed the average stock fund return from 1988 thru 2007, according to Dalbar, Inc., which published "Quantitative Analysis of Investor Behavior" (July 2008). According to Dalbar, the average stock fund has returned 11.6% while the average stock fund investor has only earned 4.5%. Dalbar labels the 7.1% difference the "Investor Behavior" Penalty.

Now the "Investor Behavior" penalty is not a new revelation. Dalbar first pointed it out in the late 1990s (early 2000s?) There are numerious explanations as to why investors underperform the very investment vehicles they use, but most center around peoples' inclination to chase performance. The reality is that past performance is no predictor of future performance in mutual fund land. Given that there are maybe 10,000 mutual funds out there, the task of picking a few long-term outperformers is more or less impossible. Focusing on low-cost, tax-efficient funds with a stable investment discipline is about the best one can do. Indexing fits the bill nicely.

A Market of Stocks

2009-03-29T08:56:00.000-07:00

Thought my newsletter from last fall might help delineate my thoughts on real investing versus the ubiquitus speculating practiced by most of the major players.....

From The Bleachers
By
Christopher Royce Norwood, CFA®

Vol. 1, No. 1 October 17, 2008

A Market of Stocks

Much is made of the stock market these days in the newspaper, on television and in the halls of government. Everyone on the planet surely has heard that the derivatives market has finally blown up (Warren Buffett proved prescient when declaring them “financial weapons of mass destruction” way back in 2003). Mr. Buffett wrote in his annual letter to shareholders that some derivatives contracts appear to have been devised by “madmen”. His warning that derivatives could push a company into a spiral that could lead to a corporate meltdown appear virtually Nostradamus in nature now that AIG, Lehman Brothers, Bear Stearns, Fannie Mae, and Freddie Mac have all run aground on the sharp rocks of the derivatives market. Write downs already tally north of $650 billion and the International Monetary Fund (IMF) is predicting they will total $1.4 trillion (that’s Trillion with a T) before all is said and done. And that august international body’s forecast appears downright cheery next to Nouriel Roubini’s prediction that write-downs will top $3 trillion eventually.

Why should we care what Mr. Roubini has to say on the subject? Perhaps because the Professor of Economics and International Business at the Stern School of Business in New York had the intestinal fortitude to stand in front of an audience of economists at the IMF in September of 2006 and warn that the United States was facing a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession – all have come to pass in the intervening two years except the deep recession, which Roubini sees unfolding right now.

Of course, the stock market is on track for its worst year since the 1930s. A deep, consumer-led recession will make a recovery in the market a back half of 2009 or even a 2010 affair, should it come to pass. Investors will undoubtedly collectively wish they’d found something else to do with their hard earned money like, say, gone to Vegas and bet on black, should we experience anything close to Mr. Roubini’s prediction of the worst recession in forty years prove on the mark. 2009 earnings estimates for the S&P 500 will look laughably high in hindsight – they are currently forecast at around $96, but would likely come in closer to $76 in a deep recession.

Perhaps this is a good time to shift to the topic indicated by the title up above, before readers decide we’re just a bit off the mark with it. Our fervent hope is to both entertain and educate our readers on the art of stock picking for – as the title declares – it is a market of stocks not a stock market in which we invest. To be fair, we are contrarian by nature, and a bit old fashion to boot. We recognize that index funds exist, that exchange traded funds are available with which to place your bets on red, black, or even green, but we prefer to build a portfolio the old fashion way, one well researched stock at a time. We hesitate to declare that we’re looking for an undervalued business in which to invest since we will almost assuredly be (mis)labeled as a value investor. So we will avoid the claim. Rather, we simply recognize that a share of stock means a share of ownership in a corporation, which entitles the stockholder to a share of the profits, should there be any.

Now oddly enough, we have found over the years that companies that make increasing amounts of money are deemed more valuable (eventually) to investors than those who don’t, and the stock price of said company invariably rises over time as a result of the increasing stream of cash finding its way into the shareholders’ pocket, a truly wonderful outcome for those of us who enjoy turning a profit with our investing. It is our belief that we are buying ownership in a business that guides our search. Not for us the pursuit of a stock, simply because it is rising – that game belongs to the many speculators who invest with a six to twelve month time horizon. Speculators they are because they invariably buy a stock in the hope that it will trade higher in the coming quarters, allowing them to sell at a tidy profit and move on to the next piece of paper. The many mutual fund managers, institutional asset managers, and individuals who choose to rent a stock (and we are now fairly describing upward of 90% of the investors out there) are not interested in the value of the underlying business. They care only whether the stock price will rise in the short run, and turn to such devices as earnings revisions, upside surprises, relative strength indicators and insider buying to divine the short term future of a company’s stock price. We, on the other hand, care very much what price we pay for a company. Just as we choose not to overpay for a car, house, vacation, or that big flat panel TV that makes Peyton Manning’s flapping and stomping prior to the snap looking even more like a blue heron dancing in the shallows (Of course we are fans, season ticket holders as a matter of fact).

Don’t misunderstand however. We have owned all manner of stocks in our 20 years of investing. Technology stocks, drug companies (back when big pharma was considered a growth industry), the King of Beers, and the royalty of soda pop (Coke) have all found their way into our portfolios. We will buy anything in any industry if the price is right, and we are very patient in waiting for that happy event to occur. For instance, Coke was the poster child of expensive back in the late 1990’s, peaking in the vicinity of 55 times earnings if we remember correctly. We even used it as a marvelous example of a great company that was no longer a great investment. But we didn’t hesitate to pay some 20 times earnings in 2005, with the stock in the low 40s, nor did we hesitate to sell it some two years later in the high 50s when the price-to-earnings multiple no longer matched the company’s growth prospects. A market of stocks, not a stock market, and stocks as certificates of ownership in an ongoing business – two of the guiding principles of our investment philosophy.

INTC $14.28

Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.

In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.

In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three-year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams often chooses to buy back shares with excess cash. We think it unfortunate, because managers tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.

Yet another way to do the math without the distortation of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.

A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.

The company is currently the world’s largest semiconductor chipmaker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.

For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five-year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).

Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.

AND A STOCK MARKET

You can unglazed your eyes now and refocus on the casino – that is to say the stock market. The truth is that few investors really want to spend the time rooting around in the financial statements of publically traded companies with a view toward discovering an undervalued business worth buying. It takes time and patience and more time. We ourselves have found it a profitable way of spending our time and we’re always fascinated by the inner workings of a business and the question of its true worth. But investing is boring compared to speculating – which over the last 20 years has more or less become the nation’s national pastime in our eyes.

Which brings us full circle in this, our first edition, to the derivatives bomb that has gone off in our faces and the resulting mess in which we currently find ourselves. We’ll give you a quick recap, since most of this is now fairly well known. We hope to save some space to sketch out a roadmap for the market in the coming years as well as for the economy that underlies it.
The root cause of our current pickle is easy money. The Federal Reserve dropped rates in response to the 1987 stock market crash and has been a one trick pony ever since (or at least until very recently). The consumer led recession of 1990-91? No problem, cut rates. Mexican Peso and Asian currency crises of 1994-95? No problem, cut rates. Long Term Capital Management implosion and Russian debt crisis of 1998? No problem, cut rates. Technology stock bubble implodes? No problem, cut rates and leave them at a historically low level for a very long time, ensuring that negative real rates will spike the velocity of money and force a veritable tsunami of liquidity into … housing markets around the world! Credit markets freeze as a mountain of bad mortgages and mortgage derived financial products lose their value once house prices start following? No problem, cut rates AND PROSTITUTE THE FEDERAL RESERVES BALANCE SHEET TO THE POINT THAT HYPERINFLATION IS A VERY REAL POSSIBILITY!

Ahem, we hope we now have your undivided attention because we’d like to throw out some thoughts on what the next 10 years or so holds for stocks, bonds, commodities, and our economy. The Federal Reserve appears to have reached the limits of what a one-trick pony can accomplish and so, under Ben Bernanke’s watch, the Fed has transformed itself into a multi-trick pony, all with the aim of preventing the mountain of debt that underpins our economy from crushing our major financial companies and, in a chain reaction, the companies and consumers that depend on them for credit.

In the process, the Federal Reserves balance sheet has ballooned from around $850 billion to some $1.7 trillion in just a matter of weeks, and is likely to reach $3 trillion by year-end. We will devote the rest of this edition to explaining just why that mammoth increase in the Federal Reserves balance sheet is likely to lead to inflation on a scale not seen since the 1970s (don’t worry, we’ll save a little space for telling you what’s likely to happen in the stock market in the next few months as well).

Ready? Okay, here it is…. inflation results when too much money chases too few goods and services. Double the amount of money in circulation but hold the amount of goods and services produced constant and inflation will result. The Federal Reserve has gone one better by doubling its balance sheet on the way to tripling it from what we’re hearing. What’s more, the dollars they are pushing into the system are now backed increasingly by collateral of dubious quality, to say the least. Boat loans, subprime credit card loans, and fancy triple A rated (and worthless) CDOs now represent a goodly portion of the assets backing the greenback. Not convinced that inflation is coming? How about the Federal Reserve buying debt directly from the Treasury? Here’s how that will work if Bernanke, as is currently rumored, elects to monetize the debt. The U.S. Treasury needs to raise the dough to buy up bad assets and make equity injections into insolvent banks, insurance companies and various other corporate miscreants. No one wants the debt because they already have too much of it so the Federal Reserve simple prints up a few hundred billion more of the good old greenback and uses the newly minted cash to buy the debt from the Treasury, which turns around and hands it over to the Titans of commerce in order to salvage our financial system. Sweet deal for sure, except for the fact that no one, and I mean no one will want to hold the dollar anymore if history is any guide. And all of that new paper will push prices higher and higher and higher. We hope the Federal Reserve doesn’t do it, but then we hoped they wouldn’t give J.P. Morgan $29 billion for a bunch of Bear Stearns assets that are almost certainly worth far less because, as taxpayers, we didn’t really want to take a loss on the overvalued paper…

As for the stock market? Our forecast for almost a year now has been for a substantial low in place sometime this fall with a retest sometime next spring. We see no reason to change it at this point. In fact, here’s what I wrote a buddy just a couple of days ago

Scott,

My forecast since last winter was for a significant low in the fall, a rally into winter and a retest by next spring. My fundamental reasons were that by this fall the horrifying extent of the credit market excesses would finally be laid bare for the masses to see, resulting in a selling climax sufficient to set a bottom that would hold for a few months. My retest was based on the thought that earnings estimates for the back half of 2008 and 2009 were way too high and the institutional weenies would start selling the misses and downward revisions by the winter pressuring the market into the spring. I also felt and still feel that the recession we're in (since about last fall) would be longer than normal, lasting up to a year and a half to two years - call it over by next fall/winter (fall of 2009/winter of 2010) at the latest. Figuring the market tends to lead us out by about six months also pointed to a springtime low/retest.

For the first time in 16 months, I’m excited about doing a little buying of some of the increasingly cheap stocks out there, recognizing that we were probably six to nine months early (but I don't want to get too cute with the spring of 2009 retest thing).

Regards,

Chris

Conflicting Interests

2009-03-29T08:38:00.000-07:00

There are three main types of compensation received by financial advisors, brokers, financial planners and the like. The most lucrative by far is the commission based compensation scheme. Stockbrokers, insurance salesman, and some financial advisors and planners receive a commission when they sell you a product.

Fee-based compensation is a mix of fee for service and commission based. Some financial planners and advisors run a fee-based model, which allows them to charge a set fee for services while also receiving commissions for selling you a product or for referring you to someone who wants to sell you a product.

Fee-only advisors work for you rather than selling products to you. Fee-only financial advisors are still less common than the other two types of financial service providers, likely because they aren't compensated quite so handsomely. A major distinction between a fee-only provider and the other two types is that the fee-only provider is paid only by you, the client.

Mutual Fund Madness

2009-03-29T08:10:00.000-07:00

I've lost track of how many mutual funds exist today, but it's something over 6,000. Not that the exact number is important. What is important for investors to understand is that the vast majority of mutual funds underperform their benchmark after expenses, which currently average around 1.4% per year. Furthermore, the academics (although not Wall Street) will tell you that it's impossible to pick a fund that will outperform its peer group, except in hindsight!

Adding insult to injury, mutual funds, by and large, don't practice the long-term investing that they preach. The typical mutual fund turns over 80% of its portfolio yearly, meaning the average holding period for a stock is only about 15 months. Taxes eat away at an investors return every bit as much as the fees, not only because of the high turnover, but because you frequently are responsible for paying capital gains taxes on gains you didn't receive.