Mark's Money and Market Musings

Better Late Than Never?!?

2011-11-11T15:12:00.001-08:00

"No one ever went broke underestimating theintelligence of the American Public" - H.L. Mencken

"Few people have lost money underestimating thecompetence of the modern Federal Reserve" - Whitmore's Corollary to Mencken

Back in the Saddle

Apologies to those of you who have been left hanging for twenty-threemonths since my last blog post. Two yearsago, I felt very good about the direction I had been heading with my latest (usingthat word very liberally) missives. Whilespending time reviewing all of the posts, I believe the analysis and advicecontained therein are still sound and applicable. So, time to take up the cause again for thehandful of you out there who may be interested in more thoughts on successfulinvesting.

The goal of this blog has never been to engage in specific recommendations for personal finance; although as you will see, I will violate that precept below. Rather, my hope has always been to encourageand equip people to think in amanner befitting a successful investor. Iwill continue to press ahead with that vision.

What has been happening over the last two years? Quite a bit as it turns out. Most importantly, I have become a new father!! Kai Yoo Whitmore entered our lives almosteleven months ago. I cannot express howtransforming he has been for both Mina and me. We are so blessed to have such a precious and wonderful soul for whom tocare and to love. To give the littlefellow a bit more room to roam, we have also moved into a larger home that wasin foreclosure last January. Finally, Iam in the process of moving into money management after doing full-timeinvesting for the last nine years. Thatshould serve as a brief, if exceptionally truncated, personal recap. On to the world of investing.

Proud Papa

So What is SoPrecious About Some Metals?

Recently, I was on a plane returning from a conference inLA. While I consider myself a reasonablyaffable person, my strategy concerning plane travel is to, while not beingimpolite, generally avoid conversations extending beyond briefpleasantries. Call it a form of PTSDperhaps, stemming from a few too many cross-country flights seated next to overlyloquacious individuals sans reading materials or entertainment devices. I had just cracked open my book when I couldnot help but eavesdrop upon the conversation between two professionals seatednext to me.

"Sure, it is pretty to look at, but for what is itreally useful?"

"Well, it does have some inherent value, right? I mean, doesn't it have some dentalapplications?"

"Nah, gold is not worth crap. Even its dental uses have becomeobsolete. What is possibly the point ofowning it? I mean look at yourring. It probably cost a lot. But do you know tungsten carbide costs a tinyfraction of gold, yet is more resilient, and even more reflective?"

"Interesting point. So you think that gold is overvalued?"

"Absolutely! Imean it is only worth anythingbecause people have always said it was 'valuable.' Remove people's perceptions and it is aworthless metal. Trust me, gold is abubble that will burst."

Given my conversations with friends and acquaintances, myopinionated fellow traveler embodies the perceptions of many, manyindividuals. Particularly in light ofthe fact that gold is now trading at the upper end of it historic valuationlevels, this seems to be a particularly good time to address what role, if any,owning gold and other precious metals should occupy in one's portfolio.

By way of full disclosure, I am not a disinterestedindividual when it comes to precious metals. I began accumulating gold around $300/oz., silver at about $8/oz. andplatinum at approximately $800 oz. Overthe years, I have gradually added to my positions, particularly when there havebeen significant pull-backs in price. Ihave never sold an ounce of any of the metals in my possession, regardless ofmarket gyrations. When I firstrecommended gold as an attractive asset class here, it was almost three yearsand $900/oz. ago. Clearly, I find value wheremy travel companion did not.

In Defense of Gold

The first issue implicitly raised by the gentlemendiscussing gold is something called the paradox of value. Indeed, tungsten carbide probably is amaterial that has infinitely greater utility than gold. However, it is even more obvious that wateris of far greater practical use than diamonds. Yet I would scarcely expect the price of the latter to collapse(although I would not be surprised to see an escalation in the price of theformer, a discussion for another time). In essence, the conceptualization of my skeptical friend concerning gold'svalue was completely divorced from scarcity. While water and tungsten carbide may both have huge practical useadvantages, they are both relatively common. While diamonds and gold may both suffer from being of limited useindustrially, their scarcity helps makes them extremely valuable.

When gold was trading in the $300-800 range, I used to callit an insurance policy that paid you a premium to hold it in the form ofsignificant expected capital appreciation. And while it can no longer be called historically "cheap" (althoughthis is not to say that gold does not have room to appreciate further), I wouldargue that it merits a place in every investor's portfolio.

What I mean by an insurance policy is that precious metals,and gold in particular, are the ultimate anti-crash assets. I am not talking about any type of crashhere. Precious metals went down withvirtually all other assets back in the '08-'09 financial implosion (althoughgold went down very little by way of comparison to the vast majority of assets).No, the kind of crash I am talking about is the sort when currenciescollapse.

Now I know that most people tend to view the integrity ofthe US dollar as sacrosanct. It has beenthe reserve currency for three generations now. If you talk to most traditional money managers, they will tell you the"safest" asset is US government bonds. After all, they have the "full faith andcredit" of the federal government backing them and are denominated in thealmighty dollar.

I see such faith as deeply misplaced. Without going into too much detail at thispoint, the US can be characterized as "Greece Lite." For years now, our public finances havebeen deteriorating quite dramatically. The mostrecent skirmish between Republicans and Democrats over raising the debt ceilingis just the beginning of a what will be a protracted process in an effort bypolicy-makers to make Uncle Sam's balance sheet remotely solvent, one which Ithink will most likely lead to stalemates and "kicking the can down theroad." Or simply put, politics asusual.

We as a nation are having the ignominious distinction ofseeing our Debt-to-GDP ratio surpass 1.00. What does that mean, and why does it matter? Well, in order to clear our federal balancesheet, we would collectively have to cough up a cool $15 trillion, or basicallyan entire year's worth of total economicproduction! That prognosis is actuallyrosy if one considers the level of unfunded liabilities (in the form ofMedicare, prescription drug and Social Security obligations). Depending upon the accounting methodsemployed, the federal government is in the hole between $60-115 trillion! Considering that the total non-government nationalassets equal about $80 trillion, these are problematic obligations.

All Roads Lead toInflation

So what is a bloated, decrepit and hoary super-power to do? What the US should do is dramatically slash spending it cannot afford, as wellas non-regressively tax consumption so as to broaden and deepen the tax base. Since this has no chance of being politicallyviable with either party, what the government will do is provide more bread and circus to the masses.

The Federal Reserve has already begun to do something thatwill effectively lighten the debt load. It sounds innocuous enough. Whether gussied up as QE1, QE2 or QEadinfinitum, it is also known as "monetizing the debt." In plain English,it amounts to the same noxious thing: printing money. Now do not get me wrong. The effect of printing money for thedebtor/counterfeiter is great. That muchcannot be denied. Who would not like amassive cash infusion that requires no more effort or cost than Bernanke makinga few keystrokes on the Fed's computer system?

The problem is that there is no such thing as a long-term free lunch in the world offinance and economics. Whether it wasNero debasing the silver content of the denarius almost two-thousand years ago orMugabe debasing the Zimbabwe dollar to the point of literal worthlessness in2008, students of economic history know that the results of money printing areeventually ruinous.

This leads us to the two main reasons why people shouldconsider holding metals like gold, silver and platinum. First, precious metals are a storehouse of value. I am old enough to remember with somevividity the stagflation of the 70's. Most non-tangible assets did not keep up with the level of inflation. Hence stocks and bonds underperformed. People's standard of living declined as thedollar bought less and less over time. Inflation typically is characterized by confiscation of wealth throughthe decline of real purchasing power by most citizens.

One of the few assets to perform spectacularly well duringthe 70's and into the very early 80's was gold, literally increasing in pricemore than twenty-two fold from trough to peak. When dollars are being created willy-nilly, the amount of available goldbarely budges every year. I noted in apast post that the world's supply of gold would fit into a cube slightly largerthan sixty-feet on each side; pretty rare stuff indeed. When thinking about the price of gold, bothtoday and in the future, it would behoove investors to consider the denominator- the US dollar. It is simple economicsthat as the supply of something goes up, the clearing price of that item shoulddecline. Logically, if the amount ofdollars created is dramatically increasing (which it is), yet the amount ofgold is remaining relatively fixed (which is also true), the value of thelatter in terms of the former should increase.

Second, gold is worthy of occupying a place in portfoliosbecause it constitutes holding realcurrency. I once had a prolongeddiscussion with a financial services professional who had substantial assetsunder his management. He expressedincredulity at my assertion that gold represented an attractive asset class (thiswas even before gold breached $1000/oz.). When I pressed him for his assessment ofdesirable investments, he identified short-term treasuries and cash as the bestplaces to be in uncertain, volatile times. I was taken aback by what I saw as a glaring contradiction in hisanalysis. On one hand, he rejected goldas it was a "barbarous relic" that had no intrinsic value andgenerated no income. On the other hand,he placed a large portion of his clients' funds in US dollars, which as a fiatcurrency has no intrinsic value and,in a zero-percent interest rate environment, generated essentially no income. Furthermore, whereas gold is an element whosesupply could not be increased at the discretion of desperate central bankers,the same most certainly cannot be said of US dollars. So which would you rather hold overtime? Which would you be more confidentwill get you a decent amount of goods and services in the future? Which asset will not be debased in the future?

I find it noteworthy that, controlling for quality of inputs,gold will buy roughly the same amount of food, clothing and shelter today as itdid centuries ago. Indeed, most peopleforget that for years the only paper money that held value over long periods oftime were those backed by a gold standard, and that as recently as 1971, the USbacked its currency with gold. Thehistory of fiat currencies does not bode well for the future of the US dollaruntethered to a gold standard.

Bubble Babble

One of the most common arguments I hear from traditionalmoney managers, pundits and analysts is that at nearly $1800/oz., gold isclearly in a bubble, having increased in price seven times from its lows abouta decade ago. I think this isnonsense. This is not to say that goldcannot experience a dramatic pullback from here. I could easily see it declining by as much as30%, depending upon macroeconomic events going forward. But having shorted tech stocks in 2000, andmortgage lenders several years after that, I feel as if asset bubble analysisis a personal forte. And I see none of the traditional signs of abubble when it comes to the prices of precious metals.

For instance, I actually know very few individuals that owngold, much less any other precious metal. I can literally count on one hand the number of people of whom I amaware whose portfolio comprises more than 10% gold or other preciousmetals. Amongst money managers, exposureto gold is even rarer. My favoriteinvestment guru, Marc Faber, describes speaking before hundreds of moneymanagement professionals and asking everyone in the crowd who owns gold toraise their hands; nary an arm moves. Ownership of silver or platinum (which is interestingly trading at lessthan the price of gold - a relative historical anomaly) is far rarer.

As far as I am concerned, the ultimate litmus test for anasset bubble is my not-exactly-patented "cocktail chatterindex." So far, it is two fortwo. In the late 90's and into 2000, Icould barely pick up a martini (or more truthfully a Midori sour) withouthearing someone rave about their returns in Xyz.com. Fast-forward seven years and I was unable toquaff a glass of syrah without being assaulted with tales of zero-downmortgages, condo-flipping and acquisition of "investment properties." To date I have yet to be verbally accosted byanyone claiming to have doubled their money by owning gold bullion or to havefinanced a vacation by owning silver futures. When that happens, I will have to reconsider my analysis.

Tread Cautiously

Importantly, I am not predicting an imminent rise in theprice of precious metals. As Imentioned, I think there is a very good chance that we could see price declinesfrom these levels. But from a long-term perspective, I think preciousmetals represent a very good risk-reward profile. This is particularly true when consideringwhat I believe to be relatively unattractive prospects in more traditionalassets such as equities and (especially) government bonds.

What would change my analysis or cause me to be wrong in myexpectations for precious metals? Quitesimply, a debt-deflation trap should the Fed and/or other key central bankersbe unsuccessful in their efforts to reflate the world economy through massivemonetary stimulus. Personally, I thinkit is more likely than not that Bernanke and his ilk will be successful intheir efforts to de facto destroy thecredibility of the US dollar. Butnothing in investing is a sure thing.

Accordingly, I think if investors presently have no exposureto gold and other precious metals, it would be worthwhile to considerpurchasing small quantities at regular intervals (monthly or quarterlyperhaps). To have less than 5% of one'sportfolio in precious metals is, in my opinion, a serious oversight. A higher weighting would be even moredesirable.

I promise it will be earlier than the Fall of 2013 beforeanother post!

Buy and Hold Investing Redux

2009-12-17T11:08:00.001-08:00

Thou speakest wiser than thou art ware of.

Shakespeare, As You Like It

As regular followers know, I have been posting a series of blogs that will eventually amount to seven tips for investing based upon my foray into this world over the last decade or so. The last post was one which I knew would leave me frustrated and dissatisfied. The topic (Exploding the Myth of Buy and Hold Investing) is so vast so as to justifiably warrant treatment as a book. No blog entry (no matter how grandiloquent) could possibly suffice in adequately covering the subject. I found myself omitting point after point, for fear that each new issue would spawn several others which should logically be examined.

Reader Ruminations

I was already considering a follow-up blog attempting to fill in some of the larger gaps in my analysis, while clarifying and qualifying other points, when one of my more intellectually gifted friends posted the following comment:

Hi Mark,
Thanks to your posting, I have learned that I am a proud member of the Boglehead tribe. However, it is not because I believe the market is efficient and rational, as you suggest. In fact, I love reading the clever books by behavioral economists who demonstrate how irrational we all are. The problem is that I think it is just as hard to predict a crash as it is to predict a winning asset class (maybe harder). Thus for me, targeted short selling would likely be disastrous, especially given my lack of willingness to spend a lot of time researching. So, buying and holding low cost, diversified investments still seems like the least bad strategy (unless you have some great inside information you are willing to share!). As a way of illustrating my position, the last time I noticed your posting, it was in March, 2009 and you were giving the general advice to stay out of the market due to the pervasive financial uncertainty. Being a Boglehead who blindly feeds my 401K in all markets, I didn't listen to your advice and I now am a lot richer as a result. I am sure another crash is coming sometime and somewhere, but at this point, I am planning to continue to keep on Bogling. As a fall back, I plan to never retire.
I really enjoy your blog!
Happy Holidays! Joel Schmidt

A very thoughtful and articulate comment, thanks for the feedback, and Happy Holidays as well, Joel. Indeed, I believe there is no shame in being a proud Boglehead. He is not only one of the sharpest minds to have gained prominence on Wall Street, but he also has perhaps the purest heart (a far rarer trait in the world of finance). I have in the past referred to him as the (Living) Patron Saint of Investors. I highly recommend his books, most notably Common Sense on Mutual Funds.

Joel does bring up the most difficult element associated with NOT being a buy-and-hold-forever investor -- timing. Bogleheads correctly point out one actually has to be right about timing not just once, but twice: when to initially get in (out) of the market, and then when to get out (back in).

Let me be VERY clear about something. I do not (at least conventionally) in any way advocate market timing. Quite the contrary, I make virtually all of my investment decisions with a window of at least five, and usually closer to ten or fifteen, years. Despite making my living as an investor, I have gone almost six months at a time without executing a single transaction.

I depart from the Bogleheads in that I believe at the extremes (in terms of time, market sentiment and valuation), it behooves an investor to make discretionary buy and sell decisions. I would characterize my investing philosophy as buy-and-hold-until-the-asset-becomes-overvalued. Or maybe buy-and-hold-until-an-even-more-undervalued-asset-presents-itself. Given the unwieldy nature of either moniker, an imminent how-to book by yours truly is not in the cards.

Mania Mentality + Paltry Dividends = Market Avoidance Therapy

To specifically address Joel's comment, and while possessing no insider information whatsoever (actually resolutely classifying myself as an outsider), I think there are at least two ways in which to identify a coming market crash. The first is very unscientific, and which I have mentioned in the past - mania mentality. Investing should be about as much fun as watching paint dry. Slow, steady and relatively modest returns should be the norm. Similarly, investing in almost every normal era in American economic history is something off the radar screen of most individuals.

Conversely, when people experience stratospheric returns far in excess of long-term norms for a particular asset class, and/or when millions check the balance of their 401(k) account to gleefully take note of their capital gains more often than they check the weather forecast, these are signs that bubble mania is rampant. In times like those (say 2000 for stocks, and again with the housing market in the years thereafter), history shows us that even over the medium-term (say 5-15 years), one is better off avoiding the asset class in question.

The second, more scientific, method for identifying overvalued assets is to look at relevant quantitative data. I will admit that for the lay investor who does not want to devote much time managing her portfolio, most of these numbers will be too arcane. Specifically, as a deep value investor, I look to such metrics as price-to-book, price-to-cash flow, price-to-earnings growth, and the like. But let me give you one quantitative measure that is accessible and (hopefully) understandable to the lay investor: dividend yield.

For many decades, dividends made up half, and oftentimes more, of the total returns that investors received (capital appreciation being the other component). Between 1945 and 2001 the dividend yield for the overall US stock market averaged 4.1%. When dividend yields come down dramatically, this is almost invariably the hallmark of an overvalued market that is destined to fall.

An Illuminating Illustration

Let me use an example to help demonstrate why this is the case. Let us assume that ACME Inc. is a hypothetical company which is huge and diversified. As such, its stock price is representative of the market as a whole. At the beginning of Year 1, it is selling for $25/share and pays a dividend of $1 (hence a 4% dividend). That same year, investment fever begins to spread throughout the country (since this is a hypothetical, pretend the last 10 years never happened and that investors are not so shell-shocked) and the economy is deemed quite healthy. ACME's stock price jumps, closing out the year at $40.

Now this is an important point, and one of the reasons why dividend yield can be a helpful valuation tool for assessing stock markets -- companies do not tend to increase or decrease their dividends significantly from year to year. This is unlike almost every other investment metric that can vary wildly (stock price, PE ratios and earnings being the most notable). Even after a blockbuster year, companies are loath to significantly boost dividends. This is because dividends are generally paid from the free cash flow, and companies do not want to overextend should their fortunes quickly reverse. When a company announces a dividend cut, this is seen by the market as a sign that it must be in dire straights. The market usually punishes such an announcement with a marked drop in its stock price. Therefore, in a great year, a company like ACME might increase its dividend a fairly modest 5%, to $1.05. This leaves the dividend yield at the end of Year 1 at 2.6% (dividend of $1.05 divided by its stock price of $40).

In Year 2, market madness continues. ACME's stock ends the year at $65, and the rest of the market moves up at a similar pace. After another great year, ACME boosts its dividend to $1.10, driving its yield down to 1.7%.

Finally, in Year 3, as investors everywhere are building castles in the air, ACME's stock soars to $105. After another solid year of earnings, the company boosts its dividend to $1.16/share. But now the yield has plunged to a scant 1.1%.

So, what is an investor to do? A typical lemming would, after all the amazing returns had been already achieved, plunge as much money into stocks like ACME as possible.

The buy-and-hold-forever investor would have already achieved great returns owning ACME and other stocks like it in broad-based index funds throughout it stock price ascendancy. However, this same investor would continue accumulating the ACME's of the market (even after a 300% price appreciation) every payday in her 401(k)/IRAs/brokerage accounts.

The contrarian/buy-and-hold-until-the-asset-becomes-overvalued investor would bail, concluding that the combination of bubble mania, as evidenced by market psychology, and terrible valuations, as measured by dividend yields and other metrics, create an awful prognosis for ACME and comparable companies going forward.

Back to (Harsh) Reality

Now the dividend and price appreciation numbers used in the aforementioned example were not selected haphazardly. For simplicity purposes I condensed the time frame, but between 1990 and 2000, the S&P 500 also increased more than fourfold in price, while its dividend yield plunged from 4% to a paltry 1.1% (an all-time low). This was about as close to a clarion call for an asset bubble as one could ever expect to see.

Please note that the superiority of contrarian investing over the buy-and-hold-forever approach is not remotely based on precise market timing. I stopped buying US equities at the end of 1998, more than a year before the S&P peaked. As such, I missed out on one of the S&P 500's best years, watching from the sidelines as it gained more than 20% in 1999. But when the market tanked (which it always does after an asset bubble emerges), I and my contrarian ilk were quite happy to have forgone the final ephemeral burst of gains as the market sine curve reached its apex.

The lack of importance of market timing (at least as measured by reasonably short durations of time) for contrarians such as myself is further highlighted by the fact that even after the S&P temporarily bottomed in October 2002, I did not purchase any US equities (other than select energy and mining stocks whose performance was largely unrelated to the overall US market). Why? Even at much lower price levels, US stocks did not represent a good value proposition. The dividend yield for the market did not even rise to 2%. Moreover, as detailed in other posts below, another asset bubble was fomenting in the residential real estate market. This was artificially propping up the US economy (which from a fundamental perspective looked disastrous). Accordingly, it appeared obvious that lower lows were coming for US stocks. So long term, patient contrarians such as myself watched as the market went up more than 70% in the next five years, convinced this was the mother of all headfakes in the market.

Essentially this "ought" decade was a lost one for equity investors in all three of the major markets (US, Europe and Japan). Actually, any investor who avoided investing the the US stock market after August 1996 would have been rewarded by having a lower entry point on her investment. This again highlights how unimportant market timing is. Well, let me qualify that. A colleague of mine once coined the term "meta-market timer" to describe me after hearing my approach. I think that is fair. With a decade-long time horizon, I think a diligent and enlightened investor is able to identify both attractive and unattractive assets from a valuation perspective and act accordingly.

I should note that while I have personally engaged in the short-selling of assets I deemed to be overvalued, particularly in 2000 and 2007/2008, that it would, as Joel correctly mentions, be a disastrous approach for 99%+ of investors. Rather, the strategy I advocate for almost everyone is simply to avoid these overpriced assets if you do not have them, and sell them if you do. One only has a limited supply of money to invest, so why tolerate exorbitantly priced assets in one's portfolio? Or, looked at slightly differently, why would one not want to sell and reap the profits when asset prices are dear?

Of Automaton Investing and Lost Opportunity

This segues into my last criticism of the buy-and-hold-forever approach. It treats broad-based (generally US) stock and bond indices as the only asset classes investors should consider. Even before I disavowed my membership as a Boglehead, I recall reading in his book on mutual funds that an investor should not look any further than within our borders for investment opportunities. This is sort of like a prospective auto buyer arbitrarily limiting herself to only purchasing Jeep brand vehicles (apologies to any Jeep owners out there).

There is a huge opportunity cost associated with restricting one's investments to total market stock and bond index funds, particularly when one further limits their holdings to US based assets. For instance, while investing in broad-based equity indexes was dead money (or worse) in the last decade, it was a spectacular time to be invested in precious metals (gold in particular was up 300%+), energy, agricultural commodities, industrial metals, and companies producing all of these assets. Emerging markets also performed very well vis-a-vis more developed markets. Some of the best opportunities in currency markets also presented themselves (shorting the dollar and pound, going long the Canadian dollar and yen).

When an investor limits oneself to a narrow spectrum of investments, buying those assets every payday no matter what the cost, and then does not sell even when prices obtain dizzying heights, she will inevitably achieve suboptimal returns. These returns will almost invariably best those of the lemmings, as well as those achieved by investors relying upon expensive, fatuous financial services professionals. Hence, as mentioned in my last post, buy-and-hold-forever investing is the "least bad" approach to managing one's finances that does not depend upon some level of valuation analysis.

Now What Did I Say Again?

One problem with writing a blog with the limited intellectual resources yours truly possesses is remembering what I penned. Joel correctly noted that Bogleheads have been rewarded since the market lows in March by having money in stocks. His recollection was that at that time I was encouraging people to stay out of the market.

I looked back upon my posts during that time. I was certainly blustering invectives against the moronic policies of both the federal government and the Federal Reserve, arguing that these actions would be counterproductive to the long term health of our economy. I also contended that these policies would be largely futile in terms of affecting the real economy even in the short-term, and with unemployment at 10% and underemployment at 17%, I stand by that assessment. I also mercilessly took Wall Street to task for its rank hypocrisy in advocating government bailouts of the financial services industry, while for decades arguing that the government should refrain from intervening in the free markets when it better suited their interests.

But I could not find anything imploring investors to stay out of the stock market. Indeed, the most recent post relating to specific investment advice I could come across was from February 4, entitled Portfolio Reclamation Project. In that blog entry, I first commented upon the nature of the 45% market crash from its October 2007 peak. I then made three specific buy recommendations: TIPS (up more than 8 1/2% while comparable long-term treasuries are down almost 20%), gold (up about 23%) and (for the first time since 1998!) high quality stocks. I was specifically bullish on Microsoft (up 64% compared to a 30% increase in the S&P 500 index).

Why the change from my bearishness expressed as recently as July 2008? Attractive valuations!!! For instance, the market crash drove dividend yields for the S&P 500 up to 3%+ for the first time since 1991! To add icing to the cake, rock bottom stock prices were coupled with a contrarian's dream - horribly negative sentiment. Virtually nobody wanted to own stocks. Baron Rothschild back in the 18th century is reputed to have said, "Buy when there is blood in the streets." This investment advice has withstood the test of time, and is just an extension of my first tip -- do not run with the crowd/lemmings. It is almost without exception in your financial self-interest to zig when others zag and vice-versa (at least when sentiment extremes of despair and euphoria manifest themselves). So I was backing up the dump truck and loading my portfolio with plenty of stocks that were selling for bargain basement prices (most of them were not US stocks, but many were).

The Best of Both Worlds

So I certainly do not fault Joel's analysis that by staying in the market and adding to his positions no matter what market conditions present themselves, he is richer for it since March. But so are those of us who are contrarians and saw the market crash as a tremendous buying opportunity. An important difference is that those of us who were out of the stock market when prices were exorbitant did not see a 50% haircut in our stock portfolios between late 2007 and March of this year. Investing really is as easy as "buy low, sell high."

I do not expect to post another entry until after Christmas, so let me wish everyone a very blessed and joyous holiday season!!

Tip #3: Exploding the Myth of Buy and Hold Investing

2009-12-10T12:00:00.000-08:00

"Those who live in glass houses shouldn't throw stones." American Proverb

"Gentle Reader." Now this is a term/literary device whose usage was last prevalent during the Victorian era. But in the century or so since, it has been increasingly out of favor in the world of literature. People generally find it to be bracing and intrusive to a narrative, taking them out of the moment, if you will. But I have always been rather fond of authors who make use of of it. To me, there is both an intimacy and a fondness connoted when I read it.

Why wax nostalgically upon an archaic literary device that most contemporary readers dislike while penning a blog about investing? Well, Gentle (and hopefully patient) Reader, I found a most embarrassing error several days after posting my last blog. While fulminating at the incompetency rife throughout the financial services industry, I noted that those employed therein were largely, among other unflattering nouns, "imbiciles." While being the only word that was misspelled in my last missive (and corrected since then), the irony of this particular faux pas is not lost upon me.

Now who knows? Perhaps no one made it to the eighth paragraph to even spot my blunder. I would like to think, however, there were those that saw it and refrained from sending me a rather pointed comment noting the extent of my intellectual failings. That was kind.

But on to the third tip of seven regarding the investing lessons I have learned. From my perspective this is the most important of the series and will be perhaps the most controversial.

There is a certain type of smug investor who I am sure is fully on-board with my first two investing tips (in short, they are 1) avoid following the crowd and 2) eschew expensive financial products/professionals). This investor has read the books proving most people lose money by using a "rear-view mirror" approach to investing (what was the hot performing stock/mutual fund/sector/country last year?) as well as the fact that Wall Street as a whole does not beat the market.

Accordingly, this investor resolutely advocates that the only sensible investing strategy is to simply buy a suitably comprehensive low-cost index fund (say the S&P 500, or, better yet, the Wilshire 5000), and hold it until one needs the money in retirement. Sometimes called "Bogleheads" (after John Bogle, the revered founder of the Vanguard Group and stalwart proponent of index-fund investing), these individuals are among the most stoic and disciplined investors on the face of the planet. Whether markets are deemed to be high, low or in between, they just keep contributing to their 401(k), IRA and/or brokerage accounts every payday.

Undergirding the supreme confidence these investors have in the superiority of their approach is the devotion to the concept of "efficient markets." In brief (sorry for the foray into macroeconomics for those of you who eschewed the stuff in college), the efficient markets theory posits that whatever the price of a particular asset or index is at any given time, it is the "right" price. By that I mean that it reflects all the relevant publicly available information. Hence, any attempt by naive investors (such as myself) to proclaim that certain assets might be bargains, while others are overpriced, is unprofitable guesswork.

Why? Because any information/insight that I am using (assuming I am not acting upon illegally obtained insider information) is available to everyone else in the marketplace. So if I see an asset selling for $10 that is really worth $11 based upon its intrinsic value, one of two things will happen according to those who adhere to the efficient markets theory. The price could immediately jump to $11 if my belief that the asset is undervalued is predicated on sound information and analysis, as everyone else in the marketplace would see the same opportunity. While there might be a few quick traders who make a buck as the market price almost immediately jumps to $11, the vast majority of investors would be unable to profit. Alternatively, if my analysis is incorrect due to either false information or faulty thinking, I will make no profit and the market price will stay at $10.

For those self-satisfied Bogleheads out there, the fact that every year some hot fund managers beat the market does not in any way shake their confidence that trying to outsmart the market is a loser's game. They very calmly note that any bell distribution curve representing all active mutual fund managers would have at the far right hundreds of individuals whose seemingly extraordinary performance is explained by pure chance. They are in essence the coin-flipping monkey who tosses heads eight times in a row; a rare event, but one that has nothing to do with inherent skill. After all, two, and even three standard deviation events happen all the time in the real world.

I know the psychology of Bogleheads so well you see, because I used to count myself as one of them. Between 1998 and the early part of 2000 I was supremely confident that trying the beat the market yourself, or, worse still, paying some financial adviser to do the same, was futile. However, let me assure you that after being an investor over the course of the most tumultuous decade in finance since the 1930's, I am absolutely convinced that the "buy and hold forever" investor achieves less than optimal returns.

Before considering the evidence, I want to challenge the analytical underpinnings and assumptions that form the basis of efficient-markets theory. The most important viewpoint with which I take issue relates to the market itself. As noted above, the buy and hold investors look at the market as sort of an omniscient deity; the manner in which it prices assets is always "right," reflecting the collective wisdom of all market participants, who in turn are acting both with access to all relevant information and in their own economic best interests. This last assumption means people are "utility maximizing individuals," or, more plainly stated, that we generally act in a rational manner so as to increase our own wealth. This has been a core assumption of orthodox modern economics for many years.

After being an investor for over a decade, I have a very different view of the market. Rather than the accretion of the best and brightest market participants, whose wisdom exceeds any single actor or even set of actors, I posit that oftentimes the market is more accurately an aggregation of stupidity, naivete, impetuousness, and short-sighted thinking. Quite a stark contrast to the orthodox view, I must admit. Now I should qualify this view to some degree. Specifically, as the asset markets veer to the extremes in prices, the market itself is governed less by profit-maximizing, rational thinking. Rather animal spirits (greed in the time of raising prices, and fear in the time of declining prices) grip most market actors and induce them to act in ways that are not in their own long-term economic self-interest (but is very much in the interest of contrarian investors who take the other side of their trades).

As I mentioned, I was a staunch believer in efficient-markets theory and had been so since my sophomore year in college when I read A Random Walk Down Wall Street for my Macroeconomics class. My Road to Damascus experience came in the Spring of 2000. Specifically, the day was March 10, 2000. I was sitting at my desk trying to draft a legal brief, but my mind was on the other side of the continent. In NYC, the NASDAQ had just surpassed 5000 (almost 10 years later it is trading for less than 45% of that level)! For those of you who may not have been following investing back then, this capped an unsurpassed rise for the NASDAQ from a low of 1200 less than three years previously. No major stock index had ever increased by more than 315% in 35 months.

My intellectual worlds were colliding in a most irreconcilable manner. My college and graduate economics background was telling me that the prices levels for the NASDAQ and the high-flying stocks of which it was composed must be justified and sustainable. Why? Because that is what the market was saying.

But just like Keyes (played brilliantly by Edward G. Robinson) in the film masterpiece Double Indemnity, I had this "little man" inside of me, telling me something was amiss. Nothing made sense. The vast majority of companies seeing really stratospheric increases in their stock prices were the ones that made no actual profit, much less paid any dividend. When I queried my friends who owned many of these stocks as to the nature of their businesses, I often received smug, but vacuous, remarks about how XYZ.com was using the internet to leverage its sales. But sales of what? Many of these investors did not really understand what these companies were specifically hoping to do.

This March day was largely wasted from a billing hours perspective, but was transformative for me as an investor. Eventually I concluded that, despite everything I had taken away from my academic training, it was possible to "outsmart the market." At least at that point in time, where greed and the desire for fast riches seemed to be blinding people to the fact that speculation, as opposed to investing, usually ends in tears. Hence, I placed my first short order (an investment whereby you make money if the price of a stock goes down, but lose money should the stock price appreciate) that same day.

In the decade since that time, I have found that the market has repeatedly "mispriced" a plethora of assets: the overinflated US Dollar, cheap gold, undervalued emerging market equities, overvalued real estate, overly affordable industrial and agricultural commodities, as well as expensive (October 2007) and then cheap (March 2009) stocks. Fabulous opportunities to both buy and sell various assets have consistently presented themselves throughout this most tumultuous decade.

Before closing, let me briefly examine the perils of buy and hold investing. Its proponents point to the fact that over very long periods of time, one would not have lost money investing in a broad US stock index, assuming dividends were reinvested, during any twenty-year time period in the stock market's history. I think there are many investors who find that to be cold comfort after seeing what happened in 2000, and then again in 2008. Importantly, had an investor bought the S&P 500 index ten years ago and held it through the middle of this year, she would have zero capital appreciation to show for it. Once inflation is factored in, the investor would have lost purchasing power on her investment even if dividends are considered. During that same time period gold (a most despised, and hence incredibly attractive, asset in 1999) has increased in value four-fold.

Another example showing the pitfalls of buy and hold investing relates to a question I used to pose to people in the era of the tech crash of 2000. I would ask, "What is the longest period of time one could have invested in the broad US market and received zero capital appreciation in real (inflation-adjusted) dollars?" Back in 2000 people were still very unaccustomed to sub-par returns in the stock market. Answers I received varied from as little as 3-5 years, all the way up to about 15 years. The correct answer - 55 years (1929-1984). That is a long time to be patient. While the proponents of buy and hold investing will point out that in the "long-run" people have never lost money in the markets using their approach, I am reminded of John Maynard Keynes observation that, "in the long run we're all dead."

The moral of the story? Buy and hold investing is terribly flawed and will cost you large sums of money if you are buying and/or holding over-valued assets!! Do not misunderstand. Buy and hold investing is superior to almost all other market strategies. And if you are going to make an investment mistake, this is probably the least bad one to make. But one will be far better off eschewing assets when they are being bid up beyond price levels justified by sound fundamental valuation analysis.

Tip #2: Avoid being Devoured by the Parasites

2009-12-02T16:39:00.001-08:00

Light gains make heavy purses - Francis Bacon

Well, as usual my ambition exceeded my accomplishments when it comes to this blog. I had hoped to have posted two or three more entries since Thanksgiving. But the combination of holiday travel, a new fitness/health regimen, trying to keep up with the many developments in the investment world and (admittedly) procrastination have caused me to fall behind schedule. My apologies.

Over the long weekend the financial markets were roiled by what looked to be a massive debt default (well, temporary suspension of payments is how the debtor preferred to characterize it) in Dubai. This seemed to remind investors that, while financial/asset markets have vigorously bounced since last Winter, problems continue to manifest themselves in the real global economy. Over-capacity and slack demand are ongoing issues around the world. Unemployment continues to plague the US, Europe and much of Latin America. While governments across the continents continue to engage in unprecedented deficit spending, the private sector continues to exhibit signs of economic malaise.

As a brief aside, there is a high correlation between coming asset busts and grandiose building projects. Dubai is presently constructing the Burj Dubai, slated to be 162 floors! This will eclipse the height of the current tallest building in the world (the Taipei 101 Tower) by over 1000 feet. Plans for constructing the Taipei 101 Tower in turn occurred prior to the global tech bust of 2000. Up until Taiwan's behemoth building was erected, the Petronas Towers in Kuala Lumpur had been the world's tallest building; it was built in 1998, just in time for the East Asian financial crisis that leveled Malaysia's economy. Indeed, the Empire State Building, the tallest building on earth for over forty years, was finished just as the Great Depression was decimating the US economy and would continue to do so for over a decade. Hence, one may wish to avoid investing in nations which are planning to erect the tallest man-made vista.

At some point the dichotomy between asset markets and the real economy will have to be reconciled. In my opinion, there are only three possible outcomes. First, asset markets could correct down in recognition that structural problems in the global economy will continue to plague us all. Second, the global economy could trend higher, thereby justifying the "forward-looking" asset markets' price levels. Finally, all the stimulus throughout the world could continue unabated, leading to massive inflation, the likes of which have not been seen in decades. In this last environment, non-fixed income financial assets should hold their own, if not increase further (even adjusting for inflation). Most tangible assets should see huge gains in the event of significant inflation. It will be intriguing to see how things unfold to say the least, as the investment implications of the various individual scenarios described above are quite disparate.

But on to other matters. As I mentioned last week, I thought I would try to distill some of the most valuable lessons I have learned as an investor in these series of blogs. The first blog focused on how running with the crowd/lemmings is usually the best way to achieve poor returns, particularly prior to key market inflection points. I would now like to focus on the role financial institutions play in almost inevitably sabotaging your investment returns.

One should never forget that the financial services industry is the equivalent of the "House" in Las Vegas; it always wins in the long-run, and always does so at the expense of its patrons. Since I first published a PDF financial/investment newsletter in the wake of the stock market crash at the beginning of the decade, I have been a merciless critic of Wall Street (see also blogs below). And given what they extract from investors, I think it entirely justified to place them under very close scrutiny, as Americans collectively are charged almost $100 billion in various fees by financial services firms!

Now I do not have a problem with people being paid fairly for providing some value-added service. I will gladly pay money to a mechanic that can fix my theretofore inoperable car. I have no skills in auto mechanics. And as a fan of Adam Smith and David Ricardo, I am a firm believer in specialization of labor. But the problem with the financial services industry is that it collectively not only fails to add value for the unfortunate souls who entrust their hard-earned money to it, but Wall Street actually fails to achieve market returns once their exorbitant fees are considered.

As harsh as it sounds, the vast majority of financial services professionals are imbeciles, twits, scofflaws and/or scoundrels. And let's face it, individuals working as investment professionals would be deriving most of their income from profitable investments as opposed to the fees they collect from managing your money if they could consistently obtain above-market returns. But this is not the case by a long shot.

Now the average investor under-appreciates the way in which his/her returns are savaged by bloated Wall Street fees. Many individuals I talk to have no idea what the expense ratios are for the mutual funds they own in 401(k), IRA and/or brokerage accounts. The fact of the matter is that actively managed mutual funds can charge fees that oftentimes exceed 2%. Now that might not seem like much, but compounded annually over ten years, a 2% expense fee costs an investor almost 22%, which is a significant drag on your returns. This becomes all the more brutal over a decade like the one we have experienced since 1999, where overall returns are almost flat. In that case, you have less than 80 cents left for every dollar invested, despite the market being flat. So what seem like trifling fees actually can make a huge difference in how successful one's investments will be, particularly over very long periods of time.

Accordingly, I am convinced the vast majority of investors would be best served by investing in a properly constructed portfolio of low-cost index funds. Next time - The Myth of Buy and Hold Investing. Likely to be the most iconoclastic blog of this series. My apologies for the unedited nature of this entry; I am late for a poker game.

Seven Tips from Seven Years, Tip #1: Avoid Running with the Lemmings

2009-11-24T14:07:00.000-08:00

Wisdom is the principal thing; therefore get wisdom: and with all thy getting get understanding.

Proverbs 4:7

On November 25, 2002 I took a leap of faith. At the time I had recently left the practice of law but was not certain what my next career step should be. For the previous 3-4 years I had been investing, initially in my 401(k) account, and then supplementing that with a brokerage account. Since I had saved a little over a year's salary that I could use as seed capital, I concluded that trying my hand at investing full-time was the option for which I had the greatest amount of enthusiasm.

Seven years and 6800+% later, I am still plugging along. The journey has not been easy, nor has it been particularly smooth. Being an investor is the ultimate eat-what-you-kill way of making a living. Volatility can wreck havoc on one's nerves and net worth. But on this anniversary of stepping out into the great unknown with no safety net by way of an alternate source of income, I have reflected upon the many lessons I have learned as an investor. Over the next week or so I will expound upon the seven insights that have proven to be most valuable to me.

Avoid Running with the Lemmings. The biggest mistake most investors make is reversing the most basic maxim of investing: Buy low, sell high. When I first started investing in the late 90's, Asia had just gone through a massive asset bust. Foreign investment was being yanked out at record levels. Accordingly, many Asian stocks were trading for pennies on the dollar. It was a wonderful time to run against the crowd and buy, buy, buy. But most retail investors saw the huge negative returns around 1998 and sold whatever stocks/emerging market mutual funds they had at what ended up being multi-decade lows.

Conversely, much of the foreign investment money that was being pulled out of Asia in the late 90's went flooding into the NASDAQ. Annual returns of 40, 70, 100% and more became de rigeur for investors. Making money had never been this easy, or fun. It was as simple as finding a publicly traded company that utilized or serviced the internet somehow, and then using the internet while "at work" to follow the hour-by-hour upward movement of your stock!! The old fuddy-duddies (such as yours truly) who were wringing their hands about outrageous valuation multiples, lack of earnings and unsustainable growth rates, were written off as morons who lacked the vision to appreciate the transformative nature of the New Economy. Like any mania/bubble, enough people got super-rich that it sucked in the lumpen-investors. Even those who were otherwise financially sober, cautious investors could only stand watching their neighbors and colleagues make huge sums of money for so long before jumping into the easy money fray.

But just as it appeared the stampede of lemmings (driven to frothing madness by the Wall Street shills constantly paraded out on CNBC) would trample every skeptic in their inexorable path to further financial riches, the cliff appeared. At first it was somewhat akin to Wily Coyote's ill-fated pursuits of Roadrunner. The NASDAQ dipped hard. But while no longer running on solid ground, and instead careening into thin air, the lemmings kept pumping their legs; this was not a crash, but rather a dip which provided a buying opportunity. The masses were convinced, as had been dutifully drilled into their heads by the unholy alliance of Wall Street and the financial media, that a prolonged downturn in the stock market was unthinkable. By the time most people realized they had been sold a bill of goods, 401(k) and brokerage accounts across the country had been brutalized; years of savings evaporated.

But I have to admit, the REALLY instructive thing about investing is what would occur in the following 5-7 years. I mean prior the 2000, the most recent market crash had occurred when the most sophisticated piece of technology in existence was a vacuum tube. Few investors had been alive during the stock collapse of 1929, so it was easier to cut them some slack for not foreseeing the imminent market downturn in the Spring of 2000.

But by 2002 investors had seen first hand a full-blown investing mania and the financial destruction it had wrought. These should have been grizzled, shrewd and deeply cautious individuals who would be well nigh impossible to hoodwink again, right? Oy Vey.

First came the housing bubble. This was actually precipitated by Greenspan's stupid and misguided efforts to avoid a recession brought about by the aforementioned stock market crash. People became even more zealous in their faith that the housing market was their financial savior. Construction of residential homes grew at a pace that was more than 6.5 times the rate of population growth. But with more than 1/3rd of home buyers purchasing as second homes or for investment purposes, there was an illusion of never-ending demand and ever-escalating prices. Lemmings everywhere got their legs pumping again. Home and condo flipping became the new day-trading (with similar prospects for long-term success). And once again, the financial services industry stood at the ready to give investors plenty of rope with which to hang themselves (as well as the institutions loaning the money, but that is another story): zero-down, negative amortization loans, zero percent interest teaser rates, and no documentation mortgages. It was all good. Collectively people believed that we could somehow all get rich by selling our houses to one another ad infinitum. But it was just a game of musical chairs with too many participants.

By 2007 other asset markets began to join the easy-money party. Stocks were particularly frisky. While the NASDAQ never ascended to its 2000 high, all the broader indexes had significantly exceeded their fin de siecle pinnacles. By the end of the year, for the only time in my (albeit brief) investing career, financial commentators were bullish on every financial asset; whether it was American stocks, foreign equities, gold, bonds, real estate, commodities, art or fine wine, "experts" projected ongoing price increases. This was as close to a bell ringing for the top of a market I have ever seen. 2008 obviously came as an unpleasant surprise for most everyone in the investment world.

So, other than being a very self-indulgent, long-winded and irreverent review of recent American financial history, what is the take-away? Well, all of the above events demonstrate that the quickest way to lose large sums of money is to follow the crowds when investment manias/bubbles arise. Similarly, when the masses eschew and revile a particular asset, that usually represents a very attractive entry point. Essentially investors operate within a continuum of greed (which in its most extreme form manifests in high levels of complacency) and fear (the hallmark of which is often panic-selling). As a deep contrarian, I firmly believe the only way to achieve substantially above-market returns is to bet against the crowd when extreme sentiment manifests itself in the markets. At one point my investment strategy was almost as simple as finding out what friends, colleagues and acquaintances were doing with their money, and taking the opposite side of the bet. It has served me quite well over the years.

Well, thanks to the wonders of modern technology, I am posting this as I descend into JFK for a visit with my in-laws. The next installment will be how to avoid getting consumed by the parasites. I hope one and all (and by that I mean the two people who are reading this) have a wonderful Thanksgiving!!

Don't Drink the Kool-Aid

2009-03-18T16:36:00.000-07:00

“Heads we win, tails you lose.”

Mark’s First Maxim for Wall Street Denizens

My apologies friends. I have started this blog several times in the last few weeks or so. But every time I began outlining its content, my WIFF (Whitmore’s Indignation and Fulmination Factor) began to escalate uncontrollably. Since I have lived in a virtual 24/7 state of outrage since the government bailouts began last Fall, this was not a good thing. And unlike Dr. Evil, I do not have a Mr. Bigglesworth to stroke in order to reduce my frustration level.

But this missive could not be delayed any further, regardless of its health implications for moi. Maybe it was Citigroup having the audacity to tell its employees that the bank was actually profitable thus far this year (assuming of course you do not factor in the $300+ billion in toxic assets still on its books, the $45 billions in government funds it has received, its tax liabilities, and a variety of other trifling details). Perhaps it was the laser like focus upon which the public has directed its attention to the AIG bonus fiasco. At least $450 million (when properly characterized) in extra compensation appears to have been given to the geniuses that managed to put the company in a position in which it needed $160 billion in government aid simply to remain solvent. It also could have been the adroit display of verbal pugilism (even if some of it was below the belt) by Jon Stewart when CNBC personality/buffoon Jim Cramer came on his show last week.

Whatever the impetus, I am going to eschew my traditional outline (lest my WIFF go red-line), and let this be more of a stream of consciousness endeavor. Please bear with me.

Separating Wheat from Chaff

Back when I practiced law, I learned to make an important distinction. While I generally disdained the field, some of the most diligent, scrupulous and upstanding individuals I knew were attorneys. I have great respect and admiration for these people, and many are among my closest friends.

Similarly, I have family members and friends who are in both the financial services industry and real estate. While I have heaped great scorn upon these sectors as a whole, obviously there are really talented, earnest and hard-working individuals employed in these fields. I am fortunate enough to know many such people. Indeed, the long run health of our economy largely depends upon folks such as these transforming their industries. So please do not mistake my vitriol directed at the boneheads, scoundrels, loafers, scofflaws and boorish know-nothings who generally compose the financial sector of our economy as applying to any specific individuals who are employed therein (other than those I specify).

When Doing Something is Worse than Doing Nothing

When the financial crisis really began to pick up steam last Fall, a huge lie was perpetuated by policy-makers, pundits and financial executives alike: What was good for Wall Street was good for Main Street. This simple little deception allowed all manner of shenanigans, tom-foolery and hood-winking to take place.

The logic of this great lie was superficially sound. The financial sector of our economy had grown substantially over the last two decades. A greater percentage of stock market wealth was concentrated in that sector than had ever been the case in our history. A huge percentage of the population was employed in financial services, and many others were dependent upon the health of this industry.

So in comes Henry Paulson, scion of the Wall Street elite, and proposes that there might be some loose change in the sofas of the Treasury Department, say to the tune of $800 billion or so, that should be used to bail out all the poor financial institutions in tatters. Of course he argued that circumstances were so exigent that this massive program must be implemented immediately. There was no time for dispassionate reflection upon the specific merits of TARP, or worrying about how the money was going to be earmarked. No, action must be taken, as confidence was ebbing, and the credit markets desperately needed greasing. Moreover, Mr. Paulson represented that this money was actually an investment, or at worse a loan to Wall Street (in reality, funds used for TARP have already seen 30-35% losses that do not expect to be recouped according to Barron’s).

You see dear old Henry and most of the Wall Street executives continued to maintain that their impaired assets were artificially undervalued by a marketplace that had just gone crazy. Once the marketplace returned to normal, and asset prices resumed their lofty levels, the crisis would pass and the government could recoup its money.

But this was only part of a unified effort by republicans and democrats alike to save the likes of AIG, Bear Stearns, Citigroup, Fannie Mae/Freddie Mac, Goldman Sachs, etc.

Hypocrisy, Moral Hazards and Social Injustices

I have discussed at length why I think it is bad policy-making to spend trillions of dollars trying to avert an unavoidable, and indeed necessary, recession (see Save (for) Yourself, Save the World). But let me focus my acrimony on how the bailouts for the financial sector are pure and simple just ethically repugnant.

First, for the financial services sector to aver that it is deserving of any government assistance is the height of hypocrisy. Without boring the reader ad nauseum with history, the titans of finance lobbied Congress tirelessly throughout the last 25 years for Congress to remove government oversight and regulations (many of which had been imposed as safeguards in the wake of the financial crisis which caused the Depression). Throughout this time period, the constant justification was that if government would simply “unshackle” the industry and let free markets work, the financial sector would be more efficient and everyone would make more money. And boy, did it work. Between 1981-2003 the financial services portion of the S&P 500 index grew three times more quickly than the rest of the index (which itself appreciated hugely). People were making more money than many ever thought possible (recall the priceless ETRADE commercial during the 2000 Superbowl – “he’s got money coming out the wazoo.”) For Wall Street, laissez-faire capitalism was the greatest thing ever.

Well, until it was not. Apparently the vaporization of mid-six figure plus bonuses cause investment bankers and their ilk to bust out their Marx-Engels readers and become rabid socialists! Wall Street executives went from being Masters of the Universe to hat-in-their-hand mendicants. But instead of seeking nickels and dimes, they begged for hundreds of billions of dollars collectively. They have been hoisted on their own petard, as the very oversights and regulations they removed could have prevented these idiots from taking speculative and leveraged positions that ultimately proved their undoing. But now, they ask, nay expect, you and me via Uncle Sam and all their chums in DC to bail them out by taking on all their bad investments and impaired assets. Needless to say, they are not getting much sympathy from yours truly.

Second, the bail out of financial institutions is beyond outrageous due to the moral hazard that is perpetuated in the marketplace. I have previously discussed the notion of the “Greenspan put” and its deleterious impact on asset markets and the economy (see From Whence We Came Part II). In brief, for almost a full decade now, the Fed via Mr. Magoo (aka Alan Greenspan) and “Helicopter Ben” Bernanke have been moving heaven and earth monetarily in an effort to keep their game of musical chairs going.

Wall Street figured out how to master this game very early on. They would speculate recklessly with all kinds of overpriced, often highly leveraged assets that were still going up in price (first tech stocks, then mortgage backed securities and credit derivatives). Wall Street firms would make billions and billions of dollars for themselves, their clients and their shareholders. Then these kooky, inflated assets would, as is always the case, decrease in price.

Now in a functioning capitalist economy, this is where the notion of “market discipline” would come into play. You see if someone in the late 90’s speculated that Beannie Babies would keep appreciating, they would have lost a lot of money. Hopefully they would have learned something about imprudence and act differently in the future. If not, they would eventually go bankrupt, while other economic actors survived. This is economic Darwinism, and I embrace it. The smart never lost money. The adaptable learn from their mistakes and avoid making the same ones in the future. The incompetent make the same mistakes and eventually do not have the resources to recklessly and foolishly speculate.

But in his sage-like wisdom, Greenspan determined that nobody on Wall Street, no matter how dim-witted, should have to suffer the consequences on their incompetence! Hence, whenever these over-priced assets in which Wall Street idiots had substantial investments began to deflate, Greenspan was there to artificially cut interest rates to zero, thereby insuring other assets would inflate absurdly. Wall Street was thus always bailed out from its own stupidity.

At least until last year. As I have said before, you can only keep stimulating an economy artificially before it no longer responds (the law of diminishing returns). This is where the game of musical chairs ends and everyone realizes that all the seats are taken. First Bear Stearns needs help. But by bailing out Bear Stearns, the government sent two very clear messages to Wall Street and its owners/investors: 1) we will shield you from your own past stupidity; and 2) as a precedent for the future, certain enterprises will be deemed to be too important to fail. Somehow Lehman must have been on the outs with DC insiders, as it was the only entity of any significance that was allowed to go bankrupt.

But instead of Bear Stearns being the precedent, it should have been Lehman. Companies fail all the time. People lose jobs. While it is justifiable for the government to provide need-based assistance to those affected individuals and families who are having difficulty sustaining themselves, it is not justifiable to extend corporate welfare to enterprises whose mean incomes oftentimes exceeded $300,000. The message sent simply encourages future speculation, as now there is virtual certainty that no matter how moronic/reckless their actions, financial institutions will be able to siphon tax dollars ad infinitum to cover up their losses.

Finally, any concept of social justice is done great violence by these bailouts. This is almost so obvious that it does not warrant elaboration. This is evident by the way in which the AIG bonus issue has sparked the collective ire of the nation with such ferocity (just today AIG’s CEO stated that some of its employees were receiving death threats).

But one thing makes my blood virtually boil. Thousands of individuals making six, seven, and even eight figure incomes will receive more in income that is attributable from taxpayer sponsored bailouts than they will pay in taxes. Think about that. Or maybe you should not, as I would hate to spread an offshoot of the WIFF virus. But seriously, how can any society in good conscious create the most expensive bailout program ever seen on earth in which its most wealthy citizens benefit so disproportionately???

This is among the most massive wealth redistribution plans ever seen on earth, yet until recently, no one seemed to give the fairness issues much attention. The spin-masters were initially successful in making this a program deemed necessary to save the economy. But now reality is beginning to hit. Namely, that the economy will not likely be saved by this, and that in the process we are providing the greatest degree of assistance to those who are most able to care for themselves financially.

I had one discussion with an extremely bright investment banker a couple of months ago in which my WIFF reached what may be heretofore unsurpassed levels. Our a wide-ranging debate related to the state of the economy and government actions in the face of our economic crisis. Now this is someone who is quite vocal in their opposition to most government support programs for welfare recipients, mentally ill individuals and the like. Yet he was arguing for the TARP program that doled out money to troubled financial institutions. When confronted with the apparent contradiction, he conceded that he had a “soft spot” for the bailout program. Well, few things warm my heart like knowing there will not be investment bankers deprived of purchasing Patek Phillippes as gifts to themselves for a year of great work!

Concerning Weak Retorts

Oh, you may hear nonsense like these bailouts and bonuses are needed to keep bright capable people that are the only ones that can get us out of this mess. I doubt if I am not the only one that realizes that these are the people that got us into this mess. Needless to say, I am not overly optimistic that they will deftly navigate financial waters going forward.

Moreover, this sounds like the most hollow threat I can imagine. I mean the implication of this counter argument is that if we do not continue to employ these morons in the financial services industry they will take their impressive skill sets elsewhere. Let’s think about this. Resumes noting one’s experience at: losing billions of dollars through idiotic, leveraged trades; managing a division that earned a -75% return; running a company that required more than $100 billion in government bailouts. These people will clearly be in high demand everywhere.

In fact, the only compelling thing I have read arguing for the TARP program and the Wall Street bailouts that have accompanied it has come from Barron’s gifted columnist Alan Abelson. He noted that hundreds of billions of dollars is actually a small price to pay in order to prevent the thousands of investment bankers and other financial service professionals from entering the workplace as teachers, nurses, engineers, or a wide variety of other occupations that really matter. We may be dodging a bullet there.

The Worst Investment Advice Ever

2009-03-04T16:49:00.000-08:00

When a wise man gives thee better counsel, give me mine again.

Shakespeare, King Lear

I am convinced that 99.9% of reported financial news/analysis is at best a waste of time. Investors tend to be focus upon “noise,” such as a drop in some particular economic indicator, and risk losing sight of the forest through the trees. But once in a while I come across something in the financial media so much more abominable that it warrants special opprobrium.

Let’s travel back in time together nine years, to the halcyon days of early 2000. Ahhh, doesn’t everyone feel better already? Y2K was perhaps the biggest non-event of our lives. Asset prices everywhere were buoyant. Jobs were plentiful. The government actually had a budget surplus, and was thereby reducing the national debt!! Sorry, I am a little dizzy here from the disorientation . . . . Ok, better now.

Of course everyone was happy other than yours truly. My delicate psyche was already troubled by disturbing trends in both personal spending and overall debt levels, as well as what appeared to be unsustainable increases in the stock market. And no sector had experienced greater gains than the tech sector. Now I am just a naïve simpleton; technology largely eludes my ken of understanding. I have to be tutored in the use of Excel. But as an investor, I simply could not see how companies that employed really smart, tech-savvy individuals, yet operated businesses with no track records, tiny customer bases and paltry revenue streams could be valued at billions and billions of dollars.

So while this Chicken Little was warning of the impending sky-earth collision in March 2000, I stumbled across an investment advice column online. In it, the “advisor” recounted the content of a letter he received from a reader seeking guidance. The poor fellow was in a very common situation. He was in his mid-late 50’s and was employed in a lower management position with some company. So here he was in the twilight years of his working life, yet had never gotten around to putting away much money in his retirement account. He had begun to do some back-of-the-napkin calculations one day and realized that his projected financial needs/wants upon retirement would exceed his social security payments. This epiphany suddenly made him a very motivated saver/investor. So he was going to max out his retirement contributions to try and “catch up.” But even at a maximum level, he was concerned about falling short of his retirement needs. He thus asked for this advisor’s portfolio allocation suggestions, both for what relatively small amount he had in his 401(k) at the time, as well as for future contributions.

The advisor began by making some general observations about how in younger years, investors should generally be invested heavily in equities, since stocks have higher long-term returns. These investors can also handle short-term losses given their long investing horizon. Conversely, older investors should start to funnel an increasing amount of their investments into more stable, fixed-income securities, even if they have less up-side. This percentage for someone like the reader might be 40% stocks and 60% bonds if he were an individual with a large sum in his 401(k). Even though I was advising that people have little or no money in the US stock markets at that time, I cannot take issue with the fact that this is good generic advice for any time equity markets are not at bubble levels.

The advisor went on to talk about the reader’s specific situation. Since this investor was way behind in saving for retirement, he would have to take on greater risk with his 401(k) allocation (my eyes began to widen). Specifically, the investor should be putting 80%+ into the stock market (my jaw dropped). And within the stock market he should put most of the money into the tech-laden NASDAQ due to its expected “higher returns” (incredulous, I was in a virtual apoplectic trance)!

This advice was imbecilic and deleterious on three levels. First, if someone has inadequate funds to maintain a desired lifestyle, the most important goal should be capital preservation, not capital appreciation. As such, advising this poor gentleman to place most of his saved income into the riskiest asset class at the time that was not a start up was utterly negligent, and placed the investor in financial harm’s way.

To understand the need to emphasize capital preservation better in this case, let’s imagine that after saving and scrimping all year, this fellow is able to sock away $10,000. Should he make 30%, he banks $3000 and feels good. But in the event his investment goes South 30%, he is now down to only $7000 in savings. But importantly, in order to get back to his initial $10,000 level, he must now obtain returns of 40%+. So volatility to the downside is much worse to his financial health that a commensurate gain is beneficial.

Economic behaviorism is a school of thought to which I adhere. Studies by economic behavioralists have shown that individuals suffer a greater magnitude of displeasure when an investment goes down x% that they receive satisfaction from the investment going up x%. This makes sense intuitively. When you receive something you have not had, you are generally pleased, but not necessarily ecstatic. But when you lose something that you have had, the sting can be very great indeed.

From a pragmatic perspective, it was even more important to prevent significant losses in this man’s retirement account. Assume he wanted to retire at 65 and then take a couple of trips a year with his wife and enjoy life. He figures out how much he needs to have saved to do all that, and then concludes that his investments would have to go up a total of 70% to make that happen. So he eschews bonds and safer equities, and plunks down his hard earned savings in high-flying tech stocks. But instead of gaining 70%, they lose the same amount. The effect? Now it is not an issue of trying to fit in that second trip each year. Rather, he may be unable to make his mortgage payments (more older Americans owe significant amounts on their houses than ever before, so this is not an unrealistic problem). Similarly, the man may conclude that he cannot retire until he is much older.

The second way in which this ranks as the worst investment advice I have seen in the financial media is that this counsel was provided on the eve of the great tech implosion of 2000. Now many financial advisors/professionals at the time claimed that they could not be blamed for being caught unawares, as most of their colleagues we similarly blind-sided by the precipitous fall in stock prices. Rubbish! The same reason the current housing crash should not have surprised people who claim to be real estate experts applies to tech crash of 2000: anytime there is an unprecedented increase in the magnitude of returns for a particular asset class, investors (as opposed to speculators) should generally run for the hills.

Stocks are like any other asset. There is some notion of intrinsic value that applies to companies. Those of us who invest based upon fundamentals look at a variety of metrics to determine how attractive stocks are priced. This method can be applied to individual companies, or markets as a whole. And while its application is far from scientific or fool-proof, it can give one a general idea of whether the stocks in question are investment worthy. When applying these analytical tools to the NASDAQ in the early part of 2000, it was apparent that the market was over-valued to an extent never seen before. So for this advisor to justify his recommendation of tech stocks based upon very recent, ephemeral and unsustainable gains in the NASDAQ was appalling by any standard of responsible financial advising. But this was not unique. I talked to dozens of people that were getting similar advice from their financial professionals as well.

Finally, the advisor made the mistake of treating stock market returns like an actuarial table. Sure, if one charts out the last 80 years or so, average returns in the stock market look pretty impressive (although a lot less impressive than they did back in 2000!) And in 2000, even ten year returns for tech stocks looked remarkable. But this is like driving by looking at nothing else but the rear-view mirror. Generally when one sees such complacency in the markets, danger is lurking around the corner. Of course even being able to see the corner and adjust one’s direction assumes that one is looking at the road. In this case, investors and their advisors en masse drove right through the barrier and off a cliff. One should never forget that asset markets make very quick and violent reversals. Expected returns can be dashed in the process.

I periodically think of the poor gentleman and the terrible advice he received from the investment "professional." I hope he got a second opinion that was remotely sensible given his situation. You see, the 70%+ loss scenario I outlined above was not arbitrary. In the nine years since March of 2000, that is the magnitude of losses in the NASDAQ index. It would have been far better advice to have told the reader to go to a roulette table once a year and put his entire annual savings on black. The total expected losses would have been much less than buying tech stocks in early 2000.

This topic came to mind due to the fact that I have had numerous inquiries from friends who are trying to assist their parents, many of whom have suffered huge losses in retirement funds, manage the money that is left. Since many older individuals rely upon these accounts for a stream of income, the relevant question is usually whether they should cut their losses in stocks and get out, or stick it out expecting some imminent rebound. However, without doing a painstaking analysis of someone’s entire finances, it is impossible to proffer general advice on this topic responsibly.

But it is possible for me to implore folks, whether you are managing your own personal finances, or those of your parents, to determine what level of income is needed to support a minimally accepted lifestyle. Frankly we in this country are blessed, as no one will ever be in a position of starving, and few will be unable to find long-term shelter. Social security and other state programs alone address these needs. But once the investor determines one's future acceptable standard of living, the savings that will support that level should be in very secure investments. Generally this would be something like Treasury Inflation Protected Securities, short-term fixed income instruments, and possibly certain investment grade corporate bonds.

Reader Appreciation

I began this enterprise in a rather sputtering manner last July. While always having a passion for assisting people who might not be otherwise financially inclined make smart decisions concerning their money (or at least avoid making poor ones), I am not by nature a self-promoter. However, after a close friend told me that a “blog unread is simply a diary,” I realized I hate diaries and needed to do something about that. Accordingly, I started to let people know this personal endeavor exists, mostly through contacting Facebook friends.

In the month that I have spread the word, this is now the most tracked blog dealing with either investing or personal finance that is networked through Facebook, with 100 individuals who have signed on as followers. It is also the most followed blog under the topic of “ranting.” I am not sure how I should feel about that.

Since letting folks know about this blog, I have received excellent and supportive comments, as well as ideas to make it better. All of the input is greatly appreciated, and please keep it coming.

I would encourage any of you that are reading this to pass along my blog link to friends who may also find it of interest or use. The more people who follow this, the less likely I am to feel like these entries are akin to those of a 13 year-old girl.

The Abyss Deepens

2009-03-02T09:41:00.000-08:00

A trillion here and a trillion there, and pretty soon you are talking about real money

Since my last fulmination, government intervention in the economy continues to escalate. The new administration announced Friday that taxpayer ownership stake in Citigroup is now greater than 35%. Citigroup used to be the most highly valued bank in the world, worth in excess of $300 billion. Now you can buy two shares of the formerly storied financial institution for less than the price of a morning latte. Absent government intervention, Citi would have been forced into bankruptcy months ago (by way of full disclosure, I had been short Citigroup for over a year until recently covering my position).

Just this morning the Treasury and Fed threw another $30 billion of taxpayer money at what used to be the most highly valued insurance company in the world – AIG. Total government support for this hapless corporation has thus increased to a mind-numbing $160 billion. This is more than $500 in support for every man, woman and child in the US. The government calls its bailout an “investment.” I do not know about you, but I would rather take my $500 and choose how I will invest it myself.

In my last blog, I mentioned that there were plans in the works for a massive $50 billion federal mortgage bailout program for “homeowners.” Actually, that is a bit of a misnomer, as the problem is that the people being bailed out generally own very little, if any, of their homes. But apparently $50 billion seemed too inconsequential of a sum, so the Obama administration upped it to a $75 billion program in a futile effort to arrest falling home prices, as well as spare Americans from rising foreclosures.

Oh, and late last week the new administration announced it will be setting aside an additional $250 billion to purchase “toxic assets” from banks in its budget proposal for Congress. This is on top of the $700+ billion set aside by the Bush administration for the same purposes. For taxpayers this is great news of course. We get to have almost $1 trillion of our hard-earned dollars buy assets that are deemed by financial institutions to be so impaired that they cannot sell them on the free market to anyone else. This will clearly be a fantastic government investment. In the meantime financial institutions and their owners can breathe a collective sigh of relief that H.L. Mencken was literally correct: “No one ever went broke underestimating the intelligence of the American public.” This is particularly true when that intelligence is channeled through its politicians. Financial institutions throughout the country will have foisted upon us poor saps “assets” which are in actuality liabilities. This will undoubtedly cost the American taxpayers billions and billions in losses.

Some people are doing the math as to what the price tag of all this spending will cost this coming year should Obama’s budget get approved: $3.6 trillion dollars!! This constitutes more than one quarter of the entire economic output of the nation. By way of a minor detail, the government will be coming up just a tiny bit short in terms of balancing the budget under the proposed spending plan. The shortfall? Let’s see, add this, multiply that, carry the one. Ah, a mere $1.75 trillion dollars. That will add more than 15% to our existing national debt of almost $11 trillion dollars, which is already increasing at a rate of almost $25,000 per second. It took the federal government until the second Reagan administration, or almost 200 years, for the national debt to reach $1.75 trillion. But if the administration has its druthers, fiscal year 2010 alone will rack that up.

The government is clearly pouring money into the economy at a heretofore unprecedented scale. So how is that working out for us thus far? Hmmm. This morning the overall stock market officially pierced the previous lows of last November. The S&P 500 (a market-weighted index of the largest 500 companies in the nation) had its worst opening two months for a calendar year ever (depression era included). The index is actually at a lower level than it was at the end of Clinton’s first term twelve years ago!!

But twelve years ago is nothing when it comes to the fall in national output as measured by the fourth quarter gross domestic product (GDP) numbers. The economy shrank at an annual rate of 6.8%. This was the worst contraction since 1982, harkening me back to the day when I was blithely listening to Duran Duran and reeling from the fact that my new nickname at middle school was “Zitmore.” Consumers certainly do not appear to be taking much stock in the government’s efforts to jump-start the economy. At no time in the last 50 years have so many people polled voiced concerns over a deepening recession and rising unemployment.

"Economic developments in recent months have been consistently worse than the worst-case scenarios," noted Stephen Stanley, chief economist for RBS Greenwich Capital, on Friday. Well, that is not true. There were a small minority of us Nervous Nellies who thought that the logical result of the biggest credit bubble in history would be the worst economic fallout since at least the Great Depression. I will say that most of us who were in that camp have been stunned at the rapidity with which things have unraveled in the last several months, without any signs of a meaningful short-term bounce along the way.

Even Warren Buffet, the richest man in the world and one of its greatest investors, is struggling. Berkshire Hathaway lost 11.5 billion in net worth during 2008, the worst performance in Buffet’s 35 years of running the company, even accounting for inflation. Since peaking with the rest of the US stock market in the Fall of 2007, Berkshire’s share price is down 45%, sending it to the same level it was almost ten years ago.

Unlike 99% of CEOs or investment professional, Buffet issued a very forthright mea cupla: “During 2008 I did some dumb things in investments.” Wow. What a breath of fresh air. Unlike most of the logic-impaired (I am trying to be diplomatic for once) financial company executives that have been grilled by shareholders, the media and Congress alike, Buffet shouldered responsibility for making bad decisions that cost real people very real sums of money (although at $74,000 for a single A share in Berkshire Hathaway, one can safely assume that widows and orphans were not the primary victims of Warren’s lapses in judgment).

While 2008 was not a year of excellence for the Oracle of Omaha, I would not count Mr. Buffet out. He has proven himself to be one of the shrewdest, most canny investors ever. So unlike my contrarian babble, we should all sit up and take notice about what he thinks concerning the economy: “We're certain, for example, that the economy will be in shambles throughout 2009 -- and, for that matter, probably well beyond” (emphasis added).

Something about “all the king’s horses and all the king’s men” seems fitting when it comes to the Obama administration’s colossal fiscal efforts to revive the economy.

There is a noticeable trend for my blogs to be getting longer. In an effort to spare my readers eye strain, I will try to post shorter blogs more frequently. This will mean some will be more current events driven like today. The next one will relate to a more practical financial advising matter, which I will post by Wednesday. Social justice and government programs will have to wait. Cheers!

Save (for) Yourself, Save the World

2009-02-17T15:16:00.000-08:00

’Tis true that we are in great danger;
The greater therefore should our courage be.

Shakespeare, Henry V

I hope everyone had a great Valentine’s Day weekend. And what connotes love better than a meandering missive on personal finance, the economy and government policies? In an effort to spread the love, I am going to try an experiment with my blog. I know there are those who may not be enthralled with following my various diatribes about flawed fiscal plans, corporate greed, housing busts, misguided monetary policies, etc., and are simply looking for some practical advice. Alternatively, there are those that may already be well-versed in the basic elements of sound financial planning and even portfolio management. These people may only be interested in economic analysis and disquisitive ranting. So for a while I will try to cast a wider net – the first part of my blog will be dedicated to some (hopefully) practical household finance issues, while the latter section will be focused upon broader policy/investment issues. Hopefully, everyone will be able to find something of use or interest.

Our new president is also trying to spread the love, $787 billion worth of love to be precise. Upon signing the massive stimulus package into law today, President Obama said the occasion marked “the beginning of the end” to our nation’s economic troubles.

I really like President Obama. He is smart, earnest and hard-working. In many ways Obama represents the very best of our nation, and the principles upon which our country was built. He inspires hope and admiration. I would happily have him as a two-on-two basketball teammate (although I think I might choose a different bowling partner). Moreover, outside of Rain and Stephen Colbert, I can think of few more fearsome competitors in a dance-off. And while my political views may be to the right of his in several areas, unlike some conservative buffoons, I genuinely wish him great success.

Having said that, Obama may as well have been posing in front of the Hoover dam with his finger shoved in a noticeably growing crack while making that statement. Similarly apropos, he could have filed a five-story office building with hundred dollar bills and blown it up. Clearly Wall Street was unimpressed with the fact the Stimulus Plan is now law; the stock markets were savaged to the tune of 4% today.

Obama’s bold proclamation is not nearly as much of a blunder as the infamous “Mission Accomplished” banner above Bush’s head aboard the USS Abraham Lincoln. But it is certainly in the same vein. By raising the prospects that our economic woes may soon be a thing of the past, President Obama risks over-promising and under-delivering.

Rather than seeing this as the beginning of the end, I would argue that we may just now be seeing the end of the beginning. To me, there will be middle and end phases to our economic troubles yet to come. But more about this below.

Of Dead Car Batteries and Moribund Economies

Not long ago I was ready to leave the house to meet some friends for lunch. Upon trying to start my car though, I discovered the engine would not turn over. Marshalling every iota of my meager automotive skills, I attempted to jump the battery. Much to my chagrin, the battery would not even hold a charge.

After postponing what was sure to be a tasty Malaysian meal with excellent company, I called AAA (thanks to my better half’s preparedness/membership). Shortly thereafter a familiar looking gentleman arrived at our house prepared to assist.

“Nice to see you again!” exclaimed a gregarious man with a noticeable Ethiopian accent.

It then occurred to me that he had helped my wife and me before when her car would not start while we were downtown. He proceeded to attach cables to the battery and had me start up the car so it could idle for several minutes.

“How is business for you?” He apparently recalled my occupation as an investor.

“Oh, great! Thanks for asking.”

“Can I ask you a question?”

“Of course.”

“I came to this country years ago with my wife. We worked very hard. Eventually I bought this truck and started a business. We now have a house and children.”

“Congratulations! You have a great deal about which to be proud.”

“Thank you. I look around today and talk to people, and there is nothing but gloom. Nobody wants to start any business. People do not want to spend money. But by refusing to spend money or take risks, does that not just make everything worse?”

“Hmmmm. You are correct in that as people spend less that causes the economy to contract even more. And it is true that jobs are not created if people are not starting businesses.”

“Exactly! And with interest rates so low, does it not make sense to borrow money to do something?”

“Like what?”

“We were thinking about buying another house, or maybe starting another business.”

“Well, I tell people the first goal of investing is not to make money, it is to avoid losing money. The danger is that the economy will worsen, and you will not only lose your own money, but also the money you borrowed, while still owing interest on the loan.”

“But did you not say that the economy is deteriorating because people have these very fears? Isn’t it just these negative attitudes that make the economy worse? Is it not hope and positive thinking that will make things better?”

By this time, we were ready to see if the battery could maintain a charge on its own, and I was pondering the very good questions and observations posed to me. Upon removing the jumper cables and checking the battery with a variety of probes, my new friend said the battery needed to be replaced. While he sprung into action, two points sprung to my mind. But I only felt comfortable sharing one of them.

“What you describe is akin to something known as ‘prisoner’s dilemma’ in the social sciences?”

“Prisoner’s dilemma?”

“Imagine a band of ten criminals in cahoots with one another are all rounded up. The police know, but cannot prove, they are responsible for a serious armed robbery in which several people were assaulted. However, they were all caught having broken into a warehouse. Let us say that should they all be convicted of burglarizing the warehouse, they would each receive a three-year sentence. However, if they were convicted of armed robbery and assault, they would each receive ten-year sentences. The police decide to separate and interrogate all of them. Each is made an offer: Rat out your crew and you will be given immunity from prosecution as well as witness protection.

“Interesting. So what happens?”

“Well based upon social science modeling and experiments, most people would choose to ‘defect,’ or rat out the gang. This, despite the fact that in that scenario, the group as a whole is worse off, serving a total of ninety-years in prison. If everybody stayed quiet, the group as a whole would be three times better off, serving only thirty-years of collective time.

“So let us apply that to the economy. It is true that in the short-term, everyone would be better off if we all began borrowing money and spending once again, as this would certainly stimulate the economy. But the individual will likely be better off saving money and avoiding debt during bad times. So it is safe to assume that households will do what is in their own best interests, even if they know that their actions, if imitated throughout the economy, will cause further economic deterioration. Should you borrow and spend in an effort to do your part to turn things around, you risk financially over-extending yourself at precisely the time when things will probably get worse.”

By this time a new battery was installed and it was time to test it. My engine turned over without hesitation.

“I see. So I should do nothing?”

“Have you started saving for your children’s higher education?”

“Hmmmm. No. Not really.”

“I suspect that will be an investment that will pay dividends far in excess of any stock, bond or piece of property.”

After a warm handshake we parted ways. I had a new battery. I am not sure with what my new friend left.

So what was the second point I did not want to bring up at the time? A concept that is probably heretical to most readers, and is certainly unconscionable to every policy-maker:

What this Country Needs is a Good Old-Fashioned Recession

Throughout the polemic debates raging on Capital Hill about what should be done about the financial crisis, there is one point upon which there is utter and complete consensus: the government must do something to bail out people and businesses who have buried themselves in debt and bad investments. This is a most grave misconception, and one that I am convinced will make things much worse in the long-run. I will make three points this week as to why the approach taken in DC is disasterous policy-making.

1. Capitalism is “creative destruction.” The primary advantage of capitalism is the way in which it efficiently and quickly allocates capital throughout and economy. Adam Smith called this the “invisible hand.” Essentially the market, left to its own devices, naturally adjusts to any economic circumstance based upon supply and demand. As we discovered 20+ years ago when communism collapsed under its own waste and inefficiencies, capitalism is the greatest system in the world when it comes to generating wealth. However, this system is not one without its costs. One of the great economists, Joseph Schumpeter, noted that capitalism's very essence is "creative destruction."

With very few exceptions, when the government intervenes in the marketplace, it does so at the cost of reducing overall wealth. This is not to say that such intervention is never justified (a topic that will have to wait until next week). But to do so to save businesses or people from bankruptcy based upon their own decision-making is horrific policy-making.

I grew up in an era of stereo 8 tapes (for those younger readers, please consult your resident octogenarian for information about this archaic audio format). Back in the day I felt quite cool popping in my Captain and Tennille eight-track tape and turning up the volume (did I mention I was a very pathetic child?) At some point in the late 70’s, people stopped buying these tapes and players. First cassette tapes, and then later CDs, were viewed by the marketplace to be superior formats (for instance, both actually had rewind capabilities). Stereo 8 accordingly died an ignominious death.

I am sure that there were thousands of people whose jobs were tied to the manufacture and distribution of eight-track tapes. The government could have stepped in to stave off corporate and personal bankruptcies by extending loans or subsidies to this industry. But intervention would have extended the production of goods the marketplace no longer wanted, and employed people in positions that would only continue so long as the government maintained its largess.

Moving ahead to the present, by stepping in to "bail out" those industries/market sectors that would otherwise go bankrupt, the government prevents the natural winnowing process inherent in efficient markets. So instead of our economy receiving the proper signals that we need a lot fewer investment bankers, mortgage lenders, auto assembly-line workers and the like, huge quantities of capital continue to be misallocated when Uncle Sam saves jobs/businesses that should go away.

2. A serious recession is both inevitable, and ultimately necessary. The Holy Grail of both economics and government policy-making is ending the business cycle. Actually, let me clarify. It is to eliminate the “bust” portion of the business cycle. Who does not like a boom after all? Booms are like attending weddings with open bars.

But let us return to the dreams of those hoping to make recessions a thing of the past. Somewhat ironically, the greatest hope on this front has occurred when the economy has been poised at the edge of great financial precipices. On the eve of the great stock market crash of 1929, noted economist of his day, Irving Fisher, proclaimed, “stocks have reached what looks like a permanently high plateau." I suppose from ground level, cliffs can occasionally be mistaken for plateaus.

As recently as 2007, Fed and Treasury officials were confident that economic fundamentals were “sound” and future growth prospects looked bright. Once cracks began to emerge in the very foundations of the world economic order, these same officials offered assurances that the government stood ready to act in a way to minimize any slowing of the economy. Now that a full-blown economic catastrophe is upon us, we are promised that ultimately trillions of dollars with be spent in a herculean effort by the government to revive the economy. Moreover, it is taken for granted that such action is necessary given the circumstances. Balderdash!

While I am skeptical that there will ever be an end to the boom-bust cycle inherent in market economies, of this I am certain: A bust cannot be avoided after the most pronounced and unsustainable boom the US economy has ever seen. Marc Faber likens the need for a recession to the human body needing sleep. In an expansive phase of an economic cycle all kinds of frenetic activity and growth takes place. In this euphoric time, companies expand business operations, consumers buy more goods, and everyone takes on more debt. But just as the body needs its time of inactivity and rest, so economies need times of contraction to purge excesses and repair balance sheets.

To push this analogy further, it is possible for the body to stay awake longer than is natural. Initially this can be done by sheer will power. Eventually artificial stimulants are required. Being an inveterate crammer throughout college and grad/law school, I recall the drill quite vividly. Determination was enough through about 2:00 a.m. A candy bar could take me through 3:00 a.m. at which point I started brewing coffee. By 4:00 a.m. I was double-fisting Mountain Dew. Anything beyond 6:00 a.m. and I was looking for a Red Bull IV drip. The later I pushed my body to stay awake, the worse the repercussions. After one grueling 38 hour stint without sleep, I did not stir for 14 hours. It took me a week to feel like myself.

So it is with the economy. Yet the Fed has for years been artificially stimulating the economy through below-market overnight interest rates (see blogs below). This is the economic equivalent of mainlining NoDoz. It should be no surprise that our economy soared to heights not previously achieved. But just as there is a law of diminishing returns when it comes to taking stimulants to stay awake, the current zero-interest rate environment appears to be doing little to revive our economy that has already begun to slumber.

By preventing a serious recession at all costs in the futile attempt at staving off inevitable, and painful, economic adjustments the economy must make (reducing debt and consumption), the government simply prolongs and intensifies the pain. Moreover, thanks to its massive non-market based intervention in the economy, it reduces the overall net wealth of the nation by untold billions. It is truly execrable.

3. The government’s solution to drunkenness? More alcohol! Listening to politicians, pundits and policy advisors alike, the one message that gets through is the need to “stimulate” the economy so we can get back to the business of our nation. What is that business? Why, it is getting the consumer confident enough again to consume! It is getting the banks stable enough to resume loaning money. And above all, it is getting everyone, individuals and businesses alike, secure enough about the future to start borrowing again. We are constantly bombarded with talk of the “credit crunch.” The solution, taken for granted by one and all, is to inject hundreds of billions of dollars into the banking system to make credit easier for all to obtain. Indeed, a particularly important and popular element of the of the stimulus plan passed last week are tax incentives and rebates for first time home-buyers as well as new car purchasers.

Am I the only one that thinks this entire plan will not just be ineffectual, but counter-productive? Just prior to the financial crisis, household debt relative to income soared to unprecedented levels, while at the same time net personal saving in the US went below zero for the first time in 80 years! Consumption as a percentage of the overall economy reached 70%, far exceeding its historical norm. The ratio of household debt to assets had soared more than 50% in less than a decade. According to a recent research report by Merrill Lynch, overall private sector debt exceeded $15 trillion by the end of 2007, reaching a new high even as a percentage of national income.

In the brief period of time since the financial crisis started, 10% of mortgage borrowers are either behind on their payments, or in a state of foreclosure (and indeed the new administration is proposing a $50 billion plan in an effort to arrest further foreclosures). And while savings rates have climbed to a paltry 2% of national income, this is almost 85% lower than the level it was at the beginning of the 80’s.

So let me get this straight, the uniform consensus on Capitol Hill is that the solution to the financial crisis is to do everything possible to encourage further consumption and borrowing? Does it even make sense to anyone that long-lasting economic growth can be achieved by consuming more and more consumer goods that eventually depreciate in value to zero? Or borrowing ad infinitum? As I have argued before, whether we are talking at the household or macroeconomic level, I have never heard of spending one’s way into prosperity. Nor can one borrow their way to riches (at least riches that will not have to be paid back with interest).

Real economic strength is based upon savings and investment, not borrowing and consumption. More than anything else, we need to encourage Americans to rebuild their balance sheets, eliminate debt and set aside money that can be invested. This is in the long-term best interests of the US.

But far from encouraging and fostering this transition, policy-makers are adamant in their efforts to eliminate the short-term pain that inevitably comes with such a paradigm shift for our economy. In so doing, I am convinced they will retard the very processes already naturally and necessarily at work in the economy.

Adam Smith had it right. This is obviously a sprawling, dissertation-worthy topic, and I have not done justice to any of the points above. But I will attempt to sum up my simple-minded perspectives.

Whether it has been from my closest and smartest friends, or new friends that know how to replace a car battery, I often get questioned about the “savings paradox.” This is the concept that during economic crises individuals who look out for their best interests by saving more actually do harm to the economy as a whole, and hence ultimately themselves, since they are not spending as much. And once this behavior is replicated, the economic damage spreads.

My response: By saving money you are actually helping the economy make what will inevitably be a painful, but necessary, transition towards sustainable growth. This process would occur naturally, thanks to the “invisible hand” at work in the marketplace. But allowing this process to unfold in the least destructive manner possible would require courage, and lots of it. Americans must be courageous enough to suffer through a painful period of economic dislocation. Moreover, courageous politicians must emerge to tell Americans what they need to hear, not what they want to hear. Sadly, courage appears to be in short supply, and no where is this more evident that in DC.

So the main danger is that in a desperate attempt to prevent exactly the contraction process the economy needs to purge the excesses that have built up as a result of a rampant and malignant credit bubble, the government will waste hundreds of billions of dollars and prolong the recession/depression.

This is not to say that the government should stand idly by and allow the effects of economic dislocation ravage the members of society already living at the margin. But that discussion, along with the ways in which the current government policies violate basic tenets of social justice, will have to wait until next week.

Portfolio Reclamations Project

2009-02-04T14:11:00.001-08:00

"We haven't the money, so we have to think"
-Lord Rutherford

Times change so very quickly. Fifteen months ago the US stock market was scaling new all-time peaks. Unemployment was comfortably under 5%. Consumer confidence was near six year highs. Goldman Sachs was paying its average employee in excess of $660,000 a year. Banks were, well, solvent. Home prices in my region (Seattle) were very close to their all-time highs. In short, life was good. People were feeling ebullient, at least when it came to the economy.

Fast forward to the present. The overall stock market is down almost 45%. Unemployment is over 7% with many (myself included) thinking it is headed towards 9%. Consumer confidence readings are at record lows (and they have been charted since before I was born!) Home prices have declined between 20-25% nationally, with some markets being savaged even more brutally. Hundreds of billions of dollars have been needed to prop up a banking system that would otherwise be insolvent. On Monday of last week alone, IBM, Texas Instruments, Pfizer, Sprint, Phillips, Home Depot, Caterpillar and ING announced layoffs totaling over 50,000. Here in Seattle, Boeing, Starbucks and (gasp!) Microsoft have all announced layoffs as well.

Even the poor suffering souls at Goldman have had to tighten their Italian belts and figure out a way to get by on average salaries that barely exceed $360,000. Oh, the horror! By the way, we the taxpayers paid for about 91% of those salaries thanks to the $10 billion bailout package the former investment bank received from Uncle Sam (find your happy place Mark, find your happy place)!!!

I do not bring up these sobering statistics to boost the sales of anti-depressants. Rather, given the regular influx of inquiries I receive from people about what in the world one should do in this catastrophic economic climate, I am breaking with my general policy to avoid providing specific investment advice. These are very dire times. Individuals in this country have collectively lost trillions of dollars, largely based upon the actions and recommendations by the very financial service professionals that either directly caused the present crisis, or failed to see it coming.

Let me provide a few provisos and one general observation before proceeding. First, each household has unique financial needs. Hence, one should not simply apply these thoughts without first determining what your unique financial circumstances are, and which of these investment ideas are appropriate for you and your household.

Second, as an investor I simply try to find assets that in my estimation have the best risk-reward profile. But there is no investment of which I am aware that has no risk in the long-term (including US Treasury bonds). And usually the investments that offer the greatest opportunity for reward carry some of the largest risks. Hence do not take any of these thoughts to be the equivalent of "sure things."

Third, I believe in long-term investing. This means I am using at least a ten-year horizon. I do not attempt to divine the direction of any asset class in the short-term. Indeed, I am probably the world's worst market timer. I am used to purchasing assets and seeing them decline in value for months, and in some instances years. So there is a real possibility that even if some of these ideas are successful in the long-term, one may see ongoing short-term losses.

As for the general observation - act defensively when it comes to financial matters. If given the opportunity, savings should be favored over spending (even more than would be the case in normal economic times). Debt reduction should be one's highest priority (particularly consumer and other high interest debt). The main reason for the economic crisis we are in is debt (see blogs below). There are those (whose glasses are generally roseate) who think that we will see the economy come roaring back to life sometime this year. I do not fall in that camp. The problems we face economically are systemic and chronic. While assets markets may rebound significantly in the short-term as news becomes "less bad" (again, I am not the person to ask), there is not any easy fix for our broken economy.

So, in light of all of that, the investments I like:

Treasury Inflation Protected Securities (TIPS). Never heard of them? Well do not feel bad, you are not alone. In essence, these are US Treasury bonds (considered by many to be the safest investment in the world) that pay two types of interest. The first is a base amount that is guaranteed to be paid every year. It is typically quite small, a handful of percentage points. Not very exciting or interesting so far. But the second is based upon what the Consumer Price Index is each year. So in effect, you receive back your money, plus the rate of inflation, AND the base interest rate. In times where preservation of capital is paramount, I can think of no better place to have money parked where it is both secure, and is assured of providing positive after-inflation returns (the only returns that should matter for any investor).

Gold. I know gold is neither considered a traditional asset class, nor is it recommended by the vast majority of investment professionals. It is after all, a "non-performing asset." It is not like investing in a business, where one can at least hope for/expect revenue growth. Nope. Gold just sits there. But that is sort of the point. You see gold will buy you roughly the same amount of food and other basic necessities as it did back in the times of Christ. There is not much gold. The entire world's supply of gold would occupy a cube 60 feet by 60 feet by 60 feet (granted it would weigh 160,000 tons). It is a storehouse of value. And in today's environment, where "Helicopter Ben" Bernanke (see below Looking Ahead to 2009) promises to litter the landscape with increasingly worthless dollar bills, having a tangible storehouse of value whose supply is not subject to any electronic printing presses is a nice thing. Furthermore, it is one of the few assets that is not someone else's liability. Other tangible assets potentially worth having some interests in are silver, platinum and oil, along with those companies that dig the stuff up.

High Quality Stocks. Now this is not a recommendation that I expect will yield the kind of returns to which people have grown accustomed. Again, I am pretty bearish on the future state of the US economy. And if the economy is not zipping along, it is hard for corporations, and their stock prices, to excel. Having said that, I think there is some upside, and not a ton of downside, in stocks that meet at least four of the following five criteria: 1) have little to no debt; 2) pay solid dividends; 3) are "wide moat" businesses (dominate an industry or area of business in such a way so as to make entry by competitors difficult, if not impossible); 4) trade at very cheap valuation multiples (such as price-to-earnings, price-to-book, price-to-cash flow); and 5) are not in the financial services industry. Frankly, there are not a lot of those companies around (although I understand one of them has some campus in Redmond).

As for investments to be avoided:

Residential Real Estate. I do not expect houses to be a good investment as an asset class for the rest of my life. Seriously. My favorite question I posed to housing market bulls during the heady earlier years of this decade was: For the 105 years prior to 1997, what was the average annual after-inflation returns for residential real estate in the US? I typically had guesses as low as 5%, and as high as 10%, or even 15%. The answer: -.5%. That is not a typo (forgive the others). Houses, as an investment, did not even keep pace with inflation for over a century. And when one thinks about it, this should not be surprising. Like gold, a home is a non-performing asset. Unlike gold, it actually falls into a state of disrepair over time. Roofs must be replaced, paint reapplied, pipes fixed, etc., etc. I always encourage people to view their home as a way of avoiding paying rent, not as an asset likely to intrinsically appreciate beyond the cost of living. Unlike stocks, I will be shocked if housing prices rebound in the near term. In addition to all the bad news regarding prices well known by one and all, the following should be a sobering fact for those expecting an imminent upturn in the housing market: according to the Census Bureau, a record 19 million homes were uninhabited at the end of 2008. Think we might have some more over-supply to work through?

Long-Term Treasury Bonds. I have already written about the basis for thinking these are terrible investments below (see Looking Ahead to 2009), so I will not rehash. Suffice it to say that since I wrote that blog, long-term treasury bonds have declined in excess of 15% in value. There should be considerable downside yet to come.

US Financial Institutions. This is the call that has the biggest chance of going awry. Indeed, the wise, hoary Warren Buffet is on the opposite side of the trade with me on this one. The argument for investing in these companies is two-fold: 1) they have been absolutely bludgeoned senseless, and have to be cheap at these levels; and 2) the big ones now have the express backing of the US Government, and are thus not going under. As a deep contrarian, I am quite sympathetic to the first point. And I do not rule out the possibility that there are well-run banks out there that have been taken to the woodshed and smacked silly by the market along with all the culpable/incompetent financial institutions. But as a whole, I still think the risks for the sector exceed the potential rewards. As a nation, we are still choking on debt. Banking bulls pin some of their hopes on the scuttlebutt concerning the creation of a US "Bad Bank" that would pool all or many of the toxic assets held by US banks and transfer the losses to . . . (any guesses?) the US taxpayer. Well, in addition to being yet another "Bad Idea" that has come from DC in its handling of this financial crisis, I do not think that will be enough. As long as the housing market languishes (and we know my thoughts on that), more impaired assets will find themselves on the balance sheets of many US banks. And while bondholders get bailed out when the US government takes over a failed bank, the stockholders generally do not.

There you have it. As things stand now, you could do a lot worse than simply squirreling money away in a low-interest bearing account. And again, I think being cautious and defensive at this time makes a great deal of sense. Nevertheless, there are always opportunities to judiciously put money to work.

In an effort to address the specific interests and concerns of those of you who follow these periodically penned meandering thoughts, please feel free to pass along any question, comments or suggestions.

From Whence We Came Part II

2009-01-24T07:37:00.000-08:00

"I don't have to tell you things are bad. Everybody knows things are bad. It's a depression. Everybody's . . . scared of losing their job. The dollar buys a nickel's work, banks are going bust, . . . and there's nobody anywhere who seems to know what to do, and there's no end to it."

Any guesses as to where the quote above is from? Perhaps an Op-Ed piece in the New York Times last week? Maybe some talking head on This Week's roundtable discussion last Sunday? A recent speech by some politician criticizing the manner in which the financial crisis has been handled?

Nope. None of the above. This is from an on-air monologue/rant delivered by the newscaster Howard Beale in the acclaimed 1976 movie Network (a fine flick if you have not already seen it). One of the reasons why the movie won four Oscars, including best screenplay, is that it adroitly captured the Zeitgeist of the mid-70's in the US. I am old enough to remember the era (although I was admittedly more concerned with cartoons, baseball cards and comic books than unemployment, inflation and poor stock market returns). Times were tough. Jobs were hard to come by. People worried about the future. What little extra money that did come into a household was oftentimes saved for an even rainier day.

Why dredge up a quote from a movie that is over thirty years old? To highlight the fact that up until about twenty years ago it was taken as a fact, albeit a sad one, that economies regularly experience busts. Accordingly, people acted a lot more responsibly, more cautiously, when it came to matters of personal finance. Debt was taken on only when necessary, and was paid off promptly. There was more fear about insolvency and potential unemployment, and less greed. Stocks were viewed as assets whose value could just as easily decline substantially as they could rise to the sky.

But something began to change, at first subtly and almost imperceptibly. I put the genesis of this around 1988. By then the economy had grown without interruption for six straight years. Perhaps even more importantly, the stock market had gone up dramatically since bottoming out in 1981. And despite "crashing" in October of 1987, it had already scaled new highs just months later. Indeed, people who panicked and sold were about 25-35% poorer than those who kept their heads and stuck it out. By this time communism had also been handily defeated. America was now the world hegemonic power, both militarily and, to a large degree, economically.

The movie Wall Street had also been released the previous year. The angst and despair of Howard Beale was replaced by the uber-confident and audacious Gordon Gekko. Fear? Doubt? Caution? No, no, no. Conquest, acquisition, and, above all, greed. Mr. Gekko, with all of his consumate charm and demure nature, made the case that "greed is good." This began to resonate with the masses, and became a new sign of the times.

For the next 20 years people were actually rewarded for "bad" behavior in the economy. Debt was not even called debt. It was "leverage." And the prevailing wisdom was that assets (which were taken for granted would appreciate) must be leveraged for maximum return. I mean even a society like ours in which 8th grade math skills are the norm could figure out the arithmetic. $1000 invested in an asset that increases 10% yields a $100 return after one year. The same asset using one's own $1000 plus $1000 of borrowed money yields $200. And with $9000 borrowed, the original $1000 of your own would fetch $1000 profit (minus interest on the borrowed money).

With banks and all forms of financial institutions being deregulated (see "From Whence We Came Part I below), and interests rates falling throughout this time, borrowing money was never easier, or cheaper. Remarkably, there were virtually no consequences for "bad" behavior on the part of corporations or individuals. The nervous Nellies, their portfolios comprising 60% bonds and living in apartments until they could scrape together a 20% down payment for a home, were left in the financial dust by those who bought their stocks on margin and their houses with little to nothing down.

Oh sure, there were minor hiccups along the way. Some regions experienced short-lived slumps, and there were two very shallow recessions in 92 and 2001. But even the tech crash of 2000 did not cause much of a stir; for most Americans, whatever losses they suffered in the stock market were more than offset by gains in the home prices.

And for this 20 year neo-gilded age, one man towered above all others in esteem and respect: Alan Greenspan, or the "Maestro" as Bob Woodward prefers to call him. Whenever the economy began to hit sour notes, the Maestro was there, baton in hand, to get it in tune once again. Shrewd and smart people on both Wall Street and Main Street began to take their cues from the respected economist turned central banker. He believed in confidence above all else. And he never met a bubble he did not love. People realized that here was the most powerful man in the world (really) prepared to do their bidding to keep the economy zooming along.

Hence the term "Greenspan put" entered the financial lexicon. A put is a particular type of option that pays off only if an asset goes down in value. The concept was that should any significant asset in the economy (homes and stocks being the two most important) go down in value, Greenspan would be there lowering interest rates to whatever level necessary to stimulate borrowing and spending enough to get the economy growing again. Hence asset prices would return to their previous levels and keep going higher. That was the theory at least.

In this environment, fear was seen less frequently than investment bankers dining at McDonald's. Money had never been easier to make. With interest rates cut to levels below inflation for a good portion of the new millennium, leverage increased to levels heretofore never seen. Greed was ever more pervasive.

Bob Woodward's moniker for Mr. Greenspan was indeed apropos, but for a reason not contemplated by the revered journalist/author. In reality, the Maestro was conducting a national symphony serving as the source of a grand game of financial musical chairs. As long as Greenspan could his orchestra playing ad infinitum, the party would continue.

But alas, just as no musician can play without rest, and no reveler can imbibe forever, neither can any economy pile on ever mounting debt without it eventually choking. And that, dear reader, is where we find ourselves presently.

And it will have to be next time (sorry Matt), that I take up the savings paradox. Simply put, it is the fact that when individuals do the right thing in a bad economy (save more, spend less), it actually further weakens the economy, and thus all the individuals who are acting in their own best interests.

My So-Called Life (as a Contrarian)

2009-01-17T13:18:00.000-08:00

Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference

Robert Frost

Life is hard enough. But some of us seem to magnify its difficulty in a variety of ways. Me? I have held views about the markets and the economy that were/are not only in the minority, they were/are deeply unpopular. Being a contrarian inherently means that a (usually vast) majority of other people think you are stupid. As if that were not bad enough, when you are a contrarian during good economic times (and particularly economic bubbles), people can actually be hostile to the content of what one has to say.

Accordingly, I am used to being a social pariah by now. During the late 90's through the turn of the millennium I would attend a variety of casual parties and social events. While most people would prattle on excitedly about XYZ.com and the dramatic gains they were realizing, I would be the dour-faced attendee warning people of a crash that was quite likely in the offing.

Flash forward five years. The same cocktail parties and the like. Now it is ebullient discourse concerning the real estate market. Oh, the glory of zero-down payments, retirement homes, vacation properties, remodeling, buying up, flipping, etc. It was all so intoxicating. Money had never been so easy to make (and the quantity of cash-out home-equity loans evidenced that). But morose Mark was there trying to take away the punch bowl, worrying about such inconvenient things as household indebtedness, variable-rate mortgages readjusting at higher levels, unsustainable price gains, and overinvestment in residential housing. It was the social kiss of death. Indeed, one woman stopped seeing me after we had a tiff over whether her planned condo purchase would be a good investment.

But this social phenomenon actually speaks to a very important investment principle - one must not let emotion cloud analysis and judgment when it comes to investing. I think it is a basic tendency in most human beings to be generally optimistic. I actually view myself to be of this ilk. Accordingly, when presented with the same bullish drivel that has been rife in the financial and popular media for roughly the last 20 years, or analysis that warns of bad economic tidings, it is more comfortable to focus on the former and write off the latter.

Great investors simply perform risk/reward analysis. It is very similar to seeing somebody with an umbrella under there arm on a cloudy, yet presently dry, day in Seattle. It is safe to say that the typical person in that situation is not hoping it will rain. Rather, it is more likely that the person checked the forecast and discovered that rain was likely.

Similarly, I cannot imagine any investor that actually hopes for an economic crisis such as one we find ourselves in today. After all, it is far easier to make money when asset prices are increasing. However, if rigorous analysis indicates such a crisis is coming, it is simple prudence to manage one's portfolio in a manner so as to profit from such an event (or at least lose as little money as possible).

I bring all of this up because I remain convinced that the only was an investor is able to achieve exceptional returns is by being a contrarian during times of extreme optimism or pessimism. Indeed, I look forward to the day when not only is there caution in the marketplace, but something more akin to revulsion (a point I do not believe we have yet reached). From a long-term investing perspective, that will be a great time to be a bull.

Looking Ahead to 2009

2008-12-25T18:49:00.000-08:00

"There are two times in a man's life when he should not speculate: when he can't afford it and when he can." - Mark Twain

Happy Holidays from Indonesia! I am traveling with my new in-laws and enjoying a marvelous trip that started in Seoul, took us here to Jakarta, and will conclude in Bali. As we rapidly approach the New Year, many of us take this time to both look back, reflecting upon the year that was, and look forward, thinking about what we hope to accomplish in the next twelve months. While I typically eschew giving general investment advice for a variety of reasons in a medium such as this, breaking from the historical analysis I began last blog to offer some contemporary observations may be timely.

If there is one thing last year should have conclusively proven, it is the perils of speculation and greed. For years, nattering nabobs of negativity such as myself have been concerned about the unsustainability of an economic boom predicated upon the inflation of paper assets and home values. US incomes after inflation have barely gone up in the last ten years. Yet first stocks and then real estate values escalated rapidly. People spent more and saved virtually nothing.

Worse, the housing bubble encouraged people to pile on mortgage debt at levels that were literally unprecedented. It was as if people collectively lost their senses, believing that by buying and selling their homes to one another, vast wealth could be created. Of course, in reality this massive misallocation of capital (which is what always occurs during financial bubbles) has led to the unprecedented destruction of wealth and crushing debt burdens.

As far as 2009, do not expect any quick rebounds in the real estate markets. I have heard some make the pitch that with home prices this depressed, tremendous opportunities exist. I could not disagree more strongly. For years residential real estate construction and investment exceeded population growth by a factor of roughly five. For over a year, more than one in three homes was being sold either as a non-primary residence or for investment purposes. The combination of over-supply and hyper-speculation will likely take much longer to work itself out than 22-24 months (roughly the point at which US home prices peaked). Weak to dismal job prospects coupled with huge numbers of adjustable-rate mortgages resetting at higher rates in the coming months will mean that foreclosures and falling prices will be the likely hallmarks of the US real estate market.

Beyond buying homes, let me identify what I believe to be the worst investment for 2009: long-term (30-year) US Treasury bonds. As I write this, these bonds are yielding a most paltry 2.61%. There are three main reasons why this represents a catastrophic investment for anyone with a long-term horizon. First, the US budget deficit is exploding. It is likely to get much worse as the US government seems hell-bent on saving every heretofore well-heeled Wall Street financier whose Hermes wallet happens to be empty. This will lead to the US Treasury flooding the market with bonds to finance this spending/bailout orgy. Basic laws of supply and demand indicate that the US must offer higher yields in order to goad investors into absorbing future US debt issuance. This would mean that the value, or price, of currently issued US debt will go down.

Second, the Fed in its inestimable wisdom has put the world on notice of its intention to inflate the economy by any and all means. This means printing dollars. Indeed, even before Bernanke was hand-picked by Greenspan to succeed him, the current Fed Chairman's nickname was "Helicopter Ben." He got this name as a result of his response to a question about the prospect for America falling into a deep depression like that of the 30's with price levels falling. Bernanke noted that such a prospect could be averted, as the Fed could drop money from helicopters if necessary. While this may be comfort to pilots currently out of work, it scares foreign holders of US bonds to death. Such action (running the printing presses to pump money into the economy) erodes the value of the dollar vis-à-vis other currencies. Yet we rely upon those same foreign investors to buy the majority of US bonds. Any appreciable decrease in purchases from these overseas investors will also cause long-term bond values to decrease in the future.

But the third, and most important, reason to avoid long-term US Treasury bonds is precisely because Bernanke (or his successors) will at some point likely succeed in their efforts to reinflate the economy. Over the last 200 years, average returns on long-term US Treasury bonds have been more than 3.5% above inflation. So to achieve just average returns, a holder of a 30-year US Treasury bond at today's yield, inflation would have to average -1% through 2040!!! Essentially, the US would have to be in one generation-long depression. As bearish as I have been, even I think that is almost impossible. If inflation simply returned to its post-WWII average level, investors would have negative after-inflation returns, despite tying up their funds for 30 years. Far worse, should inflation return to levels seen in the 70's, investors would see massive capital losses on 30 year Treasuries. In sum, it boggles my mind how any long-term investor would for a moment consider such an investment.

Accordingly, I think it is highly prudent for individuals in the New Year to liquidate any mutual funds they own which have significant holdings of long-term Treasury bonds. Obviously, if investors directly hold such instruments, they should be sold now.

There is actually a way to make money in the event that long-term Treasuries decline in value. However, I would not recommend it for most individuals. ProShares UltraShort Lehman 20+ Year Treasury Bond (ticker symbol TBT) is an exchange traded fund (like a mutual fund, but trades like a stock) that goes up in value 2% for every 1% decrease in the price of long-term treasuries.

While I personally own it, there are several reasons why typical investors will want to eschew it. To begin with, just because long-term Treasury prices have reached record/bubble-like levels does not mean they can go even higher. Indeed, TBT is down substantially from the level I first bought it at. Most investors hate losses more than they love commensurate gains. This problem is magnified by the fact that the fund is leveraged 2-1, thereby increasing the amount of money lost to investors in the event long-term Treasury bonds continue to go up in price. Finally, I am a firm believer that individuals should not own investments, the nature of which they do not understand. Since most individuals do not find the bond market to be enthralling (who can blame them?), few possess the knowledge critical in determining whether TBT is appropriate for their portfolio.

In general, I expect 2009 will continue to see extreme levels of market volatility. While the real economy throughout the world will likely worsen appreciably, it is possible that stock markets may see significant run-ups. However, with weakening economic fundamentals, I continue to see few investment opportunities on the long side that represent real value for the investor (as opposed to speculator). Having said that, keeping a few gold coins under the mattress may not be such a bad idea.

I hope everyone has a very Happy New Year!

From Whence We Came Part I

2008-12-03T15:17:00.000-08:00

"Those Who cannot Remember the Past are Condemned to Fulfill It."
- George Santayana

My doctor has recently informed me that my blood pressure has escalated. Having had a front row seat to the unbelievable policy-making that has emerged from our nation's leaders in response to our economic crisis, it is no wonder.

Before launching a whole series of invectives in a future blog concerning the unjust and incompetent decisions emanating from what was once, and should have remained swamp, aka Washington D.C., a little review of past history is in order. There was once a quaint and innocent time in American economic history when: people used to be required to put at least a 20% down payment before buying a house; bankers used to be dour individuals, reticent to lend money to those but the most credit-worthy; and investment advisers used to caution people about the steep losses that might befall those investing/speculating in potentially risky assets (i.e. stocks and real estate). It was a more sober time perhaps. People were worried more about the prospect of capital losses than capital gains. While less fun than the carefree modern era of finance, it was also more stable. Most people relied upon setting aside part of their incomes on a regular basis in the event that rainy days should come to pass. Great fortunes were not gained as frequently, but neither were vast fortunes lost.

But starting in the 80's, change began to occur. Not, from my perspective, all for the worse mind you. Far from it. Paul Volker proved himself to be perhaps the most courageous and talented central banker in American history. By raising interest rates in a time of economic crisis and inflation, he arguably caused the most severe recession since the depression. But in so doing, he also broke the back of what had been rampant inflation since the days of LBJ's The Great Society programs. Moreover, the economic power of unions began to wane significantly, thereby unshackling to a large degree human capital, and leading to greater employment. Absolute and marginal tax rates were lowered, providing greater incentives for both individuals and corporations to work hard.

But with the good, usually comes the bad. As corporations prospered, particularly in the financial sphere, so did their influence grow in DC. This, coupled with more conservative politicians, led to legislation pushing all forms of deregulation concerning financial institutions. As the good times of the 80's continued into the 90's, something quite pernicious began to develop. Fewer and fewer controls and oversight were in place to regulate financial institutions.

Increasingly egregious conflicts of interest arose for financial services companies as they tried to serve the interests of their clients and their shareholders. Similar conflicts confronted individual brokers and financial advisers, as they were compensated through commissions only received by selling certain financial products. And the more they sold, the higher their incomes.

All of this came to a head as we approached the turn of the millennium. Stock prices, and particularly those in the tech sector, had achieved returns that exceeded anything seen in modern US financial history. They were so fantastic that anyone with a cursory understanding of investing history should have been aware of the fact that it was unsustainable. There has never been a major asset class which has appreciated ad infinitum without facing serious price declines along the way.

Had the financial institutions safeguarding the vast majority of American savings and investment funds been properly serving the interests of their clients, two types of warnings would have been issued. First, the institutions themselves would have disseminated "sell" recommendations on hundreds of tech companies, and the sector as a whole, based upon the gross overvaluation of the sector. Ahhhh, but Wall Street was reaping billions and billions of dollars in fees creating IPOs and providing other services to the very tech companies it was making buy and sell recommendations about for its retail investment clients. Often it was the very same individuals at investment banks that first launched an IPO for a company and then issued the bank's "analysis" of the company from an investment perspective. Virtually without exception, every tech company was a great "buy" for the investing public. Far be it for Wall Street to have the courage to bite the hand that was feeding it by declaring that the vast majority of these companies being rushed to market: had no track record of success; operated in wholly speculative market sectors; were largely run by tech wonderkids who had little, if any, management experience; and were massively overvalued by any objective finance metric.

Second individual brokers and financial advisers would have been calling each of their clients warning them of the dangers of an precipitous fall in US stocks. Remarkably, from the anecdotal evidence I gleaned at the time form talking to friends and colleagues, the opposite occurred. Brokers and advisers were mostly encouraging their clients to "follow the returns." Even though the gravy train had long left the station, and was about to be utterly derailed, the average retail investor was still being sold on the story of vast profits to be made by investing in companies engaging in tech endeavors that few brokers/advisers took the time or effort to understand. As these financial service professionals usually generated more revenues for themselves by having their clients purchase stocks or equity-based mutual funds, it appears that greed and neglience trumped prudence.

This takes us to the precipice of the new century in our story, as well as the role (or lack thereof) played by the Fed and the agencies tasked with overseeing financial companies. But that will have to wait for the next installment.

The Greatest Failure

2008-11-13T11:39:00.000-08:00

"Where are the customers' yachts?"

-Anonymous (possibly apocryphal question posed to a New York City tour guide when showing a group the dock in Manhattan where most of the yachts belonging to Wall Street executives were moored)

Apologies for my long hiatus. Many things have changed since I posted my first blog here. For starters I am married (not the most newsworthy development nationally perhaps, but that which has mattered most to me). More relevant to America and the world writ large is the incredible melt down in virtually every asset market, the ongoing deterioration in the real economy, and the election of Barack Obama as President of the United States.

As noted back in July, I have been expecting large losses to occur in the financial and real estate markets. Now it did not take any particularly keen or arcane insight on my part to see this coming as an investment professional. My entire professional life is focused on nothing but analyzing the world economy and asset markets, and then identifying particularly good places to put money to work. Conversely, I, like every other investor must also spot those areas to avoid. For reasons I will go into momentarily, it was obvious that real estate and stocks presented huge risks, with little opportunity for profit.

Therefore, I find it both startling and confounding how 95% (perhaps an underestimate) of investment professionals failed to warn their clients about the likelihood of massive declines in asset prices. From my simplistic point of view, a crash in the housing and equity markets was absolutely inevitable (and indeed necessary - a point that will have to be fleshed out another time).

There were a variety of reasons for this. The most basic being that the US has been in a lifestyle bubble for almost a decade. We have gone from a savings based economy to one predicated (precariously) on debt; from an economy that was sustained by increases in real (after-inflation) income increases to one that relies upon ongoing asset appreciation (first stock, then houses). This hit a critical mass level when financial institutions gave loans to people with little, or even no collateral, to buy houses they could not afford at interest rates that were held temporarily low. The only way this house of cards could persist is if housing prices kept rising to the sky. Ah, but the laws of gravity apply even to the ethereal realm of finance.

Could you blame people if they looked around and saw all their neighbors getting rich simply buying and selling each others' houses and did not want to get in on the action themselves? Well, maybe a little. Nevertheless, the greatest failures can be attributed to the banks, real estate agents,mortgage companies, PMI insurers, Wall Street brokers and the like who induced and encouraged THEIR clients, like lambs being led to the abattoir, into making some of the worst financial decisions imaginable. Whether that was: buying the house they really could not afford at the top of an obviously bubbleesque market; purchasing the stock of banks and mortgage lenders who stood to lose trillions collectively when the bubble burst; or refinancing homes with cash-out mortgages used to fund lifestyle purchases.

Do not get me wrong. There is plenty of blame to go around for the intractable mess in which we find ourselves. But it seems to me that there should be a special inner circle of perdition for those financial and real estate professionals, most of whom had fiduciary duties to protect the interests of their clients, who failed to wisely counsel them. Of course compounding my outrage is the fact that so many of these professionals have massive conflicts of interests. Most earn the majority of their incomes by peddling particular products, whether it makes sense for their clients to buy them or not.

Sadly, having studied financial bubbles and their aftermath for some time now, I cannot say there is a great deal of hope for an imminent recovery. Global stock markets have collectively lost more than $35 trillion from their recent peaks (making the combined $1.35 trillion government infusions from the US and China look rather anemic). Many more trillions have been lost in world real estate markets. Yet as the global economy continues to founder ever more gravely, I have heard most financial professionals urge people to stay the course. Paying heed to such advice so far has lead to 45% losses over the last 13 months in the overall US stock market. Hopefully, people are beginning to regain their senses, if only slowly and one by one.

So what is one to do? Well, a comprehensive answer is beyond the scope of this particular missive, and there is no cookie-cutter approach to asset management that works for all anyway. But everyone can and should assess the manner in which their money is being managed. Do you have a financial professional whose livlihood is connected to how your money is specifically invested (i.e. commissions for sales of particular assets)? If so, you should seriously consider either educating yourself and then managing of your own assets (a topic for another time) or at least finding a well-regarded financial advisor who charges an hourly rate. That way, s/he does not have a vested stake in steering you towards particular investment vehicles.

Finally, if you do have an investment professional that did not warn you that the stock/housing markets were at least at risk of falling precipitously by the end of 2007, you should seriously consider firing the person regardless of the manner in which s/he is compensated.

If the last year has proved anything, it is that through greed and incompetance the financial service industry has utterly failed in being good stewards of our money.

An Opening Salvo on Bastille Day

2008-07-14T18:55:00.000-07:00

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity . . ."

Charles Dickens, A Tale of Two Cities

While I expect that this will be a relatively untrodden area of the internet super-highway (I mean how many people really want to expend precious leisure time perusing a blog related to finance/investing), at least I will have an outlet in which I can engage in a variety of tirades, rants and disquisitions. A warning to readers up front: I love a good (or even bad) run-on sentence, I tend to write the way I think (lots of parenthetical breaks) and I have the grammatical skills of a second-grader. Reading this will likely not be pretty.

As for me, I am a former lawyer who has been a professional investor/pro bono financial adviser for the last six years. As a way of doing penance and possibly escaping that special circle in Hades reserved for litigators, I have been attempting to steer people into responsible personal finance decisions for almost a decade. Upon leaving law I published a sporadic financial newsletter for a couple of years. In a way, this is a reincarnation of that project. However, being a staunch Luddite, it has taken me several years to try the whole blogging thing. This, despite the fact that numerous friends have been prodding me to do so for far too many years. So that is a little bit about me and this enterprise.

Whenever I do financial advising for people I make explicit to them that I wear two very distinct hats when providing counsel. The first is my generic financial advising hat. Namely, there are many things that any good sound financial adviser should be telling people (save more than you spend, diversify your portfolio, make long-term financial goals, etc.). The second hat is very different. It is one in which I give specific guidance based upon my beliefs about the desirability of particular investments. This advice is informed by my personal beliefs about the global investing milieu.

While the opening passage of Dickens' masterpiece quote may be a bit histrionic for the circumstances the US faces today, there is no doubt we are in a period of extremes and excesses. It is with the second hat I noted above that I will focus a good portion of the analysis contained in this blog. My views are both unorthodox and contrarian. The vast majority of investment professionals would either take strong issue with my point of view, or simply disregard it as such utter nonsense that is not even worth seriously considering. But I have always loved a good argument, and exposing the financial services juggernaut for being the emperor with no clothes that it is gives me unparalleled satisfaction.

In short, I believe the US is in the early phases of what will be a long, inevitable period of hegemonic decline. There are very few traditional investment vehicles (e.g. domestic stocks and bonds or real estate) that will provide impressive investment returns over the next decade (at least after considering inflation). It will require particularly canny and shrewd investing to achieve success.

But I will leave it to future posts to flesh this out.