Author Archives: Bob

The Benefits of Rebalancing

If stocks historically have higher returns than bonds, then selling stocks to buy bonds reduces portfolio returns over the long-term.  Conversely, for those with the fortitude to sell bonds and buy stocks when there’s blood in the streets, the process reverses.  The effect is more likely reduced volatility than increased returns.

I’d rather build a portfolio by planning for liquidity needs rather than putting the client’s emotional IQ in control of his asset mix by managing to control volatility.  Warren Buffett doesn’t rebalance.  I prefer to manage risk in the context of valuation.  That, I can control.

A Better Financial Planning and Investment Process

When you meet with a financial planner, you might expect to answer a series of questions designed to measure your risk tolerance.  If you are a moderate risk investor, you’ll get a portfolio constructed to accept moderate volatility.  If you are conservative, you’ll get a safe portfolio with limited growth potential.  In other words, your emotional state dictates your investment strategy.

Emotional investing does not often lead to good outcomes.  As an investor, I believe emotions can be your worst enemy.  Evolution wired us as herd creatures based on the safety of numbers.  Straying from the herd is dangerous.  We seek affirmation, which leads to the tendency to buy high and sell low.  According to research from Morningstar Inc., investors routinely underperform the funds they invest in. It is hard to make money doing what everyone else is doing, but we like to buy things after they’ve already demonstrated good performance.

Investing based on an assessment of emotional condition puts disposition at the forefront of investing strategy.  This seems to be the way the financial planning profession approaches investment advice.

I believe that the most important aspect of financial planning is identification of goals and the liquidity required to fund those goals at the right time.  Rather than build the portfolio around an emotionally based risk number, I suggest starting with a rational assessment of liquidity needs.  The greatest risk is having to sell a security when the price is temporarily depressed, converting a temporary loss into a permanent loss.  Let’s address that risk by planning for liquidity events.  The remaining balance can be invested to maximize returns rather than pander to your emotional state.

Emphasize fundamentals like Warren Buffett.  Make tactical adjustments based on fundamentals, and try to keep emotions out of the equation.

The Taper Effect

As of 7/25/2014, the S&P 500 is up over 7% YTD. That’s on top of last year’s 29.6% gain. It’s enough to make some people nervous.

I believe an important consideration that seems to have eluded the Breaking News focused media, is the reduction in the Fed’s bond-buying program to $35 billion. The program has already been reduced from a high of $85 billion/month, with five straight cuts of $10 billion each month since November. I think the dramatic reduction in the bond-buying program greatly reduces the risk of unintended consequences of continuing large purchases in the unprecedented program.

But there is another shoe to drop, and that’s the eventual rise in interest rates. As long as fundamental indicators continue to improve, the market should be able to sustain current “normal” valuation levels despite higher, but “normal” interest rates. Steady as she goes.

Financial Engineering, a Personal Example

In 2002 I refinanced my house to lower the interest rate but kept the payment the same.  This allowed me to get a larger mortgage and walk away with cash.

On 11/20/2002, I deposited $10,000 of the refinancing proceeds to a College 529 Plan for my then 1-year old son.  By 1/1/2003, the value of the account had declined to $9,797.07.  As of June 30, 2014, the account was worth $30,365.04.  There have been no other additions to the account.   Using 1/1/2003 as the start date, the annualized return has been 10.4%, despite the worst financial crisis of my lifetime.

The best part is, it didn’t cost me a penny out-of-pocket.*

* Net cash flow impact of both transactions.  Investing involves risk of loss.  Past performance is not a guarantee of future performance.  This example is intended to illustrate a creative solution to long-term investment goals.  This strategy might not be available currently for numerous reasons, including changes in mortgage underwriting standards.

Great Ideas, Bad Timing

The stock market is setting new highs, but fundamental economic data remains subpar. For the past several years, we have expected “next year” to finally break out to a GDP growth rate of at least 3%, representing an escape velocity to grow our way out of the credit crisis doldrums.

The zero interest rate policy sustains the slow growth scenario, but there is only so much Fed monetary policy can do. The fundamental problems are fiscal in nature, and until Washington decides business and rich people are not the cause of the problem, we’ll continue to trudge along. Policies to stimulate business and job creation would be a nice start. Can you name one pro-business policy? Requiring businesses to offer health-care helps some people with medical issues, but does it stimulate job creation? Raising the minimum wage has noble intent, but if you are running a business, you’ll sharpen your pencil again before expanding.

No one can say how long the divergence between disappointing GDP growth and a rising stock market will last. Either the economy’s pent up demand overcomes Washington’s bureaucracy and grows faster, or we’re in for a correction. Let’s ignore the possibility of change in Washington for the meantime.

The key takeaway is, plan for liquidity, lean toward equity with the balance, and hope Washington will get out of the way. Lyndon Johnson pushed his Great Society programs at the same time as he funded the Vietnam War. We had a miserable decade in the stock market. Obama is pushing social reforms at the same time we try to recover from a credit crisis. Great ideas, bad timing.

Where the Wild Things Are in the Economy

One takeaway from 2008 – 2009 is that sometimes diversification does not work as planned. Most investment asset classes declined in the credit crisis.  Cash is the conspicuous exception.

As noted in last Friday’s post, reserving for liquidity is even more important than usual (given my perception) of the elevated prospects for a market convulsion, as we make our way back to the old normal.  There’s a lot to be said for cash as an alternative to bonds.  If interest rates or inflation spikes and bond prices plunge, and if cash is available to scoop up the bargains, losses on long positions can be mitigated.

Holding cash means accepting a negative rate of return on an inflation adjusted basis.  Long-term, this is a losing strategy.  As a tactical allocation, it means not being greedy.  And if you need liquidity, it’s just common sense.

Finally, if the US dollar falls in a currency crisis, the price of imports will rise.  Perhaps the best way to hedge against the currency risk of cash, is an expanded international allocation denominated in foreign currency.  But if the “correction” is global, then the US dollar will be as good as other currencies and might prove to be a safe haven.  If this seems like a circular argument, that shows how interconnected things have become.

Bubbles

During the past 20 years, we suffered 2 vicious corrections, 2000 and 2009. Attribution is simple. In 1999, tech stocks took off to the moon on the back of internet hype. Then, the combination of low interest rates, a love of real estate born of the prior equity bubble, mortgage securitization, and other factors led to soaring house prices. By 2007, houses were generally highly leveraged and overpriced. The collateral damage of the housing and mortgage crisis spread throughout the economy in ways few had imagined.

Which brings us to today. Allow me ask the obvious, what is overpriced today and which dominoes might prove vulnerable in a correction? Our artificially low interest rates and corresponding bond valuations seem the most likely candidates for disruptive movements.

The factors driving interest rates are complex, and countless financial instruments are tied to interest rates. This is not to predict economic Armageddon, but the dominos are set. There are paths to unwind QE without disruption, but we have not been down this path before. We can hope the path to normal will not be too disruptive. I am acutely aware of what I don’t know, but I have an idea where it might come from. This is fat tail risk.

When liquidity is important, it is important to reserve for it. If managing volatility is important, you might pay a steep price to hedge. Much like the crisis of 2000 and 2009, this one, if it occurs, will likely pass within a few years. I suggest reserving for liquidity needs anticipated within 3 to 5 years, and staying the course with the balance. Manage risk, don’t try to avoid it (you can’t).

A Simple Perspective on Equity

People often trade stocks as if they were baseball cards. They know when a company (player) is doing well and they speculate that if performance continues, they will be able to sell the stock (card) for more money.

What if Congress passed a law that prohibited the sale of stock. You could buy it, but you couldn’t sell it (never mind the inconsistency). As in musical chairs, the music stopped. How would you feel about what you own if you were stuck with it? If you made investment decisions based on the principal that the value of an investment is a function of the cash it can give you back, this probably would not be a big deal. You made wise capital allocation decisions.

If you have speculated on the greater fool theory, assuming someone will pay more for something without intrinsic value, you might be in a bad spot.

Business owners usually run their business to generate cash and profits. Maybe they plan to sell someday, but they know that future valuation will be based on profitability and/or liquidation value, not speculation.

When buying stock, consider whether you’d want to own the whole company if you could afford it.

Tax Day

Although the fiscal cliff crisis was resolved a year ago, the price of the tax increase was not clear.  Now that April 15th, tax day, is here, the impact can be assessed.  In the first quarter of 2014, tax receipts from individuals were up about 15%, for an additional $35 billion of Government revenue.  This is money that was not spent to help business create jobs.  This fiscal drag is reflected in consumers postponing purchases, and in many cases selling stock to raise the cash to pay their tax bill.  In contrast, last year tax refunds were up 15%, which might explain last year’s better than expected consumer spending and market performance early last year.

Last year’s fiscal cliff settlement raised payroll taxes and marginal tax rates for high-income earners.  Many exemptions and deductions continue to be phased out, and the maximum tax rate on capital gains was raised.  For many who pay estimated taxes, or pay through withholding, the increase was not collected during the year.  Finally, now in the first quarter of 2014 and the days leading up to April 15, the bill has come due.  The impact of the fiscal cliff is finally being felt with a one-year lag.

Moving forward, the worst may be behind us.  Consumer spending, first-time filings for unemployment benefits, (and the weather), continue to improve.  As the economy continues its upward trend and tax induce stock selling abates, the market may continue to track upward driven by improving corporate earnings.

The Market Correction of 4/10/14

Yesterday the stock market had a bad day. The S&P 500 index lost 2 percent and is now negative for the year. The NASDAQ was down more than 3%.

Bear markets and corrections tend to be shorter and steeper than bull markets generally. The cacophony on CNBC featured technical analysts drawing channels on charts showing how far above trend the market is. Using these minimum and maximum points to draw channels presumes that the overvaluation and undervaluation of markets, at extremes, is equal. I believe that is flawed logic.

In 2009, the bottom fell out of the market, in large part due to illiquidity. Leveraged funds were forced to sell what they could, which in many cases were the better capitalized public companies that predominate major indexes. I believe the overshoot on the downside, from panic and illiquidity, tends to exceed the wall of worry melt-up climb and climatic exuberance of bull markets. In other words, don’t assume the middle of the channel is the deepest part (to use a boating metaphor), or the best representation of intrinsic value.

Commentary was quick to draw comparisons to 2000 and 2009 corrections. I see little to compare. In 2000, valuations were about 50% higher on average than today. The internet bubble burst. In 2009, we experienced a banking crisis precipitated by a collapsing housing and mortgage market, with repercussions few imagined.

One legitimate concern today is the effect rising interest rates will have on corporate earnings and the economy in general. To the extent companies use debt to finance operations, and consumers use credit to buy from companies, the rising cost of money will be a drag on profits from the expense side, and consumption from the revenue side. That is certain to squeeze net margins, and suggests today’s historically average price/earnings multiples may be optimistic.

However, a big offset is the improving job and housing markets that point to a normalized economy. With improving housing and jobs, we may continue the slow healing of the economy from the mortgage crisis. As for yesterday’s sell-off, I see no need to panic. In fact, I see a clearance sale.