Thursday, July 30, 2009

Is Now the Time to Buy Commodities?

Bert Whitehead, M.B.A., J.D. ©

Commodities are hot! When is the best time to buy?

Most of us are inclined to try to figure out the best time to buy an investment. However, studies by academicians, pension funds, and other objective sources, however, have shown that market timing never works. It is useful to know the three rationales for market timing to better understand why it is futile: the Past, the Present, and the Future. We also explain the alternative to market timing.

The Future: Doomsday scenarios are generally based on some ‘inevitable’ future event which is unprecedented although it may have some basis in truth. Buy commodities because the world is running out of oil! Buy gold because China has too much of our debt! Inflation will cause worldwide financial collapse…so buy commodities! Timing systems based on outlandish possible scenarios sell investment newsletters, and get headlines.

Sometimes a prediction will actually come true, e.g. in the early 90’s globalization and computerization were predicted to dramatically drive the stock market up. That did happen, but the Dow never got to 36,000 as some predicted. There are too many countervailing forces in the economy to predict the future, and exaggerated claims don’t come true because they are offset by other economic changes.

Real estate was supposed to crash by the end of the 1990’s because of demographic trends, e.g. the end of the baby boomer house-buying era. Instead, real estate boomed because more boomers bought 2nd homes, households became smaller, people live longer, immigration swells our population, etc. These other factors offset the expected drop in demand for housing. When housing did crash about 10 years later, it was totally unexpected by the experts – and caused by artificially low interest rates!

The Present; The ‘recency effect’ occurs when you expect that what ever is happening now, or has been happening, will continue to happen. When the stock market is falling, people generally believe it will continue dropping and run for the exits. When it is rising, people become convinced it will always keep rising and pile investment dollars on just as the market peaks.

The market seeks balance by testing extremes. If anything, it is likely that whatever is happening now will not continue, certainly not indefinitely. Again, other economic factors come into play that offset existing trends. Relying on current trends to continue is a financial recipe for heartburn.

The Past: Our whole investment industry is predicated on analyzing past performance of a stock, or group of stocks, or a money manager to determine future performance. As you probably know the tagline on every investment recommendation is: ”Past performance is no guarantee of future returns!”

There are long-term 15-20 year trends in the markets that are remarkably consistent over any 15-20 year period. For example, a portfolio of 50% stocks and 50% bonds over the past 80 years has averaged 8.2%. Interestingly, most of the 15-20 year periods during that time frame show an annual return in that range.

That is no guarantee that this long-term historical trend will continue, but it is useful for long-term planning purposes. Most importantly, a 15-20 year trend offers no clues about how you should invest your money now.

The Alternative: So if market timing based any of these three rationales is unreliable, how do you know whether you should invest in commodities now? We espouse an approach based on balancing your portfolio according to your particular situation. We do not predict or rely on timing of any exogenous factors such as oil prices, the likelihood of war, the possibility of a California earthquake, etc.

What is important is that your portfolio takes into account the endogenous factors in your life. This includes job stability, how many kids you have to send to college, the amount of risk you take outside the portfolio (e.g. owning a business, real estate investments, etc.). A key factor is: “How much risk do you need to take to reach your goals?” If you are comfortably retired, it is ridiculous to measure your portfolio’s suitability based on your rate of return…it’s more important to make sure you don’t lose what you’ve got!

Our approach is known as ‘Functional Asset Allocation.’ It addresses the reality that there are only three possibilities that your portfolio has to deal with: Deflation (what we are experiencing now); Inflation (which we may have to deal with next); and prosperity (which hopefully will return soon).

Treasury bonds are the absolute best protection against deflation. Yes, they always have a very low yield, but when deflation hits – ‘safety trumps yield.’ A good mixture of large cap, small cap and international stocks has proven to be the best approach in times of prosperity. Inflation is hedged by having sufficient cash reserves (since short term interest rate increase during inflation), having a long-term fixed rate mortgage, as well as unhedged foreign mutual funds or gold which protect against a drop in the dollar.

With these simple investments in your portfolio, you don’t have to guess what will happen next. Whatever happens, your portfolio will be able to handle and grow. This approach runs counter to the advice you get from the media and most investment advisors because they base their theories on the assumption that you want to get the best rate of return you can…and only they can help you time the markets. Maybe that is true of billion dollar pension funds, but for real people it is nonsense because you have a finite lifespan. Your portfolio has to reflect the realities in your life.

So what exactly is the function of investing in commodities? For ordinary people, investing in commodities is actually dysfunctional – it doesn’t reliably protect against inflation, deflation, or necessarily rise during prosperity. It is a gamble, pure and simple. I suggest that it is preferable to take the $25,000 you have been told to invest in commodities and take it to the craps table in Las Vegas. At least there when you lose it, they give you a really nice room and free dinners. Charles Schwab never does that…

Wednesday, July 15, 2009

What Have We Learned?

Bert Whitehead, M.B.A., J.D.

Who knows what will happen in the next few weeks, but the markets have bounced off their lows from March (except real estate…). Some say we are in recovery mode, but I’m not so sure. Maybe it’s time we take a deep breath and ask ourselves what we have learned from this experience. Here are 5 lessons most of use should have learned before, but had to re-learn.

1) This recession caught everyone off guard. Most economists didn’t see it coming, nor the government, not even the money managers who are always bragging about their superior market timing. There were a couple of experts who now are claiming that they did indeed predict this, and it is inevitable that some did accurately predict this.

So can we conclude that we should find out who these prescient money mavens were, and start doing what they tell us to do?

I think not. To begin with, market predictions are a lot like fortune cookies: usually they are a bit vague and so, after the fact, can be construed to be ‘right on the money.’ For example, a forecast in 2007 noted that “the market near-term can be expected to be very volatile and the winners will be not the stocks you would generally predict.” Looking back, that seems to be what happened…but it is hardly specific (or maybe you have to subscribe to the newsletter to get the specifics!).

It is obvious that if a newsletter publisher could predict the market, they wouldn’t be spreading their secrets – they would be making a killing trading stocks. “There is no ‘guru’ and many false prophets.”

2) When we think back to the earlier part of this decade, we all knew that the government was stretching to make mortgages affordable to increase the percentage of homeowners, a noble social goal. Maybe we shook our heads at how much the standards had changed, and how easy credit was to obtain. Of course the banks certainly knew what they were doing.

Now it is easy to see how this house of cards couldn’t last. But few could see the huge impact it would have in the financial markets. Most stock brokerages and financial advisors don’t even advise their clients on real estate. To them, the world of finance was all about stocks and bonds. Most consumers have to rely on commission-driven mortgage brokers. So that’s one thing we have learned: “Real estate is an important financial asset and people need good independent advice to make sound decisions.”

3) When interest rates started to rise, especially ‘safe bonds’ like municipal bonds, or GM bonds, it seemed to be very savvy to start chasing yields. Then we find out that these high-flying securities are much more risky than they used to be. This shouldn’t be a new lesson: “Higher returns always mean higher risks.” Often we just have to learn it again every ten years or so (remember dot-coms?).

4) Everywhere we turned frantic financial advice abounded: “Get out now, the market is going to tank!” “Now’s the time to buy – stocks are very undervalued!” When people ask me where the market is going, I review last week’s survey results of the 5% of the money managers who do 95% of the trading. Exactly half of them were convinced the market was headed up, and half were sure the market was going to drop.

The survey is run every day, and the results are always the same. Why? Because for every buyer there always has to be a seller…and one of them is wrong! It’s not the smart people selling to stupid people, because these 5% of the traders do 95% of the trades. The media is like financial pornography. They get you excited, and encourage you to act on impulse; you act on your ‘gut instincts.’ Then you are inevitably disappointed and discouraged with the result. Another lesson re-learned: “To be a successful long-term investor, you must ignore the investment media hype.”

5) If you were a prudent investor, you would analyze every investment or have your advisor do it professionally. There is historical data going back decades, and it is much easier to see the trends when the data is displayed in colorful charts and graphs. Alas, none of those trends forecast what would happen in the past 2-3 years. Could this be a new lesson learned(?):
“Past performance does not guarantee future results.”

Many investment models, including many derived from Modern Portfolio Theory, proved useless in this market. In our next blog we will review the defeats and successes of current investment theories…unless a more critical development arises which requires comment.