Tuesday, December 8, 2009

How to Spot a Bubble

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

If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?

I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.

Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.

The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.

In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.

Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.

China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.

This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.

Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.

Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.

What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.

We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Thursday, November 19, 2009

What Deflation Looks Like

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

For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?

Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.

For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.

The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.

These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.

The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).

Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.

Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.

The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.

Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.

Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!

What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.

Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.

We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Wednesday, October 14, 2009

Once Burned, Twice Shy

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

Investors are feeling almost euphoric. While the market hasn’t rebounded to a Dow topping 14,000 (where it was in Oct, 2007), it is up 58% flirting with 10,000 from the 6,500 bottom we experienced on March 9th of this year. This sharp rebound is a relief but can be scary in its own right.

SELL NOW! Many investment gurus are predicting another round of market
setbacks. P/E ratios (i.e. the relationship of earnings to the price of stocks) are high at about 20. (15 is considered normal.) Their observations focus on the negative realities we are still experiencing, such as unemployment, the housing collapse, and unprecedented government spending and impending inflation. The ‘smart money,’ they say, is going into hibernation or reinvesting in exotic currency and commodity offerings.

BUY, BUY, BUY! Other investment mavens are optimistic. On this side the ‘smart money’ notes that the steepest market drops are historically followed by higher and higher stock prices. The market is a leading indicator and is looking ahead 9-18 months. The stage is set for a global recovery and owning stocks is the place to be.

Who can you believe? Keep two things in mind: 1) the ‘smart money’ in both groups represents only 5% of the traders but accounts for 95% of the stock transactions every day, and 2) every day a ‘survey’ is taken, and 50% of the ‘smart money’ thinks the market is going up while the other half thinks it’s going down. It has to be that way, because for every buyer there must be a seller – and one of them is wrong!

It is enticing to try to forecast what will happen next, and the experts can be very convincing. Usually they focus on one or two factors that support their conclusion, and their position appeals to one of the two most dangerous emotions for investors: Fear and Greed.

Fear made some people jump out of the market at the end of last year or the start of this year. They panicked and sold all of their stocks. Perhaps they felt burned, yet satisfied knowing that they were ‘right’ as the market tumbled downward until March 9. Now many of them are kicking themselves for turning shy and not getting back in as they watched stock prices spiral upward. They wonder if they should buy back into the market now is it too late? Is the market due for a correction?

This is the market timer’s dilemma: they first have to decide when to sell. Then they have to decide when to get back in. So both decisions have to be right. Statistically, they will get both right 25% of the time; the other 75% of the time they will make an error.

If Greed wins out and they put everything back in the market now, they run a 50% chance of being ‘whipsawed.’ As soon as they buy back in, the market nosedives. So their Fear kicks into gear and they sell out again and take a large loss to avoid a huge loss. Then, of course, stocks skyrocket. I have experienced this myself. It is a very depressing experience.

Market timers can get so caught up in their timing schemes that the market takes over their whole lives. They constantly watch ‘the market’ and listen to talking heads expound while reading about the latest investment fad. In the end, they would be better off financially and emotionally if they had a clear plan and stuck to it.

We use Functional Asset Allocation, an investment strategy format that is designed for real people. It incorporates real estate as well as stocks and bonds/cash. We seek to balance the portfolio in relation to total net worth, rather than try to time the market. As we balance our clients’ investments, we want to lower their investment costs, reduce the overall volatility of the portfolio, and, especially, make their portfolio tax efficient. We make decisions about things we can control by understanding the difference between what is certain and what is speculation. We position clients to enjoy a ‘market rate of return.’

By using a 15year bond ladder with Treasury bonds, we provide clients with a safety net so they don’t have to time their investing activity. They keep their real estate, even when the market tanks. They continue to dollar cost average into the stock market when it falls and rises. By maintaining a balanced portfolio, our clients are always positioned for any economic environment. They have investments to hedge against inflation, deflation and to participate when prosperity returns.

An investment advisor once commented to me that we could get a much higher rate of return by using municipal bonds and junk bonds instead of U.S. Treasuries. I acknowledged that, if an investor can time interest rates successfully over a long period of time, the gains might offset the extra taxes and transaction costs involved. But I explained that all our clients need to do is to get a market rate of return. We don’t take the extra risks that are required to try to ‘beat the market.’ We sell sleep.

You may be a bit shy about getting back into the stock market now because you got burned badly during the last downturn, which was the worst in the last 50 years. The key to not getting burned is to adjust your expectations and have a balanced portfolio that is geared for your particular situation. It’s the best way to experience the rewards of long-term investing and protect yourself against emotion-induced investment losses.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Tuesday, September 22, 2009

The Inflation Bogeyman

Bert Whitehead, M.B.A., J.D. © 2009

“Inflation Adjusted” projections are the standard in the financial planning industry. I don’t use ‘inflation adjusted’ numbers, and haven’t for over 20 years. This raises eyebrows and sparks wonderment.

It’s not that I deny that prices increase over time and that the dollar becomes less valuable. The point is that inflation is not the key economic driver for real people, except perhaps those who are living at a subsistence level (keep in mind that the average household income is ~$50,000 per year). When gasoline prices spiked to over $4.00 a gallon, it is likely that you complained about it, but it didn’t really affect your lifestyle. But, if you were living on a subsistence level, expensive gasoline probably did take a toll.

Inflation adjustments became the rage in the 1970’s when oil prices, wages, and expectations devastated the value of the dollar. The financial planning industry, which encompassed mostly life insurance sales people at that time, found a terrific tool. By simply adjusting the inflation assumptions upward by 2-3% and projecting out over 30-40 years, it was easy to make a convincing case that you needed to buy more life insurance!

It’s like holding a yard-stick level while grasping one end in one hand. If you barely move your wrist so the stickmoves up by a teeny amount near your hand, the ‘long-term’ end of the yardstick jumps up a foot or two. Very scary.

Back then inflation was raging at 14-15% a year. Most financial planners made their projections using a 10-12% inflation adjustment. Being conservative, I used an 8% per year inflation adjustment. Some of my clients then are still my clients…so, tell me: was an 8% assumption too high or too low?

Most people, including professionals who have the benefit of a rear-view mirror, quickly respond that 8% was much too high. If compared to the actual annual increase in the Consumer Price Index (CPI), it was indeed too high – the actual rate of inflation over a 30-year period starting in the late 1970’s was in fact only 3.7%!

But when I meet with clients now who were clients then, their own ‘standard of living’ increased at about a 10% rate. Why? Because one spouse went to law school and the other became a tenured professor at a college, and their increasing affluence enabled them to move from a Chevy to a Pontiac to a Cadillac. Now they vacation in Europe instead of trekking ‘up north’ to camp. So the ‘inflation rate’ is not the predictor of future living expenses: it’s the increase in your standard of living that matters.

“But the dollar won’t buy as much in my retirement as it does now!” exclaims a client. Yes, that is true for the most heavily weighted goods and services in the CPI calculation. But when you are retired, you don’t need to worry about rising costs in education, real estate, or medical (assuming you have insurance or Medicare).

In my experience, retired clients in their late 70’s or early 80’s actually see their living expenses shrink – even if the CPI is increasing. Why? Because they have ‘been there, done that, and have the T-shirt.’ As we age we generally become less mobile. Keeping up with the latest fashions is no longer an imperative. Our cars last longer, and we keep our outdated computers and telephones longer, dreading the ordeal of having to ramp up another learning curve. Recent industry studies have confirmed this phenomenon.

Again, the real driver in financial projections for real people is your standard of living, not the U.S. CPI. Once you accept that fact, a key endogenous reality becomes apparent … financial independence depends on your own spending habits. Handling this is not difficult. Usually your earnings outpace inflation while you are working, and if you save 10+% of your earnings, your savings and market increases in a well-balanced portfolio will more than offset inflation.

There is a problem, of course, if your income increases substantially and you increase your standard of living accordingly. Movie stars, rock bands, athletes, etc. with meteoric incomes often don’t moderate their standard of living. They think their popularity will never end. When their gravy train stops, they are faced with bankruptcy.

The reason we focus on clients’ net worth rather than the return on their investments (ROI), is because it is net worth that should correlate with increases in standard of living. The rate of return on your investments is one variable that can affect your financial success. But other more important variables include how much you save (yes, even when you are retired!), how you manage debt, your spending patterns, and certainly how much you earn.

Money managers focus on quarterly investment returns (inflation adjusted, of course). They evaluate returns on their investment portfolio in relation to various stock indexes to justify their value-added in a client relationship. They are not comprehensive financial advisors and, to our way of thinking, they are tracking the wrong variable. Real people are impacted much more by how much they pay in taxes, how much they save, real estate decisions, and their spending patterns than by their investment ROI.

We focus on achieving market returns in a client’s overall portfolio. A market rate of return is usually all a client needs if they live within their means. Our “value-added” certainly includes keeping clients’ portfolios properly allocated with solid investments. But we concentrate first on what we can help clients control by helping them pay less taxes, manage their debt, recognize the risks they are taking outside their portfolios, and warn them about dangers they may face.

This is a long way from figuring out how much your inflation adjustment should be. Indeed, the Inflation Bogeyman is not as scary to your financial future as most people think!

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

Wednesday, August 26, 2009

Getting the Highest Yield Today

Bert Whitehead, M.B.A., J.D. ©2009

How can you expect to make money with your money when short-term interest rates are lower than you have ever seen? Short term Treasury Bills (T-Bills) for 30-90 days pay virtually zero percent. Lock in your money for 1-2 years and you can expect 0.5% to1.0% these days. As with every investment, higher returns mean higher risks. Let’s review your alternatives.

Bank C.D.’s – There is a significant spread in yields offered by various banks. Today you will find FDIC insured banks paying 1.0 to 2.0% on 1-2 year C.D.’s. This is twice as much as Treasuries are paying, and your money is still guaranteed by the US government, right? So what’s the catch?

There are a couple of minor considerations, e.g. interest from Treasuries is exempt from state income tax but interest earned on CD’s is not. Also, if you cash in a CD early, you are charged a penalty equal to 3 months interest. A short term ‘T-Bill’ cashed in early may be sold at a small premium or discount, depending on which way interest rates move – so this is generally a small overall advantage of T-Bills.

The biggest danger with high-yield CD’s is that the best yields are generally offered by the weakest banks. If the bank fails, the FDIC moves in and takes over and usually sells it to another bank. You are guaranteed to get back the balance of your account including accrued interest to the date the bank is closed (up to $250,000 now). Normally this takes only a short time, like a couple of weeks or less. But if there are problems (bad record keeping, fraud, etc.) your money could be tied up over a year – and you are not paid any interest from the time the FDIC shuts the bank down.

There can be other inconveniences, such as ATM’s shut down, checks not honored for awhile, etc. but that would not necessarily affect you if you only have CD’s at the bank.

Money Market Funds – These funds buy very short term commercial paper (30-90 days) and have been long considered very safe as they are committed to maintained $1.00 par value ( so you couldn’t lose your principle). But a large fund (Reserve) ‘broke the buck’ last year and the net asset value dropped to $.93. This set off a panic, so the feds stepped in and guaranteed deposits up to $250,000 until Sept. (since extended…probably forever). These funds are immediately available, but are paying generally less than 0.10% -- so on $1,000 you would earn $1.00 in one year.

Municipal Money Market Funds -- These funds hold very short term municipal bonds (less than one year maturity). Many municipalities have huge unfunded pension liabilities and are facing lower tax revenues, and so are considered ‘junk bond’ quality. They are paying less than 0.25% - so they really aren’t usually worth the bother for the extra risk/reward ratio.

Short Term Muni Bonds – these pay somewhat higher yield than muni money market funds, currently around 0.5-1.0%. Usually clients don’t have enough money to diversify buying individual bonds, so diversification provided by short term muni bond funds is attractive…of course the fund passes on their expenses so the yield is less. I consider this very risky because bond funds generally add lower quality in their mix to improve their yield. These bonds are so risky that current issues are not insurable. Consider that the state of California has had to resort to sending IOU’s to their citizens for tax refunds because they don’t have enough money.

Other High Yield Offerings – We are always glad to review investment options for clients, Most of the time there is significant risk involved in these offering. Some however merit consideration. For example, Schwab Bank is offering FDIC insured savings accounts that pay 1.35% (guaranteed up to $250,000).

Obviously Schwab only offers this to its own best clients, so they aren’t tempted to switch their deposits elsewhere. So you’re not likely to see it advertized to the general public. We can provide information and assistance to client who is interested in reviewing this option.

One advantage is that you can get a Schwab Bank checking account along with it so the funds are easily transferable on-line to other Schwab brokerage accounts or by writing a check to other institutions as desired. Keep in mind however that this is likely a ‘teaser rate’ and so it may be reduced without notice.

In summary, there are few good options to invest short-term cash. Unless you have a very large sum of cash I don’t think it’s worth the bother to hop from one bank to another to chase an extra ½% for three months. We do stay on top of this for you and monthly update the ‘Cash Options’ we maintain to give clients advice on current rates. If you have any questions or concerns, please contact your Cambridge Advisor.

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.

Monday, June 22, 2009

Maddoff Schemes and 5 More Financial Pitfalls

Bert Whitehead, M.B.A., J.D. © 2009

You probably know someone who knows someone who invested in Maddoff’s Ponzi Scheme. These ‘investments’ pay handsome returns, but not because the money is actually invested, but because investors who cash in on their ‘profits’ are paid off with cash received from new suckers.

With the recent market collapse, we are hearing of more and more of these frauds. That’s because these scams run out of cash when people take money out faster than new ‘investors’ are putting new money in. As Ben Bernanke quipped, “When the tide goes out, we can see who’s naked.”

This blog will discuss the Maddoff scheme as well as other classic ways investors lose money in investments -- and how you can protect yourself. Some of the safeguards I will discuss have been outlined in a series of articles by my colleague, George Marrotta, a Research Fellow at Stanford’s Hoover Institution which I have linked if you are interested in perusing.

1) The simple rule that Maddoff’s investors ignored is: “Don’t Let Your Advisor Have Custody of your Investments.” Maddoff’s investors sent their money directly to him; the paper statements they received were made up by him and his staff. Using Schwab or other independent custodians allows you to review your statement directly on-line at any time. Always make out your checks to Schwab with your account number on it, and check your statements to make sure the deposit was received. Cf. www.emarotta.com/article.php?ID=320

2) Even with the safeguard of having an independent custodian custody your assets, it is still possible to get embezzled. There were recently two cases which individual advisors stole several million dollars from client accounts. In these cases, the advisors had very elderly clients and instructed them to sign transfers from their Schwab accounts to the advisor’s account, or the advisor had check writing authorization on their account.

This of course could happen to any of your accounts at a bank. The safeguard is simple: Make sure you review your bank and brokerage statements yourself every month and review withdrawals and transfers out to make sure you know what they were for and you received the money.

3) As we get older, it is much more difficult to keep track of everything in our lives. Your finances are one of the first areas impacted by old-age forgetfulness. If you find yourself becoming confused and forgetful with your finances, it is important to have someone in your life that you trust to review your finances with you. They can double-check to make sure mistakes aren’t being made. Where we notice that a client is becoming forgetful, we will bring it up and suggest a neurological exam, since this condition can greatly impact your financial situation if not dealt with appropriately.

4) The biggest scam I see our clients exposed to are private investment ‘opportunities.’ These usually have very nice glossy sales brochures and a salesman/organizer with a smooth line of snappy patter. These often involve unregistered securities which are virtually impossible to evaluate because there is not adequate financial information, disclosures, conflicts of interest, etc. to work with. We suggest you don’t even consider unregistered securities, even with (or especially with) friends and family. Time-shares are one of these scams.

5) If offered the opportunity to get in on the ground floor, ask them to email you a prospectus or ‘offering memorandum.’ I review a number of these deals every month for clients. Then I explain the risks involved, how the money is being used including payment of the organizers, the conflicts of interest involved, etc. This is the information which is technically ‘disclosed’ but that most people don’t read or understand. Once these factors are explained, clients generally take a more sobering approach to these deals.

6) It is also important to recognize and avoid financial hooks. In many investments the salesperson earns hefty commissions. This is disclosed in the fine print which no one reads. One clue is that you are charged a hefty surrender charge or penalty to get out in the first 5-10 years. For more information, go to www.emarotta.com/article.php?ID=324.

I do believe that a financial advisor should save a client more than the advisory fee charged. Often the savings in taxes, lower investment costs, avoiding commissioned products, insurance evaluation, getting better mortgage deals, etc. produce savings which are readily apparent.

But over my 37 years of doing financial planning, I think I have saved clients even more money by talking them out of inappropriate investments and keeping them from getting scammed.

If you have been dissuaded from an investment by your advisor, I’d like you to let me know about it. I’d like to do a blog someday on ‘Investment Horror Stories!’

Wednesday, June 3, 2009

How Long Does It Take to be a Long-Term Investor?

Bert Whitehead, M.B.A., J.D. © 2009

This year’s market bottom in March wiped out all the market gains in your portfolio since 1996 (13 years)! This has left many commentators sniveling about the stock market as an inferior investment vehicle. But I’m sure everyone reading this has consistently been told that you have to be a ‘long-term investor’ to profit in the stock market.

So if 13 years isn’t long enough, how long is long enough?

When I started as a Financial Advisor in 1972 we were in the recession that started in 1967. The Dow hit 1000 in 1967 and didn’t get beyond 1000 again until 1982 (15 years). There was a widespread belief in the 70’s that the market could never go over 1000.

The financial pundits at that time subscribed to the theory that whenever stocks went beyond 1000, companies would always issue more stock. The additional supply would force the stock prices down, So the supply/demand curves intersected at 1000.

This year the market bottomed at 6600 in March ‘wiping out all the gains’ since 1996! But if you look at the peak in 1982 when the Dow was at 1000 and compare it to the peak in 2007 when the Dow hit 14,000, the market rose 9.8% per year ‘peak-to-peak over that 24 years. Clearly the ‘permanent market cap’ at 1000 the academicians theorized has been discredited.

Even measuring the ‘trough-to-trough’ bottoms from 607 in 1974 to 6600 this year (25 years), the market increased an average of 10.0% per year. On top of this add in the 4-6% in historical dividend payouts and the total average annual returns are easily over 12%.

The stock market has consistently been the most accessible investment over the long term! These kinds of returns are available to every person by simply consistently dollar-cost-averaging into a large cap indexed mutual fund over the long term.

Deciding not to invest in the market now, especially for younger people, could be the worst financial decision you could make in your life. And remember: you are younger now than you will ever be for the rest of your life .

This analysis explains why Cambridge Bond Ladders are for 15 years, rather than the 5 years many other advisors suggest. Fifteen years cash flow will last you through any recession. To fully reap the profits of the stock market an investor should have a 25 year horizon. That’s how long is long enough!

Tuesday, May 12, 2009

Inflation:The Next Scourge?

Bert Whitehead, M.B.A., J.D. © 2009

The stock market (S&P 500) closed on May 8 ahead of where it was at the beginning of the year. Since the low point on Mar. 9 it has risen 37%. Keep in mind that the stock market is a leading indicator. If recent trends are not a ‘false bottom’ the recession should end in 9 to 18 months, based on historical performance. Of course, we have been reminded that history is not a trustworthy predictor of future results…

There are other signs that the economy is starting to bounce back. Unemployment isn’t rising as fast as it has been, some companies are showing a profit. Consumer confidence is rising. Those are positive factors.

Nonetheless, we are still mired in deflation. Prices are actually dropping (social security recipients are startled that they are not receiving a cost of living adjustment this year). Every month there have been fewer people employed. More companies are going broke, real estate is still in crisis, banks and other financial institutions still haven’t been resuscitated. Now we are seeing state and local governments get in line for federal bailouts. The rest of the world also seems to be caught in this deflationary vortex.

Just as it seems like we might be turning the corner, the pundits are already spooking us about inflation. Inflation may be our next challenge, but further deflation is more likely for the near term and very possible for even the next 10 years. It looks like two of the auto companies are going to end up being owned by the unions and the government, and the financial industry has been in effect ‘federalized.’

Skeptics question whether business decisions will now be politicized, and determined by political considerations rather than by market forces. This could result in many new cars built to be small and energy efficient, which the government wants. But in the past buyers have spurned those in favor of larger vehicles. Will overseas auto companies move in to fill the demand? Unless gasoline prices go back to $4-5/gallon, most Americans want to buy their SUV’s. If Detroit won’t make them, someone else will.

If everything keeps falling in place, and recovery is in sight, we will have to deal with the trillions of dollars in government debt. The fed has been issuing a huge increase in Treasury bonds to fund the Stimulus programs. The concern is that, if and when we do pull out of this deflationary spiral, the world will be awash in US dollars.

This could result in higher interest rates which the government would have to pay to induce people to buy US bonds. Right now, the feds are buying bonds themselves to keep long-term interest rates (and hopefully mortgage rates) down. But at some point we will have to pay the piper. That means that this increase in the money supply will create higher inflation. Or will it?

As with most economic issues, there are too many variables to predict with certainty the outcome. If the dollar drops relative to other currencies, which we would expect with inflation, our goods become cheaper for people in other countries and our exports would increase. Because imports would be more expensive here, we would reduce our trade deficit.

During the 90’s Greenspan was baffled by the low inflation we experienced relative to the growth in the money supply. When he left office, he pinned it on the higher productivity the US enjoyed because we were able to outsource low productive jobs abroad. Generally high productivity which we typically see during recessions holds down inflation. During our current recession we have seen productivity increase, as companies shed less productive jobs.

Another factor is the savings rate of citizens. Japan had virtually no inflation in the 90’s when they increased their national debt exponentially to stimulate their economy. But because their savings rate increased, the extra money supply wasn’t spent and prices stayed level. We are now experiencing a significant increase in consumer savings, and we see a reduction in debt (partly because it’s too hard to get a loan now!). Unless the increased money supply is actually spent, there aren’t more dollars chasing too few goods.

The reality is that inflation will be our next threat if the government keeps spending at the rate they have been. There are factors which may absorb the impact of inflation, so it is not certain how much it will affect us.

In balancing portfolios to protect clients against inflation, we focus on the asset classes which provide the best buffers. Cash and inflation adjusted savings bonds are effective as their yield increases along with inflation. Mortgaged real estate is one of the best protections. While real estate is a long-term inflation hedge, it is too regional to reliably provide much protection unless it is mortgaged at a long-term fixed rate. Unhedged foreign equity mutual funds can be a buffer, except (as we have seen lately) world currencies have been moving up and down together. In some situations we recommend clients buy gold bullion coins.

Inflation is likely to drive interest rates higher, so some clients become concerned because the nominal value of their Treasury bonds drop. Not to worry: the bond will be worth its face value on maturity, and that is what we count on to provide the guaranteed cash flow for your retirement.

Many clients are taking advantage of the lower stock prices now to increase their dollar-cost-averaging into stocks. We are recommending to others that it is a good time to refinance their homes at lower rates to decrease their needed cash flow. When we meet with you next we will look forward to reviewing your portfolio relative to your current situation. We are proud that our clients’ portfolios have weathered this ‘storm of the century’ relatively unscathed and look forward to moving on with you on your journey to “FIPOM” (Financial Independence and Peace of Mind)!

Monday, April 27, 2009

Are We Turning The Corner Yet?

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

Finally we have seen some positive news on the financial front, and many optimists think we have hit the bottom and the stock market bounced off its low-point. It’s nice to be able to take a breath from the brutal onslaught of bad news over the past year.

We have been preaching about the dangers of being out of the market, even when it is falling, While it has been psychologically stressful to maintain equity positions over the past year, recent market activity points to the reason to refuse to market-time.

Interestingly, the average gain for the S&P 500 in the 1 year following the low close for the 8 bear markets that occurred in the last 50 years is +36.5%. The current bear market is the 9th bear market of the last half century. The closing low point (so far) of this 9th bear market was 677 and it took place 7 weeks ago on 3/09/09. In the last 7 weeks, the S&P 500 has gained 28.5% (not counting the impact of reinvested dividends.

Our clients pay us to ‘watch their backs.’ So without being an outright pessimist I think that we are still in a perilous financial situation. The future of the auto industry is teetering and we may see 2 of the ‘Big 3’ bite the dust in the next few weeks. The economic reality goes even deeper than that. We are restructuring our national economy to be able to participate in a global economy.

Our prosperity over the past 15 years was based on a world-wide spending spree, fueled by cheap credit and over-leveraged real estate. The current government nostrums are designed to spur more spending, but no meaningful programs have addressed the banking and real estate collapses. We see the impact of these issues everyday in the ‘For Sale’ and ‘For Lease’ signs in almost every neighborhood and commercial area.

Each client’s situation is different, and so the approach best suited to you depends more on what is going on in your own life. If the breadwinner in your family is out of work, or you have kids in college, or are faced with disability, or are retired (or hope to be soon) – these are the key factors in your investment allocation. While the stock market may look great, it is a mistake to be kicking yourself for having missed out on the steep increase recently.

For clients in transitional or distressed situations, we want to maintain an extra cash cushion. If your life situation is stable and your bond ladder is on-track, dollar cost averaging into the stock market is very advantageous. Now that tax season is over, we have scheduled appointments with each client to review your portfolio and make adjustments as appropriate.

It is a mistake to conclude, based on the past 2 months market activity, that you should now jump in with both feet. It is likely that we may not hit bottom until next year, and then it may take a couple of years to fully recover. Market timing is a futile waste of energy.

Treasury bond rates are low, and the feds are buying bonds to keep long term rates down, so it will be advantageous for many clients to refinance at lower rate (unless you owe more on your house that it’s worth). Jumbo mortgages (i.e. more than $417,000) however still carry very high rates and it is seldom worthwhile to refinance those.

This experience of living through the worst economic period since the Great Depression of 80 years ago will have a lasting positive impact on most of our clients. The losses will ultimately be recouped, and we are able to outlast even a continuing downturn. More importantly it has made many of us aware that we were frittering away money on things we didn’t really value. This lesson I think has to be re-learned by each generation as we discover that our Schwab statements aren’t the scorecard for our real wealth.

Wednesday, April 8, 2009

Best Case vs. Worst Case April 2009

Bert Whitehead, M.B.A., J.D. ©2009

How will this recession play out? I like to ask people that question (although many of them think I should know). I have noticed a strong correlation between a person’s economic outlook and their political leanings. The extremists on both sides focus on certain factors in the global meltdown to support their point of view. I’d like to examine the extremes on both sides and explain why both an extreme positive or negative outlook is at best a very remote possibility.

The Best Case: The Stimulus plan works as designed world-wide and the economy bottoms out at the end of this year. The rebound is very rapid so that the stock market is back up to 13,000 by the end of 2010 and unemployment drops to 5% and we all sing “Happy Days Are Here Again!” The government devises regulations for banks and oil producers with congressional oversight to control their profits and pricing. Taxes are raised on businesses, investors, and high income earners to pay for energy, education, and health care services while lowering the deficit with the increased revenue. Increased government spending causes inflation which threatens to get out of control.

The Worst Case: The worldwide economy reels toward collapse with the US government selling bonds to provide money to support an ever-expanding list of government-provided entitlements, bailouts, and subsidies. More pressure is applied to other countries to follow our lead, resulting in rising stagflation worldwide and hyper-inflation in some countries threatens to spread globally.

Gross Domestic Production world-wide drops precipitously. Higher tax rates to target the most productive sectors of the economy result in less total government revenue as sales and incomes drop. Small businesses close, or start operating under-ground. Unemployment rises and pushes the world into a global depression. Protests and crime increase as populations become more impoverished. War looms.

The Truth: Neither of the two above scenarios are going to play out to the conclusion. This economic cycle will end and we will recover at some point. Stimulus programs may do more harm than good, but we are not going to become a socialist country. The dollar will not collapse and putting all your wealth in gold or another currency to avoid being wiped out is nonsensical..

There are simply too many economic factors at work to be able to determine the outcome. Most changes in a free market are self-correcting, e.g. as the dollar weakens, more foreigners want to buy US goods, services and real estate, which ultimately strengthen our economy and the dollar rises again. Supply and demand result in short-term price swings as markets seek balance by testing the extremes. Lower beef prices mean more people will start eating beef, and then ranchers will grow more steers. The outlook is further clouded by completely unexpected events such as a California earthquake, or a war in the Middle East that shuts down 50% of the world’s oil supply.

Most readers of this blog have already been impacted by this recession, and those who haven’t yet are likely to be in the next year. The worst reaction, however, is to bank on an extreme scenario. It is just as foolish to sell everything you own to buy gold because some writer ‘proves’ that hyperinflation is inevitable. It is folly to put all your assets into real estate because it’s so cheap now, and you believe that the big turnaround has already begun. Home prices are still dropping, and I remember the wisdom of my father: “Son, never try to catch a falling knife!”

The proponents of both extremes have personal agendas that focus their paradigms. Politicians and government economists want us to believe that the trillions we are spending is a brilliant idea. Those who predict doom-and-gloom profit handsomely as stoking fear sells their books and newsletters. Emotionally it is easy for us to assume the short-term upswing in the stock market means the recession is over, or seeing the market drop 25% in a couple of months means we are headed to Armageddon.

The final outcome of this historical financial crisis will likely to take 3-7 years to work out, and I doubt that we will bottom out before 2011 or 2012. Political agendas of both parties were a factor in creating this circumstance. Many regulations now scorned were once endorsed by both parties, e.g. encouraging mortgages to provide home ownership for all Americans. This seemed like a good idea at a time but most see that financial regulations need to be adapted to suit a society where many people are very naïve in financial matters.

People on both sides of the aisle should be concerned and active in this conversation. Our political process depends on our input. But don’t let it ruin your life. Don’t let the extremists in the political arena and their counterparts in the financial media lead you to take precipitous moves with your investments.

Functional Asset Allocation takes your personal situation as the primary driver in allocating your investments. While changes will need to be made this year, we want you to be able to survive any economic trend. Our job is to make sure you can sleep at night.

Friday, March 13, 2009

Have the Rules Changed?

Bert Whitehead, M.B.A., J.D. © 2009

We are experiencing the worst economic crisis since the Great Depression, and we are likely to see further erosion. It’s a perfect storm brought on simultaneously by a financial crash, a real estate crash, and an economic crash. Investors who have always ‘played by the rules’ by diversifying their portfolios are confronted by the reality that all asset classes are collapsing, except for long-term Treasuries and perhaps gold. Small businesses are closing, real estate across the nation has tanked, and even the safety of banks and insurance companies are questionable.

So have the rules changed? Many investment strategies which have long been considered sacred don’t work anymore. The basic principles which we use in Functional Asset Allocation, however, are sound. That means that investment portfolios should be based on ‘endogenous’ factors that reflect the client’s individual circumstances.

Most investment strategies have been based on Modern Portfolio Theory. This assumes that the correlations of investment performance should be the dominant consideration in constructing and managing a portfolio. Investment managers all promised they could ‘time the market’ to take advantage of the next asset class which would out-perform the market.

Those strategies are always based on ‘exogenous’ factors such as interest rates, historical performance of stocks, oil prices, etc. Long-term US Treasuries have never been considered as the core of a portfolio, because brokers don’t make any money on Treasury bonds unless they are constantly being traded.

For our clients, we are re-evaluating the appropriate investment risk exposure based on each individual situation. The ‘invisible hand of the market’ has radically rebalanced our portfolios so that most are now heavily weighted in bonds and cash vs. stocks. We do not slavishly sell out bond ladders to boost the client’s exposure to stocks.

The current economic cycle has magnified the risks clients are exposed to. Job security is questionable, real estate values have plummeted, and businesses across the board are faltering. In reviewing clients’ portfolios we take we consider three primary risk factors:

1) How much risk does a client need to take to achieve financial independence, i.e. how much is enough? If you already have enough to survive this financial cycle, we will recommend that you take less risk in your portfolio than previously.
2) How much risk are you already taking? If you have your own business, or are subject to being laid off, or are concerned about becoming disabled, it is appropriate certainly to take less risk in your portfolio since these risks are greater now than last year.
3) How much risk is appropriate for your situation? If you have dependents, kids to send to college, too much leveraged real estate, etc. your portfolio should be more conservative. If you are single with a good job and in good health, you may want to be more aggressive. Note that this has nothing to do with ‘risk tolerance’ which is an unreliable and irrelevant factor when balancing a portfolio.

We generally try not to reduce clients’ exposure to market risk by selling off stocks and equity mutual funds despite market drops. This cycle will pass eventually and maintaining a position in the market is critical to rebuilding your portfolio. Clearly younger clients have a once-in-a-lifetime opportunity to achieve financial independence by dollar cost averaging in the market now through their 401-K’s and other pension options.

When extra cash is available, we want to reinforce or add to clients’ bond ladders where appropriate. And in today’s markets, a heavy cash position is often appropriate. We are also cognizant that the government stimulus, which is being funded with a flood of Treasury debt, will likely cause serious inflation down the road.

The problem is that the current deflationary cycle may last 1-2 more years, or possibly 5-10 more years. Rather than selling Treasuries, we are positioning clients for inflation by increasing their cash cushion (which will earn higher interest in inflationary cycles) and urging clients to remortgage their homes with 30 year mortgages if they can do so for a rate that is 1.0% or more less than their current rate.

We are monitoring the investments which are held by our clients, and may make short-term suggestions during your tax appointment or by email. After tax season we will be reviewing your portfolio with you in depth to identify the appropriate amount of risk we suggest in your circumstances and the corresponding rebalancing required in your portfolio. The market is so volatile and unstable currently that we are avoiding unnecessary market moves.

Occasional market rebounds, as we recently have seen, don’t indicate that this economy has turned around. A single swallow doesn’t mean spring is here. While most polls indicate that the general public is optimistic about the federal government stimulus and other bold intervention, the overwhelming consensus of the business and financial communities is very negative. Market reaction has exacerbated fear and panic among investors.

The concern is that government reaction to the crisis is not focused on the central problems: financial institutions and housing. It is the uncertainty whether massive splintered federal spending, knee-jerk regulation, and laws targeted to special interests is doing more long-term harm with little to show in short term gain. This recession is world wide with most countries even worse than we are, and international markets are now increasingly concerned about the stability of Treasury debt.

As a result we really don’t know which way the market and the economy is headed. Many government economists are confident that the recovery will begin this year, though more stimulus spending may be needed. Wall Street is generally more pessimistic, expecting this downhill slide to last 5 years or more. That would mean even lower interest rates, further stock market drops, and real estate stagnation. It is not prudent to guess at this point which way the economy will go over the next 3-6 months and make major shift in portfolios.

No matter what happens, we want to take whatever steps are needed to protect you financially. The rules of Functional Asset Allocation haven’t changed, but it is likely that your world is changing and we will make sure your portfolio is adjusted accordingly.

Friday, February 27, 2009

Five Stupid Things Smart People Are Doing With Their Investments

Five Stupid Things Smart People Are Doing With Their Investments

Bert Whitehead, M.B.A., J.D. © 2009

The collapse of the financial markets has sparked terror for many investors. It’s hard to watch your regular 401-k contributions invested in solid mutual funds, and then vanish each month. If you are laid off, the fear of depleting your savings is gut-wrenching. If you are retired, unless you have a bond ladder, you may be thinking of going back to work. If you were planning to retire soon you may be postponing those plans. None of these options are very desirable.

People being people, our financial decisions are often based on how we feel rather than a rational process. Often these times lead people to take drastic action. They hope to reclaim all of the money they have lost in one brilliant financial move. The problem is that such approaches to investing are blatantly stupid, and I have seen the wreckage caused in the past when clients decided to ‘go for broke.’ This is the Gamblers Last Gambit: one last grasp to win all the losses back in one grand stroke. Here are five ways I’ve seen this happen with investors:

1. In 2002, a client who had lost a sizable portion of his money on the dot-com bust, sold every stock he had left and put it in cash. Vowing never to invest in the stock market again, he stayed on the sideline in 2003, when the market increased 30%, and missed the chance to have his portfolio recover.
2. Just recently a woman left her stockbroker who had her over-exposed to financial stocks which lost 80% of their value. Then she took the rest of her money and decided to buy puts and calls herself to make up her losses. In less than 6 months, she’s lost most of what she had left.
3. Another couple last year decided to sell their Treasury bonds last year, because they had appreciated so much. They planned to hold on to the cash and buy the bonds back when interest rates went back up. Meanwhile they have been earning less than 1%, and interest rates continue to drop and they can’t afford to buy their bonds back.
4. Then there’s the fellow who withdrew all his IRA savings and bought lottery tickets so he could retire early. (OK, he had brain cancer, so that’s an excuse).
5. Finally, there was a very smart financial advisor I knew in the 1990’s. He became a fan of the doom’s-day prophet of the time, and convinced his clients to sell all their assets and buy gold. He also did this with all his investments. (Not a good move in the ‘90’s!)

Now financial gurus are touting gold, or risky investment strategies, playing on investor’s fears to induce them to pay them for their secrets. Every stockbroker wants people to sell their Treasuries and let them invest the money = “Give me your money and I’ll make you rich!”.

Your situation is unique. We understand the broad context of your life situation and tailor your investments accordingly. It is futile to try to ‘hit a home run’ in this economic environment.

It takes patience. That’s why stocks are called long-term investments. For younger clients this is the best opportunity for you to guarantee your retirement. With stocks so low, continuing to dollar-cost-average now is a once in a life-time chance. For retirees with bond ladders, you have a 15-20 year investment horizon if you just wait for the economy to rebound. Taking sudden action now is folly.

The best thing to do is to stop listening to financial news on TV, reading the ‘ain’t it awful headlines’ and always looking for a guru to tell you the key to financial success. If anyone knew that, which there isn’t, they wouldn’t tell you because if everyone did it, their strategy wouldn’t work anymore. Face it: they make money selling newsletters to incite greed and fear. If you want to get rich quick, start your own newsletter!

“Fools rush in where Angels fear to tread.”

Tuesday, February 17, 2009

Danger: Inflation/Stagflation Ahead?

Danger: Inflation/Stagflation Ahead?
© 2009 Bert Whitehead, M.B.A., J.D.

Now that the ‘Stimulus Bill’ is in place, how is the government going to pay for all of these new programs and tax cuts? Anticipating the need for additional funds, the Treasury has already begun to issue more Treasury securities* and has scheduled more auctions. So if the government piles on more debt, does this increase in the money supply mean we are on the brink of hyper-inflation, or a return of the ‘stagflation’ of the 1970’s?

Not necessarily: if our nation’s productivity increases in tandem with the money supply, inflation is not likely. In the ‘70’s we had declining productivity combined with entrenched inflation, and the result of high unemployment and high inflation was dubbed “stagflation.” Normally in the beginning of a recession, there is an increase in productivity since production does not drop as fast as employment. For example, in the last quarter of 2008 productivity rose 3.2% in the nonfarm business sector, as hours fell faster than output.

As new employment is stimulated, the plan is to be able to increase productivity simultaneously. There is some concern that, since the jobs initially funded will all be in the public sector, productivity will fall (since productivity only measures business, non-farm business and manufacturing output). Keynesian economics, which is the theory this strategy is based on, projects that the stimulus to the public sector and government spending will ignite private investment and job creation. There is broad disagreement as to whether this worked for FDR in the 1930’s, since the depression didn’t actually end until we entered WW II.

If it doesn’t work, we may well go into a prolonged recession, like the ‘lost decade’ discussed in my last blog. If it does well, the business sector will hopefully recover in a couple of years and start creating new jobs and we will again enjoy prosperity. But government does not create new jobs. If the jobs which are funded are to continue, the government has to keep funding them.

So the danger of inflation will depend on whether we end up becoming dependent on deficit spending. If our economy is worse in 2-3 years, there will be many who will argue that we didn’t spend enough, and insist on increasing government subsidies. This would be aggravated if businesses can’t get back on their feet and unemployment increases. This could produce very painful stagflation.

We don’t know if we face inflation/stagnation, or recession and a dead decade, or reignited prosperity. We don’t do market timing; we seek balance. Our clients are protected by long-term Treasuries if deflation continues. We keep our clients’ positions in equities so when the economy does recover, they will participate in prosperity. So now we are reviewing our client’s portfolios to make sure they will withstand inflation.

Gold and unhedged international mutual funds in the past were bulwarks against inflation. Now gold can be easily traded through ETF’s and so it has become very speculative, which would not be dependable in inflation. Being diversified with international holdings may not be effective since inflation would likely be worldwide.

Having a fixed rate mortgage on your residence is a very effective offset to inflation. Interest rates parallel inflation, so even if you parked the mortgage proceeds in a money market fund, high inflation would raise money market rates. Plus there is an advantage in paying off your mortgage with cheaper dollars.

In recent years, the US Treasury has started issuing ‘TIPS’ (Treasury Inflation Protected Securities). The interest rate on these varies based on the inflation rate. These are not a good replacement for your bond ladder, since they don’t offer protection against deflation. A strong strategy to protect against inflation, if you don’t have a mortgage on your house, is to take out a $300,000 mortgage and use the proceeds to buy TIPS.

Finally we recommend that clients keep an extra cash cushion in this volatile economy. While short term interest rates are low now, cash does provide insurance against higher inflation since interest rates would increase in lock-step. Clients with uncertain job prospects or high expenses looming should maintain additional liquidity. Cash also enables clients to be nimble in these uncertain times and handle unforeseen emergencies without decimating their portfolios.

If you would like to discuss these issues more to see how your portfolio would be affected, feel free to call your Cambridge Advisor for an appointment.

*Treasury Securities include:
Treasury Bills = 1 month – 2 years
Treasury Notes =2 years – 10 years
Treasury Bonds = 10 years – 30 years
This is the only distinction between Treasury bills, notes, and bonds.

Monday, February 2, 2009

Past Performance is No Guarantee

Past Performance Is No Guarantee…
by Bert Whitehead, M.B.A., J.D. © 2009

In the past 75 years (1934-2008) the S&P stock index has suffered total return losses of more than 20% in four different calendar years, the most recent was last year’s 37.0% decline. In the year after the three previous 20%+ declines, the index gained an average of 32%.

The danger of liquidating stocks now is when the market does turn around it will likely be very sudden. Investors who seek an all-cash haven will miss out on the growth

Most clients have bond ladders with US Stripped Treasuries that have appreciated significantly. It is tempting to sell the treasuries to reap the capital gain now, and plan on buying them back when interest rates go back up.

We don’t recommend selling as the bond ladder gives you certainty. If this recession comes to an end soon, increases in stock values will allow your portfolio to correct itself. If the recession persists, however, you will not be able to replace your ladder for the amount you sell it for now.

There is a 20-30% chance that we may be facing a ‘Dead Decade.’ This financial phenomenon is rare, but it does occur. Japan went through a ‘Dead Decade’ in the 1990’s. The Nikkei stock market dropped from 37,000 to 10,000 and never closed above 15000 for 10 years. At the same time, interest rates dropped in Japan to 1.0-2.0% even for long term government bonds.

We don’t try to time the market, and are not predicting that a ‘Dead Decade’ is in store for the US. However, we do plan for a prolonged economic squeeze, which may well suppress interest rates even below current levels. This is the most dangerous possibility we may face.

While the changes we are experiencing are exogenous, many clients are feeling the effects endogenously. We are stressing to keep high liquidity during this post-election turmoil, and not selling long-term investment assets. Each individual’s situation is different, so your investment portfolio must take into account the risks which you may face.

It is easy to believe that the past will be repeated, but when it comes to the market, history is not a reliable predictor of future performance.