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Don’t Celebrate the New Market High!

by Ted Schwartz

As we near new “all-time highs” for the Dow Jones average, the financial services community seems about to throw a party. I say leave the champagne on ice! I don’t want to be a curmudgeon, but…..

The very lowest bar for any investor is the rate of inflation. If your investments don’t at least keep up with the rate of inflation, you have lost money in terms of real buying power. There is no reason to save if you do not at least keep your current buying power.

So, the Dow all time high was reached in October of 2007. The website has a calculator that computes the inflation from then through January of 2013 at over 10%. So, if we hit a “new high” it will mean that market losses over the past five plus years are all the way down to 10% in real terms! The clock will continue ticking on inflation, so who knows when you will finally really break even in this market. Hardly seems like a reason to celebrate to me.

Do Investors Understand Risks and Rewards?

By Ted Schwartz

I am a long term believer that good investing is a balancing act of evaluating how much you expect to make from an investment and how much risk is involved in trying to make that return. I believe this is a dynamic and changing calculation. When investments are expensive, your risk will increase and your expected return will drop. Not a good idea!

So, I was shocked to see the money flows for 2012 in mutual funds. About a hundred billion dollars went out of Equity Funds and into Intermediate Term Bond Funds. The expected returns for these bond funds are near an all-time low at this point. Their coupons (the amount paid to you in interest) are often about the same as the expected rate of inflation. So, in real terms you get nothing from that component. The only way you could make any money on the valuation side would be for interest rates to decline even further. This is not impossible, but there is not much room for further rate decline. History says rates will rise, the only question is when. That means the potential returns on these investments are very, very small indeed.

The risks? Due to rates being so low, relatively small increases in rates would likely cause relatively large declines in bond prices. A one percent increase in interest rates (still leaving us well below normal) would likely cause a loss of 5% or more in bond values. A two percent change would likely elevate this to double digits.

Why take the risk of these losses to potentially have such a small return on your investment? That is the question for which I cannot find a good answer. Anyone?

A Fine Whine


By Ted Schwartz

This week I met with two very bright individuals who parroted the CEO cry that we “need certainty” before the economy will improve and companies will hire people. At the same time, I am reading Taleb’s, Antifragile. His whole point would be that things in life are not predictable and actual results often do not even approximate the outcomes we think are possible. Taleb would argue that certainty is a bad thing, making us more fragile to the problems that will inevitably crop up in the future.

For me, the whole notion of certainty being a necessity goes against the grain of everything I know. The rationale for why entrepreneurs can earn more than employees is that they are taking a risk. The reason equity investors make more than fixed income investors is referred to as the risk premium. You expect to earn more due to the increased risks you take. Now, the cry is that we have to be assured of future results and of what taxes we will owe on our profits. We now refer to things like “making the tax cuts permanent.” The chart below shows the changes in the maximum marginal rates since 1913. Does this look like we offered “certainty” and low taxes up until President Obama arrived on the scene?


Let’s not forget that we experienced a huge amount of growth during the period since 1913. During this time frame we also experienced almost 20 recessions. Yet, we did not have entrepreneurs constantly saying they would not hire or invest unless they were given certainty of results. It is the cry of the 21st century entitled, “the successful class must be assured results before taking any risks.” It really can’t work that way.

Musings for a New Year

By Ted Schwartz

We begin the New Year with a market surge due to clearing the lowest hurdle imaginable. The “Cliff” agreement pleases almost nobody and solves almost nothing. Yet, the markets are right to rejoice this very small step. My belief is that the vote really tackled only one question, one not relating to wither revenue or expenses. This was an up or down vote on whether public officials were willing to compromise in order to do the people’s business. In the Senate, 90% of both Republicans and Democrats voted yes to this very simple and basic notion. In the House, we passed this on a much closer vote and almost refused to vote on it at all.

The question of whether we can move from this very simple vote to ones that actually address revenue and expenses in a meaningful way lies ahead. It is not very heartening that this first step was so difficult to get behind us.

As we look to the New Year, we are cautiously optimistic. Not being in the business of forecasting, we can none the less check the current conditions of the economy. Things are slowly improving on most fronts. Housing and other economic measures show slow improvement at this point. The stronger positive for the market is the relative rewards offered investors for owning stocks versus other investment opportunities. Stocks are somewhere around their long term average expected returns while safer investments continue to offer their lowest returns by historic measures. It is not a stretch to say that safe investments (CDs, Treasuries, etc.) offer a negative return when you factor in inflation. So, we believe investors have to accept the risks of owning equities in order to attempt to have positive growth from their investments.


In terms of our Tortoise (the well diversified portfolios that we endorse) and Hare (the equity market as represented by the S&P 500 Index) last year, the Hare won by a convincing margin. Despite a small loss for the fourth quarter, the S&P closed the year up over 15%. That far outpaced the returns for commodities and bonds for the year. The Dow Jones Moderate Portfolio Index (representing a well- diversified portfolio) was up just over 2/3 of the S&P for 2012. For two years, it is up a bit less than 2/3 as much as the S&P 500 Index. For three years, the diversified portfolio trails the S&P by about 20%.

So, isn’t it time to hitch our trailer to the S&P and take off? We think not!! The tortoise still wins by not losing as much. For five years, the Dow Jones Moderate Portfolio Index doubled the return of the S&P 500. For ten years, it has outperformed by almost 20% (and that excludes the bear market of 2000-20002). The Tortoise wins and… avoid a lot of ulcers on the voyage. If you truly believe we have finished a secular bear market that began in 2000, you might advocate increasing risk in order to capture more returns. We see no evidence that we have begun a bull market, so….we will continue to be a Tortoise in 2013 and the foreseeable future. The Tortoise has many more ways to succeed and win the race.

The name Capstone was chosen many years ago and was a very purposeful choice. The name was selected because we wanted to convey the idea that what we offered was quite necessary (“a crowning achievement”), but was not sufficient in and of itself.  Money and its accumulation are very important to our clients, but they do not define their success nor are they equivalent to a successful life. A well-managed group of financial goals and a sturdy plan to implement them help a person be “anti-fragile” to borrow an idea from Nassim Nicholas Taleb. A super-diversified group of assets helps you avoid vulnerable economic outcomes as you age.

Since selecting this name many years ago, we have only seen more and more of society concentrating on money as the only issue of merit. Financial cliffs, political squabbling, education as only vocational training, etc. give us a short sighted view. As we look to the future, we must not lose sight of the more important things in life. Let’s relook a quote from Robert Kennedy in 1968:

“Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans.”

That is the essence of why we chose Capstone as our name. We help you add a crowning piece on your life plan, but we do not deal with the areas that truly define you and your value. We believe our service is of great utility, but we cannot replace those moments that make your life a joy. We wish you a very happy and prosperous New Year as you head a bit further down your path. We look to the New Year with considerable hope for the future. Things continue to improve slowly (with far too little help from our public servants).

A look ahead to 2013

By Ted Schwartz

Well, it turns out the world did not end on December 21. Shocking, isn’t it? So, we have to look ahead to what we might expect in 2013.

Dr. Doom here is actually mildly optimistic. We are not in the business of forecasting, but we think taking the patient’s vitals does give you an idea of what his condition is. So, we have many risks due to the inability to agree on public policy as I pen this. However, even the lowest expectations that I have for our public servants does not entertain the likelihood that they will plunge us into a recession on purpose as opposed to finding at least a half-baked solution to the fiscal cliff.

Once that is behind us, I see a slow positive momentum building. Things are getting better, though not quickly. Housing is showing signs of having bottomed and that should help along with generally improving conditions elsewhere. The biggest threat to the markets may come from over confidence and high expectations rather than actual problems. The backdrop that I see propelling markets is a beginning of money flowing towards rather than out of equities. They are fairly valued while bonds are way overvalued. We believe this will cause investors to realize the equity risk is more appealing at this point than the risks of bonds given their extremely low yields. Despite the fears around taxation of dividends recently, we believe that investors will find those dividends appealing versus the yields they can get in fixed income.

Unfortunately, we think we will not see serious solutions to our long term problems discussed or implemented in 2013. That means the next “Black Swan” will continue to lurk in our future and may even find some nourishment next year.

Election Distortion

By Ted Schwartz

If you tune in to politics recently, you are encouraged to take sides in a false dichotomy. You are asked to choose between the people who believe in the free market and the people who believe in government (AKA “Socialism”). This is an absurd choice as both paths would lead to total destruction. Unfettered free markets are not in place to deal with long term societal issues. The government is not in place to deliver optional goods and services to people in an efficient manner. So, fortunately, we have a hybrid system that attempts to carve out a middle ground that allows us to muddle through. So, the real question for this and every election is, what is the optimal mix going forward of government and capitalism.

Free market capitalism seems to be the optimal system to provide goods and services to people. As its focus is primarily on profitability, a layer of regulation is necessary to protect the health and welfare of the public. Too much regulation can harm the market system and too little leads to toxic excesses (see 2008!).

The government’s main role is to look after society’s best interests now and in the future. That includes many complex and unprofitable tasks (how do we protect people from fire, workplace safety, what goods and services should we provide to poor children, how do we protect the earth for future generations, what infrastructure is needed to support the private sector).  These big picture items are beyond the scope of the market economy. Some tasks offer no hope of profit ever and some offer no current profit so will be shirked by the market economy.

Both the government and the private sector have a tendency towards waste and excess if left to their own devices. We, the voters and taxpayers, are charged with closely monitoring these systems, serving as a check and balance to unfettered power, and ultimately choosing where we should set the mix of government and private enterprise to maximize outcomes. It is a very tough and very important decision that we face, but it is not the decision bandied about on television and in the media.

Give Bill Gross an F in Financial Physics!

By Ted Schwartz and Kevin Starkey


Bill Gross has always been one of the few voices that we at Capstone believe is worth listening to. The world’s largest fixed income manager got that way through solid performance over decades. His thinking is usually lucid and his worldview often intriguing. As other financial industry talking heads are peddling something and Bill sells fixed income, could he be selling something new?

That said, he seemed to fall off of a turnip truck this week. He forecasted anemic real GDP growth of 1.5% per year for the US for the next decade. We are not forecasters, so will not take issue with this gloomy forecast.  However, he went on to say that “if real GDP grows at 1.5%, then a diversified portfolio of stocks and bonds would probably grow at 1.5% as well.”

While GDP growth would certainly be correlated to expected stock returns, the 1:1 correlation that Mr. Gross throws in to the equation has been pulled from thin air. The long term growth rate of GDP is rather consistently around 3% per year. The long terms real return of stock is around 6.5% per year. In other words, stocks have historically grown at a rate far higher than GDP.

Why would this be true? Well, financial physics is about the basics of return on equity. As companies are already earning money every day as we enter Mr. Gross’ 1.5% decade, the companies have earning that are considerable to add to their bottom lines before we consider growth. Companies can 1) distribute money they earn through dividends; 2) they can use it for share buybacks that should increase stock prices; 3) they can use it for expansion, acquisitions, and debt reduction which should increase net earnings. All of these choices should yield shareholder returns well in excess of Mr. Gross prediction of GDP growth. So, even with his dire prediction, we may hope for returns that are rather paltry but well above Mr. Gross’ calculations. Stay tuned for the pitch!