Archive for the ‘Changing Times’ Category

Market volatility is driving investors crazy, everyone seems
unhappy with almost everything (government, Wall Street, you name it). It is
enough to make me think people need to take a deep breath, exhale, and pause
for a moment.

We did not name our business Capstone by random assignment
or dart throwing. A capstone is a crowning achievement, a finishing touch if
you will.  If you
have carved out a meaningful life, our belief was that careful management of
your assets could improve your life (expanding your freedom and allowing you
time to allot to chosen goals).

It seems like people in the U.S. are currently concerned
only about jobs, money, taxes, and real estate. These are not the items which
comprise a meaningful life in and of themselves. The World Database of
Happiness shows the United States ranked 20^th in happiness.  The World Health Organization ranks us 37^th
in health care. We rank 14^th in education, according to a recent
OECD study. We are at best in the middle of the pack for homicide rates around
the world.

Shouldn’t we put some of our focus on improving these areas?
Wouldn’t that help us lead more satisfying and meaningful lives? There is still
a lot of wealth in our country and a pretty decent standard of living compared
to most around the globe. Perhaps a deep breath and a grateful nod to our
abundance could be useful every once in a while?

Yes, new year, new acronym!! But I think this a crucial one.  For years, the tenets of mainstream investing have involved buy and hold and investing based upon your risk tolerance. The mainstream is moving towards accepting the concept that buy and hold is not a winning strategy to always pursue.

Regarding risk tolerance, an aggressive investor was counseled to take more risk than a conservative investor. In mainstream portfolio management this really meant that the aggressive investor owns more equities and the conservative investor owns more fixed income. It is time to end this myth also.

First, we grant that the appetite for risk is a crucial ingredient in formulating portfolios. Someone whose goal is to grow their money at a faster rate will of necessity need to take more risk than someone who has a lower tolerance for loss or who simply does not need to grow their money as fast in order to meet their financial goals. The problem is that risk does not equal the proportion of equities and fixed income in a portfolio in a static balance. To make this traditional assumption is to totally ignore the potential reward of an investment!

For instance, Investment A has a potential loss this year of 15% of your principal. Should you make this investment? Would it make a difference to you whether the potential reward from this investment was 10% this year or 20%? It sure would to us!

The best way to understand the situation might be to look at the cost to purchase an investment per dollar of earnings. If it cost you $10 instead of $20 to purchase a dollars worth of earnings in the stock market this year, your reward is twice as large as when you have to pay double for that same amount of earnings. A rational person must include this in their calculations and be willing to adjust their risk accordingly. In order to grow money successfully, you increase risk when there is increased potential for rewards and decrease it when the potential rewards are smaller  We call this……. Variable Risk Investing (VRI)! We will be writing more on this topic in coming weeks and will also have some longer essays on this idea.

Near the end of last year, we saw a real gem on the internet. The internet job site Glassdoor.com had published some of the oddest and most difficult questions that job seekers were asked last year. This one caught our attention and we want to respond.

According to the article, a person applying to become an analyst at Goldman Sachs was asked:

“If you were shrunk to the size of a pencil and put in a blender, how would you get out?”

This really caught our attention as we were losing sleep over the very same question!! Really? Really? Your firm was in the mix of those who nearly brought on another great depression and that is what you need to learn about prospective employees? Why bother about fiduciary responsibility, ethics, morality, making sound decisions, or the Golden Rule?

Our mind wandered to the pharmacological state of the questioner? Would somebody grounded on our planet and able to pass a sobriety test really ask this of a prospective candidate? Probably not, but this is Hollywood……no, we meant Wall Street.

Next thing we know news broke of the questions surrounding the deal struck between Goldman Sachs and Facebook, involving Goldman Sachs’ wealthy  private clients. Take these sentences from the Facebook Offering documents:

“There may be conflicts of interest relating to the underlying investments of the fund and Goldman Sachs.” Material in the documents is described as “not guaranteed as to accuracy or completeness.”

Given what we have all gone through in our economic crisis, isn’t it good to affiliate yourselves with people who, if they were reduced to the size of a pencil and placed in a blender, could get out?

Well, we have all reluctantly survived another political campaign. The government has become the object of everyone’s scorn. They are at fault for everything that might be wrong in your life. Just two years ago everything wrong in America was the fault of banks, corporations, and Wall Street. It is always comforting to know who is responsible for all life’s ills, isn’t it?

In reality, we have transferred our debt problems from individuals and corporations to the government (this process is referred to by the dirty word “Bailout”). Why didn’t we ever blame individuals for any of these problems? That is simple. You don’t get many votes by informing the voters that they have made foolish decisions that are not sustainable. Nope, it is much better to blame “them” (the government or the corporations) for all of our woes. Ultimately, of course, we are the government and the corporations, but……..that is a small detail that can be easily overlooked.

The world of behavioral finance teaches us that a dollar is a dollar. We often ascribe different meaning to it (e.g. “government debt is worse than my personal debt”), but that is unrealistic thinking that leads us astray. We need to bring our books into better alignment. Our future cannot be one in which we continue to consume by spending money that we don’t have.

So, a simple idea. We must all admit it is pretty much an across the board problem that we have. People, corporations, and the government made bad decisions, spent money they didn’t have, believed that doing so was not a problem, and now the “chickens have come home to roost”. If all three conspired to cause this problem, then don’t all three have to be involved in the solution? By having a realistic discussion and a holistic solution, we could successfully address our long term issues. We can and must move forward together, learning to live within our means, deciding what that costs and how we will pay for it, etc. This means that we need to behave like…………….grownups!!!

We really don’t know where the markets are going from here. We are in a range bound market, where the only certainty seems to be that whichever direction we go for a week or two, we go back in the opposite direction with about the same velocity. Will the next breakout be towards the upside or downside? As market realists, we are totally stumped as to the answer to this crucial question. Will emotions reign? Rational thinking and valuations? Very hard to know at this point. But, what a cottage industry of guessers we are creating.

The Bears are out in force, making predictions that can make them famous. After all, don’t we all want to follow the thinking of the person who “got it right”. Bob Prechter is a well know follower of Elliott Wave Theory. More importantly, he is no dummy. He knows that if you make 10 predictions, you have a better chance of being right once and that people will forget the other nine predictions. So, a couple weeks ago, he predicted Dow 1000!!!! Ouch!!! Is that impossible? No, but neither was the prediction by bulls in 2000 of Dow 36,000. Both are highly unlikely outcomes to a realist, but they cannot be rule out entirely. Now, Prechter predicts a 20% decline in stocks as being on the horizon. This doesn’t negate his Dow 1000 prediction, but certainly gives him another chance to be a “genius”.  It is like the lottery-you want as many tickets as possible to increase your chance of picking a winner!

SoGen’s Albert Edwards is predicting an S&P 500 drop to 450, a drop of about 60%. Gold hawkers are out everywhere with their bear stories-that equities will crash, the dollar will disappear, etc.  These horrors cannot be ruled out by a rational person, but they are highly unlikely outliers in the future’s possible outcomes.

On the flip side, the perma-bears continue to function as always. It is always the right time to invest and they can always show you why. When desperate, they will find non-causal links that are mind bogglingly stupid (i.e. 7 times out of 10 the Dow rises by more than 20% when the New England Patriots lose their opener by more than 7 points)! Stocks are cheap they cry and the rally is just beginning. We rationale folks can’t rule out everything they say either.

Realists need to resist all this noise. Most likely the market is range bound today by one essential truth-the market has it pretty much right and stocks and other assets are pretty fairly valued. If that is the case, we can expect stocks to rise at a fairly slow rate in the coming years, but do it with a great deal of volatility, if that unfolds, we won’t have a new “genius” who made an amazing call on the markets meteoric rise or fall.

As those of you who follow our thinking know, we are hardly in the “perma-bull” category of the financial services world. We remain concerned about the fundamentals and valuations, along with the somewhat limited prospects for growth. We try to be realists, rather than bulls or bears.

Doomsday marketers are everywhere now and they are succeeding in their marketing efforts. One famous doomsday fellow predicts the Dow will fall to 1000! That would mean that stocks would fall by over 90%. If earnings were flat, that would mean that the return on your investment (earnings versus investment) would be over 50% per year when the market is at 1000.

We don’t know about you, but we would gladly put all of money into stocks well before our return would be need to be 50% per year. Alternatively, we might consider that earnings would have to fall 90% from current levels. As current earnings are rebounding from rather low levels, it is hard to imagine that scenario either. Anything can happen, but this is about as likely as being struck by lightning.

But the doomsday crowd is succeeding in frightening people and we are getting calls about how to invest in the likely fall of the market. We don’t say that a market crash is impossible or that a decline will not take place. We do say that profiting from a market decline is the most difficult strategy to employ and that the skill and timing required to do so successfully is daunting.

First, stocks have an upward bias. This is just common sense. A big company makes money every day, so it is literally “worth” more each day. The counter balance to this is that the market has over valued the stock (i.e. investors are paying too high a price in order to own part of the company) and so it will fall even though its worth is increasing daily. So, our common sense means it is relatively harder to make money on stocks falling as opposed to their increasing in value.

Second, let’s go back to the notion that we are market realists. One of our favorite market realists is Jeremy Grantham. He has long produced his 7-year market forecast with astonishing accuracy. He basically normalizes earnings and uses them to figure out likely returns over 7 years given current valuations. His latest forecast shows positive real returns (above the rate of inflation) for all stock classes over the next 7 years.

Many are below normal, but all are positive. These seven years will likely include some big plus and some big minus periods. But, if at the end of the day returns for the period are positive as he predicts, you are once again swimming upstream by trying to invest in a market fall.

We believe we are in a difficult environment and that you need to take more risk when stocks are cheap and rising and less risk when stocks are expensive and falling. To try to make money based on the doomsday scenario,…….., just doesn’t make much sense to us. It is betting on a long shot.

Finally we have bi-partisanship in the Senate!!! Senator Tom Harkin (Democrat, Iowa) was joined by Committee Republicans in approving an amendment to stop the SEC from being able to regulate equity indexed annuities. These controversial products are often sold by people who don’t understand them adequately to other people who are totally clueless about how these products worth. All for a big fat commission check, of course!

Senator Harkin is someone who has at times impressed us by seeming to stand up for the common man. Yes, at age 69 he now stands firmly against the people and for the insurance companies. He wants to make sure that one of the most abused products on the market is not regulated with rules to protect consumers. Iowa has a lot of insurance company employees and, we assume, contributes handsomely to the coffers of the Senator.

At almost 70 years of age, it is time for anyone to “do the right thing”. In this case, the right thing is simple and apparent to anyone. Yet, for a change, we are close to Senator Harkin and our elected officials acting in a manner that is to our direct detriment. Thanks a bunch!!

Yes, we have been repeatedly cautious about market valuations this year. We have said that prices have gone too far and too fast and that risks are rising as a result. We have sold some positions and increased our cash positions (because we did not see much that seemed compelling to buy). However, the speed and depth of yesterday’s market collapse was not something we foresaw at all. It was shocking to everyone, including us.

We did not see the market rising as quickly and steeply as it did in 2009 and now we certainly did not expect this rapid a drop. What can we learn from this? First, the market volatility of 2008 is not totally behind us. We still remain in a turbulent market, range bound in the long term but able to climb steeply and then fall sharply. It is a market best suited for hard work and diligent processes rather than passive investing.

The other problem from yesterday was the fact that we seemed to have computers running amuck. Much of the speed of the descent stemmed from computer trading programs, flash trading, etc. The passive investor believes the “market is efficient” and correctly prices stocks at all times. Yesterday afternoon, in that case, all American businesses lost more than five per cent of their total value in less than ten minutes and then regained most of that value over the next hour and a half. I don’t think even the staunchest advocates of efficient markets would like to defend that proposition. So, we had computers and people losing their grasp on reality and nearly causing a calamity worse than the oil spill in the Gulf. It seems to us that we need to replace some of the speed of computers with some more level headed market makers. Flash trades and High Frequency Trades take place on Wall Street in milliseconds. We don’t know about you, but we like to consider our decisions a little longer than a millisecond before we make them. If we don’t want to risk more meltdowns (or melt ups), we need to get some rational people back in front of the market, instead of just the computers that people have programmed to respond quicker that we can poor mortals can think.

We all know the story of the tortoise and the hare. Most of us have seen examples of  this concept in action at times during our lives. Now may be one of the times to see the tortoise beating the hare at investing.

Let take two investors, each of whom has $100,000 to invest. Investor A (the tortoise) gets 20% of market up and 20% of market downs. Investor B (the hare) gets 100% of market ups and 100% of market downs. Now, let’s add some volatile market returns (certainly not beyond the realm of possibility). The market goes up 50% and falls 40% in year 2.

Investor B has a lot more fun at cocktail parties than Investor A. Our hare (B) gets to brag about the huge returns in year one, while the tortoise (A) tries his best not to discuss his portfolio. Arithmetically, our hare ends up with a 5% annual average return (up 50% and down 40%). Our poor tortoise averages only 1% per year (up 10% and down 8%).

The hare, unfortunately, has only $90,000 of his original $100,000 investment left after year 2. Perhaps his excitement was worth $10,000 but we are not that interested in excitement here at Capstone. The tortoise has $101,200 to show for his investment. He averaged less arithmetically, had less excitement, but saw the return of his principal along with a small return on his principal.

When the odds of favorable outcomes are heavily on your side, it may be better to be a hare. When the odds are more neutral or against you, think hard about being a tortoise. The tortoise can make a bit of money in a turbulent environment while the hare loses his.

The debate rages on. The rise in stock this past year has caused the buy and hold folks to peak up from their gopher holes. They are once again touting their strategy (or is it the ultimate lack of strategy?). So, knowing that buying and holding the S&P 500 for the past decade was a very poor strategy, I decided to look back on an even more humorous concept, The Money Magazine list of 10 stocks to “buy and forget” for the last decade that they published in 2000.  A quick look at how we fared by buying and forgetting:

Stock                                       Price in 2000                          Price 12/31/2009

Nokia                                      $54                                          $12.85

Enron                                      $73                                          AARGH!!

Nortel                                      $77                                          $.002 (Wow!)

Oracle                                      $74                                          $24.53

Broadcom                               $237                                        $31.47

Viacom                                    $69                                          $31.50

Univision                                 $113                                        *(36.25)

Charles Schwab                      $36                                          $18.82

Morgan Stanley Dean Witter  $89                                          **$29.60

Genentech                               $150                                        ***(95.00)

• *Purchased by Broadcasting Media Partners in April, 2007 for $36.25 per share
• **Does not include value of Discover spinoff (not enough to avoid losing $$)
• ***Purchased by Roche in March 2009 at $95 per share

So, our version of the old joke- How do you become a millionaire investor? Subscribe to Money Magazine, cling to the buy and hold philosophy through thick and thin, have a 10 year time horizon, and……start with at least $4 million dollars!!!

Maybe take those buy and hold recommendations with a grain of salt???