Archive for the ‘View on Market’ Category

OK, that wasn’t there real name (it just sounded similar)-but it should be! We received an email today from a money manager headlined by their recent returns- plus 15% in 2009 and plus 34% in 2008! Wow, who wouldn’t want to use a company with the foresight and skill to come up with those returns over the past two years!!

Charlatan then proceeds to give you more info on their marvelous returns going back to 2004. When you come to the disclosures at the bottom (you know, the small print that nobody reads), things start to get a bit alarming. First is this potential problem- “ The performance data represents a combination of hypothetical and actual past performance.” Oh? This isn’t all their actual performance? That could be a problem.

“Returns are presented net of an assumed annualized investment management fee of 2.75%, deducted at a rate of 0.6875% quarterly.” Wow, they do have these terrific returns after fees, but that sure is a high fee for money management. We would say they are more than double what fees should be in order to be a fiduciary and put the client’s interests first. But still, they made you all that money in a horrible market after their fees!

Then much further down in the disclosure is the explanation of the combination of hypothetical and actual past performance. “All results prior to October 2009, rely on backtesting. Backtested performance is purely hypothetical and does not reflect actual trading in clients’ accounts. Results were achieved through retroactive application of a strategy that was designed with the benefit of hindsight. Accordingly, these results should not be viewed as indicative of the adviser’s skill.”

Oh my God! From 2004 to now, the actual data started in October of 2009. All the rest of that skilled approach we can pay an outrageous fee for- “purely hypothetical”. Any idiot can put together an investment program that is marvelous for any past period. Hindsight-always 20-20. How will it work in the future? Probably not too well, judging from our hypothetical projections!

Our question is-if the SEC is supposed to protect clients (and advisors who don’t read well or think clearly), why is any Registered Investment Advisor allowed to send out any data that isn’t their actual performance. Performance means, according to Merriam-Webster, something “accomplished”. Hypothetical performance seems like a contradiction in terms. Something accomplished, but in this case we are just pretending that we accomplished it. Come on, SEC. Let’s protect somebody!

In the end, 2009 was a year for the markets that truly surpassed everyone’s wildest dreams. When markets were down almost 30% in March, there was nobody out there who saw a year in which the S&P 500 would finish with a positive 26.5%. We were amongst those who saw a buying opportunity. We were buying for what we saw as a positive opportunity that would play out in a one to five year time frame. For it to play out in a nine month time frame was beyond anything we considered.

Despite the fantastic finish of 2009, the S&P is still off 24.9% from its October 2007 peak. That is still a huge drawdown (i.e. loss from peak to now) that investors cannot afford. That is why we still believe that active investment management using a wider playing field than the traditional stocks, bonds, and cash is required in order to help you achieve your financial goals. Our management style has worked well through this period and we feel it will continue to produce results in 2010 and beyond.

In terms of what to expect in 2010, we do not know what the market will serve up. There is still momentum in the equity market and lots of money on the sidelines that could push prices higher as it comes into the market. It is our feeling, however, that it is a time for caution. While very high quality investments seem to be priced around their historic averages, poor quality companies seem very expensive and at risk of a large tumble. So, we believe that quality large companies are the area to overweight going forward and low quality investments should be underweighted.

We expect there to be some opportunities to enter into investments at low prices as the year goes on. As always, we will try to take advantage of inefficient market pricing of assets.

Lastly, we want to thank each and every one of your for your loyalty and faith in us over the years. As we look at the millions and millions of your dollars that we are entrusted to manage, we are truly honored by your commitment to us. Every day we feel fortunate to be where we are in this difficult environment and seek to continue to earn your continued loyalty. We really mean it- Thank you!!  

You got to know when to hold ‘em
Know when to fold them
Know when to walk away- Kenny Rogers, The Gambler

It was a year that came in like a bear and went out like a bull. All told, that left us with a surprisingly strong bull year. When the days were darkest, we think investors panicked and sold when assets were the cheapest, best buys we will see for a very long time. How else can we explain investors dumping GE stock for less than $6 a share? Oh, but that was months ago and memories are short. We now have investors willing to drop their money on assets that look very risky to us. What will 2010 bring us? We think it will most likely bring us some more big ups and downs on the roller coaster.

Is it time to hold ‘em or fold’em? As an intelligent gambler, that should depend on what you are holding. It is, in our opinion, no time to bluff when you don’t have much in your hand. Look to take some profits in areas like high yield bonds and stocks with little or no earnings. If you are holding some aces, we would stick with them for now. Keep your eye on the game however. If is turns against you once more, don’t be afraid to fold ‘em and live to fight another day.

It was a terrific year which did much to restore account values. However, it appears unrealistic that this bull run can go on too much longer. As we move from underpriced back to overpriced, the odds start to stack up against us in the short run. Be careful and thankful as we welcome in a new year!

As those of you who have been acquainted with us for long know well, we believe avoiding the Style Box approach to investing that is promoted by Morningstar is the best thing you can do. Style boxes provide very little true diversification and drag down portfolio results by as much as 3% per year.

Now, Advisor Perspectives has published an interesting study showing that the Morningstar Star Ratings fail to predict performance through a market cycle. So, moving from a “3 star” fund to a “4 star” fund is no better than flipping a coin to decide which fund to hold. Russel Kinnel of Morningstar admits the star rating is “not a forward looking measure”.

This finding does not surprise us at all. Investing with style boxes and star ratings using a rear view mirror approach is a losing concept, particularly in a secular bear market. You need strategies and tactics that make sense moving forward, emphasizing return of capital as well as return on capital.

Should you be a buyer or a seller between now and year-end? That seems to be the question on everyone’s mind as we enter December. The answer is, of course, that it depends. If you were wise enough to invest early in this bull market you should be considering peeling back some risk at this point.

That is, reducing your level of investment in high yield bonds and/or low-quality stocks. We would not advise abandoning them altogether but taking some reasonable profits. If, on the other hand, you are late to the party and are now thinking about taking money from the sidelines and placing it back into the market we would suggest you do that with caution. Specifically, you don’t want to chase gains that have taken assets to above fair value. Many parts of the market are currently overheated and likely will not produce above-average results going forward.

Looking at it in another way, you need to determine whether the odds are on your side or against you going forward. They certainly don’t seem to us to be strongly in your favor. On the other hand, we certainly have no reason to be sure that the market will not continue to run from here. A plan to cautiously reinvest might be the most prudent. You could plan to buy into the market monthly for the next six or eight months. If we did then see a market correction, you could use that opportunity to alter your plan and  purchase more aggressively into the market.

Your focus should be on buying high quality assets on which you have conviction that they will do well for years to come. That should be a recipe for success as we move forward through turbulent waters.

The market surge continued this month, though perhaps sanity is beginning to finally come back to the table. For the first time during this huge rally, quality seemed to matter a bit. The Russell 2000 (an index of 2000 small companies) has fallen to its 90 day trading average while the indexes of larger companies continue to trade well above their average. We see this as a trend that is likely to continue for quite a while. We have no idea whether this market is at a top right now, but we do know that the risks are growing that we could see a correction at any time. When the correction comes, do you want your portfolio focused on quality companies selling at average prices or low quality companies with no current earnings? To us, that is one of the easiest questions to answer that we have seen. The strategy, oft times referred to by Jeremy Grantham, is known simply as “survive to fight another day”. If you own good quality companies with earnings and dividends, they will still be around in a couple years even if we hit another large market slide. We can’t say that is true about owning a small company with no earnings in this economic environment.

On the flip side, we also expect the higher quality stocks to outperform should this market continue to escalate. These companies have good earnings, fair pricing, cash on hand, etc. Their future is bright, they have to wear shades! On the flip side, we continue to have a negative outlook for the Russell 2000 stocks.

In currency, we think the dollar may have a short rally in coming months, followed by a return to weakening against emerging market currencies. While we hope to participate in this area, we are not rushing into it with guns a blazing as we think the dollar may rally for a bit first.

Lastly, do we think the economy is fixed or sinking? That seems to be the topic that everyone is weighing in on. Our belief is that it was not as bad as most thought last November and isn’t as good as many think this November. We think things are getting worse more slowly and that the turnaround will be slow and muted from here. That seems to us to denote a period of slow growth and small returns, not the continuation of a huge bull market that   will make us all rich.

We spent a day recently with a group of advisors who cling to all the orthodoxies of financial services (Modern Portfolio Theory, static asset allocation, etc.). According to them, all you need to do is divide up your money into a bunch of style boxes (e.g. large company value stocks) and keep it there. We know that this has been a dangerous belief for the last decade and we think it will continue to be dangerous in the future.   But, it got us thinking about what people still call “modern”.

Modern Portfolio Theory basically states that the selection of assets (stocks, bonds, and cash) is the major factor in determining risk and return for a portfolio. It was developed in the 1950s by Harry Markowitz. That is over 50 years ago. Is it time to re-consider whether we need something even more “modern”? Markowitz, of course, never talked about the style boxes that have become part of the orthodoxy of financial services. Style boxes were invented by Morningstar in the early 1990s. So, a marketing scheme that was invented more than thirty years later has come to be considered by many financial advisors to be an essential part of “modern portfolio theory”. What else has transpired since this modern theory was published?

Hawaii and Alaska became states the year that Markowitz’ book was published.

WalMart was founded in 1969, a decade later.

The NASDAQ stock exchange began in 1971.

The first color television broadcast was in 1974, 25 years after the “modern” theory.

The term personal computer was first coined in 1975.

Enron did not come into existence until 1985.

The World Wide Web was invented in 1989.

So, we shouldn’t throw out Markowitz’ theory because of its age, but we need to consider whether or not it still applies and perhaps tweak it a bit if it is to be relevant in the 21^st century. A few things may have changed during the past 50 years! Perhaps most importantly, his message has been transformed to mean what the financial services industry wanted it to mean rather than what he actually said. He never told anyone to fill a bunch of artificial “style boxes” and hold on to overpriced assets in a bear market. That would not be a Nobel Prize winning concept.

Lost in the froth of the recent market is the fundamental truth of why anyone buys stocks in the first place. In investing, you are buying a future stream of earnings. So, if you buy a one year CD at the bank that pays 2% interest, you are investing in an extremely low risk choice that has a 2% future stream of earnings. The reason stocks historically have higher returns on investment is that they involve more risk (i.e. you expect a larger future stream of earnings from stocks because you are accepting a far greater degree of risk than in a CD, a US Treasury Bond, or a corporate bond). So, you make a rational decision to invest in a stock because you believe the risk you are taking is justified by the higher expected return.

At the turn of the new millennium, stocks were priced extremely high compared to historic norms. The return, not surprisingly, has been pathetic so far this decade. We have had a secular bear market and investors would have been better off choosing almost any other investment vehicle for the past 9 years. Commodities and gold have led the way, offering an excellent return on investment during this period. The low return on equities makes perfect sense by fundamental standards.

We believe that this fundamental truth has been lost on investors and that we are at a crossroads. The highest quality stocks are priced near historic norms and we believe you can make the case that owning them going forward is a rational decision. You stand to receive a larger income stream on your investment than in safer instruments. According to the Wall Street Journal, the Russell 2000 stocks (an unmanaged index of smaller companies) has an expected Price to Earnings ratio of 55 as of this morning. So, if everything goes well (no small feat in this economy), an investor should reap an earnings stream of less than 2% for the next year from investments in the Russell 2000 stocks. Why would an investor make the choice to buy these stocks at this time with a lower stream of income than in any other investment? We believe another wave of punishment will arrive for those who choose to ignore the fundamental fact that these companies are not currently a prudent investment. Perhaps then investors will come to grips with the fact that buying stocks is a rational decision based on the choices that exist when you make an investment choice.

For the first time since the huge rally began in March, we were faced yesterday with a decision that was painful. We like alternative energy. No, we love alternative energy! If our economy is to rebound and grow, it will be a driver of growth. But, this pullback has revealed considerable weakness in the sector. Yesterday, one of our alternative energy positions hit the price that triggers a sell for us. We had to face the choice, process or emotion. Of course, we stuck with our process and sold the position. We hope to own it again in the future and to see it grow and produce considerable profits for our clients. For now, however, it had slipped in price and momentum to where we needed to sell the position before it damaged portfolio values any further. The trigger (a loss beyond the normal range of pullbacks and advances) has told us that now is not the time, based on risk and reward, to hold this position. We will see you again down the road, friend!

We enter another week beginning with a stupendous market rise. With more and more experts sounding words of caution on this market, the bulls seem to respond ever more resolutely by moving the market to new highs. We have seen this movie before. We don’t know when it will end, but we know it is not a happy ending. We need the financial equivalent of the term “post 9/11”. Have we really learned nothing? Isn’t the value of a stock determined by what the return on your investment is likely to be? Once again, the riskiest stocks seem to have the lowest return on your investment going forward, but are the stocks that are rising the fastest.

I understand taking risks when they make sense. For instance, investing in emerging markets makes sense because these economies are likely to have much faster growth over the coming years. So, the risk you take may be rewarded by larger returns than safer investments. Small, financially less stable U.S. companies do not fit this profile. As a group, they are more likely to be losers moving forward than their higher quality counterparts (who have cash to fund operations and growth) and there is no proof that they are about to enter a period of strong growth.

Investors should approach this market with great caution. They should let their gains ride, but with a very short chain from here. Capture profits and limit losses as we move forward in an overheated market. Live to fight another day by remembering we are in a “post 2000” market.