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.

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.

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.

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???

Today Senator Dodd dropped from his financial reform packet the demand of a fiduciary duty on those who give investment advice. Simply put, this means that you the client will continue to be taken advantage of by the vultures that put themselves first at all times and that this will remain legal!

There are a myriad of financial products that will continue to be sold due to their high commissions and the story selling that surrounds them. Whether they are appropriate for you will continue to be up to you to determine. Of course, whether these are good solutions for you or not will require you to study investments and financial planning for a few years as many of these products are complex and intentionally opaque. An equity indexed annuity is a prime example of the difficulties you will encounter in understanding and evaluating whether something is a good investment. Not only are these complicated (though the sales pitch is simple), but you are unlikely to know about similar or better products available with FDIC insurance that may be preferable. Why won’t you know about them? Because they pay far smaller commissions so they will not be presented by sales people who do not have to put your interests first.

The thought that you would pay someone for investment advice (whether that is by fee or commissions) who is not legally bound to at least try to put your interests first is absurd. That the financial services industry at this late date would campaign to avoid this level of responsibility is deplorable. Given all that we have gone through, you would hope that putting clients first would be acceptable to all moving forward.

What should you do? I think there are two questions that should be foremost in your mind when dealing with anyone in financial services (insurance, stock brokers, financial planners, etc.). First, ask them if they are acting as a fiduciary? If they do not respond in the affirmative, make sure you ask them how they are compensated for a transaction and how much they are compensated for the transaction. If they are not forthright in disclosing these answers (e.g. they say their compensation is built into the product and you don’t pay anything additional), then you need to run for the exits. If you get a reasonable answer, then you may choose to proceed with the transaction. Just remember-caveat emptor.

The “sales forces” of financial services are out there now beating the drums for this new decade. Surely after a poor decade we should return to the norm by having excellent returns on our investments, shouldn’t we? Unfortunately, this decade is not really setting up to be any easier for investors than the previous one.

Stocks are certainly not beginning the decade by being cheap by historic measures, so we should expect an average to below average return. Thus, the range bound or secular bear market is likely to continue for some time in equity markets. Unfortunately, commodities and bonds are no longer cheap like they were at the beginning of the past decade. So, returns will be still tough to come by moving forward.

We think the key moving forward will be to be tactical with your risk budget. By that, you or your advisor needs to keep an eye on what are the risks and what are the potential returns of investments. So, if the stock of a great company has fallen to a very low price, buying the stock may increase your risk but be justified by potentially large gains. On the other side, if a stock is very expensive by historic measures it may have rather limited potential appreciation and considerable potential loss. To sell that position and reduce your risk may be the prudent decision. 

So, while investors traditionally have to decide on how much risk to take and stuck with that decision, we believe the prudent course is to adjust your risk budget by the opportunity available to garner good returns. You might still average the same amount of portfolio risk through a market cycle, but get to that average in a way that benefits your bottom line.

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!

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!!  

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!

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.