Archive for December, 2009
New Normal is the Old Normal
By Bruce Wimberly (Contributing Writer to Investing Caffeine)
Pimco bond gurus love to talk about the “new normal” as if there is such a thing in financial markets. The problem with promoting such a view is that it assumes markets are static. Ask John Meriwether and his pack of Nobel Prize winning colleagues at LTCM how static the markets are? The point is nothing is normal about the markets or the economy for that matter. No one has a magic crystal ball that can predict the future and if you did you would certainly not promote it on CNBC. Mohamed El-Erian and his bond fund mavens (see also article on Bill Gross) are the poster children for the “new normal.” I will give them credit it is a great marketing gimmick. Not only does it sound cool but it covers just about everything while packaging it into a nice neat sound bite. Talk about media hounds –does El-Erian actually have time to run Pimco after spending hours getting his make-up ready for the countless interviews he gives each day? And what is up with the 1970ʼs mustache?
In the world according to Pimco the new normal, “reflects a growing realization that some of the recent abrupt changes to markets, households, institutions, and government policies are unlikely to be reversed in the next few years. Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors…. But, hold on, I am getting ahead of myself here. I still have a few more preambles”! Iʼll bet he does.
El-Erian is never short on opinions. As an investor all I really care about is what does this mean for asset prices? Ok, so global GDP is going to slow as consumers and institutions repair balance sheets, government policies are becoming more burdensome, and unemployment stays high. Check. Got it. While I am not El-Erain I think what he really meant to say is, “We have already established our bond positions and if you want to help our shareholders you should follow our example and invest on the short end of the curve and be wary of inflation. The Fed is printing money and history suggests this will end badly.”
As a formal multi-billion dollar fund manager, I happen to agree with the guy. While I think he could have been more direct with his message, there is no way the fed can inflate us out of this mess without their being some pain down the road. The United States cannot print its way to a recovery. Todayʼs long bond auction is just the first shot against the bow. The 4 3/8% coupon went off at a price of $97.6276 for a 4.52% yield versus a 4.49% prior. In other words, the so-called “new normal” really is the old normal and rates are heading higher my friends.
In this so- called “new normal” of higher rates what should an investor do? First, avoid the treasury bubble like the plague. This is where irrational exuberance is occurring the most. Wake-up people. What Pimco bond managers should be telling you is, “Donʼt buy our funds” (except Reits, Tips and Commodities). Bonds are going to get killed. That is the “new normal”. The “new normal” is inflation is your worst nightmare for bonds and bond buyers. Yes, bonds had a great run the last decade and that is the point! History will not repeat itself. The “new normal” is stocks will outperform bonds over the next ten years handily. Yes, stocks might get hit in the short run as rates rise but in the long run they are a far better asset class to weather inflation. The simple truth is businesses can raise prices. That is all you need to know. Donʼt anchor to the last ten years, as Pimco would like you to do. Donʼt worry about slick slogans – like the “new normal”. Just think about all the assets that have poured into Pimcoʼs funds over the last 10-15 and ask yourself “is this likely to continue?”
To paraphrase Wayne Gretzky great investors “skate to where the puck will be”. In my opinion, that leads you away from the mutual fund behemoth that is Pimco and the safe haven of bonds and back into equities. Yes, the S&P 500 has gone nowhere the last 11 years and that is my point…. the “new normal” is the old normal and equities regain their long term return advantage over other asset classes.
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and equity securities in client and personal portfolios at the time of publishing. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Stewart Makes Skewered Beck-Kebabs
Since Fox news-host, Glenn Beck, has been peddling death and destruction, John Stewart, host of the The Daily Show, decided to dish out some devastation of his own to Mr. Beck by skewering him on several issues. Specifically, Stewart questions whether Beck’s Armageddon view on the economy may be influenced by an economic conflict of interest in gold (not just a political axe to grind)?
Beck on Gold
View The Daily Show Clip on Glenn Beck
As the third party mentions, “If you are worried about worrying, you go out and you buy gold.”
Is Glenn Beck a worried, gold lover? (see other IC articles: Gold #1 & Gold #2) Well, judging by the seven responses of Beck specifically spouting out “gold”, along with his panic-filled quotes, I would say “yes”:
- “America is burning down to the ground!”
- “Here are the three scenarios that we could be facing: recession, depression, or collapse.”
- “Here’s our second scenario: global civil unrest.”
- “You are the protector of liberty. You are the guardian of freedom.”
If these feelings were not enough, Beck also goes on to compare the country’s situation to Nazi Germany.
Do any of these issues worry you? Well if they do, then good for gold prices and good also for Glenn Beck, because he is a paid spokesman for Goldline.com, a site that sells gold.
This is how John Stewart boils down the incestuous relationship between Fox, Goldline.com, and Beck:
“This is a kinda nice feedback loop. Glenn Beck is paid by Goldline to drum up interest in gold, which increases in value during times of fear, an emotion reinforced nightly on Fox by Glenn Beck. Alright, I’m almost sold. Fox is vouching for Beck, and Beck is vouching for Goldmine.”
Gold Pricing & Demand
With gold prices setting new all-time highs earlier this month, one might expect gold demand to be sky-rocketing…actually not. Just last month, the World Gold Council said gold demand totaled 800.3 tons in Q3, down -34% year-over-year. What’s more, the supply of gold inventories is at record highs (Comex) and mining production rose +6% over the same time period. Generally speaking, economics would say the combination of these factors would be a bad formula for prices.
Beck and the CEO of Goldmine.com use inflation adjusted prices based on the last $850/oz. peak in 1980 to rationalize $2,000/oz+ targets for gold. If that’s the case then I guess NASDAQ targets of 10,000 (2x of the 5,000 year 2000 peak) shouldn’t be out of the question either (the index currently trades around 2,190)? In the meantime, I’ll let the speculative gold dust settle and comfortably watch from the sidelines.
Source: InvestmentTools.com
Hemorrhoid Hypocrisy on Healthcare
In an earlier The Daily Show episode, Stewart questions the consistency of Beck’s changing views on healthcare. So which one is it? Is it the best healthcare program in the world, or the one that doesn’t care for Glenn Beck and the “schlubs that are just average working stiffs?”
In creating a feeling of alarm regarding healthcare reform, here’s what Beck had to say in the middle of the healthcare reform debate:
- “You’re about to lose the best healthcare system in the world.”
- “America already has the best healthcare in the world. We do take care of our sick.”
Rewind 16 months earlier upon completion of Beck’s hemorrhoid surgery:
- “Getting well in this country, can almost kill you.”
- “No matter how much the health care system would try to keep me down, I’m back.”
See Daily Show Clip on Healthcare and Glenn Beck
All this bickering can upset your stomach, but after John Stewart’s skewering of Glenn Beck, I have this sudden urge for shish kebabs. Bon appétit until next time…
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (VFH) and RTP in client and personal portfolios at the time of publishing. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Rogers: Fed Following in Path of Dodo
Jimmy Rogers, the bow-tie boss of Rogers Holdings and past co-founder of the successful Quantum Fund with George Soros, is no stranger to making outrageous predictions. His latest prophetic assessment is the Federal Reserve Bank is on the path of the Dodo bird to extinction:
“Don’t worry – the Fed is going to abolish itself. Between Bernanke and Greenspan, they’ve made so many mistakes that within the next few years the Fed will disappear.”
Given the shock and awe that transpired from the Lehman Brothers collapse, I can only wonder how investors might react to this scenario….hmmm. If this doozy of an outlandish call catches you off guard, please don’t be surprised – Rogers is not shy about sharing additional ones (Read other IC article on Rogers). For example, just six months ago Rogers said the Dow Jones could collapse to 5,000 (currently around 10,472) or skyrocket to 30,000, but “of course it would be in worthless money.” Oddly, the printing presses that Rogers keeps talking about have actually produced deflation (-0.2%) in the most recently reported numbers, not the same 79,600,000,000% inflation from Zimbabwe (Cato Institute), he expects.
I suppose Rogers will either point to a data conspiracy, or use the “just you wait” rebuttal. I eagerly await, with bated breath, the ultimate outcome.
Is U.S. Fed Alone?
If the U.S. Federal Reserve system is indeed about to disappear after over nine decades of operations, does that mean Rogers advocates shutting all of the other 166 global reserve banks listed by the Bank for International Settlement? Should the 3 ½ century old Swedish Riksbank (origin in 1668) and the Bank of England (1694) central banks also be terminated? Or does the U.S. Federal Reserve Bank have a monopoly on incompetence and/or corruption?
Sidoxia’s Report Card on Fed
I must admit, I believe we would likely be in a much better situation than we are today if the Federal Reserve board let Adam Smith’s “invisible hand” self adjust short-term interest rates. Rather, we drank from the spiked punch bowls filled with low interest rates for extended periods of time. The Federal Reserve gets too much attention/credit for the impact of its decisions. There is a much larger pool of global investors that are buying/selling Treasury securities daily, across a wide range of maturities along the yield curve. I think these market participants have a much larger impact on prices paid for new capital, relative to the central bank’s decision of cutting or raising the Federal funds rate a ¼ point.
Although I believe the Fed gets too much attention for its monetary policies, I think Bernanke and the Fed get too little credit for the global Armageddon they helped avoid. I agree with Warren Buffett that Bernanke acted “very promptly, very decisively, very big” in helping us avert a second depression while we were on the “brink of going into the abyss.”
Beyond the monetary policy of fractional rate setting, the Fed also has essential other functions:
- Supervise and regulate banking institutions.
- Maintain stability of the financial system and control systemic risk of financial markets.
- Act as a liaison with depository institutions, the U.S. government, and foreign institutions.
- Play a major role in operating the country’s payments system.
I will go out on a limb and say these functions play an important role, and the Fed has a good chance of being around for the 2012 London Olympic Games (despite Jimmy Rogers’ prediction).
Sidoxia’s Report Card on Rogers
As I have pointed out in the past, I do not necessarily disagree (directionally) with the main points of his arguments:
- Is inflation a risk? Yes.
- Will printing excessive money lower the value of our dollar? Yes.
- Is auditing the Federal Reserve Bank a bad idea? No.
My beef with Rogers is merely in the magnitude, bravado, and overconfidence with which he makes these outrageous forecasts. Furthermore, the U.S. actions do not happen in a vacuum. Although everything is not cheery at home, many other international rivals are in worse shape than we are.
From a media ratings and entertainment standpoint, Rogers does not disappoint. His amusing and outlandish predictions will keep the public coming back for more. Since according to Rogers, Bernanke will have no job at the Fed in a few years, I look forward to their joint appearance on CNBC. Perhaps they could discuss collaboration on a new book – Extinction: Lessons Learned from the Fed and Dodo Bird.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (VFH) at the time of publishing, but had no direct ownership in BRKA/B. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Getting Debt Binge Under Control
Given the endless daily reminders about our federal government’s insatiable appetite for debt, the inevitable collapse of the dollar, and the potential for civil unrest, the average citizen might be surprised to find out the overall debt situation has actually improved. While our federal debt has been exploding (see also Investing Caffeine D-E-B-T article), households and businesses have been tightening their belts and cutting down on the debt binge of recent years. In fact, the overall debt for the U.S. grew at the slowest rate in a decade according to The Business Insider.
Source: The Business Insider. Steady debt growth decline.
As you can see from the nitty-gritty in the Federal Reserve chart below, total Nonfinancial Debt grew at +2.8% in the 3rd quarter of 2009 (comprised of -2.6% Household Debt; -2.6% Business Debt; +5.1% State & Local Government Debt; and +20.6% Federal Debt).
What does this all mean? Not surprisingly, we are seeing the same trends in the debt figures that we are seeing in the components of our GDP (Gross Domestic Product). We learned from our Economics 101 class that the equation for GDP = C + I + G + (NX), which explains the components of economic growth.
- C = Consumer spending (or private consumption)
- I = Investment (or business spending)
- G = Government spending
- NX = Net exports (or exports – imports)
Consumer spending has been the biggest driver of growth before the financial crisis (fueled in part by the contribution of debt growth), accounting for more than 2/3 of our GDP. Now, with the consumer retrenching dramatically – spending less and saving more – we are seeing government spending (i.e., stimulus) pick up the slack.
These same dynamics are playing out in the total debt figures. Since the consumer is retrenching, they are saving more and paying down debt. Business owner debt has been chopped too, either by choice or because the banks simply are not lending. Here again, the government is picking up the slack by ramping up the debt growth.
Encouragingly, all is not lost. Economic principles, like the laws of physics, eventually take hold. Fortunately consumers and businesses have gone on a crash diet from debt – and the banks haven’t accommodated the pleading cash-starved either. Now legislators in our nation’s capital must do their part in dealing with the weighty spending. The overall debt progress is heartening, but Uncle Sam still needs to get off the Ho-Hos and Twinkies and start shedding some of that binge-related debt.
Read Full Business Insider Article
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and equity securities in client and personal portfolios at the time of publishing. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
China Executes Wall Street Solution
China is taking an innovative approach to white collar crime…execution. Yang Yanming, a rogue securities trader, completed his death sentence this week for embezzling $9.52 million (a daily rounding error for Goldman Sachs, I might add). Not exactly a cheery topic for the holiday season, but nonetheless, apparently an effective technique for cracking down on illegal behavior. Last I heard, there has been no mention of a $65 billion Chinese version of the Madoff Ponzi scheme? I wonder what kind of risks the financial division of AIG would have undertaken, if involuntary death sentences were considered as viable options in the back of their minds? China in fact carries out more annual executions (via lethal injection and gun) than any other country in the world.
Part of the recent financial crisis can be attributed to the culture of Wall Street and the investment industry, which centers on exploiting “OPM,” an acronym I use to describe “other people’s money.” Often, industry professionals (I use the term loosely) assume undue amounts of risk in hopes of securing additional income, no matter the potential impact on the client. The thought process generally follows: “Why should I risk my own capital to make a mega-bonus, when I can swing for the fences using someone else’s?” And if OPM cannot be secured from individuals, perhaps the capital can be borrowed from the banks – at least before the bailouts occurred.
OPM does come with some caveats, however. Say for example the OPM comes from the government. When TARP (Troubled Asset Relief Program) funds got crammed down the throats of the banking industry, the auspice of reduced bonuses didn’t sit very well with many of the fat-cat Wall Street executives. Financial institutions prefer their OPM with few strings and little to no accountability. Goldman Sachs (GS), JP Morgan (JPM), and Morgan Stanley (MS) weren’t big fans of the government’s pay scale, so these banks paid back the TARP funds at mid-year. Citigroup (C) is still negotiating with the U.S. Treasury and regulators to remove the scarlet phrase of “exceptional assistance” from their chests.
This subject of accountability brings up additional doses of blame to distribute. Not only are the gun-slinging bankers and advisers the ones to blame, but in many cases the clients themselves shoulder some of the responsibility. Either the clients’ start drinking the speculative “Kool-Aid” of their advisor or they neglect to ask a few basic questions for accountability. Just as Ronald Reagan stressed in his conversations with the Soviets, it is also imperative for clients to “trust but verify” the relationship with their advisor (read how to get your financial house in order).
One thing we learned from the crisis of 2008-2009 is that trust is a scarce resource. Investors can “luck” into a trustworthy relationship, but more often than not, just like anything else, it takes time and effort to build a worthy partnership.
The suppliers of OPM have gotten smarter and more skeptical after the crisis, however the managers of OPM haven’t discarded risk from their toolboxes. In addition to the general rebound in domestic equities, we have seen emerging markets, commodities, high-yield bonds, and foreign currencies (to name a few areas), also vault higher.
Regulatory reform for the financial industry is a hot topic for discussion, although virtually nothing substantive has been implemented yet. Incentives, accountability, and adequate capital requirements need to be put in place, so excessive risk-taking (like we saw at the AIG division handling Credit Default Swaps) doesn’t compromise the safety of our financial system. Also, traders need to be incentivized for making responsible decisions and punished adequately for participating in illegal activities. I know the President has a lot on his plate right now, but perhaps the Obama administration could set up a brief meeting with the capital punishment committee in Beijing. I’m confident the Chinese could assist us in “executing” a financial regulatory system solution.
Read Full Reuters Article on Rogue Chinese Trader
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (VFH) and BAC, but at time of publishing had no direct positions in GS, AIG, JPM, MS and C. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
China: The Trade of the Century?
So it goes, Britain was the country of the 19th century, the United States was the country of the 20th century, and China will be the country of the 21st century. Is investment in China hype or reality? Here are some points in China’s favor:
- Large Labor Force: With a population exceeding 1.3 billion people, China has plenty of labor available to expand GDP (Gross Domestic Product).
- No Nonsense Government: An authoritarian government has its advantages. While pornography (see article) and unrest may be problems, infrastructure projects are not.
- Education: Chinese culture values education. As a result, China is slowly shifting away from its roots as the globe’s manufacturing and piracy capital. Intellectual property is appreciated more now that China is becoming a leader in emerging technology areas, such as solar power.
- Trade Surplus & Currency Reserves: Must be nice to have trade surpluses and massive currency reserves (~$2.3 trillion). This is what happens when you are in a position to export more than you import.
- Manageable Debt: China’s Debt/GDP ratio is less than 25%. You can compare that to the U.S. at around 100% and Japan at over 200%. Disciplined fiscal management provides the Chinese government with more options in dealing with the global slowdown (e.g., stimulus).
- Long Runway of Growth (Read More): China’s long runway of growth has allowed it, and should continue to allow it, to grow at above average growth rates – in the 3rd quarter of 2009 the Chinese economy grew at a very healthy +8.9% rate.
With all these positives, it’s no wonder China is the darling of the world. Given the constructive outlook, how can investors take advantage of the Far East opportunity in China? Our good friend at Investing Caffeine (figuratively speaking), Burton Malkiel (Princeton Professor of Economics and Chief Investment Officer at AlphaShares), is bullish about China and is sharing his preferred participation method…an all-cap China exchange traded fund (ticker: YAO) – Read more about Malkiel and Active vs. Passive Investing (12/8/09 Post).
Just how bullish is Professor Malkiel?
“I think China will continue to have the highest growth rate of any major country in the world, and within 20 years, China will be the world’s leading economic power.”
And he puts his money where his mouth is. Last year the professor shared his Chinese exposure in his personal portfolio:
“My portfolio is probably 20 percent Chinese, and that includes not only indices but also individual companies.”
Risks: The Price to Play
Professor Malkiel is not blindly diving into China – he researched the markets for years before taking the plunge. In an article from last year (From Wall Street to the Great Wall), he highlighted some of the inherent risks:
1) Foreign Neighbors: China continues to have tense, although cordial, relations with some of its neighbors like Taiwan and Japan. Their dealings are stable now, but the future is uncertain.
2) Social Unrest: An uneven distribution of income can lead to serious social unrest, especially in the rural parts of the country. If the government can’t keep the economy humming along, those left behind may fight back.
3) Environmental Degradation: China is building nuclear, wind, and solar projects at a frenetic pace, but China is also the globe’s largest emitter of greenhouse gases (relies on dirty coal for 70% of its energy), according to CNN. If China becomes an irresponsible power hog, there could be damaging effects to the economy.
4) Corruption: This continues to be a problem, but Malkiel points out the case of Zheng Xiaoyu, a former director of China’s FDA (Food and Drug Administration) equivalent. In 2007, he was executed after being found guilty of taking bribes.
5) Banking System: Malkiel notes that China continues to have a fragile banking system with a lot of bad loans. Due to political reasons, certain government owned entities may receive risky loans in the name of creating jobs – even if it means keeping unhealthy zombie banks alive.
Trading Strategies:
Beyond investing in AlphaShare ETFs (YAO), Malkiel advocates considering the other options, such as the “A”, “H”, and “N” shares. Unfortunately, the more inefficient “A” shares, which trade in Shanghai and Shenzen, are largely unavailable to investors outside of China. However, the “H” shares and “N” shares are available to international investors. “H” shares are listed on the Hong Kong Stock Exchange and the listed companies follow globally accepted accounting principles. The “N” shares come from companies registering with the SEC (Securities and Exchange Commission) and trade either on the NYSE (New York Stock Exchange) or NASDAQ exchanges.
Lastly, Malkiel knows he is not the only investor to pick-up on the China growth story. Multinationals are investing heavily in China, and these domestically based companies can serve as indirect investment vehicles to benefit from the attractive fundamentals as well.
Professor Malkiel calls China the “growth story of the world.” Simple math shows us that this Asian juggernaut (the third largest country in the world by GDP) will soon pass Japan in the number two position and the U.S. is likely only a few decades ahead after that. Having explored and studied China firsthand, I concur with many of Malkiels conclusions, which opens the possibility that China could reasonably be the top country (and top trade) of the 21st century?
Full Malkiel Article: From Wall Street to the Great Wall – Investment Opportunities in China
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, like FXI, at the time of publishing. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Passive vs. Active Investing: Darts, Monkeys & Pros
Bob Turner is founder of Turner Investments and a manager of several funds at the investment company. In a recent article he reintroduces the all-important, longstanding debate of active management (“hands-on”) versus passive management (“hands off”) approaches to investing.
Mr. Turner makes some good arguments for the active management camp, however some feel differently – take for example Burton Malkiel. The Princeton professor theorizes in his book A Random Walk Down Wall Street that “a blindfolded monkey throwing darts at a newspaper’s stock page could select a portfolio that would do just as well as one carefully selected by experts.” In fact, The Wall Street Journal manages an Investment Dartboard contest that stacks up amateur investors’ picks against the pros’ and random stock picks selected by randomly thrown darts. In many instances, the dartboard picks outperform the professionals.
Given the controversy, who’s right…the darts, monkeys, or pros? Distinguishing between the different categorizations can be difficult, but we will take a stab nevertheless.
Arguments for Active Management
Turner contends, active management outperforms in periods of high volatility and he believes the industry will be entering such a phase:
“Active managers historically have tended to perform best in a market in which the performance of individual stocks varies widely.”
He also acknowledges that not all active managers outperform and admits there are periods where passive management will do better:
“The reason why most active investors fail to outperform is because they in fact constitute most of the market. Even in the best of times, not all active managers can hope to outperform…The business of picking stocks is to some degree a zero-sum game; the results achieved by the best managers will be offset at least somewhat by the subpar performance of other managers.”
Buttressing his argument for active management, Turner references data from Advisor Perspectives showing an inconclusive percentage (40.5%-67.8%) of the actively managed funds trailing the passively managed indexes from 2000 to 2008.
The Case for Passive Management
Turner cites one specific study to support his active management cause. However, my experience gleaned from the vast amounts of academic and industry data point to approximately 75% of active managers underperforming their passively managed indexes, over longer periods of time. Notably, a recent study conducted by Standard & Poor’s SPIVA division (S&P Indices Versus Active Funds) discovered the following conclusions over the five year market cycle from 2004 to 2008:
- S&P 500 outperformed 71.9% of actively managed large cap funds;
- S&P MidCap 400 outperformed 79.1% of mid cap funds;
- S&P SmallCap 600 outperformed 85.5% of small cap funds.
Read more about the dirty secrets shrinking your portfolio.
According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (passive strategies). If you doubt the popularity of passive investment strategies, then look no further than the growth of Exchange Traded Funds (ETFs – see chart), index funds, or Vanguard Groups more than $1 trillion dollars in assets under management.
Although I am a firm believer in passive investing, one of its shortcomings is mean reversion. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. Active investing can take advantage of mean reversion, conversely passive investing cannot. Indexes can get very top-heavy in weightings of outperforming sectors or industries, meaning theoretically you could be buying larger and larger shares of an index in overpriced glamour stocks on the verge of collapse. We experienced these lopsided index weightings through the technology bubbles in the late 1990s and financials in 2008. Some strategies may be better than other over the long run, but every strategy, even passive investing, has its own unique set of deficiencies and risks.
Professional Sports and Investing
As I discuss in my book, there are similarities that can be drawn between professional sports and investing with respect to active vs. passive management. Like the scarce number of .300 hitters in baseball, I believe there are a select few investment managers who can consistently outperform the market. In 2007, AssociatedContent.com did a study that showed there were only 22 active career .300 hitters in Major League Baseball. I recognize in the investing world there can be a larger role for “luck,” which is difficult, if not impossible, to measure (luck won’t help me much in hitting a 100 mile per hour fastball thrown by Nolan Ryan). Nonetheless, in the professional sports arena, there are some Hall of Famers (prospects) that have proved they could (can) consistently outperform their peers for extended durations of time.
Experience is another distinction I would highlight in comparing sports and investing. Unlike sports, in the investment world I believe there is a positive correlation between age and ability. The more experience an investor gains, generally the better long-term return achieved. Like many professions, the more experience you gain, the more valuable you become. Unfortunately, in many sports, ability deteriorates and muscles atrophy over time.
Size Matters
Experience alone will not make you a better investor. Some investors are born with an innate gift or intellect that propels them ahead of the pack. However, most great investors eventually get cursed by their own success thanks to accumulating assets. Warren Buffet knows the consequences of managing large amounts of dollars, “gravity always wins.” Having managed a $20 billion fund, I fully appreciate the challenges of investing larger sums of money. Managing a smaller fund is similar to navigating a speed boat – not too difficult to maneuver and fairly easy to dodge obstacles. Managing heftier pools of money can be like captaining a supertanker, but unfortunately the same rapid u-turn expectations of the speedboat remain. Managing large amounts of capital can be crippling, and that’s why captaining a supertanker requires the proper foresight and experience.
Room for All
As I’ve stated before, I believe the market is efficient in the long run, but can be terribly inefficient in the short-run, especially when the behavioral aspects of emotion (fear and greed) take over. The “wait for me, I want to play too” greed from the late 1990s technology craze and the credit-based economic collapse of 2008-2009 are further examples of inefficient situations that can be exploited by active managers. However, due to multiple fees, transaction costs, taxes, not to mention the short-term performance/compensation pressures to perform, I believe the odds are stacked against the active managers. For those experienced managers that have played the game for a long period and have a track record of success, I feel active management can play a role.
At Sidoxia Capital Management, I choose to create investment portfolios that blend a mixture of passive and active investment strategies. Although my hedge fund has outperformed the S&P 500 in 2009, that fact does not necessarily mean it’s the appropriate sole approach for all clients. As Warren Buffet states, investors should stick to their “circle of competence” so they can confidently invest in what they know. That’s why I generally stick to the areas of my expertise when I’m actively investing in stocks, and fill in the remainder of client portfolios with transparent, low-cost, tax-efficient equity and fixed income products (i.e., Exchange Traded Funds).
Even though the actively managed Turner Funds appear to have a mixed-bag of performance numbers relative to passively managed strategies, I appreciate Bob Turner’s article for addressing this important issue. I’m sure the debate will never fully be resolved. In the meantime, my client portfolios will aim to mix the best of both worlds within active and passive management strategies in the eternal quest of outwitting the darts, monkeys, and other pros.
Read the full Bob Turner article on Morningstar.com
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but had no direct position in stocks mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
FDIC: Busted Piggy Bank
Just as Bank of America (BAC) has decided to pay back $45 billion in TARP (Troubled Asset Relief Program) money, and the employment picture brightened with the recent improvement in the unemployment rate, our banking piggy bank, FDIC (Federal Deposit Insurance Corporation), has been busted. Recovering macroeconomic indicators haven’t allowed our banking system to get out of the woods quite yet. This struggling FDIC news comes even before the inexorable collapse expected in commercial real estate (see Wilbur Ross’ comments on the subject).
Sheila Bair, the Chairwoman of the FDIC, indicated with her sobering remarks that these trends will not disappear overnight:
“For now the credit adversity we have been discussing for some time remains with us, and we have been discussing for some time remains with us, and we expect that it will be at least a couple of more quarters before we see a meaningful improvement in that trend.”
With the FDIC adding 136 banks to its “problem list” in the third quarter (bringing the total to 552), the regulator was forced to pull out $38.9 billion from the piggy bank, officially draining the rainy day fund into the red.
Fixing the Problem
How will the FDIC replenish its hollow piggy bank? Ms. Bair has recently endorsed a letter sent to House Financial Services Committee Chairman (Barney Frank) that would force secured creditors (mainly banks) to create a slush fund for potential large bank failures that pose a threat to the system. Ms. Bair designed the program this way because all banks – big or small – would be forced to “evaluate the solvency of our largest financial firms.”
Due to the continuation of bank failures and loan loss deterioration, the FDIC fund balance slipped to a negative -$8.2 billion (the first time since dealing with the failing thrifts in 1992) for the September period. Therefore, Ms. Bair put forth an emergency measure that requires insured banks to prepay three years of insurance premiums by the end of 2009. This action is expected to raise approximately $45 billion in funds. Although the reserve piggy bank had an upside down balance, the FDIC can still keep the lights on and cover employee payroll because the regulatory entity still has $23.3 billion in cash and marketable securities on its balance sheet.
With the taxpayers flipping the bill for bailouts galore over the last two years, and Goldman Sachs (GS) wheelbarrowing out bonuses to their employees, Ms. Bair and politicians are looking to the industry to now shoulder more of the bank failure burden. Let’s hope the piggybank can be replenished so taxpayers don’t have to go scraping through their wallets again.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (VFH) and BAC, but at time of publishing had no direct positions in GS. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Fuss Making a Fuss About Bonds
Photo Source: Evan Kafka (BusinessWeek)
Dan Fuss has been managing bond investments since 1958, longer than many of his competing managers have lived on this planet. At 75 years old, he is as sharp, if not sharper, than ever as he manages the flagship $18.7 billion Loomis Sayles Bond Fund (LSBRX). Over his 33-year tenure at Loomis, Sayles & Company (he started in 1976), he has virtually seen it all. After a challenging 2008, which saw his bond fund fall -22%, the bond markets have been kinder to him this year – Fuss’s fund performance registers in the top quartile on a 1-year, 5-year, and 10-year basis, according to Morningstar.com (through 12/3/09). With a track record like that, investors are listening. Unfortunately, based on his outlook, he now is making a loud fuss about the dreadful potential for bonds.
Rising Yields, Declining Prices
Fuss sees the bond market at the beginning stages of a rate-increase cycle. In his Barron’s interview earlier this year, Fuss made a forecast that the 10-Year Treasury Note yield will reach 6.25% in the next 4-5 years (the yield currently is at 3.38%). Not mincing words when describing the current dynamics of the federal and municipal bond markets, Fuss calls the fundamentals “absolutely awful.” Driving the lousy environment is a massive budget deficit that Fuss does not foresee declining below 4.5% of (GDP) Gross Domestic Product – approximately two times the historical average. Making matters worse, our massive debt loads will require an ever increasing supply of U.S. issuance, which is unsustainable in light of the aggressive domestic expansion plans in emerging markets. This issuance pace cannot be maintained because the emerging markets will eventually need to fund their development plans with excess reserves. Those foreign reserves are currently funding our deficits and Fuss believes our days of going to the foreign financing “well” are numbered.
Fuss also doesn’t see true economic expansion materializing from the 2007 peak for another four years due to lackluster employment trends and excess capacity in our economy. What does a bond guru do in a situation like this? Well, if you follow Fuss’ lead, then you need to shorten the duration of your bond portfolio and focus on individual bond selection. In July 2009, the average maturity of Fuss’ portfolio was 12.8 years (versus 13.8 years in the previous year) and he expects it to go lower as his thesis of higher future interest rates plays out. Under optimistic expectations of declining rates, Fuss would normally carry a portfolio with an average maturity of about 20 years. In Barron’s, he also discussed selling longer maturity, high-grade corporate bonds and buying shorter duration high-yield bonds because he expects spreads to narrow selectively in this area of the market.
Unwinding Carry Trade – Pricking the Bubble
How does Fuss envisage the bond bubble bursting? Quite simply, the carry trade ending. In trading stocks, the goal is to buy low and sell high. In executing a bond carry trade, you borrow at low rates (yields), and invest at high rates (yields). This playbook looks terrific on paper, especially when money is essentially free (short-term interest rates in the U.S. are near 0%). Unfortunately, just like a stock-based margin accounts, when investment prices start moving south, the vicious cycle of debt repayment (i.e., margin call) and cratering asset prices builds on itself. Most investors think they can escape before the unwind occurs, but Fuss intelligently underscores, “Markets have a ferocious tendency to get there before you think they should.” This can happen in a so-called “crowded trade” when there are, what Fuss points out, “so many people doing this.”
The Pro Predictor
Mr. Fuss spoke to an audience at Marquette University within three days of the market bottom (March 12, 2009), and he had these prescient remarks to make:
“I’ve never seen markets so cheap…stocks and bonds…not Treasury bonds.”
He goes on to rhetorically ask the audience:
“Is there good value in my personal opinion? You darn bethcha!”
Bill Gross, the “Bond King” of Newport Beach (read more) receives most of the media accolades in major bond circles for his thoughtful and witty commentary on the markets, but investors should start making a larger fuss about the 75 year-old I like to call the “Leader of Loomis!”
Adviser Perspectives Article on Dan Fuss and Interest Rates
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including fixed-income) and is short TLT. At time of publishing, SCM had no positions in LSBRX. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Sukuk: Islamic Loophole for Dubai Debt Debacle
Islamic followers can be capitalists too. Although oil prices (currently around $77 per barrel) have fallen from the peak near $150 per barrel in 2008, oil rich nations have gotten creative in how they raise debt-like financing. Critical to fueling the speculative expansion in some oil rich areas has been the growth in sukuk bonds, which have been created as a function of an exploited loophole embedded in Islamic finance principles.
U.S. Does Not Have Monopoly on Debt Driven Greed
The pricked debt bubble that spanned a range of entities, from Icelandic banks to Donald Trump’s empire (read more), has now spread to Dubai commercial real estate. At the center of the storm is Dubai World, a quasi-government owned conglomerate of Dubai, which is in the process of negotiating a $26 billion debt restructuring with the government and sukuk bondholders. The overleveraged Dubai market ($80 billion in total debt) is home to the tallest building in the world, largest man-made islands, and a ski-resort based in the desert – all projects built with the help of debt in the face of collapsing real estate prices. Critical to Dubai World’s debt restructuring is a $3.5 billion sukuk bond issued by its commercial real estate subsidiary Nakheel Development (“Nakheel”). So what exactly is a sukuk (plural of sakk)?
Investopedia lists the following definition for sukuk:
“An Islamic financial certificate, similar to a bond in Western finance, that complies with Sharia, Islamic religious law. Because the traditional Western interest paying bond structure is not permissible, the issuer of a sukuk sells an investor group the certificate, who then rents it back to the issuer for a predetermined rental fee. The issuer also makes a contractual promise to buy back the bonds at a future date at par value.”
Sukuk “No-No”s
The generation of money on top of money – interest payments or what’s called “Riba” – is strictly forbidden by Shari’ah law. As a result, issuers must issue and repurchase sukuk at par (original value), not at a discount or a premium. Shari’ah law encompasses more than Islamic law, it also covers the amorphous spiritual and moral obligations demanded from the religious practitioners. In order to ensure compliance with Islamic principles, many financial institutions and funds typically have a Shari’ah Board monitoring the details of the sukuk. Shari’ah law is very consistent with the teachings in the Quran (the Western version of the Bible). Mixing finance and religion may seem strange on the surface, but I guess if we use world history as a proxy, we shouldn’t be surprised that money and Muhammad somehow find a way to coexist.
Click Here to View CNBC Interview on Sukuk Bonds
Sukuk Structure & Market
The core Islamic finance principles underpinning the sukuk market have been around for more than 1,500 years, but the actual sukuk market was actually introduced in Malaysia around 1990. Since then, the market has been on a continual uptrend. What makes this $1 trillion Islamic debt market (HSBC estimate) even fuzzier is the scores of sukuk structures (See Ijara Sukuk chart below – very similar to a sale-leaseback arrangement), and the diverse geographic issuer/investor base. For example, greater than 60% of Nakheel’s investors are based outside the Middle East (a large portion in Malaysia). Making matters as clear as mud, each geographic region and structure has its own interpretation of legal rights and Shari’ah law. Layer on issues such as derivatives, bankruptcy rights, and penalty fees and you end up with only more complexity. What’s more, many of these sukuk bonds involve Special Purpose Vehicles (SPVs) – made famous by the off-balance sheet variety used by Enron Corp. – in order to get around the Islamic issuance loopholes.
Source: Moody's Investor Service
Sukuk Liquidity
The illiquidity of sukuk market hasn’t made resolving the Dubai debt restructuring any easier. The sukuk market doesn’t come close to matching the liquidity of traditional corporate and sovereign debt markets. Little trading is done in secondary markets because most investors in sukuk bonds follow a buy and hold strategy. The lion’s share of trading in this immature market gets completed through inter-institution, over-the-counter transactions. A recent $500 million sukuk deal issued by General Electric (GE) last month has only raised awareness for the financing structure (pre-Nakheel restructuring). As oil rich states strive to diversify their economic bases, I would expect more deals to get done, in spite of the recent Dubai mess. How severe the recent Dubai sukuk black eye will be depends on how Nakheel, the United Arab Emirates (UAE), Abu Dhabi, bondholders, and other constituents restructure the pending sukuk obligations by the December 14th deadline.
The recent debt restructuring talks in Dubai highlight the complexity of this relatively new Islamic financing structure. With very few sukuk bankruptcy cases in existence, the structures remain largely untested and uncertain. How the Dubai debt debacle ultimately gets resolved will have a significant impact on this nascent, but rapidly growing market. Until the sukuk restructuring is settled, Dubai may just need to put the construction of that next man-made island on hold.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Information and data from Moody’s Investor Service (Shari’ah and Sukuk: A Moody’s Primer 5/31/2006), CNBC interview 12/2/09, Financial Times 12/1/09, and other articles. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct positions in GE. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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