Posts tagged ‘equities’
More Treats, Less Tricks
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (November 2, 2015). Subscribe on the right side of the page for the complete text.
Have you finished licking the last of your Halloween chocolate-covered fingers and scheduled your next cavity-filled dental appointment? After a few challenging months, the normally spooky month of October produced an abundance of sweet treats rather than scary tricks for stock market investors. In fact, the S&P 500 index finished the month with a whopping +8.3% burst, making October the tastiest performing month since late 2010. This came in stark contrast to the indigestion experienced with the -8.7% decline over the previous two months.
What’s behind all these sweet gains? For starters, fears of a Chinese economic sugar-high ending in a crash have abated for now. With that said, “Little Red Riding Hood” is not out of the woods quite yet. Like a surprising goblin or ghost popping out to scare you at a Halloween haunted house, China could still rear its ugly head in the future due to its prominent stature as the second largest global economy. We have been forced to deal with similar on-again-off-again concerns associated with Greece.
The good news is the Chinese government and central bank are not sitting on their hands. In addition to interest rate cuts and corruption crackdowns, Chinese government officials have even recently halted its decades-long one-child policy. China’s new two-child policy is designed to spur flagging economic growth and also reverse the country’s aging demographic profile.
Also contributing to the stock market’s sugary October advances is an increasing comfort level with the Federal Reserve’s eventual interest rate increase. Just last week, the central bank released the statement from its October Federal Open Market Committee meetings stating it will determine whether it will be “appropriate” to increase interest rates at its next meetings, which take place on December 15th and 16th. Interest rate financial markets are now baking in a roughly 50% probability of a Fed interest rate hike next month. Initially, the October Fed statement was perceived negatively by investors due to fears that higher rates could potentially choke off economic growth. Within a 30 minute period after the announcement, stock prices reversed course and surged higher. Investors interpreted the Fed signal of a possible interest rate hike as an upbeat display of confidence in a strengthening economy.
As I have reiterated on numerous occasions (see also Fed Fatigue), a +0.25% increase in the Federal Funds rate from essentially a level of 0% is almost irrelevant in my eyes – just like adjusting the Jacuzzi temperature from 102 degrees down to 101 degrees is hardly noticeable. More practically speaking, an increase from 14.00% to 14.25% on a credit card interest rate will not deter consumers from spending, just like a 3.90% mortgage rising to 4.15% will not break the bank for homebuyers. On the other hand, if interest rates were to spike materially higher by 3.00% – 4.00% over a very short period of time, this move would have a much more disruptive impact, and would be cause for concern. Fortunately for equity investors, this scenario is rather unlikely in the short-run due to virtually no sign of inflation at either the consumer or worker level. Actually, if you read the Fed’s most recent statement, Fed Chairwoman Janet Yellen indicated the central bank intends to maintain interest rates below “normal” levels for “some time” even if the economy keeps chugging along at a healthy clip.
If you think my interest rate perspective is the equivalent of me whistling past the graveyard, history proves to be a pretty good guide of what normally happens after the Fed increases interest rates. Bolstering my argument is data observed over the last seven Federal Reserve interest rate hike cycles from 1983 – 2006 (see table below). As the statistics show, stock prices increased an impressive +20.9% on average over Fed interest rate “Tightening Cycles.” It is entirely conceivable that the announcement of a December interest rate hike could increase short-term volatility. We saw this rate hike fear phenomenon a few months ago, and also a few years ago in 2013 (see also Will Rising Rates Murder Market?) when Federal Reserve Chairman Ben Bernanke threatened an end to quantitative easing (a.k.a., “Taper Tantrum”), but eventually people figured out the world was not going to end and stock prices ultimately moved higher.
Besides increased comfort with Fed interest rate policies, another positive contributing factor to the financial market rebound was the latest Congressional approval of a two-year budget deal that prevents the government from defaulting on its debt. Not only does the deal suspend the $18.1 trillion debt limit through March 2017 (see chart below), but the legislation also lowers the chance of a government shutdown in December. Rather than creating a contentious battle for the fresh, incoming Speaker of the House (Paul Ryan), the approved budget deal will allow the new Speaker to start with a clean slate with which he can use to negotiate across a spectrum of political issues.
Source: Wall Street Journal
Remain Calm – Not Frightened
Humans, including all investors, are emotional beings, but the best investors separate fear from greed and are masters at making unemotional, objective decisions. Just as everything wasn’t a scary disaster when stocks declined during August and September, so too, the subsequent rise in October doesn’t mean everything is a bed of roses.
Every three months, thousands of companies share their financial report cards with investors, and so far with more than 65% of the S&P 500 companies reporting their results this period, corporate America is not making the honor roll. Collapsing commodity prices, including oil, along with the rapid appreciation in the value of the U.S. dollar (i.e., causing declines in relatively expensive U.S. exports), third quarter profit growth has declined -1%. If you exclude the energy sector from the equation, corporations are still not making the “Dean’s List,” however the report cards look a lot more respectable through this lens with profits rising +6% during the third quarter. A sluggish third quarter GDP (Gross Domestic Product) growth report of +1.5% is further evidence the economy has plenty of room to improve the country’s financial GPA.
Historically speaking, October has been a scary period, if you consider the 1929 and 1987 stock market crashes occurred during this Halloween month. Now that investors have survived this frightening period, we will see if the “Santa Claus Rally” will arrive early this season. Stock market treats have been sweet in recent weeks, but investors cannot lose sight of the long-term. With interest rates near generational lows, investors need to make sure they are efficiently investing their investment funds in a low-cost, tax-efficient, diversified manner, subject to personal time horizons and risk tolerances. Over the long-run, meeting these objectives will create a lot more treats than tricks.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced 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.
The Fallibility of Tangibility
Why do so many star athletes end up going bankrupt? Rather than building a low-cost, tax-efficient, diversified portfolio of stocks and bonds that could help generate significant income and compounded wealth over the long-term (yawn…boring), many investors succumb to the allure of over-exposing themselves to costly, illiquid, tangible assets, while assuming disproportionate risk.
After all, it’s much more exciting to brag about the purchase of a car wash, apartment building or luxury condo than it is to whip out a brokerage statement and show a friend a bond fund earning a respectable 4% yield.
Many real estate investors in my Southern California backyard (epicenter of the 2008-2009 Financial Crisis) have experienced both ruin and riches over the last few decades. The appeal and pitfalls associated with owning tangible assets like real estate are particularly exemplified with professional athletes (see also Hidden Train Wreck). Consider the fate suffered by these following individuals:
- Mike Tyson: Famous boxer Mike Tyson tore through $300 million on multiple homes, cars, jewels and pet tigers before filing for bankruptcy in 2003.
- Julius Erving: Hall of Fame NBA player Julius “Dr. J” Erving went financially belly-up in 2010 after his Celebrity Golf Club International was pushed into foreclosure. Dr. J. was also forced to auction off coveted NBA memorabilia (including championship uniforms, trophies, and rings) along with foreclosing on his personal $2 million, 6,600-square foot Utah home.
- Mark Brunell: Pro Bowl quarterback Mark Brunell was estimated to have earned over $50 million during his career. Due to failed real estate ventures and business loans, Brunell filed for bankruptcy in 2010.
- Evander Holyfield: Heavyweight boxing champion Evander Holyfield burned through a mountain of money estimated at $230 million, including a 235-acre Utah estate, which had 109 rooms and included at least one monthly electric bill of $17,000.
Caveat Emptor
Inclusion of real estate as part of a diversified portfolio makes all the sense in the world – this is exactly what we do for clients at Sidoxia. But unfortunately, many investors mistake the tangibility of real estate with “lower risk,” even though levered real estate is arguably more volatile than the stock market – evidenced by the volatility in publicly traded REIT share prices. For example, the Dow Jones SPDR REIT (RWR) declined by -78% from its 2007 high to its 2009 low versus the S&P 500 SPDR (SPY) drop of -57% over the comparable period. Private real estate investors are generally immune from the heart-pumping price volatility rampant in the public markets because they are not bombarded with daily, real-time, second-by-second pricing data over flashing red and green colored screens.
Without experiencing the emotional daily price swings, many real estate investors ignore the risks and costs associated with real estate, even when those risks often exceed those of traditional investments (e.g., stocks and bonds). Here are some of the important factors these real estate investors overlook:
Leverage: Many real estate investors don’t appreciate that the fact that 100% of a 10% investment (90% borrowed) can be wiped out completely (i.e., lose -100%), if the value of a property drops a mere -10%. Real estate owners found this lesson out the hard way during the last housing downturn and recession.
Illiquidity: Unlike a stock and bond, which merely takes a click of a mouse, buying/selling real estate can take weeks, if not months, to complete. If a seller needs access to liquidity, they may be forced to sell at unattractively low, fire-sale prices. Pricing transparency is opaque due to the variability and volume of transactions, although online services offered by Zillow Group Inc. (Z).
Costs: For real estate buyer, the list of costs can be long: appraisal fee, origination fee, pre-paid interest, pre-paid insurance, flood certification fee, tax servicing fee, credit report fee, bank processing fee, recording fee, notary fee, and title insurance. And once an investment property is officially purchased, there are costs such as property management fees, property taxes, association dues, landscaping fees and the opportunity costs of filling vacancies when there is tenant turnover. And this analysis neglects the hefty commission expenses, which generally run 5-6% and split between the buying and selling agent. Add all these costs up, and you can understand the dollars can become significant.
Concentration Risk: It’s perfectly fine to own a levered, cyclical asset in a broadly diversified portfolio for long-term investors, but owning $1.3 million of real estate in a $1.5 million total portfolio does not qualify as diversified. If a portfolio is real estate heavy, hopefully the real estate assets are at least diversified across geographies and real estate type (e.g., residential / commercial / multi-family / industrial / retail mall / mortgages / etc).
Stocks Abhorred, Gold & Real Estate Adored
With the downdraft in the stock market that started in late August, a recent survey conducted by CNBC showed how increased volatility has caused wealthy investors to sour on the stock market. More specifically, the All-America Survey, conducted by Hart-McInturff, polled 800 wealthy Americans at the beginning of October. Unsurprisingly, many investors automatically correlate temporary weakness in stocks to a lagging economy. In fact, 32% of respondents believed the U.S. economy would get worse, a 6% increase from the last poll in June, and the highest level of economic pessimism since the government shutdown in 2013 (as it turned out, this was a very good time to buy stocks). These gloom and doom views manifested themselves in skeptical views of stocks as well. Overall, 46% of the public felt it is a bad time to invest in stocks, representing a 12% gain from the last survey.
With investor appetites tainted for stocks, hunger for real state has risen. Actually, real estate was the top investment choice by a large margin, selected by 39% percent of the investors polled. Real estate has steadily gained in popularity since the depths of the recession in 2008. Jockeying for second place have been stocks and gold with the shiny metal edging out stocks by a score of 25% to 21%, respectively.
Successful long-term investors like Warren Buffett understand the best returns are earned by going against the grain. As Buffett said, “Be fearful when others are greedy and greedy when others are fearful,” and we know stock investors are fearful. Along those same lines, Bill Miller, the man who beat the S&P 500 index for 15 consecutive years (1991 – 2005), believes now is a perfect time to buy stocks. Investing in real estate is not a bad idea in the context of a diversified portfolio, but investors should not forget the fallibility of tangibility.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including SPY, but at the time of publishing, SCM had no direct position in Z, RWR, or any other security referenced 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.
Investing, Housing, and Speculating
We all know there was a lot of speculation going on in the housing market during 2005-2007 as risk-loving adventurists loaded up on NINJA loans (No Income, No Job, and No Assets) and subprime CDS (Credit Default Swap) securities. But there is a different kind of speculation going on now, and it isn’t tied directly to housing. Instead of buying a house with no down payment and a no interest loan, speculators are leaping into other hazardous areas of danger. Like a frog jumping from lily pad to lily pad, speculators are now hopping around onto money-chasing industries, including biotech, social media, Bitcoin, and alternative energy.
As French novelist Jean-Baptise Alphonse Karr noted, “The more things change, the more they stay the same.” Irrespective of the painful consequences of the bubble-bursting aftermaths, human behavior and psychology addictively succumb to the ever-seductive emotion of greed. Over the last 15 years, massive fortunes have been gained and lost while chasing frothy financial dreams in areas like technology, housing, and gold.
Most get-rich-quick dream chasers have no idea of how to invest in or value a stock, but they sure know a good story when they hear one. Chasing top performing stocks is lot like jumping off a bridge – anyone can do it, and it feels exhilarating until you hit the ground. However, there is a better way to create wealth. Despite rampant speculation, most individuals understand the principles behind buying a house, which if applied to stocks, can make you a superior investor, and assist you in avoiding dangerous, speculative investments.
Here are some valuable housing insights to improve your stock buying:
#1.) Price is the Almighty Variable: Successful real estate investors don’t make their fortunes by chasing properties that double or triple in value. Buying a rusty tool shed for $1 million makes about as much sense as Facebook paying $19 billion (1,000 x’s the estimated 2013 annual revenues) for a money-losing company, WhatsApp. Better to buy real estate when there is blood in the street. Like the stock market, housing is cyclical. Many traders believe that price patterns are more important than the actual price. If squiggly, technical price moving averages (see Technical Analysis article) make so much money for stock-renting speculators, then how come day traders haven’t used their same crossing-lines and Point & Figure software in the housing market? Yes, it’s true that the real estate transactions costs and illiquidity can be costly for real estate buyers, but 6% load fees, lockup periods, 20% hedge fund fees, and 9% margin rates haven’t stopped stock speculators either.
#2). Cash is King: It doesn’t take a genius to purchase a rental property – I know because practically half the people I know in Southern California own rental properties. For example, if I buy a rental property for $1 million cash, is it a good purchase? Well, it depends on how much after-tax cash I can collect by renting it out? If I can only net $3,000 per month (3.6% annualized return), and be responsible for replacing roofs, fixing toilets, and evicting tenants, then perhaps I would be better off by collecting 6.5% from a low-cost, tax-efficient exchange traded real estate fund, without having to suffer from all the headaches that physical real estate investing brings. Forecasting future asset price appreciation is tougher, but the point is, understanding the underlying cash flow dynamics of a company is just as important as it is for housing purchases.
#3). Debt/Leverage Cuts in Both Directions: Adding debt (or leverage) to a housing or stock investment can be fantastic if prices go up, and disastrous if prices go down. Putting a 20% down payment on a $1 million house works out wonderfully, if the price of the house increases to $1.2 million. My $200,000 down payment is now worth $400,000, or up +100%. The same math works in reverse. If the price of the home drops to $800,000, then my $200,000 down payment is now worth $0, or down -100% (ouch). Margin debt on an equity brokerage account works in a similar fashion, but usually a 50% down payment is needed (less risky than real estate). That’s why I always chuckle when many real estate investors tell me they steer clear of stocks because they are “too risky”.
#4). Growth Matters: If you buy a home for $1 million, is it likely to be worth more if you add a kitchen, tennis court, swimming pull, third floor, and putting green? In short, the answer is yes. The same principle applies to stocks. All else equal, if a company based in Los Angeles, establishes new offices in New York, London, Beijing, and Rio de Janeiro, and then acquires a profitable competitor at a discounted price, chances are the company will be much more valuable after the additions. The key concept here is that asset values are not static. Asset valuations are impacted in both directions, whether we are talking about positive growth opportunities or negative disruptions.
Overall, speculatively chasing performance is tempting, but if you don’t want your financial foundation to crumble, then build your successful investment future by sticking to the fundamentals and financial basics.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct discretionary position in FB, Bitcoin, or any other security referenced 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.
QE: The Greatest Thing Since Sliced Bread*
Quantitative easing (QE), or the Federal Reserve’s bond buying program, has been a spectacular success. Arguably, the greatest innovation since sliced bread. Don’t believe me? I mean, if you listen to many of the experts, strategists, economists, and blogosphere pundits, the magical elixir of QE can be the only explanation rationalizing the multi-year economic recovery and stock market boom. Don’t believe me? Well, apparently many of the bearish pros make sure to credit QE for all our financial/economic positives. For example…
- QE is the reason the stock market is near all-time record highs.
- QE created seven million jobs in the U.S. over the last four years.
- QE turned around the housing market.
- QE turned around the auto market.
- QE weakened the U.S. dollar, resulting in flourishing exports.
- QE has lowered borrowing rates, thereby cleansing consumer balance sheets through deleveraging.
- QE is the reason Facebook Inc. (FB) hired 1,323 employees over the last year.
- QE is the reason Google Inc. (GOOG) has spent $7.8 billion on R&D over the last year.
- QE explains why McDonald’s Corp. (MCD) plans to open more than 1,400 stores this year.
- QE explains why Warren Buffett and 3G capital paid $28 billion to buy Heinz.
- QE is the reason Elon Musk and Tesla Motors (TSLA) invented the model S electric vehicle.
- QE exhibits why Target Corp. (TGT) is expanding outside the U.S. into Canada.
- QE is the reason why S&P 500 companies are expected to pay $300 billion in dividends this year.
- QE is the reason why S&P 500 companies were buying back shares at a $400 billion clip this year.
- QE is the basis for corporations spending billions on efficiency enhancing cloud-based services.
- QE led to a record number of new FDA drug approvals last year.
- QE has caused a natural gas production boom in numerous shale regions.
Wow…the list goes on and on! Heck, I even hear QE can take the corrosion off of a rusted car battery. Given how incredible this QE stuff is, why even consider tapering QE? Financial markets have been volatile on the heels of tapering the 3rd iteration of quantitative easing (QE3), but why slow QE3, when the FED could add more awesomeness with QE4, QE10, QE 100, and QE 1,000?
All of this QE talk is so wonderful, but unfortunately, according to all the bearish pundits, QE has created an artificial sugar high, thus creating an asset bubble that is going to end in a disastrous cratering of financial markets.
I know it’s entirely possible that QE may have absolutely nothing to do with the financial market recovery (other than a bid under Treasury & mortgage backed security prices), and also has no bearing on why I buy or sell stocks, but I guess I will need to hide in a cave when QE3 tapering begins. Although the end of dividends, share buybacks, housing/auto recoveries, acquisitions, expansion, innovation, etc., caused by QE tapering sure does not sound like a cheery outcome, at least I still have a loaf of sliced bread to make a sandwich.
*DISCLOSURE: For those readers not familiar with my writing style, I have been known to use a healthy dose of sarcasm. Call me if you want a deeper explanation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE II : Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and GOOG, but at the time of publishing, SCM had no direct position in FB, TSLA, MCD, BRKA, TGT, or any other security referenced 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
Time to Trade in the Investment Tricycle
This article is an excerpt from a previously released Sidoxia Capital Management’s complementary newsletter (May 1, 2013). Subscribe on the right side of the page for an entire monthly update.
As the stock market continues to set new, all-time record highs and the Dow Jones Industrial index nears another historic milestone (15,000 level), investors remain cautiously skeptical of the rebound – like a nervous toddler choosing to ride a tricycle instead of a bicycle. Investors have been moving slowly, but stock prices have not – the Dow has risen +13% in 2013 alone. What’s more, over the last four years the S&P 500 index (which represents large companies) has climbed +140%; the S&P 400 (mid-sized companies) +195%; and the S&P 600 (small-sized companies) +200%.
The gains have been staggering, but like the experience of riding a bicycle, the bumps, scrapes, and bruises suffered during the 2008-2009 financial crash have caused investors to abandon their investment bikes for a perceived safer vehicle…a tricycle. What do I mean by that? Well, over the last six years, investors have pulled out more than -$521,000,000,000 from stock funds and piled those proceeds into bonds (Calafia Beach Pundit chart below). For retirees and billionaires this strategy may make sense in certain instances. But for millions of others, interest rate risk, inflation risk, and the risk of outliving your money can be more hazardous to financial well-being, than the artificially perceived safety expected from bonds. The fact of the matter is investing inefficiently in cash, money markets, CDs, and low-yielding fixed income securities can be riskier in the long-run than a globally diversified portfolio invested across a broad set of asset classes (including equities). The latter should be the strategy of choice, unless of course you are someone who yearns to work at Wal-Mart (WMT) as a greeter in your 80s!
Investor Training Wheels
I don’t want to irresponsibly flog everyone, because investing attitudes have begun to change a little in 2013, as investors have added $66 billion to stock funds (data from ICI). Effectively, some investors have gone from riding their tricycle to hopping on a bike with training wheels. With this change in mindset, surely people have commenced selling bonds to buy stocks, right? Wrong! Investors have actually bought more bonds (+$69 billion) than stocks in the first three months of the year, which helps explain why interest rates on the 10-year Treasury are only yielding a paltry 1.67% (near last year’s record summer low) – remember, bond buying causes interest rates to go down. If you really want to do research, you could ask your parents when rates were ever this low, but some readers’ parents may not even had been born yet. The previous record low in interest rates, according to Bloomberg, at 1.95% was achieved in 1941.
Over the last five years the news has been atrocious, and as we have proven, investing based off of current headlines is a horrible investment strategy. As we’ve seen firsthand, there can be very long, multi-year periods when stock performance has absolutely no correlation with the positive or negative nature of news reports. To better make my point, I ask you, what types of headlines have you been reading over the last four years? I can answer the question for you with a few examples. For starters, we’ve endured financial collapses in Iceland, Ireland, Dubai, Greece, and now Cyprus. At home domestically, we’ve experienced a “flash crash” that temporarily evaporated about $1 trillion dollars in value (and 1,000 Dow points) within a few minutes due to high frequency algorithmic traders. How about unemployment data? We’ve witnessed the slowest, jobless U.S. recovery in a generation (since World War II), and European countries have it much worse than we do (e.g., Spain just registered a 27% unemployment rate). What about political gridlock and brinksmanship? We’ve seen debt ceiling stand-offs lead to a historic loss of our country’s AAA debt status; a partisan presidential election; a deafening fiscal cliff debate; and now mindless sequestration. Nevertheless, large cap stocks and small cap stocks have more than doubled and tripled, respectively.
Fear sells advertising, and sounds smarter than “everything is rosy,” but the fact remains, things are not as bad as many bears claim. Corporations are earning record profits, and hold trillions in cash (e.g., Apple Inc.’s recent announcement of more than $50 billion in share repurchase and $11 billion in annual dividend payments are proof). Moreover, central banks around the globe are doing whatever it takes to stimulate growth – most recently the Bank of Japan promised to inject $1.4 trillion into its economy by the end of 2014, in order to kick-start expansion. Lastly, the U.S. employment picture continues to improve, albeit slowly (7.6% unemployment in March), allowing consumers to pay down debt, buy more homes, and spend money to spur economic growth.
Dangers of Being Informed
Hopefully this clarifies how useless and futile newspaper headlines are when it comes to effective investing. As Mark Twain astutely noted, “If you don’t read the newspaper, you are uninformed. If you do read the newspaper, you are misinformed.” It’s perfectly fine to remain in tune with current events, but shuffling around your life’s savings based on this information is a foolish plan.
If the concerns and worries du jour have you nervously riding a tricycle, just realize that you may not reach your investment destination with this mode of transportation. I understand that it is not all hearts and flowers in the financial markets, and there are plenty of legitimate risks to consider. However, excessive exposure in low-rate asset classes may be riskier than many realize. If you’re still riding your investment tricycle, you’re probably better off by grabbing a helmet and pads (i.e., globally diversified portfolio) and jumping on a bike – you are more likely to reach your financial destination.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), WMT and AAPL, but at the time of publishing SCM had no direct position in any other security referenced 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.
Damned if You Do, and More Damned if You Don’t
Source: Photobucket
In the stock market you are damned if you do, and more damned if you don’t.
There are a million reasons why the market should or can go down, and the press, media, and bears come out with creative explanations every day. The “Flash Crash,” debt ceiling debate, credit downgrades, elections, and fiscal cliff were all credible events supposed to permanently crater the market. Now we have higher taxes (capital gains, income, and payroll), sequester spending cuts, and a nagging recession in Europe. What’s more, the pessimists point to the unsustainable nature of elevated corporate profit margins, and use the ludicrous Robert Shiller 10-year Price-Earnings ratio as evidence of an expensive market (see also Foggy Rearview Mirror). If an apple sold for $10 ten days ago and $0.50 today, would you say, I am not buying an apple today because the 10-day average price is too high? If you followed Robert Shiller’s thinking, this logic would make sense.
Despite the barrage of daily concerns and excuses, the market continues to set new record highs and the S&P 500 is up by more than +130% since the 2009 lows – just a tad higher than the returns earned on cash, gold, and bonds (please note sarcasm). Cash has trickled into equities for the first few months of 2013 after years of outflows, but average investors have only moved from fear to skepticism (see also Investing with the Sentiment Pendulum ). With cash and bonds earning next to nothing; gold underperforming for years; and inflationary pressures eroding long-term purchasing power, the vice is only squeezing tighter on the worrywarts.
Are there legitimate reasons to worry? Certainly, and the opportunities are not what they used to be a few years ago (see also Missing the Pre-Party). Although an endangered species, long-term investors understand backwards looking economic news is useless. Or as Peter Lynch wisely stated, “If you spend 13 minutes a year on economics, you’ve wasted 10 minutes.” The fact remains that the market is up 70% of the time, on an annual basis, and has been a great place to beat inflation over time. It’s a tempting endeavor to avoid the down markets that occur 30% of the time, but those who try to time the market fail miserably over the long-run (see also Market Timing Treadmill).
Equity investors would be better served by looking at their investment portfolios like real estate. Homeowners implicitly know the value of their home changes on a daily basis, but there are no accurate, real-time quotes to reference your home value on a minute by minute basis, as you can with stocks. Most property owners know that real estate is a cyclical asset class that is not impacted by daily headlines, and if purchased at a reasonable price, will generally go up in value over many years. Unfortunately, for many average investors, equity portfolios are treated more like gambling bets in Vegas, and get continually traded based on gut instincts.
Volatility is at six-year lows, and investors are getting less uncomfortable with owning stocks. Although everybody and their mother has been waiting for a pullback (myself included), don’t get too myopically focused. For the vast majority of investors, who should have more than a ten year time horizon, you should understand that volatility is normal and recessions will cause stocks to gown significantly, twice every ten years on average. If you are a long-term investor, like you should be, and you understand these dynamics, then you will also understand that you will be more damned if you don’t invest in equities as part of a diversified portfolio.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced 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.
Fence-Sitting: The Elusive Art of More Data and Pullbacks
The world of financial markets is full of fence-sitters, especially in the professional realm. Why? Well, for starters, fence-sitting provides the luxury of never being wrong. If fence-squatting observers do nothing and provide no opinions, then they cannot by definition be wrong or mistaken. Why should a professional put their neck out for an economic, sector, or investment specific forecast, if there is a potential of looking stupid or losing a job?
For many, the consequences of possibly being wrong feel so horrendous that participants choose instead to sit on the non-committal fence. In most cases, the fence posts on any financial issue or investment align along the comfort of consensus thinking. Unfortunately, consensus thinking has a limited shelf life, because the views held by the majority are constantly changing. Repeatedly modifying personal opinions to match consensus views may prevent the bruising of egos, however, this naïve strategy can be destructive to long-term returns. Here are a few examples:
2000
Consensus View: New Normal tech stocks will continue explosive growth; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2006
Consensus View: Home prices will rise forever and leverage is beautiful; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2010
Consensus View: Greece and European collapse to cause a double-dip global recession; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2011
Consensus View: U.S. credit downgrade will be bad for Treasuries and rates; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2012
Consensus View: Uncertainty surrounding election bad for equities; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2012
Consensus View: China’s slowing growth and real estate bubble expected to cause a global double-dip recession; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2012
Consensus View: Impending fiscal cliff bad for equities; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2013
Consensus View: Debt ceiling debate bad for equities; Consensus Outcome: ???; Investor Net Result: ???.
2013
Consensus View: Looming sequestration bad for equities; Consensus Outcome: ???; Investor Net Result: ???.
In recent years the market has continued to climb a wall of worry, but will this year be different? We shall soon see.
Placing the concern du jour aside, if consensus fears coalesce around a specific upcoming event, chances are that particular issue is already factored into existing expectations and price structures. Therefore, rather than wasting personal “worry” bandwidth on those fears, investor anxiety should be dedicated to less prevalent but potentially more impactful unknown concerns. Or if you need clarification about the unknowns to worry about, perhaps Donald Rumsfeld can clarify the situation by highlighting the risk of “unknown unknowns”:
I Love Data and Pullbacks!
When faced with apprehension or uncertainty, many fence-sitting investors revert to wanting more data or waiting for a better price. For example, I often hear, “I love stock XYZ, but I want to wait for the earnings to come out,” or analyst day, or share buyback announcement, or merger closing, or restructuring, etc., etc., etc. For strategists and economists, they are famished for the next critically irrelevant weekly jobless claims number, Federal Reserve policy minutes, ISM monthly manufacturing data, or latest consumer confidence figure.
More data for fence sitters is not sufficient. I often listen to stock-pickers say, “I love XYZ stock, but not at the current $52.50 price, but I’ll back up the truck at $51.50!” Okay, so you’re telling me that you think the stock is worth +40% more, but you want to litigate the purchase price over $1?!
Sadly, there is a cost for all this fence-sitting: a) if good news comes out, investment prices catapult higher and the investor is stuck with a pricier investment; b) if bad news comes out, that long-awaited price pullback is usually not acted upon because fundamentals have now deteriorated; or c) in many cases the price grinds higher before the long-awaited jewel of information is disseminated. The net result is further fence-sitting paralysis, which paradoxically is not helped by more information or a price pullback.
The other reason fence-sitters say or do nothing is because articulating a gloomy thesis simply sounds smarter. For instance, saying “The reason I’m on the sidelines is because we are in a secular bear market due to the debasement of our currency as a result of inflationary Fed monetary policies,” sounds smarter and more compelling than “Stocks are cheap and are already factoring in a lot of negativity.”
Investing is an unbelievably challenging endeavor, but for those fence-sitters with an insatiable appetite for more data and elusive pullbacks, I humbly point out, there is an infinite amount of information that regenerates itself daily. In addition, there is nothing wrong with having a disciplined valuation process in place, but if your best investment ideas are predicated on a minor pullback, then enjoy watching your returns wither away…as you sit on your cozy fence.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any security referenced 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.
The Rule of 20 Can Make You Plenty
There is an endless debate over whether the equity markets are overvalued or undervalued, and at some point the discussion eventually transitions to what the market’s appropriate P/E (Price-Earnings) level should be. There are several standard definitions used for P/Es, but typically a 12-month trailing earnings, 12-month forward earnings (using earnings forecasts), and multi-year average earnings (e.g., Shiller 10-year inflation adjusted P/E – see Foggy P/E Rearview Mirror) are used in the calculations. Don Hays at Hays Advisory (www.haysadvisory.com) provides an excellent 30+ year view of the historical P/E ratio on a forward basis (see chart below).
Blue Line: Forward PE - Red Line: Implied Equilibrium PE (Hays Advisory)
If you listen to Peter Lynch, investor extraordinaire, his “Rule of 20” states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of approximately 18x times earnings when the current 2011 P/E multiple implies a value slightly above 11x times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.
Just because prices have been chopped in half, doesn’t mean they can’t go lower. From 1966 – 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from about 800 to almost 14,000 in 25 years. Even though equities have struggled at the start of this century, a few things have changed from the market lows of 30 years ago. For starters, we have not hit an inflation rate of 13% or a Federal Funds rate of 20% (~3.5% and 0% today, respectively), so we have some headroom before the single digit P/E apocalypse descends upon us.
Fed Model Implies Equity Throttle
Hays Advisory exhibits another key valuation measurement of the equity market (the so-called “Fed Model”), which compares the Treasury yield of the 10-year Note with the earnings yield of stocks (see chart below).
Blue Line: 10-Yr Treasury - Red Line: Forward PE (Hays Advisory)
Regardless of your perspective, the divergence will eventually take care of it in one of three ways:
1.) Bond prices collapse, and Treasury yields spike up to catch up with equity yields.
2.) Forward earnings collapse (e.g., global recession/depression), and equity yields plummet down to the low Treasury yield levels.
AND/OR
3.) Stock prices catapult higher (lower earnings yield) to converge.
At the end of the day, money goes where it is treated best, and at least today, bonds are expected to treat investors substantially worse than the unfaithful treatment of Demi Moore by Ashton Kutcher. The Super Committee may not have its act together, and Europe is a mess, but the significant earnings yield of the equity markets are factoring in a great deal of pessimism.
The holidays are rapidly approaching. If for some reason the auspice of gifts is looking scarce, then review the Fed Model and Rule of 20, these techniques may make you plenty.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced 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.
Your Portfolio’s Silent Killer
Shhh, if you listen closely enough, you may hear the sound of your portfolio disintegrating away due to the quiet killer…inflation. Inflation is especially worrisome with what we’ve seen happening with commodity prices and the drastic fiscal challenges our country faces. Quantitative Easing (read Flying to the Moon) has only added fuel to the inflation fear flames.
Whether you’re a conspiracy theorist who believes the government inflation data is cooked, or you are a Baby Boomer just looking to secure your retirement, it doesn’t take a genius to figure out that movies, pair of jeans, a tank of gas, concert tickets, or healthcare premiums are all going up in price (See also Bacon and Oreo Future).
Inflation starting to heat up. Source: IMF/Bloomberg via Financial Times
Companies are currently churning out quarterly results in volume and seeing the impact from commodity prices, whether you are McDonald’s Corp. (MCD) facing rising beef prices or luxury handbag maker Coach Inc. (COH) dealing with escalating leather costs, margins are getting crimped. Investors, especially those on fixed income streams, are experiencing the same pain as these corporations, but the problem is much worse. Unlike a market share leading company that can pass on price increases onto its customers, an investor with piles of cash, and low yielding CDs (Certificates of Deposit), and bonds runs the risk of getting eaten alive. Baby Boomers are beginning to reach retirement age in mass volume. Life spans are extending, and this demographic pool of individuals will become ever-large consumers of costlier and costlier healthcare services. If investments are not prudently managed, Baby Boomers will see their nest eggs evaporate, and be forced to work as Wal-Mart (WMT) greeters into their 80s…not that there’s anything wrong with that.
Every day investors are bombarded with a hundred different scary headlines on why the economy will collapse or the world will end. Most of these sensationalist scare tactics distort the truth and overstate reality. What is understated is what Charles Ellis (see Winning the Loser’s Game) calls a “corrosive power”:
“Over the long run, inflation is the major problem for investors, not the attention-getting daily or cyclical changes in securities prices that most investors fret about. The corrosive power of inflation is truly daunting: At 3 percent inflation – which most people accept as ‘normal’ – the purchasing power of your money is cut in half in 24 years. At 5 percent inflation, the purchasing power of your money is cut in half in less than 15 years – and cut in half again in 15 years to just one-quarter.”
In order to bolster his case, Ellis cites the following period:
“From 1977 to 1982, the inflation-adjusted Dow Jones Industrial Average took a five-year loss of 63 percent…In the 15 years from the late 1960s to the early 1980s the unweighted stock market, adjusted for inflation, plunged by about 80 percent. As a result, the decade of the 1970s was actually worse for investors than the decade of the 1930s.”
Solutions – How to Beat Inflation
Although the gold bugs would have you believe it, we are not resigned to live in a world with worthless money, which only has a useful purpose as toilet paper. There are ways to protect your portfolio, if you are properly invested. Here are some strategies to consider:
- TIPS (Treasury Inflation Protection Securities): These government-guaranteed tools are a useful way to protect yourself against rising inflation (see Drowning TIPS).
- Equities (including real estate): Bond issuers do not generally call up there investors and say, “You are such a great investor, so we have decided to increase your interest payments.” However, many publicly traded stocks do exactly that. Wal-Mart Stores (WMT) is an example of such a company that has increased its dividend for 37 consecutive years. As alluded to earlier, stocks are unique in that they allow inflationary pressures placed on operating profits to be relieved somewhat by the ability to pass on price increases to customers.
- Commodities: Whether you are talking about petroleum products, precious metals (those with a commercial purpose), or agricultural goods, commodities in general act as a great inflationary hedge. Another reason that commodities broadly perform better in an inflationary environment is because the U.S. dollar can often depreciate, which commonly increases the value of commodities.
- Short Duration Bonds: Rising rates are usually tied to escalating inflation, therefore investors would be best served by reducing maturity length and increasing coupon.
There are other ways of battling the inflation problem, but number one is saving and investing across a broadly diversified portfolio. If you want to secure and grow your nest egg, you need to use the silent power of compounding (see Penny Saved is Billion Earned) to combat the silent killer of inflation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, TIP, equities, commodities, and short duration bonds, but at the time of publishing SCM had no direct position in any other security referenced 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.
Winning Coaches Telling Players to Quit
How would you feel if your coach told you not only are you going to lose, but you should quit and join the other team? Effectively, that is what Loomis Sayles bond legend Dan Fuss (read Fuss Making a Fuss), and fellow colleagues Margie Patel (Wells Fargo Advantage Funds), and Anthony Crescenzi (PIMCO) had to say about the chances of bonds winning at the recent Advisors’ Money Show.
This is what Fuss said regarding “statistically cheap” equities:
“I’ve never seen it this good in half a century.”
Patel went on to add:
“By any measure you want to look at, free cash flow, dividend yield, P/E ratio – stocks look relatively cheap for the level of interest rates.” Stock offer a “once-in-a-decade opportunity to buy and make some real capital appreciation.”
Crescenzi included the following comments about stocks:
“Valuations are not risky…P/E ratios have been fine for a decade, in part because of the two shocks that drove investors away from equities and compressed P/E ratios.”
Bonds Dynasty Coming to End
The bond team has been winning for three decades (see Bubblicious Bonds), but its players are getting tired and old. Crescenzi concedes the “30-year journey on rates is near its ending point” and that “we are at the end of the duration tailwind.” Even though it is fairly apparent to some that the golden bond era is coming to a close, there are ways for the bond team to draft new players to manage duration (interest rate/price sensitivity) and protect oneself against inflation (read Drowning TIPS).
Equities on the other hand have had a massive losing streak relative to bonds, especially over the last decade. The equity team had over-priced player positions that exceeded their salary cap and the old market leaders became tired and old. Nothing energizes a new team better than new blood and new talent at a much more attractive price, which leaves room in the salary cap to get the quality players to win. There is always a possibility that bonds will outperform in the short-run despite sky-high prices, and the introduction of any material, detrimental exogenous variable (large country bailout, terrorist attack, etc.) could extend bonds’ outperformance. Regardless, investors will find it difficult to dispute the relative attractiveness of equities relative to prices a decade ago (read Marathon Investing: Genesis of Cheap Stocks).
As I have repeated in the past, bonds and cash are essential in any portfolio, but excessively gorging on a buffet of bonds for breakfast, lunch, and dinner can be hazardous for your long-term financial health. Maximizing the bang for your investment buck means not neglecting volatile equity opportunities due to disproportionate conservatism and scary economic media headlines.
There are bond coaches and teams that believe the winning streak will continue despite the 30-year duration of victories. Fear, especially in this environment, is often used as a tactic to sell bonds. Conflicts of interest may cloud the advice of these bond coaches, but the successful experienced coaches like Dan Fuss, Margie Patel, Anthony Crescenzi are the ones to listen to – even if they tell you to quit their team and join a different one.
Read Full Advisor Perspectives Article
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP), but at the time of publishing SCM had no direct position in any other security referenced 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.
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