Posts tagged ‘taxes’

Uncertainty: Love It or Hate It?

Source: Photobucket

Source: Photobucket

Uncertainty is like a fin you see cutting through the water – many people are uncertain whether the fin sticking out of the water is a great white shark or a dolphin? Uncertainty generates fear, and fear often produces paralysis. This financially unproductive phenomenon has also reared its ugly fin in the investment world, which has led to low-yield apathy, and desensitization to both interest rate and inflation risks.

The mass exodus out of stocks into bonds worked well for the very few that timed an early 2008 exit out of equities, but since early 2009, the performance of stocks has handily trounced bonds (the S&P has outperformed the bond market (BND) by almost 100% since the beginning of March 2009, if you exclude dividends and interest). While the cozy comfort of bonds has suited investors over the last five years, a rude awakening awaits the bond-heavy masses when the uncertain economic clouds surrounding us eventually lift.

The Certainty of Uncertainty

What do we know about uncertainty? Well for starters, we know that uncertainty cannot be avoided. Or as former Secretary of the Treasury Robert Rubin stated so aptly, “Nothing is certain – except uncertainty.”

Why in the world would one of the world’s richest and most successful investors like Warren Buffett embrace uncertainty by imploring investors to “buy fear, and sell greed?” How can Buffett’s statement be valid when the mantra we continually hear spewed over the airwaves is that “investors hate uncertainty and love clarity?” The short answer is that clarity is costly (i.e., investors are forced to pay a cherry price for certainty). Dean Witter, the founder of his namesake brokerage firm in 1924, addressed the issue of certainty in these shrewd comments he made some 78 years ago, right before the end of worst bear market in history:

“Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.”

 

Undoubtedly, some investors hate uncertainty, but I think there needs to be a distinction between good investors and bad investors. Don Hays, the strategist at Hays Advisory, straightforwardly notes, “Good investors love uncertainty.”

When everything is clear to everyone, including the novice investing cab driver and hairdresser, like in the late 1990s technology bubble, the actual risk is in fact far greater than the perceived risk. Or as Morgan Housel from Motley Fool sarcastically points out, “Someone remind me when economic uncertainty didn’t exist. 2000? 2007?”

What’s There to Worry About?

I’ve heard financial bears argue a lot of things, but I haven’t heard any make the case there is little uncertainty currently. I’ll let you be the judge by listing these following issues I read and listen to on a daily basis:

  • Fiscal cliff induced recession risks
  • Syria’s potential use of chemical weapons
  • Iran’s destabilizing nuclear program
  • North Korean missile tests by questionable new regime
  • Potential Greek debt default and exit from the eurozone
  • QE3 (Quantitative Easing) and looming inflation and asset bubble(s)
  • Higher taxes
  • Lower entitlements
  • Fear of the collapse in the U.S. dollar’s value
  • Rigged Wall Street game
  • Excessive Dodd-Frank financial regulation
  • Obamacare
  • High Frequency Trading / Flash Crash
  • Unsustainably growing healthcare costs
  • Exploding college tuition rates
  • Global warming and superstorms
  • Etc.
  • Etc.
  • Etc.

I could go on for another page or two, but I think you get the gist. While I freely admit there is much less uncertainty than we experienced in the 2008-2009 timeframe, investors’ still remain very cautious. The trillions of dollars hemorrhaging out of stocks into bonds helps make my case fairly clear.

As investors plan for a future entitlement-light world, nobody can confidently count on Social Security and Medicare to help fund our umbrella-drink-filled vacations and senior tour golf outings. Today, the risk of parking your life savings in low-rate wealth destroying investment vehicles should be a major concern for all long-term investors. As I continually remind Investing Caffeine readers, bonds have a place in all portfolios, especially for income dependent retirees. However, any truly diversified portfolio will have exposure to equities, as long as the allocation in the investment plan meshes with the individual’s risk tolerance and liquidity needs.

Given all the uncertain floating fins lurking in the economic background, what would I tell investors to do with their hard-earned money? I simply defer to my pal (figuratively speaking), Warren Buffett, who recently said in a Charlie Rose interview, “Overwhelmingly, for people that can invest over time, equities are the best place to put their money.” For the vast majority of investors who should have an investment time horizon of more than 10 years, that is a question I can answer with certainty.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including BND, but at the time of publishing SCM had no direct positions 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.

December 9, 2012 at 1:37 am 4 comments

Fiscal & Political Chemotherapy

Chemotherapy is a treatment that uses a mixture of toxic drugs designed to destroy cancer cells, so patients can recover to a healthy state. Similarly, our government system combines a mixture of toxic politicians designed to destroy our nation’s problems, so Americans can benefit from a healthy, expanding economy. In the long run, history teaches us that despite painful periods of political battles, beneficial results are eventually achieved.

Unfortunately, in the short run, political side effects relating to our country’s legislative process can result in extremely unpleasant outcomes, just like experienced during chemotherapy treatment (including nausea, vomiting, hair loss, and fatigue). Politically, we are going through a comparably repulsive period. The good news is, regardless of your political persuasion, a major source of contention is now behind us in the rearview mirror (i.e., the presidential elections) and we can temporarily recover from the barrage of venomous super PAC commercials that have temporarily halted.

Regrettably, the looming “Fiscal Cliff” poses larger consequences than election outcomes, if these out-of-control economic issues are not credibly resolved (see Fiscal Cliff: Repeat or Dead Meat?). Most Americans realize a responsible mixture of real spending cuts coupled with limited tax hikes, like proposed by the bipartisan Simpson-Bowles commission is a great starting blueprint to hammer out a deal. For the time being, I’m happy to hear both Republicans and Democrats are playing nicely in the sandbox. Republican Speaker of the House, John Boehner has signaled he is willing “to put (tax) revenue on the table” and President Obama has said he is “open to compromise.” So what’s all the worry then? We already know that $600 billion in tax increases and spending cuts kick in seven weeks from now, which has the real potential of spinning our economy into another recession if Congress doesn’t act.

You don’t need to go far back in history to see what the effects could be from continued gridlock or a lackluster agreement that kicks the can down the curb. For starters, last year’s initially unsuccessful debt ceiling negotiations resulted in a swift kick in the pants for stocks, as investors watched the S&P 500 index crater -18% within three short weeks. If the $600 billion impact of the Fiscal Cliff and sequestration actually occur, many pundits are predicting up to a -4% hit to GDP (Gross Domestic Product), which makes it virtually certain the economy will slip back into recession.

This game of political chicken can last only for so long. Congressional approval ratings are near record lows, and if inaction continues, voters will ultimately take powers into their own hands and vote out apathetic politicians.

Preparing for the Melt-Up

Would I be surprised to see a market pullback in the coming weeks and months? The short answer: NO. While I may be cynical about the short-term probabilities of a bipartisan “grand bargain” because brinksmanship will likely win in the coming weeks, as both sides jockey for negotiating leverage, I am also keenly aware of the melt-up risk that few investors are currently talking about. You don’t have to be a brain surgeon or rocket scientist to see the amount of pessimism that has built up over recent years. If you don’t believe me, you can just look at the following charts to get the gist:

i) A half of a trillion dollars has been pulled out of the equity markets by nervous investors, despite the market more than doubling from its 2009 lows.

Source: Calafia Beach Pundit (Scott Grannis)

ii) Panicked bond buying has caused the yield on the benchmark 10-year Treasury note to evaporate by about -90% since its peak more than 30 years ago.

10-Year Treasury Yield (Source: Yahoo! Finance)

iii) Fear insurance has been gobbled up by worrywarts as witnessed by gold prices sky-rocketing more than 500% in a little more than a decade.

Historical gold prices (Source: InvestmentTools.com)

A grand bargain doesn’t guarantee a return to the stock market circa the 1990s, but in an environment where trillions of dollars have been stuffed under the mattresses of corporations and individuals, earning next to nothing, it won’t take much to ignite the animal spirits of investors. Changing the perception of a market that sees the glass as -90% empty to the view of a glass 10% full, could lead to a happier 2013 for equity investors. However, if no Fiscal Cliff agreement is made, locating me may be a challenge – I suggest you try me in my bunker.

While our fiscal and political health conditions have reached crisis levels in recent years, there are reasons to be optimistic, now that a hotly contested presidential election has concluded and discussions move forward on a Fiscal Cliff solution. Chemotherapy involves a toxic and destructive regiment of harsh medicines, but in certain situations, like the present political environment, investors need to survive the unpleasant side effects before economic health and prosperity can be gained.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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 positions 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.

November 11, 2012 at 11:39 pm 5 comments

Autumn, Elections and Replacement Refs

Article is an excerpt from previously released Sidoxia Capital Management’s complementary October 1, 2012 newsletter. Subscribe on right side of page.

As September has come to a close, the grand finale of our annual seasons has commenced… autumn. How do we know autumn is here? Well, for starters, the leaves are changing colors; the weather is about to cool; and the NFL replacement referees are watching Sunday football games from their couches.

While 2012 is split into quarters, football games and investment seasons are also divided into four quarters. Right now, the economic fourth quarter has just started and the home team is winning. As we can see from the stock market scoreboard, the S&P 500 index is up +15% this year (+6% in Q3) and the NASDAQ index has catapulted +20% through September (+6% also in Q3). The U.S. home team is winning, but a fumble, blocked kick, or interception could mean the difference between an exciting win and a devastating loss.

Another game divided into four parts is the game of presidential politics. However, presidential elections are divided into four years – not four quarters. Five weeks from now, we’ll find out if our Commander in Chief Obama will get to lead our team for another game lasting four years, or whether backup quarterback Mit Romney will be called into the game. The fans are getting restless due to anemic growth and lingering joblessness, but for now, the coach is keeping the president in the starting lineup. Both President Obama and Governor Romney will take some head-to-head practice snaps against each other in the first of three scheduled presidential debates beginning this week.

Bernanke Changes Rules

The New York Jets have Tim Tebow for their secret weapon (1 for 1 yesterday!), and the United States economy has Ben Bernanke. Although our home team may be winning, it has required some monetary rule-changing policies to be instituted by Federal Reserve Chairman Ben Bernanke to keep our team in the lead. Just a few weeks ago, Mr. Bernake instituted QE3 (3rd round of quantitative easing), which is an open-ended mortgage buying program designed to lower home buying interest rates and stimulate the economy (see Helicopter Ben to QE3 Rescue). The short-term benefits of the $40 billion monthly bond buying binge are relatively clear (lower borrowing costs for homebuyers), but the longer-term costs of inflation are stewing patiently on the backburner.

Source: Calafia Beach Pundit (Scott Grannis)

As you can see from the chart above, August median home prices are up +10% for existing single-family homes over the last year. Housing affordability is at extremely attractive levels, and although the bank loan purse strings are tight, a modest loosening is beginning to unfold.

Economy Playing Injured

Our starters may still be playing, but many are injured, just like the jobless are limping through the employment market. Encouragingly, although unemployment remains stubbornly high, the number of people collecting unemployment checks is a lot lower (-1.25 million fewer than a year ago). Not great news, but at least we are hobbling in the right direction (see chart below).

Source: Calafia Beach Pundit (Scott Grannis)

Time for Fiscal Cliff Hail Mary?

If a team is losing at the end of a game, a “Hail Mary” pass might be necessary. We are quickly nearing this fiscal Armageddon situation as the approximately $700 billion “fiscal cliff” (a painful combo of spending cuts and tax hikes) kicks in at the end of the year (see PIMCO chart below via The Reformed Broker).

Running trillion dollar deficits in perpetuity is not a sustainable strategy, so for most people, a combination of spending cuts and/or tax hikes makes sense to narrow the gap (see chart below). Last year’s recommendations from the bipartisan Simpson-Bowles commission, which were ignored, are not a bad place to start. What happens in the lame-duck session of Congress (after the elections) will  dramatically impact the score of the current economic game, and decide who wins and who loses.

Source: Calafia Beach Pundit (Scott Grannis)

Heated debates continue on how the gap between expenses and revenues will be narrowed, but regardless, Democrats will continue to push for capital gains tax hikes on the rich (see tax chart below); and the Republicans will push to cut spending on entitlements, including untenable programs like Medicare and Social Security.

Source: The Wall Street Journal

The game is not quite over, but the fourth quarter promises to be a bloody battle. So while the replacement refs may be back at home, the experienced returning refs have been known to blow calls too. Let’s just hope that autumn, the season of bounteous fecundity, ends up being a continued trend of sweet market success, rather than a political period of botched opportunities.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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 positions 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.

 

October 1, 2012 at 11:29 am Leave a comment

Fiscal Cliff: Will a 1937 Repeat = 2013 Dead Meat?

Source: StockCharts.com

The presidential election is upon us and markets around the globe are beginning to factor in the results. More importantly, in my view, will be the post-election results of the “fiscal cliff” discussions, which will determine whether $600 billion in automated spending cuts and tax increases will be triggered. Similar dynamics in 1937 existed when President FDR (Franklin Delano Roosevelt) felt pressure to balance the budget after his 1933 New Deal stimulus package began to rack up deficits and lose steam.

What’s Similar Today

Just as there is pressure to cut spending today by Republicans and “Tea-Party” Congressmen, so too there was pressure for FDR and the Federal Reserve in 1937 to unwind fiscal and monetary stimulus. At the time, FDR thought self-sustaining growth had been restored and there was a belief that the deficits would become a drag on expansion and a source of future inflation. What’s more, FDR’s Treasury Secretary, Henry Morgenthau, believed that continued economic growth was dependent on business confidence, which in turn was dependent on creating a balanced budget. History has a way of repeating itself, which explains why the issues faced in 1937 are eerily similar to today’s discussions.

The Results

FDR was successful in dramatically reducing spending and significantly increasing taxes. Specifically, federal spending was reduced by -17% over two years and FDR’s introduction of a Social Security payroll tax contributed to federal revenues increasing by a whopping +72% over a similar timeframe. The good news was the federal deficit fell from -5.5% of GDP to -0.5%. The bad news was the economy went into a tail-spinning recession; the Dow crashed approximately -50%; and the unemployment rate burst higher by about +3.3% to +12.5%.

Source: New York Times

Source: Blue Mass Group

What’s Different This Time?

For starters, one difference between 1937 and 2012 is the level of unemployment. In 1937, unemployment was +14.3%, and today it is +8.1%. Objectively, today there could be higher percentage of the population “under-employed,” but nonetheless the job market was in worse shape back then and labor unions had much more power.

Another major difference is the stance carried by the Fed. Today, Ben Bernanke and the Fed have made it crystal clear they are in no hurry to take away any of the monetary stimulus (see Hekicopter Ben QE3 article), until we have experienced a long-lasting, sustainable recovery. Back in early 1937, the Fed increased banks’ reserve requirements twice, doubling the requirement in less than a year, thereby contracting monetary supply drastically.

Furthermore, we live in a much more globalized world. Today, central banks and governments around the world are doing their part to keep growth alive. Emerging markets are large enough now to move the needle and impact the growth of developed markets. For example, China, the #2 global superpower, continues to cut interest rates and has recently implemented a $158 billion infrastructure spending program.

Net-Net

Whether you’re a Republican or Democrat, everyone generally agrees that job creation is an important common objective, which is consistent with growing our economy. The disagreement between parties stems from the differing opinions on what are the best ways of creating jobs. From my perch, the frame of the debate should be premised on what policies and incentives should be structured to increase competitiveness. Without competitiveness there are no jobs. At the end of the day, money and capital are agnostic. Cold hard cash migrates to the countries in which it is treated best. And where the money goes is where the jobs go.

There is no single silver bullet to solve the competiveness concerns of the United States. Like baseball (since playoffs are quickly approaching), winning is not based solely on hitting, pitching, defense, or base-running. All of these facets and others are required to win. The same principles apply to our country’s competitiveness.

In order to be a competitive leader in the 21st century, here are few necessary areas in which we must excel:

Education: Chicago school unions have been in the news, and I have no problems with unions, if accountability can be structured in. Unfortunately, however, it is clear to me that for now our system is broken (a must see: Waiting for Superman). We cannot compete in the 21st century with an illiterate, uneducated workforce. Our colleges and universities are still top-notch, but as Bill Gates has stated, our elementary schools and high schools are “obsolete”.

Entitlements: Social safety nets like Social Security and Medicare are critical, but unsustainable promises that explode our debt and deficits will not make us more competitive. Politicians may gain votes by making promises in the short-run, but when those promises can’t be delivered in the medium-run or long-run, then those votes will disappear quickly. The sworn guarantees made to the 76 million Baby Boomers now entering retirement are a disaster waiting to happen. Benefits need to be reduced and or criteria need to be adjusted (i.e., means-testing, increase age requirements). The problems are clear as day, so Americans cannot walk away from this sobering reality.

Strategic Government Investment: – Government played a role in building our country’s railways, highways, and our military – a few strategic areas of our economy that have made our nation great. Thoughtful investments into areas like energy infrastructure (e.g., smart grid), internet infrastructure (e.g., higher speed super highway), and healthcare (e.g., human genome research) are a few examples of how jobs can be created while simultaneously increasing our global competitiveness. The great thing about strategic government investments is that government does NOT have to do all the heavy lifting. Rather than write all the checks and do all the job creation from Washington, government can implement these investments and create these jobs by providing incentives for the private sector. Strategic public-private partnerships can generate win-win results for government, businesses, and job seekers. If, however, you’re convinced that our government is more efficient than the private sector, then I highly encourage you to go visit your local DMV, post office, or VA to better appreciate the growth-sucking bureaucracy and inefficiency.

Taxes / Regulations / Laws: Taxes come from profits, and businesses create profits. In order to have a strong and competitive government, we need strong and competitive businesses. Higher taxes, excessive regulations, and burdensome laws will not create stronger and more competitive businesses. I acknowledge that reckless neglect and consumer exploitation will not work either, but reasonable protections for consumers and businesses can be instituted without multi-thousand page regulations. Reducing ridiculous subsidies and loopholes, while tightening tax collection processes and punishing tax dodgers makes perfect sense…so why not do it?

Politics are sharply polarized at both ends of the spectrum, but no matter who wins, our problems are not going away. We may or may not have a new president of the United States this November, but perhaps more important than the elections themselves will be the outcome of the “fiscal cliff” legislation (or lack thereof). If we want to maintain our economic power as the strongest in the world, solving this “fiscal cliff” is the key to improving our competiveness. Avoiding a messy 1937 (and 2011) political repeat will prevent us from becoming dead meat.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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 positions 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.

 

September 23, 2012 at 10:55 pm Leave a comment

The Fund Flows Paradox

How is it that the stock market has more than doubled over the last three years, when investors have been dumping stocks like they are going out of style? If you don’t believe me, and you think jovial investors are jacking stocks higher, then please explain to me why billions of dollars are hemorrhaging out of equity funds on a monthly basis over the last five years (see Fund Flow data chart below)?

Source: Calafia Beach Pundit

If by small chance you buy my argument that skeptical investors continue to doubt the sustainability of the three-year doubling in the stock market, then why is the Volatility Index (VIX) trading like investors are sunbathing at the beach while licking lollipops? For those not keeping score on the VIX (see also The VIX and the Rule of 16), typically a reading below 20 is interpreted as investor overconfidence and/or complacency. On the flip side, readings above 20 usually indicate pessimism or fear.

As you can see from the chart below, we have spent a good portion of the last few years on both sides of the 20 mph VIX speed limit, and currently at a reading of about 17, investors have slowed down to enjoy the scenery.

Source: Yahoo! Finance

So with massive selling and a cheery reading on the VIX, how can these bipolar data-points be reconciled? Therein lies the “Fund Flows Paradox.”

Take Me Out to the Ballgame

If you equate equity investors to fans at a baseball stadium, the fund flow data clearly shows investors are tired of losing money and have been leaving the game in droves. Instead of staying at the equity baseball stadium, those fatigued stock investors have decided to head over to the adjacent bond arena. The equity stadium will never completely be empty because financial markets always have speculative traders. In baseball terms you can think of these short-term traders as the emotionally volatile die-hard fanatics, who will stick around regardless of whether the home team wins or loses.

So while sentiment gauges like the VIX, or sentiment surveys conducted by AAII (American Association of Individual Investors) may be temporarily flashing contrarian bearish signals, one should be cognizant that these data points do not include the petrified opinions of investors who have raced out of the stadium. Eventually when the home team’s winning streak is long enough, investors will return back to the stadium from the bond arena. While there is no sign of individual investors coming back to the stock game anytime soon, in the meantime patient and disciplined investors have had plenty of opportunities to take advantage of. With massive numbers of individual investors and sellers sitting on the sidelines, the markets require relatively little buying to push prices higher.

Over the last few years, not only have equity valuations been broadly reasonable, volatility spikes during the last few summers have  also created amplified opportunities. With the wall of worries currently blanketing traditional and new media headlines (i.e., European crisis, U.S. election uncertainty, unsustainable and slowing profits, pending tax cut expirations, Mideast turmoil, etc.) there is no sense of urgency to pile back in to the equity markets.

The doubling in stock prices have occurred on low volumes, largely on the backs of a smaller institutional investor base, not to mention high frequency traders and speculators. While sentiment surveys may currently provide some insight into short-term equity trader attitudes, don’t let these volatile and unreliable data cloud the true underlying pessimism of the masses who have left the stock stadium in large numbers. Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.

Opinions are interesting, but actions speak louder than words. Spend more time looking at the actions of the fund flow data, rather than the opinions of various short-term sentiment surveys or short-term options trader statistics. Adjusting your focus to investor actions and behavior will provide a truer gauge of overall investor sentiment and assist you in solving the “Fund Flows Paradox.”

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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 VXX, 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.

April 21, 2012 at 11:26 pm 15 comments

Investors Sit on Fence and Watch New Highs

Article includes excerpts from Sidoxia Capital Management’s 3/1/2012 newsletter. Subscribe on right side of page.

We’ve seen some things jump during this 2012 Leap Year (mainly stock prices), but investors have not been jumping – rather they have been doing a lot of fence sitting. Despite the NASDAQ index hitting 11+ year highs (+14% in 2012 excl. dividends), and the S&P 500 index approaching 4-year highs, investors have been pulling cash out in droves from equities. Just last month, Scott Grannis at Calafia Beach Pundit highlighted that $355 billion in equity outflows has occurred since September 2008, including $155 billion since April 2011 and $6 billion siphoned out at the beginning of 2012.

Once again, listening to the vast majority of TV talking heads has decimated investor portfolios. However, ignoring the dreadful, horrific news over the last three years would have made an equity investor 100%+ (yes, that’s right…double). Somehow, the facts have escaped the psyches of millions of average Americans as the train is leaving the station. Certainly in 2008, a generational decline in equity markets was accompanied by horrific headlines. Those who were positioned too aggressively suffered about 15 months of severe pain, but those who capitulated with knee-jerk reactions after the collapse did incredibly more damage by selling near the bottom and locking in losses. Only now, after the Dow has exploded from 6,500 to 13,000 over the last three years have investors begun to ask whether now is the time to buy stocks.

Of course, making decisions by reacting to news headlines is a horrible way to manage one’s money and will only lead to a puddle of tears in the long-run. Psychological studies have shown that losses are 2.5x’s as painful as the pleasure experienced from gains. The wounds from the 2000 technology bubble and 2008-2009 financial crisis are still too fresh in investors’ minds, and until the scars heal, millions of investors will remain on the sidelines. As usual, average investors unfortunately get more excited after much of the gains have already been garnered.

Investing should be treated like an extended game of chess that requires long-term thinking. As in investing, there are many strategies that can be used in chess. Shadowing your opponent’s every move generally is not a winning strategy. Rather than defensively reacting to an opponent’s every move, proactively planning for the future is a healthier strategy. Don’t be a pawn, but instead create a long-term, low-cost investment plan that accounts for your current balance sheet, future goals, and risk tolerance in order to achieve your retirement checkmate. But before you can do that, you must first get that rump off the fence and put a plan into action.

 

Hot News Bites

  Chili Pepper

How Do You Like Them Apples? Apple Inc. (AAPL) has become the most valuable company on the planet as it has surpassed a half-trillion dollars in market value at the end of February. Thanks to record sales of new iPhones, iPads, and Mac computers, Apple has managed to stuff away close to $100 billion in cash in its coffers. What’s next for Apple? Besides introducing new versions of existing products, Apple is expected to innovate its television platform later this year.

Greece Dips into Euro Purse Again: Euro-zone ministers approved a $172 billion rescue package for Greece to avoid default for the second time in less than two years. In addition to the Greek citizens, private bondholders are sharing in the pain. The deal calls for debt holders to write down their Greek debt by 74%; demands stark austerity measures (Debt/GDP ratio of 120.5% by 2020); and a continuous monitoring of Greece’s fiscal standing by a European task force.

Taxes-Schmaxes: There’s nothing more exciting in politics than the discussion of taxes. OK, maybe former Speaker Newt Gingrich’s moon colony proposal is a tad more interesting. Nonetheless, Congress voted to extend the payroll-tax cut through December, and both President Obama and presidential candidate Mitt Romney unveiled their new tax plans. Although Obama’s plan hopes to tax the rich, both politicians have plenty of tax-cuts embedded in their plans. In an election year, apparently debt and deficit amnesia have set in.

Investors “Like” Facebook: Although investors appear to be “Like”-ing Facebook in advance of its initial public offering (IPO), employees and owners seem to be even happier, considering the company is estimated to reach up to $100 billion in value once shares begin trading. I can’t wait to read CEO Mark Zuckerberg’s status update when he cashes in on a portion of his stake of $25 billion or so.

Gas Prices Empty Wallet: Improving global economic data is not the only reason behind escalating gasoline prices (currently averaging $3.73 per gallon for Regular). Iran reduced its sales of crude oil to Britain and France after those countries stopped importing Iranian oil, and Iran stated it has made progress on its nuclear-development program. Can’t we just all get along?!

Plan. Invest. Prosper.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, FB 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.

March 2, 2012 at 8:07 pm 1 comment

Invisible Costs of Trading

Source: Photobucket

You can feel them, but you can’t see them. I’m talking about invisible trading costs. Although some single transaction trading costs can run as high as hundreds of dollars at the large brokerage firms, investors are generally aware of the bottom-basement commissions paid on trades executed at discount brokerage firms like Scottrade, TD Ameritrade (AMTD), E-Trade (ETFC), and Charles Schwab (SCHW) – generally less than $10 per trade. Unfortunately, these commissions are estimated to only account for 20% of total trading costs1. What most investors are unaware of are the host of invisible trading costs and expenses associated with active trading.

Here are some of the invisible costs:

Bid-Ask Spread: Besides the explicit commissions charged, traders must incur the implicit costs of the bid-ask spread. Let’s suppose you have a stock trading at $12.50 per share (ask price) and $12.25 per share (bid price). If you were to immediately buy one share for $12.50 (ask) and sell immediately for $12.25 (ask), then you would be -2% in the hole instantly – more than double the $7.95 commission paid on a $1,000 investment. Effectively, the investor would already be down about -3% the instant the small investment was made.

Impact Costs: The issue of impact costs is a bigger problem for larger institutional investors, although thinly traded stocks (those securities with relatively small trading volume) can even become expensive for retail investors. Suppose the same stock mentioned previously initially traded at $12.50 per share before you transacted, but reached $13.00 per share upon completion (with an average $12.75 price paid). The $.25 cent increase (average price minus initial price) translates into another -2% increase in the costs.

Taxes: It’s not what you make that matters, but rather what you keep that makes the difference. If you make a decent amount of money actively trading, but end up giving Uncle Sam more than potentially 40% of the gains, then your bank account may grow less than expected.

While my examples may shed some light on the costs of trading, an in-depth study using data from Morningstar and NYSE was conducted by three astute professors (Roger Edelen [University of California, Davis], Richard Evans [University of Virginia], and Gregory Kadlec [Virginia Polytechnic Institute]) showing that an average fund’s annual trading costs were estimated to be 1.44%, higher than an average fund’s overall expense ratio of 1.21%.

Unfortunately from an investor’s standpoint, as much as 30% of all trading costs can be attributed to money naturally pouring in and out of funds, due to fund share purchases and redemptions. Therefore, wildly popular or out-of-favor funds will have a detrimental impact on performance. I know firsthand the costs of managing a large fund, much like captaining a supertanker – you create a lot of waves and it can take a while to change directions. Smaller funds, however, can navigate trades more nimbly, much like a speedboat leaving behind smaller cost waves in its wake.

Style can also have an impact on trading costs. Value-based funds that sell into strength or buy into weakness can be considered liquidity providers, and therefore will experience lower trading costs. On the flip side, momentum strategies effectively pour gasoline on hot stocks purchases and pile on damaging sales to cratering losers.

Emotional Costs of Trading

More impactful, but more difficult to quantify, are the emotional trading costs of greed and fear (i.e., chasing extended winners out of greed and panicking out of losing positions due to fear). Constantly hounding winners and capitulating your losers may work in a few instances, but can lead to disastrous results in the long-run. Even if an investor is correct on the sale of a security, the investor must also be right on the subsequent buy transaction (no easy feat).

With that said, there are no hard and fast rules when buying/selling stocks. Buying a stock that has doubled or tripled in and of itself is not necessarily a bad idea, as long as you have credible assumptions and data to support adequate earnings/cash flow growth and/or multiple expansion. Consistent with that thought process, a plummeting stock is not reason enough to buy, and does not automatically mean the price will subsequently rebound. Reversion to the mean can be a powerful force in security selection, but you need a disciplined process to underpin those investment decisions.

Spiritual Savings

As I have stated in the past, investing is like a religion (read more Investing Religion). Most investors stubbornly believe their financial religion is the right way to make money. I personally believe there is more than one way to make money, just as I believe different religions can coexist to achieve their spiritual goals. Through academic research, and a lot of practical experience, my religion believes in the implementation of low-cost, tax efficient products and strategies used over longer-term time horizons. I use a blend of active and passive management that leverages my professional experience (see Sidoxia’s Fusion product), but I would fault nobody for pursuing a purely passive investment strategy. As John Bogle shows, and has proven with the financial success of his company Vanguard, passive investing by and large materially outperforms professional mutual fund managers (see Hammered Investors article).

Investing can be thrilling and exciting, but like a leaky faucet, the relatively small and apparently harmless list of trading costs have a way of collecting over the long-run before sinking long-term performance returns. Sure, there are some high-frequency traders that make a living by amassing a large sums of rebates for providing short-term liquidity, but for most investors, excessive exposure to invisible trading costs will lead to visible underperformance.

Read more about trading cost study here1

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Vanguard funds), but at the time of publishing SCM had no direct position in AMTD, ETFC, SCHW, Scottrade, MORN, 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.

December 15, 2010 at 12:05 am Leave a comment

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