Weekly Commentary October 29th, 2012

The Markets

Who’s right, consumers or businesses?

As it relates to the U.S. economy, consumers seem to feel optimistic about it while businesses are hunkering down.

This split showed up in last week’s release of the first estimate of third quarter gross domestic product (GDP), defined as the output of goods and services produced by labor and property located in the United States. The government said GDP grew a modest 2.0 percent. How we got to the 2.0 percent growth rate is where it gets interesting.

For background, GDP consists of 4 major components:

1)      Personal consumption expenditures

2)      Business investment

3)      Government spending

4)      Net exports of goods and services

Source: Department of Commerce

Of these four components, the first one – personal consumption expenditures – typically accounts for about 70 percent of the total. So, if consumers are optimistic and in a shopaholic mood, that bodes well for economic growth. And, in the third quarter, they were as consumer spending accounted for most of the 2.0 percent increase in GDP.

Businesses, on the other hand, were rather subdued. Capital spending actually declined in the third quarter as, “Slower world growth and worries about a budget crisis at home have spurred U.S. business to take a more cautious stance on hiring and investment,” according to MarketWatch.

Now, all we have to do is get businesses to drink the same Kool-Aid as consumers and we’ll be off to the races!

DO YOU PREFER TO BUY THINGS when they go on sale or do you prefer to pay full price? Now, before you snicker, consider that many people do prefer to pay full price. Why? Take clothing as an example. If you want to be trendy, you’ll likely pay full price since most clothing stores don’t put the latest fashions on sale.

Other folks, while still “fashion conscious,” prefer to wait until an item goes on sale so they can get it at a “bargain” price. And, chances are, if you’re patient, you can get that desired piece on sale as the store makes room for the next season’s clothes.

How people shop for clothes can be very instructive in how to invest successfully in the financial markets. Here are several comparisons to think about:

1)      Buy what’s on sale. Like clothing, investments occasionally drop to a point where they seem like a bargain. Just as smart shoppers like to buy clothes on sale, shrewd investors like to buy securities they believe are temporarily out of favor.

2)      Buy at full price. Well, maybe not. It’s fine to buy trendy clothes at full price because of the psychic rewards of being sharply dressed. But, investors should focus on making money, not on having bragging rights at the cocktail party about owning the latest high-flying, change-the-world Internet company.

3)      Buy only what you need. Consumer’s closets have limited space so most clothes shoppers have a limit on how many suits or coats they buy. Likewise, investors should buy only what they need to help meet their goals and objectives. Specifically, there’s no need to take extra risk if a lower-risk portfolio has a reasonable chance of helping you meet your goals.

Interestingly, investors often think very differently about how they approach buying clothes and making investments. With clothes, many people prefer to wait for a sale and are apt to buy more if they can get them at a deep discount. Conversely, when investments go “on sale,” meaning, their price has dropped, investors often shy away.

As an advisor, part of our job is to help make investing more like bargain clothing shopping. We look for investments that are on sale, that meet your needs, and will last for more than one season. Unlike tie-dyed shirts, we think this type of investment strategy will never go out of style.

Weekly Focus – Think About It…

“You don't want too much fear in a market because people will be blinded to some very good buying opportunities. You don't want too much complacency because people will be blinded to some risk.”

--Ron Chernow, American biographer

Weekly Commentary October 22nd, 2012

The Markets

Twenty-five years later, are there any lasting lessons from the October 1987 stock market crash?

You may recall that on October 19, 1987, the Dow Jones Industrial Average plummeted 22.6 percent. This drop was far steeper than the 12.8 percent decline on October 28, 1929, the day many consider the start of the Great Depression and it “immediately raised fears of an international economic crisis and a recession in the United States,” according to the Los Angeles Times.

Although the crash was mind-boggling and is firmly etched in investment lore, on a long-term performance chart, it shows up as just a blip. In fact, in the first eight months of 1987, the Dow rose more than 40 percent, and, despite the crash, the Dow – amazingly – finished the year with a gain.

With the benefit of 25 years, here are a few investment lessons to remember:

1.      Don’t panic. The crash was painful, but the market was back to breakeven just two years later.

2.      Valuation matters. Traditional valuation metrics such as price earnings ratios and dividend yields were flashing red back in 1987 which suggested the market was ripe for a fall – so pay attention to valuation.

3.      Stay diversified. Even though correlation among asset classes tends to rise during times of market stress, it’s still important to own a variety of asset classes as over time, it may help balance your portfolio.

4.      Invest responsibly. People who borrowed money to invest in the stock market or made high-risk bets got burned when the market crashed. Always invest within your risk tolerance so a repeat of 1987 won’t put you out of business.

Sources: Los Angeles Times; The Motley Fool; Forbes

When asked what the stock market will do, the great banker J.P. Morgan replied, “It will fluctuate.” Indeed, as October 1987 shows, stocks do fluctuate – sometimes dramatically. Knowing that and remembering the four lessons above could help make you a better investor.

HOW GOOD ARE YOU at predicting the future? Well, despite a bazillion bits of information at our fingertips and unbelievable computing power, humans are still pretty bad at it.

Let’s use an example that gets to the heart of the financial crisis. As described in Nate Silver’s book, The Signal and the Noise, back in 2007 Standard & Poor’s Corporation (S&P) gave investment ratings to a particularly complex type of security called collateralized debt obligation (CDO). For CDO’s that were rated AAA – the highest rating possible – S&P said the likelihood that a piece of debt within those CDO’s would default within five years was a miniscule 0.12 percent. That’s about one chance in 850.

Now, you probably know where this is going. Guess what the actual default rate was? According to S&P, it was around 28 percent. Simple math says the actual default rate was more than 200 times higher than S&P predicted and, as Silver wrote, “This is just about as complete a failure as it is possible to make in a prediction.”

It’s easy to poke fun at bad predictions; however, there is a larger point here. First, we can’t predict the future so we always need a plan B. And, second, we need to differentiate between risk and uncertainty.

Economist Frank Knight said risk involves situations where we can calculate the probability of a particular outcome. For example, actuaries can calculate the probability of a 60-year old male dying within 10 years because they have historical mortality statistics that don’t change much from year to year.

By contrast, uncertainty has no historical data to use as a solid basis for making a prediction. For example, predicting the outcome of war in Syria is not knowable because there’s no set of historical data or probability distribution on which to base the prediction.

It’s just our luck that the financial markets seem to contain elements of risk and uncertainty. However, we can try to use that to our benefit by being cognizant when the risk/reward seems to be in our favor while at the same time, having plan B in case uncertainty tries to spoil the party.

 

Weekly Focus – Think About It…

“It is a truth very certain that when it is not in our power to determine what is true we ought to follow what is most probable.”

--Descartes, French philosopher, mathematician, writer

Weekly Commentary October 15th, 2012

The Markets

Two widely watched indicators just hit five-year extreme levels – and that’s a positive for the economy.

Consumer sentiment hit a five-year high in the preliminary October reading, as measured by the University of Michigan-Thomson Reuters sentiment gauge. This gauge “covers how consumers view their personal finances as well as business and buying conditions,” according to MarketWatch. Higher levels of sentiment could translate into higher consumer spending and help propel the economy.

And, the second indicator, housing foreclosure filings, hit a five-year low in September, according to RealtyTrac. Foreclosure filings include default notices, scheduled auctions, and bank repossessions. In September, there were 180,427 foreclosure filings. By contrast, that number was above 350,000 in mid-2009, so, yes, foreclosure filings have improved significantly over the past few years.

And, for good measure, let’s throw in a third indicator – weekly jobless claims – which fell to their lowest level in more than four years for the week ending October 6, according to Bloomberg. Lower claims “may mean employers are seeing enough demand to maintain current staff, a necessary first step to bigger gains in hiring,” according to Bloomberg.

While these three indicators look good, “Earnings pessimism among U.S. chief executive officers is climbing to levels last seen when the Standard & Poor’s 500 Index was mired in bear markets,” according to Bloomberg. In fact, analysts are now forecasting a 0.9 percent decline in corporate earnings for the just completed third quarter, according to Bloomberg.

Good news, bad news, what’s an investor supposed to take from this? Well, like the movie by the same title, it’s complicated. The economy continues to recover and rebalance from the Great Recession and this leads to some indicators looking good, others looking bad, and some looking just plain normal. 

DO YOU WANT TO KNOW THE SECRET to Warren Buffett’s remarkable investment success?

First, some background. Buffett partially owns a company called Berkshire Hathaway and he uses this as his vehicle for making investments in other companies. So, when people say Buffett is a great investor, they’re looking at the performance of Berkshire Hathaway stock which, in turn, tends to reflect the performance of the companies Berkshire owns.

Further, a recent academic paper by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen, titled Buffett’s Alpha, said, “Buffett’s performance is outstanding as the best among all stocks and mutual funds that have existed for at least 30 years.”

Now, here’s the secret to Buffett’s spectacular returns according to the paper’s authors:

We find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails.

Let’s look at each of those components:

1)         Cheap: defined as value stocks with low price-to-book ratios

2)         Safe: defined as stocks with low beta and low volatility

3)         High-quality: defined as stocks of companies that are profitable, stable, growing, and have high dividend payout ratios

4)         Leverage: perhaps shockingly, the authors discovered that Berkshire magnified its returns by leveraging its capital by 60 percent financed partly using insurance float with a low financing rate

Source: Buffett’s Alpha paper

This is not a buy or sell recommendation on Berkshire Hathaway stock, rather, it shows Buffett latched on to a good strategy early in his career, used leverage to magnify his returns, and stuck to the strategy even when it suffered large declines.

Now that we know “how” Buffett achieved his outstanding return (including the surprising leverage), does this in any way diminish his results? No. In fact, it’s probably just the opposite. Buffett figured this strategy out more than 30 years ago and researchers are just now catching up with him!

 

Weekly Focus – Think About It…

“Research is to see what everybody else has seen, and to think what nobody else has thought.”

--Albert Szent-Gyorgyi, Hungarian biochemist

Weekly Commentary October 8th, 2012

The Markets

Encouraging, but still lackluster.

That’s how one analyst described the September jobs report released last Friday by the Labor Department. On the encouraging side, the unemployment rate dropped to its lowest level since January 2009 and the previous two month’s reports were revised upward to show 86,000 more jobs were created than originally reported. On the lackluster side, “At the recent pace of job growth, it would take about 28 months to recoup all the jobs lost during the last recession,” and “The U.S. is still short about 4.1 million jobs compared to its pre-recession peak,” according to MarketWatch.

This middle of the road jobs report continues the tug-of-war trend we’ve seen in the economy. Neither the recessionary forces nor the expansionary forces in the economy can gain an edge. Like a chess match that ends in a draw, the opposing economic forces seem to just about neutralize each other and we end up with modest growth that doesn’t please anybody.

So, what has to happen for the economy to shake off its lethargy and get back to an energizing growth level? Here’s a top six wish list:

 

1)                  Solve the upcoming fiscal cliff situation.

2)                  Solve the European sovereign debt situation.

3)      Reduce the stubbornly high long-term joblessness rate and the alarmingly high youth joblessness rate.

4)      Complete the de-leveraging process for certain sectors of the economy, including the banking and household sectors.

5)                  Complete a smooth transition of leadership in China and light a fire under its economy.

6)                  Replace the highly partisan atmosphere in Washington with constructive collaboration.

Source: The Guardian

 

What are the odds of resolving some of these issues? Well, if you believe the stock market, the odds look reasonable as the Dow Jones Industrial Average continues to hover near a five-year high. Going forward, we need to turn the “hope of solving” into the “reality of solving” to keep Wall Street’s optimism from turning to pessimism.

IS THE U.S. “TURNING JAPANESE?” Over the years, analysts have compared the “lost decade” in the U.S. stock market to the ongoing “lost two decades” in Japan’s stock market and wondered if we are heading down the same path. With a wink to the 1980 New Wave hit from The Vapors, let’s take a look.

Japan

On December 29, 1989, Japan’s Nikkei 225 stock average, the broad measure of the Japan’s stock market, peaked at 38,916. Five years later, it closed at 19,753, representing a loss of 49 percent.  But, it didn’t stop there.

As of last week, after more than 22 years since the 1989 peak, the Nikkei 225 is still down. In fact, it closed at 8,863 – a stunning loss of 77 percent.

Despite this dramatic decline and the tremendous indebtedness of the country, Japan’s economy and society have not imploded. Japan is still the third largest economy in the world, unemployment is low, and the society is civil.

United States

Our stock market, as measured by the S&P 500 index, peaked on October 9, 2007 at 1,565. That peak was followed by a more than 50 percent decline. However, unlike Japan, the U.S. market bounced back strongly and, as of last week, the S&P 500 index closed at 1,461, representing a decline of about 7 percent over the past five years.

Now, some people say we should go back to the March 24, 2000 peak in the S&P 500 index of 1,527 and consider that the starting point for a lost decade. Fair enough. Using that date, the U.S. stock market is down about 4 percent over the past 12½ years, excluding reinvested dividends.

Despite this weak stock market performance and the growing indebtedness of our country, we still have the world’s largest economy, our society is civil (mostly), and, while unemployment is lackluster, it’s not disastrous.

Comparison

Five years removed from the peak in each market, Japan was down 49 percent, while the U.S. market was down just 7 percent.

From the peak of Japan’s stock market through last week – a stretch of more than 22 years – its stock market average is down 77 percent. In the U.S., using our March 24, 2000 peak, we’re down only about 4 percent over the intervening 12½ year period.

So, looking strictly at the numbers, we have not “Turned Japanese.” While reasonable people can argue about our government’s policies and the Federal Reserve’s actions, we can take some comfort in knowing that our economy and stock market, while lackluster, are still persevering.

 

Weekly Focus – Think About It…

“The measure of success is not whether you have a tough problem to deal with, but whether it is the same problem you had last year.”

--John Foster Dulles, former Secretary of State

Weekly Commentary October 1st, 2012

The Markets

Despite all the concern about the fiscal cliff, the sovereign debt crisis, and saber-rattling in the Middle East, the U.S. stock market has posted a strong year-to-date gain.

With just three months left in the year, the Standard and Poor’s 500 index is up 14.6 percent, while the NASDAQ composite index, which measures more than 3,000 stocks on the NASDAQ exchange, is up 19.6 percent.

Drilling down to the U.S. economy, it’s like a tale of two cities.

In the “depressed” city, economic indicators such as orders for durable goods (e.g., cars, planes, machinery, and washing machines), GDP growth, and manufacturing activity are weak. In fact, last week the Commerce Department released its final report on second quarter GDP – the broadest measure of economic activity in the U.S. – and it wasn’t pretty. It was revised downward to show just 1.3 percent growth. That’s down from the previous estimate of 1.7 percent and is barely above stall speed.

Moving down the interstate to the “booming” city, we have other indicators showing a healthier economy. Housing prices and sales volume, for example, are both up in double-digit percentages from a year ago. Consumer confidence is at a four-month high. On the jobs front, unemployment is still unacceptably high, but the unemployment rate has declined this year as has the number of people filing for new weekly unemployment claims. And, the biggie – the stock market – has risen steadily and recently hit a nearly five-year high.

So, which “economic city” will overtake the other as we head into the final stretch of the year?

Well, to a large degree, the answer may reside in the hands of the Fed, Congress, and the political dealmakers in Europe. The Fed’s trying to do its part by greasing the economy with cheap money. Congress, on the other hand, has yet to step up to the plate and show it can prevent the fiscal cliff from tanking the economy. And, in Europe, Spain is in the crosshairs as market watchers nervously calculate the impact of each attempt – or non-attempt – to solve the country’s huge debt and unemployment crisis.

While Dickens’ Tale of Two Cities was a bit dark, we suspect the U.S. economy will eventually find a way to rise to the occasion, even if there are some additional bumps along the way.

HERE ARE A FEW STATS about wealth in the U.S. and in the world:

·         There are 2,160 billionaires in the world.

·         The combined wealth of these billionaires is $6.2 trillion.

·         There are 187,380 people in the world worth at least $30 million.

·         The combined wealth of the people worth $30 million or more is $25.8 trillion.

·          Eighteen of the 40 richest people in the world are from the United States.

·         The net worth of the median American family in 2010 was $77,300.

·         The net worth of the median American family in 2007 was $126,400. The majority of the decline in net worth between 2007 and 2010 was due to the crash in housing prices.

·         The top 10 percent of American households had an average income of $349,000 in 2010.

·         The average net worth of these top 10 percent households was $2.9 million.

Sources: CNBC, Bloomberg, New York Times

 

Do any of these numbers surprise you? No doubt they’ll be a hot topic for discussion as politicians negotiate the upcoming fiscal cliff situation.

 

Weekly Focus – Think About It…

“The most important thing in life is to stop saying ‘I wish’ and start saying ‘I will.’ Consider nothing impossible, then treat possibilities as probabilities.”

--Charles Dickens, English writer and social critic