YOU Are the Product
The retail brokerage industry began in New York City in 1792 with the signing of the Buttonwood Agreement. It established the organization now known as the New York Stock Exchange and fixed commissions for customers at one quarter of one percent. One hundred eighty-three years later, the discount brokerage industry began with the deregulation of stock commissions through the Securities Acts Amendments of 1975.
I’m offering this history lesson to make the point that just because you can’t see the costs associated with a purchase, it doesn’t mean they’re not there. As Robert Heinlein famously said in his 1966 science fiction novel The Moon is a Harsh Mistress: “there ain’t no such thing as a free lunch,” noting that bars which serve a free lunch also charge more for drinks.
The New Scientist recently reported on Purdue student Abhinav Pathak’s research into the battery usage of free games for mobile phones. He found that the Angry Birds uses about 20% of the total power it consumes on the game itself and the remainder on determining where the user is, downloading location-appropriate ads and keeping the wireless connection open. In a more candid approach, I recently downloaded free Avery software to create custom note cards. It makes the design process much easier and it’s obvious what Avery gets out of providing the software - increased sales of their extensive line of blank card stock.
“Rollover your 401(k) and get a year of free trades.” Does this advertisement sound familiar? Variations on that theme are legal because of the deregulation of commissions but, from a business perspective, how is it possible? How can the brokerage firm give away something that has had cost associated with it for well over two hundred years?
Since brokerage firms are retail businesses, it’s possible that we’re seeing an example of a loss leader, a deeply discounted deal advertised in hopes of bringing you into a business. Once there, the retailer anticipates that you’ll spend money on more appropriately priced items. In this case, perhaps if you accept their offer, you’ll also transfer your non-retirement account and the brokerage firm will be able to charge its normal commissions. After a year, the free trade period is up but the firm hopes the friction which is part of any transfer process will keep the account with them instead of the customer chasing after another offer.
In addition to commissions, there are less obvious ways that a brokerage firm can make money. During the housing bubble, new mortgages were replacing old ones at a previously unheard of rate and Merrill-Lynch stockbrokers were paid for referring their customers to another M-L division for new mortgages. Even in more normal times, brokerage firms have additional sources of income. It’s easy to enter an order to purchase a stock on-line and see that the commission was added as expected but do you pay attention to the firm’s role in the transaction? Did they act as your agent, buying in the open market or as principal, selling shares from the brokerage firm’s own inventory? If principal, do you have any idea what the firm might have paid for the security you bought? It was almost certainly sold at a profit. Likewise, buried in the contract you signed when you opened the account is language describing what’s called “payment for order flow,” a concept originated by the investor’s good friend Bernie Madoff. These are fees paid to brokerage firms by market makers for routing orders through them instead of the NYSE.
Both of these factors make it difficult to determine whether you really got a good deal or not. Although “best execution” is broadly required on the aggregate of all trades made for all customers, it’s pretty hard to tell how a small investor who is unable to demand the best prices did on any particular transaction.
If you purchase Microsoft Word each role is clear. You are the customer and the transaction is complete when you pay for the software. If you use the free Google Docs instead, the transaction isn’t complete until an advertiser buys an ad. Of course, every time you log back onto the website, you see another ad, so in some ways, the transaction may never be complete. Many people have embraced Facebook as a way to connect with family and friends. It seems to be free but if you stop to think about it for a moment, users are not Facebook’s customers: advertisers are. As has been said in several places, including Jim Calloway’s law blog (in a post about Google’s new privacy policy): “If you are not paying for the product, you are the product.”
Breezy Speculation
As I’ve said to many clients, the first item on any financial planner’s job description should probably be something like:”can accurately foresee the future, allowing clients to make money in all market conditions and be perfectly insured against all adverse events”. The investment world has a long, if not particularly distinguished history of people attempting to do just that, especially regarding market action. Sometimes the predictions are offered for the general good, sometimes specifically for clients or subscribers and sometimes basically to sell books.
Over the twenty-plus years I’ve been professionally involved in investing, I’ve noticed that one of the most common approaches to making predictions is to suggest that we’ll continue to get more of what we’ve recently experienced. In 1999, Harry Dent wrote a bestselling book called The Roaring 2000s, in which he predicted the continued upward movement of the stock markets, assuming tech stocks would continue to increase in value as they had through the late 90′s. He had an MBA from Harvard and used lots of charts and graphs to make his point. He appeared on various talk shows, sold a lot of books and even advised a mutual fund into which people invested over a billion dollars. The NASDAQ index was about 4100 when he predicted it would be somewhere between 13,000 and 20,000 by 2010. In fact, the decade has been called “lost” by many investment commentators with the NASDAQ finishing at 2650.
Perhaps commentators like Mr. Dent tend to predict “more of the same” because people find that approach logical, thus easy to accept. My research suggests that markets and rates tend to move in cycles instead, so I spend most of my time looking for signs of an impending change in direction. That said, I am no more capable of predicting markets than was Mr. Dent. But, predictions are expected of planners as the year unfolds, so let me offer some thoughts about what the rest of 2012 might bring.
An increase in First Class postage has already been announced, meaning a personal letter will cost another penny to mail. We have a supply of one-cent stamps here at the office for anyone who failed to lay in a stock of forever stamps and needs a few to round out their supply.
This being an election year, I’ve heard several suggestions that Congress isn’t planning to do much since it could all be undone next year. Without commenting on that approach, I think several items will have to be dealt with, including preferential treatment of capital gains. Right now, the thoughtful folks who write the Kiplinger Tax Letter seem to think the current top rate of 15% will be extended past the end of this year but nothing’s certain, so consider taking long-term gains this year. Investors who must take Required Minimum Distributions from their IRAs have been allowed to make a direct gift to a charity in several of the past years and the Kiplinger editors believe that option will be allowed again this year.
Presidential candidates seem to run on the economy, either taking responsibility for its success or promising to fix it. It’s entirely too early to conclude that ours has recovered but employment figures are improving and the inventory of homes for sale appears to be declining. However, there are still lots of foreclosures to be processed as the robo-signing issue is resolved and documents start flowing again. We believe this is likely to be another good year for stock markets but we continue to hedge our clients’ portfolios against other outcomes.
Except for California, where local laws have caused oil production to fall by a third over the past 20 years, I’d say $6.00 per gallon gasoline is not going to be a widespread problem. Capitalism has exhibited a remarkable ability to heal itself, as higher oil prices tend to bring additional capacity into service. More specifically, the recently announced slowing of China’s rate of economic growth will free millions of barrels of oil for use by the rest of the world.
If I might, I’d like to return to Mr. Dent for a moment as I conclude my thoughts. His mutual fund eventually closed and its remaining assets combined with another AIM fund but he hasn’t give up on making forecasts. He predicted another bull market in his 2006 book The Next Great Bubble Boomjust ahead of the market’s 2008 crash. His 2009 book, The Great Depression Ahead, was published just in time for the recovery which seems to be gaining traction.
Even as I make a few very general predictions, I know that I don’t have a secret window into the future. I’ve drawn today’s title from a comment about prediction-making that CNN correspondent Jeff Greenfield made on Jim Lehrer’s Online NewsHour: “It’s the least intellectually taxing question that somebody can ask or the least intellectually taxing answer somebody can give, and one of the least challenging discussions for an audience. You’re not actually talking about history, culture, facts. You’re talking about what one of my law school professors used to call breezy speculation, or the initials thereof.”
It’s Greek to Me
William Shakespeare’s Julius Caesar is a tragedy told in four acts. Early in the play, Casca and Cassius are discussing a speech by Cicero and today’s title is drawn from that conversation. As Casca tells the story, those in attendance seemed to appreciate Cicero’s oration but, to a Roman, the words were meaningless. Some people may find the current headlines about the Greek economy equally foreign, so I thought I’d try to provide a translation.
Let me begin by relating the Greek situation to the US economic crisis of 2008. One of the companies which was saved was the insurance giant AIG. Why was it chosen while other companies were allowed to fail? The basic answer is what’s known in economic circles as “counter-party” risk. Before lending, most investors try to protect themselves by at least checking a company’s credit rating but many go further and purchase insurance. Prior to the crisis, AIG had been offering insurance against the default of those extremely complicated mortgage-backed bonds which were being pushed by virtually all US brokerage firms. As the value of those bonds was called into question, the likelihood of AIG having to pay billions of dollars in claims grew.
The British AIG office which sold the bond insurance had collected millions of dollars in premiums but hadn’t done a thorough job of evaluating the potential risks. Had AIG been required to make good on all the claims it faced, it would have been forced out of business. That potential failure represented significant counter-party risk to all of those whom AIG insured and that’s what made its bailout seem appropriate to our government officials. The Federal Reserve made an enormous line of credit available and AIG used it to pay claims; those who had purchased insurance received the benefit they had contracted for. Cynics note that Goldman Sachs was among the largest recipients of these payouts and is also a company well-represented at the highest levels of our government.
A very different scenario was considered and discarded, a systematic “unwinding” of AIG’s positions through bankruptcy or liquidation. This is the general approach being planned for Greece. Instead of fully repaying creditors at government expense, they will receive only partial repayment. In the interest of fairness, such losses are almost always taken pro rata, with each investor receiving the same percentage of the amount owed. This strategy is common enough that those discounts from full repayment have a name: “the haircut”, a term you have probably heard in relation to the Greek settlement. Under the current plan, owners of Greek bonds would be reimbursed for only about half of their face value, i.e., each would receive a 50% haircut. Since those bonds have recently been selling at discounts of 50% to 60%, the markets seem to be expecting something along this line.
In exchange for the bailout from other EU governments, Greek citizens will be forced to accept significant changes in their lifestyles. I’m not sure the political labels democratic and socialist still have exact meanings but years of socialism have left most Greek workers in enviable, if unsustainable, job situations. Over the years, extra staffing, short work weeks and early retirement were traded for labor peace. From this side of the Atlantic, retirement at fifty seems like a fairy tale and we wonder why the Greeks have reacted so strongly but that’s simply the social contract. Just as our country once promised a lifetime of middle class employment to high school-educated auto workers who were willing to “check their brains at the door”, Greek workers have planned their lives around those deals struck with the government. It’s clear that things must be normalized but it’s also clear that disruptions are going to spread through the Greek economy during the transition.
Prime Minister Georgios Papandreou asked that the bailout question be put to the populace, an uncharacteristically democratic strategy which led to the failure of his government. No politician wants to be hated by his constituents and Papandreou apparently decided that effective resignation was preferable to waging a long and politically damaging fight.
As progress is made on the restructuring front, I think it’s worth asking who Greece’s counter-parties are. The largest of them are banks from other EU nations but the list probably also includes you and me. Just as our money market and bond mutual funds were owners of 2008′s mortgage-backed bonds, they may very well be owners of today’s Greek bonds. The managers’ quest for high yields with which to entice us has proven once again that there’s no investing reward to be had without commensurate risk.
The scene which provided my title also offers the words with which I’ll bring this article to a close. Considering the political posturing which is taking place in Greece, across the European Union and in our own country maybe this will seem appropriate: “There was more foolery yet, if only I could remember it.” Unfortunately, most of us are going to be able to remember this situation much more clearly than we might prefer.
The Virtuous Cycle
| By now, most everyone is familiar with industry’s efforts to bring new electric cars to market. Whether primarily stimulated by environmental concerns or the various tax breaks which have been made available, all auto manufacturers are working on perfecting these “green” vehicles. If you’ve paid much attention to stories about their development, you may have heard today’s title mentioned. It’s an engineering term describing a system in which developments provide positive feedback for each other. In the case of electric vehicles, new technology might make batteries more efficient, allowing them to be smaller and lighter. Such batteries would allow the vehicles themselves to be smaller and lighter, meaning they would require less battery power to operate, quite possibly leading to further efficiencies.Some readers may be more familiar with its opposite - the vicious cycle. A recent example of this phenomenon is Boeing’s attempt to bring its 787 Dreamliner project to fruition. Years behind schedule, Boeing is about to make their first delivery to All Nippon Airlines. Besides numerous assembly-related problems, the plane turned out to be heavier than planned. That meant that room had to be added for additional fuel to propel the extra weight. More fuel, of course, weighs more, so requires - well, you get the picture.
Those who don’t share my interest in engineering may appreciate that this is also a term with application to economics. In the mid-to-late 2000′s, we watched people speculate by purchasing houses to flip. They often borrowed more than the home’s value, so that any slowdown in the buy/sell cycle left them unable to make their payments. As the least solvent of these investors were forced to sell, the value of nearby homes fell, reducing equity and putting other owners at risk. All of this made the bonds which were secured by the underlying mortgages less valuable and that elevated the problem beyond individuals to institutions. Mortgage loan problems felled the once mighty Lehman Brothers in September of 2008. Perhaps closer to home, these issues certainly played a role in the 73 bank failures recorded through September 11th of this year, not to mention the 297 which failed in 2009 and ’10. Fortunately, history includes a long list of virtuous cycles too, in which each improvement has opened the door for another. One that most of us appreciate every day is the regular increase in computing capacity. Back in 1965, Gordon Moore’s “Law” predicted that computing power would double every 18 months. The reason for the increases? The reduction in size and power consumption of the transistors and other components from which computers are built. According to Michio Kaku’s recently published Physics of the Future, today’s singing birthday card contains more computing capacity than was available to all the Allied forces combined in 1945. Still thinking about manufacturing, Kaizen is a Japanese word meaning “improvement” or “change for the better”. Popularized after the Second World War and made famous by Toyota, it’s basically a philosophy of continuous improvement. Kaizen is one of the most important reasons that “Made in Japan” has an entirely different meaning now than it did pre-WW2. The fact that Toyota was required to recall nearly four million vehicles last year shows that cycles can reverse if progress comes to be taken for granted. Virtuous cycles work at an individual level too. Since we are often involved with multiple aspects of our clients’ lives, their health can be as important to us as their finances. Does it seem logical that someone who is overweight might be more inclined to experience joint problems? This is a fairly common situation in which improvements can reinforce each other. Weight loss may forestall joint replacement surgery, make surgery more likely to be successful when it eventually becomes necessary and allow for easier post-surgical recovery. Budgeting is another example where a virtuous cycle can improve our clients’ lives. Those who spend less are automatically saving more, usually resulting in reduced stress and increased ability to enjoy life. Because anyone can spend less, it’s entirely possible to turn a vicious financial cycle into virtuous one. Having additional assets offers more flexibility, whether someone is facing an unexpected financial problem or considering retirement. And, of course, retiring is going to be that much easier for those who are already spending less. At a very basic level, financial planning involves providing options for our clients as every decision point arrives. We help them explore their options and reach decisions that meet their needs, providing peace of mind and often leading to another virtuous cycle. |
Matthew 6:27
I don’t believe I’ve used a scriptural reference in one of my articles before but this seems like an appropriate time to look back and see how much human nature may have changed since Biblical times. Responding to His followers’ concerns about what they had to wear and eat, Jesus encouraged them to focus elsewhere, saying: “Who of you by worrying can add a single hour to his life?”
As I write this, we are experiencing yet another market crisis, this one fueled by renewed fears regarding European economies. Once again worry abounds and people are questioning their investment strategies. While it’s natural to be concerned when being bombarded by negative financial news, there is more than one way to deal with those concerns. Warren Ward Associates is a firm which specializes in planning. We also manage investments for many of our clients but only within the context of a plan which extends through the rest of their lives - often beyond. Ignoring headlines is never easy but framing investment decisions as being just one aspect of a lifelong strategy can help. Since our clients are investors, not traders, one of our roles is helping them keep day-to-day distractions in perspective.
Although recession is a word with a specific definition, our collective sense of how the economy is doing has a power all its own. Even though this recession officially ended in June of 2009, the hundreds of thousands of un- and under-employed feel like it’s still going strong. In fact, according to a Gallup poll taken last week, 80% of us believe we’re still in recession. Mark Zandi, chief economist of Moody’s Analytics, recently wrote that “Sentiment can be so harmed that businesses, consumers, and investors freeze up, turning a gloomy outlook into a self-fulfilling prophecy. This is one of those times.” Although economists sometimes seem to be pretty far removed from the world in which the rest of us live, I agree completely with his comment. Regardless of the definition, this recession will not effectively be over until a majority of our citizens believe it is.
What influences our feelings? Some people look to holy writings but many others turn the media. Depending on your preferred news source, you are likely to get reporting which includes some sort of bias. One of the key aspects of WWA’s approach to maintaining a long term view is studying publications representing all sides of important issues. That said, there are a few people who command attention whenever they speak and the list certainly includes America’s sitting president.
Barack Obama presented his new stimulus plan to congress and the American people just prior to the publication of Zandi’s comment. Since sentiment is so critical to our financial futures, presidents almost always appear optimistic, lest people’s fears be increased. Emphasizing this fact, Businessweek recently called Obama our Confidence-Builder in Chief.
In fact, there’s nothing new about a president assuming that role. Although he campaigned for the 1932 presidential election offering more in the way of good humor and paternal advice than details, Franklin D. Roosevelt’s first inaugural address was suitably solemn. Delivered at the depths of the depression, he outlined how he hoped to govern and reminded Americans that the nation’s “common difficulties” concerned “only material things.” One of his best-known quotations is drawn from that speech: “The only thing we have to fear is fear itself”. It’s obvious that a president’s word is not law but let me quote from that speech one more time. “Finally, in our progress toward a resumption of work, we require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency.” If you remember the details surrounding the banking crisis which began in 2008, you might assume that his advice went unheeded. In fact, his suggestions were implemented in mid 1933. Unfortunately, the protections he asked for were successfully lobbied back out of existence in 1999.
Recent market turmoil has not shaken our belief in the need for long term planning, nor has it fundamentally altered our investment approach. We continue to believe in the eventual efficiency of markets and have so advised our clients.
Let me close by returning to the Bible, to Matthew 6:34: “So do not worry about tomorrow; for tomorrow will care for itself. Each day has enough trouble of its own”. Whether we look back a few decades or a few thousand years, human nature doesn’t seem to have changed very much. As planners, we believe it is our job to focus on our clients’ long term goals, always attempting to constrain any urge to take tactical action in a strategic situation.
“Life is just what happens while you are busy making other plans”
Longtime readers may remember past articles in which I suggested that people as different as Albert Einstein, TV character Pa Cartwright and my mother each had something to offer those in need of financial planning advice. Today, I’d like to mention John Lennon as another possible source.
Lennon, of course, was the edgier of the two primary writers of Beatles’ songs, the other being Paul McCartney. John was comfortable commenting on a wide range of topics, making him extremely quotable. One of his most famous appears above. It comes from the song Beautiful Boy (Darling Boy), written for his son, Sean. With the recent demise of News of the World, it’s become a bit harder to keep up with Sean’s life but since he has found success as a musician, writer and actor, it’s safe to say his talent is considerable. Whether or not good planning played a role is a little more difficult to determine.
Quoting a line out of context offers an easy way for a writer to cite someone famous as being supportive of a personal opinion. At a glance, John’s may seem to be an indictment of the planning process but I think a more careful reading might lead to a different conclusion. The lines preceding the more famous ones are “Before you cross the street, Take my hand”. Reflecting on John’s advice to his son, I’m not sure he’s so much suggesting that planning isn’t important as he is that a plan has no value unless it is acted upon. To put it more simply: plans, once conceived, should be executed.
It might seem unlikely that anyone would go to the trouble and expense of preparing any sort of plan then ignoring it but that’s something we see from time to time. Periodically, a big city attorney or salesperson will come to town offering a free dinner which includes a presentation describing all the ills which can be resolved with a revocable living trust. Even though the benefits of the trust are sometimes overstated, at least a few of the attendees always spend big bucks on these documents. We generally learn of the purchase when a client bashfully produces a large three-ring binder which begins with a few personalized pages followed by a hundred or so more of boilerplate containing a lot of blanks which they must fill in. Sometimes, they ask us for help completing the forms. Sometimes, they simply ask what they’ve purchased.
Typically, these binders include a will and other useful documents but focus on the trust, a legal strategy which can be useful in avoiding the probate process - assuming that’s the best course of action. I have written before that trusts have their place, as does unsupervised probate estate settlement. What we object to is people being encouraged to spend a lot of money on a binder without knowing exactly why they are doing so. As financial planners, we believe that such a document may be useful as part of a more comprehensive strategy but that a bound revocable trust alone does not constitute a financial plan. We are happy to help people complete these documents but we often find ourselves feeling that a local attorney could have provided something simpler, more personal and almost certainly at lower cost.
On the other hand, we have encountered situations in which people had begun a completely appropriate plan then either never completed it or failed to add the signatures which would render it legally binding. So far, with the help of various attorneys and CPAs, we have been able to accomplish what we believed the person’s wishes to be. That process is always painful for those left behind. It also takes additional time and costs more money to resolve a situation that could have been dealt with much more easily in advance.
I think both of these unfortunate circumstances fall under what is to be hereinafter known as the Lennon Rule of Financial Planning: “Life is just what happens …”.
As planners, people allow us to help them deal with different situations occurring at different stages of their lives. We expect to “take a client’s hand” as she or he plans for or deals with a difficult situation of any sort. As I reflect on the song, I think it’s really a lullaby. It’s John’s attempt to reassure his son that everything will be all right and that he will be there for protection. The song opens “Close your eyes, Have no fear, The monster’s gone, He’s on the run and your daddy’s here”. It’s certainly a stretch to suggest that sufficient financial planning will hold every monster at bay but we do think that identifying potential problems and helping our clients be prepared to deal with them is a good place to begin. That process lies at the heart of the work we do at Warren Ward Associates, although we sometimes require a little help from our friends - including John Lennon.
The Good, the Bad and the Ugly
I generally stay away from political themes in my writing, if for no other reason than I don’t want to alienate half of my readers by taking a position which appeals to the other half. I’m going to make an exception today because I think the issues relating to the debt ceiling and the budget will have an impact on all of our lives beyond the planning and investing issues I usually address.
About twenty-five years ago, a Swedish friend told me that he admired the US because our politicians started with varying positions but always seemed able to work out compromises to keep the country moving forward. Back home, he said, all it took to get elected was to promise that the government would provide something else. His fellow citizens were well acclimated to the socialist approach of high taxes but almost everything - from health care to a college education - being provided by the government. Flash forward to 2011 and I suspect his opinion might have changed, as our politicians now seem more likely to take extreme positions to please a narrow band of the electorate, allowing them less room for compromise.
After passing a new debt ceiling on August 2nd, congress left Washington for its August recess and the president prepared for a bus trip across the country to do some business and raise some campaign funds. All 536 of them apparently believe that the debt problem has been resolved and they are free to return to their “business as usual” mode. I fear, however, that they are wrong and that it may be some time before business returns to usual. On August 4th, the market sold off broadly, giving up about 5% of its value and the New York Times reported an 82% disapproval rate for congress. On August 5th, S&P downgraded our government’s debt. Perhaps I’m not the only one who’s concerned.
According to the Department of the Treasury, the national debt has increased more than 55% in the past four years. In reflecting on changes in US politics since my friend expressed his admiration, I would say this is a bipartisan issue, with all sides wanting the government to be able to provide more but no side having a concrete plan to do so within the context of a balanced budget. Yearly government spending is about $3.6 trillion, or about $36,000 per US family and tax receipts are about $1.6 trillion, or about $16,000 per family. If you or I were faced with a discrepancy like that, I’m pretty sure we’d do whatever it took to bring things back into balance. Unfortunately, neither congress nor the president seems to consider this an urgent issue.
The title of today’s article, of course, comes from the 1966 Clint Eastwood movie. In it, he portrays a bounty hunter who conspires with (and against) most of the other characters in a very bloody story, riding away at the closing credits having abandoned his partner in crime once again. The title has entered our language as shorthand for a complicated situation like the one we face today. In that context, here’s how things appear to me.
The Good? Well, it is certainly good that we have a debt ceiling deal and that the US will continue to pay its bills. It’s also good that our treasury bonds continue to be the preferred investment for people and governments all over the world who are looking for safety.
The Bad? I don’t believe that the very remote connection our elected officials appear to have with the bulk of the population, and perhaps reality, bodes well for our future. And, of course, the specter of future wrangling and additional rating downgrades isn’t likely to be healthy for our country and its economy.
The Ugly? At best, economic news continues to be mixed. We are starting to hear questions about a double-dip recession and hundreds of thousands of us are suffering through being out of work. That said, corporate profits have been quite healthy, largely because most businesses have resisted hiring new employees. More than one Chief Financial Officer has been quoted as saying she’d never again be caught without a healthy supply of cash, yet it’s spending that cash which will put people back to work and eventually bring an end to the recession.
Does that make business the culprit? Opinions abound but I’d say it has more to do with government than business. We are one of only two countries in the developed world with a debt ceiling and a real decision about ours has not been made, simply postponed. Nina Olson, our national taxpayer advocate, reports that there have been 4,428 changes in the tax code over the past ten years including many which were made retroactively or were deliberately temporary. This sort of uncertainly makes life difficult for anyone whose job it is to make long term decisions. The recession will not end until people begin going back to work but it’s hard to imagine any rational business person making a long term investment in staff at a time when politicians can’t agree on a long term direction for the country.
I have heard politics described as “the art of the possible”, where various beliefs represent a starting point but compromise must be achieved for progress to occur. An increasingly fractious congress offers me little encouragement that our political situation will morph from ugly to pretty anytime in the near future.
Never make predictions, especially about the future
Although I’ve quoted Yogi Berra before, I believe this is baseball player and manager Casey Stengel’s first trip to the plate with a title for one of my articles. As nonsensical as his statement might seem at first glance, there’s a certain practical truth to it. Even with computerized equipment and PhDs providing interpretation, weather forecasts aren’t always right. Sports betting has been popular since the time of the ancient Greeks precisely because no one knows the outcome of a contest until it’s over. At the beginning of this year’s baseball season, the odds of the Cleveland Indians winning the World Series were given as 125:1, third worst in the major leagues. At the end of May, the team had the best record in baseball with 26 wins vs 15 losses.
If most people understand that predicting the weather and the outcome of sporting events is chancy, why do so many try to predict the movements of the stock and bond markets or seek out the predictions of others? Consider this scenario: suppose on January 1st of this year, you had been able to accurately foresee the natural disasters in Japan, the turmoil sweeping the Arab world, continued woes at EU banking institutions, spiking commodity prices and Standard and Poor’s threatened downgrade of our government’s debt. How would you have thought the stock market might react? I doubt if many would have guessed the S&P 500 would gain over 7% by the end of April.
Since it isn’t possible to predict the future, let alone the market’s response to it, what’s an investor to do? A good place to begin is remembering that the market is a leading indicator. That is, it broadly reflects investor expectations for the future rather than today’s headlines. I learned the aphorism “buy the rumor, sell the news” more than twenty years ago as a newly minted stockbroker. Since markets tend to act before things happen, the effect of any one event is likely to be minimized by the time it actually occurs. Another way to say this is that the effect of an event has already been “priced into” the market. Although markets are truly unpredictable, the collective intelligence of investors tends to respond to changes in the investing landscape with reasonable efficiency. I’ve heard the stock market described as the place where the smartest people in the world meet to trade but I’ve rarely heard it described as rational. It isn’t logical to think of the market as having a mind of its own but it’s certainly true that the collective decisions of all those thoughtful investors must make a certain amount of sense - even though the results regularly surprise us. The remarkably effective concept of crowd sourcing has been well described in the book “The Wisdom of Crowds…” by James Surowiecki. I have a copy to lend or it’s available at Viewpoint and elsewhere.
Headlines are specifically written to command our attention so, since markets generally move in advance of reality, it’s rarely profitable to base investment decisions on the daily news. Establishing an appropriate long term investment strategy makes it easier to avoid responding instinctively to negative news. A carefully considered portfolio can provide a useful counterbalance to any single day’s headlines. During the market correction of 2008, some investors became afraid and started withdrawing their assets from the markets. The more sellers there were, the further prices fell and the more difficult it became to resist responding to the admittedly scary news. However, those investors who withdrew from the market then faced what I think is the greater quandary of correctly timing their re-entry. Those who decided to “wait until things look better” certainly bought back in at higher prices. In fact, they may not have returned to the market yet, missing out on a significant upward move which includes that 7% gain from January through April this year.
Let me be clear that Warren Ward Associates has no special insight into what the future holds. Nothing about the future is predictable, including interest rates, inflation and the other factors which move markets. Knowing that, we attempt to structure a suitable investment portfolio for each client, considering both time horizon and tolerance for risk. We believe that, with appropriate planning, it is possible to weather the day-to-day storms and achieve a reasonable long term return.
I’d like to close with a quotation from someone nearly as famous as Casey Stengel. “When the number of factors coming into play in a phenomenological complex is too large, scientific method in most cases fails. One need only think of the weather, in which case the prediction even for a few days ahead is impossible.” Who said that? None other than Albert Einstein, who might have made a pretty good financial planner if he hadn’t been distracted by other pursuits.
Bubble, Bubble, Toil and Trouble
| Let me begin by extending apologies to William Shakespeare whose line from Macbeth actually begins “Double, Double…”. I’d like to spend a few minutes following up on my recent article ’til the Music Stops by commenting on the social networking company Linked-In and other tech companies which have recently “gone public”. This process, through which funds are raised (and founders and early investors take personal profits), is known as an Initial Public Offering or IPO.
Linked-In’s share price famously doubled by the end of its first trading day. That has encouraged other tech companies to consider doing their own IPOs and brings the tech stock bubble of the late 1990′s to mind. Most people agree that it began with Netscape’s extraordinary valuation in 1995. A very inventive company, Netscape produced the first dominant web browser as well as SSL security and JavaScript, both of which are still in wide use today. Unfortunately for investors, Netscape is now an almost invisible part of AOL. Many such companies went public and made headlines but few survived. Well-known on-line retailer Amazon continues to be an investor favorite but other stars of the tech boom have not done quite so well. For example, Monster.com (now known as Monster Worldwide) currently trades at something close to its IPO price of $15 but, during the bubble, its shares went to almost $88. After spending many millions of dollars on Super Bowl ads, other briefly famous companies which have disappeared include Pets.com, Compuserve (also part of AOL) and Hot Jobs.com (now part of Monster). Of course investors’ money disappeared along with them. After reading about Linked-In’s great success and hearing that Microsoft recently paid over $8 billion for Skype, individual investors have been asking once again how they can get their share of the easy money from investing in tech IPOs. Headlines make it seem that significant returns are the norm but University of Florida Professor Jay Ritter has written extensively about IPO pricing and suggests something quite different. His research indicates that in most cases high prices are simply not justified. I am a subscriber to the wireless access provider Boingo. I know it to be an excellent company providing dependable service at a reasonable price. It went public in May at $13.50, ended its first day at $12.10 and currently trades for around $9. I think this example might help put a more personal face on Professor Ritter’s somewhat dry academic research. Twitter is among the companies expected to go public in the near future. Average monthly usage has fallen over 10% in the past year and nearly half of all Twitter accounts are now inactive. Is that slippage a harbinger of its future profitability? If so, how should potential investors respond? Warren Ward Associates avoids investing in IPOs as a matter of policy. We are simply not interested in any investment about which there is little or no publically available information on which to base an opinion. This stance might sound familiar to some long time readers. In 2005, I wrote about a potential housing bubble in an article titled Tulip Bulbs, Tech Stocks & Housing Prices, In it, I mentioned the book Extraordinary Popular Delusions and the Madness of Crowds, noting that its author catalogued multiple economic bubbles. Here’s a quote from my article: “neither Tokyo’s housing bubble of the late 80s nor the “dot com” stock bubble of the late 90s is mentioned at all. Perhaps that’s because, as wise as the author is, the book was published in 1851. Although times change, human nature, by and large, does not.” Please remember that in the case of both the tech and housing bubbles, consensus that prices had become unreasonably high formed only in hindsight. From the investment advisor’s point of view one problem with bubbles is that there is always money to be made during the run up, even though losses are assured when the bubble eventually pops. As I pointed out last week, investors make money as long as the music is playing but stand to lose much, perhaps all, of it when the music stops. We believe those clients who trust us to manage their assets consider us their “get rich slowly” advisors. Our approach tends to offer protection from market corrections, partially due to practices such as avoiding IPOs. Let me close with another line from Shakespeare’s mordant play. Following a series of deaths, Macbeth faces his own with these words: “It is a story, told by an idiot, full of sound and fury, signifying nothing.” That’s a very pessimistic comment, one I hope will not be repeated by those individual investors who try and fail to get a share of the easy money hoped for in the IPO markets. |
’til the Music Stops
Fortune magazine recently published an excerpt from a new Bernie Madoff book. As I read once again about regulators’ half-hearted attempts to investigate someone they considered to be above suspicion, I wondered how many similar books will be written and, perhaps more importantly, how many of them will actually be read.
A check with Viewpoint, our local bookstore, shows that about 20 Madoff titles have already been published. While there’s really no way to answer my second question, I think it’s important that the investing public becomes familiar with these too good to be true deals. There are dozens of examples to choose from, with Madoff’s simply being the largest in recent history. Don’t forget Allen Stanford and his Antigua bank-issued CDs and Indianapolis-based Tim Durham’s systematic looting of Fair Finance. I suspect there have probably been cons nearly as long as there’s been money and, regardless of what’s promised, they exist only to generate money for their perpetrators.
Do participants ever have second thoughts after investing in one of these deals? Unfortunately, only rarely. One reason is what is known as confirmation bias, the tendency to look for data supportive of a decision already made or belief already held. Just as someone who is a regular church attendee might be likely to see a divine hand in a positive outcome, someone who has made an investment is likely to look for data which validates that it’s a good one. In the words of historian and author Michael Shermer: “Smart people believe weird things because they are skilled at defending beliefs they arrived at for non-smart reasons”. Few of us like to admit mistakes, so this effect can be seen in numerous situations but it is especially pervasive in the investment world. Unfortunately this includes the multiple regulators who failed to catch Madoff at his game, apparently having already decided he was innocent.
A second reason people are unlikely to change their minds is that they enjoy, perhaps even become dependent upon, the above average returns which are typical of the initial phase of these deals. This second explanation reminds me of the game musical chairs. It’s great while it lasts but someone is certain to be left standing when the music stops.
If you encounter a deal that sounds too good to be true, what should you do? One thought is to solicit a second opinion from your attorney or planner. During the tech stock bubble of 1998 & ’99, Warren Ward Associates systematically reduced our clients’ exposure to small cap growth stocks as the category continued to outperform the general market. As you might imagine, there was some push-back as we made the adjustments away from that year’s hottest performers. However, our clients were quite relieved to find themselves doing better (i.e., losing less) during the subsequent market correction.
For Ponzi schemes such as Madoff’s to work, early investors must make unusually good returns. Although completely legal, initial public offerings bear some similarities to these schemes, and IPOs played a significant role in that late 90′s tech stock bubble. Quite a few new stock issues ran up in value on their first day of trading, a fact well-documented in the media. This had the unfortunate effect of making quick gains look easy, which enticed small investors to try to participate. What apparently was not nearly so well publicized was the reality that there were multiple losers for each winner, a topic to which I’ll return in my next article.
Because it’s simply not possible to predict the future with any degree of accuracy, we believe a disciplined approach to investing is best for the long term. That occasionally leaves our clients with smaller positions in the very hottest sectors of the market, instead owning securities which may be temporarily out of favor. We sometimes think of this as a “get rich slow” strategy but it is one we have seen work with reasonable success over complete market cycles.
As I finish, let me return for a moment to the rush to publish Madoff books, since there may be a musical chairs aspect to that as well. As long as these books are selling, authors and publishers will be rewarded for continuing to bring them to market. However, it’s only a matter of time until public interest fades. At that point, new books on the topic will no longer sell - quite likely leaving one or more authors standing.
