Is the "Deck" Really Stacked Against the Individual Investor?

A savvy client called me today and asked what I thought about an article that appeared in Barron's last weekend.

In the lead column written by Barron's Alan Abelson (in the August 28, 2010, issue), he mentioned a piece that had been sent to him from a magazine called International Economy.

Abelson wrote that he had never heard of the publication, and neither have I. Still, he spent part of his weekly musings talking about the article called "The Marginalizing of the Individual Investor", and concluded that the authors raised some pretty legitimate points.

http://online.barrons.com/article/SB50001424052970204885704575447721568324514.html#articleTabs_panel_article%3D2

Basically the authors (named Harold Malmgren and Mark Stys) believe that the ordinary investor is being systematically pushed out of the stock market due to the rapid growth in high frequency trading (HFT).

According to the authors, not only do HFT dominate trading, and so order flow, but the ability to capitalize on pricing anomalies in a nanosecond overwhelm the value of fundamental analysis, and make momentum trading the only way to successfully navigate the markets:

For decades, professional investment advisers have continued to teach reliance on “value investing” and “buy-andhold” as long-term guides to successful investment. Chief economists and market prognosticators for financial institutions also continue to urge us to keep focused on “market fundamentals” rather than sell when jostled by disruptive events, expecting “efficient markets” to generate a “fair price” in the whirlwind of market trading. Technology may now have overridden such investment concepts. High-frequency trading platforms are focused solely on ramping up speed and volume so as to maximize tiny gains per transaction. Computerized algorithms that are momentum-sensitive are increasingly high-frequency trading- driven, raising serious doubts about traditional concepts of how markets should work. Investment strategies based on fundamentals such as a company’s long-term performance have been swept aside by high-frequency trading algorithms hunting for inefficiencies in daily pricing and super arbitrage opportunities. In so doing, they open investors to a new form of risk that has not been accounted for in most “buy and hold” asset allocation models.

http://www.international-economy.com/TIE_Su10_MalmgrenStys.pdf

I can see why the authors came to the conclusions they did. As I wrote last week, the data from Ned Davis research indicates that the degree of correlation between stock price movements across all different sectors and industries is currently near an all-time record high - almost 0.80.

Moreover, there is no denying the popularity of exchange-traded funds (ETFs), which make it easier for investors to buy, sell and even short large groups of stocks in a fairly easy fashion. There are now nearly $1 trillion of ETFs outstanding currently.

Finally, market data would also suggest that large program trades being executed by either hedge funds or proprietary trading desks on Wall Street are often as much as 40% of the daily trading volume on the major stock exchanges.

So, my client asked, are we going to start managing money any differently?

My answer at this point is: Not yet.

The dean of security analysis (and mentor of Warren Buffett) was Benjamin Graham. Graham once said that while the stock market is a voting machine in the short run, it is a weighing machine in the long run. That is, while short term stock price movements can often seem random, the longer term trend of market prices will be determined by fundamentals.

Buffett even described the stock market as manic depressive. Sometimes it seems that everything is for sale, and the market despairs that nothing will ever go well again. Other times the market only wants to go higher, as investors are filled with confidence that the world has been forever changed for the better.

The corollary to this is Buffett's dictum that one should be greedy when all are fearful, and fearful when all are greedy. This is why Buffett was a big buyer of stocks in the Panic of the fall of 2008.

It seems to me, then, that today's HFT truly make short-term market timing impossible. Stock prices could vary widely based on programs that are little known to anyone outside the select few that are "in the know".

However, just because prices may more randomly today than they have in the past, I think that Graham's view still is intact - namely, the longer term "weight" of fundamentals will eventually determine stock price trends.

But I think the whole issue of HFT may something to follow closely, especially for regulators.

In Toledo, the 'Glass City,' New Label: Made in China - WSJ.com

I grew up in Toledo, Ohio, so I found this article from yesterday's Wall Street Journal interesting.

The point of the article is the irony that Toledo - nicknamed "The Glass Capital of the World" since it provided glass to the auto industry - needed to import the glass for its new glass museum from China.

Here's an excerpt:

It was a similar story for the Toledo Museum of Art. Only a Chinese company and Spanish and Italian companies could produce the oversize curving panels needed for the futuristic design of its Glass Pavilion. Sanxin says it was paid under $1 million; people involved in the project said it would have cost up to 50% more in Europe.

"We did get some grief about the fabrication until we explained we didn't have a choice," says Carol Bintz, an officer of the Toledo Museum of Art who led the project. "We couldn't find anyone in the United States that could do both the size and make the curvature."

Toledo is now in the midst of struggling to reinvent itself, and to move away from its dependence on the auto industry, but it's difficult. A number of other states are also trying to move towards new technologies to create jobs for it citizens, so in some ways it has become a bidding war in attracting business.

But it's doubtful that Toledo will ever again be a "glass capital". The article describes what China's glass capital looks like; I doubt most American would like this type of industry in their cities:

China's "Glass City" features a skyline of concrete cooling towers characteristic of nuclear power plants, not the expensive equipment Western glassmakers use to reduce pollutants like nitrogen oxide. Mr. Liu says 10% of his capital expenditure goes into pollution controls, that he meets all national standards and is switching to cleaner natural gas.

But Mr. Liu's plant features construction that looks slapdash by Western standards. It is run by engineers seated on wooden benches. A nearby silica sand producer spits mucky water onto the parched land. And trucks ply Shahe roads loaded with bags of synthetic soda ash, the product of a chemical process environmentalists forced out of the U.S. in 1985.

Most of China's glass output is such low quality, it has no market other than China. And much of the Chinese glass now hitting U.S. shores is chiseling into market extremities where profit margins are thinnest: the cheapest salt shakers, table tops and replacement windshields.

It struck me that in some ways China's glass manufacturers today are a little like the Japanese automakers were compared to the U.S. manufacturers a generation ago. Back in the 1960's, "made in Japan" was synonymous with "cheap" and "poor quality" - a far cry from today, when Japan's auto makers dominate world markets, while all but one of the U.S. manufacturers are bankrupt.

Read more: http://online.wsj.com/article/SB10001424052748703428604575418680197041878.html?KEYWORDS=toledo#ixzz0yCOhpUSo

Getting a Will: Six Common Questions - NYTimes.com

Deborah Jacobs brought this good article from the New York Times to my attention on LinkedIn.

Estate planning and wills are subjects that most people like to delay talking about, for obvious reasons. However, taking a few hours to discuss minor details like how to title your assets could someday save your heirs a considerable amount of taxes.

One of the most simple steps - but often overlooked - is to hold your assets in a revocable trust rather than titling in your own name. Here's why:

One of the big reasons people set up revocable trusts, also known as living trusts, is to avoid probate, the court-supervised process to settle a deceased person’s estate. Why? Depending on where you live, probate can be a costly and lengthy process. Attorney, court and other fees often cost up to 5 percent of the value of the estate, Ms. Randolph said. Many Californians choose to use revocable trusts for that reason, she said. Be sure to check the probate laws in your state.

Here’s how the revocable trust works: you put all of your assets into the trust, which remains in your control and can be changed at any time. For the trust to work, you need to retitle all of your assets to the trust (a “pour over” will is also typically used to transfer, or “pour over,” any assets that weren’t in the trust at the time of your death). After you die, a trustee that you name distributes the assets according to your instructions, all while avoiding probate.

Thanks Deborah!


Getting a Will: Six Common Questions - NYTimes.com

Interview with Robert Shiller

This is by way of the blog Zero Hedge.

Robert Shiller of Yale was the author of Irrational Exuberance, which correctly forecast the stock market bubble of the late 1990's. His later work on the housing market was also mostly spot-on, and the Case-Shiller index is one widely cited in the press and academia in describing the current state of housing.

So this interview is worth watching.

Fair warning: Professor Shiller speaks in a fairly monotone voice, so watching this piece for 20 minutes could be tough. The "good' parts (to me) start around 14 minutes or so into the interview, so if you want to skip ahead, by all means.

Or, if you don't want to watch at all, here's Shiller's conclusions: Shiller thinks we are very close to a "double dip" recession; bonds are not in a bubble, but reflect rational fears; and housing could be in trouble for years if we follow the Japan pattern.

Fed Ready to Increase Its Buying of Long-Term Debt - NYTimes.com

The Big Speech by Fed Chairman Ben Bernanke from Jackson Hole, Wyoming, seems to be well-received by the markets.

Stocks are up nicely (S&P+1.3%) despite the fact that the economic data released today was uninspiring (second quarter GDP revised lower to +1.7% from +2.4%, and the U. of Michigan Consumer sentiment numbers show more pessimism than last month).

Meanwhile, the bond market is getting rocked: the 10-year Treasury yield has "soared" by 15 basis points to 2.64%.

Guess the bond folks were hoping for a combination of weaker GDP data and/or more Bernanke mention of Fed direct intervention in the credit markets.

The best line in the talk, I thought, was the following (tip of the hat to Louise Story from the NY Times, who mentioned this on Twitter):

“Central bankers alone cannot solve the world’s economic problems,” he {Bernanke} said.

To which I say: Amen. The Fed has thrown money in the system, driven interest rates down to their lowest level in decades, and yet interest-sensitive sectors like housing have not responded.

One scary statistic: the housing data released a couple of days ago indicated that there was not a single home worth more than $750,000 sold in the month of July in the United States. Not good news for either coasts of the United States, where most of the high-priced housing in the U.S. is located.

My sense is that the other parts of the federal government would love the Fed to come to rescue so that they do not have to address any of the incredibly difficult fiscal challenges that we face.

On the other hand, low interest rates are driving investors crazy, and pushing them in the direction of high yield and emerging market debt in a desperate attempt for more income. I think the swap from stocks to emerging markets bonds makes no sense, but neither does buying higher grade debt issues at yields less than 1%:

Aug. 27 (Bloomberg) -- Investors withdrew a net $7.1 billion from equity funds tracked worldwide in the week to Aug. 25 and put some $5.2 billion into bonds amid concern economies in the U.S. and Europe are losing momentum, EPFR Global said.

A net $5.4 billion was redeemed from U.S. stock funds, while inflows into emerging markets were the lowest in 13 weeks, EPFR said in an e-mailed statement. Developing-nation bond funds took in $1 billion, on course for a record-setting year, while U.S. bond funds drew $2.5 billion, according to the Cambridge, Massachusetts-based research firm.

Fed Ready to Increase Its Buying of Long-Term Debt - NYTimes.com

http://noir.bloomberg.com/apps/news?pid=20603037&sid=aPRxN9th86fU

Amazing Trick Shot Serve by Roger Federer

OK, I know I'm supposed to be focused on the markets and the like - but we're also heading into the US Open, so when I came across this video on Twitter (via YouTube, where it has already been viewed 5.5 million times) I couldn't help but look.

The question is: Does Federer really make this shot (and in a sports jacket, no less):

The Cost Of Phone Calls Is Headed Toward Zero - 24/7 Wall St.

Ten years ago, in 2000, I attended a technology stock conference here in Boston.

One of the keynote speakers was John Chambers, chairman of the Internet equipment routing company Cisco. At the time Cisco was one of the "hot" tech stocks*, so the meeting room was packed.

If you ever have the chance to hear Chambers, you should. He speaks in the native drawl of West Virginia, where he grew up, and has an admirable ability to frame complex technology discussions in simple, down-to-earth language.

He made a number of good points in his talk, but two in particular still resonate with me a decade later.

First, he was critical of the Japanese government for spending its fiscal stimulus funds on infrastructure projects like repaving highways and straightening out rivers. Chambers argued this was a waste of money, and that the government should instead be investing in Internet and IT projects. While his comments were of course dismissed at the time (since Cisco would obviously be a beneficiary), can anyone look at Japan's economy today and not believe that perhaps much of their stimulus spending could have been better spent?

The second point was one that has also stayed with me, and one that has saved me and my clients a considerable amount of money.

During the talk, Chambers said: "All you have to know about telecommunications is: Voice will be free."

By this he meant that the price of phone calls and any other telecommunications would eventually move to zero.

This didn't mean that the cost of providing the services would be free. No, what Chambers was implying was that the huge costs of providing static-free, reliable telecommunications would doubtlessly rise, but it would be very hard for any company to make any money doing so.

And so it has come to pass. Today only two telecommunications companies in the United States - Verizon and AT&T - have any profits at all. However, these profits are the result of landlines, and not cellphones, where every company today is losing money. As the subscriber base erodes for landline phone service (do you know anyone under the age of 30 that installs a phone in their home or apartment?), the future for all telecommunications companies looks bleak.

As I have been discussing frequently on this blog for the last few months, I believe the investment theme for the coming years will be income. Investors will be demanding more income in the form of dividends from their stock investments for a variety of reasons, but mostly because an aging population is going to need income to live on. Moreover, with the disappointing stock returns of the past 12 years, it will be harder for corporate boards to argue that they can invest their cash better than their shareholders can.

Today, in most client portfolios, I have largely avoided investing in any telecommunication stocks or bonds. I believe these companies are in big trouble: huge infrastructure costs, large legacy health care and pension liabilities, and a declining revenue base. The stocks look attractive due to the high dividend yields they currently sport, but I think that the combination of rising costs and declining prices is a recipe for longer term disaster.

The recent announcement by Google that it will now offer free phone service to its Gmail customers is another step in the "voice will be free" environment that John Chambers discussed 10 years ago. As this post from the blog 24/7 Wall Street discusses, it will probably be only a matter of time before other Internet providers begin to offer similar services.

The Cost Of Phone Calls Is Headed Toward Zero - 24/7 Wall St.


*One Wall Street analyst was so in love with Cisco that he claimed that the company would soon be the first corporation worth $1 trillion. Now, 10 years later, Cisco stock is off by more than two-thirds, and the company has a market cap of $121 billion. However, Cisco continues to be one of the dominant players in the Internet equipment space, proving once again that company fundamentals and stock prices do not always move in the same direction.

Hard-nosed Fed sends global markets reeling - Telegraph

Good post from Ambrose Evans-Pritchard in the London Telegraph yesterday.

Every commentator, it seems, is claiming that US bonds are in "bubble", and that bond investors are being set up for a major shellacking. And yet, compared to the rest of the world, US interest rates are essentially in lock-step. Only the credit-stressed countries like Ireland and Greece are seeing high interest rates.

So either the entire world has gone mad (a possibility, I suppose) or the markets are rationally looking at the recent U.S. economic data and heading for the safety of government securities.

Here's an excerpt from the column:

Yields on 10-year bonds fell to 0.92pc in Japan and record lows of 2.23pc in Germany and 2.88pc in the UK. They hit 2.47pc in the US, a Depression level. Irish spreads ballooned to the highest since the launch of EMU. Greek spreads neared 900 basis points, as if the EU's €110bn bail-out never happened.

"This has been one of the most interesting days in finance ever," said Andrew Roberts, head of credit at RBS. "We are right at the tipping point. Yields are about to collapse even further, equities are about to turn over. The end game approaches, probably in next few weeks."

(Mr. Roberts of RBS seems to set a new standard from sangfroid: while he is convinced that the end game is near, he finds all of this "interesting".)

Hard-nosed Fed sends global markets reeling - Telegraph

The stock market recovered somewhat today, and yields actually rose slightly on US Treasurys. We are still following the Japan playbook: stock prices and bond yields are moving in the same direction.

That said, let's hope we're not going to follow the rest of the Japan experience; Mr. Evans-Pritchard continues:

For the Japanese this has become a nightmare. Their V-shaped rebound has been cut off short of its 2008 peak. Growth stalled to just 0.1pc in the second quarter. Unemployment has been rising for four months.

Yet it is their curse to have a currency that strengthens at the wrong time, pushing them deeper into deflation. The Japanese repatriate their foreign wealth in storms, driving up the yen. The dollar-yen rate hit ¥83.6 yesterday, prompting ever warnings from Toyko that intervention nears. Finance minister Yoshihiko Noda said the moves were "disorderly" and posed a threat to stability. "I am watching currencies with great interest," he said.

(Note that Noda-san agrees with the aforementioned Mr. Roberts that all of this is "interesting").

I don't think that we're necessary near the "end game" but we are obviously in a slow patch for the economy. The effects of the government stimulus for housing and durable goods is apparently wearing off, and there doesn't seem to enough demand right now to keep the recovery moving that began a year ago.

The World According to Ned Davis Research

I have written several times on this blog about Ned Davis Research (NDR). Started by (surprise) Ned Davis in the early 1970's, the firm has expanded to four different office locations, including one here in Boston.

NDR's specialty is research targeted to institutional investors, driven by a vast amount of data. It produces something like 15,000 different charts covering stocks, bonds, commodities, etc. on both the U.S. and global markets.

In any event, I went to an NDR breakfast meeting this morning, where one of their senior analysts shared a number of insights from their recent research efforts.

Overall, NDR remains positive on the outlook for stocks, particularly relative to bonds.

That said, they are concerned about the outlook for stocks in 2011. Their data indicates that stocks typically have a strong 12 month return after the end of a recession (they figure the recession ended in June 2009). After that, however, returns are much more modest.

In general they favor large cap stocks versus small cap, and value stocks versus growth.

Other insights:

1. Correlations among stocks are at near record levels. Currently the correlation between all stocks in the S&P 500 is 0.80 compared to 0.56 on average (NDR's data goes back to the late 1960's). This has meant that there has been little opportunity to add value to portfolios through stock picking - beta has been key;
2. Although NDR remains modestly overweight relative to their benchmarks in equities, they are becoming more defensive in their sector allocation. They are finding value in areas like consumer staples, health care, and energy;
3. NDR's data also indicates that shifting to dividend-paying at this point in the cycle makes sense. This is consistent with their view of becoming more defensive;
4. They also like gold, and gold stocks, as part of their portfolio strategy.

The big problem for the market and the economy is the huge debt burden that continues to weigh on just about every sector of the economy. There are only a few ways to repay debt, as we all know, but none of these are conducive to a stronger economy.

NDR is still bullish on emerging markets, which was a little surprising to me given their cautious market views. However, they argue that the emerging stock market correlations have become more in-tune with the global markets, and the combination of strong growth and attractive valuations makes the emerging markets worthwhile investments.

Finally, I should note that I do not agree with NDR's views on gold. It seems to me that bulk of the upward move in gold occurred in the 1970's, when gold moved from $35 an ounce in 1971 to $850 in 1980. Gold is at $1,200 now, but this implies a very meager return for the last 30 years. Moreover, you can't spend gold on living expenses - it's only worth what someone else will be for it.

Deflation: How low will they go? | The Economist

I was going to write about the appeal of utility stocks today*.

However, based on what I'm hearing from my clients, I think I better go back to the bond market.

When I returned to the office yesterday, I had about a dozen messages waiting. All of the subsequent discussions focused on interest rates, income needs, or some variation on the same theme: low interest rates are brutal on investors.

At this writing, 10-year Treasurys are yielding slightly more than 2.5%. Any Treasury note maturing in under 2 years yields less than 1/2%.

Put another way, if you invest $100 today in a Treasury that matures in August, 2012, you will have about $1 more than you have today - in two years.

So: are bonds still a good investment?

To me, you have to start with bond investment basics. Even in "normal" times, all any bond investor should expect is to get interest paid every 6 months and principal back at maturity.

Bonds can play a very useful role in a balanced portfolio since they can even out any equity market swings, so from both an income and capital preservation perspective bonds continue to be attractive.

On the other hand, with yields so low, it's hard to get rich buying high quality bonds these days, especially in the shorter maturity area.

In my opinion, the best investment opportunity in fixed income today can be found in the lower rated municipal bond arena, where yields are still pretty high. However, this assumes that you have a decent credit analyst picking the bonds and can handle less liquidity.

In addition, based on my client feedback, most investors are pretty skittish about municipal finances, and are not eager to buy even general obligation bonds.

This morning's Economist magazine blog has a pretty good post on the bond market. The most interesting quote from HSBC economist Steven King:

I'm inclined to think that bond yields are appropriately low at the moment and, indeed, might fall further. I accept that fiscal positions are terrible but, as with Japan, that proves nothing. Yields are likely to remain low because (i) aging populations will shift their investments out of assets delivering capital growth into those that deliver a steady income stream (ii) productive potential growth was overstated in recent years and, as perceptions drop, real yields will end up lower (iii) related to this, cash rich companies bereft of interesting investment ideas will be under pressure to return cash to their shareholders (iv) in a deleveraging world, deflation is more likely than inflation (v) in a bid to avoid deflation, central banks will be forced to expand their balance sheet holdings of government debt.

I said a couple of weeks ago that I thought interest rates might move higher in the short term only because we have had such a strong bond market rally since the end of the first quarter. I still think this might happen, although I obviously missed the most recent interest rate leg downward.

From a longer term perspective, I am inclined to agree with Mr. King: interest rates are low for lots of reasons, and will stay that way until we are able to wring the excesses out of the global economic system.


Deflation: How low will they go? | The Economist



*I think that regulated utilities that yield more than 5% offer a compelling alternative to corporate bonds, albeit with some capital risk.

Are Small Investors Really Fleeing the Market?

I had a great time on vacation with my family last week. "Investing" in family time is always a great idea, and will yield priceless memories!

But now I'm back to thinking about investments.

Yesterday's New York Times had a front page story about investors fleeing the stock market. Here's an excerpt, with the full link below:

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

If that pace continues, more money will be pulled out of these mutual funds in 2010 than in any year since the 1980s, with the exception of 2008, when the global financial crisis peaked.

Small investors are “losing their appetite for risk,” a Credit Suisse analyst, Doug Cliggott, said in a report to investors on Friday.

http://www.nytimes.com/2010/08/22/business/22invest.html?pagewanted=1&_r=1&ref=homepage&src=me

But wait. Turning to the Times's business section in Paul Lim's column, you read this:

...while investors have been retreating to government bonds, they’ve also been pouring new money into so-called risk assets like junk bonds, emerging-market debt and emerging-market stocks. With so much attention being paid to the Treasury market, these trends have gone largely unnoticed, Ms. Cohen said.

In fact, this year through Wednesday, a net total of $21 billion flowed into mutual funds and exchange-traded funds that concentrate on stocks based in fast-growing developing economies like China, India and Latin America, according to Lipper, the mutual fund tracker. By comparison, investors pulled a net $8 billion from domestic equity funds, even though domestic stocks are considered a core holding.

Meanwhile, high-yield or junk bond funds — which were crushed in 2008, when investors fled assets that exposed them to credit risk — have attracted around $4.5 billion in new money.

James W. Paulsen, the Minneapolis-based chief investment strategist for Wells Capital Management, adds that, at least in comparison with the dark days of 2008, there are other signs investors aren’t as risk averse as the trend in Treasury yields may imply.

He noted that even though investors seem genuinely concerned about the health of the recovery, two of the best-performing sectors this year have been industrial stocks and shares of consumer discretionary companies, which are both economically sensitive areas of the market.

http://www.nytimes.com/2010/08/22/business/22fund.html?ref=your-money

So what's going on here?

I have a thesis that I will be developing more in the next few weeks. Hopefully this will be helpful in understanding the apparent contradiction in U.S. investors fleeing the domestic stock market in favor of more exotic areas like junk bonds and emerging markets.

In the first part of the twentieth century, investor demanded high dividend yields in return for stock investments. Andrew Carnegie, for example, moved much of the proceeds from the sale of Carnegie Brothers Steel (now called U.S. Steel) into stocks paying a 5% dividend. These stocks were further backed by gold. The shrewd Scotsman would never have put his money into investments that would not fund his extravagant lifestyle.

The thinking was simple: Why should someone give up their hard-earned capital to a corporation without receiving a generous cash dividend in return?

In the 1950's, stocks yielded considerably more than government bonds. If memory serves (again, I need to do more research), stock dividend yields were around 5% while U.S. government debt yielded around 2%.

It wasn't until the 1960's - when stocks enjoyed a huge upswing in the "go-go years" - that investors accepted the notion of lower dividends in return for more capital returns.

So today, investors are either focused on yield (junk bonds) or fast-growing economies (emerging markets).

I think we may be heading back to the era of investors demanding more upfront returns from their stock investments, or at least give some reason for optimism.

And I think what we're seeing in the market today is a reflection of investor frustration with the promises that have been made by corporations that have not panned out in terms of capital appreciation.

Tax Report: How the Experts Are Handling Their Own Roth IRA Conversions - WSJ.com

Interesting discussion on Roth IRA's.

This article originally appeared in the Saturday, August 14, edition of the Wall Street Journal.

What strikes me about this report is that none of the experts are simply converting all of their assets.

For example, while I am a fan of Ed Slott (I have read a couple of his books on IRA's), it seems to me that his conversion ideas involves a lot of paperwork, and lots of chances for administrative issues (6 different Roth accounts, plus keeping his original IRA open):

An IRA advisor and vocal Roth advocate, Slott, 56 years old, says he converted nearly all his six-figure IRA in January. With his advisor's help, he separated the funds into a half-dozen Roth accounts, each for a different asset class or sector such as energy, health care or real estate. Slott says he plans to monitor his Roths and then reverse the conversions (called "recharacterization") of accounts that have dropped in value or lagged behind. The tax law allows this move as late as Oct. 15 of the year after the conversion date. So he has a 21-month window to decide which accounts to undo, and how much tax to pay. Yet his taxes will be figured as of his conversion date last January. "It's the way to get the biggest bang for my tax buck," says the Long Island, N.Y., accountant. But he left a few hundred dollars in his regular IRA so that it could receive any money from reversed conversions, which cuts paperwork.

The other advisors all seem to be doing partial conversions or, in the case of Natalie Choate, not sure she will do the conversion process at all since she is reluctant to write the tax check.

As has been discussed several times here, the Roth conversion decision is more complex than it would appear, even to the experts.

Tax Report: How the Experts Are Handling Their Own Roth IRA Conversions - WSJ.com

Random Glenings Goes on Vacation

I will be on vacation next week, enjoying the beautiful summer weather on Nantucket.

See you soon!

Money managers play defense in their municipal portfolios - Investment News

A couple of days ago one of my clients asked me to sell a few municipal bonds in his portfolios.

No problem, I said - rates have fallen a lot, and we can probably realize a few capital gains.

But when I took my orders to our bond desk, and got the bids back, I was surprised.

My client's municipal bonds - one a general obligation of the state of California, and the others New Jersey revenue bonds issued by a couple of the largest medical facilities in New Jersey - were largely shunned by the bond dealer community. The bids in fact reflected yields well north of 5%.

If I had sold the bonds, my client would have realized a significant capital loss, we decided to simply hold on.

What's going on?

Turns out that lower quality, investment grade municipal bonds are being avoided by most clients, even though it is hard for me to imagine a scenario where a credit like California (currently rated single-A) would not pay its obligations to bondholders.

Then I ran across this story in Investment News, where several municipal bond specialists were quoted as saying that they were focusing strictly on the highest quality bonds. Frankly, this to me does not seem to make any sense.

Unless you are envisioning total financial Armageddon, it is hard to believe that the entire municipal bond market will be defaulting at the same time. True, there may be credits that have problems, but if you have the time and resources to manage a municipal bond portfolio correctly, it would seem that opportunities abound.

Let's take the California issue as an example. My client's bond matures in 2013, and carries a 4.75% coupon. At a market price of 100, this is yield-to-maturity of 4.75%. US Treasury notes in 2013 yield 0.80%. Any way you look at it, an investor would be much better served by buying the state of California paper, although the Cal paper has less liquidity.

Even in the Great Depression of the 1930's, there were no state defaults. The percentage of municipal debt that has ever defaulted has been very low for numerous reasons, not the least of which is the simple fact that states and most municipalities cannot go into bankruptcy.

I'm not saying that municipal budgets don't face some serious issues. However, it seems to me that this is the time that a true investor can step up and demonstrate their ability to analyze municipal credits.

Back to the article. This is fairly typical of the mindset of some municipal managers. Let me pick on one manager from a firm here in town (I have shortened the names):

One of the biggest risks that muni bonds face is the public perception that there is about to be a wave of defaults among municipalities, Ms. T. said.

The potential risk is that as rumors about the pending fall of municipalities gains traction, it will cause liquidity problems for the muni market because that liquidity is so reliant on retail investors, she said.

Regardless, S. has spent the past several months unwinding the credit risk of its muni bond funds, Ms. T. said. The firm has sold out of the lowest-quality bonds.

S. also has begun significantly underweighting general-obligation portfolios, Ms. T. said.

“It's a legitimate concern that credit quality is deteriorating,” she said. “But we don't think we will see widespread defaults in the general-obligation market.

So let me understand what Ms. T. is saying. Yes, she says, there seems to be the perception that there is going to be a wave of defaults. But, no, she knows this is not likely to happen.

But we're going to sell anyway, says Ms. T, because investors are calling us. Moreover, even if our clients are "buy-and-hold" investors who have no intention of selling their bonds prior to maturity, we're selling because the lower quality bonds will be less liquid.

Geez - talk about your head-scratcher.

Fortunately, there seem to be other managers who look at today's market situation for what it is; namely, an opportunity for strong research and insightful managers to demonstrate their skills:

At the same time, many managers, such as Eaton Vance Corp. and Nuveen Investments Inc., are stepping up their research efforts to sniff out the potential for credit risk at different issuers.

“With most of the insurers being downgraded, there needs to be more research on all the bonds in the universe,” said Cindy Clemson, co-director of muni investments and a portfolio manager on Eaton Vance's muni bond team. Ten percent of new muni bonds issued are insured, down from 50% in 2008, according to the Municipal Securities Rulemaking Board.

Eaton Vance recently hired a re-searcher and plans to hire another analyst to bring its total team to nine people to address the increased need for vetting new muni bonds.

The fear present in the municipal bond market today is, I believe, an opportunity to be exploited, much as we saw in the fall of 2008.

Money managers play defense in their municipal portfolios - Investment News

Investing in Deflationary Times

I first sent this email out in late 2008 to clients but I thought it might be useful to revisit the topic.

The most important point, to me, is that you do not necessarily have to abandon investing during a slow growth, deflationary environment. High quality companies with low debt burdens can thrive in today's environment, so purchasing both corporate debt and stocks can make considerable investment sense.

On the other hand, low quality credits should be avoided. This is already happening in the municipal market: while high grade (AA and higher) muni prices have rallied along with Treasurys, lower quality munis (BBB and single-A) have lagged badly.

Hi,

For people like me who have spent most of their careers worrying about inflation, we now have to consider how best to invest in a deflationary environment, even it exists for only the next year or so. We have also studied Japan* as a potential guide as to what might happen.

The most important conclusion: there are numerous ways to have good investment results in a deflationary environment, assuming that general economic conditions recover somewhat in the second half of 2009. However, there are also several sectors that will suffer during deflation, so careful sector and asset allocation are important.

More specifically:

1. As long as we are in deflationary conditions, bond yields and stock prices will move in the same direction. That is, as interest rates move lower (as measured by US Treasury notes), so too will stock prices, and vice versa. Our rationale is that falling government bond yields are a sign of a weak economy, while yields should begin to rise as conditions improve and investors become less risk-adverse. Thus, the credit markets will remain a key variable for stock investors;

2. Credit quality will be vitally important. Companies with strong balance sheets, the ability to raise prices, and the wherewithal to buy other companies selling at depressed prices will be clear winners, while smaller companies (especially leveraged ones) will be at risk. This means that large cap stocks should be favored over smaller stocks;

3. Borrowers are in a tough spot. Deflation favors the lender, who is repaid with in the future with more valuable dollars. While initially this might seem to be good for banks, it actually increases the risk of higher credit problems. We will continue to be very cautious on investing in the financial sector, especially banking and credit card companies, where we anticipate further significant write-offs next year;

4. Corporate bonds offer very attractive real (i.e. inflation-adjusted) yields, but we would stick with high quality names with unquestioned ability to repay debt. In the municipal sector, we’ve been focusing on municipal bonds rated at least “AA”;

5. Foreign markets probably will not recover until the US begins to show some signs of life. This is particularly true of the emerging markets which are importing to the US;

6. Commodities typically do not do well in deflationary times. However, this time may be different. The forces (namely, the emerging markets, especially China) that drove commodity prices higher are still with us even with a weaker economic backdrop. While prices may move lower nearer term, we would not abandon the group.

* Remember that the Japanese stock market peaked in 1989. Land prices soared, spurred by lending practices that were later found to be wanting. As the twin bubbles began to deflate, the government and Japanese central bank tried nearly everything to turn their economy around. Massive public works spending projects ensued; the Japanese central banks cut rates to 0%; and huge doses of monetary stimulus were applied, but nothing seemed to work. By 1998 the major city banks in Japan were essentially nationalized. Lead by Prime Minister Koizumi, by 2002, the Japanese economy was showing signs of life, but by 2007 Japan was once again slipping into economic weakness. Today Japan is once again in a full-fledged recession.

Fed Signals Fear of Double Dip - Business - The Atlantic

The stock market is getting hit hard today, but on relatively thin August-type volume. We'll have to see whether the market is actually signaling any important changes once September gets underway, and Wall Street staffing returns to normal.

More important, however, is the message from the bond market, which is not good for the economy. As I write this note, the Treasury has just completed a regularly scheduled 10 year note auction. Notes were sold at an average yield of 2.73%. If participated in the auction, you can now sell the notes for a profit, since yields have now dipped to 2.69%.

This note from The Atlantic magazine sounds fairly ominous in its discussion of the FOMC statement yesterday. Here's a clip:

This is certainly one of the most significant FOMC statements we've seen in a while. The Fed made clear that it still doesn't believe deflation is a problem, which would have been significant enough news in most months. But the committee also acknowledged that the labor market recovery appears to have stalled and took some modest action to try to get the economy moving again. Will the market treat this move as great news that the Fed really cares, or realize that the economy must be in really awful shape if the central bankers felt the situation was urgent enough to further loosen monetary policy?

It's hard to believe that it was just three months ago that the Fed was talking about raising interest rates, and withdrawing some of its monetary stimulus in the wake of the encouraging economic data that had been released this spring.

Fed Signals Fear of Double Dip - Business - The Atlantic

Are Corporations More Leveraged than We Believe?

When talking about the current economic picture, most analysts assume that the balance sheet of Corporate America is in pretty good shape, with roughly $1.8 trillion in cash reserves. The debt problems seem to be confined to the government and consumer sectors.

Indeed, a number of columnists have written that it is outrageous that corporations are not spending their cash more aggressive, especially when it comes to new job creation.

However, as this recent article from MarketWatch (reprinted in Yahoo Finance), perhaps corporations are actually much more leveraged than generally believed.

According to this view, much of the corporate cash hoard is actually the result of massive borrowing done by corporate treasurers who are fearful that the money markets will freeze up again a la the fall of 2008.

In addition, a large chunk of corporate cash is being held overseas, which means that it cannot be repatriated back to the U.S. without incurring significant tax penalty.

I had the chance to speak to one of our bond managers here at the bank. She said that she had been struck by the fact that so many of the recent corporate bond deals apparently had no other purpose other than corporate treasurers raising funds at historically low interest rates. Once the bonds have been issued, she noted, many of the borrowers seem to have just moved the funds into Treasury bills.

In other words, anecdotal evidence suggests that perhaps corporations are not as flush as it would appear.

Here's an excerpt from the article:

According to the Federal Reserve, nonfinancial firms borrowed another $289 billion in the first quarter, taking their total domestic debts to $7.2 trillion, the highest level ever. That's up by $1.1 trillion since the first quarter of 2007; it's twice the level seen in the late 1990s.

The debt repayments made during the financial crisis were brief and minimal: tiny amounts, totaling about $100 billion, in the second and fourth quarters of 2009.

Remember that these are the debts for the nonfinancials — the part of the economy that's supposed to be in better shape. The banks? Everybody knows half of them are the walking dead.

Central bank and Commerce Department data reveal that gross domestic debts of nonfinancial corporations now amount to 50% of GDP. That's a postwar record. In 1945, it was just 20%. Even at the credit-bubble peaks in the late 1980s and 2005-06, it was only around 45%.

Wonder if the Fed is worried about corporations now too?

the-biggest-lie-about-us- companies: Personal Finance News from Yahoo! Finance

Saying Recovery Has Slowed, Fed to Buy U.S. Debt - NYTimes.com

Shows what I know!

This morning I posted a note saying that I thought interest rates could move higher, albeit for a relatively short period of time. Then, this afternoon, Mr. Bernanke and most of the Fed Reserve board decided to use some of the funds that the Fed has received from its portfolio of mortgage-backed securities to buy a relatively small amount of U.S. Treasury debt to try to boast the flagging economic recovery:

The Fed’s new stance marked the completion of a turnabout from a few months ago, when officials were discussing when and how to eventually raise interest rates and gradually shrink the $2.3 trillion balance sheet the Fed amassed through its response to the 2008 financial crisis.

In buying new Treasury securities to the tune of about $10 billion a month — a small fraction of the roughly $700 billion in Treasury debt sitting on the Fed’s balance sheet — the Fed will not let the balance sheet shrink for the time being.

More than anything, the announcement was a signal to the markets that the Fed was concerned about the pace of the recovery, and had shifted from its more optimistic assessment earlier this year, that economic growth was sufficiently strong to begin thinking about how to gradually return to normal monetary policy.

As I write this, Treasury bond prices are soaring - the 10 year Treasury now yields 2.75% - the lowest level since March 2009 (when the economy was considerably weaker). 2 year Treasury notes yield just 0.51%

While I'm obviously feeling a little chagrined at my mistimed market call, I am more interested in what the Fed must be seeing in the data.

I'm also not sure what this move accomplishes. Mortgage rates already stand at multi-decade lows, but housing is still sluggish at best. Corporations have been actively raising money - but then simply hoarding the cash.

My suspicion is that the move is largely a compromise within the Fed to try to accommodate those politicians and a Fed governor that are worried about inflation (recall that one of the nominees for an empty Fed post - MIT economist Peter Diamond - has met serious resistance to his nomination because he said he wasn't worried about inflation).

Saying Recovery Has Slowed, Fed to Buy U.S. Debt - NYTimes.com

Fed to Meet, With Concerns on Deflation Rising - NYTimes.com

A few months ago, when the Treasury 10 year note was yielding more than 4%, I told my clients (and the readers of this blog) that I thought that deflation was the bigger concern, and that interest rates would soon be heading lower, not higher. This was not a consensus opinion - no, in fact, I was in a distinct minority.

So now deflation, and lower interest rates, have now become an increasingly popular view. Even the New York Times carried a front page story this morning talking about the need for the Fed to act soon to try to stave off a Japan-like deflationary economy in the U.S.:

A string of developments, including the weak jobs report last Friday, has altered the sentiment within the central bank, leading Fed policy makers to stop worrying for the moment about the increasingly remote prospect of inflation. Instead, they are increasingly focused on the potential for the economy to slip into a deflationary spiral of declining demand, prices and wages.

As I have mentioned numerous times on this blog, any time an opinion becomes a widely held consensus, investors should start thinking about heading in the opposite direction.

And I think this might be one of those times.

Mind you, I still think that interest rates are heading lower - eventually. I also believe that the Fed - and the federal government - needs to act, either through aggressive quantitative easing or another round of fiscal stimulus. However, I think it is unlikely that the either the Fed or the federal government is likely to act in the next few weeks.

But I'm thinking this might be already priced into the bond market, and that we could see a spike higher in interest rates over the next few weeks.

I'm not exactly sure how to play this, but for the time being, I would be cautious about getting too aggressive about setting up portfolios for lower interest rates.


Fed to Meet, With Concerns on Deflation Rising - NYTimes.com

The Media Equation - New York Magazine’s Lessons for Harman and Newsweek - NYTimes.com

I thought this was a pretty interesting story.

It seems to be the widely held belief these days that media companies will not be able to survive unless they can charge readers for on-line access. Rupert Murdoch is leading the charge with his attempt to force readers to pay for much of the Wall Street Journal on-line comment, as well as the London Sun.

However, New York magazine has been able to be profitable (albeit a small one) despite offering free content. As David Carr's column in this morning's New York Times notes, in 2003 New York was purchased for $55 million by a group of investors lead by the late Bruce Wasserstein. Based on its current level of profitability, it now appears that this purchase price was a bargain:

But the company is doing good business with its suite of Web brands — Vulture, Grub Street, Daily Intel and others, and profits from those enterprises could yield the kind of valuation that makes the $55 million purchase price seem cheap.

In a way, New York magazine is fast becoming a digital enterprise with a magazine attached. Visitors to the magazine’s various Web sites have doubled since 2007, digital sales are up 70 percent over last year and now constitute 35 percent of the revenue at the company. Its MenuPages app has been downloaded to iPhones over 160,000 times and Vulture, the magazine’s pop culture site, is bulking up in hopes of becoming a national presence. The company said that already 75 percent of its visitors to its various sites come from beyond the New York market.

“We’ve always been inherently limited by geography, and the Web has allowed us to build out something for ‘high-slash-middlebrow’ culture for a national audience that nobody is really occupying,” Mr. Moss said.

The Media Equation - New York Magazine’s Lessons for Harman and Newsweek - NYTimes.com

FT.com / Comment / Analysis - America: States of distress

There have been a lot of articles written over the past few months about the perilous state of municipal finances. This one from the FT does a particularly good job, I thought, especially as it highlights the huge role that pension obligations are playing in creating this mess.

Here's an excerpt:

Shortfalls in public pension funds are the heart of the matter. State pension deficits are estimated to total at least $1,000bn, according to the Pew Center on the States, a think-tank. Illinois’ pension funds – which pay out to retired teachers, state workers, university staff, judges and politicians – are funded at less than 40 per cent, the lowest proportion of any US state. The gap between assets and liabilities was about $71bn by last September, the most recent available figures.

The unfunded liability could by now have grown to $80bn – more than twice the state’s total annual budget, says Ralph Martire, executive director of the Center for Tax and Budget Accountability, a think-tank.

Some say the shortfall is even bigger. Joshua Rauh, of Northwestern University’s Kellogg School of Management, notes that states generally assume their investments will generate 8 per cent returns a year. “It’s an economic fallacy,” he says. “It would be like taking money from your savings account, putting it into the stock market and then writing down the cost of your mortgage.”

And yet, so far, Illinois has been able to sell enough bonds to keep itself afloat. Most investors assume (as I do) that at the end of the day, the federal government will bail out any state facing insolvency. But that doesn't mean that they're not paying a price:

In spite of recent credit downgrades by Fitch, and Standard & Poor’s, Illinois raised $900m in capital markets last month. In a roadshow covering the US, Europe and Asia, officials and bankers convinced investors – nearly one-third of them non-US – that Illinois would always pay its bondholders.

The selling point was that the state requires itself to make bond payments before all other bills. It also offered a hefty premium to comparable US Treasuries – as much as 3.25 percentage points on debt due in 2035. Corporate bonds with similar ratings were paying lower yields. The Illinois bonds have since rallied.

While the markets still have the appetite, the state continues to borrow. It issued $3.5bn in debt last year to pay its pension contributions and plans another $4bn bond for this year’s payment. However, this moves debts around rather than tackling long-term problems.

The state slashed $1.4bn from the current year’s budget, but cost-cutting alone is no solution. Illinois is not, in fact, profligate. Although it is the fifth biggest state by both economy and population, it ranks 45th in state spending as a percentage of gross state product and 46th in its combined state and local tax burden as a proportion of income.

As a group, then, municipal bond holders are pretty sanguine about a situation that most would consider pretty dire. While I too am confident that municipal bonds will pay as promised, I'm not sure that it might not be a little more of a bumpy ride than investors are anticipating.

About 20 years ago, I was involved in selling investment products to Japanese investors. One of the largest funds that I helped sell was sponsored by Fannie Mae. While Fannie Mae was never officially guaranteed by the US government, virtually every investor assumed that the federal government would never let either Fannie or her brother Freddie Mac go out of business.

That feeling was correct - Fannie and Freddie debt has paid as promised. However, both companies are now wards of the US government, with hundreds of billions of taxpayer funds necessary to prop the two companies up. Stockholders of course have been wiped out.

But even though the agency debt was repaid, I can tell you that probably none of the debt holders felt totally secure. And I suspect that the municipal market may be heading in the same direction.

FT.com / Comment / Analysis - America: States of distress

Consumers Find Ways to Spend Less and Find Happiness - NYTimes.com

This article from this morning's New York Times was very interesting. I'm not sure I'm ready to move to a 400 square foot condominium just yet, but it seems to work for the couple that is profiled.

As I've mentioned in previous posts, my wife Christina and I have been on a campaign to try to reduce the clutter in our house. Personally, I can tell you that I haven't missed any of the "stuff" that had seemed so important to keep over the last few years.

It was good to read that we're actually confirming what social scientists have already known; namely, that in the long run material positions matter less to one's happiness than other experiences like travel. As the article notes:

Buying luxury goods, conversely, tends to be an endless cycle of one-upmanship, in which the neighbors have a fancy new car and — bingo! — now you want one, too, scholars say. A study published in June in Psychological Science by Ms. Dunn and others found that wealth interfered with people’s ability to savor positive emotions and experiences, because having an embarrassment of riches reduced the ability to reap enjoyment from life’s smaller everyday pleasures, like eating a chocolate bar.

Alternatively, spending money on an event, like camping or a wine tasting with friends, leaves people less likely to compare their experiences with those of others — and, therefore, happier.

Consumers Find Ways to Spend Less and Find Happiness - NYTimes.com

Your Money - The Coming Class War Over Public Pensions - NYTimes.com

I've actually been surprised we haven't seen more stories about this.

Here's an excerpt:

Taxpayers, whose payments are also helping to restock Colorado’s pension fund, may not be as sympathetic, though. The average retiree in the fund stopped working at the sprightly age of 58 and deposits a check for $2,883 each month. Many of them also got a 3.5 percent annual raise, no matter what inflation was, until the rules changed this year.

Private sector retirees who want their own monthly $2,883 check for life, complete with inflation adjustments, would need an immediate fixed annuity if they don’t have a pension. A 58-year-old male shopping for one from an A-rated insurance company would have to hand over a minimum of $860,000, according to Craig Hemke of Buyapension.com. A woman would need at least $928,000, because of her longer life expectancy.

Who among aspiring retirees has a nest egg that size, let alone people with the same moderate earning history as many state employees? And who wants to pay to top off someone else’s pile of money via increased income taxes or a radical decline in state services?

This obviously is a difficult question. Public employees in many cases worked for less money than they might have earned in the private sector with the knowledge that they would receive a generous pension and health care benefits at retirement. Yet it is becoming increasingly clear that these promises are bankrupting many municipalities, not to mention the cutbacks in municipal services.

What a mess.

Your Money - The Coming Class War Over Public Pensions - NYTimes.com

FT.com / Markets / Insight - Yen has edge over gold in battle for supremacy

This article from the FT discusses two of my favorite topics these days: gold and deflation.

First, as to the investment merits of gold, here it is:

The inconvenient truth is that gold is not really an investment at all. Since it generates no return and thus has no fundamental value, the same arguments can be used to justify any price – $500 an ounce or $5,000. Gold buyers are simply trusting in the bigger fool theory – that someone else will take it off their hands at a higher price. They are speculating, not investing, and like all speculators what they are speculating on is the speculations of other speculators. Packaging it in an exchange-traded fund makes no difference.

Actually, the column's author (Peter Tasker) makes the interesting observation that yen-based assets - including bonds - have actually been a much better store of value than gold over the last few decades. True, yields on Japanese government bonds look ridiculously low, but Japan is suffering through a serious bout of deflation, so any positive returns are actually pretty decent returns:

Best of all, the yen is not a sterile asset like gold. It generates a return. Officially CPI deflation is 1.5 per cent, which means holders of yen get a tax-free gain of 1.5 per cent in purchasing power every year. However, according to the American scholar David Weinstein, the official numbers understate Japanese deflation by several percentage points.

If he’s right – and intuitively 1.5 per cent does seem too low – then Japanese cash is generating a very competitive return. Maybe that’s why Japanese households and companies have been stockpiling it, come rain or shine.

Here's what I don't get: I continue to read financial stories that claim that the Treasury bond market is the latest bubble, and that yields on US government debt are sure to soar any day now. Why? Oh, say the bears, don't you see the huge government deficits, and the market will be demanding much higher yields due to our profligate government.

Well, maybe, but Japanese government debt as a percentage of GDP is now something like 200% of GDP (the US is "only" 125% of GDP, if you include Social Security and other obligations) yet yields continue to move lower.

I agree with Mr. Tasker: buying gold here is simply another speculation on a commodity which may or may not work out (maybe you should have bought wheat futures - wheat's up +90% over the last month!). It is hard to due any fundamental analysis on gold, since the dynamics of the gold market are murky.

Bond yields may move higher, but it will take a policy response to make this happen. Today's weak jobs figures confirm again that the US remains mired in a slow growth economy, and reliable yield will continue to be sought after by investors.

FT.com / Markets / Insight - Yen has edge over gold in battle for supremacy