Wednesday, June 29, 2011

Do You Need Longevity Insurance?

Most of us probably pay too much for insurance.

This is not as startling a statement as it might appear. The huge financial fortunes that have created companies such as Prudential; Metropolitan Life; and Berkshire Hathaway have been based on the idea that most of us are willing to pay to protect ourselves against events that either have a low probability of occurring or may never happen.

We all have homeowners' insurance, for example, even though statistically the odds of a house burning down any particular year is extremely remote. The prospect of losing everything in a fire is, for most people, too devastating to take a chance.

When it comes to insuring against events in our old age, however, both we and the industry are still evolving. For example, long term care insurance was really not needed a generation or two ago since most people simply didn't live long enough to need it.

Another idea whose time might be coming is longevity insurance.

The idea here is pretty simple, according to an article written by Tara Siegel Bernard in Tuesday's New York Times:

You can agree to begin collecting the insurance at a much later date in the future, like your 85th birthday. So if you live past your life expectancy, you’re covered. And since most people don’t know when they’re going to die, this allows you to spend down your retirement savings more liberally because you know your payments will kick in later. The big risk, of course, is that you won’t see a dime because you die before you can collect.

Ms. Bernard goes through some numbers later in the article, based on a new policy offered by New York Life. I need to spend more time on the math, but on the surface the idea makes some sense.

I do have a couple of concerns, however. First, this is still a fairly new product, which means that the industry is still not clear on how to price longevity insurance. And, second, it is also possible than an individual might be be better off by simply taking the premiums that they would have paid the life insurer and invest in the market themselves.

Still, a worthwhile read.

Tuesday, June 28, 2011

Thoughts on Software from Brent Thill at UBS

There's been lots of talk in the press about a new tech bubble, especially in the software area.

Much of this chatter relates to the huge valuations attached to companies like LinkedIn and Pandora Media when they have been brought public in recent weeks. Private estimates now value Facebook at around $100 billion even though Facebook's revenues in 2010 were just over $2 billion.

When Google tried to buy Groupon for $8 billion a few months ago, Groupon turned it down flat. Many tech observers thought that company management was crazy, but now it appears that the private market value for Groupon is twice Google's offer.

This is concerning, especially for a group that is producing prodigious top line growth but very little in the way of profits.

I just heard UBS software analyst Brent Thill today at lunch. Brent is a first-rate analyst, in my opinion, and has been following the group for more than a decade.

Brent said that the IPO pipeline for software companies is a robust as he's seen it in 10 years. Small tech companies, it seems, are rushing to the public market while prices are generous, and investor demand for new concepts in social media and cloud computing appears insatiable.

All this makes Brent uneasy. It gives Brent pause when industry leaders like Larry Ellison of Oracle say that their deal activity has slowed due to excessive valuations.

Brent noted that in the past, Oracle has paid anywhere from 0.5x to 4.0x Enterprise Value/Revenues for acquisitions. But when I glanced down the list of the stocks that Brent covers, exactly one of them (Microsoft) trades below 4x EV/Rev.

More typical is VMWare, which now trades at a cool 50x P/E, or 10.5x EV/Revenues. Virtualization is a crucial part of today's tech world, but this is a very full valuation for VMW.

Brent still sees some upside for the group - there's too much cash chasing too few names - but it seems that we are in the late innings for stock performance for the group, especially for the newer "concept" stocks.

Monday, June 27, 2011

The ROI of College is 2x the Stock Market

I posted a note last week discussing the (very) high cost of college education.

As it turns out, Dave Leonhardt had a column in yesterday's New York Times opinion section that made a very good case for colleges.

Mr. Leonhardt notes that only about 1/3 of high school graduates go on to college, while another 10% get a degree from a two-year program. And while it is true that higher education is expensive:

The evidence is overwhelming that college is a better investment for most graduates than in the past. A new study even shows that a bachelor’s degree pays off for jobs that don’t require one: secretaries, plumbers and cashiers. And, beyond money, education seems to make people happier and healthier.

“Sending more young Americans to college is not a panacea,” says David Autor, an M.I.T. economist who studies the labor market. “Not sending them to college would be a disaster.”

And for people like me, who work in the investment world, there is this:

...the returns from a degree have soared. Three decades ago, full-time workers with a bachelor’s degree made 40 percent more than those with only a high-school diploma. Last year, the gap reached 83 percent. College graduates, though hardly immune from the downturn, are also far less likely to be unemployed than non-graduates....

The Hamilton Project, a research group in Washington, has just finished a comparison of college with other investments. It found that college tuition in recent decades has delivered an inflation-adjusted annual return of more than 15 percent. For stocks, the historical return is 7 percent. For real estate, it’s less than 1 percent.

College Degrees Are Valuable Even for Careers That Don’t Require Them -

Interesting counterpoint to my Friday post.

Friday, June 24, 2011

Is College Worth It?

Faithful reader Steve Plouffe suggested I post a comment about college tuition costs:

I have a son who will be a junior at Wesleyan University. You have to be a pretty good student to gain acceptance at Wesleyan, according to the Wesleyan Argus:

...admission for the Class of 2014 was the most selective it has been in the University’s history. Out of 10,656 applicants, the University admitted 2,125, translating to a 20 percent admission rate. In contrast, the rate two years ago was 27 percent. The University hopes to enroll 745 students....

Still, Wesleyan is not cheap, and tuition costs keep rising. Tuition for the 2011-12 school year will rise by 3.8%, which is roughly in line with increases for prior years.

But, according to the New York Times, Wes is not alone in raising its tuition:

Tuition and fees at private nonprofit colleges and universities will increase by an average of 4.6 percent — about $1,228 — for the next academic year, according to the National Association of Independent Colleges and Universities. The average tuition increase was 4.5 percent last year and 4.3 percent the previous year, down from average annual increases of 6 percent in the decade before the economic downturn.

Private College Costs Rising 4.6 Percent -

College education, it seems, is one of those rare commodities where demand rises along with cost. Like fine wine, the more something costs, the higher the cost of tuition the strong the demand for admittance.

But is it worth it?

Well, to my wife and I, this is a no-brainer: we were mostly concerned about getting our son into the best school possible, regardless of cost.

But not everyone agrees. Bill Gross of Pimco - arguably the best bond manager of our generation, and manager of the largest bond fund in the United States - writes about college tuitions in his most recent monthly newsletter.

And, to Mr. Gross, college is fast becoming somewhat of a scam:

Fact: College tuition has increased at a rate 6% higher than the general rate of inflation for the past 25 years, making it four times as expensive relative to other goods and services as it was in 1985. Subjective explanation: University administrators have a talent for increasing top line revenues via tuition, but lack the spine necessary to upgrade academic productivity. Professorial tenure and outdated curricula focusing on liberal arts instead of a more practical global agenda focusing on math and science are primary culprits....

Conclusion to ponder: American citizens and its universities have experienced an ivy-laden ivory tower for the past half century. Students, however, can no longer assume that a four year degree will be the golden ticket to a good job in a global economy that cares little for their social networking skills and more about what their labor is worth on the global marketplace.

I don't know when this cycle will change - I can remember the same complaints about tuition costs when I was going to Michigan in the 1970's - but it does seem logical that at some point there will be a point where students and their families will say: Enough.

Still, I think this point may be further away than perhaps Mr. Gross thinks. Once my son completes his four years at Wesleyan, I doubt that Mrs. RG and I will be as concerned about tuition cost as we are today.

Thursday, June 23, 2011

Are the Emerging Markets A Better Bet than US Stocks?

Richard Bernstein was formerly chief market strategist for Merrill Lynch. Rich made a number of very good market calls over the years he was at Merrill, including a prescient call advising investors to switch from tech stocks to oil stocks back in 2000.

Rich has since left Merrill to start his own investment advisory shop, and now manages money for mutual funds as well as individual accounts.

However, Rich still gives a number of presentations, and he usually has some pretty good observations.

For example, I saw this short piece in Financial Analysts magazine. Here's an excerpt:

U.S. investors might not know it, but the Standard & Poor's 500 Index has now outperformed the BRIC nations' equity market for almost 3 1/2 years, Richard Bernstein told attendees today at the second annual Innovative Alternative Strategies Conference in Chicago.

Rich continues to more bullish on US stocks than the emerging markets sector, bucking the consensus that says you should always invest in countries with the highest growth rates:

Challenging the conventional wisdom, Bernstein said that he considered U.S. small-cap companies to offer more potential than any other asset class in the next decade. "The projected earnings growth rate of U.S. small-cap companies is 50% higher than that of Chinese companies," he said.

S&P 500 Beats BRICs For 3-Plus Years, Bernstein Says

There's one other point that I would add to Rich's comments. Based on data from Ned Davis Research, the volatility of the emerging markets is nearly twice that of the US large cap markets.

Wednesday, June 22, 2011

Five Reasons Not To Be Bearish On Stocks

It's been remarkable how quickly the prevailing mood among investors has turned sour.

It was only two months ago, in April, when my biggest concern about the stock market was the high degree of bullish sentiment.

At that time, a number of surveys indicated that nearly 75% of investors surveyed were positive on the outlook for stocks. Meanwhile, nearly the same percentage of investors were bearish on bonds - most were looking for long maturity Treasury bond yields to soar.

Then the correction came, and stocks are now off about -8% from their spring peaks. And, predictably perhaps, surveys now indicate that bearish sentiment is as high as the lows in the summer of 2010.

We all know the bearish story: Housing is still crumbling; unemployment is too high; and the federal government is gridlocked. Investors find 0.37% yields on Treasury notes preferable to stocks yielding 3% or more.

I've been telling clients a five reasons not to turn to cautious:
  1. I've been using the "Cyrano Principle" argument that I have discussed earlier this week. Yes, there are lots of problems in the world, but they are always fairly well-known. In my opinion, the capital markets are already reflecting a good deal of bad news;
  2. What are the alternatives to stocks? It is hard to make a long-term investment case for bonds yielding less than 2%, and money market fund yields are essentially nil.;
  3. I also find it interesting that the uber-bears on the economy and stocks have no problem piling into corporate bonds; if the world is really going to implode, corporate credit will get smacked along with the stocks. Buying single-A rated corporate bonds yielding 2% (which is about where they are trading) doesn't give you much downside protection;
  4. Valuations on most large cap stocks are reasonable, if not downright attractive. This morning's Financial Times notes that Apple is trading at 13x earnings, despite the fact that Apple's sales are expected to grow by 60% this year. IBM, by comparison, is also trading at the same 13x P/E ratio, but sales growth is expected to be one-tenth of Apple's.
  5. The "nightmare" scenario that most of us remember - the extreme bear market of 2008 - occurred in a world that was blithely unaware of the subprime mortgage risk that was lurking in the financial system. If anything, investors today are almost entirely focused on risk;
  6. Earlier this week Bloomberg noted that stocks are trading at their cheapest valuations since 1985 - is this the time to flee to the sidelines?

Tuesday, June 21, 2011

Are Euroblock Problems Already Reflected In Market Prices?

I mentioned the "The Cyrano Principle" in my blog post yesterday.

Veteran market strategist Laszlo Birinyi discussed The Cyrano Principle in last weekend's New York Times. The idea, as Mr. Birinyi was quoted saying, is:

"If the problem is as obvious as the nose on your face, the chance are the everyone else knows it, too" The markets, he said, are very good at digesting this news and adapting to it. Sooner or later, he says, "unless there is some truly dramatic surprise - and not just something the market is well aware of" - stock will resume what he expects to be a long run higher.

Which brings me to the current buzz about Greece and the euro block.

I don't know which way the Greek parliament will go today - the discussion of austerity measures has brought widespread protests among the Greek populace, who seem to like getting lots of benefits paid for by foreign creditors (no fools, these Greeks) - but I really don't think it is going to make that much different in the markets.

Moreover, I would also bet that the Greeks can continue to thumb their collective noses at the rest of Europe for the very simple reason that a Greek default would hurt the rest of Europe more than it would hurt Greece.

Jeremy Warner had a good column about the situation in last Friday's London Telegraph. Here's Mr. Warner's observation:

Give us the money, the Greeks can say, or we’ll pull the whole house down with us. As Europe’s policy elite is only too painfully aware, the cost of refusing is likely to be infinitely greater than that of coughing up, however politically unpalatable it might seem to the solvent north. Neither the IMF nor the eurozone can afford to let Greece go.

Mr. Warner goes on to write that a Greek default would inevitably lead to defaults by Ireland and Portugal, followed possibly by even Spain. And in the papers today there are several articles discussing the idea that the real problem in euro land awaits in Italy.

In short, I keep looking for events that don't seem to be already widely discounted in current market prices, and so far am coming up short.

Or, put another way, when billions of dollars are flooding in 2-year Treasury notes yielding 0.38%, it is hard to say that the world isn't already well aware of the financial storms raging in Europe right now.

Monday, June 20, 2011

Laszlo Birinyi and "The Cyrano Principle"

There was a good column by Jeff Sommer in yesterday's New York Times about the current market environment.

The mood of investors has changed dramatically in the last couple of months, and no wonder. The fiscal crisis in Greece is threatening the euro zone. Unemployment remains stubbornly high. Recent US economic data has shown an economy that is slowing, and there are more worries that the collapse in housing is going to lead to a second recession.

With the federal government worried about a $14 trillion cumulative budget shortfall, it seems very unlikely that we will see any fiscal stimulative package any time soon.

Oh, and it is also unlikely that the Fed will be doing another round of quantitative easing, given the prevailing political mood in Washington.

But, as the article notes, maybe all of this already in the current stock market prices.

The piece quotes veteran market strategist Laszlo Birinyi about the market. Mr. Birinyi views the recent market pullback as simply a correction in a secular bull market, and believes that investors should be adding to stocks, not reducing.

Here's Mr. Birinyi on something he calls "The Cyrano Principle":

As for Mr. Birinyi, he cites what he calls “the Cyrano Principle”: “If the problem is as obvious as the nose on your face, the chances are that everyone else knows it, too.” The markets, he said, are very good at digesting this news and adapting to it. Sooner or later, he says, “unless there is some truly dramatic surprise — and not just something the market is well aware of” — stocks will resume what he expects to be a long run higher.

Stocks Haven’t Fallen That Much, Despite Recurring Worries -

I agree with his view. Yes, I know the data is soft, but markets typically get walloped by unforeseen events, not those that are so widely broadcast as today's financial woes.

And then there's this: At a time when investors are still piling into Treasurys yielding well below 1% (on shorter maturities), stocks on many measures are very cheap. Here's a piece from this morning's Bloomberg:

Analysts are boosting profit forecasts even with the global economy showing signs of weakness. S&P 500 earnings may rise to $99.61 a share in 2011 from $84.58 last year and $61.52 in 2009, according to data compiled by Bloomberg. That’s an increase from the forecast of $95.37 on Jan. 3 and $98.70 on April 29, the data show.

Should stocks stay at current prices and the analyst prediction come true, the S&P 500 would trade at 12.8 times income on Dec. 31, the lowest level since 1985 except for the six months after Lehman Brothers Holdings Inc.’s bankruptcy in September 2008 and nine months in the late 1980s, according to Bloomberg data. Companies in the S&P 500 are forecast to earn $24.31 this quarter, up from $24.16 at the start of April.

Now, to be sure, Wall Street might be too optimistic. Merrill's US quantitative strategist Savita Subramanian has noted a worrisome divergence between rising analysts' forecast and a more cautious corporate management tone. For this reason Ms. Subramanian is less optimistic on stocks than, say, Mr. Birinyi.

But still: How much "bad news" is already in stock prices?

Friday, June 17, 2011

The Rise and Fall of Fannie Mae

About 20 years ago, while I was employed at the investment firm Scudder, Stevens & Clark, I developed and marketed several mortgage-backed securities funds targeted at Japanese institutional investors.

This was a terrific experience for me. The funds were a success, and performance was very good. In addition, for a period of about 8 years or so, I had the chance to go to Japan two or three times a year to meet with investors.

Two of the funds I marketed were sponsored by Fannie Mae. Fannie was an important part of our marketing story, since most international investors knew Fannie.

Foreign investors assumed that Fannie Mae carried the implicit backing of our government. And, of course, this proved to be the case a couple of years ago, when the U.S. government bailed out both Fannie and Freddie Mac.

I was very impressed with the people I worked with from Fannie. They were very smart, and worked long hours. In addition, investors in Fannie Mae enjoyed terrific returns, since the stock was one of the best performers in the 1990's.

The head of Fannnie Mae during those years was David Maxwell. Mr. Maxwell embodied all of the qualities that I admired about Fannie Mae: smart, driven, and very skeptical of Wall Street.

Here's what author Jim Collins wrote about Maxwell in 2003 in Fortune Magazine's profile of the 10 Greatest CEO's:

No. 7 David Maxwell turned a turnaround into art

Fannie Mae was losing $1 million a day when he arrived--"an opportunity to make [it] into a great company."

In 1981, as the stock of Chrysler hit an all-time low, America was beginning its enthrallment with the man hired to save it. Lee Iacocca would soon be a national icon--bestselling author, star of more than 80 commercials, and everyone's image of a turnaround artist.

That same year, as the stock of Fannie Mae hit an all-time low, a different executive was hired to save the deeply troubled mortgage lender. David Maxwell would not become a national icon--nor even a recognizable name. Yet by the time both men retired in the early 1990s, Maxwell's Fannie Mae had beat the stock market at a rate more than twice that attained by Chrysler under Iacocca.

More inspired than inspiring, more diligent than dazzling, Maxwell took a burning house and not only saved it but built it into a cathedral. Some steps, such as selling off $10 billion in unprofitable mortgages, were classic fireman stuff. But his deepest genius was to frame the rebuilding around a mission: strengthening America's social fabric by democratizing home ownership. If Fannie Mae did its job well, people traditionally excluded from owning homes --minorities, immigrants, single-parent families--could more easily claim their part of the American dream. If turnaround is an art, Maxwell was its Michelangelo.

Unfortunately, when David Maxwell retired in 1991, he was succeeded by James Johnson, formerly head of Lehman Brothers.

In my opinion, Johnson was everything that Maxwell was not. He epitomized what Main Street thinks of Wall Street: very political, slick, and wildly overcompensated for his efforts.

We all know what happened. Fannie Mae transformed from one of the most successful government programs ever to a massive government headache requiring hundreds of billions of bailout money from the government.

David Brooks had a column in the New York Times this morning titled "Who is James Johnson?" He discusses Mr. Johnson's role in what has turned out to be one of the largest financial debacle's in our country's history. Here's an excerpt:

The Fannie Mae scandal has gotten relatively little media attention because many of the participants are still powerful, admired and well connected. But Gretchen Morgenson, a Times colleague, and the financial analyst Joshua Rosner have rectified that, writing “Reckless Endangerment,” a brave book that exposes the affair in clear and gripping form.

The story centers around James Johnson, a Democratic sage with a raft of prestigious connections. Appointed as chief executive of Fannie Mae in 1991, Johnson started an aggressive effort to expand homeownership.

Back then, Fannie Mae could raise money at low interest rates because the federal government implicitly guaranteed its debt. In 1995, according to the Congressional Budget Office, this implied guarantee netted the agency $7 billion. Instead of using that money to help buyers, Johnson and other executives kept $2.1 billion for themselves and their shareholders. They used it to further the cause — expanding their clout, their salaries and their bonuses. They did the things that every special-interest group does to advance its interests.

Who Is James Johnson? -

I wasn't going to buy "Reckless Endangerment", since I feel like I have already relived the last decade enough.

But I think I might now, if only to read about how a company that I deeply admired was perverted and ultimately destroyed by a group of insiders.

Thursday, June 16, 2011

Two Views on Asset Allocation

This is a very difficult time for investors to figure out how to position their portfolios.

Low interest rates are the main culprit. Throughout most of my 30 year career, bonds offered a safe, albeit boring, alternative to riskier asset classes.

You weren't going to get rich buying bonds, but you could be assured of steady returns and principal stability, which obviously appeals to many people.

But no longer.

In the wake of the latest eurozone crisis, Treasury bond yields have once again moved sharply lower. Two year Treasury notes now offer a unappealing 0.38% yield to investors, which is about half of the yield of a year ago. Even 10-year Treasurys are now yielding 2.92% at this writing.

Most high quality corporate and municipal bond yields have moved sharply lower as well.

In my opinion, with rates so low, it is hard to make a strong investment case for bonds for all but the most gloomy investor. Bonds can still play an important role in asset allocation, but with the full recognition that their primary role is principal protection, not total return.

I say this for a couple of reasons.

First, today's rates offer little inflation protection. True, there seems to be little signs of inflationary pressures today, but who knows how long this will last?

Second, if rates tick up only modestly from today's levels, the total return (price change + coupon) from a bond portfolio will turn negative. Of course, this will not matter if you are not planning to sell a bond prior - but will you really be happy looking at your portfolio of bonds that are priced below cost for the next few years?

We had a spirited discussion yesterday at our Investment Policy Committee here at the bank about asset allocation. As you might expect, there was a wide range of opinions.

Several people disagreed with me. They point to recent economic data as a sign of slowdown in the U.S. economy; in such an environment, high quality bonds should proper.

Bond bulls also point to the problems in the eurozone. If the Greek contagion spreads, the euro block could be threatened. In addition, the financial sector will be hit hard, since they are large holders of bonds denominated in euros. Dollar-denominated assets should prosper in such a scenario.

I understand all of that, but I still think that the odds favor dividend-paying stocks.

So, too, does Bill Gross of Pimco. Here's a excerpt from a recent article, along with the link:

Pacific Investment Management Co. (Pimco) managing director Bill Gross is perhaps the nation’s foremost bond guy, but he says investors looking for real returns should turn to consistent dividend-paying stocks like Coca-Cola, Johnson & Johnson or electric utilities rather than U.S. Treasuries.

In remarks made during Wednesday’s opening session of the Morningstar investment conference in Chicago, Gross echoed themes he recently wrote in his monthly investment commentary for Pimco, the Newport Beach, Calif.-based money manager with $1.3 trillion in assets

Specifically, he noted the Federal Reserve has kept interest rates lower than they should be in hopes of inflating the economy and boosting riskier asset classes, such as stocks. That’s been a boon for the latter but hasn’t translated into success for the former. Meanwhile, much of the Treasury yield curve wallows in negative territory compared with expected future inflation.

That means Treasury investors “are getting their pockets picked,” Gross told the audience.

Wednesday, June 15, 2011

Why Buy A Home Now If Prices Are Going to Continue to Fall?

Robert Shiller had a good article last weekend in the New York Times about the role that future price expectations might have on overall economic activity, particularly as it relates to housing.

Shiller, of course, is the Yale professor who famously wrote the book Irrational Exuberance in 2000, which correctly forecast the popping of the technology stock bubble.

He then turned his attention to the housing market, and together with Karl Case of Wellesley College came up with the Case-Shiller index of housing prices that is now widely followed.

Shiller has also been prescient about the future course of housing a few years ago, and even wrote a bearish chapter on housing in one of subsequent editions of Irrational Exuberance.

Dr. Shiller was in the news last week with the forecast that housing prices could decline -25% from current levels.

He subsequently backpedaled somewhat on this forecast - noting that predicting the trend of housing prices was like trying to predict the weather - but I think the point remains that he is more bearish on housing than most economists.

That said, many surveys of people actually involved in the business of building and selling houses are more in line with Professor Shiller.

For example, Diana Olick of CNBC posted a tweet on Twitter that indicated that a recent survey of home builder sentiment reached lows not seen since February 2009.

The problem is largely expectations rather than fundamentals. Low mortgage rates and falling house prices has driven affordability of buying a new home to levels where, on a purely financial basis, it makes more sense to buy than rent.

Yet no one wants to buy and watch the value of their new home drop by another 10% or 20%. Or, put another way, the expectation of lower future home prices has become a major impediment to any improvement in housing.

This is the point that Shiller made last Sunday:

Even for people who have other reasons to buy a house, there may be little urgency to do so. Our 2011 survey found that the median expectation for home price appreciation next year is just 1 percent. So it won’t be surprising if new home sales remain abysmally low and few jobs are created in the hard-hit construction industry. And it shouldn’t be a shock if the personal savings rate stays at around 5 percent, as it has recently, up from around 1 percent in 2005. This would mean that consumer spending will not drive a strong recovery.

The Sickness Beneath the Slump - Economic View -

Hopefully he is wrong in his bearish sentiment, but given his track record it's hard to bet against Robert Shiller.

Monday, June 13, 2011

Pop Quiz: Which Portfolio Has More Risk?

Here's the question: Based on historic data since 1950, which portfolio mix has a greater risk:

Choice A: 70% Stocks/20% Bonds/10% Cash

Choice B: 0% Stocks/90% Bonds/10%

The answer can be found at the end of this post.

I was at a Global Quantitative Strategy conference yesterday sponsored by Merrill Lynch. It was a very interesting day, with speakers focused on a variety of topics.

Simply put, the idea behind quantitative analysis is to use data-driven, computer analyses to find market opportunities. One goal that practitioners of quantitative analysis is to try to remove emotions from their investment activities.

I won't go into everything that was discussed yesterday, but will try to touch on a few of the presentations over the next few days.

The first speaker yesterday was Nicholas Barberis, a professor from the Yale School of Management whose specialty is behavioral finance.

Behavioral finance has become a "hot" area in investment management, since it attempts to incorporate how psychology can impact investment decisions.

Professor Barberis pointed out that most of us focus on the risk of events that have a fairly small likelihood of actually happening. Some of us suffer from the fear of flying, even though millions fly each year without incident. We demand vaccines or preventative measures for illnesses that have only the remotest chance of occurring.

In investing, most conversations I have with investors focus on the possibility of a repeat of the 2008 stock market meltdown, when the S&P declined by more than -30%. However, if you go back to 1926, there have been just 11 years that the stock market has declined by more than -10%.

Or, put another way, in 87% of the years since 1926 the stock market has either gained or experienced a small decline. Only 3 of the last 84 years (4%) of the years had declines that were of the magnitude of 2008.

And yet most investors I speak to these days are more focused on the risk of stocks than bonds, even though bond yields are historically very low.

So the Answer to the Pop Quiz, based on Ned Davis Research data:

Choice A has a negative return 23% of the time over the last 60 years. On average, the return of the 70% stock/30% fixed portfolio has been +15%.

But here's the surprise. Choice B - the all bond portfolio - has had a negative return 25% of the time (or slightly higher than the portfolio skewed towards stocks) but the average annual return has been slightly less than +10%, or nearly 1/3 lower than the portfolio having stocks.

Put another way, the all-fixed portfolio had more risk, and lower returns, than the equity portfolio.

So if you chose Choice A, consider yourself rational.

Friday, June 10, 2011

Telco Woes Continue: "Voice Will Be Free"

Unlike my current unease with the financial sector - which I view as more of a tactical opinion - I have not been a fan of the large telecommunications companies for many years, despite their generous dividend yields.

My view point on the sector was originally established almost 11 years ago, after attending a talk by John Chambers, CEO of Cisco. At the time, Mr. Chambers announced that "Voice will be free."

Chambers was referring to the inexorable decline in the costs of making telephone calls the the consumer.

Subsequent events have proven him right. Most wireless plans, for example, offer free long-distance calls during the evening and weekends. You can now make international calls on Skype for a fraction of what a traditional carrier would cost.

The problem that most telcos face is that a large portion of their profits come from the traditional wireline business.

For example, according to Bernstein analyst Craig Moffett, while only about17% of the revenue at AT&T comes from residential wireline, about 40% of AT&T's EBITDA came from the same source.

The same is roughly true at Verizon; 21% of Verizon's revenue, but 57% of EBITDA, comes from residential wireline.

Why is this a problem? Well, the wireline business is sinking like a stone. According to Moffett, residential access lines have cumulatively declined by 53% since the end of 2000, or around the time that I heard John Chambers's pronouncement.

In 2005, 7% of U.S. households had "cut the cord", and did not have a wireline phone in their home; today, just 5 years later, this figure has reached of 27% households in the U.S.

So how are the telcos earning their money? Well, one way has been charging for data transfer, or texting. And now this is under attack, as yesterday's Wall Street Journal pointed out:

Text traffic will come under more pressure in the months ahead. This week, Apple Inc. showed off an application that will allow iPhone and iPad owners to bypass carriers and send text messages over the Internet to other people with Apple devices.

Read more:

The article goes on to note that numerous other servers are finding ways to offer consumers faster and cheaper ways to communicate with their cellphones.

In short, while I might be worried about the financial sector in the short term, I think that the secular decline for large telecommunications in this country is firmly in place.

Thursday, June 9, 2011

Three Different Looks at Bank Stocks

Banks continue to make headlines.

First there's the public dispute between Treasury Secretary Timothy Geithner and European regulators about how best to try to regulate the banking sector.

For the sake of brevity, I won't go into all of the details here, but sufficient to say that (once again) the Americans do not agree with the Europeans.

Former IMF chief economist Simon Johnson has been harshly critical of U.S. banking policy for several years now, and wrote a book called 13 Bankers which essentially eviscerates everyone involved in the financial crisis of 2008.

He wrote a blog post today in the New York Times which continues this general theme of harsh criticism of Secretary Geithner. I am noting it here not necessarily because I totally agree with his thoughts, but rather to give an indication of just how hard the regulatory headwinds are beginning to blow:

Mr. Geithner’s thinking on bank size is completely flawed. The lesson should be: big banks have gotten themselves into trouble almost everywhere; banks in the United States are very big and have an incentive to become even bigger; one or more of these banks will reach the brink of failure soon....

...The right conclusion for Mr. Geithner should be: huge cross-border financial operations are immune from orderly resolution; such companies should therefore be run on a completely segmented basis, with separate capital requirements and no recourse to parent companies. Consequently, capital requirements should be much higher than currently proposed by any official, for capital is the buffer that stands between bad management decisions and taxpayer bailouts when bank resolution is not possible.

Ah, you say, this is all very interesting, but what does it mean for my portfolio?

Here's a couple of videos that might help. The first is features former Morgan Stanley strategist Barton Biggs, who now runs a $1.3 billion hedge fund called Traxis Partners. I have long been a fan of Mr. Biggs, who is a very smart investor as well as a terrific writer.

He doesn't like bank stocks in here, believing that their book values are overstated. He does, on the other hand, like big tech companies, which I will discuss in my next post tomorrow:

Finally, from Jim Cramer of Mad Money fame. I know, Cramer can sound ridiculous sometimes, but there was a time that he was a very successful hedge manager himself, and in this piece about bank stocks he makes some comments that I think make sense.

Unlike Mr. Biggs, Cramer looks at the stock charts of some of the big financial companies and concludes that they are "dead money" for a while. Yes, they could rally for a couple of days, but Cramer's view of the charts is that many of the stocks have broken down, and that they are closer to "value traps" rather than investment opportunities:

Wednesday, June 8, 2011

Jamie Dimon Takes On the Government

I've written several times over the past week about my concerns regarding big banks.

It's not so much that I think we're heading for a repeat of the credit crisis of 2007-08. I think that the aggressive Fed intervention in the capital markets has mitigated this risk.

No, the problem for the banks is more fundamental. First, loan growth remains tepid. True, some sectors - like small business lending - have shown some signs of life over the last few weeks. Overall, however, weakness in housing, and general caution in Corporate America, has left the banking system awash in liquidity, and a dearth of qualified borrowers.

The other potential problem is regulation. The final details are yet to be ironed out, but it currently appears that US banks in general - and money center banks in particular - are going to have to add considerably more capital cushion than is currently required.

If the banks are forced to increase their capital, this will almost certainly drive down returns.

This prospect does not make Jamie Dimon of JP Morgan happy. Mr. Dimon has been quite vocal recently with his dissatisfaction of the proposed changes in capital requirements. Since he is head of one of the largest banks in the world - and arguably the most widely followed - his comments have received widespread notice.

It's hard to know whether Dimon is simply posturing for negotiations that are currently occuring behind closed doors, or whether he has already lost the argument. Still, it is certainly worth following.

Here's an excerpt from a column from CNBC (via the blog Net Net):

... it seems that what provoked Dimon were recent signals from a Fed governor that the largest banks might face an additional capital surcharge, above and beyond the new capital and liquidity requirements agreed to last year in Basel.

At Basel, regulators agreed to more than double the minimum common equity requirement for banks to 4.5 percent from 2 percent, with an added liquidity buffer of 2.5 percent. That means banks will have to have total risk reserves of 7% of weighted assets. Regulators did not reach a consensus on proposals for an additional buffer—or "surcharge"— for "systemically important financial institutions"—which is regulator speak for Too Big To Fail.

Many of the largest European and American banks have been lobbying hard against the new surcharge, but these efforts appear to be failing.

Tuesday, June 7, 2011

Time to "Party" Like 1937?

Most strategists have been relatively sanguine in their comments regarding the recent string of weak economic data. The stock market has also been weak, but this is not totally unexpected after a strong first quarter.

After all, we saw the same pattern last year - a good start to the year, a mid-year pause, then a strong finish.

However, as also I noted yesterday, the people closest to the economic data are worried. It's not so much that May's employment report was well below expectations - after all, it's only one month - but rather the trend of economic reports is unmistakably lower.

The difference between 2010 and this year is the tone in the political debate. Fiscal policy discussions are mostly focused on how to cut spending, rather than new federal programs that might help job creation.

Fed policy is also unlikely to be as friendly as last year. The financial system is already flooded with liquidity, and lower interest rates appear to have had only a minor impact on interest-sensitive areas like housing.

Last year, stocks moved sharply higher with the added stimulus of the Fed's QE2 (remember Bernanke's editorial in the Washington Post advocating high stock prices?). In addition, Congress passed a number of tax incentives at year-end designed to bolster economic growth.

At the time, economists were falling over themselves to raise economic forecasts. This optimism now appears to have been premature.

Now, in mid-2011, it seems more likely that the government will slash spending in an effort to reduce the federal deficit. And judging from comments from Fed officials (other than Bernanke), there seems to be more internal debate about the need to raise interest rates to head off a possible surge in inflation rather than continue the current accomodative policies.

If this becomes the direction of government policy, I will need to seriously re-evaluate my current bullish stance on stocks.

The best analogy can be found a couple of generations ago, in 1937-38.

Paul Krugman writing in the New York Times last Friday had a good piece about the parallels with 1937. Here is an excerpt from his piece:

Earlier this week, the Federal Reserve Bank of New York published a blog post about the “mistake of 1937,” the premature fiscal and monetary pullback that aborted an ongoing economic recovery and prolonged the Great Depression. As Gauti Eggertsson, the post’s author (with whom I have done research) points out, economic conditions today — with output growing, some prices rising, but unemployment still very high — bear a strong resemblance to those in 1936-37. So are modern policy makers going to make the same mistake?

And here's what Fortune magazine writes earlier this week:

As the Eggertsson paper notes, the Fed's fearful tightening in 1937 halted a recovery that had taken years to develop and dealt sharp blows to employment and production (see chart, above right). A premature response to the next energy shock could surely do the same to the current economic upturn, as shallow as it now appears.

Why the Fed will repeat its worst error - Term Sheet

Monday, June 6, 2011

Is the Economy Faltering? The Trend is Not Great

Years ago, when I attended the University of Michigan, I had the chance to hear Paul McCracken speak.

Mr. McCracken had been chairman of the Council of Economic Advisors under President Nixon. He also served as an economics advisor to Presidents Kennedy, Johnson and Ford. In other words, he was a important player in developing economic policy throughout the 1960's and 1970's.

It was a real treat for a fledgling business student like me to hear from someone like Paul McCracken, so I remember his talk to this day.

One of the main things I recall was McCracken's distrust of economic forecasting, in particular econometric modeling. Instead, to get some sense of the health of the economy, McCracken used to wander down to the department where they actually compiled the data.

McCracken said that the folks that compiled economic data from a wide variety of sources were usually the best equipped to judge economic trends, since they spent most of their working hours gathering and preparing reports.

I remembered Professor McCracken's words this morning, when I read an article in the Financial Times that highlight the concerns that Keith Hall, commissioner of the U.S. Bureau of Labor Statistics, raised about the recent trends in economic data.

In particular, the jobs report last Friday was dismal. The U.S. only added 54,000 jobs in May, well below this year's average gain of 182,000. While it is only one month, the overall trend is well below what one would like to see in an improving economy.

Here's an excerpt:

Some analysts suggest that the {employment} slowdown might reflect supply chain disruptions or extreme weather events such as the tornadoes that hit the U.S. in May, rather than any deeper slowdown.

But Mr. Hall said this is hard to see in the data. "There was really no jump at all in people reporting work disruption. So whatever has happened this month is probably not a weather effect." / US / Economy & Fed - US data chief warns on employment

Many Wall Street analysts have been quick to point out the similarities between this year and 2010. Last year, the economy also showed signs of faltering in the spring, yet we ended last year on a fairly strong note.

However, I worry that this year might be different.

Last year's fourth quarter growth spurt was helped by a number of factors that probably will not be repeated this year.

In particular, the second attempt by the Fed to lower interest rates was announced in late August, and asset prices jumped. In addition, in the aftermath of the November elections, Congress passed a number of tax cuts which were intended to spur consumption and investment.

This year, however, the mood in Washington is different. I doubt that even Bernanke has enough political capital to begin a third round of quantitative easing. And with most of the tax in Congress about cutting spending, and raising taxes on wealthier Americans, it is hard to see a significant dose of fiscal stimulus any time this year.

And so I am heeding Professor McCracken's words, and focusing on what the data is telling us.

Friday, June 3, 2011

Bullish on Bank Stocks: A Contrarian View

Yesterday's note discussed my current dilemma regarding investments in bank stocks.

As you could probably tell, I am leaning towards reducing my positions in the financial sector, despite the fact that financials represent about 15% of the S&P 500.

As luck would have it, Jason Goldberg from Barclays was in town yesterday. Jason has followed large-cap and mid-cap banks for a number of years now, and is a first-rate analyst.

Unlike the consensus - including me, perhaps - Jason is a raging bull on the banking group, and believes that today's prices represent an opportunity for investors with a longer term time horizon to make some serious gains.

Jason acknowledged that he has never seen sentiment so negative towards his group. Everywhere he goes, he said, investors can list a number of reasons why they don't want to invest in bank stocks.

Although regulatory pressures could potential hurt the group (especially if banks are required to hold more capital), by far the most common concern is around tepid loan growth.

However, concerns about slow loan growth do not square with recent data.

For example, loan growth over the last few weeks has been ahead of the pace of the first quarter of 2011, according to the Federal Reserve.

As the brokerage firm Jeffries noted in a recent report, Commercial & Industrial loans increased +1.3% over the last 6 weeks. C&I growth was +0.7% in the first quarter of 2011.

Then there's valuation.

Jason noted that a couple of banks - Bank of American and Citigroup - are trading below tangible book value, and other banks are trading at the "cheaper" range of their historic valuation. At the same time, earnings reports for most banks have been actually pretty strong.

So what will it take for the bank stocks to start behaving better?

Jason went back to last year, when banks languished for most of 2010 and then rallied strongly into the close of the year. The bank stock surge at the end of the year was mostly the result of a sense that economic growth in 2011 might be better than anticipated, and that banks might actually show better earnings than Wall Street forecasts.

Now, however, the economy appears to be weakening again.

It is not clear whether this is a temporary phenomena (we had a similar economic pause in the early summer of 2010) or whether we are dangerously close to a more prolonged slowdown.

But I still conclude with the same observation as yesterday: if you think this is just a pause in economic activity, now is the time to be buying financials.

On the other hand, the more bearish view would of course lead you to the opposite conclusion.

Thursday, June 2, 2011

What To Do With Bank Stocks Now?

Financials were crushed yesterday.

The weak housing numbers, and growing evidence that the economy is slowing at least temporarily, is causing investors to move to other, more defensive sectors.

I have been generally cautious on the financial group. The debt that was created in the housing boom years of the last decade is unfortunately still lurking on bank balance sheets.

With house prices declining in most parts of the country, and real income growth a challenge for most American workers, it will probably take years before the housing market returns to normal.

I last tackled this question in January 2011 in Random Glenings. Here's an excerpt from what I wrote then, with the full link below:

Anemic loan growth; unrecognized loan losses; low interest rates; and possible "irrational exuberance" about future prospects - all should add up to a group that should be avoided.

And yet the financial sector has been on a tear over the last few months, boosting the returns of the S&P. Bank stocks in particular outperformed the market in December by 800 basis points. Woe to the equity manager that is either underweight or avoids the group.

So now my colleagues and I have to figure out what to do.

What we did, earlier this year, was add slightly to our financial weightings mostly through the use of the Financial Sector exchange-traded fund (XLF). This allowed us to get closer to our market benchmark (the S&P 500) but spread our risk among a basket of financial companies.

Now I am wondering if we should cut back again, but wondering if all of the "bad news" is already in the financial stock prices.

For example, CNBC had a piece which indicated that many hedge funds have been large sellers of bank stocks:

After making a killing buying the big banks at their nadir, savvy investors are moving on. Bank stocks are still cheap, but investors expect lackluster revenue growth and new regulations to keep prices depressed for some time.

"Financials have become hated in recent months," said Alan Villalon, a senior bank analyst at Chicago-based Nuveen Investments, which owns bank stocks

If you look at the bank stock universe in general, most are trading at a valuations that are about in the middle of the range of the last 5 years. This would seem to suggest that if one wanted to cut their financials position, it's not too late.

Valuations aside, it seems that the decision of whether to sell financial stocks or not is largely a market.

Ned Davis of Ned Davis Research (NDR) noted in a research piece a couple of weeks ago that financial stocks typcially begin to deteriorate 7-8 months, on average, prior to a stock market peak, based on the last ten NDR-defined bull markets since 1976.

Mr. Davis went on to say:

What bothers me about the Financials, beside their leading tendencies and connection to the debt bubble, is that all of this poor action has come after the massive stimulus by the Fed and the government to help this sector get bailed out from its own mistakes. Profits are up, and the Financials have been allowed to hide their toxic assets by not marking all their assets to real market prices, and the Fed has made the yield curve so wide that the banks are minting profits...Yet the banks are still underperforming.

Lots to think about this morning.

Wednesday, June 1, 2011

I Know I Was Looking for Lower Yields, But This is Ridiculous

I have been writing on this blog for last year or so that I expected interest rates to move lower, not higher.

This has been a decidedly out-of-consensus view. Most commentators and investors were convinced that rates were headed higher, including one of the best bond managers of our generation, Bill Gross of Pimco.

So what's happened?

Rates are plunging lower. At this writing the 10 year Treasury is yielding less than 3%, down nearly 75 basis points from just 4 months ago. The 2- year Treasury note offers a whopping 0.48%.

Corporate and high yield debt yields are also moving lower. Yesterday's Bloomberg pointed out that for the first time since 1987, the earnings yield of the S&P 500 is higher than the average yield on junk bonds, according to Barclays.

Investors and savers are dying for yield, and yet there is little to be had.

All of this is happening against a backdrop of considerably improved economic conditions than 2 years ago. Most corporations are reporting good, if not, record earnings, despite tepid top line growth. Stocks have nearly doubled since the lows of March 2009.

Still, rates are moving lower because housing prices are moving sharply down, and the economy is showing signs of slowing.

Low interest rates, at some point, become a curse, not a blessing.

Or, to put it another way, I kinda wish that I had been wrong on rates, and that the so-called bond vigilantes had pushed interest rates higher.

I manage a number of balanced portfolios for clients, using a combination of stocks and high quality bonds. The idea of bonds in these accounts is to provide some measure of protection, and hopefully some modest degree of income.

Problem is, that if interest rates don't move higher soon, it will be harder to maintain a significant weighting in bonds.

One of the best alternatives to bonds, it seems to me, remains large cap, dividend-paying common stocks. True, stock prices can be volatile, but it seems reasonable that the value of most stocks will be higher 5 years from now than they are today.