Monday, January 31, 2011

Time to Be Concerned About Emerging Markets Stocks?

The situation in Egypt is the center of attention for the investment world right now.

As usual, one of favorite columnists has an interesting perspective. Here's Ambrose Evans-Pritchard in yesterday's London Telegraph:

The surge in global food prices since the summer – since Ben Bernanke signalled a fresh dollar blitz, as it happens – is not the underlying cause of Arab revolt, any more than bad harvests in 1788 were the cause of the French Revolution.

Yet they are the trigger, and have set off a vicious circle. Vulnerable governments are scrambling to lock up world supplies of grain while they can. Algeria bought 800,000 tonnes of wheat last week, and Indonesia has ordered 800,000 tonnes of rice, both greatly exceeding their normal pace of purchases. Saudi Arabia, Libya, and Bangladesh, are trying to secure extra grain supplies.

Egypt and Tunisia usher in the new era of global food revolutions - Telegraph

Mr. Ambrose-Pritchard goes on to describe the challenges that confront leaders around the world in feeding their people. He notes that there is probably enough capacity to raise sufficient foodstuffs, but it will take strong global leadership.

From an investment standpoint, I think you have to be at least cautious on the emerging markets at this point. True, Egypt and Tunisia are not exactly world stock market leaders but they are symptomatic of a trend that could ruin the current global love-in with equities.

As has been written in many places, the growing wealth gap between most of the world's populace and the relatively few that have enjoyed the benefits of globalization could eventually turn out badly, in my opinion.

It is all well and good to look at macroeconomic data from places like China and Brazil and be bullish on business prospects in those countries. However, an unsettled populace can easily scare foreign capital, and reverse the upward trends in prices.

Friday, January 28, 2011

Japan: Deflation + Downgrades = Good Stock Market

S&P downgraded Japan's credit rating yesterday citing, among other factors, the fact that Japan's ratio of government debt to gross domestic product is now above 100% (and rising).

The downgrade is somewhat symbolic, it would seem, since most of Japan's deficits are financed by domestic savings (unlike other countries, like the U.S., which rely on the kindness of strangers to finance their profligate ways). The S&P action sent a shiver through the credit markets.

Deflationary pressures, meanwhile, show no sign of abating, despite the government trying everything in the Keynesian playbook to try to get prices moving higher. Japanese 10 year government bonds offer a whopping 1.2% yield.

The employment outlook for younger Japanese is depressing, to say the least. Older Japanese workers - whose pensions and savings have been decimated over the last 20 years - have been reluctant to retire, and opportunities for college graduates are limited.

This morning's New York Times carried a long piece about the difficult employment outlook for even the most talented Japanese students:

Last year, 45 percent of those ages 15 to 24 in the work force held irregular {temporary} jobs, up from 17.2 percent in 1988 and as much as twice the rate among workers in older age groups, who cling tenaciously to the old ways. Japan’s news media are now filled with grim accounts of how university seniors face a second “ice age” in the job market, with just 56.7 percent receiving job offers before graduation as of October 2010 — an all-time low.

“Japan has the worst generational inequality in the world,” said Manabu Shimasawa, a professor of social policy at Akita University who has written extensively on such inequalities. “Japan has lost its vitality because the older generations don’t step aside, allowing the young generations a chance to take new challenges and grow.”

So what does the Japanese stock market think of all of this?

A savvy client sent me this piece yesterday from Reuters:

Nomura's new Japan stocks fund draws strong demand
TOKYO Jan 27 (Reuters) - A new Nomura Asset Management mutual fund that invests in undervalued Japanese equities has attracted $887 million worth of retail money, an official from the fund's distributor Nomura Securities (8604.T) said on Thursday...

That was more than double the amount of last year's top newly launched fund, which was offered by Daiwa Asset Management and totalled 34.5 billion yen, data from fund research company Lipper showed.

"The stock market is expected to be in an upward trend for a while and there were many investors wanting to benefit from that," the official at Nomura Securities said....

...Japan's Nikkei benchmark average .N225 has jumped about 10 percent over the last three months, outperforming a 7.7 percent rise for the Dow Jones industrial average .DJI and a 2.2 percent rise for Hong Kong Hang Seng Index .HSI, Thomson Reuters data shows.

It is almost axiomatic that economic data and stock market performance do not mirror each other, and Japan seems to be the latest example.

Thursday, January 27, 2011

The Scary Math of Long-Term Care

I had a post yesterday about needing income in retirement, so I thought I would continue the thought today.

There was a coach at Florida State named Bobby Bowden who coached until he was in his late 70's. When asked by reporters why he didn't retire, Bowden supposedly replied "There's only one other major life event after you retire, and I don't want to sit around and wait for it."

While Bowden was correct, what most people really have to plan for is the unfortunate fact that medical costs also increase in retirement. A serious illness requiring significant care can decimate the life savings of someone who may think they have sufficient assets to prepare for any eventuality.

On Twitter yesterday I came across a post that from a site called "MoneyMinded Moms". I had never visited the site, but they posted a chart that does a pretty good job of illustrating the challenge confronting even well-off retirees.

Here's the excerpt, with the full link below:

If care isn’t needed at a younger age, chances are greater than 60% at age 65 that we will require extended care at home or in a facility.1 A recent industry report shows that the average long-term care insurance claim is 2.8 years,2 but the caregiving time for Alzheimer’s or stroke victims can be many years. At the national average cost of almost $75,000 a year for ten hours of home care at $20 per hour, it doesn’t take long to wipe out a family’s assets.3 Take a look:

Posted Image

What Are the Odds of Needing Long Term Care?

I think that most of us would consider a couple with $500,000 in savings to be pretty well-off, and yet this chart clearly shows how quickly these funds can be used up.

Moreover, if these funds are mostly in fixed income today, assuming a 4% yield (which is what the chart uses) is actually pretty aggressive. As I mentioned yesterday, most of clients are reluctant to buy bonds with maturities much longer than 5 years, and yields for investment grade securities in the 5-year sector are well below 3%.

What's the solution?

Unfortunately there is not one magic answer, but a series of trade-offs and alternatives. Long-term care insurance might seem to be one sound idea, for example, but some of the policies written today are pretty expensive for the coverage they offer.

Wednesday, January 26, 2011

Borrowing to Pay Expenses in Retirement?

One of the most frequent discussions I have with clients these days is about their desire to have their investment portfolios produce more income.

There are a number of choices, but none offer the absolute security of a bank account.

For example, with the overwhelming consensus among the media that interest rates are headed higher in the very near future (a view not shared by Random Glenings, by the way), clients are reluctant to buy longer maturity bonds, despite the much higher yields that are available.

Another alternative - dividend-paying common stocks - has received a better reception, although the memories of the stock market debacle of 2008 still linger with most. Still, the lure of reasonable yields plus the chance for capital growth seems reasonable to many investors.

Regardless of the investment choice, however, there is no denying that one of the most serious problems facing retirees is the fact that they are dipping into principal to meet daily living expenses.

There is another alternative which, fortunately, to which my clients have largely avoided: debt.

According to the New York Times this morning, however, a growing number of retirees have been using high-interest credit card debt to pay their bills, which could eventually lead to financial disaster:

Study after study shows that more of {elderly} are living with heavy credit card debt, regularly swiping cards to pay for things like gas and groceries. And as the balances pile up, the elderly cope in a number of ways. Some...permit their adult children to step in, while others seek outside counsel in an effort to preserve their independence. Some elderly debtors are trapped in limbo, too proud to ask for help but too strapped to pay off the debt.

Retirements Swallowed by Debt -

With the job market still in tough shape - especially for older workers who, in many cases, lack the skills to compete for available positions - an elderly person who finds themselves heavily in debt has very few alternatives to repayment.

And with interest rates probably staying low for at least the foreseesable future, this could be a problem that will continue to grow.

Tuesday, January 25, 2011

Off to Davos? Not This Year.

Somewhat to my surprise, Random Glenings did not receive an invitation to the World Economic Forum at Davos, Switzerland this year.

At first I was, well, a little disappointed. However, after reading Andrew Sorkin's piece in this morning's New York Times, I felt better.

Turns out that admission to the heady atmosphere in the Alps is pretty steep. Here's an excerpt:

There are several levels of membership {to the World Economic Forum}: the basic level, which will get you one invitation to Davos, costs 50,000 Swiss francs, or about $52,000. The ticket itself is another 18,000 Swiss francs ($19,000), plus tax, bringing the total cost of membership and entrance fee to $71,000.

But that fee just gets you in the door with the masses at Davos, with entry to all the general sessions. If you want to be invited behind the velvet rope to participate in private sessions among your industry’s peers, you need to step up to the “Industry Associate” level. That costs $137,000, plus the price of the ticket, bringing the total to about $156,000.

Of course, most chief executives don’t like going anywhere alone, so they might ask a colleague along. Well, the World Economic Forum doesn’t just let you buy an additional ticket for $19,000. Instead, you need to upgrade your annual membership to the “Industry Partner” level. That will set you back about $263,000, plus the cost of two tickets, bringing the total to $301,000.

Andrew Ross Sorkin: A Hefty Price for Entry to Davos -

I have a client who used to attend Davos yearly but decided a couple of years ago that it was no longer worth the time and expense. After reading Mr. Sorkin's piece this morning, I can understand his point.

My client had one final suggestion for me: read The Economist magazine. In his opinion, most of what will be discussed in Switzerland over the next few days can be found between the covers of the venerable British publication. And since I have been been a loyal Economist reader for many years, I will take some solace in his idea.

Monday, January 24, 2011

Forecasting is Tough, Especially About The Future

A couple of years ago I passed the exam to become a Certified Financial Planner (CFP).

I thought it would be useful to help my clients not only with their investment decisions but also to be able to offer other kinds of financial advice as well.

And indeed it has been helpful. More and more these days I find that clients are more interested in making sure their financial plans are sound rather than focusing on market outlooks and the like.

However, one of the things you quickly discover when you are trying to help someone plan for the future is that so many of the "answers" you come up with depend on your assumptions.

For example, at the end of the 1990's, it was conventional wisdom that one should put a significant part of retirement assets in stocks, since equities were clearly the best way to grow assets. Indeed, after 17 years of 19% compounded returns (which was the case at the end of 1999), using a 12% per annum growth rate number for equities in the planning process seemed somewhat quaint and conservative.

Well, we all know what happened. For the last 10 years, the S&P 500 has returned 15% (including dividends), or less than you might have earned by buying long-term bonds (where you almost doubled your money in the same time period).

For someone who retired in 2000, this meager performance wasn't just a curious factoid: this had a real impact on their lifestyle.

Another consideration was highlighted in an article published this weekend by the New York Times. The article discusses how important the return on your assets play not only while you are working but in the final years prior to retirement. Here's an excerpt:

The problem is that even if you do everything right and save at a respectable rate, you’re still relying on the market to push you to the finish line in the last decade before retirement. Why? Reaching your goal is highly dependent on the power of compounding — or the snowball effect, where your pile of money grows at a faster clip as more interest (or investment growth) grows on top of more interest. In fact, you’re actually counting on your savings, in real dollars and cents, to double during that home stretch.

But if you’re dealt a bad set of returns during an extended period of time just before you retire or shortly thereafter, your plan could be thrown wildly off track. Many baby boomers know the feeling all too well, given the stock market’s weak showing during the last decade.

With Retirement Savings, It’s a Sprint to the Finish -

I would add one additional point. The correct withdrawal rate from your retirement account can also be dependent on the returns on your assets in your early years of retirement. If the market tanks right after you need the money, for example, you could find yourself running out of money if you don't change your withdrawal percentage fairly significantly.

Of course, if you're an optimist, if the market rises right after retirement, life could be better than expected.

Put another way, being a CFP tells you that the one of the most important points to remember in retirement planning is to consider various alternatives - the future is always uncertain, and probably different than anyone expects.

Friday, January 21, 2011

How Safe Are Municipal Bonds?

In 1995, shortly after then-President Clinton received a "shellacking" in 1994's mid-term elections, the House Republicans had a showdown with the White House.

The Republicans were determined to make changes in fiscal policy that President Clinton was equally determined to stop.

At one point, not only did the Republicans threaten to shut down the U.S. government, but there was also talk in Washington that perhaps the federal government should defer some of the interest payments due on the U.S. Treasury obligations to reduce the budget.

The world gasped. The thought that the strongest and richest nation on the planet would stop paying interest on the money that it had borrowed was unthinkable, particularly when it had more than sufficient resources to meet its obligations.

We all know the rest of the story. Not only did the government continue to function normally, but the Republican tactic backfired, as the electorate realized that it wanted no part of any politician that would recklessly ignore its obligations. Clinton went on to win re-election easily in 1996, while the "Republican Revolution" was essentially dead.

I was reminded of this period this morning, when I read the story in the New York Times that there is quietly a movement afoot in Congress to allow municipalities to potentially file for bankruptcy.

Included in the legislation being considered would be the right to consider municipal bond holders as unsecured creditors in a bankruptcy filing, meaning that they could potentially face significant losses on their bonds:

Bankruptcy could permit a state to alter its contractual promises to retirees, which are often protected by state constitutions, and it could provide an alternative to a no-strings bailout. Along with retirees, however, investors in a state’s bonds could suffer, possibly ending up at the back of the line as unsecured creditors.

I don't know whether this is just a negotiating tactic on the part of the government to try to force government employees and their unions to reduce their pension and health care costs, but it is certainly a development worth watching.

However, the reason I was reminded of the mid-1990's showdown was the similar situation that most municipalities find themselves in. True, most are facing huge deficits, but most also have the means to maintain any and all debt obligations.

Yesterday's Bond Buyer carried a long article on subject. Here's a couple of excerpts:

In addition, interest payments on state and local bonds generally absorb just 4% to 5% of current expenditures, as was the case in the late 1970s, according to the center.

Municipal bond defaults have been extremely rare, with the three major rating agencies calculating the default rate at less than one-third of 1%, the center said. Between 1970 and 2009, only four defaults were from cities or counties and most others were on non-general obligation bonds that financed the construction of housing or hospitals.

And then there's more:

“States and localities devote an average of 3.8% of their operating budgets to pension funding,” it said. “In most states, a modest increase in funding and-or sensible changes to pension eligibility and benefits should be sufficient to remedy underfunding.”...

Some observers warn that governments in dire crisis have added to unfunded pension liabilities about $500 billion in unfunded promises to provide state and local retirees with continued health care coverage. But “it is inappropriate to simply add the two together,” the center said.

Pension promises are legally binding, but retiree health benefits are not and typically can be changed, according to the report. In addition, states’ retiree health benefit plans differ widely.

“Given the different origins, scope, and potential solutions to problems in each of these areas, calls for a 'global’ solution — such as recent proposals to allow states to declare bankruptcy or to limit their ability to issue tax-exempt bonds unless they estimate pension liabilities using a riskless discount rate — make little sense in the real world of state and local finances,” the center said in the report. “Indeed, some proposed solutions could worsen states’ long-term fiscal picture.”

If there were any defaults by a major municipal borrower, interest rates for all borrowers would soar, as creditors demanded much higher yields in exchange for more risk.

I have no doubt that the municipal market will be under some pressure in the next few weeks, as Congress and municipalities across the U.S. struggle with some unpalatable alternatives. But I still believe this represents a very good investment opportunity for longer-term investors.

Thursday, January 20, 2011

"What About Brazilian Bonds?"

Earlier this week I received a call from one of my clients.

This client - who's a retired accountant executive, and a pretty savvy guy - had a couple of CD's maturing, and was searching for better yields than the local banks are offering.

I gave him my opinion: Longer maturity U.S. bonds, especially higher quality municipals, offer very attractive yields in a disinflationary world. Given that AA-rated municipals in the 10-year maturity range are offering yields that are 120% of comparable Treasurys, I suggested that at least a portion of his fixed income money be moved into this sector.

No, that wasn't what he wanted - my client is convinced that U.S. interest rates are going to be headed considerably higher in the next year or so, and so wants to stay on the shorter maturity end of the U.S. bond market.

But then he startled me with a question that I really hadn't expected from a relatively conservative investor:

"What about Brazil? Aren't rates pretty high down there? Is there any way I can get some Brazilian bonds?"

I confessed to my client that I really wasn't too well-versed on the bond markets of South America, so we're not going to invest in that region, but it got my curiosity going.

I turned to one of my favorite columnists - Ambrose Evans-Pritchard of the London Telegraph - to see what he could offer. And sure enough, Mr. Evans-Pritchard had just written a column about Brazil.

According to his article, Brazil is struggling with high inflation rates, largely due to the flood of foreign capital coming into the country. It seems that global investors - especially those in the United States - are frustrated with the low rates in their own countries, and look at countries like Brazil as attractive alternatives.

Problem is, Brazil doesn't really want the foreign money, since it drives up the value of the Brazilian real, which moves inflation higher and makes Brazilian exports less competitive globally:

Brazil’s trade deficit doubled last year to $71bn, and there is evidence that the strong real is letting Asian exporters eat into Brazil’s industrial base. The government has already adopted 28 anti-dumping measures against China, covering steel, tyres, synthetic fibres, chemicals, shoes and toys. China’s annual exports to Brazil have jumped from $5bn to $26bn in five years.

Still, the central bank in Brazil just raised short term rates to 11.25% to combat inflation, which is running at an annual rate of about 6% (i.e. real Brazilian rates are above 5%, which is among the highest in the world).

So how does this all turn out? Mr. Evans-Pritchard continues:

Marcelo Ribeiro from the Pentagono Asset Management said Brazil is repeating its age-old pattern of boom and bust. "Brazil is wrongly perceived as the world’s best investment play. Fiscal policy is ultra-loose and sooner or later the fiscal vigilantes will force dramatic changes," he said.

Mr Ribeiro said Rio’s richest district, Leblon, is now more expensive than New York’s Upper East Side, and Brazilian tourists find London cheap. There has been an explosion of derivatives contracts on the real. "These are all signs of a gigantic bubble," he said.

Wednesday, January 19, 2011

What to do With Bank Stocks?

A number of the accounts that I manage compare their results versus the S&P 500.

"Beating the benchmark" for these accounts is obviously important for lots of reasons. Consequently, I tend to spend a considerable amount of time studying where I have placed the "bets" in the portfolios.

One of the areas that I am struggling with in the financial sector.

It's hard to believe, but it was only two years ago that the financial group as a whole, and bank stocks in particular, were very close to a complete meltdown. Only strong government intervention prevented utter chaos.

Now many bank executives - including JP Morgan's Dimon and Barclay's Diamond - have essentially declared that the crisis is over, and the future for the banking sector is now rosy.

Recently released bank earnings have been for the most part pretty encouraging. For example, even though the market was generally disappointed by Citigroup's earnings report yesterday, the fourth quarter of 2010 marked the fourth consecutive quarterly profit for the big banking conglomerate.

And yet I still can't believe that the "all clear" is in place for the sector.

This morning's Financial Times had a short piece that summarizes a lot of my concerns; here's an excerpt:

Borrowing costs have been at rock bottom for so long that this fact is almost forgotten. Sure, it looks good that JP Morgan's non-performing loans for the fourth quarter fell another 4 per cent. But a firm-wide run rate of $15 billion is still at mid-2009 levels, which itself is two-thirds higher than a year before that. With a monetary policy backdrop that could not have been more generous to struggling companies and consumers, such a small decline in NPLs is hardly comforting. On the contrary, it is terrifying.

Banks have been holding onto their loans either nonperforming or in default longer than in previous credit cycles. This allows them to avoid having to recognize losses.

In addition, banks have so much much liquidity that loan repayments are actually more of a cause for concern than happiness, since loan growth is so anemic. Put another way, many banks have no use for the funds from either the Fed or a repaid loan, so they would rather a borrower continue to pay even a reduced rate of interest.

That said, bankers seem to be partying like, well, good times have returned.

Bonuses have returned with a vengeance to Wall Street as well. Indeed, CEO Bob Diamond of Barclays essentially told British regulators last week that they should just get over it; bank bonuses need to be paid to retain valued employees, so stop hounding him about the matter.

(Ah, those pesky regulators!).

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.

Tuesday, January 18, 2011

It is the Best of Times, or The Worst of Times - Depends Who You Listen To

There were a couple of articles in this morning's Financial Times that did a good job, I thought, of summarizing where we are in the market at this juncture.

Bullish sentiment is widespread. According to the FT, bullish sentiment as measured by the American Association of Individual Investors, is at its highest level since 2005.

The "Trading Post" column (also in this morning's FT) notes that the SP 500 has risen by +8.7% since the end of November 2010. Since the start of September 2010 (i.e. right after Bernanke's talk at Jackson Hole in Wyoming, where he discussed the second round of quantitative easing), the market is up +23.2. Money is now moving back into domestic equity mutual funds, after spending most of last year heading towards other sectors.

The market's relative strength index (which technicians call RSI) is now around 77; normally anything over 75 is considered a sign of an overextended market. And the Vix index, a measure of expected market volatility that tends to rise in nervous markets, is just around 15, which is lowest level since July 2007 (or right before the market hit a record high in October).

And yet, the fundamentals are mixed at best.

Wall Street analyst earnings forecasts are becoming less bullish on the companies they follow. Quoting from the FT:

Figures from Birinyi Associates, a research firm, show that the ratio of upgrades {to earnings} to downgrades of S&P500 companies by analysts has been declining since July, when upgrades peaked versus downgrades. From January to July last year, there were 425 more upgrades than downgrades. Since then, there have been 140 more downgrades than upgrades.

Finally, this weekend's Barron's Roundtable was full of bearish pronouncements from its distinquished participants. Here's a sample quote (courtesy of the blog Zero Hedge):

Marc Faber: “If you measure the stock market not in dollars but gold, it is down 80% since 1999. I no longer regard the U.S. dollar as a valid unit of account. People shouldn’t value their wealth in dollars because one day, in dollars, everyone will be a billionaire."

Bill Gross one-upped that one: “We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential. And, on the short end of the yield curve, we are looking at creditors receiving negative real interest rates for a long, long time. That, in effect, is a default. Ultimately, creditors and investors are at the behest of a central bank and policymakers that will rob them of their money. / Equities - Conditions always less febrile before a fall

Friday, January 14, 2011

Warning to Investors: Voice Will Be Free

About 10 years ago I was at a technology conference here in Boston. The keynote speaker was John Chambers, CEO of Cisco.

Chambers made a statement then that has stuck in my mind:

"If you remember one thing from my talk today, it should be this: Eventually Voice will be Free."

What Chambers meant was while the demands for telecommunications - both voice and data transmission - were doubtlessly going to rise exponentially, the cost of transmission would be driven relentlessly to zero.

Because of Chambers' comment - and also based on doing a lot of fundamental research - I have largely avoided investing in the telecom area, both on the stock side as well as the bond.

Frankly, I believe that names like Verizon and AT&T are going the way of General Motors and Chrysler - large corporations saddled with huge legacy liabilities (pension and health care) and whose products are basically unprofitable. I don't know when, but I believe that at some point in this coming decade we will start to read more about the financial woes of the telecom companies.

I ran across this article from Fortune which described investors in the telecom sector as "chumps". Here's why (I have added the emphasis):

..Since 2000, Americans have gained the power to communicate in ever more ways while somehow paying less to do it. The nation's telecom tab is down 22%, in inflation-adjusted dollars.

And yet over the same decade, the expansion in consumers' communication power was unprecedented. Two major telecom services that were largely used by the wealthy in the 20th century have spread to the masses. Cell phone use tripled between 2000 and 2010; now virtually every adult has one. And the number of high-speed residential Internet connections jumped from 2 million to 74 million. All this happened as the nation's total telecom bill shrank.

How was that possible?

Thank digital technology, fierce competition—and investors willing to build networks at an economic loss. When Craig Moffett of Bernstein Research recently tried to add up the economic value produced between 2000 to 2010 by AT&T (T), Comcast (CMCSA), Verizon (VZ), Echostar (SATS), and the like—the total he came to was horrifying. So far in the 21st century America's telecom networks have destroyed nearly $200 billion.

Every single type of network—cable, cellular, satellite, take your pick—has destroyed wealth for its investors.

Telecom investors: The 21st century's biggest chumps? - Fortune Tech

Like so many industries in the past - think airlines and autos as prime examples - simply knowing that a product may be popular in the future is not sufficient to make them attractive investment opportunities.

Thursday, January 13, 2011

Be Careful What You Wish For: Is Buying Gold A Bet Against Your Own Currency?

I first saw this quote from Charlie Munger (Warren Buffett's investing partner at Berkshire Hathaway) last weekend in the Financial Times. It was reprinted on The Big Picture blog, authored by Barry Ritholtz

“I like working and understanding what works and what doesn’t in human systems,” he said. “To me, that’s not optional. That’s a moral obligation. If you’re capable of understanding the world, you have a moral obligation to become rational. I don’t see how you become rational hoarding gold. Even if it works, you’re a jerk.”

If you're looking for something to do this weekend, the link contains a two hour interview with Mr. Munger.

Munger to Goldbugs: ‘You’re Jerks’ (U Michigan 2010) | The Big Picture

I like this quote from a variety of standpoints.

First, putting a small gold position in your portfolio may make you feel savvy and aware but, in all likelihood, will do little for your overall financial health. If the gold holding is correct, it probably means the rest of your portfolio has been trashed.

Second, buying gold is in effect (as Munger suggests) almost a bet against your own currency. No one will be happy for you if you're correct. Just try to take gold coins to your local supermarket to buy groceries.

Finally, buying gold is probably not based on any sort of fundamental analysis. Gold is almost exclusively used in jewelry, as it is soft and has no other industrial uses. Tracking gold supplies, and who actually holds the gold, is almost impossible. In my opinion, if you want to make a play in commodities, using industrial metals like copper seems to make more sense.

Wednesday, January 12, 2011

Rich, or Just Well-Off? It's All Relative

I thought this was a very interesting piece from the Economix blog of the New York Times.

I work with a number of clients who, by most statistical measures, could be termed very well off, if not wealthy. And yet most of them do not in their own minds feel rich.

I suppose there are a number of reasons for this. Many of my clients, for example, came from relatively modest backgrounds to achieve financial success in their chosen fields. However, they still remember those days of living on very tight budgets, struggling to make ends meet, and find it hard to leave their frugal habits behind.

However, as the Times piece indicates, there could be another reason. In the very high income brackets, the differences in income become much more pronounced (I have added the areas of emphasis):

... for the bottom 90 to 95 percent of Americans, the income distribution is relatively flat. For an American household in bottom 30 percent of the distribution, a move upward of five percentiles (to the 35th percentile) would mean an increase in cash income of a just few thousand dollars. Same goes for a family at the 40th percentile, and at the 60th percentile.

But... around the percentiles in the mid-90s...the monetary divisions between percentiles grow much greater. Those in the middle earn a little less than people a few percentiles up from them, whereas those at the top earn a lot less than their counterparts in nearby, higher percentiles. For example, those who aspire to hop from the 30th percentile to the 35th percentile would need in increase their cash income by $4,000 annually (or by about 17 percent); those who aspire to hop from the 91st percentile to the 96th percentile would require an increase of $324,900 (or 171 percent).

In other words, at least in dollar terms, there is much greater inequality at the very top of the income scale than at the bottom or in the middle.

Why So Many Rich People Don't Feel Very Rich -

In other words, a high net worth client in comparison to the general population is considerably better off, yet in comparison to the group they might socialize with in tony places like Nantucket or Palm Beach the same client feels - dare I say it - poor.

Tuesday, January 11, 2011

Stock Analysts and Forecasts

“Isn't it interesting that the same people who laugh at science fiction listen to weather forecasts and economists?”


I posted a note yesterday discussing the perils of using longer range forecasts to make investment decisions.

As it turns out, even analysts - who presumably spend all day, every day - thinking about the stocks that they follow are also fallible.

Yesterday Bloomberg carried a piece describing the results of a study of Wall Street analysts (tip of the hat to loyal reader Bob Quinn for pointing the piece out to me):

Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg. Now, banks’ favorites include retailers and restaurant chains, the industry that did best in last year’s rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits.

Analysts Prove Hazardous as Contrarian Stocks Surge (Update3) -

This is not, by the way, to necessarily trash the Wall Street community but rather to point out how difficult it is to make good recommendations that will deliver superior investment returns relative to the market.

The article carried the following quote which encapsulates the problem:

“When you have a stock that has 15 analysts covering it and it has 15 buys, I can’t imagine it has much outperformance left,” said {Don} Wordell, whose $1.64 billion RidgeWorth Mid-Cap Value Equity Fund topped 98 percent of peers in the past five years. “You’ve got a stock that has 15 sells on it, you’re set up there to have some strong outperformance.”

It seems to me that the value of Street analysts lies in the access that they typically have to management and other industry leaders. In my opinion, you don't use the Street's "buys" or "sells" for investment decisions but rather as a good source of scuttlebutt which helps you think about a particular sector or company.

Monday, January 10, 2011

"Predicting is Very Difficult, Especially if It's About the Future"*

*Nils Bohr, Nobel laureate in Physics

The beginning of each year brings a flurry of forecasts and outlooks. This year has been no different.

For example, based on my unscientific survey, most seem to feel that everything in the markets will be higher a year from now: interest rates, stocks, etc. Moreover, most of the folks making these pronouncements are pretty smart people, with impressive credentials.

Now, it may very well turn out that all of these will indeed occur. However, what if they're wrong?

This was the topic of a column in yesterday's New York Times. It is well worth reading if only to remind yourself of the unreliability of forecasting.

For example, just look at the opening paragraph - sounds very familiar to what most are saying right now:

IT was such a comforting forecast: By the end of the calendar year, a steady stream of corporate profits would extend the stock market’s long-term rally, raising the Standard & Poor’s 500-stock index by more than 12 percent, plus dividends.

Taking Market Forecasts With Many Grains of Salt -

But, as the author Jeffrey Sommer notes, here's what happened:

{The forecast} came at the very beginning of 2008. In January of that year, the future, as seen by the professional soothsayers, was about as rosy as could be. But it was completely wrong.

As it turned out, 2008 was a catastrophe — engulfing investors in the worst financial crisis since the Great Depression. But based on the numbers compiled in a Bloomberg survey at the beginning of that year, not a single analyst had even the slightest inkling of the dire events that were about to transpire.

None predicted, for example, that by year-end, the market would fall. Yet its actual decline was breathtaking: roughly 38 percent. Investors who relied on the consensus outlook endured one of the worst debacles in modern history.

Mind you, I'm not saying that we're heading for a repeat of 2008. However, it seems to me to be useful to consider all types of different scenarios when considering investment alternatives simply because forecasts can be notoriously unreliable.

Friday, January 7, 2011

"P/E's Don't Matter"

Like many investors, I am naturally drawn to valuation as a measure of whether a stock or bond is an attractive investment or not.

Problem is, sometimes traditional valuation tools will lead you invest in areas that may look "cheap" based on numbers but lack any investment catalyst.

True growth stocks, on the other hand, may look expensive but can offer explosive returns to investors if their underlying growth rate justifies the multiple.

Case in point last year was Apple. Throughout the year, bears and worriers (put me in the latter camp) felt that Apple was trading at valuations that were too rich - but then AAPL was up nearly +60% last year.

My friend Bob Quinn has an expression for this. Whenever I mention to him that a stock is trading at a level that is too rich, he usually quickly says:

"P/E's don't matter."

Bob's being a little facetious, of course, since he looks at valuations also. No, what he really means is that I shouldn't simply ignore an investment idea because it looks expensive, or invest in a bond or stock because it looks too good to be true.

This morning's Financial Times had a good column (authored by James Mackintosh) about the Japanese stock market.

Talk about what seems to be a great opportunity!

For the last two decades Japanese stocks have gone nowhere, and the traditional valuation measures now appear quite compelling. Mr. Mackintosh explains:

...Forward price/earnings ratios...peaked at more than 70 {20 years ago} but now stand at 13.6 for the Topix index of the entire market. Leave aside the past few months, and they have been lower only once in the last 20 years, in 2008. ...Other measures make Japan look even cheaper. Prices are only just above book value, compared with double book in the US, and both price-to-cash flow and price-to-sales ratios are far lower than the US. Japan, renowned for decades for paltry dividends, now has a higher dividend yield than the US (although big US companies still yield slightly more).
You get the idea. If valuation alone is your investment driver, then Japan would be a big part of your investment strategy.

And yet, with the yen continuing to surge against the dollar, Japanese export growth will almost certainly continue to struggle, which will hurt the big Japanese multinational companies. It could instead turn out that the market is recognizing that earnings and profitability going forward will be less than expected, and that the Japanese stock market will remain a laggard relative to the rest of the world.

But I gotta confess: It sure looks tempting.

Thursday, January 6, 2011

It's Good to be Goldman Sachs

Earlier this week I posted a note about the purchase of a small portion of Facebook by Goldman Sachs on behalf of some of its well-heeled clients.

I found the deal - which valued Facebook at $50 billion, or 25x its annual revenue - priced at wildly optimistic levels (although I am a big fan of social media).

Well, it turns out that Goldman Sachs Capital Partners felt the same way, at least according to this morning's New York Times (I have added the highlights):

Goldman Sachs Capital Partners — a group that manages and invests for pensions, sovereign wealth funds and other prominent clients — was given the initial opportunity to invest $450 million in Facebook, said the people, who were not authorized to speak publicly on the matter...

But the unit’s chief, Richard A. Friedman, a longtime Goldman partner, decided the Facebook deal was not suitable for his clients, in part owing to the high valuation and to a mismatch with his investment criteria. The $450 million investment values the Web company at $50 billion. After Goldman’s deal, some industry experts cautioned that Facebook’s growth would need to accelerate rapidly over the next couple of years to justify such a steep price — a risk with many brand-name technology upstarts.

A Goldman Unit Is Said to Have Rejected Facebook -

But there's more. After rejecting the offering for itself, Goldman then turned around and placed it with their clients.

Why would they do this? Read on:

...In the Facebook deal, Goldman is investing $450 million, at an implied $50 billion valuation. Goldman clients, however, are paying a 4 percent placement fee and a 0.5 percent expense reserve fee for their shares, as well as giving up 5 percent of gains. That means Facebook would need to be worth closer to $60 billion before they make any money.

Beside those fees, Goldman is likely to earn additional money from ancillary business, with the biggest victory coming from an eventual initial public offering, perhaps as soon as 2012.

Given all that, Goldman could still make money even if Facebook’s value drops to $40 billion, according to analysts’ estimates.

Looking at the last sentence: Facebook could drop -20% in value and Goldman still makes money.


Wednesday, January 5, 2011

Fourth Quarter 2010 Letter to Clients: "Clouds on the Horizon"

I’m Still Bullish, But There Are A Few Warning Signs to Watch

My last quarterly letter to you listed “10 Reasons to be Bullish on Common Stocks”.

And, sure enough, we had a very nice rally in the fourth quarter, with the S&P climbing more than +10%.

So you would think at time when one of my predictions came true (believe me, there have been plenty of other times when I haven’t fared so well), I find myself a little uneasy about certain aspects of the recent stock market move.

Some of the same factors that lead me to be bullish in September are still in place, i.e. the fundamentals still support stocks. Here are just a few bullish signs:

  • Fed policy remains accomodative;
  • The recent tax legislation from Washington is really just another fiscal stimulus package that should boost economic growth;
  • The third year of a Presidential cycle is historically good for stocks;
  • Corporations remain flush with cash (nearly $2 trillion) that could be used for M&A activity;
  • Competing investment alternatives – money market funds and short maturity bonds – still are offering very little yield.

With valuations still reasonable relative to historic levels, stocks should continue to play an important role in most investors’ portfolios.

My concern, I think, is really more that the consensus view on the market has now shifted 180 degrees. Where most were bearish at the end of last summer, now most seem to be bullish.

For example, there is not a single Wall Street strategist calling for a down market in 2011. Not one. Individuals seem to be returning to the stock market as well – flows into domestic equity funds have turned positive for the first time in a number of months.

I could go on but I hope you get my point. The fundamentals for stocks look just fine, but bullish sentiment seems to be too prevalent. The current market offers opportunities, but primarily in those sectors that have lagged the broader market averages.

For example, large cap stocks offer reasonable valuations and in many cases attractive dividend yields. Names like Colgate; Procter & Gamble; Exxon; and IBM may not create excitement at your next cocktail party but they’re probably going to make you good money this year.

International stocks lagged U.S. stocks last year but growth prospects in many countries outside our borders are better than ours. Besides the emerging markets – whose biggest problems seem to be that growth has been too robust – some European countries also seem to be doing well, especially Germany. Now is the time to be thinking about adding to international exposure, in my opinion.

Turning to the bond market, I would ignore the nay-sayers and consider adding to intermediate maturity paper, especially in the municipal market. Space doesn’t allow me to go through all of my bond thoughts (please see my blog for more details: but sufficient to say I think bonds will continue to play an important role for balanced accounts.

Finally, away from the markets, the most recently passed tax package from Washington contains a number of important tax elements, especially with regards to estate tax planning. We have some expertise in this area, so please feel free to let me know if you would like to set up a meeting with one of our wealth management folks.

With best wishes for the new year,

Tuesday, January 4, 2011

Clouds on the Horizon?

I've been working on my quarterly/year-end letter to clients.

While I remain positive on the near-term outlook for the stock market, I am worried that my positive outlook seems to be squarely in the consensus, which usually is trouble.

I turned bullish on stocks in September, which turned out to be a pretty good call (believe me, not all of my forecasts have been so prescient). However, where my call in early fall was solidly non-consensus, now it seems that bullish sentiment is considerably more widespread.

For example, not a single Wall Street strategist - not one - is predicting a down year for stocks in 2011. Mutual fund flows into domestic equity funds are turning positive for the first time in many months. The media is full of confident predictions that 2011 will be the third strong year in a row for U.S. stock markets.

Many of the factors that have been helping global markets remain intact. Fed policy remains extremely supportive of capital markets. Valuations are not unreasonable. Corporate cash levels are ridiculously high, which probably means a wave of M&A activity in the next few months. With interest rates so low, a reluctant public will be forced to move off the sidelines and invest in stocks, especially dividend-paying stocks.

So far, so good.

However, with bullish sentiment so widespread, when will all of the "good news" be priced into the market?

Moreover, while there is no denying that the economic data recently has been positive, it is not clear just how much of the recovery has been fueled by a combination of fiscal/monetary stimulus that at some point will be pulled.

Here's an excerpt from an article from The Economist which does a good job capturing this:

That leads to another potential flashpoint for 2011: the lack of global co-ordination. Gone is the consensus seen at the G20 meeting in April 2009. Europe will be pursuing austerity, China is trying to rein in bank lending but America has opted for another fiscal stimulus. This is a throwback to pre-crisis 2007, with American deficit-financed consumption set against Chinese surplus-creating exports.

It seems certain that the Federal Reserve will continue to accompany fiscal stimulus with the monetary equivalent in the form of near-zero interest rates and further quantitative easing. The need for such extraordinary measures is an indication of how weak the economy continues to be. But while the developed world is still fighting off deflation, the developing world is worrying about inflationary pressures, with gold near $1,400 an ounce and oil back above $90 a barrel.

Buttonwood: In a spin | The Economist

I think that you have to stay invested in stocks at this time: the old adage of "Don't Fight the Fed" should be every investor's mantra.

But I suspect in a few months, as cries for cutting fiscal spending are realized, and the Fed is forced to gradually move to the sidelines, stocks might be, shall we say, challenged.

Monday, January 3, 2011

Is Facebook worth $50 billion - or more?

You probably saw in this morning's papers that Goldman Sachs (along with a Russian partner) are using a "special purpose vehicle" which allows it to skirt SEC regulations and investing $500 million in Facebook. According to the piece in the New York Times, this now values Facebook at $50 billion:

Facebook, the popular social networking site, has raised $500 million from Goldman Sachs and a Russian investor in a deal that values the company at $50 billion, according to people involved in the transaction.

The deal makes Facebook now worth more than companies like eBay, Yahoo and Time Warner.

But buried later in the article is the following:

The Facebook investment deal is likely to stir up a debate about what the company would be worth in the public market. Though it does not disclose its financial performance, analysts estimate the company is profitable and could bring in as much as $2 billion in revenue annually.

So let's think about this: Facebook is barely profitable, and could perhaps generate $2 billion in revenue. Goldman's clients (again, please note that Goldman itself is not investing in Facebook - it only doing so on behalf of its well-heeled customers) are paying 25x revenue for a barely profitable company.

Then there's more. Facebook is still a private company, and apparently has no plans to go public any time soon (although news reports indicate that it is a possibility in 2012). Usually companies in the private market trade at a discount to publicly traded companies simply because they are less liquid.

If we assume a fairly typical 25% private market discount for Facebook, this would imply that Goldman analysis indicates that a publicly-traded Facebook would be worth around $75 billion.

Now, I know what the response to my incredulity will be: I just don't get it. My critics might say:

Facebook represents the future of internet. Not only are there more than 500 million Facebook members, but once Facebook adds such capabilities as email and search to its functions, it will become the most important space on the internet.

Well, maybe I am missing the point, but perhaps there is something else going on: Valuations of internet companies are once again reaching irrational exuberance stages.

Facebook is a company with tremendous potential, and CEO Mark Zuckerberg deserves a huge amount of credit. However, I think you have to assume a huge increase in revenues starting soon in order to justify today's valuations.

Moreover, while Facebook's community is unparalleled, it does have some pretty formidable competitors like Google that are trying to keep their own market share.

Sunday, January 2, 2011

The Surest Bet of 2010.... now the surest bet of 2011.

Namely, interest rates are going to rise.

Never mind that this has been the "smart money" thinking for the last 3 years, only to find interest rates remaining low. Never mind that there is very little evidence of inflation pressures in the most sectors of the economy.

No, the papers continue to be filled with confident predictions that out-of-control fiscal spending combined with easy monetary policy will almost certainly lead to higher interest rates.

I don't agree with the consensus - I think we continue to be in a disinflation, if not deflationary world - but what bothers me is that very few seem to worry about what happens if they're wrong.

I posted a note last week about the elderly couple who recently visited a local bank* in search of investment advice. One of the points made to the couple was that bond maturities in their account would be kept very short, since interest rates were sure to be rising very soon.

Well, this bank better be right, because their decision could prove to be very costly for their clients - not to mention the impact on their lifestyle.

Moreover, implicit in their advice is that they will be able to know when interest rates have reached the appropriate point at which it is "safe" to go back into the bond market.

Let me give an example. Let's just say the couple has $100,000 to invest in bonds. They aren't planning to trade their account actively - they are looking for fixed income to provide stability and some income for their daily living expenses.

Put another way, their "benchmark" is not any widely followed institutional benchmark (e.g. the Barclay Government/Corporate Index) but rather their investment portfolio allows them to live the way they would like.

If they follow the local bank's advice, their $100,000 invest will, for this year, produce essentially no income, since money market rates are around 0.2%. More precisely, if money market rates stay around current levels for all of 2011 (note that the Fed has given absolutely no indication that federal funds rates are due to rise any time soon), their bond portfolio will produce about $200.

Now, a couple of weeks ago, the Massachusetts Housing Authority issued AAA-rated bonds with maturities out to 2035. However, the bonds with a 12-year maturity had a 4% coupon.

Let's say our couple took their $100,000 and invested in 12-year bonds. This would produce $4,000 per year versus $200 in a money market fund.

Now, let's say our local bank is right, and interest rates go higher from here - but don't do so until 2013. Moreover, let's just say rates go from 4% to 6%.

By 2017, which was the better strategy?

Our unsophisticated investors who bought 4% bonds now would have earned $28,000 in 7 years. By comparison, our local bank's advice would have produced $24,600 (3 years of money market rates + 4 years of 6%). In other words, the "smart" bet would have actually been more harmful to the couple than if they had simply bought a bond for income, and not worried about price fluctuations.

My point of all of this is that I really believe we are entering a period when investors should be focused on two objectives: income plus capital appreciation. The latter cannot be really expected from bonds starting from today's levels - common stocks will have to fit the bill. No, bond should be viewed as income vehicles, with a little safety thrown in.

*no, this local bank was not my employer Boston Private Bank and Trust company