Investment Choices in a Low Return World

It has been said that democracy is the worst form of government except all the others that have been tried.
-Winston Churchill

When I look at the asset markets today, I am reminded of Churchill's quote.

Investors and savers face a fairly unappetizing menu of investment choices these days.

• Stay in cash and earn nothing for the next two years?
  

• Buy high quality bonds with yields at 60-year lows?

• Buy stocks whose returns over the last decade or so can best be charitably described as mediocre?

Yikes.

You already know where I stand on this: I think that dividend-paying, larger cap stocks offer the best combination of income and capital appreciation potential.

Still, there is no question that stocks will continue to show more volatility than most would prefer as the world struggles with the mountain of debt we accumulated over the past decade.

The Economist has written in this week's issue about the difficult choices facing investors these days.

For example, the article cites a Deutsche Bank study on bonds:

Deutsche Bank’s study suggests that, if yields revert to the mean, investors in 30-year Treasury bonds will suffer an annualised loss of 3.3% over the next five years and 1.3% over the next ten; investors in ten-year bonds will suffer annualised losses of 4.3% and 2% respectively.

http://www.economist.com/node/21532286

And what about commodities? Here's The Economist's view:

The problem with gold, and other commodities, is that with no yield or earnings they are hard to value. Demand from Asian countries has certainly pushed up prices; non-oil commodities have trebled over the past decade. But if the economy does start to slip into recession, commodity prices could fall very sharply; they almost halved between March and December 2008. This year they have dropped by around a fifth since February.

I could go on, but you get the idea: there are very few safe havens in today's world.

Still, as both The Economist and other analysts have suggested, buying higher yielding equities trading at reasonable valuations offer the best potential returns from a relatively meager list of alternatives.

The key, in my opinion, will be to focus on companies whose dividend is not only attractive today, but has the potential for growing along with inflation in the years to come.

Fortunately, there are numerous companies that fit the bill. Corporate America flush with cash, and margins are at record levels. Payout ratios for most companies is at historically low levels, which gives the chance for dividends to grow.

Stocks Do A Three Year Round Trip

Last week, on October 3, the S&P 500 closed at exactly the same level that it closed on October 3 three years ago: 1099.23.

As John Authers noted in his column in the Financial Times last weekend:

"Buy and hold" investors in US stocks had spent three of the most exciting years in financial history getting back to exactly where they started...

Stocks have endured a lost decade. And looking just at the past three years, all the gyrations since then have left us exactly where we were only three weeks after the fall of Lehman Brothers.

http://www.ft.com/intl/cms/s/0/5c82c53a-f0d0-11e0-aec8-00144feab49a.html#axzz1affz7M13

No wonder investors are discouraged.

The question is whether the period going forward will be any different than the fall of 2008, when stocks started the swan dive that did not end until March 2009.

I think it will be, although there is still the possibility of a negative political "surprise" from either Europe or Washington.

Unlike the fall of 2008, when the credit markets were virtually shut, corporate America is flush with cash, and credit is widely available for most credit-worthy borrowers. In addition, most corporations report that business trends remain favorable, although corporate CEO's have been very careful in their expansion plans.

Economic data also suggests an economy that is expanding, albeit at a tepid pace. Last Friday's non-farm payroll report, for example, indicated an economy that was adding jobs at a rate faster than most economists had predicted.

Still, stocks are searching for the catalyst that will restore a sustainable rally, and that seems to be lacking at this point.

Are ETF's To Blame for Stock Market Volatility?

I am a big fan of exchange-traded funds (ETFs).

Following in the footsteps of index funds, ETF's became popular about a decade ago.

As originally conceived, the ETF concept is simple: offer investors a low cost, tax-efficient way to gain access to a particular market segment without taking the risk of a single security.

There are more than $1 trillion of ETF's now outstanding, so I am not alone in my enthusiasm for the product. Indeed, ETF's and low-cost Vanguard index funds are really the only segments of the financial products markets that have shown significant growth this year.

However, as with any good idea, the ETF concept has been morphing into different product types that tend to be more complex and, of course, more profitable to the provider. There are more ETF's outstanding today than actual stocks, and the number of new ETF introductions keeps growing.

You can now put your hard-earned savings into an ETF that can offer leveraged bets on any or all parts of the markets, for example.

Andrew Ross Sorkin wrote a piece for the New York Times yesterday quoting investment guru Doug Kass as indicating that these leveraged ETF's are partially to blame for the wide swings in stocks prices that we often see at the end of the trading day:

{Kass} says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or E.T.F.’s....

To Mr. Kass, these E.T.F.’s are the “new weapons of mass destruction.” (His description is an homage to Warren Buffett’s widely quoted line that derivatives are “weapons of mass destruction.”)

“They’ve have turned the market into a casino on steroids,” Mr. Kass said. “They accentuate the moves in every direction — the upside and the downside.”

Mr. Kass... may be right: at the end of every day, leveraged E.T.F.’s have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the E.T.F. made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged E.T.F.’s use options, swaps and index futures to keep themselves in balance.

You might consider the E.T.F. the new derivative.

http://dealbook.nytimes.com/2011/10/10/volatility-thy-name-is-e-t-f/?scp=3&sq=andrew%20ross%20sorkin&st=cse

Columnist Herb Greenberg also wrote about ETF's and market volatility in a piece published on CNBC:

ETFs, or exchange-traded funds, which started as a sound idea but, with Wall Street being Wall Street, have all but turned into a monster... even the biggest operator of ETFs, BlackRock, is concerned about the direction some ETFs have taken—becoming too complex and confusing, with so-called double- and triple-leveraged ETFs leading the charge...

With most ETFs mindlessly mirroring various indexes of everything from the S&P 500 to the illiquid stocks of makers of lithium batteries, THEY have become the market. (Stats showing that the market has never been more correlated to itself—another way of saying everybody is trading in and out of the same things at the same time—have never been higher.)

http://www.cnbc.com/id/44857612

I don't have enough data on the impact of ETF's, or leveraged ETF's, on the market, but it would be interesting to see the numbers.

What I really worry about, though, is an ETF provider that lacks the sophisticated management tools of, say, Blackrock, State Street or Vanguard.

Packaging and managing an ETF is more difficult than it might appear at first glance, particularly in volatile markets.

Steve Jobs's"Amazing" Estate Plan

I have no way of checking this story - only Steve Jobs's family and estate attorneys know the facts for sure - but it seems reasonable to assume that the authors have done some pretty thorough research.

Steve Jobs, of course, died a very wealthy man. Most estimate put the wealth of one of Apple's founders in the neighborhood of $6 billion or so.

However, it appears that his estate tax bill will be essentially nothing.

According to this article which appeared on The Trust Advisor Blog, after Jobs had his first brush with death in 2003 he put the vast majority of his assets in trusts.

Most of Jobs wealth was in the form of three huge stock positions: Disney (he was a 7% owner); Pixar; and, of course, Apple. Since these assets were moved into trusts, so none of them would be part of his estate.

His house would have naturally gone to his wife Laurene (as the surviving spouse) but apparently he put this in trust also.

Jobs was famous for not taking a salary from Apple in recent years, which meant that he probably had little in the way of assets other than his stock holdings.

His estate plan would also explain why Jobs did little in the way of large philanthropic gifts like his fellow billionaires Warren Buffett and Bill Gates. Since most of his assets were in trusts, and he didn't have any salary from Apple, he might simply not have had the money.

Here's an excerpt from the blog:

Given his efforts to keep his personal life private, we won’t ever know exactly how his estate plan allocates his wealth — unless, of course, he wanted the world to know.

We do know that it involved a network of at least two trusts. California records show that he and his wife, Laurene, moved their Palo Alto house and other real estate into two trusts when his liver was failing in early 2009...

Completely under the radar, SEC filings reveal that Jobs was also busy moving the rest of his material wealth — 5.5 million shares of Apple stock and 138 million Disney shares, a memento of his other baby, the animation company Pixar — out of his estate and into a trust.

Since he basically earned nothing from either Apple or Disney since then, it’s possible that he died with no real assets in his name...

http://thetrustadvisor.com/news/stevejobs

Given the elegance of the products he designed, it is not surprising, I suppose, that his estate plan was so clean and effective.

Or, as he might have said, it's "amazing".

Finally! Regulators Take on the Computers

It appears that even regulators are getting tired of high frequency trading.

As I written earlier, many people - including myself - regard computer-driven trading (most of which is no more than front-running) would like to see high frequency stock trading curbed, if not eliminated.

So I was pleased to pick up the New York Times yesterday morning and see on the front page ("above the fold", no less) a story entitled "Clamping Down on Rapid Trades in Stock Market". Here's an excerpt:

Regulators in the United States and overseas are cracking down on computerized high-speed trading that crowds today’s stock exchanges, worried that as it spreads around the globe it is making market swings worse.

The cost of these high-frequency traders, critics say, is the confidence of ordinary investors in the markets, and ultimately their belief in the fairness of the financial system....

http://www.nytimes.com/2011/10/09/business/clamping-down-on-rapid-trades-in-stock-market.html?pagewanted=1&_r=1&sq=high%20frequency%20trading&st=Search&scp=3

I think we'll expect the usual push-back from Wall Street, but I think that anything that help restore confidence in equity investors will go a long way to helping the individual investor.

Saving the Euro

The fate of the euro will be decided over the next few weeks.

The key player in the drama - Germany - is conflicted over its desire to save the euro and its anger and irritation at having to bail out its more profligate neighbors.

Meanwhile, austerity measure proposed in Greece, Italy and other countries are drawing nationwide protests.

There have been any number of proposals on how the euro can be saved. I don't know which will be adopted - if any - but they all have one thing in common: they're going to require huge sums of money.

However, an article yesterday in the New York Times suggests that vast sums of money alone may not be enough.

Written by Peter Boone and Simon Johnson, the piece discusses one current proposal which suggests that a mere 4 trillion (!) euro bailout package should do the trick.

This is a mind-boggling number: the authors note that the GDP of Germany is around 2.5 trillion euro, so the bailout would involve either direct funds or guarantees totaling 50% more than the yearly economic of the largest economy in Europe.

Yet they also suggest that a massive bailout package may not save the day. Moreover, if additional funds were to be needed after the initial financial infusion, there is the real question as to when donor fatigue would set in, i.e. when would the German citizenry say, enough is enough:

Lech Walesa famously remarked that it was easier to make fish soup from fish than to do the reverse. So it is with fiscal crises — once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used....

Putting in place a huge financial package is not enough. Policies have to adjust across the troubled euro-zone countries so that nations stop accumulating debt, and the periphery moves rapidly from being among the least competitive nations in the euro area to the most competitive — and this includes lower real wages, even if debts are restructured appropriately.

The European leadership is a long way from even recognizing this reality, let alone talking about it in public.

http://economix.blogs.nytimes.com/2011/10/06/the-4-trillion-euro-fantasy/?ref=business

In other words, even if a massive bailout package is announced tomorrow, it is not clear that the eurozone will be saved unless fundamental changes are enacted.

Interesting thoughts going into a long weekend.

Steve Jobs, and Tobin Taxes

I'm not going to write about Steve Jobs this morning - the papers and media are full of great memories - but I wanted to mention again how much I found his 2005 Stanford commencement talk inspirational.

The full text can be found at the link below, but here's an excerpt from his talk:

Your time is limited, so don't waste it living someone else's life. Don't be trapped by dogma — which is living with the results of other people's thinking. Don't let the noise of others' opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary.

http://news.stanford.edu/news/2005/june15/jobs-061505.html?wpisrc=nl_wonk

Back to the markets:

This past Tuesday afternoon, at about 3:30, I was in the midst of a conference call with an investment committee of an important client.

I have two screens on my desk, so while one screen had my PowerPoint presentation, the other had stock markets updates flashing.

When we started our call, the screen was mostly red: stocks were largely down for the day.

Then, about 15 minutes into our call, a funny thing happened: the stock market turned around, and suddenly my screen turned from mostly red to mostly green, as stocks suddenly moved sharply higher.

What the heck was going on?

The official explanation was that there was a story written by the Financial Times that suggested that European governments were close to some sort of rescue package for Greece.

(This report, by the way, turned out to be false.)

What really seems to be going on is a market increasingly divorced from fundamentals. Instead, the direction of the market is being set by high frequency, computer-driven trading and leveraged hedge funds. These investors care little about fundamentals or economics; instead, they are looking to hop on stocks if they are going higher, or short them if they are going lower, with a time horizon of five minutes or less.

Here's what Reuters wrote yesterday:

In less than one hour on Tuesday, the U.S. stock market surged by 4 percent -- for no apparent reason.

The last hour of trading was the most volatile final hour in two months -- and it occurred at a speed that frightens many, from experienced hedge-fund managers to mom-and-pop investors.

The late-day "melt-up" that pushed the S&P 500 index .SPX out of bear-market territory might be construed as good news. But it brings back echoes of the "flash crash" that saw markets dive by several hundred points in a matter of minutes, and it's a big reason many are staying away from the market.

"Everyone is scared in both ways -- the shorts are scared, the longs are scared, everyone is scared. The high-net-worth investor is very, very scared," said Stephen Solaka, managing partner at Belmont Capital Group in Los Angeles, which manages money for independent wealth advisers and family offices.

Tuesday's move was the latest example of an erratic, high-octane stock market increasingly driven by levered exchange traded funds and complicated hedging and options strategies that unwind with dizzying speed.

It's a far cry from when the U.S. stock market was viewed as a place for capital-raising by businesses seeking to expand and a place for investors looking to put their savings to work.

http://www.reuters.com/article/2011/10/05/us-usa-markets-volatility-idUSTRE7945WA20111005

There has been a lot of talk recently about instituting a small transaction tax on every stock or bond trade. Originally called the "Tobin tax" after the economist who first mentioned the concept back in the early 1970's, the idea would be to try to encourage longer-term thinking in the investment community by taxing trading.

Wall Street, of course, hates the idea, and mentions all sorts of reasons why such a tax will either not work or will penalize pension funds.

But the real reason the Street hates such a tax is that it would make high frequency trading considerably less profitable, and reduce trading volumes in general.

If a transaction tax were to be enacted in all of the world's major markets - so that traders couldn't avoid the tax by simply moving their activities to another market - I think it might go a long way to making stocks more palatable to individual investors. Yes, the markets would continue to move up and down, as they always have, but at least the direction would be determined by reality, and not cyberspace.

I think a Tobin tax is worth a serious look.