Sunday Morning Coffee

And we’re back! Barron’s had a couple of interesting items this weekend.

First was an article that included a recap of how some the Harvard, Yale and Stanford endowments have done and the results for the year were pretty middling when compared to a simple 60/40 mix of plain vanilla stocks and bonds.

The reason to mention this is not to make an argument for so called endowment style investing (they heavy weighting they all seem to have in private equity makes it impractical for most market participants) but to point out the shortsighted nature of the critique. First, there is no investment strategy or method that can beat the market over every rolling 12 month period.

Another factor here is the time horizon of the fund and the way in which it may be similar to that of an individual investor. A college endowment essentially has an infinite time horizon and although there are several reasons why they report results the way they do, a given one year result very rarely matters. Down 20% in an up 25% world would probably be an exception as would down 80% in a down 50% world but I would submit that up 2% in an up 10% world would not adversely affect the school’s ability to function even if it did cost someone their job.

Individuals clearly do not have infinite time horizons but someone who is 50 or 60 really does need to think about the long term. For these folks the portfolio needs to grow for quite a while longer and then produce a sustainable income for quite a while after that. And so again in most 12 month rolling periods the result may not be that important. Down 20% in an up 25% world would be very bad because aside from the drop, up 25% years don’t come along very often. Dropping 80% regardless of the circumstance would of course be a deathblow but up 2% in an up 10% world would not send anyone back to the drawing board.

In that context this circles back to having the right expectation for results over the time frame relevant to you. As a matter of philosophy this leads us to look at the entire stock market cycle and hoping to mostly go along for the ride on the way up while trying to avoid the full brunt of any large declines.

The other item from Barron’s was an article about Fraport (FPRUF) which is the Frankfurt, Germany airport stock. I started writing about these types of infrastructure investments many years (including toll roads). These should be good long term high yielding cash flow stories (and I think they are) but the shares prices can trade like deep cyclicals which is to say they can go down a lot during bear markets. 

Before the Red Sox game on Tuesday there was a ceremony commemorating the 2004 team and they drove around on the Duck Boats and Joellyn got that first picture as they went by. The second picture is a wall of antique sewing machines from a store in SoHo. The final picture is from the NY Fire Museum. 

Read more!

The Big Picture for the week of September 30, 2012

We are headed back to Arizona early on Saturday. A few pictures from our Friday in New York. The first picture is from the Knight Capital trading room which is actually in Jersey City, NJ.

The second picture is a parking lot on Spring Street next to the New York Fire Museum. Interestingly both the Boston and NY fire museums can't hold a candle to the one in Phoenx--go figure.

Friday was Random Roger day at the MLB Fan Cave! We stumbled across it by accident and although it was closed while we were there, the guy working inside held the door open for me and let me take a picture.

We stumbled across this view by accident as we were walking around.
Read more!

Someone Needs to Pay!

In the last few days it seems like there has been a little more coverage in various media circles about why no one has gone to jail as a result of the bank crisis. A lot of people probably want a pound of flesh for what was a horrible time in financial history, maybe it is more correct to phrase that in the present tense.

The push back is that there have been no convictions because there is no evidence of actual illegal activity. Obviously unethical is not the same thing as illegal. The solution is complicated and I certainly don't have all the answers but it seems to me that a basic building block of running an investment bank is knowing the law and spending a lot of money to figure out every legal thing that can possibly be done without breaking the law. If you can accept that banks want to do everything they can without getting in legal trouble then it increases the likelihood that nothing illegal was done--or very little that was illegal was done. Again, unethical and unscrupulous are not the same as illegal.

If the law that existed was broken then great nail them to the wall but it does worry me that a lot of time, man hours, money and any other resources you can think of could be spent and yield no results. Conceivably any resources expended trying to find evidence of illegal activity could be spent on how to fix things going forward. One thing that is true is that no matter how many people could go to jail, it would not restore the value of anyone's home or make anyone more financially literate. People feel bitter (rightfully so) toward the financial system, feel that the market is rigged against them and are probably still nowhere near literate enough to address their financial needs.

I guess part of my assumption here is that there are not enough resources to both search for wrongdoing and trying to help everyday people fix things from here. If this does frame it correctly then my vote would be to help people from here but if there are enough resources to to do both then great do both although I think it will be very difficult to find evidence that the then existing laws were broken.
Read more!

Off to NYC

We hit up the Boston Fire Museum, went to the Red Sox game and saw my sister in between. We also went by the Boston Federal Reserve building which is a peculiar cold war era building. Amusingly the guy at the Boston Fire Museum asked us about the Hall of Flame in Phoenix that I posted pictures of a few weeks ago.

We had once in a lifetime seats in the first row behind the visiting dugout. We are headed to New York, to see my father, do some touristy things and visit the Knight Capital trading floor. Hopefully regular blogging will resume tomorrow.

Read more!

Nordic Safe Havens

The WSJ had this article yesterday about banks in Norway and Sweden becoming destinations for what amounts to scared Eurozone money looking for a safe place to park, or maybe hide is a better word.

We have owned a Norwegian stock, Norwegian sovereign debt and a Swedish stock for many years. We bought in for what I perceived, many years ago, as superior fundamental soundness from the top down. More often than not these holdings have done well, occasionally shooting the lights out but occasionally lagging too. As long term holds they have added value but for the last few years they have not done as well. A little over two years ago we added a Danish stock as well that started out very well and then has merely drifted higher.

Over the last three months these three stocks have outperformed the SPX meaningfully which hopefully will go on for quite a while. It might be because of the safehaven flight that the WSJ is talking about but I think the article is more of a short term catalyst compared to the stronger top down fundamentals that I believe continue to be part of the thesis.

When I write about investing for the long term this is what I have in mind. People who realize they are investing for the long term toward the goal of having enough money when they need it can take this kind of perspective as opposed to someone who must beat the market this quarter in order to stay in business. In thinking long term, obviously I believe I have been correct with the Nordics and of course believe that for the long term they will continue to do very well (or I'd sell them) but again this is a long term belief. When these stocks were lagging some they continued to pay great dividends and as mentioned above now they might be in for a period of outperformance, hopefully a long run of ourperformance.

I think that being able to take a long term view makes managing a portfolio much easier. In monitoring the names we own in the Nordic space over the years there have of course been ups and downs in the prices but no thesis-altering news. To the extent it can resonate that the share price of good companies can go down without changing the story, it becomes easier to hold on to the stock for the long term (repeated for emphasis).
Read more!

Trade Executed

We had a very easy ride to Boston (thankfully).We will be here for a couple of days and then New York City for a couple of days.  I have a couple of work related things to do along the way, we are going to a couple of Red Sox games, seeing family, doing a couple of fire department related things and seeing a couple of friends.

Yesterday we executed a trade for most large accounts and RRGR in buying Genuine Parts (GPC). Depending on the client we are targeting a 2-3% weighting. The idea was pretty simple, we increased equity exposure, added some yield and this is a name I would expect we would be able to hold onto in the face of a downturn if the end of the cycle comes in 2013 or 2014 as I think will be the case.

The company’s biggest division sells auto parts, you probably know the name NAPA Auto Parts, there a couple of other divisions including industrial components and oddly an office supply division that, although only a sliver of the business, I wouldn’t mind seeing them sell. There is very little debt and the company has been raising its dividend since the pilgrims landed (slight exaggeration).

If my long running theme of generally reduced price appreciation in domestic indexes holds up then increasing the yield of the portfolio becomes important. As a note I don’t believe in owning dividend payers exclusively as that would exclude certain market segments and make for weaker diversification IMO.

One other thing to circle back to is the comment on index price appreciation or lack thereof. Net net there has been very little progress in the indexes for many years. The SPX is currently at a level first hit in December 1999. In the last few years there have been some great trading opportunities but progress for investors has been tough to come by although with some luck in country selection (and avoidance) and domestic sector avoidance portfolios can have performed decently in the last ten years.

The pictures will get better, Joellyn got some great ones with the "good" camera from the room while I was out getting our morning mochas.

Read more!

Something No One Needs

The WSJ ran an article over the weekend noting that it will soon be easier for individual investors to access things like private placements and other forms of earlier stage investments thanks to the JOBS Act of 2012.

Everyone views these things differently of course but there is nothing simple about early stage investing and reducing the barriers to entry for this space strikes me as a terrible idea to be avoided.   If various barriers are being reduced or eliminated it opens the door to companies with relatively weak investment merits becoming available to a population of investors who may not be able to adequately evaluate such companies.

Studying private companies with less stringent reporting requirements is obviously a much different level of analysis than studying AT&T (T) or Proctor & Gamble (PG). This will probably be pitched as democratizing and good for America and that might be true but the net effect for individuals that invest will probably be that they get separated from the money they put up.

The building block here is that with an adequate savings a portfolio of a few diverse broad based funds gives a good shot of having enough when you need it, provided panicked reactions are minimized. Note that the context here is not about beating the market it is about having enough money when you need it.

Short post, we are flying out to Boston later today.



Read more!

Sunday Morning Coffee

David Kelly, one of the JP Morgan perma-bulls, said the following in a Barron's article about the fiscal cliff this week;

The stock market may have priced in the worst-case scenario, so a post-election kumbaya moment could result in some upside...

By kumbaya he means some sort of agreement that staves off the fiscal cliff. Regardless of your politics or your expectations for the market over any time period you care about, this is a ridiculous comment. Year to date the S&P 500 is up 16% which is pretty close to up a lot and except for a two month drop in April and May it has been straight up. Maybe he will be correct about the market continuing higher but "worst case" is laughable.

Just a quick rant today.



Read more!

The Big Picture for the Week of September 23, 2012

The original intention of this site (after the first two or three posts when I ran out of non-market related things to talk about) was to create a record of opinion that would hopefully be useful as our firm tried to grow. As the site (fortunately) exceeded the scale and reach I envisioned the intention shifted a little; still a useful record of opinion but also content for anyone who was interested in managing their own portfolio to occasionally get little snippets that might be useful.

In most instances I believe that the ability to manage ones own portfolio boils down to time available to spend on the task relative to the type of holdings used. A portfolio of 45 stocks will take much more time than a portfolio of four or five broad based funds. I also think a huge part of the equation in terms of making things a easier is understanding some of the behavioral quirks that can impede progress or in some instances blow people up.

In this week's posts we've delved into the behavioral aspects thanks to some of the comments in the Seeking Alpha syndicated versions of these posts. Some of the comments have shown very little regard for risk which I find to be very shocking given how recently the stock market cut in half.

Just as yesterday's post was inspired by reader comments, today's post in inspired by this comment;

The only black swan negatives on mid-stream MLPs (outside of exploding interest rates which will kill everything else as well) would be tax policy changes and a secular decline in nat gas use.

That the reader is using the term black swan incorrectly is not a big deal of course but I do think the comment reveals something interesting about perceived risks. In the last 12+ years the market has cut in half two times and I believe (not an original thought) that in both cases the market was done in by things that very few people saw...by things very few people could see coming.

The above comment is right about one threat to MLPs that may or may not ever come to pass to adversely effect the space but the comment seems to not allow for the possibility of a threat that cannot be reasonably foreseen. If I am reading this correctly then the next question is what percentage of market participants have not acquired the awareness to be be concerned about what they don't know.

As a matter of philosophy I believe the ultimate result that people achieve, that is having enough when they need it, comes down to savings rate and how they fared during downturns and what sort of self-destructive they did or did not succumb to over the years. There are countless other professionals who think this as well and plenty of research out there to back it up but ultimately it is  just a school of thought for you to buy into or dismiss.
Read more!

Risk Can Kiss My Grits

If you remember the TV show Alice from the late 70s you probably remember the character Flo whose tag line was kiss my grits. I couldn't find a picture of Flo that was funny enough so I went with the sign that was supposed to be for the restaurant.

Earlier this week I had a post about recent MLP IPOs and whether they might be a sign of a maturing mania. Seeking Alpha re-ran that post and it drew a lot of comments with a surprising tone to several of them. To read through the comments there would appear to be very little regard for risk.


In my post I talked about being able to get plenty of yield (for anyone wanting to concentrate their portfolio in that way) without putting 20-25% in MLPs, I mentioned allocating to various yield products to build a yield. Several of the comments however revealed investors with far more than the 20-25% in MLPs that I think is way too much. Here was the most interesting snippet from all the comments;

I'm over 50% in MLPs and have been for quite awhile. And within the MLP universe you can be fairly diverse.   

 
I was really surprised to read that, really surprised, and I would add there were other comments that were kind of in the same ball park. The comment excerpted above acknowledged the need to keep close tabs but we have all seen the sentiment from the excerpted quote before. To me it was the same as being diversified by owning a search engine, a web hosting company, an etailer and a B2B company.

There was also this comment;

My fairly large portfolio is 35% in REITs, 23% in BDCs, 21% in MLPs and pays me 10% annual dividends. I don't really give a "feather or a fig" about the risk involved!

Holy cow.  

In the last 42 months the market is up more than 100% and while there have been a couple of small declines along the way, the move since the March 2009 low has been huge and based on the comments it has inspired a willingness on some portion of the investing public to eschew risk (I realize how unscientific a comment thread left on one blog post is).

I do believe the comments on blog posts can capture a sentiment that exists. Four years ago after a large decline there were many emotional and irrational comments left on my posts and I view the above as just as emotional and irrational after the market has doubled.

In December 2008 I wrote a 2009 outlook piece called Expecting a Massive Rally which drew 100 comments. Most of them were along the lines of "Dream on! There will obviously be tradable bounces in any market, but this one has no chance of a solid long term rally" and "Well the $CPC and ISEE are both at levels of market tops, so sorry Rog, the market is about to CRACK" and finally "These guys have been calling bottoms all throughout 2009. They have been wrong all along. But we're supposed to buy it this time?"

The intention here is not to call a top as Bernanke has actually commented about the stock market making people feel better but the excitement in the first two excerpted quotes is a behavior that we've seen before and often it has hurt people. It is the same type of psychology that causes people to buy high, sell low and end up grossly overweight the wrong thing at the wrong time. There may never be a consequence for being more than 50% in MLPs, right here right now that is unknowable, but there are certain behaviors that if recognized and avoided allow for a much better chance for long term portfolio success. 
Read more!

Should Anyone Buy MLPs Yielding 19%?

Yesterday the WSJ had an article about recent MLP IPOs that offer higher yields from non-traditional partnership assets. I had a similar post a couple of weeks ago but the Journal piece includes mention of a partnership that pays off of sand used for fracking and another one based on gas station revenues.

These alternative MLPs are being portrayed as being riskier than some of the more mundane MLPs and while I don't know for a certainty that they are riskier, the significantly higher yields are a good indication that they are. Working on the assumption these new alternative MLPs are riskier it is a repeat of past market behaviors. The IPOs are being created to meet investor demand for higher yield. The arc of this is that as the theme/mania/whatever you want to call it matures, the quality of the IPOs get progressively worse. I do not know what inning we are in with this, it could be very early days but the pattern is one that recurs.

Hopefully it is clear that MLPs yielding 4-6% will generically have less risk than those yielding 8-9%. Northern Tier (NTI), the gas station MLP, was priced at its IPO to yield 19% and now that it is up a lot the yield at the current price is expected to be 12%. It looks like it has not actually paid out yet and I have no idea what the actual payment will be. The article cites a couple of these that have done well so far and one that has done poorly.

MLPs have been doing very well for a while now along with many yield oriented equities which creates a sense of comfort which creates a willingness to take a little more risk until something bad happens. Again this is a pattern that repeats often but does not have to happen every time. It is worth understanding the behavior and the pattern, though.

If you read enough you will find suggested allocations to MLPs as high as 20-25% of a portfolio. I think that kind of weighting is very aggressive. Every so often odd things happen in narrow segments. In October 2006 you may recall that the Canadian government announced changes in the way the Canadian royalty trusts would be taxed which caused a meltdown in the group. The hindsight brigade might say that they would just hold on in the face of an outlying event but based on the price action people were clearly selling in a panicked fashion into the news.

Anyone wanting to build a portfolio that yields 4-6% can probably do so without having to put 20-25% in one segment/product. I want to be clear that a portfolio that yields 6% is not going to be well diversified in my opinion. If your reading 4-6% and thinking "more like 8-10%" then I hope you realize the risk you are taking and if you don't think you're taking a lot of risk then I hope you don't learn the hard way.

MLPs have a place in a diversified portfolio and also yield-centric portfolios. Allocations smaller than 20-25%, like maybe 5-10% each could go to MLPs and REITs, there are obviously sectors known for yield that could be modestly overweighted without putting 25% into one of these sectors, there are a coupe of high yielding low volatility country funds out there along with some high yielders in sectors that may not be thought of for their yield. Most people are probably aware that dividends in the tech sector have been going up a lot in the last few years. There are also plenty of foreign stocks with hefty yields.

So anyone wanting a lot of yield can find it without putting 25% into one niche. One risk factor that does not come up enough in related articles is the extent to which going all out for yield exposes the portfolio to interest rate risk. Rates are very low and the Fed is committed to do all they can to keep them low but if rates go up then a portfolio with a very high yield is vulnerable to a big drop. Some might say that as long as the dividends keep flowing and growing they will be fine and maybe that is so but this line of thinking reminds me of the quote related to boxing about everyone having  plan until they get hit in the mouth.
Read more!

The Definitive Retirement Number

With a hat tip to Chuck Jaffe Fidelity has run the numbers and figured that having eight times your final salary in the bank or brokerage account or 401k is the magic number. And to help benchmark along the way, at age 35 people should have one year's salary set aside, at age 45 it should be three times and at age 55 people should be up to five years salary set aside.

The objective here is to replace 85% of the final income which as Jaffe notes is up from the "rule of thumb" of replacing 75% of the final income. There were some details missing and no link to the  research by Fidelity. There was no mention of a withdrawal rate or whether the 85% includes Social Security benefits. If not then the withdrawal rate would have to be astronomically high.

To use round numbers, let's say the final salary is $100,000 so the target savings balance would be $800,000 with an income objective of $85,000. If they are not including social security then obviously the withdrawal rate would be more than 10%. If it includes social security then the total benefit for a couple might be about $3000-$3300 per month in today's dollars so the portfolio would need to come up with $3783-$4083 per month which works out to a withdrawal rate of 5.3%-5.7% which is a big bogey. If the money is in an IRA of some sort then there is the additional problem of taxes on the withdrawals.

There may be more to it though, again no link was provided.

Long time readers will know that I believe in taking no more than 4% out annually. If that means ratcheting down the lifestyle then so be it. People want what they want but if that does not fit with reality then something has to give.

Another cornerstone here has been that focus should be paid to the spending part of the equation. People who live below their means don't need to focus on a percentage of their income they need to focus on their spending needs and whether those needs might go up or down after they retire and then they either have enough or they don't. It is not unreasonable that moderately well to do couple could have a $60,000 lifestyle, $1 million saved, $10,000 in income from sort of monetized hobby, $36,000 in combined social security benefit and so only need $14,000 from the portfolio.

If the above couple had saved $600,000 instead of $1 million they would not be placing a heavy burden on the portfolio at $14,000 and might be able to grow the portfolio meaningfully before possibly needing to increase the withdrawal. This would of course rely in some measure on what the market does; it is not realistic to think a portfolio will go up by 40% in five years if the market is flat. It could happen, it just wouldn't be an assumption that people should make.

I would also not give up on the notion of being able to reduce spending in retirement. No financial plan can account for every possible life circumstance but with a little planning it is feasible to have the mortgage paid off upon retirement (or maybe sooner). I found a stray reference that the average mortgage payment is 20% of income. Who knows if that is accurate but if it is, that along with not saving 10% of income anymore would allow for a 30% reduction in expenses before even needing to consider any lifestyle changes.

While we can appreciate the positive aspect of what Fidelity is trying to do with this sort of research  (the negative is that it is just an AUM grab) it seems that most people don't start to think about retirement until their 40s or 50s and we know that very few people that age have three, four or five times their annual income socked away. Great for those who do but for those who don't; something will have to give. They will have to live a more modest lifestyle than they envision and do something that creates an income for a little longer than they envision.

Related bit of humor; I was talking to one of the other firefighters yesterday, who is of retirement age but chooses to work, about department business. As the conversation wound down he asked what I had done today (meaning Sunday) and I said "hiked, watched football and got some work done, how about you?" Without missing a beat he said "I practiced retirement; I took a nap."
Read more!

The Big Picture for the Week of September 16, 2012

As a follow up to yesterday's post a reader made the following comment;

Without their [he means the Fed] actions, we would be in a huge depression at the moment. IMHO,

I think there is a different outcome that could have been possible. Things happened the way they happened so it is all that we know but all along I supported taking a tougher route but one that I believe would have been much faster.

There were several instances in the early aftermath of the crisis the Fed/Treasury bailed out equity and debt holders of financial institutions. There was an instance where Goldman Sachs got 100 cents on the dollar for AIG paper that it held (I believe it was on AIG paper, please leave a comment if I have that wrong) as just one example.

I would be all for bailing out depositors through FDIC or SIPC as the case may be but not market participants aka equity holders and debt holders. I would also be for bailing out people whose brokerage accounts get caught up in a firm that shuts down which is different than bailing out someone who owned Wamu, Wachovia, Fannie and Freddie.

Iceland took the most difficult path (let the banks fail) and started showing signs of natural demand coming back a couple of years ago. Depending on how you count we are four or five years in and the Fed has essentially said there is no end in sight in the effort to try to avoid whatever it is any of us think they are trying to avoid. The example of Iceland merely shows that biting the bullet can result in a faster turnaround not that it will result in a faster turnaround.

Whether for political reasons or other reasons our Fed and our Government have tried to repeal the economic cycle which has only delayed a resolution until who knows when. To make a rather blunt comparison, I have disclosed in the past that when I was in highschool I had a very rare form of cancer--thank god it was easily treated. The best treatment back then was 48 very rough weeks that went by quickly an a couple of years later I was going to college in San Diego and playing a lot of beach volleyball and being sick was a speck in the rearview. The tough treatment was clearly the best treatment.

Collectively we are not willing to do the tough thing. People seem unwilling to endure hard times (for not being able to look forward to the other side of the hard times?) and politicians seem unwilling to tell voters about doing the difficult thing because obviously they care more about getting reelected than anything else.

Occasionally in life we need to do difficult things and that is just how it is. My own life experiences tell me that short cuts or things that try to avoid doing the difficult thing only makes it worse.

As for the picture; a heavy post so a light picture.
Read more!

Fed Comes Out With Latest Software Version; 3.0

Or maybe it was version 2.7.5.12--humor attempt.

The Fed launched what many are calling Quantitative Easing 3. Included in the announcement was that the pedal will be to the metal into 2015. A reader asked the following after the news;

Fed announces QE 3, buying mortgages to further push historically low rates even lower. Must be nice to own a money printing press! Where do you think this will end, Roger, and how do you think it will affect/add risk to the market. I fear that when our house-of-cards comes crashing down, 2008 will look like a picnic.

There are a few different things in there to address. The starting point for me in trying to think about these things is that we now live in a distorted world. Unprecedented action on the part of the Fed is influencing many things in my opinion. Whether you are bullish or bearish, you are so in a world that is distorted in a way that it never has been before. Two or three years from now it will still be distorted in a way that it never has been before, so we are told.

My thesis for the US before the crisis started was that growth in the economy and the stock market would generally muddle and be relatively unattractive compared to select foreign countries. Net net that is what we have gotten but stocks have been more volatile than I would have thought; down 50% and then up 100%.

The current state of the economy is not horrible it is merely well below what we expect from recoveries. Jobs have not come back the way they should have by now, likewise GDP and as far as housing there are some signs of life but for now I just think of it more humbling as no longer imploding. Regardless of whether you agree with my description in this paragraph or not the numbers and the way you look at them comes in a Fed-distorted world.

As far as when this will end, the Fed keeps extending the date so obviously they don't know when it will end. I read or heard somewhere that the various versions of QE that come have diminishing returns; number 3 will be less effective than number 2 which was less effective than number 1. This theory makes intuitive sense to me and could be important if true.

If you can accept that GDP and jobs are well behind where they should be at this point in the cycle then consider that the numbers such as they are have come from desperate Fed action but only produce weak results and further action from the Fed will yield ever weaker results and we are left to wonder where, when or if meaningful natural demand will come back.

Until it does we will continue to live in a distorted world. In terms of how it will end, I do not believe it will end in such a way that makes 2008 look like a picnic. What I think is more likely is a winding down of the easing. I think there will still be economic cycles and stock market cycles with the expansion/bull phases not going up as much as they used to and the recession/bear phases going down a little more than they used to.

This is not a catastrophic outcome it is a wildly anemic outcome. As far the stock market I doubt there will too many four year periods where stocks cut in half and then go up by 100%. I think it was John Hussman who observed that the typical bear market retraces about half of the bull market run. We might still be in the snap back from 2008, but I think we will see average annual stock market growth of 4-5% and maybe the bear markets take back a little more than half of that.

Several years ago I wrote that I thought our fundamentals called for higher interest rates (this was before QE) and while I believe that fundamental argument is still intact it is obviously no match in the markets for the Federal Reserve. One way this goes haywire would be if rates started going meaningfully higher further out on the curve. This has not happened and I am not sure what the specific catalyst would be but meaningfully higher rates would gum up the works.

One reason why I do not think the market will stop rotating on its axis is the chance for surprises has greatly diminished, as it relates to the financial crisis. The Fed is effectively printing money, anyone not know this? In the last few years anyone who did not know the possible consequence of printing money now does know or at least has an awareness of the consequences. If natural demand never comes about then it is possible that consequences like price inflation could remain relatively muted (relatively muted in the context of a 15% CPI).

Another point about equities is that I do not think they are insanely priced. The low from March 2009 was in part an overreaction as people thought the financial world might be ending. The nature of panics like that is that there is some element of fast retracement that takes back a meaningful chunk of the decline which is exactly where we are now; most of the decline has been made back but there is still a ways to go. I am not one to make a bullish argument based on PE ratios and similar metrics but while I don't necessarily think the market is cheap on a PE basis I do not think it is grossly overvalued. Markets can pull back by any amount at any time but I do not think the valuations call for a massive decline.

The above is what I think has the highest probability; muddling not imploding. Of course discipline to our strategy will will be the first priority.
Read more!

WSJ Warns Stocks Are Riskier Than We Think

Yesterday the WSJ ran this article which was a follow up to this article. Article number one (the followup) took reader questions and posed them to Zvi Bodie for answers. Article number two (the original) was about the extent to which stocks don't become less risky with longer time horizons. Stocks are riskier than we think is what Bodie would have us take away.

Zvi Bodie is a professor at Boston University and has done a lot of work on this. His bottom line, as I read him, is not that far away from Nassim Taleb's idea of putting 90% in t-bills from around the world and using the last 10% for risk taking. Instead of t-bills from around the world Bodie likes TIPS and related inflation products.

The logic is easy to understand and something we've talked about here before. Getting great returns for 20-30 years doesn't mean much if you get cut in half right before retirement (paraphrase from the WSJ article). The idea of stocks being less risky with a longer time horizon stems from having more time to recover from a large loss and so the idea of stocks having more risk with a long time horizon is tied to the idea of a large decline coming when you can least afford it.

The big drawback that I think I see with Bodie's idea is the consequence of forgoing the opportunity for growth with so much of the portfolio. If 60-70% in equities is "normal" for many people then for anyone following Bodie's strategy there would be 50-60% of the portfolio that would be giving up the opportunity for growth. Maybe I am missing something but that will have to be made up with a much higher savings rate and based on various studies published we are collectively terrible savers.

As I have said before there is something intellectually appealing about these sorts of alternative asset allocations but they may not be practical for people who cannot save 30% of their income which is going to be most folks.

The stock market has an up year a little more than 70% of the time and the original article acknowledges that in the same sentence as saying but if you then lose half of it at the wrong time which is why I continue to believe that for most people having a normal portfolio while adhering to some sort of trigger point for taking defensive action makes the most sense.

On the way to down a lot for the market it is going to go through all sorts of potential trigger points. Having to alter retirement plans because your portfolio dropped by 50% a year or two before you plan retire certainly would be a deathblow but a 10% decline should only be an inconvenience.

On the surface, down 10% in a down 50% world might seem wildly optimistic but maybe not under the following scenario. I have been pretty clear over the years that zero in equities is a very large bet that I am not willing to make for clients but maybe it makes sense for someone who is very close to retirement to sell all of their equities upon a breach of their favored trigger point?

I've never thought about this before so bear with me as I work through this. For someone who is about to start taking an income from their portfolio a 2008-like decline is very likely going to be plan altering. However the risk of selling out is that it was a head fake and the market rockets higher. So the choice becomes opportunity cost or real loss.

Each person comes that equation in their own way but of course someone could split the difference by getting very aggressive upon a breach of their trigger point (the context is a year or two from needing the money) like maybe selling down 50% of their equity exposure. The risks are the same but the consequences are potentially smaller.

Anyone who would do this would need to come back to equities at some point because they will still be in their 60s (probably), could easily live much longer and so need growth again, hopefully after the dust settles.

I will give this more thought, I'm not sure what I think of this idea.
Read more!

Position Sizing of Diverisfiers

A Mr. Richard Feder from Fort Lee, New Jersey writes in and asks;

Hey roger I have often wondered when there is 3% allocation to gold how does that make it a realistic diversifier (assuming gold has a low correlation to the other 2 classes). You would need 400% move in Gold to give sufficent weight to balance the moves in other classes. I often see mutual funds with this token allocation- Does it work?

In years past I wrote frequently about the role of diversifiers in the portfolios I manage. The above question was left on yesterday's post which included a quick mention of gold and the reader apparently is familiar enough with this blog to know I prefer a low to mid single digit weighting.

So the first point would focus on a word in the previous paragraph; diversifiers. When the market is doing very well, like it has for the last 42 months, the importance of diversifiers will diminish. They become more important when the market is warning of trouble--I would look at the 200 DMA, the yield curve and the 2% rule for this type of read.

My approach is from the top down, trying to protect the entire portfolio. In the last bear market we used several diversifiers including the SPDR Gold Trust (GLD), absolute return funds and the ProShares Double Short SPX (SDS) along with selling some positions. Each position was targeted in the 2-3% range and grew in relation to the portfolio as things shook out. The combo of diversifiers allowed us, in my opinion, to achieve our goal of avoiding the full brunt of what turned out to be a large decline while at the same time not leaving us overly exposed to some sort of unforeseeable calamity in any single product.

Whether it was enough just in gold, as the reader asks, is a subjective thing but again not what we were focused on. What we were focused on was trying to minimize the drop in the bottom line dollar figure of the portfolio.

Another point to make is that I still believe equities offer the best long term growth potential, even if that will mean more in the way of foreign exposure. To repeat from past posts, the objective is an equity portfolio that is hedged with diversifiers as I perceive are needed. I do not want a portfolio of diversifiers hedged with a little bit of equity exposure.

In trying to prepare clients mentally for the then coming downturn a few years ago I frequently said that finding out after a large decline that you had too much in equities is a bad situation to be in. At the same time there was increasing sentiment in the comments here and elsewhere about putting it all into funds like the ones John Hussman manages. So this sentiment about extremely low volatility funds came after the large decline. Now the pendulum has swung back such that pundits are advocating buying dividend stocks instead of CDs. Cash that needs to be held in cash probably should not go into stocks, lousy yields notwithstanding.

Hopefully the theme of consistency comes through in these blog posts. Most of the time equities do well and so it makes sense to maintain something reasonably close to your target allocation most of the time. If you target 60% to equities then staying close probably means 50-70% not 20-30%. This, along with reasonable diversification should keep you relatively close to the market's upside.

If you have in interest in trying to avoid the full brunt of large declines then I would suggest using objective trigger points that you can stick to. At such a time that the market is warning of a large decline would be the time to consider increased exposure to diversifiers.

By the way the reader's name is not Richard Feder and I doubt he is from Fort Lee, this is a Saturday Night Live reference from the Gilda Radner years.

The picture was my favorite truck from the Hall Of Flame Museum that we visited last week.
Read more!

Is Everything We Know About Stock/Bond Allocations Wrong?

There was an interesting article at Seeking Alpha over the weekend in which author Daniel Moser dissected the 60/40 stock bonds allocation. His starting point was that the "normal' 60/40 portfolio grossly tilts risk toward the equity portion such that a 60/40 exposure results in a 95/5 allocation of risk taken. I read the article twice and did not see where he defined how he measured risk so to keep my post simple I will just work with his assumptions.

He then tweaked a very basic starting point of SPY/AGG into a combo of SPY and some different bond funds such that the stock bonds mix was 40/60 yielding a more balanced mix of risk between stocks and bonds. What Moser appears to be doing is something that Cliff Asness from AQR has talked about which is allocating risk not necessarily allocating asset classes.

In noting that a 60/40 portfolio consisting of SPY and AGG and that almost all of the risk is saddled on the SPY side of the ledger Moser notes that "most will agree, this is hardly a diversified portfolio."

Moser is asking some good questions but I could not find where he tells us why it makes for poor portfolio construction to have 95% of the risk (again he did not define what he meant) isolated in the equity exposure. What he seems to be saying is that risk (what he means by the word) should be more balanced between the two asset classes so I think he was saying allocate more to bond but take more risk with your bonds and then you can have less exposure to equities.

This doesn't make a lot of sense to me, if that is what he is saying, for a couple of reasons. First, depending on how more risk is taken in the fixed income market you might as well be in equities; at times the correlation between equities and high yield debt can be very high. The other thing is that many people think they own any fixed income at all to offset normal stock market volatility (volatility and risk are not the same thing).

If that is the reason that many investors own fixed income (I believe it is) then it is not clear what the benefit would be to less equities but increasing the risk of the fixed income allocation. Also missing from the discussion was the fact that risk can change over time. Generically speaking the US ten year has more risk at 1.7% than it did at 2.7% than it did at 5.7%. Bond risk going forward could be much different than it was looking back.

I would say that I do not believe that the risk needs to be allocated in the manner that I think Moser is talking about. If the conversation gravitates to several different asset classes as Asness is talking about then that could very well be a different story.

Again, I think the article ask a very good question. Having a suitable asset allocation is a crucial element to a financial plan succeeding but it is also difficult to construct. Go too aggressive and the risk becomes panic selling at a generational low but going too conservative could result of course in coming up short.

Because this is so important it is worth exploring different theories (for those inclined to spend the time) and if Mr. Moser comes back to tell us why we should consider his theory I will be very interested to read.

For now I will continue to view equities as the core asset class and use the other asset classes to try to smooth out the ride and reduce correlation. At our firm this obviously includes fixed income and gold for almost every client but also but has also included foreign currency and absolute return.

The second picture is from the training I attended over the weekend, we are about to go in and find the fake baby. It was very hot but at least it was unusually humid...
Read more!

Sunday Morning Coffee

Barron's has a reference to a new emerging market acronym this weekend; MIST which stands for Mexico, Indonesia, South Korea and Turkey. The common link here apparently is a rise in consumer spending. iShares has ETFs for all these countries and Market Vectors also had an Indonesia fund.

Since BRIC was first coined there have been several emerging market acronyms (or the like) including CIVETS, N-11 and now MIST. BRIC is attributed to Jim O'Neil from Goldman Sachs and it was brilliant. Although I have written about these other catchy names I think it is time to close the book on the name gimmicks.

It is unclear that there is much value in investing in a fund, like the various fund that leverage the BRIC name, which arbitrarily lump countries together. CIVETS was someone's idea of the most promising countries at some point in time. I could not find who came up with the concept but HSBC actually launched a fund somewhere targeting those countries although I could not find it on Google Finance.

Perhaps the BRIC countries should have been lumped together when the term was created but the stories on the ground in these places seems to have diverged such that other than being all large emerging market countries the significance seems to be eroding. At some point the countries in questions decided to change it to BRICS to include South Africa which is a baffling outcome considering the original term is a catch phrase.

In past posts I've argued that even the term emerging markets no longer has any meaning.

My preference for foreign investing has always been to pick countries from the top down and then to pick whatever will hopefully be the best proxy for each country. Obviously best proxy will depend on the person making the decision and could include individual stocks, country funds or maybe some other sort of specialized ETF. It hopefully goes without saying that investing in gimmicks won't work out very well most of the time.

Today will be the last day of the fire training I have been taking in Mesa. The training has been a stretching of my comfort zone that has involved doing things in smoke, unable to see while wearing a breathing apparatus and turnout gear. The turnout gear is as thick a coat and pants as you can imagine and the breathing apparatus enhances the challenge too. The weather has been relatively cooperative but still very hot by most standards. 
Read more!

Avoid Feeling Helpless

As mentioned in an earlier post I am in Mesa for fire training through the weekend. Thursday morning we had a keynote speech from Burton Clark, who is very distinguished in the fire service industry. In his presentation he circled back several times to his having felt helpless in certain situations as being a catalyst which lead to his taking action which often went on to positively impact many other people.

He does not like feeling helpless. I have blogged in the past about my own quirk of never wanting to feel financially helpless. Based on society's problem with indebtedness, overall financial illiteracy and studies we read about low 401k balances it seems as though many people are on their way to financial helplessness. This is not about being wealthy so much as being self-sufficient, being able to pay your bills, absorb reasonably sized one-off events and not have your life turned inside out due to spending beyond your means.

The focus here on things like saving more, spending less, monetizing a hobby, going to great lengths to avoid portfolio meltdowns are all aimed toward avoiding feeling financially helpless. As Woody Allen once said; there is no situation where having more money made it worse.

Chances are that if you take the time to read stock market blogs you are less likely to end up being financially helpless. If you read this site then perhaps this concept resonates with you.

Last night we went to the Hall of Flame Museum which had some amazing trucks that I'll post in coming days including the one above.
Read more!

The Kind of Stock You Don't Need to Buy

For some unknown reason the name Sycamore Networks (SCMR) popped into my head last night. Sycamore, if you don't remember the name from 12 years ago, makes networking products. I traded it a couple of times as the internet bubble was inflating (I worked in a different part of the industry back then). It made stuff that made the internet work and was named after a tree so what's not to love :-)

I have not looked at the name in ages and haven't owned for even longer. While I have no plans to buy the stock personally or professionally I think I kind of root for it because I made money on it so long ago. Nothing wrong with having irrational thoughts if you don't act out on them.

Anyhoo, a few days ago I posted about a study from the SEC that tried to assess whether individual investors should buy individual stocks or not. The general tone of my response was that for most market participants, the suitability of individual issues boils down to the time they have to devote to the task and their perception of their own ability. I went on say that using a couple/a few individual stocks in moderate weightings as part of a strategy relying primarily on funds is not ruinously reckless. The stocks chosen may not do well but it would not be suicide.

A name like Sycamore would not fit the bill. While I think it says something positive that the company is still in business, this is not a name that too many people need to buy. The stock in the middle of a nine year downtrend, save for a couple of spikes upward along the way, has been losing money and will continue to lose money and did a one for ten reverse split almost three years ago. Strangely, though, it has a little over $12 in cash versus a share price just under $15--so maybe there is no company, just a bank account?

Where the context is a portfolio for a do-it-yourselfer who does not want to spend 40 hours or more per week on his portfolio but wants to try to do a little better than an SPY/EFA combo the siren call of some must have fad, deep value play, "special situation" and so on is probably best to be avoided.

Short post, I am down in Mesa for a couple of days attending a fire training, doing may day job early in the morning and in the evening. The tree is not a sycamore it is a massive kauri tree in New Zealand. 
Read more!

Hobby Monetization

You may have seen the show American Pickers on the History Channel where the guys drive around the country "picking" other peoples' stuff. They find some neat stuff and the show is generally fun to watch.

On this week's episode they visited a guy with a lot of antique automobile memorabilia like things related to gas stations including a lot of antique gas pumps. The stars of the show like to buy this sort of stuff but this particular person did not want to sell any of his gas pumps because he "is going to restore them for his retirement."

Whether he restores them or not could have been hoarder-speak and will never know what happens but this gentleman clearly loves the memorabilia in question, appeared to have dozens of these pumps and the show gave the impression that he indeed knows how restore them.

If you look around a little bit on the interweb you will find old gas pumps for sale ranging from $5000-$15,000. One related website gave a wide estimate of 20-100 hours to restore a pump and I would assume that amount of time would not pertain to beginners. For someone who'd spent their first 60 years around these things then finding them (or having them in a back shed), restoring them and selling them would be well inside the wheelhouse.

I don't know the costs involved in restoring a gas pump but using the numbers above, if the profits range from $2500-$7500 then it doesn't take too many restored gas pumps during the year to supplement a decent income and/or relieve the burden off of an investment portfolio. One gas pump per calendar quarter would go pretty far for someone living an $80,000 lifestyle and 20-100 hours over the course of a three month period is not an unreasonable time burden.

A related example could be camping trailers like the one pictured. There is a market for vintage/retro/antique everything and some narrow slice of the population with the access and know how for all of it. The point here is not that you should go out an learn how to restore espresso machines, motorcycles or anything else but to circle back to an often repeated idea; retirement is going to be different for many of us. For many it will mean having income from some sort of job. People who can accept this probability early have a better chance of figuring out how to make money from something they love doing and would do for free.

It is reasonable to think that people who must work would rather do something they enjoy as opposed to being forced to take something that will pay them an income.

Often in this context you will see negative comments about being the Walmart greeter which I won't dump on. I don't know any Walmart greeters but there was a guy reviewing receipts at our Costco for at least ten years who loved the job in a way that is difficult to believe unless you saw it firsthand. Where someone can love that so much, so too could someone love being the Walmart greeter. Just as this may seem odd to some, I'm sure my interest in firefighting seems odd to others.
Read more!

One Pro's Take Part Two

A reader left a very thought provoking comment on yesterday's post in criticizing the asset allocation featured in Barron's over the weekend. The reader wisely cautioned against being too conservative and said that the allocation laid out in the Barron's article was "a certain path to mediocrity."

First as far as being too conservative, in the end you need what you need and you either have enough or you don't. What is the difference between running out of money for being too aggressive or too conservative? You're out of money just the same.

However I believe that having the correct asset allocation is more important. If someone has the wrong allocation then they are more likely to succumb to emotion at the worst time causing a worse result than just being too conservative. One quick note is that asset allocation is not necessarily the same thing as conservative or aggressive. In generic terms a portfolio with 100% invested in equities with general characteristics that utilities stocks usually have is probably going to appear to be more conservative than a 50/50 portfolio where the equity portion is invested stocks that have characteristics associated with lottery ticket biotech stocks and the fixed income portion is all in high yield bonds.

As to the portfolio out of Barron's being mediocre, the short answer is that each of the segments in that portfolio could be managed such that they each dramatically outperform their respective benchmarks. Were that to be the case it would be incorrect to say the portfolio was mediocre.

It is very likely of course that the portfolio from Barron's would dramatically lag the stock market in a year like 2009 where stocks go up 25% and so someone might think the portfolio is indeed mediocre. However it seems plausible that such a portfolio could very easily have done very well on a relative basis in a year like 2008 where the stock market went down a lot and so the results would be far from mediocre.

In thinking about the above paragraph it would seem the word mediocre is not the right way to think of it. An asset allocation, which is what we are talking about, is either suitable or it isn't. In years past I talked about late 2008 being the wrong time to find out you had too much in equities--or put differently the wrong time to find out you had the wrong asset allocation.

An asset allocation along the lines of what was put forth in Barron's will be suitable for some portion of the investing public although it is clear that the commenter in question prefers some other allocation, probably one he views as being more growth oriented, the kind of growth that has been traditionally available from equities. In generic terms, the next time the market goes down a lot will a portfolio that targets 70% in equities be mediocre? No, it will just risk being down a lot with the market.
Read more!

One Pro's Take on Asset Allocation

For the last couple of weeks Barron's has run profiles of wirehouse advisors from their annual top 100 advisors list. Joe Montgomery was the advisor this week and has the following target allocation for clients;

Domestic Equities 10.8%
Foreign Developed Equities 10.9%
Emerging Market Equities 4.8%

US Bonds 15%
Foreign Developed Bonds 19%
Emerging Market Bonds 8.9%
Floating Rate 3%

Alternatives 25.9%

Cash 2%

To be clear the above is not a recommendation from me it is what some guy who has been successful enough for Barron's to want to profile.

The article is very thin on details like there being no explanation as to what alternatives means. It could include things like commodities, REITs, absolute return and market neutral. It is not clear how the asset classes are built in the portfolios but there is a hint of fund use as they do use the Eaton Vance Emerging Markets Local Income Fund (EEIIX) for that exposure.

Clearly foreign exposure is preferred but there was no fundamental explanation, just a colorful quote about US centric investing being antiquated.

In the profile Montgomery used the word democratizing and clearly anyone wanting to emulate the above mix could easily do so with ETFs which is democratizing. If you are unfamiliar, there are floating rate ETFs including one from iShares with symbol FLOT. The 3% weighting to floating rate seems reasonable from the stand point that paper in this space tends to be lower quality.

In terms of the equity and fixed income space with ETFs, that is ground we've covered countless times before and obviously there is infinite content with idea all over the interweb. Using individual issues may or may not be in your wheelhouse which is of course why the existence of ETFs is democratizing.

Back to what alternatives might be, there are ETFs for most of those spaces too. You know about the various commodities funds which includes all encompassing funds that own everything to funds that own narrower segments like grains or industrial metals to many individual commodities. Index IQ has quite a few alternative strategy funds to replicate various market neutral-ish strategies. There are some ETFs in the long short arena but many more with the traditional mutual fund wrapper.

One final point of interest is is how little equity exposure there is. Equities provide an opportunity for growth yet a large segment of Montgomery's client base appears willing to forgo that opportunity. Anyone willing to forgo that opportunity should either already have a lot of money accumulated relative to their needs or have a very high savings rate.
Read more!

The Big Picture for the Week of September 2, 2012

New York Magazine had an article about an SEC study that long story short concluded that stock picking should mostly be left to professionals. The article was mostly about financial literacy, there was a little about the disadvantages that retail investors face and it concluded rather directly that;

it's basically impossible for the retail crowd to beat the market on any consistent basis

I think the framing of the argument as spelled out in the article is incorrect. If the context is the entire US population then yes stock picking will be a bad idea as only a very small portion of the entire population will have the inclination to spend the time needed to own individual stocks. Most of the US population's attachment to the stock market is through a 401k where picking stocks isn't an option anyway.

From there the conversation then needs to gravitate to the narrower subset of the population that participate in markets, should they pick individual stocks? I think this is the wrong question too. Individual stocks take more time than narrow based ETFs which take more time than broad based ETFs.

For people interested enough to spend the time the realistic answer is some combination of funds and individual stocks consistent with their level of interest and their perception of their own ability to analyze individual stocks. Portfolio size also matters. Someone who is very young might be very interested in markets but not begun to really accumulate enough to put into stocks yet.

Despite what some would have you believe there is nothing insanely risky or ruinous about owning a handful of dividend or large stocks in moderate weightings as part of a diversified fund portfolio. Take the following example of an investor who ten years ago put 5% each into Chevron (CVX), Microsoft (MSFT), Johnson & Johnson (JNJ) and Bank of America and then put the rest into some combo of  the S&P 500 (SPY), the EAFE Index (EFA) and emerging markets (EEM).

This seems plausible even if not ideal due to the overlap with SPY. The names were and still are widely held and widely known. According to Google Finance for the last ten years SPY is up 59%, EFA is up 57%, EEM is up 255%, CVX is up 192%, MSFT is up 25%, JNJ is up 24% and BAC is down 77%. The four stocks made for good sector diversification but obviously three of them lagged badly but if you do the math you can see there was nothing ruinous with the strategy and again the stock picking turned out to have been poor.

Depending on the weight to EEM that someone might have chosen ten years ago the portfolio could have come out way ahead of the S&P 500 despite the general poor performance of the individual stocks. The above numbers do no include dividends and JNJ is a client holding and a name we own in RRGR.

Now, ten years later the funds available offer a much wider selection for anyone so inclined to build a simple, mostly fund portfolio with a handful of individual stocks. Someone starting out today building a similar ten year portfolio as outlined above might use a low volatility fund instead of SPY, maybe a couple of country funds for developed foreign and of course there are now many more fund choices for emerging market exposure.

In thinking about picking four stocks one way to reduce the likelihood of choosing something that goes to zero would be to avoid a fad. The first thing that comes to mind here is solar. It is an immature industry and it makes sense to expect the landscape as we now know it will change. Given that many investors know more about foreign stocks than they did ten years ago maybe one or two of the four individual stocks could be foreign. It is very unlikely that the long standing big phone company or big energy company from a foreign country will go bust. The big oil company in Finland might go on to lag meaningfully for the next ten years like JNJ but is very unlikely to go bust.

I believe Neste Oil is the big oil company in Finland, it trades at 14.7 times 2011 earnings and yields  3.8% but we do not own the name it is just an example.

The example from 2002 forward may or may not have beaten the market depending on the weightings of the funds but it would not have ruined anybody either. The important thing from the standpoint of a do-it-yourselfer is that the funds covered a lot of ground and the stocks were not weighted where they could have been ruinous.

I would submit that not making potentially ruinous decisions, like 40% in BAC ten years ago, is more important than beating market. Also more important than beating the market is not doing anything truly stupid at the worst possible time like panic selling in March 2009. I'm sure many would say now that of course that was the low and a time to buy but obviously there were a lot of people selling stock or else the market wouldn't have been cascading lower. A third thing that is more important than beating the market is having an adequate savings rate during the accumulation phase.

So while excerpt quoted above may or may not be true it does not have to matter for investors who understand that their real goal is simply to have enough money when they need it.
Read more!