China Pullback.

As I highlighted in the Stimulus Withdrawal section of my most recent client letter, when the governments of the world get serious about withdrawing monetary and fiscal stimulus, things could get ugly.

So far this year, the S&P 500 is down around 3% on a price-only basis. This may be a “healthy correction” in process, but it’s curious why the correction started just recently.

There has been a lot of speculation about why. The most popular explanation is, of course, political. President Obama and former Fed Chairman Paul Volcker are threatening to take a hatchet to the big bad bailout banks (tip of the hat to Donald Coxe).

Large bank stocks have sold off, and regional bank stocks have done well. So, there is some substance behind the political claim. But, bank stocks have not been the most significant component of the sell off. In fact, one can more reasonably look at commodities to see what may be going on.

Oil and copper prices are off around 12% since their peaks in early January. Natural gas prices are off around 14%. Could it be that the threat to large U.S. banks is causing a sell-off in commodities? Doubtful. Or, is it a reflection of a more fundamental pull-back in economic activity. And, if so, why?

Okay, enough teasing. China decided to rein in credit expansion by raising bank reserves and increasing borrowing costs. I think markets are reacting to this credit tightening because they understand that China, and other emerging markets with respect to China, are providing the marginal units of growth to the world economy.

Not surprisingly, the Shanghai Composite is off 8.4% since January 21st. Perhaps the U.S., Europe and Japan are no longer leading the world economy, and markets are reflecting what is happening in the far east.

What will happen now? I don’t know, and neither does anyone else. But, what China decides to do going forward with respect to government stimulus and credit creation is likely to drive markets for some time to come.

Unless you know someone with close ties to the highest levels of Chinese government, I don’t think anyone will be able to guess what will happen next, either.

This is no time to be overly bold or assume that timing the market is possible. It’s up to the whims of Chinese politicians in my opinion.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Bonds and cash just aren’t that safe

Bonds are seen as safe. So is cash. But, that’s not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won’t be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can’t default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren’t the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Value investing principles

Value investing works.

Whether you look at academic research, or successful value investors like Warren Buffett, or examine it from a behavioral finance perspective, or just understand it intuitively, value investing is an investing discipline that beats all other methods (that I’ve examined).

The ideas behind value investing aren’t very complicated, but can be difficult for people to grasp:
1) a business has a value that can be determined
2) part of that valuation is based on an unknown future, so you want to buy far below assessed value
3) buying below value–with a margin of safety–reduces the cost of errors due to a) judgment, and b) an unknowable future.

The concept, then, is to value a potential investment and then compare that value to the price one can buy it from the market–its stock price. If the price is significantly below value, you should buy it. If the price is equal to or above assessed value, you shouldn’t buy it or you should sell it.

That’s it in a nutshell, but it’s more complicated to implement than that, and the main reason is psychology.

It’s very difficult for people to buy something going down in price because 1) it’s almost always cheap for a good reason, and 2) they think it will keep going down in price. Also, it’s difficult to sell something that’s gone up in value because people tend to think it will keep going up.

This psychology is the main reason, in my opinion, why most people either don’t get or can’t apply value investing principles.

Value investing also seems counter intuitive to a lot of people. They can’t stand buying what isn’t doing well, regardless of price to value. They want to buy what’s hot, not what’s not.

I’ve tried to explain value investing principles to many people over the years, and they either get it or they don’t. If they get it, you can see it in their eyes. If they don’t, they tend to say, “but…but…but….”

I say things like, “it’s not an issue of whether a $150 sweater is better than a $50 sweater, it’s an issue of whether you should buy a $150 sweater selling for $200 or a $50 sweater selling for $25.”

People who get value investing quickly grasp that analogy. People who don’t, don’t. In fact, they tend to reply, “But…but…but…the $150 sweater is nicer.” To which I reply, “For $200?”

The cold, hard fact is that people who pay $200 for $150 stocks get lousy returns, and people who buy $50 stocks for $25 build wealth over time.

The evidence supports that proposition quite convincingly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Measuring long term performance

One of the things that really hurts individual investors is not focusing on long term performance.

In repeated studies by Dalbar, they find that individual investors, on average, receive only about one quarter of the return generated by the average mutual fund. When funds are up 12%, they get 3% returns. When funds are up 8%, they get 2%.

One reason is bad advice. Not all planners and advisors are experts in their field. In fact, many have huge conflicts of interest in the advice they give (like a 5% commission on the gross value invested into a fund they “recommend” to you).

Another reason is fees. Investors are frequently unaware of the up front, on-going, and back end fees they are paying (especially in 401(k) plans). High fees eat into returns over time, sometimes dramatically.

A third reason is chasing performance. Investors, whether through bad advice or on their own, tend to sell what does poorly and buy what does well. The Dalbar study mentioned above showed that investors as a whole would actually do better if they stayed put. That may sound counter-intuitive, but it works.

One element that complicates this investment selection process is that most investors don’t understand the numbers they’re presented. Specifically, many investors focus too much on short term returns when they need to focus on much longer time periods. This is through little fault of their own; no one sits students down in high school or college and explains compounding interest and the noisiness of market data (why not!?).

Let me give an example of my performance over time to illustrate this point. For my growth investors I’ve beat the market (after fees) by approximately 1.7% annualized over the last 4 years and 8 months. But, that performance didn’t come smoothly (just ask my clients). It came in fits and starts that would confuse anyone looking solely at short term returns.

For example, I beat the S&P 500 only 45% of the 56 months invested. How could I beat the market if it were only 45% of the time? Like I said, because performance comes in fits and starts. If I beat the market by a large amount 45% of the time and lose by a small amount 55% of the time, I can still beat the market.

I beat the market 51% of the quarters invested, 67% of the years, and 100% of the 3 year periods. Longer periods are more meaningful.

Does that mean 3 years is enough time to measure? No! Looking at my personal portfolio over the last 14 years (after deducting a simulated fee), my numbers are 53% of months, 53% of quarters, 65% of years, 69% of 3 year periods, 89% of 5 year periods, and 100% of 7 and 10 year periods. Once again, longer periods reveal more information.

Does that mean 7 years is enough? No! Even the best money managers under-perform over long periods. A lot of great managers have racked up poor results over the last 10 years even though they will probably do better than average going forward.

Measuring long term returns is only a part of the equation of selecting a money manager. Selecting someone because they out-performed one month, quarter, year or even 3 year period is foolish. There is too much noise in markets to use such short periods.

Consistently beating over 3 year periods is more meaningful than having beat over one 3 year period. 5 year records are more meaningful than 3 years, 7 over 5, and 10 over 7.

In addition to good long term records, investors have to find someone who has the right process and a disciplined manner of applying it. They need to understand what the manager is doing, in layman’s terms, and believe in that methodology strongly enough to stay put when things look scary (and they will look scary at some point–just count on it!).

Most importantly, investors have to find someone they trust. A charlatan with the right process, discipline and convincing methodology will still rip you off.

Measuring long term performance is but one element in selecting an investment manager because investors must also judge the character of the person they are considering. I’m not saying it’s easy, but it is important.

(for full disclosure on performance calculations mentioned, please see my website; please note that my website won’t reflect year-end performance until 1/18/10)

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.