Mike Rivers' Blog

What's in a name?

noreply@blogger.com (Michael Rivers) — Tue, 24 Jan 2012 17:42:00 +0000

Quick quiz. Would you prefer to work with a: 1) financial planner, 2) investment planner, 3) money manager, or 4) wealth manager?

If you feel like I just asked if you like: 1) pizza, 2) pizza, 3) pizza or 4) pizza, you are not alone. The financial intermediaries who claim to be these things can't keep it straight, so no one should expect clients to, either.

In a recent study by Cerulli Associates, Inc., 1,500 financial intermediaries were found to mis-identify themselves as something they weren't, frequently exaggerating the services they offer.

According to the study, 59% of financial intermediaries identified themselves as financial planners--certified to work with clients in building comprehensive plans that include insurance and estate planning. Cerulli's study, however, found that only 30% of those 59% actually fit that description.

22% of financial intermediaries called themselves investment planners, who focus on asset management, retirement and college savings plans. 56% of the survey's respondents actually fit that description, which makes it sound like a lot of investment planners try to pull themselves off as financial planners.

11% described themselves as wealth managers, who do comprehensive planning for wealthier clients, but only 6% actually fit the description. Once again, it sounds like an inflated title is used in hopes of generating business.

It turns out that money managers, who manage and build investment portfolios (that's what I am), were the only group that accurately described what they do. Apparently, they knew what they were and weren't afraid to describe themselves as such.

I must admit, I've run into this confusion a lot with clients, prospective clients, and even friends and family. Someone asks what I do, and I describe that I manage money for people. Then, they say, "So, you're a financial planner," or "So, you're a stock broker." I don't blame them for the confusion, but I do blame my industry.

There are a lot of honest people in the financial services business, but it doesn't seem like a large majority. Specifically, a culture exists that focuses on commission-based sales, and convincing people to purchase "products." An old industry adage is that insurance products aren't bought, they're sold. Looking at how most financial intermediaries are compensated, you'll see that the adage is all too true.

I'm highlighting this not just to pat myself and other money managers on the back (whoopee, I'm on Team Honest!), but to illustrate how the financial services industry seems to thrive while confusing clients.

A helpful term to look for is fiduciary. A fiduciary "must act for the benefit of their clients and place their clients' interests before their own" (CFA Standards of Practice Handbook).

When you go to a Ford dealership, you don't expect a commission-based salesperson to recommend a Toyota, but when you are talking to a doctor, lawyer or another professional, you should expect them to treat you fairly.

When dealing with a professional, you are placing yourself in a position of trust with someone who is an expert in a field where you aren't. It would be unfair, and frequently illegal, if the professional used that position of trust to benefit themselves at your expense. That is why so many legitimate professional organizations require members to adhere to a code of ethics (and will boot you if you don't!).

When a so-called financial planner earns a 5% commission (yes, on the gross amount of the dollars you invest) because you invest in the mutual fund they recommend, that's not adhering to a fiduciary standard. When an insurance agent earns a 10% commission selling you a whole life insurance policy or variable annuity, it should be clear their supposed advice is tainted by a big conflict of interest.

The best way to protect yourself, whether you're dealing with someone who claims to be fiduciary or not, is to ask how they are compensated. That should make it clear whether they are serving themselves first, or you.

What's in a name? It turns out, a lot.

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.

Caveman brain and variable cycles

noreply@blogger.com (Michael Rivers) — Tue, 17 Jan 2012 15:04:00 +0000

Almost everyone claims to be a long term investor, but few truly are.

A person's real attitude toward investing only becomes obvious with time. One person initiates an investment approach and sticks to it for 20 years, while another switches after it doesn't "work" over three. The result is almost always good performance for the person who sticks to one approach, and terrible results for the person who changes course every three years.

In my opinion, the cause of this short-term-orientation is twofold.

First, human psychology really does a number on us. Our caveman brain evolved to handle different problems. You don't need more than three years of data to decide whether you should run from a hungry lion or a pack of wolves. But, hunter-gatherers and farmers need to think longer-range to survive. Unusually bad winters and poor rainy seasons don't happen every year, but when they do, you'd better have enough food and clothing stored, or you won't survive. On an evolutionary time-scale, this thinking is pretty new to us. As a result, we make lots of mistakes when our caveman emotions take over from our long-range, reasoning mind.

I'm as prone to this difficulty as everyone else, much to my distaste. My biggest investing mistakes are seldom a refusal to sell something bad, but impatiently selling something too soon. I, too, have suffered from short-term-orientation with investments that weren't "working," only to see them take off shortly after selling.

I sold Berkshire Hathaway in November 2009 (having held it for 3 1/2 years) shortly after Buffett bought the Burlington Northern Santa Fe railroad. Buffett was clearly signaling that his company would never grow like it had in the past. The stock then jumped 21% in four months. I was right about underlying growth, but wrong to have sold at a low price to fundamentals.

I sold UnitedHealth in November 2010 (3 1/2 year holding, also) after company management had repeatedly described how new health care legislation could rapidly change their business model. The stock proceeded to climb 44% in the eight months after I sold. Once again, I was right on the fundamentals of the business, but wrong on the decision to sell when price to fundamentals were still too low.

My purpose in giving these examples is not to highlight what a moron I am (I've actually gotten many more right than wrong--no really!), but to illustrate that even someone aware of the psychological traps of investing can still fall into them. The solution is better process, which is fertilized with a thorough, rational analysis of past mistakes.

The second reason I think short-term-orientation sets in has to do with the fundamental nature of investing and business cycles, which are wildly variable in amplitude and duration. Just as you can't decide the quality of farmland without considering weather cycles, so you can't decide what's going on with an investment without considering investing and business cycles--and that makes analyses more difficult.

Investing cycles are caused by the boom and bust mentality of investors. One year investors eagerly pay 20x earnings for an investment, and another year they won't pay 5x. This boom-bust cycle is caused by the psychology of investors as a herd. They go from euphoria to terror and back again over time, and no one can predict how long the cycle takes or when it will reach its zenith or nadir.

Business cycles, which are less psychological than investing cycles, are caused by a variety of things (including government policy, fads and fashions, competitive dynamics, just to name a few). Like investing cycles, business cycles follow unpredictable paths that can distort the information investors need to make good decisions. A rational analysis of long-term sales and margins over the full cycle is required, as is an in-depth analysis of industry and company dynamics. Is a downward cycle permanent, or temporary? Has a paradigm shift occurred that makes the business model defunct? Only time will tell.

Investors generally have a hard time handling investing and business cycles. Its easy to panic and "throw in the towel" when the future is unknown, but it rarely generates good investment returns. People would love to know if their investment approach is working by seeing results right away, but the world is too complicated to say one, three or even five years of data are enough. It depends, and each cycle is different than the last. It's more constructive to look at long data samples, but few have the patience or desire for such work.

Given that, what's the solution?

First, you'll only stick to an approach over the long run if you really--deep down--know it works. If you've looked at the long term data, you'll know that value investing crushes growth investing over the long term. If you spend enough time picking the right approach (or the right manager), it's possible to ride through periods of under-performance that can last as long as a decade. If not, you'll panic and abandon ship at just the wrong time.

Second, you'll have to do battle with your psychology. You will feel emotions when your investments tank. You will want to throw in the towel when something isn't working for several years. Be ready to fight your emotions with reason, data, analysis, or whatever else helps you. I've found temporary distraction works, as does exercise, deep breathing, meditation, reading. Do what you must to hold emotion at bay and focus on the facts. Only then will you stick to your approach.

Our caveman brain and variable cycles make sticking to an investment approach very difficult, but not impossible. The rewards, however, are truly extraordinary and well worth the time, effort and intermittent anxiety.

Find the right approach, and stick to it!

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.

Big bad banks?

noreply@blogger.com (Michael Rivers) — Tue, 10 Jan 2012 21:51:00 +0000

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years. Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn't together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

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.

Five year snap-back

noreply@blogger.com (Michael Rivers) — Mon, 09 Jan 2012 18:02:00 +0000

Each quarter, Barron's publishes how mutual funds performed by sector. Sectors in this case refers to how mutual funds are categorized, like funds invested in large, mid-size or small companies, growth or value, bonds, international, gold, real estate, science and technology, etc.

I find this information interesting not because I think quarterly or annual performance is meaningful--it's not. You have to look at much longer periods, like five or ten years, to get meaningful information, and Barron's publishes that as well.

And, here's where things get interesting. If a particular sector has done well over the last five years, does that mean it is likely to continue to do so going forward? Not at all. In fact, a good case can be made that the sectors that do best over the last five years are seldom if ever the one's that do best over the following five years.

And, that's what I look for in Barron's tables. I look for the sectors that have done best and worst over the last five years because the best will likely become worst and the worst will likely become best.

The analysis isn't quite that simple, of course (nothing worthwhile in life is that easy), but some interesting data points can be gathered that might prove useful in guessing about the future.

For instance, the best performing sector over the last five years was precious metals (8.09% annualized). That's not at all surprising given that gold and silver have been on a tear over the last decade. Will it be best going forward? I doubt it. I'd guess precious metals will continue to do well for a few more years and then tank. Good luck trying to jump off the elevator before it plummets.

What else has done well? If you guessed U.S. Treasuries, good for you. They were the second best performing sector out of 103 sectors(!) with an annualized five year return of 6.99%. If you think that one will be the best performing over the next five or ten years, please don't operate heavy machinery.

The absolute worst sector was short bias funds with a -16.61% annualized return. It's almost impossible to make money, long term, by going short all the time. If the world falls apart, short bias funds will perform best over the next five years. But, then again, you have to wonder whether property rights will be enforced or if the dollars you withdraw will be worth anything.

The Japanese stock market was the next worst sector, with a -13.27% return. I'd guess that Japan is a very good candidate for a turn-around, but they culturally seem to scorn shareholders so I personally hesitate. Unlike short-bias funds, I think this one has a good chance of looking brilliant in five or ten years.

The third worst was financial services (-11.09% annualized). The crash and recovery from 2008 to 2009 makes that unsurprising, and a very likely candidate to out-perform over the next five years. Like Japan, it has the clear ability to turn around, and everyone hates it, so it's a great contrarian bet.

After looking at the best and worst stand-outs, I look at small versus large and value versus growth. Anyone who has studied finance knows that, over the long run, small beats large and value beats growth. The support and records behind that, both theoretically and empirically, are so strong and long that there is very little reason to believe it will change going forward.

However, the long term record also shows that small doesn't--each and every year--beat large, and value doesn't always beat growth. In fact, long periods of time go by where just the opposite happens. Such periods are usually followed by a snap-back to historic averages--and profit-making opportunities.

The last five years are very interesting along this dimension, because growth has crushed value and small has beaten large by a much larger margin than is historically usual. This leads me to believe (and has for several frustrating years now) that value will greatly out-perform growth over the next five years and large will greatly out-perform small.

I'll admit that I don't invest with this approach as my starting point: I don't examine the Barron's tables and then go do research accordingly. Quite the opposite, the Barron's tables simply verify what I've been seeing in my bottom-up (security by security) research--that precious metals and U.S. Treasuries look very expensive, and that Japan and financials look very cheap. It also confirms my experience that large companies seem to have much better return prospects than small, and that value looks much better than growth.

Barron's report of five year performance isn't a magic crystal ball, but it does provide some interesting information. I think we're likely to see a five year snap-back, and my fundamental research confirms that assessment.

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.

A bird in the hand is worth two in the bush

noreply@blogger.com (Michael Rivers) — Mon, 02 Jan 2012 16:42:00 +0000

Generally, investors are an optimistic lot. They tend to expect next year will be better than the last one. They tend to over-estimate their abilities. They tend to mistake luck for skill.

Investors are people, after all, and people tend to be over-confident. For proof, simply look at the success of lotteries. The odds are terrible, but the potential payout is huge, so people generally love to play.

If you ask a lottery player what chance others have of winning, and what chance they themselves have of winning, you'll almost always get two different answers. "I am special," they seem to say, "and I will prevail over the odds."

As far as evolution goes, this is a great attitude to have. Pessimists make lousy leaders, are chronically unhappy, and don't tend to do what is necessary to succeed. Optimists, in contrast, tend to be better leaders, happier, and more confident in doing what they need to succeed.

When it comes to investing, though, the evolutionary program doesn't work very well.

Investing is basically a contest with other people--not a contest with nature. The goal is not just to pick winners, but to pick winners before other people do. Seeing that Apple has succeeded doesn't do you any good, you have to have seen it before others and acted on that conviction to benefit.

This is why optimists tend to make lousy investors. They invest boldly because they are so sure of themselves. Unfortunately, they are not alone, and investment prices reflect the over-confidence of so many optimists investing boldly.

Optimists assume that high growth will continue. They assume they know more than others. They assume the distant future will look like the recent past. Unfortunately for them, it seldom does.

This attitude isn't just reflected in the actions of individuals, but in their investment advisers, too. People tend to choose optimistic advisers. They want someone who confidently and boldly predicts good things will happen. They don't really want a straight-shooter, they want a leader who they believe will take them to new heights.

This compounds the problem, because even pessimists tend to prefer optimists as advisers. That leaves even fewer pessimists doing the actual investing, thus causing prices to over-reflect the optimistic attitude.

So, why do pessimists make better investors? Because, unlike optimists, pessimists tend to under-estimate their abilities, they tend to think things will get worse, they tend to mistake skill for luck. Instead of investing in "high potential growth," they tend to invest in actual performance.

A bird in the hand is worth two in the bush. The performance that has actually occurred is worth more than the potential that hasn't. High growth always slows over time, and low or negative growth almost always improves more than expected.

The pessimist invests in the bird in the hand instead of hoping for two in the bush. It rarely turns out there are two in the bush, and even when there are, they are almost impossible to catch.

The pessimist tends to generate better investment results because he isn't over-confident. He doesn't invest in potential, but in the actual. Being unsure of his ability to predict the future, he doesn't try. The pessimist ends up selecting investments that optimists hate, and thus pays a very low price for it.

What happens going forward? The optimist ends up paying a high price and finds out the future isn't quite as good as he confidently predicted. The pessimist ends up paying a low price and finds out the future isn't quite as bad as he worried. The optimist's investment tanks on disappointment; the pessimist's investment rallies when things turn out less bad than most predicted.

This process is so counter-intuitive that few follow it. Who brags they invested in a near-dead company? Who loves to brag that they invested in Apple? It's human nature, right?

To get better results, though, you need to be a bit more skeptical. You need to worry that potential growth will falter, to question your confidence, or to find someone more paranoid than you to do the worrying for you.

It may sound counter-intuitive, but it works. When it comes to investing, hope is foul language.

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.

All eyes on China

noreply@blogger.com (Michael Rivers) — Mon, 26 Dec 2011 17:03:00 +0000

Most investors are focused on Europe, but they should be focused on China instead, because what happens in China is likely to have a greater impact than what happens anywhere else.

There are many candidates for focus next year. The one that makes all the headlines is, of course, Europe. Its economy, as a whole, is still the largest in the world, after all. If that economy collapsed, or the European Union came apart, or the currency union changed dramatically, then it would, without doubt, impact the global economy. But, a lot of what's happening in Europe is already discounted in market prices. News on the front page is rarely a big mover of markets because markets anticipate change more than react to it. And, although Europe's economy is large, it doesn't contribute much to global growth. There's a small chance that Europe is the big mover of markets next year, but I doubt it will be.

Japan is a dark horse that may have a big impact on the global economy next year. Its economy is still #4 behind Europe, the U.S. and China, but hasn't grown in 22 years. The issue from Japan isn't earthquakes or tsunamis, but debt. Japan is the most indebted country in the world if you compare its overall debt to the size of its economy. The amazing thing is that they pay the lowest interest rates in the world on that debt. The reason rates are so low is that the Japanese are so willing (and compelled) to buy Japanese government debt. When retirees start to outnumber savers, though, Japan will have to start raising debt at much higher interest rates. If markets start to anticipate that inevitable transition next year, Japan could be the big mover of markets. I doubt it will be, though, because I don't think that crisis will come to a head for another couple of years.

The Middle East is, as always, another dark horse that could greatly impact global markets. Although the Arab Spring is making the headlines, the greater concern involves ancient rivalries between Arabs and Persians, and between Iran and Israel. If Iran succeeds in creating unrest between Shia and Sunni on the Arabian Peninsula, or if Israel becomes increasingly worried about and takes action regarding Iran's nuclear program, then oil prices will rocket and the global economy will tank. Like Japan's issues, these are unlikely to come to a head next year. But, unlike Japan's issues, the Middle East is unlikely to face an inevitable conclusion in the short to intermediate term.

The good old U.S. of A. is another place to focus next year. It's an election year, so many both inside and outside North America will be curious to see how our political field changes and how that could impact the global economy. The U.S. economy is huge, but is growing so slowly that it has less impact on the global economy than it did five or ten years ago. In my opinion, our political transition is unlikely to change things much, so I doubt it'll have a big impact on markets. Not only is Congress unlikely to tackle our debt issues during an election year, but the Fed is also running low on monetary ammunition.

China, I think, is the most likely candidate to move markets next year. It is both the world's 3rd largest economy and the fastest growing. It is also the biggest supplier of goods to Europe and the U.S., the 1st and 2nd largest economies. It has a huge impact on emerging market growth, too, because so many emerging economies supply China with the raw materials and other inputs that fuel their manufacturing powerhouse. In 2013, China is going to go through a major political change (every 5 years, there's a major changing of the guard) that's likely to be anticipated by markets in 2012. At the same time, China is trying to tamp down high inflation and an overly-exuberant real estate market. Add all these factors together with a bunch of global investors over-focused on Europe, and you have a high probability that China is the one moving markets next year.

I'm not alone in doing this, but I'm watching with great interest what happens to oil and copper prices and on the Shanghai Stock Exchange. Oil futures (which are high, but not outrageously so) seem to be reflecting concerns in the Middle East more than growth in China or emerging markets. Copper has fallen over 20% since last spring, but has not yet declined to global recessionary levels. Shanghai, like copper, has been falling since spring, and is down at levels last seen in the spring of 2009, when U.S. markets were hitting bottom.

I don't really know what will happen in markets next year, but I'm watching China with greater interest than Europe. If China tanks, the world economy will follow; if China thrives, markets are likely to do much better than expected.

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.

"Where's the market going next year?"

noreply@blogger.com (Michael Rivers) — Wed, 21 Dec 2011 16:17:00 +0000

Some people love to ask questions they don't really want an answer to.

When people find out I'm a professional investor, they frequently ask where I think the market is going next year (especially in December). Having no ability to read minds, I assume their question is sincere and I launch into a description of what I do and don't know. About one-eighth of the way into my overly thorough explanation (I tend to talk too much), I can see their eyes glaze over as they imagine themselves someplace more pleasant...

Having gone through this routine hundreds of times over the last ten years, I've learned that most people don't really want an answer. I don't know if they are making polite conversation, or if they want me to express a certainty no human possesses, but I get the impression they'd really like to hear me say, "up, Up, UP!!!," or "sell everything and buy gold!" But, I have the dual problem of being brutally honest (just ask my wife) and overly verbose, so they end up quite disappointed.

If you really don't want to know what I think, or if you desire precise descriptions about the future, then please feel free to let the mental fog drift in, and imagine yourself on a sunny beach with an adult beverage of your choice...

If, however, you'd like my opinion, please read on.

Sorry, but I really don't know if the market will go up or down next year (for a longer term assessment, see below). No one else does, either, so this isn't a matter of professional negligence on my part, but the nature of the beast. There are no short-cuts to building wealth any more than to getting an education, losing weight for good, pursuing a worth-while career, or building fulfilling relationships.

Stock market returns include three parts: 1) dividends, 2) earnings growth, and 3) crowd psychology. Dividends and earnings growth tend to be relatively stable and are easy to predict over the intermediate to long term (3+ years). Crowd psychology, however, isn't at all predictable and tends to completely overwhelm the impact of dividends and earnings over the short run.

Anyone who says they can predict crowd psychology a year in advance belongs in a circus side-show, or on Wall Street as a strategist (the latter pays much better than the former, just in case you're weighing the options). And that's why no one, not even brilliant people with decades of experience and multiple degrees from esteemed institutions, can tell you where the market is going next year.

Sorry to disappoint you, but it can't be done.

If, however, you'd like to know what kinds of returns to expect from the stock market over the long run, then I do have something to say. For, crowd psychology tends to dampen out over time, thus regressing to the mean. Because this tends to occur over several years, it is possible to make reasonably accurate assessments of long term returns.

On that score, I'm likely to disappoint you, too. I think the S&P 500 will return around 3.5% to 6.5% over the next 5 years. That includes dividends, earnings growth (including inflation), and a regression in crowd psychology back to the mean (I include 6 year projections each quarter in my client letters, which can be accessed here).

How can I expect such modest returns even though the market has gone nowhere for 11 years? It all comes back to crowd psychology. People tend to go from greed to fear and back again over long periods. There are long cycles of 15 to 20 years with several smaller 3 to 7 year cycles along the way.

For example, in 2000, people were euphoric. Then their hopes were dashed into 2003, but not completely. They became greedy again in 2007, but not as much as they were in 2000. Those happy feelings were shredded again into 2009, and this time people became even more depressed than in 2003, but not completely despondent.

Before we get to a long term market bottom, we're very likely to get to the completely despondent point. That could result in a flat market for the next 5-10 years, or a cataclysmic crash and then gigantic boom over the same time period. I don't know because of that predictability-of-short-term-crowd-psychology thing. Historically, it's more likely to be bust then boom, but who knows?

What I do know is that down cycles like the one we're experiencing end, and are followed by up cycles. Everyone would like to know the timing of such events, because you could make a fortune timing it perfectly, but no one does.

I will offer a warning that it won't be fun when the down cycle ends. For starters, the news on the front page will look terrible. No one will want to invest in securities. Stocks will sell at very low prices relative to historic dividends and earnings. Articles will appear saying that stock investing is dead. At that point in time, when you'll want to run screaming from the room, is when a new bull cycle will begin.

That's also why I'm not trying to time the cycle. I'm almost fully invested and plan to remain that way. Why?

First, its impossible to pick the exact bottom, so anyone trying to do so is likely to miss it and think it's still in the future. By the time they realize it's in the past (which can only be demonstrated with hindsight), they'll have missed a huge part of the up-side.

Second, remaining invested will allow me to generate slightly better returns than the market through the down-cycle. This may sound like a foolish endeavor (like catching a falling knife), but beating the market by even 3% a year over the down-cycle means I'll start the up-cycle with 65% more money than I otherwise would. That's a much nicer place to be than guessing about about market bottoms when the world is in total panic (remember 2003 or 2009, when people truly thought there was no bottom in sight?).

I do have a view on the market, but it's not for the next year, and it's dour for years, then very profitable after. The problem is: most people don't want to hear that.

That's okay, I need someone to buy from and sell to over the cycle.

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.

Ducking thunder

noreply@blogger.com (Michael Rivers) — Wed, 14 Dec 2011 16:59:00 +0000

It's hard not to feel a bit shell-shocked by current events. Each piece of bad news makes a person want to duck and cover until the storm passes. Although I understand this feeling and can sympathize with it, I don't think it's constructive.

When you hear a loud clap of thunder, it's hard not to duck. The problem is that by the time you've heard the loud noise, it's much too late to do anything about it (not that ducking would help anyway). The danger is long past and you're just reacting instinctually and uselessly at that point.

The same is true in financial markets. Unless you're a professional trader working at one of the world's financial centers, by the time you hear the bad news it has long ago been reflected in security prices. Whether it was Baron von Rothschild 200 years ago or instantaneous computer trading today, you and I are not going to benefit from trading on the news.

That doesn't mean we can't interpret the news more intelligently and act on it in the fullness of time, but thinking that we can duck and cover at the sound of thunder is total folly.

This reminds me of my experience in pilot training. Not surprisingly, you don't want pilots to panic or freak out when an emergency occurs. Our human instincts don't serve us well in the cockpit, so they train pilots through repetition--in a full-motion simulator--to keep their cool in emergencies and successfully deal with problems.

We called it "dial-a-death" because the instructor pilot literally had a dial where he chose the emergency you were to handle. The first several times you were given a tough emergency, it was hard not to freak out, but over time you could learn to keep your cool even under the toughest of circumstances. For me, the key was to breath deeply and get very focused on properly diagnosing the problem and then meticulously taking corrective action. If you sat there thinking about the consequences and how worried you were, you were doomed.

I think this analogy is perfect for financial markets, too. We need to be ready for emergencies by preparing ourselves mentally. We need to expect things to go wrong instead of hoping, uselessly, that they won't. We need to know how to act when things go wrong so our instinctual desire to duck is suppressed and we do what we know we need to do. We need to focus on controlling the things we can control instead of wishing we could control the things we can't.

How do we prepare for financial emergencies? Go into the situation with your financial house in order:

spend less than you make
save the difference (pay your future self, first)
invest your savings wisely (by being prepared for both good and bad market conditions that you know will happen, but not when)
have enough cash at your disposal to handle life's inconveniences
get enough insurance
set up an estate plan

Also, know what not to do:

panicking won't help
don't assume see can see bad financial conditions coming (don't worry, no one can consistently)
don't assume that bad times won't come
don't believe you can "go to the sidelines" until the storm is over
don't try to time when to get out and get back in (you will almost always do both way too late)
don't inundate yourself with bad news that makes you want jump out a window (good pilots don't stare at burning engines, they focus instead on putting the fire out)

If you're more opportunistic (and this is clearly not for everyone, just like flying airplanes), be ready to benefit from others' panic. Be ready to sell your safest holdings and buy what the panicky sellers are abandoning recklessly. Financial panics are always the best time to invest, and precisely when your instincts most desire to seek cover.

Just like pilots can learn to handle terrifying emergencies, you can learn to handle and profit from financial panics. Be prepared, have a plan, take deep breaths, and don't try to duck--it's already too late.

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.

Why I'm all about value

noreply@blogger.com (Michael Rivers) — Wed, 07 Dec 2011 16:27:00 +0000

Investing in glamorous stocks generates lousy returns; investing in out-of-favor, unloved and even hated stocks generates great returns. And, that's why I'm all about value.

The return from investing in stocks can be roughly broken into two parts: 1) how a company does, which is what almost everyone focuses on, and 2) investors' general attitude toward a company.

Most investors, whether individual or professional, focus almost exclusively on #1. They look at growth, sales, profit margins, competitive positioning, return on capital, new products, distribution, marketing, etc. Don't get me wrong, this is vitally important stuff. But, it's only half the picture.

Just as important is investor perception. When a company is loathed, its price reflects that fact. People sell investments they loath. They don't want to talk about such investments at cocktail parties. Most of all, they don't want to try to explain why they've bought something unpopular.

When a company is loved, its price reflects that fact, too. People buy investments they love. They're excited to talk about such investments at Christmas parties and how they are going to make a fortune. With these investments, people enjoy explaining why they bought it, and how much money they've already made (sometimes including all the relevant facts).

But, loved companies aren't as good investments as those that are loathed. The reason is simple: it's in the math.

Loved companies sell at a high price relative to underlying fundamentals. All those people who love a company buy it, and that drives its price up. Loathed companies sell at low prices to underlying fundamentals. Everyone who hates it sells it, and its price reflects that.

If all that mattered were the fundamentals, then loved companies would almost always out-perform loathed companies. But the math of returns reflects both fundamentals and the price paid for those fundamentals.

Perhaps a theoretical example will better illustrate my point. Say two companies, Loved and Loathed, both make $1 per share in earnings.

Loved is growing at 15% per year. Because everyone loves Loved, they pay a high price for it: $30 per share, or 30 times earnings (this is not unusual, Apple sells at 15x, Google at 20x, and Amazon at over 100x!).

Loathed, on the other hand, isn't growing at all. Because everyone loathes Loathed, it sells at a very low price, or 5 times earnings (think Merck after Vioxx, or BP after Mecando).

Now, what happens going forward?

Even supposing Loved can maintain 15% growth for five years, people eventually become less excited about it. They know such high growth can't last forever, and a fad eventually becomes boring to those excited about the newest thing. As the saying goes, ardour cools. Instead of being willing to pay 30 times earnings, investors are only willing to pay 20 times earnings (still a very generous premium). Over five years, earnings per share will have doubled, but stock price will only go up 33% ($2 earnings per share times 20, $40 on a $30 investment is a 33% return).

Loathed, on the other hand, continues to be a dog. It doesn't grow at all over the following five years. In contrast to Loved, everyone who hates Loathed has already sold it and gets bored with hating it over the following five years. When investors become surprised that Loathed doesn't go out of business, the price starts to recover. Although Loathed earns the same $1 per share it did 5 years earlier, people are eventually willing to pay 10 times earnings for a no-growth business. Over five years, Loathed returns 100% ($1 earnings per share times 10, $10 on a $5 investment is a 100% return).

My example above may seem contrived, but that's how things really work out. There are countless research papers from Fama and French, to James Montier, to David Dreman supporting my contention. Or look at the investment records of Warren Buffett, Walter Schloss, Robert Rodriguez, O. Mason Hawkins and Wally Weitz.

If you think this is a smooth ride, think again. It's no fun owning Loathed. People will think you're nuts (believe me, I know). Almost no one will want to talk to you about investing--especially at cocktail or Christmas parties. But, it pays very well.

Making this approach even tougher, investing in value goes out of favor for long periods of time, too. Value grossly under-performed from 1995 to 2000, before dramatically out-performing from 2000-2005. Value has gain been out of favor over the last six years. C'est la vie!

It may look ugly, be unpopular, and under-perform for long periods, but value investing works by capitalizing on investor perception. That's why I'm all about value.

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.

Hero to toad

noreply@blogger.com (Michael Rivers) — Wed, 30 Nov 2011 15:52:00 +0000

Investing is a brutally competitive business. Unlike being a doctor or plumber, where you fix things in reality, investing is all about how you perform relative to your peers. No one gets an appendectomy, or has their pipes unclogged, and then asks how that fix compares to all other fixes done by all other professionals. If the problem gets fixed, the customer is happy.

Investing is more like sports in this way. Hardly anyone asks about a football, baseball or basketball players' career stats. Instead, people want to know how athletes stack up to the competition, and more specifically, how many championships have been won.

I was reminded of this recently with the announcement that Bill Miller is retiring from managing Legg Mason's Value mutual fund. You may not have heard of Miller, but he became famous in the early 2000's for beating the S&P 500 year after year. Amazingly, he managed to beat the S&P 500 every calendar year for the 15 years ending in 2005. This made him a deity among many individual and professional investors.

If Miller had retired in 2005, he would still be touted as the hero he seemed to be. He'd be able to write best-selling books, make a fortune with speaking engagements, and perhaps even milk that hero status for the rest of his life.

Instead, Miller stayed on the job and has gone from hero to toad. Not only did he fail to continue out-performing the S&P 500 every year after 2005, he managed to lose a huge amount of his clients' money (after making a ton for them prior to that). Investors have abandoned him en masse as his fund went from over $20 billion in assets to around $2 billion, now.

A good question to ask is whether Miller "lost his touch," or if he ever had a touch to begin with. I don't think Miller lost his touch, I think the odds simply caught up with him.

Looking at Miller's record, you'd see that he didn't out-perform every period, he just happened to out-perform calendar years over 15 years. Change the date to October 31st instead of December 31st, and you would have seen that he didn't out-perform every year. Added to that, he really didn't out-perform the market by that much over those 15 years. His edge was small and has been completely erased.

Look deeper into his process, and you'll see an almost blind contrary approach--buy what others hate and wait. Because the market always recovered nicely between 1990 and 2005, Miller looked like a genius (even though he wasn't). In fact, I believe Miller was one of the most over-rated money managers of the last 20 years.

Does that make Miller the toad he is being treated as now? Not at all. Miller out-performed most (probably 80%) professional and individual investors. He's neither a hero nor a toad, but clearly an above average money manager.

And yet, people's perception of him is based on his retirement date, not his career stats. One feels for Bill Miller like one feels for sports greats that never win the championship. They are always seen as "could-have-beens" instead of the out-performers they are. Such is life.

Many seem to forget the role that luck plays in life, and particularly in sports and investing. Many that seem great, are both good and lucky; and many that seem mediocre are actually much better than perceived.

Think for a second, about Steve Jobs. Looking at his career in 1985, 1990 or 1995, he seemed like a loser to most. Even in 2000, when he was clearly (in hindsight) on the come-back trail, most (including me) had written him off as a has-been. Then he went on to change the computer, mobile phone, music and movie-making industries and become what many consider the greatest CEO ever. It's sad to say it, but perhaps cancer saved Jobs' reputation from the fate of Bill Miller.

Look, too, at Robert Rodriguez, one of the best mutual fund managers alive. He under-performed the S&P 500 over 15 of 18 5-year periods from 1973-1991. But, if you invested with him in 1968, you'd have three times the money you would have had investing in the S&P 500. It pays to back the right horse, not the one who just looks pretty. Looking at Rodriguez's process, I could see he was great. Not so much with Miller.

Investors with the right process win in the long run, even if they don't rack up amazing, headline-grabbing statistics. Look at how they do what they do, not just the results. Look for the Jobs or Rodriguez that hasn't broken out instead of the famous show-boat who might be short-term lucky instead of long-term good. Look for single-minded focus, an ability to learn from mistakes, and an inherent love of the game and you'll likely find a winner. If you over-simplify the process and look for the bandwagon everyone else is jumping on, you're likely to find the odds will catch up with you, too.

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.

Profit magnitude AND duration

noreply@blogger.com (Michael Rivers) — Wed, 16 Nov 2011 15:35:00 +0000

It's not enough to focus on a company's profitability--especially if it's huge; you must also understand the durability of that profitability.

A single payout of $1 million is not worth as much as a lifetime payout of $150,000 a year forever (unless you can get better than 15% returns forever). The same is true with buying businesses (whether in the form of a whole private business, or shares of stock).

This may seem elementary, but some investors lose this focus when they dwell on short term high or low profits. A couple of examples may help concretize this point.

Exxon Mobile is a hugely profitable company. But, there are non-trivial questions about whether it can replace its current productive capacity over the next 10 years.

Or, consider Apple. It's hugely profitable right now, but can that profitability be sustained and grown in the face of many smart and well-resourced competitors (that are spending 2x to 4x as much on research and development)? The answer to that question is vitally important for Apple's valuation.

Or, what about Sprint (the telecom company)? It's clearly not making money now, but the price paid for the company should reflect profits 5 and 10 years from now as well as this year. Does Sprint's valuation reflect its current profitability or its profitability over time?

Think about Research in Motion, the maker of Blackberry mobile phones. It had rapidly growing sales and profits within the last year, but both have started rolling over. Will that trend accelerate, continue, or reverse? The value of the business hinges on the outcome.

I don't mean to imply that answers to these questions are easy--they aren't. In fact, I'll be the first admit I don't have the answers to any of those four questions. But, they must be thought about in order to achieve good investment results.

I should know, I've fumbled that ball several times in the past (business analysis is extremely complex, and no one is omniscient). I bought Reebok and Novell in 1996 after years of outstanding profitability. Over the following 10 years, though, both saw profitability and their stock prices tank--a great lesson that durability of profits is more important than recent magnitude.

Think about stalwart companies like McDonalds, or Coca-Cola, or Proctor & Gamble. They have extremely high profitability and almost zero chance of seeing that profitability vaporize like we could see happen with Exxon, Apple, Sprint or Research in Motion. That's why their stock prices are almost never as low relative to fundamentals. Investors as a whole get this concept, even if they forget it at times (1999 and 2000 for technology, 2005 and 2006 for housing).

As I said last week: it's not about market share, it's about profitability. Now, I'd like to add that it's not just about profitability, but also durability. Your investing future depends on both.

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.

Profits, not market share

noreply@blogger.com (Michael Rivers) — Wed, 09 Nov 2011 18:17:00 +0000

As a shareholder of Dell, I must admit to being frustrated by all the focus both Wall Street and the media apply to market share. Listening to them, you'd think all that matters is market share. They're wrong.

What matters in business is profits. Not market share, but profits and their sustainability. Market share is a measure of sales relative to other companies. It's a top-line focus. Profits are bottom-line. It's the money a company makes, it's a measure of value-added, and it's the money a business has to compete in the future.

In Wall Street and the media's defense, there are some businesses where market share is all important. In Internet search, for example, Google dominates with high market share and very high profits. There's a network effect in search that hugely rewards number one. Number two and below not only don't make much money, they lose big-time (just ask Yahoo! and Microsoft (another holding of mine)).

Let me give you a quick theoretical example of how to gain very high market share but lose in the end. Buy $30,000 Honda's sell them for $15,000. I guarantee you'll have #1 market share. But, you'll be out of business so quickly it won't matter. Now, buy those Honda's and sell them for $29,000. Once again, you'll have very high market share and you'll last longer, but you'll still be out of business in the long run, guaranteed.

Now, back to the computer market.

A couple of years ago, Acer overtook Dell by grabbing the #2 market share spot. Was that #2 in profits? Not at all. In fact, Acer gained #2 market share selling netbooks. Remember those. Perhaps not, because they've been almost completely supplanted by tablets--mostly Apple's iPads. Acer gained market share selling a cheap, low profit margin product. Dell didn't follow. Since then, Acer has fallen back below #2 and Dell continues making profits and competing successfully. Dell focused on profitability, not market share, and it worked.

Fast forward to today, and Lenovo just overtook Dell for #2 in market share. Instead of selling netbooks, Lenovo is dominating sales in China and doing very well in emerging markets. Their profit margins? 1.85% at last report on an accounting basis. Dell's profit margins? 5.8% on an accounting basis (7.6% on a cash basis).

Now, think about that. Profits are what is used to buy inventory, innovate new and better products, build supply chains, hire productive employees, etc. Just for the sake of the argument, let's assume Lenovo is selling a product that's just as good as Dell's (which is unlikely with so much lower profit margins). Lenovo is essentially selling $30,000 Honda's for $30,555 and Dell is selling them for $31,740. Lenovo is making $555 on each sale and Dell makes $1,740--more than three times as much!

That's the money each company has to pump back into the business. Lenovo would have to have over three times the market share to have the same amount of profits to plow back into the business in order to be competitive. Does Lenovo have three times Dell's market share? Not even close. In other words, Lenovo cannot compete by focusing on market share, it must either focus on profitability or risk losing that market share over the long run.

I'm simplifying the argument a bit to make things clear, but my point is still valid. For a company to survive and thrive over time, it's about profitability, not market share. An over-focus on market share is the wrong way to think. It's a focus on effects, not causes.

In the long run, Dell doesn't need high market share to succeed. It needs profitability. That, it has.

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.

Euro-Scary!

noreply@blogger.com (Michael Rivers) — Wed, 02 Nov 2011 17:56:00 +0000

I've been writing since December 2009 about how sovereign debt will evolve into the next sub-prime credit crisis, and how it will all start to come apart with Greece.

One of the first really ugly steps down this path began this last week as members of the European Union decided to write down Greece's sovereign debt by 50% (only 21% for government holders--"All animals are equal, but some animals are more equal than others").

To commemorate this unraveling, I decided the scariest thing I could turn my Halloween pumpkin into this year was the euro--Europe's supposed common currency. At right, that's my Jack-O-Lantern at the top, with my wife's cat and my daughter's Blue from Blue's Clues below.

My mother-in-law was not, I think, amused by my choice (she's German), but I was. Not only was Europe's plan inadequate, but it also set in motion some market dynamics that may reverberate for some time.

One of the games European officials decided to play was to describe the 50% write-down as a voluntary restructuring instead of a default. This may seem like a minor technicality, unless of course you own Greek debt and bought insurance on its default (which won't be honored, now). It sounds like the Europeans are going to violate the sanctity of contracts, and that has left a lot of folks who bought insurance scrambling, and with big questions.

Can you buy insurance on sovereign debt and really be insured? It doesn't look like it. In fact, the market's rally last week may very well have been due to investors having to cover investing positions rather than a positive evaluation of Europe's "solution."

No, Europe has not solved Greece's debt problem. They just kicked the can down the road a little farther (a 90% write-down will more likely be necessary, followed by major structural reforms to Greece's economy).

No, this solution will not build confidence that Ireland, Portugal, Italy or Spain's debt problems can be solved, not to mention Belgium and France (French, German and British banks own a ton of Greek, Irish, Portuguese, Italian and Spanish debt--now you know the real reason why they are searching for solutions).

No, this will not be good for the economy in the long run. No, this is not a model for solving the same huge problems that exist in Japan and the U.S. (due to Medicare, Social Security, Illinois, California, New York, etc.).

This problem will be with us for a while--probably another 5 to 10 years. But, when we get past it, the global economy and stocks will go on a 15 to 20 year bull market.

Until then, we'll have to be satisfied with lower returns, preservation of capital, and a little amusement as Greek Tragedy justly punishes those who haven't learned from history.

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.

The Inflation Path

noreply@blogger.com (Michael Rivers) — Wed, 26 Oct 2011 19:12:00 +0000

To most people, inflation seems quite mysterious. This is not without good reason.

First of all, it's an abstract concept. Inflation is not when the price of some things go up. Just because the price of gasoline or wheat increases doesn't mean inflation is happening. Inflation is when the price of everything, on average, goes up. This concept isn't just abstract, it's almost impossible to measure over the short run. Inflation isn't usually obvious until it's really climbing.

Another reason inflation seems so mysterious is because so many misunderstand when it is or isn't happening. Politicians and economists are notorious for saying inflation isn't happening when it is, and saying inflation is happening when it isn't. Anyone paying attention would think inflation is completely inexplicable.

It's not. Inflation is simply when the money supply increases faster than production of goods and services. That doesn't mean it's easy to measure, but we do know what it is.

Inflation is also terribly destructive. As Keynes said, it is a very easy way for governments to confiscate tremendous amounts of wealth without the populous seeming to notice. That is, until inflation gets very high. Then it rips an economy and government apart (starting with the poorest, I might add).

A quick look at history will reveal that few governments collapse because they have bad policies or default on debt, per se. The thing that will destroy a country more easily than anything (besides war) is inflation. The record is quite clear.

The path to inflation is also easily understood. Many writers have described the process accurately, usually after an exhaustive study of history. Peter Bernholz perhaps describes it best in Monetary Regimes and Inflation: History, Economic and Political Relationships.

To start, you have a government conservatively financed with low taxes and limited power. As the government extends its power over time, it gets to the point where it cannot raise taxes enough to further grow its power (people eventually refuse to pay the higher taxes either direct protest, or indirectly by violating the law). At that point, a government starts to borrow. The borrowing starts low and gets higher as time progresses. At a certain point, the borrowing becomes high enough that those lending to the government demand higher interest rates. That's when things start to come apart, and that's when the government starts creating money much faster than economic growth. And, that's when inflation goes ballistic and things finally come apart.

This path is not followed precisely each time, but that's generally the path to high inflation.

For example, some governments realize they are creating money too quickly and reign things in. This is possible not solely because the people or government decide to be more rational, but because the size of government debt and spending is not too large relative to the rest of the economy. It wasn't hard for the U.S. to get inflation back under control after the Revolutionary War, Civil War, World War II, and the 1970's (Vietnam War), because our government debt and spending weren't yet too high relative to the productive capacity of the economy. But, it's not necessarily the case that cooler heads can prevail if the debt is too great.

The best defense against inflation is a precious metal standard, usually gold or silver (and gold has been far superior to silver, historically).

The next best thing is a paper money standard with an independent central bank (independent of political authorities--particularly elected officials). Unfortunately, this "next best thing" has always and everywhere been an intermediate step on the way to high inflation, usually by way of making the central bank beholden to elected officials.

I mention this because Barney Frank, a Congressman more responsible for the housing crisis than Wall Street and all the banks in the U.S. put together, is currently suggesting we make our central bank, the Federal Reserve, beholden to elected officials. Like F.D. Roosevelt tried to stack the Supreme Court to force his policies through, Barney Frank wants to make the Federal Reserve more directly swayed by the Congress.

Now, I'd like to step back to put my above comment into context. The U.S. government has gone from being conservatively financed (we've had an income tax for less than half our history), to grabbing more and more power (economically, militarily, socially, etc.). That power has been expensive, so much so that we had to start issuing larger and larger amounts of debt to finance that growth in power. As that occurred, the U.S. went off its domestic gold standard in 1933 and off the international gold standard in 1971. Since then, we've had higher and lower inflation (to the degree our independent central bank kept things in check--almost always against the will of politicians!). With the growth of our welfare state, particularly in the form of Social Security and Medicare, our government has racked up tremendous financial obligations, far out-weighing our military spending or any other spending (including those dreadful bank bailouts).

Governments get into trouble when debt grows to exceed 90% of the economy. That's when the economy slows because of the debt millstone around its neck. We're either there, now, or very close. We also know that governments get into trouble when the deficit of spending versus tax revenues grows to over 20% of spending. We're around 30% now.

So, as our government has grown in power, it has gotten into so much debt that it is close to preventing the economy from growing its way out of the problem. And, it has abandoned the best thing to prevent high inflation--a precious metal standard. Added to this, there are elected officials who would like to remove our last line of defense--the independence of our central bank.

Not good.

High inflation doesn't have to happen here, but we are getting farther and farther out on a limb that can lead us to tumble off into serious trouble. We can decide to turn around and scramble back toward the tree. That would require us to keep our central bank independent at a minimum, and then get back on a precious metal standard. It will also require us to reign in our government's size relative to our economy (that means spending cuts and the restructuring of our tax system).

The inflation path is clear, and we keep taking steps down it. Perhaps it's time to turn around.

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.

Why is anyone surprised?

noreply@blogger.com (Michael Rivers) — Mon, 17 Oct 2011 15:40:00 +0000

Great article by Jonathan Weil last week from Bloomberg.

Less than three months ago the European Banking Authority said Dexia SA (DEXB) had passed its so-called stress test with ease. The French-Belgian lender's July 15 new release carried this headline: "2011 EU-wide Stress Test Results: No Need for Dexia to Raise Additional Capital."

Then last weekend, 86 days after getting its clean bill of health, Dexia took a government bailout to avoid collapsing. Nobody was surprised this happened. Nor should anyone have been.

The regulators who gave Dexia a clean bill of health were not incentivized to do a good job of credit analysis. They were incentivized to "calm the markets."

If investors had listened to the speculators, who were incentivized by the profit-motive, they would have avoided Dexia. If investors listened to the government's appraisal, they were led to the slaughter.

This has happened time and again, but people keep expecting the government will rescue them from the "bad guys."

Look at Barney Frank and Fannie Mae, or the SEC and Bernie Madoff, or Ben Bernanke and the housing market. The list goes on and on and on.

The short-selling speculators have a huge incentive to get their analysis right. And, in general, they do. Look at government officials and their record in uncovering malfeasance. It's terrible.

So why do people run in fear from the "bad guys" who almost always get it right, and run to the arms of the government officials who almost always get it wrong?

Beats me. But, they get what they deserve.

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.

Bad Bank! Now, go to your room!

noreply@blogger.com (Michael Rivers) — Wed, 12 Oct 2011 22:25:00 +0000

As an occasional investor in banks (I currently own Wells Fargo and would like to buy US Bancorp, M&T and Park National), I have to admit to being somewhat surprised at all the bad press banks have faced recently.

As usual, it seems to be a perception versus reality issue, but I believe there is a willful ignorance on the part of both the press and the general public. I suppose I should elaborate before the hate-mail gets sent.

First off, not all banks are the same. Just as you shouldn't judge a person by their skin or gender, you shouldn't rush to judge an organization simply because it belongs to a particular group. There are good banks and bad banks, just like there are good and bad people.

Several investment banks, like Bear Stearns and Lehman Brothers, were gambling with tax-payer dollars, and they deserved to go bankrupt. Their shareholders and bondholders should have reaped what they sowed, though, and taxpayers need not have been involved. Nor should bankers have been allowed to gamble with tax-payer dollars. I don't blame a 3-year-old for asking for a full-sugar and caffeine soda 5 minutes before bed; I do, however, blame their parents for giving in. So it is with banks. I expect a very small minority of bankers will be vicious (that must be accepted in any society), but the real fault lies with a government that supported and encouraged that vice, not with all bankers as a group.

Most U.S. banks aren't like that, though. They are more like the Bailey Building and Loan Association from It's a Wonderful Life: they take in deposits on which they pay interest and lend those dollars out to borrowers at higher interest. They don't gamble with tax-payer dollars. In fact, they provide the vital life-blood that keeps a modern economy like ours flowing. Lumping all banks together because we know of a couple of bad ones has parallels with Ku Klux Klan "reasoning."

Also, just because a bank has been "bailed out" doesn't mean they are bad, either. Keep in mind the U.S. Treasury and Federal Reserve didn't give many banks a choice on taking a "bail-out," and most of those good banks didn't need or want it. Once again, this reasoning is like blaming someone raped or mugged for "giving in" instead of blaming the real perpetrator. Just because some people are ignorant of these facts does not forgive their avowed but poorly informed conclusions.

Second, a lot of what banks have been blamed for recently is the result of well-meaning politicians that are clueless to the point of being vicious. Let's take the recent furor over Bank of America charging $5 per month for debit cards.

A bunch of politicians have decided, in their infinite wisdom, that banks are charging too much for interchange fees. Instead of letting customers, banks, networks, merchant acquirers, and merchants decide what's fair, the Federal Reserve is now inserting itself in the process of free interaction to dictate what fees the participants can charge each other.

These same politicians also decided they don't like overdraft fees. It's not nice, they say, to charge people for trying to buy things they don't have the money for. The bank should say thank you to their unmathematical customers instead of charging them for borrowing money without making prior arrangements. (As a side note, I have paid overdraft fees several times in my life and didn't enjoy it. I did not, however, blame the bank or society at large for my mathematical mistakes, I was mad at myself.)

What is the rational response of an organization that has bondholders, shareholders, employees and more-mathematically-inclined customers to take care of? Raise the same amount of money elsewhere in the form of additional fees! Why should some bondholder have to eat that overdraft fee or lost revenue from interchange? Why should the shareholder, or employee, or customer? They shouldn't!

No rational person expects one bus-driver to take a pay cut to support another bus-driver who is too lazy to know how much money they have in their account. Nor do most people think that politicians should arbitrarily cut a bus driver's pay because some passengers don't feel like paying that much. So, why would it be any different for banks?

Banks are now quite logically raising additional fees and turning away customers it used to accept. In addition, fewer customers are getting credit and debit cards, fewer merchants can afford to accept the cards, and services that were once free--like checking accounts--now frequently require fees.

This is all quite logical and predictable, even to narrow-minded politicians who wish they could have their cake and eat it, too. The only surprising thing is that they thought their laws would have no unintended impact!

Third, politicians are crying for banks to lend more money while--at the same time--raising their capital requirements (if banks lent more money, all else equal, they would violate the old capital requirements--let alone meet the new ones). Politicians are also saying banks aren't being generous enough in offering credit to those who need it while--at the same time--bemoaning the fact that banks have so much bad debt on their books. The blatant contradictions in both of these views should be obvious to anyone with knowledge of banking, but that apparently isn't required for politicians who regulate banks.

We don't need to send banks to their room for being bad. We need to unshackle them so they can do their jobs. I've read that banks now need 1.2 employees to keep up with regulatory requirements for each employee taking deposits and making loans. Perhaps if banks weren't so busy meeting all these new and old regulatory hurdles, they wouldn't be gambling with taxpayer dollars, charging high interchange and overdraft fees, and they'd be making more loans, offering more services and getting the economy going again.

That doesn't seem very likely, though, given all the shrieking from the press, public and politicians about how bad banks are.

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.

Thank you Mr. Jobs

noreply@blogger.com (Michael Rivers) — Thu, 06 Oct 2011 14:48:00 +0000

Steve Jobs was a hero of mine, and the world will truly miss him.

My parents bought my first computer, an Apple IIe, for me in the early 1980's. I learned to do computer programming with it and spent countless hours playing games. I also used it to get through high school--writing papers, doing science projects, etc. I'm an avowed computer geek and have loved using a computer to make things happen ever since.

Steve Jobs was the indomitable spirit who brought that productive and enjoyable experience to me. He was a hero because he had overcome great odds to create a huge, profitable and productive industry: personal computers. That alone would have put him in the business hall of fame. But, that wasn't enough for Jobs.

Jobs was ousted from the company and industry he had created in 1985. That failure was the fertilizer from which he re-invented himself and then several industries. Jobs struggled with his company, NeXT Computer, from 1985 until it was bought by Apple in 1997. Not unusually for Jobs, he was ahead of the industry with NeXT. Also during that time, he bought The Graphics Group from Lucasfilm and turned it into Pixar, which was bought by Disney in 2006. Behind the scenes, he was laying the groundwork to transform the entertainment, consumer electronics, telecommunications and computer industries.

And he did.

Pixar changed movie making forever. Even the Disney powerhouse couldn't compete and had to buy him out to maintain its competitive position. Jobs ended up Disney's largest shareholder while dramatically changing the visual content creation industry.

After returning to Apple, Jobs cleaned the company up. He pruned unsuccessful business lines and refocused the company on its roots: user-friendly software. His NeXT operating system evolved into Mac OS X. He launched iTunes to make user-friendly software the gateway to digital content. He launched the iMac to integrate his software into hardware that exploited its benefits. He launched the iPod to exploit the benefits of iTunes. He launched the iPod Touch to exploit and perfect the multi-touch user interface. He launched the iPhone to bring multi-touch and user-friendly software to the phone business. He used his iTunes platform to distribute applications (apps) to the iPod Touch and iPhone. The iPod Touch and iPhone then came together in the iPad--seen as a replacement for using a PC for content consumption. iTunes now seems to be transforming into iCloud, which will broaden and deepen Apple's digital content distribution.

Jobs transformed more industries than anyone before, and perhaps ever after.

He was a creative light, a genius with technology, a perfectionist with standards few could match, a visionary, a brilliant pitchman, and wonderfully successful and rich. He deserved all he earned, both in reputation and money, and left us with more than we could ever repay him.

With his life over at 56, people will forever wonder what he could have done if he'd lived longer. What else could he have come up with? What other industries could he have remade? Unfortunately for us and him, we'll never know.

Perhaps one of his greatest triumphs is seldom mentioned. I'll call it the Wal-Mart effect. When Wal-Mart comes to town, it lowers the prices of goods for all consumers in the area, even those who don't shop at Wal-Mart.

Jobs did the same thing in his industries. Every brilliant idea Jobs had was mimicked by others. Windows took 10 years to catch up to Macintosh, but tons of people who never touched a Mac benefited.

Jobs raised the game of competitors in all the industries he touched: music distribution & usage (where he protected the rights of artists), mobile telephony, computers and computer software, gaming, etc. The Jobs effect is as likely to be missed as Jobs' own products.

Jobs has been a hero of mine since I was a pre-teen, and he'll be a hero forevermore. Thanks, Mr. Jobs.

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.

The China Premise

noreply@blogger.com (Michael Rivers) — Wed, 28 Sep 2011 19:12:00 +0000

In analyzing financial markets and the economy, almost everyone holds a premise that's the proverbial elephant in the room: what will happen with China.

For those who believe global growth will have severe problems, their premise is that China is most likely an accident waiting to happen. Those who believe the opposite, that global growth will take off again, almost certainly hold the view that China is a growth machine that will pull the whole world forward.

If someone holds a view on commodities, currencies, stocks, bonds or gold, I can almost guarantee that behind their view is a premise about what will happen in China.

That premise may be explicit. Jim Rogers, a noted commodity investor who once worked for George Soros, is a China bull and makes no bones about it. He moved his family to Singapore and is having his daughter learn Mandarin Chinese because he thinks she won't be able to succeed without it.

Jim Chanos, the famous and successful short seller, is on record saying China is a bubble that will soon pop. He's putting his money where is mouth is, too.

Some hold their premise implicitly. I've heard many agriculture and base metal investors insist that prices can only go up. They may not lay out the case explicitly, but if you ask them you'll find they see endless growth and demand from China.

Others are certain that debt deflation (the unwinding of bad loans) will keep the global economy in the tank for a decade or more. Once again, they may not come right out and say it, but if you ask them, you'll almost certainly find that they assume China can't keep growing fast enough to overcome bad debt.

The most intellectually honest will admit they don't know what will happen. After all, it's up to the Chinese. I agree with the bears that China's command and control economy will end badly (the history on this subject doesn't leave much room for doubt)--IF it stays on its current path. But, that's a big IF.

I also agree with the bulls that China has a lot of runway simply playing catch-up with developed markets, and IF they foster free market reforms (rule of law, representative government, property rights, flexible labor markets, private allocation of capital, etc.), then they can be a huge growth story for a VERY long time. Once again: big IF.

Perhaps the best path is not to guess.

If you could invest and do well regardless of whether China tanks or soars, wouldn't that seem the best path? Granted, if you knew how the story would end, you would make more money betting boldly in that direction. But, is anyone really certain they know what will happen and--more importantly for investors--when?

What happens in China will impact world markets. In the short run, this spells opportunity whether boom or bust. I think making a guess on this over the next few years is a fool's errand. It's better, instead, to prepare for either outcome because getting the timing right is impossible (or lucky).

Making explicit one's China premise is important to understanding one's view of world markets and the economy. More important than one's premise, however, is whether its based on sound reasoning or gut feel and conjecture.

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.

QE3, Operation Twist and Balderdash

noreply@blogger.com (Michael Rivers) — Wed, 21 Sep 2011 15:35:00 +0000

"What's in a name? That which we call a rose
By any other name would smell as sweet."

--Juliet, from Romeo and Juliet, William Shakespeare

Balderdash - A senseless jumble of words; nonsense, trash (spoken or written)

-- Oxford English Dictionary

The Federal Reserve is likely to take action today to "boost the economy." This is yet another attempt in a long line of failed efforts that not only won't work, but will almost certainly make problems worse.

Whether they call it QE3 (quantitative easing, part III) or Operation Twist (named for the 1960's dance and first tried during the Kennedy administration) or Glimdragbig (a word I just made up), it will feature the Fed toying with interest rates (most likely by creating money) in an attempt to get the economy "moving."

The Fed may call it something other than what it is, but it will still smell. They may use elaborate jargon (nonsense) to mask its true nature, but that won't change the facts.

The Fed's underlying premise is that free markets work...until they don't. Has the Fed ever correctly forecast when markets will stop working? Of course not. In fact, they are almost always too ebullient when they should be cautious, and overly worried when they should be upbeat.

But, despite these consistent failures, they still pass judgment on markets and they supposedly know when markets have stopped working, and therefore when they should intervene to "get things going."

As Dr. Phil likes to say, "how's that working for you?"

In case you haven't noticed, economic growth is anemic at below 2%, and unemployment is high at over 9%. And, this is after countless fiscal and monetary (and regulatory) interventions over the last 3 years.

Why aren't interventions working? Because the first part of the Fed's premise is right: markets do work. If you let people freely choose and act, and prevent them from initiating force against each other, they will--over time--rationally allocate capital and other resources to productive ends, thus resulting in real growth and higher employment.

What the Fed has been doing is preventing this mechanism from working. Interest rates are at the heart of any modern economy. It's the time value of money, and therefore drives economic choices at the most fundamental level. If you screw with those rates, people will mis-allocate capital and the economy will stagnate or shrink.

Sound familiar? If you need more empirical support, please see Japan over the last 20 years and America during the 1930's as examples of interventions galore resulting in anemic growth, stagnation, or shrinkage (or the Soviet Union, or China under Mao, or North Korea, or Cuba, East Germany, Venezuela, you get the picture!).

Stock, bond, and commodity markets are likely to respond favorably to any Fed intervention--just like they always do (after all, everyone loves a party when someone else is paying). The dollar is likely to sink (except perhaps relative to Europe, which is even more of a basket case than America) and gold is likely to rally.

That doesn't mean the economy will grow, nor does it mean unemployment will shrink. Once again, interventions are leading to greater and greater mis-allocations of capital and thus will cause slower growth than would otherwise occur.

There is good news in all this, and that's that much of the American economy is relatively free. In such places, people are innovating, adapting, employing and growing. As long as the bone-heads bureaucrats don't intervene too much, such productive people will eventually create enough growth to overcome the negative effects of repeated intervention.

It may take time, though, so patience will be necessary. In the meantime, lets all hope the interventionists will stop distorting markets so they can do their thing. At that point, we'll have an upward spiral to be truly optimistic about.

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.

"Going to the sidelines"

noreply@blogger.com (Michael Rivers) — Fri, 16 Sep 2011 15:50:00 +0000

Most investors have a recurring fantasy they can dodge market volatility.

When markets start to tank or look scary, such folks want to "go to the sidelines," which means parking their money in cash or safe bonds, "until the skies clear."

When you ask them how they know when to go to the sidelines and when to come back, they frequently tell you they just FEEL it.

To that, I have one thing to say--BALONEY!

Feelings tell you nothing about markets, all they tell you is your emotional state. Those who use their feelings to guide their investment decisions get nowhere.

Many of these people went to cash in the fall of 2008 or the spring of 2009. In cash, they have earned maybe 2% returns if they were lucky. If they had invested whole-heatedly at those times, they'd be sitting on 50% gains or more. Those feelings don't look too smart in hindsight.

Market prices tank when people get scared. That's when the bargains appear--when people aren't selling for economic reasons but because of their emotional state.

The same thing can be said on the upside. If people feel euphoric--like in early 2000 or late 2007--then it might be time to get more conservative.

Your emotions tell you just the opposite of what to do, so don't listen to them.

My best investments were made when I was scared. I normally feel sick to my stomach when I purchase investments with the best upside. My emotions are terrible guides, and so are yours.

When markets get scary or euphoric, it's time to look at the data. What kind of returns will I get given current prices and normalized earnings. When I get nervous, I look at the data. When I'm feeling optimistic, I look at the data. I always look at the data, not my emotions.

For those who think they can go to the sidelines until the skies clear, I wish you the best of luck--you'll need it!

If you want to make a bundle on your investments, invest aggressively when you feel scared and get conservative when you're euphoric.

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.

Kindling the jobs fire

noreply@blogger.com (Michael Rivers) — Wed, 07 Sep 2011 16:08:00 +0000

One of the most interesting skills I learned going through Air Force survival training was how to build a fire. It comes in handy on camping trips, with fireplaces, and in post-apocalyptic scenarios that only a worrier like me could dream up.

You need three things to build a fire: fuel, heat and oxygen. In the right proportions, you generate warmth and light; but, in the wrong proportions, you'll get neither. Too much fuel and you'll smother the fire. Too little and it will die out. Too much heat and you'll burn right through your fuel. Too little and you'll have no fire at all. Too much oxygen and you'll blow the fire out. Too little and the fire can't grow.

Building a fire is more art than science. Having built quite a few over the last 22 years, I've learned how delicate the process can be. It seems simple in the best conditions--just throw some paper and wood together and light it. In the worst conditions, however--when the fuel is wet, the wind is blowing hard and it's bitterly cold--a fire can be very difficult to build and keep going.

I couldn't help but think of building a fire when reading recent articles about how to get the U.S. jobs machine pumping. Jobs growth, which is really just a derivative of economic growth, is like fire: it requires the right ingredients in the right proportions. The wrong ingredients in the wrong proportions will snuff it out before it can even get going.

In the best conditions--with a well-skilled workforce, property rights, labor flexibility, and readily available capital--jobs growth will seem to occur magically. In the worst conditions, however--a workforce trained for jobs the market doesn't need, lots of rules and regulations preventing property protection and labor flexibility, and a dearth of capital--and job growth can be difficult to impossible to build and keep going.

It seems like the real job creators of the world--financiers, businesses, entrepreneurs--have been joined by policy makers trying to "help" get the fire going. The policy makers may mean well, but they're simply preventing the right ingredients from coming together in the right proportions. Their incessant meddling is snuffing the fire out time and again.

Job growth requires economic growth. Economic growth will not occur by taking money from Bobby and giving it to Billy. Nor will it occur by printing money. Real growth occurs when capital is available, property rights are protected, labor can seek its own terms, and job skills match market demand. No magic is necessary, and jobs will grow and flourish in such conditions.

But, any attempt to meddle with ingredients or proportions, especially in bad economic conditions like we're in, and you'll see unemployment continue to stagnate or climb. If you want real--instead of illusory--job growth, its time to get policy makers out of the way.

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.

Bonds and Gold

noreply@blogger.com (Michael Rivers) — Wed, 31 Aug 2011 14:36:00 +0000

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I've been surprised to see both gold and bonds do so well over the last decade. After all, deflation and inflation are opposites: when one performs well the other usually doesn't. This makes bonds and gold both doing well a bit of a paradox.

But in today's mixed message environment, it makes sense from a certain perspective. Investors are running scared. They seek safety in some form--any form.

They correctly see that bad debt (lending which can't be repaid) leads to deflation, so they want to own bonds as protection. Just look at Japan over the last 20 years: bonds performed much better than stocks. Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services. Witness Weimar Germany in the 1920's or the United States during the 1970's. In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works...until it doesn't. Let's look at what Paul Harvey called "the rest of the story."

Bonds were a lousy investment from the bottom of the Great Depression until the 1970's. Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany...until hyperinflation ended. Then it tanked. Same with 1970's inflation here in the U.S.: gold was great...until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing. It only pays to ride the wave as long as you know exactly when to get off. Getting the timing wrong--even by a little--will lead to poor results. But, in case you don't know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it).

Warren Buffet doesn't time the market. Neither did Peter Lynch. Look at the Forbes 400 some time and scout out the market timers--you won't find a single one. Trying to time the market doesn't lead to permanent wealth--it leads either to temporary or decreasing wealth.

Which is why most investors shouldn't focus on bonds and gold. If you can time the market perfectly--and good luck on that--you can ride bond/deflation or gold/inflation. If you are a mere mortal, then don't try juggling nitroglycerin.

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do--buy productive assets at cheap prices, which is when everyone hates them. Productive assets are things that generate cash. Gold doesn't. Bonds do, but the cash they generate isn't protected against inflation (except for TIPS, but they have their own problems). You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc. These are assets you put money into and get back over time. They can adjust to both inflation and deflation.

Does that mean they do well in all markets? NO! Investing is not about what does well over a week, month, quarter, year, or even 5 years. You invest for the long term, not for a short term kick-back--that's speculation!

But, producing assets work like a charm during both inflation and deflation. Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation. They do poorly initially, but work very well over time. That's because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while...until they get slaughtered. The cycle on bonds and gold tend to turn very quickly. It will only be obvious in hindsight that the tide has turned--and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well--over the long run--regardless of whether we experience inflation or deflation. That's how I'm betting.

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.

Surmountable mortgage mess

noreply@blogger.com (Michael Rivers) — Thu, 25 Aug 2011 13:06:00 +0000

I've been watching the housing and mortgage markets with great interest for years.

When working for my former employer (2002-2005), I watched (but didn't follow) as he doubled- and tripled-down on investments associated with the housing market. As his employee, I worked hard, struggling to understand the individual investments, but never fully got my arms around them. I knew enough to be very cautious, but that was all.

Now, after watching the boom and bust over the last decade, I believe I have a much better understanding of how the housing, mortgage and financial markets work (or don't work) together. I've watched, researched, studied, invested and blogged on the subject over the last six years (my blogs from the spring, summer and fall of 2007 are particularly revealing of my concerns).

So, it was with great interest that I read an article in the Wall Street Journal today, The Mortgage Hangover. I highly recommend it to anyone who sincerely wants to understand the boom and bust of the housing and mortgage markets over the last decade (and not just looking for evidence to confirm one's conclusions beforehand). The article is not perfect, but it does a great job of highlighting many of the important details.

Specifically, it describes how the mortgage market was distorted over the last decade in the Bronx. You may think that Bronx real estate has nothing to do with Florida, Nevada, California or Colorado real estate, but it does. In fact, I believe it represents a microcosm of all U.S. real estate.

The problem started with well-meaning politicians who wanted everyone to have a home. That problem was exploited by real estate and finance workers who were heavily incentivized to take things to the brink (which was the inevitable result of bad policy). When those problems led to collapse, the same well-meaning politicians tried to prevent the resultant suffering. Once again, those efforts are creating new problems instead of solutions.

The good news is that the mortgage and housing problems can be fixed. It requires that housing and mortgage markets be allowed to reach clearing prices (where free buyers and sellers agree to exchange without any distorting incentives from politicians). When that happens, housing and mortgage markets can begin growth afresh.

I'm not saying the process will be pretty, but it will happen. The destination will be the same no matter how well-meaning those who disagree. The only question, now, is how quickly or slowly we get there. Policy can impact the duration of the pain, not its intensity.

The bad news is that politicians and voters are unlikely to take the fast approach. This is unfortunate, because U.S. economic and employment growth are unlikely to recover until the housing market recovers. The longer we put off clearing prices in the housing and mortgage markets, the longer until employment and our economy truly improves.

Mortgage and housing markets need not wallow in freakish misery. Recovery, both for those markets and the U.S. economy, could start soon. But, with continued meddling in housing and mortgages, recovery will take much longer and be much less robust. It's time to face the inevitable, hold our noses, and take our medicine.

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.

NOT just pieces of paper

noreply@blogger.com (Michael Rivers) — Fri, 19 Aug 2011 16:26:00 +0000

Successful investing, like everything in life, requires the right approach. Such an approach isn't just a to-do list, but a way of thinking. The wrong way of thinking leads one to easily stray from the correct path, whereas the right way leads one to successfully stay on track.

Weight loss programs are a great example. If your weight loss plan is a crash diet with no thought for what happens after, you're very likely to fail long term. If your approach is to implement a permanent lifestyle change that includes diet and exercise, then you can and likely will succeed. The thinking behind the approach is vital to success.

Nowhere is right thinking more lost than on investors. Instead of thinking of stocks as partial ownership in businesses, they think of stocks as mere pieces of paper trading in a highly abstract "casino" somewhere in New York. And that's why most generate lousy results.

Santa Cutie, there's one thing I really do need, the deed; To a platinum mine - J. Javits and P. Springer, Santa Baby, originally sung by Ertha Kitt

A stock certificate is partial ownership in a business. You don't own a piece of paper, but the underlying business. Ertha Kitt is not excited about a piece of paper called a deed, or even what some other person is willing to pay for that deed on any given day, but for the platinum in the mine and what it's worth in the real world.

Let me give an example to make this even more concrete. If you have $20,000, and find four other friends with $20,000, you can buy a $100,000 house together. If that house rents for $1,000 per month, then you'll generate $12,000 a year of revenue. If you have $2,000 of costs each year for real estate taxes, upkeep and management, then the house has net income of $10,000 per year. That's a 10% yield for each partial owner ($10,000 net income/$100,000 investment = 10%; $2,000/$20,000 = 10% for each of the five owners).

The deed to the home, or the partial deed specifying that you own 1/5 of the home, is a piece of paper. But, what you actually own is 1/5 of the home and 1/5 of the income.

Now, suppose some bone-head comes along and offers $50,000 for the home you paid $100,000. You and the other 4 owners are free to send him packing. His offer is no sweat off your brow, because you have partial ownership in a stream of income--specifically: $2,000 for the $20,000 investment you made.

The offer of $50,000 is no obligation for you. You need not lose sleep at night or panic that such an offer is made. You can check to make sure the home is still rented, count your annual cash intake, double check the expenses, and go about your merry way thinking very little about Mr. Bone-head.

This is the same attitude investors should have.

Instead of freaking out when the deed to their partial ownership drops 50%, they should check to make sure the business isn't going under and can still generate profits long term, but then go about their merry way. There's no need to panic if your partial ownership is generating 10% on original investment. There's no need to lose sleep when you own a business with profits and assets. But, it's very easy to lose sleep when you think you own of a piece of paper in some vault in New York and people are offering 50% less than what you paid.

Right thinking here is crucial. If you know nothing about the profits of the enterprise, you're likely to panic. If you think of the deed as a piece of paper or symbol on a computer screen, you'll probably panic. If you think about the underlying business, you can remain calm. In fact, you may even realize that a 50% drop means your 10% yield has become a 20% yield to the Mr. Bone-heads of the world and buy more partial ownership from them.

Most people lose their shirts investing because they panic and sell when Mr. Bone-head offers 50% off their original investment. Sometimes businesses really do go under, but it's much more rare than market panics. On extremely rare occasions, countries and stock markets completely collapse and people lose everything. The vast majority of the time, though, investors get lousy returns because they buy after things go up and then panic and sell when things go down. They buy and sell like that because they are focused on stock symbols instead of businesses.

Stocks are not mere pieces of paper, but ownership in businesses. Thinking of them as such can lead to success. Thinking of them as blips on a screen is doomed to failure.

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.

Market rollover has little to do with U.S. fiscal problems

noreply@blogger.com (Michael Rivers) — Wed, 10 Aug 2011 18:41:00 +0000

One of the most important rules of statistics is that correlation is not causation. What this means is that just because two things happen one after the other (or around the same time) does not necessarily mean one caused the other. If I cough and then thunder roars, that doesn't mean my cough caused the thunder. A causal connection must be established before one can be connected to the other. Statisticians, not surprisingly, have a name for mistakenly labeling correlation as causation: spurious correlation.

The stock market's recent drop has lead many commentators to assume that recent action (or, more properly, inaction) by the U.S. government in dealing with its precarious fiscal situation caused the stock market to fall. That's not necessarily so. Just because the two things happened around the same time doesn't mean one caused the other.

In fact, the stock market most recently peaked late last April, and has been in the process of rolling over ever since. More tellingly, U.S. Treasury bonds have rallied strongly since our government failed to deal with its debt problems. If market participants were scared about U.S. government debt, they'd be selling U.S. Treasuries and buying commodities and foreign assets. On the contrary, commodities (except gold) have been falling and foreign assets have been tanking, and U.S. debt has been rising strongly.

No, the real reason for recent market drops is slowing global growth. ECRI (the Economic Cycle Research Institute, www.businesscycle.com) started discussing a global slowdown early last May. Do you think, perhaps, market leaders and ECRI saw the same data in late April when markets peaked and started rolling over?

Indeed, recent economic data has been confirming that global growth is slowing. Most interestingly, growth has been slowing markedly in China--which has been by far the biggest engine for global growth over the last 3 years. At the same time, inflation numbers coming out of emerging markets, especially China, have been frustratingly high.

I don't think markets are reacting particularly strongly to government inaction with respect to U.S. debt. I think they are reacting to slowing global growth, and that more closely explains why bonds would be up and stocks and commodities would be down.

The unique exception here is gold. Gold is rallying strongly, probably because gold market participants expect the governments of the world to react to slowing global growth with more stimulus (spending borrowed money and printing currency). Either bond markets or gold markets are wrong, although I can't say I know which.

What I do know is that tanking markets are a big opportunity. Contrary to popular belief, it's better to buy investments when they get cheaper, not when they get more expensive. With that in mind, I'm hoping that markets tank and serve us up some super-bargain pricing!

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.