Posted by: Jerry Verseput | November 26, 2009

Playing Games With Inflation and Clunkers

The rate of inflation is a pretty important number.  In addition to being an indicator of whether things are getting more expensive or not, it is also used to judge the effectiveness of monetary policy, and to adjust the rate of payments for programs such as Social Security, military retirees and survivors, food stamp recipients, and a host of other programs.  The Consumer Price Index (CPI), which is the primary measure of inflation, affects payments in some way to almost 80 million people.  In other words, it’s a pretty important number.

To calculate the CPI, a complex formula is used to determine the price of certain products in several geographic areas.  This is where the games can be played, and where Cash For Clunkers comes in.  If a friend (or fellow taxpayer) gave you $100 to help buy a new TV, and you bought the TV for $500, what would you say was the price of the new TV?  Well, the number on the price tag was $500.  The guy who came into the store at the same time as you and bought an identical TV paid $500, the same as you did.  The fact that your friend gave you $100 did not lower the price of the TV.  However, in the latest release of the Consumer Price Index according to Bob Arnott (chairman of Research Affliates, LLC), if you were given $4500 from other taxpayers to help buy a new car as part of the Cash For Clunkers program, the $4500 was considered a price reduction of the car, making the car look cheaper and reducing the inflation number.

With the hundreds of billions of dollars being spent on stimulus, this type of game can be played for quite a while, but not forever.  A low inflation number helps GDP growth look better because GDP growth is measured relative to inflation.  However, at some point, the shifting of money has to slow down and the actual rate of inflation (and GDP growth) will show up.  Hopefully, actual growth will have kicked in by then, but this certainly seems like a potential problem in the not-too-distant future.

Posted by: Jerry Verseput | November 4, 2009

Don’t Pay For 529 Accounts

A recent edition of Investment News had one of those front page advertisements that’s meant to look like the front cover of the magazine.  The tag line was “Think 529 plans are small time? Top-producing advisors say THINK AGAIN”.  This caught my eye because 529 plans sold by brokers are a pet peeve of mine.  The advertisement (from Legg Mason) made it clear that there’s a lot of money to be made by selling 529 plans to unsuspecting people trying to save for college.

The reason I say “unsuspecting” is that there is no reason to pay a commission to an advisor for a 529.  Every state except Washington (not sure what Washington is waiting for) has a no-load 529 program that can typically be applied for on-line.  Most programs have age-based portfolios that automatically adjust risk as the child approaches college, so an advisor is not typically adding a lot of value by picking specific mutual funds.  The main differences between 529 plans are due to the manager who administers the plan and whether the particular state gives a state tax deduction for residents participating in the plan.  A tax deduction is something that should be seriously considered if it’s offered.  34 states offer some amount of deduction and 7 states don’t have state income tax anyway.  Of course, California is one of the remaining 9 states that doesn’t offer a deduction.

There is no restriction on which state’s 529 plan you can invest in, so it comes down to which manager does the best job and has the lowest fees.  I like the following:

California (Manager: Fidelity) – in particular, I like the age-based Index portfolios

Utah (Manager: Vanguard) - very low expenses

Alaska (Manager: T. Rowe Price) – age-based portfolios are a little more aggressive

Iowa (Manager: Vanguard) – very low expenses

Each of the above plans have low-costs, an easy application process with no application fee, and great underlying funds.  Since a 529 plan is meant to be a “set it and forget it” type of investment, I see no reason to pay the commissions and extra expenses for a broker-sold plan, and there just seems to be something wrong when an investment company advertises how much money can be made off of “selling” 529 plans.

Posted by: Jerry Verseput | October 7, 2009

Make Sure Joint Accounts Work As Intended

Posted by: Jerry Verseput | September 22, 2009

WISE (What I SEe): Market Perspective

If my investment strategy was based in any way on what I think the market is going to do, I would have been out of the market a long time ago.  Fortunately, that’s not the case because the market just keeps going up regardless of what I think it should be doing.

Since March 9, the S&P 500 is up 57%.  The price move took a short vacation in June, but then got moving again in July and hasn’t really looked back.  That’s an amazing move, and has happened despite the fact that unemployment keeps going up and earnings are way down.  Most people recognize that the market doesn’t go straight up, and advisors, particularly those who didn’t trust the recovery initially, have been waiting for a significant pullback in order to jump on the train.  For many investors and advisors, missing out on a significant recovery is almost as bad as losing money in a downturn.  What’s happening is that everytime there is a small pullback, or even just a pause, investors who have been kicking themselves for not being in the market get worried that this may be the only pullback they get.  Therefore, they put money into the market before prices have a chance to drop very much, which causes the pullback to end and the uphill march to continue.  Below is a chart of the S&P 500 ETF (SPY) since early March, with the 50-day Moving Average and a Volume chart included.

SP500 chart

 

What’s interesting is that the average volume is now about half what it was back in March.  Stock prices are still going up, but volume is going down.  Since prices only go up when there are more people wanting to buy at a particular price than want to sell, that means that investors are still not willing to take their profits.  But that time is coming.  I thought it would have happened quite a while ago, but what I think doesn’t seem to influence the market.  What’s indisputable, however, is that this market has come back a long way in a very short amount of time.  At this point, new investment in the market is probably “nervous investment”.  Many investors who have waited to see if the recovery was real finally decide to get back in.  If you’ve waited for a 50% recovery before finally venturing back into the market, imagine the feeling when a few big institutional investors decide to take some profits.  This tends to create a chain reaction of selling that results in a significant pullback.  The problem is that too many people have been expecting this pullback, and the market almost never behaves in such a way that the majority of analysts look smart.

So when will the pullback happen?  As soon as the CNBC experts start to speculate that maybe we’re in the next sustained bull market and that there is no longer a risk of a big pullback.  I don’t know the exact day, but I still expect it to be sooner rather than later.

Posted by: Jerry Verseput | September 3, 2009

IRA/401k – The Government Loan You Didn’t Know You Had

I don’t normally talk bad about IRAs and 401k’s. After all, they help people save, think long-term, and they make up the bulk of my business.  The problem I see a lot, however, is the idea that tax-deferral is the best thing since sliced bread (why sliced bread is so great is another question), and that tax-deferral “let’s your money grow faster”.  Hogwash (although that’s not the word I was thinking of).  It is much better to think of tax deferral as a government loan that they would like you to invest for them. Let me explain.

The Money Isn’t Yours

I’m going to use an IRA as an example, but everything can be applied to a 401k, 403b, or any other tax-deferred account.  If you contribute $5000 to an IRA and you’re in the 25% tax bracket, $1250 of that contribution belongs to the federal government. You get to keep it…for now, and as it grows it will make your account look bigger, but that piece of your account will always belong to the government.  If the $5000 grows to $50,000 by the time you need it and you’re still in the 25% tax bracket, the government’s piece will have grown to $12,500. In other words, you simply invested it for them.  Tax deferral did not make your account grow faster or “put more money to work for you”.

The Advantage (or Disadvantage)

Tax deferral is only an advantage if the government decides to take a smaller piece of it when you withdraw the money. If your tax rate is lower when you need the money, then essentially the government has decided to not take back their entire share.  In that case you have beaten the system.  However, if tax rates go up, or you need substantial income when retired, or tax brackets don’t keep up with inflation (a way to raise taxes without the political ramifications), the government could require a larger share of your IRA.  In financial terms, this is known as “bad”. So tax deferral is really a bet on future tax rates and how much income you will need in retirement.

Theory versus Reality

When people compare Traditional IRAs and Roth IRAs, they typically assume that more money goes into the Traditional IRA because of the tax deduction.  However, in real life, most people end up investing the same amount whether it’s a Traditional or Roth IRA (the same applies to 401k’s).  The money that was contributed to the Roth was simply taxed as part of a paycheck, so the taxes were paid with “outside funds” – money that’s not earmarked for retirement. In theory, the taxes you will eventually pay on the Traditional IRA could also be paid with outside funds, but only if you diligently saved the money from the tax deduction and it grew at the same rate as the IRA.  Not likely.  In most cases the taxes on a Traditional IRA get paid with retirement funds.   So the net result is that more actual retirement money can be put into a Roth IRA or Roth 401k, effectively increasing the limits for retirement savings.

This is not an argument for or against 401k’s or IRAs.  I’m just pointing out that if anyone gets all giddy about the benefits of “tax-deferred growth”, it is simply a bet that your tax rate will be lower in the future.  Your money is not growing any faster, and in fact, tax-deferred accounts almost force you to pay the taxes with money earmarked for retirement.  If you’re thinking “I wish I would have thought of this earlier”, it’s not too late.  Starting next year, anyone can convert a Traditional IRA to a Roth IRA.  If you can pay even a small part of the taxes with outside funds, this may be a great way to save more money for retirement.

Posted by: Jerry Verseput | August 27, 2009

Is The Market At A Critical Level?

I use technical analysis (stock charting) to try to figure out whether a stock, sector, or the market in general is either in an uptrend or downtrend. This is pretty basic, but it makes sense to me that when a stock repeatedly hits a certain price and bounces back up, there must be buyers waiting for that price.  It’s simple supply and demand.  On the other hand, I don’t get too excited with patterns that look like a head and shoulders, or a cup and handle, or the profile of Mount Rushmore.

Fibonacci retracements fall into that  “profile of Mount Rushmore” category for me (I made that up, by the way).  For non-investment geeks, Fibonacci levels attach some significance to certain percentage price moves, specifically 23.6%, 38.2%, 50%, 61.8% and 78.4%.  For followers of Fibonacci levels, a price bounce following a severe fall would be expected to hit one of the Fibonacci levels.  If the price moves through one level, it would be expected to continue until it hits the next level.  By the same token, each level could represent resistance and signal an end to the bounce.

Well, based on the S&P 500 high in October 2007 (1575) and the market low in March 2009 (671), guess how far the current recovery has retraced…38.2%.  In fact, the S&P 500 crossed that point (1016) last Friday and stopped.  One thing this tells us is that given the market drop in 2008, the market recovery is actually not as spectacular or unheard of as many TV personalities would lead us to believe.  So far, it’s a fairly typical Fibonacci retracement.  The question it raises is whether this is actually a critical level, or is this Fibonacci thing just a bunch of hocus-pocus.  I don’t know, although there’s a possibility that so many people watch these levels it becomes a self-fulfilling prophecy.  In any case it is interesting that the market has decided to pause at this specific level.

As of right now, the S&P 500 is stalled at 1020 (close enough to 1016).  If we get a pull back, the Fibonacci guys would expect a fall to about 885 (23.6%).  If we get through this level, the next critical level will be 1123 (50%).  Again, I don’t necessarily buy-in to this stuff, but it is interesting that we are currently sitting right at one of these levels.

Posted by: Jerry Verseput | August 25, 2009

Conventional Wisdom That’s Not So “Wise”

There are several investment “rules of thumb” and ideas thought of as conventional wisdom that have perhaps outlived their usefulness and accuracy.  Here are a few that I continue to run into.

“You can expect about a 10% return on stocks” – The obvious question is “how long do I need to stay invested to guarantee a 10% return”, and the truth is “probably longer than you expect”.  The 10% number is calculated by picking a starting year in the distant past, typically some low point during the Great Depression, and a more recent year that’s typically prior to 2008.  This time period included long stretches (multiple decades) where stocks ended at the same place they started.  Market research shows that positive and negative return cycles average 17 years in duration, so a couple of down years does not mean things will soon be back to “normal”.

“The market behaves randomly” – This was popularized by Burton Malkiel in his book “A Random Walk Down Wall Street”.  Malkiel stated that “a blindfolded monkey throwing darts … could select a portfolio that would do just as well as one carefully selected by experts.”  The Wall Street Journal tested this in 1998 (using journalists instead of monkeys), and the pros won in 61 out of 100 contests.  Not very impressive.  However, even Malkiel recently stated that markets behave randomly, except for the phenomenon of momentum.  In other words, the market tends to move in trends, and although it’s almost impossible to predict exactly when a trend will start or stop (although many try), it is possible to recognize one once it’s underway.

“You can’t time the market” – This comes out of the theory that you can’t avoid down days without missing the few big up days that provide most of the return, and leads to the concept of buy-and-hold at all costs.  However, most investors have a limit where they must exit the market in order to preserve what they have left.  Referring to this as “timing” provides lots of support to the argument that timing the market is detrimental.  However, buying low and selling high can be achieved when emotion is taken out of the equation, particularly when momentum is taken into account.

“Warren Buffett, the greatest investor in the world, is a buy-and-hold advocate” – Although this statement is true, Mr. Buffett does not practice buy-and-hold like your average mutual fund owner.  Unless you are in a position to buy a company, install the management, and hold them accountable for long-term performance, comparisons to Warren Buffett are probably not justified.

“Diversification will protect against losses” – As we saw in 2008, diversification alone is not enough, with even bond funds taking double-digit losses.  What makes matters worse, most if not all traditional equity classes (U.S./foreign, large-cap/small-cap, etc) are now so correlated, they are essentially inneffective at providing any kind of diversification.  Under most market conditions, diversification can provide lower volatility and improved long-term returns, but it requires assets that are truely non-correlated, and it still does not provide absolute protection.

I’m sure there’s more of these, but these are just a few that I continue to run into.

Posted by: Jerry Verseput | August 21, 2009

Market Is On A Roll – Be Careful

The market is firing on all cylinders, and without a doubt, this is a great and welcome thing (unless, of course, you’re still waiting to get back in).  The Dow closed today above 9500, which gets it back to November 5 levels.  Ben Bernanke said today that the economy is near a recovery, and Treasury prices fell significantly as investors dumped Treasuries and put money into the stock market.  All this is great if you’ve been in the market for the last couple of months, but now is also a time to be careful.

The S&P 500 is now up 15.5% for the year.  That’s not bad, but nothing compared to the 53.1% it has recovered since March 9.  That’s a huge gain in a relatively short amount of time, and at the risk of looking a gift horse in the mouth, it makes me a little nervous.  Here’s why.

Markets can “melt up” just like they can meltdown.  A melt up is caused by investors with cash becoming increasingly scared that they are missing the gains (which they are).  The higher and faster the market goes up, the more emotional investors it tends to attract.  Again, the same thing as a meltdown but in the opposite direction.  At some point, some big institutional investors who caught a good chunk of the recovery will take some profits and cause the market to drop by some amount.  Imagine if you finally made the decision today to get back in, after the market has made a 50% gain, and next week the market starts pulling back.  The natural reaction would be “Oh no, I’m wrong again!” (although maybe with more expletives).  Many of these investors get back out at the first sign of trouble, which compounds the problem and creates a severe pull-back.

This happens all the time, and the chances for a strong pull-back get higher when the market goes up fast.  This is why many professional traders (not the reporters on CNBC) would rather see a smooth, orderly recovery instead of panic buying.

So given a 50% gain in less than 6 months, is a severe pullback inevitable?  No.  Mainly because when everyone expects the market to do something, it rarely happens.  At least on the expected timetable.  The point is to be cautious.  After a 50% rise from the bottom, many institutional investors are sitting on large gains and many new investors have recently entered the market.  That makes conditions rather precarious.  I would like to see the market sit still for a while, which basically lets the market catch up with itself and the emotional buying to slow down.  In the meantime, I’m happy to ride the rally, but with my finger on the dump button.

Posted by: Jerry Verseput | August 17, 2009

Modern Portfolio Theory Isn’t Dead

It took me a while to comment on this, but InvestmentNews had an interesting article titled Is Modern Portfolio Theory Dead?  As a quick and simplified summary, MPT describes the relationship between investment risk and expected return (higher risk should yield higher long-term return).  It also states that a diversified portfolio will lower risk.   The author (Brad McMillan) argued that MPT has been working just fine for portfolios that contained bonds, managed futures and other non-correlated assets, but that “many of us did not appreciate the …correlation potential of equities.  We bought large-cap and small-cap, domestic and foreign, emerging markets and real estate investment trusts, and said we had a diversified portfolio…In 2008, equities acted like equities.”

So if buying large-cap and small-cap, domestic and foreign, emerging markets and real estate, does not help diversify a portfolio, why do we complicate portfolios by holding separate funds for each of these?  The historical data certainly supports the fact that most of these categories do not operate differently enough to diversify a portfolio.  Large cap and small cap classes have correlated by about 95% over the last 5 years, so I agree with that part.  I also agree that alternative investments such as managed futures, commodities and other non-correlated asset classes can help improve diversification.  However, simply accepting that traditional equity classes all correlate misses additional improvements that can be made to strengthen portfolios.

The correlation problem stems from the fact that a large U.S. energy company and a small foreign energy company will probably behave similarly when oil falls from $150/barrel to $35/barrel.  This was not necessarily the case 30 years ago, but is definitely true today.  Since large cap mutual funds and small cap mutual funds often chase the same sectors, as a whole there just isn’t enough difference to help diversify a portfolio.  The same holds true for U.S. versus foreign funds, and to a lesser extent, value versus growth funds.  However, low correlation between stocks can still be found if you divide them by sectors.  Energy sector stocks don’t have a lot of influence on Healthcare sector stocks, and Technology stocks don’t affect Utility stocks very much.  So the problem is not necessarily that all equities behave the same, but that we tend to categorize them into groups that behave the same.

My conclusion is that Modern Portfolio Theory is not dead, as seen by the fact that portfolios containing non-diversified asset classes (fixed income, managed futures, etc) did better in 2008 than equity-only portfolios.  However, that doesn’t mean we should give up on diversification within the equity class, which often makes up the largest portion of a growth-oriented portfolio.  Diversifying equities by non-correlated sectors instead of the mutual fund-oriented large-cap/small-cap, U.S./foreign, and growth/value  classes results in much less correlation, and is a better implementation of Modern Portfolio Theory.

Posted by: Jerry Verseput | August 12, 2009

More Free Money

The Fed decided to put off any economic withdrawal pains by extending the supply of free money, the economic equivalent of crack.  The market seemed to like it (as most addicts would), as well as the Fed’s opinion that there is no inflation on the horizon.  So for now, the best thing to do is continue to ride the market up, but with a finger on the dump button.  Here are a few things that have me nervous about this rally:

- When trading volume hit its peak last October, the S&P500 was around 900 and volume was 3X to 4X what it is now.  The S&P500 is now at 1000.  The market can go up on light volume, but typically falls back to areas of heavy volume.

- Extremely low interest rates have been driving the dollar down, which is good for stocks (temporarily) and makes our debt cheaper, so it’s good for politicians too.  However, the Fed said today it would stop buying Treasuries in October.  Although I’m not an economist, it seems that if the government is buying lots of bonds, that would keep the price high (and therefore yields low).  When this huge buyer is taken out of the picture, demand and bond prices will drop, which causes yields and interest rates to rise.  That can end badly (high inflation), depending on how much government purchases of Treasuries have propped up prices.

A lot of analysts and advisors are talking about the inevitable pullback that will happen, and the inevitable return to high inflation.  The problem is that whenever something is “inevitable” in the market, it almost never happens the way most people anticipate.  My firm prediction is that the market will go down again.  I’m just not going to say when.  However, since I’ve now predicted it, I can claim credit for an accurate prediction.

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