March 2009 - Posts

• Disciplined Investing in a Difficult Market

  When difficult periods of market activity arrive, they remind investors of the importance of a disciplined approach to investing. The following discusses some of the lessons recently reinforced.  Whenever a market crisis enters the picture, investors can count on certain words being bandied about in the media, such as unprecedented, new territory, unfamiliar and extraordinary. The events themselves may well be unprecedented, but the basic lessons these events reinforce are not. But with the downfall of prominent companies such as Lehman Brothers, Merrill Lynch, AIG, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), investors can take this opportunity to recognize some basic principles of prudent investing for the next time unprecedented market activity occurs. What Happened In the case of Lehman, the firm’s downfall was fueled by troubled real-estate investments. From 2004–2007, Lehman posted record profits, but also began accumulating billions of dollars in risky securities, loans and mortgages tied to real estate. This trend continued into 2008, as the company posted a profit in the first quarter while increasing its exposure to Alt-A loans (which are loans riskier than prime mortgages, but less risky than subprime). As the values on those mortgages fell, the company attempted to raise additional capital, but was unable to do so. One of the final straws came shortly before the company announced its intention to file for bankruptcy. News leaked that talks involving a substantial investment from Korea Development Bank had failed. Merrill Lynch faced a similar situation. Like Lehman, Merrill carried tens of billions of dollars in risky, hard-to-sell assets when the credit crunch took full effect in 2007. Those assets deteriorated in value, forcing the company to raise additional capital. However, losses continued to pile up, and subsequent attempts to raise capital did little to lift the company’s deteriorating stock price. As The Wall Street Journal (WSJ) points out, AIG was healthy in many ways, but a single unit caused massive losses that weighed down the company. This unit sold credit-default swaps, which were designed to protect investors against defaulting assets, including subprime mortgages. “The division’s problems largely drove AIG to report $18 billion in losses in recent quarters, forcing AIG to put up billions more in collateral, straining its financial resources. Downgrades from ratings agencies and relentless pressure on the company’s stock exacerbated its already weak position.”1 Market activity such as what has recently happened typically serves as a painful, yet necessary reminder of why equity investing has had greater returns than other, “safer” instruments. Risk is always present. However, bear markets also reinforce several other important investing principles. Stock Prices Incorporate Known Information Between January and September of 2008, several firms saw their stock prices battered as the market reacted to news about the health of each company. The firms mentioned above each saw their stock prices fall during 2008. However, investors still appeared to be shocked when each firm met its fate.   Changes in Stock Prices   Stock Price Jan. 2 Stock Price Sept. 2 % Change Since Jan. 2 Stock Price Sept. 16 % Change in September Lehman Brothers $65.30 $17.45 –73.3% $0.30 –98.3% Merrill Lynch $53.71 $29.11 –45.8% $22.18 –23.8% AIG $58.59 $22.20 –62.1% $3.75 –83.1% Fannie Mae $40.20 $7.50 –81.3% $0.48 –93.6% Freddie Mac $34.42 $5.20 –84.9% $0.26 –95.0% Such a move augments the notion that markets incorporate known information into stock prices. In the case of these companies, the market recognized that they were in trouble, and the stock price fell. However, the market did not know the full extent of the trouble until each company met its fate. This is reflected in the changes seen in the stock prices in September. In all but one case, the price fell more percentage-wise in two weeks than it had since the beginning of the year. Individual Stock Speculating Consider the cases of investors who held individual shares of some of the battered companies. The collapse and subsequent takeover of Fannie Mae and Freddie Mac left many investors in its wake. The WSJ discusses the tale of one investor who believed he could profit from the situation at Freddie Mac. In early September, this investor purchased about 25,000 shares of the company at $5 per share, believing the price would rebound. Instead, the government takeover drove the price down significantly further. “Now he says he is out more than $100,000 — money that he was saving for his young sons’ college education.”2 About the only solace this investor may find is knowing that even the most reputable of investors fell victim to investments in these companies. Famed investment manager Peter Lynch disclosed that he held Fannie Mae — which he has cited many times as a favorite stock — in his personal portfolio because he believed the company would post big earnings in 2011. “‘I can be just as dumb as anybody else,’ he says wryly.”3 Diversification Lehman Brothers in particular reinforced the notion that investors should be wary of holding significant percentages of their assets in their company’s stock. Shortly after the news about the impending bankruptcy broke, the WSJ noted in a September 12 article that Lehman employees lost about $10 billion in paper wealth when the stock price plummeted to $4 per share. The employees owned an estimated 25 percent of the company.4 To say that Richard Fuld, the company’s CEO, held a significant stake in the company might be an understatement. Fuld had accumulated 10.9 million shares of Lehman stock during his 41 years with the company. As of January 31, those shares amounted to a worth of $695 million. That September article showed those shares had plummeted 93 percent in value, leaving Fuld holding shares worth $45.8 million. However, the freefall did not stop there. Two weeks later, the WSJ reported that Fuld sold some of his shares after the company filed for bankruptcy. By that time, the share values had dropped to mere pennies, and Fuld sold 3.17 million shares (or about 30 percent) for $660,209.5 One can only wonder just how much equity vanished from the portfolios of other Lehman employees. Remember, the $10 billion in equity that Lehman employees lost was cited when the company’s stock was hovering at $4 per share, not the pennies per share where the stock currently sits. Hindsight Bias Investors may also hear about how “inevitable” each company’s downfall was. By now, some may be convinced that anyone who was paying attention could have seen each of these situations unfold long before it actually happened. However, investors should be wary of the instinct to view such situations as easily recognizable. This sudden inevitability has another side effect, one that can be even more damaging to investors and their portfolios. In a September 16 article in the WSJ, columnist Jason Zweig points out that looking back at what now appears to have been obvious could create problems for investors as they look toward the future. “By retroactively fooling us into thinking that we knew how the past would unfold, hindsight bias tricks us into thinking we know how the future will unfold,” Zweig writes. “But if the past took you by surprise, why should you believe you can decipher the future?”6 He related the story of Scott Jaffa, an investor who called the September 15 stock market plunge a test of his psychology. “Because he does not need the money ‘for another 30 to 40 years,’ he asked rhetorically, ‘why should I worry myself about its performance over a period of days or weeks or even months?’”7 Investors would do well to follow in this investor’s footsteps. But as Zweig pointed out, it does not come naturally. “A year and a half ago, Mr. Jaffa destroyed the online access code for his 401(k) so he could no longer have instant access to his retirement accounts. His goal was to make it ‘significantly harder’ and to require ‘human interaction’ before he could trade on his emotions. That enabled him to watch the market's decline without acting on it.”8 Summary Investors can look to their advisors for help controlling such emotions. A good advisor will help clients remember the importance of adhering to their well-developed plan.    -------------  1   Monica Langley, Deborah Solomon and Matthew Karnitschnig, "Bad Bets and Cash Crunch Pushed Ailing AIG to Brink." Wall Street Journal, September 18, 2008. 2   Craig Karmin, "Small Fannie, Freddie Holders Take Issue With Washington." Wall Street Journal, September 12, 2008. 3   Karen Blumenthal, "Bogle's Bets: Pros Offer Advice on Investing Now." Wall Street Journal, September 24, 2008. 4   Randall Smith, Susanne Craig and Annelena Lobb, "The Lehman Stock Slide Hits Home: Employees Face $10 Billion in Losses." Wall Street Journal, September 12, 2008. 5   Nicolas Brulliard, "As Lehman Liquidates, so, Too, Do Executives." Wall Street Journal, September 24, 2008. 6   Jason Zweig, "How to Handle a Market Gone Mad." Wall Street Journal, September 16, 2008. 7   Ibid. 8   Ibid.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2009, Buckingham Family of Financial Services.  All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Posted Mar 29 2009, 02:19 PM by Jim Cornfeld

• Black Swans

  When the market experiences significant swings, some investors may be tempted to try to time the market in an effort to boost returns. The following explains why it is extremely difficult, if not impossible, to enhance returns through market timing efforts. In his book The Black Swan, Nassim Nicholas Taleb notes three things that constitute a black swan:1 It is an outlier, as it lies outside the realm of regular exceptions. It carries an extreme impact. Human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.   In other words, events that occur without any forewarning that they would occur are considered black swans. The events of September 11, 2001 are an example of a black swan, as is the stock market crash of October 19, 1987, when the Dow fell 23 percent in one day. If investors could avoid the effects of black swans, the impact on investment returns would be enormous. Consider the following: The working paper, “Black Swans and Market Timing: How Not to Generate Alpha,” studied stock market returns in 15 developed countries (including the U.S.) for varying time periods, ranging from 31 years for Canada and Thailand to 79 years for the U.S. The authors found that if investors could avoid the worst 10 days, their returns would be 150 percent more than the returns of buy-and-hold investors.2 This makes market timing a tempting strategy. However, before being tempted, consider these words of wisdom from legendary investor Peter Lynch, who noted that he had never seen a market timer on Forbes’ list of the richest people in the world: “If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”3 Lynch’s warning is supported by the evidence demonstrating the staggering odds against the likelihood of successfully timing the market, such as the aforementioned working paper. Here are some of the paper’s findings: Stock Returns Are Not Normally Distributed Black swans appear with far greater frequency than predicted by normal distributions. For example, for the Dow Jones Industrial Average, 29,190 trading days (107 years) produced a daily mean return of 0.02 percent and a standard deviation of 1.07 percent. This means investors should expect 39 days to produce returns above 3.22 percent and 39 days to produce returns below –3.17 percent. However, there were six times the number of returns outside that range — 253 daily returns below –3.17 percent and 208 above 3.22 percent. Also consider the evidence in the following table:  Mean Returns   Returns Standard Deviations From the Mean Best 10 Days 11.10% 10.4 Best 20 Days 9.37% 8.8 Best 100 Days 5.92% 5.5 Mean Return 0.02% N/A Worst 10 Days –10.46% 9.8 Worst 20 Days –8.73% 8.2 Worst 100 Days –5.87% 5.5 Impact of Missing the Best and Worst Days The table above also demonstrates how the markets' returns (both good and bad) often come from short bursts. The following table shows how missing the best days and worst days of the market would affect overall returns.  Missing Best and Worst Days     Change in Terminal Wealth Best 10 Days –65% Best 20 Days –83% Best 100 Days –99.7% Worst 10 Days +206% Worst 20 Days +532% Worst 100 Days +43,397% The author concluded: “These figures speak for themselves and should help investors notice the odds they are against when trying to successfully time the market. A negligible proportion of days determines a massive creation or destruction of wealth. The odds against successful market timing are just staggering.” International Markets Produce Same Results The departure from normal distributions was clear in all 15 countries studied:  Australia Italy Switzerland Canada Japan Taiwan France New Zealand Thailand Germany Singapore United Kingdom Hong Kong Spain United States Across all 15 markets, the average number of outliers was more than five times higher than expected. Also, in 14 of the 15 countries (with the exception of Australia) missing the 100 best days resulted in a loss of initial capital invested. Conclusions In his book Common Sense on Mutual Funds, John Bogle said “After nearly 50 years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”4 Bogle understood that investors do not earn returns smoothly over time. Instead, they earn them largely as a result of unpredictable bursts and crashes. Given that so much of the action happens on a small number of days, the odds of successfully predicting the days to be in and out of the markets are close to zero. The real danger for investors is not being there when the big up moves occur. The winning strategy is to both accept that markets cannot be timed and build the expectation of black swans into an investment plan. Forewarned is forearmed. In addition, broad global diversification (including an allocation to high quality fixed income assets sufficient to reduce overall portfolio risk to an acceptable level) helps mitigate the impact of the inevitable appearance of black swans. As the working paper’s author, Javier Estrada, concluded: “Much like going to Vegas, market timing may be an entertaining pastime, but not a good way to make money.”5 1   Nassim Nicholas Taleb, The Black Swan. (Random House, 2007). 2   Javier Estrada, “Black Swans and Market Timing: How Not to Generate Alpha.” Working Paper, November 2007. 3   Peter Lynch, “Fear of Crashing.” Worth, September 1995. 4   John Bogle, Common Sense on Mutual Funds. (Wiley, 1999). 5   Javier Estrada. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2009, Buckingham Family of Financial Services.  All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Posted Mar 25 2009, 06:34 PM by Jim Cornfeld

• Seeking Shelter From the Storm

  Investors seeking shelter from the current market storm may be tempted to try to bet on the next winning investment sector. The following discusses why such a strategy may not be in investors' best interests.  ___________________________________________________ Many investors may be seeking safe havens from the current market storm. Others may be looking for those "diamond in the rough" stocks or investing sectors that will get their portfolios back on track after such a devastating period. Perhaps lessons from the Great Depression can provide such investing insights. As luck would have it, there is one sector that produced significant returns in the three years following the market crash of 1929. Those looking for that safe haven may want to get ready to jump into ... logging. In a February 14, 2009 article in The Wall Street Journal, columnist Jason Zweig teamed up with the Center for Research in Security Prices (CRSP) to see how various investing sectors performed 1930-1932 (after the stock market had lost one-third of its value in the crash). Logging was the only industry to post positive returns during that time period with a cumulative gain of 40 percent. It should be noted that the sector contained two stocks: one company that made trees into packing materials and one that turned timber into matchsticks. It is doubtful that many investors would have pegged the logging industry as being the mostly likely to rebound from portfolio devastation of the Great Depression, which is why remaining diversified is likely to prove to be the right strategy for investors. History has continued to show that rebounding returns come from some unexpected places. Consider some more recent evidence. In the year following the 1987-1989 bear market, the top performing market sector was financial stocks, returning 64.9 percent in the 12 months following the trough of the preceding bear market. Of course, investing in financial stocks in this market may seem more like holding a lightning rod to the sky than ducking out of the downpour. Similarly, the year following the 2000-2002 bear market saw information technology stocks rise up as the top performing investing sector. At that point in time, investing in technology-related stocks would likely have been a difficult call for many investors, as technology stocks are typically blamed for that bear market in the first place. History has shown that market rebounds typically come quickly, and the top performing sectors are often unidentifiable. Some investors may still scramble to find the perfect place to park money until the storm passes. Few (if any) can know when markets will recover and what sectors will lead the way. And history has also shown that those who do make such correct predictions are more likely to be lucky than good. According to the historical evidence, trying to pick winning stocks and time the market is more likely to lead to investors lagging the returns of the market, rather than outperforming them. Consider the evidence by Timer Digest, which tracks buy and sell calls from financial newsletters. The publication showed that of the 112 market timers tracked from 1991 through 2000, only one managed returns that beat the S&P 500 Index. If that is not enough, consider the story of Benjamin Graham, considered one of the finest stock pickers to walk the earth. The Father of Security Analysis Graham wrote two books - Security Analysis (first published in 1934) and The Intelligent Investor (first published in 1949) - that are still considered among the finest investing books ever written, even today. Warren Buffett summed up The Intelligent Investor by simply calling it, "By far the best book about investing ever written." Graham's basic investing philosophy was to thoroughly analyze stocks and to only buy stocks once they were considered dirt cheap. This underscores the premise that working hard enough at analyzing stocks will eventually produce superior returns. However, Graham seemed to recant this stance shortly before his death in 1976. Here's what he told The Journal of Finance: "I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Security Analysis was first published; but the situation has changed. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost." In an article in Slate magazine, Henry Blodget said that Graham's words reflected a more diversified and high-level stock selection strategy, rather than attempting to pick individual winners or sectors. "Specifically, Graham recommended screening stocks using simple valuation and fundamental criteria and then buying large groups of them, the same way a modern ‘passive' fund (such as a value-oriented index fund) does. What Graham did ‘recant' was the idea that by studying companies in detail, one could identify a few super-promising opportunities that could safely deliver market-crushing returns." Summary During difficult market conditions, many investors may be tempted to seek out the fast-recovering sectors in hopes of getting their portfolios "back on track." As history has shown, the odds of choosing the right stocks or sectors are slim and largely based on luck. Even investing legends such as Graham recognize the fallacy of trying to pick the next winners. The preferred strategy for investors should be to remain diversified.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2009, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Mar 18 2009, 02:18 PM by Jim Cornfeld

• Diversification: Is It Working?

  Overview: Diversification has proven to be a winning strategy for most investors, who believe that it will protect them in all bear markets. However, the recent market volatility has shown that is not the case. The following discusses how investors should view diversification. _________________________________________________ A common refrain from investors during this financial crisis has been: "I am as diversified as it gets. I have substantial exposure to small-cap, value and international stocks. Yet every single asset class dropped during this downturn. As far as I can tell, there was no protection at all from owning all these asset classes. I would say that diversification does not protect during a steep downturn." What went wrong? Absolutely nothing. The problem is that many investors do not fully understand the concept of correlation of returns. Correlation of Returns Prudent investors build portfolios that include asset classes with low correlation (the measure of the strength of the linear relationship between two variables). Values can range from +1.00 (perfect correlation) to -1.00 (perfect negative correlation). Positive correlation means that when one asset produces positive returns, the other tends to also produce positive returns, and vice versa. Negative correlation means that when one produces positive returns, the other tends to produce negative returns, and vice versa. Thus, the lower the correlation of returns, the more effective the asset class is as a diversifier of portfolio risk. The following table demonstrates the relatively low correlations of the S&P 500 Index to various asset classes. Indexes Annual Correlation to the S&P 500 Index Fama-French Large Value 0.75 Fama-French Small 0.70 Fama-French Small Value 0.52 Wilshire REIT Index 0.18 MSCI EAFE Index 0.61 MSCI Emerging Market Index 0.33 Based on these historical relationships, many investors expect each of these asset classes to do poorly from time to time, but not all at the same time. Unfortunately, these investors make the mistake of not putting enough emphasis on the key words: "tends to." The problem for such investors is they fail to understand that correlations are not stable; they drift. And while international stocks and emerging market stocks are exposed to some different economic and political risks than U.S. stocks, they are also exposed to some of the same risks that can impact the global economy. When those risks show up (typically during times of financial and/or political crises), correlations among all asset classes tend to turn high. Just when the benefits of diversification are needed most, they go AWOL. A popular investing expression is that "the only thing you don't know about investing is the investment history you don't know." Knowing the history of returns would have prevented investors from misunderstanding the benefits of equity diversification. The latest financial crisis revealed nothing new about correlations. For example, major equity asset classes produced negative returns during the global recession of 1973-74 as the S&P 500, large-cap value stocks, small-cap stocks, small-cap value stocks and international large-cap stocks fell 37, 26, 53, 41 and 33 percent, respectively. There was no place to hide. The same thing happened both during the Asian contagion in the summer of 1998 and in the aftermath of the events of Sept. 11. And the systemic risk of equities showed up again when the financial crisis that began with U.S. housing prices falling sharply spread around the world in the summer of 2008. Major equity asset classes experienced dramatic bear markets. In some cases, it was the worst since the Great Depression. The following table shows the total return for various asset classes during each of the aforementioned crises. Note that in each crisis, the correlations of returns rose dramatically. The only difference this time is the depth of the bear market.   Asset Class July-August 1998 (%) September 2001 (%) January-October 2008 (%) Domestic Large-Cap -15.4 -8.1 -32.8 Real Estate  -15.8 -4.2 -31.5 Domestic Large-Cap Value -14.7 -7.8 -29.3 Domestic Small-Cap -26.0 -14.8 -32.8 Domestic Small-Cap Value -22.8 -14.4 -24.6 International Large-Cap -11.5 -10.1 -43.3 International Small-Cap N/A -13.3 -47.9 Emerging Markets -26.7 -15.5 -53.1   The Lesson Most of the time, risky asset classes do not exhibit high correlation, and many even have very low correlations. Among the asset classes that have low correlation with U.S. equities on average are real estate, international small-cap stocks and emerging market stocks. The reason for the low correlations is that economic and political conditions impact the various asset classes in different ways most of the time. However, in times of global crisis, risky assets tend to correlate highly. And that leads us to the important lesson the markets teach us. In times of crisis, the only effective diversifier of equity risk is very high-quality fixed income investments. (The safest of which are obligations that carry the full faith and credit of the U.S. government.) During the most recent crisis, while equity asset classes were experiencing severe bear markets, U.S. Treasury instruments were providing positive returns. Before concluding, there is one more important point we need to address. Is the Investment World Flat? The financial media has run numerous stories about the rise in global correlations. The story goes something like "We are becoming one globally integrated economy ..." and gives the impression that the benefits of diversification are greatly reduced. It seems that this is becoming conventional wisdom - an idea so accepted that it goes unchallenged. However, before one accepts such "wisdom," we can look at the evidence. Consider the correlations between the S&P 500 and the MSCI EAFE. From 1970-2007, the annual correlation was 0.586. By dividing the full period in half, we can see if there has been any trend toward rising correlations. From 1970-1988, the annual correlation was 0.623. From 1989-2007, the annual correlation was 0.614. Obviously, there has not been a general rise in correlations. The recent rise in correlations is nothing more than a result of the financial crisis. We have had crises in the past, and we will likely have them in the future. And the correlation of risky assets will likely rise as well. Conclusion It is important that investors understand that correlations are not static and are likely to rise to high levels during times of crisis. Thus, the winning strategy is to make sure that portfolios have sufficient allocations to high-quality fixed income assets - an amount sufficient to dampen overall portfolio risk to the level that does not exceed your ability, willingness and need to take risk. Spanish philosopher George Santayana said: "Those who cannot remember the past are condemned to repeat it." The financial markets have provided investors with lessons to remind them that broad global diversification across equity allocations would not protect them from all bear markets. Investors who do not have sufficient amounts of high-quality fixed income assets to reduce overall portfolio risk to an acceptable level are likely to fail the tests that the markets provide. Finally, it is important to understand that even the smartest people make mistakes, but it is a mistake to repeat or perpetuate them. Therefore, investors without sufficient allocations to high-quality fixed income assets that dampen overall portfolio risk to an appropriate level (based on their ability, willingness and need to take risk) should rewrite their asset allocation plans to correct that error.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2009, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Mar 16 2009, 11:27 AM by Jim Cornfeld