April 2009 - Posts

• Why Our Advice Remains the Same

  It can be hard to hear that the best course of action during tough market times may be to do nothing. It can be even harder to hear that same message over and over as things seem to get worse. But it is a message we would not repeat if we did not truly believe it was in your best interests. The following discusses why our message is not wavering despite the market. ____________________________________________________________ Buy and hold. Rebalance. Stay the course. That is the advice we repeat again and again. Over the long term, that advice has served our clients well. Yet, in the face of the persistent bear market, a common refrain from investors has gone something like this: “Yes, that advice has worked in the past. However, this time is different. It obviously isn’t working now! The market just keeps going down and down. There must be a better alternative than to sit and do nothing.”           While we empathize with investors who feel a great sense of loss, we don’t believe we are being stubborn. Our advice has always been (and will always be) based on the scientific evidence, not on our opinions about where the markets may be headed. And while this crisis is certainly different in some ways than other crises, we see no reason to change the investment advice. Market Efficiency For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to be first convinced that markets were no longer efficient. In other words, the market was now mispricing assets and was slow to react to new information.   It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. After Treasury Secretary Timothy Geithner unveiled the Treasury Department’s plan to clean up toxic assets, the market reacted immediately, as evidenced by several indexes leaping to their highest one-day gains since last fall.   We see no evidence that active managers were able to predict this bear market. In fact, while there was a wide dispersion in individual stock returns (some stocks, like Wal-Mart were actually up), almost every single diversified mutual fund produced large losses. This would not be the case if markets were somehow inefficient. It is also important to note that there is no evidence that active managers consistently outperform in bear markets.   We believe that the market was and continues to be highly efficient. It is just that the news has been persistently worse than expected, causing prices to fall. This is what causes bear markets.   Market Timing As to trying to time the market, we again rely on the historical evidence. When a client suggests just getting out until things are clear again, we point out that the evidence on market timing is even worse than on stock selection. For example, the publication Timer Digest showed that of the 112 market timers tracked from 1991 through 2000, only one managed returns that beat the S&P 500 Index. We don’t like those odds. Neither should investors.   One reason that market timing fails is that so much of the market’s return occurs during very brief and unpredictable periods. Another reason is that investors have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. Investors that go to cash may be “whipsawed.” They will get out after a severe drop, miss a big rally and jump back in only to experience another severe loss. They end up worse than if they simply stayed the course. That is why we believe going to cash is not the winning strategy. The Difference Between Information and Wisdom We can define information as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess (above market) profits. When we ask people why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” Then they give a laundry list of negative items. The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices? After all, that is why prices have already gone down.   They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?   Many investors have considered selling because of concerns about the “Europeanization of our economy.” Should investors sell? To answer that question, one must understand that these concerns are well known by the market. While concerns about government intervention, higher taxes and an increased ratio of debt to gross national product can all affect stock prices, those concerns are already reflected in prices. That is why stock prices moved lower as the new administration unveiled its policies. As Bernard Baruch stated, “Something that everyone knows isn’t worth knowing.”   Investors feeling the need to sell should also consider the following. There is a “universe of risk.” Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks. The Relationship Between Risk and Expected Return    If the perception of risks are high (which they are during bear markets), so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high (after bull markets when risk premiums are low) and selling low (afterbear markets when risk premiums are high) when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.   “Defensive” Strategies Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven’t matched the promise.   Vanguard examined the performance of several different signals based on “conventional wisdom” to see if they actually translated into better risk-adjusted returns.1 As one example, the authors studied whether investors could improve portfolio performance by defensively shifting equity exposure toward less-cyclical, lower-beta sectors (such as health care, consumer staples or utilities). This strategy is based on documented evidence that certain sectors tend to thrive in different stages of the business cycle. Unfortunately, they found that "a defensive investment strategy based on the leading signals of bear markets and recessions (focusing primarily on recessions) would not have resulted in better results than following a buy-and-hold strategy." Among the problems they found are "the low predictive power of even the best signals of bear markets and recessions, and potentially high transaction and tax costs."   Another signal they examined is the presence of an inverted yield curve (short-term interest rates exceed long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is noisy: "For the period 1952 through 2006, the yield curve has inverted 19 times, but the U.S. economy lapsed into recession only nine times."   They also examined the forward-looking price-to-earnings ratio. The concept is based on the idea that a bear-market signal is given when the ratio is at historic highs. Unfortunately, this indicator is also noisy and, thus, has provided no value.   While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.” Summary Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”2 Thus, our advice will continue to be the same, because that is what the science demonstrates is the most likely way to achieve one’s goals. When we find compelling evidence, published in peer reviewed academic journals, that there is a superior alternative strategy, we will do what smart people do; they change their strategy in the face of new evidence. Until then, our advice remains: buy, hold, rebalance and stay the course.    1   Joseph Davis and Christopher Philips, Noisy Signals: A Challenge to Tactical Strategies. Vanguard Investment Perspectives, Spring/Summer 2008. 2   Peter Bernstein, Wimps and Consequences. Journal of Portfolio Management, October 1999. 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 Apr 20 2009, 12:36 AM by Jim Cornfeld

• Hazardous to Your Wealth

  The massive downturn in the market in 2008 provided active managers and stock forecasters several opportunities to demonstrate their value. The following shows that even with a low bar set for outperformance, they had a difficult time meeting the challenge. _________________________________________________________ There’s little doubt 2008 was a tough year for investors, as the stock market turned in one of its worst performances in history. The S&P 500 Index, for example, was down 37 percent for the year — the worst performance for the S&P 500 since 1931, when it fell 43 percent.   But such a dramatic downturn in the market should have provided active fund managers with ample opportunities to outperform. Even turning in stock picks that simply finished the year in the same place they started would have significantly outperformed the market.   Given the massive amount of media coverage of the current market conditions, one would think that managers that beat the market would be heavily touted right now. But those stories seem to be few and far between. In fact, by looking back at some of the predictions offered in late 2007 and early 2008, investors can see that active management still has not proven to be the winning strategy.   Swing and a Miss In a December 31, 2007 article “What the Pros Are Saying,” BusinessWeek surveyed several prominent investment analysts and managers about their thoughts on the performance of the stock market during 2008. One money manager surveyed had previously achieved fame by advising clients to sell before the stock market crash of October 1987.   Her outlook was much more upbeat this time around. She predicted that the Dow Jones Industrial Average (DJIA) and the S&P 500 would both post 20 percent gains. “Our models show the S&P 500 is undervalued by 25%.”   Not quite. The DJIA fell by 31.9 percent and the S&P 500 finished 2008 down 37 percent. As an added insult, this manager had been advising clients to buy stocks her firm felt were significantly beaten down, specifically mentioning Lehman Brothers (which failed), Bear Stearns (which was rescued by JP Morgan) and Merrill Lynch (which was absorbed by Bank of America).   Big Bets on Big Banks The January 7, 2008 Forbes article “Seize the Day” acknowledged that financial stocks had been hit hard by the credit crunch. Still, investors looking for cheap stocks with good potential were steered toward banks: “Those who buy bank stocks should be well rewarded over the next couple of years.”   To be fair, the article’s author was looking further down the road than just in 2008. Still, the group of stocks recommended to investors reads like a who’s who of the top financial bad news makers of the year:   Company Name 2008 Return Bank of America –63.1% Citigroup –76.0% KeyCorp –61.6% JP Morgan –25.1% Washington Mutual –99.8% Freddie Mac –97.8% Benchmark 2008 Return S&P 500 –37.0%    Best of the Old and Best of the New How about the top fund managers of today? Would they be able to spot value in the market chaos? Could they outperform the market and keep their impressive track records? The December 24, 2007 Fortune article “Old Masters and New Classics” profiled the magazine’s best bets for funds that would deliver solid returns. “Old or new, one thing’s for sure: With the stock market booming or swooning depending on the news of the day, it’s more worthwhile than ever to have one of these steady hands guiding your investment decisions,” the article read.   The article picked six funds: two large-cap, one mid-cap, one small-cap and two international funds. An evenly weighted portfolio of these six funds would have returned –41.7 percent in 2008. By comparison, a portfolio of two-thirds S&P 500 and one-third MSCI EAFE Index would have yielded a return of –39.1 percent in 2008.   Summary Even though the poor market performance in 2008 provided opportunities for many prognosticators to demonstrate their abilities, few lived up to the challenge. Instead of following their advice, investors would be better served to listen to advisors who account for an investor’s ability, willingness and need to take risk and who build financial plans to match. 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 Apr 14 2009, 04:32 PM by Jim Cornfeld

• Is Inflation Inevitable?

  The significant amount of stimulus being injected into the economy may have investors wondering what this will mean for inflation. The following discusses why inflation fears may be premature.  _________________________________________________________   One of the most frequently asked questions regarding the stimulus being pumped into the economy is: What should we do about the resulting inflation problem we are going to face? While there is risk that the massive budget deficits and the monetary stimulus will translate into rising inflation, this outcome is not inevitable. One only has to look to Japan to see that inflation is not inevitable.   In 1990, the Japanese economy went into a tailspin. The stock market and real estate values collapsed, and the Japanese government took action by both adopting a zero interest rate policy and also embarking on a program of massive fiscal stimulus, including significant spending on infrastructure. The Japanese government ran large budget deficits, and the result is that the country’s debt to gross national product ratio is nearly 200 percent. Yet despite the monetary and fiscal stimulus, the biggest concern for Japan has not been inflation, but deflation.   Regarding the United States, the velocity of money has been falling due to a rapid drop in spending. To offset the sharp drop in money velocity, the money supply must be increased, or the economy would collapse. And with banks, corporations and consumers deleveraging, the government is the only one left to offset deleveraging’s negative effects (hence the fiscal stimulus).   Because of the collapse of consumer and business spending, there is no real threat of inflation in the short term. (In fact, the greater risk is deflation.) However, once the economy recovers and the velocity of money increases, the Federal Reserve will need to remove the excess liquidity it has injected, or inflation will soar. Hopefully, the Fed has learned from the mistakes of 2003, when it kept the realfederal funds rate in negative territory. (The nominal rate remained at 1 percent while inflation was 2 percent, and the economy was already recovering from the recession.)   The need for fixed income investments remains unchanged. Investors should consider owning TIPS and high-quality, short- to intermediate-term securities to minimize the risks of unexpected inflation. In addition, TIPS provide the added benefit of having negative correlation to equities. Investors can also consider a small allocation to commodities through an investment in fully collateralized commodity futures as an inflation hedge. Commodities tend to have their best performance during periods of rising inflation.   Summary  While the size of the stimulus employed to counter the effects of the severe recession increases the risks of inflation, the Japanese experience demonstrates that the outcome is far from certain. Thus, investors should be wary about reacting to the noise from the “talking heads” advising them to alter their well-designed plans. Investors should check with their advisors to see how their investment plan is designed to address inflation fears. For those who are not adequately prepared for inflation possibilities, they should consider tailoring their fixed income allocations to address that need.   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 Apr 06 2009, 06:30 PM by Jim Cornfeld