Housing Has Yet to Reach it’s Bottom
As housing prices slow their massive drop from the highs we saw in 2006, economists and market analysts alike want to have their voice heard when they call for a bottom in the housing market. It just isn’t time yet. The Case-Shiller Home Price Index, a measure of home prices in the U.S., recently reported that prices fell 3.7% compared to the year before. David Blitzer, Chairman of the Index Committee at S&P Indices said “Despite continued low interest rates and better real GDP growth in the fourth quarter home prices continue to fall. Weakness was seen as 19 of 20 cities saw average home prices decline in November over October.” It’s regrettable, but the pain in the housing market, although may have eased, has not fully dissipated.
For housing to have bottomed we would need to see a significant pickup in the economy with consumers going out and soaking up the excess inventory that is still in the market. But with GDP in 2011 growing at the slowest rate in any non-recessionary year since 1947 according to Credit Suisse, it’s hard to make the argument that the U.S. economy has fully recovered. The economy as a whole has too many wounds that need heeling before the housing market can stand on its own two feet. We still have 10.7 million homeowners who are underwater with their mortgages; 13 million Americans are still unemployed, and the amount consumers are able to save as a percentage of their personal income is still dropping. People just do not have the ability to buy houses like they once did before the financial crisis. Was it not for continued lifelines from the federal government (through the FHA, Freddie Mac & Fannie Mae), the housing situation would have already deteriorated even further. Fortunately the glut of supply of homes has been going down, hitting a level in December which had not been seen since March of 2005. We are likely to continue to see bright spots like this going forward, but they are by no means at this point indicative of an absolute bottom in housing.
Well aren’t houses selling at a bargain price by now? They most definitely are. Prices are at historic levels that many haven’t seen in their lifetimes. The unfortunate fact is, when it comes to financial markets, history has shown asset prices hardly ever simply come down to ‘fair value’ and then stop. Just like home prices sky rocketed past what was believed fair value in the 2000s, they will likely drop right past fair value on their way down as well. I look forward to the day when the pain associated with home values disappears; we just aren’t to that day quite yet.
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Bernanke’s Two Years Resolution
Statistics show that the extreme majority of people have already violated their New Year’s resolutions and January isn’t even over yet! Most folks don’t even make it a week. Our Federal Reserve Chairman has not only claimed a resolution for the world economic stage but signaled his intention of keeping this commitment into 2014. The equity markets liked the news.
This is similar to me promising not to eat sugar cookies over the same time frame. First, I don’t like sugar cookies all that much! Many of the critics of the dovish Fed policy are concerned about hyperinflation at these historically low rates. Interestingly enough, Bernanke goes to bed at night praying for inflation! Not only does he hope the worrywarts are correct, he hopes for it sooner than later.
The Fed is doing its best to raise asset prices. The more your home is worth and the higher your 401k is in value, then the more your financial confidence in the future. That’s all true for the most part. The following assumption is just that: An assumption that one action will cause the next action. The Fed hopes (think Keynesian economic theory) that as consumer confidence rises due to the increased value in their assets, that consumer spending will increase causing businesses to reinvest in both production and hiring. Some would call that pushing on a rope, others high expectation with high-risk stakes. Regardless, the Fed is all in! That’s poker parlance for committed – like it or not.
We do know higher asset prices make people feel better. The questions are: Will higher asset prices slow the consumer deleveraging (paying down debt faster than they accept new debt), and will businesses be convinced the consumer is here for an extended stay if the consumer does decide start to spending. If the business world believes this is real, spending may increase. This may work out!
The second issue is that we all want what we cannot have. Though I am not a huge sugar cookie fan, the mere fact I am suppose to ignore them for the next two years makes saying no more difficult. Imagine coming home from school and smelling the house of freshly baked cookies! Yummy. Just as my friends will encourage me to eat just one cookie, the Federal Reserve will be under great pressure at the first sign of inflation to renege on their honest intention to keep rates low. Can willpower withstand the temptation to cave? Will the business community buy into the scheme? Will consumers change their ways over interest rate policy?
For those of you who have read this column for the last decade, you know my answer is a resounding “NO” to all the above. We will have to wait and see how it all shakes out, but in my opinion the consumer’s willpower will trump the actions of the Fed. The will is to be fiscal and financially sound. Deleveraging will continue in most areas.
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Changes Ahead
That title could represent just about any facet of our lives the last several years. The only certainty seems to be constant change. The governing body of municipalities has faced the same fast paced world but without the convenience of being able to make swift changes, even when they are necessary. The state of Michigan just acted on their problems and their solution will come to a state near you in the foreseeable future.
Some may think this is a yawn of a story, that it is no big deal, that taxes have to be paid at some point so why not automate the system. Others will see through the story and find the root of the problem: States need money and need it now. Governments can’t run on air and promises to pay. And if people aren’t paying their taxes then the government will find a way to make sure they do—more regulation that impacts us all to keep a few under control. I hate that, but do understand the need.
When you take a distribution from a qualified retirement plan like a 401k or a 403b, the custodian is required to withhold 20% of the amount and remit it to the federal government on your behalf. This is not true if you roll the money into an IRA and it is not true if you withdraw money from an IRA. This only happens when you call the custodian and ask for a distribution. Regardless of whom they are or where they are located, regardless of your age and tax bracket, the custodian is mandated to hold back 20% for taxes.
Michigan just arrived at a bright idea to help speed tax payments and assure tax payments are made. “If the 20% withholding for the federal government works then we might as well do it ourselves!” If you are a Michigan resident, call your custodian to ask for a distribution. You will find they will have to withhold 4% and change in taxes for the state of Michigan. It is money you would have had to pay – at some point – and now the state gets their piece of the pie sooner with no chance you can’t pay later on.
Again, many will read this story with little interest. Perhaps you are not a Michigan resident. Perhaps you don’t have a 401k or don’t plan on taking a distribution anytime soon. This is still relevant, my friends. Our governing bodies are going to find ways to make sure they get the appropriate tax dollars and get them in the fastest most assured way possible. That means regulations, changes and challenges for the way many individuals operate.
In the mean time, the proverbial patch is to roll your distribution to an IRA before asking for the withdraw. My guess is that they will try to plug that option eventually, but for now it is one way to circumvent the required tax withholding.
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The Contrarian Wall Street Consensus
Each quarter Wall Street firms put out their estimates for what they believe companies will have earned during the previous quarter. The world of economics seems very confusing and muddy to most, but a recent statistic caught our attention. According to a MarketBeat article by Jonathan Cheng, analysts are more in agreement than they have been since 1986 pertaining to their estimates for S&P 500 company earnings. The current economic confusion mixed with currency fluctuation and European woes would seem to create a larger gap than normal.
Regardless, when it comes to economics and the financial markets, crowded beliefs tend to generate wrong opinions. Just like in 2000 when the mass consensus was that tech stocks just couldn’t go down or in 2005 when houses would always go up in value. Something just doesn’t smell right when everyone shares the same opinion. Group-think usually errs on the side of too much greed or too much fear – two of the primary emotions driving the markets.
But in this case, Wall Street’s estimates for prior quarter corporate earnings have not been set too high. According to Thomson Reuters, analysts in October expected S&P 500 companies to report 15% growth compared to the fourth quarter of 2010; they have since then lowered their expectations to 7.8% growth for the same time period. That is a large change in a short period of time.
Perhaps the economy has weakened significantly more since October and that’s why Wall Street analysts don’t have high of hopes for corporate America. That argument could clearly be made, but on the other hand, we have seen the unemployment rate drop from 9.1% to 8.5%, industrial production has risen, and the manufacturing sector has improved. Something is clearly spooking the analyst.
The general consensus by analysts is to expect lackluster results for Q4. It is not unlikely that the new “low bar of earnings estimate adjustments” that have been set have been stumbled over by the majority of reporting companies. In other words, they probably went too far. We do not expect stellar reports for the quarter, but our firm will be more focused on the outlook companies give as a key take away from this earnings season rather than analyst expectations.
What remains more important in our opinion is the success of individual companies going forward. Recent history suggests that a company’s success or failure comes more from the sector they represent than the executions of the individual company. That is far from what we’ve experienced the last 40 years. Traditional thinking is that a company’s earnings come from the consumer interest in the product, current commodity prices, and governmental regulation far more than the individual company’s ability to execute the business model. Those days are past!
We expect to see clear winners and clear losers in the coming quarters. Use the current market volatility as a way to buy great companies on the dips, and drop the losers on the market lifts!
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Why the Fed is More Important than Hotdogs
As past elections have shown, what seems important truly isn’t. I’d like to think voters pay more attention to the policy statements made by politicians running for office and less attention to what the candidate’s third cousin twice removed once said twenty years ago or how many hotdogs the candidate ate at their last rally. Unfortunately I’d probably be wrong. As that important day in November approaches everyone in D.C. will be doing everything they can do get their man or woman elected. And this attitude is not limited to D.C. politics; it extends to the Federal Reserve as well.
Each year four of the voting members of the Fed rotate to give every regional president a turn feeling important during significant voting events. Well, this year three of the four Fed presidents losing their voting privileges happen to be three of the votes against further monetary action by the central bank. Their replacements are expected to vote inline with Fed Chairman, Ben Bernanke. This might just be all that’s needed for the central bank to think up creative ways of poking its big finger into the metaphorical economic-balloon, hoping this time will be different and the balloon won’t pop.
Take for instance the Fed’s recent announcement that it will begin making interest rate projections several years out. This plan is scheduled to begin after their next policy meeting January 25 and is meant, according to the Wall Street Journal, to serve two purposes. According to the WSJ article by Kelly James, the first purpose served is increased transparency. “This is partly to assuage longstanding concerns about the methods and motives of one of the country’s most powerful institutions. It is also meant to make monetary policy more effective by lowering volatility and uncertainty in the market around the path of future rates.”
Secondly, “this new strategy could help get the Fed out of its fixed, ‘mid-2013’ low-rate pledge and equate to some additional policy easing. The new projections will anonymously show the range of rate forecasts from all 17 members of the Fed’s open-market committee, including the nonvoting ones. The inclusion of forecasts from some of the more hawkish nonvoting members this year could confuse the message. But the projections will likely show the Fed is even more biased towards low rates for longer than the mid-2013 language currently suggests.”
What does all of this have to do with the election and hotdogs? As his past actions have shown, Bernanke is a proponent of keeping the government’s wallet open and letting the wind blow as much money out and into the market as possible in hopes of economic improvement. An improving economy with lower unemployment gives President Obama a larger platform to stand upon while running for reelection. Senate Republicans, of course, are positioning themselves accordingly in an effort to block Obama appointments to the Fed.
Remember, the election I more about the Incumbents than it is Republicans or Democrats!
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2012…What a Year It Will Be
The current tea leaves suggest a volatile market and lack luster economy in 2012. Unemployment will continue to be a headline as will other economic numbers that leave the politicians scratching their heads for short term solutions. Next year will be remembered more as a battle of Washington versus a structural reality than it will be a story about bulls and bears. The driving force will be the election followed by the political spin. Individual companies will perform at growing and profitable levels while others within the same sector fall short.
We find ourselves heading into year 12 of Americas lost decade – at least for the S&P500 which started January of 2000 at 1,334 and now resides near the 1,200 mark. Pundits will discuss if we are heading back into a recession without realizing we never left and the word probably starts with a “D’ not an “R.” This is our time in history to clean out the excess and eliminate weaker companies from the mix. It is time for the greatness of America to shine through and realize some areas have to change.
The biggest unknown for 2012 is the crisis in Europe. Some say we are insulated from their issues but that resonates of a previous comment made by Ben Bernanke in 2008: “We believe sub-prime has been contained.”
Unfortunately the volatile theme of 2011 will likely persist into the next year. You can count on “Hail Mary” passes from American and European governments that attempt to salvage their respective economies but their efforts will only mask the issues for so long. We are in a part of the economic cycle that is critical for long term success – removal the excess. Consumers will continue to deleverage. It is painful but necessary.
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Santa Claus may be real after all – 12/24/2011
We have all heard the axioms about when to buy and sell. One heard often in the mainstream financial circles is, “sell in May and go away.” Looking back at all the volatility the market has experienced this year shows that some of those silly sayings would have served an investor well.
According to the 2012 Stock Trader’s Almanac, when stocks fluctuate, “they do so in well-defined, often predictable patterns. These patterns recur too frequently to be the result of chance or coincidence. How else do we explain that since 1950 all the market gains were made during November through April, compared to a loss May through October?” We all know what happened in May of 2010, and we experienced a high in the major indices in May of this year as well.
The next axiom we experienced this year was, “the first five trading days determine the whole year.” For over 60 years, when the S&P 500 is up over 2% during the first five trading days, which has occurred 16 times, the year has ended with a gain. How did the first five days fair for 2011? Not great. The S&P 500 was up around 1%. Although when the index is between 0.4% and 2% it has ended the year in positive territory 78% of the time.
October has been known as a ‘bear market killer” with 11 bear markets bottoming out in October since World War II. Although the decline that began in May of this year barely qualified as a bear market (20% decline), the recent low did occur on October 4th, which was followed by the largest gain for the month of October since 1986.
So what axiom do we have left for this year? Can’t forget about the Santa Claus Rally, which we are currently experiencing! Not only does Santa bring presents to boys and girls, he also historically brings positive gains to traders during the period between Christmas and News Years. From 1905 to 2005, the last week of December has experienced a rally 65% of the time. It would appear we are seeing a similar rally this Christmas season. The likely explanation for this phenomenon is light trading volume as many traders take vacation, the investment of Christmas bonuses, and some investors implementing end-of-year tax strategies.
Although these sayings can be fun to look back on, a truly prudent investor should not put all of their eggs in the basket of ‘sell in May and go away’ or investing based on the first five days of January. What is important to remember is that with all the issues going on in Europe and the inflated unemployment rate here at home, we can always stake a little hope in Santa to push us into the green before the big crystal ball drops us into a new year.
So, from all of us at the Financial Enhancement Group, we wish you and your families a Merry Christmas!
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Show Me the Money…the REAL Money! 12/16/11
With the recent collapse of MF Global, and the subsequent “disappearance” of $1.2 billion in customer funds, a new light has been cast upon the manipulation of financial accounting by corporate bean counters and executive helmsmen—and rightfully so. I find it comical, yet outrageous, that the three heads of MF Global can sit before a Congressional committee, plead ignorance, and then get away with it!
The manipulation of financial reports isn’t new in corporate circles. In fact, it’s become so commonplace that there’s now a pleasant euphemism used to mask the charade—earnings management. Though the phrase sounds like sugar, it’s a bitter pill that if swallowed and allowed to fester, can cause repeated acid reflux and diminishing net worth.
Under current accounting rules, companies are permitted to take liberties (“make decisions”) to show an increase in net profits; however, those liberties are occasionally inaccurate and can lead an investor into bondage then losses. For example: a particular company decides to accrue revenue aggressively this year rather than spread revenue out conservatively over a few years, resulting in inflated revenue this year and lower real revenue in future years. That’s because every accounting move requires offsetting accountability or the books won’t balance. The manipulation will eventually manifest itself unless future growth covers the decision. They are betting on the come so to speak.
The point is that as investors, we must enter any financial endeavor through the gates of skepticism, with eyes of hope wide open. These are trying times for us all, including corporate and political leaders. According to Stansberry’s Investment Advisory, “The 10 largest American bankruptcies in history have all occurred in the last decade: Lehman Brothers ($691 billion), Washington Mutual ($327 billion), WorldCom ($103 billion), General Motors ($91 billion), CIT ($80.4 billion), Enron ($65 billion), Conseco ($61.4 billion), MF Global ($41 billion), Chrysler ($39.3 billion), and Thornburg Mortgage ($36.5 billion).” All of these companies sold themselves as viable leading up to their collapse.
And almost every major Wall Street firm has engaged in investment fraud. “All have paid massive fines to the SEC,” according to Stansberry Investment Advisory, “but in only one of these cases was any firm held criminally responsible. And that firm was Arthur Anderson – Enron’s accountant!” That does cause pause.
A few of the common ways companies manage the books are by changing depreciation methods, reducing reserves for bad debts, manipulating the valuation of inventories, changing assumptions about investment income or investment assets, and one of the biggest, adjusting pension account assumptions to show an increase in pension income and reduction in pension expenses—all of which inflate the bottom line, which in turn can lure unsuspecting and unsophisticated investors.
That’s not all! Our government also manipulates figures to present their proposals—like corporate bailouts. We have all made mistakes. I sure have. No one is perfect. That said, we must bring honest ethics back to the business world as the standard, not the exception.
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Thank you Santa! 12/7/11
Markets tend to end the year with a December bounce called the “Santa Clause Rally.” Santa came a little early this year. The S&P 500 gained 4.3% on the last day of November 2011. In comparison, the S&P 500 had the same gain over the previous 43 days! Some days seem to matter more than others! Christmas hadn’t arrived yet but the world’s central banks announced they were banding together to make emergency funding available to Europe’s troubled banks—and the stock market enjoyed one of its best days in years. The Dow Jones Industrial Average jumped by nearly 500 points, putting the index in positive territory for the year.
After a month of choppy volatility that has kept investors on edge, it was a welcome respite. It appears that—at least for now—the world as we know it isn’t ending. But given that our retirement portfolios are on the line, we should read headlines like these with a skeptical eye. The coordinated action by the Fed, the European Central Bank, the Bank of England, the Bank of Canada and the Bank of Japan should guarantee that, at least for the time being, we don’t have another 2008 “Lehman Brothers moment” where the financial system goes into cardiac arrest. That’s the thinking, at any rate.
But the action does nothing to address the excessive government debts that led to this crisis in the first place. Italy still has debts in excess of 120% of GDP, and much of the remaining Eurozone is following in Italy’s steps. And while we appreciate the enthusiasm of policy wonks who suggest Europe can grow out of its problems, provided Eurozone countries implement the proper free-market reforms, we simply cannot share in their enthusiasm. Aging demographic trends in the Eurozone make the fast growth of the post World War II years next to impossible.
This is concerning friends. Many of the thoughts in this article came from the HS Dent Foundation of which I am a board member. During our biannual retreat a few weeks ago, Harry Dent pretty much summed up the current environment like this: “I went from bearish to scared when the market rallied on the announcement of $1.4 trillion infusion into Europe’s financial system.” That is simply not a warm and fuzzy feeling.
Europe has some very difficult choices to make—like whether there should be a unified Europe at all.
These things create uncertainty, and markets tend to hate uncertainty. That said, our advice is to expect a lot more market turbulence. Hope for the best, but prepare for the worst.
Regardless of what happens in the European sovereign debt crisis, life will indeed go on. European states have defaulted on debts numerous times over the centuries. The cycle of debt and default is, for better or worse, part of the rhythm of history. What will surprise some will be nothing more than a repeat of history for others. Expect change—and be prepared for it!
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When Good Managers Fall From Grace 11/23/2011
It’s lonely at the top. And as they say, the bigger they are the harder they fall. Bill Miller from Legg Mason is likely one of – or was one of – the biggest. Bill Miller has been booted. In the 90s and early 2000s, Bill beat the major indices 15 years in a row. He was a personal hero! Recently his performance has been a reminder that “past performance is not necessarily indicative of future results.” At one point he managed over $20 billion. People clamored to get in the fund. The fund now sits near $3 billion with a five-year annualized returned of -9.6%. Bill Miller bet large and wrong on financials in 2008, sending his Value Trust fund down 55% for the year. He will still be remembered as Morningstar’s fund manager of the decade in the 1990s.
John Paulson is another manager who has had a rough year, down 47% through September. Paulson became well known for his bet against subprime mortgages in 2007, making nearly $3.5 billion and then making an additional $5 billion last year. Paulson made and additional $4 billion from his personal investment in his hedge fund and $1 billion from fees he charged. But this year his bet on financials like Capital One, Wells Fargo, and Citigroup has lead to poor performance. Personally, after having a $5 billion year, I am afraid I would be pondering the age old question of “when is enough enough?”
Another star manager that isn’t having his best year is Bill Gross, the co-manager of the PIMCO Total Return fund. Bill also received the honor of being a Morningstar manager of the decade, considered the “bond king” by many investors. Earlier this year, Gross publically called for a drop in bond prices and positioned his fund accordingly, only to watch from the sidelines as bond yields hit historic lows with bond prices skyrocketing. Bill turned to using leverage to help boost his funds performance, reporting in September that his fund had -19% cash due to use of derivatives and other complicated investment vehicles. Recently this bond manager has been investing in mortgage-backed securities in anticipation of further government assistance in the mortgage industry, as well as his attempt to seek out additional yield on behalf of PIMCO.
At the end of the day, Miller, Paulson, and Gross will always be considered some of the best money managers in history. Regardless of the accolades and the fame, I assure you that the ego bruising will leave a sting that lasts longer than they would like. They all seemed to have forgotten one major rule: the market can be wrong longer than most of us can remain financially solvent! The market can be a fickle mistress at times, causing every investor to experience rough patches. It’s how we as investors handle these tough periods that truly reflects our personal character, investment discipline, and our ability to manage risk.
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Communicating In Chaos 11/19/2011
We can only imagine the frustration unsuspecting individuals must feel about the market movements recently. Your eyes are not playing tricks on you! The market is near completely red or completely green almost every day of late. The news stories are half good and half bad and sometimes what is perceived good still leads to a bloody market day. What is going on?
Chaos is the best word for it. We are all much more connected to currency valuation and fluctuation than we know. We have just hit a high in our exports, now 14% of our GDP. That means we are making money off of other countries buying our goods. That’s the good news! The bad news is they are poised to slow down.
“We’ve had such strong exports to Europe and now with the European financial crisis those will come down, appear to be coming down” Commerce Secretary John Bryson told Reuters last week in an interview. “There’s not reason to think we can improve meaningfully in Europe.”
That being said, markets in the Asia Pacific region seemed to have saved the day. The most recent trade data shows U.S. exports reached a record $180.4 billion in September, largely because of Asia and despite European turmoil. Whether exports will rise, fall, or wash is difficult to predict.
And though the crisis in Europe has caused a nauseating ride in the equity and currency markets, and uncertainty in the global bond markets, there was good news this week to support a possible turnaround in the economy. New U.S. claims for jobless benefits hit a seven-month low last week, and there were signs of stability in housing, with permits for home building soaring 10.9 percent. And recent retail sales and industrial production data point to more stable growth, decreasing the likelihood of another recession.
In addition, consumer prices fell for the first time in four months, giving some relief to strapped households and hope to retailers that consumer spending will rise over the holidays. But despite all of this good news, chaos still abounds in the financials.
Joel Naroff, chief economist at Naroff Economic Advisors said about the numbers, “Economic conditions are moving upward at an accelerating pace; however, two major roadblocks stand in the way of solid growth: Rising oil prices and European debt issues.” Naturally we would add the demographic challenge of the baby boomers making the wall even taller to climb.
It is possible that Washington will throw a successful Hail Mary pass and navigate a miracle. We are the greatest country in the world! More things than not seem to point toward challenges ahead. The old saying goes “The bigger they are the harder they fall.” I pray our country stands strong.
Know what own, why you own it and how you plan to exit should that become necessary. Most people I talk to know they own “things” but they cannot answer the questions so necessary to survive in this period of chaos.
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MF Global 11/12/2011
Mark Twain once said, “History doesn’t always repeat itself, but it does rhyme.” Now MF Global rhymes with Long Term Capital Management and others who’ve gotten in over their heads using leverage. Sadly, the implications extend beyond those who took the risk.
The Player
Jon Corzine, CEO of MF Global, loved big, scary, and leveraged trades. This risk appetite developed while he was at Goldman Sachs, but there he had a strong safety net in the form of well-established risk management controls. As the boss of MF Global, Corzine neglected the safety net and went all in on aggressive trading.
The Trade
MF Global purchased foreign bonds and then used them as collateral to finance the purchase itself. If the European countries behind the bonds defaulted, the collateral would become practically worthless. Think Greek bonds.
The second major risk MF Global took on was one of liquidity, which the firm lost once it saw its credit rating lowered by Moody’s and demands from FINRA to raise capital. MF’s creditors demanded additional collateral for the funds the firm had borrowed for the trade, causing a forced liquidation and eventual bankruptcy. On October 25th, the firm reported a $186 million loss, sending its share price plummeting 67 percent.
MF Global had $40 billion in assets, which was just shy of the requirement of $50 billion set by the Dodd-Frank Act to be considered ‘systematically important.’ This prevented the firm from access to lines of credit, asset purchases, or repurchase plans by the federal government in order to prevent its failure. The investment firm’s bankruptcy will be the eighth largest in U.S. history.
Lessons Learned
We always remind our clients to know what they own, know why they own it, and know their exit strategy. Simple rules can go a long way to keeping yourself out of the poor house. We have always paid great attention to our custodians – the institutions that hold our clients’ funds – and this sad situation should be a strong reminder of how important these institutions become. When an investment firm like MF Global begins making aggressive proprietary trades, rather than concentrating on what is best for the clients, nine times out of ten and twice on Sundays, something will go wrong.
This is eerily similar to the recent article we wrote on the movie Margin Call. Leverage was used, went unchecked and eventually somebody got hurt. The history of financial meltdowns demonstrates a standard governmental response; as long as innocent parties not directly involved are impacted by the actions of others, accounting standards and oversight will be increased. We all pay more for those unwelcomed regulations and yet inevitably somebody or some company finds new and inventive ways to find more leverage. There will always be people who try to fly too close to the sun and their clients will be the ones that get burned. Hopefully, integrity and commonsense will return as more than fairytales. Until then, expect more government attempts to control us all.
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401(K) Matching Contributions Making A Comeback 11/5/2011
A recent Towers Watson report suggests a resurgence of 401(k) matching contribution plans by employers, lending a ray of light to an otherwise gloomy financial forecast. Matching contribution plans not only encourage workers to invest in their own retirement, they’re one indicator of a company’s financial strength. And with Towers Watson reporting that nearly 75 percent of the defined contribution (DC) plans suspended after the financial crisis hit have now been reinstated, businesses seem to be showing new signs of life. But will that life be sustained with new waves of economic turmoil pounding American and European shores?
Americans began embracing the 401(k), which gets its name from section 401(k) of the Internal Revenue Code, as an alternative to the traditional retirement pension in the 1980s, Today, it’s estimated that about 60 percent of American households have some form of 401(k) retirement plan, most of which have matching employer contributions, whether one-for-one or only in part. Needless to say, when employer cutbacks to highly valued matching contribution plans spread throughout the business sector, employees and their retirement preparations took a big blow.
It can’t be overstated just how important matching contributions have become to employees and the financial markets. They are often the primary source of enticement to get employees to participate in retirement plans. Without employer matching finds, many employees would fail to participate in these plans all together, which would in turn impact the financial markets further.
But did you know that employers have a vested stake in the success of these retirement plans? Employers depend upon a predetermined employee retirement cycle. Without adequate participation by employees, many employees would not be able to retire on schedule, thus impacting the employer’s labor costs, among other things. Thus, placing the burden of retirement solely on the employee becomes problematic.
The news that employers are reinstating these treasured contribution plans is especially welcome given the current state of U.S. home values. Real estate, namely one’s primary residence, has been another traditional retirement vehicle hit hard by the financial crisis. Home values have plummeted, negatively impacting net worth and equity. Many homeowners have seen the value of their homes cut in half. If you’ve lived in your home for 30 years, working hard to pay it off so you can live off the equity in your golden years, the prospect of doing that now seems implausible. Matching contribution plans established by your employer may be the trusted lifeline you need in this economic hurricane.
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Margin Call and Monsters in the Closet 10/29/2011
Margin Call is a newly released horror flick. No blood, no guts. In fact, the movie isn’t listed as a horror flick and the monster was never formally introduced. He is a permanent fixture in finance.
Margin, or leverage, is the use of capital that you do not own to buy more assets—and it has lead to every boom and bust cycle throughout history. A “call” is when the banker says your collateral is no longer sufficient to cover the leverage. That’s when the dancing stops.
Depicting typical corporate behavior, when strapped for cash, the company depicted in Margin Call cuts the risk management division. This is similar to a household. When there isn’t enough money to go around, insurance premiums are often first to go unpaid. None of us plan to use our insurance, but we all need to eat. Cut what isn’t critical and live to fight another day! That strategy only works until something fails. The primary reason booms go so far and ultimately fall so quickly rests squarely on human nature. Very few people ask what’s wrong when life looks rosy.
This film demonstrates a rule that we hold near and dear at the Financial Enhancement Group: “It is okay to be wrong, but it isn’t okay to be wrong long.” Simply put, when you recognize you’ve made a mistake, fix it fast! Margin Call portrays the CEO as a monster because when he learns of a threat—that their risks are larger than their checkbook—he responds decisively.
The CEO correctly ordered full liquidation the next day—the right action, but one with a predictable outcome. Prices fell in the morning, plummeting throughout the day. Thanks to mark-to-market accounting, collateral value dropped and the margin calls began forcing more sales, and more margin calls. One sale perpetuated a domino effect across Wall Street—swift, unstoppable, and with zero immunity.
The man who realized and fixed his error was made to be the villain. Society tends to blame those driving the bust more than those who drove the boom. How did prices inflate to a point that forced the company to sell? Because people and institutions broke a cardinal rule: If you don’t know what it is, how it works for you, or how you plan to sell it, don’t buy it! Buyers merely boarded the train and trusted the conductor! Everyone was doing it, so it must be the right thing to do!
In that regard, we could all learn from our two year olds who are always asking, “Why?” Always question, and remember things change!
Two emotions control investors: Greed and fear. Greed only stops in the face of fear. As prices rise, unsuspecting investors join the party, driving prices even higher. The price gushes skyward until the momentum and force (leverage) run out. The further the price falls the faster it falls. Meet the real monsters in the closet: People and their emotional behaviors!
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Is Greece the Grease? 10/22/2011
Wide World of Sports™ proclaimed, “The thrill of victory or the agony of defeat,” and Wendy’s restaurants coined the greatest slogan ever, “Where’s the beef?” Both catchphrases bring a familiar smile to my face; but now, rather than athletes and a feisty old woman, these sayings make me think about the challenges to creating the right investing mix in today’s economic environment.
“The Thrill of Victory” used to mean experiencing profits by doing the proper homework, technical analysis, demographic pattern evaluation, and by ultimately choosing the right company. Being willing to admit when you were wrong and sell a holding was also important. But the last few months of correlation – the behavior of one stock versus another – have been almost universally systematic. That means the majority of your performance has come from simply being a market participant rather than a wise investor.
“Where’s the Beef” once compared the meat in the average hamburger compared to that of Dave Thompson’s Wendy’s single. Today, the beef is in reference to earnings surprises — and with more than 60% of the 128 companies reporting thus far having beaten earnings estimates, there’s plenty of beef!
Bonds and stocks are confounding the markets even more. According to Bespoke Investment Services, they have the highest negative correlation – a good thing for diversification, but way out of the norm – since the tracking started.
Risk is also much greater now than people understand. Either that or the market is way undervalued. Something is amiss.
Change happens and we even embrace that fact, but you should always examine the root cause of any change. Ask yourself: Is this change permanent or temporary? The majority of readers will raise an eyebrow and do nothing different from what they did yesterday, but today’s markets demand attention. Something strange is going on and watching flatfooted is not the best strategy, in our opinion.
Traditionally, systematic risk impacts your position by 65% of the normal movement. That means 65% of your result is dependent upon the overall market movement — good or bad. The other 35% is based upon picking the right companies. Also according to Bespoke, right now, that correlation is above 90% and the implications to money managers, mutual funds, and hedge funds is enormous.
The primary culprit appears to be the European Union, specifically Greece. The market continues to fluctuate dramatically on the smallest rumors – good or bad – coming from the Germans and the EU monetary committees. Little countries that get to vote on ratification of bailouts and economic support are causing huge ripples! If money weren’t involved, this would be comical. But the fate of the EU itself is in question.
Is Greece the grease that’s driving the market in singular force each day? If Greece fails, does the entire system crumble? Is the entire market vastly undervalued if Greece suddenly recovers? Inquiring minds want to know — need to know! Rest assured, we are watching very carefully and will advise you on the appropriate actions to take — in any event.
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Boxing and the Markets 10/15/2011
Boxers know every moment is one of risk and opportunity. Every punch or counter punch inevitably exposes your body to being clobbered unmercifully. Standing flat-footed, face covered, will lead to your body being pummeled. At some point you must take action. Every decision has risks associated with it, but the pain of doing nothing equates to the inevitable lights out moment.
Lately the equity markets and economic confusion have provided their own form of abuse. Some chose to stay out of the proverbial ring and accept what little interest is paid. The risk of the big right hand is gone, but the jabs of inflation and taxation are coming. Though the wear and tear on your body may be delayed this round, the eventual pain from negative real interest rates will be just as deadly.
There are “investors” who have decided simply to ignore the changes and hope for the best. They remind me of boxers who go to the match with their favorite punch and refuse to acknowledge when the opponent has them figured out. Just because you had a good strategy in round three doesn’t mean it will work in round eight.
The punches and counter punches have been extreme lately. The last 60 days (August 9th- October 12th) have looked like this: The S&P500 was +9.9%, then -7.2%, then +10.2%, then -8.1%, then +5.6, then -5.6%, then +7.6. Then -9.1%, then +7.4%, then -9.9% then up 11.3%! A whipsaw as a description would be an understatement. Though the systemic risk – at least domestically in our opinion – is less than that of 2008, the volatility is eerily similar.
What to do? Simply ducking, hiding your face and or recklessly swinging will expose your body to certain pain. A boxer would suggest taking calculated risk, using a fluid strategy and focus on winning the fight not just each round. Your favorite financial writer would suggest that we expect market volatility, but that we choose only to buy investments that make sense in a segmented economy. Segmented means there will be clear winners and clear losers over time. In some cases the clarity is already here and in other cases it will take time.
We must also be very fluid in our strategy. There were investments procedures that made sense 10 years ago that simply don’t pass mustard any longer. The advent of technology has not only changed the way the companies we own function but it has changed the way we should own the companies! We all know in our own lives – school, medicine, hobbies, and entertainment – that technology has changed everything. Think of what you understand the best and ask yourself how much technology has changed the way you interact within that realm. The changes to the financial world have been no less and yet many invest like nothing has changed at all. The markets can be brutal but with good planning you can move like a butterfly and sting like a bee!
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Crystal Clear Earnings 10/8/2011
Wall Street likes clarity. With that in mind, it’s the analysts’ job to assess the risk to a particular business model and to forecast earnings expectations. The easier the model is to understand the more Wall Street is willing to invest in the stock. The challenge today is that clarity doesn’t exist, so the need for analysts is greater than ever before.
Over the past 40 years, many companies have ridden the wave of a loyal, ever-growing consumer base. That lent an element of predictability to the markets and a sense of surety to investors looking to jump in. But innovation in the area of technology has created unique challenges to that traditional approach. The reason: Consumers are changing.
Technology has and will continue to develop at breakneck speed. As more and more companies flood the marketplace with improvements to the last technological mousetrap, consumers are more apt to jump ship and go with the new. That creates uncertainty in the marketplace, which leads to increased volatility. Add to that the growing global economic crisis and you can see why investors need more help today than just a few years back.
Gone are the days of loyal consumers and predictable re-investiture; in are the days of battened down corporate hatches, the hoarding of cash, and a general corporate prudence. What are investors to think?
The waters began to get cloudy in the mid-2000s as housing slowed and business managers began to see slowing consumer expenditures. By the time we reached the economic collapse in the fall of 2008, businesses had reigned in all reinvestment possible. Companies have been simply holding on, hoping to survive the storm. Washington tries to persuade us that the tides have calmed and that spending should resume, but corporate America simply isn’t buying the tune.
Many media pundits – and politicians – presume the markets will return to their glory days once corporate America begins to re-embrace their previous revenue models. We disagree with that logic.
Simple logic argues against the prudence of big business investing in old revenue models knowing their consumer base has changed. Businesses would be better served as an entity to invest in expanding their offerings, investing in newer revenue models that compliment the changing consumer appetite, and by focusing on building credibility with foreign consumers. But that frustrates Wall Street and angers the politicians in Washington who’ve been bitten politically by the faltering economy and high unemployment rate.
In our opinion, the market will continue to bounce around as it has for the last 11 years. Short term will bring volatility en mass. Many corporations will reinvest their capital, but not the way the politicians would like or expect. This will create greater investment opportunities and lower stock prices in the near term. We all want clarity, but success will be far from crystal clear in the near future. The markets are going through a sea change; thus, discerning risks and opportunities in these murky waters requires expert analysis.
