Following Germany...to Where?

In spite of continued strength in the leading economic indicators we watch, the market can’t seem to muster a sustained rally. Furthermore, market volatility is extremely high, with the market seemingly locked in crisis mode in spite of strong corporate profits and an over-priced bond market. What’s keeping the stock market cheap is the crisis in Europe.

Europe’s banking crisis is somewhat different than the 2008 U.S. bank crisis. At the height of the bank panic, a run on the banks occurred where banks could no longer tap the U.S. bond market for capital. Banks couldn’t roll over debt. The resulting lack of “liquidity” threatened to spawn a full-fledged bank run. The government stepped in with bank-backed funding (TARP funds) to reassure bank customers and creditors. Ultimately, TARP halted the panic and eventually the vast majority of the banks were able to pay the government back, with the government making a profit.

Unfortunately, many believe that the problem in Europe stems from those institutions being insolvent, meaning that shareholders could be wiped out and borrowers won’t be fully repaid. In general, we don’t know if this is true. In the case of Greece, at least, it is definitely true. Greece can’t afford its current debt burden, so the owners of Greece bonds will definitely lose principal unless they are bailed out by someone willing to come to the table with a checkbook.

The Germans are one of the few entities with a big enough bank account to fund the bailout, but oddly enough the Germans aren’t anxious to subsidize the losses of its Eurocurrency partners.

Germany isn’t the only country working to resolve the problem. France, and others, are also working overtime to save the euro. Although neither camp wants to trash the euro, the two alternatives being considered are polar opposite prescriptions for how to resolve the crisis.

Our view is that the German plan – whatever it is – will prevail.

Germans (legalistic believers in the rule of conviction) advocate that the rule of law should determine what happens next. France and others in the creditor class (expedient believers in the rule of responsibility) believe that the end justifies the means. Aware of the suffering that would occur if the crisis isn’t resolved soon, France feels a responsibility to prevent economic catastrophe by whatever means are available. Germans want to use the current treaty to force the spendthrift nations to live within their means in order to protect lenders. Troubled free-spending nations in Southern Europe want to print money a la the U.S. “quantitative easing” policies in order to inflate their way out of debt.

It’s not a matter of right and wrong. People have values. Money doesn’t. Money, in and of itself, is value-less. Nor is it merely a matter of expediency. In the short-run, the best solution is to hit the printing presses. However, as the Germans remember, bad short-term fixes can have dire long-term consequences. While the socialists in Southern Europe push for a quick fix, the Bundesbank fears the hyperinflation which might result from a continuation of spendthrift policies.

As several experienced analysts have observed, it rarely makes sense to bet against the Bundesbank.

My best guess is that Germany won’t cut a check to Greece, per se, but eventually Germany will give the OK for a Quantitative Easing program in Europe. Europe can follow the Federal Reserve’s lead and simply buy up the outstanding debt of the troubled countries, assuring borrowers a market for Italian and Spanish debt.

Germany will not agree to this plan until it has extracted a price from the spendthrift countries that led them into the crisis. At summit after summit, Germany is enforcing the adoption of new austerity measures and tighter banking controls on other EU members. All but the United Kingdom have agreed in principle, although getting country-by-country approvals will take months.

These are not easy measures for Greece, Italy, France and the other EU member countries to adopt. They must be doing it for a reason, however. I believe that they are adopting these new policies with the understanding that once these policies are in place, Germany will step up to the table with much needed help. I believe that Germany is holding approval of a quantitative easing program hostage to these austerity and responsibility measures.

In the end, however, Germany must be holding out a carrot. Otherwise, why would the other countries agree to such politically costly treaties?

Until the final solution is in place, the risk is that a large bank could fail. It could happen any day, and one large failure could trigger others. Time is not the friend of a crisis.

Some have estimated that Europe needs to roll over or borrow nearly $250 billion in 2012. In the past 12 months, estimates are that the region has only succeeded in borrowing $17 billion. Somehow, despite markets that are effectively closed, Europe needs to find investors willing to risk nearly 15 times more money in 2012 than was wagered, unsuccessfully, in 2011. All the while, austerity programs and the near certainty of a new recession in Europe from sovereign spending cutbacks and bank credit-tightening make these investments much more risky next year than was the case in 2011.

Do you see anyone out there with a checkbook looking to make an investment in Europe? China took a pass. Republicans in the Senate have given a thumbs down to the idea that IMF funds (from the U.S.) be used. The Central Banks are on board, but the traditional political institutions outside of Europe won’t stand for it. Traditional fixed income investors aren’t going to fund the Old World until the entire region steps up to back the bonds of individual countries. Buyers of Spanish debt are on strike until they know that someone, other than Spain, is willing to back those bonds.

Until agreement is reached on a solution, yields are likely to ratchet higher until they are high enough to attract equity money into the arena. However, once the sovereign risk is taken out of the equation, Spain, Italy, Greece and others will once again be able to access the market.

Germany can say, all day long, that the current treaty won't allow the region to backstop individual countries.  In reality, either an ECB-backed bond or some form of quantitative easing IS the end game for Europe, but Germany won't approve the plan until it has won concessions from its more profligate partners.  It is blatent brinksmanship, but in a distressed situation the lender gets to write the rules.

The euro has been an interesting indicator. While the U.S. market goes up with each meeting in Europe (and there have been a lot of them), the euro itself is getting ready to re-test lows and is likely a better indicator of eurosummit achievement (or lack thereof).

However, once the solution is unveiled, the market could easily “melt up.” But will it melt up FROM current levels? Or back TO current levels?

In any event, we remain in a high risk market. We have reduced (but not eliminated) risk in equity oriented accounts. While the chances of a melt down and a melt up are roughly equal, the PAIN involved in a meltdown would drastically outweigh the happiness felt if we were to melt-up. Furthermore, judging by the price action of the Eurocurrency itself, the trend remains down, at this moment, so we remain on high alert.

The good news is that this is occurring in the background at a time when the U.S. economic turnaround is marching forward. In the long run, the good news surrounding the potential for a full U.S. economic recovery outweighs the headlines overseas. In the short run, all asset classes seem to be correlated, so it’s hard to imagine a crisis in Europe not coming back to haunt U.S. equity investors.
 
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate. 

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Changing From Worse to Bad

U.S. businesses are doing remarkably well, so much so that it feels to me like the Great Recession is slowly morphing into a new, different, and better stage of recovery. The U.S. stock market seems like it wants to rally off of very low valuations, but concerns about the European debt crisis are a giant overhang preventing the rally from gaining momentum. It feels like the weight of the world is on the shoulders of Germany’s Angela Merkel as she tries to negotiate a settlement to this crisis.

Back home in the U.S., the economy feels like it is coming out of a recession. Consumer confidence is low, but retail spending is reasonably strong. Corporate America has been in recovery mode since June 2009, but the tepid recovery has restrained hiring. Consumers are hampered by both high unemployment and punitive savings rates (what economists now call “financial repression,” which describes the Fed’s practice of forcing rates down in order to subsidize the recapitalization of the banking sector).

The great news is that the problems in the U.S. seem to be evolving from one of excess supply to one of not enough demand. We are moving forward from The Great Recession to a run of the mill recession. With a little more activity, we could move beyond recession to recovery. But, hey – this is America! If there’s one thing we still know how to do, it’s shop!

Since 2007, the economy has been dealing with an excess of housing inventory. At first, we just built fewer units. Soon, however, unqualified borrowers who should never have received loans began receiving foreclosure notices, pumping up the inventory of foreclosed but not yet sold homes. By 2009, the excess inventory had shut down the U.S. building sector. A million construction workers lost their jobs and a huge segment of the U.S. economy closed down. Bank regulators forced banks to call loans on struggling builders, wiping out all but the most deep pocketed firms.

The recession we face in 2012, however, looks much less daunting. Although the inventory-to-sales ratios are still high, the “problem” has shifted from the numerator to the denominator. Home inventories are still a bit high, but nothing like the levels seen in 2009. If economic activity was anything near normal, and household formation wasn’t in collapse, then the industry might be fairly close to stabilizing.

At a Grand Junction Chamber luncheon this week, Richard Wobbekind, the Senior Associate Dean for Academic Programs at the University of Colorado, agreed that household formation as been far below norm, and that an employment recovery would dramatically improve the construction industry’s supply/demand balance. He also agreed with the notion that the recession we’ve experienced for the past three years, as a result of supply excesses, will look a lot different than the slow growth period ahead of us, which results from a lack of economic vigor.

Stimulus efforts in 2009 failed to revive the U.S. economic engine. We are now much closer to economic equilibrium. Real estate inventories are down. Over-leveraged businesses were forced into foreclosure by the banks, while low savings rates have encouraged consumers to de-leverage as well. Only the government sector lags in the de-leveraging department. If regulatory or monetary stimulus were used, today, I think that they would have a much improved chance of succeeding. In 2008, we applied the wrong type of stimulus, at a time when the economy was just too moribund to keep going once the stimulus ended.

In spite of continued strength in the leading economic indicators we watch, the market can’t seem to muster a sustained rally. Furthermore, market volatility is extremely high, with the market seemingly locked in crisis mode in spite of strong corporate profits and an over-priced bond market. What’s keeping the stock market cheap is the crisis in Europe.
 
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, because of the crisis in Europe, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Asset Allocation Folklore Revisited

When people thought the sun revolved around the world (geocentrism), the quality of navigational advice was sketchy at best, and might have been downright dangerous at times. For the past twenty years, the quality of investing advice has been tainted by the idea that the one-time selection of investors’ stock/bond portfolio mix accounts for 93.6 percent of the ultimate portfolio return. The idea that investors should try to “time the market” is considered heresy. This flawed perspective has been perpetuated by the marketing department of financial behemoths, widely read financial periodicals, and (more than likely) your broker, regardless of his or her employer. Unfortunately, this common asset allocation myth is causing investors to make bad decisions regarding their financial future and threatening the financial house of investors across the globe.

Wall Street has taught most financial advisors that it is a waste of time to manage their degree of exposure to risky assets. Finally, however, in his February 2010 Financial Analysts Journal article, asset allocation guru Roger Ibbotson observes that “the idea that “asset allocation policy” explains more than 90 percent of performance has become accepted folklore... The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent” as claimed by traditional industry thinking.

Indeed, asset allocation is extremely important – but the famous Brinson, Hood and Beehower article, “Determinants of Portfolio Performance” published in 1986, never concluded that a static policy is therefore best.

But as a result of the traditional interpretation of that 1986 study, nearly all financial advisors place clients in a static (never changing) mix of stocks, bonds and/or cash. In nearly every market environment, and in all economic conditions, investor allocations to the magical mix stay constant. As a result, clients pay advisors significant fees but get no real advice in return about when to increase or decrease exposure to stocks, the asset class most likely to cause investors to lose money. In addition, clients underutilize stocks because many are unwilling to accept so much portfolio volatility through good times and bad.

Upside volatility is great, but downside volatility is what investors remember. In fact, the entire industry gets accused of doing nothing for their money, when part of what financial advisors deliver is general financial planning advice, but advisors price it in the value-added clothing of a true investment manager. Consequently, consumers neither seek nor get either financial planning advice (which they probably need) or investment allocation advice (which they want, but can’t find an advisor willing to provide this guidance).

Many advisors have replaced actively managed portfolios with an indexing approach, but indexing leaves clients vulnerable to market volatility because they are forced to “buy and hold” through all types of markets. Investors who cut back on equities may have to reduce return expectations and, therefore, their standard of living in retirement, and reducing equity exposure leaves investors more vulnerable to inflation at a time when inflation is creeping higher and shadow inflation statistics suggest that the real level of inflation is much worse than is officially reported.

May-Investments solution is to allow “Beta” (the fancy statistical name for portfolio volatility) to vary so that in high risk markets, clients aren’t completely exposed to a huge market decline. If “asset allocation policy” is the most important determinant of portfolio return (and it is), then a flexible Beta approach allows a portfolio’s allocation to stocks, bonds or cash to vary according to the current economic environment and market opportunity set investors face.

A flexible approach allows risk to be reduced during the most dangerous times. In addition, cash can be set aside so that it is available to repurchase stocks when either risk is reduced, or stock prices become more attractive. By timing markets (imperfectly, but as well as we can), we can transform volatility from merely being a statistical proxy for market risk into the generator of opportunity for future returns. Buy low, sell high. Isn’t that the idea?

Galileo was considered a heretic for supporting heliocentrism, and most traditionalists in the financial services industry view our approach with equal disdain. Galileo spent the last nine years of his life living under house arrest, condemned by Pope Urban VIII’s inquisition of being “vehemently suspect of heresy.” There is no substantiation to the rumor that he recanted at his trial by muttering the rebellious phrase, ‘I could agree with you – but then we would both be wrong.’
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Nine Unintended Consequences Facing Europe

When people ask how I’m doing amidst this market and economic uncertainty, my standard answer is that, “although I’m not feeling quite as good as the U.S. stock market, I’m doing a lot better than Europe.”

It’s been about a month since the latest grand resolution to the European crisis was unveiled and I still see little that makes me think that investors are any safer than before. Indeed, it is hard to find where any concrete decisions have been made, or any concrete actions taken. To the degree that the succession of summits achieved anything, the unintended consequences of these pronouncements are likely to cause more problems than have been solved, thus far.

First, the summit meetings have officially endorsed the fact that a Greek bailout is necessary. A year ago, EU officials were denying the need for a bailout and blaming speculators for making things appear to be worse than they were. The markets’ pessimistic view, however, proved far more prescient than the politicians public statements. And now the markets are turning their backs on Italy, which is watching its bond yields climb toward 7%, a level which some observers say will make Italy the next domino to fall.

Second, the summit also endorsed the need for a bailout of banks all across Europe as a result of Greece’s failure to meet its sovereign debt obligations. By setting a price of 50 cents on the dollar for Greek debt, other Greek bondholders will need to write down the value of their own holdings. The “mark to market” process creates the need for many banks to reduce the market value of their own investments, and has already resulted in a U.S. investment bank (M.F. Global) going under. The process of contagion has now officially commenced.

The third summit achievement is that the process of forcing banks to accept “voluntary” swaps into new bonds worth half as much is that credit default swaps were rendered ineffective as a hedge against Greece’s default. In addition to rendering Greek hedges worthless, owners of credit default swaps that protect against Italian and Spanish default swaps have to start assuming that their hedges are worthless as well. Rewriting the rules helps prevent the contagion from spreading throughout the derivatives complex, but it also renders CDS products worthless. Without a way to hedge exposure, the yields on Spanish and Italian debt have moved significantly higher, accelerating the day when the crisis jumps well beyond the borders of the Greek isles.

Fourthly, the summit began to quantify the amount of financial damage expected ahead of us. The summiteers proudly announced the need to increase the size of the European Financial Stability Facility by more than a trillion euros ($1.4 trillion dollars). Moreover, the EFSF funds were to be used in addition to German and French government funds. In spite of the acknowledged need for this huge new bucket of bailout money, it was quickly apparent (at least, to me) that little progress has been made in finding a source for this funding. The press releases trumpeted an upcoming trip to China, but as of last week it didn’t appear that a check from Beijing was immediately forthcoming. A weekend meeting of G20 leaders also came up empty. A lot of dinner meetings are happening across the globe, but so far no napkins have been returned on the back of which can be found a plan for sourcing those bailout dollars.

Fifth, the summit series clearly established a need to recapitalize the European banking system. Banks across the old world are in search of new equity capital to shore up their battered balance sheets. In August, the new IMF leader (Christine Legarde) was roundly criticized for suggesting that banks on the continent might need more than 200 billion euros to shore up their capital position. French and German leaders feared that her comment would create a panic in the markets. At the summit, after comparing notes, the leaders admitted that the real number is more like 300 billion euros, even worse than Legarde had estimated. Instead of a panic, the announcement resulted in a stock market rally.

Europe will soon find that banks in need of capital are loathe to reduce the offering price of equity listed for sale – the dilution hurts both managers and shareholders too much. The easiest way to shore up a bank’s capital position is to start calling in loans and stop lending money. Having established a need to recap the banking system, the summit will be remembered as the start of the Great Recession in Europe, which will make it even harder for Spain and Italy to get a handle on their deficits.

Sixth, the upcoming bank write-offs will decimate bank earnings, making it even more difficult for banks to secure capital and resulting in Europe adopting the U.S. approach of using artificially low short-term interest rates to recapitalize banks in its system. As we’ve seen in the U.S., European savers will see their incomes drop to nothing, hurting consumption, and probably causing the value of the euro to continue its decline.

Seventh, if China does become the lender of last resort, you can assume they will want the preferred collateral position that usually goes along with providing debtor-in-possession financing, leaving existing sovereign debt holders (the European banks) facing even larger write-offs than currently anticipated. Oh, and by the way, China will have less money available to keep financing U.S. deficits, so the higher pressure on interest rates may finally begin to impact the U.S. Treasury as well.

Eighth, all of this bailout money doesn’t come without strings, of course, so big government austerity measures are being required of many of the bailout recipients. This, clearly, is leading Europe into a new recession, which threatens both the U.S. and the global recovery as well. While there have been instances where Europe has gone into a recession while the U.S. did not, those cases are the exception rather than the norm. With increased globalization, the risk of a recession in Europe spreading throughout the developed and emerging market economies ought to make investors across the globe sit up and take notice.

Ninth, the Germans prevailed over the French at the summit, which concluded that local governments must first bail out their own institutions before they will be allowed to tap into the EFSF. If BNP Paribas needs capital (and it does), then if the bank can’t raise it on its own, by next summer, the French government needs to provide the bailout. Say good-bye to France’s AAA bond rating. More importantly, say hello to more frightening headlines in Spain and Italy. It is not clear whether Spain or Italy has the money to bail out its own institutions. That, after all, is why it is so important to have the EFSF ready and funded. Between now and the day when Italy’s banks get their EFSF bailout money, there will be a lot of bad headlines about the state of sovereign debt in Rome.

In spite of the summit, it is still not clear that Greece will be able to pay its debts, still estimated to be about 120% of the nation’s economic output. When France loses its AAA-rating, the EFSF will likely lose its gold-plated AAA rating as well. If lending dries up and recession spreads through Europe, the bad loan problems will get much worse than anticipated in last month’s summit, when only sovereign debt was the topic du jour. Much more is needed to solve the problem, which has now spread beyond Greece.

It is as if the whole world knows that Italy is really the problem, so the summiteers got busy….trying to solve the issues facing Greece. It is not so much that the summit moved in the wrong direction. Rather, the summit failed to resolve key issues. For instance, no $1.4 trillion sugar daddy has been found. Little real progress has been achieved, although policymakers did finally acknowledge the seriousness of the issues! The crisis is moving faster than the committees and summits and bureaucrats in charge of fixing the problem.

The European crisis still feels like a slow motion car wreck, in progress. It still feels more like early 2008 when the financiers were slow to admit to the size and seriousness of the sub-prime debt debacle. In mid-2008, Freddie Mac and Fannie Mae were still being defended by their government sponsors, overpaid bank CEO’s were still claiming they were appropriately reserved while in the back office the risk managers were stumped by the challenge of pricing toxic mortgages for which it was impossible to find a bid, anywhere. Hedge funds were blowing up, banks were failing, yet many economists refused to acknowledge that the U.S. was in a recession, which had in fact started in December of 2007. The unrevised economic statistics were still unclear. By the time that the final statistical revisions were in, three years later, the depth of the economic chasm was all too easy to see.

Our U.S. economic indicator still shows strong growth. U.S. corporate earnings have been very strong. Our traditional technical indicators are giving a green light. Yet I am reluctant to take my foot off the brakes because, in general, market volatility is still extremely high. If the market turns down, it likely won’t be a short drop. When the market burped in August, stocks fell 15 percent in about ten trading days. Asset class correlations remain high, which is typical of a market in panic mode. There are few places to hide, other than cash equivalents. Maybe it’s a “high risk/high reward” market phase that we’ve entered. It is not clear to me if there will be a high reward to investors. I have absolutely no doubt, however, that we’re in a “high risk” environment. Most of our recent portfolio moves have been to reduce portfolio risk. While they haven’t been well-timed, they have reduced portfolio volatility.

In addition, probably as a result of the heretofore unheard of volatility, our traditional technical indicators aren’t working very well. Our past five trades, with 20/20 hindsight, have not gone well – so the obvious next step would be to STOP TRADING! Because our dynamic asset allocation strategies aren’t working amidst today’s volatility, I am left with the choice of either putting all of our money in the market until volatility declines and we can once again implement our dynamic strategies, or sticking with today’s lower risk portfolio until we see how things go in Europe.

For now, I would prefer to have less exposure to risk so I have thus far decided to retain our substantial investment in cash equivalents, even though a number of timing indicators have recently turned bullish. In my view, most of the timing indicators that we watch may, like our own, be miscalibrated for the high volatility environment we’re in. While typically a skeptic of technical indicators, at the moment I have absolutely no confidence in any of them, even in indicators that have been helpful for us in the past.

There is still good news in the world, although you may have noticed that I’ve failed to incorporate much of it into this blog post. I’m not anticipating the end of the world. I still don’t think that we’re facing another decline to the lows of March 2009. In the long run, I still believe that a decline will be the precursor of another significant market rally.
 
Until world markets more fully reflect the risky environment we’re in, however, I would like to have a substantial reserve on the side which can be reinvested, at much better prices, should Europe’s summiteers fail to get in front of the slow motion car wreck that is still unfolding across the pond. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Predicting Community Banks Failure

Community Banks of Colorado was taken over by the FDIC and remaining assets were given to Bank Midwest, out of Kansas City, MO, itself owned by National Bank Holdings Corporation, chaired by Timothy Laney, an alumnus of Bank of America and, more recently, Regions Bank. Taxpayers will protect most depositors. Only shareholders and savers with money in excess of the current $250,000 FDIC limit could face losses. A review of Community Banks’ declining financials shows that the takeover was entirely predictable.

The lack of research about local banking institutions leaves many large depositors worried about whether their bank will be the next to fail. Regulators don’t like to make rankings public so that they don’t cause a run on a troubled institution.

As a result, savers may be overly anxious about keeping their savings in a local bank, depriving local lenders of resources that could be invested in the community to create jobs. Instead, money flows toward “too big to fail” institutions who are increasingly investing in government bonds – funding the big government juggernaut – but leaving local job creators without sufficient expansion capital. While big banks increase fees to make up for their lack of interest income with a host of new fees, including the appropriately-named new Durbin fee on debit card transactions, smaller institutions are prevented by the regulators from making loans in the areas they know best, to local investors who are best suited to take over management of the millions of homes across the country that sit in foreclosure portfolios.

Finding objective information is difficult, but relying on rumors just increases the level of anxiety. Several local banks have been the subject of rumors in the past year, including Community Banks.

Large depositors with concerns about their deposit institution should do the research for themselves on the Federal Financial Institutions Examination Council web site. (https://cdr.ffiec.gov/public/) The site makes it easy to view or download data for individual institutions.

In our research for a local foundation client, we focus on a few key statistics to keep the analysis manageable. The first ratio we review is the Tier One Leverage Capitalization which measures the amount of investor money at risk before losses would impact depositors with savings above the FDIC guarantee levels. Most of the local institutions have nearly 10% in tier one capital. As of June 30, Community Banks of Colorado’s capital ratio had declined to only 1.66%, meaning another 2% in bad loans was all it took to wipe out the equity.

We also look at the total past due loans and leases. At Community Banks of Colorado, there was another 11.31% in past due loans as of mid-summer, so it shouldn’t have been a big shock when the equity was wiped out. In our review, we concluded that only one of the remaining twelve institutions is “under water” in the sense that its past due loan percentage is greater than its current tier one capitalization. In all of the other banks, even if every past due loan went bad, there would still be equity left to protect depositors from future losses.

In our review of thirteen local institutions, Community Banks was far and away the most likely institution to fail. Unfortunately, as tight regulatory policies force banks to walk away from more and more borrowers, forcing additional foreclosures, these numbers do change over time so you need to perform the analysis on an ongoing basis.

The benefit of performing this research, which only takes about an hour to complete, is that depositors can make an informed decision before allowing a local bank to keep deposits in excess of the FDIC lending limits. The data is reliable, compiled by the bank regulators who are paid to look over the shoulder of the industry. And while it isn’t exactly kept in an easily understood format, analysts who identify a few key ratios can make sense of the mountain of data that is available.

 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Occupy Wall Street Turns Ugly

Drunken youth cruise around Wall Street looking to pillage, but unlike the MBA’s who have been doing this for years under the blue chip label of Goldman Sachs, this time the mob is looking to tear down capitalism, although they’re not certain what will replace it. Like the flash mobs in London who were looking for extreme thrills rather than making shrewd and considered philosophical judgments, the Occupy Wall Street mob is defined as much by the company they keep as by the actions they take, which thus far have included rioting against the rule of law, blockading bridges, and hoisting thought provoking signs that say things like, “eat the rich.” It’s almost disgusting enough to make me want to take the side of the Goldman bankers.

But the protesters have gone too far, this time. Amidst the protests, arrests, and accusations, they appear to be consorting with Hoofy the Bear. Bear markets are typically defined by a 20 percent decline. Looking at this market, year-to-date (not from the April high), the S&P 500 was down -7.4% at the start of trading Friday. The NASDAQ had declined -5.5%. However, other markets were already well into bear market territory at this point. Mexico and France are each down -18%. Germany is -20%. Large China companies have fallen more (-27%). Brazil and India are down -29%, while Russia has fallen -31%. Small cap Chinese companies have dropped -39%. For most of the world, we have passed well into bear market territory.  U.S. assets, certainly our bonds and to some degree our stocks as well, have benefited from the global flight to quality that accompanies the street riots in London, Greece, and now the United States.

Our portfolios have been building cash due to our concerns about...

• the crisis in Europe,
• the bear market in stocks, and
• concerns about a new recession in the U.S.

The good news, however, is that we are probably done selling into weakness and have begun to think about redeploying cash, at much more attractive levels, as events unfold.

The crisis in Europe is not an “if.” It is happening now and I don’t see how more frightening headlines can be averted. It is a bit like re-living 2007 and watching the subprime lending car wreck unfold. While trusted public officials deny plausibility, the facts tell a different story (see linked Stratfor analysis). I believe that the market is going to have to deal with the reality of a bank crisis in Europe. Until it does, we are just biding our time.

In 2007, first a few hedge funds owning subprime folded. Then bank managers claimed that their total exposure was limited to a few billion dollars. While Jim Cramer screamed about the system coming down in 2007 around us, the Federal Reserve lowered interest rates a little bit and the stock markets lumbered higher. Then came Bear Stearns. And then Fannie Mae, Wachovia, and Lehman Brothers. By the time it was over, the President was talking about nationalizing the banking system.

Fast forward to Europe where the politicians are still claiming that default can be averted and the central bankers have managed the problem by cutting interest rates this week. In the meantime, Greece can’t borrow money in the private markets, it can’t pay back what it has borrowed already, and it is just about out of cash. Everyone knows they will default. The European Central Bank is now just moving around chess pieces in its attempt to reduce the impact of the event. Whether Greece remains a member of the European Union is anybody’s guess, but – frankly – who cares? What matters is whether the virus spreads to Italy and whether France gets shut out of the bond markets when forced to rescue its own banks.

This week Dexia became the first big bank to fail. A big bank operating mostly in France and Belgium, that had previously passed the European bank “stress tests” with flying colors.  Dexia shareholders were wiped out. The regulators are looking to put all of the bad assets into one bank, owned by shareholders (wiping them out), while moving the other banking operations into good banks that will be backstopped by the governments of each of the countries. The hope is that the impact of the crisis can be limited to private investors without resulting in a run on the banking system. And that, in short, is the hope for the entire European banking system. With luck, and a lot of planning, and very deep pockets at the central bank level, this solution will work.

Dexia is not the only proof that the run on the banks is already underway. French-owned Societe Generale’s Chief Executive Officer told Reuters Insider TV today that the system isn’t “insolvent,” but merely experiencing a liquidity crisis. For the banking system, however, a liquidity crisis is tantamount to a death sentence. Banks are going to be closing down – are already being closed, in fact – and bank shareholders are in the process of being wiped out. In the meantime, the politicians are in denial.

The Presidents of France and Germany are planning to meet this weekend. When the French bank regulators start closing down banks, France’s Nicolas Sarkozy would like to tap into the slush fund that the European central bankers have thrown together to backstop Europe’s financiers. As George Soros has pointed out in the past, however, it is not the borrower that sets the rules in a credit crisis. The primary source of bailout funds will be the Germans, and it has been Germany that has been calling the shots thus far. The Bible says that, “the borrower is servant to the lender,” and the wisdom of that proverb is never more clear than in a crisis. This weekend, it is likely that Germany will dictate that countries tap into their own funds to rescue the banks within their borders. The European Financial Stability Facility (the EFSF is the Old World’s TARP fund) will be reserved for nations who lack the wherewithal to bail out their own institutions.

France, now a AAA credit, is headed for a downgrade. The EFSF won’t be tapped until the headlines are talking about how the banking crisis could bankrupt Portugal, Spain, and Italy. Huge sums of money will be printed in order to prevent the bank crisis from getting out of control. Just as the U.S. printing presses have been running overtime, look for tremendous expansion of the supply of Eurodollars as well. And, yes, the U.S. will have to chip in to prevent contagion.

Unfortunately, Europe is not the only problem in the headlines. The U.S. economy, too, threatens to be an issue.

As it stands now, our concerns about a new recession may not be realized. In any case, I believe, the uncertainties will increase and anxieties about a new recession will grow.

The Conference Board’s traditional Leading Economic Indicator is reaccelerating as this bear market unfolds. That reacceleration is unprecedented. Even more interesting to me, our own May-Investments Leading Economic Indicator is still moving higher. I am hopeful that perhaps our concerns about entering a new economic dip will be for naught. Whether we actually have another recession or not, I think that the sense of uncertainty will increase over the next month.

Just last week, the Economic Cycle Research Institute released a report declaring that the “U.S. Economy (is) Tipping into Recession.” While some jobs statistics released recently have been better than forecast, job growth is still lackluster by any measure – so bad, in fact, that in earlier times the current degree of unemployment would almost certainly be associated with being in a recession already. And while the unemployment numbers were applauded by the press and the market, the layoff numbers were projecting many more layoffs in the coming months. Very few statistics show any real economic strength. The vast majority show an economy barely stumbling along – and the best of them indicate that the recent month isn’t much different than the month before.

The economy is on a precipice. Add uncertainty about Europe to the mix, and additional forecasts for recession seem like a very probable outcome.

Interestingly, research by Leuthold Weeden Capital Markets suggests that it really doesn’t much matter if we head into a recession or not. Bear markets associated with recessions are no worse than bear markets that are not associated with falling into a recession. The typical bear market goes down 30% in each instance.

Our current cash position is testimony to what we believe about the current market cycle. Leuthold’s major trend indicator flashed a warning signal on August 3rd that allowed their Asset Allocation funds to step back from the market early on in the sell-off. Investors Business Daily has twice moved to “Market in Correction” status since the beginning of August, and remains in that status currently.

This bear market was also unprecedented in that it gave almost no notice ahead of time. There were few if any warning signs of internal weakness. One day the market was peaking, and within two weeks it was flirting with “bear market” territory (-20%).  Not since 1938 has the topping process come as such a surprise.

For several reasons, we believe that the sell-off isn’t over. First, volatility remains high. Typically, at a bottom, volatility spikes up when the bottom is set. Though we have had days where volatility increases dramatically, we haven’t seen it return to normal levels. Now, two months into the beginning of the bear market, volatility seems to be riding at a much higher plateau, roughly twice the level of normal volatility. A spike from these levels will be truly gut wrenching.

Nor has the market become so inexpensive that buyers are likely to move in and begin scooping up bargains. If last Monday (October 3rd) is to be “the bottom,” then Leuthold points out that the market will have bottomed at the third most expensive level (based on normalized earnings power) in history. The times when the market bottomed at higher levels were in 1998, on the way up to the tech bubble, and again in 2002, on its way back down.

The Leuthold conference call noted that in their opinion, market bottoms are established by an “end to selling” rather than new buyers coming in to the market. Like most trading generalities (e.g. there were “more buyers than sellers”), this is unprovable. However, I think the point is well made that “selling” drives prices lower. When the European banking crisis hits full stride, it is hard for me to imagine that the pace of selling won’t pick up.

It is true that for every seller there is a buyer, of course. In this case, it is the buyers who establish a “fair price.” Just like the borrower is servant to the lender in a credit crisis, the sellers’ need to get out of a security is subservient to the buyers’ determination of what constitutes a “fair” price. For every seller there is a buyer, but the two do not have equal market power.

The spike up from Monday’s low suggests that market participants are reading the news from Europe and concluding that there are processes and institutions being put in place to resolve the European crisis. From my point of view, the fact that these institutions are being created is proof of the crisis that is to come. My fear, however, is that the anxiety that will be created as bank after bank closes its doors, and as the newspapers speculate on whether Spain and Italy and even France will be forced to default, will create a wave of selling pressure.

In the event that happens, it is the buyers – those of us with cash available for investment – that will determine what constitutes a “fair” price for investment. Market power will be on the side of those investors who have cash available and are willing to act as buyers amidst the chaos.

We have probably sold our last position. We are currently considering what to buy, and what (to us) looks like a fair price to begin buying. Baron Rothschild once said that, “the time to buy is when there’s blood in the streets.” We hope it doesn’t get to that – either in Europe or with the Occupy Wall Street mob.

Unless investors have cash on the sidelines at times like this, however, it doesn’t matter. Because our clients have cash available for reinvestment, we are hoping to be able to take advantage of the volatility which I believe lies just around the corner. It is not my choice that the world has turned ugly. It is, however, my observation that investors are coming in to a very dangerous period. Buy and hold investors will bear the brunt of the downturn and will be anguishing about the question of “is it too late to sell?”

For better or for worse, we will be consumed with the question of “what should we buy?” Not only is it a more positive question to be asking since it turns volatility upside down and makes it the creator of opportunity, researching opportunities also keeps us off the street at night, when the Occupy Wall Street mobs are running rampant. Capitalism is not pretty. Volatility is ugly. But we’re not in the fashion business.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Retirement Roadmap Leads to Success

If I told you that six out of ten diners trying to reach Casa Bonita set forth without an address or map, you would probably be surprised to find any of them at the final destination. Yet the majority of workers set sail for retirement without a plan, but are surprised to find themselves adrift in a sea of uncertainty while the miracle of compound interest eats away at their retirement chest. Failing to plan, some say, is a plan to fail. But no one wants a failed retirement. Obstacles to planning rob savers of security, success, and peace of mind.

For too many people, a “financial plan” is either an outdated document gathering dust on the shelf or a painful memory of an expensive process where a financial salesman rifled through their private affairs in search of a commission opportunity.

Without a plan, however, people wrestle with retirement choices without the facts needed to make a good decision. Investors don’t know how much they need to invest in order to achieve their unspecified goals. In fact, the whole season of retirement raises a frightening series of questions when it ought to be an exciting reward for a lifetime of hard work and achievement. Humans have a thankless habit of converting luxuries into problems. Without solid planning, we may convert the once unheard-of privilege of retirement into a myriad of quandaries and dilemmas. It is even worse when workers plunge into retirement before they are financially ready to make the leap from earned income to living off their pile of financial assets.

Those who do try to plan often end up asking a financial salesman to design the plan, which ends up being biased toward whatever product he sells. Others rely on do-it-yourself rules of thumb that fail to account for individual circumstances. Free web-based tools typically fail to address the real world problem of return volatility. A more robust solution would use a Monte Carlo analysis to examine what happens when stocks start out the retirement period by underperforming the original expectations. Printed plans that sit on a shelf fail to address the year-to-year changes that impact our lives, and our financial resources, as time goes by.

At May-Investments, financial planning is an ongoing process. Just as we continually monitor the markets to search for new opportunities, our approach to financial planning is also dynamic – ever changing as client circumstances evolve. Our plans are flexible and dynamic, a continuing dialogue about clients’ unknown futures so that we can make changes to the real-time strategies we’ve employed.

Plans don’t go stale because the planning process is never “done.” Sophisticated financial planning tools help individuals identify risks, collaborate with other professionals (CPA’s and estate planning counsel) during the process, import assets directly from their investment accounts and tweak goals and assumptions throughout the year. Comprehensive financial planning clients are more confident about their futures, and feel more in control of their future. With better financial direction, more know they are on track to realize their goals. There is also a correlation between the amount of assets accumulated and their willingness to participate in a comprehensive planning process – although there is a question of which came first, the plan or the assets.

Sadly, the folks who could most benefit from participating in a financial planning process are probably among the least likely to be reading this article. Those who have the worst sense of direction aren’t particularly interested in articles comparing compasses. The benefits to planning, however, are even more profound for those who haven’t done much of it in the past. We actually use something called a “financial roadmap” as the basis for our planning process. Don’t leave home without it.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Four Things To Know Before You retire

Is “retirement” an experiment that failed? The difficulties facing our country, and retirees specifically, make us wonder whether the plans people have made to spend more than half their life outside of the workforce are realistic. Succeeding at “retirement” is more difficult than many imagined. Nonetheless, we can offer four suggestions on how people can jump start their retirement planning effort.

The politicians competing for the Presidency debate whether Social Security is “a Ponzi scheme” or merely an entitlement program headed for insolvency. Wall Street seems to be focused on using retiree funds for their own enrichment with little or no regard for the impact of its actions on taxpayers or even its own customers. Academic research assumes that investors should adopt a “buy and hold” strategy throughout the business cycle, forcing many investors to take on more volatility than they can stand. And the complexity of the decisions confronting retirees grows worse, it seems, with each new law that Congress passes.

As a result of these problems, few retirees are able to negotiate the labyrinth of choices alone, and are understandably wary of trusting the advice that comes from financial service professionals. Forced to move forward without trustworthy guidance, investors may too easily panic when the market environment turns negative, which turns a paper loss into a real loss to investors’ net worth.

Hopefully the following four steps will help workers prepare of the onset of retirement.

First, investors should put “Social Security” into the proper perspective. Know that Social Security is a “social insurance” program that was never intended to be, nor funded as, a true “retirement plan.” Governor Perry calls Social Security a “Ponzi scheme” and in a sense, he is right. The older generations live off of contributions by the younger generation. As a “retirement plan” it has never been actuarially sound. However, the program was not designed to be a place where contributions are invested to be withdrawn at retirement.

Social Security is an “insurance” plan. It is designed to insure against the risk that seniors out-live their savings. When the program was established, the age when benefits could be withdrawn was higher than the average life expectancy of its participants. The average contributor was never expected to withdraw a single dime from the system. Only the oldest of the seniors – those who lived beyond the average life expectancy – were expected to access those funds.

When we started living longer, politicians refused to “cut back on the entitlement” and raise the age at which benefits could be withdrawn. The perception of voters shifted to social security as the place where funds are invested in order to facilitate retirement – and the earlier the better. This doomed the program to insolvency and investors need to re-orient their thinking or risk their retirement on the rocky shores of political expediency. Workers are not “entitled” to an early retirement. Not in Greece. And not here. If workers want to retire early, they need to save for that goal.

Successful retirees should view social security as an insurance policy that provides an income stream in the event that they live longer than normal, which puts them at greater risk of out-living their financial resources. Therefore, in order to retire “early,” workers need to create a separate retirement account where they can invest additional funds to provide income during the years after retirement, and before taking social security. Politicians debate the passage of legislation to create “private retirement accounts,” yet we already have a myriad of retirement accounts (IRA’s, SEP’s, SIMPLE plans) that fit this need. We don’t need legislators to create another new type of retirement plan, we need politicians with the integrity to stand up and fess up to voters that social security is not now, nor has it ever been, a “retirement plan.”

Retirees need to create a separate “bucket” of money, typically a specific type of retirement plan, to use in funding the “early retirement” years. Lacking such a stand-alone pot of resources, workers need to plan on working, delaying the date when they start taking social security distributions as long as they can. For most people, early retirement should be fully funded by private savings, leaving social security to provide insurance against the risk of retirees outliving their own financial resources.

Second, investors need to shift their thinking to accommodate the differences between investing for “accumulation” and, in later years, using investments to provide an income for life (investing for the distribution years). The investment industry has not kept up with this need. It is still pushing accumulation strategies on its customers when that is not, necessarily, their primary need.

At May-Investments, we divide money into two buckets for the purposes of what the industry calls “asset allocation.” The first bucket, we call “green money,” is conservatively invested and designed to provide clients a secure income stream for the next five to ten years. Green money may be invested in bank certificates of deposit, a bond ladder, or fixed or indexed annuities that provide a lifetime income benefit. May-Investments does not sell annuities, but we do recognize that they are often an important part of the solution.

Because annuities have often been abused in the past, some readers may automatically “tune out” recommendations that incorporate annuities as part of the solution. However, people should know that a June 2011 Retirement Income study by the U.S. General Accounting Office suggests that annuities are actually underutilized as a tool for providing lifetime income, especially for less-than-wealthy retirees. We can e-mail copies of the report, titled “Ensuring Income throughout Retirement Requires Difficult Choices,” to anyone interested.

Recent professional research is also beginning to incorporate the value of annuities in designing portfolios for investors during the distribution phase. A 2007 study by Richard K Fullmer, CFA uses annuities as a benchmark against which traditional stock/bond portfolios must compete. Based on the principles that (1) investors should never risk more than they can afford to lose, and (2) that no one should buy insurance that they do not need, his approach uses annuitization as a strategy alternative that is most appropriate for older investors who cannot afford to risk outliving their resources. Other studies have been evaluating the benefits of adding annuities to supplement more traditional stock and bond allocations in order to reduce the risk.

Investors need to keep an open mind to the conclusions drawn by the GAO and others about the potential for including annuities in an investment program. It is impossible to generalize. For some individuals, annuities should be the primary solution. For others, there may be no reason at all to use them. Every individual is unique, and each individual’s plan draws on their unique set of resources in order to meet their unique set of retirement goals.

Third, investors need to set aside the misunderstanding that proper “asset allocation” means a “static” (never changing) distribution among asset classes. While some diehard passive investors may be more comfortable having a fixed allocation to stocks, both in good times and bad, our view is that if your portfolio advisor suggested the same portfolio in October 2007 as in March 2009, something is wrong. The risks and opportunities at the top of the market were much different than what investors faced at the market bottom. Why does it make sense that the investment portfolio wouldn’t reflect these markedly different set of circumstances. Investors who owned essentially the same portfolio in late-2007 as in early 2009 ought to be asking whether their portfolio is ‘buy and hold’ due to choice, or inattention?

Yet the common myth throughout the industry is that “market timing doesn’t matter.” We all know that isn’t true. When the market crashed in 2008, the size of the allocation to stocks was all important. In fact, the hallmark study used by the industry to justify a do-nothing asset allocation policy proved quite the opposite – that asset allocation is the primary determinant of investment returns. Rather than ignore it completely, as most in the industry do, it makes sense to manage the portfolio’s risk profile across the market cycle. When stock prices are high and economic fundamentals are weak, it makes sense to reduce portfolio risk. At lower prices, and going into an economic rebound, it makes more sense to take risk because – generally speaking – risk-taking is more highly rewarded at that point in the cycle.

Fourth, retirement planning is not just about the money. It’s about your life! There are so many factors to consider that influence investor satisfaction with how their investment portfolios are doing. For many, managing risk is far more important than maximizing return. Having an advisor who is free to pick among a variety of solutions and vendors is also important. For others, the peace of mind that comes from having established a plan, and having the discipline to monitor the plan on an ongoing basis, imparts more comfort than any specific investment discipline can provide.

At May-Investments, financial planning is an ongoing process. Just as we continually monitor the markets to search for new opportunities, our approach to financial planning is also dynamic – ever changing as client circumstances evolve. Our plans are flexible and dynamic, a continuing dialogue about clients’ unknown futures so that we can make changes to the real-time strategies we’ve employed.

Investors should take time to have a plan prepared and share this plan with appropriate family members and professional advisors. The financial roadmap that we develop with clients helps us understand their priorities, goals, and where they hope to end up. Whether you get help in preparing a plan is optional. However, the benefits of planning, whether on the back of a napkin or in real-time using a dynamic software program (our preference), are only available to those who take the time to determine what road they should take into the retirement years.

Create a bucket of savings that allows you to retire early. Adjust your investment strategies to provide lifetime income as appropriate for the distribution years. Actively manage your exposure to risk depending on where you are in the market cycle and prepare a game plan that you can dynamically monitor in order to enjoy the peace of mind which you deserve.

There is so much more to a successful retirement than what happens in the investment portfolio. On the other hand, we all know that investment failure can create stress that makes it difficult or impossible to focus on friends, family and community involvement that are the ultimate reward for a lifetime of hard work. Jonathan Clements once wrote that, “retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money.” With the right preparations, the person who happens into retirement – stays in retirement!

 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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MPT Is Still Just A Theory

Most investors are basing their investment strategy on an oversimplified theory of investing that is better suited to writing dissertations than it is to managing an investment portfolio.

The tools most advisors use to build portfolios are based on Modern Portfolio Theory (MPT), which is the idea of creating a portfolio that balances risk and return using a computer-generated distribution of holdings designed to maximize return achieved per amount of risk taken. MPT works in theory, only because of the unrealistic assumptions made in constructing the theory.

MPT assumes that the future unfolds in a random fashion. In reality, future returns are much more likely to fall – from high valuation levels and when economic fundamentals weaken – and rise when the opposite is true. In statistical jargon, the distribution of returns are not in a normal bell-shaped curve. Returns are skewed by price levels and economic fundamentals. As a result of MPT, most investors keep the same (static) portfolio construction through good times and bad, rather than ramping up risk and return during the good times, and taking less risk when the outlook is less favorable. Taking the same amount of risk, in both good times and bad, reduces optimal return during good times and produces more painful losses in down markets. Ideally, portfolio Beta (the sensitivity to market risk) should be flexible, depending on where you are in the market and economic cycles.

MPT also assumes that probabilities don’t change and that investors don’t make mistakes. While not all investors admit their mistakes, or learn from them, all experienced investors have made them. MPT assumes that everyone has good data, can reasonably calculate the probability of future events, in a rational and error-free decision process. These assumptions pretty much rule out anyone and everyone who has experience investing in the market.

Finally, MPT is typically a backward-looking method. In theory, it should look forward. In practice, however, it uses historical returns as an input. So even in a world where long-term bonds pay only about 2.2 percent and are likely to decline in price in the future, your advisor’s computer will likely estimate a 5 percent return on bonds looking into the future. The entire investment industry, it seems, is dependent on a classic garbage-in/garbage-out process for constructing portfolios.

To do a better job, computers need accurate future return numbers as input, but crystal balls are in short supply. At the very least, “efficient frontier” simulations should be based on forward-looking estimates, but I know of no brokerage or advisory firms that are prepared to take on the liability of customizing those inputs.

May-Investments solution is to admit mistakes, adjust portfolio risk based on the current market environment and economic fundamentals, and to try to stay in the way of what’s working in the market – and get out of the way of what isn’t, allowing current market action and industry-specific economic fundamentals (rather than a computer simulation) to drive our portfolio construction process.

By proactively managing portfolio risk throughout the market cycle, we hope to be able to take the most risk only when risk-taking is being rewarded, and more effectively preserve wealth when markets turn down.

Plasma ray guns are great weapons, in theory. Hollywood used them in Star Wars, The Terminator, StarTrek and dozens of lesser known works of fiction. Like MPT, plasma guns are theoretically possible. In reality, however, plasma torches which have existed for some years can project plasma streams only about a foot. If an intruder breaks into your home, common sense says that an old-fashioned colt revolver would be a better choice.

The markets turned ugly in August. Are you still relying on Modern Portfolio Theory to protect your financial house?
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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S&P Downgrade Sends Volatility Higher

As if today’s 634-point stock market sell-off after the S&P downgrade of U.S. government debt wasn’t bad enough, the path taken by the sell-off was even worse. Because of how the sell-off unfolded throughout the day, we decided to reduce risk in the model portfolio, selling an exchange-traded fund mid-day and an industrials sector mutual fund at day’s end.

The key to the decision to reduce portfolio risk was the steadily increasing volatility (VIX) index throughout the day. An early morning spike in the index suggested that the market would be able to handle the ratings downgrade with only modest damage; eventually the market stabilized at around -300 points. But then the volatility index rose to new highs as the market struggled to hold its ground. When the VIX index approached its old spike level, we executed trades to sell our exchange-traded fund holding, the only intra-day sale that was possible in the model portfolio. Even worse, as the afternoon progressed, the VIX index climbed to even higher levels, suggesting that there is a significant risk of another sell-off tomorrow morning.

With the market moving so quickly down, we felt the need to protect assets and increase the amount of cash on the sidelines.

So, if the market falls another 1,000 points from here – what is that, two days trading? – there will be enough money on the sidelines, in cash equivalents or in gold, to buy a meaningful position of stocks at the lower price levels. We’ve always said that falling stock prices feel a lot worse if you don’t have any cash on the sidelines with which to take advantage of the new, lower prices. We haven’t had enough on the sidelines, thus far. With the rising volatility statistics, it was time to have some dry powder on the side.

If the market rises 1,000 point tomorrow morning, the decision of when and how to reinvest actually gets much more difficult.

The easiest way to explain this market, which is selling off much faster than the economic fundamentals would seem to justify, is that the market is factoring in a new recession that isn’t yet evident in the economic indicators. Today’s updated May-Investments Leading Economic Indicator is, once again, pretty flat. Neither is the Conference Board’s LEI warning about an upcoming downturn. But the falling stock market and rising bond prices are typical of what happens during an economic recession.

The stock market looks very reasonably valued – unless a recession causes earnings estimates to dramatically decline. One thing we don’t want to do is sit still and watch the market decline 50%, as it did in the 2008 sell-off, and do nothing to protect portfolios.

The risk that the shattering of consumer confidence will result in lower consumer spending and a new recession cannot be ignored simply because the traditional Leading Indicators, nor the May-Investments indicators, are confirming the risk. We all know that the effective monetary policy for small businesses is tight. There is no more room for fiscal policy to stimulate. More off balance sheet borrowing by the Federal Reserve may just lead to more credit downgrades. Given the lack of stimulus options available, it wouldn’t be shocking for the economy to turn down and if profit margins get squeezed, then valuations can easily come down also.

As I’ve heard people say several times in the past few years, “hope” is not a strategy. “Stubborn-ness" is not a strategy. Our strategy is to “get out of the way of where it’s not working.” At market extremes, it makes sense to go contrarian. At this point, however, it seems to make more sense to follow our discipline, have some cash on the sidelines, and reduce risk while this credit market disruption plays itself out.

I still don’t think that the U.S. is the big problem. But the Asian and European markets closed before the worst of the selling hit the U.S. market, so they are likely to be selling off tomorrow and wondering which European sovereign debt rating (e.g. France’s Aaa-rating) gets lowered next. Also, most individuals own mutual funds, not stocks or exchange-traded funds, and Monday’s market close will be their first opportunity to sell out. Those trades will hit the market Tuesday morning and may explain the big sell-off late in the afternoon on Monday.

Reducing risk in the portfolio enables us to reduce the amount of “fear” in our own thinking about the portfolios. With money on the sidelines, falling prices become an opportunity to buy instead of just a painful reality. We can focus forward, on the recovery to come, instead of just looking backward and regretting missed opportunities to sell.

This is all part of investing in stocks. It is why stock returns, going forward, will likely be higher than those available to bond or cash investors. This is why we don’t want short-term money invested in stocks, and why we’ve been encouraging people to make certain that only “risk” money is invested in stocks. Sometimes, like today, having a discipline forces us to make decisions that we begin second-guessing the moment we execute the trade. Having a process reduces the impact of emotions on strategy, but it doesn’t eliminate the feelings of emotion – the responsibility for making buy and sell decisions about other people’s money. That’s all part of managing money.

But it would be much more difficult, and emotional, if we had no discipline at all.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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What next after 512-point sell-off?

Today’s 512-point drop in the Dow left investors frightened about the future, disgusted with the Congressional folly that has brought us to this point, and wondering what action to take next. Although I am not as anxious about “the future” as others, the question of what to do next weighs heavy on investors’ minds, including mine.

Before I make a decision, some perspective is in order. Since July 22, the S&P 500 stock index has fallen -10.8%, including today’s jaw-dropping plunge. We finally achieved what many market historians consider “a correction.” Corrections happen, fairly often. The magnitude of the drop was not as frightening as how quickly it happened.

To put this drop in perspective, keep in mind that in spite of this today’s drop, the market is still up 6.5% from a year ago. To be hiding in cash in order to avoid this most recent bout of normal market volatility, at current interest rates, a bank certificate of deposit owner would have to hold their CD for 13 years or more to make up for the return on stocks over the past year.

To give more perspective, the “standard deviation” for the stock market is typically around 15%. This means “15 percent, plus or minus.” In essence, occasional 30 percent market declines are all well within the “normal” market environment.

The 2007-2009 decline of more than 50 percent is considered a “black swan” because it’s almost never supposed to happen. With that black swan event in our recent past, investor memories naturally jump to fears of another market rout, when in fact we’ve just barely reached the point where we’d call this a “correction” at all.

This sell-off feels bad, but not because of the severity of the decline. As market corrections go, thus far this has been relatively modest. The sell-off feels horrendous partly because we have short memories. Let’s be honest, tell me what “correction” you remember that didn’t feel awful! It feels even worse now because it happened after the debt ceiling fiasco which has left investors afraid of how our overly large government is bereft of credibility, impotent and incompetent, unable to address the very real challenges we face.

In fact, however, the U.S. economy continues to muddle through, lurching forward in much the same fashion as it has been all year. In April, while spirits ran high and the market reached new heights, weekly jobless claims languished around 400,000 per week. Today’s number, while called “disappointing” by the media, was right at 400,000. What has changed is not the absolute number, but rather the lack of confidence in our ability to turn the tide.

The total number of people receiving unemployment is still at nearly an all-time low since February 2009, when it skyrocketed after the 2008 financial panic. Housing affordability is near an all-time high. Today’s chain store sales met expectations, and are up +4.6% from year-ago levels. Auto sales weren’t booming, but haven’t weakened much except that Honda and Toyota still don’t have much product to sell because of the tsunami. The Institute for Supply Management numbers were weaker than expected, but still indicate growth. Factory orders were down, but not as much as expected. Construction spending is weak, but still up. Falling oil prices, while painful to the portfolio, may prove to be a welcome relief to U.S. consumers.

For the most part, the economic reports announced this week were either neutral or only slightly weaker. There has been little in the U.S. to justify this correction except that consumer and investor sentiment is awful. But therein lays an important clue as to where investors should be looking. Don’t look in the U.S. For all of our warts, and for all of the tragedy playing out in U.S. economic policy, the U.S. economy is limping forward like the cowboy in the old John Wayne movie that just won’t die, no matter how many arrows Washington’s progressive bureaucrats shoot in his direction.

The economic problem is primarily overseas. The debt ceiling fiasco appeared to be causing the market sell-off but when our self-made problem was finally resolved, the markets continued to go in the wrong direction. As bad headlines in Europe continued to get ink, investors have realized that the real problem isn’t with our own governmental incompetence, but rather the natural result of socialist policies in southern Europe.

But, even here perspective is in order. The Greece problem, though not quite resolved, seems to be inching toward a temporary solution. The bad press arrived when the bond prices of Italy and Spain began falling, especially versus German bond prices. Falling bond prices preceeded the meltdown in Greece, too, and the media has begun to paint all of Obama’s progressive partners in Europe as a collection of fiscal basket cases one step away from default.

While I’m no long-term fan of Italy’s fiscal rectitude or Spain’s entrepreneurial zeal, these nations are much more than a hop, skip and a jump from the mess in Greece, which was the poster-child for Enron-style sovereign bookkeeping. When Greece blew itself up, short-term interest rates rose to above 20% as Greece’s sovereign debt fell to cents on the dollar. With Spain and Italy, their interest rates have soared…to about 6.5%. While it’s true that Greece’s rates did go up above 6% on the road to oblivion, it is truly a leap of logic to assume that because Italy’s rates are now above 6%, that they won’t stop until their bonds, too, are selling for cents on the dollar.

Hey, let’s face it. Given the left-wing orientation of the political establishment in much of southern Europe, their interest rates ought to be at least 6%! Perhaps investors across the globe are finally realizing that these socialist welfare states really are much more risky than Germany. I am not going to conclude that disaster is around the bend, simply because Italians are finally paying an honest rate for the lira they borrow.

The fact of the matter is that Europe has some very real problems to resolve, and that paying for these past mistakes will be quite costly. I can only hope that the U.S. Congress is paying attention (although I seriously doubt it). Moreover, China has been working hard to reduce its growth rate from “on fire” to merely “breathtaking.” The end result of these terrible twin trends might very well be a global recession. And given our weak recovery, the U.S. economy might get dragged down in a global soft patch.

So, the investors’ dilemma is this. Should investors sell because the debt-ceiling compromise is a disaster and the U.S. economy is collapsing? I don’t think so.

However, in my view the issue is really whether the rest of the world is falling into a new global recession that threatens the U.S. recovery as well. This is the risk facing our portfolio. The mutual fund model portfolio sold its last (explicitly) international funds in mid-February, when we got rid of our Latin America and Asia investments. Our only international stock holdings are owned as part of a sector portfolio, and (mostly) as holdings in our gold and precious metals fund, which (most days) has been helping to hedge the decline in stocks.

Based on the facts, alone, I would have no trouble standing up to this sell-off. As uncomfortable as it is to own stocks in this environment…or maybe even because it is so uncomfortable to own them, intellectually I think that is the right call.

However, our discipline requires stepping to the side if the market enters bear market territory, which is right around the corner. We are probably a day or so from beginning to take money off the table. The gold position, alone, not only didn’t protect us much (today), it was actually part of the problem.

We often acknowledge our lack of a crystal ball. On days like today, in particular, it would sure come in handy. If we'd had it ten days ago - even better.  In its absence, we have a discipline that requires moving money off to the side in a down market. If this sell-off continues, we will have passed “correction” territory and be squarely in the midst of another bear market. If that happens, we have little recourse but to yield to the momentum of the market until more is known about the magnitude of the global slump.
 
Everyone wants to sell at the top. We’ve never even pretended that is our discipline. We’ve always promised to try to get out of the way of what’s not working. Unless today was capitulation day and the market recovers tomorrow or Monday, then we will move assets out of the way until things stabilize. Remember, we would likely never move all to cash. However, what looks to me like an over-reaction to a more rationally priced Italian bond might be much more serious, so we will follow the discipline and the next two days will determine what we do next. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Economic Growth Ignores Partisan Gridlock

Several people have asked me why the U.S. media circus du jour, concerns about the U.S. debt crisis, don’t seem to be bothering me as much as the Washington D.C. policy wonks think it should.

First, the market doesn’t seem to care much about the latest attempt at political grandstanding. If the market were worried about the U.S. defaulting on its Treasury debt, then the price of Treasury Bonds would be falling (i.e. interest rates would be going up). Instead, we see bond yields flirting with all-time lows despite rising inflationary pressures. The recent bond auctions have been well received – there appears to be no shortage of buyers. I don't know who is buying, and I can't imagine why, but the fact of the matter is that Treasury Bonds aren't suffering as a result of the bad p.r. that we've been generating. And while the stock market will swing day-to-day based on the latest headlines coming out of Washington, individual stocks are moving up based on strong earnings reports and continued merger and acquisition news. Cash rich companies are buying earnings rich competitors, driving prices higher in the process. Companies may be afraid to hire new employees, but they’re not afraid to purchase market share at current valuation levels.

 Also, May-Investments Leading Economic Indicator keeps moving higher.

• Retail sales continue to grow,
• Export activity is giving the manufacturing sector a boost,
• Drilling activity (nationally) remains quite strong and
• Banks are finding a few new borrowers.

Having spent most of the last three years kicking half of their old borrowers out the door, now banks are so overwhelmed by the generousity of U.S. taxpayers that a small amount of the bounty is actually finding its way out into the business community.

The money supply is growing at a 6 percent rate of growth – a key indicator for a closet monetarist like myself.  Finally, corporate profits are very strong. While the profits in the banking sector are, in my opinion, illusory (banks aren’t replenishing loan loss reserves the way they ought to, which bloats earnings and bonuses at the expense of honesty and transparency), the profit rebound experienced by most large publicly traded companies is nothing short of remarkable. With access to the public debt markets, these companies don’t face the same capital shortage as local businesses. They’ve cut labor expenses, interest expenses, and inventories. The rebound in profit margins and reported earnings is very real.

 As a result, the economy keeps growing.

The U.S. economy is a strong and powerful force. It took an inordinate amount of stupidity for Wall Street’s sub-prime mortgage cabal to bring the economy to its knees. Then an arrogant government attacked the engine of prosperity, creating a wave of panic and that is restraining the ensuing recovery. Soon, hopefully, the nightmare of endless deficits will be behind us and we will stop buying far more government than we need. It will still take awhile to pay off the debts incurred during the past decade of economic insanity, but at least the direction will reverse.

As they say, when you’ve dug yourself into a deep hole and you don’t know how you’ll get out – first, stop digging.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

Go to Investments main page.