Four Ways To View A Dollar

I’m glad I know sign language, it’s pretty handy. I used to have a fear of hurdles, but I got over it. Have you noticed that writing with a broken pencil is pointless?

I love puns. Words have so many meanings. Sometimes the multifaceted perspective about a single word causes confusion, but other times it’s the basis for humor. In financial planning, we often allocate money among different asset classes, security types, tax types, and buckets with each bucket having a different purpose and time horizon. We view each dollar from about four different angles – so many different perspectives that sometimes it no longer makes cents (get it?). Your financial advisor may take it for granted that you understand which point of view is being discussed at any point in time, but in reality the four-faceted view of each dollar is as often as not a source of confusion.

A dollar might be invested in a certain asset class. It could be invested in “stocks,” for example. And that same exact dollar might be invested in a mutual fund, as opposed to an individual security. The same dollar. It’s just a different way to slice up the portfolio pie. The dollar could be invested in an Individual Retirement Account (an IRA). This is just a type of tax deferred investing account. The IRA could be in a portfolio “bucket” designed to grow and protect the investor against the ravages of price inflation. Other “buckets” might be designed to provide income, or college money, or “fun money” or “pin money” for next Christmas.

We are constantly sorting money among different buckets. Sometimes, however, these different ways of viewing a single dollar can cause confusion.

For example, sometimes we ask clients how money is invested, wanting to know if it’s allocated to stocks or bonds, and they tell us that it is in an IRA, or a mutual fund. And no doubt the language of money is an equal opportunity obfuscator, perplexing and bewildering clients at least as often as it happens to us.

While each client situation is different, our solution is often to begin with a financial planning exercise to determine what overall asset allocation mix – which combination of equities, fixed income securities, real estate and other asset classes – helps clients meet their long term spending goals.

Next, we look at the taxable nature and investment purpose for each of the different portfolio “buckets” available for investment. For some people the Individual Retirement Account may be the perfect place to have tax deferred higher risk investments, like equities. Moreover, we may try to postpone taking distributions for as long as possible and take as little out as we can, to pass the assets on to heirs. For others, the IRA may already be so big and the deferred tax liability is already so great that we may want to slow down the growth by investing in fixed income securities, and tap the account hard for income during the income distribution years of retirement. Only by looking at both the goal of each account, and the tax status of each bucket, can we determine where we should allocate our growth dollars (what we call “red money”) and where we should place the less risky fixed income (“green money”) types of investments.

At this point, we still haven’t recommended whether to buy a stock, invest in a mutual fund or exchange traded fund, or buy an annuity or bank certificate of deposit. Each individual bucket has its own unique purpose, asset class, tax status and then, finally, type of security recommendation would be appropriate. Recommending securities, first, without taking the requisite planning steps, is all too often the industry norm. When a broker looks at a bucket of money and sees only the potential for a product sale, the joke is on the investor – and it isn’t funny.

This planning process can be short-circuited by investing each bucket in the same allocation, or always using the same type of securities in every bucket. Financial planning software rarely differentiates which bucket will be tapped first for distributions, and which will be last in line. In a good financial plan, however, your advisor has helped you know the order of distribution, the funding plan and distribution schedule for each bucket, and each portfolio strategy is tailored to each individual bucket while still working together at an aggregate level to present clients with an appropriate asset allocation well suited to each client’s personal risk profile and unique investment goals.

With a unique but cohesive planning strategy, it is easier to evaluate whether each portfolio bucket is meeting its goals and objectives. It is also easier to see that clients remain on track to reach their retirement long-term spending goals. Finally, clients are less likely to drastically change asset allocation, say cutting back on stocks at the worst possible time, because the overall strategy makes sense to them and makes them less likely to change horses mid-stream. The last thing we want for investors is that they “kick the bucket” and “upset the apple cart” at the wrong time, which could threaten the viability of their long-term plan and ultimately result in far too much spilt milk.

Okay. Now I’m just mixing metaphors and abusing altogether far too many puns. You can bet your bottom dollar that it’s time for this treatise on buckets to end. I really need to get a handle on this article if readers are going to grasp what I’m trying to say. Oh, editor. Please just make it stop.

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

July 2013 Portfolio Summary

As the summer rolls on and the market continues up, the May-Investments portfolios sit pretty fully invested and well positioned, we believe, for the current market environment.

Generally speaking, the mutual fund portfolio has nine fully invested positions and a tenth position in gold, which is only a partial position but the remaining cash in the portfolio is tentatively scheduled to increase our investment in the precious metals asset class.  We’re just waiting for it to stop falling before we double up.  It has been a long wait.

Eight out of ten positions are in U.S. stocks.  The U.S. market is much stronger than most international markets and alternative investments, so we are less diversified than we would be were that not the case.  We are over-weighted in financials (banks and brokerages), healthcare (biotech as well as a more broadly diversified fund), and consumer cyclicals (automotive and a more diversified consumer discretionary fund).  We are under-weight technology (but do have a position in software).  Our position in Japan is back up to a full weighting.

In the Custom Wealth Management portfolios, the core equity portfolio is fully invested again after a management buyout at Zhongpin, a Chinese pork producer, forced the sale of one stock and opened up room for a couple new positions.  The “flexible middle” part of the portfolio is fully invested, home to exchange traded funds in the financials, healthcare, and consumer cyclicals sectors, as well as an automotive industry sector mutual fund.  In the diversification part of the portfolio, we have Japan and a partial position in gold.  We also own the S&P MidCap 400 Value Index position, which isn’t much of a diversifier, but reflects the fact that few markets are keeping up with the U.S. market.  Why diversify when the best performing market seems to be our own?  Generally speaking, the remaining cash is set aside for us to allocate back into precious metals at some point in the future.

It looks like the economy may continue with its slow growth on into the latter part of 2013.  For the past three months, the May-Investments Leading Economic Indicators have posted modest increases, reversing a three-month decline during the first quarter of the year.  The fear of sequestration during the first quarter turned out to be worse than the reality of sequestration thereafter.

There is modest strength in retail sales, global shipping, corporate profits and manufacturing new orders.  Weakness is apparent in the outlook by small business owners, drilling activity, and capacity utilization, and the rate of growth in commercial & industrial loans and the money supply (M2) is declining. 

Overall, the LEI isn’t projecting robust growth, but at least there is a slight upward trend. The indicators are supposed to help us look forward about six months, so hopefully our January forecast for continued economic growth throughout the year will remain on target through the rest of 2013.

If so, I would expect markets to cooperate as well.  As money begins to dribble in off of the sidelines, valuations (Price/Earnings ratios) are adjusting up.  Corporate profits have increased slightly, but as P/E ratios increase the value of stocks goes higher and the strong performance of stocks is attracting the attention of investors who are getting paid almost zero, nada, zilch to have their life savings invested in banks.  Today’s low interest rates continue to enable huge deficits by the government at the expense of consumer spending, particularly by seniors.  It probably isn’t a good thing that “savings” are being moved into “investment” accounts, but it’s happening every day and it’s one reason why the market keeps rising even as the pace of economic growth simmers down.

The biggest market risk remains…the political mess in Washington D.C.  While we got past the debt cliff and have even moved past the onset of sequestration with minimal fanfare, the budget wars are far from over and it’s never too late for the folks in Washington to step in and make matters worse.  It seems to be what they do best. 

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

Throwing Her Hat In The Ring

Throwing your “hat in the ring” is an early 19^th century boxing term. An 1810 article reported that “a young fellow threw his hat into the ring and followed, when the lame umpire called out ‘a challenge.’ …He then walked round the ring till a second hat was thrown in, and the umpire called out, “the challenge is answered.”

Given the rough and tumble world of political service, it may be appropriate to use a boxing term to describe Barbara Traylor Smith’s July 19th announcement that today she filed papers noting her interest in serving out the distinguished Harry Butler’s remaining term on the Grand Junction City Council.

Having served the community through the Grand Junction Rotary club, and more recently as Chairman of the Strive Foundation board, Barbara’s commitment to the local community is already well established. This latest challenge allows her to focus more time studying the issues confronting Grand Junction and learning more about how the community wants the City to serve its citizens in the future.

Here at May-Investments, we understand that it is a big commitment and we are enthusiastic in our encouragement about her decision. At work, as in retirement, “it’s not about the money. It’s about your life!” We want Barbara to feel free to contribute what she can to the city where we all live. Although it would be nice to coast and let others do all the work, that’s not the way it works in real life. After considering her family, faith, and business commitments, Barbara believes that she can make a positive contribution while still meeting her primary responsibilities. At May-Investments, we want everyone to reach their God given potential and are excited for Barbara as she steps up to this challenge.

We wish her the best. And, by all means, feel free to give her a call about potholes needing attention in the event that she is selected by the City Council to step into the ring.

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

The Style Box Paradox

Zeno’s dichotomy paradox refers to a philosophical conundrum where someone wishing to get from point A to point B must first move halfway before completing the journey. However, since they always have to complete half the journey first, and the half-journeys can go on ad infinitum, the Greek philosopher was forced to conclude that they would never arrive at the destination but would forever be stuck at various halfway points. It’s a great theory, but it just doesn’t make sense in the real world. People get to their intended destination all the time.

In investing, the theoreticians often study portfolios in the context of investment style boxes. Some portfolios are characterized as small cap value while others are classified as large cap growth. Classifying portfolios in this way is helpful in understanding fund performance looking backward over a discreet time period. However, classifying portfolios by style box classification is not particularly helpful while building portfolios. In the real world, bottom up investors shouldn’t care that much what style box the stock falls in. A more helpful way to classify stocks when constructing the portfolio is by industry and sector. At May-Investments, our portfolio building process has always emphasized sector rather than style box classification. We might look for a consumer stock with good earnings growth prospects that sells for a reasonable valuation, but we really don’t care how the stock is classified by the style box methodology.

A recent Fidelity Investments study explains that, “beyond company-specific factors, sector exposure has been the most influential driver of equity market returns.” While passive indexers mimic their marketing masters who repeat ad nauseam the myth that stock selection doesn’t matter and that a static asset allocation makes up 85% of investor return, in reality the studies showed that asset allocation is so important that it shouldn’t be held static, and that stock picking and sector selection actually matter a lot. While these facts inconvenience the passive indexing crowd, that doesn’t change them.

Style box investing, while great for performance attribution, helps little during the portfolio construction process. It’s a great theory, but it just doesn’t make sense in the real world. The Fidelity study notes that managing sector exposure is key because, “of the distinct risk and performance characteristics of the 10 major sectors.” While a specific stock’s style box attributes fluctuate constantly as ever-changing financial characteristics evolve, companies’ sector and industry attributes remain fairly constant. Moreover, these consistent performance drivers have a wider dispersion between the best and worst performing categories. “Equity sectors tend to have significant performance dispersion relative to each other, which is a key attribute for any alpha-seeking equity allocation strategy,” Fidelity observes. In other words, for investors trying to focus their portfolio on the best performing investments, more can be gained by focusing on sectors where the difference between the best and the worst is significantly wider than is the case with styles.

Another key difference is that different sectors have lower correlations to one another. This makes it easier to diversify risk than can be done using a style box orientation. “During the 2000s, the average correlation of sectors versus one another was 0.52, while the same average correlation among style box benchmarks over the same period was 0.76.” The higher the correlation, the higher the risk that all types of styles will rise and (more importantly) fall at the same time. Fidelity goes on to note that portfolios created with equity sectors “are more efficient – providing higher return and lower risk – than those created using style box components.”

Vanguard Fund founder, John Bogle, has made quite a stir lately criticizing the exchange traded fund industry for creating industry specific ETFs and branding the investors who use them as some form of wild speculator. Bogle, of course, made his fame and living off of passive investing. To his credit, he developed a firm based on low-cost investing strategies. To maintain that his approach is the only legitimate strategy is a bit arrogant, however. The lowest price car in the U.S. is the Nissan Versa S Sedan, priced at $12,780. The car comes with a manual transmission, a less fuel efficient engine, 2 wheel drive, bad ground clearance, a hardtop and very few bells and whistles. Are we all fools for not buying the lowest priced car, as Bogleheads suggest? Or are there other reasons to prefer a different way of viewing the world?

Anyone interested in getting a copy of the Fidelity Investment Insights white paper (Equity Sectors: Essential Building Blocks for Portfolio Construction) can e-mail us and we will be glad to forward a copy of the study.

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

Economic Indicators Up For Second Month In A Row

The economy has been sending mixed signals for most of 2013. May-Investments developed its own Leading Economic Indicator to help our firm understand the current economic environment. Today’s LEI readings are again forecasting continued economic growth during the months ahead. After weakening earlier in the year, the month of May proved to be the second straight up month.

May-Investments developed its in-house indicator rather than rely on the Conference Board’s traditional LEI. With the Federal Reserve adopting Enron-style off balance sheet financing vehicles in order to move the government’s new bond issuance out the doors into buyers’ hands, the old economic indicators became obsolete and the Conference Board’s new indicator is untested. In the meantime, investors are having difficulty understanding whether today’s economic growth is a mirage, an encouragement, or a house of cards about ready to fall and take investors down with it.

Our economic indicator peaked a year ago when activity in the drilling patch declined, small business owners retrenched, and purchasing manager new orders dropped off. Whereas eight of ten component indicators were rising in March of 2012, by the end of May only half of the indicators were on the rise. In October, 2012, only three were moving higher. As 2013 began, in spite of our positive economic forecast for the year, the May-Investments Leading Economic Indicator began trending down again.

In April, however, small business optimism improved slightly and the decline in drilling activity was less significant than it had been a few months back. Overall, the upturn represents less of an “improvement” than it does a less forceful downtrend than at the beginning of the year.

Retail sales are still an area of strength, but they are not as strong as they were a year ago, or in January, and are what we are watching mostly closely for signs that the recovery will continue. Global shipping rates remain weak and bank lending is not growing as fast as it did in 2012. A slowdown in the growth rate of the money supply is also surprising, and worrisome, given the moves that the Federal Reserve continues to make to try to flood the economy with money. We are thrilled that the LEI moved up, but it is too early to conclude that there is much strength there.

As things are now, we stand by our forecast for continued economic growth during 2013. We had projected Gross Domestic Product (GDP) growth of +2.5% this year. We projected an economy that would be making progress in its move back toward normal. As of the most recent GDP report at the end of May, the U.S. economy is growing at a +2.4% rate, pretty much as we expected. Hopefully this recent upturn in our Leading Economic Indicator suggests that slow steady growth rate can continue throughout the rest of this year.

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

Japan ETF Trade

The Japanese stock market has been on a tear since Prime Minister Shinzo Abe initiated his own version of Quantitative Easing (printing money) which appears to be QE100X (quantitative easing “on steroids”).  Money has to flow somewhere, it seems, and these days the money seems to flow directly into the stock market.  In response to the rapid printing press strategy, the value of the yen promptly and materially declined in value.  Japan’s twenty-year bear market seemed finally to come to an end, and it did (for a few months).

As we mentioned in our Tuesday Noon Classes in April, our strategy calls for moving money toward asset classes that are working.  The strong and seemingly sustained strength in the Japanese market led to our initiating positions at the beginning of May.

The Japanese market kept rallying into mid-May, and then the short-lived rally came to an end.  The Nikkei 225 turned down and never really looked back, entering bear market territory this week.  At the moment, to generalize, we have small losses in our positions and are frankly not in the mood to take a big loss. 

The Japanese market ran up fast in furious in 2013.  The iShares Japanese Index ETF (ticker symbol EWJ) is still up about 11% year-to-date, in spite of the market currently being in “bear” territory.  The Japanese market is another QE-driven asset class with an ETF that is quickly attracting widespread hedge fund interest, somewhat reminiscent of gold in 2011.  The main difference is that gold wasn’t just coming out of a 20-year doldrum when it ramped up.

For the most part, I have viewed the recent sell-off as somewhat appropriate given how fast the Japanese stocks moved up earlier in the year.  Some “consolidation” would actually be a good thing.  Stocks don’t go “straight up,” typically.  Those that do go parabolic usually do so just before crashing back down again.  A little correction would have been welcomed.  At the beginning of the week, it seemed more like a time to add to positions, rather than a time to bail out.

Then came Wednesday night.

On Wednesday night, the Japanese market fell about -6.5%, overnight.  As you can imagine, this created a bit of consternation as I watched the sell-off unfold that night.  Moreover, the yen (currency) was also moving a lot.

When we bought the iShare (EWJ), we chose the exchange traded fund security that demonstrated the best liquidity characteristics.  There are other ETFs available that try to eliminate the impact of currency adjustments by hedging away currency moves.  We weren’t buying EWJ in order to speculate on the yen, one way or the other.  We have, however, seen futures-based ETFs disappoint investors as the constant and costly futures trading result in those securities underperforming our expectations.  We chose EWJ in order to avoid the currency issue, prioritizing liquidity and low expense ratios over currency strategies.

Instead, this week it became clear that one way or another, currency is going to be part of the equation.  To be honest, not understanding the currency impact as well as I should have, when I saw the dollar/yen relationship moving –1.5% on Wednesday night, the pessimist in me pretty much assumed that the currency was moving against us as well.  On Thursday morning, I came in to the office expecting to see EWJ moving down –8% (just days after doubling up on some of those holdings).

So, imagine my surprise when EWJ closed UP over 2% that day.

This caused me to do a couple of things.  First, I jumped for joy.  The security we owned performed 10% better (in a day) than I had expected.  Luck was on my side.

However, it also meant that I really didn’t understand how this ETF was working, not nearly as well as I needed to.  If it meant that I could be 10% lucky on one day, I could just as easily get a 10% disappointment on (literally) the next day.  That was unacceptable.  So the first thing I did was cut our position in half until I could get a better understanding of what was driving the performance of this security.  In theory, it’s really not that tough.  ETFs are usually pretty straightforward instruments.  The Nikkei 225 Index goes up or down, and this ETF should follow.  But at the end of Thursday, I had all sorts of questions.

Why is the Nikkei suddenly so volatile?  Moving –6.5% in a day is not the norm for a healthy market.  How could the U.S. market response to the previous night’s plunge be so different?  EWJ opened up, and just kept getting stronger.  It never reflected the sell-off at all.

There are four fundamental factors that I needed to monitor in order to come up with the answer.  First, the action on the Nikkei stock exchange is the primary influence on returns.  Second, the movement of the currency is significant – more significant than I had originally wanted to believe.  Moreover, in my shock at the –6.5% decline in the market, I had assumed that the currency was also moving against me.  In fact, the yen was increasing in value on Wednesday night, which reduced the dollar-denominated loss to a –5% market move.

Third, ETFs trade at a premium or discount to their net asset value and this, too, was having a bigger impact than I had expected.  ETFs normally trade pretty close to net asset value, by design.  If the computer-generated valuation of the stocks in the index is $10, then the ETF might trade at a discount of $9.98 or a premium of $10.02, but in general discounts and premiums aren’t material.  One of the reasons that we prefer exchange traded funds (ETFs) to closed-end funds, which also trade at discounts and premiums to net asset value, is that market makers can generally keep the gap to a minimum.

On Wednesday night, before the Japanese market opened, EWJ was trading at a pretty hefty 2.5% discount to net asset value.  As a result, the first –2.5% decline in the value of the Nikkei 225 was already “baked in” to the price of EWJ.  Now, instead of having to explain a 5% variance, I’m down to only a 2.5% variance in what happened to EWJ as compared to my expectations.

Finally, at the end of the day on Thursday, EWJ was trading at a 4% PREMIUM to the Nikkei 225.  As the trading day continued, it is quite possible that money was flowing INTO the EWJ exchange traded fund.  As buyers came in to “buy the dip” in the Japanese market, the demand for EWJ shares was so strong that they actually began to trade up versus the security’s intrinsic value (the “net asset value”).  Also, the U.S. market was trading up during Thursday, and certain large Japanese stocks like Honda and Toyota trade on the American exchanges, so the intrinsic value of the Japanese market was moving up even though the Japanese market wasn’t open at the time.

The bottom line is that our positions in EWJ are still slightly below cost.  If EWJ goes down much more, we will cut our losses and sell out.

Second, the volatility the yen is having an enormous impact on the valuation of our EWJ investment.  We really wanted to ignore the currency impact on this investment.  That was naïve.  Just because we don’t want to be currency speculators, and use a security that doesn’t focus on currency hedging, doesn’t mean that we will be able to.  Once again, the political ramifications of easy money policies are creating enormous uncertainty in the markets.  There’s just no way around it, these days.

Third, the market makers aren’t doing a particularly good job of closing the gap between the price of EWJ and its net asset value.  This is a pretty new problem.  Normally, gap issues only impact investors during times of crisis.  In normal trading times, the gap is relatively immaterial.  Right now, that’s not the case.  Hopefully it’s just an unusual time for this particular ETF, rather than a sign of big underlying liquidity issues across all of the international markets.  Still, we’re going to have to treat EWJ almost like a closed-end fund, limiting buying opportunities to times when there is a significant discount, and taking advantage by selling into premiums, as we did on Thursday.

Lastly, I have a sense that the underlying fundamentals in Japan are not what’s driving the market.  The Nikkei was said to dive because U.S. quantitative easing policies are about to “taper” off.  Why would U.S. monetary policy cause a –6.5% mini-crash in Japan?  That doesn’t make much sense.  Unless, of course, what’s driving the Japanese markets higher are U.S.-based investors, using EWJ as the preferred speculative tool.

In watching markets, this week, it did not appear that EWJ (the U.S. trading tool) was following the Japanese market.  It appeared the EWJ was LEADING the Japanese markets.  It seemed, at times, like the entire Japanese market was responding to what EWJ was doing over here.  The tail seemed to be wagging the dog.

If that’s true (and I’m not at all sure that it is), then it would appear to be somewhat like when all of those U.S. investors bought gold ETFs in 2011, which drove the real markets higher as the financial demand for gold overwhelmed the actual supply in the physical markets.  Could it be that financial demand for the Japanese market, through hedge funds buying ETFs, is the source of Japan’s rally?  If the fundamentals in Japan aren’t improving, and the source of the Nikkei rally, then that’s a big deal and makes me much less willing to own shares of EWJ in the portfolio.

In any case, this week’s buy-then-subsequent-sale of EWJ shares is not something that I ever want to do again.  Because the Japanese market mini-crash wasn’t being reflected in the U.S. traded shares of EWJ, mostly because the ETF swung overnight from a 2.5% discount to a 4% premium, we took advantage of the gift and reduced the size of our exposure.

Soon we’ll have to decide if we’re going to completely eliminate it, or not.  If Abenomics works and this finally helps Japan begin to climb out of its twenty year recession, then we’ll get back in and just pay more attention to the yen and the gap between the ETF and its net asset value.

On the other hand, if we decide that the fundamentals in Japan aren’t driving the Japanese market, but rather it’s just U.S. speculators pushing that market around, then I’m not as inclined to stick around.  If trading in U.S. markets determines what the Japanese market does the next day, then something’s wrong.  If Japanese news causes its market to rise and fall, on its own, and then the U.S. ETF simply reflects these changes, then that’s an asset class in which I will consider investing.

Right now, it’s not clear what’s the driving force with this investment.  If trading activity doesn’t start making sense, and I mean soon, then we’ll just exit the rest of our position.

You know what they say about markets and poker.  If you don’t know who the patsy sitting at the table is, then it’s time to fold your cards and go home.

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

A Question For Secretary Lew

I’ve met two U.S. Treasury Secretaries in my lifetime.  Technically, when the Stanford Committee On Political Education dined with G. William Miller, he was a former Secretary.  He was relatively disgraced at the time, so the campus speaker bureau paid a lower fee than we would have paid for Paul Volcker, his successor.  Volcker later became a national hero for having the courage to raise interest rates until the inflation beast was tamed.  Often times, doing the right thing requires a thorough understanding of what ails us, in order to do the unpopular, but ultimately necessary, thing.

Last week, I had my 45 seconds of fame with Jack Lew, the current Secretary of the Treasury Department during the Colorado Capital Conference. 

I would have enjoyed having more time - enough time to have an extended discussion, but that wasn’t in the cards.  I decided, instead, to ask a question that sends a message, just in case the administration official with the most direct influence on my financial well being was in a mood to listen.

After noting that in 2009, bank examiners came into our neck of the woods and forced local banks to cut back their real estate loan books, forcing them to call in loans (even ones that were current) at the worst possible time – and making things worse than they needed to be – and then after noting that even now the mortgage markets remain much tighter than necessary, with even millionaire clients having difficulty getting loans that ought to be a lay-up, I told Secretary Lew that I did not blame him.  After all, he was just newly appointed to the position.

Prior to that, he’d been doing a bang-up job for the administration on debt reduction, as he is the author of sequestration.  Before that, he was a Chief Financial Officer at Citigroup, joining the firm just as the real estate bubble was getting going, shepherding that failed organization into the financial crisis and collecting multiple million-dollar bonuses funded by taxpayers as it unfolded, before finally jumping back to the mother ship to re-join the newly elected Democratic administration. 

Now this man who helped sink the ship at Citigroup is in charge of defending Americans against a Federal Reserve hell bent on impoverishing the elderly with 0 percent Certificate of Deposit rates in order to bail out a banking sector so flush with cash that it can’t think of anything to do with the money, other than return to the days of multi-million dollar bonuses for its hard working executive staff.  Is he up to the job?  Is he even trying to fix the problems in the banking sector?  Is he even vaguely aware that the problems exist?

Which is why I asked him if he was aware of the fact that the Treasury Department, itself, is part of the problem.  If he’s not aware of this, then he probably isn’t working too hard to find a solution, was my thinking.

Others heard his response, which was long-winded and in which he noted that we don’t want to return to the days of “no-income check and low-doc loans.”  I would agree with him on this point, which was (alas) irrelevant to the question that I asked.  He also pointed out that evidence of problems in 2009 is not important to today, however the mortgage loan example that I gave him happened only a month ago.

I didn’t want to be one of those people who demand 120 seconds of fame by asking a 3-minute question, so I left out a few other examples of why I believe that the Treasury Department, itself, is part of the problem.

For example, I’ve been told that banks which used to specialize in farm and ranch lending are now no longer allowed to have an above-average concentration in…farm and ranch loans.  Every institution must conform to the average, which is itself constantly declining because there is no longer any incentive to be particularly good at a certain type of lending.

These days, clerks at Fannie Mae and computers programmed to reflect the new bank Examiner requirements are making lending decisions, easily automating tough decisions that once required experienced credit analysts to decide.

Nor did I question the current regulatory imperative to consolidate the banking industry, forcing small community banks to merge into the fold of growing regional giants.  This, they think, will ease the burden on regulators.  However, it wasn’t the community banks that were the root cause of the sub-prime crisis.  Ground zero for those problems were the financial industry giants who packaged up toxic loans in order to sell them through their investment banking subsidiaries.  You know;  companies like, well, Citigroup.

The Treasury should be pushing back against the Federal Reserve.  The Fed’s charter is to protect the banking system.  The bankers in the system are doing quite well, frankly.  Wells Fargo’s CEO, on the backs of government subsidies and benefitting from Dodd-Frank regulations that have left it with nearly 100 percent market share of the local mortgage business, was paid $19.8 million in 2012.  Now, I happen to believe that Wells Fargo is one of the most profitable and rational of the big money center banks, but if they’re paying Stumpf $20 million bucks a year, I maintain that they are not in need of their free money subsidy.  Savers, most of whom are retirees and many of whom are low income elderly, are the folks in need of an advocate.

Logically, that advocate should be the Treasury Department, rather than the Fed.  The Treasury Secretary is the President’s key advisor on the people’s financial plight.  He’s supposed to be on our side, right?

But, to fix a problem requires a certain amount of insight.  Enough, for example, to realize that a problem exists.

I asked Lew a “yes” or “no” question.  Is there an awareness at Treasury that they are part of the problem?  The Treasury Secretary’s long-winded statement should probably be interpreted as a “no” answer.  I sure didn’t hear a “yes” hiding in there anywhere.  Really, is it that hard in Washington to admit that the government is not perfect?  In any case, I was discouraged by his response.  I see no signs that the leadership at Treasury is going to do anything to fix the problems that he refuses to acknowledge.

Volcker had the knowledge to understand what it would take to whip inflation, the courage to take unpopular measures in the interest of restoring long-term health, and the integrity to do what was best for the people of America, even when they didn’t like him (or the Administration) for doing it.  Jack Lew, I’m afraid, is a political hack who neither understands the problem nor has the integrity to acknowledge there even is a problem.  His crowning achievement up until now, sequestration, is both foolish and cowardly, and designed to fail by relying on formulas instead of accepting responsibility for making responsible budget cuts.

He is unlikely to understand what ails us or take the unpopular but necessary actions required to make things better. 

Fortunately, worldwide, the resilience of America’s economy is still the envy of the world.  But someone in Treasury needs to start working on these problems.  As someone once said, what good does it do if we’re still nothing more than the best looking horse in the glue factory?

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

2013 Colorado Capital Conference

I just returned from the Colorado Capital Conference, hosted by Colorado Mesa University, the University of Colorado, and Senator Mark Udall’s office.  Hopefully the conference organizers will post Congressman Tipton’s opening remarks, or even the session where Treasury Secretary Jack Lew dropped in for a quick visit.

There were several points where the legislators emphasized how well both parties work together to help Colorado, and how we need to work together to begin making progress on unemployment, the deficit, and other problems.  Senator Udall reiterated his support for a Simpson-Bowles type of compromise, as well as his support for a balanced budget amendment.  The Budget Hero exercise we discussed demonstrated just how hard it will be find a solution.  While meeting within our diverse groups, the face-to-face time led to a more civilized conversation, but it is also much more difficult to slash and burn programs when personally faced with an advocate for that issue in the group.

At the end of the conference, it was hard to understand how our legislators are having as much difficulty as they are.  The people I met were hard working, smart, open to other ideas – even from the other party.  Still, we asked them tough questions about the irrational formulaic budget cutting method we’ve adopted (sequestration), trillion dollar deficits, cumbersome and nonsensical education regulations and tax rules, and an arrogant bureaucracy that wants to dictate how many days a week the local school cafeteria can serve potatoes. (More than one day?  It literally took an act of Congress to get them to change.)

Should we blame Congressional leadership?  The Administration?  Is it the fault of Congressional gerrymandering?  Would redistricting or more open primaries help?

It was a fascinating opportunity to meet some of the problem solvers and public servants who are working together to solve some of these problems.  I came away with more of an appreciation for our representatives in Washington.  However, I am even more convinced that government has over-reached and is crazy out of control.  When even good people can’t make the bureaucracy listen, what hope to mere citizens have?  Because even the lawyers acknowledge that the laws are strangling the teachers and businesses and doctors trying to help people, there is hope that something might be done to change the status quo.  I do hope they’ll try more, smaller solutions and fewer 2,000-page legislative opuses (like Dodd-Frank).

Personally, meeting the lawmakers helped me come to terms with our blue state status.  While I may not have personally supported a number of the folks whom I met at the conference, these are sharp, experienced people, with Colorado-moderate tendencies, and worthy of support for the hard work that is ahead of them.  I wish them luck, but at election time we should hold them accountable, too.  While the problems are dire, I think that we’ve put capable people in charge.  I wish them the best and am far more optimistic about the future than I was before making the trek to the Capital.

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

Embracing the Four Stages of Retirement

Planning is vital to enjoying a happy and peaceful retirement. Not just financial planning, but preparation in a wide range of areas. Our retirement planning practice breaks the planning issues into four distinct stages in order to focus the planning effort and we encourage people to start planning at least ten years before hitting their retirement date.

While successful retirees share the trait of planning for retirement, many people appear to be overwhelmed by the thought of laying the foundation for success in the final season of life. Of the eight traits that we teach people, it’s the most important habit shared by successful retirees and it’s not nearly as difficult as people fear. For those that don’t plan ahead, they increase the amount of anxiety they experience and potentially miss out on time sensitive planning opportunities that could help them improve their financial situation in retirement.

May-Investments breaks the planning process into four discrete stages and then applies complex retirement planning software to give clients a sense of what their financial future may look like. While the planning tool is sophisticated, more than anything else it is going through the process, itself, that makes the big difference. We look at the big picture and we tell people that ‘it’s not about the money, it’s about your life!’

In the first stage of retirement planning, clients are still working and accumulating assets. The primary questions to answer involve, “how much is enough?” (or “what’s my ‘number?’ as the insurance ads used to say). One key question is when the client should file for Social Security benefits, which is an area where poor planning can lead to irreversible mistakes.

In the second stage, prior to taking Social Security benefits, the question is often about whether or not to factor part-time work into the plan. A planned work slowdown can both enable an earlier retirement and increase the total level of satisfaction in retirement. The vocational transition this involves also makes it a great time to consciously develop new social networks that, once in place, will help people throughout the rest of their lives.

The third stage involves full, active retirement. Collecting social security benefits and with a retirement income plan kicking in, these folks are some of the most active people in the community. Days are filled with travel, leisure, and community involvement surrounding each person’s passions and expertise. While this is the stage that most people think about when planning for “retirement,” the prior two stages are even more important in helping people truly enjoy this third stage of maximum activity.

The fourth stage, full retirement, involves handling well the health and other challenges that we face during our final season of life. In this stage, we cement our legacy in both spiritual and financial arenas. Hopefully we are creating memories for others that build them up as we manage a new set of financial risks and health challenges. Drawing down financial resources, it is a time when many retirees face an important decision regarding whether or not to annuitize financial risk (hand that risk off to others). Although it is the time when long-term healthcare plans are put into effect, by the fourth stage it is probably too late to craft a long-term healthcare plan. That issue needs to be addressed much earlier, while there are more options available so the optimal choice can be made.

Starting early, breaking things down into smaller and more manageable stages, and systematically reviewing the retirement plan ensures that the plan is current, flexible, comprehensive and implemented properly. As with most disciplines, it is something that many people will implement easily on their own, but most will need a coach on the side to structure the process and bring the right tools to the table. The only way to “lose” in the planning process, is to fail to start.

Retirement, like life, is a process rather than a destination. There is no single “number” above which your financial wealth will assure you a happy and healthy retirement. Happiness and peace of mind seem to require a concerted planning effort, but planning in the fun sense – preparing for a season of life focused on passions and relationships, should beat the daily office grind, even if you do currently enjoy your job. Embracing these four stages of retirement, in the planning process and beyond, can help you “Retire Right” and enjoy the opportunities that await you beyond the working years.

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

ETF Swap in Mutual Fund Accounts

The portfolios recently sold shares in the iShares MSCI EAFE Index fund (EFA), which invests in companies in the Morgan Stanley Capital International Europe, Australasia, and Far East markets.  With the proceeds, we purchased the iShares Dow Jones International Select Dividend fund (IDV).

Swapping from EFA to IDV is a bit more arcane than our normal portfolio move and we wanted to explain the (very simple) rationale behind the switch.

Fidelity Investments has had a small number of exchange traded funds which trade no-commission, much like the no-transaction-fee mutual funds which we typically use.  EFA has been on that list, but very few other ETFs (including IDV) were included as NTF exchange traded funds.

About a month ago, Fidelity inked an agreement with Blackrock, the company that sponsors iShares, to broaden the number of exchange traded funds that trade without commission on the Fidelity platform.  Importantly for us, there were several ETFs which we do normally use to track alternative asset classes that are now included.

We are believers in actively managed mutual funds, but at times the advantages of ETFs are large enough that they make sense instead.  One of the disadvantages, particularly with the international mutual funds, is that we are locked in for a minimum 90-day holding period.  If clients need those funds for any reason, or if the market starts breaking down and we would like to get out, which definitely happened in the 2008 crash, the ETFs have the advantage of less onerous minimum period holding fees.  Instead of charging 2% of principal for selling a mutual fund early, as is the case with our Matthews Tiger Fund (MAPTX), with the ETF selling before 30 days costs us, at most, $17.95 per trade.  If the markets are indeed starting to crash, $17.95 is nothing.

So, as a result of the new deal between Blackrock and Fidelity, the EFA iShare was being removed from the No-Transaction Fee platform (I have no idea why), and IDV is being added to the NTF platform.  We had until April 30 to get out of EFA, commission-free.  I’ve been holding on, trying to determine whether the international fund can hold its position in the portfolio, but thus far it has been doing fairly well and we simply are running out of time to make the swap on a transaction-fee basis.

Small changes in trading fees don’t often trigger portfolio changes, but it did in this case.  Every $17.95 helps. 

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

Tax Smart Retirement Strategies

The January 2013 tax hikes make tax planning more important than ever. Two strategies we’ve identified are of particular interest to retirees trying to make their savings last as long as possible.

The higher tax rates and lower deductions already passed by Congress, along with new “means testing” of entitlement programs which is likely to come, make it more important than ever to smooth out income sources. Spikes in annual income result in onerous tax rates and, more than likely, will result in reduced benefits from Social Security and Medicare during the high income years.

Retirees need to think about smoothing earnings to the degree that is possible. Having money in an Individual Retirement Account (IRA) is good because gains aren’t reported until money is distributed from the IRA. Outside of the IRA, gains tend to be more “lumpy.” However, all money taken as a distribution from a traditional IRA is taxable at ordinary income rates, so retirees who are taking $60K to $80K in traditional IRA distributions are pushing themselves up into a pretty high tax rate. It would be better, if possible, to spread money between a Roth IRA (which is “after tax” money, so distributions aren’t taxable) and a traditional IRA. A retired person taking out $30K to $40K from each may be in a much better tax situation than if it all comes out of a traditional IRA.

So make Roth conversions during low income years, and take advantage of that funding source as a non-taxable source of cash during the normal years.

Similarly, pre-funding charitable giving could also help smooth taxable income. During big income years, if cash flows allow, a person could put several years’ taxable donations in a Charitable Giving account and get a large deduction to offset the large amount of income. Then, in later years, rather than giving a portion of taxable income, less (taxable) income can be recognized while still meeting charitable giving obligations through the charitable giving account. For tithers, rather than having to earn $111K in order to maintain a $100K spending lifestyle, and paying high marginal tax rates on the extra $11K, the year’s tithe could be paid from the pre-funded tax-deductible charitable giving account.

A community foundation is a great place to establish a charitable endowment fund as a legacy planning strategy, however the Western Colorado Community Foundation (WCCF) is best suited to provide a long term philanthropy strategy. To create a bucket to build up giving for 1 to 5-year stretches, it will likely become necessary to use the charitable giving organizations set up by Schwab or Fidelity Investments to help donor giving strategies.

A charitable giving account could also be useful as part of a college financial planning program as well, although it is really only useful for people who maintain some control of their reportable income. For salaried workers, there’s not much that can be done. On the other hand, salaried employees tend to have much smoother income streams than entrepreneurs, who often enjoy very lean years that will hopefully be offset by the occasional windfall.

Finally, entrepreneurs selling a business can also structure a business sale to smooth reported income. Rather than taking a large lump sum, it may make sense to retain real estate assets that can be leased to create a smooth long-term revenue stream, or the entrepreneur may want to set in place a consulting contract that stretches out several years in order to reduce the size of a lump sum payment income spike that would push them up into the high tax bracket, or consider an installment sale instead of a large up front payment.

Most importantly, don’t succumb to the temptation to over-emphasize tax planning, however. It is an important consideration, but certainly not the most important thing to consider. After all, planning for retirement isn’t about the money. It’s about your life!

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

Market Uptrend Under Pressure

Today the Investors Business Daily changed its market scorecard to “uptrend under pressure.”  IBD has been whipsawed as many times as we have, in recent years, but it still makes sense to pay attention to what the overall market is doing.  Stocks and commodities “go up like an escalator and down like an elevator.”  Trying to avoid a big drop doesn’t make sense, and then doesn’t make sense again, and then doesn’t make sense, until suddenly it’s the only thing that does make sense.  Trying to reduce risk in highly risky markets is at the core of our “Flexible Beta” strategy, so we haven’t stopped paying attention when the markets raise warning flags.

IBD’s scorecard isn’t the only thing that makes us worry about whether 2013 will be as good of a year as we’d been expecting.  A quick study of which asset classes and sectors are doing well, and the most recent update of our May-Investments Leading Economic Indicator, also gives us pause for thought.

Bonds and defensive stocks, especially utilities, often do best during tough times.  Bonds recently took a breather from selling off and yesterday the moving average convergence-divergence (MACD) signal just turned positive.  That’s a concern because bonds are not cheap.  The primary reason for them to do well is if the economy is heading for a downturn.  Ditto for utility stocks.

International stocks also seem to be moving from strength to weakness.  Unemployment in the Eurozone hit a record 12 percent in February.  While rates in Greece and Spain are above 26 percent, the recession is evidenced throughout the continent.  In Greece and Spain, half of the young adults under the age of 25 are unemployed.

Commodity stocks have been hit hard, too.  Gold stocks are selling at prices equivalent to where they sold at the height of the financial panic in the Spring of 2009.  Flows out of gold bullion exchange traded funds are down 20 percent in recent months.  Investor sentiment is extremely negative.  While normally this is a contrarian sell signal, it hasn’t signaled a turnaround thus far.  We don’t think that people have to get excited about gold stocks for them to do much better.  We just need to see an end to the “dumping” of shares.  After all, the last time that gold shares sold at current levels, in 2009, the price of gold was about $900, well below today’s price of $1,550.

At the beginning of each month, we update our Leading Economic Indicator inputs.  Of the ten variables that make up our LEI, about half are updated at the beginning of each month.  When we input the most recent data, it appears that our LEI chart is turning down again.  The pattern looks very similar to 2007-8.  (Note, however, that the market conditions are quite different than in 2007, so my overall level of concern is not the same.) 

Our technology sector indicator, as well as the Institute for Supply Management (ISM) “New Orders” index, both turned negative for the first time in several months.  We’ve been thinking that 2013 would be a year of modest continued growth, but the factors that often point to which direction the economy is headed are beginning to tell a different story.  Unfortunately, the story being told is consistent with weakness that is beginning to develop in the stock market.

May-Investments response to increased risk is to reduce our holdings of stocks owned in exchange traded funds to quickly and cost effectively reduce overall stock exposure.  Because the U.S. market retains its “most favored” status among global investors, most U.S. sector ETFs have yet to hit what we consider to be “sell” signals.  This is a good thing, partly because we are still in sectors that enjoy relatively better performance than the rest.  Our positions in financials, healthcare, and consumer cyclicals are still doing better than average.  If this market trend turns down, however, we don’t expect them to somehow avoid the trend.

Most portfolios still have about 10 percent invested in cash equivalents.  We have said before that we’re not sure if that 10 percent represents our last investment “in” to the market as it recovers, or the first 10 percent to come “out” of the market in the next downturn.  After spending the first quarter of 2013 looking for what to buy with that money, this past week we’ve been forced to turn our attention to the fact that maybe we ought to be looking at what we next need to sell, instead.

We’ve been on an escalator for four years now.  The current bull market is already longer-than-average, if not “long in the tooth.”  Investors need to remember that sometimes markets feel more like an elevator (down) than an escalator (up).  We certainly haven’t forgotten.

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

Bear Market Hits Gold Stocks

After the interest rate bubble pushed bond prices to all-time highs, the Dow Jones Industrial Average has surged into new high territory as well.  In contrast, the stocks of companies that mine gold and other commodities are in the midst of a full-fledged bear market.  More importantly, May-Investment clients own positions in these companies and clients are asking why we aren’t “getting out of the way” of this asset class that really isn’t working, at the moment.

Many May-Investments clients have owned gold and precious metals investments, through mutual funds, exchange traded funds, or individual stock positions since March of 2009.  While positions may have been sold and repurchased in the interim, generally speaking we have been owners of gold for the past four years.  We have even more reasons to own these companies now than we had originally.

In 2009, gold stocks were going up and the government was running the printing presses on overtime, igniting concerns about dollar-devaluation.  Since then, the price of gold has increased, earnings throughout the sector have generally increased, and the psychology has shifted from positive to greedy and now to extremely negative.  From a valuation perspective, too, it is much easier to make the case for gold, today, than it was in 2009 (when just about everything was cheap).  Today, gold is like a relic from 2009; while some other asset classes have doubled off the lows, gold mining stocks languish back at 2009 prices.

One thing that is abundantly clear now, however, that wasn’t as apparent in 2009 was that gold doesn’t respond well to our normal trading rules.  In August of 2009, we sold our position for a modest gain because gold was lagging other parts of the market, which were rallying quite a bit.  Only three months later, gold more than caught up and we bought back in, at a much higher price, at which point gold once again took a breather.  While momentum hasn’t worked all that well, anywhere, in the past couple of years, it has been particularly dangerous to gold investors.

In the summer of 2012, it was clear that our discipline was telling us to sell gold again.  We hung on, and in the third quarter of the year gold soared higher, moving so quickly that gold moved from the bottom performing asset class to the top spot for the quarter, up more than 30 percent in only three months.  As it turned out, rather than a “buy” signal – this would have been a “sell” signal for gold.  Since then, the gold Exchange Traded Fund is down nearly 30 percent.  Had we sold in June and bought back in, in October, we would be much worse off.  Trading gold, using our traditional trading rules, would have been a very costly mistake.

Instead, we are forced to make a longer term decision about keeping gold, or selling it.

One of the original reasons for buying gold miners still applies.  More than ever, the U.S. government continues to print money so aggressively that it is hard to imagine it not resulting in currency devaluation.  Throughout history, many governments have tried to print their way out of a financial crisis, convinced that ownership of a printing press is a license to overspend, but none yet has managed to avoid paying consequences for unrestrained monetary growth.  Moreover, in 2009 it was mainly the U.S. government that was experimenting with this new theory of “Quantitative Easing.”  Now, Europe and Japan have jumped on the easy money bandwagon, too.

After this new bear market in gold stocks, the gold mining companies now sell for about the same price as they did amidst the Great Recession of 2009.  The price of gold, itself, which is the source of revenue for companies that are in the business of converting gold reserves into precious, shiny metal, is actually worth about 70 percent more than it was in 2009.  While no longer selling at its peak, the metal itself is worth significantly more than it was when we first bought into gold mining companies.

Not surprisingly, given the rise in the value of what is stored in the basement of gold mining companies, the companies themselves are far more profitable than they were back in 2009.  Earnings in the sector, generally, have tripled since early 2009, when we first invested in these companies.  In spite of this, their stock prices have done a round trip back to 2009 levels.

Compare this with the stock market, generally, which has appreciated significantly since 2009 and now sells for roughly 15-times corporate earnings power.  Gold miners, however, are currently valued at only about 10.6-times earnings.  Comparing gold companies to the broad stock market, the gold stocks sell at a cheaper valuation and are about as uncorrelated to stocks as anything else out there, making it a good diversifying investment for a growth portfolio.

Another popular asset class is inflation-protected Treasury bonds, which promise to pay investors a certain rate of interest in addition to ratcheting up bond principal to keep up with inflation.  In the long run, gold is also likely to keep pace with inflationary pressures.  However, according to the Baseline gold miners industry index the gold stock sector is comprised of stocks paying an average dividend yield of about 3.5% per year, while 10-year TIPS bond yields are negative (about -0.61% at the most recent Fed auction).

Inflation protection and yield are things that everyone seems to want, unless it comes in the form of a gold miner stock, in which case the current bear market psychology trumps every other investment attribute.

The speculative fever in 2011 popped when the U.S. economy failed to succumb to political gridlock and resumed its growth pattern.  The number of speculators in the gold futures market is down significantly from the excitement that accompanied gold’s spike to $1,900.  The net positions of large futures speculators have been cut by 45 percent, while short interest in the gold futures market have increased as speculators reverse the bullish bets made only 18 months ago.

In the meantime, real demand for gold seems to be holding up.  Ned Davis Research group believes that central bank buying by the People’s Bank of China accounts for a lot of this demand for real gold.  About the same time that China’s central bank stopped investing in U.S. Treasury securities, demand for gold spiked higher.  Their thought is that, “the desire to own physical gold (strong hands) remains solid, in contrast to paper gold (weak hands).”

Essentially, by March of 2012 my gold investment feels as contrarian as my skepticism about tech stocks in 1999, my concern about a real estate bubble in 2006, and my interest in junk bonds at their nadir in 2009.  We’re in the midst of a vicious bear market for gold companies.  And if a bottom can be called based on the degree of pain experienced by “long and wrong” bulls, the bottom has got to be close.

A recent “Seeking Alpha” article expresses a technical case for gold and gold stocks making a technical bottom.  Please be aware that the author’s views do not necessarily represent May-Investments view, but many readers of this blog will find this article of interest.  Furthermore, that author talks about specific investment securities which are typically not owned by May-Investments clients.  We don’t typically like to blog about specific securities, but found the article of interest in how it discusses the possibility that gold is at a bear market nadir.

So is this a great time to add to our existing positions?  That’s the problem with bear markets.  They are particularly vicious in their last days, which makes bottom fishing tough.  The ferocity of this sell-off remind me a little bit of 2008, when one of the first indications of big problems around the corner was a nightmarish sell-off in international stocks and commodities.  It might be that the commodity bear market is just an indicator that it’s a good time to sell, everything else.  Hopefully not.

The recent sell-off also correlates to a short-term boost in the value of the U.S. dollar, particularly versus the yen and the Eurodollar.  Maybe the sell-off in gold just means that the other currencies involved in Quantitative Easing are blowing themselves up?  Whatever the case, the weakness in gold accounts for a great deal of my grumpiness, of late, particularly as other parts of the portfolio surge to new highs. 

At this point, we’ve re-experienced a bear market in gold and gold mining stocks, and to some degree in commodity stocks, generally.  It is important to recognize the grinding pit in the stomach that accompanies a bear market, because often times that is the signal that it’s time to buy.  If so, it’s time to buy the gold mining stocks.  My main regret, of course, is that they are already in the portfolio.  So it seems like a poor time to cut bait and run.

It took less than 6 years for the bear market in U.S. stocks to round-trip back up to 2007 highs.  My guess is that we’ll see new highs in the gold mining stocks long before 2019.  The reason that gold doesn’t trade well is because it is so volatile.  For the past 18 months, we have experienced the downside of volatility.  Looking forward, I think it’s high time we once again enjoyed the upside volatility that gold and other commodities can deliver.

If the stock market is right, and it is signaling continued economic expansion, then we ought to be cycling on into the late stages of economic recovery, which is identifiable by rising interest rates and higher commodity prices.  If so, better times for gold could be right around the corner.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Dow Hits New Record High

Today’s media is focused on the new high set by the Dow Jones Industrial Average index yesterday, and apparently an even higher and newer high, today.  While I’m generally happy that the markets have been strong, as we anticipated in our January economic forecast, the fact that we’ve hit a new high neither makes me excited, nor anxious.  I’m in the camp that “it’s just a number” and, despite the hubbub, a pretty meaningless number at that.

Still, it's certainly not bad news that we finally recovered back to the 2007 market high.  In fact, it didn't take all that long, historically speaking.  Ned Davis calculated that it took 5.4 years for the market to make its roundtrip after its 54% 2007-2009 decline.  In the two previous crashes (declines of 40% or more), it took 9.8 years to bounce back after the 1974 bear market, and 25 years to recover after an 88% plunge during the Great Depression.

Setting a new high doesn’t make the market attractive, nor expensive.  Granted, I’d rather have the market move up than down, but the fact that it is now at a “new high” doesn’t necessarily make it expensive, nor does it indicate anything about the market’s future prospects.  Think about it.  Bank savings accounts make “new highs” every day.  Their principal doesn’t go down, and each day they earn a tiny fraction of a percentage in interest, which is added to yesterday’s total, so that each day the savings account makes a new personal best.  But this steady progression upward doesn’t make it an attractive investment because the alternatives to savings accounts are (generally) doing so much better.  What makes a savings account attractive, or not, is its rate of return (i.e. its income-generating power).

With stocks, what makes a market attractive is its income-generating power and its valuation related to its future earnings potential.  In the case of stocks, the Dow Jones Industrial Average currently trades at only 13.5-times earnings.  For most of the past 20 years, this group of stocks has traded at more than 15.5-times earnings.  Based on current projected earnings, if the Dow just gets back to that average multiple of 15.5X and current earnings forecasts are met, the index could rise to nearly 18,000 in the next few years.  That cheap current valuation, and potential for additional upside, is what makes equities exciting, not the fact that we’re at a new high.

Folks worried that the current market is expensive, because the last time it reached this level it peaked, ignore the fact that earnings power is much stronger now than was the case in 2007, the last time we were at these levels.  Inflation-adjusted earnings are just getting back to 2007 levels, but in 2007 the earnings were jacked up by a number of builders and financial companies that has faked their earnings amidst the real estate bubble.  Today, it is harder to find similar instances of earnings puffery, although some companies are clearly beneficiaries of today’s unrealistically low interest rate environment.  In general, however, earnings quality is much better today than was the case back in 2007.

Still, we will caution investors not to get too excited about the stock market.  Particularly when the government is holding down interest rates, punishing savers in an unsustainable attempt to juice the financial markets, some might be tempted to invest “savings” in the stock market.  We’ve always said that it’s a mistake to confuse “green money” (savings, which typically can’t tolerate the ups and downs of the stock market) with “red money.”  We’ve had our red money mostly invested in the market since 2009.  Investors who succumb to the temptation to move “green money” into the market are taking a big risk that interest rates go back up and the next time the market falls, they will succumb to the temptation to take it out of the market at just the wrong point in time.

We’ve often said that we prefer it when pop culture “news” dominates the front page instead of business or economic events.  We would much prefer Britney Spears in the headlines than things like “sequestration” or “tax increases” or “unemployment.”  Having said that, if the media is going to focus on an economic story, probably the best event they could focus on would be the market reaching new highs.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Housing Moves Past 2008 Financial Crisis

Amidst the doom and gloom “sequestration” headlines has been good news about the U.S. housing sector.  Homebuilding seems to have moved beyond the crisis that began almost 10 years ago with easy money, government policies designed to put people into homes regardless of their ability to pay, and a financial sector more than willing to package toxic sub-prime debt and sell it to overpaid investment managers who weren’t paying attention to the enormous housing bubble that these policies created.

As with the technology bubble before it, severe pain accompanied the bursting of the bubble, and it took nearly a decade for the industry to recover some sense of normalcy.  (Hint: bond investors and taxpayers, beware.)

The good news is that the housing industry is finally well on its way to getting back on its feet again.

Although very few experts will date the recovery the same way that I do, it’s fairly obvious that the real estate market bottomed exactly one year ago today, on February 28, 2012.  That is the day that I closed on the sale of our old house on Catalina Court.  That date represents the absolute nadir of home values in Mesa County, and most likely the rest of the country.  I don’t want to overstate the importance of personal, anecdotal evidence.  It is quite probable that Europe and Asia will be on a different timetable.  For most of North America, however, I think it’s safe to say that 2/28/2012 was the bottom.

Prices have been going up and prices should continue to rise, at least until they’ve reached an equilibrium with replacement costs.

And I would like to take this opportunity to personally apologize to all of my old Paradise Hills neighbors for the horrible comparable sale that will haunt real estate appraisals in that neighborhood for the next few years.  On the upside, we found fantastic buyers who, word has it, are a real asset to the cul-de-sac.

This week’s Case-Shiller home price index confirms that home prices are on the rise, and also the time frame of February 2012 as marking the bottom.

The main reason that prices are starting to move up is that the swollen “shadow” inventory of existing homes, and especially foreclosed and “distressed” homes, has declined significantly in the past year.  The National Association of Realtors inventory statistics reported this week that total inventories, reported in months’ supply, are at a record low.  At the onset of the Great Recession of 2008, the industry professionals were quick to cut prices and unload inventory while existing homeowners were reluctant to recognize how quickly values were falling.  New home inventories plunged, almost as fast as sales.  Having cut new home inventories at the outset, the industry kept them low for most of the past four years.  However, during 2009 – 2011, existing home inventories ballooned and for most of the past four years the gap between low “new” and high “existing” home inventories grew.  This inventory of existing homes for sale, and additional foreclosed real estate inventory on the books of banks (the so-called “shadow inventory”), weighed heavily on real estate values.

Home prices fell furthest when distressed sellers had to unload existing homes “at any price.”  Given the dramatic oversupply of existing home inventory, buyers were able to purchase homes at prices well below replacement cost.  This isn’t news to anyone reading this blog, of course.

What is new is that this month’s statistics indicate that the excess inventory has been worked off.  The fact that “total (home) inventory” is at a record low confirms this.  This should dramatically reduce or eliminate the number of distress sales.  Supply and demand are no longer so out of balance that buyers can drastically under-bid sellers, and be successful.  As a result of both government policies and the horrific unemployment numbers, we started with too many "renters" who were given mortgages without equity and eventually these renter-owners needed to be replaced, in many instances, by landlord-owners.  This transition was painful and costly.  But with these pricing pressures relieved, home prices finally bottomed and should now rise to where home prices are roughly equal to replacement cost.

Now we are seeing experienced home builders, in Mesa County and other markets, go back into the homebuilding business.  The only way they can do this is if they are able to sell product above cost.  Therefore, prices generally should rise at least to the point where houses are selling above replacement cost, which wasn’t true at the bottom, a year ago.  There's no way that you could rebuild my old house, and acquire a lot, and put in landscaping, for our selling price - even after factoring in about 13 years of deferred maintenance because I'm not too handy of a guy.

The dwindling supply of existing homes means that more demand will be met through new home construction.  During the bubble years, new home sales peaked at around 1.3 million homes per year.  Recently, we have been selling nearly 425,000 annually, up significantly from 2009/2010 levels.  With the excess existing home inventory worked down, new home sales will likely continue to improve to something in the range of 600 thousand to 1 million, annually.

There will be some “wealth effect” as homeowners “write up” the value of their homes, but I wouldn’t expect this to be significant.

What will likely be significant is that the shift from people buying existing inventory to new homes will reduce unemployment, some, and begin to put upward pricing pressure on copper, lumber, and building materials prices.  After all, one reason that we haven’t experienced inflation in recent years is that there has been virtually no demand in the U.S. for new construction.  Looking out into 2013 and 2014, this should change.

It will also be interesting to see if construction methods change as well.  Necessity is the mother of invention.  During the good times, buyers weren’t cost sensitive and builders were happy making money the old fashioned way.  With new Computer-Aided Design technologies and pre-fab building techniques, it will be interesting to see if new companies and processes emerge as this new cycle progresses.  If you know of any such stories, please give me a call.  Talking with a skilled professional in the plumbing trades, which is an industry which is increasingly moving toward pre-fabricating systems that are quickly assembled on-site, it’s not an easy transition to make.

It is good news, however, that we are making headway working through the real estate bubble.  I still don’t expect the construction industry to lead the U.S. out of its current economic doldrums, which is traditionally how the economy does get out of a recession.  But maybe, if the recession lasts long enough, and the building industry continues to improve, it will have a greater impact than I expect.

Homebuilding stocks, which are very cyclical, historically trade in a wide range around a Price/Earnings ratio of roughly 11.5-times earnings.  Based on current earnings, the stocks trade at a multiple of about 28X.  Even based on projected 2014 earnings, the stocks are expensive at 16.2X forecasted earnings.  This is clearly an instance where the stocks rebounded in anticipation of the industry fundamentals.  Still, industry earnings in 2014 are only expected to recover to about 20 percent of 2006 earnings levels, and the stocks themselves remain at only 50 percent of their previous highs.  There could be more upside, but current valuations make it hard for me to get too excited about investing in those companies.

Whether the stocks are ahead of themselves, that’s the question.  Whether the future of the homebuilding industry looks better than the recent past – well, that looks like a much better bet and this week’s industry statistics help explain why.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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