Administrivia

We've changed our name! May-Investments, my Grand Junction-based registered investment advisor that provides custom wealth management services, has announced a name change from “Scout Partners, LLC.” The new name was chosen with the encouragement of clients, “who like seeing me take accountability for the investment results by having my own name on the door.”

The name change is effective immediately though firm ownership remains 100% local and in all other ways, such as its existing relationship with Fidelity Investments as its primary custodian, the company remains the same.

We needed to make a change to satisfy some out of state lawyers, and the old name caused enough confusion that it really wasn’t worth fighting over. Our strategy of total capitulation seems to have worked, so we can focus on actively managing client portfolios and continuing to protect clients from what has been, thus far, a pretty tough market.

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

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True Capitulation or a Sponsion?

As the market sold off in the first half of 2008, investors have been looking for the point of capitulation where stock prices surrender to the bearish sentiment of the day until finally the last seller succumbs to his willingness to take any price, even a rock bottom price, for the value of his shares. Optimism is surrendered. Hopes for a higher price disappear. The financially defeated investors yield, allowing for the market to bottom. When the last seller throws in the towel and there are no more sellers left to dump shares, then there is no place for the market to go except up.

In bank stocks, July 15 was a classic point of capitulation. Worry spread that two of the biggest banks around, Fannie Mae and Freddie Mac, were going belly up because their stock prices were falling swiftly toward single digit levels. The combined enterprises, once valued at over $100 billion, fell some $80 billion in market value and took a great deal of investor confidence down the drain as well. Worries about the creditworthiness of some $5 trillion in outstanding debt obligations spread throughout the banking sector. It would be hard to find a bank somewhere that doesn’t have these agency bonds on their books. If agency paper was to be the next victim of the sub-prime lending debacle, then no bank or savings & loan would be safe. Acknowledging that these stocks were in fact too big to fail, without saying so explicitly, the Fed stepped in with legislation to effect the quick nationalization of these companies, if necessary, so that the debt issues of these institutions wouldn’t lose value, even if their stock prices did fall to $0. This dramatic move, along with some technical requirements that made it harder for short sellers to dump shares in bank stocks, resulted in the mother of all short-covering rallies.

Eight days later, the bank sector was up 50%. Wachovia shares doubled. Capitulation, it seemed, had finally arrived.

The odd thing about capitulation is that there have been times throughout history when defeated armies have surrendered to lower ranking soldiers who lack the authority to sign off on the deal. A sponsion is an agreement by an agent not authorized to cut the deal. The sponsion must later be ratified by those in power for it to be binding.

I worry that the financials, as important as they are, lack the requisite authority to mark the beginning of a new bull market. Financials will spend the next several months trying to rebuild their credibility, retool their business models, and strengthen their balance sheets. The last seller may have decided that he’d take $7.80 for his Wachovia shares, but after the stock bounced to $17 new investors in the name remain scarce. For a true capitulation, one that signals a great buying opportunity for investors, we need some other sectors to attract new investors and start moving the market higher.

The main driver of 2008, financials, is a long way from having the authority to assert leadership. Energy stocks, the other prime mover during the past 6 months, have moved so high that each move up only made the subsequent tumble more painful. No, for this really to be a profitable point of entry, I believe that export-driven sectors like technology and health care need to start moving up. So far we’ve only experienced a short-covering rally in the financial sector. The result has been a sponsion. We eagerly await ratification by stronger areas of the market.

One area of the market that is looking better is the small cap growth stocks style (represented by the IJT iShare). Morningstar notes that this ETF has large concentrations in energy and industrial materials areas which have helped performance, but so has a 12% weighting in software and hardware stocks, and a more than 15% weighting in healthcare. In contrast, the utility iShare has started losing money recently, losing money when oil prices rise on interest rate fears, and losing money when oil prices decline because many utility sector stocks trade like the energy manufacturing company that they are. In any case, the heads “you win” and the tails “I lose” characteristics which the utility stocks have recently displayed have cost them a place in the asset allocation mix.

For clients invested in our ETF model, this gives us another chance to continue with our move out of ETFs and into the mutual fund model. Clients have sold their XLU shares and will be using the proceeds to purchase holdings in the software sector where we believe shares are attractively valued and industry fundamentals remain healthy.

For clients already invested in the fund strategy, we have reviewed current portfolio holdings and see no reason to change them at the moment. Companies in the healthcare sector are looking strong, and short-term bonds are struggling to maintain their place in the portfolio, but having just added biotech holdings to the fund strategy, we’re not anxious to double-up on healthcare quite yet. Nor are we willing to let go of bonds given our concerns that a true point of capitulation may not have been reached. Capital, once lost, is hard to recover. We’ll wait for a few more signs that the July 15 low point has been ratified by the capital goods, technology and healthcare sectors before we let go of any more of our defensive positions.

The individual stock strategies have stepped up, proactively, to begin adding to holdings of semiconductor, healthcare equipment, and insurance names. Even the individual stock portfolios retain some dry powder, though, in the form of cash equivalents and holdings in a closed-end bond fund. We are hoping that what we saw in July was a bottom. Heck, we even think that it’ll prove to be a bottom. But having invested much of our cash from the sidelines during the first two weeks of July, we are now in the unenviable position of “hoping” that we reached the low point on July 15. The market feeds off the dashed hopes of investors, so we’re a little bit uncomfortable hoping for signs that an economic rebound is coming. There are many reasons to expect a rebound, but not a lot of signs that it has arrived yet.

The individual stock portfolios are “buying low” in anticipation of the rebound. Both the ETF and the mutual fund strategies are waiting a bit longer for confirmation that the capitulation was for real.

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

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Give Back the Nobel Prize, Professors

Investment opinions are a dime a dozen. What matters in investing is whether or not the talking head has his money invested in an idea. To the Securities and Exchange Commission, typically salaried employees newly graduated from law school who are spending all their money on new suits and are fortunate enough to have a federal pension so needn’t worry about their future like the rest of us do, talking your portfolio is considered a conflict of interest. Certainly, when a mad money hedge fund manager calls his friends at CNBC to talk up a stock while at the same time dumping his shares into the market demand that the TV show creates, there is an integrity issue with both the manager and the TV program in question. However, the managers that I respect most invest their own money in the funds they are managing. It helps concentrate their focus. It simply makes more sense to invest with a particular investment manager if he or she is invested along with you. The opinion of a forecaster who thinks the market has bottomed but has his own money locked away in bank certificates of deposit is suspect, to say the least. Don’t listen to what the talking heads say. Watch what the smart money does.

To start at the beginning of the Investment Heresies eMag, click here

The smart money ignores what is taught in most business school classrooms.

Forbes columnist Ken Fisher’s company has more than 20,000 high net worth clients. He now stewards over $40 billion of their savings. Fisher admits to being actively biased against Stanford University business school grads, even though Stanford sits next door to his Woodside, California home and headquarters. Uber-investor, Warren Buffett, didn’t build the Berkshire portfolio by indexing it. The only reason that hedge fund moguls like Ken Griffin, Steve Cohen, and Paul Tudor Jones want to know the composition of the benchmark index is so that they can game it, beat it, and take advantage of those who blindly invest based upon it. While the academic community loudly beats the drum of indexing (buying and holding a broad portfolio of stocks based on their relative weights in a third party “index”), increasingly the so-called smart money is moving toward active portfolio management strategies and away from what is taught at the universities.

Down the hill from Fisher’s sprawling office complex in Palo Alto, California, Stanford University boasts twenty-seven faculty members who have won the Nobel Prize since the university was founded, including sixteen still living Nobel Laureates, many of them who won the prize for their work in economics. Though Stanford has one of the best economics departments in the nation, with a faculty second to none, most investors would be better off subscribing to Forbes Magazine for a decade if they want to become knowledgeable investors. Though going to college is incredibly important, the value of what is learned in the college classroom is questionable in any vocation, and in economics this fact is aggravated by the fact that so much of what has been learned during the past forty years has been rubbish. A quick walk down Stanford’s Hall of Greats leaves you scratching your head and wondering what in the world the Nobel Prize Committee could have been thinking. Then again, if a camel is a horse designed by a committee, maybe we shouldn’t be too surprised.

• Kenneth Arrow

Kenneth Arrow, Stanford’s oldest living Laureate of the economics persuasion, was recognized in 1972 for his work on general equilibrium analysis. Arrow’s worked focused on specific products or industries and tried to determine the optimal combination of economic factors (price, supply, wage and material inputs, etc…) to produce a result where changing any factor, though it might generate gains for one individual, will hurt others by more than the gains received by others. In this “Pareto Optimal” solution, though perfection may not be reached, at least things are as good as they could ever get.

Done right, this mode of thinking requires unusually complex numerical computation, which is right up the computing alley of a school sited at the epicenter of Silicon Valley. In fact, it is so difficult to test the math behind these models that it wasn’t until the 1970’s that computing power had advanced to the point where some of the models could be tested using real world statistics. Not coincidentally, that’s about the time that this branch of economics started losing proponents. Over time, Dr. Arrow’s own work began focusing on the shortcomings of the theory, since there was so much more to write about if you changed sides of the table.

The first thing to broadside the theory was the Achilles Heal of almost all economic work, “the assumptions” required to create the model in the first place. General Equilibrium Analysis assumes, for example, millions of perfectly efficient markets that all roll up into a final product. You don’t just have a market for a Yugo. There’s the market for the Yugo’s drive shaft, steering wheel, tires and rearview mirror. If any of these items are bundled together and bid out as a package, efficiencies that could result in Pareto Optimality can be lost. The theory assumes away the possibility of economies of scale so that your new online bookstore start-up is assumed to really not be at any disadvantage to a colossus called Amazon.com. This assumption makes the world much easier to model, but isn’t very realistic (in case you’re thinking about putting some money into the idea).

Arrow’s theory also assumed perfect knowledge among all market participants, which we now know (thanks to the 9/11 tragedy and subsequent intelligence mistakes made prior to the U.S. invading Iraq) just ain’t so! We might as well just assume we’re all rich, and avoid the tiresome steps required to actually accumulate the wealth. As in the great movie “Field of Dreams,” spend it and the money will come. On the other hand, this hasn’t worked out all that well for the sub-prime borrowers and lenders who actually adopted that mantra during the real estate boom.

Arrow also developed “Arrow’s Paradox,” which looks at the potential for developing a voting system that would accurately weight the preferences of two or more people, given three or more alternatives. Arrow proved that no voting system could effectively provide an end result which would be pareto optimal. No democratic method could be designed that would result in a perfect outcome. The outcome of his paradox was that the best solution would be one imposed upon the entire group by a single decision-maker, hopefully of the benevolent persuasion, who could enforce an optimal decision. In non-mathematical terms, his theorem states that no voting method is fair, every ranked method is flawed, and the only voting method that isn’t flawed is a dictatorship.

The only problem with the conclusions drawn from Dr. Arrow’s rigourous mathematical proof is that the real world has proven them to be false. Dictators don’t implement optimal solutions and the freedom of choice for rational adults, when withdrawn, is almost always a mistake. Poor assumptions, wrapped in convoluted mathematical equations, lead to pretty useless conclusions.

As we assume in the investing world, “reality matters.”

Next post: A Prize For The Most Useless

To start at the beginning of the Investment Heresies eMag, click here

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

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Time to Buy the Banks?

Investors have been bottom-fishing in financials since last November. The sector is cheap by many measures, but an equally important question is whether it is yet timely. November’s buyers, we now know, were a bit early.

Tough times in the banking sector started early in 2007 with the first signs of trouble in the sub-prime sector. Newly minted loans were going bad, even before their first anniversary, and hedge funds were unable to sell their holdings when redemption requests came in from investors. A “market route” in July of 2007 left bank stocks -15%, and those brave investors who stepped in to buy the stocks selling at 85-cents on the dollar were quickly rewarded. By September, the bank stocks had rallied about 10% in a relief rally.

We know of no investors who bought in July and sold in September, however. Too bad. By November banks had fallen, again, this time to 80-cents on the dollar. December saw headlines of various foreign nationals and big mutual fund companies committing new money to the sector. By defining bank stocks as cheap because they were selling at a hefty discount to their previous highs and because they had very high dividend yields, many very large and sophisticated investors made some very regrettable investments.

As 2008 began, banks began cutting dividends and raising equity at distress prices, diluting the earnings power and decimating the dividend yields available to the old shareholders. Boards started firing CEO’s and investment banks destroyed their own credibility by raising additional capital to cover losses that management had previously said they wouldn’t report. Massive write-offs, insufficient cash flow, an uncertain dividend outlook and shrinking accounting (book) values for the banks makes it unclear whether a bank purchased for 80-cents on the dollar is selling at a discount or a premium.

To our way of thinking, it hard to imagine that ground zero in the sub-prime debacle would bottom out at only down -20%. Especially given banks’ high operating leverage and a black box of loans that, frankly, nobody outside the now discredited loan committee can actually value, a banking problem is more likely to lead to the sector losing 50% of its previous value, which it has now done.

Analysts are now using “distress sale valuation ratios” developed during the Savings & Loan crisis 15 years ago. Based on these ratios, finally some of the banks are starting to look cheap.

It might finally be time to bottom-fish. Unfortunately, we have no better insight on this matter than did the big institutional investors who were buying Citibank and MBIA last December. By our definition, these stocks are not yet timely. Timely stocks are able to attract new money into the sector. Stock prices are going up, not setting new lows every day. In “What Works on Wall Street,” James O’Shaugnessy showed that one of the worst buying strategies is buying stocks off the “new low” list, which is where the bank stocks now reside. Calling bottoms is tough. Moreover, bottoms are often preceded by a crescendo of selling into a climactic sell-off, so those who are early may spend the next two years just getting back to even.

Instead, we choose to miss the bottom. So far we’ve missed “the bottom” at least four times in the past year. We missed it last year in July, again in November and January and March. Soon, perhaps this time, we will really miss it in earnest. The money we’ve saved by not being too early, however, is too great to overlook. There are values being created in the banking sector, and we should be able to profit when the industry rebounds.

We choose not to guess at when banks will bottom. The industry is almost certainly undervalued given the massive industry-wide sell-off in the sector. We will wait until they are clearly more timely before committing our money to the sector. As this year clearly demonstrates, sometimes it’s more important what you don’t own when building a portfolio, and “being early” is often just an aphorism for “being wrong.”

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

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Looking Ahead

GJretire has three major sections. Part I: Don’t Believe Your Professor, challenges several core investing principles. Interestingly, neither the Fourth Estate (the press) nor the hallowed halls of academia have been very useful in pointing investors in a new direction. Maybe it’s because these bedrock institutions are so completely overrun with sloppy thinking socialists who just don’t begin to understand how money works. It would be like having me write about the symphony. The result would be, I’m quite certain, disastrous. You really can’t reasonably dissect something about which your fundamental beliefs are so thoroughly misguided. I know virtually nothing about music theory or the history of music.

I took piano lessons for many years, and was even pretty good in pedestrian terms, but I never really “got it.” I love musicals. I adore ballads. I even have traces of rhythm. But I’m not really a student of music and I don’t begin to understand it, just as very few university professors or professional journalists really understand business and finance. They treat investors like an alien species. They either deify or vilify especially the most successful investors, but they rarely understand the beauty of the service capital allocators perform.

To start at the beginning of the Investment Heresies eMag, click here

As a result, there is a lot of rubbish taught in business and finance programs that needs to be unlearned. These are not the self-interested myths fostered by Wall Street, but rather economic theory gone haywire and preached as dogma from the front of the lecture hall with the confidence and self righteousness that only an academic can produce. That these theories are illogical and don’t work, that they sound like chopsticks in the real world of finance, doesn’t matter to them. The theories are accepted. They are beyond refute. And they sometimes are as foolish as the day is long.

Part II: Don’t Believe the Salesman gives lay investors some new insights into just how rotten the industry is at its core. It’s not a matter of “is it rotten?” Everyone knows that it is. A local radio announcer mentioned a survey that was talking about just how low and slimy are the lawyers in this country. While, naturally, not disputing that fact, I was nonetheless disappointed to hear the radio announcer note at the end of the segment that of course the only form of life even lower than lawyers was financial advisors. It was said in such a matter of fact way. I wanted to scream.

Granted, it’s a little like politicians, which all the world knows are dishonest bums yet somehow the electorate remains under the impression that their bum is actually the exception who proves the rule. Similarly, retail investors seem to all accept the badness of the lot yet refuse to fire their own slimy rogue because they are, after all, such a nice guy or gal. Investors refuse to hold their advisors accountable for the misdeeds of the industry, yet maddeningly they have the audacity to hope for better treatment in the future!

They see their advisor’s big house and expensive car and believe, against the laws of logic and experience that the advisor’s wealth came from smart moves in the market. True, their own accounts have not experienced or benefited from this wisdom, but somehow investors are able to convince themselves that their advisors’ high net worth is a function of the advisor’s own investment wisdom rather than a sure sign that high fees are soaking up returns that really ought to belong to clients, but are being diverted to financial advisors instead!

Fred Schweb asked, “Where Are The Customer’s Yachts” in his 1940 classic. Yet 65 years and scores of scandals later, the “customers man” is still getting away with indulgences of the worst sort while investors sing the blues.

Part III: Structure Your Investments For Success provides step by step instructions that take these heretical theories and translate them into simple steps that investors can use to manage an investment program. It’s not an exhortation that you, too, can discover your inner Warren Buffett. That would be stupid. Far too many books go that route, and investors usually end up in investment purgatory as a result of trying this approach.

What “GJretire” will do, however, is put investors back in charge of hiring competent professionals to manage their investment program. The only thing that stands between the commoditization of the financial services industry (which is a great thing for consumers) and the financial dark ages is a little bit of consumer education. In between the stupid stories and self righteous pronouncements, I hope to be able to give readers that tiny spark of recognition that enables them to break away from the financial service monoliths that seem to hold your financial destiny hostage. They haven’t been on your side in a long time. Admit it. It’s time you took back responsibility for your own future.

• Why You Should Care:

An article several years ago by Jonathan Clements in the Wall Street Journal points out that in retirement savings, a modest boost in annual returns can make a big difference when it's time for you to retire. Using the example of a 40 year-old investor with $80,000 in savings who saved an additional $6,000 a year until he reached the age of 65, our hypothetical investor's retirement income (figured in today's dollars) would be $27,665 if he earned 7% on his savings. By boosting earnings by just a half a percent (to 7.5%), his projected retirement income increased 15% to $31,719 a year. At an 8% return, he boosted his retirement income by 31%, and at an 8.5% return, our hypothetical investor's retirement income grew to $41,626, more than 50% higher than what it would have been had he only earned 7% on his money.

How do you implement an investment program which will increase your investment returns? You recognize that the world has changed, rendering most investment advisors obsolete (Heresy #1). You realize that risk and return are not always correlated (Heresy #2).  Successful investing can be simple (Heresy #3) as you realize that standard deviation is not the same thing as risk (Heresy #4). You accept that market timing is not a foolish endeavor (Heresy #5), use clever advertising as a sign of what mutual funds not to buy (Heresy #6), and acknowledge that the style consistency consultants don’t know what they are talking about (Heresy #7).

Then you start holding advisors accountable. You realize that most advisors lie about their track records (Heresy #8). You conclude that mutual funds and exchange traded funds are still the best vehicle for the majority of investors (Heresy #9) and take heart in knowing that many hedge fund advantages are available to traditional mutual fund investors (Heresy #10) with much lower fees. You do the research to know that in spite of what you’ve heard, small cap value stocks are less risky than their large cap or “growth stock” bretheren (Heresy #11) and you open your mind to the notion that fixed income investments are not only for generating income (Heresy #12).

Finally, you structure your investment program for success. Knowing that two brokerage accounts are simpler than one (Heresy #13), you take advantage of the "free lunch" which is available to smart investors (Heresy #14) and come to grips with the fact that if you can divide by 10, you can invest your own portfolio (Heresy #15). And by all means, know enough to admit that you should delegate investment research to an experienced professional and find a fund newsletter that saves you thousands of dollars (Heresy #16) while boosting your portfolio returns. Lastly, in the event that you still find a need for a financial advisor (and many people will) you are as impersonal as possible when searching for your personal advisor (Heresy #17).

The world has changed; competition has rendered most investment advisors obsolete. Take advantage of it!

Next post: Give Back the Nobel Prize, Professors

To start at the beginning of the Investment Heresies eMag, click here

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

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Retail versus Institutional Investing

Retail investors are typically individuals with relatively small sums of money to invest. In contrast are the institutional buyers, with the megabucks. Institutional investors include insurance companies, foundations, pension funds, mutual funds, and banks. These organizations, and the investment advisors who manage their money, have billions and trillions of dollars to invest. In the late 1970's and early 1980's, pension fund money generated the bulk of the institutional commission dollars generated. By the late 1980's and throughout the 1990's, mutual funds were king of the mountain. After the tech bubble burst, some of these billions began flocking to hedge funds.

To start at the beginning of the Investment Heresies eMag, click here

How much money does it take to rise above "retail" status? A lot. Is $1 million enough? No way. Most big banks and wealth management shops turn away all money management accounts that fall below that level. Some customers with accounts between $500,000 and $1 million may permitted to stay, but are given 1-800 telephone numbers for account inquiries and deal with new hires at a service center. Accounts with more than $1 million, traditionally the amount required to be considered a "high net worth" client, are given a personal investment advisor, but these days the portfolio manager follows a strict investment model and his job performance is measured mostly on new sales. Shockingly, at the big banks, management may care more about how many checking account referrals a portfolio manager has made than about the performance of his clients’ stock portfolios. For them, it’s all about cross-sales and what they call “share of (your) wallet.” They focus not on investment performance, but on selling customers as many products as possible because this makes it more and more inconvenient for customers to change banks.

Thus, to even be considered a wealthy individual requires a net worth of much more than $1 million! In fact, it probably takes about ten times that much money to begin to play in the institutional arena. Moreover, a $10 million investor can probably expect to pay at least $100,000 per year in money manager fees. Below that amount, you’re considered part of the hoi polloi, along with Homer Simpson and the Beverly Hillbillies.

The mutual fund supermarket invention is important because it allows retail investors to buy institutional money management expertise directly. It puts a professional advisor on the customer’s side of the table instead of leaving investors dependent on sell-side brokers for advice.

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  • What is the problem with the old way?
  
  

Colossal financial service firms now dominate the industry. Under the leadership of Sandy Weill, for example, Citigroup acquired company after company, banks, brokerages, insurance companies and asset managers, adding account after account until they probably acquired an account or two of yours. The consequence of this asset gathering frenzy has not been greater oversight of client accounts, but rather fewer choices for the customer and less attractive alternatives for the advisor. Moreover, these giant firms think they own you, the customer. Rather than being a business dedicated to helping advisors serve the needs of people, these firms force their advisors to sign “non-compete” agreements, cut resources and compensation available to advisors, and then sue the advisors when they vote with their feet and leave for greener pastures. Now the broker/dealer side of these firms is petitioning the S.E.C. to be able to sell you securities at a mark-up into your account even in fiduciary accounts where they are supposed to be acting as a buyers agent for you. As far as they are concerned, the money in your account belongs to them.

Trust departments are even worse. Some affluent folks, when they die, create trusts to avoid estate taxes by creating long-term accounts for the benefit of someone else, often next generation family members. A trustee, often a large bank or brokerage firm, is named to be in charge of the money. Trustees are fiduciaries, meaning they are supposed to act as a proxy for the benefactor in the best interest of the beneficiaries. Trustees, however, view that money as their own. A real beneficiary who might want to spend the money that has been left for them is quickly labeled a spendthrift. The problem with spendthrifts is that they spend down the assets in the account, which reduces fees to the trustee. Trustees have every incentive to turn down even legitimate requests. It’s also very difficult to change trustees. It requires agreement on the part of all beneficiaries, who are generally kept in the dark about investment performance. I know of one small business owned in a trust which was sold after the death of the business owner to the trust officer managing the estate, at a hefty discount, after which the trust officer promptly retired and moved to Florida.

In the meantime, the notion that Wall Street or the big banks are looking out for investors’ interests is patently absurd. Take Goldman Sachs, widely considered one of the best firms on the Street. During the technology bubble, Goldman’s global and domestic underwriting effort was second to none. In 1999, Goldman was the lead underwriter in 47 initial public offerings, second only to Merrill Lynch. More than four-fifths of the 1999 IPO’s were technology and internet companies. A year later, they claimed over 20% market share in bringing what were eventually proven to be pseudo-companies to the market, enriching themselves and dot-com founders at the expense of their clients. Nowadays, when you ask firm strategist Abby Joseph Cohen about that era, she claims that Goldman was timely in turning negative on tech stocks. However, you’d never know it by what was sold to customers.

More recently, the bubble has been in real estate, especially the overpriced kind sold to people who can’t afford it. Goldman has been an active underwriter of this debt, especially to its hedge fund clients. Interestingly, when the sub-prime bubble popped and prices of the garbage securities sank like a stone, Goldman Sachs reported an extremely strong finish to its 2007 year. It had sold the securities short, so it stood to make billions of dollars when prices came tumbling down. Give Goldman credit for being smart. They knew this merchandise better than anyone else because they had underwritten it. And they knew to sell it short, because it was toxic. They will continue to earn great bonuses ($623,000 per employee in 2006) because of how they treat customers…but not because of how well they treat customers. Goldman is easy to pick on only because they are so good at what Wall Street does. This is simply the way Wall Street works, and the big banks worship at the same altar. The banks really want to be like Merrill Lynch. They would function in exactly the same fashion, if only they weren’t so incompetent.

Why anyone thinks their broker is on their side is beyond me. That is just not how it works on the island of Manhattan. Brokers sell products. They represent the product manufacturer, whether the product is a stock (like webvan.com), a bond (issued by a mortgage factory like now bankrupt Delta Financial), or a mutual fund. Twenty-five years ago it was oil & gas limited partnerships, which ultimately proved to be extremely illiquid and valuable only because of the tax write-off they provided when they became practically worthless when the oil boom went bust. Today it’s expensive “manager of manager” platforms, hedge funds, closed-end funds and unit investment trusts. Twenty-five years from now it will be something else, unless investors wake up and change how they get their financial advice.

Brokers are only required to offer suitable products, whereas a fiduciary is actually required to look after the client’s best interest. It matters not that the company in question is nothing more than a bad idea on a napkin with a well connected board which will be given stock at a price far below what the investing public will pay. What matters is the demand side. During the tech bubble, there was huge demand for anything of a dot-com origin, and manufacturers like Goldman Sachs and the venture capital community made a bundle giving investors a fix. Investors wanted excitement, and the brokers delivered. As long as it was suitable, it was saleable. And suitable is a very broad term.

Investors have an amazingly short memory. Merrill Lynch has one of the most widely recognized brands in business, but how many investors remember its connection to the Orange County bankruptcy in 1994 when the county treasurer lost $1.7 billion by borrowing $2 for every $1 in county funds to buy $3 worth of mortgage-backed securities from Merrill Lynch and others. The securities in question were suitable. The investment advice that the county received? Not so much. Merrill Lynch paid $437 million to settle litigation with Orange County, and another $30 million to dispense with a criminal inquiry. But investors remain bullish on Merrill Lynch, nonetheless.

By the time of the tech craze, the overall quality of Wall Street research sank to the point where during the bubble analysts chased bonus pool money controlled by the investment underwriting side of the firm. Highly paid shills like Henry Blodget (and there were many others) wrote glowing reports on companies which they privately viewed as essentially worthless.

Advisors at full-service firms, who hadn’t been told that their research units had sold out, used to let the firm keep as much as two-thirds of their commissions to pay for firm wide resources…like research. A broker generating $300,000 in fees might only take home $100,000 in salary, with the rest going to support the shenanigans in the New York office. Not surprisingly, as the bubble in technology exploded and the general shoddiness of the research effort became more pronounced, individual advisors began to re-think the advantage of letting the house keep so much of the take, given that the support being provided to the retail brokers had all but dried up. By changing broker/dealers from a major Wall Street firm to an independent broker/dealer, a financial advisor might keep all but $30,000.

Investors need to realize, however, that they are no longer tied to the old order. Just as Johannes Gutenberg by inventing the movable type press eventually enabled the distribution of the bible to the masses and was a key factor leading to the Renaissance, the development of the discount brokerage mutual fund supermarket has wide ranging consequences for how investors organize their investment program.

Martin Luther split the Catholic Church by publishing translations of the Bible in German. The Vatican lost its exclusive control over access to, and interpretation of, God's word. Martin Luther's followers studied scripture on their own and were able to challenge the Pope's interpretation of the words they were reading. Where once information had been centralized to the benefit of a few, suddenly it was available to the many. Individuals re-evaluated the Church's role in society, instigating a broad cultural reformation that eventually resulted in the concept of individual empowerment taking root.

Individual empowerment is why now investors can break away from Wall Street to find mutual fund firms willing and able to invest on their behalf without the self-interest and self-dealing that permeates so much of Wall Street. The research to find these good funds is available. Just as Gutenberg made the Word of God accessible to the masses without requiring a life solely devoted to intense scholarship, so these new web-based brokerage accounts open the world of institutional money management to anyone with an internet connection.

Next post: Looking Ahead

To start at the beginning of the Investment Heresies eMag, click here

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

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“Cautiously Optimistic”

Cautiously optimistic is a classic fence-sitter cliché. Most Wall Street strategists invoke the term so they can claim to have forecast whatever happens next. If the market falls, they can cite their “cautious” outlook. If the market rises, then their optimism was justified. The problem is not with the cautiously optimistic outlook, per se, but rather with the fact that they always have that outlook, at market tops and bottoms, and that an outlook that never changes is the same thing as having no opinion at all.

So, it is with great humility, that we confess to being cautiously optimistic. Looking back, we’ve been less than happy campers about the outlook for this market, generally, and the financial sector in particular. So, in our defense, though we’re forced to use the cliché today, it’s not the only opinion in our forecasting toolbox. In addition, at the worst of the recent liquidity crisis, when funding for Bear Stearns dried up in a fortnight, our portfolio positions matched our bearish outlook. Our fund portfolios had 40% of the portfolios invested in bonds or bear market funds to attest for our concerns about the market.

In our hearts and our guts and our minds, we remain pretty cautious. We think that problems in the financial sector are not past. Though the worst of the liquidity crisis is hopefully in the rearview mirror, money remains tight in the mortgage and private equity sectors. When companies like AIG stumble, the markets remain skittish. Looking ahead, even if the funding crisis is past, it’s hard to know how much a bank will earn in this new world of conservative lending, and after the share dilution that is occurring as the sector recapitalizes itself. Technology and industrials might lead us into a new bull market, but we’re not looking to the financials to lead the way. Add in high gas prices and the inability of mortgage rates to move lower, and our caution seems pretty rational.

The optimism in our outlook comes from the market itself, which has held up very well in the face of this crisis. The economy, too, has held up in spite of plunging consumer confidence and a disaster in the financial and real estate sectors. We’re nine months into probably the worst real estate contraction since the depression, yet we’re still not even sure if we’re in a recession and reasonably strong payroll growth is absorbing most of the laid off workers.

It’s hard to ignore the fact that the market is telling us that things are fine. Last Fall, while the market was setting new highs, we were convinced the market was overlooking the facts. Now however, with the facts laid bare for all to see, the market still refuses to blink. Maybe it sees something good around the corner that we’re missing. This month we are reducing our bond weighting and increasing, slightly, our exposure to the potential for good news. Let’s hope the market is right!

On June 2 our ETF model sold its Long-term Treasury Bond iShare holdings, which suggests some interesting potential scenarios going forward.

In the optimistic scenario, the progression beyond the abyss of the March liquidity crisis combined with very reasonable stock valuations based on forward looking earnings projections could mean that the recent lows provided an excellent opportunity to buy stocks. In April, the Alger Funds CEO and Chief Economist opined that, “we firmly believe that years from now the present will be seen as one of the great ‘if only’ markets, a time when the stocks of quality growth companies could be purchased for a song.”

In this sunny scenario, there is no way that bonds can keep up with the long-term profit potential of great stocks purchased at a discount to intrinsic value.

However, one of the reasons that many strategists are so bullish on stocks is that they are priced so inexpensively as compared to historically low long-term interest rates. Could it be that the market is telling us that bonds, not stocks, are currently mispriced? Treasuries are especially expensive. Corporate bonds, high yield bonds, mortgage-backed products haven’t experienced a rate dip. If anything, rates have trended higher in those areas. Heck, even long-term treasuries haven’t come down much from pre-crisis levels. The rates that have fallen most are short-term Treasury rates. This is typical of a liquidity crisis, where money seeks safety at any price.

So if we’re past the liquidity crisis (and let’s hope we are), then interest rates are probably headed higher. That is what the fundamentals suggest, and that is probably the message from our long-term Treasury iShare. Owning it since December, we sat out the worst of the stock market sell-off. Going forward, however, the market might be thinking that long-term Treasuries, which are very sensitive to changes in the level of interest rates, might not be the safe haven that investors expect.

The message from our model might not be that “the coast is clear,” but rather simply confirmation that long-term rates are headed higher.

The stock market will respond to other factors. If stocks are headed higher, it will be because the sinking dollar means that our manufacturing sector has regained its competitive position in world markets. Continued economic expansion will allow our globally dominant technology sector companies to keep growing profits. A resolution to the political worries might bring investors back into the health care sector. There’s plenty of money on the sidelines. The key question in our minds is whether the economy can rebound in the face of $130 crude oil prices.

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

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