Retirement Roadmap Leads to Success

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

For too many people, a “financial plan” is either an outdated document gathering dust on the shelf or a painful memory of an expensive process where a financial salesman rifled through their private affairs in search of a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

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

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

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

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

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

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Four Things To Know Before You retire

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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MPT Is Still Just A Theory

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

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

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

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

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

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

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

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

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

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

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S&P Downgrade Sends Volatility Higher

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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What next after 512-point sell-off?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Economic Growth Ignores Partisan Gridlock

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

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

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

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

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

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

 As a result, the economy keeps growing.

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

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

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Insuring Against EuroRisky Behavior

Last year’s bailout of Greece didn’t “take.” While the markets recovered and eventually rallied, similar to the September 2007 U.S. stock market rally, government policies didn’t really solve, or even admit to, the seriousness of the crisis and the market peaked soon after. A continuation of EuroRisky behavior has implications for our U.S. oriented portfolio as well.

The first thing we’ve done is to avoid “ground zero” exposure. The portfolios, especially the fund portfolios, have little exposure to international equities. Interestingly, European stocks are among the short-list of asset classes that we would consider “buyable” based on recent market performance. For the moment, however, we’re not real interested in adding what could be the next “Lehman Brothers” back into the portfolio. We’ve owned it in the past. We’ll own it again in the future. Right now, however, we remain skeptics.

We recently took steps to reduce or eliminate our exposure to the insurance sector as well. The big problem with the profligate spending habits of Greece, Spain, Portugal and other large governments running disastrous deficits (which shall remain nameless, just in case there remains one more clueless U.S. Treasury buyer; I wouldn’t want to be the one that causes our own house of cards to tumble prematurely) – the problem is that the eventual default by Greece may threaten many European banks with insolvency.

If a European bank defaults, and that bank is a counterparty to a credit default swap (CDS) owned by a U.S. bank, then the virus jumps over the pond faster than you can say “derivative.” Furthermore, since we haven’t done much of anything to restrict CDS gambling by the best and the brightest on Wall Street (probably former Lehman bankers hired by Citigroup), then the risk of what the Fed calls a “systemic problem” remains a huge risk. And because we bailed out most of the criminals responsible for the sub-prime crisis, there remains little incentive for the banks to have cut back on their gambling with depositor savings. This includes a great deal of gambling with big, “safe” European banks on the other side of the bet.

Once the banking crisis re-starts, it will likely impact nearly all big banks in the sector because 1) they are all “black boxes” and 2) can’t accurately measure their CDS exposure and 3) have lied to shareholders so many times that no ones believes a word of what management says. Our guess is that the sell-off will once again spill over into the insurance sector, which demonstrates some of the same tendencies toward gambling that hurt the banks and investment companies in 2008.

We’re not saying that the sell-off will definitely be a repeat of 2008, but only that it could be as painful. Moreover, the insurance stocks would be much too close to the center of the crisis. Finally, the insurance stocks – although they have generally tracked the overall market since we purchased them in February – this past week have begun trading down more than the market, along with the banks. We believe that the problems in Greece are the reason, and until we can see that the crisis in Greece isn’t ramping up, we would rather reduce or eliminate that particular risk from the portfolio.

“What to buy with the proceeds” remains a problem. The market remains very narrow, although a few new asset classes have risen to “buyable” status. In general, however, the market is becoming very defensive, for whatever reason. If that is signaling further weakness ahead, perhaps holding a bit of cash will help preserve capital, instead of using it to buy “defensive” stocks that merely fall less than the market in a sell-off.
 
A year ago, we made a mistake during the first Greek crisis by being more defensive than we should have, given 20/20 hindsight. We may be about to make that same “mistake” again. It’s difficult to know what to hope for at times like this. We are “hoping” that the bureaucrats in Europe find a solution to the Greek problem. However, we are not comfortable relying on them to do so and have de-risked the portfolio a bit over the past few months just in case the Greek crisis continues to get worse.  
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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