Investment ReviewSeptember 1997
Dollars and Sense
Volume 4, Number6 │February 2013
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Dollars and Sense February2013
Market Update
January 2012
Month in review
Month / YTDS&P TSX Index / 2.3% / 2.3%
Dow JonesInd. / 5.9% / 5.9%
S&P 500 / 5.2% / 5.2%
NASDAQ Comp / 4.1% / 4.1%
MSCI World / 5.1% / 5.1%
S&P TSX Financials / 3.3% / 3.3%
S&P TSXEnergy / 2.5% / 2.5%
S&P TSXUtilities / 4.2% / 4.2%
S&P TSXInfo Tech / 9.7% / 9.7%
S&P TSXMaterials / -3.5% / -3.5%
US Dollar / 0.5% / 0.5%
Euro / 3.4% / 3.4%
British Pound / -1.9% / -1.9%
Crude Oil (WTI) / 6.2% / 6.2%
Natural Gas / -0.4% / -0.4%
Gold / -0.7% / -0.7%
Copper / 2.8% / 2.8%
Aluminum / 0.6% / 0.6%
Zinc / 3.1% / 3.1%
Income
Senior Gold Producers Income Corp (GPC)
Can-Energy Covered Call ETF (OXF)
Money Market Rates
Current Highest GIC rates on the market (Feb.5th)
1 yr-1.70%
2 yr-1.95%
3 yr-2.05%
4 yr-2.25%
5 yr-2.45%
Raise minimum 50% cash
in your portfolios.
This market currently
MakesNO sense!
“Up and Away in My Beautiful Balloon” (Nic Colas)
by Nic Colas, BNY ConvergEx Group
My newly-turned-85-year old mother recently informed me that she is “Having a bit of a middle age crisis.” Since English is not her first language, I tried to tell her that this particular turn of phrase was usually reserved for people turning 40 or perhaps 50 years of age. The typical symptoms are a desire to trade in the family car for a convertible. In its more virulent form, that urge extends to trading in the first spouse for a newer, flashier model. For my mom, it seemed to signal an uncertainty about whether to start knitting another scarf, or go all-out and begin working on a sweater. I talked her off the ledge – we settled on a Rastaman-style knit cap. Crisis averted, at least for now. I just hope she doesn’t expect me to wear it.
Still, the urge to use large round numbers as an excuse for some navel-staring is a common one; consider the attention around the 14,000 level for the Dow Jones Industrial Average. Most institutional investors benchmark themselves against the S&P 500, which closed Friday at a distinctly non-large-round number of 1513. Still, the Dow is the longest running measure of the performance for U.S. stocks. Started in 1896 with 12 constituents and formed by adding stock prices together, it essentially the financial equivalent of an aging movie star who still makes headlines when they take an eighth husband or go into rehab for the umpteenth time.
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Dollars and Sense February2013
So let’s use the Dow’s crossing of the Rubicon of the 14,000 level to consider both how we’ve gotten here and ponder the way forward. Three topics fall readily to hand:
#1 – Equity prices are now much more a tool of central bank policy than in past economic cycles. Consider the “Traditional” equity market storyboard that defined the start of every economic upturn over the last 30 years. It begins with a slowdown in economic activity and the customary Federal Reserve response to lower interest rates. This tends to jump-start bank lending in the mortgage and auto markets, since the Fed has effectively lowered the cost of money to the banking system. Over time, homebuilders and auto assembly/parts plants add more workers, and the unemployment rate begins to decline. While these sectors of the economy are relatively small, the incremental activity here sparks demand in other sectors. This virtuous circle feeds on itself and the domestic economy begins a period of lasting expansion.
This cycle has followed that path, but at a much more sluggish rate as both the financial sector and consumers try to reduce their debt loads. House prices have apparently bottomed, but excess supply of foreclosures means new construction is still distinctly sub-par. Auto demand has finally returned to “Normal,” but that’s come a full six years after the downturn. Previously cycles have been more like 4-5 years from trough to normal.
You don’t need to be tinfoil-hat conspiracy theorist to appreciate that the Federal Reserve’s liquidity measures – Quantitative Easing I, II, III and IV – have pushed capital into the equity market. With interest rates still in the 2.0% neighborhood for 10 year Treasuries, thanks to the Fed’s bond purchases, where else would you expect capital to flow? I am sure the Federal Open Market Committee understands this shift and welcomes the possibility that rising equity prices will spur some “Wealth effect” spending.
Less well appreciated is that the Fed’s policies also, intentionally or not, dampen volatility. It seems no coincidence that Dow 14,000 and CBOE VIX 12.9 are very comfortable bedfellows. The “Fear Index” could just as easily be called the “Confidence about the predictability of the future Index,” although it’s certainly not as catchy a moniker. Equity market participants clearly understand now that the Fed is solidly on their side, even if it took a few years to receive that message.
#2 – Where’s the smart money? The “Rock star” money manager has historically been another feature of a rising stock market. The 1980s and early 1990s had “Buy what you know” Peter Lynch and “Screw the BoE” George Soros. The tech boom had countless moneymaking traders and managers printing money from Web 1.0.
In contrast, the move from the lows in March 2009 to now has relatively few poster boys and girls when it comes to the merits of active management. Many-times-burned-now shy professional managers have been cautious on this march higher. Hedge fund managers have trouble both matching market returns and maintain their historically less-correlated stance relative to equities. Mutual fund managers struggle with redemptions, which require maintaining cash levels to meet those requests while still remaining invested.
Rock star managers are, I think, an underappreciated part of building confidence in capital markets. Retail investors see a successful manager and think, “I can do that.” Institutional asset allocators can justify giving such a manager more capital, encouraging overall positive flows into stocks. Over time, those rock stars beget other well-regarded managers, trained under their tutelage. But just compare the strongly positive money flows into largely unmanaged, index tracking ETFs to the redemptions we’ve seen for years out of actively managed mutual funds. The tide may be turning here – Investment Company Institute data for the first few weeks of 2013 finally show positive flows into U.S. stock funds. Now, we just need a few opinion leading managers with great track records to come to the fore.
#3 – Now what? Over the long term, stock markets have one purpose: to reflect the prevailing opinion about corporate earnings, market-based interest rates, and macroeconomic growth. A short menu, to be sure, but any other input just ends in tears. The Fed’s liquidity actions have been a Band-Aid, yes, but not one that can stay on forever.
As I consider the way forward for U.S. stocks, I always return to Spring 1994. It was then that Alan Greenspan’s Federal Reserve started to hike rates, after a period of several years where it had kept short-term rates quite low. The 10-year U.S. Treasury had already started to move higher in yield, from 6% to 7% and eventually topping out at 8%. The S&P 500, which had begun the year around 470, tool months to bottom at 420, an 11% decline.
Yes, the U.S. economy was growing much more quickly in 1994 than it is now. Job growth, GDP expansion, car sales, house construction… It was an expansion that puts the current one to shame. Still, 1994 is a relevant – and cautionary – tale about market psychology. U.S. stock investors thought they had it all figured out as they exited 1993 – a growing economy and an accommodative Federal Reserve. Pretty much what we have now. How and when this changes – and it will change – is the challenge investors now face.
Overcoming 3 Bad Investing Behaviors
by Russ Koesterich, iShares, Blackrock
Many finance experts assume that investors act rationally to maximize profits while minimizing risks.
But as we write in our new Market Perspectives paper, investors routinely make a number of irrational missteps that can be explained by a growing body of behavioral finance research, which studies how people make money-related decisions. Here’s a look at three of these common investing bad behaviors.
1.) Stock market avoidance. Many people avoid risky assets like the stock market despite the high cost of staying out of such investments, particularly in the current, low-yield environment. Consider, for example, that adjusted for inflation, the return on cash left in a bank account was negative for 2012. In comparison, world equity markets as measured by the MSCI All Country World Index returned 13.4% in US dollar terms during the same period.
Why do some investors shy away from stocks? Behavioral finance studies have found that investors are roughly twice as sensitive to losses as they are to gains. In addition, people tend to evaluate gains and losses over a relatively short time horizon that may not be in sync with the longer horizon over which investment goals are expected to be achieved. This extreme fear of losses in the near term, combined with people’s tendency to look at each investment in isolation, helps to explain low stock market participation rates.
2.) Insufficient Diversification. Another common investor mistake is to have an under diversified portfolio. In a 1991 to 1996 study of the customers of a large US discount brokerage, more than 25% held only one stock and more than 50% held three or fewer stocks. However, a well-diversified portfolio should include at least 10 to 15 stocks, which only 5% to 10% of the investors held in any given period. And generally speaking, the
more diversified portfolios performed better: the most diversified investor group in the study earned more than 2% a year higher returns than the least diversified group[1].
Behavioral finance concepts behind this mistake include investors’ tendency to use certain rules of thumb (for example, dividing assets evenly into funds) for allocation decisions and to opt for familiar home-market stock names that can be recalled easily.
3.) Inefficient Trading. Many investors tend to move in and out of positions in an inefficient way, reducing their potential profits. This may be because individual investors are often overly confident in their own abilities to beat the market, and thus trade excessively and hurt their portfolio performance. (Dan Morillo recently talked about overconfidence and investing in his blog post on failed New Year’s resolutions)
Investors also often make the cognitive mistake of extrapolating from past returns, buying assets whose prices have gone up in the expectation that prices will continue to increase. At the same time, people tend to be more likely to get rid of stocks that have done well in the past and to keep the losers so as to avoid the mental pain associated with realizing losses. In behavioral finance, this latter concept is known as “the disposition effect”, and it’s particularly striking considering that based on tax considerations, people would be expected to sell losers to exploit capital losses and defer taxable gains.
The good news is that you can take certain steps to possibly help mitigate the impact of these common mistakes. These include:
- To feel more comfortable about investing in risky assets, consider focusing on how one’s overall wealth is doing rather than focusing on each asset in isolation. This can help give each asset credit for its portfolio diversification benefits. In addition, consider viewing investments from a longer time horizon, which can help smooth out fluctuations in stock market performance.
- Consider increasing portfolio diversification by investing in well-diversified index funds or exchange traded funds.
- Consider rebalancing a portfolio periodically with a rules-based or systematic investment approach to help lessen investor biases.
Why Do People Hate Rising Stock Prices?
by Cullen Roche, Pragmatic Capitalism
There’s a general disdain for rising market prices. Why? Because, the odds are, you aren’t participating in all of the gains. There’s some sad math behind the reality of the stock market and that math says we all can’t benefit from the market’s rises. You see, all securities issued are always held by SOMEONE. The market, in the aggregate, is the market. And we don’t all have all of our chips in the stock market, because, by definition, we can’t. When I buy stocks someone else sells their stocks. Again, all securities issued are always held by someone. And the fact that someone owns stocks means someone else doesn’t own stocks.
So, when stock prices go up there’s an inevitable sense of opportunity loss (by someone). You feel like you’re missing out on gains you could have potentially been a part of. You feel like you’re falling behind. This is a perfectly common reaction, but it’s also totally unreasonable and almost certainly misguided. Why? Because we don’t really have to be involved in all of the markets gains all of the time. What we really need our money to do for us is outperform potential purchasing power loss and protect us from the risk of permanent loss in a manner that is consistent with our risk tolerances and portfolio needs. That is, we need to create SAVINGS portfolios that create a sense of certainty and protection in what is really a savings account (not an investment account).
I started Orcam in large part because I want to help people better understand the role of the portfolio in their lives. It’s not there so you can get involved in the aforementioned herding race that many engage in on the way to inevitably underperforming the stock market (as most do after taxes and fees). Your SAVINGS portfolio is there as a residual income from your primary source of income. You get “rich” by maximizing this primary stream of income and then putting it to good use by protecting it and understanding how to construct portfolios that help you avoid falling into the pitfalls that are generated by the fear of opportunity costs.
It’s totally natural to hate rising stock prices. After all, it’s a certain sign that someone is benefiting from something that you’re not. But the worst response to this opportunity cost is to believe that you need to position yourself in a manner that will almost certainly result in excessive risk on the way to chasing returns. That’s just classic herding mentality that will likely result in excessive risk and uncertainty in what is ultimately your savings portfolio. So yes, it’s okay to hate rising stock prices. But it’s not okay for you to respond to rising stock prices irrationally.
The Fed’s Asset-Inflation Machine
From an op-ed by George Melloan, posted in the WSJ, and can be read in full here
The Fed’s Asset-Inflation Machine
Asset inflation often produces something called “wealth illusion,” the belief that pricier asset holdings necessarily make one permanently richer. Illusions are dangerous. Eventually, painful reality intervenes.
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President Obama and Mr. Bernanke worsened the effects of the 2008 crash by adopting the same Keynesian antirecession measures—fiscal and monetary “stimulus”—that had failed before, most dramatically in the 1970s. Stanford economist and former Treasury official John Taylor recently argued persuasively on these pages that “stimulus” measures had retarded rather than speeded recovery.
Mr. Bernanke will have great difficulty letting go of the near-zero interest rate policy without severe consequences for both the Fed and the economy. The Fed’s own economists recently warned that the Fed itself could lose as much as $100 billion on its vast portfolio when bond prices finally fall from their artificially elevated levels. Meanwhile, higher interest rates will cause the cost of financing government debt to skyrocket.
The Fed policy of quantitative easing is designed to rebuild the asset inflation edifice that collapsed in 2008. German banker and economist Kurt Richebächer provided some of the earliest warnings of the dangers. In his April 2005 newsletter, he wrote that “there is always one and the same cause of [asset inflation], and that is credit creation in excess of current saving leading to demand growth in excess of output.”
Richebächer added that “a credit expansion in the United States of close to $10 trillion—in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000—definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation.” Richebächer died a year before the debacle of 2008. The crash that surprised so many bright people wouldn’t have surprised him at all.
The rising Dow is of course good news for savers, who have been forced into equities to try to find a decent return on investment. Thanks to Fed policy, “safe” 10-year Treasury bonds yield a near-zero or negative return, depending on whether you measure price inflation at the official rate or at higher private estimates.
Winners on stocks or land holdings should happily accept their gains as the best to be expected in a very unsettled financial environment. But they should also remember the 2000s, when so many people thought their newfound riches were real and cashed them in for yet more debt, such as home-equity loans.
They later had a rude awakening. The “wealth illusion” of asset inflation is seductive, which is why central banks in charge of a fiat currency and subject to no external disciplines so often drift in that direction. Politicians smile in satisfaction and powerful Washington lobbies cry for more.
But an economy built on an illusion is hardly a sound structure. We may be doomed to learn that lesson once again before long.