YoungResearch » E.J. Smith

The Dollar Game Is Rigged

E.J. Smith — Tue, 31 Jan 2012 13:00:29 +0000

You’re getting less than $0.20 on a 1971 dollar. You can see the decline in my chart.

And based on the Fed’s rock-bottom interest-rate policy, there’s no reason to believe it’s getting any better. That’s why you want to study the Wall Street Journal op-ed by David Malpass. He writes:

Wednesday’s meeting result could have been worse. The Fed might have announced more purchases of U.S. Treasurys and mortgage securities. It already owns nearly $2 trillion worth and has no limit on its expenditures, which fall completely outside the federal budget. Bond traders have been pleading with the Fed to announce further purchases so they can buy first and score big profits.

Stopping Fed asset purchases would help growth by allowing market distortions to subside. It’s clear there’s been no benefit from the Fed’s unprecedented balance-sheet expansion, up 250% since 2008: no increase in private-sector credit (flat since 2009) and no impetus to the economy, which has been particularly weak in the quarters following Fed asset purchases.

Near-zero interest rates penalize savers and channel artificially cheap capital to government, big corporations and foreign countries. One of the most fundamental principles of economics is that holding prices artificially low causes shortages. When something of value is free, it runs out fast and only the well-connected get any. Interest rates are the price for credit and shouldn’t be controlled at zero. It causes cheap credit for those with special access but shortages for those without—primarily new and small businesses and those seeking private-sector mortgages.

Future Dividends, Coupons, and Principal

E.J. Smith — Tue, 24 Jan 2012 13:00:44 +0000

Your purchasing power is your lifeblood in retirement. On my office credenza is The Theory of Investment Value by John Burr Williams, first published in 1937. Chapter five is titled “Evaluation by the Rule of Present Worth, Section I. Future Dividends, Coupons, and Principal.” Burr writes:

[D]ividends, or coupons and principal, must be adjusted for expected changes in the purchasing power of money. The purchase of a stock or bond, like other transactions which give rise to the phenomenon of interest, represents the exchange of present goods for future goods—dividends, or coupons and principal, in this case being the claim on future goods. To appraise the investment value, then, it is necessary to estimate the future payments. The annuity of payments, adjusted for changes in the value of money itself, may then be discounted at the pure interest rate demanded by the investor.

This month, Moody’s downgraded Illinois’s state debt from A1 to A2, thereby increasing its borrowing costs on $800 million in 10-year general obligation bonds by 110 basis points to 3.1%. You have to wonder whether you’d like to partner with this state, or any state for that matter. Illinois bondholders who need to raise cash in a hurry may not like what rising interest rates do to their principal value.

For stocks, getting a juicy dividend is one thing; seeing that stock pay you the dividend year in and year out is another. Burr would ask, is there leverage being used to prop it up? Is the payout ratio sustainable? What is the government risk? All of these questions were as relevant in 1937 as they are today.

Last week, headline inflation came in at 3.0%, with food up to 4.7% and energy down to 6.6%. If inflation really kicks in, those juicy dividends may not have much cash left in the tank to keep pace. Bond coupons may be negative in real terms if swallowed up by inflation. Having some flexibility to work the yield curve will come in handy. And dividends, coupons, and principal must be adjusted for expected changes in the purchasing power of money.

Owning the Best Performers

E.J. Smith — Tue, 17 Jan 2012 13:00:48 +0000

In its quarterly funds report printed on January 9, The Wall Street Journal lists the 45 largest stock and balanced funds by assets. The best performers of this group for 2011 were a gold ETF, SPDR Gold (GLD), up 11.2%, and a balanced fund, the Vanguard Wellesley Admiral shares (VWIAX), up 9.7%. The worst performers of the group of 45 were both emerging market funds, each down about 19%. On average, U.S. stock funds were down 2.9% and U.S. taxable-bond funds were up 4.6% last year.

The two best five-year average returns on the list were, once again, SPDR Gold and Vanguard Wellesley Admiral shares, up an average of 19.4% and 6.1% per year, respectively. The average five-year return for U.S. stock funds was a loss of 0.4% per year, and the average taxable-bond fund recorded a gain of 4.9% per year.

The proof is in the pudding. A counterbalancing strategy helps keep you in the game. And as a bonus, it’s fun reading performance figures when you own the winners.

Random Short-Term Markets

E.J. Smith — Tue, 10 Jan 2012 13:00:27 +0000

There’s no shortage of financial soothsayers out there selling their wares. Some of their sales tactics are relentless. I know because my customers tell me. I also read until my eyes feel like they’re about to fall out of my head. The sheer magnitude of news and financial data to dig through daily is simply breathtaking; therefore, your ability to quickly separate the wheat from the chaff is an absolute must. It’s not taught in a book—it’s more of an art than a skill. Some of the best investment advice or comments can come when you least expect them. Last week while teaching my kids how to play Monopoly, my daughter asked: “What happens when the bank runs out of money?”

And sometimes the most recognized names can throw you off track. Burton Malkiel, author of A Random Walk Down Wall Street, offers up timeless advice, like the importance of diversification. But what about some of his op-eds? Like the one in last week’s Wall Street Journal, where he makes short-term predictions about where to put your money in 2012. Much of it is good—especially when he writes not about stock predictions, but about emerging market demographics:

Demography also favors the emerging economies. Dependency ratios (nonworking age to working age population) are far more favorable in emerging markets. Soon Japan will have as many nonworkers as workers, and Europe and the U.S. are not far behind. Emerging markets, such as India and Brazil, will continue to have two to three workers for every nonworker. Even China, with its one-child policy, will have favorable demographics and a large potential labor force until at least 2025. Countries with younger populations tend to grow faster.

But, a couple of years ago, in late 2010, Malkiel recommended overweighting China. The following year, last year, China’s Shanghai index lost 22%. Here’s what he wrote last week:

Much worry has been expressed about real-estate prices and construction activity in China. “It’s Dubai times 1,000,” says one hedge-fund manager who predicts an economic collapse. Obviously, an end to China’s growth would be a significant blow to the world economy.

But parallels to the U.S. real-estate bust and the resulting damage to the economies and financial institutions of the Western world seem unwarranted. The absorption of vacant space remains extremely high in China, where hundreds of millions more people are expected to move from farms to cities. And unlike the U.S., where people bought new homes with little or nothing down, Chinese buyers make minimum down payments of 40% on a new home (and 60% on a second home).

Malkiel has a fine axe to grind, trying to sell more copies of his latest edition book and trying to prove he’s been right all along. Unfortunately, it’s the followers of his short-term soothsaying who lose money hoping to bank on his advice. To their dismay, they likely don’t have royalties or book sales to fall back on and lost real dollars when China’s market lost over a fifth of its value.

Your 2012 Bond Fund Resolution

E.J. Smith — Tue, 03 Jan 2012 13:00:05 +0000

I hope you made some good money in bonds last year, because it was not a good year for all bond funds. Through November, Bill Gross’s Pimco Total Return Bond Fund, perhaps the most widely held bond fund in 401(k)s, underperformed 90% of its peers, according to Morningstar. Morningstar estimates outflows of $3.6 billion through November. Jeff Tjornehoj, senior analyst at Lipper, expects moderate outflows of around $200 million from the Pimco fund for December, marking the first outflow in a calendar year since the fund’s inception in 1987.

Many 401(k) participants suffered in 2011 with their Pimco Total Return Bond Fund position. I’ve spent countless hours reviewing investment options in 401(k) plans and can tell you, when it comes to bond fund choices, it is slim pickings in far too many plans.

When picking funds in your own 401(k) plan, you want to pay attention to a bond fund’s sensitivity to interest rates—measured by its duration. The bond’s duration is an approximation of the percentage decline in its value for every 1% increase in interest rates. The smaller the duration, the less sensitive a fund is, and therefore the less risky in terms of interest rate fluctuations. As of November 30, the Pimco Total Return Bond Fund’s duration was 7.46—meaning that a 1% increase in interest rates would correspond to a loss of approximately 7.46% of the fund’s value. The most recent five-year Treasury auction was at a record-low 0.88%, so over time, expect rates to go up.

If your investments are not restricted to a list of funds in a 401(k), my preferred bond strategy for you is to own the bonds outright and ladder them. You can control the average maturity and when rates go up hold them until the principal is returned. And if you’re stuck with only a handful of bond funds to choose from, stick with the high-quality, short-maturity ones.

OK, so interest rates have pretty much nowhere to go but up. But please, please don’t let this deter you from owning bonds in your portfolio. Make it a New Year’s resolution to have a solid short-term bond component in your portfolio.

Hedge Fund Bubble

E.J. Smith — Tue, 27 Dec 2011 13:00:37 +0000

You’re going to love this. Hedge funds had a terrible year. As of mid-December, the Dow Jones Credit Suisse Core Hedge Fund Index was off 8%. The index is an aggregate of funds using seven different hedging strategies: convertible arbitrage, emerging markets, event driven, fixed-income arbitrage, global macro, long/short equity, and managed futures.

Hedge funds are paid using a formula known as “2 and 20”—2% on assets under management (AUM) per year and 20% of profits. If you have a $10-million portfolio and a hedge fund loses 8%, you’re actually out 9.84% or left with $9,016,000 (8% loss on $10 million is $800,000, plus 2% fee assessed on the ending balance of $9.2 million of $184,000 equals a loss of $984,000 or 9.84%).

But here’s the rub. Check out what happens in a year of 10% gains. In my example, your $10 million grows to $11 million (yippee!) before fees (argh!). The hedge fund managers take their $200,000 or 20% of profits and$216,000 or 2% on AUM for a total haul of $416,000 or about half of your gains—an implied management fee of 3.8% on $11 million—leaving you with $10,584,000.

What tends to happen, at least recently, is that a hedge fund will string together a number of solid years of returns, grow assets, and then—whack!—will lose big-time. Portfolios can lose a quarter of their value literally in the blink of a few months. But get this: all the fees that were diligently paid by the client in the good times aren’t returned, even though the money is gone. There’s no clawback. And as is often the case, the fund closes and managers start a new one with a higher baseline.

If you’ve been a dedicated reader of this site, then you know not to buy into this stuff. Hedge funds and annuities charge some of the highest fees in the industry. What is a reasonable fee? How much is your time worth? You know how difficult it is to manage money effectively. As a point of reference, a fair advisory fee would be less than 1% per year on your assets. Clearly the hedge fund “2 and 20” bubble isn’t the answer—especially when it’s handily beaten by “boring” dividend-paying stocks.

Dividend Religion

E.J. Smith — Tue, 20 Dec 2011 13:00:10 +0000

Here’s a shocker: Sun Life, Canada’s third-biggest insurer, will stop U.S. sales of variable annuities and life insurance to individuals at year-end due to “unfavorable product economies.” In other words, you’re not the only one getting slammed by the Fed’s artificially low interest rates. But rest assured, for every annuity promise no longer being made by Sun Life, there are dozens more out there that will try to keep the dream alive. They’ve got bills to pay. And their stocks—life and health insurance companies—are one of the worst-performing sectors this year, off 25% YTD. Individual investors don’t stand a chance against the marketing blitz from annuities. Annuity providers feast when markets are crazy—especially when economic times are at their toughest.

Since August, according to the Investment Company Institute, money has been leaving stock funds. Yet over the past four months, the price increase for the Dow Jones Industrial Average alone has been about 4%. So it wasn’t the best time to bail out on stocks. Add dividends to the mix and it’s been even brighter for stocks. You need to ignore the potentially empty promises made by the insurers and get yourself some dividend religion. I like the idea of your adding Young Research’s Retirement Compounders, with its 5% dividend yield, to your portfolio. If that sounds good to you, then what are you waiting for?

Bond Dilemma

E.J. Smith — Tue, 13 Dec 2011 13:00:24 +0000

You might as well throw darts at the financial pages. To Burton Malkiel, who authored the book A Random Walk Down Wall Street, picking stocks is about randomness. He believes that all knowable information is priced into stocks and bonds when you buy them.

I’ve been reviewing my sixth edition of Random Walk from 1996, which has cover art showing a dart stuck into the financial pages. In Malkiel’s view, a rising tide lifts all ships. Yet he covers much more than that view over the book’s 522 pages.

What isn’t helpful is that investors read his op-ed promoting his latest edition (the 10th, 2011) and think the coast is clear for whatever he’s recommending without reading his book. I believe based on anecdotal evidence that investors use his endorsement and invest more money than they can afford to lose—a bad four-letter word, especially in retirement. That’s why his most recent op-ed recommending muni bonds makes me nervous.

In his op-ed in The Wall Street Journal last week called “The Bond Buyer’s Dilemma,” Malkiel wrote:

The fiscal problems of state and local governments are well known, and the parlous state of municipal budgets has led to very high yield spreads on all tax-exempt bonds. Many revenue bonds with stable and growing sources of revenue sell at quite attractive yields relative to U.S. Treasurys.

For example, the New York/New Jersey Port Authority gets reliable revenues from airports, bridges and tunnels to support its debt. Long-term N.Y/N.J. Port Authority bonds currently yield close to 5%, and they are free of both federal and state and local taxes in the states in which they operate.

I pulled out the folder I keep on Malkiel to reread his op-ed from September 26, 2001, called “Don’t Sell Out,” written days after 9/11. It was the right advice for the time—not only for investors but for the country. But the thrust of the piece depended on the notion that stocks were cheap on a relative P/E basis. He wrote, “Some investors fret that stocks are still over-priced, despite the recent sell-off. But a study of P/E ratios suggests the market is fairly valued.” With the benefit of 20/20 hindsight, you can see for yourself the returns in subsequent years on my chart of the S&P 500 Total Return.

Warren Buffett has made a pretty good living proving markets are not as random as Malkiel’s theory. Obviously he’s got a slight advantage over you or me. But with the bailout of Goldman Sachs, he played the role of the market and set the pricing by acting as the lender of last resort. His stock-picking record compares quite well to the random walk over the last 10 years.

The sixth edition of Random Walk preceded the tech bubble. The seventh edition preceded the real-estate bubble. I wonder now with the 11th printing if we’re not about to see the bursting of the government bubble.

Best Buy Annuities

E.J. Smith — Tue, 06 Dec 2011 13:00:28 +0000

You don’t want to forget your sunglasses. I made that mistake before going in to a Best Buy recently. Blinded by the bright lights, I felt like I was in an airplane hangar with a wall of TV echoes to match. It’s no surprise to me the stock is off by 50% in five years. The same HD marketing blitz reminds me of the sales tactics used for annuities.

A major provider of annuities is using HD in its ads to lure investors—“HD” in this case meaning highest daily value. It’s a flashy-red sales gimmick that takes your eye off of the costs you’ll incur or the time you’ll waste trying to understand it. It’s no surprise to me that the stock prices of some of these annuity-providing insurers are off anywhere from 40% to 98% in the last five years. Maybe insurers can pull a rabbit out of a hat and meet their annuity promises. But the promises they’ve made still depend on the market.

In November, German bunds, the benchmark of euro-zone bonds, had their worst 10-year auction in history and lost 4% on the month. You don’t need a calculator to see how ugly a year of that might look. China’s economy is on pace to grow 9% this year. Yet its stock market is off 22%. Sometimes the sure bet isn’t the best investment.

In his Wall Street Journal article “Price Charts Can Mislead,” Simon Constable points out that in the decade ending November 30, the increase in price of small stocks outpaced utilities. The iShares Russell 2000 Index was up 61% compared to 29% for the Utilities Select Sector SPDR. But, once dividends are included, the utilities ETF returned 84% compared to 81% for the small-stock ETF. Put another way, 55% of the utilities’ gain came from dividends—a message that is counter to HD or highest daily pricing.

A nation of spenders has taken too many expensive trips to Best Buy, Europe, Disney, you name it. They’re up against it like never before and invest in products they don’t know much about. The USA Today article “Many Have Little to No Savings as Retirement Looms” points out that more than half or 54% of retirees have less than $25,000 saved. Best Buy and annuities would love to have that money.

The $100,000 Range Rover Boom!

E.J. Smith — Tue, 29 Nov 2011 13:00:58 +0000

You can go to a local U.S. Range Rover dealership this weekend and buy a nicely equipped Range Rover HSE for $85,000 or a Supercharged for over $100,000. If you finance it in U.S. dollars, at least you know what you owe. If you want to be as fancy as your new car, you can borrow in a foreign currency and pay it back with your local currency. You’ll be styling with the best of the hedge fund managers if your currency appreciates. But what happens if the bottom falls out?

That’s exactly what happened in Iceland this decade. In his new book, Boomerang, Michael Lewis writes about what happens when a nation of fishermen turns into a nation of hedge fund managers. He explains how with their newfound expertise and with local interest rates running near 15.5% the Icelanders borrowed in yen or Swiss francs to buy Range Rovers. But when the Icelandic krona cratered, owners of Range Rovers financed at the equivalent of $35,000 suddenly owed $100,000. Visiting Iceland at the time, Lewis commented to a local about the unsettling explosions outside his hotel room. It turned out that those explosions were the solution to the Range Rover debt:

To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is set it on fire and collect the insurance: Boom!

Check out Michael Lewis’s Boomerang for some more examples of the mistreatment of money.

YoungResearch » E.J. Smith

The Dollar Game Is Rigged

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