On Investing

Investing has changed significantly during the 25 or so years that I have been following both the market and also the tools available for an investor to participate within the market.  The following trends are key:

  • The cost of trading and investing has declined significantly.  Trades used to cost more than $25 and now are essentially free in many cases.  Mutual funds used to have “loads” of 5% or more standard when you made an investment, meaning that $100 invested only went to work for you as $95.  These sorts of up-front costs have almost totally been eliminated
  • ETFs have (mostly) replaced mutual funds.  ETFs “trade like stocks”, meaning that you can buy and sell anytime (mutual funds traded once a day, after being priced with that day’s activity) and they don’t have income tax gains and losses unless you actually make a trade (mutual funds often had gains due to changes in the portfolio that you had to pay taxes on even if you were just holding the fund)
  • CDs and Government Debt are all electronic.  You used to have to go to a bank for various governmental bond products or to buy a CD.  Now you not only can buy all of this online, you can choose from myriad banks instantly rather than settle for whatever your main bank (Chase, Wells Fargo, etc…) offers up to you
  • Interest Rates are Near Zero.  One of the key concepts in investing is “compound interest”, where interest is re-invested and even small, continuous investments held for a long time can end up amounting to large sums (in nominal terms, because inflation often eats away at “real” returns).  However, with interest rates basically near zero, you need to earn dividend income or take on more risk (i.e. “junk bonds”) in order to receive any sort of interest income.  There is no “safe” way to earn income any more
  • Read more

The Liquidation of Markets

Every weekend I read Barry Ritholtz’s recommended reading and there are a lot of gems in there. Recently he posted this Credit Suisse graphic about markets at the turn of the 20th Century by market share and compared it with 2014 on the topic of global equity investing.


In his article he mentioned the fallacy one might fall into as a UK equity investor in 1899… why bother investing in the USA when the UK market is so much larger? And then this line of thought ends up missing the huge growth in US market share over the next century.

However, the real issue here isn’t the relative change in market share by the different countries; it is the fact that almost all of these markets were entirely extinguished at one time or another by political, economic or military events that wiped out the investors.

Read more

Investing Related Items

Over at Trust Funds for Kids I’ve been updating the portfolios and researching relevant topics for detailed analysis.

One interesting item to me is ADR’s or American Depository Receipts, which represent foreign stocks trading in US markets. “Sponsored” ADR’s trade on NYSE and NASDAQ and “unsponsored” ones trade on the OTC or “pink sheet” markets. Recently one of my stocks (Siemens) went from a sponsored to non-sponsored ADR status and I started researching it here.

I also researched the impact of currency moves on a portfolio, focusing on the Australian dollar vs. the US dollar and its effect on a particular Australian Bank Westpac. It is interesting to view the two elements in an intertwined fashion, since the US dollar was a poor performer over the last 5 years relative to many other currencies.

Finally I look a bit at performance over the last year and marvel about how easy it is to assess performance these days with free graphing and overlay tools, compared to the manual effort in past years’. It still is difficult to always properly factor in dividends and the timing of cash flows (investments), but that’s a different story.

Cross posted at LITGM

America 2.0 Looks To Be Worth Around Twenty Five Cents on the Dollar

A while back I dissected the debt of Detroit, the classic America 2.0 case. By this, I mean a gigantic government presence, working with manufacturing and unions to push off obligations into the future with no clear plan of really what to do. In the end, of course, it all came crumbling down and yesterday we got a slight glimpse into just how bad it can get.

To review, here is the diagram I had to make after reading several sources on the subject, to help wrap my head around the calamity that was the city of Detroit’s books:

This looks crude, and it is, but it really helped me get my brain around the nightmare.

From everything I have been reading, Kevyn Orr is getting ready to propose that the general obligation and pensions get settled out at .25 on the dollar. That sounds a bit expensive to me, and as Lex Green said to me in an email certainly isn’t “fire sale” prices yet, but that is what the consensus seems to be saying.

In an odd bit of news, many private foundations have been trying to gather enough money to offset an auction of Detroit’s art collection, estimated by some to be worth up to a billion dollars. If I were Orr, that would have been the first thing I would have done is liquidate that stuff, but I am quite a bit less sensitive than I would need to be to ever consider a career being a politician.

All of this is subject to the whims of the BK judge, but if I were a retired Detroit fireman, I would certainly begin tightening the belt stat, if that wasn’t done already.

This may affect municipal investments, but honestly I imagine any fallout from it is already baked into the pie.

Is Chicago next? We shall soon see.

From a political standpoint, the Republilcans should make the Democrats own this just like they should own Zerocare ™ and the nightmare in Illinois/Chicago that is coming down the tracks. How easy can it get for a Republican? All they have to say is “look at that” and they should get easily elected in any of a number of districts in 2014.

(Disclosure – I have many different municipal investment vehicles in my portfolio).

Cross posted at LITGM.

Landmark Case Possibilities With Detroit Chapter 9

Today, the trial begins to determine if Detroit can enter chapter 9 bankruptcy. I have been trying to read a lot about what this means for the muni bond markets. As of right now, not much. But in the future, possibly a lot.

Here is a great piece on the subject and one that I will refer to through this post. It is written by the Chicago Fed, and explains what is going on, and how the Emergency Manager, Kevyn Orr, is going about trying to right the ship. The document is short, but somewhat dense. I had to read it three times and making some notes helped me understand it better.

After making this diagram, I joked to myself that this is probably a better flow chart understanding of the City of Detroit’s debt than any sort of financial documents the city of Detroit had prior to the EM taking over. But I digress.

After the issue of letting Detroit go Chapter 9 is resolved (I guess I don’t really see any other option) there are several interesting issues that may affect the muni bond market moving forward.

The debt looks like this, in simplified form:

Water and sewer debt – $6bb

General Obligation debt (limited tax backed and unlimited tax backed) – $1bb

Pension Obligation Certificates and associated swaps – $2.3bb

Pensions – $3.5bb

Other Post Employment Benefit Obligations – $5.7bb

First, Orr has decided that the only things that he will be treating as secured debt will be the water and sewer system bonds (backed by a pledge of revenues from the utility system) and the “double barreled” UTGO (unlimited tax general obligation) and LTGO (limited tax general obligation) bonds. Double barreled means that these certain bonds have separate income streams derived from the State of Michigan. This is significant because no General Obligation bond in the muni universe in any Chapter 9 filing has ever been impaired (with the exception of the disastrous Jefferson County, Alabama filing in 2011). Basically, Orr is offering ten cents on the dollar to EVERYONE that is not secured. This includes pensions, OPEB (other post employment benefit) plans, pension obligation certificates, swaps, and all the rest. In the middle of this, the fact that Orr treated the UTGO debt (which can be funded by unlimited property tax levies) just like all of the other debt is a first. This will also be settled in court, and will affect the perception of a lot of other cities’ GO debt as relates to the backing by property tax levies.

The next Big Deal to the muni bond universe is that there is a conflict between state and federal law as to if Orr can pound down the pensions and OPEBs. Law in the State of Michigan says he can’t but federal law has no issue with it. There is no law on record that addresses this and I am sure it will be a bitter battle to the end. If there is some sort of sweeping Tenth Amendment ruling that says that you can’t touch the pensions, this will affect the debt of a LOT of large cities that have similar state laws in place, such as Chicago, LA and others that have giant unfunded pension obligations. But to me, winning this in court is one thing for the pensions, actually getting the money out of the city of Detroit, that has none, is quite another. I am sure that they would at that time try to get preferred secure status over the utility bonds, but I don’t think that will really happen.

So far, the markets have just shrugged their shoulders at this whole affair, with the small exception of punishing the bonds slightly from places in the State of Michigan. I am sure that as this disaster winds its way through the courts, that this may change. Being an investor in the muni market, I will be keeping a close eye on how this plays out, as well as the soon to be crisis in Puerto Rico.

Cross posted at LITGM.

Customer Protection in Brokerage Accounts

The Wall Street Journal has an article in their November 24, 2012 issue titled “Protecting a Small Account” with the tagline “What the Spate of Brokerage Blowups Means for Investors”.

The article discussed some recent events where brokerages went bankrupt or ran into financial troubles, specifically smaller or regional firms. They give some generic advice, such as research your firm or and carefully check your brokerage statements each month for evidence of unauthorized trades.

The overall risk is that if a firm goes bankrupt while holding your money, The Federal Securities Investor Protection Corporation (SIPC) provides the following guarantees:

The Securities Investor Protection Corporation protects customers against the loss of missing cash and/or securities in their customer accounts when a SIPC member broker-dealer fails financially. SIPC either acts as a trustee or works with an independent court-appointed trustee in a brokerage insolvency case to recover funds.

The statute that created SIPC provides that customers of a failed brokerage firm receive all non-negotiable securities – such as stocks or bonds – that are already registered in their names or in the process of being registered. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims for customer cash and/or securities custodied with the broker for up to a maximum of $500,000 per customer. This figure includes a maximum of $250,000 on claims for cash.

The simplest answer to this potential risk is to split up your assets so that you don’t have more than $500,000 with a single brokerage firm.

However, there are downsides to doing this. For one thing, larger firms give bigger discounts as you consolidate assets. Vanguard, for example, gives a large number of free trades and provides lower cost mutual funds, along with other services. In order to get certain types of brokerage services at other firms it helps to be a larger scale customer, as well.

Based on a review of Vanguard, Fidelity and eTrade, the major firms also take out insurance with Lloyds of London for additional coverage beyond the SIPC minimums. Per Vanguard’s web site:

To offer greater protection and security, Vanguard Marketing Corporation has secured additional coverage from certain insurers at Lloyd’s of London and London Company Insurers for eligible customers with an aggregate limit of $250 million, incorporating a customer limit of $49.5 million for securities and $1.75 million for cash. Coverage provided by SIPC and certain Lloyd’s of London and London Company Insurers does not protect against loss of market value of securities. The policy provided by certain Lloyd’s of London and London Company Insurers is subject to its own terms and conditions.

In addition to a Lloyds policy, Fidelity describes additional protections available to investors at their site here. Key additional items:

Broker CDs, which are issued by an FDIC-insured institution and held in Fidelity brokerage accounts, are also eligible for FDIC insurance. The coverage maximum for IRAs and brokerage accounts is $250,000 per bank. All FDIC insurance coverage is in accordance with FDIC rules.

I inadvertently tested this over and over during the 2008-9 crash as CD’s I bought from high yielding bank through my brokerage account repeatedly failed and the cash investment, plus accrued interest to date, was transferred back into my cash account with every failure. I certainly wish that I had those high yielding CD’s back today, since interest rates are now below 2% even for 5 year CD’s, but I digress…

There are important exceptions to the coverage, including stocks bought on margin and futures contracts. If you are using these sorts of instruments then you need to do additional research.

Cross posted at Trust Funds For Kids

Vanguard and BlackRock (iShares)

About ETFs

ETFs (Exchange Traded Funds) are an alternative to traditional active or passive mutual funds that trade on exchanges.  There are many advantages to ETFs over mutual fees including:

1) tax efficiency – mutual funds deliver you capital gains (and losses) even when you don’t make any trades due to internal fund activity.  These gains and losses are avoided (in the vast majority of cases) for ETFs, UNTIL YOU SELL

2) liquidity and stock-like features – ETFs are often more liquid and you can buy and sell them on the exchange immediately, and you can see their prices transparently.  Trading like stocks also allows you to do things like use leverage, etc… which you can’t do with mutual funds

3) lower prices – historically ETFs have had lower prices than mutual funds, and did not have origination fees or “loads” like many funds did

The primary disadvantage that used to be levied against ETFs was that you had to pay brokerage fees each time you made a trade, and if you invested regularly (i.e. payroll deductions) these costs added up over time.  This argument has been diminished by lower trading costs across the board and changes in investor behavior.

Vanguard and ETFs

Vanguard was originally slow to adopt ETFs, despite their advantages, because Vanguard thought that ETFs enabled rapid trading which was against their business model of supporting long term investors.  However, over time, Vanguard has gotten into the ETF business and as brought their low-fee ethos to the ETF arena.  Vanguard ETFs are now among the most popular offerings and have been gaining in market share.

Note that Vanguard has a unique ownership structure.  Vanguard is owned by its mutual funds and charges at cost to the mutual funds, and does not make a “corporate” profit.  This is in contrast to competitors that not only charge the cost of doing business but also must make a profit to pay to the corporate parent.  Many of these companies have grown large and very profitable over the years (as funds under management increase) while Vanguard has been able to  turn its increasing scale into cost reductions for its products (i.e. if there are more customers and more fees, the fee that they need to charge per unit of dollar under management goes down assuming their costs are not completely variable).


BlackRock bought iShares, who were one of the pioneers in the ETF space.  While iShare ETF fees were not high by industry standards (in general), the arrival of Vanguard has put pressure on iShare products and they began losing market share.  As a result, iShare products reduced fees and are now in a sort of “price war” with Vanguard.

A Wall Street Journal article titled “BlackRock Wages Reluctant Fee Fight” describes a recent earnings call where the CEO (Fink) of BlackRock talked with analysts:

Mr. Find railed against competitors that sell investment products to certain clients “at cost”, or without profit.

You can call that fee pressure, Mr. Fink said.  But he had another term for it: “stupidity”… Although Mr. Fink didn’t single out any rivals in his comments, observers took the barbs to be aimed at Vanguard.

What is interesting about Mr. Fink is that he did not offer a reason for WHY his company was better for investors than Vanguard.  This is analogous to the famous line of “Where are the Customer’s Yachts?” about how Wall Street always seems to makes money while their customers (investors) don’t always fare as well.

Fink had an opportunity to explain why the profits that iShare pays to BlackRock (beyond the fees necessary to run the ETFs) result in superior products for customers and investors, and he didn’t take that bait.  The reason, of course, is that there isn’t any reason why his products should cost more than Vanguards’ to the end customer, because they are essentially interchangeable (where they have equivalent products) which means that they have no extra value.

Fink seemed to be saying that it was “stupid” for Vanguard to be in business where they weren’t making any corporate profit, and just using their economies of scale to reduce prices (rather than paying that money to shareholders).  It is certainly true that Bogle, the founder of Vanguard, could have been a billionaire if he had monetized his inventions (the index fund), but instead he started the one company on Wall Street that definitely does NOT provide yachts for its’ employees.  Whether or not the average investor wins or loses on Vanguard products is up to the product mix, market activity, and customer activity, but it isn’t due to Vanguard taking off an inordinate share of fees to pay a corporate parent in the form of profits.

Mr. Fink didn’t offer a defense because there isn’t one.

Cross posted at Trust Funds For Kids

Faith vs. Experience for Investing

A recent Wall Street Journal titled “The Young and the Riskless” details how “twentysomethings” are not investing in stocks, but instead are putting their savings into less risky investments. The tag line on the article is:

Twentysomethings are seeking safety from market volatility at precisely the wrong moment in their investing lives. Here’s how to get back on track.

From the outset I was struck by the author’s presumptuous and scolding tone. I also like their strategic use of the word “volatility” instead of the more appropriate term of “losses” when describing market events over the twentysomething’s financially sentient lifetime, which would be something like the last 10-15 years.

Per the charts in the article

The percentage of young investors who say they’re willing to take above-average or substantial risk has declined from 52% in 1998 to 31% in 2011. 52% of investors in their 20’s who say they will “never feel comfortable in the stock market”. 33% of 20-somethings’ non-401(k) portfolios held in cash, versus 27% for all investors.

It is important to understand how “faith” in the market is typically defined in the popular financial press. Faith usually means putting your money in an index fund (or ETF), with low fees, continuing to do so regardless of market conditions, and relying on the belief that “in the long run” it will all turn out alright and you will be able to retire rich. The “financial calculators” have an assumed rate of return that you receive on your money, similar to the same calculators that public pension funds use, and they are typically “set” between 6% and 10%. Due to the “miracle of compounding returns” you can amass large sums of money in the future.

The problem with this mantra is that NO ONE has been winning with this strategy for a LONG time. What you see, instead, is that money put into the market is often battered immediately by volatility and is worth a fraction of what you put in only months prior. If you change jobs regularly (once every 2-3 years, as younger people often do) and are an avid 401(k) saver (which is recommended), many times when you pull out your money it will be valued far less than what you put in, or about even when the company match is taken into effect (depending on vesting). This can be demoralizing. I know that when I left companies in the late nineties and after the dot-com collapse I started putting more of my money into cash-like investment selections (despite warnings from my employers’ 401(k) educational materials) just because I hated moving balances worth a fraction of what I held back out of my pay when I left to start with a new company.

Also, in order to win “in the long run”, you have to stay with it in the short run. This means that when stocks plummet, you need to stay in the market and keep investing. If you decide to cut your losses and run, or stop putting new money in during market troughs, you don’t get the same benefits when the stocks rise later. This post I wrote basically said that no matter what you did in 2007, it turned out to be a loser, but if you bought during the trough in 2008 (or held throughout) you saw big gains later as the market turned back around (to where it was before). BUT if you didn’t stick with the markets, you didn’t benefit from these gains and ended up as a net loser. It is VERY HARD mentally to keep investing when markets are going down, but if you don’t buy low there is no way you can even conceptually win in the “long run”. If you bail, for sure you are going to fail, assuming you are following the mantra (which is what the WSJ article’s author was lamenting).

Kids see their parents’ struggles. Their parents have been believers in the markets, since the bear markets of the 70’s were replaced by the bull markets of the 80’s and 90’s. If you retired in the 90’s, after years of investing in the doldrums, you not only benefited from high interest rates which appeared to “goose” the compounding effect, but you also essentially did some great “market timing”, buying low and selling high. But the parents of today’s twentysomethings didn’t retire in the early 90’s, they kept working, and watched their investments suffer along. Now the parents’ are in a bind.

Not only did the markets get hit, but there isn’t really an underlying foundation of belief in WHY the market should do so great “in the long term”. In the past you could look at the track record of the US and show how we weathered recessions, panics and depressions, wars whether declared or un-declared, and always came out ahead. But today everything seems to be static or declining; our unemployment rate is high, we have high “real” inflation from commodity price increases (oil, food), and the cost of services like a college education or health care (if you can get insurance at all) is very difficult to bear. In order for the market to rise, the country needs to be productive, well run, and growing – does this seem to be today’s perception of American performance? This lack of an underlying narrative in why markets should rise of the long term (other than it has happened in the past), combined with the miserable ACTUAL performance during the last decade and a half, is killing confidence in the “long run” hypothesis that markets go up.

Another element of caution is that not only did stocks crater (or stay flat), but everything else fell apart too, in defiance of what the typical financial media said would occur. Housing became a miserable investment, rather than the guaranteed path to wealth that was painted in the press. Can’t you remember people saying that renting was “throwing your money away”? I remember having many, many people look at me in a dumbfounded fashion when I told them that I rented for over a decade when I could have easily bought. This thinking has obviously changed radically, despite record low interest rates (high rates would have made the housing problems unimaginably worse, at least in the short and medium term).

Read more

A Great Article on Asset Allocation

In today’s Barron’s magazine there is an interview with Dennis Stattman of BlackRock Global Allocation called “Mixing It Up in an Uncertain World”. In this article he discusses his world view and his views on asset allocation. It is a great article and highly recommended.

Dennis starts by explaining that our current situation is odd.

The first thing you have to realize… is that it is an artificial environment because of extraordinary government measures, both on the fiscal and monetary side… but our portfolio strategy has to take into account with what is going on with our unit of account, the US dollar.

Read more

It Is All Market Timing

When I first started in investing one of the cardinal rules (for the general public) was “don’t try to time the market”. From a practical perspective this meant that you were supposed to continue putting money in the market whether it went up or down and then hold for the long term.

Everyone knew that the market does move in cycles, such as the giant bust at the time of the great depression in the 20’s and the 30’s when stocks crashed, wiping out many investors. Another classic example is the Japanese stock market which peaked in 1989 at around 39,000 before falling to a low of 7000 in 2009, over 80% below its high (today it is around 10,000). Even the most cursory review of the chart shows that if you sold at the peak and / or bought at the trough (this hasn’t worked yet in Japan because the market hasn’t moved back up yet) you’d make a tremendous amount of money; but the popular wisdom is that it was “too hard” for an individual investor to determine when to enter and exit the market so don’t try at all.

To some extent “re-balancing” is a form of market timing, because as stocks rise in value if you practice the model you are supposed to sell off some stocks and buy bonds (or whatever else is in your portfolio, could be commodities or real estate) which accomplishes much of what market timing is supposed to do. Re-balancing is more complex because it involves multiple asset classes which each have their own valuations but you could say that re-balancing is at least a “cousin” of market timing.

Read more

Mispricing Risk on Bonds

Interest rates are at an all-time low.  Companies are able to borrow money and pay almost no interest under the most favorable of terms.  This one caught my eye:

SAN JOSE, Calif.–(BUSINESS WIRE)–eBay Inc. (NASDAQ:EBAY) today announced the pricing of a $1.5 billion underwritten public offering of its senior Notes, consisting of $400 million of 0.875% Notes due 2013 (the “2013 Notes”), $600 million of 1.625% Notes due 2015 (the “2015 Notes”) and $500 million of 3.250% Notes due 2020 (the “2020 Notes”). The public offering price of the 2013 Notes was 99.793% of the principal amount, the public offering price of the 2015 Notes was 99.630% of the principal amount, and the public offering price of the 2020 Notes was 99.420% of the principal amount, in each case plus accrued interest, if any. The offering is expected to close on October 28, 2010.  eBay intends to use the net proceeds from the offering for general corporate purposes, which may include working capital, acquisitions and capital expenditures.

It is completely astounding that a company with a business model like eBay is able to borrow for:
– 2-3 years at under 1%
– 5 years at under 2%
– 20 years at a bit over 3%

These are not secured debt items; they are notes – and per the description above, eBay can use the money for anything they want, including working capital, which means that they can use the money for ANYTHING.  THIS IS LESS THAN 1% ABOVE THE RISK FREE RATE (i.e. what you can get for Treasuries).  This is absolutely unprecedented.

This article in today’s Wall Street Journal essentially tells the same story with Wal-Mart.  Wal-Mart was also recently able to sell debt at an absurdly low premium over the risk free rate.  Per the article:

Wal-Mart sold $750 million worth of three-year bonds paying 0.75% a year. It sold $1.25 billion of five-year bonds paying 1.5%, $1.75 billion of 10-year bonds paying 3.25% and $1.25 billion of 30-year bonds paying 5%.

The difference between Wal-Mart and eBay is that WMT also has an instrument that delivers yield as well as some potential for appreciation; a stock paying a dividend.  The dividend on the shares of WMT yield a bit over 2% a year and receive preferential tax treatment (due to the dividends received deduction) to boot.  Per the article:

Wal-Mart has raised dividends by an average of 16% a year over the past decade. If it merely raises them by 10% a year in the future, the yield on the stock will surpass that on the 10-year bonds within about five years. It will surpass that on the 30-year bonds within 10 years.

I have no idea why someone would buy debt, which has many risks (the risk of inflation in the economy, as well as a company specific risk) with this sort of minuscule premium, especially when taxation is so unfavorable (it is taxed as ordinary income today and highly likely tomorrow).

This is the equivalent of a “bubble market” for bonds.

Cross posted at LITGM and Trust Funds for Kids

Lack of New IPOs and Impact on Performance

If you read typical finance articles out in popular media you commonly see facts and figures about how US stocks outperform other investment classes over “the long term”.  As I do my own research I tend to see threads leading back to the premise that US stocks are entering a new environment going forward and past results are going to be less and less relevant in predicting future performance.  One of the reasons for this is the fact that the United States has ceased to be a dominant player in launching new public companies, and in fact is now mostly an also-ran when compared to Chinese markets or even Brazil as of late.

The Agricultural Bank of China is about to come out as an Initial Public Offering next week that will be one of the largest IPOs of all time.  Per this article:

Hong Kong and China have dominated the global IPO market. That dominance will only increase when Agricultural Bank of China starts publicly trading next week.  In 2009, Hong Kong was the world’s largest IPO market, with companies raising a combined $32 billion in capital, according to Dealogic, a data-tracking firm. This year, China is on track to assume the mantle, with $31.7 billion raised by early July.

The Wall Street Journal had a recent article titled “How to Fix the IPO Market” by Jason Zweig.  I didn’t agree with their analysis or recommendations but the article did have a lot of useful facts and figures that illuminate the changes in the public markets in the United States, such as the following:

Ten years ago, around 9,100 companies filed annual proxy statements with the Securities and Exchange Commission. Last year, roughly 6,450 did; so far in 2010, only about 4,100 have, estimates Wharton Research Data Services.  In two-thirds of the years from 1960 through 1996, the number of initial public offerings exceeded the number of stocks that dropped out. Since then, however, there have been more deaths than births among stocks every year: 7,725 stocks have disappeared over that period, while just 4,299 new ones have arisen to replace them, according to Wharton.

What is happening is that existing companies are swallowing up smaller companies and other ones went bust during the market tumult.  New companies, however, haven’t joined them.  Recently there was a bit of a hoopla about an IPO for Tesla Motors, which raised $266M.  However, prospects for the car maker are cloudy and the stock has declined below its offering price since then.  If Tesla, a loss making niche enterprise, is the future of our growth companies, we are in trouble.

The reason that this matters is that the entire “stocks outperform over the long run” is based on data from a few markets that haven’t suffered major disruptions (war, occupation) which pretty much brings you down to US and UK market data, mostly US data.  And this data was based on a continuous growth in companies launched through IPOs with a growing market for companies; today the market for US based companies is small and much of the new and larger IPOs are happening overseas.

There is nothing wrong with overseas markets growing; it is just that the US markets seemed to have stopped, and investor money (both US and foreign based) is going where the IPOs are.  While we do not see the “full” effect of this trend, because many large multinationals are still US based and doing well, we will see it in the future as the newer companies don’t fill in the gaps and come through the ranks at some point in the future.

This doesn’t mean that I am saying that US markets will go up or go down as a result of this; I am just saying that the long term data was based on a premise that new companies would grow to replace the old (“creative destruction”) but in fact the new companies aren’t coming up in the footsteps. Perhaps stocks are best in the “long run” in aggregate across all markets but it may not be US based stocks if we just have aging companies and the young, growth companies are nurtured elsewhere.

Cross Posted at LITGM and Trust Funds for Kids

Bond Bubble?

A recent Wall Street Journal article titled “Bond Fund Managers See Signs of A Bubble” discusses the state of the bond market and large inflows into bond mutual funds by investors seeking returns and attempting the avoid the risk that they see in the stock market.

A key element to understanding this or any other analysis on bonds is the difference between holding an individual bond to maturity vs. buying a fund that invests in bonds. They behave very differently. If you buy an individual bond and hold it for its life, unless that company goes bankrupt or has some sort of liquidity event, you will receive back your principal at some point in the future and interest payments along the way. Unless you are unlucky and it goes into default, it is a predictable stream of payments. Bond funds, on the other hand, invest in a whole range of individual bonds and do not necessarily hold them to maturity. Bond funds are significantly impacted by interest rates; when interest rates RISE, the value of their bond holdings immediately falls and investors receive losses. If interest rates FALL, investors in bond mutual funds receive gains. Thus holding individual bonds, once purchased, is mostly about default risk for that particular issue, while investing in bond mutual funds is primarily about the direction of interest rates and also overall default risks across all issues.

This situation is summarized as such in the article:

Interest rates will likely rise in coming years from a base of almost zero today. But investors mostly only know what they have seen in the past 25 years, which for the most part has been period of steadily declining interest rates and rising bond prices.

There isn’t any “up side” to bond mutual funds right now, from an interest rate perspective, because rates are almost at zero. If rates are going to change they are going up. In addition, low interest rates means less pressure on entities that require debt financing, and rising interest rates will not only slam bond fund values but they will increase the default risk on bonds in the fund as those entities must pay a higher price to refinance future needs.

Compounding the problem is that many investors don’t remember when bond funds did lose money for a prolonged period.

Read more

Dividend Cuts and Interest Rates

Recently I wrote about how Interactive Brokers was offering to lend money at 1.25% in order to purchase stocks yielding 5% or more in dividends. I was struck by the low rate that they were able to offer as interest and the fact that there was a large universe of large companies offering such high dividend payouts (and not just companies that had a stock price decline with a dividend cut yet to follow so it was unusually high relative to the stock value).

To give Interactive Brokers some credit, the ad was kind of “tongue in cheek” in that it was made to look like it was written on a napkin like the classic business plan but there were enough elements there to get me thinking about what an odd state of affairs this represented.

Just recently this model started coming under siege. The Fed recently began tightening interest rates, increasing the discount rate to 0.75% from 0.5%. While the Fed has been denying that this is part of a long term policy shift, the markets have started to feel otherwise, as markets went down and yields increased on government debt. This won’t directly impact the 1.25% that they are able to borrow for on the “napkin” today, but it seems to be trending that way, even if this is just a first step.

On the other side, 2 large European firms just cut their high dividends. Daimler Benz (DAI), manufacturer of Mercedes autos, suffered a loss and canceled their dividend, leading to a drop of 4.6% in their stock price in one day. Societe Generale, a large French investment bank, cut their dividend from $1.2 Euros to $0.25 Euros (a drop of 79%) and their stock also fell 7.2% in a day.

The question is – how can companies pay out such high dividends in a sustainable manner when there isn’t much growth in the world economy and many of them are in mature industries? While 2 stocks don’t constitute a balanced statistical survey, they show that dividends are a function of profits and long-term profit view and to talk about them in an “historical” view is backwards.

The other side of this is that investing for yield in such a volatile area as stock prices shows that not only did the long term value of the income stream from dividends drop significantly (in the case of Daimler it dropped to zero, and for Societe it dropped by 79%) but then you can also see the impact on the underlying value of the shares, which dropped 4.6% and 7.9% in ONE DAY.

Cross posted at LITGM and Trust Funds for Kids

Leverage, dividends and our insanely low interest rates

Like the famous Seinfeld episode where Kramer struggles to figure out how to profit from the fact that Michigan offers a 10 cent return on recycled bottles, I have been starting at this ad from Interactive Brokers for some time now. This had has been run in myriad financial papers and I have seen it all over the place. It is notable for the fact that it looks like it was drawn “on the back of a napkin” like the fabled dot-com business plans.

The specific elements of the investing plan are as follows:
– Interactive brokers can make margin loans at 1.25% annual interest. This LOW rate of interest is made possible by the country’s current super-low rate policy
– Some stocks are offering dividends as high as 5%. In the current low interest rate environment (you are likely to get 2% on CD’s & government paper, and almost nothing on your money market and bank deposits), that 5% rate seems very enticing, especially since dividends are taxed more favorably on individuals than interest income (dividends are as low as a 15% rate, while interest income is as high as 35%+)
– Interactive brokers will offer you LEVERAGE. By leverage, this means that they will LOAN you more money than you have in your brokerage account so that you can invest and magnify your returns, either UP or DOWN

Read more

We Are Wrong on Rate of Return

In this article titled “Why Many Investors Keep Fooling Themselves” by Jason Zweig from the Wall Street Journal, Mr. Zweig does an excellent job of explaining why individuals assume that they will receive a rate of return that is too high, which means that either they are not saving enough to meet their goals or that they are taking too much risk of running out of money.

This post describes what the rate of return means in practical terms, and why it is important.

One of the core elements of investing is the assumed “rate of return”. Along with your base investment (or amount that you are periodically adding, say annually), your time frame (number of years out you want to go), the “rate of return” is the percentage variable used to determine whether you will have enough to retire and / or meet your needs for a specific goal (such as will you have enough funded to send your child to college).

Read more

Buying CDs Through A Brokerage

Recently I covered iBonds, which are a government bond that you can purchase online that provides assurance against increases in inflation and other tax benefits. The amount you can purchase is limited, however, to $5000 / year, and you can’t redeem them for 12 months, which makes them unsuitable as a short-term cash vehicle.

Certificates of Deposit (CDs) Through a Brokerage:

If you are looking for a practical way to earn interest income with the minimum risk possible than certificates of deposit are a good alternative. When I was growing up you had to physically go to a bank and set up a CD, and then you had to retain paperwork for each instrument. In addition, you wanted to disburse your funds among a number of banks to get around FDIC limits, as well. Finally, the CDs were not easily redeemed, although you could redeem them in some circumstances depending on the issue with a penalty on interest.

Today – all of above disadvantages and inconveniences with certificates of deposits have been eliminated. You can buy CDs online (I used to go through a voice broker, but last time the guy showed me how to do it myself, online, so now I will just purchase them that way), they are integrated with your brokerage statement so there is no additional paperwork (on issuance, or at year end for taxes) beyond what you already receive, and also there is a “secondary” market when you can re-sell your CD if you need the proceeds sooner. There is no “guarantee” that you will be able to sell your CD at the price you want, but since a CD is a simple commodity with a rate, timing payment frequency, and a duration, I’d expect that you’d be able to sell it for something very close to the market price and receive not only your cash back but essentially be made whole on your interest. However, the overall interest rate market may have changed which would mean that your CD would be worth “more” or “less” if you had to sell it – longer dated CDs that I purchased a couple of years ago are now selling for more than 100 cents on the dollar (say 102) but that would only come into play if I decided to sell them prior to their redemption date, which I don’t plan to do.

Read more

The Midas Touch

Some months ago, back when it seemed that he might actually matter in some small way, I was talking to a Ron Paul supporter. He angrily demanded to know why I was amused that anyone would take Dr. Paul seriously.

I said that one of the many, many crazy plans Dr. Paul had for this country was to move us back to the gold standard, and I pointed out that China mined more gold every year than the US. While the US was in the top three, Russia was not that far behind. Did anyone in their right mind want to simply hand that kind of power to Russia and China? What happened if they cut back on production, and the gold supply dried up?

Since that conversation, China has moved into first place so far as gold production. I never thought Dr. Paul had even the ghost of a chance, but it is certainly a good thing he didn’t.

But remember how I said that the reason why it was a bad idea was because China and Russia might collude to squeeze off the gold supply? Looks like Obama’s policies might be doing something similar.

Follow that last link and read how a gold investor thinks that confiscation is now possible. Hey, it happened under FDR!

Comment Thread for Private Stock Exchanges

Background is at Facebook, Twitter and peers for sale – privately.

My initial impression is that this could be an ingenious adaptation to an obnoxiously overregulated environment. Or it could be crushed by regulators and their enablers; given that a Republican Congress and President were willing to saddle us with Sarbanes-Oxley seven years ago, it is not easy to imagine our current complement of parasites reacting dispassionately to private stock exchanges.

Note that I do not meet the minimum qualifications (net worth $1M, annual income $200k for past 2 years); this is just to elicit discussion by knowledgeable people (the minimum qualifications for which I also do not meet).

Municipal bond troubles ahead

The municipal bond market is a critical source of funding for states and local government in the United States. These bonds are traditionally free of Federal taxes (assuming they meet some criteria, which most of them do) which allows them to raise money about 25% cheaper than equivalent taxable bonds of the same credit quality, all else being equal. Bonds are also often exempt from state taxes in the state that originated them, a concept that required a 2008 supreme court ruling because of allegations that it violated interstate commerce rights.

In general, municipal bonds have lower default rates than other equivalent bonds based on prior history, and the recovery rates for those bonds which DO default is higher, as well. As a result of these historical trends, municipalities are generally able to issue debt at lower interest rates and find buyers.

While history is important, I would be wary of the market right now. As you can see in this article, the governor of California is starting to request that the Federal government provide a backstop for their bonds. In a prior article, I noted that the entire issuance of an Illinois bond sale went to a single purchaser, who just happened to be a big bank receiving large amounts of Federal funds (it helps sometimes to have lots of people from Illinois in the White House, I guess).

Read more

Unwinding of a Fund of Hedge Funds Position

I made a mistake several years ago, but I didn’t know it at the time.  It wasn’t a dreadful mistake, but one which I thought I would share with you to perhaps give some guidance and solicit some comments.

About 5 years or so I was sold on purchasing some shares (are they really shares?) of a fund of hedge funds.  I will admit right off the bat that I didn’t know what it does, what it did, or how it works.  I trusted my financial advisor as he told me that it was a great way to diversify my portfolio.

Last October/November I decided to look at every single one of my investments and decide if I needed to sell the position and rebuy (to take the tax loss) or to hold, or to simply sell.  I decided that this fund of funds needed some investigation.

Read more

What I’ve Learned About the Stock Market

Anyone who has a retirement fund or personal investments has an interest in the stock market. I have an additional interest because I am the fiduciary in charge of trust funds I set up for my nieces and nephews and track at trustfundsforkids.com.

When the stock market started cratering in 2008, I didn’t take immediate action, for the most part (I was going to say didn’t do anything “rash” like sell off, but in hindsight of course probably that would have been under the category of “smart”). I did sell off financials (owned ICICI, an Indian bank, and GE, which is essentially a giant financial conglomerate with a few businesses stuck in there) immediately, and although my exposure to that sector was limited in those funds, those stocks had not done well.

Now I am trying to re-visit the stock market and do some research to consider what to do next. I am starting out with what I’ve learned from this debacle. As always, do your own research, this is just my 2 cents based on my experience and body of knowledge.

1. Watch the level of debt, and the timing of debt – for many years there was an absence of a risk premium, which meant that newly emerging (risky) companies could raise debt very cheaply, such as only a couple of points above the treasury rate. Today, it is unlikely that these types of companies can raise any money AT ALL, and if they did it would be at a rate perhaps 10 percentage points above Treasuries (i.e. if Treasuries are at 4%, they would pay > 14% for financing). Companies are moving into bankruptcy rather than try to refinance at these rates – companies like Charter Communications, for example. Even if bankruptcy is avoided (or deferred) the company would have to be highly profitable to earn enough to cover that level of interest payments – and most companies can’t profit when their cost of capital is that high. I won’t even comment on the 33-1 leverage used by investment banks because we all know how that turned out

2. Guessing the actions of the US Government is important – during the cold war, “Kremlinologists” attempted to divine what was occurring at the top levels of the Soviet government, since it had a direct bearing on our policies. For example, the Feds let Lehman die and saved AIG, although in both cases their equity value evaporated to the point that a 100% equity loss and a 98% equity loss were a toss-up either way. The subtle way in which by saving AIG they benefited Goldman Sachs (since AIG was a major counter-party to Goldman Sachs) would be something worth understanding, for example. The Feds also didn’t bail out Fannie Mae and Freddie Mac preferred shares, which caused whole ranks of smaller institutions to fail. In general, if you are investing in an industry that looks likely to need government help, you should get out now, because whether or not you have a few equity crumbs or go to zero is a Hobson’s choice you don’t want to face

3. Correlation between asset classes is higher than you expect – Basically unless you were 100% in gold or treasuries you were likely hurt badly in this market. Foreign stocks, US stocks, many debt instruments, preferred stocks, real estates and most commodities (excluding gold) all dived together. One of the “core” beliefs of “modern portfolio theory” is that if you spread your investments across classes with lower correlation to one another, you will do better over time. Modern portfolio theory basically didn’t save anyone in the time frame we are talking about here

Read more