Fear and Greed Revisited
“The only thing new in this world is the history you don’t know.” — Harry Truman
The market has been going straight up since early October. Now we might go the other way for a while. What is the implication for long-term investors? Consider a little historical perspective.
We are somewhere near the end of the greatest sustained drop in long-term interest rates in the entire history of the United States. 10-year Treasuries closed today at 1.94%. But in case you haven’t noticed, food prices, gas prices and health care costs are flying. The Fed may intend to keep rates low for another 2 years, but the market may have different ideas. It’s hard to imagine how a 2% nominal return on 10-year bonds can produce anything resembling a real (adjusted for inflation) return.
Luckily, things are more promising on the equity front. The (trailing) earnings yield of the S&P 500 is around 7.5% — 3.7 times the yield on 10-year treasuries. The last time we saw that multiple was in August 1954.
A cynic could almost suggest that this is Bernanke’s real agenda: keep rates low for so long that investors finally capitulate and start buying stocks.
I believe in capitalism. But for capitalism to work, investors have to at least be able to maintain the purchasing power of their money. At the end of 2011, we completed a 10-year run during which investors in the S&P index lost 2% on a compound annual average real return basis. Worse, on a year-to-year basis looking back to 2000, cumulative real returns were negative every single year through 2011. This is extremely unusual — the last time it happened was from 1973 to 1983. And the longest negative streak before that was from 1937 to 1944.
What happened following these bad stretches of the past? From 1944 to 1954, the S&P produced a real return of 12.9%. From 1983 to 1999, the S&P produced a real return of – hold the phone – 14.6%!
There is still a boatload of money on the sidelines. In the last couple of weeks, we may have finally seen a reversal of the four-year trend of outflows from equity mutual funds. But it’s a drop in the bucket — money market funds, bond funds and corporate cash are still extremely high by historical standards.
Bill Gross is all over the press talking about the risks in the world markets and the need to play defense. It’s important to remember that Bill’s performance is measured on a quarter-to-quarter basis. People planning for retirement should be focused on what’s going to happen in the next 30 years. Think about it. Even if you were too early and loaded up on stocks in 1978, your real return to 1999 would still have been 12.1%. At 12%, your money doubles every six years.
So I reiterate the point I made in September:
The real issue for long-term investors is to have an investment plan that includes a significant commitment to stocks, get invested, and stick to it. If you’re on the sidelines, take a deep breath and a long-term view and get back in the game.
Holiday Cheer: Perspective
Are you frozen in the headlights as an investor today? Appalled by the size of the deficit and the national debt? Disgusted with the partisan gridlock in Washington? Unable to comprehend a solution to the problems in Europe? Feeling like the economy is hopelessly stuck and it will take years for us to recover — if we ever do?
Sometimes it helps to look back.
In this linked article The Good Old Days? Jim Parker of DFA points out that
“previous generations have stared down and overcome far greater obstacles than we face today”.
During the last 85 years, the stock market has produced a compound annual return, after inflation, of 6.6%, turning a $100,000 investment in January 1926 into $23.6 million today. Somehow, despite all of our efforts to screw it up, capitalism has always worked.
Just trying to cheer everyone up. Happy Holidays!
Rick
Fear and Greed
It is said that the two emotions that drive all markets are fear and greed. When the markets were so euphoric in 2005 and 2006, greed was the prevailing emotion. Conversely, when the markets were in a freefall in 2008 and 2009, fear was rampant.
For most of this quarter we have been in the fear camp. Thus our focus has been on the negative cast of all facts.
Consider the following:
- Price of Gold (see notes below) — near all time high ($1805)
- Cash on corporate balance sheets in U.S — all-time high
- Money market Funds + bank savings deposits — close to the all-time high of 2/2009
- Yields on U.S. Treasuries — all-time low
- U.S. home sales — dismal
- Mortgage Originations for 1-4 Family Purchases — 2010: 42% of the 10-year average
- U.S. Equity mutual fund flows — outflow of $335 billion in last 4 years
- The VIX Index (see notes below) — 34.8, up from 15 two months ago
- U.S. savings rate — 5%, up from 0% in 2007
Taken together, this data paints a picture of extreme gridlock: investors huddled on the sidelines, still reeling from the near-apocalypse of 2008-2009, focused primarily on the return OF their capital, rather than the return ON their capital; American consumers desperately deleveraging and saving as much as they can (to the extent they are able, given the dormant state of the real estate market); U.S corporations with $1.9 trillion in cash on their balance sheets,* waiting (with ever-diminishing faith) for some sign of responsible behavior out of Washington and a discernible pulse from the American consumer.
But there are two sides to every story and every set of facts. Mohamed El-Erain, PIMCO’s CEO, recently observed: “When I look at the balance sheet of multi-nationals, I have never seen them as strong – they’re pristine.” U.S. corporations are producing record profits, projected to exceed the all-time high earnings of 2007, and yet the S&P 500 is trading well below its long-run average of a 15 P/E, even pricing in a recession with a 25% drop in earnings from current levels.
The speculative expectation has been expunged from the residential real estate market; housing is once again being viewed as shelter, instead of a lead-pipe cinch as a path to vast riches. And in Europe, where there is still a ton of work to be done to restructure and recapitalize the banking system, at least the folly of the last seven years is apparent to all. It’s not likely that banks will resume lending money based solely on credit ratings and undocumented assurances as they did in Greece, and it will be a long time before Europe will field a new set of fools to roll over for Wall Street’s rapacious sales practices.
In my experience, news has momentum – it tends to overrun the mark in either direction. When it’s bad, it’s always hard to imagine it how it can possibly get good. Sometimes it’s just a function of looking at the facts of the day in a more optimistic way.
There’s a lot of money on the sidelines. Stocks are cheap. Yields on bonds are not even vaguely compelling. U.S. bank exposure to European sovereign debt is (reportedly at least) moderate. Corporate balance sheets are stronger than dirt. Stock repurchases by U.S. companies have increased each quarter for the last 8 quarters. We got through Libya without committing ground troops. And Cal and Stanford are 3 and 0.
In my old bond trading days at Salomon Brothers, traders were taught to “buy ‘em when nobody wants ‘em”. By that standard, it’s probably time to back up the truck. But the real issue for long-term investors is simply to have an investment plan that includes a significant commitment to stocks, get invested, and stick to it.
Professor Jeremy Siegel from Wharton studied the wealth accumulated in stocks, bonds, and T-bills measured from the eight major market peaks in the last century – in other words, positions bought with perfect poor timing – and concluded that for 20-year holding periods stock accumulations beat bonds by about two-to-one. For 30-year periods, stocks beat bonds four-to-one and Treasury bills five-to-one.
But we’re not at a market peak today. Stocks are cheap. We have a long time to work through the problems.
My advice: if you’re on the sidelines, take a deep breath and a long-term view and get back in the game.
*There is, of course, offsetting debt against much of this cash hoard. But corporate treasurers seem to be following the counsel that Mike Milken always gave – “raise capital when you can, not when you want to.”
The VIX Index
One measure of fear trumpeted by the press these days is the VIX index, a contract that expresses a measure of the market’s expectation for stock market volatility over the next 30 days. The VIX index today stands at 32.8, up from 15 a couple of months ago. That’s a big increase, but for perspective, the VIX reached 79.13 on October 20, 2008. The VIX actually measures volatility in either direction, so it is not technically accurate to characterize it simply as the “fear index”.
Gold Market Metrics
The outstanding supply of gold is measured in metric tonnes, which is not the same thing as a ton of bricks. All of the gold ever mined totals 168,300 metric tonnes. For a visual, if all of that were put into a cube, it would measure only 67.7 feet per side. At today’s price ($1805), the value of all of that gold is $9.7 trillion, about a trillion less than the market cap of the S&P 500. But 12% of the total has been used in fabrication, 50% has been used in the manufacture of jewelry, and 2% is missing in action, thus 64% is mostly out of commission. 18.7% of all gold is held in private hands and 17.2% comprise official (central bank) holdings. These last two categories combined are considered by some to be the “financial market” for gold, since in theory central banks could liquidate their holdings. By this measure, the “financial market” for gold at today’s price is $3.5 trillion. For benchmarks, the S&P 500 has a market cap today of $11 trillion, the global market for equities is in the neighborhood of $55 trillion, global commercial real estate is about $24 trillion, and global bonds total $95 trillion. By those benchmarks, the gold market is pretty small. The amount of press it gets is pretty large.
Michael Lewis made an interesting observation in his article for Vanity Fair this month on Germany’s role in the European financial crisis:
The E.C.B. has a rule—and the Germans think the rule very important—that they cannot accept as collateral bonds classified by the U.S. ratings agencies as in default. If Greece defaults on its debt, the E.C.B. will not only lose a pile on its holdings of Greek bonds but must return the bonds to the European banks, and the European banks must fork over $450 billion in cash. The E.C.B. itself might face insolvency, which would mean turning for funds to its solvent member governments, led by Germany. (The senior official at the Bundesbank told me they already have thought about how to deal with the request. “We have 3,400 tons of gold,” he said. “We are the only country that has not sold its original allotment from the [late 1940s]. So we are covered to some extent.”)
3,400 tons (tonnes) is about 5.6% of the financial market for gold, worth about $200 billion today. Germany is a signatory to the Central Bank Gold Agreement which limits annual sales by its 15 signatory nations to 400 tonnes a year, so liquidating the German position would take a while. About $120 billion of gold bullion changes hands every day on the London Exchange, so liquidity wouldn’t be a problem. But there have been almost no sales of gold by central banks since CBGA 3 started in 2009. It seems like it would be an unpleasant surprise to the market if Germany actually started selling.
Sources:
Federal Reserve Statistical Release – Money Stock Measures H.6, September 15, 2011
Investment Company Institute, Historical Flow Data, Mutual Fund Flows
The World Bank, Global Equities Data Table: Market Capitalization of Listed Companies (Standard & Poor’s, Global Stock Markets Factbook and supplemental S&P data)
Prudential Real Estate Investors, March 2011
World Gold Council, Liquidity in the Global Gold Market, April 2011
London Bullion Market Association, LBMA Survey of Loco London Gold Turnover Q1 2011
Are You Racing with a 300-Pound Coxswain?
Confronting the hostile mathematics of equity mutual funds
A coxswain in a racing shell is sort of like a jockey in a horse race — their contributions are in the areas of strategy, management, coaching, encouragement and steering, all intended to be delivered in a small, light package. Coxswains weigh about 120 pounds — if less, they are required to carry sand bags to bring them up to the mark; if more, they are just adding unnecessary drag. In a world where boat races are usually won by a few seconds, a heavy coxswain pretty much assures defeat.
It’s the same thing in mutual fund investing. High costs create drag and kill performance. Portfolio management fees, operating expenses, 12b-1 fees (collectively “the expense ratio”), front end loads, contingent deferred sales charges, trading commissions, market impact costs, and taxes — all combine to reduce an investor’s chance of earning the market rate of return.
Why do investors continue to pour billions of dollars into high cost funds? Because they don’t realize that they have a choice.
About half of all mutual funds are distributed through what is euphemistically called the “Advice Channel”: full-service brokerage firms, banks, insurance companies and financial planning firms. Within that world, there are two camps: “advisors” who receive at least some compensation based on what their clients invest in — and advisors who don’t.
I would propose that the quality of advice offered by people with a financial stake in what goes into your investment portfolio is suspect. If you are a client of a brokerage firm, for example, you should not be surprised if you find that the only funds that are offered to you or put into your account are funds on which your brokerage firm earns some sort of a commission. It’s highly unlikely that your broker will ever show you Vanguard funds or DFA funds. Brokerage firms have high overhead — those costs must be passed on to someone. You’re it.
In order to make the advice channel work, the mutual fund industry has created a dizzying array of investment choices through something called the “multi-class share structure” — A shares, B shares, C shares, etc. (Please see Appendix A.)
Unless you know, in advance, exactly how long you are going to hold these kinds of mutual funds, it’s virtually impossible to make a rational decision on which share class to buy. Yet your broker leads you through this maze of choices as if he’s giving you wise counsel. In reality, it’s just a bunch of razzle-dazzle designed to distract you from asking the questions you should be asking: Is that all there is? Isn’t there a more efficient way to invest?
Let me be blunt. If you look in your portfolio and you see A Shares, B Shares, C Shares, etc. the first reason you have been sold that product is not because it is a great investment, but because your broker is getting paid to sell it. It may be a very reputable fund, possibly even with a well-known manager. And sometimes these managers outperform the market for extended periods of time. But in the long haul, you are destined for disappointment because the math is against you. You have a 300-pound coxswain.
Here is a real-life example:
A friend of mine came to me with a portfolio constructed for her by Merrill Lynch Asset Management. Merrill had carefully chosen 13 retail mutual funds (no doubt right off their “approved” list) and then invested my friend’s money in the A Shares of each fund. She was down 4.5% before the music even started. The funds had a weighted-average expense ratio of 0.94% and a weighted average turnover of 64%, (meaning that the managers of the funds in her portfolio, on average, sold 64% of the stocks they held each year and bought different stocks, incurring substantial trading costs and taxes in the process).
Turnover is expensive. Morningstar published a study last year that concluded “the average equity fund pays approximately 0.30% of assets a year in brokerage commissions… and while the average brokerage cost is significant, much more startling are the huge fees paid by some individual funds that in some cases approach or exceed the entire expense ratios of many core funds”. In addition, “the market impact and opportunity costs are the tougher and more important pieces to measure because they can easily dwarf brokerage commissions”.
Market Impact Cost? The research of Fama and French has concluded that a measured exposure to risk in small and value stocks can increase your expected returns, since risk and return are related. But for years, the argument against investing in small, value, and international (especially emerging market) companies was that the cost of trading their stocks would overwhelm the additional return they offered. This is the issue of market impact. A stock may be quoted 10 bid, 10 ½ offered but the bid can literally evaporate when a large block is offered for sale. 100 shares might trade at the quoted bid, but the balance of the block will trade at a lower (and often much lower) price. This is especially true In the case of less-liquid stocks. Market impact is a huge cost for most money managers, generally considered to be much greater than commission costs.
When I added up all of the costs imbedded in my friend’s portfolio it looked like this:
So, to be crystal clear, what these numbers are saying is that this portfolio would have to beat the market by 3 1/2% to 4%, on average, for this person to actually get the market rate of return.
As my old friend Harry often says, “That dog don’t hunt.”
Study after study has concluded that no one can either consistently time the market or consistently outperform the market through superior stock selection. Yet that is exactly the business strategy of the vast majority of mutual funds. In the pursuit of outperformance (for the bragging rights that will bring in more assets under management), active managers blithely churn their portfolios, creating unseen and unreported transaction costs and taxes. 65% of all of the money invested in mutual funds is taxable, and yet managers routinely create capital gain income and taxes for their investors, because it is not captured in the measurement of the manager’s performance.
It’s a credit to the marketing skills of Wall Street that investors continue to pour money down this drain. And what is truly amazing is how many really wealthy, very successful, and very smart people allow themselves to be led down this path.
Is there an alternative? Absolutely. Once you turn your back on timing and selection, successful investing becomes a challenge of finding the most efficient and effective vehicles for compounding your capital. The costs described above can be cut by 60% to 75% by using the right funds. And the expected returns of these funds, designed to efficiently capture the opportunities in higher-yielding asset classes of the market, can substantially enhance portfolio performance.
But that’s a story for another time.
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Appendix A
A shares carry a front end load – an upfront sales charge that can be as much as 5%. So if you have $100,000 to invest, only $95,000 of your money is actually put to work. Brokers suggest that this is a good deal, because A shares have the lowest management fees and administrative costs (“expense ratios”) and don’t carry the “contingent deferred sales charges” typically associated with B shares.
B shares, on the other hand, are described as a good deal by brokers because they don’t have upfront sales charges. However, they tag you with contingent deferred sales charges (CDSC) and 12b-1 fees. CDSC are charges levied against an investor who chooses to sell his fund “early” — within a pre-defined period, usually 6 to 8 years. 12b-1 fees are a charge to existing investors in a mutual fund to pay for the fund manager’s marketing costs to attract new investors to the fund. Since it is widely accepted that smaller funds are more nimble and thus have a better chance of outperformance, paying 12b-1 fees on a fund is sort of like paying money to handicap your own investment performance. Also, the expense ratio of B Shares is higher than A Shares.
C Shares have no upfront charges and the deferred sales charges expire after one year. Catch-22? The expense ratio is higher than on the A shares or B shares.
A Dying Banker’s Last Instructions
Here’s one that hits close to home: the story of Gordon Murray as reported in the NY Times on November 26, 2010, entitled A Dying Banker’s Last Instructions.
Gordon and I had simultaneous careers on Wall Street – he at Goldman Sachs, Lehman and First Boston and I at Salomon Brothers and Drexel Burnham. We both worked in fixed-income institutional sales.
We were eventually introduced by a friend who thought we had a lot in common. When we compared notes, we found that we were both disillusioned with working on Wall Street. We had started our careers when the prevailing ethic was that your word was your bond and the best way to build a business was to maintain long-term relationships with clients by putting their interests first. But as time went on it became less and less rewarding to stick to that program and at various times we had each been criticized for being too soft, or naïve, for the business. Clearly mainstream Wall Street had chosen to follow a different path.
We met again a couple of years ago — Gordon had turned his back on a lucrative offer to return to First Boston and joined Dimensional Fund Advisors instead. I had discovered DFA as I was starting On Keel Capital. We both recognized the same thing in DFA – a dedication to investment truth as developed through rigorous and relentless empirical research and an unwavering commitment to putting clients’ interests first.
In his interview with the NY Times, Gordon claims he learned more about investing in one year of working for DFA than he had learned in 25 years on Wall Street. I’ve had exactly the same experience – through numerous DFA seminars, I resumed the education in modern portfolio theory that I had started under Bill Sharpe at Stanford Business School and got caught up on all of the refinements, and the practical application thereof, of the last 30 years. DFA is a magnet for the best and brightest minds in investment research.
Gordon decided to go out swinging – to spend many of his final days detailing what he has learned about successful investing while working at Dimensional. His book is called The Investment Answer.
As he said the NY Times and RIA Biz, sound investing is not rocket science, and the book is “written in language intended to make it intellectually accessible to virtually anyone – and to keep it short and to the point.”
Writing this book was an act of enormous determination and courage. It makes me happy to know that Gordon, who is one of the all-time great guys, has had the chance to end his career on the right side – with truth and justice as his legacy.
View From the Abyss
The market of the last two years has dealt us many painful lessons.
During the extended bull market that began in 1989 and ended in 2007, many of us came to believe that we had unusual perspective on unappreciated value in some individual stocks, or that the tax hit from selling long-held or concentrated positions was to be avoided at all costs. Plenty of managers could boast market-beating returns. Diversification was for wimps.
Oh well.
The numbers have all changed. How much had you saved for your children’s college education? Were you thinking about hanging up your cleats? It might be time to rerun the numbers.
I believe, as my father told me over and over again: “there is no free lunch”. Uncle Bernie and Sir Allen Stanford are just the latest reminder that if something seems too good to be true, it probably is. But the mathematics of the market has demonstrated repeatedly for over 200 years that over extended periods of time, a well-diversified portfolio of stock investments will produce a return that will more than allow investors to maintain purchasing power. And that, after all, is the principal objective.
The manifestations of principal risk ebb and flow, but inflation, like death and taxes, is inexorable. As our government tries heroically to shock our economy into a heartbeat, trillions of dollars are being pumped into the system. When the multiplier starts to blip again, inflation risk will push principal risk right off the stage.
I think it’s time to get very organized financially. Update the will, take a fresh look at your estate plan, look at your investments holistically — are you really diversified, or do all of your managers own the same stocks? The market’s down – you might find you are back in the neighborhood of your cost basis on some of your long-held (or inherited) stock positions and it would be a great time to diversify your portfolio. And if you haven’t done it already, it’s certainly it’s a good time to harvest losses to shelter future gains.
It’s time to have a plan. Maybe you have always been too busy to actually have a plan. I know more than a few people (ahem) who were so busy trying to make money that they weren’t particularly thoughtful about investing it. You might have done OK – but who knows? Did you actually carefully measure your total portfolio return? Or did you just bask in the glory of your successes and overlook the fact that inflation was eating your lunch on the cash that you never got around to investing?
The mission of On Keel Capital is to help you achieve total financial integration. I will use my considerable powers of persuasion to help you clean up all of the niggling details of your financial life. I will help you remember the nights that you couldn’t sleep over the last two years so that we can together develop an investment program that is suited to your particular tolerance for risk.
And we will invest in portfolios that pursue return by controlling the things that can be controlled, rather than tilting at the windmills of illusory outperformance.
