Sunday, December 28, 2008

General Misperceptions of “The Madoff Affair”

I had not intended to devote another blog to what the French have called “The Madoff Affair” before securing additional perspective and information. However, recent writings and holiday party discussions have highlighted a lack of understanding about the workings of the investment world. In this context, I offer the following points which have not been covered in the press.

Bernie Madoff entered the brokerage world as a proprietor of an Over-the-Counter dealer in Puts and Calls, one of the first types of derivatives traded beyond the stricter rules of exchange-traded securities. The price spreads between the Bid and Asked at the same strike price (face value) could be quite large, as there was little in the way of competitive bids and offers at the same strike price. Much of the Put & Call business came from retail oriented firms who were incentivized to concentrate their business with one or more dealers by being paid for their order flow. Many of the Put & Call Dealers were attempting to lock in the spread. In order to get more people involved, dealers sold combinations of Puts and Calls, either in or out of the money. (Meaning at least one side of the trade approached profitability if it were not for the premium paid for the option.) If you find this description a bit hard to follow, so did the regulators, leading this portion of the market to be aptly described as the “Wild West.” Regulators did not have the appropriate tools or business knowledge to oversee Madoff’s activities.

Bernie learned his trade well. With the founding of the Chicago Board of Options Exchange (CBOE), the game changed as spreads narrowed and trades were recorded for all to see. Bernie adapted quite well. He used the payment for order flow approach plus a significant investment in some of the faster computer software and hardware available to earn a significant share in all principal markets in the country. Some people thought he substituted his own capital through the use of options to offset imbalances. If there was any such activity, I believe now, it was the use of his investment firms' orders that had the advantage.

Madoff created two separate firms according to function. The first and by far the largest in terms of employees and image was the old Put & Call firm, which was one of the country’s largest brokerage firms, trading a large share of orders, probably not volume. One of the key benefits of this arrangement was that the brokerage firm could act as a custodian for customer securities. Most investors are familiar receiving monthly account statements, though only recently have these reports included performance calculations. Many smaller, non-publicly owned brokers like Madoff, are only audited once a year, conducted by less prominent accounting firms, and publishing only a statement of financial condition, not a profit and loss statement. Except by sampling, individual accounts are not reviewed.

The second firm that Bernie Madoff created was a registered investment adviser. This was a very unusual firm in that it did not charge for its services. The given reason was that the combination of the firms would make its profits from the trading in the brokerage firm. (Perhaps this distinction may play a role in their legal defense. The courts will have to decide whether the investment firm actually gave advice to these brokerage accounts.

Apparently most of the money that was “managed” came in through what is called “feeder funds.” Feeder funds are a common way for hedge funds and offshore funds to receive capital indirectly. There has not been enough disclosure as to what multiple functions these feeder funds supposedly provided to Madoff. The range of possibilities include some or all of the following: (a) an introducer to a disclosed adviser or fund, (b) a purported fund of funds with only one sub-fund, or (c) a bank or brokerage firm providing leverage at the fund or account level. It will be the jurisdiction of the various regulators or courts to determine what functions were actually offered or performed, and who had what level of knowledge regarding fraud.

Undoubtedly the biggest misperception was that the investments could regularly produce, with very rare deviations or losses, a predictably performing vehicle capable of producing higher returns than bonds with less volatility than stocks. In the aftermath of the Tech Bubble, and the more recent liquidity/credit collapse, investors felt comfortable, indeed conservative, putting so much of their wealth into this wonder. How could they be wrong when so many of the most respected people and organizations in their world also invested knowingly in Bernie Madoff’s wonderful money maker?

Not enough time has passed and the disclosure has been too limited to draw conclusive lessons from this great tragedy. Two lessons are of paramount importance: First, that diversification should be an absolute requirement for all portfolios, particularly institutional accounts. Second, one should search for investment advisers who have disclosed skills and a history of competitive investing.

I am currently in the process of helping a non-profit organization who has been hurt in this affair.

Sunday, December 21, 2008

Correlations: Useful, Labels: Misleading.

One of the characteristics of an equity Bear Market is everything goes down. Mathematically this phenomenon is described as the narrowing of correlations. In other words, almost every stock goes down about the same amount.

Because I am comfortable reviewing the performance of over 16,000 funds each week, in some regards I have a distinct advantage when developing investment policy. As an example, you might find the following method useful in developing your own investment strategy.

Most people look exclusively at the best fund in its class or at least the average performer. I take a very different approach when using fund classification as a tool for fund selection.

In this case I looked at the second worst performing fund in major so-called asset allocation buckets, broken down by investment objectives, using the 52 week period ending December 11, 2008. (I will be happy to discuss with anyone the benefits of excluding extreme examples.)

Key: (G) = growth, (C) = core, (V) = value

Second worst among Large Capitalization funds:
(G) - 60.22%
(C) - 55.58%
(V) - 52.27%

Second worst among Mid-Cap funds:
(G) -61.47%
(C) -58.88%
(V) -57.48%

Second worst among Small Cap funds:
(G) -61.52%
(C) -62.94% *
(V) -59.68%
* In the case of Small Cap Core funds, I used the fourth worst fund as the others had more derivatives in the portfolio.

Second worst among International Large Cap funds:
(G) -56.13%
(C) -54.26%
(V) -53.97%


1. Note the narrow performance correlation of these funds
2. Poor performance ranged between -52.27% and -62.94% compared to the average S&P 500 index fund of -40.21
3. International diversification in large caps did not help.
4. Slightly smaller losses were experienced in value oriented funds.
5. One can be exposed to losing half of one’s investment in many places.

Similar exercises can produce the same relative results when applied to most securities indexes.

In this “sound bite” world it is important to recognize that various labels, e.g. stock market, blue chip, growth and value, are not particularly useful in the selection process.

Please let me know if I should plan to write about selection criteria and due diligence in future blogs.

Monday, December 15, 2008

Round Peg in Square Hole Produces Splinters

After a shocked weekend dealing with what the French will call “The Madoff Affair,” Sunday night finds me thinking about the lessons that have been forgotten. First and foremost, is the lesson that unbelievably good results do not overcome the need for due diligence. The appropriate outlook is the one that cautious investors have relied on since the beginning of handing one’s own money to another: Unbelievably good results ARE unbelievable. Part of the unquenchable belief is imbedded in the alchemy of academics, confusing volatility with risk. In my book MONEY WISE, I try to focus readers’ attention on the real meaning of risk. The real meaning of risk is the large, permanent loss of assets that can change one’s ability to meet life’s goals. In the Madoff case, investors experienced few fluctuations in their consistently high monthly returns. With little or no volatility, the resulting returns produced unbelievably high risk-adjusted returns. We have seen this action occur previously, right before the last Act’s denouement.

Diversification is a basic lesson for all investors, but overlooked in the Madoff affair. No regulated insurance company, and almost no mutual fund could tolerate such little diversification. Many investors (either directly or in funds) concentrated a substantial part of their liquid wealth with these funds. Perhaps more distressing, some used fiduciary responsibilities to direct their charities to do the same. A portion of these same people were moving out of checking accounts this past summer to produce diversification and to get their balances below FDIC insurance levels, as we did. Otherwise intelligent and sophisticated investors were so greedy to capture all of the good returns that they forgot about the discipline of diversification.

The unexpected results of the bankruptcy of Lehman Brothers and the de facto collapse of AIG were not from the size of their debt loads, but from the counter-party risks which froze the assets upon which others had primary claims. The brilliance of the Madoff affair was in not charging a performance fee for superlative investment returns as an adviser, but rather conducting these as brokerage accounts for which they were the exclusive custodian or sub-custodian. Thus all of the risk (and all of the disclosing information) was located in just one place. Thus every investment account had one huge, unrecognized, counter-party risk. The absence of a known auditor sealed the unreliability of the information.

With the exception of this single or small group of perpetrators, all the rest were victims in the Madoff affair - particularly the recipients of the various investing charities. Throughout history we have other examples of “Ponzi Schemes.” Let us hope that in the future people will take more care in turning over their money to unbelievably good results.

P.S.: We feel especially sorry for those investors who entered the Madoff world through an international bank or through another brokerage firm and believed that the stable returns were analogous to fixed income, therefore suggesting that this investment could be done with the benefit of margin. I have heard that in some cases the margin may have been as high as two to three times the original investment. The big lesson here remains that rates of return do not describe the risks of ultimate loss.

Sunday, December 7, 2008

"Four Aspects of a Four-Letter Word"

In MONEY WISE, I wrote a chapter on risk, emphasizing the four root causes for investments turning out badly: Overconfidence, Personality Change, Leverage and Unanticipated Events. Each of these contributed to the loss of capital in 2008.

In late 2007 and early 2008, many recognized that there were storm clouds on the horizon. The problems looked to be excesses on the top of reasonably sound fundamentals. Historically, the general market on average over a ten year period has two declines of over 10%; with the largest decline being less than 25%. Furthermore, history indicates that once in a generation a decline of 50% occurs.

Using this history as a guide, like many analysts I was concerned, but not ready to materially change investment portfolios. Many of us believed we would have a decline followed by a rigorous recovery. Under those circumstances the prescription to avoiding being too smart was to buy and hold relatively high quality securities.

One year later in the fall of 2008 we see a much different landscape. What went wrong?

The first risk ingredient I discussed in MONEY WISE was Overconfidence. Many professionals erroneously thought that experiencing market declines for forty or fifty years would qualify as the complete relevant market experience. Many, myself included, felt that while age does not equate with wisdom, it helps.

Because there had not been a fixed-income led stock market crash since the Great Depression, many of us “equity guys” missed it. Having grown up in the financial services industry, and in many cases on a first-name basis with the CEOs of major firms, I was able to see that most were honest and hard-working leaders with their own fortunes tied up in their companies – thus they were poised to do the right thing. We were all over-confident.

Personality change is another source of risk. (Normally the most prevalent personality change risk is that of the investor, investment committee or key manager.) As the operating baton of management was turned over from experienced, known individuals to younger management, it was logical to assume that they were being replaced in-kind. In many cases, this proved not to be the case as the new leaders wanted to prove that they were better than those they replaced. Some expanded their product and geographical ranges beyond the old footprint. Often the expansions were in products that were unfamiliar to the new leaders, their control mechanisms, and the bulk of their middle management. Thus a change in managers was also a marked “Personality Change.”

Another “Personality Change” of note occurred during this presidential election cycle. Many thought that there would be a continuation of the present policies, perhaps slowed by a bulky Congress. As the campaign progressed however, investors became concerned about comments packaged for the fringe elements on each side. Fortunately the new Administration sounds as if it will be vigorously centrist.

Much has been written about leveraging and deleveraging, but little has focused on the benefit of being correct or wrong about future price trends. In the period of the five years ending in 2006, those using financial leverage have been winners and in many case big winners. The reverse became more evident in late ’07, and made public when their financial statements were published earlier this year.

Much less has been written about operating leverage. Operating leverage occurs when revenues exceed or contract relative to a fixed cost break-even point. During periods of high sales growth, operating leverage produces significantly higher earnings growth than sales growth. Operating leverage is extremely important in high fixed-cost manufacturing industries.

Over the past year, even with the rapid expansion of consumer demand in the major developing countries, world unit growth began to fall. The result was depressed operating leverage and diminished earnings and stock-prices. Ironically, in this case a lack of leverage (operating) contributed to the problem.

The final cause of risk discussed in MONEY WISE is the risk of unanticipated events. In my own case, I recognized many of the structural weaknesses in the financial community, but because they had been there for years, I never expected that they would all arrive at their comeuppance at the same time. We all missed the greater, global, significance of the increasing failure rate in subprime mortgages. The interconnections between the equity markets and fixed-income derivatives were theoretical to many, and the possibility of a simultaneous collision of these forces posed an extreme example of an unanticipated event.

Each of these four aspects of risk and their appearance in 2008 provide valuable lessons for all investors. In the future I hope to use this space to write about understanding additional aspects of risk when building long-term portfolio strategy.

I welcome your own thoughts and your personal risk avoidance strategies.

Sunday, November 30, 2008

An Attitude of Gratitude

During the Thanksgiving period and similar Harvest festivals in other countries and cultures we become more mindful to be thankful for what we have. This week, Thomas Dolan in a Barron’s editorial comment, noted he was grateful for our market system. I agree. Dolan feels the price discovery aspects of a free market are beneficial for the financial community and others. As we have been taught, if the markets are sufficiently informed, prices eventually reach an equilibrium point where both buyers and sellers find value. (Whether the interventions of various governments around the world will aid in this discovery of equilibrium is an interesting and worthwhile discussion for another time.)

As part of our Thanksgiving weekend tradition, my wife Ruth and I conduct informal market research at the nearby high-end Mall and in local stores in our small town. At 8:30 AM on “Black Friday” I arrived at the Mall with a family member. This was after the early morning openings of department and promotional stores, but prior to the mandatory opening of all stores. We were able to park closer to the entrance than on a normal week-end. Not a good sign for the merchants.

Walking through the Mall we saw many people carrying store-labeled shopping bags, but appearing only to have a single, relatively light weight box or bag. Many people must have entered the Mall through the “anchor” department store, but walked through without buying anything. The exception was the one department store which was heavily advertising promotional prices. Their shopping bags were being carried by perhaps half the shoppers we saw. Three stores did have good crowds. The first was a department store renowned for good service and quality, as well knowledgeable sales people. The Apple store also drew a good crowd of mostly, but not all, young people. However, Apple did not need the entrance line it had set up, Finally, one of the two mobile phone stores had somewhat more shoppers than its normal crowd. At the other cell phone store the handful of clerks outnumbered the potential buyers. My initial conclusion is that shoppers were being highly selective in their purchases.

Later that morning I went to the downtown retail section of our community and found plenty of parking available. I noticed that traffic was lighter than normal on our Interstate highways. Obviously there were fewer shoppers involved with competitive shopping. Perhaps the arena for finding the best prices has been captured by the Internet. Current gas prices are no longer a plausible excuse for weak retail sales. The dampening factor could be that we live in an area which is a financial services “ghetto”, Many of our neighbors work in or around Wall Street, and others have sizeable portfolios which have taken a steep hit.

On Saturday, Ruth returned to the Mall initially to pick up some clothes being altered to fit a more slender frame. The magic of a good merchant persuaded her to consider unintended purchases. She found great bargains seriously marked down, and not advertised. Discussing her Saturday experience, Ruth commented that buyers were not only being more skillful buying at perceived great price, but in many cases upgrading quality from the their everyday purchases. Our Thanksgiving research demonstrated that the market system is working and that determined shoppers were finding their equilibrium points. This is good news.

Analysts seek to extrapolate investment conclusions through small, hopefully representative samples. The skilled retail shopper and the relatively low purchase price of individual stocks and domestic stock funds suggest that both shoppers and investors are waiting. What are they waiting for?

Lower prices are not necessarily the answer, as demonstrated by shoppers’ willingness to step up to higher price goods if they truly represent a bargain in price and quality. My guess is that retail investors and a substantial number of institutional investors will become buyers in earnest when their confidence returns, even if that means cheap prices are not at hand.

The lack of confidence is one of the reasons for currently lackluster retail sales. Many families, including our own, are cutting back on the quantity of planned Christmas presents. In doing so, we hope to avoid embarrassing family members and friends who are experiencing difficult times.

Substituting a large amount of gifts by a smaller number of high quality items is a good example of the market system working selectively. As we get closer to Christmas, a sudden surge in the retail trade or in participation in the market, may signal the early stages of a return of some confidence.

I am extremely appreciative that we live in a culture where the market systems often direct our economic moves.

Sunday, November 23, 2008

Will 401(k) Miracle Help All Investors?

Those who were in school in the 1940s and 1950s had teachers who lived through “The Great Depression.” They focused their lectures on various government programs for unemployment insurance, the willingness to run a peacetime deficit, and a more enlightened tariff policy that would prevent another Depression. Why then on November 20th, 2008 did stock market measures set the record for the largest annual decline (50%) since the beginning of recorded market history in the 1870’s?

The economy is in a period of contraction and official unemployment is in the mid single digit range. (The most credible pessimistic estimate for the future is in the high single digit range.) Perhaps, a more important statistic is the under-employment total, which measures those who want to work full time for an employer other than themselves, and is now just shy of 12%. I have not seen any under-employment estimates of the future over 15%. In the Depression, excluding farmers, the low point was calculated to be 28%. If the market is tied to the perception of the future economy, the current market decline is overdone by perhaps 50%. But as traders know and investors too often forget, the only real indication of value is the current price.

I believe the current price is more a measure of how bad we feel than an estimate of what the future will provide. There is a good reason for this pessimism, but not about the economy itself. The reason for the pessimism is that having surpassed record declines, we have lost all of our historical yardsticks.

In the US Marine Corps, we were trained the best defense was an offense. In a similar manner at the race track one learns that the percentage of winning favorites multiplied by their odds, most often produce a loss if one bets an equal amount on each race every day. This suggests that it pays to bet selectively against the crowd. With the perspective of these two schools of great learning, I have a positive outlook for the market long term.

One of the many reasons to bet against the pessimistic crowd is the miracle of the 401(k), 403(b), and 457 plans that allow and often encourage employees to defer a small part of their current wages into a tax deferred savings plan. These plans did not exist in 1929 and in the 1930s. As of 2007 there were $4.5 trillion in defined contribution plans and another $4.7 trillion in Individual Retirement Accounts (IRA), with over half invested in equities. The Total Retirement Capital last year stood at $17.6 trillion, again with a significant portion invested in equities.

Why do these figures make me optimistic? With US Treasuries’ yields below the actuarial requirement for Defined Payment plans, with endowments’ planned spending rates above these miniscule yields, and with the expected investment income of many 401(k) plans, the current income generation of bonds will not help enough, therefore they will buy equities not bonds.

In addition, with Defined Contribution plans needing to invest hundreds of billions of dollars, I foresee steady buyers of equities each and every year. With the sellers currently capitulating and the buyers waiting, the mid-term the outlook is good for the stock market. Therefore, my answer to the question, “Will 401(k) help all investors?” is YES.

In the near future I will use this forum to discuss whether 401(k) and similar plans should be investing for capital preservation (after inflation) or for capital appreciation. As the answer to this question is largely a function of individual facts and circumstances, I appeal to our readers to pose specific questions (no names of funds, please) that focus on investment strategy for them.

Sunday, November 16, 2008

Reserve the Reserves

When examining the financial condition of wealthy people, I find it useful to them to determine the sources of their money. This is especially true when dealing with reserves of short term cash. There is a separate value attached to money from various sources, even though in truth, money is fungible. The difference of cash generated from the sale of non operating investments such as stocks and bonds is very different from cash that is left over from spending.

One could say that only those who are generating more cash than the amounts that they are spending are truly wealthy. The others are just rearranging their poker chips. Thus a family of limited means spending less than they are earning is on the way to becoming wealthy, in contrast to the family which is spending a couple of million dollars a year more than all of their income. Supporting their costly “life style” could result in becoming poorer either by intention or not. The mechanics of dealing with ultra high net worth investors (UHNW) is easier than the family on the upward trajectory, but the psychological factors are much more difficult and intense.

I find that excess cash generated has a very different psychological meaning than an equal or greater amount generated by the sale of securities. The excess cash generates a feeling of upward progress and can be utilized in any fashion desired without damage to the fortress of wealth. The cash generated from the sale of securities is either to fund spending, or in these trying days, to alter the asset allocation in one or more portfolios. (I advocate multiple mini-portfolios in my book MONEY WISE.)

My advice to all those who are fortunate enough to have cash is to drop your expenditure rate on your personal needs, and increase your support of charities. Remember that charity begins at home (or with your family - particularly a relative currently having an extraordinarily difficult time). To those holding cash/short term instruments, I recommend more than ever to be prudent, particularly if you are acting as a named or un-named fiduciary.

Recently I spoke to an executive MBA program who visits New York to be lectured by various “experts.” I was horrified to learn that a number of these so-called experts stated that they were all in cash and have been for two years. While one might congratulate them on their trading skills (if true), the advice was far from prudent. Limiting your investment to one type of asset not only requires the extreme confidence of being right, but also the vision to predict important trends and the discipline to get on before the train leaves the station. The long term penalty for being wrong can undermine the future of a family or a charity.

While I don’t know when a bottom price will occur, if it hasn’t already, I am confident that there is a bottom price for all surviving investments. History suggests that after a bottom, prices will irregularly move higher until the next top is achieved to be followed again by a decline of some magnitude.

In looking back from the next peak, a favorite technique of historians and analysts, one would find that there was a period of time to buy very inexpensive assets. However, the “cheap” period is relatively short in duration. Our increasingly efficient market perceives unusual value before prices move up to fair value on their way to fully priced value and beyond. Not participating in the ‘cheap’ period will produce mush lower returns for long term investors.

There are many reasons to adopt my mini-portfolio approach to investing toward specific long term goals and obligations, but one of the best is that one can set different reserve amounts for each goal. For example, one would have a different reserve level for next year’s college tuition than for a newborn’s senior year. When setting reserve levels for oneself and for your spouse/companion, actuarial assumptions adjusted for current health conditions are a good starting point for retirement planning.

Returning to the subject of cash reserves, I do not view reserves as an important part of income generation as the yields are currently too low. Unfortunately for prudent investors, top quality yields will have to rise to the high single digit levels before they become a major income generator. While there are intriguing fixed income credits in the marketplace today, they are not without risk and belong in the risk assumption portion of a portfolio. Some of these credits could be appropriate for one mini-portfolio but not others. For example the tenth year slice for retirement might be appropriate, but not for next year’s tuition.

In summary, one should analyze the amount and quality of reserves one has. Over-reserving for some of the portfolios can be as dangerous long term as under- reserving. Reserves are an important ingredient to the overall structure for each of your portfolios.

Sunday, November 9, 2008

Augmented Unemployment Report Leads to Augmented Balance Sheets

The world being circular, when you begin going in one direction you eventually come back to where you started. This circumnavigation also applies to words. Recently on Bloomberg radio I heard a cogent discussion of the impact of unemployment statistics on the domestic economy. The speakers very quickly blew past the Department of Labor’s official unemployment number of 6%+, focusing instead on what the department calls “an alternative measure of total unemployment.” This “augmented unemployment” statistic takes into consideration part time workers who want to work full time, those who have dropped out of looking for employment, and a portion of the “self employed” who would prefer to be on someone else’s payroll. This augmented number is over 11%, possibly 11.8% for November.

From the standpoint of an analyst or policy-maker, the difference between 6% and 11% is huge. Basing decisions upon misleading data can have serious consequences to a national economy or to an individual’s wealth.

In the investment world, we see something of a contrary relationship. Simplistic “value” investors often feel a stock is “cheap” relative to its book value as presented in balance sheets. A careful analysis of what makes up book value, particularly for a company that has grown by acquisitions, include a number of items generated by acquisitions such as the value of customer lists, an updated value of real estate (useful for an acquisition, but not for an acquirer) plus the remaining net difference between the price paid and all other assets which is labeled “goodwill.” This is not the first time that accounting rules and investment usage differs.

The accounting book value is measured against price to determine whether a stock or a market is currently attractive. On this basis, many investors believe much of today’s stock prices are attractive compared to history. Those of us who have grown up in the financial community prefer to rely on “tangible book value” which is lower than reported book. I often advocate reconstructing a balance sheet to determine true value under varying assumptions. Many accountants and investors have accepted that an augmented book value is more useful than a book value generated by hard assets.

Then why is it so difficult for wealthy individuals, particularly ultra high net worth (UHNW), to develop their own augmented personal balance sheet?

One of the elements of an augmented personal balance sheet would be what someone would pay for his/her home less the expenses of the sale, including taxes, less the cost of replacement living accommodations. This figure should be modified by the difference between the mortgage on the old dwelling and the new. Another example of an asset to be added to your balance sheet is the value of your business-related mailing lists. (If you do any significant amount of fund raising for any non-profit or political organization your personal mailing list could be quite valuable to another fund-raiser.) There are other assets that could and perhaps should be added, such as a portfolio of unexploited patents, sale of a brand name, current ownership of debt selling well below maturity value, etc. The augmented personal balance sheet should a complete list of actual and potential liabilities or commitments.

The augmented personal balance sheet can make the difference between an estate that accomplishes the grantor’s desires and one that produces just the opposite. In one specific example, a rather extensive list of specific dollar commitments to personal or charitable beneficiaries was designed both to meet those obligations and to reduce the residual estate so that a bunch of spoiled trust fund babies were not created. But, in this case, because little or no value was placed on various intellectual properties-patents, brand names or badly out dated valuations of real property, the residual estate was many times the expected amount, creating just the situation and resulting behavior pattern the grantor wanted to avoid.

The same result might occur if the grantor, while alive, used too small a valuation on his/her assets relative to liabilities and thus had reserves too large for future payments. This type of discussion and analysis should be done privately and often with other professional advisers present.

Traditionally when the Marines have landed their basic units; platoons, companies, battalions, regiments and divisions, are augmented with additional specialists and firepower. Thus, I am quite comfortable with the process of augmentation as it is often needed to accomplish the mission.

I discuss these principles in my book, Money Wise, and in my recent interview with Steve Forbes on's Intelligent Investing site. I hope you find it as interesting an experience as I did.

Sunday, November 2, 2008

Ultra High Net Worth Grantors & Charities: Plans “B”, “C” and “D”

If the wealthy really believe in the good works of specific charities, they need to step up their investment of time and money to prevent charities from having to play the alphabet soup game.

‘Tis the season for charities to push for collections through cookie sales, luncheons and galas to meet the fund raising goals set in the “Affluent Times” of a year ago. This could be described as executing Plan “A.” Judging by last minute invitations to fill a table at prestigious events and low returns from auctions silent and live, Plan “A” is coming up discouraging short.

Depending on which non-essential, pricey consumer item one focuses on, sales fell off a cliff in August, September, and October. Confirming this trend is the decline in discretionary spending for ball gowns and high-end vacation homes. Unfortunately, gifts to charities are also way below budget - in many cases below levels of sustainability.

This is the budget season for charities, be it your Alma Mater, hospital, social services organization, or cultural institution. In each of the board meetings of the organizations that my wife and I sit on, expenses are being scaled back almost to the point of endangering the mission. Existing fund raising efforts are being pushed to be more effective. Thus, we are in Plan “B,” which is to continue the existing mission(s) using diminished, available resources. This is the plan which most military leaders are eventually graded, however some of us conservative investors fear that Plan “B” won’t work.

So far there is little talk about Plan “C” where “C” stands for cutbacks. Due to funding short falls, organizations may be forced to cease funding major commitments which could amount to 10-25% of Plan “A” expenditures.

A difficult by-product of Plan “C” is the compensation review of hard-working, effective senior level staff who are generally paid only a percentage of what similar work would command in business. In a Plan “A” World, this works well, however when commercial wages are being cut back, (which can happen soon), the ratio of high paid non-profit staff rises to perhaps an unsustainable level in the eyes of major contributors. As most non-profits are thinly staffed in senior positions by very hard working people, a reduction of their pay can lead to them being forced to leave. This would affect many donors at all levels who identify with staff leadership almost as much as with the charity’s mission. Staff departures at this level make necessary the consideration of Plan “D.”

Plan “D” is based on the belief there will not be a quick, cyclical recovery, placing into question the sustainability of a charitable unit. Plan “D” would merge the unit into a larger, perhaps umbrella organization. As an investor, a buyer and a seller of companies, I have a high level of skepticism that mergers work. Most that fail presume that revenues (in the case of charities, grants) will grow by just expanding the product line without significantly expanding the number of sales people. The flawed strategy also holds that a larger group might generate more favorable purchase discounts on products and services that can be essential e.g. advertising, cars, etc. For Plan “D” to work, a crisp execution is necessary.

The wealthy, that is anyone that has funds in excess of current needs, should be changing their priorities, moving grants/gifts to charities from a discretionary expense to an obligation level. This is the time when both present and future programmed dollars can mean the survival for many purveyors of good works. What is also extremely important is to make available one’s skills in sales, administration as well as the mergers & acquisitions of good people and organizations.

An important part of my approach to building a personal augmented balance sheet is the segregation of different demands on one’s wealth. Ideally, each charitable obligation should have its own portfolio of assets to meet the charity’s immediate and long term needs. The squeeze on today’s gift dollars should motivate people to create specific asset bases to support specific charities. There is no better time than now to start this process.

Sunday, October 26, 2008

Joe the Plumber and his Personal Financials

Much has been written about Joe the Plumber and Joe’s concerns to maximize income in order to invest in his business. He correctly sees the need for capital to meet obligations to himself, his family, his business and/or some charity. If we could see his “personal balance sheet,” as advocated in my book Money Wise, we could also see his self-defined obligations to his retirement, to his wife Joy, and to the local hospital among other needs.

In recent meetings with the many charities that I am involved with, there is concern about the ability to accomplish their missions. They fear a number of pledges will not be fulfilled in full or on a timely basis. Their concerns are similar, but not identical, to our friend Joe’s worries.

Both arise due to the lack of financial clarity that comes from an understanding of one’s own personal financial condition but no understanding or sympathy for the party on the other side of their concern.

Based on past experience, people of limited to modest incomes continue to give to charities during periods of financial turmoil. Most continue to contribute each time they attend a religious service. They are using a “pay-as -you-go” strategy keyed off their current income. Historically there has been a very high level of predictability in these flows.

One of the major differences that occur as people move in stages from modest incomes to Ultra High Net Worth (UHNW), is that their lives can now be better described by a “personal balance sheet” than from an income statement. One of the ways to measure where you are in the path to becoming UHNW, is to understand how much of your charitable gift decisions are based on your income statement and how much on a “personal balance sheet.” While “The Good Book” requires tithing, or giving 10% away, few people in today’s world meet that standard. Single digit percentage allocations to charitable gifts are more the norm. Even in today’s crisis of confidence, I suspect that this pattern will continue when total annual giving is below $1,000 to $2,000 per year.

One of the many items to augment a personal balance sheet is a reserve for grants to charities. I am an advocate of a “funded reserve” with its own separate portfolio of investments, with the appropriate short term securities to meet current pledges and longer term instruments to meet longer horizon pledges, perhaps adjusted for inflation.

An augmented personal balance sheet depicts pledges as a liability with the same force on the grantor as any other debt. On the asset side, one of the portfolios is the funded reserve for grants. Much trickier is to measure the “psychic income” derived from feeling good by doing good. Perhaps this measurement can be a below-the-line addition to the combined financial and psychic income results for the year.

What should you, the grantor do in face of the current financial crisis of
confidence? You should first assure the charity in question that you recognize your obligation and you should determine if the organization is able to meet its minimum goals. Has the charity responded to the climate by cutting back expenditures and/or deferring spending?

For your part, deliver as much as possible to meet the charities’ short term absolute needs. An enormous lesson for both the individual grantor and the charity is that both need rainy day funds to cushion sharp, unexpected contractions similar to what we are passing through now. A reasonable starting point for these rainy day funds would be 10% of the expected annual funding, with an agreement to notify the other party when only 5% is left.

Both sides may have to put off work on the new Joseph and Joyce Wing of the local hospital while donors are forced to back to plumbing jobs, making the flow of cash work as well as it can until new supplies arrive.

Sunday, October 19, 2008

Turning Points Provide Hope for Everyone's Wealth

In a world of so much uncertainty, I find relief that people eventually follow their intelligence and act in their best economic interest. After many years of resistance, large portions of the U.S. population are finally beginning to get it right. This causes me to shout, “It is working – there is hope for wealth!” These fundamental behavior shifts are being carried out by people of very modest incomes as well as those who are described as Ultra High Net Worth (UHNW).

The recent decline in gasoline consumption is my first example that there is hope. As Americans, have been told how wasteful we have been for at least the last thirty years. We heard, but did not listen.

In 2008 the price of gasoline skyrocketed to over $4.00 a gallon. Then for the first time, perhaps since WWII days, the number of miles driven by cars on American roads dropped significantly. On now-crowded commuter trains, a frequent conversation topic is where to find the cheapest gas. The lowest I’ve heard this week was in the $2.50 range.

The drop in gas prices was caused by consumers changing their behavior: driving less to avoid paying too much; not by Congressional regulation outlawing speculation and speculators. (As I mention in my book Money Wise, we saw the same trends in the 1930’s, when Congress held hearings to investigate speculation.) People will change their behavior (and will largely benefit from doing so) when given sufficient information and motivation.

The second example, which I think is the best news in many years, is that the savings rate for the second quarter of 2008 shot up to 2.7% of income, after being below 1% for many years. In some quarters the rate was less than zero, as people borrowed more than they were making.

During the third quarter of 2008, the economic slowdown became more pronounced. In recent conversations with various companies, charities and merchants, I have found business has come to an almost complete stop, with high ticket transactions nearly non-existent. As saving is the opposite of spending, I expect that we will see an acceleration of the savings rate when third and fourth quarter savings rates of 2008 are published.

Why am I so excited about the increase in the savings rate? The major precursor to wealth for everyone is savings. In many cultures, people of very limited means save a great amount of money. For example, years ago a business acquaintance in Hong Kong was having difficulty meeting his office rent and he was notified by the building manager that his rent was about to go up. He begged the manager for some concessions. He was told he had to discuss his problem with the building owner. He asked for a meeting and it was arranged quickly that the owner would visit him in his office.

He was flabbergasted when at the appointed time, the lady who had been cleaning his office walked in. Not only was she the owner of this building, but a number of other buildings as well. Over many years she saved her money from cleaning and invested wisely in small Hong Kong office buildings. She kept working to earn more and to watch over her investments. The key to her becoming wealthy, she learned, was to spend as little as possible and save/invest as much as possible.

There are many, but not enough, people in this country who have similar behavior practices. They recognize that their long term desires are larger than their likely income, so they must become savers/ investors.

If we define wealth = freedom, then the small income saver is well on his/her way to wealth. In contrast is the ultra high net worth investor who is spending more than what is coming in, and in the process destroying his/her wealth. The challenge for many UHNW people is to consider gifts to charity and others as an investment that should payoff in psychic benefits.

Those who have saved and invested wisely are now faced with challenging their children and grand-children to do the same. These discussions will benefit both the child/grandchild and greater society. The benefit will be converting the savings/investments into jobs, high tax revenues and enlarging the vital pools of capital which fund our future.

Sunday, October 12, 2008

Fear is a Four Letter Word

In polite society, if such a forum exists today, a “four letter word” refers to a description which is not to be used. While both love and hate are four letter words, one is viewed positively, and the other as unfortunate. I use the word fear as descriptive as
to what is driving investors and also as unfortunate.

As a professional investment advisor and an investment committee and/or board member of a number of non-profit organizations, I spent this last week strengthening relationships. Some callers “just couldn’t take it any more.” Some wanted to reduce equities by 50% from today’s levels. Others reported they had sold all of their domestic stocks and bonds. Not only did they want to temporarily reduce their anxiety, but they were reaffirming their belief as to how smart they finally were. Yet they all believed the stock market would rise again eventually.

Unfortunately the sellers did not have the advantage of attending my first place of analytical instruction, the race track. Any serious handicapper would doubt the ability to place three winning bets in a row. Those driven by temporary fear almost by definition commit themselves to a program of sell, switch, and buy. Very few can do all three successfully. From my study of money managers, and particularly mutual fund managers, those with much larger-than-their normal cash positions miss the relatively easy winnings in the early stages of recovery. During the uncertainty surrounding turns to the upside, cash becomes too comfortable. They do not want to risk the relative performance rank they achieved on the downside.

What will be the best stocks to own once the recovery begins? Those with cash will continue to look backwards and buy the stocks that went down the least or the ones that went down the most. In each case there is an equilibrium price the stock will return to, as if stock prices have memories. While both approaches have worked occasionally, they do not consistently work. (They are fighting the odds of the three bet parley.) If the investor did not raise an inordinate amount of cash relative to his past patterns, he/she can improve their odds significantly. First their focus can be on owning the best stocks for the future. They can fund these purchases by using some of their cash or switching out of their pre-decline holdings. For most managers it is easier to switch than commit the cash that had recently made them a winner.

What Should Be Done Now

First, remember what you have paid for the following advice = zero, which could be exactly its worth. Second, observe what happened on Friday, the 10th of October. Third, focus on the odds of a continuing trend. On Friday, the Dow Jones Industrial Average moved over 1000 points, changing direction 18 times in the last trading hour alone. While the average did finish lower, the intraday price action is suggestive of capitulation. Those who have been driven by fears of a greater collapse have sold at almost any price.

Finally, in a world where traders believe the trend is their friend, one should start to bet on a trend reversal. On the basis of this market analysis and using the individual portfolio segments as suggested in Money Wise, my recently published book, start to add to your buying program of specific stocks that have an above-average future and/or a group of mutual funds that have diversified strategies.

Let me know how you are feeling and doing as you find more positive four letter words.

Monday, October 6, 2008

Brilliance, Guilty and Bounce Back


Writing this blog on the Sunday after the Emergency Economic Stabilization Act (EESA) has become law, has caused me to think through my immediate reactions and my long term investment strategies. Others should as well, remembering what has been attributed to Mark Twain: “The opposite of progress is Congress.”

EESA started out as a brilliant investment analysis of a clogged, dysfunctional mortgage market that was preventing banks from lending to other banks and from extending new credits to existing customers. The original, politically naïve, work-out plan evolved into a vehicle to address too many other political needs of Congress at election time. Paulson recognized that under the universal mark-to-market accounting rules, banks and other mortgage providers could not make any new mortgages. Too many existing mortgages and mortgage securities were being valued with no known bids, roughly the equivalent of having little or no equity in them. Without the equity from these assets, their various balance sheet ratios could not support any additional assets with implied risk. The magic of the Paulson plan is that it creates the illusion that the mortgages have some value.

(The key to making a loan to you is the financial institution’s ability to borrow from someone who is examining its financial statements. In other words, if a bank can not borrow, it can not lend. While you may feel that your great aunt's shawl and fans have significant value, unless you can find a professional buyer, the lender can't count the shawl and fans as good capital.)

Paulson’s solution was to hold reverse (or “Dutch” auctions) to offer to buy the most “toxic” mortgage securities at the lowest prices. This creates a bottom for the market by putting a price on the most problematic paper. Institutions can then price their remaining securities at equal to, or better prices.

Disclosure: As he was evolving his thinking through “listening tours,” I have met with Secretary Paulson twice at small meetings of the New York Society of Security Analysts.

Under present accounting rules, assets have to be priced at tradable prices. Assets may also be valued by an internally created mathematical formula (“market by myth”). These values are referred to by their catchy titles: Level 1, 2, or 3. Under Paulson’s structure, financial institutions can move some assets from Level 3 to Level 2, which automatically improves their capital ratios. Even those that don’t move up their Levels. The financial institutions with assets that they could not price can now maintain that the mere existence of the Troubled Assets Relief Program (TARP) means that there is a potential market for the securities that they could not sell previously. These moves should go a long way to unclog the mortgage and related markets without a wholesale change of the mark-to-market rules. (The US Government has never had an audit under generally accepted accounting standards and thus they alone can carry assets at purchase price.)

I am happy with this solution to unclog the housing market. However, I am unhappy to see these principles extended to credit card receivables, a subject which merits a separate discussion.

The Guilty

Any time something goes wrong there is an immediate search for the bad guys who created the problem. In this case that great moral philosopher Pogo got it right by saying, “We have met the enemy and the enemy is us.”

There is enough blame to include just about everyone. Mortgages and particularly mortgage securities could not be sold if there were no buyers. These buyers disregarded the common sense rules I describe in Chapter 10 of Money Wise, “Bad Things Happen: Taming and Managing Risk.”

Two of the causes for bad things are (1) Overconfidence and (2) Unanticipated events. Think of retirees directly purchasing this soon-to-be toxic paper, either directly or through fund vehicles. They heard “fixed income” and in their mind translated that to mean “fixed solution.” Nothing could go wrong, particularly through the implied guaranty of some third party institution. “They wouldn’t lie to me face to face,” many assumed. No, they did not intend to lie to you (or perhaps more importantly lie to themselves) they just didn’t know any better. They did not do their homework on massive defaults. Both the buyer and the seller were overconfident.

One of the other causes for “bad things” is unanticipated events. In scientific literature these events are called the emergence of the Black Swan. For many centuries Europeans believed that swans only came in white. The discovery of black swans in Australia changed their expectations. While we knew that some people could not afford to make the home purchases that they did, we did not recognize that their numbers would be swelled by the simultaneous lowering of underwriting standards, changes in accounting rules and a slowing economy diminishing the income potential of both new buyers and current owners. Real estate problems of this size were last created in the 1920s and the resulting foreclosures and slump in real estate prices did not happen until the early 1930s.

The retirees mentioned above, and/or their agents violated a basic investment rule: Know What You Own. They did not recognize that mortgages and related securities were a distinct asset class. There may be a sign of vulnerability any time an undifferentiated asset class is more than 10% of the total portfolio. If the single asset class exceeds 25%, there must be other assets invested to hedge the primary asset class driver. Finally, there is a smell test: If one is urged to borrow against this asset, or if the seller is heavily leveraged, and too demanding of a quick purchase, there is the risk that time can work against the buyer.

Bouncing Back

We are all human and therefore are capable of making mistakes. Despite being a Trustee of Caltech, I have learned that humans are not as predictable as the laws of physics. One of the great lessons of the 1990s was that Long Term Capital Management, with all the brain power of a couple of Nobel Prize winners, not only failed, but could have pulled down half of Wall Street had it not been for the Federal Reserve’s behind the scenes pressure.

A lesson from LTCM’s collapse is that very smart people can, and do make mistakes. A second and more powerful lesson is that a number of the LTCM participants were able to raise money and start new ventures, in some cases from the same groups that had invested in LTCM. Wall Street believes in bouncing back and often funds those who have fallen with the belief that with more caution, they can succeed the second time around.

For a fuller discussion of “Bouncing Back: The Art of Recovering from Mistakes,” see chapter 12 of Money Wise.

Monday, September 29, 2008

Expect Unintended Consequences From This Weekend

I am writing this on the weekend that various members of the U.S. Congress and their staffs (working with, and/or against, members of the outgoing administration) prepare a bill that would mandate the use of taxpayer funds to rescue our economy, and to a large extent the global economy from various governments’ past mistakes. The noisy minority of the public is clamoring for the scalps of the perpetrators. While Congress, for the most part, gives lip service to the crowd around the guillotine, they don’t want the blame game to gain momentum.

The truth is one of the biggest contributors to our current market-clogging problem is the government. This guilt does not stem from government’s malevolence to those who are trying to earn capital. The mistake made by these good people is that they did not fully contemplate the laws of unintended consequences.

The difference is that the government has so much power, few can be heard questioning its wisdom. History has shown however, that leaving economic issues for the most part to the private sector, produces fewer mistakes. These mistakes are often then corrected through the brutal, competitive system.

“Good” efforts by government powers has often led to bad results for our society. Some examples are:

Support for first time home buyers
Result: Questionable qualifications for social purposes.

The repeal of two sections of the Glass-Steagall Act
Result: The recombination of two very different cultures, compensation approaches and regulatory setups for clients.

Trading in pennies
Result: Much less expensive for large traders to take advantage of retail customers who have left the daily market.

The practical destruction of the specialist system
Result: Specialists are needed to support two-way markets during periods of stress.

Fair Value Pricing
Result: Only individuals can now buy without an immediate write down in declining markets.

Restricting Short Sales
Result: A curtailment of early identification of trouble and future required buyers

Whatever comes out of this weekend’s negotiations, if anything, will create its own mischief. These new constraints on the market place functioning is a further devaluation of the old trading (tactile) manuals on how to survive and profit from other people’s transactions.

There are at least two, somewhat related events that encourage optimism. First is Warren Buffet’s purchases of stock in Goldman Sachs on very favorable terms not available to others. In addition, his lock, stock and barrel purchase of Chesapeake Energy at a very depressed price due to rumors as to its solvency, is positive. (Point of disclosure- our hedge fund and I, personally have been long time holders of Berkshire Hathaway stock.)

The second event of note is that the stock prices of Financials, beaten-down as a group during the turmoil in September, continue to trade above their July or earlier lows.

Long-term strategic buyers should use this period to slowly begin additional buy programs and to be prepared that the lack of historic trading practices may give the investor even more favorable prices, interspersed with extremely sharp price spikes as the natural sellers into a rally are reduced in number.

> Sunday Morning Post Script (1)
5:30 am – Reactions to the announcement of the Agreement in Principle on what the press insists on calling “The Bailout Plan”
1. Making a dangerous assumption that the announcement is accurate, my first reaction was the plan would be viewed as highly inflationary.
2. My second reaction is that no matter who heads the next administration and more importantly the make up of the U.S. Senate, we are looking at higher taxes at the Federal level and for many states as well.

>Sunday Morning Post Script (2):
10:30 am - My reactions after some sleep and a brief look at the “talking heads” on cable.
1. Until we see the actual details of the law and the regulations, we do not know the size of the problem; thus we are reacting to shadows without knowing how far the silhouette is from the candle.
2. The plan recognizes the major issue is not credit which is weak in many places, but liquidity which is almost non-existent. The “brilliance” of the plan is that it is creating a low quality Treasury window. For some, the mere existence of this window may mean that private liquidity will come back - knowing that if necessary the questionable assets can be sold to the Treasury.
3. Wall Street/Bank equity owners do not benefit from this liquidity plan directly, the main beneficiaries will be those seeking credit which are beyond the financial community.
4. Congress is lousy at communicating to the public and this increases the likelihood of a more powerful than usual “law of unintended consequences”.
5. In some ways because of point 4, we are lucky that the plan did not address Paulson’s pleas for a clearinghouse for derivatives, which is a larger problem.
6. I expect a significant relief rally for stock prices because the absence of new short sellers and the destruction of the NYSE specialist system.
7. New tactical trading plays will evolve quickly, while longer term strategies will evolve more slowly. The need for liquidity reserves will grow.

Sunday, September 21, 2008

Keep Your View Long Term

Last week we saw the government outline in sketchy detail a massive financial support package for the ailing US economy. Some have questioned why it took so long to come to the rescue. Critics don’t understand either the complexity of the problem or how Washington works. In order to get both Congressional leaders and foreign dollar buyers to accept these moves as the complete solution, the apparent size of the problem had to appear to shrink. Neither group will be able to grasp the full situation before the program begins to unravel. While the economic problem is housing prices, the financial problem is much bigger.

The timing and the positioning of these events were dictated by the political season. Let's hope that the smoke and mirrors work until the next administration is sworn in.

In all of the chatter about solutions, both the Treasury and the Fed pushed for the creation of a clearinghouse for derivatives. The notional value of all derivatives outstanding in the US markets is in the hundreds of trillion dollar range. (Where is Carl Sagan when we need him to go the next higher level?)

We are not only unclear about the absolute size of this liability, but also the identity of the owners, as most of these trades are private or over-the-counter.

A simple mortgage packaged as a structured note can be briefly owned by ten different entities, each of whom has hedged their perceived risks through the use of derivatives of different natures and maturities. In some cases the participants in the derivative trade have had each other as a counterparty on other trades and thus have reduced their net risk. However the market does not know the net amount that is owed to which party and when. If there is a central clearinghouse, the marketplace would be aware every moment in time which player had a debit or credit balance.

Until we can size the problem we don’t know large the needed potential bailout needs to be. At this time I am guessing it to be over one trillion dollars.

When the global markets learn more about the approved bailout program and its impact on perceived inflation, we should monitor the rates that central banks around the world sell their gold reserves. If they slow down further, watch out.

For Us the correct short term investment strategy now remains elusive. No matter who manages to get the control of the Senate, (which is what is really important in the November election), the next four years may not be very satisfying. The stage could be set however, along with other developments for real global growth which will carry us forward.

If you are a long term investor as an individual or as a fiduciary for an institution, I would recommend closely following the drama addressed above, but not to change fundamental investment strategy. My book, Money Wise, is for those who are looking to evolve their lifetime investment strategies and perhaps extend them to multiple generations.

We should not make our primary focus the markets even after the election, the end of year, the first term of the new administration or even the second term. Instead we should focus on periods of ten years or longer. In doing so, I submit the prospects for the prudent investor may well be better than any other time in our lifetime.

Saturday, September 13, 2008

The Need for Speculators

The US Congress will soon be dealing with a report that allegedly points the finger at “speculators” being a principal cause in the run up in the price of oil. For Congress that means gasoline at the corner service station. In a knee-jerk reaction there will be a call to ban or curtail the activities of these devils even though the report does not conclude that speculators were the cause for the run up in gasoline prices.

Before condemning such a move by the Congress, I believe one should understand the essential difference between an investor and a speculator. An investor (perhaps this person should be called a historian) is comfortable projecting the future from an examination of the past. One might call such a person is a trend follower. As human behavior and weather cycles have not changed much for hundreds of years, the odds of a continuation of past trends are a good, but not perfect, guide to the future.

A speculator is someone that believes that the current time is different in some important respect such as product, people, or prices. The ultimate question for any market participant is who is going to buy (sell) this security when the current price has too much risk built-in?

Most investors are governed by their internal price disciplines. Often when one investor is worried that a price is overly generous or overly depressed they need to find a market participant who sees things differently. Thus after considerable upward momentum the investor needs to find a speculator who believes “this time” it is going to be different, and thus is a buyer of the investor’s securities.

In the same fashion, after a sustained decline an investor searches for a speculator who believes that the “normal” cyclical bounce will not follow, and that prices will continue to decline. In my examples the investor wins over the speculator, which is not always the case in practice. The speculator must win enough to be enticed into the game or they won’t play. That is why waves of speculation are dispersed in history to allow for new participants to follow their speculative urges.

Our sympathy is for our readers and clients who are long-term investors. We all need speculators to provide generous exits and cheap entry points. From a national policy perspective, speculation provides the grease that encourages markets to be efficient and aids in price discovery by often providing the other side of the trade.

Sunday, September 7, 2008

Thursdays Down, Fridays Up

Another Friday gain led by the financials after a Thursday decline again led by the financials. This is now a regular pattern at least in the late summer. This pattern may have no long term meaning, but I think it could be sending a number of messages. First, we are in a period of low volume mostly driven by prop desks and their kissing cousins, the trading variety of hedge funds. With very little capital in the hands of specialists and other floor traders, few are taking the other side of any momentum. The significance of this is that under these conditions the market will appear to be more volatile, but volatility with low volume is not likely to be of significance. What may be significant in the rise in prices for financial service securities (stocks, bonds, CDOs) is that traders do not want to be caught with short positions when a Sunday night merger or acquisition is announced before trading begins Sunday evening in the Far East or Europe in the early morning. This fear of the traders may also be affecting the run of the week pricing for selective issues such as Lehman, etc.

The significance to these patterns for the long term investor is this is not your grandfather’s market. Many of the tried and true techniques of the past just won’t work the same way in the current market. Perhaps long term investors should use a +/- 5% box around the current price and only look for significance when a price breaks out of this volatility prison. That way the investor is distinct from the trader and will not lose his focus on long term results.

Sunday, August 31, 2008

The Alphabet Bottom

As mentioned in my book, MONEYWISE one recognizes an optimist by one who gets out of bed in the morning. As optimists, after any significant decline, we start looking for signs of a bottom and we use chart patterns as our models. We label bottoms as they appear to be described by letters. The most dramatic is the “V” shape where there is a sharp decline to a singular point price level and then a recovery without any meaningful interruptions. We see these types of bottoms in a single day chart. They signify that a large seller or sellers are accommodated by getting out at any price. Then the buyers come in to buy cheap stocks. Most of the time a single “V” bottom does not lead to a substantial recovery, but prices turn down again and form another “V” at similar prices. This formation is often labeled a “W” or, if separated by some time, as a double bottom. “V” and “W” bottoms appeal to short term traders who have taken advantage of exhausted former owners. The new owners or more correctly, renters, look to enjoy an immediate robust recovery. These people are not the readers who will get the most out of Money Wise.

The longer term investor who thinks in ten year and longer goals, and who will get the most out of reading Money Wise, will be looking at what can best be called a “U” shaped bottom. This bottom formation takes a while to develop, in some cases, years. Often this pattern is typified with low relative volume, a narrow trading range which can exhibit high daily volatility but not much forward movement. The result is that there are fewer market price headlines and commentators refer to dull or mixed markets. Few analysts focus on the fact that during this time of base building companies are catching up to their stock prices and are moving ahead of them. Often during these periods companies sort out their opportunities, they leave certain businesses, price points, and distribution channels. New, invigorated management come to the fore at the operational level and some changes are made at the executive level.

I believe that we are in a “U” shaped pattern which should allow long term investors to feel that in general they have seen the bottom and begin to look for the elements of better stock prices. These elements will not be in the headlines or sound bites, but can been seen in walks through shopping areas and malls. The numbers of cars on the road or searching for parking spaces are other clues. Lack of inventory in stores and plumbing supply locations can be viewed positively. I am starting to see some glimpses of these clues. Thus, I am cautiously betting on a “U” shaped bottom as in the United States.