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.