Investment Policies for Investment Personalities

INTRODUCTION

One of the basic tenets of my book MONEY WISE is that one's personality will shape how one invests. In Chapter 14, I briefly identified ten investment personalities as shown below:



* Absolute

* Confident

* Uncertain

* Relative

* Fiduciary

* “Star”

* Bored

* Guilty

* Financial Death Wish

* Paralytic



Actually each of us is likely to be some combination of these personalities and some of us will change personalities in the future due to life circumstance changes. Nevertheless, this framework is a good place to start to evolve one's investment policies. Most of my clients invest with us in various selected funds, but the same principles could be used with individual stocks and bonds as long as there is appropriate diversification.

At this time of the year the press is full of economic, financial, and market predictions. Most of these predictions are for the current period, meaning up to one year. For the most part, the fund investor leaves individual security selection and timing to the funds' managers, so they are not primarily focused on periods as short as one year. For the investors that we serve, our approach is to look to the longest term that the account will permit. For me, that is the rest of my life and to the extent that I am dealing with my heirs, both individual and charitable, to the rest of their lives. To put this into practice, I will focus at looking into the next ten years by reviewing the past ten. Bear in mind no one can truly foretell the future, and based upon the past, we have every reason to believe new discoveries, new industries, new laws and certainly new taxes, will impact us in this ever-changing geopolitical world.

The ten year data by my old firm (now known as Lipper, Inc.) is shown for groups of funds sliced into various categories. Depending on the availability of data, I use fund averages or established fund indexes.


Ten Year Compound Growth Rates
as of December 31st, 2009

FIXED INCOME FUNDS

Emerging Market Debt 11.09%
US TIPS 6.77%
General Bond 6.59%
US Treasuries 6.24%
Corporate Bonds BBB 6.11%
High Current Yield 4.80%
Balanced 2.79%
Money Market 2.60%

EQUITY FUNDS

Global Natural Resources 14.57%
Emerging Markets 9.40%
Small Company Value 8.73%
Global Flexible 5.63%
Small Company Core 5.24%
US Diversified 1.13%
Small Company Growth -0.63%
S&P 500 Index -1.19%
Growth -4.51%


CONCLUSIONS

In looking at these ten year results, one can reach a number of conclusions:

1. Emerging market debt benefited from a material increase in the perception of its credit quality and in some cases an improved currency.



2. Inflation while declining, had a real impact.



3. Higher credit quality was not penalized.



4. Being risk adverse still produced positive results.



5. The world appears to be running short of natural resources at current costs of production.



6. For the total period, bond investors did better than stock investors in the emerging markets.



7. The willingness to combine bonds with stocks worked.



8. US diversified equity funds' putrid returns were still better than the S&P 500 index funds.



9. Smaller companies did better than large ones particularly of the growth variety.

Being something of a contrarian, I am willing to bet that a number of these trends in the next ten years will not be as strong as they were in the last "lost" ten years, or will be reversed. In setting their investment policies in early 2010, different investment personalities will view both the past data and the odds of reversals differently. The following are my initial suggestions to the investment personalities listed above. These suggestions would be modified in individual discussions with each as accounts:

The Absolute Investor, with her fear of significant loss and willingness to accept more limited gain, might opt for some fixed-income laddering, but would be wise to include some TIPS.

The Confident Investor, believing that he has timing skills at least equal to the market, would be attracted to the global natural resources area as well as emerging markets, with heavy emphasis on the so-called "BRIC" countries.

The Uncertain Investor would feel less anxious with a portfolio of money market instruments, TIPS, as well as exposure to a global flexible fund.

The Fiduciary Investor would be similar to the Absolute Investor, but would add one or two index funds.

An investor who wants to boast about his current successes (the "Star" Investor), would be attracted to the narrowly-based exchange traded funds and similar products that are invested in specific industrial segments or specific emerging countries.

Regarding the Bored Investor: Boring is as boring does, with a combination of S&P 500 index funds and money market funds.

The Guilty Investor, who needs to be punished because of some unidentified sin, will load with larger growth funds because of their recent poor record and could well be punished most severely by having a very successful portfolio. Woe is me.

A cousin of the Guilty Investor, but who is more manic, is the Financial Death Wish Investor, who is likely to be attracted to what is currently doing spectacularly well due to leverage and will be attracted to funds investing in high current yield ("junk bonds").

The Paralytic Investor, often the result of a diverse investment committee, will diversify unhappily into index funds, money market funds and global flexible funds.

Next week I am inclined to describe what policies I would like to follow in some of my own accounts.

Further, I would welcome anyone's thoughts as to what I have suggested in this blog.

The “Fifth Season” for Investors

Introductions

As an analyst, I was always intrigued with the term that retailers used to describe the time that was spent marking-down their inventory after their financial year closed. For financial statement purposes, (read: borrowing requirements), they needed to adjust ending inventories to provable levels. This period was called the “fifth season.” As an analyst looking at electronics companies’ years ago and financial service companies more recently, I separate the inventory adjustments from the operating results of the fourth quarter. For publicly traded companies, we can make some guesses but we do not know the adjustments to compensation and after-the-close price adjustments, among other items. Only when I work on private companies and non-profit institutions do I regularly see the post-period adjustments. I am still waiting to see a fifth season financial statement.

Investors also have a fifth season that can aid in their own portfolio management. As with most things of value, these facts are hidden in plain sight. The facts hide in the Internal Revenue Services’ required calendar year-end statements. Most of these arrive in the first six weeks of the year. Those who are invested in various forms of partnerships must wait until they receive their K-1 forms. As these documents come in, there is a natural tendency to gather them up for tax preparation work by an accountant or other tax preparer. When reviewing these documents, the focus is almost exclusively on the identification of taxable income. While this is important, it is a lost opportunity to construct the investment section of a personal balance sheet. Those who have read my book MONEY WISE, will know that I believe a properly drawn personal balance sheet with all assets and liabilities, contingent and intellectual, is the key to sound investing. For those who do not want to deal with judgments required to build such a statement, one can still use the formats used in reported financial statements to guide one’s investments. Looking forward on the investment horizon, are your investments where you want them to be? Are your investments in the optimum tax and estate set-up? These are the questions that one should be asking in the “fifth season.”

With the New Year, 2010 offers tax differences that you may not have dealt with before. The most publicized and uncertain of these changes is the absence of the federal estate tax. As this is a moving target, I am not going discuss the longer-term implications of actions today on your personal financial balance sheet and those of your individual and charitable heirs. I am calling to your attention the removal of the income limit on converting a regular investment retirement account (IRA) to a Roth IRA.

Restructuring your Retirement and Estate Plans

Allow me to set the stage for a person who can get optimum benefit from converting their regular IRA to a Roth IRA from a portfolio management viewpoint. Prior to January 1st , 2010, those with income of $100,000 or over were barred from making this conversion, so I am addressing a relative small slice of the population, but numbering in the millions. Most sizeable IRAs are the result of converting a corporate-sponsored retirement program, either from a defined-contribution or defined-benefit plan. For some individuals, we are talking about accounts valued into eight figures. At the same time, many of these people have sizeable after-tax funded investment accounts from earned or inherited wealth. In the early years of IRA accounts there were no restrictions on individuals setting up accounts, even though they were covered by other retirement plans. Many who have shifted employers have multiple IRA accounts.

For example purposes, I am assuming we are dealing with an individual who has a personal after-tax account and a couple of IRAs. Prior to 2010, assume that the size of the personal account was reasonably close to the size of his or her largest IRA. From a tax and estate management point of view, the personal account should have been loaded with equities, where the gains would have been taxed at the more favorable capital gains level while the account holder was alive, and passed to heirs on a date of death basis. The IRA should have been loaded with high income-producing investments, typically bonds and big dividend paying stocks. The income derived would accrue tax-deferred until it was paid out to its owner or his or her heirs. From an overall portfolio management standpoint, the IRA was the reserve element that provided something of a safety net under the more risky, hopefully higher return, equity-oriented account. Note that there is nothing in this two part portfolio set-up to prevent the use of market judgment impacting some reserves in the equity account, and concerns for interest rates and inflation in the IRA.

How does the Roth conversion opportunity change the investments in these portfolios? First, nothing has to change. Second, a decision needs to be made on where the funds will come from to pay the income tax on the conversion. The money can come from either the personal account or the IRA. This decision allows the taxpayer the chance to rebalance the two accounts. Third, if there are more than one existing IRA account, there is no need to convert them all to a single Roth IRA. One might choose to delay moving some to reduce the amount of taxes due in one year, or if there is a belief that one would be in a much lower tax bracket in the near future.

Where to Invest in 2010 for the Future?

The investment results for 2009 were a sizeable after-shock to the earthquake that hit the investment world in 2008. Some investors may feel that these results are normal, cyclical behavior and we can go back to investing as before. Others may feel that we have gone through a seminal period which should lead us to re-examine our thinking and modify our policies.

Space constraints do not permit me to suggest how each of the eleven different investment personalities described in MONEY WISE should view last year’s results and develop plans for the future. Stay tuned for next week’s blog, but the impatient can contact me before next weekend by using the “Comment” button on the blog or by replying to the email version. I will gladly send you the excerpt.

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Boxing Day and Bond Funds

As members of this blog community know, my wife Ruth and I do our investment research by visiting the local high-end shopping mall near our home. We have commented on the density of the crowd of shoppers on “Black Friday,” (the day after Thanksgiving or the following day) in my blog this year and in 2008. This year, the mood at the mall on “Black Friday” was subdued, as evidenced by our ability to find a parking space close to our favorite second floor entrance. What a difference it was a month later!

“Boxing Day” is a term that comes from the time of Henry VIII, when presents were re-gifted, wrapped in boxes and given to the poor. In secular modern America, the day is one to return gifts of wrong size or wrong taste. On a rainy, cold 26th day of December this year, the car line to get into the mall spilled over to the adjacent highway, and could have been a mile long at one point. Both local police and mall security people were out in force to keep traffic crawling along in the anxious search for parking spaces. Walking in the mall, we encountered many more people than we encountered on any day during the shopping season. (Many of the habitués of this mall have at least a black belt in competitive shopping.) Clearly many people were returning gifts, but judging by the new shopping bags with the word ‘sale’ imprinted on them, they were also buying. Some may have been using their new gift cards with the perception that the cards contain a "decay mechanism," motivating people to use them quickly on what they might have believed to be favorable prices and available merchandise. In actuality, many bargains were scooped up already by Christmas/Chanukah gift buyers. The intensity of buying was high, with lengthy lines at cash registers to ring up new purchases. The well-dressed crowd was not only buying merchandise, they were also showing off their new forms, and were wearing full daytime makeup and assorted items of “bling.”

The analyst in me could not help seeing what I felt was unusual volume and participant vigor. My training suggests that when one sees these conditions, something of importance is happening. Here are my guesses. First, store visitors make a reconnaissance visit early in the season to determine price and availability, and think they can do better at the post-Christmas sales. Second, some shop the Internet and receive goods from the very same stores that pay the high rent for location in the mall. Their gifts are more easily exchanged in-person at the mall than by mail or express delivery. Third, there was significant growth in the purchase of gift cards this year. All three of these motivations drove people to the mall on Boxing Day 2009.

In last week’s blog I said I would discuss lessons from mutual funds this week. Throughout 2009, the volume of both gross and net sales of bond mutual funds has been higher than those for equity funds. In many historic ways, this is remarkable. Bear in mind that one of the steadiest inputs to fund assets are the monies from 401(k) salary savings plans for retirement. My experience as an adviser to a number of such plans at different income levels is that on average, about two thirds or more of 401(k) money goes into equity funds. Further, once most people set their initial asset allocation, they do not change it. Some may have shifted into bonds in 2009 as a reaction, perhaps an over-reaction, to the stock market performance in 2008. My guess is that the over-reaction is enough of an explanation for the high sales of taxable bond funds. In addition, retail taxable brokerage accounts do not appear to be increasing their trading of stocks at the firms that I monitor, and/or in which I invest. Fixed-income underwritings are strong, with both the public and institutions buying.

What is happening to cause this wide-scale interest in bonds and bond funds? As with most trends, there is both a long-term shift and a more current accelerator. For many years, the buyers of bonds looked to interest payments to fulfill specific spending needs, often retirement spending. (Remember the phrase that someone was “living on fixed-income?” For some, this included interest payments and slow moving pension plans.) The eventual repayment of principal was a significant event, either to cause a reinvestment or to make a significant purchase of an asset. (This could be to pay off a mortgage or to send a child to college or similar such expenditures.) Historically, once a high quality bond was issued at a currently acceptable interest rate, the vast majority of the issue would be held to maturity. Over time, some bonds would come back out on the market to meet estate needs or to meet the needs of a change of circumstances. With the recent rise of professional fixed-income managers, trading profits in addition to interest income were promised, and some delivered. Today fewer bond issues are locked up, and it is not unusual for bonds to have transaction turnover rates similar to stocks. They have become trading vehicles. Becoming trading vehicles changes some of the participants in the market place. In today’s low interest rate environment, trading can add or subtract much more than the coupon rate on the security.

What do bonds have to do with Boxing Day? To add to potential trading profits, traders look to find what they believe to be mis-priced issues, similar to the differences in pre- and post-holiday sale merchandise. Often the mis-priced securities are scarce. One of the reasons they are mis-priced is that the bonds may have been difficult to sell, which created a liquidity discount in terms of price, or a premium in terms of rate. Not dissimilar to post-holiday shoppers fighting over the one remaining great sweater in the right size. Inventory and liquidity are interrelated.

In taxable bond land, 2009 was in some respects three years in one. In the one year ending December 24th, the average non-money market fund had a total reinvested return of 19.53%, according to my old firm. The average income yield on high quality bond funds was in the range of 5%. In the long term funds, the average rates of return in 2009 rose from the Corporate “A” Rated Bond fund return of 15.95%, to Loan Participation funds returning 42.01%, and High Yield funds 50.82%. In my judgment, these are dangerous returns. To show the excess returns compared with the long-term trend for the five years ending on Christmas Eve, 2009, there were six different types of bond funds which had average annual reinvested compound returns between 4% and 5%, and two above 5%, (GNMA funds at 5.1% and Emerging Market Debt funds at 7.25%).

Next week we will look at the equity sides of the investment house, which did better in 2009 after such severe contraction in 2008 that the five year returns are below the fixed-income levels.

Nevertheless, just as the intensity of manic shoppers in the mall on Boxing Day is exhilarating, it sends a warning sign of an unbalanced activity. Translating that into bond land, I would prefer to be a supplier rather than a buyer of bonds. The summer sales are likely to have fewer buyers and more bargains.

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More Positives than Negatives Ahead

Using an often-repeated term of Donald Rumsfeld, the job of investors looking to their future returns could be characterized as a search for the “unknown unknowns,” (as opposed to the “known unknowns”). This is the exact task before me today. Based upon past experience, I do not believe that the future will suddenly reveal itself to me with such sufficient clarity that I can immediately place orders for individual securities or funds. Since the unknowns are truly unknown to me, I start collecting what is apparently known to me. I cast my net wide to gather bits and pieces of the current scene with the hope that, in sum, I will get useful insights into the future. The members of this blog’s audience will have to determine whether what follows is useful or insightful for them.

In terms of the real economy, the most bullish press account that I have seen is about FedEx, which has been a long term holding of the PRIMECAP fund that we own for clients. FedEx stated on the busiest shipment day of the year that its shipments were up 17% over the busiest day in the prior year. Citing this improvement, the company announced that it would resume salary increases and make contributions to its retirement plan. This comes from a company that recently reported a 30% decline in earnings. While a possible reason for the surge of shipments is a shift in the behavior of clients’ inventory management, I find the company’s wage and benefit decision to be encouraging.

I find it somewhat ironic that the Russian finance minister announced last week that the Russian recession was over. Note that the US recession has not been declared ended, though many believe it to be over. Considering mineral production and mining are much more important than financial and other service sectors in Russia, the minister’s declaration is a good sign for the global recovery. (One wonders whether Russia is becoming more of a capitalist state as the US is becoming more socialist.) A possible sour note to the global recovery is the announcement that Tokyo Steel has reduced its prices for the second time in three months. This decrease is in the face of rising Chinese spot iron ore prices. Clearly there are leads and lags to the global recovery story.

Gold is always a barometer of people’s fears and the willingness of those who will take advantage of these feelings. There are six Indian gold ETFs which had a 57% increase in the number of shareholder accounts in the six months ending September 30th, 2009. In the same period, these six ETFs saw assets rise 72%, showing some fear for the value of the Indian Rupee. Taking advantage of this increase in demand for gold at the retail level, the United Nations has recently licensed its own gold bullion coins to be minted and sold in Europe. The so-called World Government appears to be taking advantage of the inflation that is being seen in practically all of its members. Judging by how well the UN manages its own fiscal affairs, my guess is that we may well be seeing a top in the price of gold. That does not mean a near-term peak in inflation fears.

In the heart of almost every stock market bull is a Chinese noodle. Not only is China becoming the paramount buyer of many commodities (it has been reported that Chinese-built Cadillacs are outpacing those sold in the US), Chinese interests are becoming increasingly active in a number of stock and bond markets around the world. The National Social Security Fund of China intends to raise its maximum overseas investment from 7% to 20%. Within two years the fund will be at $ 146 billion. The fund’s goal is to beat inflation by producing an average annual rate of return no smaller than 3.5% in the 2008-2012 period. In the “out years,” the gain must be higher, as it lost $5.77 billion in Fiscal 2008. There are similar demands on other sovereign wealth funds who have suffered losses in 2008, and in some cases 2009. This suggests to me that in so-called high quality paper, we will see more speculation. Too early to call it the next bubble, but one we need to watch.

As the Chinese become wealthier, one should watch their consumer behavior. One interesting trend is that expectant mothers in China are traveling to Hong Kong to give birth. There are three possible reasons for this trend. Healthcare is better in Hong Kong, the purported advantage of the child having a Hong Kong passport, and/or a decision on the part of the parents to have more than one child. (Interesting how individuals react to the plans for them dictated by their government. I believe expectant mothers are part of a global medical tourism trend.) As the Chinese become more concerned about inflation there will be a sharp increase in the proportion of car purchases that will be financed, expected to rise from 8% currently to perhaps the 70% found in India, but not as high as the 85% found in the US. This is important as it will drive greater use of financial services, which eventually will be a plus to the global financial services industry.

One of the safest bets about the future is that the US financial service industries will undergo material structural changes. In a well-reasoned opinion piece in The Wall Street Journal by Robert Wilmers, the CEO of M&T Bank, the financial results of the five largest bank holding companies are contrasted with the rest of the bank holding companies. The five are Bank of America, Citigroup, JP Morgan Chase, Goldman Sachs, and Morgan Stanley.

Through the first nine months 2009, these five banks earned $30.1 billion compared to combined losses at the remaining bank holding companies. The “big five” lost $14 billion last year. The turn-around in their fortunes did not come from increasing lending, but from their trading activities. The first three banks alone had trading revenues of $26.8 billion in the nine months, having lost $41.3 billion in the year before. The two new to the bank holding status probably did even better. The rest of the bank holding companies aren’t in that league in a meaningful way.

Prior to the 1920s there was a separation of commercial and investment banking which was stipulated under the National Banking Act. In the heyday of speculation of that era, it was repealed. Due to the collapses set off by the use of leverage and banks bailing out their lending customers by securities underwriting sold to their depositors, the Glass-Steagall Act was passed. Ten years ago the Graham-Leach-Bliley Act repealed two of the four sections of the separation of commercial and investment banking law. This week, Senators John McCain and Maria Cantwell introduced a bill to return to the separation. Something is going to happen. I will be watching it closely not only as a concerned citizen, but also as a portfolio manager and investor in a financial services hedge fund. Currently we have no positions in banks that are primarily commercial banks. We expect both long and short opportunities will present themselves in 2010 and beyond.

Bottom line: I see a market for opportunists in 2010 on the one hand and not a bad market for long-term investors on the other hand.

Ruth and I wish our readers and their families a very Merry Christmas.
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Next week I would like to focus on what I see in terms of mutual fund trends that will be of use to our members.

Please let me know your own thoughts on these topics.
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WILL IT BE SAFER TO GO INTO THE WATER AFTER THE FINANCIAL SERVICES LEGISLATION?

By a slim majority, the US House of Representatives believes it can make all forms of securities investment safe. As perhaps Henry Higgins of “My Fair Lady” might declare, “How delightfully, naïve.” Staying with this musical theme to describe all of the losses sustained by investors, I say “It takes two to tango.” The buyer seeks the advantage of ownership and/or use of some asset and the seller sees some disadvantage in maintaining the position. In the language of the law, they are consenting adults. Not for one moment am I saying that there was sufficient disclosure of facts and motivations on both sides. What I do believe is that the buyers did not look carefully at the disclosures and historic backgrounds provided. In my mind it is questionable whether additional disclosure within the legalese framework would have prevented a willing and anxious buyer from completing the transaction. The seller also could have sought better disclosure on the ability of the buyer to pay for the asset, particularly if it was going to be paid for over time. The motivation and sophistication of the buyer might well have helped the seller avoid some of the after-sale problems. In truth, there was insufficient prudence around many of the transactions of the last several years. Disclosure documents, like prospectuses and instructions for most electronic gifts received at this time of year, remain in their envelopes or in their shrink-wrapped places. Think of the uplifting language that confronts voters when they are asked to vote on various bond issues. I doubt that the Congress or the Government in general will be able to produce reader-friendly documents. Further, there is a belief on the part of the drafters that they have addressed all of the issues that have caused people to lose money or to put the economy at risk. There is an old expression among the religious which states, “We plan, and God laughs, recognizing our human frailties.”

The biggest drawback to this less-than-complete legislation is that it is meant to generate the feeling that both individual transactions and the economy will now be safer. From my standpoint, this is unlikely to be true. Just think of all the scandals that occur after each of the so called “reform” laws or movements. I believe the Romans got it right when they enunciated “Caveat Emptor,” which translates to “buyer beware.” We will be at great difficulty to prevent greed-driven buyers from over extending themselves. Many of the factors that drive buyers are discussed in my book MONEY WISE, now available in paper-back edition, and in e-Book versions on Kindle and Nook. Knowledge however, is rarely a driver for investors.

There is something novel in the legislation as currently presented, which is to attack the compensation of employees of large investment banks and other enterprises, supposedly to prevent them from putting the economy at risk. There are a couple things wrong with this approach. First and foremost, most of the large losses were not contemplated as possible before the series of transactions began. If you will, this is the “Black Swan” risk of an unanticipated event. Normally we count on greed and fear to keep prices in some appropriate plane of equilibrium. In the heat of the cheap money- driven frantic dance, there was little fear expressed by either the buyers or sellers. Clearly at the end of the musical chairs, one did not want to wind up with cash and its depreciating value. Second, the cap on compensation and bonuses are focused on employee agents. These are often highly paid people representing very large financial and industrial organizations that are successfully playing with the house’s money. A good bit of the so-called “shadow banking” participants are organized in some form of partnerships, where the partners are participating in the trading gains of the partnerships. A number of these partnerships have capital bases larger than many of the banks that received “TARP” money. Most of these groups are hedge funds, and they remained solvent without any taxpayer assistance. (Caveat Emptor: I manage a small financial services hedge fund.) As someone who owns shares in many publicly traded brokerage firms, I see a significant risk that talent is moving from these large, visible firms to smaller and often private groups, thus escaping the salary and bonus limits.

As unfortunate as it may be, a prudent investor should assume the passage of both of the so-called reform bills on Healthcare and Financial Regulation. There are two safe bets one could make on the outcomes. First, expenses for the buyers will rise, and second there will be large scandals in time, as some will learn how to play the new game ahead of the regulators. Changing conditions always create opportunities for wise and legal investments. Some of these opportunities are likely to be overseas where money is regulated differently, and there is a rise in the need for financial services, particularly in Asia. Domestically, a sure bet is that in the aftermath of Healthcare and Financial changes, there will be legitimate confusion, which will put a premium on groups that can guide affluent users. Intermediaries that possess bureaucratic and communication skills and are trusted, are likely to increase their share of revenue and profits. The sales forces of some brokerage firms and a few insurance companies come to mind.

What are the opportunities that you see?
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W

Symbols or letters carry a lot of assumptions and emotions. The most feared letter right now is “W,” referring to a chart pattern not to a former President. Depending on who is asking the question, it either refers to the economy or the market, and for some both. Those that fear the “W” pattern in terms of the economy, acknowledge that we have already hit bottom in terms of GDP or similar measures, not unemployment. They fear another decline, or perhaps a series of saw tooth moves that introduce the “Japanese Disease” into the US economy. According to John Mauldin, Japan has not added any jobs since 1989, and what is worse is the fact that Japan’s nominal GDP today equals its 1982 total. Mauldin contrasts that statistic with the US, where our jobs are approximately at the 2000 level, with our nominal GDP at the 2004-5 level. He and others are fearful that tax increases will kill job creation and will lock us into very slow growth and perhaps stagflation. But on the other hand, securities analysts and most portfolio managers are not professional economists, but are often forced to have their own thoughts on the economy.

All of those who got out of bed this morning, including me, are optimists. My view is that those who are fearful of the “Japanese Disease” are somewhat like those who believed in the flat earth centuries ago. All of their learned thinking was based on what was known at the time. They were dealing with a closed system that was not open to new inputs. The new inputs that I am counting on are technology, rising consumer demand from emerging economies, and the output of our educational institutions (students who want and will change the world). Unlike Japan, I foresee a growing population in the United States, not an unmixed blessing, which will increase the demand for goods and services sold here. One hopeful example is that a German auto producer is switching jobs from Germany to Alabama. Bottom line: I believe we will see some forward progress for the US in the years and decades ahead.

The “popular press” and many others want to believe that there is a tight correlation between the movements of the economy and the stock market. For many years, there is little in the way of correlation and there are periods of inverse reactions. The followers of known data on the general economy are somewhat like the “flat earthers.” The stock market is an auction of expectations. When the market has steep declines it is usually after a period of excesses. I do not see much excess currently, except in some commodities and in some fixed income securities. Credit has not expanded, with the exception of margin debt, however still below the 2007 peak. Thus, I believe the inevitable stock market correction will be limited to a 10-20% decline, not a 25% fall opening a new bear market.

In viewing these comments, please remember my only promise to the institutions and people that I manage money for is that I will be wrong some of the time, and it is our collective challenge to know when mistakes happen and to make appropriate changes.
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hand portion of this screen. If you are not sure, use the box above to review past blogs that may interest you.

We encourage feedback from members of our viral community.

The Good and the Bad about “Black Friday”

Several members of this blog’s audience asked me about revisiting the topic of last year’s blog on the weekend after Thanksgiving Day. (Note that I am referring to “members” rather than “readers,” as there are now enough regular visitors to this site to cause me to believe that we now have something of a viral community.) Similar to last year, my intention was to visit both the nearby glitzy high-end mall and the local downtown on Friday following our favorite holiday. There were two interventions however, which prevented me from completing my mission on Friday.

The first intervention began late Wednesday, when I was happily notified that there was going to be an earlier-than-anticipated, sizeable contribution to the money we manage for a long-term client. One’s initial reaction to cash flow into an account, after expressing gratitude, is to apply the new money in the exact proportion in the existing allocations. However, my rule is that any addition or subtraction to an account is an opportunity to reexamine the entire structure of the account to optimize the potential net reward. (The term net reward includes risk reduction as well as looking to the upside.) In this particular case, a number of the mutual funds which this account holds are “hard closed” to new money. A few other funds are in limbo or have portfolio managers whose actions are a bit disturbing, thus I am not comfortable adding new money. In one case the inflow was large enough that it could fund a number of new positions without causing too great diversification. Much time was devoted on Friday to examine whether the new fund candidates had sufficiently different portfolios from one another that we weren’t double counting our exposure. Further, we reviewed all the funds’ total expense ratios to watch that we were not inadvertently raising the costs to the client’s beneficiaries. (This work will continue next week.)

The second intervention, which may be much more important to investors around the globe, was the announcement on Thanksgiving Day that Dubai World was asking the holders of its $ 60 billion debt to extend maturities by six months. In view of the near-term memory of the credit crisis that became a liquidity crisis coming out of sub prime mortgage defaults, the markets reacted violently. Dubai World’s real estate subsidiary, Nakheel, has a bond issue that is due for repayment on December 14th. Prior to the announcement, I am told that the bond was trading at 109 and on Friday was quoted in the 40's. In response, European and Asian banks led their markets down. In the US, significant, initial lenders to Dubai were weak. (The reason I stress initial lenders is that we have learned from the residential mortgage decline, that often the initial lenders sell out all or almost all of their positions.) Both Goldman Sachs and NASDAQ OMX fell in sympathy with their Dubai customers’ problems. As with the residential mortgage problems around the world, there were signs of trouble prior to the headlines. I know one respected investment manager, who upon returning from Dubai, stated that Dubai was out of cash to complete its various projects or to start new ones. As this brewing crisis had too great a potential to be really disruptive to our existing investments (let alone any new investments), I was glued to my computer and television screens on Friday. Thus, I did not go out except briefly for a late lunch after the NYSE early close for the day. (I expect some calming news will come out before the Tokyo market opens Sunday evening.)

Having delivered my excuses for working on Black Friday, I will now briefly describe my positive and negative reflections to my abbreviated visits to both the mall and our suburban downtown, along with a number of insightful conversations. Perhaps, the single biggest clue to how the shopping season was going is that both the mall and downtown had ample parking spaces available. In fact, I found better parking than on a normal Saturday. Walking around, we did not encounter crowds. In a number of stores the slimmed down sales staff outnumbered the purported customers. Some stores did have customers, but were not overflowing. My wife Ruth, who had a Black Belt in shopping when we married 23 years ago, noted that there were no customers at numerous cash register positions and one store had only four shoppers waiting to pay for their selected merchandise. Casual conversations with various sales clerks revealed no interest in contacting supervisors to get a more favorable price on a high-priced item. A major department store was advertising a short fur jacket rather than their normal full length fur, in their way lowering price points.

Focusing on prices was revealing. Several stores had significantly lower-than-normal priced merchandise in their display windows. Not lower prices on their normal products, but lower value, lower priced goods. Perhaps, the most revealing input we got was how the mall’s management reacted. Prior to the season there were a number of empty store-fronts. Most of these are now filled with “pop-up” stores that can quickly open with easily moveable fixtures, signage, and support equipment. These “pop-ups” are usually for seasonal items or marketing tests. Often these stores do not occupy the full store bay of the prior tenant, adding short space stores to the category of short-sale real estate transactions. The mall management is vigorously protecting its base. According to local real estate gossip, the mall gave significant rent concessions to a brand name merchant to prevent them from moving out of the mall and into the town, (reversing the normal pattern). I suspect there must have been a major concession, as the downtown now has 19 vacant stores. (We saw a similar pattern when we visited Birmingham, Michigan recently; another wealthy suburban community that has had a vigorous downtown retail district.)

An additional cause of concern to me is that it now appears appropriate to call this the “Shopping Season.” In our politically correct world there is little mention of Christmas or Chanukah. Religion and religious events seem not to be discussed in polite society. This approach has supposedly been taken so as not to offend anyone. As a Marine, I find this a defensive, or worse, a passive stance. We should stand for care and concern for others, which can even include our families and friends, but most importantly to those who are less fortunate. The muzzling of religious and spiritual thoughts is an attack on another pillar of our society. Institutions are important to our way of life, and incidentally important to how and in what we invest. Without strong, viable institutions in which we believe, we will be lost in a morass of meaningless politeness.

The job of a good analyst is to see things that others don’t. In the aforementioned “glitzy” mall, there are a number of higher-end jewelry stores. In these times one would expect to find at least one of these stores to be in the bankruptcy process. I found it encouraging that, in an auction of one store’s assets, the winning bid was by a respected professional liquidator. To my mind, the existing competitors were more logical buyers, as they already have sales outlets to sell the acquired merchandise, and wouldn’t have to employ the failed store’s people. That a professional would put up cash to buy merchandise from a failed firm in order to sell it out of existing locations, is a very positive sign. I hope they make a lot of money on this bet. Their past history would indicate that the odds are good.

One of the reasons that the US has been traditionally successful is that we adapt to calamities well. We rise to the occasion. Taking a leaf out of the liquidator’s book, adding the “pop-up’ stores, lowering price points but maintaining price discipline, are all signs of adapting to the current economic problems. Unlike a number of other recessions which impacted lower wage people primarily, the current one is a trickle-down recession with the problems hitting the wealthy either before, or at the same time, as the general population. Thus the adaptability at the high end is a good sign that unless materially higher taxes don’t prevent it, the high end will lead us out of the recession.

Therefore I expect we are coming out of our recession if we haven’t already done so. While we may take a little bit of time in making new equity fund commitments with new money, we think we will look back from the future and see that today’s prices will look as opportunities.

Please share your thoughts and reactions.