When It Comes To Money, Boring Is Beautiful

December 2009

Most cable news is built on the delivery of opinion mixed in with a sprinkle of news (even CNBC).  Apparently, we enjoy listening to opinion because their ratings are pretty good. 

But too many strong opinions can be confusing and problematic for an investor trying to navigate today’s financial markets.  If you aren’t already at least a little confused regarding appropriate investments to make with your money, then you probably aren’t paying much attention. 

But does being a little confused make for a weak investor?  Maybe, if confusion results in never doing anything or throwing caution to the wind by just jumping in.  But for those of us who take a balanced approach to managing risk and return, it just means that we won’t be participating dollar for dollar in booms or busts.  It results in longevity, and usually a little more money in our back pocket.

Following is an example to illustrate the importance of balance:

An investment that makes 100% in year one, then loses 60% in year two, results in a 20% “average annual rate of return”.  But when you do the math on $100k generating the same results you wind up with 20% portfolio loss and $80,000 left to live on.  

An investment that makes 15% in year one, then loses 12.5% in year two, results in a 1.25% “average annual rate of return”.  Again, applying the math on a $100k generating the same investment results leaves the investor with a portfolio gain of .625% and $100,625 to spend. 

Yet when it comes to selecting investments, most people would’ve chosen the first portfolio if they neglected to include the actual dollar amount to invest when doing their analysis.  Why?  Because the “industry” knows our brains are hard wired to gravitate towards simple information that results in fear/greed (average rates of return, for example), and that is what the “industry” sells.  When you read most publications, you will find that most funds are rated by stars or you will see advertisements with average rates of return.  But as you now know, that information can be misleading. 

The important takeaway is that we spend money, not advertised rates of return. 

So do you want the “screaming eagle” roller coaster ride (usually with less money to show for it after your ride is over), or would you rather enjoy a ferris wheel and have some extra pocket change when your ride has come full circle?    

I love roller coasters as much as the next guy, but I prefer to get my thrills at the theme parks.  When it comes to money, boring is beautiful. 

Below are some facts that are noteworthy; unfortunately, they don’t contain a crystal ball and might still leave you searching for answers.  But they are facts, not opinion. 

 General stock market facts 

• The market (S&P 500) fell 57% from its peak in October 2007 to its low in March 2009.
• With the S&P 500 at 1109 (yesterday's close), the market had risen 64% from its closing low.
• During the same time, the dollar has fallen in value approximately 15%.  Dollar down, stocks up and vice versa (at least for now). 
• As of this writing, the dollar index is hovering around $75.50.  For those of you who manage your own money, it could be worth your time and money to understand the dollar/stock market relationship over the past 15 months (key values on the dollar, what could speed up or reverse the dollar's decline, how other investments might react, etc.). 
• Researching secular bear markets of this magnitude across the globe (defined as a 40% drop in equity prices persisting for at least one year), we came across 19 bear markets since 1929.  The average bear market drop was -56% over a period of 29 months followed by a 70% rally over a period of 17 months, then a -25% correction over a period of 13 months, followed by a 52% wide trading range over a period of 5.6 years.  (There is no prediction inherent in this research, just historical facts.)   
• Corporate profits have improved along with the rise in stock prices. 

No one refutes the notion that much of the improvement on the demand side has been government induced via low rates and various stimulus measures.  The debatable aspect of current policy is when stimulus will be pulled away (higher rates, less or no government stimulus), and whether the consumer will be able to pick up spending when the government pulls its support. 

Immediate Positive Market Forces

• Accommodative Fed policy (low interest rates).  The Fed has indicated that rates will stay low for an “extended period of time”.
• Inflation is low.
• Corporate balance sheets are in pretty good shape, and corporate profits have improved much more than anyone thought imaginable just a few months ago.
• Valuations at 1109 on the SP 500 are a little rich, but they (valuations) are not deemed to be in bubble territory given the current environment of low interest rates and low inflation.
• GDP grew at a rate of 3.5% in the third quarter, although most of it was attributable to "cash for clunkers" and the tax credit for first time homebuyers.  Most forecasts are for 3% in Q4, 1.75-2.5% in Q1 2010.

 Immediate Negative Market Forces 

• 10.2% unemployment and probably climbing a little higher.  Employment is typically a lagging indicator, but some argue that this time may be different.

• Consumer sentiment fell for the second straight month as reported last Friday.  So far, the market has shrugged off any bad news, but its ability to continue this trend may be challenged if negative consumer sentiment results in weak holiday sales? 

• As the rally has matured into October and November, the up days have been on decreasing volume (a weak technical indicator).  This typically is not a bullish signal, although this has not stopped the rally in the past few months.

• Potential for a short term rebound (positive correction) in the dollar.

• Potential geo-political risks.  These risks are always present, but the economy and markets are much more fragile now than during normal times, so I believe it is worth keeping these risks in mind. 

Potential Intermediate Term Market Tailwinds

• Corporations could maintain healthy earnings even if the recovery remains jobless.

• Demand from emerging economies could spill over into our exports.

• We can't fully discount the possibility that the Fed engineers a perfect landing (improving employment picture, and continued low inflation).

Potential Intermediate Term Headwinds

• Higher inflation than we have been accustomed to in the past 10 years or so may be around the corner.

• Tax rates will likely be higher a few years down the road.

• Onerous legislation could pass which would hurt corporate profits.

• Stimulus induced purchases are borrowing from future demand needs.

A market move of 5-15% up or down is very realistic in the immediate and intermediate term.

Be diligent in your research, wise in your decision making, stay on top of the facts as they change often, and remain flexible.

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