Financial Pragmatist

An Update from Altamont Wealth Management

2011-08-10T15:49:00.000-07:00

Equity markets the last few weeks have exhibited extreme volatility. Though your portfolio is structured to weather such storms, you will notice greater fluctuations in your portfolio's value. Approximately 11% of the decline has happened in the last week. Last summer, the markets experienced an eerily similar decline of 17%. This was followed by a quick market recovery.

Markets hate uncertainty and there has been a lot of it lately. First there was the political fight over raising the debt ceiling that was settled only after much internal strife and politicking. At the same time second quarter Gross Domestic Product (GDP - the sum total of all goods and services produced in this country) were weaker than expected. This was followed by a poor purchasing manager survey, disappointing consumer spending report and weak job creation.

The final knife fell with Standard & Poor's (S&P) downgrading the U.S. government's credit rating. The impact of the ratings change on the Treasury market should have been negligible. It was the timing of the S&Ps action that was significant. It came at a time when the markets were deaing with many issues and unknowns: the housing downturn, the deleveraging of households and businesses, the European sovereign debt crisis, and the end of the Feds QE2 (I talked about this in the last two newsletters). The downgrade was the tipping point for the equity markets. Ironically, the downgraded U.S. debt (Treasuries) has performed well increasing in value and pushing interest rates down further. The Federal Reserve did step in yesterday and take the unprecedented action of saying that interest rates will remain low through June 2013. This has helped take some uncertainty off the table but not enough.

Despite all these problems and the increased volatility in the equity markets, I do not think we are headed for another recession. Instead, we are seeing the markets grappling with the new reality of slower growth in the developed countries. Many of our multi-national corporations are poised to take advantage of this shift but it won't help with job creation in the U.S. So we will dodge the recession bullet but it will feel like a recession with high unemployment and low wage growth.

Despite the ishares S&P500 EFTs being down 5.3% year-to-date at Tuesday's close (August 9, 2011) many of the assests in your portfolios continue to perform well. Pimco Global Multi Asset, Pimco Foreign Bond Unhedged, Pimco Developing Local Markets, Pimco Total Return, Pimco Unconstrained Pimco Commodity Real Return, and Thornburg bond funds are all positive for the year and in several cases have racked up double digit returns. These funds have performed well and are keeping your portfolio stable in the face of recent equity declines.

I appreciate your continued confidence. I am gratified to see the checks and balances in everyone diversified portfolios working so I do not anticipate taking any drastic actions. I anticipate that sometime this year the equity markets will rebound off these oversold lows. In the meantime all the hedging strategies embedded in your investments will keep your portfolios from feeling the full brunt of this financial storm.

Drive or Fly - Which is Most Economical

2011-07-19T15:49:00.000-07:00

If you were wondering this summer if it was cheaper to fly or drive on your vacation WELL I have the perfect website. It is a calculator on the BeFrugal.com website. http://www.befrugal.com/tools/fly-or-drive-calculator/

Besides the information you would expect, it incorporates the number of people traveling, the make and model of your car, price of your hotel rooms, tolls, taxis, rental cars, baggage fees plus more. It is really well done!

So take a minute and check to see if it pays to fly or drive!

VC and PE Culture Clash

2011-07-06T22:22:00.000-07:00

Venture Capital and Private Equity may seem to do the same thing but that is deceiving. Here is a great NY Times article that discusses how each has a different mindset and culture. It revolves around the recent Private Equity sale of Skype and how former employees stock options were handled. Basically, Private Equity operates in the New York Investment Banker mode of rape and pillage while the Venture Capital firms are west coast relationship oriented. It is the short term kill versus the long term relationship. I don't think that Silicon Valley will favor the PE mode of business over VC if given the choice.

http://dealbook.nytimes.com/2011/07/05/in-silicon-valley-a-culture-clash-sullies-a-romance/?scp=1&sq=Private%20equity%20and%20ventrue%20capital&st=cse

International Dividends

2011-06-27T14:29:00.000-07:00

It has been a tough market so far this year. Most of the early gains have been retraced. As of Friday the S&P 500 was up only 1.8%. The majority of that gain came from dividends. Investing in dividend paying stocks has always been a great defensive play. The U.S. and International markets face some daunting headwinds over the next few months with the Federal Reserve ending its second Quantitative Easing program (QE2) and in Europes continuing problems with its Sovereign Debt. In light of the problems facing the market, it is worth considering a global dividend strategy.

The Unemployment Picture

2011-01-25T08:50:00.000-08:00

"Moving on is a simple thing; what it leaves behind is hard. "
Dave Mustaine

Paper thin, tepid, anemic; these are the words being used to describe the American economic recovery. Why are so many experts so cautious when the recession is officially over? Because this is unlike most post World War II recessions.

Most recessions are caused by tight monetary policy. The economy tends to turn around as soon as interest rates fall and more money is available to banks and borrowers. This recession was caused by loose monetary policy and bad lending practices. So just lowering interest rates (which are already historically low) will not help. The Federal Reserve has resorted to purchasing bonds (QE2 or “Quantitative Easing Round 2”) to try and pump more money into the system but, this will have only a limited effect.

A quick fix is not possible this time. The unemployment rate is emblematic of the problems facing the U.S. economy. The unemployment rate in December did drop to 9.4%. However, only 103,000 jobs were created. The U.S. economy needs to create 125,000 a month just to keep pace with population growth. A strong economic recovery really requires job growth of over 200,000 a month. So currently we are only creating jobs at half this rate.

Another reason that the unemployment rate dropped from 9.8% to 9.4% in December is many people just stopped looking for work. The real unemployment rate is estimated to be over 16%. To put this into perspective that would be as if the whole state of California were unemployed.
This is a new problem in the U.S. Unlike Europe, we are not used to dealing with long term chronic unemployment. The average unemployed worker in December had been out of work for 34 weeks, an increase of 19% from a year ago. The percentage of unemployed that have been out of work for over 28 weeks increased to almost 45%.

The government hopes that its stimulus programs will encourage companies and corporations to start hiring again. However, this may not fix the unemployment problem because many businesses are already looking for new employees and are having a difficult time finding qualified applicants. The Department of Labor reported in the fourth quarter that there are more than 3 million new job openings. If all those positions were filled the official unemployment rate would fall below 7%. So why aren’t these positions being filled?

Many economists believe that there is a mismatch between the job candidates’ skills and the qualifications employers require. This type of unemployment is notoriously difficult to fix. It is a shift in an economy from one set of jobs to another which require different skills.
A new report by Godofsky, Van Horn and Zukin from the Rutgers University’s John J. Heldrich Center for Workplace Development follows workers who have been displaced. It tries to capture the state of those unemployed during the Great Recession by interviewing workers unemployed in August 2009 and then re-interviewing them in March 2010 and November 2010. The results were startling. By November 2010, 54% of the participants were still unemployed. In addition, 13% had given up looking. In other words, 67% of those unemployed in August 2009 had not found a full time job.

For the one-third that had successfully found employment, it was not a bed of roses. Only 43% of the employed found jobs in a few months and over a third had been out of work for over a year. In addition, more than half the re-employed say that their new jobs will not allow them to get by financially and most were still looking for a better job. A third said that they took a reduction in fringe benefits. Over 40% had to accept work in a different field and almost 70% of these workers took a pay cut.

Only one-third of those unemployed in August 2009 believe that they will recover financially and return to where they were before the Great Recession. Over 80% say their finances are in fair to poor shape. It is not a pretty picture. Those displaced by the Great Recession are falling out of the middle class, and it is unlikely that they will ever regain their footing.

I would submit however, that the Great Recession only accelerated these dislocations in the labor market. It is ultimately the pace of innovation and technological change that is causing dislocations in the U.S. labor market. Jobs for unskilled labor are fast disappearing but so are many middle management jobs. Technology allows companies to do more with fewer workers and as a result flatten their organizations by eliminating the middle.

In addition, jobs can travel anywhere due to technology. So now many skilled workers are competing with workers located all around the world. New technologies create new jobs as they destroy others. It is this pace and these dislocations resulting from creative destruction-ism that is so unsettling. We see the results of this accelerating upheaval in our own lives and those around us. New statistics show that the chance that someone in your family will suffer a cut in pay or lose their job in any given year has increased to 26%.

The lesson from all this is to invest in human capital. Workers need to keep investing in their own training and update their skill set. Since it is now commonplace for workers to be constantly changing employers, it will become less common for companies to pay for or provide anything but direct skill training. So each person will need to actively manage their education and retraining through their entire career. Retraining and re-inventing ourselves will become imperative in order to stay employed and have a forward moving career.
The good news is that America continues to be the global leader in innovation and new ideas. The robustness of U.S. ingenuity and creativeness is the envied around the world. The way out of our current economic malaise is to innovate our way out of it. This will only further accelerate the pace of change, but hopefully more jobs will be created than destroyed.

But how will the least skilled be re-employed? Since the least skilled vie for jobs with unskilled labor around the world, their plight will not be easily resolved. To attract unskilled jobs to this country the cost of labor must drop to be competitive with the rest of the world. So in the long term unskilled labor will continue to experience a declining wages. Only when the cost of labor is competitive will manufacturing jobs return to this country. The good news is that manufacturing jobs have begun to return but the bad news is that the jobs are at reduced wages and benefits.

The global economy will continue to repair itself and the unemployment rate will fall modestly in 2011. There will still be bumps along the way. Rising interest rates may cause the bond market to perform badly. Rising food and energy markets will hit the pocket-books of the poor and middle classes hard while their salaries stagnate. However, falling wages will keep inflation moderate. The economy will continue to grow, just slowly. Don’t expect a miracle cure. The economy will keep progressing through rehab but it will take years not months.

Year End 2010 In Review

2011-01-21T16:39:00.000-08:00

When money is once parted with, it can never return.
Jane Austen

The results have been tabulated and the winner is: The U.S. Stock Market. Yes, the U.S. stocks outperformed its international counterparts in 2010. While international stocks came in a distant second, bond funds began to languish. The U.S. S&P 500 Large Cap Index actually generated double digit gains of 15.1% return for the year.

These results seem implausible given the haphazard manner in which the returns were generated. In fact, more than half the gains for the year were generated in December. The S&P 500 rose 17 out of 22 trading days for the month. It was the best December in almost 20 years. If this were a ride at Disney most entrants would have thrown up by now, and the ride doesn’t seem to be getting any smoother or predictable.

In addition, the riskier the asset in 2010 the better it performed. U.S. Small (S&P 600) and MidCap (S&P 400) stocks each rose 27% while U.S. Large Caps (S&P 500) rose 15%. In all U.S. equity arenas (Large, Mid and Small Cap), the riskier Growth strategy outperformed Value. The Mid Cap (S&P 400) Growth ishares were up 30% while the Value strategy rose 22%. The same was true in the Small Caps (S&P 600) where Growth strategy delivered 28% compared the Value strategies 23%.

International stocks lagged the U.S. but still delivered solid performance. The Developed Countries’ index (MSCI EAFE Intl) grew 8% while the Emerging Markets fared better producing a 16.5% return. Similar to the U.S., the riskier international stocks performed the best with International Small/Mid Cap Growth funds, growing 22.3%.

As the year ended it became clear that there was a divergence in performance for bonds and stocks. Bonds became a trouble spot in December as interest rates began to rise. Much of this decline was in response to the positive economic news and despite the Federal Reserve announcing that it would be purchasing bonds. This market intervention (quantitative easing round 2) is referred to QE2 by the press. The Fed is buying bonds in order to pump more money into the financial system and drive long term interest rates down. Despite the Fed’s efforts long term interest rates have been creeping up. Remember, as interest rates rise the value of bonds fall. This trend will most probably continue next year making it even more difficult to generate consistent income in most retirement portfolios.

Commodities had a fabulous fourth quarter rising 16% after being essentially flat for the year. This surge was caused by strong demand for raw materials from emerging markets especially China. Investors continued to be drawn to physical assets (e.g. gold, silver) due to concerns about the continued instability of the international markets. This pushed prices in many commodities to multi-year highs that are probably not sustainable in the short term. Some of these gains have been erased in the first weeks of 2011 but the long term outlook for commodities remains strong.

Libby Interviewed

2011-01-04T15:41:00.000-08:00

I was interviewed by George Avalos of the San Jose Mercury and the Contra Costa Times. Here is the article that was published today.

http://www.contracostatimes.com/real-estate-news/ci_17001081?nclick_check=1

How Are The Banks Doing? It Depends Who You Ask

2009-04-24T12:11:00.000-07:00

What is going on with the banks? What are they doing with all that government TARP money? Are they crumbling, are they lending, are they solvent, are the toxic assets causing them to fail or are they just fine? As usual the answer isn’t simple and depending who you ask you will get a different answer. It all depends on your perspective.
As a bank executive your job is keep your bank alive. The primary reason companies fail is they spend more cash than they collect, In other words, they are cash flow negative. Based on recent financial reporting announcements, banks are cash flow positive due to increased fees from transactions they have facilitated and increased deposits. Many still have negative earnings due to write downs (on bad loans) but they can pay their bills and keep the lights on. So bank executives are relieved that the panic seems to be over and their banks can remain viable ongoing concerns.
However bank executives aren’t happy that their pay has been limited by government regulation related to the TARP funds. They also don’t like being lumped in with big bad wolf - AIG. So they want to give the government back its TARP funds as quickly as possible. Bank execs could care less about lending more money and stimulating the economy because there few incentives to make a lot of new risky loans. From a bankers perspective it would be better to hold on to the cash and use it to pay back the government’s TARP funds.
To make matters worse for the bank execs, the government wants the banks to sell their troubled (toxic) assets in order to free up capital to make new loans. These toxic loans have not been written down to their current market price because execs view these prices as just a market glitch. The current market for these assets is essentially frozen. The few transactions that take place are at a greatly discounted price. Many of these securitized investments are receiving a large portion of the interest and principal payments on time. So bank executives see no reason to sell these assets for a loss when they are generating an adequate cash flow. Now that the panic in the credit markets has subsided, the bank executives see no reason to cooperate with the government if it is not in their best interests.
The government’s objective is to get the economy up and running. To do this they need the banks to be lending. It is the lack of liquidity in the markets that caused most of the panic. The banks were leant the TARP funds to show the financial markets that the Treasury and the Federal Reserve had no intention of letting any more of the larger banks fail. In return, the banks were supposed to increase lending to consumers and companies thereby stimulating the economy. However, the banks are not cooperating and lending has fallen. An analysis by the Wall Street Journal of Treasury Department data showed that the largest banks refinanced 23% less in new loans in February than in October 2008 when TARP was launched.
Supposedly the government is stress testing the banks to see if they can survive tough market conditions. However, it is not in the governments best interests to have any of the banks fail this test. If most of the banks failed the government would not be able to prop them up again. The stress test may only be a political tool the administration is using to make the banks keep the TARP funds.
The Treasury Department wants to avoid any political backlash stemming from the banks reduced lending. The Obama administration wants the banks more accountable. It wants them lending. Currently, the government has little say regarding how the banks operate due to how the TARP legislation was structured by former Treasury Secretary Paulson. Since bailout funds are dwindling the Treasury has few options and little clout with the banks. One option that the Treasury has begun to consider is turning the TARP loans into equity (stock in the banks). This costs the taxpayers nothing. The losers in all this will be the investors that own bank stocks. Investors will find their ownership positions diluted and the value of the stocks would fall substantially.
So how are the banks doing? It depends who you ask and what metric you use.

Don't Count on the Consumer

2009-04-20T15:02:00.000-07:00

The U.S. economy remains mired in a deep recession. How deep, well fourth quarter’ GDP declined 6.3% which was the biggest drop in output in 26 years. GDP figures for the first quarter are not available yet but are expected to be down an equivalent amount. Earnings and profits will also be down substantially in the first quarter after falling 20% in the fourth. These are horrendous results.
There have been encouraging signs in recent weeks and the panic has subsided but the recession is not over. The economy is still contracting and though the rate of decline seems to have moderated there are still problems to overcome. Hope is growing that things will improve even though the banking system is not yet operating normally. In Federal Reserve Chairman Ben Bernanke's words, there are signs of "green shoots," through snow in early spring. The economy is no longer in free fall but it is still in intensive care and the markets may be getting ahead of themselves.
The outlook for jobs however remains bleak. The unemployment rate is officially 8.5% in the U.S. and 11.2% in California. However, the real national unemployment rate is over 10% when you add in those that have been looking for a full time job for more than a year and those under employed (working part time but seeking full time). One out of every ten adults is unemployed and it will only get worse before it turns around.
Unemployment will continue to move higher as businesses downsize in response to falling sales and constrained credit. We have at least eight more months of rising unemployment before it starts to turn around. The unemployment rate is a lagging indicator because businesses will not begin hiring until the economy is expanding and well into recovery.
The lag is usually significant as the charts of previous recessions show below. These graphs were compiled by JP Morgan Asset Management which allows their charts to be reproduced. The gray bars are recessions and the black lines show the market low. The green line is the total return of the S&P500 which increases from the market lows. It is interesting to look at the orange line representing the unemployment rate because it typically builds higher even after a recession is over and the markets have moved significantly off their lows. In many cases, unemployment remains high for months after a recession is over.

The recovery from this recession will be held back by weak consumer demand. The American consumer will not be rejuvenating the economy by borrowing and spending. In fact the consumer isn’t consuming. He has started saving again and paying off debt. Americans have recognized that they need to have a contingency plan in case they lose their jobs or ever want to retire. The current argument that the average taxpayer will spend their tax refunds is faulty. Most taxpayers will save their refunds in case their salaries or jobs are cut. After watching their portfolios self destruct and the equity in their homes disappear, the average American is not spending recklessly. For the first time in twenty years the personal savings rate is on the rise. Debt payments as a percentage of disposable income have begun to fall. The American consumer is scared of losing what they have worked so hard to achieve and is finally planning for that rainy day.

Emerging Market Recovery

2009-04-13T09:26:00.000-07:00

Stocks have now advanced around 35% from their lows in early March. The Dow and S&P indices are down only in the mid single-digits for the year while the Nasdaq is actually up 5%. I fully expect that we will give some of this back. It is normal for the markets to bounce around like this when the market is making a bottom. Volatility will remain high and the market bounces will be erratic and chaotic until the economy is clearly in recovery.

The emerging markets are beginning to come back to life especially China. The government’s massive stimulus program has helped China avoid sliding into a very severe recession. The Chinese economy is not hampered by many of the same problems plaguing the U.S. The state-dominated economy was able to successfully implement a massive stimulus program in November and without any delays started massive infrastructure projects. This has partially offset slumping export of Chinese goods. One note of caution, in order for China to have a sustained rally, demand for Chinese products from the rest of the world must begin to recover.

In addition, Chinese consumers are very thrifty and are not burdened with heavy debt unlike their western contemporaries. So Chinese consumers are unencumbered by large credit card bills, loans and/or mortgages and are starting to spend again.

The emerging market stock exchanges have moved up sharply maybe a little too sharply in recent weeks. The MSCI Emerging Market International ishares (EEM) are up almost 13% year-to-date. This recovery has been very rapid but the fundamentals do not support such a large swing. I would not be surprised if we gave some of this back.

The Chinese have historically been ravenous consumers of commodities. A rapid recovery could spark an increase in commodity prices and inflation. Currently, we are in a slightly deflationary environment but this could change if demand for commodities increased rapidly. It is difficult to tell if the rally in China and other emerging countries is sustainable. At least the panic is over and the global economy can begin to heal. As the recovery takes hold it will be important to closely monitor commodity prices for signs of inflation.

One Out of Every Ten Americans is on Food Stamps

2009-04-09T10:29:00.000-07:00

Our recent economic woes have hit everyone but it has impacted those with the least the most. Nothing brings home the plight of many Americans as recent the recently released government statistics on SNAP/Food Stamp participation. As of January one out of every ten Americans (32 million) is receiving food stamp assistance, the highest participation rate ever. How does this compare to the good times when the economy was humming along in 2000? Well, the number of people participating in Food Stamps in July was 16.8 million individuals, 15 million less than today.
As the economy has continued to weaken and unemployment has surged many households are in trouble. It has hit every region of the country with every state reporting a year-over-year increase in families requesting and receiving aid. The pain was not felt by just the families living in the Sunbelt states and the industrial heartland. In fact, you may be surprised by some of the states that have been hit the hardest.
Eleven states reported greater than 20% increases in their caseloads from the previous year. Idaho experienced the highest year-over-year increase surging 32% followed by Utah (29%), Florida (29%), Nevada (29%), Arizona (25%), Wisconsin (25%), Georgia (23%), Vermont (23%), Maryland (22%), Texas (22%) and Massachusetts (21%). Below is a chart prepared by Food Research and Action Center which shows by state the annual increase in Snap/Food Stamp participation.
The non-profit and private sectors food banks have been overwhelmed by the surge of people needing help. Many local food banks are struggling to stay open because contributions have dried up.
Granted that Food Stamp statistics are lagging indicators like the unemployment rate but it does show the pain that many Americans are experiencing. It will likely get worse so it is important for all of us to look around our own communities and help. Our lives are so busy that it is easy to miss that others need your help. So on this Christian holiday weekend make a donation (of time or money) to your local food bank or food pantry and help combat hunger.

Weekly Market Recap

2009-04-06T12:26:00.000-07:00

The U.S. markets rallied for their fourth week. We are now well up from the lows experienced in early March. Last week the S&P 500 rose 3.3% to 843 and the Nasdaq Composite advanced 5.0% to 1,622. Value stocks finally showed strength because the Financial Accounting Standards Board revised the mark-to-market rule giving bank stocks a boast. Value stocks however still lag growth stocks year-to-date. In fact, large to mid-cap growth stocks are now positive for the year.

Though the current rally has provided much needed relief, it does not mean the markets are only headed up. We have seen rallies galore since we started this ascent into hell last year. This is the fifth 10%-plus move we have seen in the past year and the previous rallies did not hold. For this rally to be sustainable the banks and the credit markets have to be functioning and stable.

The economy is still deteriorating. Last week, the official national unemployment rate reached 8.5% (an additional 660,000 jobs were lost in March). The real rate of unemployment is over 10% when you add in those that have been looking for a full time job for more than a year or those under employed (working part time but seeking full time). One out of every ten adults is unemployed and it will most probably only go get worse before it turns around.

This and other data suggest that the economy contracted in the first quarter by approximately 5%. Luckily some of the recent economic data related to housing sales, retail sales and consumer confidence is pointing to a moderation in the rate of decline. The Federal Reserve is also doing its best to pump money into the system and bolster up the banks. The economy is beginning to bottom out but the data is not pointing to a robust or steep US recovery. The economy will begin to stabilize the second half of the year but the going will be rough.

First Quarter 2009 Market Performance

2009-04-02T12:43:00.000-07:00

I was quoted in yesturdays Contra Costa Times article on the First Quarter Performance.

Hope you enjoy!

Area stocks outperform market indexes

The stocks of Bay Area and East Bay public companies out-performed their counterparts on the national stock markets during the first quarter — but only by falling less than the Dow Jones 30, S&P 500, and Nasdaq Composite.
By the time the January-March period ended on Tuesday, the East Bay 50 index had fallen 2.7 percent and the Bay Area 100 index was down 0.2 percent. The Dow Jones Industrial Average plunged 13.3 percent, the S&P 500 slid 11.7 percent, and the Nasdaq fell 3.1 percent.
Those three-month losses came despite a general upswing in the stock markets towards the end of the first quarter.
"We seem to have gained some traction in the stock markets in March," said Libby Mihalka, president of Altamont Capital, a Livermore-based financial planning firm. "But we're not out of the woods yet."
The big problem now is financial gremlins continue to haunt broad stretches of the nation's economic landscape. And that has spooked investors.
"Short-term, there are so many things that are unknown," said Royce Charney, president of Oakland-based Trust Administrators, a financial company. "You still have all the bank and financial institution issues, and now we're dealing with the auto industry. But for long-term investors, the market still looks attractive."
Charney defined the long-term
"The collapsing financial system and the problems with the auto companies are hurting consumer psychology the most," said Richard Welty, president of Lafayette-based Welty Capital Management.
Among industry sectors during the quarter, the best-performing national index was the Morgan Stanley Retail Index, which rose 6.3 percent. The weakest sector was the Bloomberg Real Estate Index, which lost 33.7 percent of its value.
The best-performing East Bay companies during the quarter were primarily in the high-tech and biotech industries:
 Novabay Pharmaceuticals jumped 188 percent. Emeryville-based Novabay said a deal it struck to develop and commercialize one of its dermatological compounds could produce $50 million in milestone payments for Novabay.
 Zhone Technologies soared 130 percent higher. Oakland-based Zhone lost money in its fourth quarter, but the loss was in line with expectations. The wireless communications also landed some key deals and moved forward with plans to serve the rural United States.
 Neurobiological Technologies was up 116 percent. The Emeryville-based biotech company said it would seek the sale of the company or its assets.
 Socket Mobile was up 79 percent. The Newark-based maker of mobile-computing devices reported record annual sales in 2008, although the company lost money during the year and the fourth quarter.
 SYNNEX Corp. jumped 74 percent. Fremont-based SYNNEX, a technology services company, announced fourth-quarter profits that beat analysts expectations by a wide margin.
Walnut Creek-based PMI Group was the worst-performing East Bay stock, falling 68 percent. The mortgage insurer reported a smaller fourth-quarter loss. PMI also was jolted by a downgrade by Fitch, which warned that PMI faces more losses and reduced liquidity.
Concord-based Pacer International fell 66 percent. The freight logistics company's fourth-quarter results fell short of estimates for earnings and revenues.
The best-performing Bay Area company was XTENT Inc., a Menlo Park medical devices company whose stock rocketed 367 percent higher. But the improvement may have been due to XTENT's disclosure during the quarter that it had hired an advisor to help it sell some core assets, sell the entire company, or seek a merger partner. XTENT also decided to eliminate 115 jobs, or 94 percent of its workforce.
Investors should be prepared to confront more volatility during the second quarter of this year, financial planners said.
And even after the volatility fades, and the economy starts to look better, it's still quite possible that a rebound won't produce much to cheer about.
"We're going into a slow-growth economy," Mihalka said. "Things will stay slow. And then we may have inflation.

Rally Not Sustainable Without Bank Recovery

2009-03-30T14:22:00.000-07:00

The U.S. stock markets rallied for a third week. The S&P 500 index was up 6.2% last week. Stocks have now rallied approximately 25% up from their lows of less than three weeks ago. The rally has pushed the S&P 500 index into single digit losses for the year (down 9%) and for a few days moved the Nasdaq briefly into positive territory until it fell on Friday.

The market loved all the positive economic news it received last week starting with the 5.1% increase in existing home sales followed by a 4.7% increase in new home sales. Durable goods orders rebounded 3.4% and consumer spending rose 0.2%. All these indicators came in at better-than-expected levels. These could be signs that the economic recession may be moving past its peak but it is still too early to tell.

The market also rose last week because investors enthusiastically embraced the Obama’s Administration bank recapitalization plan. The Treasury Department outlined the Public-Private Investment Plan (PPIP) which gives banks the means to remove toxic assets from their books freeing up capital to make new loans. This plan should help the banks and the credit markets to recover and begin lending. Nonetheless, these market rallies cannot be sustained over the long run until the banks are on sound footing. This is not to say that the success of the PPIP is guaranteed. There are numerous details and glitches that need to still be worked out if the PPIP is to be successful. There are, however, numerous reasons to be optimistic about the prospects of this program. The PPIP combined with all the government fiscal programs should eventually bring about a resolution to the credit crisis.

The recent rallies have been encouraging from a technical perspective. Trading volume has been increasing on upward moves and declining on pullbacks. This is crucial to building a bottom, but it creates painful volatility as the markets over shoot on the latest news. There is still much negative news out there, including high levels of unemployment, a very troubled auto industry and an extremely fragile financial system that could still be subject to negative shocks. A market like this will create exciting rallies and sickening declines. These market gyrations are an important part of the bottom building process as the market challenges asset pricing over and over again. So it is important for investors to keep a long term perspective despite the excessive level of volatility.

Forget the Sideshow: Just Resuscitate the Credit Markets

2009-03-23T15:20:00.000-07:00

For the second week in a row, equities managed to post a positive gain despite heavy profit-taking at the end of the week. The S&P 500 gained 1.6% to close at 769. From the early March lows the market is up 20%.

The big news is the Federal Reserve’s announcement to institute a program to buy $1 trillion worth of mortgage-backed and Treasury securities in an effort to boost economic growth. The market for mortgage-backed securities has been frozen for months. The Feds attempt to thaw this market has been well received. The move is designed to lower mortgage rates so many homeowners (that are not under water and have jobs) can refinance. This should increase homeowners' cash flow and reduce foreclosures. In addition, this may induce prospective buyers to begin purchasing homes, thus bolstering the battered housing market.

Unfortunately while the Fed is doing its best to prop up the markets, save the banks and jump start the economy, Washington is too busy with its own sideshows. This one comes complete with a freak show of politicians berating AIG bonus recipients. While the outrage engendered by these bonuses is understandable, the grandstanding and legislative response is not productive.

If this proposed tax on bonuses received by TARP recipients is enacted, it will surely hurt the Fed's efforts to prop up the banking system. The bonuses are egregious but it is more important to get the economy jump started than to pursue a witch hunt. Stabilizing the banks should be our first and last priority. If we cannot stabilize the banks the economy will get much worse and the credit markets will freeze up further. Stabilizing the banks and greasing the gears of the credit markets should remain the government’s focus, not sideshows and witch hunts. Punishing these bonus recipients isn’t necessary because in the end the markets will extract its own retribution in the form of reduced pay or no job at all. Sooner or later these kings of finance will find that their industry has changed and the pickings are slim to none.

I anticipate the markets will be a little choppy but the rally will continue at a slow pace. If you are not in the stock market, I highly recommend that you start dollar cost averaging back in.

Turnaround or Bounce? Look To The Banks

2009-03-17T10:31:00.000-07:00

Last week’s positive move in the stock market was overdue, but it is unclear whether this is the beginning of a turnaround or merely a bounce from oversold conditions. There is some evidence that market conditions are improving. Last week’s rally was broad-based and volume was heavy, which are strong technical factors. Additionally, lower-quality stocks have been outperforming, which typically happens as markets turn around. However, it is very possible that we are still bottoming-out.

There was good economic news last week. Retail sales figures were surprisingly positive. January’s data was revised to show that sales actually rose, and February’s numbers were down only slightly. All told, it appears possible that overall first-quarter retail sales growth will net out to around zero, a much better scenario than was widely anticipated only a few weeks ago.

Today more good news. An unexpected rise in housing starts and a more moderate increase in wholesale prices point toward a brighter economic outlook. Another plus, the market appears to have leveled off before the recently passed stimulus package has started to have any effect.

That said, the overall economic environment remains troubled, and as Federal Reserve Chairman Ben Bernanke said last week, “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort.” The banking system needs to stabilize before we see a full recovery.

Housing Prices Plunge in December

2009-02-24T09:50:00.000-08:00

The Case-Shiller index showed accelerating price declines in December. Every city experienced declines. Denver and Dallas held up the best declining approximately 4% in value from sales of existing homes in December of 2007. Sun Belt cities continued to post the worst declines with Las Vegas and Phoenix sliding 33% and 34%, respectively. San Francisco posted the worst monthly drop ever, a 31% decline. The rest of California fared no better with San Diego and Los Angeles both falling 25% and 25%, respectively.

The S&P/Case-Shiller home-price index is a closely watched gauge of U.S. home prices in 20 major metropolitan areas. The housing market will continue to deteriorate at least through the summer and probably through the rest of the year.

Deteriorating housing prices cause buyers to sit on the sidelines thus causing housing prices to fall further. This is a deflationary spiral that is hurting the economy. Consumer confidence dropped to an all time low of 25 in February. This is the lowest reading since the index's inception in 1967. This new reading shows consumers do not expect economic conditions (i.e. employment and business conditions) to improve in the next six months. In fact, 40% of respondents said they expect economic conditions to instead worsen. Under these conditions, few consumers are willing to buy a new home especially if they expect the housing market and economy to worsen. So the spiral continues …..

The only glimmer on the horizon is the new Obama housing stimulus plan. It is an elegant plan but it may not be enough. The plan is expected to help 9 million families refinance their mortgages to avoid foreclosure by using incentives and subsidies. Unfortunately, the plan is structured to offer the least help to homeowners in markets that have receded the most (the Sun Belt States, California, Florida and Michigan). It is a start and will help shore the housing market up in some parts of the country but it will not completely bolster the collapsing housing market.

Interactive Housing Market Graph Link

It is not likely that the economy will turn around in 2009.

Inflation, Deflation, Reflation or Stagflation???

2009-02-19T10:41:00.000-08:00

In the short term, the world’s economies will not have to worry about inflation. The drop in demand for goods and services is causing prices to actually drop. This disinflation will not last long since the supply is still constrained. As demand picks up again, especially in the emerging economies, inflationary forces will emerge. The U.S. government’s stimulus programs will actually add to the inflationary forces in the future. In the short term these forces will lead to reflation, which is the reappearance of a rising inflation rate. Reflation is not undesirable since a low level of inflation has always led to a stable economy. However, if reflation leads to high inflation (above 2%) then it is considered destructive to the general economy, and our Federal Reserve usually steps in to extinguish inflationary pressures. Except this time the Fed may not be able to combat inflation. (If it fights inflation then it causes growth to further stagnate; if the government encourages economic growth it sparks rising inflation).
Inflation is usually driven by strong economic growth. As we discussed before, it is unlikely that we will experience a high growth rate for quite a few years. But inflation can occur during periods of stagnant growth if there are constraints on supplies. We are facing numerous future constraints. Our growing trade deficit, aging population, rising cost of labor around the world, and supply-constrained commodities are all contributors to inflation. Inflation with stagnant growth is called stagflation and it looks like this is where we are heading in the long run (probably a year from now). Stagflation requires a completely different investment mindset. For instance, in a world prone to inflation and slow growth, fixed rate securities like Treasuries are really not “risk free” or safe since a rising inflation rate can eat up the wipe out any real return.
Since the early 1980’s inflation, also known as the Consumer Price Index or CPI, has been steadily falling in virtually every economy from double digits down to 2% (see chart below). So inflation has not been a factor on which investors have had to focus. As inflationary pressures reappear, it will become important to reach back to the investment strategies that worked thirty years ago and update them to meet the changing securities markets. For instance, strategies that emphasize inflation-linked bonds and commodities will probably do well in this environment while stocks may under perform.
In the near term, we will be experiencing reflationary pressures coupled with a stagnant or low growth economy. In this environment, high quality corporate bonds and municipal bonds will perform the best when mixed with stocks and the slow introduction of inflation-linked securities. Commodities in the near term will not perform well but will shine when inflation takes off. Your portfolio rebalancing recommendations will reflect the realities of this new investment landscape. Please review your rebalancing recommendations and return them to us as soon as possible.
The new administration certainly has an amazing number of wild fires to deal with. It will be impossible for them to put them all out and put things to right quickly. It will take massive government intervention in the form of both tax cuts and spending on infrastructure to stop the consequences of the sudden de-leveraging of financial markets, consumers and businesses. This will be a protracted recovery. Over the last few weeks the credit markets have begun to thaw. High quality corporate and municipal bonds will recover first as yield spreads to Treasuries narrow. The stock market will hold steady and may begin to slowly recover in late 2009 but will face massive head winds in the near term.
It is important to adjust to the economic headwinds we face and shift your portfolio to reap any strategic advantage the markets offer. The markets always recover in the long term but each time it is different. The key is not to panic. Instead, focus on identifying these differences and shift your portfolio to take advantage of them. Hiding in Treasuries will not repair your portfolio but may in fact garner you further losses. Short term volatility always yields opportunities if you know where to look.

Is Your Financial Advisor A Smooth Talking Con Artist?

2009-02-17T15:56:00.000-08:00

Both the Stanford and Madoff scams have something in common. These advisors used simple techniques to separate investors from their money by promising high returns and no risk (greed). If something is too good to be true - Well It Is!!!!!!!

So here are the warning signs:

If you receive statements from only your Advisor's firm you could be in trouble. An Advisor should custodian your funds at a separate and independent company. I custodian my client's portfolios at Charles Schwab & Co. The client receives a separate statement directly from Schwab verifying their holdings. Madoff would never have been able to steal his client's money if custody of the funds had been held at another firm. Many advisers avoided the Madoff ponzi scheme because when they asked simple questions. When they found out that Madoff managed funds were not held by an independent third party brokerage firm they didn't invest. Never hand over custodian ship of your portfolio to your advisor.

If your advisor has you write a check or transfer your assets to them, you are probably never going to see your money again. I know I said it before but Never hand over custodianship to your advisor. The check should be made out to your custodian (i.e. Schwab, Vanguard, Fidelity).

Be wary of the promise of unreasonably high return with virtually no risk. There is no such thing as a free ride. This tripped up both the Madoff and Stanford investors. Stanford promised huge returns on risk less CDs. In addition, most investors assume that all CDs are FDIC insured up to $250,000. They are not. An advisor may say or promise that their CDs are insured or guaranteed but by whom? If ii is not FDIC insured don't invest. Be sure to ask alot of questions.

Do Not Invest in Anything You Do Not Understand. If your advisor can't explain it to you simply then they do not understand it or they are trying to take your money. Bottom line, it is your money so there is no such thing as a simple or stupid question. If your advisor becomes annoyed then find a new one. Do not invest in a fancy catch phrases (Stanford Investment Model or SIM) or a black box (Madoff's supposedly winner options trading strategy).

Finally, Listen to your gut. If you are uncomfortable and feel under pressure to sign with an advisor, then leave. It is alright to look foolish. In fact, it might be the smartest thing you have ever done. If after additional research and thought you change your mind, I guarantee that the advisor will still be happy to help you with your portfolio.

A smooth talking con artist is always happy to separate you from your money so stay alert!

The Economy Ain’t Hummin’ Along

2009-02-12T10:31:00.000-08:00

Banks, consumers and businesses are rapidly deleveraging. The process was so abrupt that it was though someone slammed the brakes on the global economy. (Please note if you cannot read a graph or insert double click on it and it will appear larger and less fuzzy on your computer). First, the housing market began to deleverage in 2006 sparking the financial sector to begin to deleverage in 2007 causing the consumer to deleverage in 2008 and in September the rest of the world followed. When so much liquidity is pulled from the markets and economy so rapidly the dislocations and shock waves are massive. Now only one entity is large enough to get the economy moving again, the U.S. government. The government is now moving forward rapidly to stimulate the economy as unemployment soars and economic growth stalls.
The unemployment rate is approaching the levels reached in the early 1980s. Given the recent severe declines in retail sales, business spending and employment, it is highly unlikely that the economy will improve anytime soon. It is clear that the job market will continue to deteriorate for most of 2009. It is entirely possible that we will reach the levels of unemployment experienced in 1982. Even if the much-needed stimulus bill passes soon, the economy is likely to end 2009 in roughly as bad a shape as 1982.

Currently, the unemployment rate was 7.6% in December 2008 if you include discouraged workers. In addition, another 5.2% of the labor force was involuntarily working part time. Combined the rate approaches 13%. However, this still understates the unemployment rate, because the Labor Department’s definition of discouraged workers is too narrow. If everyone looking for a full time job were counted, the rate could reach over 14%. It is estimated that unemployment reached over 30% during the Great Depression and it is doubtful we would approach this level given the size of the government’s proposed stimulus package. It is possible that we could come close to the 1982 peak rate of unemployment of 16%.
Almost half of the current work force is too young to have any real memory of how tough it was to navigate through the early 1980s recession. They only remember the mild recessions of 1990-91 and 2001. Many are unprepared for layoffs and tough times. It is a generation that spends and does not save, a generation that has systematically borrowed from future income to finance today’s wants. Now the bill has just come due and the delinquency rates on Consumer Loans and Residential mortgages are climbing rapidly. Consumers are leveraged to the hilt, and as they lose their jobs they begin to default on their car, home and credit card debt. There is no buffer, no savings since they have not prepared for the end of the leveraging party.

How to Read Your Federal Tax Return

2009-02-09T07:58:00.000-08:00

Your Federal tax return is difficult to understand. The first two pages called Form 1040 summarizes all your information. The New York Times has put together a great interactive version of this form together. It is worth a few minutes of your time to run through your tax return. Afterall, it is one of the largest bills you pay!

NYT Interactive: Walk Through your Federal Tax Return

The Economy is Still Deteriorating, But What Will the Markets Do?

2009-02-07T13:33:00.000-08:00

It is official; government economists have declared that we have been in a recession for over a year. Of course anyone living in the real world knew we were in a recession long before economists and the government officials. What started off as a housing market crisis morphed into a credit crisis morphed into a global market meltdown and finally caused the demise of the banking system as we knew it.
So we now have been through two bubbles (dot com and housing). I call them the twin peaks, or the Grand Tetons of the stock market (see chart below). Bubbles are always obvious in hindsight, after they burst. If you look at the stock market before the twin bubbles (pre-1995) and extrapolate forward at a more reasonable growth rate, maybe the current level of the market is not far from where it would have been if we had just experienced reasonable consistent growth.
The market and economy tend to swing like a pendulum. If the market swings go too far up then it must over-correct with equal force in the opposite direction. Corrections are usually just as severe as bubbles were frothy. So the recovery from the twin peaks bubble will not be a quick V-shaped one as many are hoping. This is going to take a long time and is not a normal cyclical recession. This recovery will necessitate the complete restructuring of our financial system.
It will take years to resuscitate the U.S. economy and 2009 will be terrible from an economic perspective. It is also clear that when we do recover our economy and banking system will be transformed. It has already begun with a string of bank consolidations and some bankruptcies. In order to keep the banks solvent, the U.S. government is being forced into taking large equity stakes in all the major money center banks just to keep them afloat. It is obvious that the banks need to find a new business model and ominously it will not be as profitable as it was before.
The government will insist on new regulations that will keep the financial institutions from assuming such substantial risk. In fact, the government will want the banks to adopt a business model not unlike that of a utility company because it has become clear that the economy cannot accommodate the failure of our largest financial institutions. The impact on our economy will be immense. Since the 1980s, the financial sector has driven the economy. It called the shots and became larger than the manufacturing sector. In fact it, told manufacturing and every other sector of the economy what to do. Our whole economy will now have to restructure and our growth rate will be lower as a result.
Our government’s response to the crisis has been to throw money at our financial institutions in the hopes of dousing the fire. As with any emergency action there will be unintended consequences. Instead of water and foam being dispersed everywhere to douse the fire, the Federal Reserve and Treasury are using cash. Some institutions will survive that should have been left to wither and others will fail though they deserved to survive. Government support is always inefficient, but in this case there was no alternative. To not have acted would have led to the complete failure of the banking system and our economy.
The government is now shifting its response to the credit crunch. The banking system is too damaged to recover quickly. So the Treasury will change gears and begin to purchase broad asset classes and in some instances extend further guarantees. The Federal Reserve and Treasury will also have to implement additional strategies to inject the needed liquidity to businesses and consumers and bypass the banking system. These actions change the investment landscape and shift our near term investment strategy to focus on assets the government is supporting. In this environment bonds are preferable to equities (stocks). So unlike most recessions, equities will not lead the way out of this morass. So unlike almost every bear market of the past 50 years, buying stocks after more than a 20% decline might not be the best move this time around.
At current levels stocks may look like a bargain, but are they? It depends on which metrics you use and a stock’s promise. The promise of a stock is its ability to meet or exceed its current projected earnings. The measure frequently quoted is Price to Earnings ratio, which compares the price of a stock to its trailing (last period’s) or forecasted (estimated future) earnings per share. Investors focus on future performance and therefore use forward earnings to calculate the price to earnings ratio. Trailing earnings are used to assess the reasonableness of future earnings. Unfortunately, it is tough to assess value or estimate future earnings in a volatile market. Using trailing earnings (earnings from last year) causes the Price to Earnings ratio of stocks to seem cheap (see chart). However, earnings are falling, rendering trailing earnings an un-realistic gauge of current value.

The problem is that Wall Street is still too optimistic about earnings even though expectations for the future quarters have eroded quickly. On Oct. 1, according to Thomson Financial, the Wall Street consensus was that S&P 500 earnings would rise a whopping 47% from the fourth quarter of 2007. Now, analysts think earnings actually fell 23% from a year ago. If their new forecast is correct, earnings will have fallen for six quarters in a row, the worst stretch on record. But analysts are still gung-ho about the future. Analysts expect S&P 500 earnings to be roughly flat this year, according to Thomson, but post a 33% year-over-year rebound in the fourth quarter. These forecasts depend on a quick economic recovery, which is unlikely to occur. Most economists expect something more sluggish at best.
Equity analysts tend to always be too bullish about the economy. Since the earnings slump began in 2007, analysts have consistently held high hopes for profits a year out, while busily cutting forecasts for the quarters immediately at hand. The pattern seems to be continuing in 2009. The bottom line is that at current levels the stock market has already priced in a 30% decline in earnings. So even though analysts can’t face the truth, the market already has. Are stocks cheap? Many metrics suggest that stocks should at least provide satisfactory returns going forward and possibly something better, but owning the stocks that can deliver on their future earnings promise is the key.

What You Need to Know About the New Credit Score Calculation

2009-02-06T10:40:00.001-08:00

Here is a great article by the New York Times regarding your credit scores. After you have read this article please hit the second link below and check your FICO score.

NYT Article Regarding Credit Scores

Check Your Credit Score

Fighting Recessions

2009-01-29T15:24:00.000-08:00

Since the Great Depression, presidents have tried many methods to fight recessions. Three economists explain what worked and what didn’t.

http://www.nytimes.com/interactive/2009/01/26/business/economy/20090126-recessions-graphic.html

Risk Management

2009-01-12T11:51:00.000-08:00

Here is an excellent NYT article that describes how Wall Street failed to adequately mange risk. It's a prime example of how models and statistics can be mis-used. It was human folly. The article shows how investment banking and insurance company managers ignored the coming storm signals and blindly followed a quantitative model and how this led to the financial meltdown. It was the equivalent of flying an airplane looking at only two instrument panels on the dash board and never scanning the horizon or factoring the short comings of instruments that you are using. In short a model is only as good as the person using it.

http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?scp=1&sq=risk%20management&st=cse

Happy reading!

End of An Era

2008-11-06T10:58:00.000-08:00

One minute I held the key
Next the walls were closed on me
And I discovered my castles stand
Upon pillars of salt and pillars of sand
Coldplay

Everyone ought to bear patiently the results of his own conduct.
Shakespeare

It has been over two months of financial turmoil. For over 25 years I have been studying banks, monetary policy, credit markets and financial crises. So following these events for me has been fascinating and appalling. I have been saying in my newsletters and presentations for well over a year that we were facing serious problems. I have ranted and raved that risk wasn’t priced into the market, how the misuse of derivatives was going to lead to trouble and that unless the U.S. housing market was resuscitated that things were going to keep getting worse. I just didn’t think that it would mutate to such an extreme outcome. Things are moving so fast that I will not be able to talk about everything that has happened. I will try to hit the main highlights of the last seven weeks. It is like watching dominoes fall knocking each other haphazardly. It has been unclear what impact each falling domino would have on other dominoes. I will try to walk you through the chain of falling dominoes and what the impacts have been.

As we have previously discussed, financial institutions had taken huge bets using derivatives which were not properly reflected on their balance sheets or understood by management. These derivatives amplified the impact of the collapsing housing market. It was as though an atomic bomb was detonated in the credit markets flattening many institutions in its wake.

This current episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8th in response to the failing housing markets and shriveling of the credit markets. The combined assets of Fannie and Freddie are over $5 trillion. These entities had been set up to support the housing market. Their job was to help guarantee most of the mortgages in the United States (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this rarely occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities, and snapped it up eagerly.

Fannie and Freddie were weakly supervised, and strayed from their core mission. They began using their subsidized financing to buy mortgage-backed securities, which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government wiped out shareholders both preferred and common shares), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed. The opposite has happened. The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

It is now clear that the government should not have wiped out the preferred shareholders. These shares were extensively held by financial institutions, foundations, school districts, and municipalities and were seen as ultra safe. The impact was percussive and reverberated through the market. It has taken weeks to see the full impact, but it is clear now that this was one of the reasons the credit markets completely seized up.

The following Monday the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.) Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. This may sound like a crazy way to run a business, but this is how all the investment banks were operating financing long term needs with short term debt.

Basically, when it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line. This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and/or by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

The failure of Lehman rippled through the market causing havoc. Its assets were sold in a chaotic fashion, causing stable assets to plummet in value. Lehman’s business units that made markets for many bonds and derivatives were not operating. The results were disastrous. First, the short term commercial paper market froze, which then caused some money market funds to fail (or they broke the buck). Banks stopped lending to other banks and started to hoard cash. The blood (cash) was no longer circulating and the patient (economy) went into cardiac arrest. In retrospect, allowing Lehman to fail was the worst mistake the U.S. government made. A plan to liquidate Lehman in a controlled way would have avoided much of the turmoil that followed. From this point on, fear escalated and the herd began to stampede for the exits.

The next day (Sept 16th), the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world with over $1 trillion of assets and over 100,000 employees worldwide. The loan is for two years at 850 basis points (8.5%) over Libor (the rate that banks in Europe lend to each other). The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday, Sept. 15th. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world - nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely. In addition, other large healthy financial firms had guaranteed A.I.G.’s bonds by writing C.D.S. contracts. A failure by A.I.G. would have taken some of these institutions down. Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion. Since then A.I.G. has had to borrow even more from the government to stay afloat. Its board of directors is analyzing which divisions to sell off first to start repaying the loans.

Then Merrill sold itself to Bank of America. This is the type acquisition that would normally take months to negotiate. Instead, it was thrown together over one weekend. Merrill Lynch knew it could not weather the storm created by Lehman’s failure. B of A has always wanted to own Merrill Lynch’s retail brokerage business. Merrill knew that if it did not find safe harbor (a willing buyer) before Monday morning, that it would be dead before the end of the week. So it was a shot-gun wedding. Now the dominoes fall even faster.

By Wednesday the credit markets (this is where bonds are bought and sold and funds are lent from one firm to another) has ceased to function. Investors fled the credit markets and ran to Treasuries. The price was bid up so high on Treasuries that they had no yield and investors were paying the government to hold their money for free (see chart). On the flip side, the cost of borrowing for companies soared. This stunning flight to safety started to cause serious damage to an already compromised economy. The last remaining large Wall Street firms, Goldman Sachs and Morgan Stanley, which just weeks before were considered relatively strong, came under assault. Their stock prices plummeted and no one would loan them money. Remember how devastating this was for Lehman.

Now it’s Thursday, and the Treasury and Federal Reserve begin discussions on what would become the largest financial bailout in U.S. history. The plan was to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions. The program would be run by the Treasury and use $700 billion of taxpayer’s money to fund the program. The goal was to inject liquidity into the banking system and jump start the market in the mortgage-backed-bond market back to life. The markets rallied on the news. Discussions between Congress, the Treasury and the Federal Reserve continued through the weekend on TARP (Troubled Asset Relief Program). Everyone assumed Congress would pass the bill on Monday. Congress did vote on Monday but failed to approve the bill. Fear gripped the markets resulting in the worst one day decline in the U.S. stock markets in two decades. Congress did not pass the bill because many representatives do not understand the financial markets. They saw this as a bailout of greedy investment bankers. Over a week later, the Senate passed the bill followed by Congress but the administration had to compromise on several fronts, such as pay caps for executives. The delay caused more market turmoil and the markets fell further.

In the meantime, the last two independent investment banks on Wall St., Goldman Sachs and Merrill Lynch, transformed themselves into bank holding companies. Now they will be subject to greater regulation. Instead of reporting to the relatively “hands-off” SEC, Goldman and Morgan Stanley will have much closer supervision by bank examiners from several government agencies. The firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking. In exchange, the firms get access to the Federal Reserve’s lending facilities, which should help them avoid the fate of Lehman Bros.

As officials in Washington were still negotiating TARP, Washington Mutual was seized by the FDIC and sold to JPMorgan Chase. The FDIC then pressured the weakened Wachovia into a deal with Citigroup. Four days later Wells Fargo made a richer offer for Wachovia and the legal wrangling started. In the end they decided to split the baby in half so Citicorp and Wells Fargo split Wachovia. Throughout the turmoil the FDIC has done a tremendous job of handling failing banks so there is as little turmoil in the financial system for consumers and businesses as possible.

During the week, the crisis became increasingly global. Many financial institutions and banks overseas had purchased some of our more toxic securities and derivatives. In addition, these firms had adopted the Wall Street model of high leverage and imprudent use of derivatives. They had also extended risky real estate loans in their own countries. In Europe, the week was punctuated with one state intervention after another to rescue faltering banks in Germany, Belgium, the Netherlands and Britain.

Over the weekend of Oct. 4th many of the leaders of the European Union met to try to come up with a coordinated effort, but failed. Separately, the German government said on Sunday that it would guarantee all private savings accounts in the country in an effort to reinforce increasingly shaky confidence in the financial system. The rest of the European nations followed suit on Monday. If they had not guaranteed deposits each country faced a run on their banks. European leaders still could not agree on any coordinated response to the crisis, leaving the markets in disarray. Further away in Iceland, the country’s financial system completely collapsed. The government intervened and now owns all five of Iceland’s banks. The cost of intervention in Iceland was greater than the country’s annual GDP (value of all goods and services produced in a year). The European stock markets fell precipitously.

On the same day, emerging markets took one of their biggest collective tumbles in a decade as stock markets from Mexico to Indonesia to Russia were gripped by fears of a collapse of Europe’s banking system, and concern that a global recession could drag down the price of commodities, forcing a steep slowdown in emerging-market growth. Many of the world’s fastest-growing economies thought they had insulated themselves from problems in the developed world. But economists said that simultaneous turmoil in Europe and the United States was too much for these markets to bear.

On Tuesday, Britain and Spain moved to shore up their failing banks. The violent fallout in the housing market in both countries was causing their banks to fail. Both countries stepped up to inject liquidity into the system.

At this point the markets fell further. The technical term for it is “negative feedback loop.” I just call it a panic. The Federal Reserve and European Union announced a coordinated interest rate cut. In response stocks ignored the good news and declined again. Credit markets remained frozen, with banks still hoarding cash. These declines were free falls caused by very low trading volume. The price of stocks was declining on very few trades. So there are only a few panicky sellers that are willing to sell at any price to a few brave buyers while the majority of investors sat on the sidelines watching the carnage. Once the madness starts it is difficult to stop. The market falls out of fear like a freight train and no one wants to get in front of it.

What finally calmed the markets was a direct injection of capital by the Treasury into nine of the nation’s top banks. In other words, the government is guaranteeing the basic plumbing of the financial markets. Treasury Secretary Paulson asked the nation’s top bank executives to a meeting in Washington on Monday October 13th. At 3PM Treasury Secretary Henry Paulson, flanked by Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair welcomed the executives to one of the most important bank gatherings in history.

For an hour, the nine executives listened to the Paulson and Bernanke paint a dire portrait of the U.S. economy and the unfolding financial crisis and how the government intended to buy a stake in each of their firms. Each banker was handed a term sheet detailing how the government would take stakes valued at a combined $125 billion in their banks in the form of preferred stock, and impose new restrictions on executive pay and dividend policies. The participants, among the nation's best deal makers, were in a peculiar position: they weren't allowed to negotiate. Mr. Paulson requested that each of them sign the deal and described it starkly. He told them that they could accept the government's money or risk going without the infusion. If their companies found they needed capital later and couldn't raise money privately, Mr. Paulson promised the government wouldn't be so generous the second time around. Paulson argued the plan represented a good deal for the banks: The government would be buying preferred shares, and thus wouldn't dilute their common shareholders. And the banks would pay a relatively modest 5% in annual dividend payments. Each bank was asked to participate so that no bank would look weak by accepting the capital infusion. The meeting ended at about 4 p.m. By 6:30 p.m., all of the sheets had been turned in and signed by the CEOs.

The magnitude of the infusion into the banking system calmed the stock markets and allowed the credit markets to thaw. Banks have begun lending to other banks and businesses again. The panic and fear that had gripped the markets has abated, but the de-leveraging process is now reverberating through the Main Street economy.

Umbrellas, Dinosaurs and the U.S. Financial System

2008-09-16T14:50:00.000-07:00

“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it rains.”
Bradley’s Bromide

It is storming in the financial markets and the banks want their umbrellas back and in some cases are they are then closing their doors. This is the complete restructuring of the U.S. financial system and everyone is hoarding umbrellas.

Sunday night was surreal. I was folding laundry and watching a Discovery Channel program about the lives and extinction of dinosaurs with my family. During ads I was allowed to switch the channel to the financial stations (CNBC) and hear about the extinction of the U.S. Investment Banks. In my 30 years in the financial industry I have seen restructures, consolidation and failures before but this was a mass extinction. On Sunday it somehow seemed apropos to be learning about the extinction of both dinosaurs and investment banks.

Someday I may be telling my children the story of the five investment banks that like the three little pigs built their homes of sticks and straw. Only in this case none of the five investment banks built a house of bricks. So no one was saved from the big bad wolf.

Why is this such a significant event that the press is now calling it Black Sunday? The failure of our banking system is the equivalent of a heart attack for the U.S. markets. It will take a complete heart transplant to revitalize our capital system. The flow of credit is the blood that keeps our economy humming. When banks fail, lending contracts, business can’t grow and the economy contracts. What might save us this time is the globalization of the banking system that has occurred over the last 15 years. We no longer supply the entire world’s capital needs. In fact, the funds used to prop up most of the financial system this year has come from Europe and the Emerging Markets.

It is this new global banking system that will help to resuscitate us. Our financial system will emerge more humble and more conservative (not as leveraged). We will re-emerge but gone will be the high flying dare devil acts that were so common on the street. Profit margins and growth rates for financial stocks will be much lower than the steroid pumped returns we had grown use to. Our stature in the world as financial power will shrink as well. Our economy will be contending with the fallout from this implosion for years to come. The good news is that we are dealing with our problems unlike the Japanese that just left their banks on life support and never operated.

In the long run our economy will be fine. It is important to view your investments as long run commitments. Would you buy a house and then a few days later sell it in a panic? No, so why would you treat your portfolio that way? In the short run the markets will continue to be down right frightening. Volatility is at a thirty year high. This is exactly the wrong time to be selling. In fact, this is the point when you start buying. No one can call the market bottom, so this is the time when smart investors start cherry picking.

Is your Money FDIC Insured?

2008-08-15T09:24:00.000-07:00

Three banks failed last month and some 90 more are on regulators' troubled list. Could you lose your deposits if your bank fails? Yes, you can even if you are covered by FDIC insurance. The reason, depositors don't realize that they have to obey all the FDIC's rules.

In general, you'll be O.K. if you have less than $100,000 in any one bank and up to $200,000 in joint accounts. Some retirement accounts may be covered up to $250,000 as long as they are not brokerage accounts. But just to be sure, go to the FDIC's web site shown below and plug in your account information into its calculator, the electronic deposit insurance estimator. If that exercise informs you that some of your money lacks insurance, the first step is to try changing your accounts' ownership status. For example, by titling one account in your name, one in your spouse's name and one jointly, you can insure as much as $400,000 in deposits at that one bank.

FDIC Calculator

Or you can spread your money among banks and insure an unlimited total amount, as long as you keep under the limits discussed above for each institution.

If you have so much in the bank that this seems like a lot of trouble, check out the certificate of deposit account registry service, known by its acronym CDARS. It lets you keep up to $50 million in CDs with one home bank. That bank then parcels out your holdings among other banks, so that you stay fully insured. Interest rates will be lower than you could get on your own, but then again you won't lose your money if your financial institution fails. Check out the website for more information on CDARS.

CDARS

Investment Discipline

2008-07-22T17:28:00.000-07:00

“History is merely a list of surprises. It can only prepare us to be surprised yet again.”
Kurt Vonnegut
Having experienced a multitude of market crises, I realize that history never repeats itself exactly, so I’d be arrogant not to admit that almost anything can happen from here. It is a distinct possibility that things will get worse before they get better in the stock market. Even if the economy holds up, fear and pessimism could cause of investors to panic and send the market down further than justified by long-term economic fundamentals.

At times like this, it is essential to have a sense of perspective and rely on sound long-term investment disciplines when making decisions. It is important to avoid panicking because of short-term market concerns and uncertainty. It is easy to put too much weight on negative scenarios when all you hear is bad. Inevitably, investors always flee the stock market at just the most inopportune moment, when the tremendous bargain basement deals are obtainable. I love the chart above because it shows how the average equity investor underperforms the markets. He has only earned 4.5% per year over the last twenty years due to emotional trading. Over the same 20 year period, the S&P 500 domestic stock index earned 11.9% per year and the bond market earned 7.9%. The average equity investor missed out on these returns by fleeing the market at the low and re-entering when it has already recovered. Dalbar Inc. calculated the average investor’s performance using net aggregate mutual fund sales, redemptions and exchanges by month for twenty years.
Bubbles lead investors to make errors in judgment, thereby mispricing assets on the way up. Investors do not understand the risks they are taking and what could happen. On the flip side, riskier assets often fall to bargain prices on the way down when investors are frightened. The risks become clear: investors panic when losses start to accumulate and flee the market. This pattern of overzealousness-followed-by-panic repeats throughout the history of mankind.
While the perspective gained from years of experience is useful, humbleness is just as important. It is crucial to always be open to market signals and stay intellectually honest about factors you can and cannot assess. Or else you will miss when the market is warning you that it isn’t the normal boom-bust cycle but a full scale melt down. I spend hours assessing risk, global economies and investment markets. I try to communicate what I have learned to you through my blog, newsletters, phone calls and meetings. At this point, this is a normal bear market. Fleeing the markets now would be a big mistake since stocks are priced to outperform bonds over the next five-years. Second, big market downturns invariably present opportunities - you just have to have conviction.
Since 1946, there have been nine bear market declines of 20% or more. The average drop was 32.5% over 14 months. The average bull-run lasted 70 months, with average returns over 185%. While this does not guarantee future results, it certainly provides food for thought. With major indices down about 20% from their October 2007 peaks, it would not be surprising to see the markets fall another 10%, at least from the perspective of history. Many traders are now referring to 2008 as the Year of Capitulation.
It has been a tough first half, and even some legendary money managers have taken a hit. GuruFocus.com follows the trades of legendary money managers and keeps track of their results over 6-month and 12- month time periods. If you think your portfolios performance has been dismal, you may take some consolation in seeing how many Managers of the Year and other top-notch investors have been (Marty Whitman down 43%). Even Warren Buffett is now in negative territory for both the 6 and 12-month periods just ended. Warren has a great perspective on market down turns. He said at his recent shareholder meeting, “If a stock [I own] goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all my stocks to go down 50% over the next month.” Mr. Buffett wants the price to decline so he can buy more cheaply. I wouldn't bet against any of these guys rebounding in a big way once the market picks up in the future.

Week in Review

2008-07-21T14:06:00.000-07:00

As a result of good news last week, stocks were able to break their multi week losing streak. A combination of stronger than expected earnings announcements, introduction of the governement's plan to save Fannie Mae and Freddie Mac, short covering and outright buying in the financial sector and a sharp correction in oil prices. The S&P 500 rose 1.7% to 1,261, the Nasdaq climbed 2% to 2,283 and the DJIA increased 3.6% to 3.6% to close at 11,497. Financial stocks led the way, advancing over 11% while energy, utilities and materials all declined. Inflation worries still pursist but falling oil prices will add some stability to the stock and credit markets.

Bonds - Why do we own them?

2008-07-21T07:42:00.000-07:00

Bonds are worth owning. Yes, the credit markets are a mess and bonds did fall in value during the Second Quarter 2008 but bonds offer stability. Bonds are much less volatile then commodities, stocks and residential real estate. See the adjacent chart. Bonds have a standard deviation of only 1.1% while oil's is over 9%. Standard deviation measures how scattered the returns are from the average. The more variation the higher the standard deviation. The down side is bonds earn less than stocks. So even though stocks are more risky in the long run they generate a higher return.

I view bonds as an insurance policy. How much long term return do you want to give up to gain stability? You are essentially buying an insurance policy for your portfolio the way you would for your home. In the case of property insurance, the question is how much current income are you willing to spend to protect you home from a catastrophic event. You are never going to make as much money invested in bonds instead of stocks. So how much do you need to invest in bonds to protect your portfolio from a catastrophic event? That depends on whether you need the money now or are years away from retirement. It depends on how well you can handle short term market swings. It depends on how much money you have and how much money you'll need and when. So the answer is it depends on your needs and your money personality. In other words, there is no magic formula. So it is important to carefully address all these issues when determining your allocation to bonds.

Short Selling

2008-07-18T10:13:00.000-07:00

In order to bring more stability to the stock market the SEC acted this week to retrict naked short selling. Here are three good stories on NPR (National Public Radio) that discuss who, what and why of it all.

Short-selling-profiting-from others misery

What-is-naked-short-selling

SEC Cracks down on naked short selling

Global Focus is Now Chic

2008-07-17T16:50:00.000-07:00

Look whose going global! First it was California Public Employees Retirement System (CalPERS) and now it is California's other big pension fund California State Teacher's Retiriement System (CalSTRS).

The proposal by CalSTRS' staff reflects a greater interest by institutional investors to move from a home-country bias and have their equity portfolio reflect the broader global market. CalSTRS could move some $15 billion to overseas equities from domestic stocks if its investment committee approves.

At Altamont Wealth Management, we have been actively shedding our home country bias and moving towards a global allocation for two years. It is great to hear that the large institutional pension funds are catching up.

Going-Global

Second Quarter Market Review

2008-07-16T10:22:00.000-07:00

"You make most of your money during a bear market; you just don’t realize it at the time." Shelby Cullom Davis

The first half of the year had all the thrills and chills of a bad horror flick. There were nauseating triple digit declines in the U.S. market, warnings of collapse among players in the global financial system and the subprime-mortgage-housing foreclosure crisis debacle. Then we had a rally in early spring and investors breathed a sigh of relief as many believed that the subprime monster had been tamed and the worst was behind us.

Ah, but never underestimate a bad horror movie. There was more than just one monster in this picture. The oil monster was on the rise and he scared consumers out of their SUVs. His pal, the inflation monster, also caused fear as he caused food prices and healthcare costs to rise. In response, the markets ran scared and fell hard again. These last two monsters, oil prices and inflation, delivered a one-two psychological blow to the markets. Investors had been lulled into feeling safe by the early spring rally that had pushed the market averages into positive territory for the year. Of course, everyone knows that you can never be safe until the hero, Obama or McCain, captures the monsters and saves the economy. But I am getting ahead of myself; let’s first talk about the second quarter.

So a sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with large-cap stocks dropping over 8%, resulting in a 3% decline for the second quarter. Surprisingly, Mid Caps and Small Caps hung on to have a positive quarter with the S&P400 Mid Caps rising 8.7% and the S&P 600 Small Caps up 3.5%.

Value stocks fell across the board, which is not surprising since the financial, mortgage and housing stocks are all in bad shape. Conversely, Growth stocks were positive across all market caps. Domestic high-quality bonds were down just over 1% for the second quarter and up just 1% for the year. Though not a good return in a normal environment, bonds did provide balanced investors with a modicum of protection from stock-market losses, which is part of their role.

Being diversified outside of U.S. stock market didn’t help much. Developed international markets fell 2.3% for the quarter and are down almost 11% year-to-date. Emerging markets were positive for the quarter earning 2.2% but are still down almost 10% for the year.

Interestingly, international bonds have performed well this year. They are one of the least risky ways to profit from the declining dollar. Emerging market debt has performed admirably, reflecting the rise in third world countries on the economic world stage. PIMCO Developing Local Markets was up 3.3% over the quarter and 5.8% year-to-date. PIMCO Foreign Unhedged that invests in developed countries was down 5% for the quarter but still up 5% for the year.

The only relief domestically was in the commodities markets which have profited from rising food, metal and oil prices. Unfortunately, commodities look like a speculative bubble that is going to pop.

Last Week in Review, Market Shorts at Bearish Levels

2008-07-14T09:43:00.000-07:00

Another icky week and more worries. Once again stocks declined last week in the face of credit concerns, recession worries, high oil prices and inflation fears. The S&P 500 fell 1.8% during the week to 1239. we are firmly in Bear territory now.

As we have discussed before the Fed is between a rock and a hard place. It cannot serve dual mistresses of low inflation and economic growth. So in order to keep the peace it will have to keep the Fed funds rate at 2%. It will continue to aggressively use what ever tools it has at its disposal to create liquidity and fight off market instability. We will continue to see the Fed step in as necessary as it did this weekend to provide liquidity to Fannie Mae and Freddie Mac.

The next chart highlights the amount of short interest in the market today. This measure depicts the percentage of trading volume that is betting the market will go down. Historically, levels this bearish have been fore bearers of future market rallies.

So what is the outlook from here? Presently, the U.S. equity market is in the process of making its third bottom (the first occurring in mid-January and the second in mid-March). The next notable move will probably be up as fears begins to abate.

As long as oil prices keep rising, stocks will remain under pressure, central banks will be unable to act and the risk of recession will grow. In the long term, for the markets to recover will require oil prices to abate which means the demand for oil must subside. Demand pressures should subside as the global economy continues to slow. It will become ever more difficult for oil prices to continue their unprecedented drive higher as demand pressures abate. The bottom line is that a correction in oil prices is a necessary if the world economy is to avoid a major slump, for inflation to decline and for equity markets to enjoy a sustained rally. At this point oil prices haven't shown any weakness so it is unclear when things will begin to get better.

Credit Reporting Agencies: Errors, Impacts and Problems

2008-07-07T10:15:00.000-07:00

If this can happen to a well known reporter on NPR then it can happen to you!

Terry Gross and her husband recently had a tusssle with credit rating agencies when they assigned credit problems inadvertently to her husband. They had to hire an attorney to help straighten out the mess with the rating agencies.

Terry discusses the impact of credit agencies on our lives with Prof. Elizabeth Warren, a specialist in bankruptcy and contract law at Harvard Law School. It is a very informative discussion.

http://www.npr.org/templates/story/story.php?storyId=92049490

Bruce Berkowitz, Manager of Fairholme

2008-07-03T16:44:00.000-07:00

Here are some comments made by Bruce Berkowitz, Manager of Fairhome at the 2008 Morningstar Conference in Chicago last week. He addresses potentially closing his fund, the recent change in the fund's charter and the future of his fund. These remarks were made after he had spoken on a panel.

Pimco's Mohamed El-Erian at Morningstar Conference 2008

2008-06-30T11:11:00.000-07:00

I am attended the 2008 Morningstar Conference in Chicago. I am trying something unusual. I am going to try and post my notes on the most compelling speakers and publish them. The opening address was given by Mohamed El-Erian from Pimco. He presented his current Investment Outlook. Here are my notes:

Notes Morningstar Conference 2008
June 25, 2008
Mohamed El-Erian, Pimco
Investment Outlook

New book
When Markets Collide
Co CEO and co CIO of Pimco

Objective is to share my thought about opportunities in the markets. It is a very fluid and uncertain environment. I will use a simple framework which speaks to what is happening and sheds light on opportunities and risks that we are facing.

It is hard to believe what has happened over the last year. The unthinkable has become thinkable. This is not noise, this is a signal. Understanding these signals is the key to managing money well.

A year ago, none of us would have predicted that the next crisis would occur here and not a third world country. That bank runs would occur here in the US and United Kingdom versus the rest of world. That our banking system would raise $350 billion of new capital to replace a similar amount it had to write-off. What is even more significant is that this recapitalization is from the poorer third world countries and not from traditional money centers. I could not have made these predictions a year ago.

I would submit that the markets are trying to tell us something.

If you were in the FOMC meeting, you would hear the members discuss how worried they are about inflation, employment, and the dollar. The issue: the Federal Reserve cannot fix these all of these problems simultaneously. They must pick between growth and inflation. Unlike the European central banks, whose mandate is to focus on inflation, the US Federal Reserve must respond to multiple factors.

There were signals early on of the problems to come. They cropped up as conundrums, puzzles, and anomalies. We have gone from serial inconsistencies (or sequential) to all-together simultaneous inconsistencies.

It is important to understand these changes and navigate thru portfolio asset allocation and rebalancing. These represent great opportunities but great risk. Retooling is critical but don’t fall in love with answers.

#1. Disruptions this time are taking place in the heart of the US financial system. This system is crucial to our economy. It is like the oil in your car - without it the car grinds to a halt. (Additional Explaination from Libby - Restructuring the Financial sector is the equivalent of the U.S. economy getting a heart transplant).

This is a story about systemic risk and how the banking system itself mispriced the risk.
As the market looks at risk it currently is re-pricing it through the market. Currently the market is saying through pricing that Citigroup and Goldman are riskier then Brazil and Mexico. So the contamination is very different this time. Our impact on the world is different this time.
In 2000, the breaking of the technology bubble had a greater impact on the global markets than the US. This time the origins and the impacts of this crisis are different.

The Casualties:
1. The Credibility of the most sophisticated financial system of world
2. Effectiveness of policy and the credibility of our policies
3. Highly leveraged institutions and transactions have been hurt the most
4. Just-in-time risk management system has been debunked, due to lack of confidence
5. Comfort with the “originate and distribution” model

On the whole the rest of world didn’t get hurt by this but has to deal with consequences.
Imagine a horse race. In February 2007 three horses started running a race.
“Deleveraging Process” was first out of the starting gate
“Capital Raising” – the most hesitant horse until it saw how far ahead the deleveraging horse was, then started galloping
“Policy” was the sleepiest and saw the race was long. It started only in August

The distance between horses is shrinking. You must be cautious when the distance between horses is lengthening. What counts is the distance between horses for each asset class.

We have had a sequential re-capitalization process for a while.
In the early 90s, it was the Emerging Markets.
In the early 00s and mid 00s, it was corporations like Enron.
Today it is the re-capitalization of our financial sector.
This is inherently risky to do because it is at the center of the capitalist system. (Like heart surgery – you’ve got to keep the patient alive).
Tomorrow it is the US Consumer due to the housing market and consumer debt levels.
We will end up with a stronger system after it is all over. We are very lucky these things have all happened sequentially versus simultaneously.

But the implications go beyond this. There are drivers of global change. The markets of yesterday are colliding with the markets of tomorrow. There are handoffs. The developed countries are handing off to the developing economies.

The growth handoff – the gradual realignment of global powers, has now reached critical mass. No longer will the handoff be slow. We think in linear terms like markets and infrastructure but development is now non-linear. We are use to nothing happening for a long time, but change is speeding up and now it will happen all at once. (Change in these growing markets overseas will be exponential.)

Next is the Wealth handoff. Wealth will shift to Asia, the Middle East and other Emerging Economies. There has been a turnaround in inflationary dynamics from global dis-inflation to inflationary pressures, which helps these countries.

Last:
There has been a change in the barriers of entry to markets. Emerging economies are now driving global growth. A trillion dollars of accumulation and consumption has now moved out of our economy.

The US Consumer market has hit a harsh head wind. Consumers can’t access house equity – the ATM card is gone.
It is near the time when people en masse will walk away from their homes. It has already begun - people are falling behind in their mortgage payments before falling behind in other things. Historically, this has never happened before.

There is a trader in a hot air balloon floating in the sky. He spots a man on the ground. He asks where am I? The man answers: You are in a hot air balloon floating above the ground. The trader is disgusted. This does not help him at all determine where he is. The trader yells back – Are you an analyst? The gentleman on the ground says, Yes how did you know. The trader responds, you gave me accurate information that is totally useless. The Analyst yells back, Oh you must be a trader. The trader says how did you know? The analyst responds, You don’t know where you are, how you got there and where you are going, and you are still blaming the analyst.

There are going to be opportunities and risks, and if you are like the poor trader you will not survive.

You need to have total clarity about return expectation and risk tolerance. Revisiting asset allocation for secular robustness is crucial for success. The choice of investment management vehicles in the context of this new configuration of risk will make all the difference. Portfolio and manager must reconcile challenges. You must ask yourself - What mistakes do I usually make and what could happen? Then analyze what the outcomes could be of these mistakes in this new world. Your risk management analysis should include “fat tail” protection. It is essential to set up proper procedures and structure, so don’t fall victim to human nature.

You must have a mentality of constructive paranoia. Openness to appropriate re-invention and internal mechanisms will avoid second guessing. You must have Secular and cyclical anchoring.
Understand the pitfalls of “rational fools.”

A sociologist and animal behaviorist created a test. They took a starving donkey and set up a situation where the donkey had to pick between the same amount of hay spread out or concentrated in a pile. The donkey saw no difference between the piles and refused to pick, thereby starving to death.

The moral, if we get paralyzed and do not change then we lose. Doing nothing is not a choice.

Don’t treat this as a one-time disruption. This is going to be a bumpy journey. Don’t think we are ever going back to business as usual (or the way it was before the sleeping emerging markets woke up). Don’t forget that this crisis involves opportunity and a new capital structure.

We are living through a bumpy secular transformation. Old and new markets are colliding. New opportunities are wrapped in new and complex configurations. Re-tooling is necessary for survival.

Soft decoupling process. In the past, when our economy hit the skids we took the world with us. Now we are in a process of slowly decoupling our economy from the rest of the world. Now when we slow by one unit the rest of the world will still slow, but by less. So world will outgrow moving along with us.

We will continue to experience demand shocks to commodities because the Emerging economies are driving growth. They are making new and bigger demands. They are inefficient users of commodities. Conservation is not a word they know. Commodities are now expensive and more volatile and will stay this way. The very shift in prices itself signals a new and different volatility.

Question: What will it take for the market to recover?
The key to our recovery lies in the housing market and consumer.

Last Week in Review

2008-06-23T17:40:00.000-07:00

Last week in every market segment was down including energy, materials and utilities. Overall, it was a tough week with the S&P500 down 3.1%, Nasdaq fell 2% and the Dow Jones Industrial declined 3.8%. Year-to-date the S&P500 is now down 9.3%. Small caps continue to outperform large (less negative) and growth is trouncing value investing. Market jitters continue and the bears are winning.
Oil troubles continue with prices rising to new highs. Increasing energy prices have stoked inflation fears. The numbers of speculators in the commodity markets is growing rapidly only adding to the feeding frenzy. In addition, escalating tensions between Israel and Iran is adding instability to an already rocky oil market. The scuttlebutt is that Israel will bomb Iran with assistance from the U.S. in the next six months. Oil prices will soar to over $200 a barrel if Iran is attacked. Baring an attack, the energy markets look very frothy and should retrench from these lofty levels.
Problems in the financial sector persist. Banks have only written off one-third of their bad investments and the housing market is rapidly disintegrating. These problems will not be fixed overnight. Until the housing market begins to recover the economy and markets will stay in turmoil.
Inflationary forces continue in the developed and developing world is reaching the choking point. Many economists feel inflation is not that bad because it has not spread to workers. Rising unemployment is keeping wages down. So in economist-speak inflation is not so bad.
In the real world the problem is that the collapsing housing market in conjunction with rising food, energy and healthcare costs have taken the consumer out of the market. I know I write this all the time but two thirds of our Gross Domestic Product (GDP) is generated by consumer spending. Consumers aren’t spending (look at the recent performance of retailers and automobile manufacturers). Consumer lead recessions (vs. business lead recessions) are always deeper and take longer to recover. It takes more time to build up consumer sentiment and get consumers spending again. This is not going to be an easy and quick V-shaped recovery. It will probably resemble a very wobbly wide W-shape.
The Fed is talking hard ball and many of its members want to raise the Fed Funds Rate when they meet. It will be difficult for them to raise rates any time soon because it would bring this fragile economy to a screeching halt. Instead, they will have to keep rates where they are and if things get worse they may have to lower rates again.
In the short run, the market will remain choppy with equities swinging significantly down on bad news and moderately up on good news.
I will be in Chicago this week at the Morningstar Conference. I hope to meet with numerous portfolio managers of mutual funds. I will be reporting back my findings and interviews.

Last Week in Review

2008-06-16T10:28:00.000-07:00

Concerns over energy prices, weakening consumer confidence, a mixed inflation report and some increased activity in the merger-and-acquisition calendar caused U.S. stocks to experienced mixed performance for the week. The S&P500 Index was basically flat, falling one point to 1,360. After last week, the index was down just over 6.5% for the year. Large value stocks are the worst performing for the week and the year, down 7.8% year-to-date. Small and Mid Cap stocks are still out performing Large Caps.

Data last week pointed to continued weakness in consumer confidence, which acted as a drag on stock market performance. Historically, extremely low levels of consumer confidence have often presage market rallies. In fact, in the 12 months following the 10 lowest readings of consumer confidence over the last 30 years, stocks were up an average of 20%.

The big news last week was inflation. The CPI (Consumer Price Index) for May posted its largest monthly increase since last November, primarily due to energy prices. Core CPI inflation (which excludes energy and food prices) remained low. I do not believe that inflation is low even if you exclude food and energy. The government’s method of calculating inflation is flawed. It manipulates the calculation, substitute’s goods and then under estimates the price of improved goods. Inflation is a political hot potato and the incentive is to keep it low. The government has to increase social security benefits by the rte of inflation so low inflation equates to low benefit payout increases. Broad-based inflation in the U.S. is picking up and if our inflation is the same as most of the developed world then our inflation rate is around 7% which would mean we really are in a recession.

This leaves the Federal Reserve between a rock and a hard place. Deteriorating economic growth combined with the credit market issues has forced the Fed to keep dropping interest rates. On the other hand, the Fed is feeling pressure to increase rates due to rising inflation, the weak U.S. dollar and high oil prices. At this point, the Fed is talking tough (saying they plan to raise interest rates and that the dollar should strengthen) which is helping to bolster the equity markets. However, the Fed is unlikely to raise interest rates any time soon, given ongoing credit market problems. In fact it is entirely probable that the Fed may have to lower interest rates despite their hawkish rhetoric. The near term will continue to be bumpy in the equity and credit markets. The deteriorating economic climate here and abroad coupled with the worsening energy crisis will cause the markets to struggle for the next few months.

Commodities: Short Term Bubble

2008-06-10T08:15:00.000-07:00

In January 2007 oil was $60 a barrel and this morning it is approximately $137 a barrel. It is a mind boggling rise in prices that has hurt consumers and attracted significant media attention.

Speculators are widely blamed for this rise. See the attached graph by JPMorgan which shows the marked increase in speculators participation. Speculators are partially to blame for this run up but there are sound fundamental reasons for this rise. There is more demand for oil (think emerging countries like China) and a tight supply. The third impetuous is rising political risks in the Middle East. It is very likely the U.S. and/or Israel will bomb Iran before Pres. Bush leaves office. This will destabilize the supply of oil causing the price to escalate further.

Goldman Sachs sees crude rising to $141 a barrel and possibly $200 a barrel in 2009. As with all bubbles it is hard to see where and when we will reach the top and how far and swiftly we will fall when it bursts. The bubble will burst as demand begins to wane (as growth in China continues to slow and demand in the developed country contineus to drop) and supplies stabilize. Speculators will leave the market like rats off a sinking ship. This might not happen for at least a year but it will happen. I do think long term that a 3% allocation to commodity futures is a good diversifying investment if you are using futures and the DJ AIG Commodity Index. The road will be pretty bumpy and beware of any erosion in the oil futures market.

Last Week in Review

2008-06-09T10:54:00.000-07:00

The U.S. stock market fell sharply last week. The market consistently fell during the week with only positive trading day mid week. The bulk of the decline occurred on Friday due to new unemployment data for May and another dramatic rise in oil prices.
For the week the S&P 500 declined 2.8% and is down 6.5% year-to-date. Mid and Small Cap stocks held up better than the Large Caps last week and for the year. A trend not predicted by most market prognosticators, including myself.

Last Friday’s unemployment report showed greater weakness in the labor market than expected in May. The drop was significant, with payrolls declined by 49,000 and unemployment surged to 5.5%. Some economists postulate that this spike in unemployment may be a one-month aberration; however the labor market clearly has been weakening in 2008.

The negative side of the economic story is clear, with headlines focusing on housing and higher commodity prices. The primary main story rolling forward is going to be inflation, and its impact on consumers, interest rates and the markets. Inflation and tightening credit have restrained consumption in recent months and are likely to remain headwinds for some time to come.

Last Week in Review

2008-05-27T11:00:00.000-07:00

Last week was brutal. The market traded down in front of the three day Memorial Day weekend. It is not unusual for the market to decline in front of a long holiday weekend. Many investment banks and market makers do not want to sit on a large inventory of stocks over a long weekend. What is unusual is the magnitude of that fall. The S&P 500 fell 3.5% over last week and has fallen 5.5% year-to-date. The pain was evenly spread between growth and value but Large Cap domestic stocks have fallen more than Small caps for the week and the year. No one is more surprised by these results then me. I truly thought that Small Caps would take it on the chin this year and Large Caps with their international exposure would outperform.

All major sectors of the market were negative last week and year-to-date only energy and materials sector are positive. It is not a surprise that financials are the hardest hit sector. The chart below is a pictorial summary of last weeks market action and was produced by JPMorgan.

Manage Your Credit Card Debt Away

2008-05-27T10:13:00.000-07:00

Every once in a while you find a great website that is truly helpful and not gimmicky. I ran across one such website the other day. It was created by the cooperative efforts of Utah State University Extension and WebAIM.org. The website primarily helps consumers gain control of their consumer debt. It has a great calculator that lets you enter your specific debt information for each obligation. The site then calculates how long, at that rate, it will take you to pay it off and how much it will cost you in interest. You can also see the impact of making additional monthly payments to each credit card or loan.

It will also help you establish an Emergency Fund plan so you are prepared if you lose your job or the unexpected happens. It also has a calculator that helps you determine how much debt you must pay off to qualify for a mortgage.

There is also a section that helps individuals develop a spending plan. It helps you allocate your take home pay and makes suggestions for different expense categories (i.e. food usually comprises 18% to 25% of your income).

The Educational Center has dozens of helpful how to articles on topics as diverse as selecting a credit card to how to protect your self from insurance fraud. These are pithy articles just chocked full of good tips.

You will need to setup a profile with username and password to start exploring this site but it is totally worth it.

Please pass this site on to anyone who has is having trouble managing their debts. It is also a great site for educating teenagers or kids about money. I always wonder how many kids would run up credit card debt if they knew how much it costs. There is a great article offering helpful suggestions for parents on managing allowances.

Powerpay

The Fed at Work: A Play-by-Play Commentary

2008-05-23T12:06:00.000-07:00

Relying on both conventional and unconventional means, the Federal Reserve (Fed) has been attempting to break the credit crisis’ stranglehold on the economy. It has been extraordinary to watch the Fed take actions that have not been used since the Great Depression, and a few actions that have never been used.
The Fed needs to be aggressive because the current liquidity crunch in the credit and mortgage markets is creating a negative feedback loop between the financial markets and the U.S. economy. The strain in the credit markets is putting pressure on the broader economy, leading to further weakness in the housing market, which then creates further dislocations in the credit markets, etc., etc., etc. Additional aggressive policy action by the Fed will be essential to break this self actuating spiral.
Since September the Fed has slashed its overnight lending target to 2.25% from 5.25%. It has also injected $200 billion into the credit markets by opening the Fed’s borrowing window to non-banks (such as investment banks), and has loosened collateral standards for these short term loans and now accepts lower rated asset-backed securities. In other words, an institution can pledge riskier bonds as collateral and receive Treasuries from the Fed. The Treasuries can easily be sold to generate the cash needed by the firm to meet its obligations. These loans are short term and will have to be paid back but in the mean time liquidity has been improved which will prop the credit markets up and keep the asset-backed bonds and lower credit quality bonds from falling further.
The Federal Reserve has now committed approximately half of the Fed’s portfolio to the fight and has pledged to commit more if necessary. Essentially, the Fed is using its own balance sheet as a tool to inject funds into the market right where it needs it the most. It is this type of creative aggressive action that is requisite if the Fed hopes to break the negative spiral between the economy and the credit markets.
The Fed also stepped in to ensure that Bear Stearns did not go under. Bear Stearns found itself in trouble because Wall Street began to question whether the investment bank had the necessary capital to back all its trades and bets. The firm was the highest levered investment bank (least assets to greatest debt) on the Street by a significant amount. Bear Stearns was not a very popular investment bank with its compatriots due to its aggressive brass-knuckle tactics. The combination of its bad rap and the high leverage ultimately set the stage for its demise. The firm began to go under as investors pulled their money on rumors of illiquidity and lenders called their loans and refused to extend additional credit. It was a classic run on a bank, the kind we saw Jimmy Stewart stave off in “It’s a Wonderful Life.” It was the old one-two punch. I feel no sympathy for the executives at Bear Stearns. If you swim with sharks, you do business with sharks, you act like a shark, then you are a shark and may be attacked, killed and eaten by other sharks.
The Fed stepped in and helped negotiate the purchase of Bear Stearn’s by JPMorgan for $1.2 billion in stock. In addition, JPMorgan will also absorb any losses on the first billion dollars of $30 billion of Bear’s riskiest assets. Those assets will be managed independently by BlackRock. The Federal Reserve Bank of New York is guaranteeing the remaining $29 billion, and in return, will reap any gains from that portfolio.
Why bail out Bear Stearns? After years of never allowing any of our financial institutions to fail, these banks have become so interwoven and enormous that nobody can be allowed to sink beneath the waves. Otherwise, a tsunami would swamp the hedge funds, banks and other brokerage firms that remain afloat. If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures, further hurting the economy and the housing market (the spiral). This bailout is less about saving Bear Stearns and more about shoring up the financial markets, housing markets and the economy.
On the flip side, this deal does not pass the sniff test. Why hasn’t there been another bidder? I find it difficult to believe that no one else was interested. It couldn’t have been that unstable because if the situation were so precarious, why wouldn’t shareholder ownership position be completely wiped out. Instead, a week later the bid is raised from $2 to $10 a share (a $1 billion increase in value). Is JPMorgan manipulating the situation to protect its $91.7 trillion dollar derivative exposure (per Office of Comptroller of the Currency September 2007 reported data) which is backed by only $123 billion of equity? How much of this counter party exposure did JPMorgan have with Bear Stearns? I can only surmise that JPMorgan made a sweet heart deal with the Fed and other governmental agencies. The deal would require JPMorgan to commit whatever resources would be necessary to prop up and acquire Bear Stearns. In return the Fed would not allow other suitors to bid up the price and they would not disclose JPMorgan’s full exposure to Bear Stearns. In essence, the Fed propped up both JPMorgan and Bear Stearns. One bank ate another and won. The game goes on.
The government has also reduced capital holding requirements for Fannie Mae and Freddie Mac from 30% to 20%. This frees up more money that Freddie Mae and Freddie Mac can use to purchase mortgages, thereby shoring up the mortgage-backed securities market. This increase in funds will help add liquidity and hopefully begin to break the gridlock that is crippling the credit markets. The regulatory body that oversees Fannie Mae and Freddie Mac has said they would lower the capital requirement even more if needed.
Congress has begun to do its part to break the spiral. As part of an economic stimulus package enacted last month, the cap on standard mortgages was temporarily increased from $417,000 to $729,750 in high-cost markets through the end of the year. Standard mortgages usually have lower interest rates than jumbos because they can be purchased or guaranteed by Fannie Mae or Freddie Mac. This is a great idea and could have made lower cost mortgages available in some of the most hard-pressed expensive housing markets. Unfortunately, this has just created an intermediate tier to the mortgage market. These tweener-loans are less expensive then the jumbo mortgages but the interest rates are not as low as a standard mortgage under $417,000. The loan originators are pricing the loans to reflect the additional risk they are taking with these tweener-loans because Freddie Man and Fannie Mae could decide to not purchase or guarantee them. So this part of the stimulus plan has been a bust.
Despite the efforts of the Fed, credit markets are not functioning properly. Sizable losses on subprime loans have lowered the capital base of many financial institutions. The situation is exacerbated by a financial system that has, over a period of years, become intertwined in a spaghetti-like fashion through the spread of complex financial products (CDOs, CLOs, CDSs, and the like). This complexity makes it difficult to clearly understand what assets may be at risk, how big those risks may be, and also who is at risk. This uncertainty has led financial institutions to retrench, which in turn makes credit (loans) more expensive and less available—even while the Fed tries to make credit less expensive and more available. If there are any more major disruptions in the credit, the Fed will have a very difficult time restoring equilibrium. According to Bill Gross at Pimco, what Washington really needs to do is get off its “high moral-hazard horse and move(s) to support housing prices… Authorities must act quickly, with a shot of adrenalin straight to the heart of the problem: housing prices…The decline needs to be stopped quickly in order to avert additional crises.”

PIMCO's Mohamed El-Erian, co-CEO Interviewed on NBR

2008-05-22T06:34:00.000-07:00

It is a pleasure to hear such clarity of thought after experiencing the daily onslaught of garbage media. Mohamed has it right. The dual threats of inflation and slow growth mixed with an ailing housing market are causing dislocations in the equity and credit markets. PIMCO is right on the money. The economy won't recover until the housing market does. Let's hope that Washington gets it right with its new housing legislation.

Here's the interview.

What teens should know about managing money!

2008-05-21T15:49:00.000-07:00

One of the last taboos is money. We will frequently teach our kids about the birds and the bees before we teach them anything about fiscal responsibility and money management.

If you have teenagers here is a nifty website with some great educational material. Read through the lesson plans and student resource guide for ideas on teaching your teenagers about money management. Spend a little time each week discussing how to manage money properly. After all it is a necessary life skill. Don’t let them learn the hard way. Teach them now how to manage their money so it doesn’t manage them.

Link to Guide and Lesson plans

Recession, Yes or No?

2008-05-20T13:48:00.000-07:00

Does it really matter whether we meet the economist’s technical standards for defining a recession or not? I think the answer is yes! It is clear to just about everyone that the economy is in trouble. Even our Federal Reserve Chairman, Ben Bernanke admits that it is highly likely that we are in recession. He actually used the R word.
The downward slopes of most of the graphs below speak for themselves, but here are a few highlights. Jobless claims are beginning to rise. This past week monthly job losses hit a five year record high. The consumer doesn’t need an economist to tell him that the job market is getting increasingly dicey, just look at consumer sentiment. It is not just the job market that has consumers running scared. The combination of declining house prices, skyrocketing oil and food costs, a major credit crunch as well as rising job layoffs have brought consumer confidence to its lowest point in five years. Let’s face it -we are in a recession or at least flirting with one.

How Did a Few Bad Mortgages Humble Wall Street?

2008-03-26T15:34:00.000-07:00

That was the topic this morning of a persentation I gave to a retired group of seniors interested in investments. Their name is the $ums in Retirement. A great group of guys in Walnut Creek that are retired but actively involved in improving and maintaining their financial health. I really enjoyed talking to them. I promised to post this slide which was orignally a full page article in the New York Times. It shows how mortgages were packaged and sold. If you read this and then my previous posting on Shadow banking you will have better understanding of how a few bad loans could humble Wall Street. To clearly read this graphic just click on it and it will appear full size in a seperate window. Pay careful attention how the BBB rated mortgages in step 3 are miraculously turned into AAA rated securities in step 4. Happy reading!

Shadow Banking

2008-02-26T13:51:00.000-08:00

Shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. These institutions, moreover, have never been part of the “official” banking system; they are unable, for example, to participate in Fed Treasury auctions. But as the credit crisis enters its sixth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding, sparked by the failure in mortgage-backed bonds. This in turn is creating huge instability for “real” banks, partially because regulators and bankers alike have been badly surprised by the degree to which the two (official and shadow banks) are entwined. Financial derivatives of all descriptions are involved, including SIVs, CDOs, and the most egregious CDSs. If you want to understand the shadow banking world you must learn this new alphabet soup of entities and investment vehicles. So follow along as we trace our way through the rubble.
Until this summer, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and credit default swaps (CDS) attracted little attention outside specialist financial circles. Though often affiliated with major banks, they were not always fully recognized on a bank’s balance sheets.
Structured investment vehicles, or SIVs, are bank-linked funds. In a way, they are a virtual bank. The SIVs issued short-term debt at relatively low interest rates and used the proceeds to buy longer-term debt carrying higher rates, including debt backed by mortgages. They have an open-ended structure which could stay open forever as long as they keep buying long term assets and selling short term debt. Why do this? Banks profited by setting up these structures because they pocketed the difference between the short term and long term rates, and they did not have to hold reserves for these loans that were placed off balance sheet. At their peak, SIVs held some $340 billion in assets, a figure that fell to a still whopping $265 billion by early December as they sold off some holdings.
When debt markets froze up in August the fear was that the SIVs would be forced to unload their assets in a panic. That would create big losses, the theory went, and set artificially low market prices for the assets -- forcing financial institutions to take huge write-downs. A government effort to stabilize the markets with the help of three major banks ultimately failed, but it did ward off a complete meltdown. The banks claim they are not responsible for the losses caused by these SIVs. Interestingly, despite their protestations, they are stepping up and taking the write-downs associated with these shadow entities they created.
CDOs are actually bonds, unlike SIVs which are entities which that hold assets. These collateralized debt obligations are structured products backed by an asset that has a cash flow, like a pool of mortgages. Other assets that collateralized these products are corporate bonds in various forms. Here’s were it gets really complicated; there are synthetic CDOs that never owned the asset backed bonds or loans. They gained exposure to these asset-backed loans through the use of credit default swaps. Many SIVs purchased CDOs and synthetic CDOs.
So what is a credit default swap (CDS) and why are these contracts a problem? Brace yourselves, this is a mind bender. This is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit default swaps (CDS) in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast - about $45 trillion, a number comparable to all of the deposits in banks around the world.
Originally, these contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own. However, not everyone who buys one of these contracts has bonds to insure. Some players bought them just to speculate on market movements. These investors were basically betting on which direction the value of an insurance contract would rise or fall, which they did daily based on the market’s perception of risk. In much the same way gamblers make side bets on football games, a financial institution, hedge fund or other player can make unlimited bets on whether corporate loans or mortgage-backed securities will either strengthen or go sour.
If they default, everyone is supposed to settle up with each other, the way gamblers settle up with their bookies after a game. Even if there isn't a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other (just the way an investor would have to put in more capital if the stock he bought on margin fell). Of course, Wall Street investors often use heavy borrowing to magnify their wagers. Recently, the ability of institutions to make good on their many trades with one another is beginning to falter. The turmoil on Wall Street could rock the foundations of the financial system around the globe if the major insurers of these contracts go under.
“What we are witnessing is essentially the breakdown of our modern-day banking system, a complex [or composite] of leveraged lending [that is] so hard to understand,” Bill Gross, head of Pimco Asset Management Group recently wrote. “Colleagues call it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain.” By any standards, the activities of this shadow realm have become startling. Traditionally, the main source of credit in the financial world was the official banks, which typically forged businesses by making loans to companies or consumers. They retained this credit risk on their books, meaning that they were on the hook if loans turned sour.
Why has the financial model changed so radically in the last few decades? Why did the shadow banking system develop? Banks began to increasingly sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds. This was made possible by new regulatory reforms, which have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default. They did this by passing their loans to new vehicles (SIVs) either by creating these themselves or by sponsoring outside fund managers to run them. This was a huge incentive because it allowed banks to make many more loans without having to raise more capital. These new entities have been instrumental in vastly increasing credit over the past three years. Paul Tucker, head of markets at the Bank of England, has described this as the age of “vehicular finance”.
Bob Janjuah, credit analyst at Royal Bank of Scotland, estimates that these shadow banks could have accounted for half of all net new credit creation in the past two years. Because these vehicles typically borrow heavily to finance their activities, they have also been a key reason why leverage (or debt levels) across the financial world has risen so fast without regulators or ordinary investors being fully aware of this boom.
Hedge funds have had an oversized impact on the increase in the supply of credit. Satyajit Das, author and derivatives industry expert, cites an example where just $10 million of real (non-leveraged) hedge fund money supports one $850 million mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending. This is a level of credit creation that is far beyond the wildest dreams of any banker.
Since SIVs and CDOs have never been in the business of gathering deposits from customers, their significance to the economic and financial system has not been widely recognized by regulators and policymakers. The problem now is that the business model behind parts of this shadow banking world looks increasingly shaky. Essentially, the role of regulators in this world was replaced by the credit rating agencies, which awarded high, ultra-safe ratings to the debt issued by SIVs and other vehicles on the basis of historical analysis of the probabilities of defaults and losses across the shadow banking system. Now these vehicles’ credit ratings are being downgraded. As the credit market absorbs this debt, it is contracting. The holders of these synthetic CDOs and SIVs are having the equivalent of a margin call, hence the large write downs
Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial. Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.” (I have to thank Bill Gross from PIMCO for this quote).
The problem is that it is difficult to quantify the losses and impossible to confidently forecast how restrictive credit will be and for how long. There is also fear that credit problems will spread to other areas, such as credit cards which have also had permissive underwriting standards. At this point, it seems pretty clear that banks will have more write-offs over the next few months or quarters and that structured investments (pools of debt that have been turned into securities), which are often highly leveraged, will suffer through more ratings downgrades as collateral values decline further. This suggests that the current trend of less credit and higher costs probably has a way to go. This is true not just in the mortgage market (subprime and prime) but in the consumer and small-business loan market as well.
Problems like these do not get fixed overnight. They take months and sometimes years to unravel. It is obvious that whole parts of this economy (automotive industry) as well as whole regions of the country (Detriot with almost 8% unemployment) are in recession. The temporary fiscal plan proposed by Bush can’t plug this breach. It will, at best, be a small levee holding back a briskly flowing river.
The housing market will still fall, lenders’ underwriting criteria will tighten, consumers will spend less and the economy will slow to a crawl. Why? Because borrowing will no longer be cheap. The Fed can lower the interest rate to 1% but it won’t take the 30 year mortgage rate past 5%. The mortgage lenders aren’t offering teaser loans based on short term rates anymore. Only the 30 year mortgages are primarily available. So now you’ll need to put down a 10% deposit to buy a house and can only borrow at the higher 30 year rates. Fewer consumers will now qualify for homes, cars, and credit card debt. So the consumer is out of the picture. Businesses won’t be able to attain loans as liquidity continues to dry up. As I said before that just leaves the government and its stimulus package is a joke.
This is a mess that will be cleaned up by the next administration. Until then, the economy will bungle along. It will neither recover nor fall precipitously. The economy will be in a coma. The U.S. market should bumble along in the same trading range. As long as the stock market doesn’t get an unexpected big shock (i.e. terrorist attack), we should weather the storm, a little care worn but a good deal wiser. The best scenario for 2008 is nothing happens. This is not very inspiring, but it’s unfortunately realistic. Holding the course will be this year’s mantra.

Mortgage-Backed Securities and the Housing Market

2008-02-21T16:34:00.000-08:00

Most mortgages are not held by the lender who made them to you. They are pooled with others and sold to investors such as insurance companies, mutual funds, foreign banks and pension funds. A different company processes your loan payments. Yet another company represents the investors as the trustee.

The very innovation that made mortgages so easily available, an assembly line process known on Wall Street as securitization, has caused our current problems.

The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding. In the last few years, securitization led to this explosion of bad loans because the agents writing the loans didn’t care if they would ever be paid back. They made a fee by originating the loan and then sold the mortgage (passed on the risk) to another middleman who then passed it on to some anonymous investor. The incentive was to originate loans and to heck with proper underwriting (screening the borrowers to see if they qualified).
The process begins with the entity that originates the loan, either a mortgage broker or lender. The loan is assigned to a company that will service it (collecting borrowers’ payments and distributing them to investors). A Wall Street firm then pools thousands of loans to be sold to investors who want a steady stream of cash from loan payments. The underwriters separate them into segments based on risk called tranches.

Once a pool of mortgages (trust) is sold, a trustee bank oversees its operations on behalf of investors. The trustee makes sure that the terms of the pooling and servicing agreement are met; this document determines what a servicer can do to help distressed borrowers.
By its nature, the complex design of mortgage securities creates unwanted difficulties, which are written to ensure that the middlemen make their profit with little to no risk. Almost nothing in this process is done in favor of the borrowers’ interests. In fact, the agreements require that any modifications to loans in or near default should be “in the best interests” of those who hold the securities. Loan modifications are restricted which explains why many borrowers are having difficulty renegotiating their loans.

Fifteen years ago, the last time the housing market ran into stiff trouble, government-sponsored enterprises like Fannie Mae did most of the work pooling and selling mortgage securities. These enterprises readily agreed to loan modifications, but not so this time. In fact, it is in many cases impossible to determine who really is holding the title.

This is a mess, and many more home owners will lose their homes, keeping the housing market depressed until well into 2009. Why has the implosion of mortgage-backed securities been so destructive to the financial markets? The failure of mortgage-backed bonds has rippled through the markets, hurting financial institutions and the newer non-traditional banking system. This unregulated shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. In the next few days I'll post more information about this sahdow banking system as well as credit swaps, SIVs and more.

The Math: Economy Less Consumer Equals Recession

2008-02-19T11:08:00.000-08:00

Without a doubt, investors will remember 2007 as the year that the housing market collapsed and triggered a credit crunch. The earnings of just about any company that was involved in homebuilding or lending were crushed, and resulting economic worries triggered stock declines for many consumer goods companies. Simultaneously, U.S. exports boomed, reaching an all-time high of 12.1% of GDP. Not surprisingly, companies with significant foreign-based earnings did well. Overseas stocks also delivered great returns, and as these economies continued to grow so did their demand for energy and raw materials commodities from China and other high-growth developing countries.
The last four months have been difficult for stocks as prices have declined substantially from their highs in October 2007. The markets have broken through many technical support levels -- this is true for every major index (Dow Jones, Russell, Nasdaq and S&P), which means that technical damage has been done.
The good news is that the Federal Reserve has finally woken up to the severity of the situation and is working diligently to respond to escalating economic concerns. On January 22, 2008, the Fed unexpectedly cut the fed funds rate by 75 basis points (0.75%) from 4.25% to 3.50% in advance of its policy meeting. The Fed has not cut rates in one stroke by such a large amount since 1982. In making the cut, the Fed cited the “weakening of the economic outlook and increasing downside risks to growth.” This move was desperately needed to ensure market stability and sooth investor fears. Sinc then, the Fed has continued to cut rates and has stated its willingness to cut rates further to shore up the markets.
It appears that the combined impact of the housing implosion and the fallout from the structured finance debacle has pushed the U.S. into recession - or at least whole sectors of the economy are now in recession. How protracted the economic weakness will be and what its full impact on the markets are the new questions to be answered.
The key to an economic turnaround is consumer spending because it accounts for 70% of our economy (Gross Domestic Product—GDP). The falling housing market and the resulting tightening of mortgage lending have hit consumers hard, causing them to spend significantly less. Consumers who are more and more worried about the overall economy have triggered stock declines for many consumer goods companies.
A volatile stock market does not help consumer sentiment either. When you add rising unemployment to the mix, it is obvious that the U.S. consumer isn’t going to go on a spending spree anytime soon. It will be tough to entice the consumer to start spending when it is difficult to borrow, and many are already heavily in debt. Until credit markets are repaired, the consumer won’t start spending enough to cause a recovery, and businesses will curtail spending. If consumers and businesses aren’t spending, that only leaves the federal government, a scary thought. Even the proposed fiscal stimulus plan by the President won’t be enough to turn the tide. When credit becomes this tight, a recession is almost inevitable.
How did credit get so tight? Why are funds more scarce and underwriting criteria toughening? It all started with the mortgage-backed securities and how they are packaged and sold through our unregulated shadow banking system.

Bill Fries with Thornburg International Mutual Funds

2007-12-10T13:31:00.000-08:00

Bill Fries is the lead portfolio manager manager for Thornburg's international mutual funds. He recently participated in the International Herald's global investing roundtable.
Many of my client's hold institutional shares of the Thornburg funds that Bill Fries co-manages.

Friday, December 7, 2007
The International Herald Tribune's 11th annual round table on global investing convened at The New York Times on Nov. 29. Participants in the discussion moderated by Judith Rehak were:
George Evans, portfolio manager of the Oppenheimer International Growth Fund; William Fries, portfolio co-manager of the Thornburg International Value Fund, and David Winters, portfolio manager of the Wintergreen Fund.

We are meeting amid fears that more subprime losses and a credit crunch could turn a U.S. economic slowdown into a recession, affecting Europe and Asia and even the robust emerging markets. Add worries about high-priced oil, the battered U.S. housing sector, and inflation in Europe, and it has been a year of turbulent markets. Against this background, what do you see for 2008?

Fries: After a year like we've been through, I think you have to be more cautious, because one of the things we've learned is that we don't know everything we thought we knew in terms of problems that companies might have. As far as the U.S. influence on the global economy, our monetary authorities are walking on a tightrope, because if they are too aggressive in trying to support the U.S. housing market by dropping interest rates, they likely will end up trashing the dollar even more than it has been trashed. It might be good for some U.S. exporters, but generally speaking I think it's maybe a factor of disequilibrium and would possibly lead to more inflationary pressures from industrial and energy commodities.
I think you need to be careful about company business models and the independence of companies' prospects from direct economic consideration. You want to have companies that have pricing power and the opportunity for volume gains because of innovation.

Asia has been one of the strongest markets in the past year. David, what is your view on that part of the world now?
Winters: I believe that in the history of human beings, there has never been so much material
progress by so many in such a short period of time. And it's our impression that it's not only the people who have progressed so far, but waves of other people coming behind them. So we're very enthusiastic about Asia in the long run. It doesn't mean that there are not going to be bumps along the way, but you've got enormous wealth being created, enormous demand for resources, and a wonderful work ethic. So long term, if you're any kind of investor, you've got to pay attention to what's going on in the Asia sphere.
In Europe and the U.S., I think there's lots to worry about and we think there is also quite a bit of inflation. So I think Bill is right on about pricing power and being cautious. That said, there are some gems in the U.S. and Europe, so we're optimistic long term.

Evans: The biggest story for the rest of my life is what's going on in China and India. But there's a lot that makes me more cautious now than I have been in three or four years. My caution is related to the effect that this subprime issue and related issues are going to have on the availability and price of credit, which inevitably has to have some effect on the real economy over the next few quarters. It depends also on what the monetary authorities do, but one of the marvels of the last two years is just how fantastic business has been for just about everyone. There's a lot of pricing power on everything from a diesel engine to a second-hand hull for a tanker.

Given these uncertain times, where are you finding the most interesting opportunities?
Fries: If the standard of living in emerging markets continues to move toward what Western Europe and the U.S. have had, we will probably have considerable progress in a lot of places, including infrastructure and retailing. The economic boom in China has been going on now for more than a decade at a 10 percent rate essentially, and probably has a long way to go, although it may change character. Some of the things we held when we met last year still look interesting. China Mobile, the cellular phone company, and China Merchants Bank are two that have performed very well. I like to look at history and if you accept the idea that China is in a development stage that might have been like the U.S. in the '50s, we have a long way to go in some of these institutions. Growth rates will be above average and I'm content to stay with those.

What about the more developed markets?
Fries: Europe is showing the way to develop an energy policy, and I think the price of a kilowatt of electricity at the margin from gas-fired sources is creating an umbrella that will ultimately bring green utility generating companies to the forefront. A couple of the stocks we like are E.ON, the German utility, and Fortum, a Finnish utility that is 60 percent hydro, with a big piece of nuclear and a very small part of gas.

Winters: In the U.S, the problems are well flagged, but there are opportunities as well. We do have stakes in a number of companies, and a big stake in Berkshire Hathaway, the conglomerate run by Warren Buffett. Berkshire has come back into fashion because having $40 billion in cash is a good thing in this environment.
In Western Europe, we own shares in Swatch, the Swiss company that makes watches from the basic plastic watch to the middle-range Longines to Breguet. As you have increasing wealth around the world, not everybody can have a big car or a big house, but they all can have a watch. Swatch is very conservative; they have had a stock buyback program and we like that. We also own shares in Schindler, a Swiss elevator and escalator company that is debt-free, and with the urbanization and improvements around the world, they're a beneficiary. And they also have the elevator-escalator service business. We're trying to find niches that should do well, almost no matter what happens.

Evans: We're looking for themes defined by an industry or a group of industries that will grow
sustainably faster than global average growth over the long term, and then look for the winning
companies. Obviously, in emerging markets, a theme is mass affluence. Wealth creation is creating a slew of opportunities, and we have long-standing positions in luxury goods companies like LVMH Moët Hennessy Louis Vuitton. We own Swatch as well and also Richemont, which is the parent company of Cartier and Van Cleef & Arpels. Luxury brands are selling hand over fist in emerging markets. These are not lands of modesty and when you make it, you flaunt it. Also, the vast majority of luxury goods opportunities are European companies with bullet-proof barriers to entry, high margins, and high growth. They're fantastic long-term investments.
We have quite a few investments that are benefiting indirectly from the emerging markets boom, such as ABB, a Swiss-Swedish firm in the electricity transmission business, and Alstom, the French train and subway car manufacturer, and Siemens.
Restructuring is another theme, particularly in the context of Eastern Europe. We own Continental, which is half tire business and half automotive electronics. Their tire manufacturing in Western Europe was very expensive, about €30 per tire and labor. They moved it to Romania where labor costs went down to about €3 and revolutionized the profitability of the business. Another theme we have been investing in for a long time is aging. We own the top three hearing aid makers in the world: William Demant of Denmark, Sonova in Switzerland and Siemens.

What else interests you?
Evans: I am looking at a lot of self-financed growth. When the banks are worried about lending to each other or anyone, it's a healthy thing when a company has the wherewithal to generate enough cash on a sustainable basis to finance their own opportunities. Luxury goods companies are cash generative; so are clothing retailers like Inditex, which has the Zara shops, and Hennes & Mauritz.

Winters: We have certain ways of investing in emerging markets that are different from others. Our biggest position is Japan Tobacco. They have extensive emerging markets positions and they recently acquired Gallaher, the U.K. tobacco group. By putting the two companies together they have a wonderful franchise, a play on emerging markets and developed markets as well, in Japan and Western Europe.
We also like hard assets - for example, real estate. We own a Hong Kong company called Shun Tak with significant historical real estate holdings in Macao, which is on its way to becoming the favorite entertainment destination in Asia. Real estate prices have gone up a lot and we think Shun Tak's management is very good.

I note that you own a number of gambling-related stocks. Is this also related to Macao?
Winters: We like the term "repeat human behavior," and people enjoy gaming and entertainment, so we are involved in the sector. We have a stake in Wynn Resorts, a U.S.-listed company, which is extremely well run and very shareholder oriented. It has assets not only in Las Vegas but Macao and we think they have the premiere properties in both.

And what's your take on energy and materials stocks, which have had a terrific run?
Winters: We own shares in Anglo American, the mining company. They have a big position in
platinum, which is used in catalytic converters, and as the world goes green, Anglo American is a
beneficiary. You also have base metals in there, too, and Anglo owns 45 percent of DeBeers, the
diamond company. We think Anglo is kind of a unique asset play.
And there are niches in this commodity boom. Another company we own in the U.S. is Chesapeake Energy, a natural gas enterprise. Natural gas prices haven't gone up a lot, but it has significant assets, it's well run and natural gas burns cleanly. They have a very significant land base which they are continuing to exploit in terms of looking for more assets.

Fries: One of our holdings is Gazprom, the Russian natural gas producer. To me, natural gas is the next commodity that's going to go global. It has been a local commodity and because of that you have pockets of excess supply. But as oil prices move higher I believe that ultimately, natural gas will follow. One of the principal uses of natural gas in a world that is conscious of global warming will be as the marginal source, because you can't put nuclear power plants in place fast enough. Natural gas will provide the power that will be required in Western Europe and emerging markets so that's a good place to be.

Evans: I own a bit of CVRD (Companhia Vale do Rio Doce), the Brazilian iron ore miner, and I own Impala Platinum for the same reasons as David. We're not overweight, though. The thing that has really powered the materials stocks over the past few years has been a stronger commodities market than has existed on a sustainable basis since the 1970s. Prices won't go up as aggressively in the future but arguably they are sustainable, given emerging-market demand.

Fries: We own Freeport McMoRan, but that's about the only mineral exposure in out international portfolio now. We have owned Rio Tinto and BHP Billiton in past years.

What about the beleaguered banking industry? You both own UBS.
Fries: UBS certainly got caught up in the subprime trading, and a lot of that business is just flat out going to go away. I don't think the institutional end markets that you must have in order to have viable trading are going to be buying some sliced and diced mortgages from the U.S. anymore. In the long run that's a good thing if they pay attention to where they are really strong. I think the [UBS] franchise is too powerful to be ignored and you can buy that at less than 10 times earnings.

Evans: I own UBS and some Credit Suisse, both primarily because of the wealth management
business. Credit Suisse has been a little accident-prone over the last 10 years, but I believe that
management is a lot more aware of the risk they're taking. We're typically very underweight in banks and insurance companies. I like being able to analyze things I understand and if managements at some of these institutions can't tell you what is on their balance sheets there is very little probability that I can. But, the world is getting significantly wealthier, and people want professionals to manage that money. Wealth management is a great business with a great long term trend of more and more assets being accumulated. And it's a very resilient business, too.

Another thing we've been hearing about lately is health, or health care stocks as a defensive measure.
Fries: We own Roche, which has a 54 percent interest in Genentech, the U.S. biotech leader in
terms of creating products, especially in oncology. They have over 20 products in their potential pipeline, and they have the first right of refusal for products that Genentech develops outside the U.S. The other franchise we own is Novo Nordisk, which makes diabetes products. They continue to gain share in the U.S. where there is an aging population impact of diabetes and it has a limited number of competitors. These stocks are inexpensive now because people believe that whoever wins the U.S. presidential election is likely to make it more difficult to sustain high profit margins. That's a way off, and there will be an overhang on these stocks, but we think there is good value in these businesses.

Evans: Most of our health care is franchises in medical devices like Smith & Nephew in the U.K.,which does trauma products, and Synthes in Switzerland, which does the same thing, putting bones back together with bolts and plates and helping repair hips. There are patents, and it's a competitive business but the margins do remain pretty robust and there are new products coming out. So clearly, despite uncertain times, you all are still finding opportunities around the globe, and especially directly or indirectly in emerging markets.

Winters: As an investor, it's just a wonderful time. Things have changed so much, and you've also seen now the principles of Anglo-American finance filter all over the world.

Fries: On that point, it's interesting that we haven't been able to necessarily get people converted to the idea of democratic institutions, but we've had no trouble having them embrace the capitalistic market economy.

Understanding the Emotional Side of Investing

2007-12-07T12:47:00.000-08:00

“There is a steady flow of wealth from the hopeful gambler to the men who know what the odds really are. Most people ignore probabilities and exaggerate risk.”
Tversky and Kohneman

Behavioral finance has become a very popular subject. Quantifying how people emotionally deal with their money (what mistakes they make over and over again and why) has produced many interesting findings. The late Amos Tversky, a Stanford professor, and Daniel Kohneman, a Princeton professor, did much of this pioneering work. One of their major discoveries is that a dollar of gain is not equal to a dollar lost in most people’s minds, certainly not when the dollar stakes were high. Who would bet his car against a neighbor’s similar car at even odds? Very few people would take this bet, because having no car is more of a bad than having two cars is a good. So, the value function is non-linear, which means most people have more displeasure in losing a large sum than the pleasure associated with winning the same amount. Most individuals want a two-thirds chance of winning to venture a big bet. Interestingly enough, most individuals don’t invest this way.
In addition, Tversky and Kohneman studied how investors used context in their decision-making process. In other words, people made up their minds differently depending on how the problem was presented to them. Perversely, when the potential gain in a transaction is stressed, people get nervous and wary; and when potential losses are played up, they are willing to assume what are in reality greater risks in order to avoid the losses.

For example, suppose a person has spent the day at the race track, and lost $140, and is considering a $10 bet on a fifteen-to-one long shot in the last race. This decision can be framed in two ways, which corresponds to two natural reference points. If the bettor focuses on the cash flow on hand, the outcomes are framed as a gain of $140 or a loss of $10. On the other hand, if the bettor frames his decision in the frame work of the whole days losses, then it’s a chance to get back to even (from a $140 loss) or to increase his loss a mere $10. Individuals do not adjust their reference points as they lose and can be expected to make bets they normally would find outrageous, even on dubious nags at fifteen to one. This is exactly how many investors have handled their investments. In reaction to huge losses in technology stocks, they have continued to not build a conservative balanced portfolio but have instead tried to chase gains. These investors are speculators still hoping that some day they may break even again.
It is always better to take your lumps and reset your reference points. Interestingly enough, the same reset is necessary with investment wins as losses. If your portfolio does exceptionally well, don’t start believing you are the new Superman of the investment world. Remember every time you flip a coin, it could come up heads or tails. The next flip of the coin isn’t influenced by results of the last toss.

If you want to minimize your investment risk, then don’t bet all your money on one filly or one spin of the roulette wheel. Instead invest in a balanced diversified portfolio; hold for the long term; and keep systematically investing each month through your 401(k) plan 403(b), IRAs and taxable account. Also, don’t forget to forgive yourself for all the wacky investment decisions you’ve made in the past. Remember to reset your reference points.

What can patience and diversification and rebalancing regularly get you? Well rewarded. The chart below is worth studying. Owning high-quality bonds in a down market can save you from serious losses. The value of being diversified is apparent when you consider the entire period returns (third column). Small cap, mid-cap and bonds all generated positive returns for the entire period while international stocks, Nasdaq composite and large cap stocks were all negative. If you had put everything you owned in the Nasdaq Composite in March 2000 at its peak and then held (not resetting your reference point) hoping to get back to breakeven, you just proved Tversky and Kohneman’s behavioral finance theories. I could update the chart above to include the last few years but it just further proves the point. Stay diversified and rebalance at least once a year.

Happy Holidays!

Emerging Markets Appear Vulnerable

2007-12-04T13:33:00.000-08:00

Emerging markets appear vulnerable compared to the developed international markets. For instance, China is currently facing an inflation spike (+6.5%). Inflation is rising at the fastest pace in China in more than 10 years. The culprit is almost entirely food costs, caused by supply constraints. The Chinese government is trying to contain the inflation with price controls.

Chinese consumer spending (retail sales +17.1% year over year) remains too hot and is not sustainable. Unless China can begin to rein in its growth and control inflation we could be looking at a major correction. Investing in only one country or region is risky. The investment inflows into Asian and Chinese oriented investment vehicles have been of tsunami proportions.

Is the Chinese market ready for a correction? Given the alarming growth of the iShares FTSE/Xinhua China 25 Index over the last three years, I wouldn't be surprised. It looks surprisingly like many historic investment bubbles such as the Nasdaq high tech/internet bubble and the more recent housing bubble. Will the Chinese stock market suffer the same fate as the NASDAQ or the housing market anytime soon? That is unclear, but a pullback sooner or later is inevitable.
I have not allocated a significant portion of international investments to emerging market mutual funds. Most international funds have over 5% invested in emerging markets. It is dangerous to then allocate another 10% to this sector given its inherent risk. I am firmly committed to increasing the allocation to international stocks and bonds in each client’s portfolio but not to over emphasize the emerging markets.

My goal is to structure each portfolio so that the overall equity allocation is equally-weighted between U.S. and international stocks. As we become a global economy this equally-weighted allocation just makes intuitive sense, but in the investment world this is a radical strategy. Most investment strategy is fashioned by looking at history (backwards) and frequently misses indicators that signal major shifts in the economic paradigm. The world is no longer U.S.-centric and this shift in growth is recognized in your portfolio allocation. If you decide to increase your international allocation, just make sure you do not overweight the risky emerging markets sector.

What Happens When the Easy Money is Gone? Go Global!

2007-11-27T15:38:00.000-08:00

Consumers can no longer tap their homes to support their lifestyle nor can they run up their credit cards forever (credit card debt is reaching a historic high). The subprime mortgage debacle has made it difficult for consumers to withdraw funds from their homes and caused housing prices to fall. Add in a falling stock market to this mix and the American consumer must be feeling less wealthy. Historically, a falling housing market has caused consumers to rein in their spending. As credit continues to dry up, the American consumer will have to begin living within their means. That could make things uncomfortable for a while and leave the U.S. economy in a bind.

In the past when the U.S. economy caught a cold, the contagion spread around the world. The world economy has been too dependent upon the U.S. consumer to buy its good but the world is becoming a different place. Hopefully, the global economy can slowly wean itself from the American consumer and become more dependent upon the emerging middle class in India, China, and South America.

The falling U.S. dollar will help this global shift by making imported goods more expensive. On the plus side, exported U.S. goods will become more affordable to the new world emerging middle class. This new demand for U.S. goods and a falling demand for imported goods to the U.S. could correct the trade imbalance caused by years of over spending by and over dependence upon the U.S. consumer. This scenario would allow the U.S. economy to grow albeit slowly and the world to grow apace.

Credit is drying up for the U.S. consumer making him played out as the engine for global growth. The U.S. consumer won’t be able to borrow and may have to begin to save. The easy money has dried up and we are about to find out what the world will look like without the U.S. consumer in the drivers seat. Hold onto your hat! The ride is going to be bumpy especially in the U.S.

In short, emphasizing global investments will be crucial if your portfolio is going to generate decent returns over the next few years. That means allocating half of your equity investments abroad which is a stark change from the past when the U.S. markets dominated the world.

Market Volatility is Normal

2007-11-15T16:31:00.000-08:00

If you listened to the news media this summer you might have thought the sky was falling. The sky is fine and the markets are sound, we are just experiencing the return of normal volatility. Yes, the markets go up then down and up again but this is normal. I love the chart below because it illustrates how volatile the markets usually are in any one year. For instance, in 1998 the S&P500 index (ex-dividends) generated a 27% return but at one point during the year the index was down 19%. The index has generated on average an annual 10% to 11% return despite suffering an average mid-year drop of 12.7%. The moral, stay focused on the long term (at least a three year if not 10 year time horizon) and ignore the day-to-day gyrations of the market.

If the graph is tough to read then click on it. The graph will then appear larger.

How Bad is the Housing Market? Pretty Bad

2007-11-08T15:18:00.000-08:00

The pizza guy delivers a pizza to your door. He wants to be paid in cash right now. He doesn’t care how much equity you have built up in your house. You look in your wallet and it is empty. This scene is playing out for many home owners. They can’t make their mortgage payments and the bank is knocking on their door demanding payment. These resetting mortgages payments have ballooned to a level that borrowers aren’t able to pay.
Why did the banks and secondary lending institutions make these loans to people they knew would never be able to repay? Greed! Wall Street was clamoring for these riskier mortgages because they were looking for bonds that generated a higher yield (higher interest rates) and to heck with the risk. In particular, hedge funds had an insatiable appetite for these riskier asset-backed consumer loans. Here is the bad news: the worst is yet to come. The most egregious of these risky loans (with high escalating payments at reset) were 2 year Adjustable Rate Mortgages made in 2006 and early 2007. As the above graph shows there is a massive wave of these loans that will reset in 2008. The default rate will be significant. This is like watching a train wreck in slow motion.
Unfortunately, when excesses end, things don’t just return to normal. The pendulum frequently swings far in the other direction. This quick swing sparked a liquidity crisis on Wall Street. The mortgage defaults triggered an extreme lack of interest in holding consumer-backed debt, and an inclination on the part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who have played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks during the quarter.
With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points, things have settled down, but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This is somewhat good because excess liquidity was leading many investors to make imprudent investment decisions. On the flip side, the seizing up of the credit markets in a credit-dependent economy has a ripple effect which will hurt consumer spending.

With consumers unable to use their homes as an ATM machine (consumers extracting capital from their homes largely shut down and housing prices have fallen) and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending. The primary driver of economic growth is consumer spending, which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth.

Earth quake Insurance

2007-11-04T21:47:00.000-08:00

Here is a link to an article in the San Jose Mercury News in which I'm interviewed regarding earth quake insurance.

http://www.mercurynews.com/personalfinance/ci_7366738

Hope you had a beautiful weekend and didn't feel the latest 2 plus tumbler this afternoon!

Libby Mihalka, CFA
The Financial Pragmatist

Third Quarter 2007 Performance

2007-11-02T16:16:00.000-07:00

The Third Quarter was another roller coaster ride that almost defied gravity on the downside and upside. The average general domestic stock fund was up 1.2 percent, according to Morningstar. The S&P 500 (a proxy for large stock performance in the U.S.) was up a respectable 2.1% (the ETF proxy used in the adjacent chart outperformed the index, generating a 3.1% return). The small and mid cap sectors of the U.S. markets did not fare as well.
International stocks in developed countries persevered and performed well. Interestingly, many specific country markets were down for the quarter which validates keeping your international portfolio diversified across countries and regions. A substantially weaker dollar bolstered returns from international investments this quarter so their returns were as good as or better than that of the S&P. The average foreign stock mutual fund gained 5 percent for the quarter.
International emerging-market funds continued on a tear, up 17%. Emerging markets refers to countries that are under developed and rural in nature. China and India are countries commonly referred to as having emerging economies. Growth in these regions has been astronomic (up 35% year-to-date).
Size mattered this quarter. The more super-sized your portfolio was (weighted toward the biggest large cap equities), the more bang you got for your investments. The strongest growth has occurred abroad this year and the US mega caps that have the largest international component to their earnings. The S&P500 ishares generated 3.1% third quarter while the S&P400 MidCaps and the S&P600 SmallCap ishares fell. International large caps also outperformed international small caps this quarter for the first time in years.
Growth also stole the spotlight, outperforming value despite capitalization (cap size) and country. S&P500 Growth ishares were up 5% for the quarter while the S&P500 Value ishares gained only 1.7%. This pattern was true for the smaller cap indices such as the S&P400 and S&P600 ishares, with the value shares falling and growth shares holding their value.

The reintroduction of risk was very apparent in the bond market, with high quality bonds rising in value and low quality falling. Scared by the upheaval in the credit markets, investors began piling into high-quality bonds, drove the Lehman Brothers Aggregate Bond Index up 2.8%, and caused yields to fall. For example, the yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries (flight to quality) also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated (junk) corporate bonds, to post a modest 0.12% loss for the quarter.
Other parts of the fixed income markets have not fared as well. The subprime mortgage-backed market is nonexistent, making it impossible to gauge the value of many existing securities. Many banks are writing them off as worthless. Despite this nuclear melt down, the Eaton Vance Institutional Floating Rate has performed well: although it fell 1.8% for the quarter, it is still up 2% for the year.
Commodity futures performed well this quarter due to the surge in oil prices, which breached the $80 a barrel level. The PIMCO Commodity Real Return Institutional Fund rose 10% in the third quarter generating a year-to-date return of 13%. The iPath Dow Jones-AIG Commodity Index rose a more modest 6% during the quarter and 10% for the year.

Emerging-market short-term bonds (PIMCO Developing Local Markets) continue to perform well despite volatility in the fixed income arena. Year-to-date the fund is up 4.5% primarily due to declining value of the dollar against other currencies.

Libby Mihalka, CFA

Financial Literacy

2007-06-14T11:29:00.000-07:00

Here is a great new website by Schwab designed to teach financial literacy to kids and young adults. It is well designed and has great content.

http://www.schwabmoneywise.com/index.htm

Teaching your children to be financially savvy is essential.

Libby Mihalka

Protecting the Elderly from Telemarketing Scams

2007-05-21T11:05:00.000-07:00

The Elderly are frequent targets of fraud. Here is a very scary article from the New York Times. I recommend sending or reading this article to all your elderly relatives.

I also suggest you check the credit of all your elderly relatives if they will let you help them. See the blog article regarding Identity Theft.

I would also place all my elderly relatives on the Do Not Call List which should eliminate most solicitation calls. Telemarketing calls are a way many scammers bilk the elderly.

Since mail can easily be stolen, a secured (locking) mailbox is a great idea. I would also register all of my elderly relatives on the no credit card solicitation list. This list is legitamite and is endorsed by the Federal Trade Commission.

In fact, it would be smart to implement many of these ideas for yourself. A little time now could save you from becoming an identity theft victim

Five Common Investment Missteps That Could Derail Your Retirement

2007-05-21T10:41:00.000-07:00

Here is my column in today's Contra Costa and Valley Times. They shortened the article considerably so I thought you all might enjoy reading the unedited longer piece.

Five Common Investment Missteps That Could Derail Your Retirement

As an investment manager and financial planner, I don’t know how many investment portfolios I’ve reviewed over the past 20 years. I consistently see the same missteps made by investors over and over again. These slip-ups can be avoided. Some of these are easy to fix and others may take time, effort and due diligence to resolve. Now that tax season is over, this is good time to turn over a new leaf and get your finances organized and well deployed. Here are some of the main missteps that I see frequently.

Misstep #1, A Trail of Accounts: When I meet with a clients to review their portfolio for the first time, I can expect to be handed a plethora of statements from different brokerage firms and 401(k)s from previous employers. There is no reason to have 10 different investment accounts. By having your assets strewn around so many places you’ve just made it impossible to monitor the performance of your investments and periodically rebalance. Get organized! Simplify your life by rolling your old 401(k) s and 403(b) s directly into an IRA at one brokerage firm. Open one brokerage account for your non-qualified (non-IRA) assets and consolidate. Two to three accounts are easier to follow than 8 or 10. In addition, there are definite advantages to having all of your accounts at one brokerage firm. Frequently, brokerage firms give investors a break in fees, higher money market rates and better service if all your accounts (IRAs, taxable brokerage accounts, etc.) are consolidated at one place.

Misstep #2, Track the Performance of Your Portfolio: Most investors do not know how their investments are performing. They do not know what their annualized rate of return is for each account much less the consolidated portfolio. Most people just glance at their monthly statements to see if their accounts are up or down but, they really do not know how they are doing. It is important to know your portfolio’s performance and how it compares to the major indices. Monitoring your portfolio’s performance is equivalent to knowing your batting average and how it compares to everyone else’s in your league. To be informed you need to know your stats and how they compare. If you don’t monitor your performance you won’t know what grade you received (an A or an F) and if you are on course to achieve your financial goals.

You can download this information into Microsoft Money or Quicken, and this software will calculate your return. After you have your total portfolio’s return, the next step is to compare it to the index returns. It is easy to find information on the major indices in your newspaper or on the internet. Websites like Yahoo Finance (finance.yahoo.com) and Google Finance (finance.google.com) can be very helpful in monitoring index and investment performance. Once you have the software downloads working, it will be easy to monitor your portfolio’s performance compared to the major indices.

Misstep # 3, Create an Asset Allocation: Even if they have only a few accounts, most people do not know how their assets are allocated, and approach each investment account separately. This piecemeal approach results in a mishmash of investments that does not reflect their goals, retirement plans or risk tolerance. It is important to construct an asset allocation for your entire portfolio instead of just looking at your IRA and then three months later your 401(k). The first step is to develop a coherent asset allocation plan for your entire portfolio and then decide how to implement the plan among your different accounts. A great place to start is the SEC (Securities and Exchange Commission) website (www.sec.gov/investor/pubs/assetallocation.htm). It explains the basics of asset allocation and has some good links to other resources.

Misstep #4, : Most investors don’t know anything about the investments they hold. For instance most investors are clueless when it comes to the credit quality of their corporate bonds, the fees charged on their mutual funds, the outlook on a particular stock, or other important details about their holdings. By not understanding their holdings, investors are frequently invested in very risky ventures and paying exorbitant fees.

If you do not have time everyday to devote to your portfolio, then do not invest in individual stocks or bonds. Be honest with yourself and admit that once you are invested you are never going to look at your investments again. In this situation, I would recommend you research some of the new lifecycle funds. These funds rebalance to a more conservative asset allocation as the targeted portfolio date (specified in the fund name) approaches. Unfortunately, most of these funds are too conservative (too heavily weighted toward cash and bonds) so don’t select a fund with the same target date as your retirement. Instead consider selecting a fund with a targeted date that is at least 10 years further off than your impending retirement. This will help you avoid asset allocations that are too conservative.

It is worth the time and effort to research your investments and not just opt out by using lifestyle funds. You lose control of your asset allocation and the fees are higher for lifestyle funds. I recommend using a combination of mutual funds and index funds to execute your asset allocation plan. This is a great way to diversify and manage risk. It won’t require you to daily manage your investments; bi-monthly to monthly monitoring should be enough once your portfolio is all invested.

It is important to research the cost of these investment vehicles before investing. Many investors are surprised to find out that they are paying a load or 12b-1 fee on their mutual fund investments. It is important to know the up front, annual or back end fees you will be paying before investing. Fees are usually buried in the back or middle of a Prospectus which is a legal document published by the fund company. You can also find information regarding fees and more on the internet at the Morningstar website (http://www.morningstar.com/#A1) and FundAlarm (http://www.fundalarm.com/) before investing.

In addition, it is very important to understand what the fund is purported to be invested in and what it is really holding. Janus Overseas is labeled by Morningstar as a Foreign Large Growth fund. Except Janus Overseas has a great deal more risk than any fund in this category because it is 27% invested in Foreign Emerging Markets (China, India, Thailand). This is a great deal riskier than being invested in Large Companies in Developed Foreign markets (Germany, United Kingdom, and Japan). In fact, most Large Cap Foreign funds typically have a 3% to 5% exposure to Emerging Markets. So if you had allocated part of your portfolio to Foreign Emerging Markets and then bought Janus Overseas, you would be over-weighted in Emerging Markets and have a riskier portfolio than you intended. Make sure you read the fund’s prospectus and research the funds using the two websites listed above.

Misstep #5: Not doing anything because you are too busy or are intimidated is the biggest misstep of all. It is your money and it may very well be your sole support in retirement. Take control or get help by hiring a professional financial planner. Get organized and design an investment plan that will help you meet your life goals and retirement plans. Good luck!

Libby Mihalka
The Financial Pragmatist

How to Navigate Refinancing Your Mortgage: Beware of Scams

2007-05-17T15:12:00.000-07:00

Refinancing or financing your home can be stressful. Let’s face it, the biggest transaction you will probably ever make is purchasing and financing a home. I hear a good number of horror stories about refinancing. I’ve even had some of these tricks played on me. Fortunately I knew what to do. Here is what you should know about financing your home.

Do not accept a lender solicitation you got in the mail just because it looks good. Always do your due diligence and get competing quotes from reputable lenders. Usually a lender that woes you is not offering the most competitive terms. In addition, don't pursue the lender offering the lowest rate on sites such as bankrate especially if you've never heard of them before. These are the firms that are most apt to bait and switch the loan terms at the last moment or pad the closing costs. So watch out and do your home work.

Always watch out for the old bait and switch scam. Typically this is what happens. You complete the loan application and a few days later the loan officer confirms your application has been accepted. However, the loan is not at the initial rate and terms discussed, a fact the broker conveniently forgets to mention. Many people don’t realize that the terms have been changed until they are signing documents at closing. It is important to receive a copy of the terms and rates of your loan after your application has been accepted.

Make sure you have locked down your rate and make sure you understand what you need to do in order to keep it. I recommend call the lending officer regularly through the process to ensure that your loan is moving along and the rates and terms have not changed. Frequently, you can lose your loan terms if you do not submit all your forms and documentation required by a specific date. Keep copies of all the information you have given the lender and send the information by fax or certified mail. Call to make sure it has been received. If at closing the terms of the loan aren’t what you agreed to, don’t sign the documents.

Many borrowers don’t know the terms of their loans. Many of these terms, especially in combination, could spell financial disaster. So watch out for prepayment penalties, balloon payments, and an adjustable rate. These three items together should be a huge red flag. If these are the terms your lender is offering then you should go and talk to other reputable lenders and make sure you are making the right decision.

One of the biggest scams is padding the closing costs. Most borrowers don’t know that the lender is required to give you a good faith estimate of your closing costs (GFE) within three working days of accepting the loan application. The list is itemized and contains costs that are non-negotiable such as property taxes. One scam is to low ball the GFE and then pump them up on the closing statement. It is important to get another copy of the GFE a few days before closing. If the fees are more than 5% higher then the original estimate then demand that the fees be lowered or you’ll walk.

Many of the closing costs are negotiable. Below is a mortgage broker’s website that shows a sample GFE and explains some of the fees. (Website to Sample GFE). Focus on the fees in section 800 and try to eliminate unnecessary fees and lower the lender fees. Section 1100 outlines the title company fees. This is the title company that your mortgage broker wants you to use. You can use a different title company but expect a fight from your broker. They have established relationships with title companies that frequently provide services that support their business. Frequently you can save money by employing the title company yourself but it may not be worth the hassle.

Make sure you get as complete a GFE as possible and let the lender know that you will walk away if the final closing statement is significantly different from the GFE. Incomplete GFEs are the most frequent cause of an under estimated closing costs.

Finally, look out for mortgage brokers that try to cross sell you additional services such as home owners insurance. Always get multiple bids on these services. You can almost always find better coverage at a more reasonable price if you bid out these services separately.

The Financial Pragmatist
Libby Mihalka

It is Time to Rebalance

2007-05-09T09:56:00.000-07:00

At the end of last week, the indices were all moving towards new highs. Despite slowing earnings growth the market just keeps heading up. While the long term trend is healthy, I think we are in for some turbulence. Usually when the market moves aggressively ahead, pushing toward new highs, after a while it takes very little news to derail the train. It seems inevitable as we head into the summer that the market will consolidate its gains by pulling back a little. The market will then take the summer off to digest the latest gains.

While the majority of the economic news remains positive there are negatives looming out there. For instance, there is slower U.S. employment growth, tightening credit, higher gas prices, slowing corporate earnings growth, and falling housing prices). Despite the negatives, the current situation does not warrant selling and walking away. Corporate earnings are still strong and P/E ratios are still reasonable (see chart). The current market conditions do warrant implementing a strategy of rebalancing and trimming. Increasing cash holdings over the next few weeks will enable an investor to take advantage of any pull backs. The catalyst(s) that could spark a correction is (are) unknown, but it could finally be the U.S. consumer cutting back or disappointing economic data.

It is likely that turbulence will be minor should it happen at all. The new global economy will continue to perform well pulling the U.S. market along with it. The story here is really the global economy and not just us anymore.
For right now, the market is still hot because of accelerating merger-and-acquisition activity. As of the end of last week the mid cap market has been blazing hot since the start of the year. In the last few weeks large cap domestic stocks have picked up the pace. It is very unclear whether large caps will finally outperform small and mid caps this year. It is inevitable that large caps will at some point outperform its small cap brethren in the future due to valuation metrics (see past blog postings for more information). International stocks are still chugging along with the MSCI EAFE up approximately 8% for the year. Bonds are showing some life with the Lehman Bros Aggregate index up almost 2% year-to-date.

Subprime Mortgage Debacle: What is the Impact?

2007-05-01T15:39:00.000-07:00

Last year, the market overcame a wrenching period of soul-searching in May and June (2006). Back then, the Federal Reserve was at the end of a two-year campaign to raise interest rates, and the housing boom had started to fade. The concerns that dominated the minds of investors, however, did not linger, and the market had a solid second half.

Many market specialists assert that the current concerns will play out similarly. Weaknesses like those in the market for subprime mortgages issued to borrowers with weak credit will not threaten the broader financial markets, these experts say, because the world economy is growing, corporate profits are rising, and consumers with good credit are not defaulting at high rates.

Most of us (especially those living in areas with very high housing costs) are aware that lenders have pushed the envelope in recent years and granted loans to enable people to buy homes they would otherwise be unable to afford. In so doing, many of these buyers have stretched themselves financially and have little margin for error. Low starter rates and temporary interest-only terms are winding down or expiring. The rates on these loans are resetting at a much higher level because interest rates are rising. As a result, defaults among subprime mortgages have climbed sharply. How widespread is the problem? Well loans in this segment ac-counted for 24% of loan originations in 2006, and late payments in Alternative-A mortgages are esca-lating (the default rate in this sector is in the 13% to 14% range). The result: people are losing their homes and some subprime lenders have either experienced big financial losses or gone out of business.

Research analysts at PIMCO have suggested that this is a meaningful source of risk to the housing market, since these defaulting buyers have starter homes (less expensive homes) which are the first rung on the housing-market food chain. So on its face, rising delinquencies in a high-growth part of the market could be a serious concern.

Defaults and tighter lending standards will mean that growth in the subprime arena will stall, causing demand to sag even further in the housing market. PIMCO’s analysts believe that we’re in the middle of the housing downturn, and that this will ultimately cut roughly another 1% from GDP growth over the next few quarters (and that there is at least some risk that it could be worse). Clearly that’s not good, but it is also not as bad an outcome as many others seem to expect given the extensive media play that this problem has received.

The reason the spill over effects on the economy and corporate earnings aren’t more severe becomes clear when you break the U.S. consumer into quintiles. The bottom 20 percent of U.S. consumers generate only 8 percent of consumer spending. These are the very consumers that are caught in the sub-prime lending squeeze and could lose their homes. Conversely, the top 10% represents about 40% of consumer spending and these consumers are unaffected. The subprime debacle will effect will cause dislocations in the housing market but won’t deliver a crippling blow to the economy. It is just another road hazard that the economy and financial markets will need to navigate around.

HOW TO PROTECT YOURSELF FROM IDENTITY THEFT

2007-05-01T13:54:00.000-07:00

Identity theft has become a very common crime. Law enforcement agencies are reporting that identity theft criminals have become increasingly organized and sophisticated. Simply stated, a thief or organized group of thieves acquire your personal information and use it to access your accounts or set up new ones in your name.

Much of this information is readily available in the public domain. Other information may be simply stolen from an unsecure mailbox, or obtained through fraudulent means such as “phishing” on the internet. Phishers attempt to fraudulently acquire sensitive information, such as usernames, passwords and credit cards details, by masquerading as a trustworthy entity in an electronic communication. eBay and PayPal are two of the most targeted companies, and online banks are also a common targets. Phishing is typically carried out using email or an instant message, and often directs users to give details at a website, although phone contact has been used as well. Once a person logs in to the phony site, the log-in information is captured and used by the thieves to access the real account on the real site.

Still other thefts involve tricking computer users to unwittingly download viruses or spyware by pretending to offer (ironically enough) free software that will improve their computer’s security. Once installed, these programs secretly transmit data (such as usernames and passwords) to the thieves, who are often overseas. These are just a few examples of how identify theft can take place, but approaches are always evolving so it pays to be skeptical and vigilant before providing any information to an unknown source, whether by phone, internet or in person.

The ease and speed with which identify theft can be accomplished, the losses that result, and the complexity and time required to stop the activity, are costly and nerve-wracking. Actual losses are seldom recoverable; furthermore, they are greatly exacerbated by the huge ongoing stress and hassle.

What should you do?
At a minimum, please consider the following that have been recommended by the U.S. Postal Inspection Service:

Secure your mail by either obtaining and installing a secure mailbox (if you do not currently have a slot in your door or garage door) or re-routing your mail to a P.O. Box.
Use a paper shredder to shred all personal documents before throwing them away, including the pre-approved junk mail you receive.
Remove yourself from marketing lists by contacting the Mail Preference Section, Direct Marketing Association, P.O. Box 9008, Farmingdale, N.Y. 11735, (212) 768-7277, (www .dmaconsumers.org/offmailinglist.html).
Regularly check your credit report at one of the three major credit agencies:
1. TransUnion, 800-888-4213 (www.tuc.com); or
2. Experian, 888-EXPERIAN (www.experian.com); or
3. Equifax, 800-685-1111 (www.equifax.com).
Use extreme caution about providing personal information when using the Internet. Do not download unknown programs or respond to unsolicited email notices. Links provided in email notices can be made to appear legitimate, such that the web address that is displayed in the link is not the one to which the link is connected. Scammers have been known to create elaborate duplicates of legitimate sites just for the purpose of collecting account information. If you aren’t sure about an emailed account notice, just ignore the link in the email and go directly to site on your own.

I am not suggesting that you become obsessive or paranoid, but a few relatively simple steps will go a long way towards protecting yourself. For further information, check out the U. S. Postal Inspection Service brochure and website.

Brochure (www.usps.com/cpim/ftp/pubs/pub280.pdf )
Website (www.usps.com/postalinspectors/)

The Financial Pragmatist

Libby Mihalka

Earnings Are the Key

2007-04-26T15:40:00.000-07:00

The main story is the strength of corporate earnings. The adjacent graph shows that the growth rate of corporate profits over the last five years has been incredible. In fact, the growth rate has been double digit for the last seven quarters. Even more interesting is that these record profits are not fully reflected in stock prices.

The next graph below shows the performance of the S&P 500 from 1996 through First Quarter 2007. It shows the ride up to the top of the dot-com bubble; the subsequent bust and the climb back up. Although close, the S&P 500 has still not exceeded its previous high (as of quarter end) even though the index is up 83% from its low. Stocks are significantly cheaper than on March 24, 2000 based on P/E ratios (for explanation of P/E ratio see below). In fact, stocks are 43% cheaper than from previous high.

The P/E Ratio
P/E is the ratio of Price to Earnings. The price of a stock is a function of the underlying earnings and the P/E multiple captures that relationship. The ratio shows the embedded cost for every dollar of earnings the stock is generating. In other words, if the P/E ratio is 30 then you are paying $30 dollars for every dollar of earnings.

Why isn’t the current high earnings growth rate fully reflected in current P/E ratios? Because built into P/E ratios are future earning expectations. Current stock valuations anticipate the slowing of earnings growth rate to rates closer to the historic norm from the current extraordinary levels. The market does not believe this elevated rate of earnings is sustainable in the long run. In addition, the market is building a margin of safety lest inflation doesn’t moderate and the Federal Reserve has to raise interest rates again. It is factoring in all potential risks and discounting stock prices to reflect this increasing volatility. Usually big market declines are generally preceded by stretched valuations. It is comforting to know that even though the markets were more volatile this quarter, valuations are reasonable.

However, valuations are stretched in some segments of the market, like mid and small caps (Russell 2000 index). These smaller caps have outperformed large caps for years but as a result valuations are pushed. Russell 2000 index has a high P/E ratio of 38.7 which implies a 63% earnings growth rate. It is doubtful that small caps will be able to de-liver such a strong performance forever. Conversely, the Nasdaq has a negative implied earnings growth rate. The market expects the earnings of Nasdaq-high tech stocks to contract. Growth stocks have underperformed value stocks since the dot-com bust but it is unlikely that this underperformance will last forever.

The Economic News

2007-04-22T15:06:00.000-07:00

I regularly attempt to explain the current state of the economy, the Federal Reserve’s policy stance, and other news items that could impact the markets. It is difficult to present the general state of the economy in just a few paragraphs, so I was thrilled when I discovered this scorecard designed by JPMorgan. I’ll try to regularly include it in my future newsletters. If the chart seems unclear just click on it to get a larger clearer view.

Many economists believe that we are close to full employment (5% or less unemployment is considered full employment by economists and the Fed). These gurus fear that full employment could lead to rising wages which could then cause inflation. The Federal Reserve is focused on the core rate of inflation (inflation less the volatile food and energy segments). Inflation is currently at the high end of the Fed’s defined range of acceptable. So the Fed’s board members want the core inflation rate to fall but don’t want to raise interest rates again to achieve it. The Fed wants the market to adjust itself.

When Bernanke became Federal Reserve Chairman he stated that he wanted to communicate the Fed’s intentions more clearly to investors. The unintentional result has been the inversion of the yield curve (short term interest rates are higher than long term rates). In order to get long term interest rates up, the Fed has begun to abandon its policy of clear communication and transparency. It is instead refusing to send a clear message. The Fed recently changed its stance to neutral (instead of signaling its intention by stating a bias towards raising or lowering rates) but it is all posturing. The most recent Fed minutes from its last meeting are meandering and unclear. Consider, for instance, this excerpt from the minutes:

…the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee’s predominant concern.

The Fed's mixed reactions regarding inflation are unsettling to many analysts and economists. It is all part of an elaborate game of chicken as the Fed desperately tries to balance the need to moderate inflation with keeping the economy growing. If the Fed has to raise short term rates to check inflation it might also destabilize the financial markets. If the Fed states a bias towards lowering short term rates, it could cause the markets to grow too quickly the old boom followed by bust pattern). The Fed hopes to avoid these scenarios by convincing the market to raise long term rates which should help moderate full employment and wages and hence cool the core inflation rate. It will be interesting to see who blinks first, the markets or the Fed.

The Financial Pragmatist

Libby Mihalka

The Return of Volatility

2007-04-18T10:56:00.000-07:00

With the recent choppiness in the markets, investors have become aware that stocks don’t always just trend nicely straight up.

Marc D. Stern, the chief investment officer at Bessemer Trust said in a recent interview, “We are in for some meaningful volatility for the next several years, and none of us should be surprised by that. There are lots of uncertainties to ponder.”

Investors have gotten used to extremely low levels of volatility and they may find these normal price swings disconcerting. To put this in perspective, I’ve included the adjacent chart of the Chicago Board of Trade’s VIX index. This index measures volatility based on investors’ use of options on the S&P 500-stock index. It spiked in early March from historically low levels (see the far left portion of the top chart). As the graph shows, equity volatility is near the historical average but far from the high levels (peaks on the graph) experienced during the dot-com bust in the early 2000’s. Bounces in the market are normal. A 3.5% one-day loss in the U.S. markets like the one experienced at the end of February is not unprecedented after seven straight months of gains totaling over 14%.

What is interesting is how little investors are being paid for taking greater risk especially in the bond market. The bottom graph illustrates this point. It shows the difference in return earned (spread) in a risky investment (in this case High Yield Bonds and Foreign Emerging Country Debt) compared to what is considered a risk less investment in ten year U.S. Treasuries. High Yield bonds are loans made to corporations that have compromised credit. These bonds are risky because they could default (not pay). So to compensate investors for this risk they pay a higher interest rate. The amount of additional interest compared to U.S. Treasuries varies over time. Currently these High Yield bonds are paying a historically low premium compared to the risk free Treasuries (free of credit risk).

Investors are earning less of a premium despite the increasing volatility (another measure of risk) shown in the top chart. In other words, investors are not being paid enough of a premium for the risk they are taking. Investors have become complacent about risk. They have been so focused on chasing higher yields that they have forgotten that they could easily lose money in these riskier investments.

Investors beware. Risk is back and she can be a cruel mistress!

The Financial Pragmatist

Libby Mihalka

Week in Review

2007-04-16T11:06:00.000-07:00

Let's look at the numbers.

In the last week the S&P 500 gained as much as it did in the whole First Quarter (0.6%). The stock market has bounced back and year-to-date has generated a 3% return (S&P 500). Mid Caps are still outperforming Large Caps domestic stocks. Large Caps are now keeping up with Small Cap stocks after lagging for years. Growth is beginning to outperform value stocks reversing a long standing trend. The market volatility of late February and early March does not seem to be having a lasting impact on the market.

Despite this performance, the market is facing uncharted waters. Here are
Bob Doll's opinion of the state of the economy and particularly corporate earnings growth. He is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock.

Last week was a good one for stocks, with the Dow Jones Industrial Average posting a 0.4% gain to close at 12,612, while the S&P 500® Index climbed 0.6% to 1,452 and the Nasdaq® Composite rose 0.8% to 2,491. Currently, the S&P 500 Index is on pace to end the year with a 8.5% gain, which would be broadly in line with our view that stocks should experience a reasonably constructive year.

Expectations for U.S. economic growth have continued to fade over recent weeks. At present, the consensus view is that gross domestic product (GDP) growth will come in at a 2.0% rate for the first quarter and around 2.4% for the second quarter. Expectations for the second half of the year currently peg economic growth at around the 2.5% to 3% level, but those numbers have been trending downward as well. There are some negatives in the global economic picture right now, but they are primarily concentrated in the United States (with the most notable being the housing slump). Weaker U.S. economic growth, combined with slowing corporate profit growth, has caused some to worry about the possibility of a recession. In our opinion, however, these fears are unfounded. Resilient income growth, jobs growth and employment levels are helping to keep the U.S. economy from slowing too much, and growth outside the United States continues to be strong. These factors should be enough to prevent the U.S. economy from sliding into a recession.

It is a tricky time for investors right now given all of the crosscurrents in the economy, so we thought it would be useful to take a look at some of the most important trends. First, we believe the U.S. economy will continue to grow at a below-trend level for at least another two or three quarters before returning to a somewhat higher rate of growth. Second, we think it is important to recognize that the world has shifted from a time when the U.S. consumer was the key engine of growth to a more broad-based set of stimuli — an environment that is more constructive for global financial markets. Third, we believe inflation will remain at reasonably low levels, but we recognize that inflation worries will persistently flare up given the backdrop of strong world growth and ongoing high energy prices. Fourth, we believe the U.S. dollar will remain somewhat weak given diverging economic growth prospects around the world. Finally, we expect global interest rates to remain relatively low.

So what does all of this mean for equities? The combination of slower economic growth and weaker corporate profits tells us that we are likely to see continued choppiness in trading levels, and additional corrective action is not out of the question. However, we continue to believe that attractive valuations should help stock prices to move higher over the course of the year. Additionally, although the Federal Reserve does not appear inclined to make any interest rate changes at present, we do believe that as evidence of slowing economic growth continues to mount, the central bank will begin cutting rates in the second half of the year, which would be a further benefit to stocks.

First Quarter 2007 Performance Report

2007-04-16T10:50:00.000-07:00

After enjoying a seven-month run of smoothly climbing stock prices, investors hit a nasty road bump in February. Despite the choppiness, the U.S stock market ended the quarter approximately where it started with the S&P 500 up just 0.6%.

Once again the small (S&P 600) and the mid cap (S&P400) U.S. equity market outperformed their large cap brethren (S&P 500). Mid Caps ruled the roost, gaining 5.8% for the quarter. Small Caps turned in a more than a respectable 3.1%.

Value barely continued its run of outperforming growth in the large cap arena. The S&P 500 Growth ishares fell slightly while the Value ishares rose slightly during the quarter. The reverse was true in the small and mid cap stocks as growth edged out value.

The major indexes for most Asian markets were breakeven or down slightly for the quarter. The Shanghai exchange was the one exception. It led the February global sell-off and was down significantly. European stocks fared much better but returns were less than earned in the back half of last year. Overall, over-weighting in international stocks continued to payoff during the First Quarter as the international markets continued to outperform.

The market choppiness in stocks was caused by a familiar group of concerns: a slowing American economy, rising problems with risky mortgages and signs that fast-growing emerging markets like China and India might be due for a correction.

The turmoil was triggered in late February by the Chinese government stating that it wanted to cool down its market’s extraordinary growth. This caused a big drop in the Chinese (Shanghai) market, and a subsequent dip in stock prices worldwide.

The 3.5% one-day loss experienced in the U.S. markets (in late February) is not unusual after the gains of the last seven months but it shook many investors which had become complacent. This left many investors wondering whether this was the beginning of the end of the four-year bull market that started in October 2002, or simply a pause.

Where are the markets going?

2007-04-10T09:38:00.000-07:00

The current market turmoil shouldn't spoke investors but caution is still warrented. I enjoyed reading Bob Doll's weekly commentary which captures the spirit of current market activity. So here is his Monday commentary in full. Read and enjoy!

The Financial Pragmatist
Libby Mihalka

Weekly Investment Commentary
By Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock
April 9, 2007

The U.S. stock market seems to be following a pattern of one week being up and the next being down; and last week was one of the "up" ones, despite some mixed economic reports (the Institute for Supply Management's manufacturing index declined, while Friday's payrolls report was better than expected). Market sentiment was helped by the resolution over the issue of British sailors and marines being held by Iran as well as by continued high levels of merger-and-acquisition activity. For the week, the Dow Jones Industrial Average gained 1.7% to 12,560, the S&P 500® Index climbed 1.6% to 1,443 and the Nasdaq® Composite rose 2.1% to 2,471.

In our opinion, last week was fairly typical of the type of economic environment we expect going forward—that is, one in which economic growth slows, but not so quickly as to spark a recession. Additionally, we believe that lingering signs of economic strength will disappoint those who are hoping that the Federal Reserve will soon enact rate cuts. We do believe, however, that as economic growth continues to weaken, inflation pressures will recede, which should set the stage for the Fed to begin cutting rates in the second half of this year.

Over the next couple of weeks, investors will shift gears to focus on first-quarter corporate earnings. At present, consensus expectations are for first-quarter earnings growth to be around 3% to 4%, with overall 2007 growth levels to come in slightly below the 7% mark. For our part, we continue to believe that 2007 growth levels will be a bit below that—likely around the 5% area.

One factor that has been helping to push equity markets higher despite evidence of slowing economic and earnings growth has been ongoing corporate deal activity, which has been driven by a combination of high levels of cash available to companies and attractive equity valuation levels. We have been seeing high levels of stock buybacks, mergers and both public and private buyouts. In the first quarter, like the fourth quarter of last year, there was more than $1 trillion of reported deal activity, marking the first back-to-back quarters at that level since 2000. In our opinion, this environment is likely to persist until either the availability of capital dries up or until equity valuations rise considerably.

Looking ahead, we believe that the global economic backdrop remains healthy and conducive to continued good equity market performance. The potential danger of a hard economic landing in the United States remains, although we believe such an event has a low probability of occurring. Over the next few months, we expect markets to remain bumpy as investors digest ongoing news of slowing economic growth and weakening corporate profits growth, but do not believe these events will mark the end of the current bull market.

Small Cap GARP Fund

2007-04-03T11:22:00.000-07:00

A good small cap fund is tough to find. A successful fund can find itself swamped with incoming new assets. It becomes difficult to stay in the small caps when assets under management reach over $500 million.

Here is a small cap fund that has only $115 million under management. Its track record is less than 2 years so it does not have a Morningstar rating. But its performance as a Small cap GARP (growth-at-a-reasonable-price) fund has been more than respectable. Morningstar catagorizes the fund as a growth fund but its style is more a blend. This is not an aggressive growth fund so its style will hoover between blend and growth (see the style performance chart).

My only crticism is the fund is expensive because it charges a 12b-1 fee. I try to avoid funds that charge 12b-1 fees. But if you are looking for a good Small Cap GARP style fund the Champlain fund has alot to offer.

Below is some additional information on the fund from Litman Gregory.

Also here is the link to the firm's website.

http://www.cipvt.com/

The Financial Pragmatist

Libby Mihalka

February 2007

DUE DILIGENCE REPORT: Champlain Small Company Fund (CIPSX)
Manager: Scott BraymanCategory: Smaller-Cap Growth at a Reasonable Price

Over the past few months we completed due diligence on Champlain Small Company Fund. Our history with portfolio manager Scott Brayman dates back to late 2004, shortly after he left NL Capital Management (where he managed Sentinel Small Cap Fund) to start Champlain Investment Partners. After following the firm for almost two years, we resumed coverage and have since had several phone calls with Brayman and the three analysts, a face-to-face meeting with Brayman at an investment conference, and a visit to their Vermont offices. As a result of our research, we are adding the fund to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category, reflecting our confidence in the fund’s ability to perform at least as well as the benchmark over time. Approved is a designation that reflects a high level of selectivity, and few funds we research manage to clear this bar. Below is a summary of Champlain’s investment process, the firm/team’s background, and the basis for our favorable opinion.

Summary of Investment Process:

The investment focus is on buying small-cap companies with superior business models at a good price. Brayman defines a superior business model as one where a company earns a profit that exceeds its cost of capital. He believes investing in these good businesses at a good price is a high-probability path to wealth creation. Brayman thinks about capital preservation and strongly emphasizes managing business risk. He focuses on companies with more-predictable operating results, while trying to avoid companies with less reliable business patterns that can lead to big losses. Managing valuation risk is also important. The team looks to capitalize on Wall Street’s shortsightedness or overreaction to a company’s short-term problems, thereby limiting downside potential. In managing portfolio risk, Brayman builds a diversified portfolio of 75 to 100 names. His goal is to “build a portfolio that outperforms notably in three years, and compellingly in five years.”

Idea Generation/Fundamental Research:

The team starts with the S&P 600 as its investment universe, as they believe this benchmark offers a higher-quality group of stocks than the broader Russell 2000 Index. However, they look at numerous companies outside of the S&P index as well. The process for winnowing down the universe is based on a qualitative assessment of a company’s business models to determine if it’s the type of company they want to own. This qualitative assessment is based on a number of “sector factors” that are designed to highlight predictable (i.e., consistent operating results) and defensible business models, while minimizing exposure to factors that can create high variability in cash flow, and ultimately stock prices. Brayman emphasizes the word “minimize” because in some cases it’s difficult to completely steer clear of the risks that the sector factors are designed to avoid.

Brayman applies these sector factors to five major sectors: technology, health care, financials, industrials, and consumer. In technology, the sector factor is low obsolescence risk. Brayman thinks trying to correctly time the buying and selling of the latest hot tech product is a loser’s game. Owning these companies/products would force him to make too many decisions around the success of the product, determining the appropriate valuation, as well as the timing of trades, all of which he says increases the odds of a mistake and potentially a big loss. Instead, he looks to own tech companies with recurring revenue or those that sell a unique product. In the consumer sector, he looks for brand loyalty and tries to avoid brands going out of style. In health care, he wants to minimize exposure to government payors because changes in government reimbursement are too tough to call and can lead to big stock-price declines. In industrials, Brayman wants to avoid decisions centered on the timing of economic cycles, so he looks for problem solvers and innovators in the industry. In financials, he looks for companies that have a very strong niche because he believes large-cap financials have an advantage over small-caps due to their scale and therefore a comparatively lower cost of funds.

Brayman estimates that the sector factors eliminate about 60% of the universe. For the companies that pass the sector factors, Brayman looks for superior relative growth, low debt, quality earnings (i.e., positive cash flow), proven management, and strong company fundamentals. Touching on each of the components, Brayman is looking for the best growth opportunities within each of the five major sectors. He is constantly ranking companies in each industry (based largely on feedback from the firm’s three sector analysts) to see what stocks are the cheapest and why. As for the low-debt criterion, Brayman prefers companies that are able to grow their business organically, i.e., they don’t have to go to the credit markets to fund growth. Related to debt is the “quality earnings” attribute, which Brayman defines as strong cash flow from operations. When assessing management, Brayman looks to see how they manage the balance sheet, how it deploys capital, the deals management has done, how they have followed through on what they said they do, and how they manage inventories. Brayman also wants to see managements’ interests aligned with shareholders, who they have on the company’s board, the compensation structure, and how much “skin they have in the game.” As for company fundamentals, the team evaluates factors such as the competitive environment, barriers to entry, end-market opportunity, financing, and long-term growth expectations.

Valuation:

For companies that pass the sector factors and look appealing based on the company attributes listed above, the team then turns to valuation. They look at valuation from a few perspectives because Brayman believes valuation is an art and every valuation approach has its strengths and weaknesses. Their valuation methodologies include: an internally generated discounted cashflow (DCF) model, a DCF using HOLT (a third-party valuation tool), transaction-based analyses (if applicable), and historical valuations relative to a company’s history and its peers (although this last approach gets little weight). As part of their valuation analysis the team runs through scenario analysis (particularly with the DCFs) to get an understanding of what the big swing factors are in order to get a sense for the range of outcomes. Because each valuation approach can result in a different price target, the team uses a weighted-average of the different results, where they give the most weight to their highest-conviction valuation.

When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies (i.e., a more-mature business that they can look at and learn from in order to assess trends in revenues, margins, etc.). A general rule with respect to the growth rates they are willing to use in the DCF models is that a company can only grow as fast as it can reinvest its cash flows. For example, if a company has a 10% return on investment, and is retaining 80% of earnings, by definition its cash flows can only finance 8% growth assuming the balance sheet items stay static, i.e., the company is not issuing stock or borrowing money. If a company says it’s growing much faster, the team is very skeptical and they would have to clearly understand where the capital will come from to fund the growth. Brayman is biased against companies that constantly dilute shareholders with equity or debt, leveraging up the balance sheet to sustain a higher growth rate. Generally speaking the “steady-state” growth rates used for the DCF are 5% to 6%, although some may be slightly higher at 7% to 8%. The rationale here is that Brayman also believes growth expectations are generally hyped and peak-to-peak earnings growth is about 6% over time, “yet every company is touted as a 15% to 20% grower in small-caps.” He says the reality is that the Russell 2000 growth rate is about half of the forecasted growth rate over time.

As part of the team’s valuation work, they also look at what they call “strategic value.” The team evaluates if each company has “something really special” that a larger company might be interested in acquiring. For example, if a small company has a great product but no distribution, a large company might easily fold it into its business. For these types of companies, they will selectively increase the target price by a “nominal” amount, generally no more than 10%. The team also adjusts for the dilution of options.

As for the degree of the discount at the time of purchase, the team tries to buy at a 20% to 25% discount. They will accept a somewhat lower upside for a “rock-solid company.”
Portfolio Construction: The portfolio consists of approximately 75 to 100 stocks of small companies, and to a lesser extent medium-sized companies. Position size is a function of business risk, liquidity, and valuation discount. More-predictable business models with a longer operating history will typically be larger holdings, not necessarily the cheapest stocks. Smaller positions generally have less operating history or higher levels of perceived risk. Brayman has loose sector-weighting guidelines (no more than 25% of the fund’s assets will be invested in any one industry), and overall sector weighting are a byproduct of bottom-up stock selection, not a sector call. The fund is managed close to fully invested.

Sell Discipline:

The team generally begins to trim a holding when it is within 5% to 10% of its estimate of fair value, and in most cases will sell completely when a stock hits fair value. But if a stock has a lot of price momentum (and fundamentals remain strong) the team may not sell completely in an attempt to take advantage of Wall Street’s optimism. Explaining this, Brayman says, “Historically we know that markets and stocks tend to overshoot. If they want to overshoot, we’ll let them, but we begin a program of systematically cutting back on a stock.” The team also has a “down 25% rule,” where they have to take a fresh look at the stock if it is down by 25% from the time of purchase, but in practice the team is taking a close look when the stock is down 10%.

Firm/Team Background

Champlain Investment Partners was founded in 2004. All key professionals at Champlain (both investment-team members and business operations) formerly worked together at National Life Group’s investment-management subsidiary, NL Capital Management. The four-member investment team is led by Brayman, and the fund is run using an investment process that has been in place since 1996.

While Brayman is responsible for making the final investment-management decisions, the three analysts play an integral part in generating investment ideas. The three analysts are divided by sector: health care, technology, and consumer. Brayman covers financials, industrials, and energy. Each member of the team applies the investment process to the names in their sector, determines fair value for each stock, and then recommends buy and sells.

The analyst team is made up of Van Harissis, who covers consumer stocks. Harissis has more than 20 years of investment-management experience, and prior to joining Champlain his most-recent role was lead portfolio manager for Sentinel Common Stock Fund and co-manager of Sentinel Balanced Fund. David O’Neal covers health care. Prior to joining Champlain, he was a health care equity analyst for the small-cap and mid-cap equity products at NL Capital Management. Daniel Butler follows technology. His most recent experience was as a technology analyst for Sentinel’s small-cap product.Champlain offers a small- and a mid-cap product, and the investment team is responsible for both strategies. The mid-cap product (which is currently only available via separate accounts) is often made up of companies that the team owned in its small-cap strategy, and with which they are very familiar, that migrated up in market cap as a result of their success. The only difference between the small- and mid-cap products is market capitalization. The mid-cap product can only buy stocks with a market capitalization above $1.5 billion. Brayman targets a median market capitalization of $1 billion for the small-cap product versus $4 billion to $6 billion for the mid-cap product.

As of year-end, Champlain manages approximately $585 million in domestic equity assets (including mutual fund and separate-account assets). The vast majority of assets are in small-cap.

Performance

When assessing Brayman’s performance, we take his record from Sentinel Small Company Fund into consideration, which he ran from late 1995 until he introduced Champlain Small Company Fund in November 2004. One important consideration in evaluating Brayman’s record is that there was a meaningful change in the number of portfolio holdings. Brayman started running this strategy at NL Capital in 1996, and for the first two years, Brayman was basically a one-man shop and held an average of 50 holdings. As he grew the investment team, the number of names increased. Since 1999, the portfolio has held between 75 and 100 names. Brayman contends that the higher number of names does not dilute the portfolio’s upside potential. A larger team means they can cover more ground, and Brayman’s experience is that a lot of the upside comes from interesting emerging-growth ideas, which are names that he’s confident in but doesn’t want an above-average position size for liquidity or increased risk reasons. As Brayman puts it, “Large positions are positions I’m more comfortable with. If I’m comfortable with them, a whole lot of other portfolio managers are also comfortable with them. Big gains come from names that others are uncomfortable with. But as management proves itself and peoples’ confidence goes up, there’s tremendous price upside.” Despite the increase in names, we think Brayman’s entire track record is applicable. He is still the lead portfolio manager and he is still using the same investment philosophy and process.

Since the beginning of his record, Brayman’s annualized return (through December) is 14.7% compared to 9.8% for the Russell 2000 Index iShares. (Note: Prior to the iShares’ inception, we use the Vanguard Small Cap.) A big component of Brayman’s strong outperformance is due to very good absolute and relative performance in 2000, when the fund was up 38.9% compared to a 3.8% loss for the benchmark. Outperforming in a down market is consistent with our expectations for the fund, although the extent of the outperformance in 2000 is not something we’d bank on in the future. Qualitatively, we expect the fund to lag its benchmark during strong small-cap markets, and outperform in average or weak environments, particularly when there is a flight to quality such as in calendar year 2000. Our view is based on the team’s clear focus on buying companies with consistent earnings and attractive valuations.

The fund’s historical record highlights the success of the downside risk control. Since 1996, the Russell 2000 iShares benchmark had 35 periods where rolling 12-month returns were negative. The average loss during these negative periods is 11.3%. During those same 35 periods, Champlain Small Company Fund suffered a loss in only 16 periods, and the fund’s average return was a 0.2% gain. The fund’s worst 12-month performance is a 19.9% loss, compared to a 27% loss for the benchmark. The fund has also beaten the benchmark in up markets. Since 1996, there are 86 rolling 12-month periods where the Russell 2000 iShares was positive.

During those periods, the fund’s average gain is 21.7% versus 20% for the benchmark. The fund’s best 12-month gain was 47.8% compared to 64% for the benchmark. Looking at the fund’s consistency over rolling three-year time frames, the fund has beaten the benchmark in 81% of the periods. The 10-year-plus track record provides evidence that this disciplined investment process has led to a high degree of consistency.

Litman/Gregory Opinion

As a result of our research, we feel there are a sufficient number of positives to warrant adding Champlain Small Company Fund to our Approved list in the Smaller-Cap GARP category. Below are the key positives that underlie our opinion.Champlain employs a thoughtful and well-laid-out investment process that’s designed to stack the odds of success in their favor over time. The team uses an uncommon process for generating ideas via the sector-factor criteria, which not only creates clear-cut parameters for what qualifies as a buy (or a sell in the case of a changing business plan), but aids in minimizing the likelihood of an unexpected negative surprise. In our conversations with the team, the decision-making process was clearly articulated and conversations with each of the team members made it extremely clear that the process is applied consistently. The team sticks to its circle of competence.

There is a focus on capital preservation and elements of conservatism are apparent throughout the process. The team looks for investments with a clear eye towards preserving capital (such as consistent earnings, attractive valuations, sound financials, and proven management) in order to increase the probability of a favorable outcome. By lining up these attributes, the team believes it has gone a long way to make sure the portfolio is set up for long-term outperformance. There is a definite focus on avoiding a big downside move, and the team consistently demonstrated that they are willing to be patient (and even miss out on some of a stock’s upside) to ensure that operating fundamentals are intact and they won’t have a big negative surprise on the downside.

The team does thoughtful quantiative analysis. We find their analysis to use realistic, conservative assumptions that are based on an understanding of the company, its history, and the industry, as opposed to unique insights, superior number crunching, or better information gathering. Although we don’t think the team wins by gaining an information edge, there’s a clear focus on gaining a solid understanding of the issues that could negatively impact the business, and making sure a sufficient margin of safety puts the probability of being right in their favor.

Their qualitative thinking comes out in the team’s valuation analysis where they take a well-rounded view and look at a number of methodologies and scenarios. Their goal is to be aware of their assumptions and what the sensitivities are to those assumptions. In Brayman’s words, “The more scenario analysis you do, the more probability-weighted thinking you do, which helps you to understand the potential risks.” They also have an interesting way of thinking about valuation with their “strategic value” component. Our discussions about companies where the team applied a strategic value component to its valuation assessment served to emphasize the team’s knowledge of companies and the industries.

Another positive is the team’s stability. We recognize that Champlain is only two years old, but the team has worked together previously and in our conversations with Brayman, he clearly wants to build a team that stays together. All but one of the team members has equity and Brayman is planning to give the remaining member equity in the near future. The ownership in the firm makes investment-team departures less likely.

Brayman is also shareholder-oriented. He strikes us as someone who wants to win for shareholders. He conveys a sense of high integrity, and there are clear signs of intellectual honesty as well as a willingness to admit mistakes and cull losses; there are no signs of hubris. Brayman is very mindful of assets and plans to close the fund at $1.5 billion, a level we find reasonable. Expenses are reasonable at 1.4% given the relatively small asset base.

Our decision to add the fund to our Approved list reflects our confidence in the fund’s ability to perform at least as well as a benchmark, if not better over time. As such, we would be comfortable using this fund as an alternative to an index fund. We reiterate that Approved is a high hurdle for us, and as always, we will continue to stay in touch with the team and provide ongoing updates.

While there are enough things to like about Champlain Small Company Fund to give us the confidence to add it to our short list of Approved funds in the Smaller-Cap Growth-at-a-Reasonable-Price category, we are not able to gain a high enough degree of confidence to get to Recommended. We reserve Recommended for funds that have a clearly identifiable investment edge, giving us a high degree of confidence that the fund will beat the benchmark over the long term. In the case of Champlain, we feel that they do several things well, all of which stem from a well-thought-out and consistently applied investment approach. But in the end, we couldn’t identify a specific, clear cut edge. For example, we thought both their qualitative and qualitative analysis was good in that it was thoughtful and well-reasoned, but we did not identify an edge or something that they clearly do better than the competition. When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are often based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies, as opposed to unique insights gained by digging deeper than the competition. At the same time, there’s an element of conservatism that’s used in their models, where the team doesn’t need to make aggressive assumptions in order to be right on the stock.

We think this is a positive, but again, by itself it’s not a clear edge. In the end, determining an edge is somewhat subjective, and we recognize that Champlain’s process itself may provide them with an edge. However, we don’t feel strongly enough that this is the case to recommend the fund outright.

As for concerns, we don’t have any major issues. One area we will continue to monitor is the growth of the team’s mid-cap product. Currently the mid-cap separate account is only $1 million, but the team is considering the introduction of a mid-cap mutual fund. To the extent that this product grows and detracts from the amount of time the team is spending on small-cap (either through following more names or additional marketing efforts) we would view it as a negative. All else equal, we favor teams that focus on a specific strategy.
—Jack Chee

_________________________________________________________________________________Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.

Analysis of Bernanke's Inflation Outlook

2007-03-29T11:31:00.000-07:00

Here is the transcript from an interview from last nights Nightly Business Report on PBS.
This discussion is interesting because it shows the current debate concerning the strength and direction of the markets. Battipaglia's outlook is very pessimistic and he currently has over 30% of his client's allocation in cash (50% of his client's 60% equity allocation is in cash plus a percent of the bond portfolio). His firm is really expecting the markets to correct substantially. Market timing, to this extent, leads to under performmance.

Enjoy
The Financial Pragmatist
Libby Mihalka

Joe Battipaglia of Ryan Beck & Brian Wesbury of First Trust Advisors
Analyze Fed. Chairman Bernanke's Inflation Outlook

Wednesday, March 28, 2007

SUSIE GHARIB: More analysis now on Bernanke's testimony today and market reaction. Joining us, Joe Battipaglia, chief investment officer for Ryan Beck and Brian Wesbury, chief economist at First Trust Advisors. Brian, Joe, thanks for joining us.

BRIAN WESBURY, CHIEF ECONOMIST, FIRST TRUST ADVISORS: Good to be with you.
JOE BATTIPAGLIA, CHIEF INVESTMENT OFFICER, RYAN BECK: Good to be with you.

GHARIB: Brian, let me begin with you. Do you agree with Ben Bernanke's assessment of the economy that inflation is the risk of not weaker growth?

WESBURY: I do. I think that we've seen a slowdown in housing. We've seen what I would call an inventory correction, which is caused industrial production and durable goods orders to fall over the last few months, slow down the economy a little bit in the last few months. But the real risk to the economy in the next six, 12, 18 months is inflation.

GHARIB: Joe, Wall Street seems to have thought that that slowdown in housing, now that the economy is really slowing, evidenced by all the sell- offs we've had this week. What's your analysis of what Bernanke said?

BATTIPAGLIA: The street wants it both ways. They want a soft economy and ultimately rate cuts and what a good situation that is for stocks. My worry, actually, is the economy. The Fed has never engineered a soft landing. The data is more troubling than they are letting on too. They've already changed their language to that effect and I think it's a credit- driven problem in that consumers are tapped out, and so this may well be a consumer-led slowdown with the potential for a recession at 50 percent. The market certainly not looking for that and that's what's going to be more troublesome in the next several months. Add to that the persistence in inflation. You've got a very dangerous mix here.

GHARIB: But Brian, the message from Bernanke seems to be that the next move that the Fed makes on interest rates, when it does decide to move, that it will be up. It will be a rate hike not a rate cut. Is that your take on what Bernanke said today?

WESBURY: Well, I would argue that what he really said is that he wanted more flexibility. In fact, that's almost a direct quote. And that's why they sort of pulled back. But more importantly, one of the things he wanted to do was have the market stop being telegraphed the Fed's next move. He wants the market to be a little more uncertain about what the Fed might do. And one of the reasons that he wants that to happen is he wants long-term interest rates to go up. Remember, Alan Greenspan called the low, long-term interest rate the conundrum. Ben Bernanke has theorized that maybe it's happening because of a global savings glut or something like that. He's trying to get long-term rates up and one of the ways to do that is to increase uncertainty in the markets and I think that's one of the things he's trying to do today.

GHARIB: He did say that. He said he's going to give less guidance on interest rate moves. Joe, what does that mean for the market? Is it going to be much more volatile going forward?

BATTIPAGLIA: Oh, I would say so because if he is data centric here and looking for the next bit of news on the economy and on inflation, then he's no better off than the rest of us are in trying to figure out what happens next and right now his credibility is on the line because on the one hand, he wanted to be more transparent. If you want to be more ambiguous, that's not transparent. And the other is he wanted inflation below 2 percent but he doesn't have that. He's at 2.7 or 2.3, depending on how you measure it. Credibility at the Fed is at risk, Ambiguity is a problem and the economy itself has got very weak signals coming on, six months of slowdown in durable goods and a consumer that is gliding down the path of less houses being bought, less cars being bought, retail sales slowing down.

GHARIB: Brian, Bernanke also said that he didn't see any evidence that this whole sub-prime mess is affecting the broader economy. Is that really the case or was he just trying to reassure everyone?

WESBURY: No, I think he's correct about that. I think the sub-prime issue is a problem, but it's not a problem that will have a contagion effect that drags the entire economy along. And I think this is an important point. One of the reasons that we're in the mess with mortgages and housing that we're in is because the Federal Reserve lowered interest rates to 1 percent back in 2003. You can't drive interest rates down that low without causing people, some people to make decisions that they can't live with if interest rate goes back to normal and that's exactly what's happened. But interest rates today aren't high. And that's why I won't go as far as Joe does. Interest rates today, in fact, are still very low, especially given the inflation rates that we have seen. And, therefore, I don't think we're on the front edge of a recession or a big consumer--

BATTIPAGLIA: Here's the tip of the spear on this. I need to interrupt because most people are saying the same thing, except that the biggest asset that people own are their homes. Those prices are only starting to fall and they fall by 5, 10 or 15 percent or more depending on the market. And interest rates on the teaser side are going to be adjusted up, even with the low rates that Brian speaks to, they're going to double or triple from here and they can't refinance because their home values --

GHARIB: Joe, let me jump in. We just have a few seconds. Real quickly Joe, are you changing your investment strategy because of your views on what Bernanke said and the economy?

BATTIPAGLIA: We came into this with 60 percent equities 40 percent in defense of asset classes. In our equity programs we're at 50 percent cash looking for future opportunities. So we re definitely defensive and we've lowered our S&P target for the year down to 1430. So we're essentially looking for a flat year.

GHARIB: We're going to have to leave it there. Gentlemen, thank you very much, I appreciate your thoughts.

BATTIPAGLIA: You're welcome.

GHARIB: My guests tonight: Joe Battipaglia, chief investment officer for Ryan Beck and Brian Wesbury, chief economist at First Trust Advisors.

Who is Profiting in this Economy? Not the Middle Class

2007-03-29T10:07:00.000-07:00

Food For Thought

The creation of the middle class is widely credited with pulling Europe out of the Dark (Middle) Ages. A strong middle class is the working back bone of this country. Our constitution works because it is a social contract that citizens believe allows them to work hard and prosper. The American promise is if you work hard that you will succeed, rags to riches. What happens if that no longer is true.

Statistically speaking, it has never been more difficult to work your wat out of poverty into the middle class. Is the rags to riches story dying? Leakage down has increased. In other words, you can fall into poverty but it is unlikely that you and your children will ever dig their way out.

The two main factors that kept people out of poverty were a college degree and owning their own home. As a parent, I know I will do what ever it takes to instill a love of learning, teach them how to work hard and a instill in them sense of duty to family and community. I feel it is my responsibility to get them through college and hopefully shepherd them into their first house. I don't want to see them leak down into a level of poverty from which they won't be able to rise. The trick will be not bankrupting our own retirement plans in the process.

I know I haven't addressed the impact of the trends on the social fabric of our country. The disappearance of the middle class could spell the end of democracy. People only obey rules if they believe they are fair.

I am afraid we will only see more articles like this one that appeared in today's New York Times. Where all this will lead us a s a country I don't know but I do know what it means in my household: a commitment to education and hard work.

The Financial Pragmatist

Libby Mihalka

New York Times
March 29, 2007
Income Gap Is Widening, Data Shows
By DAVID CAY JOHNSTON

Income inequality grew significantly in 2005, with the top 1 percent of Americans — those with incomes that year of more than $348,000 — receiving their largest share of national income since 1928, analysis of newly released tax data shows.

The top 10 percent, roughly those earning more than $100,000, also reached a level of income share not seen since before the Depression.

While total reported income in the United States increased almost 9 percent in 2005, the most recent year for which such data is available, average incomes for those in the bottom 90 percent dipped slightly compared with the year before, dropping $172, or 0.6 percent.

The gains went largely to the top 1 percent, whose incomes rose to an average of more than $1.1 million each, an increase of more than $139,000, or about 14 percent.

The new data also shows that the top 300,000 Americans collectively enjoyed almost as much income as the bottom 150 million Americans. Per person, the top group received 440 times as much as the average person in the bottom half earned, nearly doubling the gap from 1980.

Prof. Emmanuel Saez, the University of California, Berkeley, economist who analyzed the Internal Revenue Service data with Prof. Thomas Piketty of the Paris School of Economics, said such growing disparities were significant in terms of social and political stability.

“If the economy is growing but only a few are enjoying the benefits, it goes to our sense of fairness,” Professor Saez said. “It can have important political consequences.”

Last year, according to data from other sources, incomes for average Americans increased for the first time in several years. But because those at the top rely heavily on the stock market and business profits for their income, both of which were strong last year, it is likely that the disparities in 2005 are the same or larger now, Professor Saez said.

He noted that the analysis was based on preliminary data and that the highest-income Americans were more likely than others to file their returns late, so his data might understate the growth in inequality.

The disparities may be even greater for another reason. The Internal Revenue Service estimates that it is able to accurately tax 99 percent of wage income but that it captures only about 70 percent of business and investment income, most of which flows to upper-income individuals, because not everybody accurately reports such figures.

The Bush administration argued that its tax policies, despite cuts that benefited those at the top more than others, had not added to the widening gap but “made the tax code more progressive, not less.” Brookly McLaughlin, the chief Treasury Department spokeswoman, said that this year “the share of income taxes paid by lower-income taxpayers will be lower than it would have been without the tax relief, while the share of income taxes for higher-income taxpayers will be higher.”

Treasury Secretary Henry M. Paulson Jr., she noted, has acknowledged that income disparities have increased, but, along with a “solid consensus” of experts, attributed that shift largely to “the rapid pace of technological change has been a major driver in the decades-long widening of the income gap in the United States."

Others argued that public policies had played a role in the shift. Robert Greenstein, executive director of the Center on Budget and Policy Priorities, an advocacy group for the poor, said that the data understates the widening disparity between the top 1 percent and the rest of the country.

He said that in addition to rising incomes and reduced taxes, the equation should take into account cuts in fringe benefits to workers and in government services that middle-class and poor Americans rely on more than the affluent. These include health care, child care and education spending.

“The nation faces some very tough choices in coming years,” he said. “That such a large share of the income gains are going to the very top, at a minimum, raises serious questions about continuing to provide tax cuts averaging over $150,000 a year to people making more than a million dollars a year, while saying we do not have enough money” to provide health insurance to 47 million Americans and cutting education benefits.

A major issue likely to be debated in Congress in the year ahead is whether reversing the Bush tax cuts would slow investment and, if so, how much that would cost the economy.
Mr. Greenstein’s organization will release a report today showing that for Americans in the middle, the share of income taken by federal taxes has been essentially unchanged across four decades. By comparison, it has fallen by half for those at the very top of the income ladder.
Because the incomes of those at the top have grown so much more than those below them, their share of total income tax revenue has risen despite the reduced rates.

The analysis by the two professors showed that the top 10 percent of Americans collected 48.5 percent of all reported income in 2005.

That is an increase of more than 2 percentage points over the previous year and up from roughly 33 percent in the late 1970s. The peak for this group was 49.3 percent in 1928.
The top 1 percent received 21.8 percent of all reported income in 2005, up significantly from 19.8 percent the year before and more than double their share of income in 1980. The peak was in 1928, when the top 1 percent reported 23.9 percent of all income.

The top tenth of a percent and top one-hundredth of a percent recorded even bigger gains in 2005 over the previous year. Their incomes soared by about a fifth in one year, largely because of the rising stock market and increased business profits.

The top tenth of a percent reported an average income of $5.6 million, up $908,000, while the top one-hundredth of a percent had an average income of $25.7 million, up nearly $4.4 million in one year.

Small/Mid Cap International Investing

2007-03-27T11:11:00.000-07:00

Historically, international investing has focused on Large Cap stocks. In the mid and late 1990s, a few initial research articles were published suggesting that small/mid cap international stocks diversified the risk of a well balanced portfolio and had the potential for generating superior returns. Over the last ten years, this research has been shown to be correct. Small/mid cap international stocks have generated returns far in excess of their large cap international brethren.

There are few mutual funds that invest in this segment of the international markets. There are few analysts that follow small and mid cap companies in Asia, Latin America and Europe. Many international exchanges inefficiently handle transactions involving smaller and more illiquid companies. (These issues are also an opportunity to make substantial returns because inefficiency always equals opportunity). It is also an expensive strategy to execute. The result is that few investors have small/mid cap international exposure.

Altamont Capital Management has been invested in Small and Mid Cap International stocks for years. Many of the submanagers and mutual funds we use to implement this strategy are not available to the retail investor but there are a handful of funds worth considering. Laudus, Forward and T. Rowe Price Discovery have international small/mid cap funds that are open and available to the retail investor.

Here is a paper by Laudus Funds that discusses further the merit of small/mid cap international investing.

http://www.laudusfunds.com/common/reportDownload.asp?doc=ISMCAPWhtPpr

The Financial Pragmatist
Libby Mihalka

Private Equity Risks and Dislocations

2007-03-23T11:02:00.000-07:00

One reason the market hasn't fallen further is liquidity. The U.S. and International markets are awash in cash. It is easy to borrow at low rates. Until credit is tightened, it will be difficult for the market to sustain a significant correction.

Heavily leveraged Private equity and hedge funds are trolling the markets looking for any arbitrages or acquisitions. As the amount of money chasing opportunities increases so does the risk. It will become more and more difficult for these groups to deliver the 30% plus returns their investors have come to expect. This wall of cash may cause dislocations (deals done at unsustainable premiums) that will hasten a correction. The back end of all this will probably not be pretty.

A credit squeeze will of course also hasten a correction by drying up this excess liquidity.

Here is an interesting article that discusses this topic in greater detail.

The Financial Pragmatist
Libby Mihalka

Has success spoiled private equity?
By Sharon Reier
Friday, March 23, 2007

'Fortune favors the bold," wrote Virgil, the classical poet who glorified the power of Rome. These days few are bolder or have gathered more fortune than the private equity groups that have accounted for more than 20 percent of the merger activity so far this year in the United States and a growing proportion of it overseas.

But just as a string of record-breaking private equity bids made news from Britain to Australia — and major firms like Blackstone Group prepared initial public offerings of shares to individual investors — the risks were also climbing. Experts are apprehensive that the current easy financing via low-grade, high-yield debt could become more costly and less secure, while political opposition to the swashbuckling ways of private equity is growing.

This is not the way that the elite, insiderish, secretive private equity club might have expected things to go. But the changes reflect the fact that private equity is now in the mainstream of capitalism, and will increasingly be expected to play by the rules.

"Given the size of the industry, the level of public scrutiny has reached unprecedented levels," said Javier Loizaga, chairman of the European Venture Capital Association, at a meeting of private equity investors in Geneva this month. "Not everybody likes us. Not everybody will like us."

Certainly over the past few years private equity has delivered superior, and sometimes outstanding, returns on investment. Long-term the funds look for 15 percent returns after fees, better than investors have done in the equities markets, said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth. But over the past three years, some of the better-known firms like Blackstone and Carlyle Group have achieved annual returns of 40 percent and higher on some deals.

The theory behind private equity is that the ownership model is better and more efficient than the traditional public-shareholding model. "Asset managers and equity investors are pretty passive," said Pierre-Etienne Lorenceau, publisher of Décideurs, a magazine that covers private equity. "Investors depend on the communication policies and bullishness of the CEO and the mood of the market, and it is a very uncomfortable position."

Private equity, by contrast, gives control of the company to a small group of people: general partners, or the executives who run private equity firms and take the bulk of the risk and reward, and limited partners, or investors in private equity funds. The limited partners "know their money will actually be at work," Lorenceaux said — because if it isn't, the general partners will not hesitate to fire management or sell the company.

The sound bites may be new, but the structure is not.

In the 1980s, enabled by high-yielding junk bonds, leveraged buyout funds bought public companies with small amounts of equity and dollops of debt. Some returns were spectacular; other deals crashed. The poster child for failed deals was the $30.6 billion hostile takeover of RJR Nabisco in 1989. Chronicled in the book "Barbarians at the Gate," the deal barely eked out a profit for the winner, Kohlberg Kravis Roberts — in large part because KKR overpaid in the first place, and because problems in the junk bond market in 1990 made it impossible to refinance the debt.

Over the past few years, the financial stars have been aligned perfectly for private equity deals. Able to buy assets at low prices earlier in the decade, firms displayed an impressive ability to leverage the deals with debt, then re- leverage them to pay a dividend to investors or sell them in IPOs and to other private equity companies.

Enticed by high returns, investors like pension funds, insurance companies, funds of funds and wealthy individuals deluged private equity partnerships with money. Last year the firms raised $432 billion to put to work in deals.

Supplementing that war chest is the great wall of money available from income investors, desperate for higher yields than they can get on investment-grade credit, who have eagerly invested on the debt side. So eager have they been to buy into these leveraged loans — packaged into collateralized loan obligations, known as CLOs— that they have accepted relatively low premiums over base lending rates.

Buyers of this debt have also taken on the additional risk of what are what are being called "covenant-lite" terms. Covenants set forth legal guidelines concerning financial measures like ratios of debt to cash flow. Covenants enable lenders to declare borrowers in default if guidelines are violated.

"This is unprecedented," said Ray Kennedy, managing director of high-yield investment at Pacific Investment Management, or Pimco. "I don't think we have ever seen this level of give-ups."

The result of this overheated lending is that it has created a silly season in which private equity firms have been able to increase leverage from five and six times cash flow to as much as eight and nine times, greatly increasing the stakes — and the returns needed to pay off the debt.

It has also enabled the firms to contemplate bigger deals, like the blockbusters announced this year: $45 billion for the Texas utility TXU; the much-discussed £11 billion, or $21.6 billion, bid for the British supermarket icon J. Sainsbury; a bid of 11 billion Australian dollars, or $8.9 billion, for Qantas, the Australian flag-carrier airline.

Bigger deals, of course, mean higher fees. And Blackstone's public offering will give investors the chance to participate in the profits along with management.

But individuals will want to look before they leap into any private equity investment, experts warn, as the chances of a major change in the financial climate are increasing — thanks in part to the debacle in U.S. subprime lending market, which has cast all risky loans under a cloud. Last Friday, in fact, J.P. Morgan Chase recommended that investors reduce their holdings of collateralized loan obligations backed by high-risk, high-yield loans — the kind of debt typically used to finance leveraged buyouts.

So far the top private equity firms are confident that they can get these deals done because of continued liquidity from oil money, government surpluses from Asia and the Middle East, and hedge funds, according to Edward Altman, professor of finance and director of fixed income and debt research at the Salomon Center at New York University.

But Altman, who studies what he calls the "mortality rate" of debt, warned that more than 50 percent of the loans tied to highly leveraged transactions in 2006 involved companies whose bonds or loan financing received a CCC rating, the lowest and most risky given to new financings.

"Traditionally these result in a fairly high default rate," Altman said: A third of CCC- rated bonds default within three years of issuance, and about 50 percent default within five years.
"Investors have been accepting spreads far too low for the risk involved," Altman said.

The fact that creditors have been accepting fewer covenants on this kind of debt also means more risk — and, potentially, more recklessness. Kennedy at Pimco said that "a company could have a bad string of earnings and there would not be a default. And such conditions will mean that management teams can take more risk and won't have a lender breathing down their necks."

Then there is the growing chorus of criticism as the private equity model spreads globally. Reactions by labor groups in Europe have tended to be particularly sharp: Private equity firms are estimated to indirectly employ 19 percent of private sector workers in Britain, according to a study by the British Venture Capital Association, and between 7 percent and 9 percent in France, according to French unions.

"In Europe if people see you are getting 25 percent of 30 percent returns, they say: 'What is going on? It can't just be management wizardry,'" said Adam Lent, head of economics and social affairs for the Trade Union Congress, a federation of 62 British unions representing 6.5 million workers. "The question we are raising is, 'Who is bearing the risk?' We are pretty sure that it is not the 10 or 15 men who run the funds."

But as always, private equity is trying to keep ahead of the curve and increasingly is moving into emerging markets. Last year KKR did the largest major leveraged buyout in India — the purchase of the software business of Flextronics International for $900 million — and more private deals are thought likely to follow. Sabine Schaffer, vice president at Evolvence Capital, a private equity company in Dubai that has many investments in India, said that the prevailing view is one of cooperation.

"They are not seen as locusts," Schaffer said, referring to the epithet applied to private equity by a German politician, Franz Müntefering, in 2005. Today in India, Schaffer said, "the economy is booming. You won't see people being upset about any of the deals."

And until a major deal goes wrong, or the debt market closes, expect private equity firms to raise even more money and remain hyperactive.

"The attitude in the industry," Blaydon said, "is that when the cookie tray gets passed, you've got to take some."

Copyright © 2007 The International Herald Tribune www.iht.com

U.S. Small Cap Stocks Appear Over Valued

2007-03-19T11:25:00.000-07:00

Small Caps appear due for a correction. They have outperformed their Large Cap brethren since the dot-com bust. It is now time for Large Caps to prevail. I have discussed this trend several times in my blog and newsletters. See last quarter's newsletter posted at our website: http://www.altamontwealth.com/newsletters.html

Here is a New York Times article that further bolsters this argument.

The Financial Pragmatist

Libby Mihalka

March 18, 2007

Beyond the Bubble, With Small-Cap Stocks

By MARK HULBERT

SMALL-CAP stocks are significantly overvalued. In fact, they are even pricier, on average, than they were in March 2000, just before the Internet bubble burst. In contrast, the average large-cap stock is moderately undervalued.

This picture of a highly bifurcated stock market is painted by data from Ford Equity Research of San Diego, which tracks around 4,500 publicly traded companies in the United States. Among companies that have been publicly traded for at least seven years, the firm reports that 55 percent have higher price-to-earnings ratios today than they did in March 2000. The bulk of these pricier issues, however, are in the smaller-cap sectors. Among the very largest companies, the average P/E ratio is now just a third of what it was seven years ago.

If investors focused only on the broad stock market averages, however, they might conclude that the entire market is undervalued. According to Standard & Poor’s, for example, the P/E ratio of the S.& P. 500 currently stands at 17, based on trailing 12-month operating earnings. The comparable ratio at the end of March 2000 was 31.1, almost double the current level.
Though the S.& P 500 includes many large-cap stocks, it also contains smaller-cap issues. Why is the index’s P/E ratio nevertheless so much lower than it was seven years ago?

The answer lies in how the index is put together. The S.& P. 500 is a capitalization-weighted index, meaning that each company’s contribution to it is a function of the company’s size. That would not necessarily skew the average P/E ratio for the index itself, if the average valuations of both larger and smaller stocks were similar. But that’s not the situation today, according to Ford Equity Research: the 50 companies in the S.& P. 500 with the smallest market caps have an average P/E ratio that is much higher than it was seven years ago, while the ratio for the 50 largest-cap stocks in the index is significantly lower.

According to Ford Equity Research, the average P/E ratio among the 50 largest-cap companies is now 19, about a third of the average of 60.7 for the biggest 50 in March 2000. The average market cap for the 50 largest companies is now $123 billion, versus $153 billion in March 2000.
Contrast those numbers with those for the 50 smallest companies in the index: their average P/E ratio is now 30.7, versus 20.3 seven years ago. And their average market cap is now $3 billion, versus $1 billion.

In other words, the smallest-cap stocks in the S.& P. 500 are significantly more overvalued today than they were seven years ago. Yet their higher P/E ratios barely affect the ratio for the index as a whole. That’s because the combined market capitalization of the 50 largest stocks account for nearly half the market cap of the entire S.& P. 500, while that of the 50 smallest stocks add up to just 1.2 percent of the total.

“Investors who pay attention to the P/E ratio of cap-weighted indexes such as the S.& P. 500 therefore need to exercise great care when drawing conclusions about stocks’ relative valuations,” Richard Segarra, director of research at Ford Equity Research, said in an interview. “At best, the P/E ratios for such indexes shed light only on their largest-cap stocks; we should avoid drawing any inference from a cap-weighted index’s P/E ratio about the valuations of its smallest-cap members.”

MR. SEGARRA found that the index’s prevailing pattern also holds true across the universe of stocks that his firm tracks. As a result, an investor who emphasizes market sectors according to relative P/E ratios would have a very different portfolio today than in March 2000. Back then, he would have favored small caps over large caps — and been handsomely rewarded for this choice. The trend is seen in the annualized total returns since March 31, 2000, of three Dow Jones Wilshire indexes: 10.1 percent for the U.S. Microcap Index and 7.2 percent for the U.S. Small-Cap Index, but only 0.5 percent for the U.S. Large-Cap index.

Today, however, according to Mr. Segarra, that investor would favor large caps over small caps. Not only is the average P/E ratio of large-cap stocks only a third as high as it was in March 2000, it is nearly 10 percent below its average level of the last five years. There’s no guarantee, of course, that large caps will outperform small caps over the next five years — but there’s a good argument to be made that they will.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.

Weekly Review and Outlook

2007-03-19T10:26:00.000-07:00

Here is the weekly review by Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock Investments. I read alot of summaries, this one captures all the major market highlights and I agree with his insights. Happy Reading!

The Financial Pragmatist,
Libby Mihalka

Blackrock Commentary
Disappointing retail sales figures, ongoing problems in the subprime mortgage
market and higher inflation numbers all pushed stock prices lower last week, with the Dow Jones Industrial Average falling 1.4% to 12,110, the S&P 500® Index declining 1.1% to 1,387 and the Nasdaq® Composite dropping 0.6% to 2,373. After last week’s declines, stocks are down just over 2% for the year and are about 4% lower than their highs for the year.

The corporate earnings picture has changed somewhat over the past few weeks. From the second half of last year through early February, consensus expectations for 2007 earnings growth hovered just over the 10% mark, but then began falling. Expectations have since stabilized at around the 6.5% mark, close to where we forecasted they would be at the beginning of the year — certainly lower than in previous years, but still at a positive level.

The idea that the economy is slowing is not the debate these days, given problems in the housing market (and the associated financing issues), slowing manufacturing activity, declining retail sales and some evidence of a weakening labor market. The question facing investors now is: Does the slowdown represent a transition from a few years of above-trend growth to a period of more sustainable, but slower growth, or does the slowdown indicate that a recession is on the horizon?

Concerns over the subprime lending business have highlighted the possibility of an economic recession. Up until now, problems in the housing market have been relatively confined, and the residential real estate slowdown has not had a significant impact on the overall economy. Many observers, however, are worried that tightening lending standards could make it more difficult for the housing market to recover, potentially triggering additional credit problems and resulting in a recession. In our opinion, this outcome is unlikely. Despite all of the problems
in the housing sector, consumer spending levels have remained reasonably strong, corporate balance sheets are still in good shape and non-U.S. economies (particularly developing economies) also are quite strong. We believe that these positive factors will outweigh the negatives and that the U.S. economy will avoid a recession, although we believe a “growth scare” could still rattle the financial markets. The Federal Reserve will be meeting later this week, and we expect that the central bankers will begin adopting a more dovish tone given increased signs
of economic weakness. The Fed remains concerned about inflation, but in our opinion, inflationary fears are easing. We believe the Fed will enact an interest rate cut before the end of the year, which would help support equity markets.

Against this backdrop, we continue to believe that the long-term outlook for stocks remains good. Although we recognize that a number of risks remain, and we retain our view that short-term market action is likely to remain choppy, we do not believe that the bull market we have been experiencing since late 2002 is set to end anytime soon.

Bank Loan Investment Funds

2007-03-14T16:59:00.000-07:00

Two years ago I started investing in bank loan mutual funds for many of our clients. They are a great way to diversify a portfolio without giving up bond income. Last year our bank loan investments earned approximately 9% versus the Lehman Bros Aggregate ishares which earned only 4%. Not bad for a bond fund that is senior secured debt and regularly resets for interest rate changes.

Senior floating rate loans are loans made by U.S. Banks and other financial institutions to large corporations. Floating rate funds are less susceptible to interest rate risk than fixed rate bonds because rates are periodically reset to the prevailing interest rate. So if interest rates increase slowly this fund is less apt to generate a negative return. These loans are the senior source of capital in a borrower’s capital structure (they are first in line if the company goes bankrupt) and have some of the borrower’s assets (real estate, machinery, investments) pledged as collateral.
So if the borrower defaults on the loan the assets become the property of the mutual fund. The value of the collateral may not offset the full value of the loan but the Eaton Vance fund has tried to minimize the risk of default by monitoring creditworthiness of the borrowers carefully and spreading risk by investing the fund in over 450 separate loans. Rarely does a loan represent more than 1% of the fund’s assets. This broad diversification helps to minimize the impact of default.

Year-to-date the Instituional shares are up 2% versus the Lehman Bros Aggregate ishare ETF (AGG) which are up 1.7%.

Attached is a write up by Eaton Vance regarding bank loans.

http://www.eatonvance.com/alexandria/2096.pdf

The Financial Pragmatist
Libby Mihalka

Sam Stovall Interview

2007-03-14T14:31:00.000-07:00

Sam Stovall's insights are right on point in this interview he did for Nightly Business Report on Tuesday March 13, 2007.

There is no reason to panic in fact I see the market correction as a great opportunity to put cash to work.

Here's the transcript.

The Financial Pragmatist
Libby Mihalka

SUSIE GHARIB: Joining us with analysis of today's market sell-off, Sam Stovall, chief investment strategist of Standard & Poor's. Hi Sam.

SAM STOVALL, CHIEF INVESTMENT STRATEGIST, STANDARD & POOR'S: Hello, Susie.

GHARIB: Are we looking at a correction here in the markets or is this the beginning of a bear market?

STOVALL: I think it's the correction, not the beginning of a bear market. I think certainly this has been something that's long overdue. On February 27 we snapped a 949 straight day period in which the market did not decline by 2 percent or more in one day. And normally we see an average of four of them per year.

GHARIB: But how big a problem is this sub-prime mortgage market?

STOVALL: Well, I think certainly because it bleeds it leads, and it is a cause for concern. And as a result it's, I think, triggered this slump in sentiment for investors right now primarily because of the uncertainty surrounding what kind of an impact it could have on the other areas of mortgages and mortgage-backed securities markets. So in general I believe investors are worried that possibly they did not anticipate this and that the uncertainty is that it could be worse than they're currently forecasting.

GHARIB: You talk about the impact on other mortgage markets. There's also concern about its impact on the economy and on corporate earnings. Do you see a huge spillover effect here?

STOVALL: Not really. Because when you break up the U.S. consumer into quintiles, the bottom 20 percent represents only about 8 percent of consumer spending and that's the category that typically would be involved in the sub-prime lending. Whereas the top 10% represents about 40% of consumer spending and that's the area that's not really being affected by this and is in the prime category.

GHARIB: I was talking to another market strategist the other day who was saying that he was very optimistic about the markets, saying because there there's so much liquidity out there, although today there seem seemed to be more people talking about a liquidity crisis. Which is it?
STOVALL: Well, I think there is the concern which could be exacerbating the markets decline today. Why financials fell 3 percent, why all 10 sectors in the S&P declined on the day is because people are worrying that the engine of growth, global liquidity, as you just mentioned, could start to dry up as lenders worry about extending credit where the credit is not due or at least not likely to be paid back. We at S&P basically believe that we're still likely to see a 15-10 target for the S&P 500 at the end of this year and we remind investors don't bail out of a lot of large financial institutions. Companies like Bank of America, like Citigroup, like Wachovia offer dividend yields that actually rival the 10- year yield on the bonds. So it's not just looking good compared with the S&P 500 but you're looking at 4.3, 4.4 percent dividend yields and quality rankings that are superior because over the past 10 years they have been able to increase their earnings and dividend growth.

GHARIB: Just a few seconds left. Some people think a cut in interest rates by the Fed would end all this selling. In a few words, what do you think?

STOVALL: I think certainly it could improve overall sentiment and add to the liquidity.

GHARIB: All right. We'll leave it there. Sam, thank you so much for coming on the program.

STOVALL: You're welcome, Susie.

GHARIB: We've been speaking with Sam Stovall, chief investment strategist of Standard & Poor's.

Pictet Investments Market Outlook

2007-03-12T16:50:00.000-07:00

Here is Pictet's Investment Outlook. Pictet manages the international funds for Forward Funds. I am adding Forward International Equities to many client portfolios. As I said in the last posting, this fund has experienced management and a small asset base. A combination I love because it enables an experienced portfolio manager to quickly maneuver his way through any market. It has allowed Pictets' managers to outperform Artisan International and deliver a performance comparable to Thornburg International Value (Morningstar has previously named the managers of these two funds as International Managers of the Year).

Enjoy the summary!

http://www.forwardfunds.com/pdf/pictet/200703-PGERX-commentary.pdf

The Financial Pragmatist
Libby Mihalka