The Ignorant Investor

Business week ran a story a few weeks back on a scenario in which oil prices would soon fall. Since my continued well-being is dependent on home heating oi and gasoline, among other commodities, I wanted to note down the main thrust of the article by writer Mark Morrison.

Inventories were up in July, Morrison writes, "and demand in the U.S. is getting dialed back at a time when plenty of oil and refined products are sloshing around." What's more, speculation on prices may be running out of steam now that much of what can go wrong for the oil business- wars in the mideast, pipeline damage in Alaska, hurricanes- has happened without pushing prices past the $80 mark.

Worth noting: If $50 oil comes around, oil company stocks will get hit hard because oil stocks are about 80% correlated with the underlying oil price. That's something to think about for people like me, who is holding a bag full of BP stock. May be time to mostly end our long relationship.

On the counterpoint, we've still got an awful lot of Chinese consumers who will be wanting cars. The big question is, will their energy use support oil at $80 a barrel, or only $50. Or $30. That's something to think about when someone pushing an oil stock blithely invokes the "new Chinese consumer" as justifying ever higher prices for energy.

If I could give just a single word of advice to someone about investing, I'd suggest the following: keep your teeth clean. Brush at least twice a day. Use the floss. Pour a little listerine down the gullet and slosh it around before spitting it out. It's one thing that is totally in your control. Unlike the market, which is unpredictable and frustrating.

Experts would add to this the concepts of sound asset allocation, periodic rebalancing, and dollar cost averaging, but right now I'm focused on preventing tooth decay.

You knew it was coming. Worried over your job being shipped offshore? Don't worry- it's actually going to increase the money you earn. There's free lunch for everyone, say two economics professors:

JACKSON HOLE, Wyoming (Reuters) - Take that, Lou Dobbs. Despite much handwringing and political posturing, the surge of job outsourcing, by increasing productivity, has actually helped raise real wages for low-skilled U.S. workers, according to two Princeton University economists

I'm willing to keep an open mind, but it's hard to see how offshoring increases the income levels of laid-off auto workers. And it's hard to trust economists in this day and age when economists see themselves as the intellectual vanguard for the forces of multi-national capitalism. So why do I have the feeling that most of the people who quote this study on CNBC and Fox News will have done no more than read the abstract, if that?

Tonight there's a documentary on the History Channel called "Exodus Decoded" that argues that the Exodus really happened. I haven't seen it- probably won't see it- but Virginia Heffernen at the NY Times gives it a pretty positive review (calling it "mezmerizing") while also noting that it's maker, Simcha Jacobovici, "does not entertain competing arguments."

Decoding this last phrase, it's pretty clear what you're in for when you watch this documentary. Lots of little factoids, arranged in a way that makes the director's conclusion inescapable, with none of that dreary counterpoint provided by those untelegenic "experts" who disagree with the director and keep blabbering on about stuff like "evidence" and "competing theories."

I'm a sucker for documentaries about ancient history, and they can be separated into two types. The dull historical ones that offer alternatives and discuss current thinking based on spotty artifacts. And the fun, exciting ones with "shattering conclusions" that basically use the appearance of science or history to reinforce one's own view of the world, religious or otherwise.

Also from today's Times, and appropos of the whole religion thang, comes poll results showing that "sixty-nine percent [of the respondents] agreed that liberals had “gone too far in trying to keep religion out of schools and government.”

What schools and government need apparently, is more religion. And so I ask, how about Islam? We take a plane over to Pakistan, land at one of those thousands of religious schools they got over there, and load up a few Imams. Bring 'em back and install them in our schools and city halls to bring a little more God into our civic life. It's a cheap solution that will bring the word of God (aka Allah) to millions of our impressionable schoolchildren. Yes, there may be some squabbling over which religion gets taught in the public school, and exactly which deity actually runs the American government through our religiously-sanctioned elected officials, but nothing brings out the best in people more than arguing over whose religion is the right one.

In the Boston Globe's story Pension law to usher in 401(k) era, I noticed this gem of a line:

. . . [401k] plans still might prove less generous for workers than current pension systems but may be the best workers can expect given the economic pressures many companies face, said Peg McGlinch, legislative director for US Representative Richard E. Neal, the Springfield Democrat who sits on the House Ways & Means committee that helped write the law.

Note the phrase "the best workers can expect given the economic pressures many companies face" is used at a time when corporations have never been more profitable and when wages are stagnant for many workers. The more accurate way to put it would be, "the best workers can expect given the economic pressures that many workers face at a time when good paying jobs with robust benefit packages are thin on the ground." Really, what choice do workers have but to accept whatever they can get?

I haven't had the chance to read all about the new law, and what I saw looked good for investors. But that line just made me laugh. The PR departments at corporate America are just terrific these days. When they speak to Wall Street, they brag about how profitable they are. When they speak to Congress, they go in with the trouser pockets of their Brooks Brothers suits hanging out. Poor us, they say. Poor, poor us.

According to Reuters:

WASHINGTON- Many U.S. homeowners continue to take cash out of their homes even as mortgage rates climb and home sales slip, helping to brace the economy, economists said. This year, Americans who refinance their mortgages are expected to draw $257 billion of wealth out of their homes, according to mortgage finance giant Freddie Mac.

This is an unexpected development. House prices have been leveling off or dropping in some areas, so its an odd time to be taking on mortgage debt. It just goes to show that however cautious the mood is getting among Wall Street economists, the American homeowner doesn't think he's getting fired tomorrow and is happy to keep borrowing large sums of money against his house.

Way down in the article, one commentator explains that homeowners used to dream about burning their mortgages and living without the mortgage payment hanging over their heads every month. But now they are happy to go into serious debt to get cash to keep up their spending habits.

It's a very odd attitude. They're going to have to pay back the money eventually. All they've done is diverted future income they'll earn later into walking around money to blow today on chicks, booze, and fast cars.

Interesting chart from the St. Louis Federal Reserve, showing the divergence between P/E ratios and the S&P 500.





What it shows is that even though the market is now less optimistic about the future (and thus unwilling to support high valuations), corporate America has spent the past couple of years marking up record profits. Globalization has allowed them to find a sweet spot where consumers flush with cash from rising asset prices buy products made by low-wage workers in developing economies. The result? The companies have lowered their expenses while charging the same prices, and that has kicked profits into the stratosphere without triggering high inflation. It's only in the cost of materials that we've seen inflation- oil, metals, wood- because the supply of these isn't currently as ample as that of cheap labor.

If these record high profits prove ephemeral- if, for example, labor costs in developing economies started to rise, or consumers run out of cash to spend- we should expect to see the traditional linkage between multiple contraction and falling stock prices reassert itself. Probably quite rapidly.

It could be because I've become hostile to the idea of selecting stocks instead of buying index funds, but I read this from Money Magazine's Penelope Wang with a sense of weary skepticism:

Just as growth managers Helen Young Hayes and Tom Marsico were hailed by investors and the financial press, including Money Magazine, in the 1990s, value managers are hot today.

Take Joel Greenblatt, a hedge fund manager who teaches finance at Columbia University. His book "The Little Book That Beats the Market," which outlines a basic formula for picking value stocks, soared to the top of the bestseller lists after receiving fawning reviews.

Soon to hit the shelves is a follow-up, "The Little Book of Value Investing," a primer written by Christopher Browne, co-manager of the Tweedy Browne funds . . . Browne, whose company once did stock trading for legendary value investor Benjamin Graham, writes, "I like to think of Tweedy as the Vatican City of value investing, and although we do not have a pope, we have great cardinals and bishops."

There's nothing inherently bad about taking the value approach to stock picking, so long as you understand that the rest of the market will often turn to picking stocks by judging which ones will most attract a crowd even when the numbers look bad-i.e., "growth stocks" or "momentum investing"- and that you'll have to watch while growth investors trumpet their huge returns (remember the late 1990s?) . Value managers now argue that the value approach has been proven correct, but as always what we see is a turning of the great wheel. The yin and yang of investing in equities, ever swirling. Today value, tomorrow growth. Then back to value, then growth. That's why many investors buy both growth and value funds, so they always have a horse pulling the cart and don't have to worry whether they've got the timing right.

Checking out the investment mix in Vanguard's target retirement funds and noticed that they're way too equity oriented.

The targeted or "Life cycle" or "Life Point" funds concept involves setting up a single fund composed of some mix of the company's other funds. Investors don't want to have to decide on allocating their money among various large cap, small cap, bond or foreign funds. All they do is buy the Life Cycle fund and that's it. It's essentially one-stop shopping. Just pick the one that matches your target retirement date, the company says, and they'll handle the allocations and periodic rebalancings suitable for a person of your age or for your desired level of risk/volatility.

In Vanguard's case, for example, investors get what is essentially a pre-set package of their index funds allocated among the total stock market fund, Europe and Pacific foreign stock funds, and a bond fund. The fees are rock bottom, and the company's reputation stellar. That's good. But in allocating the money among the various funds, Vanguard leans heavily towards equities. Big time. Like 85% towards equities. And that's too risky for me.

Yes, I know that even when you're retired you'll want equities in my portfolio. But if your retirement date is 2010, barely three years away, should you have more than half your money in equities? Probably not. Most people won't be able to handle the volatility such an allocation brings. Even among someone middle aged like me, who is supposed to have a higher tolerance for risk, having 85% in equities would require some steely-eyed resolve and faith in the power of equities if we face a huge drop in prices (and let's face it- at some point we will). And these "target retirement" funds from Vanguard don't even include real estate, which is an important asset class for diversification.

I've seen other one-decision funds with much more conservative allocation mixes for given age ranges. I'm kind of wondering why Vanguard has gone overboard with equities in theirs. It's just odd. I like the concept because simple is always better. But it's still important to see what's under the hood so you know what you're getting.

I don't know about other people, but for me its when I've tried a plan and it hasn't worked out. I get frustrated, say "fuck it, this isn't working. I've wasted my time. I might as well do ______."

That blank spot there is where I insert the stupidity.

The New York Times business section does a short rundown on the current battle between Jeremy Siegel, professor of finance and director of WisdomTree, a company offering "fundamental indexing" products, and Vanguard's Jack Bogle, creater of the traditional S&P 500 cap-weighted index fund:

According to Mr. Siegel, there is a “revolution” under way, a “new paradigm” in which the traditional indexes like the S.& P. 500 will make way for fundamental indexing, which constructs indexes based on measures like companies that pay dividends, rather than just a company’s size. . .

. . Mr. Siegel says the central problem with traditional index funds, which are weighted by market capitalization, is that they overweight overvalued stocks and underweight undervalued stocks. Historically, value stocks outperform growth stocks, so an index should be constructed to invest in the cheaper value stocks rather than the expensive growth stocks.

“We should be shifting to another paradigm to look at how markets work,” Mr. Siegel said in an interview. “I don’t think the price of a stock is always in line with fundamentals. I think there are a lot of factors, which helps to explain a lot of what we see in the capital markets.”

. . . Mr. Siegel says that the market has a lot of “noise” in it and that prices are not the best measure of true underlying value, making market-cap weighting inefficient. A rise in a stock’s price may not reflect a change in fundamental value, but a lot of noise in the markets.

Bogle disagrees, saying that Siegel's approach is yet another "new paradigm" designed to outguess the market on the direction of security prices, one that is likely to fail just like the others.

What it comes down to is this: with the S&P 500 fund (or even better, the total market funds based on the Wilshire 5000), you get the benefit of all the collective wisdom of all the very smart people playing the market. Sometimes they're wrong when the value stocks, and sometimes they're right. But history indicates that you generally do better with this collective analysis than you do by following any particular manager or formula.

The fundamental indexes will rise or fall based on the wisdom of following the criteria they select. For Siegel, it's dividend paying companies. For others, it's a mix of P/E ratios, book values, price-to-cash flow, etc. I don't see this as much different than active management, since active "value" managers tend to use the same tools in their stock selections. So fundamental indexing seems like just another form of active management, albeit one that is cheaper and subject to less turnover than the typical fund.

Another alternative that's in the news is the so-called equally weighted S&P index fund represented by RSP. It's based on a version of the S&P 500 that gives each component the same weighting rather than weighing the stock by the size of their capitalization. Smaller issues end up contibuting more to returns in an equally weighted index than in the traditional 500 fund, in which the 100 stocks with the largest caps typically account for about 70% of returns. Over the past few years RSP has outdone the S&P 500 by a few points a year, basically because smaller issuers have been in a bull market as large caps have lagged. But note: when the worm turns and big caps lead, the S&P will outperform.

Over the very long term, RSP's managers say, stressing the smaller stocks lead to better returns if history is any guide. But this depends on at what point in the small cap/big cap bull market cycles you enter the market, and when you start to pull out your money. So if it's something that interests you, you can always buy both and split the difference.

At "Ask SmartMoney":

QUESTION: I'm 74 years old. My broker is asking me to invest 50% of my assets in an unlisted REIT and an unlisted equipment-leasing fund. The idea is to have a portfolio with no stocks, no bonds and a sizable income. Would you consider this appropriate?
Ben Suntag
Rockaway, N.J.

ANSWER: Appropriate? Hardly. More like nuts. Placing half your assets into two illiquid investments "makes no sense," says Ralph Block, author of Investing in REITs. "The most important aspect of investing is diversification."

It sounds like your broker is thinking more of his own income needs than yours — commissions on these types of investments typically run around 7%.

Good answer. This kind of advice is why people should never trust brokers. When the revolution comes, I'm hauling my ass over to this broker's house with my menshevik comrades and stringing him up from his wrought iron balcony. Let the old man go at him like he was an overstuffed pinata.

All brokers have wrought iron balconies, by the way. They build them on their mansions using the sweat of hard-working and overly trusting American investors. This is fact! Everybody knows this.

I'm about done reading a lot of the bloggers out there. Soooo many opinions on what's coming over the next year or two, much of which is delivered in a snide, "smarter than thou" tone that makes me grit my teeth.

I get it, I want to say. You are so fucking smart, Mr. Generic Market Blogger. Everyone but you is a total fucking idiot who can't read a balance sheet, doesn't recognize the danger of twin deficits, can't read the obvious signals in the market tape. Whatever. Alan Abelson is one of the worst for this, but I've seen a ton of other blogs with the same approach. And they all link to each other or point out when the other guy "gets it" by agreeing with their own position. Or have people commenting on the blogs that the writer "sees what's coming" and notes how it jibes with their own predictions.

What you end up getting is a single view, magnified in its significance by sheer repetition. Obviously some of these bloggers are going to be right at any given moment (and we'll have to hear about it endlessly when they are), but I don't believe anyone can predict the next nine months to a year - or three years, ten years, whichever time period you choose- with any justifiable confidence.

So I'm sick of reading their work. I've got to find something new.

Okay, it's only a guess. Over the past three and a half years Vanguard's REIT index fund (VGSIX) is up about 250% percent, with a three year average of 25% per year. That rivals the growth rate of the S&P 500 during the 1996-2000 period of "irrational exuberance."

The yields tell the whole story. You can see the effect of the market bidding up the value of these securities in the yields. I remember a few years back when a REIT might yield 9%. Now VGSIX yields about 4.28%. That's less than you can get in a nearly risk free money market fund. And VGSIX's P/E ratio is running around 48, a figure nearly as high as Google's.

These are shopping malls and office buildings we're talking about, not a whole new industry like online advertising that Wall Street may have difficulty in evaluating. It's well known that the supply of commercial and residential properties are subject to occasional cycles of boom and bust. Yet instead of caution taking hold, year to date VGSIX is up over 13%, a return far beyond any asset class but gold.

These just don't seem like rational valuations. REITs are terrific for diversifying a portfolio, and the toughest task in investing is watching a security you see as overvalued continue to score as you sit on the sidelines. But what can you do except wait for the inevitable reversion to the mean? Nothing goes up fast forever. And you don't want to be left holding the bag when it starts dropping.

Financial Columnist Scott Burns on the creation of his simple "Couch Potato Portfolio":

In the summer of 1987, just before the crash, Jerry wrote a piece on “The All Weather Portfolio.” He was worried about stock prices and wanted to develop a portfolio that was suitable for all markets. It also had to be simple, so anyone could do it. I thought it was a great idea and started looking for something really simple that would produce better results than most people were getting with CDs or the mutual fund of the moment, whether it was sold to them or came off the cover of Money magazine.

Eventually, I reduced Perritts five choices down to two. I eliminated real estate, for instance, because most Americans already have a big real estate commitment in their house. I eliminated gold because it was too fluky. I eliminated international stocks because Coca-Cola gets most of its profits abroad while Honda gets most of its profits in the United States. That got us down to domestic stocks and bonds, a two fund portfolio you could produce with two index funds.

Over the past couple of years Burns has moved away from the pure simplicity of the 50/50 split and added international funds, and, in one suggested portfolio, real estate. Yet I still like the concept of his original idea.