The Ignorant Investor

I don't understand the market's love for REITs. According to what I'm seeing regarding Vanguard's REIT fund, earning's growth is down and the fund trades at 86+ times earnings. Price to book is 2.3X, which is not extreme, but is still high. Yield is just a little over 3%. The upside has to be limited unless earnings growth is accelerated, but there's probably something going on in this market that I don't understand. Vanguard's broad-based REIT is almost back to its pre-recession levels.

This is the trouble with being an amateur forced to play in a world of professionals. I have to play the investment game to grow a retirement plan, but the markets always end up acting in mysterious ways.

Krugman writes about Britain's austerity-based plan for economic recovery:

Meanwhile, in Britain, via Yves Smith, people have been digging into the details of the government forecast, and finding that it relies on the assumption that household debt will rise to new heights relative to income:

Why? Because the only way the economy can avoid taking a hit from government cuts is if private spending rises to fill the gap — and although you rarely hear the austerians admitting this, the only way that can happen is if people take on more debt. So we have the spectacle of a government that inveighs against the evils of debt pinning all its hopes on an assumption that over-indebted households will dig their hole even deeper.

The alternative to more private debt would be widespread wage increases for private workers. But in an era when the elites can call workers greedy and overpaid, how likely is that to happen?

I frequently read The Big Picture for Barry Ritholtz's excellent insight into the markets, but I disagree with him here:

Since Bernanke gave his Jackson Hole speech, the S&P 500 is up 25% but in gold, commodity and other currency terms, the gains look not as good. In gold terms, stocks are up just 6.6%, in oil they are down 13.6%, in CRB terms they are down 8%, in Euro’s they are up 11.8%, in CAD up by 15%, in AUD up by 8.5%, in CHF up by 10.5% and in yen up by 19.5%. I make this analysis to point out the nominal world the Fed is trying to jump start to deal with too much leverage in our economy where in reality, REAL gains are the only thing that helps a country’s standard of living.

This is all true, but during the 1990s, you could have pointed to stocks and compared them with gold and seen the opposite trend. We measure the value of financial assets and currencies by auction prices set by thousands of traders. The value of assets can be traded for goods and services, but the rate of exchange varies from moment to moment. This variation is only partly based on what we'd consider reality. In large part, auction prices depend on the mood of buyers. What is popular or a "must have" for a trader in one day, can be a "must dump" the next day. How real can an asset price be when it can vary by 3,5,10 percent in a single day of trading?

The S&P500 is made up of companies that produce goods and supply services. Most of them do a portion of their business outside the dollar zone and so function across currencies and national economies. Their profits should reflect not just our standard of living, but also that of people in other countries, yet the S&P500 has consistently underperformed other equities in the past 10 years. Small and mid-sized companies, many of which presumably have a much greater exposure to U.S. currency than their larger cousins, have done much better over the past 10 years than the S&P500. Why? Because they trade at a higher multiple. They are in favor with traders, who are willing to pay 70% or so more for a dollar of earnings of a small company than they will for a dollar from the likes of GE or Exxon. If the S&P500 traded at the multiples it did in the 1990s when it was in fashion, we're be looking at levels of 25,00-30,000. We'd be having a different conversation.

I'm not making a case for that level of valuation in the S&P500, but it's happened before when traders and the public go mad for large cap stocks. And it's the kind of thing that's happening now with the price of gold. I own some GLD, and its value keeps going up. But there isn't anything any more real about it than stocks. It's a piece of paper that reflects an asset that for some reason people believe is a store of value that can't go down. All it takes is a change in fashion for it to drop like a stone.

TOKYO – Japan's government said the cost of the earthquake and tsunami that devastated the northeast could reach $309 billion, making it the world's most expensive natural disaster on record.

That's less than a third of what we've spent in Iraq over the past 8 years. Forget about our war in Afghanistan or our war in Libya. We've been suffering the fiscal equivalent of three giant tsunamis a year every year since 2003. And what can we point to after all that spending? Not new bridges. Not new rail networks. Not a new air traffic control system. Just a broken down, barely functioning nation of 24 million Iraqis with bad plumbing and intermittent electricity. And that's not even considering the cost in lives.

The Economist's Buttonwood points out some questions regarding the approach taken by Yale's David Swenson in managing Yale's endowment. I liked Swenson's book for the individual investor. Very common sense in that he points out that what he does at Yale can't be replicated by the individual investor because he has access to money managers and asset deals that cost to much for Joe Average to access. Buttonwood wonders whether Swenson's approach to using non-correlated asset classes hasn't proven as effective as people initially thought:

Another problem is that diversification means more than simply a willingness to invest across a wide range of asset classes. It also requires taking a separate stance from the herd. Some asset classes (particularly illiquid ones) can be subject to a “rowing boat” effect. Mortgage-backed securities were a classic example. Everyone rushes into them, so the price rises sharply and investors pat themselves on the back for their shrewdness. Then something happens to change sentiment. As everyone tries to rush out of the asset, the boat capsizes. The additional returns achieved during the boom turn out to be illusory.

Martin Leibowitz of Morgan Stanley has analysed the characteristics of endowment portfolios over the past ten years. He looked at three portfolios: a classic 60/40 US equity/Treasury bonds split; a Yale-like portfolio with seven separate asset classes; and a portfolio with international diversification but without the illiquid private-equity, hedge-fund and real-estate portions. What is remarkable about these portfolios is how closely correlated they all are with the S&P 500. Even the Yale-like portfolio had a correlation of more than 0.9 (where 1 is a perfect fit).

This story is directed more at professional money managers than me, but I am intrigued by the idea that the simplistic two-asset class mix are correlated to more complex portfolios.

I'm sitting on a pile of cash right now. I should have added to my holdings of bonds years ago, but I figured the inflation rate would be higher. In retrospect I was wrong, but that's the nature of market predictions. You get some calls right and feel empowered. Then you make a decision with confidence and find a couple of years later that you're wrong. So then you're underconfident and do nothing, worrying about the next move you make being the wrong one.

My cash gets almost nothing sitting in a brokerage account, so it should go into something. Short-term bond funds are paying 1-2 percent,so I'm not losing a lot of money by not buying one. The longer terms yield more, but they're expose to interest rate risk. People say rates are going to rise, but how confident can I be about that? Japan has kept rates low for a very, very long time. Our Fed may talk about raising rates, but are they believable? Stocks have been on a big run, and the upside potential is being questioned. Real estate, which I bought only recently, is crazy valued already. It's all maddening. I tend to just think about it intensely for a few days and then give up in a fit of indecision or frustration.

This is why Lazy Investor style portfolios were invented. Trying to predict the future of the financial markets leads to uncertainty, and uncertainty leads to inaction. The advantage of a fixed allocation approach is that it's mechanical. No thinking. Just buy and open a statement every now and then to see if some kind of rebalancing is needed.

The thing to remember about asset allocation is that in hindsight, one or more of the segments of an allocation don't do well. Looking back over the year's returns and comparing all the funds in the portfolio to a list of all the other funds available on the market, there will always be funds you don't own that will do better. With the benefit of hindsight, it's easy to construct a fantasy portfolio with much better returns that your own portfolio's. But look down the list today and predict the winners for the next year. Pick the five funds that will offer the highest returns in 2011. I've tried it, but the future never works out the way I expect it to. That's why I've been trying to focus on sticking with the basic allocation mix: domestic stocks (small and large cap), international stocks, and bonds. There will be a lot of investors who do better than me, but at least I won't spend a lot of time thinking about this stuff.

NASDAQ has an article up at its site that notes:

Treasury bonds and treasury bond ETFs were among the very few assets that did not decline during the worst moments of the financial crisis in 2008-2009. Even gold and silver performed erratically during this period. U.S. treasury assets proved to be negatively correlated with the broad market. As equity benchmarks were cut in half, treasury bonds ETFs soared to new, all-time highs

I read a book by money manager Robert Swenson a couple of years ago that pointed out the reason for owning U.S. treasury assets. It's not for the return. If you want high return, you go with equities or equity-like assets. Instead you buy treasuries to diversify, so that when equities start going south in a panic, there's a counter-weight from treasuries that boost bond returns during the frightening times when portfolio values are dropping.
He pointed out in his book that people will often go with corporate bonds for the extra couple of percentage points in yield they offer, but since the ability for corporations to pay bonds is highly correlated with their profits. Corporate bonds tend to do well in good times, and not so well in bad times. So if you're optimistic enough about the economy, you may as well buy equities.
Swenson might be overstating the case, but it's something to think about. Comparing Vanguard's Total Bond Market Index over 1,3,5 and 10 year periods indicates that Long Term Corporate bonds might out or under perform the broad market at times, it all equals out in the end. More or less.

Looking back over the returns from my 401K and investment accounts, what hits me is that I haven't done any of the stupid things that investment advisers say not to do, but I'm still not making much money. I don't trade a lot, I don't jump in and out of funds chasing returns, I don't panic and sell every time there's a market move.

For ten years I've done what all the books say to do: set an asset allocation, then stick with it for the long term. But the basic portfolio allocation of say, 60% stocks and 40% bonds just hasn't been a money maker. All the big, long-term gains over the past ten years has been in gold, stock options, real estate, commodities. All areas where the investment options for individuals are either limited or too perplexing to manage safely.

Yes, I could invest in currency or commodity futures, but I'd have no idea what I was doing and would quickly lose money. I could also have invested large amounts in specialized metal funds, but all the respected books said not to do this. It was the nutjobs that said to put everything in gold. But the nutjobs have won. Kudos to them. Madness worked out.

It's long been a general rule of thumb of retirement planning in books that people should allocate 401Ks according to their risk profiles. Stocks have higher risk, they say, but on average "grow by 10% a year." This was true when I was younger, but since 2000 these projects proved ephemeral. Vanguard's Total Stock Market index fund has, for example, earned a total average return of 3.67 percent as of yesterday. At the same time, the company's Total Bond Market fund, the "safe" option for namby-pamby risk averse investors, earned 5.32 percent average annual returns over the same period. It's rare to see that kind of outperformance by bonds over stocks over a 10-year period.

If the time period under consideration is expanded to include the 1990s, the 20-year picture is more in line with expectations. The Total Stock Martin fund was created in 1992, and it's average return over the course of its existence is now 8.72 percent. This is a measure of just how gigantic the returns were in stocks during the 1990s. Since 2000 we've been locked in a trading range. My portfolio goes up, then it goes down, then back up. But I never get any richer.

One of these days we'll make it past the 1990s highs of 2000 for good. But there's no way of knowing when that's going to be.

Pretty self-explanatory stuff in the Wall Street Journal today.

The chairman of the House Ways and Means Committee wants to cut the top U.S. tax rate to 25% for individuals and corporations, and cut or eliminate many popular deductions.

I understand the need to cut deductions, including ones I benefit from like the home interest mortgage deduction. But cutting popular deductions won't happen in a final bill because of the fear of voter backlash. The only provisions that will get through are the cuts for individual rates and corporations. Which means more deficits. The Republicans and conservative democrats will then demand that we reduce the deficit by cutting social security, medicare, and medicaid. It won't matter that social security taxes have been higher than necessary (i.e., in surplus) for decades and thus subsidized lower income tax rates on the wealthy. Instead, we'll be told that the poor and middle class are too greedy and that "painful cuts are required." These cuts will not be painful to the wealthy, because they don't rely on social security or medicare. But that won't matter.
It's an obvious game plan to anyone who pays attention, but most voters don't.

According to the White House's FY2012 budget, tax revenue is forecast to rise by more than 76% from 2010 to 2016. Even accepting that 2010's revenue was extraordinarily low due to the recession, that seems like an optimistic projection when there aren't strong majorities in Congress for removing the Bush tax cuts. Does anyone really believe that Obama, the Congressional Democrats, and the Republicans won't repeat last year's dance when it comes time for today's historically low rate of taxation to expire just before an election year? That sounds like a long shot.

Yesterday I raised the prospect of investing in REITs, but today I looked at the pricing history on Vanguard's REIT index. At around $19 per share the price is still well below its 2007 high of $30 per share. But during the financial crisis it dropped to under $8. Right now the yield is 3 percent. Better than a money market, sure. But not the stuff for rapidly growing portfolios. I've added a REIT fund to my 401K account, but the thinking was that it is more of a hedge against inflation risk than a real money maker.

This is one of those times I was talking about yesterday. The Japanese market is facing the prospect of a nuclear meltdown, so it plunged today. According to one trader quoted by the AP:

Peter Cardillo, chief market economist at New York-based brokerage house Avalon Partners, said fear had taken hold in the market as traders worried about the nuclear crisis and a possible slowdown in Japan's economy, the world's third-largest.

"It's a situation where you sell, and you ask questions later," he said.

This is one of those moments when you have to decide whether it's a chance to buy at a discount or stay out. You can buy an ETF for a Japan index fund (EWJ) for just under $10 right now, down from a high of $11.50 only a short time ago. But you have to go in trying to figure out whether $10 is the bottom or just a stopping point on the way to a decline of 20 or 30 percent. During the 2009 crash, EWJ briefly fell to under $7. If that's a potential floor in a new panic, even buying today could result in a 30% loss, at least in the short term.

Looking at the daily chart, EWJ opened at $9.3 and rose through the day as people bet that the panic in the Japanese market wasn't justified. By the end of the day it was above the prior day's close of $10.05, even though the Japanese stock market, which closed much earlier in the day, fell more than 10%.

Meanwhile, the S&P 500 closed about one percent down after dropping by 2.5% early in the day. Is that a sign of strength, in that the American market shrugged off early jitters. Or is it a signal that traders are nervous and are getting into their "crash" mode? I don't know. As I was through much of last year, I'm filled with uncertainty and am just relying on the benefits of doing nothing.

There's a lot of discussion in the financial press about whether the market will head higher or is about to tank. This is one of those decision points that come after a good runup in equity prices. Studies show that ignorant investors like me tend to feel most comfortable buying stocks after a long period of rising stock prices. We get in on the end of the rally just as the professionals are getting worried and moving out of them.

About two months ago I went from about 60% equities up to 80% equities, just as the trend line in the S&P 500 was turning sideways. I haven't made much money by making this move, and I've increased my exposure to a correction. So I'm acting in line with the expectations of behavioral economists.

The standard advice in dealing with this kind of decision-making is to pick an allocation among asset classes that fits a risk profile and then stick with it mechanically. This removes the need to make decisions that, at least in the case of ignorant investors like myself, tend to be mistimed.

The dilemma I'm in now goes to setting those basic allocations. We're in an unusual investing environment because of the Federal Reserve's policy on low interest rates, savings accounts and short term bonds offer almost no returns. Worse, the rates are lower than the inflation rate, meaning that every dollar left in a savings account is losing purchasing power as time passes. This has pushed up the equity markets, and it's difficult to fight the Fed on the issue. If they want to make stocks more attractive than bonds, they've got the power to do that.

Now the question is how long the Fed can maintain such low interest rates. Conventional wisdom suggests that when rates go higher, long-term bond funds will get hammered, and the stock market will lose the help of the Fed in pushing the indexes higher. So bond funds are at risk and stock funds are at risk. For the ordinary investor who doesn't have access to, or the familiarity with, exotic investment vehicles now in vogue with hedge and pension funds, there aren't many other options to choose from. A savings account will protect capital from loss, but while the money is on the sidelines its purchasing power is trickling away even in a time of low inflation. If inflation increases, it only gets worse.

So what's left? Real estate?

Paul Krugman writes today about banks jerking around borrowers in a loan modification program. A complaint filed by Nevada's attorney general...

...charges the bank with luring families into its loan-modification program — supposedly to help them keep their homes — under false pretenses; with giving false information about the program’s requirements (for example, telling them that they had to default on their mortgages before receiving a modification); with stringing families along with promises of action, then “sending foreclosure notices, scheduling auction dates, and even selling consumers’ homes while they waited for decisions”; and, in general, with exploiting the program to enrich itself at those families’ expense.

The end result, the complaint charges, was that “many Nevada consumers continued to make mortgage payments they could not afford, running through their savings, their retirement funds, or their children’s education funds. Additionally, due to Bank of America’s misleading assurances, consumers deferred short-sales and passed on other attempts to mitigate their losses. And they waited anxiously, month after month, calling Bank of America and submitting their paperwork again and again, not knowing whether or when they would lose their homes.”

I believe that the public still believes that big banks like Bank of America can't be staffed by scumbags. There's just something too horrible in the idea that a large business could be operated with the same predatory dishonesty that you'd find in the local low-rent check cashing operation across the tracks. They want to distrust the government and believe that big business can't be operated in a way that screws the little guy. Our ancestors who lived at the turn of the last century would be bewildered by this attitude.

When Erin McFarlane looks at public workers, she sees lucrative pension benefits she doesn't ever expect to get. And it makes her mad. "I don't think that a federal employee or government employee is worth any more than anybody else who does their job and does it well," said the Slinger, Wis., woman. She's been working a couple of bartending jobs since January, when she was laid off from her job at a Harley Davidson plant after almost a decade.

Doesn't make a lot of sense for Jane Sixpack to get mad at public workers when America's wealthy are the ones getting rich off her pain. She's falling for the same "divide and conquer" strategies that the wealthy have used since colonial times to keep workers from voting for policies that favor the poor and middle classes.

It's not important what the American public thinks because the media and Congress don't listen to them anyway. And if we want to be accurate about the situation, the elite people who run the country aren't worried about deficits, either. What they want is spending cuts. If they were worried about deficits, they'd be talking about cuts and tax increase.