No no Grandpa, Don't Overload Stocks!

This morning, as I chowed down my Raisin Bran, I happened to catch a personal finance "expert" who recommended that even people in their 60s should have 70% of their financial assets in stocks. 70 percent!! That's the highest I've ever heard, and while I have no readers that old that I know of, I hope younger readers can be the light and advice Grandpa and Grandma against this foolhardiness.

I've ranted before that any asset is only worth the price you pay for it. There is no such thing as a free lunch, and those who thought there was now make up the numbers in the foreclosure listings. But since I'm way too busy writing that epic called a dissertation (seriously, at times it does feel like one!), I'll leave you with this one great article from the one great magazine called the Economist. An excerpt (emphasis added):

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns. Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long.

My point isn't to stay away from stocks. It's just that stocks appear kind of pricey to me. If not for some special circumstances, I'd probably invest mostly in high quality issues, or better yet market-neutral funds which invest in these issues (actually about half my money is in one such fund), and overweight TIPS and cold hard cash (paying attention to yield, of course)

The Abuse of Math

Economist magazine had a wonderful series of stories on the recent financial crisis. Wall Street forgot the lessons of Long-Term Capital Management and embraced math in a big way. Unfortunately, they forgot that all models are based on something called assumptions, and any model is only as good as its assumptions. How way off base were the models?

Goldman Sachs admitted as much when it said that its funds had been hit by moves that its models suggested were 25 standard deviations away from normal. In terms of probability (where 1 is a certainty and 0 an impossibility), that translates into a likelihood of 0.000...0006, where there are 138 zeros before the six. That is silly.

"The Fed Rescues the Market, It's Safe to Play Again"

If you believed the hype in the media and the much of the financial world, the Fed has saved the world. By cutting the discount rate by 1 percent, financial Armageddon has been saved, and we can all go back to how well stocks will do. The media's largely been pushing this idea, the idea that somehow everyone got a little excited, so there was a correction, but now the Fed has acted and all's well.

It's easy to forget what started this in the first place. Financial institutions have a ridiculous amount of risky financial assets that have been blessed as risk-free, and the realization that the blessing was from a charlatan might mean at some point we have to realize the reality. In a classic problem of game theory, everyone's ok as long as no one brings the system down, but if the system were to collapse, it's best to be the first out of the building. So institutions and brokers and the press try to play down the CDO scam (for more on CDOs, read my previous postings, here and here)

And yet it's worth asking what indeed a Fed discount rate cut means (mind you, this is not a Fed Funds rate cut which would lower the rate consumers pay). If anything, it's cause for concern that the Fed, uptil now so concerned with inflation, suddenly perceives threats so great that it could substantially affect growth. And if the US and the world is indeed so robust, why should changes in a discount rate affect markets so radically? I would argue it's because investors today are asked to place their faith on a string on tenous assumptions, the failure of any one of which could produce severe consequences.

But ignore the killjoys like me. Believe the fantasy - the Fed has rescued the world. We can all go back to watching Cramer now. Thank you.

Let the Foreclosures Begin!

Many politicians are complaining about the rising wave of foreclosures, and insisting that government needs to step in and stem the crisis. Thankfully, President Bush has decided to do so such thing. Why not, you ask? Well, it simply isn't the government's place in a free-market system to insulate individuals from risk; such a practice simply encourages greater risk-taking and creates ever-greater bubbles until the protector is no longer able to be a hero.

Housing prices must correct! I hope to be financially in a position to benefit from a substantial correction down the road, but this isn't simply about the value investor in me who's hoping in asset price corrections to give me goods at bargain prices. We have frequently heard complaints that housing in most big cities is unaffordable. The Housing Affordability Index put out by the National Association of Realtors declined from a high of 133.2 in 1998 to 113.9 in March 2007, thanks to the housing boom. But even that understates the problem because it considers home prices across the US - the median price, for example, is $215,300 - good luck finding a home for that price in almost any decent-sized American city.

A real estate correction then is appropriate, and may be desirable in the long-term. Despite all the huey, one could argue that indeed price appreciation in excess of wages is rather undesirable, and if anything, government should consider tweaking tax policy to dissuade rampant speculation, including measures such as limiting the number of times you can flip a house before you lose capital tax gains.

This is hardly a popular position. We tend to get really excited when stocks or houses skyrocket in price, even if it means that the early buyers are being rewarded, while younger entrants are forced to pony up. But unlike stocks, housing affects livability, and government support of speculative efforts would be rather undesirable.

A side note You may have read that the Fed Reserve has been using something called repo agreements to purchase mortgage securities. Lest you think of it as a bail-out, here's a clarification I needed, from John Hussman of Hussman Funds:

Contrary to the apparent belief of investors, the Fed did not shift its policy, nor did it “bail out” the mortgage-backed securities market by “buying” them from banks. What actually happened is that the Federal Funds rate shot to about 6% on Friday morning, and the FOMC brought it down to its target rate by entering into 3-day repurchase agreements . The banks sold securities to the Fed on Friday, and are obligated to buy them back from the Fed on Monday at the sale price, plus interest. Such open market operations are designed to ease the immediate demand for liquidity, and to give the banks and dealers more time to find buyers in the open market for the securities they are trying to liquidate.

Reader Question: Leave the Stock Market?

In response to a previous post on 401k allocations, one of my readers, Jason asked if the author of a website I mentioned was suggesting avoiding stock allocation altogether. I do not know if that was Rob Bennett's point - in my reading, I didn't necessarily get that impression. But I do know a few things I'd consider.

The first is Benjamin Graham's counsel. Graham is the father of value investing, whose followers include a laundry list of super-investors including Warren Buffett (the world's third richest man), the Schlosses, the folks and Tweedy Browne, Seth Klarman and many others. Graham, in his book The Intelligent Investor, a classic investing text, ranted against paying too much for stocks and poor performance that ensued. And yet, Graham acknowledged that there was a significant element of performance that may not be captured purely by valuations, and that because of market action, it might not be desirable for an investor to stay out of markets until the next bear market. His preference was instead to reflect those inflated prices in an adjustment in equity allocation, with a 50-50 stock-bond mix in normal times, and going down as low as 25% in either asset when it was inflated.

This is precisely the tactical asset allocation many institutional investors pursue. The best, in my mind, is Jeremy Grantham of GMO. Grantham's commentaries, available for free with registration, are a must-read. In his latest piece, he points to a global bubble in every kind of asset, and GMO's own 7-year forecasts predict that based on average conditions, we can expect poor returns from our stocks, bonds, real estate, whatever. And yet there's enough variability that you wouldn't want to sit on cash. While that risk profile would justify increasing allocations to near-cash instruments, (i.e. money-market funds) yielding over 5%, a 100% allocation would be a mistake!

Also, even within the stock market, there might be reasonable investments. The one promising asset Grantham finds is "high quality" stocks. This is consistent with the opinion of others like John Hussman, who points out that quality stocks are cheap relative to garbage. He points out that the median P/E of the largest 50 stocks in the S&P 500 is 17, down from 35 in 2000, while that of the smallest 50 stocks in that index is 20, up from 10 in 2000. So people are paying more for riskiest assets than stable giants. By the way, the median P/E on the small cap universe is somewhere around 35, if I remember correctly (source forgotten).

So what's an investor to do? Well, if you're an active investor, you could reduce your stock allocation, keep your bond durations relatively short (the US bond market is going to see some blood), and focus on a bottoms-up stock picking. If you're a passive investor, focus on cutting your stock allocations, increase your short-term allocations, and hoard some cash. Sprinkle in TIPS or I-bonds. Rebalance if you haven't been doing it!

Oh, and either way, maybe pay off your debt - that can give you a guaranteed "rate of return" of anywhere from 6-9% for your mortgage, to 10-20% for credit card debt.

UPDATE: COMMENTING CLOSED This is a first for me, but as I've followed this debate, and glanced at other forums where this debate has continued, I've decided that most of the quality information has been revealed in the post and comments so far, and we're getting a combination of regurgitation of the same facts and personal attacks. So I've decided to close comments on this post. This isn't intended as censorship or bias - simply a decision to prevent this blog from getting hijacked by a rather vitriolic battle I've seen at other forums. Thank you all for your participation - heaven knows I haven't had 11 comments on too many other posts before!

Your 401k is All Wrong!

Sorry I haven't blogged in a while. I've been swamped, between family visits and working on a journal article. Hopefully I'll find more mental energy to blog - that's the key, not time, but just the ability to sit and pen my thoughts.

Meanwhile, I'm quite excited to report about a website that has captured some of my concerns about average Joes and Janes and their saving for retirement. I haven't read the entire Passion Saving website, but have liked a lot of what I read. The website talks about valuations and how they affect future investment returns.

What do I mean? Ok, so if you have a 401k or ever read a financial advice column, they would advice you to follow a certain asset allocation. Maybe you're 30 years old. Maybe you are told to do 80% stocks, 20% bonds (Nowadays, there are more exotic choices than the two, but let's stick with those two) Why? Well, stocks return more than bonds, so as a younger person, you should be willing to load up on riskier stocks.

But wait, that tells you nothing about the value. Think about it this way. Tom Brady is a great football player, but you wouldn't be betting the club on him. An investment is only good when the price is right - buy low, sell high.

"But stocks are cheap" comes the chorus. According to data from Standard and Poor's, the P/E on the S&P is 17 - that's down from over 46 in 2001, just when the market crashed. Two problems with that. One - why look at 2001 as the base year? The median P/E of the S&P since 1936 has been 15.4, so stocks certainly don't look cheap on that basis. But that's only the beginning ...

Unfortunately, the P/E doesn't correct for the cyclical nature of earnings. I have previously pointed to the work of John Hussman, manager of the Hussman Funds (my fav fund) talk about this issue. What's nice about the Passion Saving website is that it uses a much simpler way to bring the valuation issue to focus. By using a 10-year moving average of earnings for the P/E, Prof Robert Shiller of Yale, of "Irrational Exuberance" fame, shows that the P/E10 of the stock market is close to 30, the highest level with the exception of during the dot-com boom. The median value historically has been closer to 14. The value in 1982 at the start of the great bull market in stocks was under 6.

Click on the return predictor, and you'll see that based on historical valuation models, the expected real (i.e. adjusted for inflattion) return over the next 10 years is about 0.5%, which is much less than available on government bonds and inflation securities. What if the P/E10 was at its historical median. Then we could expect a 10-year return of over 6%, a pretty handsome return.

Valuations matter, and in an environment where real estate and stocks and longer-term bonds have been pushed up, the best an investor can do is to select a flexible bond fund or keep money in a short-term bond fund yielding about 5% until better options emerge.

The CDO Mess Waiting to Happen

If you haven't heard of CDOs, you haven't been paying attention to what might be one of the great financial crisis of our times. A CDO, or a collaterized debt obligation, is essentially a collection of poor quality mortgage loans that have been packaged together by the rating agencies like Moody's and blessed with a credit rating like a bond. I have blogged before about this topic. Bloomberg had a fantastic article that deals with the issue. Here's something that stunned me:

Corporate bonds rated Baa, the lowest Moody's investment rating, had an average 2.2 percent default rate over five-year periods from 1983 to 2005, according to Moody's. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 percent, Moody's found.

The Correction is Just Starting

If you believe the hype in most of the financial press, the "correction" last week was just the market needing some breathing room, because it got a little ahead of itself. All week, I've been subject to the same nonsense that "fundamentals are good" and that now is the time to go "bargain-hunting" (hmm, stocks were up 15% last year, but a sudden drop of 3% suddenly makes them bargains?) All week, I intended to pen a piece on why this was garbage, but the latest weekly commentary of John Hussman, fund manager of the Hussman Strategic Growth Fund helped explain a lot of what was on my mind (no accident since I'm a HUGE fan of Hussman - reading his weekly commentary is usually a Monday morning ritual for me!)

Needless to say, last week's decline had virtually nothing to do with China. While the decline in China (reflecting similarly overvalued, overbought and overbullish conditions) may have been a catalyst, blaming China for the U.S. decline is like having an open can of gasoline next to your fireplace and blaming the particular spark that sets it off.

What is the issue? It's valuations, silly! But what about those stories talking about how cheap stocks are relative to 2000. First, why is the year 2000, at the height of a ridiculously inflated stock bubble, a benchmark? Going across history, stocks aren't cheap. But they're even less so when you account for the historically high profit margins.

But isn't that touted as a good thing. The graph is courtesy of William Hester of the Hussman Funds, who showed that historical profit margins are rarely sustainable. Also, he showed that investors consistently overpay for those profit margins - the market has returned 3.45% annual return over 5 years when the margins when in the top 20%, and 15.69% when the margins where in the bottom 20%. Value investing - buying when no one else wants to - works!!

Additionally, Ben Inker of GMO, the investment firm that manages high net-worth individuals including Vice President Dick Cheney, points out that the surge in profitability has been in capital-intensive industries (see figure).

Hussman also takes on the popular talking points such as this nonsense of how the M&A boom means that stocks are a value - something I've ranted about previously:

A related theme is the notion that stocks must be good values because of the private equity buyouts we've been observing. It's important to understand that these buyouts are being done with OPM – other people's money – and that the main factor driving them is not low stock valuations but low risk premiums. Risky debt can currently be issued at interest rates barely above the low yields on default-free Treasuries. This will certainly end badly for investors in low-rated credits (as companies that issue sub-prime mortgages are beginning to realize). It is no indication of attractive stock market valuation. Investors should be skeptical enough not to draw conclusions from transactions that use OPM. It's interesting, for example, that analysts wax rhapsodic about corporations repurchasing their shares, while ignoring the fact that sales of personal stock by corporate insiders have rarely been higher (recently at rates of 8-10 shares sold for every share purchased). What people do with their own money is much more informative than what they do with someone else's.

So what's an investor to do? Ignore the press. Pare down stock allocations to no more than 50%, load up on high-quality debt (using a bond fund for most readers), focus on quality in stocks (harder to do if you use a mutual fund) and bonds (low duration, Treasuries or investment-grade). An investor is simply not being paid enough to take risk, as this chart from GMO shows.