Congress Waivering on Fiduciary Issue

Justin here. An article last week from WSJ's Jason Zweig highlights what fiduciary duty means to Joe Investor. The element of how congressmen play into the reform is interesting. After seeing how Senator Colburn trades his account, it seems a lot like letting my two year-old decide her bedtime . . . or if she has to hold my hand when she crosses the street (depending on how important you think fiduciary duty is.) Full article here.

In a recent interview with the Journal's Brody Mullins, Sen. Tom Coburn (R., Okla.) said that most of his money is managed by a professional adviser. The senator explained that his portfolio is heavy on oil and natural-gas stocks because energy is big business in his home state of Oklahoma.

Sen. Coburn added that he has his own account at TDAmeritrade, valued at about $70,000. He said he trades actively based on tips he gleans from Jim Cramer's "Mad Money" show on CNBC.

In 2008, Sen. Coburn traded Transocean four times in less than a month on Mr. Cramer's advice. "I lost my shirt," the senator said. He fared better with Tyson Foods, which he bought on Nov. 20, 2008, and sold less than three weeks later. "I bought it and got out because it went up," Sen. Coburn said. He added that he regretted selling Tyson so quickly, because its price kept rising after he sold.

Paul Krugman Thoughts

Justin here. I went with a friend last night to see Paul Krugman speak at the Guilford College Bryan Series. I've got a number of things on my plate today so my review/thoughts will be brief.

Best Quote: "We can no longer make money by selling each other houses that we bought with money we borrowed from the Chinese."

Second Best Quote: In talking about the similarity between the US and Japan he said something to the effect of "With the exception of our raw fish consumption, we're pretty similar. Both democracies, both have hard working intelligent citizens, both have politicians who aren't the best but aren't idiots."

Comment That Provoked a Slight Gasp from the Woman Beside Me: when answering a question about the N.C. furniture industry, Krugman said he couldn't imagine an industry that is so labor intensive lasting so long in a high wage country like the US. And he followed that up with something to the effect of "before you get too worked up about that, remember that it's only here because the high wage North East US forced the jobs south to cheaper labor." As if to say, this is only a pit stop on the way further south.

Cold Sweat Inducing Statistic: 55% of commercial loans that are to reset in 2014 are underwater. And that's considering that they started with an extremely low Loan/Value ratio that would certainly need to go up if they get rolled forward. Makes me think of a number of friends in the commercial real estate business as well and the impacts that has on other industries.

My Question That I Didn't Get To Ask: what do you do with your excess income (i.e. how do you invest)?

Overall message:

• He talked about how we got into this mess ('shadow banking', poor regulation, leverage),
• How this was/is a global crisis (Spain, UK, even countries without bubbles felt it because they were connected.)
• What we did right (cut interest rates, stimulus, flexible fed),
• How we get out this crisis quickly (no silver bullet that will save us like railroads, world wars, and IT did for recessions past . . . only remote quick fix could be green technology, but even that has a lot of barriers and lag time, and 10% unemployment is a HUGE number will take a lot of GDP growth to get over),
• How, more likely, to get out of it slowly (possibly unions (which, to my surprise got a round of applause), possible further stimulus, cut interest rates if we could go any lower)
• Final point was that Keynes said "the shortage of capital through use, decay and obsolescence causes a sufficiently obvious scarcity to increase the marginal efficiency" meaning that our ipods will break, our computers will become slow, and our tires will wear out. Although slow, this process will create demand and innovation.

Politics aside, it was a good talk. It reinforced our slow growth thesis and our propensity to seek quality dividend paying companies as well as opportunities outside the US and in fixed income.

I Probably Won't Be Dessert . . .

Justin here. Professor Jeremy Seigel recently pointed out the difference between the fear of unemployment vs the reality of unemployment here:

"The June unemployment rate touched 9.5%, and it is quite possible that that rate will eventually exceed the 10.8% rate reached in November 1982. But even if it does, unemployment will rise, at most, 2 percentage points, far less than the reported 30% to 40% of workers who fear they will be laid off. And as the economy mends, the fear of being unemployed will subside, and consumption will rise."

Professor Seigel has forgotten more than I'll ever know about economics, but I have to (very respectfully) disagree. I think it’s unrealistic to think that Joe Consumer could have 10-20% more friends, family, and co-workers lose their jobs and then somehow he'll then breathe a sign of relief and start spending because some economists think that unemployment is already far above normal. I think Joe is going to pretty scared for a pretty good while.

It’s like being in a pit of lions that, on average, will eat no more than one human in a sitting. I don’t know about you, but if I’m stuck in there and two of my buddies were just eaten (mind you that's 100% above the average), mean reversion and bell curves won’t make me any less likely to need a clean pair of underwear.

Two Wrongs Don't Make a Right - Pension Insurance

Pension insurer shifted to stocks - The Boston Globe
Posted using ShareThis

The article above gives me a pit in my stomach on a number of levels, but one in particular. I think most people would get sick thinking of the money already "lost" . . . I get sick thinking about the money that might not be gained.

I'd like to think that the Pension Benefit Guarantee Corp would operate under some pretty standard advice: if you need money in the next 5 years, maybe you shouldn't have it in stocks. I do think they need to be proactive and estimate if they'll have an onslaught of pensions to back and see if that changes their time horizon, but they also need to be able to face reality. With valuations where they are, it might very well make sense to "stay put" and not have Congress reallocate your portfolio.

As we say here: "Two wrongs don't make a right." From this observer's point of view, it seems like shift back to the old strategy right now might be wrong #2.

Note: The author recognizes that he does not possess the right mix of qualifications, connections, and unconfessed past sins that is required to work for the PBGC, the Government Accountability Office, or the Congressional Budget Office. Therefore, his opinions are merely that and should not be applied to your investment strategy or the government's investment strategy for that matter and frankly he's surprised you're reading this fine print.

Will the Dow set a new low in 2009?

Call me old fashioned, but I think there are safer and surer ways to get paid while waiting than to own a contract, valued at approximately 79 cents on 2/3/2009, betting that the Dow will set a low that is lower than 7,449.38 sometime between now and year end. 

With stocks at multi-year lows and investor pain at multi-year highs, I'm pretty sure that going long the Intrade contract is not a bet I'd want to take...but that's what makes a market.  If I understand the value proposition correctly, the buyer who's willing to pay ~ 80 cents to own this contract, now believes that there's an 80% chance that he'll see lower lows than 7,449.38 sometime this year.  Conversely the seller who's willing to sell this contract for ~ 80 cents now believes that there's a 20% chance that he'll see lower lows than 7,449.39 this year.  See Disclosure and more beneath chart.  



[Disclosure - Jonathan Smith doesn't own this, or any, contract on Intrade (or any other prediction market) and isn' making any recommendations, bets, conjectures, whatsoever. For the record, his dowsing stick isn't any better than anybody else's. Intrade.com is a prediction market, and much ado has been made by the media about prediction markets. In case you're wondering what sort of payoff the buyer of the aforesaid contract gets for his ~ 80 cent investment if he wins. The answer is $1.00. On the other side of the transaction, the seller who sold the contract got ~ 80 cents for being willing to pay a buck if he loses. After he subtracts the ~ 80 cents he gets to keep from the buck he might have to pay out, he'll be out ~ 20 cents, and so you could say he thinks there's a 20% chance the Dow will go south of 7,449.38 in '09.]

By the way, this chart used with permission by Intrade.com.

Pick-a-Pay Loans

Justin here. One of the worst financial inventions to come out of the housing boom has been the "Pick A Pay" loan.

Basically, the homeowner picks a payment they feel comfortable with, then they just pay it; it's as easy as that. You get a low payment, increasing house value, and big biceps (see picture) . . . well, not really.

What happens most of the time is that the homeowner is actually paying less than the interest! So the principal, instead of going down with every payment, actually GOES UP! You are essentially borrowing more money monthly. This was all well and good (though still not smart) while home values were rising. You can guess what happens when the house starts falling.

In May 2008, a San Francisco news station did a segment spotlighting the training videos that the company used (video here). It shows a scene where the homeowner asks the loan officer to clarify that he won't actually be paying down principal with this loan and the recommended response is "it's optional".

(Note: The company shown in the video was bought by another bank, which was bought by another bank, which then suspended the pick-a-pay program and then got bought by yet another bank.)

Recipe for Disaster: Keeping Up With The Joneses

Justin here. The single best (and by far most fascinating) explanation I've found of the current financial crisis is This American Life’s The Giant Pool of Money episode that aired on NPR. (You can listen to the 30 second promo here, the full story here, or read the transcript here.)

Mostly because excerpts like this:

“I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. I’m serious ... $540,000 to a person with bad credit.”

It made me realized that the sole cause of the crisis (literally ... the ... sole ... cause) is this: the need to keep up with the Joneses.

At every level of the chain: from countries needing to boost their investment returns so they sell out of treasuries and go to higher yielding alternatives, to homeowners taking out mortgages and second mortgages because their neighbors and friends are, to mortgage brokers creating riskier and riskier loans because their competition are, to banks buying those mortgages because the other banks are buying them.

The desire to “keep up” overtook the need to act rationally. I urge you to read or listen to it. Below are some more excerpts (emphasis mine) and my key takeaway:

"An interesting fact, here. Mike Garner's bank did not care how risky these mortgages were. This was the new era: banks didn't have to hold on to these mortgages for 30 years. They didn’t have to wait and see if they’d be paid back. Bank's like Garner's just owned them for a month or two and then sold them on to Wall Street. Wall Street would sell them on to the global pool of money."

And this:

"No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it."

And lastly, this about the current and future landscape:

"The global pool of money is avoiding anything with even the slightest hint of risk and that affects everybody, no matter who you are. It's harder to borrow money to buy a house, or build a factory, or bring your country boldly into the 21st century."

My key takeaway is this: things are generally not as good or as bad as they seem.

Translation: if Mr. Market underpriced risk on the outset of this mess (ie - he bought risky securities he shouldn’t have), is it so crazy to think that Mr. Market could overprice risk today (ie – Mr. Market might not be buying some low risk securities that he should be buying?)

The House is Falling

Justin here. When my wife and I moved to Greensboro, we looked at 10 or 15 houses before making an offer on the cheapest one of the lot. After finding out there were two other offers, we paid the asking price ($129,900) for the 110 year old bungalow that had an abundance of charm and lead paint but skimped on the closet space and bathrooms.

Almost four years, one baby, 6 restored windows and a new paint job later, I'm still scurrying across the house at 6:00am to get to my closet, one that was made for a man with much narrower shoulders than me.

Anyway, when the stock market is moving like it is now, we've found it helpful to think about stock prices in terms of home prices. We've often asked clients, "What if you had a ticker running across your screen telling you what your home was worth? What if Jim Cramer screamed about your home price on TV? What if Barron's did a story about how overvalued your house was?" You'd start to believe everything they say.

Enter Zillow, a website that is supposed to track the daily price of your house. Zillow has been out a while, but I only got around to looking up my house in the last few months (below is the 5 year chart, that circle withe the $ is where I bought the house.)

And when I looked at it, do you want to know what I felt? Regret. Seriously. I regretted buying it for more than zillow said it was 'worth' ($115,000) and regretted not selling it in May 2008 when it was 'worth' $164,000.

But, you want to know what else I felt? Relief. Seriously. I was relieved to not have gotten the email, seen the quote, or heard the news that my house was 'worth' only $120,000 in February of 2007. Relieved that I didn't panic and sell out after it "when down" 15% from my purchase price. Relieved that I knew what my house was really worth and didn't sell for less.

And then I realized that looking at Zillow is no different than reading a stock analyst report, listening to a talking head, or checking your stock portfolio daily. The analysts and talking heads might sound slick and have a clean looking chart, but chances are they don't know the real value. And your stock portfolio today is only a snapshot of what someone will pay you right now, not a true measure of what is is worth. We think the prices we'll see in 6, 12, 18, 24, heck even if it takes 36 months (which is still long before the bulk of us will need to use our investments) will tell a much different story that the 'quotes' we're getting today.

Try telling the seller of my house that it was only worth $115,000 the day before he sold it - that's what Zillow said it was worth. I think he'd argue that my bank's check to him for $129,900 is a lot more accurate than Zillow's "quote." For him, his house ended up being worth about 13% more than Zillow quoted. Would it surprise you if we had the same thing going on in the stock market today, but on a much larger scale?

Ben Graham, the father of value investing, Mr. Market, and Warren Buffett's investing career, once said:

"The investor who permits himself to be stampeded or unduly worried by unjustified market declines . . . would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment."

Words worth remembering, especially now.

Question: What Are You Doing?

Justin here. American Public Media's Marketplace has been asking different people that question ("what are you doing?") since the start of this financial crisis. Today, they asked one of our favorite people: Dan Ariely

In this three minute 'interview' (listen below) Dan says that he has decided to not look at his investment statements. His motivation is more for peace of mind than anything else. Dan found that when he looked at his dwindling account it put him in a bad mood. In other words, worrying about it didn't add a single day to his life (those are my words, not his . . . well, not really even mine.)

We'd agree with Dan's advice . . . but with a caveat. We think two of the keys to successful investing are 1) finding a person (or process) that you trust and 2) sticking to them (or it.)

The "leg-work" is done in step 1 and "stomach-work" is done in step 2.

So, if you've done your leg-work in step 1 (picking a sound, rational, time-tested person or process), then the stomach-work in step 2 should be easier (not easy, just easier).

However, if you've been willy nilly in step 1 (following the talking heads, the cocktail party stock picks, or the advisor without a process), then step 2, well . . . you better keep that motion sickness bag next to your letter opener.

Class is in Session

I stumbled upon some some great explanations of recent events from martketplace.org (as in "Hi, I'm Kai Ryssdal and you're listening to Marketplace on NPR.)

They have a number of videos by Senior Editor Paddy Hirsch. The stick-figure-on-white-board lessons are great primers on what is going on. In the short (5 minute) videos he touches all sorts of terms acronyms you hear on a daily basis but might be a little (or a lot) fuzzy on such as: CDOs, naked shorting, CDSs, The TARP, margin calls. You can find them all here.

I think the most enlightening one is on CDOs (below):


Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.

. . . so, what are we doing?

Justin here. This is from our most recent market commentary, (here):

One of our clients called, saying he had a question: “I’m just curious as to what you are doing to insure that I won’t lose a lifetime of savings?” . . . I’m going to take a cue from my old high school algebra teacher and assume that if someone in the class asks a question, chances are that other folks in the room are wondering the same thing.

In the commentary, we include an excerpt from Warren Buffett's 1987 letter to shareholders, which features his explanation of the way he thinks about the stock market - what he calls Mr. Market.

Buffet's words are so clear and helpful that is should be required reading before anyone opens a brokerage account (maybe I'll include that on my "suggestions box" form for President Elect Obama.)

As a side note, you can find all of our past commentaries here. If you'd like to be added to our quarterly mailing list, send me your mailing address and we'll be happy to send it to you the old fashioned way.

2:30 pm on April 28, 2004, did you know where your SEC Commissioners were?

Stephen Labaton, in an article he published October 3 in the New York Times, provides a close up look into one of the most arcane moments of 2008, so far.  Labaton explains how an obscure Securities and Exchange Commission decision led to an out of control financial crisis.  Read it, and you'll see why Senator John S. McCain, on the day he was quoted as saying, "If I were President of the United States, I would fire Christopher Cox today.  (That's Mr. Cox, on the left, chairman of the Securities and Exchange Commission, and Roel C. Campos, on the right, at a House hearing in 2007. Mr. Campos was on the commission in 2004 when a decision was made to change the net capital rule for big investment banks.  Mr. Cox appears to be listening out of both ears.)  As recently as March 11, 2008, Chairman Cox has said, "We have a good deal of comfort about the capital cushions at these firms at the moment.”  How do you like that?  I've read Labaton's article, silently.  I've read it, out loud.  I've read it to anyone who will listen.   And I ask the same question every time: how could Mr. Cox have been so wrong?  Give it a read. 

The editors of the Times, with whom I disagree often, published a 4 minute slideshow of the April 28, 2004 meeting (pay close attention to Item #2) between SEC Commissioners and the heads of JP Morgan, Lehman Brothers, Merrill Lynch, Bear Stearns, and Goldman Sachs, in a basement conference room at the office of the SEC.   Reading the article and viewing the audio slideshow won't lower your blood pressure, but it will provide valuable insights that the talking heads haven't. 

I'm interested in what you think about this.  I invite you to use the "comments section" found beneath this post.

Days till we reach zero

On more down days than I'd like to admit, my team mates have heard me say, "At this rate, we'll be down to zero in no time."  Now they've started saying it before I can get the very words out of my mouth.  It's "tap code" at JSCO for a bit of gallows humor that our team uses to puts things back in perspective, to put the train back on the track, to put the cart behind the horse.  You get the point.  As any fool who can push a stick in the dirt can tell you, it's not going to go to zero, even though we sometimes think it will.

Stock markets are behaving as if all the indexes will go to zero in less than a month, maybe sooner. No one knows the future, but I for one have a hard time believing that this very real, very serious financial crisis will play out by going to zero. The Dow Jones Industrial Average, a proxy for the market, has in fact experienced record of volatility and panic selling this high only three times since December 31, 1946, the end of World War II:

• October 16, 2002, when the Dow Jones was 8,036.03
• November 9, 1987, when the Dow Jones was 1,900.20
• November 5, 1974, when the Dow Jones was 674.75

The summers of 1962, when the Dow Jones was 572, and 1970, when the Dow Jones was 874, experienced high but slightly lesser volatility and panic selling.   The chart below shows the Dow Jones Industrials and our fear and volatility indexes from December 31, 1946 to the present.  Click the chart to full size. 

No one knows where and when all this panic will land.  Some wonder if it ever will.  It will.  History records that extreme volatility and panic selling do not last indefinately.  At some point, the invisible hand of Adam Smith kicks in and eliminates whatever shortage exists.  Some would say his invisible hand has already been working off the shortage of buyers.  Extreme volatility and panic selling provide wonderful opportunities to buy shares of excellent businesses at bargain prices.  Today's headlines are rarely the same as what history's judgement is going to be. 

If you haven't already seen it, study the wonderfully perceptive presentation by Weston Wellington of Dimensional Fund Advisors that Justin described in his post of October 2, part of which is below:

• "Earlier this week, I came across a presentation by Weston Wellington with Dimensional Fund Advisors, called "Is It Different This Time?" Wellington reviews our nation's past and, in particular, the media's reaction during those time. He does a great job of bringing some perspective to a volatile time.  (Justin said viewing it was guaranteed to lower blood pressure 20 points for every viewing.  If current levels of volatility and panic don't ease up soon, I'll need to view it several times a day.  I guess there could be lot worse things than reinforcing one's long-term perspective. 

This is not a recommendation to buy or sell any security, market, or an endorsement of any investment philosophy, firm, or process.  This is just a call to sit down, take a breath, and study history.

If we did more of the latter, I think we could get out of this

Friday morning's broadcast about the Wachovia Takeover included two pearls of wisdom; I heard them as the interview ended and think it's safe to assume Marketplace listeners (and Renita Jablonski) might not have heard them.  The interview is only 3 minutes long and well worth hearing/reading.  Click the player's "play" button to play; hit "pause" button at 3:03 marker to stop. 

Bonus: Chris Whalen notices tremendous people at Wachovia.

TEXT OF INTERVIEW

Renita Jablonski: Wells Fargo is buying Wachovia for just over $15 billion. That takes Citigroup and the Federal Deposit Insurance Corporation out of the picture. Citi was only looking to grab Wachovia's banking operations. The FDIC said it would step in to pick up any loan losses. Wells Fargo says this morning it will acquire all of Wachovia and that it doesn't need the government's help.

We're joined now by Chris Whalen, managing director of Institutional Risk Analytics. Chris, you've been watching these developments for awhile. What do you think of Wachovia now getting together with Wells?

Chris Whalen: I think they're a much better fit for one another. I also was really a little concerned about Citi, because you know, they have the most subprime consumer focus in their business model -- Citi's loss rate on loans, for example, tends to be twice the other large bank peers'. So I am not keen on seeing Citi buy anything right now.

Jablonski: And we should mention that Wells Fargo did play a little game of hard to get here because it had initially wooed Wachovia with a $20 billion figure, kind of pulled out of that -- that's when the Citigroup / FDIC thing started and then came back. What brought Wells back to this?

Whalen: Well I think the Wells Fargo folks ran the numbers and they decided that they needed to make a bid. If you look at Wells Fargo's perspective, they have a way of getting into the northeast, into the southeast, and that's a beautiful thing for them, cause they're now a national franchise. And once they deal with the asset quality problems, they have tremendous people at Wachovia that they can integrate into the Wells Fargo. And I think they couldn't say no -- they had to get in the game. And that's great news for all of us.

Jablonski: How important is the timing of this deal, coming down on this day of the House bailout vote? I guess this raises the question, is government intervention truly necessary right now?

Whalen: Well, not this intervention. I've been opposed to the House plan since day one, and the reason is we're fighting a battle that we should have fought six months ago in terms of liquidity, the accounting rules that started this mess. And really, the big picture here is we're going through a deflation. We're having asset values fall, a lack of a bid for many assets. We have to fix that and make leverage our friend again.

Jablonski: But I have to ask you this, I mean it seems the perception at least is that Wall Street is so much counting on this bailout at this point.

Whalen: Well, don't worry about Wall Street. Believe me, Wall Street will be there tomorrow. But we've got to stop looking at short-term market indicators as an indication of reality. I think we spend far too much time looking at the television set and far too little time talking to one another. And if we did more of the latter, I think we could get out of this.

Jablonski: Well, it was good talking to you. [read: Me give up watching TV network news and opinion shows?  No way.]

Whalen: Thank you.

Jablonski: Chris Whalen of Institutional Risk Analytics.