Brighton Perspective

Bankruptcy isn't so bad

Markets are headed for a flat to slightly up day despite continuing drama regarding swine flu and the Chrysler bankruptcy. Wow - a big company can fail! Despite the rhetoric out of DC the dissident investors had a fiduciary responsibility to do what they believe is right for their investors. Bankruptcy enables all sides to work out issues before the judge. Give this time and it won't be surprising if he end result is a superior organization. Investors will take a hit, which they should as risk seekers, but they will have done their jobs. Remember - all sides are trying to maximize their stake. There is no altruism in financial markets. It is a zero sum game. The market appears to have taken this in stride just as it did with Bear Stearns (granted not a bankruptcy) and Lehman and just as it will GM. Don't think for a minute that the markets hadn't factored in the supply chain. They have. Let's see how it unfurls from here.

When to get back into equities?

Download SSRN-Market Timing AA

This white paper discusses a tactical asset allocation process utilizing a simple moving average (SMA). When the reference index level moves above the 200 day SMA its time to invest in equities. When it moves below the 200 day SMA you sell. Unless you invest in an ETF that replicates your preferred benchmark this isn't easy to implement for most investors. However, it can be used as a piece of the mosaic regarding how and when to increase/decrease your equity allocation. As the chart below shows:



the approach has some merit. It's also clear the spread between the S&P index value and its 200 day SMA was at its largest recently and is now closing. As a piece of the mosaic, it would suggest now is not the time to increase your allocation, however, if as I've mentioned before, you're dollar-cost-averaging, or are considering doing so, now may be an appropriate time to start. If the spread continues to improve you're averaging through the buy signal. If it weakens, you can suspend contributions until an appropriate time. If you happen to be completely out of equities, you can average in or simply wait for the spread to turn positive. Keep in mind though, that the chart shows several periods in the 04-07 where the all or nothing approach would have required multiple trades. Know your risk tolerance, all or nothing if you can handle it otherwise cautiously average in.

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This paper provides an interesting statistical analysis regarding the potential shape of the economic recovery. Most likely, you've heard mention of U-shaped or V-shaped recoveries. The writer introduces an L-shaped recovery as well. He argues that while Models suggest a "traditional" V shaped recovery, the more likely scenario is an L-shaped recovery. This is so because of the financial crisis. The implication of the financial crisis is less leverage in the economy which translates to a slower recovery. Less access to available capital means less money to spend. We've argued the same scenario - we believe the reduction in leverage will persist for quite a while and will lead to a much slower and lower recovery than we've seen in the past.

Lots of Tax Hikes Coming in 2011 - Kiplinger.com

Lots of Tax Hikes Coming in 2011 - Kiplinger.com.

Clients with taxable portfolios should pay particular attention to this article and start planning now to manage your taxes (if you're not already doing so). It's interesting to see that the average rate is the same as in 1982 and that "high income" earners are paying more than in 1982. Many studies have shown that raising marginal rates does not raise revenue as taxpayers make necessary adjustments. The net result is that taxpayers will pay what they believe to be a "fair" rate.

This is contributory to the economic pressures we face now and will likely face in the future. New monetary and fiscal stimulus, particularly fiscal, will have a meaningful impact if consumers spend. But consumers will instead save if they believe the fiscal stimulus will be funded by higher future taxes. They save because they know they'll have a higher future tax bill that must be paid. Lower spending/higher savings by consumers increases the probability the government will need additional stimulus. Higher savings and tax deferral strategies combine to keep revenue growing at a lower rate than expenses. In fact, U.S government revenue (mostly taxes) grew roughly 7% annually from 1947 through year-end 2008. Government expenses grew roughly 8%. Thus we have a growing budget deficit. Surprised?

Econbrowser: Oil shocks and recessions

Econbrowser: Oil shocks and recessions.

This is worthy of your attention. Prof. Hamilton suggests that the current global recession was heavily influenced by the global oil shock last summer during which oil prices rocketed to nearly $140.00 a barrel. He suggests that oil price shocks were influential in 12 of the last 13 recessions. While they are not the sole cause of recessions, sharp increases in oil prices do act as a punitive tax on consumers. They must make very significant trade-offs between keeping gas in the tank and spending on discretionary items. Discretionary items tend to lose out in this battle which contributes to a significant slowdown in GDP (consumers account for more than 2/3rds of total GDP).

Clearly, the headline grabbing issues of today were materially involved as well but Prof. Harrison's arguments are credible and worthy of inclusion as to what lead to the recession and how best to recover going forward. it would appear from this research that managing oil prices, similar to managing inflation, should be a key component of monetary and fiscal policy.

Housing values

This is a fascinating chart! Through under-grad and grad school, I was educated to believe that residential real estate will appreciate over time at a rate consistent with that of inflation. Like most marketable assets, it will have its imbalances, but the argument should hold true. This chart provides another means of appreciating the value of real estate. It's equating the median income with the median home price over the past 30 years. You'll see the relationship does cycle and clearly disconnected in some markets in the early 2000's. That's not surprising to anyone reading the news or trying to buy or sell a house in the last few years. It's interesting to me that the relationship in almost every city listed has returned to or fallen below that of 1979. Essentially mean reversion. That doesn't mean the real estate cycle has troughed just that it's approaching what could arguably be called fair value. When asset prices mean revert however, they tend to fly by the mean so there could be more downside.

Before clicking through, try to quess which city owns the top line! It's also interesting that 3 of the top 5 lines (most out of whack in the 2000's) belong to the same state!

The Best and Worst 529 College-Savings Plans - Morningstar - Fund Spy

The Best and Worst 529 College-Savings Plans - Morningstar - Fund Spy.

529 plans shared the pain last year. Despite that, they still should be a cornerstone of your college planning efforts. There are many, many flavors from which to choose, so conducting through due diligence is a must. This article covers the best and worst according to Morningstar. There are several other excellent sites worth reviewing as well, including:

www.savingforcollege.com

Security and Exchange Commission

www.529s.com

I have recommended Utah and Michigan in the past for many of the reasons Morningstar lists for Utah in the linked article. Do your homwork, or have an advisor do the homework for you. Use common sense when selecting the appropriate portfolio - realize the additional risk you're assuming if you decide to be more aggressive than your child's age based portfolio suggests (this is accomplished by choosing a portfolio for a younger age), be patient with the results and continue to add each year (dollar cost averaging).

130/30 Funds: 130% Gimmick/30% Good Idea -- Page 2 - Morningstar - Fund Spy

130/30 Funds: 130% Gimmick/30% Good Idea -- Page 2 - Morningstar - Fund Spy.

Coming from a shop which manages 130/30 strategies for institutional investors, I have to disagree with most of this commentary. I find several issues with the analysis:

1) Based on a single year and a year which is hardly representative of historical market performance (up or down).

The theoretical argument is that no time period is long-enough to determine true manager skill from luck. One year is insufficient for any analysis but is particularly useless for this analysis as virtually every stock and bond went down in 2008 and almost indiscriminately. When stocks follow a defined trend and when correlations are exceedingly high, as in 2008, active managers have little opportunity to add value. As an aside, it shouldn't surprise most that passive strategies outperformed active in 2008.

2) Posits that 130/30 managers are attempting a double alpha strategy - that is, they intend to provide excess return from their long holdings as well as from their short holdings.

Most 130/30 managers will, instead, argue that their intended excess return (alpha) is the net of their long and short exposure. That is, they are not intending to be double alpha managers. In fact, the institutional argument is that most managers, particularly the traditional long-only managers entering 130/30, should simply short index futures. This argument is made on the assumption that these managers are simply financing their leveraged long exposure which is where they truly intend to add value (their best ideas).

3) I am not familiar with anyone who positioned 130/30 as "too good to be true" strategies. They serve a purpose of providing the potential for higher return while reducing volatility. More on that in a moment.

4) Short-sale proceeds must be held as "collateral" with prime brokers and are not used to purchase more stock.

In a traditional prime brokerage account, this is essentially true. Short-sale proceeds are held by the Prime Broker and earn the T-bill rate of return minus the PB carry (usually 25 bps). In most 130/30 strategies, the managers use an "enhanced" prime brokerage account in which the PB charges a "through the middle" fee rather than a carry. The "collateral" isn't the short proceeds but the long holdings. Thus the proceeds are available for investment. This is essentially how the 30% long leverage is employed.

5) Defining risk as beta.<br><br>Defining risk as beta is insufficient though useful to this analyst's analysis. 130/30 strategies will define risk as either tracking error (volatility of excess returns) or standard deviation (volatility of total returns). Tracking error for 130/30 strategies is typically in the 4% range. I would expect standard deviation to be slightly below that of a long-only benchmark.

I do agree with the analyst's comments regarding shorting experience. It does matter. Understanding which stocks are "hard to borrow" and the potential impact on the portfolio is relevant. Managers with short experience will have methods of addressing these issues, such as excluding "hard to borrow" stocks from their universe or by increasing the expected transaction costs associated with trading the stocks (causes the optimizer to ignore the stock).

130/30 strategies can and do make sense for portfolios. The intent is to provide the potential for more alpha while reducing total volatility and reducing total portfolio volatility (the short exposure dramatically changes return patterns which leads to much lower correlations with long-only strategies which leads to lower portfolio volatility).

The one fund mentioned happens to be the oldest 130/30 open-end mutual fund and is managed by an individual with short experience. It's also one of the few fundamental strategies. Most 130/30 funds are quantitative because of the need for risk management. While not perfect, quant strategies can offer better risk management than fundamental strategies.

So rather than dismissing these out of hand, give them time to develop. I expect time will demonstrate they can add value and are not 130% gimmick/30% good idea. Lame title by the way.

A Crisis of Ethic Proportions - WSJ.com

A Crisis of Ethic Proportions - WSJ.com

A well written article on the need for a renewed emphasis on ethics and fiduciary duty. I had a conversation with the proctor while taking the CFP exam last month. He asked me if I thought that current events would lead to a change in exam topics as well as in B-school courses. I stated that I thought ethics needed to be elevated again. When I took the CFA exams in the mid to late 90s ethics were front and center and were a determining factor in pass/fail determination. I don't think that's the case today in most arenas. We've move to what Bogle refers to as moral relativism with regard to ethics - essentially if its ok for him its ok for me. Clients need to challenge their advisors to live up to their responsibility to do what is in your best interests. I've noted before that advisors should be willing to acknowledge their fiduciary duty to clients and if your advisor won't do so, reconsider your reasons for working with that advisor.

Housing market improving?

I receive periodic email alerts from Zillow regarding the estimated value of my home. The past couple have shown an increase in value for the first time since late 2007. The last one also showed an improvement for my zip code for the first time since mid 2006. This is another piece of anecdotal evidence. By itself it doesn't necessarily mean much but I'd contributes to the mosaic. Good news from Goldman yesterday is also valuable. More better than expected news from Alcoa, CSX and Citi will also be affirming. Of course, unexpected bad news will suggest we may have another leg down. While I'm hoping for good news I wouldn't be surprised to see the market back up.

Paying for College: 529 Plans Won't Cover It Anymore - Personal Finance * US * News * Story - CNBC.com

Paying for College: 529 Plans Won't Cover It Anymore - Personal Finance * US * News * Story - CNBC.com.

529s are an excellent vehicle for college planning. However, as the article indicates they shouldn't be viewed as the only options. Rather, they are a key component in the college savings plan. The tax deferral benefits of a 529 should make it the core of your plan. Be sure to select a plan and an investment strategy that fits the age of the child you're covering. Be patient with the process and refrain from being overly aggressive. If you started early you have time. As your child approaches college age, other methods of financing college can be incorporated:

1) File for financial aid even if you don't believe you'll qualify. File the FAFSA on or as close to January 1st of the year in which your child will enter college.

2) Have your child visit the guidance office at his/her high school and pick up any applications available for scholarships and grants. You'll be surprised how many are available and how many don't receive applications. Many students receive scholarships and/or grants simply because the applied.

3) Taxable investment accounts can be used to cover whatever the 529 assets don't.

4) Consider home equity - the tax deduction will help offset the cost of college.

5) Other options include loans and borrowing from your 401k but these should be considered after other options are tapped.

Finally, in the current economy many families are opting to have their college age children start at a community college and transfer after 2 years to a 4 year college. They still get that 4 year degree from a great school but at 2/3rds the 4 year cost.

What's Your ETF Gullibility IQ? - Yahoo! Finance

What's Your ETF Gullibility IQ? - Yahoo! Finance.

This is not the best written article I've read in a while. In fact, it seems to me that the author has an axe to grind rather than legitimate concerns. Start with the argument regarding non-transparency and lock-ups as critical to the success of a hedge fund. The question of transparency is an on-going one with investors, particularly institutional investors, demanding more transparency and many hedge funds intent on denying it. It is not, however, make or break as to the success of an investment strategy. While at a prior firm, we ran market neutral strategies and provided our clients with full positional transparency daily (via their custodians). If they had wanted to review our shorts and discuss these shorts with their golf buddies they could. This knowledge is of limited use, unless the golf buddy has extremely deep pockets with which he can go long our shorts and attempt a short squeeze. Very few managers have the ability do so that effectively and fewer still would consider it worthwhile. Exceptions, of course, exist, but its exceedingly rare.

Lock-ups are valuable as well to prevent fast money from moving in and out (fund of funds can be particularly guilty of this) but very, very few managers will implement a strategy with a time horizon so long as to be impacted by the lack of a lock-up. A one year short is unlikely - most stocks are too volatile to maintain short exposure for that long a period of time.

Quibbling about whether the "true" expense ratio is 1.09% or 1.11% is also trivial. There are any number of reasons for the discrepancy.

The ETF in question is a "hedge fund replication" strategy. I have not researched the investment stratey applied by Index IQ, but laud their effort to provide such a fund to the retail marketplace. "Hedge fund" strategies can serve a portfolio well - diversification, risk reduction and absolute return potential are all valuable. So any effort to provide that exposure at a reasonable price - and 1.11% is better than 2 or 3 and 20%, is commendable. So rather than offering seemingly disingenuous criticisms, lets give the ETF time to prove its worth (or lack thereof). If it fails to perform, there will be plenty to criticize.

Five Financial Moves to Make During the Recession -- and Five You Shouldn't - WSJ.com

Five Financial Moves to Make During the Recession -- and Five You Shouldn't - WSJ.com.

Take this article to heart. It's very well reasoned and offers an excellent strategy for moving forward. I've written before regarding the 5 stages of grief. Stage 5 involves letting go and moving on. This article highlights how to do that. With regard to investments, if you've done it on your own in the past, consider using an advisor. Consider using one on an hourly basis (they exist) if you're uncomfortable turning over authority. In this capacity, the advisor can be a sounding board for your plans or serve as devil's advocate. Either way, value can be added. If you have used an advisor, sit down and review your current plan. Challenge the underlying assumptions in light of the current environment and your expectations for the future - inflation/deflation, job prospects, retirement, college, etc. I expect at least some of these assumptions have changed in the last 6 months. Develop a constructive plan to move forward and incorporate much of what you read in the linked article. It will be a productive exercise.

Wells Fargo Projects Record $3 Billion Quarterly Profit - Earnings * US * News * Story - CNBC.com

Wells Fargo Projects Record $3 Billion Quarterly Profit - Earnings * US * News * Story - CNBC.com.

I've said repeatedly that financials will lead the recover just as they lead into the recession. This is the kind of news that investors will be looking for. I've noted previously that markets are discounters of forward expectations. Thus, what matters is whether news is better or worse than expected. This is better than expected and the market will initially react positively. However, it is important to remain cautious. It's still early in the reporting season and other major banks could still negatively surprise the markets. Additionally, any positive contribution gained from the relaxed mark-to-market restrictions should be discounted. We don't know yet if the valuations the banks are using under these relaxed restrictions are, in fact, representative of true market prices. Positive start for financials but its still early.

American Funds to Ax B-Shares - Morningstar - Specialists

American Funds to Ax B-Shares - Morningstar - Specialists.

This is good news for investors. I was a wholesaler in the mid 90's when B shares were first introduced and, being young and naive, thought they made sense. Investors didn't want to pay upfront for investments but had a tendency to sell out too quickly. The result was most investors didn't earn the rate of return earned by the fund itself. In fact, they earned much less. B shares made sense to me because investors didn't pay up front and had an incentive to not sell early. Thus, they were more likely to match the performance of the fund in which they invested.

However, as I've gotten older, I've come to believe B shares are detrimental to investors. As the article notes, expense ratios are higher enabling advisors and the funds to capture their fees nonetheless while back-end charges can provide both with even greater fees than if the investor had paid up front. Not as strong an argument today, but a negative nonetheless. The back-end charge can also trap investors in poor relative performers because investors will not want to incur the charge. The result is too many investors holding on to bad managers to save money. Lessons in behavioral finance!

Eliminating B shares is a positive step for investors. Now, if we can only eliminate 12b-1 fees on advisor share classes. For those us advisors operating on a fee only basis, load shares and 12b-1 fees are anathema. Too many good funds (good management, good strategy, etc) are crossed off our lists because they charge one or the other or both. Hopefully, fund companies will follow American's lead and drop B shares entirely. Then, move on to 12b-1s.

Rally: Too Flashy For Our Liking | The Big Picture

Rally: Too Flashy For Our Liking | The Big Picture.

This link to "The Big Picture" is to a post discussing comments made by David Rosenberg, of Merrill Lynch. Rosenberg's argument is that the recent rally is likely a bear rally. This is based on precedent - 5 of the 6 prior very short term rallys during secular bear markets did not signal the end of the bear market. His concern is that the current S&P 500 level is indicative of a $70 per share earnings rate and that most of that improvement in earnings is expected to be driven by consumers (based on forward P/Es).

His caution appears justified by data provided by S&P here. If you look at "Market Attributes" and do a little work, you'll see that their earnings forecast for the S&P 500, whether bottom up operating earnings or top down as reported earnings are not likely to exceed $70 per share anytime soon. Of course, they're estimates subject to revision, but.. If you click on "Operating Earnings", you'll see the estimates by sector. 2009 estimates are driven by a significant improvement in Financials from an estimated loss of $21.24 a share in 08 to an estimated profit of $10.02 per share in 09. I find it difficult to see what drivers exist in our economy currently that would lead to such a short-term turnaround. It would not surprise me to see financials improve in 09 but a $30 per share turnaround would be remarkable. Thus, it seems reasonable to assume we'll pull back or flat-line here for a while. I think more upside will need to be justified by earnings outlooks as we move through Q1 earnings season. Once again, cautiously re-enter equity markets on a dollar-cost-averaging basis can help manage downside risk while providing equity exposure.

Fiduciary Values

Fiduciary – A fiduciary is an individual or an organization legally responsible for managing assets on behalf of someone else, often defined as the beneficiary. The assets must be managed in the best interests of that beneficiary. Why is that important? Your advisor should adhere to a standard of care which best serves your interests. Specifically, your advisor should place your best interests first, act with due care and in good faith at all times, provide full transparency of material facts and work to manage and avoid conflicts of interest. These actions sound reasonable, and I’m sure are fully expected by you. Yet, many advisors choose not to acknowledge their fiduciary duty. Over the years, this unwillingness to acknowledge responsibility has lead investors to avoid using investment advisors. 

Consider, a survey conducted in 2006 by the Retirement Corporation of America found that more Americans handled their investments themselves or with input from friends and family than by using the services of an investment advisor. The primary reason was distrust regarding the motives of these advisors. Another survey was conducted by the Financial Planning Association and Ameriprise Value of Financial Planning last night. The survey placed respondents in 3 categories - Gen X (30 to 43 years old), Baby Boomer (44 to 62 years old) and Mature Boomer (63 and above). The focus was mostly on Gen X, but I found the Mature Boomers results most fascinating. For example, 41% believed they were on track toward their retirement planning goal and 51% were on track toward their goal of wealth accumulation. 86% stated they understood the financial risks related to retirement and 75% believed they understood financial issues yet only 23% actually knew how much they needed to save for retirement.

Not surprisingly, when asked why they didn't work with an advisor, 35% of Mature Boomers believed they didn't need the services of a financial advisor (almost double that of Gen X) and 28% believed they could do a better job themselves. Further, 62% believed they were very or completely in control of their financial future and 60% were very or extremely confident in their financial future. Sadly, this second survey was conducted between June and July 2008!

Many people need and, can benefit from, the advice of an investment advisor, particularly now. A number of factors contribute to the success of a portfolio and of a relationship. The knowledge that your advisors are acting as fiduciaries on your behalf, and have stated so explicitly, should help build the foundation of trust necessary for a healthy, productive relationship. Require your advisor to acknowledge his/her fiduciary responsibility to you. If he or she is unwilling to do so, consider finding an advisor that will. The bottom line is anyone involved in managing your financial well-being should be willing to acknowledge that you come first.

Trading In A Topsy Turvy World - Trader Talk with Bob Pisani - CNBC.com

Trading In A Topsy Turvy World - Trader Talk with Bob Pisani - CNBC.com.

Why is seemingly bad news greeted by positive market performance? Because financial markets are discounting forward expectations. That is, today's market performance is driven by expectations of future economic and financial performance. Current information has already been incorporated into investment decisions and thus is only relevant to market performance when that information surprises investors. If the information is better or worse than expectations, markets will react accordingly. If the information is in line with expectations, markets will yawn. So, while the media will trumpet news that fits the current narrative, it is likely to be irrelevant to market participants. Today's news is mixed, but only (so far) one piece of news was surprising. Unemployment hitting 8.5% stinks, but is unfortunately not surprising to most investors. It is an unfortunate reality of recessions that people lose their jobs. So it may depress the markets but not significantly. The surprising news is the earnings report from RIMM that not only beat expectations for current earnings but raised expectations for the future. This was better than expected and could play a role in market performance today. The key to correlating the news to market performance is to ask yourself if the news is truly surprising. If yes, expect an appropriate market response.

UPDATE: FASB Approves More Mark-To-Market Flexibility

UPDATE: FASB Approves More Mark-To-Market Flexibility.

This action by FASB has been a key driver of performance today, but for those considering re-entering the equities markets fully should pause for a moment. This action does not eliminate existing issues of illiquidity of "toxic assets". Banks may post better results as a result but that doesn't mean they are actually healthier institutions. This, in fact, could reduce transparency and could lead to negative surprises down the road. Consider - banks will use their "considerable judgement" to mark illiquid assets at a favorable price. However, at some point in the near future, the banks will either sell these assets or a market will develop. At that point, they will have to mark these assets to the sales price or to the liquid market price. It is highly possible that these valuations will differ markedly from the banks valuations. My guess is the bank valuation will be higher than the actual sale or liquid market valuation. This will lead to downward revisions at that time and renewed concerns about balance sheet strength.

So don't get too excited. This isn't necessarily a good development, probably the opposite. As I've been stating for a while now, it does make sense to be buying into equities but in a responsible way. Continue to dollar-cost-average back in and look for diversification across holdings. I still hold to the theory that financials will lead us out. March was strong, but the quarter wasn't. The March rally was off of depressed valuations and triggered by some good news. We continue to need more good news before anyone can confidently call a new rally. Again, gently work your way in and be defensive.

Consumers Aren't Dumb

Tom Vanderbilt's Amazon Blog: Safety Overhead Permalink.

This post discusses car safety and its relationship to price, but another equally valid point can be made from the chart at the end of the post. Note that the Big 3 - GM, Chrysler, Ford, are generally scattered at the higher risk, bottom to middle range of price. That speaks volumes about the issues each faces in the current environment.

Consumers are not dumb. They reasonably equate price to quality (here defined as safety) because the relationship is generally valid. If they pay up for an item they expect it to be of the highest quality. If they go cheap, they mostly recognize what they're getting. The dead zone is in the middle. That vendor has nothing on which to hang the higher price. In this case, for every higher risk, moderately priced Big 3 car, there is a Japanese/German equivalent at a lower price. If consumers are going to bear risk, they'll go for the lower price. Hence, they'll take Japan and Germany over the U.S.

Knowing this relationship exists, the vendor should then either deliver quality or low prices. The Big 3 have never consistently delivered quality and can't deliver competitive lower prices because their fixed costs are enormous. Thus, a negotiated bankruptcy makes sense. If they can drastically reduce their fixed costs, in a way only bankruptcy can provide, they have the potential to compete on price.