Brighton Perspective

Investment Policy Statements

According to a recent article in Kiplinger's Personal Finance Magazine only 36% of wealthy investors believe their advisor managed last year's crisis well. One possible explanation for this lack of confidence in their advisors is a lack of a written investment policy statement (IPS). The IPS is only mandatory for ERISA governed retirement plans but it should be mandatory for all investors. The document is your blueprint which you and your advisor will follow to construct and maintain your portfolio.

Writing the IPS requires meeting with your advisor and discussing several critical issues:

1) Return objectives - what do you expect your portfolio to earn annually? This target should be constructed carefully. Assess your current income needs and expectations about future uses of the portfolio. Your advisor can then calculate a rate of return target consistent with these needs.

2) Risk tolerance - how much risk can you bear? This is frequently the most difficult step in the process. Investors generally perceive themselves to be more tolerant of risk than they really are and the advisor must work closely with you to determine your true risk tolerance as accurately as possible. This is often done as the first step in the process because the portfolio rate of return is usually constrained by risk tolerance.

3) Time Horizon - what do you intend to do with this portfolio? Is it to be used to meet current income needs, college expenses in 5 or 10 years, retirement income needs in 15 or 20 years? Time horizon helps refine how much risk should be borne by the portfolio. You may be more tolerant of risk than your portfolio can bear because your time horizon is short.

4) Liquidity needs - this goes hand in hand with time horizon. If you need immediate liquidity, you are unlikely to invest in real estate, private equity, hedge funds, etc which don't or can't provide immediate liquidity. Instead, you'll invest in low risk, highly liquid securities such as Treasury bills.

5) Unique circumstances - this can incorporate anything. For example, you're time horizon is long, liquidity needs low, risk tolerance high, but you're planning to travel around the world next year. If you leave this out, you're advisor will likely have to make significant portfolio changes to provide you the cash you need to pay for the trip. This is the step where the advisor asks "What else do we need to consider?"

The answers to these questions define the mission statement of the IPS. The advisor will then incorporate an asset allocation, permissable investments, frequency of rebalancing, tax considerations and reporting requirements. The blueprint now clearly defines the intentions of both parties. This document should be reviewed at least annually and revised as necessary. If you don't have one, sit down with your advisor and get started on creating one. If you don't use an advisor, answer the questions above for yourself and devise your own IPS. It will serve as a useful guide and reminder as to why you made the decisions you've made for your portfolio.  I can't stress enough the value of an investment policy statement.

Don't Overlook Ginnie Maes - Kiplinger.com

Don't Overlook Ginnie Maes - Kiplinger.com.

A follow on to an earlier post - if you're a holder of Treasuries and concerned that rising yields on new issues will decrease the value of your current holdings, Ginnie Mae's should be considered as an alternative. As always, the ultimate decision should be based on each investor's personal situation. Review this article and decide for yourself. They can play a useful role - a yield roughly equivalent to 30 year T-bonds with a duration of less than 3 years is very attractive.

The Bond Vigilantes - WSJ.com

The Bond Vigilantes - WSJ.com.

This is worth watching in the coming weeks and months. The government has significantly increased spending to combat the recession. The assumption is that the spending will be financed by issuing debt and/or printing money. This can be done by issuing Treasury securities which are then sold to investors or by selling the securities directly to the Fed. Recent Treasury auctions have proven challenging for the government has buyers have demanded higher yields. To conclude a successful auction, the government essentially has to go with market demands. At some point, either the government refuses, which results in an inability to finance spending, or buyers refuse, which results in an inability to finance spending. Clearly, in both cases, if the government can't issue debt, it can't finance continued spending.

I would like that to be a good thing, because it should lead to the government searching for ways to reduce spending but it will likely lead to higher taxes instead as the government looks to taxpayers to finance the shortfall. Hopefully, I'm wrong and we'll be able to finance the increased spending without higher taxes and without higher inflation.

Nostalgianomics: Liberal economists pine for days no liberal should want to revisit. - Reason Magazine

Nostalgianomics: Liberal economists pine for days no liberal should want to revisit. - Reason Magazine.

Almost everyone can look back on periods of their youth and recall, with nostalgic wistfulness, what a wonderful time it was to be alive! However, for most, it was wonderful because we were young and naive. For me, the period from 1976 to 1988, ages 10-21 were the "Wonder Years" - playing baseball every day during the summer, football every day during the fall and winter, hanging out with friends. But, at that time, the U.S. was dealing with the end of the Vietnam War, the post-collapse fallout of the Nixon Administration, the Carter years with the Iran Hostage Crisis, double-digit inflation, and then as I was graduating from college, the post 10/87 market and economic slowdown. Wow, no so great after all!

That's the point of this article - it serves as a counterpoint to a recent article by Paul Krugman arguing that the country needs to return to the "relatively equal middle-class society" of his youth. Except, it wasn't so equal, or fair or much of anything else Krugman et al, want today. Be careful what you wish for.

The Ultimate Commodities ETF Guide

The Ultimate Commodities ETF Guide.

Difficult to blog this weekend as I'm out of town and working on a white paper. This article covers the ins and outs of investing in commodities using ETFs. The white paper on which I'm working regards an alternative approach to asset allocation. The paper should be available around June 1. In the interim, research articles such as this one - alternatives deserve a place in your portfolio for the diversification benefits and for the return contribution.

About Those 'Speculators' . . . - WSJ.com

About Those 'Speculators' . . . - WSJ.com.

This article clearly highlights the issues surrounding the government "engineering" of the Chrysler bankruptcy packaging. The UAW was "protected" despite being a minority investor (via its pension fund) and senior creditors were burdened with more significant losses. This work-out clearly contravened bankruptcy law and will set a very negative precedent. As noted in the article, the Indiana State Police Pension Fund, Indiana Teachers Pension Fund and a state construction fund all suffered significant losses despite being "senior" debt-holders. The response from the State Treasurer, who has fiduciary responsibility to the plan and to its participants, is to refuse to invest in any secured debt of "manufacturing companies, or those insurance companies who have or will be receiving bailout funds" because "the risk is too great for any prudent investor to accept". When the federal government contravenes the rule of law in the capital markets to favor a constituent the law of unintended consequences does apply. Equality of outcome does not apply to the capital markets. They are, should be and hopefully always will be, zero sum.

As VIX Continues to Decline, Is S&P at 1,000 Far Behind? - Markets * US * News * Story - CNBC.com

As VIX Continues to Decline, Is S&P at 1,000 Far Behind? - Markets * US * News * Story - CNBC.com.

The VIX measures the implied volatility of S&P 500 index options and is a proxy for market volatility. It dates back to 1990 and for most of the past 18+ years it has between 10 and 20, as noted in the article. Of interest is that VIX picked up considerably during the prior two recessions. During 1991, it hit 35 before dropping back to between 15 and 20 by early 1992. Between 1998 and 2003, it rarely ventured below 25 and several times hit 45. It then drifted down to a steady range of 10 to 15 from late 2004 to early 2007 before picking up again. As noted its now down around 30, high compared to prior strong equity market periods but well below the recent peak of 89. Technical indicators such as declining VIX and the index value approaching its 200 day moving average (within 20 points for the first time in almost a year) are favorable but fundamentals are not fully supportive yet. So, be patient and continue to dollar cost average into equities. I still don't see support for fully re-entering equity markets.

Stimulus impact in near term

A number of people, including myself, have held the opinion that the stimulus would not have the intended effect on the economy because so much of the spending was lagged 2 years or more. The huge increase in spending was sold as the only way to facilitate an economic recovery but was mostly oriented toward administration goals which weren't necessarily in need of short-term support and were unlikely to contribute to a near-term recovery.

The following chart highlights that this argument has been correct to date:

Source: Greg Mankiw's Blog

Unfortunately, we are exactly where most expected us to be without any government "stimulus" intervention. I remain concerned that the "stimulus plan" will only stimulate inflation sometime in the next 24-36 months.  This is because the lagged effect of the "stimulus" will kick in after the economy has already begun to recovery in earnest. Increased money supply coupled with the increased taxes necessary to pay off the "stimulus" debt will lead to price inflation.

Foreclosures Are Rising All Over NY Region | The Big Picture

Foreclosures Are Rising All Over NY Region | The Big Picture.

Ritholtz has written extensively about real estate risks and highlights here several articles from the Sunday NYT. Unfortunately, he highlights the writers assertion, apparently, that the highest rates of foreclosure were in primarily minority neighborhoods. The writer (or Ritholtz) then suggests there "is good reason to believe an unhealthy percentage of them involved predatory lending...". This may be true and, if so, should be fully investigated and prosecuted. It is also true that many of these neighborhoods are in close proximity to Manhattan and as such were subject to heavy speculation in the mid 2000's. Many are in the NJ region referred to as the "Gold Coast" - towns looking across the river at the City. These towns were popular with speculators because of the easy access to NYC and lower cost to rent and/or own. Therefore it's just as plausible that these foreclosures are the result of an exercised put option by the speculators and not predatory lending. I've tried to find data delineating the foreclosure rate, nationally, by owner-occupied vs unoccupied with no success. My reason for doing so is the believe that a significant percentage (and higher than in the past) of current foreclosures are on properties unoccupied by owners. This is still has a significant detrimental impact on housing prices, wealth and the economy but suggests predatory borrowing rather than lending. Unfortunately, that doesn't fit the NYT narrative and thus isn't even considered.

Robert J. Samuelson - Obama's Dangerous Debt - washingtonpost.com

Robert J. Samuelson - Obama's Dangerous Debt - washingtonpost.com.

Please read! This article highlights the serious nature of the "stimulus" spending. We cannot afford to mortgage our future to finance a dubious agenda. We need to manage spending through this recession and be prepared to cut spending as the economy recovers from the recession. If we don't, and it appears we won't, we'll be in trouble.

The Big Picture

The Big Picture.

At some point, hopefully really, really soon, someone with authority in our federal government is going to realize that keeping semi-comatose companies on life support is a waste of taxpayer money and a tremendous risk to future taxpayer standard of living. Zombie companies do not contribute meaningfully to society, they just continue to suck the lifeblood out of our economy like so many leeches. Our economy has succeeded for the better part of 200 years by letting poorly run companies fail and their assets left to be recovered by better run competitors. We've propped up too many poorly run banks, most of which will never return to productive capacity, now we're propping up poorly run insurance companies, which as Barry Ritholtz writes in the link above, should never have been in this position. In fact, the fact they are suggests that the management of these companies grossly violated their fiduciary duty to employees, policyholders and shareholders and should be or could be criminally or civilly liable for their actions.

I was asked yesterday why no one (except now Angelo Mozilo) has been indicted for any of the multitude of potentially criminal activities in these various "bailed-out" companies. I said we lacked a Rudy Guiliani (prosecuted Michael Milkin in the 1980s) willing to pursue these individuals even on technicalities. Our governmental leaders have been seduced by the siren call of these companies into presuming our economy just can't take the hit of one of these companies actually failing.

Add to this the blatant hypocrisy of various entities. We have bankrupt newspapers blasting AIG for paying bonuses and then doing the same thing while also freezing pension obligations. We have Chrysler deciding that senior management will be Fiat employees so they don't have to abide by the compensation caps, etc. Someone, somewhere, needs to just say no. Let the markets and bankruptcy law function as they should. We'll all be better off as a result.

The Better Bankruptcy Bureau - Megan McArdle

The Better Bankruptcy Bureau - Megan McArdle.

Well said!

The-Trouble-With-Public-Colleges: Personal Finance News from Yahoo! Finance

The-Trouble-With-Public-Colleges: Personal Finance News from Yahoo! Finance.

An interesting article for several reasons:

1) If you have children you should already be saving for college, ideally using a Section 529 plan

2) Our government is pushing the idea of college for everyone, yet this article notes several times "Quantity has been maintained at the expense of college". If we're already educating more students than we should, does adding even more debase the value of a degree as well as the learning experience: 'At Florida, president Bernard Machen worries about a high student-to-faculty ratio and whether his students are challenged in class and learning to think critically. "We have some evidence that our kids are not," says Machen.'

3) Why is most of the 14% tuition increase in the state of NY going to reduce the state deficit? Sneaky, little tax increase, huh!

4) Why, exactly, are college costs increasing at twice the rate of inflation (4 times 2009 inflation)?

Points 2-4 aside, a college education does make a financial difference for graduates. Do what you can to help ensure your children get their chance to graduate.

Rules Matter

Morningstar - Cliff Asness

The video link above is an interview with Cliff Asness of AQR Capital Management. He wrote a letter last week critical of the government handling of the Chrysler bankruptcy which has become an internet sensation.

The bottom line is that rules matter - contract law and bankruptcy law, at issue here, ensure a smooth functioning capitalist system. They help make it possible for organizations to re-organize themselves such that they become viable entities and if they can't become viable again to liquidate in an orderly process. This process ensures that those creditors with the highest priority are repaid as much of their claim as possible before moving on to lower priority creditors. All of this matters because it contributes to the flow of capital, promotes innovation and improves quality of life. If lenders cannot price risk because they cannot ascertain their priority, they won't lend. Lack of risk taking by the sources of capital crushes innovation and progress. This article by Richard Epstein further elucidates this point.

Disrupting the rules of the game for political expediency is at best, pandering, at worst, destructive. If we can't trust our government to play by the rules who can we trust. We are not Venezuela or Cuba, but if the government continues to disregard our legal heritage, it won't be long before we join their ranks.

Perspective

John Hussman and Jeremy Grantham take different routes but arrive at essentially the same conclusion. While we appear to be in an extended rally, which could reach as high as 1100 per Grantham, the secular market is likely to remain in a prolonged period of lean performance. Take advantage of buying opportunities, particularly if SPX crosses its 200 day moving average and holds it for a week, but be prepared to pull back at some point in the near future. Many see a short term opportunity in equities and a longer-term opportunity in high grade corporate fixed income. Either way, opportunities will exist for those willing to do their homework, and commit the time, on individual positions. For example - Bloomberg has an article highlighting the stocks with the widest spread between current stock price and analyst consensus target price.

Oppenheimer Quits Fund Group Resisting Obama Chrysler Plan - Bloomberg.com

Oppenheimer Quits Fund Group Resisting Obama Chrysler Plan - Bloomberg.com.

This is disappointing news as it enables the Task Force to push through a plan that is inconsistent with free markets and bankruptcy law in the United States. As it stands, it appears that a minority group will become the majority owner of Chrysler while formerly senior debtholders will effectively be treated as junior and paid accordingly. This doesn't bode well for the future. If investors can't hold comfort in the rule of law in bankruptcy there will be a substantial risk premium assigned to distressed securities as compensation. When capital markets participants can't trust the government to abide by legal terms and conditions truly free markets are jeopardized. I hope that I'm wrong but fear otherwise.

200 day moving average

The S&P is closing in on its 200 day moving average. That's promising for a potential end to the bear market. The index traded below its 200 day average persistently from late 2000 through early 2003 and has been under its 200 day average persistently since late 2007. I would want to see it trade above the 200 day average for at least a week, maybe 2, before feeling even somewhat confident. Fundamentals are still mixed so be patient. I've written before I want to see both fundamentals and technicals agree and we're not quite there yet, but it does give more credence to dollar-cost-averaging into the markets.

Zero Hedge: Cliff Asness "I Am Ready For My 'Personalized' Tax Rate Now"

Zero Hedge: Cliff Asness "I Am Ready For My 'Personalized' Tax Rate Now".

This is required reading. Asness runs a strong institutional quant firm, AQR. Enjoy!

Forward Expectations

We've conducted a number of client reviews over the past several weeks during which we've given our thoughts on market and economic performance in the near future. To summarize, we expect, at best, a U shaped recovery globally. There remain substantial headwinds to a significant uptick in global growth including continued slack demand in the U.S., the incapability of China to replace the U.S. as a global leader in consumption and the dependence on most other countries for U.S. demand. Without this improvement in demand by the U.S. or a suitable replacement elsewhere in the world, global growth will be slow to recover.

Brad Setser, at Follow the Money, has a good post today discussing the need to return to sustainable cross-border flows. Essentially, the global economy needs to adjust to a supply/demand equilibrium at a lower level of leverage. This would suggest a lower global growth rate going forward. We were taught in grad school in the early 90s that there was a "natural rate" of growth that was sustainable without inflation (at least in the U.S.) which was assumed to be roughly 2.5%. That was and is debatable but it seems a good target now.

The expectation of lower growth going forward will translate into market expectations for future performance. Lower global growth will suggest lower equity returns going forward, at least in the near term. The chart below  Data Source: Fama/French Forum

shows the annual risk premium (equity market return - risk free rate, defined as the annual return on short-term T-bills). Note the volatility, and obviously, that the equity risk premium is mostly negative when equity returns are negative. The equity risk premium in 2008 was (-39.96%) second only to 1931. The blue line is a rolling 10 year measure. The 10 year equity risk premium is also negative, only periods ending in 1974 and 1978 were lower. The average equity risk premium for the period 1927-2008 was roughly 7.5%. Assuming T-bill returns remain low (only 1.64% in 2008) given the current emphasis on safety, then total equity market returns should be expected to be below 10%, at best, in the near term.

Factor this into your decision making regarding asset allocation and expectations for portfolio performance. Make conservative assumptions regarding near-term (say next 2-3 years) performance and set your allocations accordingly. If markets exceed expectations, great! If not, your conservative assumptions may serve as a meaningful hedge.

The bottom line while we'd all like to see a return to pre 9/08 asset values, they're unlikely in the near future. Resetting expectations to recognize lower global growth and lower equity risk premiums should help you better position your portfolios for the long-term.

Chrysler’s Fall May Help Obama to Reshape G.M. - NYTimes.com

Chrysler’s Fall May Help Obama to Reshape G.M. - NYTimes.com.

There was a time in the distant past when companies that were no longer viable entities were allowed to file for bankruptcy. This action enabled the company to restructure debts and potentially emerge as a stronger company. The airline industry spent most of the late 80s and 90s in bankruptcy and stills exists today. There was also a time when the government didn't dictate terms to companies as to whether or not they were allowed to file bankruptcy and as to what products they would produce going forward.

The article above is remarkable for several things. First is the revisionist (already) history regarding the Chrysler bankruptcy of last week. "...this is a moment when a Democratic President said, ' I am really willing to let a company dissolve'". As news stories noted just last week, the dissident shareholder group that actually effectively caused the bankruptcy filing was "threatened" for doing so and the Administration was quick to say it didn't stand with this group. The administration, therefore, didn't willingly allow Chrysler to file.

On to GM where the administration is apparently intent on dictating what the new company will produce going forward. That's rather disconcerting as it suggests the new entity is not an independent corporation with a P/L motivation. It will be producing products that the Administration believes are right for consumers rather than responding to consumer demand for products they believe are right for them.

Finally, the Chrysler bondholders, and hopefully, the GM bondholders, made the correct decision to protect the interests of their shareholders to whom they owe a fiduciary duty. The original restructuring plan, and apparently that currently being entertained for GM, had minority stakeholders, the pension funds, assuming majority ownership of the new entity. This is absurd on its face and contravenes traditional bankruptcy law. Any fiduciary willing to accept a lesser relative role is violating its responsibility.

This process should be instructional - companies that do not produce what consumers want will not remain viable entities: companies can fail and the market will adjust rather seamlessly; politics should not be front and center in an attempt to achieve equality. I would argue the process will work well without additional involvement. If the government feels the need to inject itself, then stand by with DIP financing if needed. Otherwise, let the capital markets and the rule of law proceed.

More on SMAs

This is a crudely drawn chart using data avaiable from the S&P website. Essentially I'm showing the monthly ending index value, the trailing 12 month simple moving average and the spread between the two. Several points are intuitively obvious - the index is persistently above its SMA in positive trending markets and persistently below it in negative trending markets. This snapshot captures three recessions, 90-91, 00-01 (also Internet/Tech bubble and burst) and now.

Note that during the post Internet/00-01 recession, the index was below the SMA line for 2 full years yet the spread was never as wide as it was at the end of 2008. The 90-91 recession barely registers. I'll be watching this relationship closely over the next several weeks/months. I expect that it will serve as a confirmation of the end of the trough rather than as a leading signal of a bottom (that could have already happened at 666 in March). I can't rely on technical analysis alone but as fundamentals and sentiment improve this will be a valuable input.