The Impossible Plan Part 3

The thing is how do you go about designing an investment strategy when markets are in a free-fall? The answer is always in the timing and no one can say when or how far things will tank. For historical perspective we only have to look over our shoulder and see how well some of our esteemed economists predicted this latest mess.

My friend and client Jack wants a plan that allows him to minimize his losses during a market meltdown and, at the very least, be able to take advantage of lower stock prices. I finally decided the best possible plan was to establish a cash account far in advance ear-marked specifically to be used to buy funds, ETFs or stocks when the markets fell.

This simple idea solved several problems. It created an emergency fund; it also settled the tax question and the timing question. Jack would not have to sell anything and it allows him to buy on the cheap more of the same holdings or whatever that would be deemed special at the time. He wouldn't have to commit all his money but could dollar cost average as the situation merited.

The only question to answer is when to buy. The solution I locked onto was to use the VIX. VIX is the symbol for the Chicago Board Options Exchange Volatility Index. Basically it is a composite that measures the S&P-500 index over the coming 30 days. The number the VIX provides is a percentage to expected annualized changes in the S&P 500 index. When the VIX hits numbers higher than norm, lets use 30 for now and that can change depending on a variety of factors, than this indicates major moves either higher or lower, but historically lower values in the S&P index as investors have labeled the VIX as a measurement of investor fear.

When there is a sudden spike in the VIX I know to expect a sell-off in the markets, and I have not been disappointed in the past. A spike doesn't necessarily mean to buy that day but by following the VIX an investor can determine when to start buying quality at cheap or reasonable prices.

It wouldn't hurt to do some historical footnoting and see how well the VIX and the S&P 500 index have worked in the past. You can graph both the VIX and the S&P 500 and see how they work together to provide an investors with a strong indicator of when to buy or sell.This is not only a sound idea for uber-market collapses but also when things run sour temporarily and provide you with an idea of when to enter or leave the market.

I just hope Jack appreciates everything I do.

The Impossible Plan Part 2

Jack inherited a lot of his money and it's higher in value today even with the meltdown than when he first got his hands on it. I don'r say that to clients because clients don't want to hear what you did for them they only know what you didn't.

Anyway, I agreed with Jack that we should do some things and then after we hung up thought some more and asked myself what things? If, for example, I agreed to park his money in cash each time the market lost 10%-15% I would be facing the re-entry problem of when to move back in. Jack, knowing him as well as I do, would be calling me every hour on the hour asking me if it was time yet. I could see myself selling his investments several times a year or, at worse, several times a month. And, when moving back in, how would I know that I wouldn't be waltzing into a typical bear trap and sending my client's money deeper into the abyss?

Then there is the tax thing. Every time we, the collective me, pull the plug we have to pay taxes on his non-qualified account and that could get expensive if you pay ordinary taxes without the capital gain benefit.

Or- maybe we can just set the parameters at an extremely high percentage before 'we' sell say when the market falls 20% or 25%, but what good is that? We're down 20%-25% for crying out loud and that's what old Jack is trying to avoid and if the market pops up before we're ready to move back in we miss whatever upside there could be - maybe for the entire year.

Then we have the pay thing. How much do you charge someone to live with his or her account? If I know Jack he doesn't want to pay me a cent, simply having his account should be psychic income enough for me is the way he usually figures.

This delimma, dear friends, is that there is no easy answer when designing a plan that tries to reduce risk while maximizing return and taking advantage of economic depressions.

It truly gets complicated and my head hurt thinking about it but I finally go my little grey cells a purring and before long had an answer for my friend Jack.

The Impossible Plan Part 1

I got a call from a long-time client. We'd been through a lot, Jack and I, there have been a lot if very good times and a few not so good. One of the worst was 2002 when absolutely nothing worked and everyone should have stayed in bed for the entire year. Then New Year 2003 brought joy and a very nice double-digit some percent return across the board making everyone smile - a lot. But the rest of the 21st century was not a cake walk and every point gained seemed strained right to the end of 2007 when the markets petered out in December and fell into January 08 like a drunken sailor stumbling out of a New York taxi at three in the morning. Little did we know what was in store for us later that year.

In the early days of the new century I'd get folks come to the office expecting to chat me up for 20% something returns with little risk or volatility. They'd read about it in some magazine or point to some cousin or friend who did spectacularly during the 90s betting on dot coms and telecoms and say to me, ' I want you to do that for me.' Unfortunately the only thing I could show them was the other side of my door with the admonishment that I wasn't the broker they were looking for. ' You're looking for someone who likes your money more than you.'

Today people know better and the unrealistic pipe dream returns of the 90s are long gone and folks now simply want return of principal and get back lost profits.

Speaking of lost profits, and I am, I have people repeat to me what they hear on radio and television. One of the things is that investment risk gets less the longer one stays invested. A client will say, 'I've been with you for 20 years and still lost money in 2008 and I want to know what's with that because smart people say that by now I shouldn't have any risk at all!' Then they pull out a Morningstar report that illustrates risk decreasing as the years roll by.

I try to explain that yes, risk on equities decreases on the principal invested as time goes on but if you consider your appreciated principal your current value than the risk is the same as the first year you originally inv ested. Got all that?

Getting back to my phone call. Jack said that we had to do something so the next time something like a global economic crisis hits he doesn't get financially hurt. I wanted to say something like the last time we had this deep of a depression was about 80-some years ago and unless he knew of the whereabouts of the Ponce de Leon's fountain of youth neither of us would be around facing this similar problem ever again. But, like a good soldier I simply bit my tongue.

I had some serious thinking to do. There were a lot more things to consider that simply moving money in and out of the market.

MPT Part 2

There is no mystique about an investment portfolio that is simple. Brokers and management companies can, however, do a lot of hocus pocus and charge big fees if they get you to buy into a complicated asset allocation plan.

I've seen people during this economic crisis who've asked me what they should be doing now and I've said, 'Buy more, reinvest your dividends or go to cash if you cannot stand the pain.' But, people don't want to hear that. Give me magic is what folks want. Failing any mystical sleight of hand, give me something different is what disappointed investors want to hear, even if it could be the worse thing for them.

Asset allocation doesn't work when the whole world went to hell in a hand basket. It didn't protect one dollar when the day of reckoning came in 2008. It just didn't work! You know it, the broker knows it and the investment firms know it. When a pandemic in the order of 2008-2009 hits all bets are off and every single sector went into the toilet. Margin, cash calls and redemptions ripped the stuffing out of investment plans. I, and perhaps you, had a taste of it in 1987 but in 08/09 it was worse. It was monetary panic unlike anything anyone alive had ever seen.

People lost big time with asset allocation and Target Funds (another pet peeve of mine) that were suppose to keep them away from harm.

Warren Bufett doesn't cotton with asset allocation. He buys on discount, officially known as a value investor. He could care less if he owns 100% of something and it's all the money he has in the world as long as he bought it for less than its real value. You can always find something to buy cheap that'll get cheaper. The trick is to find something on sale at a price less that what its real value is. It takes a lot of work to do what Warren does; asset allocation is easier and more profitable for the folks selling the concept.

In a meltdown - asset allocation just doesn't work.

So- what would I suggest?

Here's just one idea. Buy a good dividend paying domestic stock fund and a solid foriegn or world divident paying mutual fund and pick some short term corporate bonds and mix up one-third all or 20-40 or 50%-50%, equities to fixed. See what happens in a year, maybe two.

This is simple; you'll probably have about 600 different stocks in your portfolio with the 2 mutual funds plus a handful of corporate fixed income bonds. The results will be you will have more time to play, less to worry about your portfolio and find it's cheaper and more efficient in the long run.

MPT Part 1

Modern Portfolio Theory, it sounds like a jazz trio but it's how a good many of today's investors manage their money. Harry Markowitz is the fellow who picked up a Nobel Prize for economic sciences for his pioneering work in MPT. Unfortunately Harry, now 81, doesn't pay much attenton to MPT when investing his own money. Harry admits he doesnt think about his own money all that much and as a result his portfolio is pretty much a hodge-podge of this and that.

MPT is a lot more complicated than the simple asset allocation most people use when working with their investments. There are computer programs designed to do nothing else than manage money-using MPT.

The average investor doesn't need all the bells and whistles of a complete MPT plan and only the basics, which include diversification and asset allocation to build portfolios.

MPT and asset allocation are like drugs for certain investors. Find yourself among a group of serious middle-aged amateur investors and Sharpe ratio, beta and alpha are passed along in the same serious vein as the names of new teeth whiteners. Me? I've sort of moved aside to a kinder, gentler place where I keep things simple for my clients and myself. For MPT junkies this is the worst sin of all. Acccording to them people like me should be taken outside the city wall and stoned.

Professionally designed asset allocation progarms sometimes run 20-to-30 mutual funds or half a dozen pages of individual stocks and bonds. The reality is you don't need all that. I read where you can effeciently asset allocate return and risk with as little as a dozen stocks. One mutual fund and a handful of individual bonds can do the trick too. Unfortunately this doesn't do for the true asset allocation purist. 'Where is your micro-cap, your REIT? OMG!'

So why the big push for asset allocation? As one mutual fund wholesaler explained to me, it sells. Clients love it. They like to see pages of individual mutual funds on their statement. The more complicated the better. It's like a Tom Clancy novel. The story is in the minutia not in the plot. Investors feel that with all that bulk in their investment portfolio something good just has to be happening. Certainly after the 2008-2009 crash you will see more and more creative asset allocation plans being touted by investment firms and I dread the disappointment that investors will have when they discover it doesn't do them any good than simply owning 2 or 3 mutual funds and a handful of individual bonds.

Another advantage of selling asset allocation plans to investors by some money management firms is that investors get a piece of some real bad funds that they wouldn't have purposely chosen if they had their druthers. Every mutual fund family has its share of dogs. These are funds that should be taken to the pound and skip the 10-day grace period and go right to the needle. Unless you're stuck in one of these awful funds because you bought it from a long-forgotten brother-in-law you wouldn't be buying it now. The fund company knows this and understands that not a new penny will hit those fund's ledgers by today's sophisticated investor unless the management company does some sleight of hand, mainly make the woof-woof fund part of a 'comprehensive asset allocation' portfolio. The reason fund management doesn't want to close a crummy fund or combine it with something else is because managers still get a handsome fee for just hanging on to investors who haven't looked at their statement in ages or lazy pension managers who haven't pulled the plug and replaced the woof in their menu.

The mutual fund company isn't stupid and won't put a substantial amount of your total investment into this woof. But, it will invest one-percent of your total investment into it, just to keep the fund doors open and allow the portfolio manager to play with some new money.

If you own one of these creations take a peek at the most minimal percentage funds and ask yourself how 1% invested in anything is going to affect your return or overall risk? Why did someone stick you with one-percent of whatever it is you got? It probably can't buy a cup of coffee but it sits proudly on your statement supposedly there to do something especially make you think it is meaningful.

It's a shame but it happens and that's that.

How Is It Possible?

I was on vacation and reading the financial news when I noticed that a company that had filed for and emerged from bankruptcy had its old company stock traded up 37% for the previous day. If you do the math someone made a lot of money. I mean a LOT of money!

How does a company that doesn't exist still keep trading even though there is nothing backing the stock?

The company, General Motors, its stock is still being traded, a phenomenon not unlike what happened when K-Mart filed for bankruptcy and emerged as the new K-Mart. People kept buying shares of the old company until one day it disappeared like the closing scene of the black and white television show, 'The Twilight Zone'. Over 91 million shares of the old K-Mart stock traded hands before the lights were finally turned off.

I remember scratching my head and wondering if someone knew something that I didn't know. The answer was no.

Folks either are clueless or think there is still a connection to the bankrupt company and there is some potential in the old company shares. I think this myth springs from the Chrysler bailout and how some people bought shares in the company and they soared in value under Iacocca's leadership. But, Chrysler never filed for bankruptcy!

The trading of valueless stock wouldn't bother me if the people buying the shares were rich folks with money to burn. Unfortunately many of these investors have no financial advisor, are looking for a quick rich scheme and cannot afford to lose one penny let alone the possible thousands they are throwing away.

Just as investors were embittered with the K-Mart fiasco today's bankrupt GM stock investors will also complain. There is plenty of warning to stay away- if they would only look.

Ignore Rebalancing

One of my gripes is the push that some financial firms have to rebalance their client's investment portfolio. I got an e-mail from a client who asked if I rebalanced client's investments and that got me started. Rebalancing is nothing more than selling your winners and holding your losers.

How does it work? Let's say you have a portfolio with one-third bonds, one-third in domestic equities and one-third in foriegn. Not everything is going to go up and down in the exact same percentage. The theory is to maximize the possibility of reducing risk and increasing the opportunities for gain that an investor removes excess profits from the winning portions and replaces the losing sectors until everything is in the same exact percentage as originally designed.

Lets keep it simple and say you have 50% in bonds and 50% in the S&P 500 Index. At the end of the year the bond portfolio has made money and the equity side has lost. The theory is that equities may have their turn next so get the allocation back to where it was so that an investor can maximize their return. What really has happened is that over the past 10-years the bond portfolio has consistently outperformed the equity side and the investor ended up feeding the losing end with more money that could have increased their profits.

If left alone the bond portfolio would have had more money each year and would have enjoyed more profits. Over a longer period of time the equities would have returned the favor but why reduce the chance of making money in a winning sector and plowing them into a loser?

Rebalancing is doing exactly what smart profitable investors don't do and almost every structured asset allocation plan implements. Rebalancing sells winners and puts more money into losers. Wall Street in its attempt to add bells and whistles to client's portfolios (and higher fees) have simply increased the chances of clients losing more money whether they invested in variable annuities or designed asset allocation plans by mutual funds or retirement plan sponsors.

Forget rebalancing. Buy good quality mutual funds, ETFs and ride your winners and cut your losers. You'll be surpirsed how much better you'll find yourself doing.

Buying On The Cheap

There are some basic investment rules. Unfortunately, human nature being what it is, people do the opposite of what they should.

For example, a major rule in investing, as in other things in life, is to buy good expensive things when they go on sale. It's like when Albacore tuna fish goes on sale at the supermarket. Folks buy a lot of it because they know the price drop is only temporary and in a day or two the price goes back to where it was. Smart shoppers stock up by the case, or certainly as much as they can.

During the economic depression everything got knocked down in price. Some stocks were already depressed and went even lower and some very good companies got crushed, along with most great mutual funds and ETFs. Great companies got sold off because hedge funds and investors were selling at any price just to get liquid or to pay their bills. It was a pandemic and common sense went right out the window.

The people who kept on buying and are buying through a systematic investment plan, such as a company sponsored 401k, will eventually find, probably sooner than later, that their accounts will be back to where they were before the folks who stuck their head in the sand or those that stopped buying completely when things got ugly- and cheap.

The simple rule is to keep buying funds and ETFs, especially during dips and down market cycles. You don't get many opportunities in life to buy quality cheap.

What If The Economists Are Wrong?

The second quarter ended with all sectors still off for the year. Bad news finally caught up to what had been a stellar quarter and tipped the scales as the markets sold off on the last day of June and had another horrible triple digit sell-off before the 4th of July holiday weekend.

Morningstar wrote that if we wanted to get a recovery moving faster the consumers who were working had better start spending. This bit of information is about as wrong as one can expect from a respected financial information service. Working consumers are scared still and salting away savings and curtailing their spending. More shopping malls will be biting the dust as more stores, both independent and chain, are closing outlets. In a few months we'll be having back to school sales and I dont expect the news to be good. With national unemployment close to double digits only a slowdown in layoffs is realistically the best possible welcome news. To see a turnaround any time soon on employment is wishful thinking. Employment is the last thing to recover in any economic downturn.

One of the major fund companies dusted off one of their all time conservative growth allocations and used it as a measure against the S&P 500 index over the past 10-years. That conservative portfolio showed a total return of 2% for the entire decade. That beat the stuffing out of the S&P 500 index which lost 39% over the same period of time.

After the boom of the 90s and as we began the 21st century some astute investors predicted that bonds and cash would be the leading sectors going forward. They were right. Equities not only lagged the most conservative portfolios over the past 10-years but begged the question if equities would at any time in the near future become once again attractive to the average investor. A pure bond portfolio returned close to 150% over the same period of time.

The global meltdown of October 2008 only exacerbated what once was a recession that began March 2000 into a full blown depression.

On the heels of this depression lurks a future inflationary period unlike any we've ever experienced. There are those of us who remember Jerry Ford's WIN button, whip inflation now, and the days of Jimmy Carter and his double digit inflation and interest rate years. We'll not only see it again but this time it'll be worse. Much worse.

Uncontrolled inflation will bring housing values roaring back like nobodies business, give everyone a huge pay raise and increase your taxes along with food, utilities and transportation. Add to this the possibility of a new energy law and the current depression may seem like a cool breeze compared to the nasty jolt we'll all get in our pocketbooks. We'll be earning more but living with far less.

Locking in your money in long term bonds, CDs or fixed annuities will just as surely destroy the purchasing power of your money as night follows days. If inflation lasts for the full future decade you can expect the cost of most goods and services to increase by 50%. Putting it another way if you plan on buying a $20,000 car today, it'll cost $30,000 in 10-years. Fixed long-term income investments will destroy your wealth just as easily as did the 2008 economic meltdown with equities.

The best that you and I can do as we approach these uncharted waters is to invest in fixed securities no farther out than 12 months and plan on establishing an investment inflation survival strategy in what may be the most challanging future decade ever.

Perception versus Reality

I can tell when the markets are about to move up and when they're a few days from crashing. I dont need to read anything, talk to anyone in the business and can do this blindfolded. Clients start calling me to tell me to sell what they already own or ask what's out there that they should be buying. Depending on which side of the trade they're on the markets will generally act inversely.

I can understand exactly what my clients are feeling. When markets fall they think there is no bottom, and when the markets start to recover they believe that the recovery is in a straight line with no deviation.

A few weeks ago I started getting those calls from clients who had sold off and placed their money in money markets. They started to get antsy seeing the indices move substantially off their lows and thinking that perhaps they had missed the bus. They didn't.

A few months ago oil was trading at a tad over $50. a barrel and with a glut of the stuff on the market investors felt sure that the price would come down. It didnt. Oil shot up over $70 a barrel and it did it because oil is traded in dollars and our dollar had weakened significantly.

Now policy makers on both sides of the Atlantic are trying to get to curb what they think is oil speculation and stop a huge run-up before it happens. China seems to understand this dollar to oil trade and has made noise for the world to move to another global currency. Why western political-types can't understand this is almost as significant.

July 8th

Everyone it seems is worried about inflation and to be honest we're a long way before the day of hyperinflation wrecks our lives. In fact, it may never happen. The reason is so simple- everyone is expecting it and mentally preparing what to do when it arrives. It's like that weird cousin that always shows up at your door when you least expect him. You tell yourself, the next time he shows up...

We are, in fact, about as close to a deflationary economic condition as we can be without officially calling it that. Excluding food and energy consumer prices rose a modest 1.8% for the 12 months ending in May.

Once the Federal Reserve releases the stimulus dollars the natural reaction is that soon after we'll revisit the days of Jimmy Carter, But, with Americans on a belt-tightening campaign and saving money like never before this may not happen. In order for inflation to take hold people have to spend money, and today's consumer appears to want to sit things out.

The problem some economic experts contend isn't inflation in a year or two but deflation here and now. When people dont buy prices fall and businesses start laying off more people to meet the lessened demand until finally closing their doors. Economists who are paid to worry dont put inflation as a relevant worry any closer to the top of the list of worrisome things than deflation.

July 7

What do the smartest guys in the room have to say about what to buy and where we are with the economy? The consensus for Soros, Paulson, Fournier and Mecher, as interviewed in the WSJ July 7 2009 is to expect more bad times, struggles for the American consumer, limp earnings and a 'possible' surge of inflation.



What do these guys like? Soros is back to Brazil, China and India, even though it disappointed him in the past. Fournier likes some health care. Paulson is into distressed debt and companies in bankruptcy proceedings while Mecher like corporate bonds.



The words to live by come from Melcher who said, 'Just because things are getting worse at a slower pace doesn't mean they're getting better.'



Like the sergean said on the cop television show, Hill Street Blues, 'Be careful out there.'

July 6th

According to Morningstar small investors poured more money into emerging market mutual funds, natural resources and metals funds and junk bond funds than they did plain vanilla domestic stock mutual funds this past quarter.


It is this increased appetite for risk for some small investors that has led to the second quarter rally. Commodities have also seen an inordinate amount of interest due mainly to the fear of impending inflation.



These investors are afraid of being left behind when the 'big rally' emerges. With today's oversea's markets in negative territory, following July 2nd domestic market losses, investors may have placed themselves into temporary jeopardy.