Brave Old World: Market Cycle Investment Management

The Market Cycle Investment Management (MCIM) methodology is the sum of all the strategies, procedures, controls, and guidelines explained and illustrated in the “The Brainwashing of the American Investor” — the Greatest Investment Story Never Told.

Most investors, and many investment professionals, choose their securities, run their portfolios, and base their decisions on the emotional energy they pick up on the Internet, in media sound bytes, and through the product offerings of Wall Street institutions. They move cyclically from fear to greed and back again, most often gyrating in precisely the wrong direction, at or near precisely the wrong time.

MCIM combines risk minimization, asset allocation, equity trading, investment grade value stock investing, and “base income” generation in an environment which recognizes and embraces the reality of cycles. It attempts to take advantage of both “fear and greed” decision-making by others, using a disciplined, patient, and common sense process.

This methodology thrives on the cyclical nature of markets, interest rates, and economies — and the political, social, and natural events that trigger changes in cyclical direction. Little weight is given to the short-term movement of market indices and averages, or to the idea that the calendar year is the playing field for the investment “game”.

Interestingly, the cycles themselves prove the irrelevance of calendar year analysis, and a little extra volatility throws Modern Portfolio Theory into a tailspin. No market index or average can reflect the content of YOUR unique portfolio of securities.

The MCIM methodology is not a market timing device, but its disciplines will force managers to add equities during corrections and to take profits enthusiastically during rallies. As a natural (and planned) affect, equity bucket “smart cash” levels will increase during upward cycles, and decrease as buying opportunities increase during downward cycles.

MCIM managers make no attempt to pick market bottoms or tops, and strict rules apply to both buying and selling disciplines.

NOTE: All of these rules are covered in detail in “The Brainwashing of the American Investor” .

Managing an MCIM portfolio requires disciplined attention to rules that minimize the risks of investing. Stocks are selected from a universe of Investment Grade Value Stocks… under 400 that are mostly large cap, multi-national, profitable, dividend paying, NYSE companies.

LIVE INTERVIEW – Investment Management expert Steve Selengut Discusses MCIM Strategies – LIVE INTERVIEW

Income securities (at least 30% of portfolios), include actively managed, closed-end funds (CEFs), investing in corporate, federal, and municipal fixed income securities, income paying real estate, energy royalties, tax exempt securities, etc. Multi level, and speculation heavy funds are avoided, and most have long term distribution histories.

No open end Mutual Funds, index derivatives, hedge funds, or futures betting mechanisms are allowed inside any MCIM portfolio.

All securities must generate regular income to qualify, and no security is ever permitted to become too large of a holding. Diversification is a major concern on an industry, or sector, level, but global diversification is a given with IGVSI companies.

Risk Minimization, The Essence of Market Cycle Investment Management

Risk is compounded by ignorance, multiplied by gimmickry, and exacerbated by emotion. It is halved with education, ameliorated with cost-based asset allocation, and managed with disciplined: selection quality, diversification, and income rules— The QDI. (Read that again… often.)

Risk minimization requires the identification of what’s inside a portfolio. Risk control requires daily decision-making. Risk management requires security selection from a universe of securities that meet a known set of qualitative standards.

The Market Cycle Investment Management methodology helps to minimize financial risk:

  • It creates an intellectual “fire wall” that precludes you from investing in excessively speculative products and processes.
  • It focuses your decision making with clear rules for security selection, purchase price criteria, and profit-taking guidelines.
  • Cost based asset allocation keeps you goal focused while constantly increasing your base income.
  • It keeps poor diversification from creeping into your portfolio and eliminates unproductive assets in a rational manner.

Strategic Investment Mixology – Creating The Holy Grail Cocktail

So what do your Investment Manager and your neighborhood bartender have in common, other than the probability that you spend more time with the latter during market corrections?

Antoine Tedesco, in his “The History of Cocktails“, lists three things that mixologists consider important to understand when making a cocktail: 1) the base spirit, which gives the drink its main flavor; 2) the mixer or modifier, which blends well with the main spirit but does not overpower it; and 3) the flavoring, which brings it all together.

Similarly, your Investment Manager needs to: 1) put together a portfolio that is based on your financial situation, goals, and plans, providing both a sense of direction and a framework for decision making; 2) use a well defined and consistent investment methodology that fits well with the plan without leading it in tangential directions; and 3) exercise experienced judgment in the day-to-day decision making that brings the whole thing together and makes it grow.

Tedesco explains that: new cocktails are the result of experimentation and curiosity; they reflect the moods of society; and they change rapidly as both bartenders and their customers seek out new and different concoctions to popularize. The popularity of most newbies is fleeting; the reign of the old stalwarts is history — with the exception, perhaps, of “Goat’s Delight” and “Hoptoad”. But, rest assured, the “Old Tom Martini” is here to stay!

It’s likely that many of the products, derivatives, funds, and fairy tales that emanate from Modern Portfolio Theory (MPT) were thrown together over “ti many martunies” at Bobby Van’s or Cipriani’s, and just like alcohol, the addictive products created in lower Manhattan have led many a Hummer load of speculators down the Holland tubes.

The financial products of the day are themselves, created by the mood of society. The “Wizards” experiment tirelessly; the customers’ search for the Holy Grail cocktail is never ending. Curiosity kills too many retirement “cats”.

Investment portfolio mixology doesn’t take place in the smiley faced environment that brought us the Cosmo and the Kamikaze, but putting an investment cocktail together without the risk of addictive speculations, or bad after- tastes, is a valuable talent worth finding or developing for yourself. The starting point should be a trip to portfolio-tending school, where the following courses of study are included in the Investment Mixology Program:

Understanding Investment Securities: Investment securities can be divided into two major classes that make the planning exercise called asset allocation relatively straightforward. The purpose of the equity class is to generate profits in the form of capital gains. Income securities are expected to produce a predictable and stable cash flow in the form of dividends, interest, royalties, rents, etc.

All investment securities involve both financial and market risk, but risk can be minimized with appropriate diversification disciplines and sensible selection criteria. Still, regardless of your skills in selection and diversification, all securities will fluctuate in market price and should be expected to do so with semi-predictable, cyclical regularity.

Planning Securities Decisions: There are three basic decision processes that require guideline development and procedural disciplines: what to buy and when; when to sell and what; and what to hold on to and why.

Market Cycle Investment Management: Most portfolio market values are influenced by the semi-predictable movements of several inter-related cycles: interest rates, the IGVSI, the US economy, and the world economy. The cycles themselves will be influenced by Mother Nature, politics, and other short-term concerns and disruptions.

Performance Evaluation: Historically, Peak-to-Peak analysis was most popular for judging the performance of individual and mutual fund growth in market value because it could be separately applied to the long-term cyclical movement of both classes of investment security. More recently, short-term fluctuations in the DJIA and S & P 500 are being used as performance benchmarks to fan the emotional fear and greed of most market participants.

Information Filtering: It’s important to limit information inputs, and to develop filters and synthesizers that simplify decision-making. What to listen to, and what to allow into the decision making process is part of the experienced manager’s skill set. There is too much information out there, mostly self-motivated, to deal with in the time allowed.

Wall Street investment mixologists promote a cocktail that has broad popular appeal but which typically creates an unpleasant aftertaste in the form of bursting bubbles, market crashes, and shareholder lawsuits. Many of the most creative financial nightclubs have been fined by regulators and beaten up by angry mobs with terminal pocketbook cramps.

The problem is that mass produced concoctions include mixers that overwhelm and obscure the base spirits of the investment portfolio: quality, diversification, and income.

There are four conceptual ingredients that you need to siphon out of your investment cocktail, and one that must be replaced with something less “modern-portfolio-theoryesque”:

1) Considering market value alone when analyzing performance ignores the cyclical nature of the securities markets and the world economy.

2) Using indices and averages as benchmarks for evaluating your performance ignores both the asset allocation of your portfolio and the purpose of the securities you’ve selected.

3) Using the calendar year as a measuring device reduces the investment process to short-term speculation, ignores financial cycles, increases emotional volatility in markets, and guarantees that you will be unhappy with whatever strategy or methodology you employ —most of the time.

4) Buying any type or class of security, commodity, index, or contract at historically high prices and selling high quality companies or debt obligations for losses during cyclical corrections eventually causes hair loss and shortness of breath.

And the one ingredient to replace: Modern Portfolio Theory (the heartbeat of ETF cocktails) with the much more realistic Working Capital Model (operating system of Market Cycle Investment Management).


Please Mr. Obama, Lend Us Your Crystal Ball

The President wants the DOL to fine professionals who make money allowing 401k participants to make “bad” investments.
So what’s the difference between a “bad” and “good” investment? Right, well in the Will Rogersian world of politicians and regulators, “the good ones only go up in price; the bad ones go down”.

“Don’t gamble; take all your savings and buy some good stocks and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” WR

Plan sponsors and other financial professionals are supposed to know which ones will go in what direction… and NEVER (as Will would admonish) buy a security that is going to go down.

“Where have all the crystal balls gone? Gone to hindsightful regulators, all of them.” PP&M, sort of.

POTUS wants investment advisors to only select the “good ones”, and they are expected to know in advance where the market may be going, in both the short run and the long. And getting paid for their efforts, well that can’t be “good”, especially when the market value goes down.

Remember, “advisors” are mostly salespeople; regulators are mostly cops.

Do any of these guys have a clue about the workings of the stock market? Which is worse: having the foxes (advisors) in charge of the hen house (401k investment (not pension) plans), or having the lunatics (politicians & regulators) running the asylum (stock market expectations)?

Both are bad, unrealistic, and counterproductive. Markets rise and fall in price… the advisory deal is to limit the amount of risk in a portfolio. Risk of loss is always involved, but it can be minimized… regulators just don’t really get it.

Participants need to be educated not coddled; costs are not the most important aspect of retirement investing, net spendable income at retirement is; stock market values will always go up and down… and that’s a good thing.

If 401k participants are expected to be retirement ready, they need to know the importance of growing income and to have investment options that can get the job done.

I’m not sure that can be accomplished in the current 401k space, but the education has been available for a long time… and it can be applied fairly easily in a “self directed” 401k environment.

And that, Mr. President, is all you should be lecturing the investment advisory community about. If a plan participant is too lazy, busy, greedy, or preoccupied to determine “what’s inside” an investment option, it is not the fault of his or her employer.

The education is out there: just read The Brainwashing of the American Investor

… and here are two Self Directed IRA or 401k income investment presentations for you to think about. 

Next Webinar April 8th

Year End Review 2014 and 2015 Preview

Let’s Talk About the Market Numbers…

Note that this report pertains most directly to portfolios operated under the guidelines, rules, and disciplines of Market Cycle Investment Management (MCIM). MCIM produces disciplined “High Quality Growth & Income Portfolios”, designed to maintain and/or to grow income regardless of the direction taken by markets or interest rates.


Both markets have been good to MCIMers this year: Investment Grade Value Stock Index (IGVSI) equities produced plenty of profits and dividend income, while the income Closed End Funds (CEFs) produced much higher yields than many “experts” would admit even exist… and occasional profits.

On the negative side, new equity investment opportunities were scarce, and many income CEFs reduced their payouts slightly, reflecting more than six years of historically low interest rates. I suspect that both conditions will be reversed soon.

A recent (unaudited) review of known MCIM “Working Capital” produced some interesting numbers, even without including year end dividends:

• Roughly 35% of total realized income was disbursed
• Nearly 25% of growth purpose capital remained in “smart cash” reserves for scheduled disbursements… and anticipated lower prices on equities. (Smart cash comes from income and profits)
• Roughly 65% of total earnings was reinvested in new and old securities
• New “Working Capital” was produced at a rate somewhere between 9% and 10%
• Less than 20% of investors made additions to investment programs, eschewing income yields in excess of 6%
• None ot selected MCIM portfolios lost Working Capital… even after culling “poorest performers” throughout the year.

Working Capital” (total cost basis of securities + cash) is a realistic performance evaluation number…. it doesn’t shrink either during corrections or as a result of spikes in interest rates. It continues to grow so long as dividends, interest, profits and deposits exceed realized losses and disbursements.

Using the “Working Capital Model” facilitates preparation for future income needs with every decision made throughout the history of an investment program… MCIM working capital grows every month, regardless of changes in market value, so long as the investor disburses less than the portfolio is producing.

Year end is always a good time for investors to review asset allocation and projected income needs… if you are over 50 and haven’t considered the subject, it’s time to do so. If you expect to start withdrawing from your portfolios in the next few years, you need to determine if asset allocation changes are necessary.

If your income allocation is not generating at least 6% in spending money, or 401k balances are subject to shrinkage when the stock market corrects, it’s time to deal with these problems.

If you are not taking advantage of 6%+ tax free yields (and a higher range in taxable CEFs), you owe it to yourself to investigate the opportunities.

<<>>                 <<>>                 <<>>

So is there a “Grinch” in your 2015 portfolio performance future? What’s likely to happen?

The Stock Market is about to finish 2014 at the highest year end number ever recorded, and with each new “ATH”, the likelihood of a market correction increases… this 6.75 year rally is the longest, broadest, and most stubborn in stock market history.

So long as income investors are abused with artificially low rates, a gradual reduction in yields is likely to hold income CEFs around current prices… higher future rates are already anticipated in current market values.

Once higher rates become reality, there are several reasons why CEF prices should firm and, over the longer term, rise, with increased income production…

But even if the correction starts tomorrow, what has nearly 40 years of financial history taught us about the MCIM “much-higher-quality-and-income-than-any-other-form-of-investment-portfolio” methodology?

The IGVSI universe, high quality ADRs, REITS, MLPs, Royalty Trusts, plus Equity and Income CEFs should logically have been expected to fare better than the stock market averages during the three financial crises of our lifetimes. Many MCIM users can attest to this, but the logic is clear.

Every security produces income, and reasonable profits are always realized. New equity investments are only made when prices have fallen 20% or more; income securities are added to at lower prices to reduce cost basis and increase yield. Not to mention the fact that MCIMers invest only in the highest S & P quality ranked companies, filtered further by dividend history, NYSE, and profitability.

MCIM users were low on equities in August 1987 but fully invested by November; they owned no mutual funds, no NASDAQ securities, and no IPOs in 1999; they lost virtually no working capital, reinvested all earnings, and rebounded quickly from the financial crisis.

Most investors, particularly Mutual Fund owners and 401k participants were blindsided, not once, but on all three occasions. The S & P 500 has gained only 3% per year in the 15 it has taken to get to its current level!

So if the rally continues, Working Capital growth will continue right along with it. But when the correction comes along, cash reserves and continued income will likely be available to takes advantage of new opportunities that arise in the MCIM select group of potential investment securities.

The longer the correction (the financial crisis took roughly 20 MCIM months to reach bottom on March 9 2009), the more Working Capital will be available when the next round of stock market all time highs is upon us.

And again, most importantly I believe, all programmed income payments will be made on time and without dipping into capital…

Dealing With Stock Market Corrections: Ten Do’s and Don’ts

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, corrections adjust equity prices to their actual value or “support levels”.  In reality, it may be easier than that.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking.

The two former “becauses” are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

Mutual Fund holders rarely take profits but often take losses. Additionally, the new breed of Index Fund speculators is ready for a reality check. If this brief hiccup becomes a full blown correction, new investment opportunities will be abundant.

Here’s a list of ten things to think about doing, or to avoid doing, during corrections of any magnitude:

1. Your present Asset Allocation is based upon long-term goals and objectives. Resist the urge to decrease your Equity allocation because you expect lower stock prices. That would be an attempt to time the market. Asset allocation decisions should have nothing to do with stock market expectations.

2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of Investment Grade Value Stocks as they move lower in price. I start shopping at 20% below the 52-week high water mark… the shelves are full of bargains.

3. Don’t hoard the “smart cash” you accumulated during the rally, and don’t get yourself agitated if you buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, and selling too soon is investing brilliance.

4. Take a look at the future; you can’t tell when the rally will resume or how long it will last. If you are buying IGVSI equities now, you will to love the next rally even more than the last… with yet another round of profits.

5. As the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There’s more to “Shop at The Gap” than meets the eye, and you should run out of cash well before the new rally begins.

6. Your use of “Smart Cash” proves the wisdom of Market Cycle Investment Management; it should be gone while the market is still falling… gets less scary  every time. So long your cash flow continues unabated, the change in market value is just scary, not income (or life) threatening.

7.  Note that your Working Capital is still growing in spite of falling market values, and examine holdings for opportunities to reduce cost basis per share or to increase yield on income Closed End Funds). Examine fundamentals and price; lean hard on your experience; don’t force the issue.

8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of media hype and propaganda. Focus on Investment Grade Value Stocks; it’s easier, less risky, and better for your peace of mind.

9. Examine portfolio performance with your asset allocation and investment objectives in focus and in terms of market/interest rate cycles as opposed to calendar quarters and years. The Working Capital Model allows for your personal asset allocation.

Remember. too, that there is really no single index number to use for comparison purposes with a properly designed MCIM portfolio.

10.  So long as everything is “down”, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should NOT be discarded during general or group specific weakness.  BUT, you must have the courage to cull them during rallies… also general or sector specifical (sic).

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional rear view mirrors. The short and deep ones are most lovable (kind of like men, I’m told); the long and slow ones are more difficult to deal with.

If you overthink the environment or overcook the research, you’ll miss the party.

Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight. Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction:

There has never been a correction or a rally that has not succumbed to the next rally or correction..

Total Return: Smoke and Mirrors?

Just what is this “total return” hoop that investment managers are required to jump through? Why is it mostly just smoke and mirrors? Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — the ultimate test for any investment portfolio.

Applied to income purpose portfolios, it is really close to nonsense, and confusing to most investors.

Remember John Q. Retiree? He was the guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio. Secretly, he wondered about having only 3% in actual spending money.

A year or so later, he’s scratching his head wondering how he’s going to make ends meet with a total return that’s approaching zero. Do you think he realizes that his spending money may be higher?

What’s wrong with this thinking? How will the media compare mutual fund managers without it?

Wall Street doesn’t much care. They set the rules and define the performance rulers, and they say that income and equity investment performance can be measured with the same tools. They can’t, because their investment purposes are different.

If you want to use a ruler that applies equally well to both classes of security, just change one piece of the formula and give the new math a name that focuses on the actual purpose of income investing — the spending money.

We found this old way of looking at things within “The Working Capital Model”; the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same, and divided by the amount invested, they produce a Total Realized Return number. The difference is what the investor elects to do with the spending money.

So if John Q had taken profits in year one, he could have spent more, or added to his income production. You just can’t spend (or reinvest) “Total Return”.

We’ve taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in a properly diversified portfolio comprised only of investment grade, income producing securities.

Most of you know of Bill Gross, the Fixed Income equivalent of Warren Buffett. He manages a humungous bond mutual fund, but how does he invest his own money?

According to a NYT Money and Business article by Jonathan Fuerbringer (January 11, 2004), he’s “out” of his  own Total Return fund and “in” Closed End Muni Funds paying 7.0% tax free. (Must have read “The Brainwashing of the American Investor”.)

Fuerbringer doesn’t mention the taxable variety of CEF, then yielding roughly 9%, but they certainly demand a presence in the income security bucket of tax-qualified portfolios like 401ks. Sorry, can’t do that now. The omniscient DOL says the net/net income isn’t nearly as important as the Expense Ratio….

Similarly, Mr. Gross advises against the use of the non investment grade securities (junk bonds, etc.) that many fund managers  sneak into their portfolios.

But true to form, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community, as he gives lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS.

Inflation impacts buying  power, and the only way to beat it is with higher safe income. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc. No interest rate sensitive security is an Island!

As long as financial intellectuals remain mesmerized with total return numbers, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer market timing decisions between fixed income and equity investments, based on statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

Investors have to commit to the premise that the primary purpose of income securities is income production… this requires a focus on spending money.

If these three sentences don’t make complete sense to you, you need to learn more about income purpose investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to total spending money and to total working capital.
  • Changes in the market value of investment grade income securities are totally and completely irrelevant, 99% of the time.

Change? What Change?

I have, for about 15 years, tried to understand why investment returns tend to be the way they are. I have noticed that over long periods the stock market moves in a very narrow growth trough. In my view there must be an attractor that makes the rate the one we see.

This is background.  It is insufficient to act upon as an investor.

I am reasonably convinced there is an attractor and for the Toronto Stock Exchange it is about 9 and 7/8%. This graphic shows how the total return index (Actual) has behaved from 1950 to now. Click for a larger image.

TSE attractor

The outside bands are the growth from 1920 at 9 7/8% plus or minus 3/8%. The graph is logarithmic.

There seems to be limits so that if the high band is exceeded, then the future actual return tends to be sharply lower and if outside or near the low band, it tends to bounce back. Something draws it back from excesses on either side.

It returns to some standard and that stand must make sense or it would not be so persistent. What makes it up?

I do not know with certainty but I have some candidate ideas.

  1. Since the stock index is in dollars, inflation will contribute some of the growth. Using the Bank of Canada records, that is 3.69% over the 1950 to 2013 period. Be careful with this one though, there are many ways to assess inflation and there is not a consistent set of principals used throughout the period.
  2. Productivity adds value. It is harder to know what that might be but it is likely about 2%.
  3. The size of the market matters. Population growth tends to create customers and thus business value. In 1950 there were 13.7 million of us and now there are 34.9 million. Average growth rate about 1.5%.
  4. Average wealth matters too because the stock market counts economic wealth alone. Real GDP per person has about tripled in the last 65 years. About 1.7% annually.

Total to here. 8.9%

The other could be things like:

  • Access to markets. The internet turns a local business into a global business for some products.
  • Cost reductions. Computers have replaced a lot of clerks. How many operators does Bell employ? Not many. What has happened to draftsmen? Some of these changes are picked up in productivity changes.
  • Competition because capital is not as crucial as it once was. It is possible to start a world class business and get it to the proof of concept level with much less capital than was needed to start old businesses like the car companies and the steel mills.
  • The rise of service industries is important too. Their margins per dollar sales is much higher than retail or manufacturing.
  • Better service and banking structures and better infrastructure
  • Longer lives.

Regardless of what makes it up, it seems to be a persistent number.

As an investor, it is not usually in your best interest to bet against the market long term without a very good reason. By that belief, it would be not so clever to expect yields over long times to be more than 10% less fees and costs to earn it. Call that 7% to 8%.

By the same token if you have a 40 year or longer time frame, then betting much lower may sound smarter, but you will shortchange the present. You cannot take the kids to DisneyWorld when they are 32.

There is always the systemic risk that some government or other will do something to make the attractor rate be much less. I suppose they could make it be much more but I will need to see evidence for that one. I already have evidence for the former.

Be wise. The world behaves in semi-predictable ways. Try to notice what drives it.  Notice the number, but pay attention to how that affects your meaning.


Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Traders Are Not Investors

“Animal Spirits” is a concept that Keynes raised in his 1936 book, The General Theory of Employment, Interest and Money.  It refers to the tendency of markets of all types to move based on non-fundamental factors.  Market sentiment is the current idea.  Crowd psychology.

Looking at the markets as a whole over long periods, we see that there are price level changes that occur that have no basis in financial or business reality but rather are based on how people relate to news, especially surprises, commentary, especially from commentators that are showmen, and internet gossip, especially from frequent commentators. These are the meals animal spirits consume.

Intelligent investors will refrain from wasting their time on this fashion item.

Since this form of material is so ubiquitous and easy to access, markets today seem more driven by news than fundamentals.  Fundamentals are liked demographics.  In the long run you cannot overcome them.

Reports can appear reasonable, but like graphs that compare incomparable things, they are contextually deficient.  “After the fed announced a rate change, markets fell.”  “In response to the European banking crisis, markets fell.”  “Markets rose with the improvement in the employment report.”  All nonsense.

Short term market action is essentially random.  “The efficient market hypothesis”   But investor behaviour is not so efficient.  Investors are emotional.

In longer periods, fundamentals win.

Maybe we can learn from that.  Investors who repeatedly hear some news tidbit and see a market move as the result, begin to believe two things.  Both likely false in the big picture, but possibly having short term value.

  1. External events cause price changes in the market
  2. Analysis of causation in the markets may be possible.

People who want to go here are not investors.  They are traders.  They are using information that they believe will be interpreted by other market participants in a certain way.  They are trading against the other people, they are not investing in the long run potential of the business in question or even of the markets in general.  Practically, they would not even need to know the name of the business.  Its symbol contains all the information needed.   It is a large game with many players.  It is a zero-sum game.  The winner is the one who defeats his fellow players.  Like tennis.

Investing on the other hand is independent of the other players.  In the Warren Buffet style, you buy good businesses, in good industries, with competent managers and adequate capital.  Then wait.  In his view the best time to sell a stock is never.

When playing “the market moves on news” game, every decision must have two parts.  When to buy at a price and when to sell at a price.  Buffet’s tend to be one decision situations.  He only sells if fundamentals change or if someone offers him more than he believes the business is worth.

All investors need to get their time frames straight.  If you are accumulating money for a purpose 30 years in the future, news will not matter over that time.  If you are playing a short-term game that feels good when you win, then other rules apply.  Be sure you know the difference.

Investors are not traders and traders are not investors.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Lifting the veil on ETFs – Part 3 of 4

By their nature, ETFs are tax efficient and can be more attractive than mutual funds. When a mutual fund realizes a capital gain that is not offset by a realized loss, the mutual fund must allocate the capital gains to its shareholders. These gains are taxable to all shareholders, even those who reinvest the gains distributions to purchase more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock), so investors generally only realize capital gains when they sell their own shares for a profit or when the ETF trades to reflect changes in the underlying index.

An important benefit of an ETF is the stock-like features offered. A mutual fund is bought or sold at the end of a day’s trading, whereas ETFs can be traded whenever the market is open. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin and invest as much or as little money as they wish.


Effects on stability
ETFs that buy and hold commodities or futures of commodities have become popular. The commodity ETFs are in effect consumers of their target commodities, thereby affecting the price in a spurious fashion. In the words of the International Monetary Fund (IMF), “Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period.”

Regulatory risk
Areas of concern include the lack of transparency in products and increasing complexity, conflicts of interest and lack of regulatory oversight. You must take the time to do your own research before investing to fully understand these risks.

John C. Bogle, founder of the Vanguard Group, a leading international issuer of index mutual funds (and, since Bogle’s retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.

The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases. According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed their 2009 targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008. Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent such as emerging-market stocks, future-contracts based commodity indices and junk bonds.

Lifting the veil on ETFs – Part 1 of 4

Recently, one of the big 5 banks did a customer survey on ETFs and one of the questions was: “What do the letters ETF mean?” The responses shared were interesting to say the least! Most thought they stood for Emergency Task Force! Another group though it was an abbreviation for Energy Transfer Fund (like a carbon offset trading scheme I presume), some said it was an Environmental Trust and still others suggested Electronic Transfer of Funds. Apparently, less than 5% correctly identified the letters as meaning Exchange Traded Funds! Interesting to say the least since ETFs are attracting lots of attention these days, for various reasons – some accurate and others not.

They’re still quite new and would-be investors are bound to have lots of questions. In this article, I am only going to touch on the generalities of ETFs and some of the more common versions. Future issues of Money Magazine and this blog will delve more deeply into each area discussed here.

An (ETF) is an investment fund traded on a stock exchange much like a stock. It holds assets such as stocks, commodities or bonds and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their apparent lower costs, potential tax efficiency and stock-like features.

What is an index?
You probably know terms such as the S&P/TSX Total Return Index (the most quoted Canadian index) or the S&P 500 Index in the US on the news. Those are indexes. An index is a selection of stocks or bonds that represents a given market. Each index has rules about how many securities are included and how they are weighted. Indexes are mainly used to measure changes in the market they represent. Remember, an Industrial Average (such as the Dow Jones Industrial Average {DJIA} is NOT an index, but that is a subject for another review!).

An ETF combines the valuation features of a mutual fund which is bought or sold at the end of each trading day for its net asset value, with the tradability features of a stock or bond which trades throughout the trading day at varying.

ETFs offer investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds except that shares in an ETF are bought and sold throughout the day through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, brokers purchase and redeem ETF shares directly from the ETF.

Index ETFs
Most ETFs are index funds that attempt to replicate the performance of a specific index. They may be based on stocks, bonds, commodities or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents or a representative sample of the securities in the index. Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the performance of the index.

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called “replication”. Other index ETFs use “representative sampling”, investing perhaps 80% to 90% of their assets in the securities of an underlying index and investing the remaining 10% to 20% of their assets in other holdings such as futures, option and swap contracts and securities not in the underlying index. There are various ways the ETF can be weighted, such as equal weighting or revenue weighting.