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).


Stock Market Corrections Are Beautiful… When

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, even technically I’m told, corrections adjust equity prices to their actual value or “support levels”. In reality, it’s much 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 unit holders rarely take profits but often take losses. Additionally, the new breed of Index Fund Speculators over-react to news of any kind because that’s what speculators do. Thus, if any brief little market hiccup becomes considerably more serious, new investment opportunities will become 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 should be tuned in to your long-term goals and objectives. Resist the urge to decrease your Equity allocation because you expect a further fall in stock prices. That would be an attempt to time the market, which is (rather obviously) impossible. 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 high quality, dividend paying, NYSE companies as they move lower in price— Investment Grade Value Stocks. I start shopping at 20% below the 52-week high water mark— the bargain bins are filling.

3. Don’t hoard that “smart cash” you accumulated during the last rally, and don’t look back and get yourself agitated because you might buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, in the right portfolio percentage, is nearly as important to long-term investment success as selling too soon is during rallies.

4. Take a look at the future. Nope, you can’t tell when the rally will resume or how long it will last. If you are buying quality equities now (as you certainly could be) you will be able to love the rally even more than you did the last time— as you take yet another round of profits. Smiles broaden with each new realized gain, especially when most Wall Streeters are still just scratchin’ their heads.

5. As (or if) 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 if you are doing it properly, you’ll run out of cash well before the new rally begins.

6. Your understanding and use of the Smart Cash concept has proven the wisdom of The Investor’s Creed (look it up). You should be out of cash while the market is still correcting— it gets less scary each time. As long your cash flow continues unabated, the change in market value is merely a perceptual issue.

7. Note that your Working Capital is still growing, in spite of falling prices, and examine your holdings for opportunities to average down on cost per share or to increase yield (on fixed income securities). Examine both fundamentals and price, lean hard on your experience, and 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 what the Wall Street propaganda mill spits out. Focus on Investment Grade Value Stocks; it’s just easier, as well as being less risky, and better for your peace of mind. Just think where you would be today had you heeded this advice years ago—

9. Examine your portfolio’s performance: with your asset allocation and investment objectives clearly in focus; in terms of market and interest rate cycles as opposed to calendar Quarters (never do that) and Years; and only with the use of the Working Capital Model (look this up also), because it is based upon your personal asset allocation. Remember, there is really no single index number to use for comparison purposes with a properly designed portfolio.

Unfortunately, only Self Directed 401k and IRA programs are able to use Market Cycle Investment Management.

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. Unless of course, you don’t have the courage to get rid of 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 grade 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. Short ones (those that last a few days, weeks, or months) are nearly impossible to deal with using Mutual Funds.

So if you overthink the environment or overcook the research, you’ll miss the party. Unlike many things in life, 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/rally that has not succumbed to the next rally/correction—

Think cycle instead of year, and smile more often.

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The Investment Gods Are Furious

Market Cycle Investment Management (MCIM) is an historically new methodology, but with roots deeply embedded in both the building blocks of capitalism, and financial psychology— if there is such a thing.

The earliest forms of capitalism sprung from ancient mercantilism, which involved the production of goods and their distribution to people or countries mostly around the Mediterranean.

The sole purpose of the exercise was profit and the most successful traders quickly produced more profits than they needed for their own consumption. The excess cash needed a home, and a wide variety of early entrepreneurial types were quick to propose ventures for the rudimentary rich to consider.

There were no income taxes, and governments actually supported commercial activities, recognizing how good it was for “Main Street” — as if there was such a thing.

The investment gods saw this developing enterprise and thought it good. They suggested to the early merchants, and governments that they could “spread the wealth around” by: selling ownership interests in their growing enterprises, and by borrowing money to finance expansion and new ventures.

A financial industry grew up around the early entrepreneurs, providing insurances, brokerage, and other banking services. Economic growth created the need for a trained workforce, and companies competed for the most skilled. Eventually, even the employees could afford (even demand) a piece of the action.

Was this the beginning of modern liberalism? Not! The investment gods had created the building blocks of capitalism: stocks and bonds, profits and income. Stock owners participated in the success of growing enterprises; bondholders received interest for the use of their money; more and better skilled workers were needed — the K.I.S.S. principle was born.

As capitalism took hold, entrepreneurs flourished, ingenuity and creativity were rewarded, jobs were created, civilizations blossomed, and living standards improved throughout the world. Global markets evolved that allowed investors anywhere to provide capital to industrial users everywhere, and to trade their ownership interests electronically.

But on the dark side, without even knowing it, Main Street self-directors participated in a thunderous explosion of new financial products and quasi-legal derivatives that so confused the investment gods that they had to holler “’nuff”! Where are our sacred stocks and bonds? Financial chaos ensued.

The Working Capital Model was developed in the 1970s, as the guts of an investment management approach that embraced the cyclical vagaries of markets. This at a time when there were no IRA or 401(k) plans, no index or sector funds, no CDOs or credit swaps, and very few risky products for investors to untangle.

Those who invested then: obtained investment ideas from people who knew stocks and bonds, had pensions protected by risk-averse trustees, and appreciated the power of compound interest. Insurance and annuities were fixed, financial institutions were separated to avoid conflicts of interest, and there were as many economics majors as lawyers in Washington.

MCIM was revolutionary then in its break from the ancient buy-and-hold, in its staunch insistence on Quality, Diversification, and Income selection principles, and in its cost based allocation and diversification disciplines. It is revolutionary still as it butts heads with a Wall Street that has gone MPT mad with product creation, value obfuscation, and short-term performance evaluation.

Investing is a long-term process that involves goal setting and portfolio building. It demands patience, and an understanding of the cycles that create and confuse its landscape. MCIM thrives upon the nature of markets while Wall Street ignores it. Working Capital numbers are used for short-term controls and directional guidance; peak-to-peak analysis keeps performance expectations in perspective.

In the early 70s, investment professionals compared their equity performance cyclically with the S & P 500 from one significant market peak to the next — from the 1,500 achieved in November 1999 to the 1,527 of November 2007, for example. Equity portfolio managers would be expected to do at least as well over the same time period, after all expenses.

Another popular hoop for investment managers of that era to jump through was Peak to Trough performance —managers would be expected to do less poorly than the averages during corrections.

Professional income portfolio managers were expected to produce secure and increasing streams of spendable income, regardless. Compounded earnings and/or secure cash flow were all that was required. Apples were not compared with oranges.

Today’s obsession with short-term blinks of the investment eye is Wall Street’s attempt to take the market cycle out of the performance picture. Similarly, total return hocus-pocus places artificial significance on bond market values while it obscures the importance of the income produced.

MCIM users and practitioners will have none of it; the investment gods are furious.

Market Cycle Investment Management embraces the fundamental building blocks of capitalism — individual stocks and bonds and managed income CEFs in which the actual holdings are clearly visible. Profits and income rule.

Think about it, in an MCIM world, there would be no CDOs or multi-level mortgage mystery meat; no hedge funds, naked short sellers, or managed options programs; no mark-to-market lunacy, Bernie Madoffs, or taxes on investment income.

In MCIM portfolios, lower stock prices are seen as a cyclical fact of life, an opportunity to add to positions at lower prices. There is no panic selling in high quality holdings, and no flight to 1% Treasuries from 6% tax free Munis. In an MCIM portfolio, dividends and income keep rolling, providing income for retirees, college kids, and golf trips — regardless of what the security market values are doing.

Capitalism is not broken; it’s just been overly tinkered with. The financial system is in serious trouble, however, and needs to get back to its roots and to those building blocks that the Wizards have cloaked in obscurity.

Let’s stick with stocks and bonds; lets focus on income where the purpose is income; let’s analyze performance relative to cycles as opposed to phases of the moon; let’s tax consumption instead of income; and let’s not disrespect the gods, the “Bing”, or the intelligence of the average investor…

So sayeth the gods. Amen!

I Want Tax free Income

The LinkedIn discussion considered ROTH vehicles invested in equities and “cash value” Life Insurance as two ways to obtain Tax Free Income… something was missing.

Why not buy tax free muni bonds in the form of Closed End Funds (CEFs)…. more than 6% tax free, in monthly increments, plus the opportunity to take profits (taxable, yes) and compound the income until it is needed. Or spend it right away, for that matter.

The vast majority of Tax Free CEFs continued (raised even) their monthly payouts during the financial crisis, and no payments were missed.

ROTHs have a “lock up” period, and cash value life insurance…. someone please tell me how this provides tax free income and when.

If left in the ROTH vehicle, should one still be buying equities? or investing in income producers?

Experienced, taxable CEFs pay in the 7% to 8% range right now… and seemed to be financial crisis proof in 2008 through 2010.

Growing income portfolios is my business… can’t be done nearly as well with funds and insurance policies. For over 6% tax free income right now, create a diversified portfolio of tax free CEFs.

Yes, market value fluctuates, but with little or no impact on income production. I want tax free income too… and this is how I get it, both personally and for my managed portfolios.

The principles explained in this video webinar are equally applicable to the Tax Free Income building portfolio:

The “Retirement Ready” 401k… exists. Right?

Income Production = Market Value Growth + Retirement Security

Unfortunately, it just isn’t available to you in the standard 401k product menu.

Since the demise of corporate Defined Benefit Plans, most employees have been forced to rely on their own investment acumen to make sense of the product menu choices accompanying an ever growing array of private and public Defined Contribution Plans.

These are savings plans that use hundreds of pooled portfolios of securities and derivatives, many with suggestive and exotic names, to invest and reinvest participant and employer monthly contributions. It is rare that any unbiased advice is available to either Plan Sponsors or Participants, and even professional fiduciaries seem a bit brainwashed when one observes the results of their investment product choices.

Recently, it was proven to me fairly conclusively, that no product specializing in top tier  S & P dividend paying companies in combination with a diversified collection of Closed End Income Funds yielding over 6% (after expenses) will ever gain traction in the “good ‘ole big boys club” described as the 401k space.

Quality, meaningful diversification, and income production, the core curriculum of college investment majors for a century or more is now deemed to be an “Alternative Investment”. This a term once reserved for the most speculative of  speculations… futures, options, indices, shorts, commodities, junk bonds, emerging markets, etc.

The speculative essence of 401k Plan product menu choices, coupled with the utter disinterest in providing meaningful income choices (even toward the end of a TDF “glide path”), just screams for a better way for employers to get, 401k-like, tax deferral and wealth accumulation benefits.

For smaller employers, a 401k “safe harbor”, self-directed, program is an attractive alternative with none of the Wall Street program investment choice drawbacks…. AND no “top heavy” or annual recalculation aggravation. Yes, there must be a “match” for employee contributions, and immediate vesting, but a maximum contribution with total matching is a major plus.

Sure this can be done without the help of a professional manager, but that will just put  you back into the same stuff of the 401k model… no known quality, no income, and a taste of every available speculation the Wall Street imagination can devise.

An ideal self-directed program would provide for professional portfolio management with an ever increasing income “purpose” asset allocation “bucket”, based on the age of each participant. For Example:

Self Directed, individually and professionally managed, portfolios for all employees featuring:

  • flexible asset allocations (ranging from 60% Equity to 0% Equity)
  • annual income growth (in all* investment and interest rate markets)
  • annual Working Capital growth (so long as income, gains, & deposits exceed losses)
  • one-to-one convertibility to a Rollover IRA
  • “ROTH” 401k availability

*Using the 2008-2009 Financial Crisis as a worst case scenario.

Many of you have attended the current series of income investing webinars (the January program video is available through the link provided below). This is the kind of program that you could create inside your 401k Plan if it were to become the “Self Directed” variety described above… isn’t it time that you got the most out of your company’s retirement income program?

Remember, that since every investment program becomes a retirement income program eventually, you need to bring your program to a place where you can say with reasonable assurance:

“A stock market downturn will have no significant impact on my retirement income”

Only private “safe haven” type 401k plans, those that are both self directed and managed with the MCIM methodology appear capable of developing annually increasing spendable retirement income. The others just don’t seem to care.

“Retirement readiness” doesn’t just happen; there’s no button you can push. Those of you who are counting on a forever upward stock market, or the promise of a Target Date Fund need to “get real”, and quickly.

Here’s the content of the Vanguard 2015 TDF as of January 31, 2015:

Vanguard Total Stock Market Index Fund ………………..34.9% (3008 different stocks)
Vanguard Total International Stock Index Fund ……….15.1% (5008 different stocks)
Vanguard Total Bond Market II Index Fund ……………..32.4%
Vanguard Total International Bond Index Fund…………10.0%
Vanguard Short Term Inflation-Protected Index Fund…7.6%

Equity Total = 50% Income Total = 50% TOTAL PROGRAM YIELD = 2.01%

So, if your Million Dollar Retirement Portfolio is in this TDF, will you be able to survive on $1,675 per month?

Have a private look at the workings of a professionally managed retirement income program; a high quality, individual security, 30% Equity portfolio, generating a million dollar prorated, $5,480 per month:


Retirement Income Investing: The Dreaded RMD

All of us are approaching retirement, many of us are already there, and some of us (myself included) are thinking about the ultimate IRS slap-in-the-face… The Required Minimum Distribution. It’s time to make sure that your retirement income program is actually ready.

Every investment program becomes a retirement income program eventually.

First off, you need to get to a place where you can say:

“a stock market downturn will have no significant impact on my retirement income”

This applies to everyone; income development is always important, and Tax Free Income (outside the IRA or 401k) is The Very Best. Only private “safe haven” 401k plans are capable of focusing on income development.

Retirement readiness requires active consideration of your asset allocation, your overall diversification, and most importantly, the quality of your holdings. Those of you who are relying on 401k assets to fund your retirement income requirements need to look inside the program.

If you are within five years of retirement, repositioning at the top of a stock market cycle (now) is essential; if you are in retirement, get your portfolio out of any employer plans and into your IRA… you just can’t protect yourself  (and especially, your income) in Mutual Funds or ETFs.

If you are approaching 70, the RMD is “in your face”… here’s how to handle it:

• Position the portfolio to produce slightly more income than you must take from the program.

• Take the income monthly and DO NOT pay the taxes in advance. Lump sum withdrawals require uninvested cash reserves and/or untimely sell transactions.

• Move the RMD disbursements into an individual or joint account and reinvest at least 30% in Tax Free Income CEFs.

• If you hold equities (in addition to the RMD income producers you need), set your profit taking targets lower than usual… and maintain the Cost Based Asset Allocation.

I’m relatively sure that some of you are currently dealing with the RMD incorrectly… with “lump sum + the taxes” distributions.

Some of you have been to my ongoing series of “live SRS portfolio review, Income Investing Webinars”.

Follow this link to the recording of the January 22nd private presentation and don’t hesitate to post it where ever you like… wouldn’t it be cool to have this presentation show up on YouTube.

Why so much ado about interest rates?

Mal Spooner
Mal Spooner

Why the popularity of shorter-term interest-bearing securities among Canadians, in particular GIC investments?  In fact, we in Canada are not the only investors who seem satisfied investing our money knowing that the rate-of-return might just barely cover the rate of price inflation, with a significant risk of actually losing money if inflation should rise even modestly.  And it is not just people who are content with the arrangement between ourselves and the borrowers of our money – banks, insurance companies and credit unions alike – corporations have been hoarding cash since the Financial Crisis too.

This past summer, Statistics Canada reminded us that corporations in Canada continued to grow their cash hoard rather than invest the funds in their businesses.  Of course, like people, companies don’t actually hold cash, but rather invest the money in low risk short-term interest bearing securities, often in Government of Canada T-bills and bonds, as well as commercial paper offered by financial institutions.

At the end of the second quarter of 2008, corporations held $373.4 billion in cash balances (Statistics Canada November 17th, 2009 study: Indebtedness and liquidity of non-financial corporations).  By the first quarter of this (2014) year the number had grown to a whopping $629.7-billion. So why the stubborn tendency to tolerate a near-zero rate-of-return?

There are at least two factors at work in my estimation.  One has to do with the economics of interest rates in the current environment, another with human nature and demographics.

First of all, what is an interest rate?  It embodies three important expectations-related factors: Real returns, inflation and risk.  We all are reluctant to part with our cash unless we’re able to earn what economists call a ‘real’ return.  Ask yourself, what rate-of-return would make you happy if there was essentially no risk (default, volatility) to speak of and no price inflation.  Whatever you buy today, will in theory cost you the same price next year and every year after that.  Most agree that the very long-term real rate of interest is somewhere between 2% and 4%.  Real Rates Canada 2004 to 2014However, you can easily see from the graph that the real rate of return provided by Government of Canada (as low risk as you can find) long-term real return bonds over the past ten years has been driven down since the Financial Crisis, as all governmental central banks strove to fight disinflation by dampening the general level of interest rates.

Has the return we expect from lending our funds really adjusted downward, or is it that the availability of securities providing the returns we normally demand has changed?  My guess is most folks would agree that the adage ‘once burned, twice shy’ aptly summarizes our tendency to be  biased by recent experience.  It is human nature to be sensitive to bad or good things that have just happened and to oftentimes unreasonably expect them to continue.  Also, we are confronted by a lack of options.  Securities available to us are not promising the rates-of-return we want, given the amount of risk we are prepared to stomach.

In fact, a quick look at one of many high-dividend oriented ETF’s, the iShares Core S&P/TSX Composite High Dividend Index ETF suggests that a collection of dividend paying stocks yielded 4.31% (as of October 2, 2014) over the past (trailing) 12 months.  As a bonus, the tax treatment of dividends is more generous than it is for interest income.  Indeed the stock market has done perhaps too well over the last few years, but judging by the massive dollars invested in short-term securities those equity returns have not been earned by everyday people. The issue is people just don’t seem to want the volatility that comes with investing in stocks; even when the selection of stocks is less risky than the overall stock market.  A real return with some risk is less attractive than no return at all, and it has been like this for quite awhile now. The second ingredient to interest rate levels is inflation expectations.

Source: Bank of Canada
Source: Bank of Canada

Admittedly, we haven’t seen a whole bunch of price inflation have we?  Central bank policy around the world has been more interested in creating some inflation, fearing that disinflation would prove devastating to our economic welfare.  These efforts are in fact evidenced by the historically low level of administered interest rates we have.  If our collective expectations concerning future price inflation are significantly different from what we are experiencing then our behaviour will reflect it. Could it be that the extraordinarily high commitment to GIC’s and equivalents is that Canadians, and Americans are doing it too, are content to simply keep their money (even at the risk of a small loss) intact until rates of inflation and returns get back to levels they think they can believe in?

The third important determinant of interest rate levels is our toleration for risk, and it exists in many different forms.  Our appreciation for the risk of default was certainly modified during the Financial Crisis; and in short order we’ve been willing to tolerate none of it.  We’ve turned a blind eye to significant stock market appreciation and even bond returns preferring to ‘check’ rather than ‘raise’ and ‘all in’ has certainly been out of the question.   But this intolerance to take risk has become very sticky at the individual level and at the corporate level.  This might have more to do with demographics than anything else.

Younger people are quite surprised to learn that real interest rates got as high as 6% – 9% during the mid-1980’s, and during the 90’s and up to the turn of the millennium ranged around the 4% level. (Source: I was there!)  There is a large proportion Canadians who lived through those times.  According to Statistics Canada there is roughly an equal number of young people as there are older people.  Ratio of old to young in CanadaHalf of us in Canada might consider those times ancient history (or have no interest at all in history), and the other half feel as if it was just yesterday that mortgage rates were in the double digits.

These more seasoned citizens look at the rates of return offered by the bond market and similar investment vehicles and say to themselves: “Hey, if I buy a longer term bond, I’m earning next to nothing anyway, so I’ll just put money into shorter term GIC’s and term deposits that are effectively earning nothing and avoid the risk of having my money tied up.”  Having experienced periods of rising inflation and higher real rates, they (and yes, I’m a member of that distinguished group) are inclined to wait until more generous returns come back – if they ever do come back.  And don’t forget, these same folks might actually have to spend their savings sooner rather than later suggesting that any risk of a big loss in the stock or bond market is simply untenable.

Most people when they think of Canada bonds, immediately think of Canada Savings Bonds.  They are not the same at all.  Normal Government of Canada bonds, held in mutual funds and pension plans for example, rise and fall in value as interest rates change.  Although we’ve been through a very long stretch of falling interest rates, which made bond prices steadily go up in value, there have been and will be periods when interest rates rise and people lose money in bonds.  It is smart to learn how the time value of money works and how and why bonds can make or lose money.  There is a plethora of online videos that can help you understand bond valuation and the investment in your time to learn bond dynamics is well worth the minimal effort.

The yield curve is simply a plot of interest rates corresponding to varying maturities at a point in time.  Ordinarily, we expect to earn higher returns the longer our money is lent to someone else.  GIC rates are lower when the hold period is 3 months than they are when your money is tied up for 3 years.  The same should be true for bonds.  But consider where we’ve come from:  US Treasury Dept. Yield CurvesThe graph shows the yield curves for US Treasury bonds as of October 2007 compared to the same today.  The 2007 yield curve reflects the uncertainty at that time about, well almost everything.  We didn’t know if we should accept lower rates for shorter investments or high rates for longer term bonds so the curve was somewhat flattish.  What would inflation be?  Which financial institution would be solvent?  Would the US government even be solvent?  Many questions but few answers in the midst of the financial turmoil.

The more current yield curve reflects today’s reality.  The only interest rates we can earn in the short-term are hovering close to zero, and since longer-term risk-free bonds are paying us barely one percent over inflation why assume the added risk.  If interest rates do rise from these low levels, then you will certainly lose money owning the longer-term bonds.

In a nutshell, people have doing what they should be doing – seeking shelter and waiting it out.   A side-effect of this behaviour is that our willingness to tolerate no return for lots of safety has stalled the return to financial market normality.  By stubbornly remaining in GIC’s, term deposits and money market funds we are inadvertently delaying what we desire – a decent return for taking some risk.  It’s only when money moves freely and to a large extent greedily that financial markets function properly.  This presents quite a conundrum for policy makers around the world, who’ve been praying that businesses invest in business instead of hoarding their cash, and people begin spending more and taking on more risk by investing their savings in more diverse ways.

There are many pundits who have suddenly jumped on the bandwagon predicting a stock market meltdown and impending bond market rout.  If they are right and this happens then we might finally get what we want after-the-fact; returns that compensate us fairly for inflation and risk.  In fact the stock market is suffering of late, and a shift (or rather, twist)  in the yield curve is already causing some havoc for bond managers.  The longer-term rates have declined rather than risen as expected, and mid-term bond yields have surprisingly risen – causing grief even for gurus like Bill Gross, who co-founded PIMCO and until recently managed one of the world’s largest bond portfolios.

If investors have been doing the right thing to feel secure, what should they be doing next?  Over my own lengthy career I’ve found that at some point it is important to combat inertia and begin moving in a different strategic direction.  As stock prices adjust downwards, take advantage of what happens.  The dividends paid on the increasingly lower stock prices become more attractive quickly, and remember they are taxed at preferential rates.  The world economy may continue to grow at only a snail’s pace, so why not test the waters so to speak and begin putting some funds into longer-term interest-earning bonds.  If inflation does creep up and interest rates increase some, then put even more funds to work at the higher yields.    Having done the safe thing during turbulent times, perhaps it’s time to do the smart thing.  Experience teaches us that the best time to be doing the smart thing is almost always when it is most difficult to do it.  The longer you earn nothing, the poorer you get.


Pitfalls of Target Date Funds… and some proposed replacements

The LinkedIn Group Communities are abuzz with the idea that, even as popular as they have become, Target Date Funds (TDFs) are just not wonderful after all…

Several fixes have been proposed. I’ve done so myself. as you know. This one is from “A Better Option than Target Date Funds” and needs some cautionary commentary.
What to say when you agree that Target Date Funds are a sham, and do little to prepare 401k plan participants for retirement?

But what to shout out loud, when the fix for a low income, inappropriate asset allocation, is a “half-gainer” into a river of high risk speculations being promoted as “alternative investment” asset classes!

Note that “alternative investment” is a euphemism for those high risk mechanisms described in Investments 101 textbooks as “speculations”.

No matter how they are sliced, diced, sauteed, or seasoned, no recipe for speculations will ever produce the taste of a fundamentally sound investment.

Similarly, when considering ETF derivatives, the risk increases exponentially with each level, so a fund of funds is likely to be riskier than the funds it contains.

The article mistakenly merges all “Life Cycle” programs and products into the TDF category. There are at least three that are retirement income focused, and asset allocated to accommodate several different risk tolerances at retirement.

They are constructed with Investment Grade Value Stocks and Income ETFs. Not sexy at all, but they should provide lower drawdowns and higher income… and they can be converted security-for-security into a rollover retirement portfolio at any time.

Target date funds do not prepare us for retirement, though they may shield us a bit from maximum correction drawdowns.

My concern with them is that the inappropriate DOL/SEC focus on fund expenses and market value is (all good intentions aside) producing a low income retirement scenario that will only generate enough income if the market never, ever, goes down.

The popular Vanguard Target 2015, for example, is more than 50% in the stock market (with no signs of reducing exposure) and generating much less than 2% in spending money.

The fund holds positions in more than 5,000 different stocks (there are less than 500 Investment Grade Value Stocks)… clearly not a retirement fund in any sense of the word. The ideal “retirement fund” never invades principal, thus allowing for growth in the annual income provided.

But the portfolio alternative being proposed in the article is absurd, or should be to any plan sponsor or fiduciary.

Commodities, private real estate, private equity speculations, and hedge funds may well be alternative asset classes BUT they are absolutely not investments. These are textbook speculations, nothing more, and certainly nothing that should ever be considered  suitable for a retirement program.

401k Drawdown… OMG

“Drawdown” has become the most feared word in the 401k vocabulary, just as “Total Return” has become the most worshipped phrase. OMG, how will plan participants be able to retire if their portfolio market values stop rising!

“Well, yeah,” you might say, “isn’t that what investing is all about. If you’re in the right sectors and the right funds, your drawdown will be minimized.” Well , yeah, that could be a viable drawdown minimization scenario if we had a crystal ball that could identify the “right” vehicles.

We don’t, and a litany of supportive sector correlation statistics just doesn’t change the basic facts of investment life that still are referred to respectfully by some as the “Market Cycle”.

Can you remember how easy portfolio management once was, simply by applying basic “QDI” principles to portfolio content selection and profit taking disciplines? It was a time when navigating an investment portfolio through the unpredictable, cyclical, undulations was indeed, a labor of love and respect for economic fundamentals… with strategies based on cyclical realities.

MPT charlatans, with “Frankensteinian” creativity, have transformed text-book-defined speculation into a passive sector-timing process based on probabilities… games of chance yet to be tested through any form of market correction.

In a program with no promise of income and no concern for fundamentals, is it any wonder market value drawdown is so feared.

Place today’s ETF and Mutual Fund equity content into the three Major Meltdowns of the past 30 years, and it’s likely that you’ll see the very same drawdown numbers… or worse, because of the artificial demand for a finite supply of real securities.

Drawdown happens; corrections are inevitable. The same MPT hocus pocus that, theoretically, is placing 401k dollars in the right sectors is, perversely, exacerbating the problem by blowing up the highest security price balloon ever, even higher.

Keep in mind as well, advisors and fiduciaries all, while we wonder at the brilliance of those who have created this ethereal (surreal), market fantasy land, that it is they (not you and I) that wield the fatal “pin”.

When the bubble bursts, remember these thoughts:

Drawdown minimization is accomplished by: investing only in “investment grade”, high quality, securities (fundamentally speaking); then diversifying among them sensibly within two “purpose delimited” security buckets; and regarding realized “base income” as the primary purpose of the income allocation and the secondary purpose of the equities.

With strict buy, hold, and reasonable profit-taking disciplines governing portfolio operations, drawdown minimization, continual income growth, and rapid recovery is virtually a sure thing… a sure thing that isn’t possible in a 401k environment that has kicked fundamental quality and income growth principles to the curb.

The swarming of AAPL.

Understanding how the shares of Apple Inc. managed to get squashed so badly has much to do with knowing a bit about investor psychology and modern market dynamics. It wasn’t very long ago that shares in AAPL were universally loved – about a year ago now, CNN made it known that Poland, Belgium, Sweden, Saudi Arabia, and Taiwan all had GDPs that were less that Apple’s market value (around $500 billion at the time).

It’s all about probabilities. If absolutely everything is going well, encouraging publicity abounds and everyone you know has both the iPhone and owns the stock, then the only thing that is left to occur is suddenly something (sentiment, earnings disappointments, hurricanes) not-so good-happens which cools investor enthusiasm. When a stock is widely held, the subsequent selling can prove disastrous for all shareholders.

In September of 2012 AAPL traded a tiny bit north of $700 per share and is now in the neighborhood of $420 give or take. Losing 40% of one’s investment in a bull market is painful.

On business television you’ll hear lots of Apple pundits (who still own the stock in their portfolios) say the company is worth far more than the share price would suggest. This may or may not be true, but the fact of the matter is that the share price does represent what it is worth to investors right now! Doesn’t it?

The answer used to be yes, but with the increase in the popularity of short-selling it is difficult to determine nowadays what a company is really worth. In many instances there is absolutely no connection between the actual economic value of a business and its stock price.

Swarming is the term now applied to the crime where an unsuspecting innocent bystander is attacked by several culprits at once, with no known motive. Because swarming at street level involves violence, it is criminal. However in financial markets it is perfectly legal and different because there definitely is a motive. The motive is to rob shareholders of their invested dollars.

In a recent (April 6th, Thomson Reuters: Reuters Insider) interview Bill Ackerman, founder of Pershing Square Capital Management and who is described as an ‘activist’ investor, admitted “There is something inherently shadowy or evil about short-sellers.” Ackerman gained notoriety when he publicly claimed the company Herbalife was nothing more than a pyramid scheme, suggested the stock was worth zero and admitted his company had an enormous short position.

When any company today stumbles (or is perceived to have stumbled) it ignites something akin to a swarming. For example, this quote is from on November 10th, 2012:

“The question has been asked by nearly every Apple watcher following a brutal two-week stretch that began with a worse than expected earnings report, quickened after the ouster of a high-profile executive and culminated with news this week that it had fallen behind competitor Samsung in the smartphone wars.”

Although one might expect the stock to decline under the circumstances, the subsequent pummeling of the share price seems a bit cruel. What happened? Have a gander at this graph of the short interest (the total number of shares that were sold short) since about a year ago. To gain perspective, in April of 2013 the short interest has grown to 20,497,880 shares. The dollar value of this is about the same as the Gross Domestic Product of the entire country of Malta.

In English, short-sellers detected vulnerability, and swarmed AAPL. The irony is that short-sellers borrow the stock from real shareholders (via third parties) in order to sell it on the market. After the selling pressure wreaks havoc on the stock price, the short-seller then buys shares at a much lower price, returns the ‘borrowed’ shares to those real shareholders and keeps the profits.

The irony is that short-sellers claim to be providing a public service. Bill Ackerman was simply exposing a company that he believed (discovered) was misleading its shareholders. He even went so far as to say he didn’t even want the profits – they would be donated to charity. The problem is that it isn’t just some big bad corporation that is punished, but its shareholders and in due course even its employees.

I’ve never claimed to be all that smart, but I just can’t figure out how aggressively attacking a company’s share price, selling stock that the seller doesn’t even own, for the sole purpose of transferring the savings of innocent investors into one’s own coffers (whether it goes to charity of not) is a noble thing. Isn’t it kind of like a bunch of thugs beating someone up and stealing his/her cellphone declaring it was the loner’s own fault for being vulnerable?

How can you stay clear of being a victim?

  • Avoid owning stocks that have become darlings. When it seems nothing at all can go wrong, it will ,and when it does there’s sure to be a swarming.
  • If there’s evidence of a growing short interest in a company, best not own the stock.
  • Instruct your financial institution that your shares are not to be available for securities lending purposes.
Mal Spooner