An Issue of Trust

Who can you trust with your money? 
If you ask the individual investor, the answer is "no one."  Not after the likes of Bernard Madoff, Allen Sanford and, now, Goldman Sachs, the crown jewel of investment banks.  So, if you follow the thinking of the individual investor by measuring "Investor Sentiment," you would have drastically cut back in stock investments in December, 2008, and you would not have returned to the stock market yet. 
In other words, you would have sold near the market low.  No wonder Warren Buffett cautions, "Be greedy when others are fearful; be fearful when others are greedy."
I follow a proprietary investment model that measures twenty one economic indicators.  I've built this model over a period of over twenty years, and use it exclusively for two purposes:

1. It is my model, and I use only data from apolitical, independent sources for analysis.  That keeps me protected from data that may have been skewed by someone who has a vested interest in whether I choose to invest or not;
2. It removes all emotion from investment decisions.  If it says that I should be 70% invested, I'm 70% invested.  No panic.  No euphoria.  No need to trust anyone but me.

 When I invested money for other people, it was an invaluable tool.  If my clients wanted to sell low, I showed them that they were doing just that.  If they wanted to buy high, again, I showed them that was a less than stellar strategy.
Discussing each indicator, and how it relates to the overall decision was the subject of a semester's work in an advanced class at UCLA for professional financial planners who chose an emphasis in investment.  Mostly geeks.  I will, however, discuss one part of this analysis, Investor Sentiment, and tie that discussion to the general feeling of mistrust that is currently pervasive with the individual investor.
If you had followed Investor Sentiment as discussed above, you would have sold when the S and P 500 was at 888.61.  It is now at 1192.13.  As reflected above, you'd have sold low and, if you buy back in, it will undoubtedly be higher. 
If, on the other hand, you would have read Investor Sentiment as a negative indicator, i.e., you did the opposite of what it suggested, you would have enjoyed a 34% increase.   Hmmm.  I'm reminded of what my grandmother said when I based my plea to do something on, "Everybody else is doing it."  Her familiar response was, "If everybody jumped off a cliff, would you do it, too?"
So, now we have both Warren Buffett and my sweet little Meema advising us to think for ourselves, and even consider doing the opposite of what others are doing.  In the particular case of the last market correction, that would have been good advice.  But, does it hold true most of the time?
As it turns out, yes.  Investor Sentiment is the most predictive of all twenty one of my indicators, if you do the opposite of what it says to do.  And, I will add, that the stock market is nowhere near the bargain it was in March, 2008, when its cost (P/E)  was about its long term average of $15.82 for every dollar of S and P 500 earnings, but even though the market has come back 75% from its low (25% lower than its high), the individual investor is still not buying.
Back to trust.  Yes, Bernie Madoff is a thief.  Yes, Allen Sanford appears to have bilked thousands of investors out of their money, touting "safe" international CDs.  Yes, it looks like Goldman Sachs took both sides of the bet that the housing bubble would burst.  But does that mean you should keep your money in the bank?  Let's take a look at how that will work for you in the long term.
The best rate I could find for a two and one-half year insured CD was 2.1%.  To calculate your "real return," that is, your return after inflation and taxes, subtract from that 2.1% the current inflation rate, or 2.1%.  Now you're at zero, but you still have to pay taxes on your interest.  For most people,  your marginal tax rate is about 16%.  16% tax on 3% is .48.  So, tax of .48 plus inflation of 2.1 is 2.58.  2.1 - 2.58 = -.48  You're losing about 1/2% annually.
If you're a woman with $100,000 that must last you for 30 years, at that rate, this money will produce about $3100 per year.  On the other hand, if you were to invest in the stock market, using its long term average return of 9%, this money will produce about $9,700 per year.
We live longer.  Inflation hits us harder.  We can put our money in "safe" investments that are guaranteed to lose money over the long term, or we can listen to Warren Buffett and my sweet little Meema.
The choice is yours.

Is Janet Yellen the Best Candidate for Vice Chair of the Fed?

San Francisco Federal Reserve Bank President Janet Yellin is Obama's nominee for Vice Chair of the Federal Reserve Bank.  Why this policy dove may be a perfect short term answer, and a long term disaster.
Mission
The primary role of the Fed is the pursuit of maximum employment and price stability.  Sounds simple.
It's anything but.
I.  Maximum Employment
To pursue the goal of full employment, the Fed must make business conditions favorable to hiring.  That means that businesses must be able to borrow easily, expand and hire employees to facilitate such growth.  As you know, banks must keep a certain amount of their deposits with their local branch of the Federal Reserve Bank in order to have sufficient liquidity to prevent panics that contributed to the Great Depression.  When short term interest rates are low, banks can more freely lend to businesses because they don't have to keep as close an eye on their cash reserves.  Money's cheap.
When rates rise, banks keep a tighter rein on lending by strengthening borrowing standards.  It's harder to get a loan, business expansion slows and jobs are harder to get.
Why not have a continuing policy of low interest rates?
II.  Price Stability
Price stability is another way of saying low inflation.  Inflation is the amount prices go up every year.  Anyone who lived through the 1970s remembers that prices rose much faster than wages.  Every year our same dollars bought less and less. 
When inflation takes hold, it's hard to stop.  People want more money to afford what they could afford last year.  If they get raises, however, their businesses have to raise prices to cover higher payroll costs, so costs rise.  A vicious circle ensues, where labor wants raises and businesses want higher prices.  What stops the circle?  A recession, when businesses lay off workers and can contain prices.  The higher inflation, the more prolonged the recession.
The problem is, during the recession, the Fed is pressured to lower interest rates to stimulate the economy.  But, r
Once inflation takes hold, it's very hard to stop.
A Dovish Policymaker
Janet Yellin is described as an inflation "dove."  That means that her decisions have been "growth and employment" oriented and less focused on containment of inflation.  You may think, that with unemployment rates hovering in the double-digits, this is just what we need.  Certainly, that political opinion would be currently popular.  But, would it be a good long term policy?
Deficits and Inflation
No reputable economist of whom I'm aware would not have advised deficit spending to stimulate the economy during the last recession.  It was a necessary evil that prevented the country from likely sinking into a Depression.  But historically, the relationship between deficit spending and inflation is problematic.
Generally, when government borrowing increases, the amount of funds that remains for businesses and individuals to borrow decreases, and the competition for these fewer dollars causes rates to increase. 
So-called inflation "doves," who generally advise keeping rates low, can accommodate both government and business lending only by printing more money for the government to buy its own debt, causing the money supply to expand and debt to contract.
Expanding the money supply is inflationary.  Instead of raising taxes to pay its debt, printing more money makes the dollar less valuable.  The cost of everything goes up when your dollar is worth less.
The Federal Reserve Board of Governors
At its last meeting, only one Fed governor, that of St. Louis, voted against keeping interest rates low.  The majority (11 members) voted to keep rates low because their perception that the risk of sinking back into recession was more significant than the threat of inflation.  Dr. Bernanke, current Fed chairman, is considered one of the premier scholars of the Great Depression.  One significant factor in its length is thought to be insufficient economic stimulus.  It is a mistake about which Bernanke argues eloquently, and apparently the majority of the board agrees.
With a propensity of more dovish members, however, it is of some concern that one who has been one of the most consistent would be considered as the Vice Chair.  Generally, upon the retirement or failure to reappoint the Chair, the Vice Chair is likely to assume this influential post.
At a time when deficit spending is so high, the national debt is ballooning and the nation only recently stepped back from the brink of Depression, is it wise to choose a member who is so dovish about inflation that she stated last February, "If it were possible to take interest rates into negative territory I would be voting for that."?
Perhaps a candidate with a more balanced approach to the Fed's dual mandate would be a more reasonable decision.

Four Extraordinary Financial Predictions for the Coming Decade

As we leave the year of the "Great Recession" behind, knowing four likely financial outcomes will show us how to position ourselves for financial prosperity in the coming decade.
FOUR FINANCIAL PREDICTIONS
1) Global growth
Emerging economies were economically superior in the last decade.  Without the effect of the tech and housing bubbles in their past, their demand is not hampered by enormous public (and private) debt.  The better run of these economies will prosper in the coming decade, and provide markets for economies weakened by the lingering effects of the recent recession.
2) Inflation
As we emerge from the Great Recession, the reality of the damage is becoming more clear.  Without government support, we'd be in a Depression.  While the steps taken by G-20 nations were inarguably necessary, it effectively covered old problems with  borrowed dollars, while keeping interest rates artifically low in order to give life to a near-death economy.
As more countries take on huge amounts of debt, the numbers of lenders who have the money and motivation to lend decrease.  It's a simple formula that we all know:  less demand for a commodity causes the price of that commodity to fall.  If nobody is buying the farmer's apples, the farmer lowers her prices.
In the case of our debt (in the form of bonds), when bond prices fall, yields go up.  Here's an example
Maturity Date - One Year.  Price of bond - $1000.  Interest paid by borrower - 4%  Yield to lender - 4%
If the price of that $1000 bond falls to $980,
Maturity Date - One Year.  Price of bond - $980.   Interest paid by borrower - 4%  Yield to lender - 6.1%
Higher interest rates mean higher inflation.  The Fed can't keep rates artificially low forever.
3) The mortgage market
We have just seen the effect of lending to less-than-qualified-borrowers in the recent mortgage meltdown.  You may be able to cut mortgages into little pieces and sell them to Iceland, but in the end, the mortgages will still go bad if the borrower can't pay it back.  Since the crisis, financial reform has stalled.  Mega-banks are repaying taxpayers for the money we spent keeping them alive, and, while lending standards have tightened, the genie has been let out of the bottle.
Investment bankers now operate under commercial bank charters.  Structure finance has diminished the barrier to entry to the mortgage market.  This demand, together with stricter lending practices, will provide additional upward pressure on interest rates.
4) Wealth transfer
Over the last decade, emerging nations have produced good for the insatiable US consumer, who bought with abandon.  Now debt laden, US consumer growth is diminishing.  Emerging nations, however, have newfound wealth.  Those nations now lend money to our government, and have a huge and growing middle class.
China is the most obvious example, but there are others.  These nations, assuming that they avoid the pitfalls of asset bubbles, will provide the majority of global growth in the early part of this decade with their newly acquired wealth.
A SHIFT IN THE PORTFOLIO PARADIGM
Before the effects of globalization, all but those who ascribed to "Modern Portfolio Theory" (those who invested a set percentage of their money in various asset classes) were confident in keeping their money largely in US equities and bonds. 
With future diminished US growth prospects, however, this investment strategy is unlikely to be as successful in the next decade.  History has shown that this strategy has not been effective in the past, as well.  Investment veteran Art Cashin, Director of Floor Operations at UBS, recently  reiterated his "theory of the 17.6-year cycle." He pointed out that the periods 1966-1982 and 1929-1947 were "lean cycles," and predicts that we are entering another such cycle at this time.
Consequently, the old benchmark of "Subtract your age from 100, put that percentage of your portfolio in high quality US stocks, and the remainder in bonds" may well be over.
What now?  If you agree with the four assumptions discussed above, Pimco's Emerging Market fund manager (and former Harvard Endowment fund manager) Mohamed Il-Erian proposes the following portfolio:
 
STOCK  15% US, 15% Non-US Advanced Economies, 12% Emerging Markets, 7% Private Equity.
BONDS  5% US, 9% International, 5% US Treasury Inflation Protection Securities.
REAL ASSETS  6% Real Estate, 11% Commodities, 5% Infrastructure.
SPECIAL OPPORTUNITIES 8%
 
With an increasing investment in fast-growing emerging markets, with an emphasis on TIPS and real assets, this portfolio seeks growth with protection against inflation.  If you agree that inflation will cause rates to rise, you'll want to delay your US bond purchases until rates are higher, and wait until gold prices fall before investing in that commodity.  Depressed real estate prices, other than commercial property, show good value now. 
Of course, as we've learned through the painful correction in the last decade, this portfolio does not include cashflow you will need in the next five to ten years.  That is best kept in short-term Treasury issues or insured savings.  Yes, rates are low now.  But, they're likely to rise, as inflation picks up, and for this money, you want return OF capital more than return ON capital.
Have a safe, happy, healthy and prosperous new decade.

A September Snapshot

September 2009 looks much better than September 2008.
We've certainly heard everyone and her mother say we're climbing out of recession. Shall we take a look and see whether everyone is actually right?
For the purposes of comparison, we'll compare the data available thus far in 2009 with the full year of 2008.
I. Manufacturing
Industrial output has averaged 97.4 over the first seven months of this year, with July actually showing upward movement for the first time this year, probably due in large part to the "cash for clunkers" program. 2008 industrial output averaged 109.6, however, so we're still down over 11% year-over-year.
The percentage of manufacturing capacity we are using has averaged 69.4% this year through July. (Full capacity is generally thought to be 84%.) Last year's was 78.3%, so here again we're down over 11%. The good news, however, is that capacity utilization has been climbing upward for five straight months.
II. Gross Domestic Product
It is generally thought that an economy our size can grow at 2.8% per year at full employment without causing inflation. In 2007, the US economy grew at 2.5%. In 2008, our economy contracted by 1.8%. In the first two quarters of 2009, GDP was -6.4% and -1%, respectively. Most economists predict flat to 2% growth in the third quarter of this year.
III. Unemployment
Last July, we looked at historic unemployment data http://womensfinancialplanning.blogspot.com/2009/07/unemployment.html and saw that unemployment generally begins to improve about one year after a recession ends. 2008 unemployment levels averaged 5.76% and this year, 8.77%. We can conclude, based on these data, that unemployment will begin to improve in the third quarter of 2010.
2010, however, is a mid-term election year, and this issue has already begun to be politicized. For that reason, the current Congress may approve an additional stimulus package aimed at improving the unemployment outlook, and, in doing so, their re-election prospects. From a strictly economic perspective, this seemingly unnecessary expenditure, and additional deficit to be added to the burgeoning national debt, would seem to be a mistake.
But, I never underestimate the lengths to which our esteemed members of Congress will go to be re-elected, so I consider an additional stimulus to be a needless, but likely event.
IV. Consumer Confidence
As you have undoubtedly heard, 2/3 of US GDP is consumer spending. As you have undoubtedly experienced, consumers are somewhat less confident than they were before this recession. To validate your feelings, consumer confidence was 103.49 in 2007, 56.76 in 2008 and, thus far in 2009, is 39.89.
Before we assume that all is lost for any potential growth in GDP owing to our cautious consumers, please take a look at the often ignored export situation, discussed recently http://womensfinancialplanning.blogspot.com/2009/07/wuvl-shape-of-our-upcoming-recovery.html
Should the hypothesis that newly enriched emerging markets will spend their dough on our exports, we may have a growth engine that could replace our previous non-stop, debt-riddled spending spree with something more sustainable.
V. Inflation
From 1973 to 1995, inflation averaged 2.8%. Most economists believe that 2.5% inflation allows sustainable economic growth and full employment. In 2007, inflation averaged 2.87%. In 2007, inflation rose to 3.85%. This year, with falling energy prices due to lessening demand, as well as consumer entrenchment in nearly all categories, inflation is .33%.
This is undeniably good news, which, of course, I will turn into something scary. At no time in history has the government printed money to the extent it has now and NOT caused inflation. History tells us it is coming, but it's not here yet.
VI. Business Inventories
When businesses are humming along, inventories used to build up in anticipation of happy consumers. Those days are over, for two reasons. The first, and most obvious, is that consumers are scared. So scared, in fact, that they're SAVING money. Weird.
Second, businesses have gotten smart. They operate as close to a build on demand model as possible, i.e., they don't build your thingamabob until you order it.
That said, however, inventories have fallen by over 6% - after building up for six straight years. They are low, and falling. When demand does return, which I believe it will through exports, then inventory buildup will help boost economic growth.
VII. Conclusion
All these indicators are pointing positive. It's been so long since we've had good economic news, we hardly recognize it when it shows up, but there it is.
The worst is over. Let's hope we keep our heads on straight and stay the course without succumbing to political pressure that will cause us to make poor economic decisions.