Greath Wealth -Investment Information & Services

The Futility of Trying to Forecast a Random Walk

Pardon me for having been a few weeks since my last blog.  I’d decided on this topic, but wanted to pursue it carefully because it’s complex and difficult.  My job is to make it simple, clear and SHORT.

First, consider the unofficial forecast rules I learned back in the summer of 1981 while working as a summer engineer for Conoco in Casper, WY:

Forecast Rules:

1. It is difficult to forecast, especially about the future.
2. The moment your pencil (or mouse/keyboard/computer) makes the first mark of the forecast, it’s wrong.  You just don’t know by how much and in what direction.
3. He/she who lives by the crystal ball soon learns to eat crushed glass.

With this in mind, can you think back a mere 10 weeks ago?  All the “expert” economists were forecasting immediate doom and a double dip recession in the immediate future.  But what did the economy do the quarter they were forecasting?  It grew at a rate of 2.0 percent a year.

Now 2.0 percent a year is nothing to be exuberant about, and yes, I still believe we may have a double dip recession.  Nevertheless, for the economy to be significantly expanding the moment they were claiming everything was falling apart bolsters my long-term skepticism of economists making the “big bucks” who don’t back up their pencils with personal positions on futures markets.  In simpler words, if they believed their forecasts, acted on them and were right, they’d all have the net worth of George Soros.

And what happened just yesterday?  Consumer confidence came in at its highest level since July.  No, it’s not setting records and yes, it’s just a data point based largely on emotion, but it is in stark contrast to what the “experts” were predicting just 10 weeks ago.

Should we throw all forecasting out the door?  Absolutely not!  We can ask some significant questions, draw substantiated conclusions, make concrete decisions and take confident action on questions such as:

• How likely is it that I’ll have enough for retirement?
• What withdraw amount will my portfolio support during retirement?
• Am I saving enough to meet my future financial goals?
• Is inflation likely?  What can I do to weather it?

The key is to discern what one can forecast and how accurately they can forecast it.  In my next blog, which I plan to write next week, I’ll start tackling a few of the above questions.

Thanks,

Rod

An Observation on Recent Market Volatility

Although the stock market is always in flux, if you think it has been a bit more volatile than normal over the past month your observation is correct.

Before we dive into an explanation of why this is happening, we first need to define what is “normal” market volatility.  Fortunately, this is easy – just stick with me for a couple paragraphs and don’t let your eyes glaze over.  Why?  It will help you sleep better by what’s happening with your portfolio.

Normal Volatility versus the Last Few Weeks.  Based on historical data, the daily standard deviation of the market is just north of 1%.  In other words, the market will normally rise or fall more than 1% (110 points on today’s Dow Jones Industrial Average – DJIA) one out of three days.  Taking this a bit further, the DJIA will rise or fall more than 220 points one day a month.

However, the DJIA moved more than 100 points in 14 of the 19 days finished October 17, 2011.  Hmmmm…that’s a bit volatile, 14 out of 19 instead of 6 out of 19 (14/19 instead of 1/3 or 6/19).

Why it’s Probably Happening.  Why is this happening?  Fewer shares are trading hands, possibly due to the big banks and brokerage houses reducing their inventories of specific stocks.  This means that fewer “buy” and “sell” orders are on the traders’ books, which means more price movement when someone wants to say, purchase 1 million shares of IBM at $177 a share (a cool $177 million purchase).

This also impacts small players because they’re watching the shares of IBM bounce up and down more than normal because fewer big players are in the market.

Yes, I could go into it with more data and more analysis, but then you would have reason for your eyes to glaze over and you’re too busy to bother yourself with market minutia – that’s why you have me.

In the mean time, you can take away two points:

1)    The market has been more volatile than normal for the last few weeks.  It’s not your imagination.

2)    It’s most likely due to fewer trades taking place, which may be caused by some of the big players lowering their equity inventory.

So no, everyone isn’t panicked and the world isn’t coming to an end.  Rather, there’s few rungs on the ladder due to fewer players so stock movements are a bit more volatile than normal.

Thanks,

Rod

Overlooked Value in Today’s Market

Although anyone who puts a value companies will tell you it’s a multi-faceted endeavor, just about anyone who has money invested looks only at one thing:  the dollar value of their portfolio.  While this is important, as it’s what’s available to pay the bills and what you can put down for that portion of your net worth, it’s an overly simplistic view of the full situation.

A more holistic view of the situation would be:  ”What’s the value of your portfolio in relation to the money the companies are spinning off; i.e., what is the value of the portfolio as compared to the earnings the companies in it are generating?”

Where am I going with this?  It’s simple:  Your equity portfolio is in much better shape now than it was in 1999.  I know, you’re saying: “That’s preposterous!”  No, it’s not.

Here’s the Situation:

On December 31, 1999 (remember Y2K?) the DJIA closed at 11,497, or approximately where it is today.  However, the S&P 500’s price to earnings ratio (P/E ratio) had an average value of 33 for 1999.  In other words, a company that earned $1 per share per year, on average, would have a stock price of $33.

In comparison, the P/E ratio for the S&P 500 today is approximately 12.  Hence, a company that today earns $1 per share per year, on average, will have a stock price of $12.  But where’s the DJIA today?  11,125 at the close on September 21, 2011, which is just shy of where it was on December 31, 1999.  Therefore, although the P/E ratio has plummeted 62 percent since 1999, the DJIA, the “market”, and our portfolios, are at approximately the same value.

What happened?  In 1999 everything was overvalued, as the historical average P/E ratio for the S&P 500 is approximately 14 – 15.  Nevertheless, we all enjoyed the emotional high of seeing a big value for our portfolio.

Another way of looking at it is that we were all wearing a shirt that was more than double the size we needed.  Yes, it has been a painful 11 years and we sure enjoyed the feeling of that oversized shirt back in 1999, but we’ve finally grown into the shirt.  In fact, the shirt is now a bit small since the market is trading a below the historical norm, especially for interest rates being so low.

So what does all this mean?  There’s once again upward room for the market to go in relation to the underlying earnings.  When will it happen?  I don’t know, as I’m not clairvoyant.  Nevertheless, don’t lose hope and bail out, as the pain we’ve all endured of the last 11 years wasn’t for nothing.  Capitalism will march on and at some point the market will head north, pulling your portfolio along with it.  Hang in.

Thanks,

Rod

PS:

If I had put you into a DFA portfolio on December 31, 1999 the equity side of your portfolio would now be approximately 1.7 times what it was on that date.  But for this illustration let’s assume you’re just getting the DJIA or S&P 500 return, which still beat approximately 90 percent of all peer portfolios.  Also, I didn’t start Schulz Financial until 2003.

Interesting News from Rhode Island

Being the smallest state in the union, Rhode Island rarely makes the news, particularly when it comes to investing.  However, a recent turn of events in the state make the situation particularly newsworthy.

The situation arose when Central Falls, the largest city in the state, became financially insolvent in late spring/early summer of this year.  This left the city with two options:

1)    Default on its bondholders
2)    Default on pension payments due its retirees (retired policemen, firefighters, etc.

Realizing that Central Falls was about to set a precedent for other communities in the state, the Rhode Island state legislature stepped in and made the decision for Central Falls.  Why?  The state government recognized that a default by Central Falls on its bondholders would create a domino effect across the state.

This is because many of the cities in Rhode Island are facing similar fiscal woes.  And if Central Falls defaults on its bondholders, other communities will likely follow suit.  The ultimate result would be bond markets refusing to loan money to any community in the state (without exceptionally high interest rates), thus driving many Rhode Island cities, and ultimately the entire state, toward financial ruin.

What did the state legislature do?  They passed a law forcing Rhode Island cities to pay their bondholders in full before paying other obligations, such as pensions.  But what’s really interesting is the teeth they put in the law.  More specifically, if the responsible city official refused to give full bondholder payment priority, the city official would have their choice of either:

1)    Be removed from office; or
2)    Be held personally liable for the bond payments due

What happened?  Central Falls paid its bondholders in full, and reduced pension payouts an average of 30 percent, with some pension payments being reduced 50 percent.

Another interesting aspect of the story is the competitive pressure Rhode Island has now placed on the other 49 states, particularly those with cities in financial trouble.  More specifically, if other states don’t pass similar laws their cities will be at a competitive disadvantage when they go to the bond markets.

This also has implications for Social Security recipients from the U.S. government.  If the U.S. keeps going further into debt it will reach a point where it, too, has to decide:  “Do we default on bondholders, thus driving our borrowing costs up and accelerating the downward financial spiral, or do we default on Social Security and other entitlement promises?”

The decision will be interesting; thus, one may want to keep Rhode Island in mind when making retirement cash flow estimates.  I wish I had better news, but reality is setting in for governing bodies and the populace alike.

Although the markets are still volatile and rocky, I’m glad most of my clients have realistic retirement expectations and portfolios to match.  We will weather this storm together, as I’m here to assist.

Thanks,

Rod

Brief Thoughts on Recent Market Volatility

I last blogged on August 2^nd, just before last week’s display of market volatility.  Again, I am not clairvoyant, but last week’s volatility doesn’t come as a surprise, given the back drop of macroeconomic factors as related to the sovereign debt situations around the world.

Specifically, known and well publicized sovereign debt problem situations exist in Greece, Spain, Italy, Ireland, the United States and just recently, France is beginning to show that its government and investors are moving toward the reality of their situation.

Although companies do not operate in a vacuum, corporate financial fundamentals in the U.S. are strong and stocks are reasonably priced.  And again, this is based on facts, not opinion or hyperbole.

For example, prior to last week’s volatility the S&P 500, as a whole, was trading at ~13 times earnings (PE ratio, which is the price of the stock divided by the amount of money a company is making on a per share basis), compared to a historical average in the range of 15-16.  Moreover, today’s 13 times earnings figure is in a lower interest rate environment than the historical average of 15-16.  Where is it now?  As I write, today’s P/E ratio is in the range of ~12.

In comparison, the S&P 500 was trading in the range of 29-34 times earnings in 1999, prior to the 2000–02 bear market and 22-25 times earnings in the first three quarters of 2008.  NASDAQ was going for something like 70 times earnings prior to its collapse in 2000, and Japanese companies were also trading in the range of 70 times earnings prior to their slide that began in the 1990s.

In addition to having substantial earnings as compared to the price of the stock, U.S. companies are sitting on record amounts of cash, even when adjusted for inflation and when calculated as a percentage of corporate assets.

Am I thus going to come out and say “stocks are under priced and one should buy”?  No, I’m not clairvoyant and unforeseen events lie ahead.  However, one can easily take away three things:

1)    Equities are reasonably priced;

2)    Companies are making reasonable profits given the environment; and

3)    Macro events (federal debt situation, etc.) will likely create some volatility.

As always, give me a call or send me an email if you have any questions or if I can be of any assistance.

Thanks,

Rod

A Brief Thought on the Federal Debt Situation

Please keep in mind that this is about financial cash flows, not politics.

It’s real simple:  Almost no one, either in politics or the citizenry, is close to reality. To be sure, all the wrangling is about “cuts” to the rate of growth to a ten year budget that the U.S. Government, and its citizens, can’t even start to afford in the first place.

The Situation. Taking the simplicity a step further, the U.S. government is currently spending $4 trillion (that’s a 4 with twelve zeros behind it) a year and taking in only $2.5 trillion a year, with an outstanding loan balance of $14 trillion.  Hence, if the government cut EVERYTHING; i.e., defense, social security, medicare, Medicaid, the EPA, education, once again, everything, by 50% TOMORROW, it would take the spending from $4 trillion to $2 trillion and thus leave $0.5 trillion for debt service.  Therefore, if interest rates were zero, it would take 28 YEARS to pay off the federal debt, or 14 years to pay it off 50% to about the level it was in 2006.

Please take a minute to reread the above paragraph, as its implications are staggering.

However, interest rates aren’t zero, thus making the situation even worse, and no American politician is going to cut today’s budget by 50% because American citizens wouldn’t let him/her do so.  It’s simple.  It’s a given.  It’s certain.

So where are things going with the U.S. government’s financial viability, its many social, military and other programs?  I’ve been forecasting cash flows for nearly 30 years and it’s not a pretty picture.  Moreover, having served the federal bankruptcy court in Corpus Christi last year as an expert witness, I can tell you from first hand experience that it’s not pleasant when there’s nowhere close to enough money to go around.

The U.S. has Stiffed Bondholders in the Past. This happened recently.  Although it was in the name of GM, when the government took over GM it stiffed the GM bondholders.  Will the government do it again, to its own bondholders, in the future?  Based on the extensive past experience from members of both political parties, I don’t believe the politicians and bureaucrats would think a nanosecond before stiffing the U.S. government bondholders if it’s to their personal advantage; i.e., increase their chance of staying in office or their government job, to do so.

Forget the Ratings Agencies. Although the ratings agencies provide data points that one needs to consider, we need to remember that Enron, Lehman Brothers and AIG all had acceptable credit ratings before they failed and dissolved to nothing, although AIG is still going.  Hence, the entity’s rating is just that, a rating.  Can any of the bondholders from Enron, Lehman Brothers, AIG or GM go to the local Starbucks and pay for their coffee with a rating report from Standard & Poors?

Printing More Dollars Won’t Work. The U.S. government can’t double the number of dollars in circulation just by running the printing presses more hours.  However, money is a representation of stored labor, and doubling the dollars in print doesn’t double the amount of stored labor.  Rather, it just cuts the value of the printed dollar in half.

Therefore, doubling the number of circulating dollars will stiff the bondholders by 50 percent and if the government doesn’t double social security it effectively cuts the social security check 50 percent.  But if the government raises social security and/or other budgets, doubling the number of circulating dollars doesn’t do any good, as they’ll just have to double again, and again, and again.  No one wants to face up to the situation.

Raising Taxes Will Have Minimal Impact. Why can’t the U.S. government just raise taxes?  First, if the U.S. government taxes 100 percent of the personal income above $250,000, it only amounts to $1 trillion, which isn’t enough to balance the budget and create a positive cash flow for one year.  And you can bet that if the U.S. government does that, the high income earners won’t be living in the U.S. the following year.

What about the corporations?  The U.S. already has the highest corporate income taxes in the world, so raising the corporate taxes, be it through raising rates or “closing loopholes”, will only chase more companies overseas, faster.  Moreover, with the global growth of capitalism and the increasing reach/impact of the Internet, it is getting easier by the day to outsource and live beyond our national borders.

It’s real simple:  The U.S. government, and the citizens who vote their politicians into power, are in a bind.  Further, almost no one is facing reality.

What to Do

So what’s an investor to do?  First, don’t panic.  That never does any good.  I’m the first to admit that I’m NOT clairvoyant, but looking down the road a bit may give us some insight.

So if the U.S. government goes broke, are you still going to drink your Diet Coke?  I bet you will.  Some how, some way, you’re going to come up with a few – whatever we’re using for trading – to pay for your Diet Coke.  And better yet, do you think some Aussie friend down on the big island is still going to drink their Diet Coke if the U.S. government goes broke?  Absolutely.

And when someone, somewhere, purchases a Diet Coke, do you think all the bright minds at Coca-Cola are going to figure out a way to make a profit on the transaction?  Absolutely.  It may be in yuan, euros, gold or dollars, but I bet they’ll figure it out or they’ll lose their job.  Their creative minds will collectively figure out a way to keep making a profit.

In short, it is my belief that capitalism will march onward, as it has for centuries, with or without the financial viability of the U.S. government.  So what’s the take away?  Ultimately, shares of capitalism and humanity marching forward; i.e., shares of stock in viable companies, will continue to have value.

Moreover, in today’s global economy just about any company big enough to be publicly traded will have at least some degree of global outlook.  They have to so that they can survive today, and they’ll have to even more so in the future.

You may want to take a minute to ready my “Samsonite Goes to Hong Kong” blog of June 28, 2011.  Just like Samsonite took its capital source overseas with minimal effort, they can also take their company overseas with minimal effort, just like Halliburton moved its headquarters to Dubai.  Some American corporate employees may be left without a job, like many factory workers of decades past, but the shareholders of the company, the owners, continue to move toward their financial goals – or they move their money to a company that is financially moving forward.  It’s brutal, but it’s reality.  Of course, it’s my job to keep my clients in the companies that are financially moving forward.

If this happens, if the U.S. government goes broke, will it be a rocky ride for U.S. citizens and the world economy as a whole?  Yes, I have to believe it will be a rocky ride.

Do I personally think the U.S. government will go broke and become fiscally unviable?  No, I have to believe that things are going to change. Nevertheless, I can’t bury my head in the sand and just hope.  That’s not what my clients pay me to do.

Also, as with any financially deteriorating situation, time to act is running out, and the longer the U.S. government and it citizens wait, the more drastic the changes will need to be.

Please accept my apology for a longer than normal blog, but this is a situation we need to address again (see my blog of May 11, 2010).

Thanks,

Rod