Hank, Here's an Idea

Dear Hank and Ben,

Since you are determined to pump liquidity into the economy, why not do it in a way that would guarantee a nice profit for the taxpayer? Is there some rule that says the taxpayer always must get hosed? If not, I'd like to propose the following outstanding investment that I believe will meet all your goals, while enriching the taxpayer.

You may have been too busy to notice, and if so, you may want to call the Secretary of Energy and ask him to do some checking. But, the energy market is so chaotic these days that it has created a unique opportunity for the federal government (as well as a small group of investors).
I know this seems too good to be true, but give me just a few seconds.

The crude price today closed below $38 per barrel. Meanwhile, the February Futures contract for the same oil is about $46 per barrel. That means if you buy oil today you can store it and sell Feb futures and guarantee a 20% return in 2 months, less expenses. That is an annualized return on your money of over 100%.

You may be wondering-if this is such a good deal why isn't everyone doing it? Good question, and according to a recent article in the Wall Street Journal, some are. The article mentions that BP and other oil companies are storing crude in tankers to take advantage of this golden opportunity. But, here's the kicker...the Federal Government is in a unique position to work this deal, as a result of available capacity in the strategic reserve. This storage option is uniquely large and low cost, and the government has the people and infrastructure in place to activate the plan. Invest a billion dollars and get $1.2 billion back in two months. I know the government can just print money, but this is almost as good, and it is a real money maker in contrast to the printing presses with their risk of unintended consequences. Just to review, here is what you can accomplish with a pen stroke:

• Inject liquidity in the market
• Guarantee a great return for the taxpayer
• Stabilize the commodity markets, which I believe are a big part of the overall instability in the economy.

For my readers, I'm sorry it would be difficult for you too capitalize directly on this idea. But, if it makes sense to you, you may want to forward it to someone in Washington.

Regards,

Energy Guru/Personal Finance Guru

Hoping for a Bottom

I got my wish. The market has now dropped so far that I’ve had the opportunity to get all the cash from my retirement plan into the market. As you may know, I was lamenting last fall that my “Dollar Cost Averaging on Steroids” system had me sitting on a huge pile of cash after a long bull run with few interruptions. So, I was wishing for some market volatility that would allow me to invest the cash at lower levels. As of last week, it was all in the market.

I should have recognized that time as one of those “Be careful what you wish for” moments. I have to admit I underestimated how painful that might be. Now, I’m wishing for a bottom. Emotionally, that feels pretty awful, but from a logical standpoint the chances seem pretty good to me. Most major bear markets have ended with long term average P/E ratios of around 10. Currently, I believe we are about 10-11. Not that this was a factor in my decisions, of course…my system works on autopilot. But, now it can’t operate effectively until we at least get some significant bounces.

While I would like to have some more cash to invest at these levels, most of what I see on financial shows is about where you can “hide” from the market. So, while I pray for a bottom, I think that discussion is worth some ether ink.

I have to admit it sounds comforting at one level, but I have a hard time believing the best thing to do is hide from a market that is on sale at it’s best valuation in 30 years. The last time valuations were this low was in the 1970’s. Of course, most profess to be ready to get back in once the bottom is comfirmed. When it will come, I’ll admit don’t know, but I heard a commentator on PBS a couple of days ago expressing things pretty much as I see them. His comment was something along the lines of “We’ll only know we have a bottom about 6-8 weeks after the fact when prices are up 30-40%.”


Be that as it may, the vehicle many are choosing as their hiding spot, US Treasuries, seems a questionable choice to me. Granted, according to conventional wisdom, these are the safest bet you can make. But, 3 month treasury bills are yielding well under 1%, and 5 year bonds are yielding only about 3%. This is because of the huge buying related to the flight to safety, but, to me, this only makes sense if you expect massive deflation accompanied by much lower interest rates. While I expect some deflation as a result of the big decrease in energy and other commodity prices, I expect this will be relatively short term. Over the longer term, I worry the massive borrowing governments are doing will lead to inflation. In fact, aside from the immediate borrowing binge, I believe the only way government can get out of the massive federal debt is to inflate their way out. And those in treasuries would be murdered by inflation. No, treasuries don’t sound so safe to me.

An alternative might be US I Savings Bonds. They yield only about 1% over inflation, but at least you are protected from inflation and don’t have to worry about rising interest rates. Unfortunately, the rules prohibit you from parking large sums there. Inflation adjusted treasuries are unlimited, and might seem a good substitute, but these would still be hurt badly by increasing interest rates.

Federally insured short term (up to 1 year) CDs seem like a better choice. They are yielding several times as much as treasuries of similar duration, and for my money are just as safe. You would do well during any deflation and you can be pretty sure you will get your money back with interest. And you can always roll them over at higher rates if interest rates go up over the longer term.

Of course, most who are hiding their money want to be able to jump back into the market at a moments notice once they have confirmed the bottom (Note that, according to the theory stated above, that might be 30-40% above the bottom!). For this purpose, money market funds would appear to be hard to beat. Yields are not as good as CDs but generally are better than short term treasuries, and they will go up rather than down in case of inflation. In the case of deflation they probably would not do as well as CDs or treasuries, but I don’t think they would do too badly. Now, with the extending of FDIC insurance to many of these accounts, they again appear to be very safe.

As for the ultimate in hiding your money, I guess you could consider your mattress… or gold. But neither of those seem too comfortable to me. If you are that worried, buy land. You can't eat cash or gold, but you can always raise your food if you have some land. Though I still don’t expect to really need it, I’ll admit I have my farm, bought and paid for several years ago.

Crossroads of Depression and Free Enterprise

I'd like to hear, dear readers, your opinion of the current markets and the apparently imminent bailout. I'll admit I'm on the horns of a dilemma.

Philosophically, I'll almost always come out on the side of free markets and reduced control and spending by the government. Besides, I can't escape the feeling that things are not as bad as they are painted. I believe that prices have been driven down to an extreme, such that once the fear recedes, issues would be priced considerably higher and a good, free market bounce could occur. After all, mortgages are going for $.20 on the dollar, and I can’t believe that many mortgages will foreclose, not to mention that the residual value of properties that do foreclose should be at least 70-80 % of the mortgage value.

On the other hand, I'm not really familiar first hand with the conditions in the money market. Those who are and have the economics background to interpret what they see, for the most part, say the markets are grinding to a halt. And, at a certain point, fear begets fear, driving irrational markets to even more irrational pricing and spilling over into seemingly unrelated areas. I'm reminded of my Dad's summary of the Great Depression..."Most people had no money, and those that did were afraid to spend or invest for fear things could get worse. So, everything just ground to a halt." That sounds eerily familiar these days, although obviously that attitude is mostly on Wall Street so far, and the general economy is nowhere near those conditions. But, following the fear begets fear rationale and the tendency to spill over, it is possible to see that shaping up. And, that fear spiral is difficult for any company or individual to reverse. Perhaps that is a role of government.

Meanwhile, I can't escape the conclusion that government regulation has contributed to the situation with the "mark to market" regulations, and government encouragement of questionable borrowing. And if I’m right that the market has been driven far below rational pricing, could it be that government could not only reverse the market psychology but make a substantial profit in the deal? Ok, given usual government performance, that seems too good to be true! Even so, I’m convinced that anything that can reverse the market psychology could return us to a positive future path rather quickly and possibly avert a rather dismal period.

So, this is your chance...What say ye?

Recent Market Chaos was Predictable

The past few weeks got me thinking about some previous posts concerning the implications of debt and leverage. In particular, the following excerpt from a post in Feb 2007 has been screaming in the back of my mind:

"Borrowing to finance an investment that makes money is one way to make debt work for you. For instance, if you borrow to buy a property which has a positive cash flow the result can be very handsome profits. Keep in mind, though, that this enhanced profit is a result of the leverage resulting from the debt and the leverage works both ways. The same leverage that produces handsome profits can result in devastating losses if your assumptions turn out to be wrong."

The column went on to give a real estate example that illustrated the issue and some advice on how to avoid problems. At the time, the advice seemed almost archaic. Today it seems a bit more prescient, although I'll admit I was thinking on a personal scale rather than the macro scale so obviously applicable today. Even so, for those who are struggling to understand the markets today or a related pressure cooker, a review of those Feb 2007 posts might be worthwhile.

If you are considering debt, give the following some consideration:

• What is the worst that can happen?
• Can I afford the debt if the worst case develops?
• Are the benefits worth the risk?

If the risks are seriously evaluated and considered, most debt will not be undertaken.

If you are already in the pressure cooker:

• Accept the reality of your situation. Denial is generally the biggest barrier to recovery.
• Sell off assets to reduce debt.
• Reduce living costs to that required to clear debt in a reasonable time frame.
• For details and support, I'd recommend some time spent listening to Dave Ramsey on TV or radio.

Amazingly, the above advice seems eerily applicable to the CEOs of many financial companies making the news these days. If you are watching the stocks of those companies, be aware the damage has been done. It is too late to unload them. The good news is that, as with individuals, if they can work through the issues, life can be good on the other side.

Blood in the Streets-Time to Buy?

Apparently, I may have been watching too much CNBC. Yesterday, when my "Dollar Cost Averaging on Steroids" (see previous posts) system flashed a buy sign, I considered passing on the opportunity. After all, the talking heads were throwing out scary statements like "collapse of our financial system", "worse than the great depression" and "worldwide economic collapse". Within the past couple of weeks, the feds were forced to bail out Fannie and Freddie, and Lehman and Merrill Lynch ceased to exist as viable, independent companies. AIG seems on the brink of being the next giant to go under, with a string of others in the line behind them. Projected losses are turning from billions of dollars to trillions (with a T).

Yet, times like these are the type that financial gurus are referring to when they talk about buying when the "blood is in the streets". The adage is true precisely because it is so difficult to find buyers in times like these. Even those who use a system designed to enforce discipline may be scared off. These are among the most difficult times to stick to the system, despite the fact that this is where the money is made (Almost as difficult are times like last fall, when my system had me selling while holding a substantial amount of cash in the face of euphoria in the markets!).

So, putting faith in the system, I maintained discipline and bought yesterday. Just like I bought near the lows in July and sold near the highs in August. Of course, it doesn't always work out so nicely. I can't guarantee we are near a bottom. If the market is up next month, I'll smile smugly. If it is down, I'll grit my teeth and buy more. After all, the reason my system all but guarantees beating the market is the discipline it imposes at times like these. If you can't pull the trigger at times like these, you are doomed to underperforming the markets, as the vast majority of investors do.

200 Month Moving Average-an opportunity to test the system

A friend recently sent me an article which highlighted the significance of the 200 month moving average (mma). The article asserted that if the S&P 500 were to drop another 20% it would hit the 200 mma, an event which has happened only a few times in the past century. Each time, it marked a massive bear market.

My friend went on to remark that this was a scary thought, being only 20% away from such a marker. Ok, that seemed like a reasonable, if dour, sentiment. At the same time, the market didn’t seem that bad to me.

He then went on to say that this would mean that if you bought the market using dollar cost averaging over the past 16.6 years (200 months), it would mean you would have received zero return over this period. Not quite… perhaps he meant to say that if you had bought the S&P 500 at the average price for the 16.6 years you would have no return. The two statements may sound pretty similar, but there is a world of difference. Dollar cost averaging implies that you buy more when the market is down and less when it is up. The result is decreased risk, as well as profit from taking advantage of volatility.

To get a quick check on the logic, I checked my 401-k, where I use an advanced form of dollar cost averaging. I reduced the balance by 20% and checked the return over the last 16.6 years. The result surprised even me, resulting in about a 9% annual return over the period. I expected a positive result, but that seemed too good to be true.

That had me doing a bit more checking. I downloaded the monthly closing prices of the S&P 500 for the past 16.6 years, adjusted for dividends and splits. Sure enough, it seemed to confirm the assertion of the article…the 200 mma for the S&P 500, according to my calculations, was about 24% below the current average. But it also revealed a few other things. The 200 mma was about 140% above the level of 16.6 years ago. In other words the 200 mma was so high because the market rose significantly in the ‘90s and has been relatively flat to downward since. It also meant that any balance in the S&P 500 16.6 years ago would have increased about 5.4% per year if it had just been left alone to grow.

Time to check what ordinary dollar cost averaging would have done to an equal investment each month in the period. When I ran those numbers, it turned out that dollar cost averaging would have also resulted in an annual return of about 5.4% on the dollars invested in the period.

All pretty positive when compared to the thinking that hitting the 200 mma meant effectively a no return market for 16.6 years, but still significantly lower than my returns. So, it was back to the drawing board to explain the outperformance of my portfolio.

I use dollar cost averaging on steroids… investing in several markets and using long term projected returns to buy when the market is below the projection and sell when it is above. Many of the markets I trade would be difficult to trace back 16.6 years, but I downloaded the S&P Midcap and Smallcap history. Sure enough, these indexes had significantly outperformed the S&P 500 ( I had to use the midcap as a proxy for smallcap for a few months, since that index doesn’t go all the way back that far). I calculated that they had returned 6.6 and 5.8% respectively in the past 16.6 years. Although significantly better returns than for the S&P 500, it still didn’t come close to explaining my returns of about 9%. So, I set up a simulation of my “dollar cost averaging on steroids” system, in which I started with 210 units about 16.6 years ago, with about 60 invested in each index and 30 in cash. Then, I simulated investing 1 unit each month for the period, using my system(buying when each market was below trend and selling when above). This resulted in a current balance of 1270, for an annualized return on investment of 8.4%, reasonably close to my actual results, considering I invest in several other indexes as well as those simulated, mainly using the same system.

Despite the fact that I’ve been preaching the merits of this system to all who would listen for several years, I’m impressed with the results. This kind of returns, in what by some measures, might be considered a poor market, is pretty amazing. Of course, investing in indexes which are doing better than the S&P 500 is part of the explanation, but that is part of the system…spreading the risk with broad diversification. The fact that this result is obtained using an easy, mechanical process and basic index investing with minimal effort makes it even more remarkable. When you consider that you get decreased risk and volatility in the bargain, it is pretty hard to beat. And, it justifies my claims that it is easy, in fact almost automatic, to beat the market using this system.

Of course, if you could guess the right market to be in and effectively jump onto the best market trends, you'd do even better. But few can do that consistently. This system helps you do something close, with ease. And it allows you to sleep at night.

Sun Emerges from Gloom and Doom

A recent article in the Wall Street Journal made much of the fact that the S&P 500 Index is only slightly higher than 10 years ago. I didn't see the article, but I've seen comments about it in several places, and I even had a comment from a friend in Indonesia. The general tone of most articles and comments I've seen are despair that the "US Markets" have had such a meager return.

All the noise put me in the mood to develop my own perspective and to look at my own returns during this "disturbing" period in the market. After all, I depend heavily on use of index funds, of which the S&P 500 is the biggest. The results brought the sun out of gloom and doom for me and confirmed the power of the investing system I use.

First, it is interesting that this one index and single period is highlighted, with a reference to the fact that the Nasdaq did even worse. A 5 or 15 year period would have painted an entirely different picture, as would a look for the 10 year period for, say, the MidCap Index.

I use a system of dollar cost averaging, agressive rebalancing and broad diversification across several indexes (You can see the details in my article of March, 2007) in my 401-K. And, so, my results beg comparison to the performance of the S&P 500 Index. After a quick look back at my performance, I came back with a smile... and a return of about 11% per year over the past 10 years! How is this possible in such a flat market, particularly by a passive system that focuses on index funds, rather than brilliant stock picking? The results are a testament to the power of a disciplined, mechanical system that uses simple, basic, money management techniques like diversification, dollar cost averaging and rebalancing to beat the markets, while reducing risk.

Spring is here, and the sun is out. The gloom and doom is pushed back, for at least another day.

Cash Comforts, but the Fed has set off a scramble to find profitable yields.

I'm certainly not advocating a run for cash. If that is your thinking, read my previous couple of articles. But, I do advocate everyone having an emergency fund, and for us retirees, the fund needs to be considerably bigger to avoid the necessity of selling low to raise living expenses. And, while the recent market action has made the cash feel a lot more comfortable than before, the Fed's response has made it much more difficult to find a decent profit on the cash part of our portfolio.

On the off chance that others are struggling with this issue, I'm documenting what I'm doing and looking for suggestions from those who may have found a better solution.

Over the past couple of years, I've been relatively happy with CDs and money market funds that paid 5-6%, or 2-3% over inflation. Suddenly though, I'm faced with money market funds, and renewing CDs at a 2% lower rate.

Three to four years ago, when interest rates were also very low, I bought I-Savings Bonds. These generally guarantee 1-2% over inflation, and driven largely by energy inflation the 5-6% yield looked relatively attractive. The inflation guarantee and the tax deferral feature also suited my needs. I still hold those bonds, although over the past several months the 4.5-5% yield made me question the decision. Now, that looks relatively attractive again. These are easy to set up and fund on-line with Treasury Direct, but be aware they do have some holding limits and penalties for premature withdrawal. Annual purchases are also limited.

Outside of that, the best thing I've found is the Washington Mutual Savings for Success program. It guarantees 6.5% for accounts which are funded by regular withdrawals from your checking account and held for a year. It is essentially an inclining balance, 1 year CD. Unfortunately the structure of the program makes it difficult to invest significant sums and I'm sure they'll try to hang on to the deposits at a lower rate after the one year guarantee. Even so, it seems worthwhile for those who keep close tabs on how hard their money is working and are looking to place even modest amounts.

Another option I've been moving toward, although certainly not cash accounts, is high dividend blue chips. It is relatively easy these days to get 4-5% dividends on solid stocks like Dow or GE that also have some growth potential.

Once you get beyond these relatively modest proposals, ideas get pretty uninspiring. Stick with the money market and hope rates head upward soon? Invest in CDs, with the anticipation that even today's low rates may look good tomorrow? Maybe the best chance to do better is to look for short term, local, promotional deals, but read the fine print carefully.

Ok, here's the best part...where you, the reader, get to enlighten us with your research and ideas. Come on guys, here's your chance to publish. Just hit "comments" and let us know what you have.

Run for the Exits? Follow the herd at your peril!!!

I normally am reluctant to comment on the happenings on Wall Street and the Beltway. After all, the philosophy I preach doesn't require either following the daily market news and politics, or forecasting what is over the financial horizon. Besides, most people have access to far more financial information and prognostication than is good for their financial health. Even while I was in Artarctica for the past few weeks, CNN kept up the steady drumbeat...The market is crashing! The economy is slowing! Democrats and Republicans agree emergency stimulation is necessary! The Fed responds to the crisis! Financial companies make emergency deals to maintain liquidity!

Back in civilization, I picked up a newspaper in Buenos Aires, and though I don't really speak much spanish, I noticed the word "crisis" was used 14 times on the front page alone. Though I'll admit I can't predict the future, I can say with confidence that good companies were selling for 15% less than they were a few months earlier. So, by using some of the cash I accumulated during the fall upmarket, I was able to buy at a lower cost.

But, I admit I've had some surprises. I didn't expect either the Congress, the President or the Fed to capitulate as they have. I suspect they've been watching too much TV as well, but it has me trying to evaluate what it all means, so let's sort through what we know.

• Obviously, we've been borrowing and spending too much and that has led to a dependency on cheap credit. The worst offenders are in some hot water.
• The economy is slowing. How much and how long, nobody knows.
• We've had a couple of bubbles inflate and burst...think dotcom and housing.
• Oil and other commodities have been on a roll for the past few years, putting a damper on growth.
• The U.S. has been driving the world economies.
• It is an election year.

That's about it. There's nothing very surprising here. Everything on the list has been known for months. And if we want to understand what is likely to happen, these are the foundation. Even so, what we might reasonably assume may be more illuminative:

• Eventually, we must be weaned from the addiction to credit. Based on this, one might theorize that the recent moves by Congress and the Fed are the reverse of what is needed. They seem designed to increase availability of credit and overspending, feeding the addiction. However, an aversion to discipline and pain, coupled with politics, are promoting giving drugs to the addict to minimize the worst effects of withdrawal. The big question is whether the process will result in a slow, less dramatic withdrawal or a feeding of the addiction leading to a Paul Volcker style, cold turkey approach. Until the last year, the former approach seemed to be in place and working, with slowingly increasing interest rates, but now I'm not so sure. Meanwhile, I'm hoping for the former, preparing for the latter, and trusting my investment system to manage the process.
• The economy is slowing, but will that turn into a crash? And how will the outcome effect investments? This is a subject for a book, rather than an article, but let me take an abbreviated attempt. I anticipate more slowing and perhaps some reasonable contraction, but no crash. Housing will continue to fall, since prices are still 20-30% above the long term trend line, but I suspect the process will take several years and it will be very uneven geographically. This will limit the annual drag to less than the long term upward trend. Oil and commodity prices may continue upward for a while, but will eventually return lower to their long term trend lines. This will relieve some of the inflationary and budget pressures resulting from the credit and housing crunch. And, amazingly, traditional energy stocks are already priced for this scenario, so they shouldn't fall too far. Gold seems likely to follow the commodity trend, although the long term gold trend is not so clear. Bonds seem poised for poor performance, since interest rates will eventually return to their long term trend, significantly higher than today. Cash seems a poor bet, with the current low interest rates ( Particulary short term rates, which are more subject to government control. Interestingly, pun intended, artificially lowering short term rates may exert upward pressure on long term rates by raising the risk of inflation.). Meanwhile, stocks in general seem reasonably priced, perhaps even underpriced for today's low interest rates, and stock prices are near long term trends. I expect a relatively slow upward longer term trend in the markets, interrupted by significant volitility as the long term trends are exposed or impeded by daily events and stories.
• In the long run, international markets will begin to take more leadership from the USA. Free trade is taking hold. Governments, on the whole, are becoming more democratic. These trends will allow billions of people to begin catching up, to the benefit of both themselves and the world economy. Progress will be uneven, but I believe the long term trend is unquestionable and positive for those not afraid to invest on a worldwide basis.
• Politics will rule in the short term, but fade in the long term. This is not only true in the ebb and flow internationally, it applies perhaps even more to the USA. Election years yield increased uncertainty, and at the same time produce more quick fixes, such as tax rebates and mortgage modifications, resulting in increased volatility. Ultimately, though, these fixes succumb to the long term realities, ie, that the USA is tending to regulation and government interference rather than freedom.

Whew, now I'm much further out on a limb than I intended to be. There will be disagreement, of course, and I'd love to hear it. Will I be right, or will I be wrong? Either way, what can you do to prosper financially?

I was just reading, in a science magazine, no less, about a psychiatrist who is trying to build a model which plays reverse psychology with market emotion to predict investment movements. In other words, they search the internet for increases in "negative" or "positive" words and then bet against that trend. They didn't mention it, but I suspect the word "crisis" is one of the negative words. Apparently they are having considerable success, and, even though I suspect the models still need a lot of work, it all makes a lot of sense. As I've mentioned many times, and implied in the lead-in to this article, my experience is that following the emotions driven by the media is a key reason for underperformance of most investors. The herd mentality almost always leads to the worst decisions. And, while I didn't actually see it in print, the news could well be summarized by red, three inch letters screaming "Run for the Exits!!!". Most investors would be well served to avoid joining such stampedes.

Obviously, I believe that markets almost always return to long term trends, and that is the basis of my system, "Dollar cost Averaging on Steriods"...track long term trends and invest anticipating a return to the trend line. Use a mechanical system to avoid running with the herd, all with only a few minutes effort per month. Beat the markets without having to always be right about the future. Best of all, do something to take advantage of the volatility. Man, I'm glad I don't have to depend on my prognostication prowess to secure my financial future. Until the psychiatrists perfect their model, I'm convinced my process will get the job done. If you don't regularly follow this blog, go back to March 2007 for an outline of how the system works.