Unfortunately, if you’re crazy enough to loan the U.S. government money; i.e., to purchase U.S. government bonds at this point, you’re out of luck. If the government goes broke, they’ll default on their bonds and you’ll be paid less than a dollar on the dollar.

What’s perhaps more likely is that the U.S. government will inflate its way out of debt by simply printing more money and thus devaluing everyone’s cash. This will, in all likelihood, create rampant inflation, thus devaluing all bonds and creating the same effect as the U.S. government defaulting on their debt. The only difference is that they take all bonds down with them in this case.

But what about stock investors? Fortunately, even if the U.S. government goes broke, I believe people will continue to drink Coke, go to McDonald’s, purchase gas, buy Proctor & Gamble toothpaste, wear out their tires and do most of the “normal” things they do in their daily lives. Hence, corporations will continue to retain monetary value.

Yes, I believe that inflation will hurt the stock market and yes, I believe there will be riots in the streets if the U.S. government goes broke. However, I also believe that people around the world (remember that most of our companies are global) will continue to go about their daily lives as best they can.

Ultimately, the U.S. will go the way of the Roman Empire. We don’t know when or how fast, but one constant in world history is that nations rise and fall. But I believe that mankind, and thus the global economy, will continue to march forward. We don’t sail around the world in wood ships anymore. And likewise, with or without the U.S. government, I believe the global economy will continue to march forward.

What do you think?

Thanks,

Rod

You may remember a post a while back about a recommendation to a client to make an investment in the S&P 100 not long after the market bottomed out and began to rise.  Although the move was particularly well timed and the money had come from bonds that had been called, I’m not about to say I saw the rapid rise in stocks coming.  Yes, it has been a rapid rise, as I just read, a day or two ago, that the last six months have represented one of the six strongest six month periods for stocks in the history of the market.

What was I thinking when I made the S&P 100 recommendation?  First and foremost was the discipline of sticking to rebalancing a portfolio.  One needs to pay attention to the basics.  It doesn’t mean you have to follow them 100 percent, but like blocking and tackling, you have to pay attention to the basics.

The second thing that was running through my mind was the rising risk of loaning money to the U.S. government, which, traditionally, is a big part of nearly any bond portfolio.

Yes, everyone in the world who can understand a standard news source knows about the rising U.S. government debt.  But today, in a Washington Times article by Richard Rahn, a senior fellow at the Cato Institute and the Chairman of the Institute for Global Economic Growth, I read the following super-interesting fact:

“The U.S. entitlement programs (Social Security, Medicare, Medicaid, etc.)…will take more than 100 percent of all federal tax revenue this year, requiring that virtually all of the other government programs, including defense and interest payments on the debt, be funded by more borrowing.”

That’s staggering, truly staggering.  Would you consider a loan to such an entity to be a low-risk investment?

I can explain and lecture on bell curves and standard deviations all day long, but everyone, including myself, has to be concerned about loaning money to such an entity, no matter what the historical profile looks like.

What to do? I’m glad, really, really glad, that none of my clients have an excessively large exposure to U.S. government bonds.  Yes, many, especially my older clients, have a significant bond position, but they’re all in highly diversified bond positions.

Also, ironically, stocks may be lower risk than loans to the U.S. government.  Will they be completely immune from U.S. government and currency issues?  No.  But even if the U.S. government can’t meet debt payments or inflates its way down the road by simply printing more dollars, millions of people around the world will continue to drink Coke, fill their cars with ExxonMobil gasoline and use a computer powered by Windows (although I’m an Apple guy).  Capitalism will march onward.

What about gold?  It’s still just an inanimate commodity.

What else to do? If you’re depending much on an entitlement program, you may wish to give your dependency some serious thought.  Do I really think the U.S. would eliminate or seriously scale back its entitlement programs?  In all honesty, none of our politicians on either side of the isle have the political backbone to take on the issue.  However, time and again over the centuries, markets and balance sheets have proven to be stronger than political will or desire.  Ironically, the 60s generation that wanted peace and sex with everyone may run begging to the churches they have despised all their lives for handouts of basic life sustaining elements like bread and water.

Do I think the day of reckoning will happen within the next one to three years, as Mr. Rahn does?  You probably know by now that I’m not about to make a specific time dependent prediction like Mr. Rahn.

However, I do think it’s safe to say that it’s highly risky to loan money to an entity going the direction of the U.S. government or to depend on such an entity for an “entitled” payment.  Thus, informed investors may want to consider making their decisions accordingly.

Have a super day.

Thanks,

Rod

Weather.  That’s good.  People are always talking about the unpredictability, or uncertainty, of the weather.  That’s how I hope investors think.  Risk is uncertainty, and we can quantify uncertainty.  Yes, not wanting to disappoint anyone, we did briefly discuss bell curves and standard deviation.  Risk = uncertainty = standard deviation.  No, it’s not a perfect analogy, but it’s the best industry and academics have found.

Living in Houston, I also liked the “driving on the freeway” description of risk.  Driving on a Houston freeway, especially during rush hour, is an uncertain experience.  It’s uncertain from both a safety standpoint and from a time required standpoint.

Although I often refer to Nobel Prize level tools and tactics, I do like to keep things, especially investment concepts, simple.  We’re all more likely to remember and understand simple explanations.  Besides, simple solutions usually work the best.  That’s what we want:  things that work the best.

Stay tuned.

Thanks,

Rod

I remember grappling with this question in a class when I was a graduate student at Duke many, many years ago.  But I got a better angle on it, as you might guess, when I went to a round-the-fireplace discussion with J.B. Fuqua, the businessman who donated $14 million in the mid-1980s to Duke’s graduate school of business and thus had his name placed on it.

J.B. grew up on a Virginia tobacco farm and didn’t have any formal education beyond 7th or 8th grade.  However, he developed a kind spot in his heart for Duke University when the school loaned him books through the mail.  And boy, did it ever pay off for Duke.  But on to J.B. and the question about money.

One of the things I remember J.B. asking us in front of the fireplace if we had read The Wealth of Nations and going on to say that he read the book every five years.  Almost immediately, I went to the bookstore and purchased my copy of The Wealth of Nations and began reading it.

As you might imagine, it’s dry and confusing.  What exactly is it?  Adam Smith’s The Wealth of Nations is to capitalism what Lenin’s Capital is to communism.  Basically, from what I remember, The Wealth of Nations is Adam Smith’s observations about what he was seeing in the British economy in the 18th century.  In short, it’s sometimes referred to as the foundation of modern economics.

Of the things I remember from the book, one thing stands out:  Money is a representation of labor. A true Adam Smith scholar would likely grill me for the inexactness of this, but to me it makes a lot of sense.

$100 will buy you a certain amount of a gardener’s time, another amount of a physicians time and still another amount of third world labor time.  Money is labor.

But what about manufacturing?  When you boil it down, manufacturing is really a service, too.  That $100 buys you a given amount of factory time to transform raw materials, which came to the factory via someone’s…..labor.  Yes, even gold comes from someone’s labor at digging up enough dirt in a given location to extract a certain amount of gold.

What do you think of all this?  Does it make any sense?  I look forward to hearing your thoughts.

Thanks,

Rod

Am I wishing bad things on Chicago city workers or anarchy in the Windy City?  No, absolutely not.  I had a college roommate from Chicago and I love the city.  However, every person and every organization must learn to live within their means.  Unfortunately, Chicago’s leadership didn’t learn to live within its means, so the city, which put them in power, is paying the price.

What will happen now?  My guess is that days like today (and there’s another two or three furlough days scheduled for 2009) will force the city’s leadership to start realizing they have limited means.

They can keep raising taxes, but it won’t likely raise any revenue as people and businesses will just move away.  Hence, they, or someone who ultimately rises to power in Chicago, will ultimately learn that hard decisions have to be made.  Money ultimately represents labor (more on this tomorrow) and they have to learn that they have a limited amount of labor.

It would be interesting to visit Chicago today to see if everyone in the city is taking the day off and going hungry.  My guess is that everyone but the government employees is going about finding a way to do business as usual, without the thousands of bureaucrats.  Maybe, just maybe, someone in Chicago will ask:  ”Do we really need all these city employees?”

A couple of decades ago corporate America went through a gut wrenching “reengineering” period as corporations learned they couldn’t have 20 layers of management where 5 layers would do.  Yes, it was painful for everyone involved, but corporations, shareholders and ultimately consumers benefitted.

Corporations had to look around and ask:  ”What are our customers really willing to pay for?”  At some point, the many layers of government will have to do the same.  It’s unfortunate the government entities didn’t learn by watching; however, it’s near certain that they’ll have to learn at some point.

Capitalism thrives on efficiency improvements, which ultimately raises everyone’s standard of living.  Now it’s time for the government entities to step up to the efficiency plate.  And as they do, ever so slowly, you can bet that consumers, and ultimately the economy, will benefit.  Yes, today will go down as a good day for capitalism.

Our children, two girls ages 5 and 7, would watch TV 12 hours a day if we let them. No, we don’t let them do that, but it’s a draw that we were constantly fighting and I didn’t like the amount of time they were spending in front of the TV. Do you ever deal with this situation?

Then, after returning from a week at family camp in June I had a major clash with my 7 year old about watching TV instead of doing what I had asked (helping unload the SUV).  As a result, I banned both children from the TV for a week, both as punishment and to give me time to think about the situation.

While I thought about the situation I considered four things:

1) Modifying our approach to TV management
2) Banning the TV for the summer
3) Banning the TV period, except for family DVDs
4) Dropping our TV satellite subscription

Pam strongly disliked 2-4, as she uses the TV to sometimes keep their attention while fixing dinner or doing other household chores. If it were up to me, I would have pursued option number 4. I don’t like the TV and I really don’t like writing a check to the satellite company every month. No, we’re not going broke, but I have no value for 99% of what’s on TV.

In addition to thinking about it personally, I consulted several of the elder members of our church for their thoughts on the situation. What did we come up with, and more importantly, how well has it worked? Bottom line: it’s worked beautifully, better than both Pam and I would have expected. It’s very simple, cheap and everyone is happy.  Yes, I realize that the same thing doesn’t work for everyone and every situation, but since this has worked so well and since it concerns money, I thought I’d share it with you.

What did we do? We told our girls that if they made their beds and picked up their room by 10:00 a.m. in the morning we’d pay them 50 cents. Additionally, they could earn 50 cents, and possibly a bit more, every day of the summer by applying themselves at the daily learning time. For example, Megan, our 7 year old, generally gets a penny for every math problem she does.

However, if they want to watch TV, they pay me 50 cents for a half hour program, with a limit of two programs a day.  Wow, did it ever create the behavior we wanted.

Almost every day now they’re quick in the morning for me to inspect their room.  (Yes, although we have a four bedroom house, we’re making them share a room at this point in their lives to encourage sharing and getting along skills.)  After the inspection I pay them each 50 cents, assuming they’ve done their job.

Then, later in the day, when they want to watch TV, they get me or Pam and dutifully pay us 50 cents for a half hour slot.  And since they know they’re limited to two 30 minute slots a day, they’re careful about how and when they spend their limited resources.  Hence, they’re also learning about limited resources and sacrifices.

Of course, I was hoping they’d forego TV and keep their ~$1 a day.  I’ve got the 7 year old to think about this and the number of dollars she could save in a month makes her head spin.  However, she can’t yet resist the daily temptation to watch her two programs.  But she occasionally gives serious thought to the saving idea.

It has also been neat to see how truthful they are about the 30 minutes and not trying to bend or argue with the rules.  We’re far from perfect parents, but Pam has done a yeoman’s work here.

As we move through parenthood I’m finding that parenting is like investing in equities:  two steps forward and one step back, while also being fun, rewarding and work.  Hence, I just thought I’d share this with you since it does concern the topic of  money.

What do you think of our situation and solution?  I’m interested to hear what you think.  I’m also interested to hear your thoughts about this occasional divergence from the normal investing topic.

Thank you for your comments, and please have a super weekend!

Rod

No, I’m not a blind optimist and I do agree that it may not be good for the U.S. government to go broke, as it is ~20 percent of the U.S. economy. And no, I don’t want to trivialize the possibility.

However, we just need to look around at the states to see what would happen if the U.S. government “goes broke”. In California (CA), is Apple Computer going broke along with the CA government? No, quite the opposite. Apple is turning in record profits.

What about in Pennsylvania (PA), where 77,000 state workers have been over a month without a pay check because the politicians are at loggerheads because they can’t agree on a budget? Well, Pam and the girls are in PA now, and when I asked Pam how Friday night was at a regional family owned amusement park Pam replied: “It was more packed than I’ve ever seen it…” I know that’s pretty unscientific, but it’s a valid anecdote that the people of central PA are definitely not starving. To the contrary, everyone but the government workers are probably relieved that one element of the state government finally stood up and said: “No New Taxes!”

Even more in support of the marginal impact of the U.S. government is an article in today’s Wall Street Journal by Zachary Karabell. Mr. Karabell argued that because the world economy is so intertwined that fewer and fewer American companies need a strong domestic economy for their earnings to grow. Yes, that’s bad for the U.S. citizens looking for a job and it’s bad for the out-of-control tax hungry U.S. government, but it’s great news for the global investor.

Yes, the U.S. government may get desperate and may print too many dollars and drive U.S. inflation through the roof. However, as we witnessed in the 1980s, at some point the currency will come under control and the market will regain its losses, either through U.S. business or through business from abroad. Yes, the American citizen will feel the pain from the situation, but the global investor will survive, and ultimately, thrive.

We don’t sail around the world in wood ships any more, and with or without the U.S. government, the world economy will march forward.

Thanks,

Rod

PS: Pam is on vacation for two weeks, ending this Wednesday, and she’ll be commenting on everyone’s site again regularly after she returns.

PS 2: Let me know if anyone is interested in our web guy’s services. He’s a good kid (30 something), easy to work with, knows his SEO stuff and as you can see, does good work.

Last week, on the drive to Pine Cove Family Camp, Pam and I began talking about the possible socialization of the American health care industry.  My stance was simply:  The government can do what it wants, but there will always be some who are wealthier than the masses and you can bet that they’ll find good health care, and the best of the physicians and other professionals will migrate to serving the wealthier crowd.

To this, Pam replied:  “What if the government makes it illegal to practice medicine privately, as it is in Canada?”  We thought a minute, and then Pam said:  “Do you remember the mercy ships we’ve heard about that provide health care for undeveloped countries by pulling a health care laden ship into their ports and serve the ultra-poor by bringing them on board the ship?  Some enterprising individual can do that, pull a boat for the wealthy into a U.S. port, take it out 12 nautical miles into international waters, provide the necessary medical procedures, and then pull back into port that evening or the next day.  There’s nothing the U.S. government can do about what happens in international waters.  Ships do it for gambling.  They can do it for health care.”

A few days later we were having breakfast with a couple of physicians and the health care situation came up.  With a solution similar to Pam’s medical ship idea, one of the physicians said:  ”Yes, if they socialize the industry and make it illegal for private practice, you can bet physicians will be setting up shop in Mexico and offering package deals that include the flight, accommodations, meals, the medical procedure and the return trip home.”  He’s absolutely right.  We’ll see the best and brightest physicians, along with the world’s best medical centers, move to Mexico and the professionals will live like kings without worrying about defensive medicine, being sued, and all the other headaches that come along with our highly regulated industry, which is about to be regulated even more.

Even more interesting is that this physician went on to say the average new physician is entering the market with $250,000 – $400,000 in debt associated with medical school and training.  Wow!  That’s staggering.  Who, in the right state of mind, would go through ~12 years of school and training, take on $250,000 – $400,000 in debt and then settle for a government paid job?  That’s definitely no way to attract the best and brightest.

So what’s the bottom line in all of this?  Markets move, and they move with more power and smarts that any government has ever dreamed of having.  Hence, when you’re thinking of “outsmarting” the market, you may want to think again.  There’s millions of people out there, and when it comes to publicly traded companies, you can bet that others are thinking the same thing.

Once again, markets are efficient.

Thanks,

Rod

As always, thank you for your kind words.  In posting today I decided to post my response to a client’s questions about where to put some money from bonds that just matured.  The clients are within ~5 years of retirement.  I have to keep the amount confidential, but it was approximately 1.5 percent of their total portfolio.  Although it’s not a huge amount, it’s still significant.  They pay me to watch every penny, which is what I do my best to fulfill.

Susan:

Thank you for getting back to me.  I have two thoughts on the $X that matured with the GRDA.  Each has its own risks and rewards issues.

The first option is to put it back into the municipal bond market.  If we were to go this route I’d highly recommend a municipal bond fund instead of single municipal bonds.  Why?  we’re not going to get significantly better returns going the single municipal bond route.  Yes, we can go with something that triple A and insured, but in today’s environment that doesn’t always mean a lot.

Have I lost faith in municipalities?  No, but I’d much rather spread the risk over hundreds or thousands of bonds, such as the DFA short term municipal bond fund or something similar, instead of putting it into one issue.  Why?  Some of the states are in financial trouble, which could trickle down to the municipalities. Can’t we go with safe states like OK and/or TX?  Yes, we could, but the federal government, with its “stimulus” plan, is threatening the states to take on huge fiscal liabilities.  As it now stands, the Feds take on the expense the first two or so years, but then dump it on the states.  That’s not good, as we don’t know which states are going to get whacked the hardest.  Hence, I’d much rather spread the risk across the entire country instead of buying a single issue that sounds good today but gets hammered with something unforeseen in a couple of years as the government fiscal landscape is changing.

How much are triple A municipal bonds getting right now?  Triple A, maturing in 5 years, as of a week or so ago, were getting 2.5 – 2.8 percent tax free.  One can get toward 3 percent if you go out 8 years, but I recommend sticking with 5 years and under.  Why?  Did you see the jump in interest rates last week? Mortgage rates climbed ~0.4 percent in two or three days.  Rates then fell back some on Friday, but still, to climb 0.4 percent in two days is outrageous.  As interest rates go up, bond values go down.  Hence, the shorter your time to maturity, the less you get hurt.  Should we invest at all in bonds with rising interest rates?  It’s not a good financial move, but its less volatile than stocks or real estate.  This is a move I don’t like to make; i.e., looking for the route of least potential pain.

What else is there?  I realize that John and you are highly skeptical of investing in stocks, but now may be a good time to get into some large “blue chip” stocks.  This would bring your portfolio back toward the long term stock and bond balance we’re seeking, as we designed a few years ago when I brought you on board with the Schulz Financial/TDAmeritrade/DFA team.

I’ll be the first to admit that I’m not clairvoyant, but the market isn’t in the free-fall that it was in from last Sep/Oct through Feb/Mar.  Also, as far as weathering out changes, I have more faith in a broad section of “blue chip” companies than a broad section of government bonds.  I don’t know if you noticed, but a couple of weeks ago one of the rating agencies (I believe it was Standard and Poors) warned the UK that it was thinking about downgrading their bond rating. And you don’t have to look far on our side of the pond to see similar things happening.

For example, I believe California’s bonds are now rated as either “junk” bonds or one step above junk bonds.  Oregon is contemplating (a) shutting down some courts; (b) letting convicted felons out of prison early; and (c) trimming its public school year from 9 months to 8 months, or some combination of (a) – (c) to save money because it’s in such dire financial straits.  NY, NJ and MI aren’t far behind.  And in the private university world, Ivy League Dartmouth College recently had its credit rating revised downward.  Yes, people are starting to realize that the U.S. government may have its bond rating reduced.  In reality, the bond has already been hit by the time the agencies take something down a notch.  Markets are efficient.

What about CDs?  Everyone who’s within ten years of retirement should have some money in CDs but we need to realize that their long term return, after taxes and inflation, has historically been negative.  Yes, CDs have increased their yield in the last couple of weeks due to the rise in interest rates, but we also need to keep in mind that inflation has gone from ~0 to ~2 percent.

In summary, we’re not out of the woods.  However, it may be a good time to take some or all of the $X that matured with the GRDA and roll it into a broad cross section of large cap “blue chip” stocks.  Another option is a municipal bond fund, and still another option is splitting it 50/50 between the two. CDs may feel safe, but, long term, too much in CDs won’t get us where we need to be financially.

What do you think?  Please drop me a note or give me a call.

Thanks,

Rod

Thank you for staying tuned and please excuse me for taking a few days off.  I tried to write yesterday, but I couldn’t get an adequate lake-side wireless connection through my 3G wireless card, so I’m writing from the inside of a Starbucks in Tyler, TX today.

Today I’ll be brief, as I just want to provide a summary of the topics we discussed in April and May.

1. The Three Factor Model.  Keep in mind that three things explain approximately 90 percent of your portfolio’s performance.  These three things are:  (a) the return of the general stock market minus the risk free return; i.e., stocks vs bonds;  (b) large stocks vs small stocks; and (c) value stocks vs growth stocks.  Keep in mind that NONE of the touted commercial sales factors, like portfolio manager, mutual fund company, market timing, etc. come anywhere close to the above three factors when it comes to explaining what impacts your portfolio’s performance.  Code word:  Focus on the three factors above.
2. The Global Economy Marches On.  Economic cycles are as old as commerce itself.  However, in general, and it’s a strong general, you drive the economy forward by going to work every day and making a living.  No one in the free world, and much of the third world, works for absolutely nothing.  Countries and societies rise and fall, but we don’t sail around the world in wood ships any longer.  Code word:  It’s a pretty safe bet that the global economy will continue with its forward march.  It’s wired into our souls.
3. Own the Casino Instead of Just Being a Player at the Casino.  No one is clairvoyant, and when it comes to investing, statistics is a factor.  Code word:  Use the things we’ve discussed to play the game as the owner of the casino instead of a player at the casino.
4. Risk:  We Can Measure It and Design for It.  Do you remember the bell curves?  If we define risk as uncertainty, we can measure it.  Moreover, we can evaluate your personal risk tolerance and time horizon, and then tailor a portfolio for what fits your personal situation.  Hence, rather than rely on non-existent clairvoyance and increase your risk by jumping in and out of the market, you’ll be ahead to get into a portfolio tailored for your situation and ride out the inevitable ups and downs of the markets.  Code word:  Don’t shoot from the hip when you can measure and design for something critical.
5. The Past Doesn’t Predict the Future.  Do you remember the comparison of 1970 – 80 mutual fund superstars to their performance in 1980 – 90?  While past performance may be an indication of future performance in many of life’s arenas, it means next to nothing when it comes to managed investment portfolios.  Code word:  Don’t let any mutual fund company convince that their ABC fund will do good the next ten years because it drummed the market in the last ten years.
6. The Market is Efficient.  As Fama hypothesized in 1965, the market processes and adjusts for all publicly available information almost instantaneously, and its movements follow a random walk pattern.  One measure of the validity of his hypothesis is the performance of index funds versus managed funds.  Code word:  Index funds have a better return, lower risk and lower cost than managed funds.  Those are things we like.
7. Design Your Portfolio.  While we didn’t give this issue the time it truly deserves, you can build a portfolio like a master chef measures and mixes his/her ingredients.  Why leave something as important as your life savings to random chance?  Get into a portfolio that’s optimally designed and built for your risk tolerance, time horizon and investment options.  Code word:  It’s possible to get more return with equal or less risk.  That’s good.
8. Investment pecking order.  We can get one step more scientific than index funds with DFA.  Past performance doesn’t predict future performance, but we do know that DFA funds are more scientifically built than index funds and that their historical performance does more than pay for the additional overhead.  However, if DFA isn’t available or if you don’t want to go that route, a portfolio of index funds is the next best option.  Bringing up the rear of the field is managed funds, but they’re often what someone has to live with because they’re ~90 percent of the market.  But even with managed funds we can apply the three factor model, dial in the risk and design a portfolio that uses efficient frontier optimization.  Code word:  Do the best you can with what you have available.

Although I’m at family camp this week, I’ll continue to blog.  Further, I plan to get back to doing it on a daily basis when we return to Houston next week.  Stay tuned, as more good stuff will follow.

Thanks,

Rod