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

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

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.

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

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

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

Why can’t they just keep printing money?  Because money is a representation of labor, and simply printing more money doesn’t increase the supply of stored labor.  Hence, doubling the supply of money in circulation will, sooner or later, reduce the amount of labor a dollar will purchase by 50%.  It’s really as simple as that.  Forget all the smoke and mirrors and pundits.  They get paid big bucks for the interviews, while you’re left with a dollar that’s worth half of what it use to be.

So what have I been doing over the years with this knowledge?  Avoiding U.S. Government bonds as much as reasonably possible.  Again, one could see and hear the train coming from way, way off.

So where, specifically, have I been investing my clients’ taxable bond money?  Unless its in a taxable portfolio, I’ve been investing in DFA’s Two Year and Five Year Global Bond Funds.  As the name implies, they’re global.  Moreover, although they’re global, their debt is very high quality.

What percentage of these funds are in U.S. Government debt?  On the two year fund, 35 percent of the funds are in domestic bonds and ~74 percent of that number is in U.S. Government bonds.  Hence, if you have $100,000 invested in this fund, only $26,000 (.35 x .74 x $100,000 = $26,000) of it is in U.S. Government debt.

Similarly, on the five year global bond fund only 22 percent of it is in domestic debt and of this, 60 percent of it is in U.S. Government debt.  Therefore, if you have $100,000 invested in this fund only $13,000 of it is in U.S. Government debt.

So what happens if the U.S. Government defaults?  It’s unlikely it will default on the entire amount, and maybe just on the interest.  Sure, any default will hurt the investor, but the exposure to U.S. Government debt in these funds is minimal.

Where is the rest of the DFA global bond fund money invested?  As mentioned above, the debt is held by high quality borrowers.  Who are these borrowers?  They vary day by day, but typical borrowers may include diversified government entities like the Swiss and Hong Kong governments (both in the top ten globally – no, the U.S. isn’t even in the top ten), and high quality corporate borrowers like Toyota (now just AA due to “weak profitability”) and Exxon Mobil

This brings up an interesting point:  What happens to a U.S. politician if the U.S. Government defaults?  Probably nothing, as they’ll just blame it on the other party and get reelected.

Conversely, what happens if a corporation unexpectedly defaults on its bonds?  Someone will likely lose his job.  And who’s in a better position to prevent a looming default, a government official or a corporate boss?  Although I have my doubts about corporate cronies, I’d bet on them any day before I’d bet on the government.

So what’s the bottom line?  Do I think the U.S. Government will default on its debt?  No, but it is certainly possible and something I’ve been looking at for years.  Yes, it will impact many things, but that’s many additional discussions.  The thing to keep in mind is that the DFA Two Year and Five Year Global Bond Funds, while not immune to a U.S. Government default, are at least well insulated.

Thanks,

Rod

More specifically, the DJIA started and ended the quarter at ~12,250, with a high of ~12,800 and a low of ~11,800.  That may sound like a big swing, but if you take the mid-point of 12,300 and consider the market took swings of +/- 4%, that’s not out of line of what to expect.

How do I get this?  I start with a market annual standard deviation of 17%, convert it to a quarterly standard deviation of approximately 8% and then draw my conclusion.  Bottom line:  last quarter’s swing was nothing out of the statistical ordinary.

What about the federal debt ceiling situation, etc.?  That’s a topic for another discussion.  But the thing to reflect on now is that last quarter was basically a break-even period in spite of some significantly bad economic news.

What should one do at this point?  Keep forging ahead…

One of the reasons may be that Asia is the home of their fastest growing markets.  Other reasons for the change may be the tax angles, the regulatory situation and/or currency exchange rates.  But for whatever reason or combination of reasons, Samsonite is going to Hong Kong to raise capital.

The take away for me and my clients is that the economy is getting more global in every aspect, every day.  Companies are no longer going overseas just to find cheap manufacturing labor or to peddle their goods, but rather to raise capital.

What’s the next logical step?  My guess is that some of the companies may be transferring their headquarters overseas just as Halliburton transferred its headquarters to Dubai a few years ago.  And they’ll be making the overseas moves for a number of reasons.

No, I’m not trying to make a political statement or forecast gloom and doom for the United States.  However, one thing I am in the midst of doing is recommending to my clients that they put an increasing percentage of their portfolios in overseas markets.  How much?  It depends on the client, the portfolio and other factors, some of which will be discussed in future blogs.

Thanks,

Rod

To be sure, it’s been ugly since the spring of 2008, really ugly. Nevertheless, the Dow Jones Industrial Average (DJIA) has hung in at around 10,000. Sure, it dipped to ~6600 in March of 2009, and it has recently rallied to 10,900.  But overall, it has generally hung in at approximately 10,000 for the last year.

With this in mind, can you imagine what the DJIA might do if we had some consistently positive economic news, for any reason?

I’m not clairvoyant, but capitalism is globally spreading and I don’t think we’re about to reenter the Dark Ages.  Hence, it’s reasonable to think that at some point things will turn positive.  Even if this doesn’t happen in the United States, it will happen somewhere and all the portfolios I manage have a global component.

Even here in the U.S., there is some interesting data, which includes:

* Americas’s large corporations are sitting on more cash than at any time in the last 60 years, even when adjusted for inflation.  Can you imagine what will likely happen when this cash comes off the sidelines and enters the investment arena, either domestically or internationally?

* Prior to the recent market rally, the price to earnings ratio (P/E) of the S&P 500 was approximately 12, even with interest rates being the lowest they’ve been in decades.  In comparison, the historical P/E ratio of the S&P 500 is approximately 14 – 15.  Moreover, it’s generally been in the high teens to mid 20s since the mid to late 1980s.  It’s just a simple calculation to see where the market would be if it returns to historical standards with an adjustment for current interest rates.

* Corporations are adjusting for the current economic environment, as evidenced by the following comment on the front page of Monday’s Wall Street Journal:  “U.S. companies are rebounding quickly from the recession and posting near-historic profits…” Businesses, as a function of the human behavior that controls them, will always organically adjust for survival and growth in the environment they face.

No, I’m not clairvoyant and I’m not making a blatant prediction about the market in the short or mid-term.  However, I do think it’s interesting that the DJIA has hung around 10,000 for the past year with overwhelmingly negative economic news surrounding the situation.  Hence, it’s only common sense to believe that the market will turn north at some point with positive economic news.

Thank you for taking a minute to consider my thoughts.  As always, drop me a note or give me a call if you have any questions or comments, or if I can be of any assistance.

Rod