The article states that market timing amounts to gambling because it is impossible to forecast market movements, and “you run the risk of missing periods of exceptional returns.”  As an example (here comes the nonsense), a $1 investment in the S&P 500 over the last 20 years would have grown to $4.84, but if you had missed the best 10 months of stock returns, the ending value would have been only $2.04.

It’s pretty easy to grab these numbers from Yahoo and throw them into a spreadsheet.  I used the Vanguard S&P500 Index fund assuming reinvested dividends.  The author used the April, 1990 to April, 2010 timeframe, so I used the 20 years ending June 1 to capture the latest downturn, which “proves” the case against market timing just as well.  In the 20 years ending June 1, 2010, a $1 investment would have grown to $4.43, and missing the 10 best months would have resulted in only $1.91.

Now for some results that were not mentioned.  What if you missed the 10 worst months, which is just as ridiculous as somehow missing the best months, but equally likely?  In this case, your $1 turned into $13.48.  Doesn’t that seem worth mentioning?  How about something less ridiculous, like missing the 10 best and 10 worst months?  Now, the $1 is $5.43, a 22% improvement!

Now let’s get a little smarter about the whole thing.  If a big positive month happens in the middle of a string of positive months (bull market), why would you get out of the market?  So let’s assume we miss positive months only when they happen after at least an 8% drop, when a portfolio would likely have been moved to cash.  Similarly, if a negative month comes after a positive trend it is likely you would be fully invested, so we’ll assume you experience the full month’s loss.  As a specific example, the monthly returns for June-Sept, 1998 were 4.08%, -1.06%, -14.47%, and 6.41%.  We’ll count the big negative return in August because the previous month would not have triggered any selling, and we’ll miss the positive return in September because August would have caused us to move to cash.  This is still incredibly unsophisticated, but it’s a heck of a lot better than the brain dead 10 best or 10 worst months.  The result with just a little intelligence added results in $6.36, a 43% improvement over buy-and-hold.

The conclusion is that anyone who uses a “missing the best [days, weeks, months]” argument to prove a buy-and-hold point is either being incredibly sloppy with the data, or being disingenuous.  I’m open to other arguments on the topic, but not that one.

• The market always comes back
• You can’t time the market
• The average return of stocks over the last 80 (or 50, or 100) years is about 10%
• A well-diversified portfolio consists of a mix of stocks and bonds
• The percentage of a portfolio invested in cash and bonds should be approximately the same as a person’s age (70-year-old should have 30% stocks, 70% bonds/cash)

One problem is that many of these nuggets and rules-of-thumb have become popular in the last 30 years.  That makes sense.  Most people have a tendency to base opinions on recent experience (even though 2 or 3 decades isn’t all that recent), and the experience of many investors does not go back more than 30 years.  The investment world is very different today than it was in the 1970’s or earlier.  In fact, mutual fund investing, which opened up access to the markets to the everyday investor, didn’t really take off until the late ‘70s and ‘80s, so it’s safe to say that most of the investing experience of the average investor has been acquired in the last 30 years.  So let’s take a look at the investment environment over the last 30 years with respect to interest rates.

The chart below shows the historical return for the S&P 500, the yield of 1-year U.S. Treasuries, and the historical return of Vanguard’s Total Bond Market Index fund (normalized to the S&P 500).  Unfortunately, I couldn’t find bond index data earlier than 1990.

As you can see from the chart, Treasury rates have been in a secular bear market since 1981, which corresponds to the beginning of an explosion in the stock market.  Since bond prices are inversely correlated to interest rates, bonds have clearly done very well.  However, the environment is about to change.

My guess is that the 30-year fall in interest rates is about to come to an end.  I know this is a bold claim with interest rates hovering just above zero, but if I’m correct it means that we are about to experience a change in the investment environment.  An environment characterized by falling interest rates tends to be good for bond investors who lock in yields at higher rates.  It also tends to be good for stocks as the cost of money becomes cheaper and frees more dollars for investing.  Obviously there are many other factors that move the stock and bond markets, but falling interest rates has been a consistent long-term influencer since 1981.

I’m not going to suggest how to modify investment strategy in light of this new environment in this article (it would make the article too long), but I do want to make the point that investments and allocations over the next 20-30 years will likely not perform like they did over the last 20-30 years.  Although the scenario of interest rates continuing to drift down is pretty much impossible, there are still two possibilities that could have very different implications.  Interest rates could move up to a sustainable but still relatively low level and stay there, or they could enter a new secular (i.e. long-term) uptrend.  Which of these two scenarios ends up being reality will largely depend on inflation.  If large deficit spending causes a devaluation of the U.S. dollar, inflation will heat up and the government will need to raise interest rates (among other things) to try to keep inflation under control.  If the Fed is able to slow down stimulus, nudge up interest rates, and keep the economy growing at a reasonable rate, we may be able to avoid a big spike in inflation and the resulting rise in interest rates.  The second scenario is preferable, but it is still very different than the long-term environment we have seen over the last 30 years.

To calculate the CPI, a complex formula is used to determine the price of certain products in several geographic areas.  This is where the games can be played, and where Cash For Clunkers comes in.  If a friend (or fellow taxpayer) gave you $100 to help buy a new TV, and you bought the TV for $500, what would you say was the price of the new TV?  Well, the number on the price tag was $500.  The guy who came into the store at the same time as you and bought an identical TV paid $500, the same as you did.  The fact that your friend gave you $100 did not lower the price of the TV.  However, in the latest release of the Consumer Price Index according to Bob Arnott (chairman of Research Affliates, LLC), if you were given $4500 from other taxpayers to help buy a new car as part of the Cash For Clunkers program, the $4500 was considered a price reduction of the car, making the car look cheaper and reducing the inflation number.

With the hundreds of billions of dollars being spent on stimulus, this type of game can be played for quite a while, but not forever.  A low inflation number helps GDP growth look better because GDP growth is measured relative to inflation.  However, at some point, the shifting of money has to slow down and the actual rate of inflation (and GDP growth) will show up.  Hopefully, actual growth will have kicked in by then, but this certainly seems like a potential problem in the not-too-distant future.

The reason I say “unsuspecting” is that there is no reason to pay a commission to an advisor for a 529.  Every state except Washington (not sure what Washington is waiting for) has a no-load 529 program that can typically be applied for on-line.  Most programs have age-based portfolios that automatically adjust risk as the child approaches college, so an advisor is not typically adding a lot of value by picking specific mutual funds.  The main differences between 529 plans are due to the manager who administers the plan and whether the particular state gives a state tax deduction for residents participating in the plan.  A tax deduction is something that should be seriously considered if it’s offered.  34 states offer some amount of deduction and 7 states don’t have state income tax anyway.  Of course, California is one of the remaining 9 states that doesn’t offer a deduction.

There is no restriction on which state’s 529 plan you can invest in, so it comes down to which manager does the best job and has the lowest fees.  I like the following:

California (Manager: Fidelity) – in particular, I like the age-based Index portfolios

Utah (Manager: Vanguard) – very low expenses

Alaska (Manager: T. Rowe Price) – age-based portfolios are a little more aggressive

Iowa (Manager: Vanguard) – very low expenses

Each of the above plans have low-costs, an easy application process with no application fee, and great underlying funds.  Since a 529 plan is meant to be a “set it and forget it” type of investment, I see no reason to pay the commissions and extra expenses for a broker-sold plan, and there just seems to be something wrong when an investment company advertises how much money can be made off of “selling” 529 plans.

A Joint Account With Rights of Survivorship is intended to simplify the ownership issues if one of the account holders dies.  Hence the term “rights of survivorship”.  However, when setting up this type of account, there is usually an option concerning whether withdrawals require two signatures or one, and whether checks are issued to Account Holder 1 AND 2, or Account Holder 1 OR 2.  Sometimes people feel like there is added security by choosing the “AND” option and requiring two signatures, but this can create problems when one of the account holders no longer has the ability to sign paperwork, particularly in the event of death.

I ran into this when I went to transfer a Joint account from a previous institution after one of the account owners died.  The surviving client set up a new single-trustee Trust account.  The transfer was rejected because the Joint account required two signatures, and a death certificate is not sufficient.  At this point the easiest course of action would be to convert the Joint account to an Individual account, but the previous advisor wanted to charge in the neighborhood of $3000 to do this, essentially holding the money hostage.  The next option was to have the account liquidated and a check issued, which could then be deposited in the client’s bank.  This worked on a previous disbursment for a relatively small amount, but the bank has a policy that any check over $1000 needs two signatures.  So hopefully you see the pattern.  Joint accounts are supposed to make things easy, but if they have the restriction of requiring two signatures, there is the potential for problems.

As a quick disclaimer, there are times when requiring two signatures may be a wise thing to do.  In the case I ran into, there should not have been a problem converting the Joint account to an Individual account except for the previous advisor attempting to extract more money before losing the client.  One call from an attorney fixed the issue in short order, but it was unfortunate that the client had to go through the stress and confusion.

Since March 9, the S&P 500 is up 57%.  The price move took a short vacation in June, but then got moving again in July and hasn’t really looked back.  That’s an amazing move, and has happened despite the fact that unemployment keeps going up and earnings are way down.  Most people recognize that the market doesn’t go straight up, and advisors, particularly those who didn’t trust the recovery initially, have been waiting for a significant pullback in order to jump on the train.  For many investors and advisors, missing out on a significant recovery is almost as bad as losing money in a downturn.  What’s happening is that everytime there is a small pullback, or even just a pause, investors who have been kicking themselves for not being in the market get worried that this may be the only pullback they get.  Therefore, they put money into the market before prices have a chance to drop very much, which causes the pullback to end and the uphill march to continue.  Below is a chart of the S&P 500 ETF (SPY) since early March, with the 50-day Moving Average and a Volume chart included.

What’s interesting is that the average volume is now about half what it was back in March.  Stock prices are still going up, but volume is going down.  Since prices only go up when there are more people wanting to buy at a particular price than want to sell, that means that investors are still not willing to take their profits.  But that time is coming.  I thought it would have happened quite a while ago, but what I think doesn’t seem to influence the market.  What’s indisputable, however, is that this market has come back a long way in a very short amount of time.  At this point, new investment in the market is probably “nervous investment”.  Many investors who have waited to see if the recovery was real finally decide to get back in.  If you’ve waited for a 50% recovery before finally venturing back into the market, imagine the feeling when a few big institutional investors decide to take some profits.  This tends to create a chain reaction of selling that results in a significant pullback.  The problem is that too many people have been expecting this pullback, and the market almost never behaves in such a way that the majority of analysts look smart.

So when will the pullback happen?  As soon as the CNBC experts start to speculate that maybe we’re in the next sustained bull market and that there is no longer a risk of a big pullback.  I don’t know the exact day, but I still expect it to be sooner rather than later.

The Money Isn’t Yours

I’m going to use an IRA as an example, but everything can be applied to a 401k, 403b, or any other tax-deferred account.  If you contribute $5000 to an IRA and you’re in the 25% tax bracket, $1250 of that contribution belongs to the federal government. You get to keep it…for now, and as it grows it will make your account look bigger, but that piece of your account will always belong to the government.  If the $5000 grows to $50,000 by the time you need it and you’re still in the 25% tax bracket, the government’s piece will have grown to $12,500. In other words, you simply invested it for them.  Tax deferral did not make your account grow faster or “put more money to work for you”.

The Advantage (or Disadvantage)

Tax deferral is only an advantage if the government decides to take a smaller piece of it when you withdraw the money. If your tax rate is lower when you need the money, then essentially the government has decided to not take back their entire share.  In that case you have beaten the system.  However, if tax rates go up, or you need substantial income when retired, or tax brackets don’t keep up with inflation (a way to raise taxes without the political ramifications), the government could require a larger share of your IRA.  In financial terms, this is known as “bad”. So tax deferral is really a bet on future tax rates and how much income you will need in retirement.

Theory versus Reality

When people compare Traditional IRAs and Roth IRAs, they typically assume that more money goes into the Traditional IRA because of the tax deduction.  However, in real life, most people end up investing the same amount whether it’s a Traditional or Roth IRA (the same applies to 401k’s).  The money that was contributed to the Roth was simply taxed as part of a paycheck, so the taxes were paid with “outside funds” – money that’s not earmarked for retirement. In theory, the taxes you will eventually pay on the Traditional IRA could also be paid with outside funds, but only if you diligently saved the money from the tax deduction and it grew at the same rate as the IRA.  Not likely.  In most cases the taxes on a Traditional IRA get paid with retirement funds.   So the net result is that more actual retirement money can be put into a Roth IRA or Roth 401k, effectively increasing the limits for retirement savings.

This is not an argument for or against 401k’s or IRAs.  I’m just pointing out that if anyone gets all giddy about the benefits of “tax-deferred growth”, it is simply a bet that your tax rate will be lower in the future.  Your money is not growing any faster, and in fact, tax-deferred accounts almost force you to pay the taxes with money earmarked for retirement.  If you’re thinking “I wish I would have thought of this earlier”, it’s not too late.  Starting next year, anyone can convert a Traditional IRA to a Roth IRA.  If you can pay even a small part of the taxes with outside funds, this may be a great way to save more money for retirement.

Fibonacci retracements fall into that  “profile of Mount Rushmore” category for me (I made that up, by the way).  For non-investment geeks, Fibonacci levels attach some significance to certain percentage price moves, specifically 23.6%, 38.2%, 50%, 61.8% and 78.4%.  For followers of Fibonacci levels, a price bounce following a severe fall would be expected to hit one of the Fibonacci levels.  If the price moves through one level, it would be expected to continue until it hits the next level.  By the same token, each level could represent resistance and signal an end to the bounce.

Well, based on the S&P 500 high in October 2007 (1575) and the market low in March 2009 (671), guess how far the current recovery has retraced…38.2%.  In fact, the S&P 500 crossed that point (1016) last Friday and stopped.  One thing this tells us is that given the market drop in 2008, the market recovery is actually not as spectacular or unheard of as many TV personalities would lead us to believe.  So far, it’s a fairly typical Fibonacci retracement.  The question it raises is whether this is actually a critical level, or is this Fibonacci thing just a bunch of hocus-pocus.  I don’t know, although there’s a possibility that so many people watch these levels it becomes a self-fulfilling prophecy.  In any case it is interesting that the market has decided to pause at this specific level.

As of right now, the S&P 500 is stalled at 1020 (close enough to 1016).  If we get a pull back, the Fibonacci guys would expect a fall to about 885 (23.6%).  If we get through this level, the next critical level will be 1123 (50%).  Again, I don’t necessarily buy-in to this stuff, but it is interesting that we are currently sitting right at one of these levels.

“You can expect about a 10% return on stocks” – The obvious question is “how long do I need to stay invested to guarantee a 10% return”, and the truth is “probably longer than you expect”.  The 10% number is calculated by picking a starting year in the distant past, typically some low point during the Great Depression, and a more recent year that’s typically prior to 2008.  This time period included long stretches (multiple decades) where stocks ended at the same place they started.  Market research shows that positive and negative return cycles average 17 years in duration, so a couple of down years does not mean things will soon be back to “normal”.

“The market behaves randomly” – This was popularized by Burton Malkiel in his book “A Random Walk Down Wall Street”.  Malkiel stated that “a blindfolded monkey throwing darts … could select a portfolio that would do just as well as one carefully selected by experts.”  The Wall Street Journal tested this in 1998 (using journalists instead of monkeys), and the pros won in 61 out of 100 contests.  Not very impressive.  However, even Malkiel recently stated that markets behave randomly, except for the phenomenon of momentum.  In other words, the market tends to move in trends, and although it’s almost impossible to predict exactly when a trend will start or stop (although many try), it is possible to recognize one once it’s underway.

“You can’t time the market” – This comes out of the theory that you can’t avoid down days without missing the few big up days that provide most of the return, and leads to the concept of buy-and-hold at all costs.  However, most investors have a limit where they must exit the market in order to preserve what they have left.  Referring to this as “timing” provides lots of support to the argument that timing the market is detrimental.  However, buying low and selling high can be achieved when emotion is taken out of the equation, particularly when momentum is taken into account.

“Warren Buffett, the greatest investor in the world, is a buy-and-hold advocate” – Although this statement is true, Mr. Buffett does not practice buy-and-hold like your average mutual fund owner.  Unless you are in a position to buy a company, install the management, and hold them accountable for long-term performance, comparisons to Warren Buffett are probably not justified.

“Diversification will protect against losses” – As we saw in 2008, diversification alone is not enough, with even bond funds taking double-digit losses.  What makes matters worse, most if not all traditional equity classes (U.S./foreign, large-cap/small-cap, etc) are now so correlated, they are essentially inneffective at providing any kind of diversification.  Under most market conditions, diversification can provide lower volatility and improved long-term returns, but it requires assets that are truely non-correlated, and it still does not provide absolute protection.

I’m sure there’s more of these, but these are just a few that I continue to run into.

The S&P 500 is now up 15.5% for the year.  That’s not bad, but nothing compared to the 53.1% it has recovered since March 9.  That’s a huge gain in a relatively short amount of time, and at the risk of looking a gift horse in the mouth, it makes me a little nervous.  Here’s why.

Markets can “melt up” just like they can meltdown.  A melt up is caused by investors with cash becoming increasingly scared that they are missing the gains (which they are).  The higher and faster the market goes up, the more emotional investors it tends to attract.  Again, the same thing as a meltdown but in the opposite direction.  At some point, some big institutional investors who caught a good chunk of the recovery will take some profits and cause the market to drop by some amount.  Imagine if you finally made the decision today to get back in, after the market has made a 50% gain, and next week the market starts pulling back.  The natural reaction would be “Oh no, I’m wrong again!” (although maybe with more expletives).  Many of these investors get back out at the first sign of trouble, which compounds the problem and creates a severe pull-back.

This happens all the time, and the chances for a strong pull-back get higher when the market goes up fast.  This is why many professional traders (not the reporters on CNBC) would rather see a smooth, orderly recovery instead of panic buying.

So given a 50% gain in less than 6 months, is a severe pullback inevitable?  No.  Mainly because when everyone expects the market to do something, it rarely happens.  At least on the expected timetable.  The point is to be cautious.  After a 50% rise from the bottom, many institutional investors are sitting on large gains and many new investors have recently entered the market.  That makes conditions rather precarious.  I would like to see the market sit still for a while, which basically lets the market catch up with itself and the emotional buying to slow down.  In the meantime, I’m happy to ride the rally, but with my finger on the dump button.