Financial Pragmatist

How Are The Banks Doing? It Depends Who You Ask

2009-04-24T12:11:00.000-07:00

What is going on with the banks? What are they doing with all that government TARP money? Are they crumbling, are they lending, are they solvent, are the toxic assets causing them to fail or are they just fine? As usual the answer isn’t simple and depending who you ask you will get a different answer. It all depends on your perspective.
As a bank executive your job is keep your bank alive. The primary reason companies fail is they spend more cash than they collect, In other words, they are cash flow negative. Based on recent financial reporting announcements, banks are cash flow positive due to increased fees from transactions they have facilitated and increased deposits. Many still have negative earnings due to write downs (on bad loans) but they can pay their bills and keep the lights on. So bank executives are relieved that the panic seems to be over and their banks can remain viable ongoing concerns.
However bank executives aren’t happy that their pay has been limited by government regulation related to the TARP funds. They also don’t like being lumped in with big bad wolf - AIG. So they want to give the government back its TARP funds as quickly as possible. Bank execs could care less about lending more money and stimulating the economy because there few incentives to make a lot of new risky loans. From a bankers perspective it would be better to hold on to the cash and use it to pay back the government’s TARP funds.
To make matters worse for the bank execs, the government wants the banks to sell their troubled (toxic) assets in order to free up capital to make new loans. These toxic loans have not been written down to their current market price because execs view these prices as just a market glitch. The current market for these assets is essentially frozen. The few transactions that take place are at a greatly discounted price. Many of these securitized investments are receiving a large portion of the interest and principal payments on time. So bank executives see no reason to sell these assets for a loss when they are generating an adequate cash flow. Now that the panic in the credit markets has subsided, the bank executives see no reason to cooperate with the government if it is not in their best interests.
The government’s objective is to get the economy up and running. To do this they need the banks to be lending. It is the lack of liquidity in the markets that caused most of the panic. The banks were leant the TARP funds to show the financial markets that the Treasury and the Federal Reserve had no intention of letting any more of the larger banks fail. In return, the banks were supposed to increase lending to consumers and companies thereby stimulating the economy. However, the banks are not cooperating and lending has fallen. An analysis by the Wall Street Journal of Treasury Department data showed that the largest banks refinanced 23% less in new loans in February than in October 2008 when TARP was launched.
Supposedly the government is stress testing the banks to see if they can survive tough market conditions. However, it is not in the governments best interests to have any of the banks fail this test. If most of the banks failed the government would not be able to prop them up again. The stress test may only be a political tool the administration is using to make the banks keep the TARP funds.
The Treasury Department wants to avoid any political backlash stemming from the banks reduced lending. The Obama administration wants the banks more accountable. It wants them lending. Currently, the government has little say regarding how the banks operate due to how the TARP legislation was structured by former Treasury Secretary Paulson. Since bailout funds are dwindling the Treasury has few options and little clout with the banks. One option that the Treasury has begun to consider is turning the TARP loans into equity (stock in the banks). This costs the taxpayers nothing. The losers in all this will be the investors that own bank stocks. Investors will find their ownership positions diluted and the value of the stocks would fall substantially.
So how are the banks doing? It depends who you ask and what metric you use.

Don't Count on the Consumer

2009-04-20T15:02:00.000-07:00

The U.S. economy remains mired in a deep recession. How deep, well fourth quarter’ GDP declined 6.3% which was the biggest drop in output in 26 years. GDP figures for the first quarter are not available yet but are expected to be down an equivalent amount. Earnings and profits will also be down substantially in the first quarter after falling 20% in the fourth. These are horrendous results.
There have been encouraging signs in recent weeks and the panic has subsided but the recession is not over. The economy is still contracting and though the rate of decline seems to have moderated there are still problems to overcome. Hope is growing that things will improve even though the banking system is not yet operating normally. In Federal Reserve Chairman Ben Bernanke's words, there are signs of "green shoots," through snow in early spring. The economy is no longer in free fall but it is still in intensive care and the markets may be getting ahead of themselves.
The outlook for jobs however remains bleak. The unemployment rate is officially 8.5% in the U.S. and 11.2% in California. However, the real national unemployment rate is over 10% when you add in those that have been looking for a full time job for more than a year and those under employed (working part time but seeking full time). One out of every ten adults is unemployed and it will only get worse before it turns around.
Unemployment will continue to move higher as businesses downsize in response to falling sales and constrained credit. We have at least eight more months of rising unemployment before it starts to turn around. The unemployment rate is a lagging indicator because businesses will not begin hiring until the economy is expanding and well into recovery.
The lag is usually significant as the charts of previous recessions show below. These graphs were compiled by JP Morgan Asset Management which allows their charts to be reproduced. The gray bars are recessions and the black lines show the market low. The green line is the total return of the S&P500 which increases from the market lows. It is interesting to look at the orange line representing the unemployment rate because it typically builds higher even after a recession is over and the markets have moved significantly off their lows. In many cases, unemployment remains high for months after a recession is over.

The recovery from this recession will be held back by weak consumer demand. The American consumer will not be rejuvenating the economy by borrowing and spending. In fact the consumer isn’t consuming. He has started saving again and paying off debt. Americans have recognized that they need to have a contingency plan in case they lose their jobs or ever want to retire. The current argument that the average taxpayer will spend their tax refunds is faulty. Most taxpayers will save their refunds in case their salaries or jobs are cut. After watching their portfolios self destruct and the equity in their homes disappear, the average American is not spending recklessly. For the first time in twenty years the personal savings rate is on the rise. Debt payments as a percentage of disposable income have begun to fall. The American consumer is scared of losing what they have worked so hard to achieve and is finally planning for that rainy day.

Emerging Market Recovery

2009-04-13T09:26:00.000-07:00

Stocks have now advanced around 35% from their lows in early March. The Dow and S&P indices are down only in the mid single-digits for the year while the Nasdaq is actually up 5%. I fully expect that we will give some of this back. It is normal for the markets to bounce around like this when the market is making a bottom. Volatility will remain high and the market bounces will be erratic and chaotic until the economy is clearly in recovery.

The emerging markets are beginning to come back to life especially China. The government’s massive stimulus program has helped China avoid sliding into a very severe recession. The Chinese economy is not hampered by many of the same problems plaguing the U.S. The state-dominated economy was able to successfully implement a massive stimulus program in November and without any delays started massive infrastructure projects. This has partially offset slumping export of Chinese goods. One note of caution, in order for China to have a sustained rally, demand for Chinese products from the rest of the world must begin to recover.

In addition, Chinese consumers are very thrifty and are not burdened with heavy debt unlike their western contemporaries. So Chinese consumers are unencumbered by large credit card bills, loans and/or mortgages and are starting to spend again.

The emerging market stock exchanges have moved up sharply maybe a little too sharply in recent weeks. The MSCI Emerging Market International ishares (EEM) are up almost 13% year-to-date. This recovery has been very rapid but the fundamentals do not support such a large swing. I would not be surprised if we gave some of this back.

The Chinese have historically been ravenous consumers of commodities. A rapid recovery could spark an increase in commodity prices and inflation. Currently, we are in a slightly deflationary environment but this could change if demand for commodities increased rapidly. It is difficult to tell if the rally in China and other emerging countries is sustainable. At least the panic is over and the global economy can begin to heal. As the recovery takes hold it will be important to closely monitor commodity prices for signs of inflation.

One Out of Every Ten Americans is on Food Stamps

2009-04-09T10:29:00.000-07:00

Our recent economic woes have hit everyone but it has impacted those with the least the most. Nothing brings home the plight of many Americans as recent the recently released government statistics on SNAP/Food Stamp participation. As of January one out of every ten Americans (32 million) is receiving food stamp assistance, the highest participation rate ever. How does this compare to the good times when the economy was humming along in 2000? Well, the number of people participating in Food Stamps in July was 16.8 million individuals, 15 million less than today.
As the economy has continued to weaken and unemployment has surged many households are in trouble. It has hit every region of the country with every state reporting a year-over-year increase in families requesting and receiving aid. The pain was not felt by just the families living in the Sunbelt states and the industrial heartland. In fact, you may be surprised by some of the states that have been hit the hardest.
Eleven states reported greater than 20% increases in their caseloads from the previous year. Idaho experienced the highest year-over-year increase surging 32% followed by Utah (29%), Florida (29%), Nevada (29%), Arizona (25%), Wisconsin (25%), Georgia (23%), Vermont (23%), Maryland (22%), Texas (22%) and Massachusetts (21%). Below is a chart prepared by Food Research and Action Center which shows by state the annual increase in Snap/Food Stamp participation.
The non-profit and private sectors food banks have been overwhelmed by the surge of people needing help. Many local food banks are struggling to stay open because contributions have dried up.
Granted that Food Stamp statistics are lagging indicators like the unemployment rate but it does show the pain that many Americans are experiencing. It will likely get worse so it is important for all of us to look around our own communities and help. Our lives are so busy that it is easy to miss that others need your help. So on this Christian holiday weekend make a donation (of time or money) to your local food bank or food pantry and help combat hunger.

Weekly Market Recap

2009-04-06T12:26:00.000-07:00

The U.S. markets rallied for their fourth week. We are now well up from the lows experienced in early March. Last week the S&P 500 rose 3.3% to 843 and the Nasdaq Composite advanced 5.0% to 1,622. Value stocks finally showed strength because the Financial Accounting Standards Board revised the mark-to-market rule giving bank stocks a boast. Value stocks however still lag growth stocks year-to-date. In fact, large to mid-cap growth stocks are now positive for the year.

Though the current rally has provided much needed relief, it does not mean the markets are only headed up. We have seen rallies galore since we started this ascent into hell last year. This is the fifth 10%-plus move we have seen in the past year and the previous rallies did not hold. For this rally to be sustainable the banks and the credit markets have to be functioning and stable.

The economy is still deteriorating. Last week, the official national unemployment rate reached 8.5% (an additional 660,000 jobs were lost in March). The real rate of unemployment is over 10% when you add in those that have been looking for a full time job for more than a year or those under employed (working part time but seeking full time). One out of every ten adults is unemployed and it will most probably only go get worse before it turns around.

This and other data suggest that the economy contracted in the first quarter by approximately 5%. Luckily some of the recent economic data related to housing sales, retail sales and consumer confidence is pointing to a moderation in the rate of decline. The Federal Reserve is also doing its best to pump money into the system and bolster up the banks. The economy is beginning to bottom out but the data is not pointing to a robust or steep US recovery. The economy will begin to stabilize the second half of the year but the going will be rough.

First Quarter 2009 Market Performance

2009-04-02T12:43:00.000-07:00

I was quoted in yesturdays Contra Costa Times article on the First Quarter Performance.

Hope you enjoy!

Area stocks outperform market indexes

The stocks of Bay Area and East Bay public companies out-performed their counterparts on the national stock markets during the first quarter — but only by falling less than the Dow Jones 30, S&P 500, and Nasdaq Composite.
By the time the January-March period ended on Tuesday, the East Bay 50 index had fallen 2.7 percent and the Bay Area 100 index was down 0.2 percent. The Dow Jones Industrial Average plunged 13.3 percent, the S&P 500 slid 11.7 percent, and the Nasdaq fell 3.1 percent.
Those three-month losses came despite a general upswing in the stock markets towards the end of the first quarter.
"We seem to have gained some traction in the stock markets in March," said Libby Mihalka, president of Altamont Capital, a Livermore-based financial planning firm. "But we're not out of the woods yet."
The big problem now is financial gremlins continue to haunt broad stretches of the nation's economic landscape. And that has spooked investors.
"Short-term, there are so many things that are unknown," said Royce Charney, president of Oakland-based Trust Administrators, a financial company. "You still have all the bank and financial institution issues, and now we're dealing with the auto industry. But for long-term investors, the market still looks attractive."
Charney defined the long-term
"The collapsing financial system and the problems with the auto companies are hurting consumer psychology the most," said Richard Welty, president of Lafayette-based Welty Capital Management.
Among industry sectors during the quarter, the best-performing national index was the Morgan Stanley Retail Index, which rose 6.3 percent. The weakest sector was the Bloomberg Real Estate Index, which lost 33.7 percent of its value.
The best-performing East Bay companies during the quarter were primarily in the high-tech and biotech industries:
 Novabay Pharmaceuticals jumped 188 percent. Emeryville-based Novabay said a deal it struck to develop and commercialize one of its dermatological compounds could produce $50 million in milestone payments for Novabay.
 Zhone Technologies soared 130 percent higher. Oakland-based Zhone lost money in its fourth quarter, but the loss was in line with expectations. The wireless communications also landed some key deals and moved forward with plans to serve the rural United States.
 Neurobiological Technologies was up 116 percent. The Emeryville-based biotech company said it would seek the sale of the company or its assets.
 Socket Mobile was up 79 percent. The Newark-based maker of mobile-computing devices reported record annual sales in 2008, although the company lost money during the year and the fourth quarter.
 SYNNEX Corp. jumped 74 percent. Fremont-based SYNNEX, a technology services company, announced fourth-quarter profits that beat analysts expectations by a wide margin.
Walnut Creek-based PMI Group was the worst-performing East Bay stock, falling 68 percent. The mortgage insurer reported a smaller fourth-quarter loss. PMI also was jolted by a downgrade by Fitch, which warned that PMI faces more losses and reduced liquidity.
Concord-based Pacer International fell 66 percent. The freight logistics company's fourth-quarter results fell short of estimates for earnings and revenues.
The best-performing Bay Area company was XTENT Inc., a Menlo Park medical devices company whose stock rocketed 367 percent higher. But the improvement may have been due to XTENT's disclosure during the quarter that it had hired an advisor to help it sell some core assets, sell the entire company, or seek a merger partner. XTENT also decided to eliminate 115 jobs, or 94 percent of its workforce.
Investors should be prepared to confront more volatility during the second quarter of this year, financial planners said.
And even after the volatility fades, and the economy starts to look better, it's still quite possible that a rebound won't produce much to cheer about.
"We're going into a slow-growth economy," Mihalka said. "Things will stay slow. And then we may have inflation.

Rally Not Sustainable Without Bank Recovery

2009-03-30T14:22:00.000-07:00

The U.S. stock markets rallied for a third week. The S&P 500 index was up 6.2% last week. Stocks have now rallied approximately 25% up from their lows of less than three weeks ago. The rally has pushed the S&P 500 index into single digit losses for the year (down 9%) and for a few days moved the Nasdaq briefly into positive territory until it fell on Friday.

The market loved all the positive economic news it received last week starting with the 5.1% increase in existing home sales followed by a 4.7% increase in new home sales. Durable goods orders rebounded 3.4% and consumer spending rose 0.2%. All these indicators came in at better-than-expected levels. These could be signs that the economic recession may be moving past its peak but it is still too early to tell.

The market also rose last week because investors enthusiastically embraced the Obama’s Administration bank recapitalization plan. The Treasury Department outlined the Public-Private Investment Plan (PPIP) which gives banks the means to remove toxic assets from their books freeing up capital to make new loans. This plan should help the banks and the credit markets to recover and begin lending. Nonetheless, these market rallies cannot be sustained over the long run until the banks are on sound footing. This is not to say that the success of the PPIP is guaranteed. There are numerous details and glitches that need to still be worked out if the PPIP is to be successful. There are, however, numerous reasons to be optimistic about the prospects of this program. The PPIP combined with all the government fiscal programs should eventually bring about a resolution to the credit crisis.

The recent rallies have been encouraging from a technical perspective. Trading volume has been increasing on upward moves and declining on pullbacks. This is crucial to building a bottom, but it creates painful volatility as the markets over shoot on the latest news. There is still much negative news out there, including high levels of unemployment, a very troubled auto industry and an extremely fragile financial system that could still be subject to negative shocks. A market like this will create exciting rallies and sickening declines. These market gyrations are an important part of the bottom building process as the market challenges asset pricing over and over again. So it is important for investors to keep a long term perspective despite the excessive level of volatility.

Forget the Sideshow: Just Resuscitate the Credit Markets

2009-03-23T15:20:00.000-07:00

For the second week in a row, equities managed to post a positive gain despite heavy profit-taking at the end of the week. The S&P 500 gained 1.6% to close at 769. From the early March lows the market is up 20%.

The big news is the Federal Reserve’s announcement to institute a program to buy $1 trillion worth of mortgage-backed and Treasury securities in an effort to boost economic growth. The market for mortgage-backed securities has been frozen for months. The Feds attempt to thaw this market has been well received. The move is designed to lower mortgage rates so many homeowners (that are not under water and have jobs) can refinance. This should increase homeowners' cash flow and reduce foreclosures. In addition, this may induce prospective buyers to begin purchasing homes, thus bolstering the battered housing market.

Unfortunately while the Fed is doing its best to prop up the markets, save the banks and jump start the economy, Washington is too busy with its own sideshows. This one comes complete with a freak show of politicians berating AIG bonus recipients. While the outrage engendered by these bonuses is understandable, the grandstanding and legislative response is not productive.

If this proposed tax on bonuses received by TARP recipients is enacted, it will surely hurt the Fed's efforts to prop up the banking system. The bonuses are egregious but it is more important to get the economy jump started than to pursue a witch hunt. Stabilizing the banks should be our first and last priority. If we cannot stabilize the banks the economy will get much worse and the credit markets will freeze up further. Stabilizing the banks and greasing the gears of the credit markets should remain the government’s focus, not sideshows and witch hunts. Punishing these bonus recipients isn’t necessary because in the end the markets will extract its own retribution in the form of reduced pay or no job at all. Sooner or later these kings of finance will find that their industry has changed and the pickings are slim to none.

I anticipate the markets will be a little choppy but the rally will continue at a slow pace. If you are not in the stock market, I highly recommend that you start dollar cost averaging back in.

Turnaround or Bounce? Look To The Banks

2009-03-17T10:31:00.000-07:00

Last week’s positive move in the stock market was overdue, but it is unclear whether this is the beginning of a turnaround or merely a bounce from oversold conditions. There is some evidence that market conditions are improving. Last week’s rally was broad-based and volume was heavy, which are strong technical factors. Additionally, lower-quality stocks have been outperforming, which typically happens as markets turn around. However, it is very possible that we are still bottoming-out.

There was good economic news last week. Retail sales figures were surprisingly positive. January’s data was revised to show that sales actually rose, and February’s numbers were down only slightly. All told, it appears possible that overall first-quarter retail sales growth will net out to around zero, a much better scenario than was widely anticipated only a few weeks ago.

Today more good news. An unexpected rise in housing starts and a more moderate increase in wholesale prices point toward a brighter economic outlook. Another plus, the market appears to have leveled off before the recently passed stimulus package has started to have any effect.

That said, the overall economic environment remains troubled, and as Federal Reserve Chairman Ben Bernanke said last week, “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort.” The banking system needs to stabilize before we see a full recovery.

Housing Prices Plunge in December

2009-02-24T09:50:00.000-08:00

The Case-Shiller index showed accelerating price declines in December. Every city experienced declines. Denver and Dallas held up the best declining approximately 4% in value from sales of existing homes in December of 2007. Sun Belt cities continued to post the worst declines with Las Vegas and Phoenix sliding 33% and 34%, respectively. San Francisco posted the worst monthly drop ever, a 31% decline. The rest of California fared no better with San Diego and Los Angeles both falling 25% and 25%, respectively.

The S&P/Case-Shiller home-price index is a closely watched gauge of U.S. home prices in 20 major metropolitan areas. The housing market will continue to deteriorate at least through the summer and probably through the rest of the year.

Deteriorating housing prices cause buyers to sit on the sidelines thus causing housing prices to fall further. This is a deflationary spiral that is hurting the economy. Consumer confidence dropped to an all time low of 25 in February. This is the lowest reading since the index's inception in 1967. This new reading shows consumers do not expect economic conditions (i.e. employment and business conditions) to improve in the next six months. In fact, 40% of respondents said they expect economic conditions to instead worsen. Under these conditions, few consumers are willing to buy a new home especially if they expect the housing market and economy to worsen. So the spiral continues …..

The only glimmer on the horizon is the new Obama housing stimulus plan. It is an elegant plan but it may not be enough. The plan is expected to help 9 million families refinance their mortgages to avoid foreclosure by using incentives and subsidies. Unfortunately, the plan is structured to offer the least help to homeowners in markets that have receded the most (the Sun Belt States, California, Florida and Michigan). It is a start and will help shore the housing market up in some parts of the country but it will not completely bolster the collapsing housing market.

Interactive Housing Market Graph Link

It is not likely that the economy will turn around in 2009.

Inflation, Deflation, Reflation or Stagflation???

2009-02-19T10:41:00.000-08:00

In the short term, the world’s economies will not have to worry about inflation. The drop in demand for goods and services is causing prices to actually drop. This disinflation will not last long since the supply is still constrained. As demand picks up again, especially in the emerging economies, inflationary forces will emerge. The U.S. government’s stimulus programs will actually add to the inflationary forces in the future. In the short term these forces will lead to reflation, which is the reappearance of a rising inflation rate. Reflation is not undesirable since a low level of inflation has always led to a stable economy. However, if reflation leads to high inflation (above 2%) then it is considered destructive to the general economy, and our Federal Reserve usually steps in to extinguish inflationary pressures. Except this time the Fed may not be able to combat inflation. (If it fights inflation then it causes growth to further stagnate; if the government encourages economic growth it sparks rising inflation).
Inflation is usually driven by strong economic growth. As we discussed before, it is unlikely that we will experience a high growth rate for quite a few years. But inflation can occur during periods of stagnant growth if there are constraints on supplies. We are facing numerous future constraints. Our growing trade deficit, aging population, rising cost of labor around the world, and supply-constrained commodities are all contributors to inflation. Inflation with stagnant growth is called stagflation and it looks like this is where we are heading in the long run (probably a year from now). Stagflation requires a completely different investment mindset. For instance, in a world prone to inflation and slow growth, fixed rate securities like Treasuries are really not “risk free” or safe since a rising inflation rate can eat up the wipe out any real return.
Since the early 1980’s inflation, also known as the Consumer Price Index or CPI, has been steadily falling in virtually every economy from double digits down to 2% (see chart below). So inflation has not been a factor on which investors have had to focus. As inflationary pressures reappear, it will become important to reach back to the investment strategies that worked thirty years ago and update them to meet the changing securities markets. For instance, strategies that emphasize inflation-linked bonds and commodities will probably do well in this environment while stocks may under perform.
In the near term, we will be experiencing reflationary pressures coupled with a stagnant or low growth economy. In this environment, high quality corporate bonds and municipal bonds will perform the best when mixed with stocks and the slow introduction of inflation-linked securities. Commodities in the near term will not perform well but will shine when inflation takes off. Your portfolio rebalancing recommendations will reflect the realities of this new investment landscape. Please review your rebalancing recommendations and return them to us as soon as possible.
The new administration certainly has an amazing number of wild fires to deal with. It will be impossible for them to put them all out and put things to right quickly. It will take massive government intervention in the form of both tax cuts and spending on infrastructure to stop the consequences of the sudden de-leveraging of financial markets, consumers and businesses. This will be a protracted recovery. Over the last few weeks the credit markets have begun to thaw. High quality corporate and municipal bonds will recover first as yield spreads to Treasuries narrow. The stock market will hold steady and may begin to slowly recover in late 2009 but will face massive head winds in the near term.
It is important to adjust to the economic headwinds we face and shift your portfolio to reap any strategic advantage the markets offer. The markets always recover in the long term but each time it is different. The key is not to panic. Instead, focus on identifying these differences and shift your portfolio to take advantage of them. Hiding in Treasuries will not repair your portfolio but may in fact garner you further losses. Short term volatility always yields opportunities if you know where to look.

Is Your Financial Advisor A Smooth Talking Con Artist?

2009-02-17T15:56:00.000-08:00

Both the Stanford and Madoff scams have something in common. These advisors used simple techniques to separate investors from their money by promising high returns and no risk (greed). If something is too good to be true - Well It Is!!!!!!!

So here are the warning signs:

If you receive statements from only your Advisor's firm you could be in trouble. An Advisor should custodian your funds at a separate and independent company. I custodian my client's portfolios at Charles Schwab & Co. The client receives a separate statement directly from Schwab verifying their holdings. Madoff would never have been able to steal his client's money if custody of the funds had been held at another firm. Many advisers avoided the Madoff ponzi scheme because when they asked simple questions. When they found out that Madoff managed funds were not held by an independent third party brokerage firm they didn't invest. Never hand over custodian ship of your portfolio to your advisor.

If your advisor has you write a check or transfer your assets to them, you are probably never going to see your money again. I know I said it before but Never hand over custodianship to your advisor. The check should be made out to your custodian (i.e. Schwab, Vanguard, Fidelity).

Be wary of the promise of unreasonably high return with virtually no risk. There is no such thing as a free ride. This tripped up both the Madoff and Stanford investors. Stanford promised huge returns on risk less CDs. In addition, most investors assume that all CDs are FDIC insured up to $250,000. They are not. An advisor may say or promise that their CDs are insured or guaranteed but by whom? If ii is not FDIC insured don't invest. Be sure to ask alot of questions.

Do Not Invest in Anything You Do Not Understand. If your advisor can't explain it to you simply then they do not understand it or they are trying to take your money. Bottom line, it is your money so there is no such thing as a simple or stupid question. If your advisor becomes annoyed then find a new one. Do not invest in a fancy catch phrases (Stanford Investment Model or SIM) or a black box (Madoff's supposedly winner options trading strategy).

Finally, Listen to your gut. If you are uncomfortable and feel under pressure to sign with an advisor, then leave. It is alright to look foolish. In fact, it might be the smartest thing you have ever done. If after additional research and thought you change your mind, I guarantee that the advisor will still be happy to help you with your portfolio.

A smooth talking con artist is always happy to separate you from your money so stay alert!

The Economy Ain’t Hummin’ Along

2009-02-12T10:31:00.000-08:00

Banks, consumers and businesses are rapidly deleveraging. The process was so abrupt that it was though someone slammed the brakes on the global economy. (Please note if you cannot read a graph or insert double click on it and it will appear larger and less fuzzy on your computer). First, the housing market began to deleverage in 2006 sparking the financial sector to begin to deleverage in 2007 causing the consumer to deleverage in 2008 and in September the rest of the world followed. When so much liquidity is pulled from the markets and economy so rapidly the dislocations and shock waves are massive. Now only one entity is large enough to get the economy moving again, the U.S. government. The government is now moving forward rapidly to stimulate the economy as unemployment soars and economic growth stalls.
The unemployment rate is approaching the levels reached in the early 1980s. Given the recent severe declines in retail sales, business spending and employment, it is highly unlikely that the economy will improve anytime soon. It is clear that the job market will continue to deteriorate for most of 2009. It is entirely possible that we will reach the levels of unemployment experienced in 1982. Even if the much-needed stimulus bill passes soon, the economy is likely to end 2009 in roughly as bad a shape as 1982.

Currently, the unemployment rate was 7.6% in December 2008 if you include discouraged workers. In addition, another 5.2% of the labor force was involuntarily working part time. Combined the rate approaches 13%. However, this still understates the unemployment rate, because the Labor Department’s definition of discouraged workers is too narrow. If everyone looking for a full time job were counted, the rate could reach over 14%. It is estimated that unemployment reached over 30% during the Great Depression and it is doubtful we would approach this level given the size of the government’s proposed stimulus package. It is possible that we could come close to the 1982 peak rate of unemployment of 16%.
Almost half of the current work force is too young to have any real memory of how tough it was to navigate through the early 1980s recession. They only remember the mild recessions of 1990-91 and 2001. Many are unprepared for layoffs and tough times. It is a generation that spends and does not save, a generation that has systematically borrowed from future income to finance today’s wants. Now the bill has just come due and the delinquency rates on Consumer Loans and Residential mortgages are climbing rapidly. Consumers are leveraged to the hilt, and as they lose their jobs they begin to default on their car, home and credit card debt. There is no buffer, no savings since they have not prepared for the end of the leveraging party.

How to Read Your Federal Tax Return

2009-02-09T07:58:00.000-08:00

Your Federal tax return is difficult to understand. The first two pages called Form 1040 summarizes all your information. The New York Times has put together a great interactive version of this form together. It is worth a few minutes of your time to run through your tax return. Afterall, it is one of the largest bills you pay!

NYT Interactive: Walk Through your Federal Tax Return

The Economy is Still Deteriorating, But What Will the Markets Do?

2009-02-07T13:33:00.000-08:00

It is official; government economists have declared that we have been in a recession for over a year. Of course anyone living in the real world knew we were in a recession long before economists and the government officials. What started off as a housing market crisis morphed into a credit crisis morphed into a global market meltdown and finally caused the demise of the banking system as we knew it.
So we now have been through two bubbles (dot com and housing). I call them the twin peaks, or the Grand Tetons of the stock market (see chart below). Bubbles are always obvious in hindsight, after they burst. If you look at the stock market before the twin bubbles (pre-1995) and extrapolate forward at a more reasonable growth rate, maybe the current level of the market is not far from where it would have been if we had just experienced reasonable consistent growth.
The market and economy tend to swing like a pendulum. If the market swings go too far up then it must over-correct with equal force in the opposite direction. Corrections are usually just as severe as bubbles were frothy. So the recovery from the twin peaks bubble will not be a quick V-shaped one as many are hoping. This is going to take a long time and is not a normal cyclical recession. This recovery will necessitate the complete restructuring of our financial system.
It will take years to resuscitate the U.S. economy and 2009 will be terrible from an economic perspective. It is also clear that when we do recover our economy and banking system will be transformed. It has already begun with a string of bank consolidations and some bankruptcies. In order to keep the banks solvent, the U.S. government is being forced into taking large equity stakes in all the major money center banks just to keep them afloat. It is obvious that the banks need to find a new business model and ominously it will not be as profitable as it was before.
The government will insist on new regulations that will keep the financial institutions from assuming such substantial risk. In fact, the government will want the banks to adopt a business model not unlike that of a utility company because it has become clear that the economy cannot accommodate the failure of our largest financial institutions. The impact on our economy will be immense. Since the 1980s, the financial sector has driven the economy. It called the shots and became larger than the manufacturing sector. In fact it, told manufacturing and every other sector of the economy what to do. Our whole economy will now have to restructure and our growth rate will be lower as a result.
Our government’s response to the crisis has been to throw money at our financial institutions in the hopes of dousing the fire. As with any emergency action there will be unintended consequences. Instead of water and foam being dispersed everywhere to douse the fire, the Federal Reserve and Treasury are using cash. Some institutions will survive that should have been left to wither and others will fail though they deserved to survive. Government support is always inefficient, but in this case there was no alternative. To not have acted would have led to the complete failure of the banking system and our economy.
The government is now shifting its response to the credit crunch. The banking system is too damaged to recover quickly. So the Treasury will change gears and begin to purchase broad asset classes and in some instances extend further guarantees. The Federal Reserve and Treasury will also have to implement additional strategies to inject the needed liquidity to businesses and consumers and bypass the banking system. These actions change the investment landscape and shift our near term investment strategy to focus on assets the government is supporting. In this environment bonds are preferable to equities (stocks). So unlike most recessions, equities will not lead the way out of this morass. So unlike almost every bear market of the past 50 years, buying stocks after more than a 20% decline might not be the best move this time around.
At current levels stocks may look like a bargain, but are they? It depends on which metrics you use and a stock’s promise. The promise of a stock is its ability to meet or exceed its current projected earnings. The measure frequently quoted is Price to Earnings ratio, which compares the price of a stock to its trailing (last period’s) or forecasted (estimated future) earnings per share. Investors focus on future performance and therefore use forward earnings to calculate the price to earnings ratio. Trailing earnings are used to assess the reasonableness of future earnings. Unfortunately, it is tough to assess value or estimate future earnings in a volatile market. Using trailing earnings (earnings from last year) causes the Price to Earnings ratio of stocks to seem cheap (see chart). However, earnings are falling, rendering trailing earnings an un-realistic gauge of current value.

The problem is that Wall Street is still too optimistic about earnings even though expectations for the future quarters have eroded quickly. On Oct. 1, according to Thomson Financial, the Wall Street consensus was that S&P 500 earnings would rise a whopping 47% from the fourth quarter of 2007. Now, analysts think earnings actually fell 23% from a year ago. If their new forecast is correct, earnings will have fallen for six quarters in a row, the worst stretch on record. But analysts are still gung-ho about the future. Analysts expect S&P 500 earnings to be roughly flat this year, according to Thomson, but post a 33% year-over-year rebound in the fourth quarter. These forecasts depend on a quick economic recovery, which is unlikely to occur. Most economists expect something more sluggish at best.
Equity analysts tend to always be too bullish about the economy. Since the earnings slump began in 2007, analysts have consistently held high hopes for profits a year out, while busily cutting forecasts for the quarters immediately at hand. The pattern seems to be continuing in 2009. The bottom line is that at current levels the stock market has already priced in a 30% decline in earnings. So even though analysts can’t face the truth, the market already has. Are stocks cheap? Many metrics suggest that stocks should at least provide satisfactory returns going forward and possibly something better, but owning the stocks that can deliver on their future earnings promise is the key.

What You Need to Know About the New Credit Score Calculation

2009-02-06T10:40:00.001-08:00

Here is a great article by the New York Times regarding your credit scores. After you have read this article please hit the second link below and check your FICO score.

NYT Article Regarding Credit Scores

Check Your Credit Score

Fighting Recessions

2009-01-29T15:24:00.000-08:00

Since the Great Depression, presidents have tried many methods to fight recessions. Three economists explain what worked and what didn’t.

http://www.nytimes.com/interactive/2009/01/26/business/economy/20090126-recessions-graphic.html

Risk Management

2009-01-12T11:51:00.000-08:00

Here is an excellent NYT article that describes how Wall Street failed to adequately mange risk. It's a prime example of how models and statistics can be mis-used. It was human folly. The article shows how investment banking and insurance company managers ignored the coming storm signals and blindly followed a quantitative model and how this led to the financial meltdown. It was the equivalent of flying an airplane looking at only two instrument panels on the dash board and never scanning the horizon or factoring the short comings of instruments that you are using. In short a model is only as good as the person using it.

http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?scp=1&sq=risk%20management&st=cse

Happy reading!

End of An Era

2008-11-06T10:58:00.000-08:00

One minute I held the key
Next the walls were closed on me
And I discovered my castles stand
Upon pillars of salt and pillars of sand
Coldplay

Everyone ought to bear patiently the results of his own conduct.
Shakespeare

It has been over two months of financial turmoil. For over 25 years I have been studying banks, monetary policy, credit markets and financial crises. So following these events for me has been fascinating and appalling. I have been saying in my newsletters and presentations for well over a year that we were facing serious problems. I have ranted and raved that risk wasn’t priced into the market, how the misuse of derivatives was going to lead to trouble and that unless the U.S. housing market was resuscitated that things were going to keep getting worse. I just didn’t think that it would mutate to such an extreme outcome. Things are moving so fast that I will not be able to talk about everything that has happened. I will try to hit the main highlights of the last seven weeks. It is like watching dominoes fall knocking each other haphazardly. It has been unclear what impact each falling domino would have on other dominoes. I will try to walk you through the chain of falling dominoes and what the impacts have been.

As we have previously discussed, financial institutions had taken huge bets using derivatives which were not properly reflected on their balance sheets or understood by management. These derivatives amplified the impact of the collapsing housing market. It was as though an atomic bomb was detonated in the credit markets flattening many institutions in its wake.

This current episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8th in response to the failing housing markets and shriveling of the credit markets. The combined assets of Fannie and Freddie are over $5 trillion. These entities had been set up to support the housing market. Their job was to help guarantee most of the mortgages in the United States (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this rarely occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities, and snapped it up eagerly.

Fannie and Freddie were weakly supervised, and strayed from their core mission. They began using their subsidized financing to buy mortgage-backed securities, which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government wiped out shareholders both preferred and common shares), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed. The opposite has happened. The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

It is now clear that the government should not have wiped out the preferred shareholders. These shares were extensively held by financial institutions, foundations, school districts, and municipalities and were seen as ultra safe. The impact was percussive and reverberated through the market. It has taken weeks to see the full impact, but it is clear now that this was one of the reasons the credit markets completely seized up.

The following Monday the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.) Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. This may sound like a crazy way to run a business, but this is how all the investment banks were operating financing long term needs with short term debt.

Basically, when it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line. This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and/or by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

The failure of Lehman rippled through the market causing havoc. Its assets were sold in a chaotic fashion, causing stable assets to plummet in value. Lehman’s business units that made markets for many bonds and derivatives were not operating. The results were disastrous. First, the short term commercial paper market froze, which then caused some money market funds to fail (or they broke the buck). Banks stopped lending to other banks and started to hoard cash. The blood (cash) was no longer circulating and the patient (economy) went into cardiac arrest. In retrospect, allowing Lehman to fail was the worst mistake the U.S. government made. A plan to liquidate Lehman in a controlled way would have avoided much of the turmoil that followed. From this point on, fear escalated and the herd began to stampede for the exits.

The next day (Sept 16th), the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world with over $1 trillion of assets and over 100,000 employees worldwide. The loan is for two years at 850 basis points (8.5%) over Libor (the rate that banks in Europe lend to each other). The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday, Sept. 15th. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world - nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely. In addition, other large healthy financial firms had guaranteed A.I.G.’s bonds by writing C.D.S. contracts. A failure by A.I.G. would have taken some of these institutions down. Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion. Since then A.I.G. has had to borrow even more from the government to stay afloat. Its board of directors is analyzing which divisions to sell off first to start repaying the loans.

Then Merrill sold itself to Bank of America. This is the type acquisition that would normally take months to negotiate. Instead, it was thrown together over one weekend. Merrill Lynch knew it could not weather the storm created by Lehman’s failure. B of A has always wanted to own Merrill Lynch’s retail brokerage business. Merrill knew that if it did not find safe harbor (a willing buyer) before Monday morning, that it would be dead before the end of the week. So it was a shot-gun wedding. Now the dominoes fall even faster.

By Wednesday the credit markets (this is where bonds are bought and sold and funds are lent from one firm to another) has ceased to function. Investors fled the credit markets and ran to Treasuries. The price was bid up so high on Treasuries that they had no yield and investors were paying the government to hold their money for free (see chart). On the flip side, the cost of borrowing for companies soared. This stunning flight to safety started to cause serious damage to an already compromised economy. The last remaining large Wall Street firms, Goldman Sachs and Morgan Stanley, which just weeks before were considered relatively strong, came under assault. Their stock prices plummeted and no one would loan them money. Remember how devastating this was for Lehman.

Now it’s Thursday, and the Treasury and Federal Reserve begin discussions on what would become the largest financial bailout in U.S. history. The plan was to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions. The program would be run by the Treasury and use $700 billion of taxpayer’s money to fund the program. The goal was to inject liquidity into the banking system and jump start the market in the mortgage-backed-bond market back to life. The markets rallied on the news. Discussions between Congress, the Treasury and the Federal Reserve continued through the weekend on TARP (Troubled Asset Relief Program). Everyone assumed Congress would pass the bill on Monday. Congress did vote on Monday but failed to approve the bill. Fear gripped the markets resulting in the worst one day decline in the U.S. stock markets in two decades. Congress did not pass the bill because many representatives do not understand the financial markets. They saw this as a bailout of greedy investment bankers. Over a week later, the Senate passed the bill followed by Congress but the administration had to compromise on several fronts, such as pay caps for executives. The delay caused more market turmoil and the markets fell further.

In the meantime, the last two independent investment banks on Wall St., Goldman Sachs and Merrill Lynch, transformed themselves into bank holding companies. Now they will be subject to greater regulation. Instead of reporting to the relatively “hands-off” SEC, Goldman and Morgan Stanley will have much closer supervision by bank examiners from several government agencies. The firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking. In exchange, the firms get access to the Federal Reserve’s lending facilities, which should help them avoid the fate of Lehman Bros.

As officials in Washington were still negotiating TARP, Washington Mutual was seized by the FDIC and sold to JPMorgan Chase. The FDIC then pressured the weakened Wachovia into a deal with Citigroup. Four days later Wells Fargo made a richer offer for Wachovia and the legal wrangling started. In the end they decided to split the baby in half so Citicorp and Wells Fargo split Wachovia. Throughout the turmoil the FDIC has done a tremendous job of handling failing banks so there is as little turmoil in the financial system for consumers and businesses as possible.

During the week, the crisis became increasingly global. Many financial institutions and banks overseas had purchased some of our more toxic securities and derivatives. In addition, these firms had adopted the Wall Street model of high leverage and imprudent use of derivatives. They had also extended risky real estate loans in their own countries. In Europe, the week was punctuated with one state intervention after another to rescue faltering banks in Germany, Belgium, the Netherlands and Britain.

Over the weekend of Oct. 4th many of the leaders of the European Union met to try to come up with a coordinated effort, but failed. Separately, the German government said on Sunday that it would guarantee all private savings accounts in the country in an effort to reinforce increasingly shaky confidence in the financial system. The rest of the European nations followed suit on Monday. If they had not guaranteed deposits each country faced a run on their banks. European leaders still could not agree on any coordinated response to the crisis, leaving the markets in disarray. Further away in Iceland, the country’s financial system completely collapsed. The government intervened and now owns all five of Iceland’s banks. The cost of intervention in Iceland was greater than the country’s annual GDP (value of all goods and services produced in a year). The European stock markets fell precipitously.

On the same day, emerging markets took one of their biggest collective tumbles in a decade as stock markets from Mexico to Indonesia to Russia were gripped by fears of a collapse of Europe’s banking system, and concern that a global recession could drag down the price of commodities, forcing a steep slowdown in emerging-market growth. Many of the world’s fastest-growing economies thought they had insulated themselves from problems in the developed world. But economists said that simultaneous turmoil in Europe and the United States was too much for these markets to bear.

On Tuesday, Britain and Spain moved to shore up their failing banks. The violent fallout in the housing market in both countries was causing their banks to fail. Both countries stepped up to inject liquidity into the system.

At this point the markets fell further. The technical term for it is “negative feedback loop.” I just call it a panic. The Federal Reserve and European Union announced a coordinated interest rate cut. In response stocks ignored the good news and declined again. Credit markets remained frozen, with banks still hoarding cash. These declines were free falls caused by very low trading volume. The price of stocks was declining on very few trades. So there are only a few panicky sellers that are willing to sell at any price to a few brave buyers while the majority of investors sat on the sidelines watching the carnage. Once the madness starts it is difficult to stop. The market falls out of fear like a freight train and no one wants to get in front of it.

What finally calmed the markets was a direct injection of capital by the Treasury into nine of the nation’s top banks. In other words, the government is guaranteeing the basic plumbing of the financial markets. Treasury Secretary Paulson asked the nation’s top bank executives to a meeting in Washington on Monday October 13th. At 3PM Treasury Secretary Henry Paulson, flanked by Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair welcomed the executives to one of the most important bank gatherings in history.

For an hour, the nine executives listened to the Paulson and Bernanke paint a dire portrait of the U.S. economy and the unfolding financial crisis and how the government intended to buy a stake in each of their firms. Each banker was handed a term sheet detailing how the government would take stakes valued at a combined $125 billion in their banks in the form of preferred stock, and impose new restrictions on executive pay and dividend policies. The participants, among the nation's best deal makers, were in a peculiar position: they weren't allowed to negotiate. Mr. Paulson requested that each of them sign the deal and described it starkly. He told them that they could accept the government's money or risk going without the infusion. If their companies found they needed capital later and couldn't raise money privately, Mr. Paulson promised the government wouldn't be so generous the second time around. Paulson argued the plan represented a good deal for the banks: The government would be buying preferred shares, and thus wouldn't dilute their common shareholders. And the banks would pay a relatively modest 5% in annual dividend payments. Each bank was asked to participate so that no bank would look weak by accepting the capital infusion. The meeting ended at about 4 p.m. By 6:30 p.m., all of the sheets had been turned in and signed by the CEOs.

The magnitude of the infusion into the banking system calmed the stock markets and allowed the credit markets to thaw. Banks have begun lending to other banks and businesses again. The panic and fear that had gripped the markets has abated, but the de-leveraging process is now reverberating through the Main Street economy.

Umbrellas, Dinosaurs and the U.S. Financial System

2008-09-16T14:50:00.000-07:00

“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it rains.”
Bradley’s Bromide

It is storming in the financial markets and the banks want their umbrellas back and in some cases are they are then closing their doors. This is the complete restructuring of the U.S. financial system and everyone is hoarding umbrellas.

Sunday night was surreal. I was folding laundry and watching a Discovery Channel program about the lives and extinction of dinosaurs with my family. During ads I was allowed to switch the channel to the financial stations (CNBC) and hear about the extinction of the U.S. Investment Banks. In my 30 years in the financial industry I have seen restructures, consolidation and failures before but this was a mass extinction. On Sunday it somehow seemed apropos to be learning about the extinction of both dinosaurs and investment banks.

Someday I may be telling my children the story of the five investment banks that like the three little pigs built their homes of sticks and straw. Only in this case none of the five investment banks built a house of bricks. So no one was saved from the big bad wolf.

Why is this such a significant event that the press is now calling it Black Sunday? The failure of our banking system is the equivalent of a heart attack for the U.S. markets. It will take a complete heart transplant to revitalize our capital system. The flow of credit is the blood that keeps our economy humming. When banks fail, lending contracts, business can’t grow and the economy contracts. What might save us this time is the globalization of the banking system that has occurred over the last 15 years. We no longer supply the entire world’s capital needs. In fact, the funds used to prop up most of the financial system this year has come from Europe and the Emerging Markets.

It is this new global banking system that will help to resuscitate us. Our financial system will emerge more humble and more conservative (not as leveraged). We will re-emerge but gone will be the high flying dare devil acts that were so common on the street. Profit margins and growth rates for financial stocks will be much lower than the steroid pumped returns we had grown use to. Our stature in the world as financial power will shrink as well. Our economy will be contending with the fallout from this implosion for years to come. The good news is that we are dealing with our problems unlike the Japanese that just left their banks on life support and never operated.

In the long run our economy will be fine. It is important to view your investments as long run commitments. Would you buy a house and then a few days later sell it in a panic? No, so why would you treat your portfolio that way? In the short run the markets will continue to be down right frightening. Volatility is at a thirty year high. This is exactly the wrong time to be selling. In fact, this is the point when you start buying. No one can call the market bottom, so this is the time when smart investors start cherry picking.

Is your Money FDIC Insured?

2008-08-15T09:24:00.000-07:00

Three banks failed last month and some 90 more are on regulators' troubled list. Could you lose your deposits if your bank fails? Yes, you can even if you are covered by FDIC insurance. The reason, depositors don't realize that they have to obey all the FDIC's rules.

In general, you'll be O.K. if you have less than $100,000 in any one bank and up to $200,000 in joint accounts. Some retirement accounts may be covered up to $250,000 as long as they are not brokerage accounts. But just to be sure, go to the FDIC's web site shown below and plug in your account information into its calculator, the electronic deposit insurance estimator. If that exercise informs you that some of your money lacks insurance, the first step is to try changing your accounts' ownership status. For example, by titling one account in your name, one in your spouse's name and one jointly, you can insure as much as $400,000 in deposits at that one bank.

FDIC Calculator

Or you can spread your money among banks and insure an unlimited total amount, as long as you keep under the limits discussed above for each institution.

If you have so much in the bank that this seems like a lot of trouble, check out the certificate of deposit account registry service, known by its acronym CDARS. It lets you keep up to $50 million in CDs with one home bank. That bank then parcels out your holdings among other banks, so that you stay fully insured. Interest rates will be lower than you could get on your own, but then again you won't lose your money if your financial institution fails. Check out the website for more information on CDARS.

CDARS

Investment Discipline

2008-07-22T17:28:00.000-07:00

“History is merely a list of surprises. It can only prepare us to be surprised yet again.”
Kurt Vonnegut
Having experienced a multitude of market crises, I realize that history never repeats itself exactly, so I’d be arrogant not to admit that almost anything can happen from here. It is a distinct possibility that things will get worse before they get better in the stock market. Even if the economy holds up, fear and pessimism could cause of investors to panic and send the market down further than justified by long-term economic fundamentals.

At times like this, it is essential to have a sense of perspective and rely on sound long-term investment disciplines when making decisions. It is important to avoid panicking because of short-term market concerns and uncertainty. It is easy to put too much weight on negative scenarios when all you hear is bad. Inevitably, investors always flee the stock market at just the most inopportune moment, when the tremendous bargain basement deals are obtainable. I love the chart above because it shows how the average equity investor underperforms the markets. He has only earned 4.5% per year over the last twenty years due to emotional trading. Over the same 20 year period, the S&P 500 domestic stock index earned 11.9% per year and the bond market earned 7.9%. The average equity investor missed out on these returns by fleeing the market at the low and re-entering when it has already recovered. Dalbar Inc. calculated the average investor’s performance using net aggregate mutual fund sales, redemptions and exchanges by month for twenty years.
Bubbles lead investors to make errors in judgment, thereby mispricing assets on the way up. Investors do not understand the risks they are taking and what could happen. On the flip side, riskier assets often fall to bargain prices on the way down when investors are frightened. The risks become clear: investors panic when losses start to accumulate and flee the market. This pattern of overzealousness-followed-by-panic repeats throughout the history of mankind.
While the perspective gained from years of experience is useful, humbleness is just as important. It is crucial to always be open to market signals and stay intellectually honest about factors you can and cannot assess. Or else you will miss when the market is warning you that it isn’t the normal boom-bust cycle but a full scale melt down. I spend hours assessing risk, global economies and investment markets. I try to communicate what I have learned to you through my blog, newsletters, phone calls and meetings. At this point, this is a normal bear market. Fleeing the markets now would be a big mistake since stocks are priced to outperform bonds over the next five-years. Second, big market downturns invariably present opportunities - you just have to have conviction.
Since 1946, there have been nine bear market declines of 20% or more. The average drop was 32.5% over 14 months. The average bull-run lasted 70 months, with average returns over 185%. While this does not guarantee future results, it certainly provides food for thought. With major indices down about 20% from their October 2007 peaks, it would not be surprising to see the markets fall another 10%, at least from the perspective of history. Many traders are now referring to 2008 as the Year of Capitulation.
It has been a tough first half, and even some legendary money managers have taken a hit. GuruFocus.com follows the trades of legendary money managers and keeps track of their results over 6-month and 12- month time periods. If you think your portfolios performance has been dismal, you may take some consolation in seeing how many Managers of the Year and other top-notch investors have been (Marty Whitman down 43%). Even Warren Buffett is now in negative territory for both the 6 and 12-month periods just ended. Warren has a great perspective on market down turns. He said at his recent shareholder meeting, “If a stock [I own] goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all my stocks to go down 50% over the next month.” Mr. Buffett wants the price to decline so he can buy more cheaply. I wouldn't bet against any of these guys rebounding in a big way once the market picks up in the future.

Week in Review

2008-07-21T14:06:00.000-07:00

As a result of good news last week, stocks were able to break their multi week losing streak. A combination of stronger than expected earnings announcements, introduction of the governement's plan to save Fannie Mae and Freddie Mac, short covering and outright buying in the financial sector and a sharp correction in oil prices. The S&P 500 rose 1.7% to 1,261, the Nasdaq climbed 2% to 2,283 and the DJIA increased 3.6% to 3.6% to close at 11,497. Financial stocks led the way, advancing over 11% while energy, utilities and materials all declined. Inflation worries still pursist but falling oil prices will add some stability to the stock and credit markets.

Bonds - Why do we own them?

2008-07-21T07:42:00.000-07:00

Bonds are worth owning. Yes, the credit markets are a mess and bonds did fall in value during the Second Quarter 2008 but bonds offer stability. Bonds are much less volatile then commodities, stocks and residential real estate. See the adjacent chart. Bonds have a standard deviation of only 1.1% while oil's is over 9%. Standard deviation measures how scattered the returns are from the average. The more variation the higher the standard deviation. The down side is bonds earn less than stocks. So even though stocks are more risky in the long run they generate a higher return.

I view bonds as an insurance policy. How much long term return do you want to give up to gain stability? You are essentially buying an insurance policy for your portfolio the way you would for your home. In the case of property insurance, the question is how much current income are you willing to spend to protect you home from a catastrophic event. You are never going to make as much money invested in bonds instead of stocks. So how much do you need to invest in bonds to protect your portfolio from a catastrophic event? That depends on whether you need the money now or are years away from retirement. It depends on how well you can handle short term market swings. It depends on how much money you have and how much money you'll need and when. So the answer is it depends on your needs and your money personality. In other words, there is no magic formula. So it is important to carefully address all these issues when determining your allocation to bonds.

Short Selling

2008-07-18T10:13:00.000-07:00

In order to bring more stability to the stock market the SEC acted this week to retrict naked short selling. Here are three good stories on NPR (National Public Radio) that discuss who, what and why of it all.

Short-selling-profiting-from others misery

What-is-naked-short-selling

SEC Cracks down on naked short selling