Warren Ward Associates

Beware of Greeks bearing...

The Dow Jones Industrial Average briefly fell below 10,000 in February of 2010. Most commentators blamed the drop on the potential default by the Greek government on its “sovereign debt”, i.e. its government bonds. A bit later, Germany (and more reluctantly, France) committed to help their economically weaker Euro-zone neighbor and global markets rebounded.

Higher interest rates are the price issuers pay for falling credit quality. Investors apparently assumed that any additional risk with Greece’s bonds was being compensated for through higher interest rates. This situation is quite similar to the credit bubble which caused the current US recession. In our case, unusually high rates of return were offered on what were described as investment grade bonds but in neither case did the rating agencies do a good job of assessing risk. Donald MacKenzie, Ph.D. from the University of Edinburgh has published an interesting paper in which he considers the recent credit crisis as a problem in Sociology. Here’s a chart excerpted from it (page 92 of PDF), comparing the anticipated bond default rates in the US mortgage financing market with the actual results. As you can see, the best estimate the agencies made was off by a factor of more than 10, the worst by a factor of over 300.

The rating agencies provided little or no warning of Greece’s credit problems although they did scurry to downgrade those bonds after the bad news came out. Speaking strictly for myself, I’d prefer that a rating agency be ahead of the curve, not behind it. However, these agencies are paid by the issuers of the bonds, so perhaps we shouldn’t be surprised that they tend to be a bit generous in their ratings.

In the fall of 2009, you could look anywhere in the financial press and find an article about the weakness of the dollar and the idea that it might lose its status as the world’s reserve currency. That concept ran counter to our thinking at Warren Ward Associates. We believe that currencies, just like market sectors, tend to move within ranges. With that in mind, it was our expectation that the dollar would strengthen again and that its position as the world’s favorite currency was never in serious jeopardy. Based on that premise, we oriented our clients’ portfolios to prepare for that outcome and were rewarded for doing so.

Did we anticipate the problems in the Greek bond market? No, we absolutely did not. However we did anticipate that something would happen and we find that most somethings can be hedged against.

According to Virgil’s Aeneid, a huge hollow horse was employed by the Greeks to sneak 30 soldiers into the city of Troy. Perhaps its best known line, uttered when the horse was discovered outside the city’s gates, is: “I fear Greeks, even those bearing gifts”. Lower quality bonds can be a gift when an investor understands the underlying credit situation and is fairly compensated for assuming the additional risk. However, being blindsided by a wholesale misreading of the risks or an issuer who simply does not tell the truth, affirms the need for diversification regardless of the asset category.

Pollywogs and Shellbacks

As far back as the early 1800’s, sailors who crossed the equator for the first time were “initiated into the court of King Neptune” via a ceremony that typically involved at least one of head-shaving, fish-kissing and the eating of raw eggs. It seems like a lot of trouble to go to, celebrating the crossing of a “line” which separates one bit of ocean from an identical one a few feet away. Fortunately, the hazing aspect of the ritual has generally fallen out of favor in recent times, although equatorial crossings continue to be acknowledged in most navies and by many cruise lines.

We also have what are basically meaningless “lines” in the investment world. Recent headlines about the Dow Jones Industrial Average crossing through 10,000 (either way) make it seem as if either those thirty stocks or the number ten thousand have unusual significance.

When Charles Dow created the index in 1896, he felt that charting the fortunes of twelve large industrial companies might be an appropriate way to gauge the overall health of an economy just coming into its own. Later, various editors of the publications he founded made substitutions and additions to the list. It is now comprised of thirty large companies, some clearly industrial (Caterpillar) and others not so much (Walt Disney). Since first moving above the 10,000 mark in March of 1999, the DJIA has re-crossed it a couple of dozen times as the markets lost and gained strength. In early 2010, after flirting with 10,000 for a couple of days, the average dropped back through on February 4th, earning headlines across the country. It moved above 10,000 again the very next day only to close below it again the next. By the time you read this, it will likely have settled comfortably on one side of 10,000 or the other.

Although I am a professional money manager, it’s quite rare when the Dow’s day-to-day movements are of particular interest to me, even those relating to a line on a chart. With many thousands of stocks and dozens of financial indicators to choose from, the widely reported movement of a group of 30 stocks seems unlikely to be a source of significant information.

One of the most challenging aspects of investing is knowing what data may safely be “filtered-out”. Media pundits, both print and electronic, often stress the importance of line crossings and almost always have an explanation for such movements. Absent a world-changing event such as 9-11, Warren Ward Associates believes that it’s practically impossible to assign a particular reason to any specific market movement. However, we do believe that markets tend to move in broad cycles, so regression analysis is at the heart of our investment approach. We attempt to invest more in those sectors which have not done as well as we expected and reduce investments in those which seem to have done better. This asset allocation tends to protect our clients from the worst of market corrections while allowing them to ride along in better markets. One way to look at our approach is that we make money for our clients by not losing it to significant market pull backs, whatever their cause.

People who have not previously crossed the equator are called pollywogs, graduating to shellback status following the initiation ceremony. No such clear definition exists in the world of financial planning and investments. Virtually anyone is allowed to use the words “financial planner” or “financial advisor” to describe themselves. Obviously, we believe that individuals earning the CFA (for investment analysis) or CFP (for an individualized approach) should be among those you consider, should you ever decide to cede day-to-day control of your own investments.

Dining Room Economics

My in-laws are wonderful people from several perspectives. They welcomed me into the family 39 years ago, raised eight children and are now comfortably retired following a lifetime of saving and investing. I am in no way surprised that they have been successful investors as they began teaching practical lessons in behavioral economics right at the dining room table.
 
Behavioral economics, you may remember, is the study of why people - regardless of their education or sophistication - sometimes make less than optimum financial decisions.
 
The past eighteen months have given us an perfect example of behavioral economics at work, albeit one that I certainly hope isn't repeated anytime soon. Although none of our clients chose to take their money out of the markets during the recent correction, several of them called asking for reassurance that remaining invested was truly in their best interests. Other individuals with whom I spoke had chosen to withdraw from the markets and they too wanted confirmation that they had made a good decision.
 
Investment management firms like Warren Ward Associates are staffed by human beings who are in no way immune from experiencing fear. However, our clients depend on us to process that fear very carefully before responding to it. In the case of both the 2000 and 2008/9 corrections, we avoided making a fear-based decision to sell. We kept our clients in the markets, thus allowing them to participate in the subsequent upturns.
 
The decision to sell stocks and bonds (i.e. leave the market) necessarily involves two different steps. First - obviously - is choosing the right time to sell. As fear levels increase, people are more likely to take that step. When fear reaches the point that the idea of actually taking a loss becomes more appealing than worrying about how much more might be lost, they act. Once that happens, investors face the second decision: when should the money be returned to the markets? A fairly common answer is "when things look better" but using that rationale guarantees that the investor will have sold low and bought high (or at least higher). This is one of the very few life situations in which generally rational people resist buying things which have gone "on sale".
 
Such apparently irrational decisions led researchers to study behavioral finance. A very simple example involves two people being asked to play the "ultimatum game". The players are known as the proposer and the responder and each starts with no money. The proposer is given a sum of money to be shared with the responder in the proportions of his or her choice. However, neither gets any money unless the split is agreed to by the responder. Logic would suggest that any split would be a good one since, regardless of the percentage the responder might receive, it is greater than nothing. As the game is played, however, it is common for the responder to reject any offer very far from 50:50, even though such rejection means that neither player gets any money. Whether that response is driven by a sense of fairness or the same fear of loss that makes people decide to sell investments below cost, the most common response isn't a rational one.
 
By standing between investors and their investment decisions, planners can ask their clients to pause and reconsider their fear-driven urges, encourage them to take the longer view and try to help them achieve better long-term results.
 
Incidentally, in case you were wondering about my in-laws' dining room lesson, it was really quite simple. The family rule was that one child got to cut the dessert, then another choose the first piece. Behavioral economics at its most basic level.

Dueling Headlines

Most people would agree that the ability to accurately predict the future would be a very useful skill for a financial planner to possess. Unfortunately, this planner is no better at that trick than anyone else but sometimes just interpreting the available facts can be of value. Along this line, I was struck by the dichotomy between two headlines found on the front page of the April 3, 2009 issue of the Wall Street Journal. One of them states:Recession Jobs Losses Top 5 Millionand the other: Stocks Leap as Fears Ebb.

 

Although considerable effort is expended suggesting the opposite, I believe that managing investments is actually quite difficult. Over the years, people have had a hard time making good investment decisions for a range of reasons including this example of accurate (but perhaps difficult to interpret) reporting. There’s no denying that our economy is struggling as jobs are still being lost, yet the four weeks ending April 3rd gave us the most dramatic upswing in the S&P 500 for any such period since 1933.

 

Our country’s economy is always evolving. A “typical” unemployment rate might be around 3% or 4% with headlines suggesting it’s somewhere around twice that today. Those directly affected find themselves in an almost impossible situation but job losses can make things harder for the rest of us too. A reduction of our workforce by a further 3% might presage a similar drop in spending, but looking around Columbus, empty store fronts and delayed construction projects suggest that business is actually much worse than that.

 

The conservative side of our natures probably believes something like “there’s no such thing as saving too much”. Yet the very significant drop in spending we’re experiencing goes far beyond what might be expected from a three or four percent reduction in employment. This implies that even those who are still going to work are holding back – causing ripples to spread further through the economy. I was talking with an employee at a local business a couple of weeks ago. He said he was not going to take his family on vacation over spring break but planned to remain at home instead. This was not because business was off and his hours reduced but because their backlog was down from three weeks to one week. He was still working full time but was afraid things might get worse and was holding onto his money just in case. Multiply his decision by the number of us still working and you see why business is slow.

 

So, assuming the Wall Street Journal is the accurate news gathering organization we believe it to be, which headline should be believed; i.e. are things getting worse or better? Since no one can be sure what’s going to happen in the future, professionals sometimes search for guidance by comparing present-day situations with similar times in the past. As I mentioned, we must go all the way back to 1933, around the end of the Depression, to find a stock market jump like we experienced in March & early April. The mid 30’s is one of those periods I study as I try to imagine what might happen in the future. The Depression did not end with that particular market rally, although conditions were certainly improving at the time. Over the years, I have come to think of the stock market as a “leading indicator” for the entire economy, as people attempt to make their investments ahead of a broadly realized improvement in the economy. One of the reasons we were loath to sell securities on behalf of our clients during the market decline was that, having failed to accurately predict the future and forecast the market drop, we didn’t want them to miss out on the recovery that we expected would follow.

 

Thus, both headlines are “right” and both provide useful information. People are starting to believe that this recession will not slip into depression and things are not going to be better for a while.

Save The Environment: Buy an SUV

Most businesses are operated rationally. Even though we have all heard the joke about a store that “sells at a loss but makes it up on volume”, I bet the proprietors of Lockett’s and Dell Brothers know exactly what price they must sell their garments for to keep the doors open. The same is true for all types of businesses. Professionals like attorneys, doctors and financial planners have little to sell but time & expertise and you may be sure we know what we must charge in order that our practices remain viable. Manufacturers are no different. Each item they make must cost less to produce than it sells for. Unless, of course, a company has a broad enough product line to sell a specific item below cost, using profits earned elsewhere to keep things in balance.

Toyota, one of the best managed companies in the world, does just that. According to the website of Rep. John Campbell (who owned several automobile dealerships before he began representing the citizens of Southern California in Congress), Toyota sells its hybrid Prius model below cost in order to offer something in the “environmentally friendly” corner of the market. Profits from Toyota’s full size Tundra pick-up and Sequoia SUV are about four times what is earned on its smaller cars. That profit allows Toyota to offer a very competitive price on the Prius, a vehicle which includes a second power train, extra batteries and sophisticated computerized controls not found in conventional small cars.

How do other companies manage to compete? Honda is one of the few auto manufacturers in the world to report a profit for 2008. Its business is quite complex, including emergency generators, solar panels and motorcycles. Despite a slump in auto sales, those two-wheeled vehicles continue to sell well, especially throughout Asia and South America. Profits from those sales supported the remainder of the company last year - including its hybrid automobiles. Like grocers who offer specific foods at prices below cost to bring shoppers into the store, manufacturers are sometimes able to support specific “halo” products with the profits of others.

We have a new President in the White House and one of the key elements of his platform was taking a greener approach to managing our economy. Many citizens say they are interested in doing their part to help protect the environment, yet we have seen wind farms opposed by local residents from Maine to California. It also seems that even the most sophisticated manufacturers may have to sell at least a few SUVs to support reasonably-priced hybrid cars.

Now that two of the “Big Three” have borrowed money from the federal government, they must be attentive to its wishes, which may include producing more cars like the Prius and fewer of the very profitable larger vehicles. Our government’s approach to energy has generally been haphazard, consisting of short-term decisions aimed at narrow issues. For example, legislation regarding the use of corn as fuel led to riots in Mexico, as corn was diverted away from use as food. I think Thomas Friedman’s recent book, Hot, Flat and Crowded, spotlights a more sensible approach. Friedman calls the oil we import from the Middle East a “petro tax” and suggests that we are funding (thus arming) the very societies which “have drawn a target on our backs”. He contrasts our item-by-item approach with the more consistent energy policies of western European countries which have taxed gasoline, thus enriching those countries’ own coffers, while encouraging development of alternative energy sources. He calls for a thoughtful, long-term strategy which would lead our country to reduced reliance on imported oil while encouraging our own industries interest in non petroleum-based energy sources.

I have written previously about how various world governments decide whether to subsidize or tax gasoline sales, a choice based strictly on political considerations. As we reconsider our approach to energy, I wonder if a simpler, more market-based solution like Friedman proposes might not be the best strategy.

The Dismal Science (of Economics)

According to the invaluable Wikipedia, historian and writer Thomas Carlyle (1795-1881) is credited with naming economics the "dismal science" in response to Thomas Malthus’ dire predictions about the result of uncontrolled population growth. Beyond specific concerns related to population, economics is also the study of capitalism and is a required topic of discussion as investment strategies are contemplated.

The continuing growth in the value of companies traded on the various stock exchanges around the world sometimes seems to take on an almost mystical aura – where is all that value coming from? Poker and most other forms of gambling are known as "zero sum games", meaning that the game itself adds no value to the total amount being gambled. For one person to win, another must lose. Yet, total stock market valuations have increased over time and, while corrections are certainly a part of the equation, it is not necessary for one person to lose money for another to gain it.

How can this be possible? Let’s begin by thinking about why companies "go public" and arrange for their shares to be traded on an exchange.

When a company finds that it needs more money than can be contributed (or easily borrowed) by its founders, it can offer a portion (a share) of its ownership to individual investors. Once such an offering is complete, subsequent fluctuations in stock price do not directly affect the company. Instead they add to or subtract from the worth of the investor-owners. Remember the huge demand for Initial Public Offerings during the "dot com" boom of the late 90’s? Company founders wanted to take some cash out of their businesses but small investors were clamoring for their chance at sudden growth through these IPOs.

It is this constant change in valuation that supports "Wall Street" in the sense that it is commonly thought of: a specific place where securities may be traded. In fact, stocks and bonds can be sold on any street corner in the world if a willing buyer and seller should happen upon each other and agree on a price. Since that is a pretty unusual occurrence, stock and bond exchanges developed to facilitate systematic trading. They exist so that share owners can easily (and transparently) buy and sell securities. Whether the market is primarily a trading floor like the NYSE or is strictly electronic like the NASDAQ, these exchanges make it possible for investors to purchase/sell literally billions of shares daily. This huge volume of transactions assures that there will always be a buyer for shares we own or a seller for those we wish to purchase. The NYSE itself is a publicly owned company, with its shares (naturally) traded on its own exchange.

At WWA, we almost never recommend very low-priced "penny" stocks, also avoiding the "pink sheets" where they trade. Beyond that, however, we really don’t care on which exchange a stock (or bond) is traded. As long as regulators continue to make such transactions both easy and secure, we can concentrate on our job of advising clients about which assets they should own and in what proportions.

That Hall of Fame Economist, Yogi Berra

Several people have asked about the problems in the "sub-prime" mortgage market and what the recent upheavals might mean to regular investors. As with all investment questions, there are at least two issues to consider. First, the underlying realities to which markets respond: interest rates, liquidity, and economic strength. Second, how people interpret and react to those realities. I feel fortunate to be able to turn to a well-known voice which has offered thoughtful (even thought-provoking) insights in the past. Yogi is popularly credited with having said "Ninety percent of this game is half mental". Although he was referring to baseball, I think his statement probably holds true for markets as well.

The founders of our country provided a framework which included certain inalienable rights but owning a home was not among them. Home ownership became an important element of the post-World War Two "American Dream" and most people since then have aspired to it. Regardless of how much we might wish things to be different, not everyone is a good candidate for home ownership. However, captialism has a way of trying to meet people’s needs. Over time, a sophisticated mortgage market developed. It allowed lenders to extend credit to less-qualified borrowers, typically at higher interest rates. An unfortunate perfect storm brought together Wall Street demand for higher-yielding securities, developers who needed to sell homes and brokers who received fees for "originating" these mortgages. What had once been a valuable service became a machine finely tuned to provide more and more loans to less and less qualified buyers. Before too long, disaster struck in the form of late payments and, eventually, forclosures.

Adding to the severity of the storm were hedge funds. I have written about these generally unregulated investment strategies before. Their original mission was to offer a true hedge against broader actions in the markets. However, as investors swarmed to them, they have tended to become more similar than different and have become key contributors to market swings. This past spring, Amaranth Advisors liquidated after having lost over $3 billion of investor assets through betting incorrectly on natural gas prices. As hedge funds lent to and became investors in mortgage companies, an unstable situation was allowed to persist until it came crashing down under its own weight a few weeks ago.

The fundamentals of our stock and bond markets are good. Interest rates are reasonably low, business is good (although not great, which has a tendency to bring an interest rate increase from the Federal Reserve) and employment is high. The "fact" portion of the equation seems to be in pretty good shape. However, the "reaction" (or as Yogi said, the "mental") portion must still be addressed.

Markets have a tendency to make wider swings than the underlying facts might suggest are appropriate. People often buy based on their hopes (some would say their greed) which tends to drive prices up, then sell based on their fears, tending to drive prices down. The word "crash" has a way of grabbing headlines but we prefer the word "correction". Our investment strategy at Warren Ward Associates has always been to keep a balance of asset classess covering multiple sectors of the US and global economies. The underlying reason for diversification just reared its head again. As we have commented in the past, whether it is tulip bulbs, tech stocks or sub-prime loans, markets have a way of being self-correcting. Or, to cite another of Yogi’s famous quotes: "It's like déjà vu all over again".

Pogo-nomics: We Have Met the Enemy and He Is Us

I know, I’m dating myself by admitting that I remember the "Pogo" comic strip which ran in the Sunday funnies when I was a child. I’m not sure in what context Pogo made the statement I’ve quoted above but I was reminded of it while writing about sub-prime mortgage problems and their negative effect on our markets. I mentioned Wall Street’s fascination with high-yielding securities, laying blame at the feet of institutions instead of individuals. In fact, those large Wall Street brokerage firms would not have been establishing investment pools made up of such mortgages absent demand for them from individual investors and their brokers. Mine has been one of many voices regularly warning people about deals that appear "too good to be true". Yet, almost every year, we are offered another example of wishing outweighing thinking.

Investments can be complicated, so comparing something new with something we already understand can be a useful way to put things into perspective. For example, a Certificate of Deposit is a time-limited savings account with a bank. Banks have government-regulated financial strength requirements and their deposits, including CDs, are backed by an ultimate federal government guarantee. Since we know the level of quality represented by CDs, I often use them as a benchmark against which other interest-paying investments can be compared. Over the years, many of my clients have heard me say "If a CD is paying 5%, what risk do we have to assume to receive 10%?" I am not opposed to taking additional risk, especially if we believe we understand something that the broader market may have missed, but I want to understand the risks before making an investment on behalf of a client. My first concern is always how their principal will be returned. Once that is clear, I’m free to think about how much they might earn on their investment.

In the case of sub-prime mortgages, the rating agencies became convinced that the large number of different borrowers in each pool would provide security for investors. The agencies regarded it as unlikely that all the borrowers would get into financial difficulties at the same time. They apparently did not consider that, with a group of people who were not qualified for home ownership under the usual rules, all of them could easily face problems simultaneously when a planned but generally overlooked rate increase went into effect. Unfortunately for the borrowers, rates rose as scheduled and many borrowers have defaulted. Unfortunately for the investors in those pools, rating agencies are paid (by the issuers) to provide their ratings but do not guarantee them, so those investors lost money too. Unfortunately for the rest of us, the lack of confidence brought on by the potential for significant defaults shocked the remaining markets. No one was left unscathed.

What can we learn from this cascade of problems? Most likely, those individuals who are in the process of losing their homes will be more careful about reading the fine print in the next contract they are asked to sign. And perhaps next time, previously trusting investors will look beyond the hype and try to understand the details of the investment they are planning.

To me, the clearest lesson of Pogo-nomics is that risk and reward are inextricably entwined and neither one can be ignored in search of the other. However, it’s easy to forget that lesson when faced with the lure of the next "hot" investment idea. That is precisely why Warren Ward Associates advises clients to invest in a diversified portfolio of stocks, bonds and real estate; we know of no other way to protect investors from unexpected corrections in the capital markets.