What the FED is Doing is Irrelevant and Here’s Why!

In talking to many clients, I realize there may be a false notion going around that suggests the FED is not doing a great job executing fiscal and monetary policy.  Actually, economic theory suggests that our government (separate from the FED) is responsible for determining fiscal policy (e.g. taxes, trade, etc.) while the FED is to carry out monetary policy. However, these two roles have been co-mingled over time, so it seems worth evaluating the question of whether the FED is doing a good job or not.  In the 1940s, an economist named Abba Lerner explored the doctrine of functional finance. It basically states that:

The first financial responsibility of the government (since nobody else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce.

In that context (which I deem as very sound), let’s tackle some simple questions…

Q.  What is the goal of monetary and fiscal policy?  

A.  To keep aggregate demand (e.g. total spending in the economy) at the level of aggregate supply (e.g. total amount of goods and services in the economy).

Q.  What is the result of any imbalance?  

A.  This is a very loaded question.  But when aggregate supply exceeds aggregate demand this will result in unemployment since the level of goods and services being offered has not enough demand to consume them all.  The providers of those goods and services will then be forced to lower prices which will cut profits and cause less business expansion thereby reducing the need for labor (e.g. a decrease in the rate of employment).  When aggregate demand exceeds aggregate supply this will result in inflation since the level of goods and services being offered is not enough for all that would like to consume them.  Thus the providers of those goods and services will tend to raise prices causing the consumer’s purchasing power to be eroded.  Although inflation is always a much easier problem to handle (vs. unemployment) the government only has two ways to control it:  raising taxes (e.g. adjusting fiscal policy) which reduces the amount of income left available for consumption or raising of interest rates (e.g. adjusting monetary policy and carried out by the FED) which makes consumers less inclined to borrow to bring future consumption forward into present-day consumption.

Q.  How does the government get into the picture?

A.  When the FED is ineffective in employing its tools to regulate the economic cycle, economic theory would suggest the government get involved as a last ditch effort to “save” an economy from recession or depression.  One example would have been the Great Recession (2007-2009) where the government raised the level of consumption by purchasing government bonds.  How did this help?  When the government bought bonds the proceeds from the transactions where passed to the holders (e.g. banks, financial institutions) through “quantitative easing”, thereby giving these institutions the wherewithal to increase their lending facilities.  The more money a bank has on deposit the more it can lend to prospective borrowers.  This was designed to compel consumers to pull future consumption forward by borrowing more at much lower interest rates.  However, this has its consequences as inevitably interest rates can not remain artificially low for an extended period of time less too much borrowing occur or the effect of quantitative easing becomes moot.  I believe the last 7 years are evidence both happened.

Q.  What is the effect of too much borrowing by the government?

A.  Not much, especially if you subscribe to Lerner’s doctrine.  Ultimately the government’s control of how much currency is in circulation nullifies the rate at which it repays its debts.  The more important focus is the government’s use of borrowed money.  It is usually to increase aggregate demand or increase the level of spending.  The question is always then how effective is this employment of borrowed funds, not how much have they borrowed.

Q.  What is the effect of too much borrowing by non-government entities?

A.  Since low interest rate policies (“LIRPs”) don’t place restrictions on who can and cannot borrow, one popular outcome is the carry trade.  One example of this has been seen in the last several years, in which USD was borrowed at low interest rates to buy foreign securities and currencies that paid higher rates of interest.  The difference between the cost of borrowing and the interest paid was called the “carry”.  Many analysts believe this phenomenon artificially pushed up the value of securities in the global financial markets causing market valuations to trade well beyond their actual worth.  On the other hand, there is also evidence pointing to borrowed cash being “sidelined” or not invested and just hoarded inevitably waiting for the next financial collapse.  The latter theory is less popular, in that, in the short run this is a relatively costly trade because there is no return being earned on sidelined cash.

Q.  What is the “so-what” of all this?

A.  Ahhhh. A much easier question to answer with a definite answer.  Regardless, of all the economic theory that can be supposed, we are living in very unconventional times.  The need for investors to earn a return for assumed risk should be paramount, but has taken a backseat to the need to avoid market volatility. At the end of the day, financial market complexity may be at its apex thereby justifying the need for prudent asset selection with constant monitoring.  An investor should consider setting realistic goals in a systematic way with the assistance of a financial professional.  Whether you think the FED is doing a good job or that government spending is out of control, your investment plan will need to be constructed to withstand the test of time; inevitably requiring it to resist the ups and downs of several economic cycles.  Time after time, I’ve seen the most successful investors create a sound plan and remain with that plan to achieve their financial goals. In that context, it really doesn’t matter what the FED does as much as what YOU do.

Invest wisely!

Falling Down the Rabbit Hole–Don’t!

Many investors might be feeling a bit like Alice in Wonderland as they relate the feeling of fantastical events in today’s investment environment.  Similar to Alice, the boredom associated with the hum drum of market cycles often lull investors into ignoring signals of reality around them.  Like Alice, investors might find themselves succumbing to the “BUY ME” and “SELL ME” signs that pepper today’s investment landscape.  So, what is the answer?  My opinion is to face reality and save adventurism to romantic vacations and to leave it out of your investment portfolio.  In other words, don’t get too cute!

It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.  – Charlie Munger

Are US stocks near a top or poised to go much higher?

For regular readers, you know my answer to this already–no.  There are a lot of reasons I think this is the case but I’ll try to focus on a couple I’ve not mentionedbefore.  Here they are:  US dollar strength and US corporate earnings.  With the US set to raise interest rates (however slow or quick) and other major economies set to lower interest rates (e.g. Europe, Japan, China, etc.), this differential causes inevitable currency wars.  Consumption and demand for goods and services drive the economic engine of all economies and ultimately each country wants to gain an advantage (usually through trading) in that equation.  Typically speaking, higher interest rate economies will attract capital thereby driving the value of a particular currency higher.  Speaking for the US, this makes the dollar relatively expensive to other currencies causing less goods and services to be demanded which affect US companies looking to make profits.  Stressed profit margins lead to layoffs and economic slowdown.  Investors should be focused on monitoring this cycle and how corporate earnings fare in the interim.   Here is a chart of the US Dollar Index (DXY), since the recession.  (courtesy of BigCharts)

What asset classes are still reasonably priced?

I will have to be very careful here since the operative word is “reasonably”.  I will confess though, that experienced investors that have had some semblance of victory in several market cycles agree that everything is not expensive–just most things.  I’ll be upfront and just give away the secret–focus on total return.  Ultimately, you want every dollar you invest to return more than that dollar.  One of the simplest ways to do that is to find investments that pay a dividend or an interest payment.  Naturally, this would turn your focus to dividend-paying stocks, real estate investment trusts, fixed income, or funds that invest in one or all of the previous categories.  Within that universe, you can begin to identify asset classes that are historically cheap.  “Historically cheap” would be defined as something that hasn’t been seen in at least one market cycle (e.g. 7-10 years).  A good example (and much publicized lately) are high yield bonds.  Because of the energy crisis that began in late 2014, yields (inversely related to prices) on this asset class started to rise during 2015 and peaked in mid-February 2016.  Although these levels sometimes signal default-like risk, for some investors it presented an opportunity to invest in a basket of securities (paying current income) in hopes that a few deeply discounted investments would handsomely reward their courage and patience.  Here is a chart of the iShares iBoxx High Yield Corporate bond ETF (HYG) since the recession. (courtesy of BigCharts)

As my grandmother liked to say, “Baby, keep the main thing, the main thing”.  I think these are words to live by, because as an investor your main goal is to grow your capital.  It often doesn’t pay to try new things and fall down the rabbit hole like Alice.  What makes more sense is to stick to what you know and understand, to focus on total return, and to exemplify patience and discipline.

Invest wisely!

Dow 18,000…What Now?

You don’t have to be a genius to realize it will be hard to find growth for a while.  Stagnant global economic growth may be a theme for some time.  Major central banks have used unorthodox methods like monetary policy stimulus to urge consumers to buy goods with cash or credit (mostly the latter) to produce economic activity.  The latest remedy to this chronic sickness of global stagnation?  Negative interest rates.  As an aside, I was just told by the firm that custodies our client assets that they will be passing on the charge to any account holding foreign currency positions.  This just means that with negative interest rates, you now pay the bank to hold your funds.  With all of this, it could be quite compelling to just sit in cash or worse, stick your head in the sand and wait for all the madness to end.  However, I have a better plan…

With the Dow Jones approaching all-time highs once again, investor anxiety is likely correlated with the upward motion.  Let’s look at the last 5 Dow milestones:

-Dow 14000 happened on June 19, 2007
-Dow 15000 happened on May 7, 2013
-Dow 16,000 happened on November 21, 2013
-Dow 17,000 happened on July 3, 2014
-Dow 18,000 happened on December 23, 2014

It seems strange that the Dow has made such highs so rapidly.  Especially considering additionally that, Dow 10,000 happened in 1999, while 14,000 happened 8 years later.Yet, it has increased at a much more increased rate since then (remember the Dow hit a low of 7,000 in February 2009).  I think this is why many feel a crash (or at least a decent pullback) is imminent.  However, successful investors like BuffettTempleton, and Swensen have one thing in common in their success (besides financial genius!)  They all have used the discipline of patience to exploit the concept of total return.  I truly believe that total return is a concept that is lost on many investors today.  Capital appreciation is desired, but having a myopic focus on just this metric under-utilizes the concept of total return and stifles portfolio growth.  Last December, I covered this but I feel it is worth a refresher in light of what we face in the markets.  When I was taking undergraduate finance courses at Prairie View A&M (go Panthers!), my professor called it the “magic of compounding interest”.  It was the concept that your original investment earned a return and that return earned a return, so on and so on.  But if you think about how powerful that principle is for a minute, it will really revolutionize your investment strategy.  Using the rule of 72, if you found an investment paying 10% interest (and there are some out there) you could use the interest payment to buy more shares paying 10% interest and repeat until you ran out of money, you would double your money in just over 7 years.  For someone starting this discipline at age 25 with consistency, they would receive 6 doubles before full retirement age.  Now, they would probably have difficulty in finding such a high paying investment during the whole time, but I think you get where I’m coming from.  Successful investors have not waited as much for the Dow to go up in value as they have simply waited on the passage of time!    Come to find out, the most valuable thing isn’t money…it’s just time.

Check out this graph illustrating the power of compounding interest (courtesy of JP Morgan Asset Management):

This most important element in executing a portfolio strategy that exploits this power is consistent investment.  Making monthly or quarterly deposits into high income generating assets and re-investing the subsequent income payments has benefited many investors throughout time.  Do you think you can let time work for you (instead of against you) for a change?  If so, you are well on your way to outstanding portfolio returns.

Invest Wisely!


Great Portfolio Construction: The Case for Bonds

Back in December, I wrote about the 5 Keys to Great Portfolio construction.  I thought that based on the recent positive market performance, a lot of investors would start coming off the sidelines.  As an asset manager and investment consultant, I am always asked questions about the timing of investment and my answer is that “time in the market is more important than market timing”.  With that, I realize investors may be looking for where to put money.  I believe the notion of portfolio construction is worth revisiting based on recent market movements.  Here we go…

As seems to be the case every 7 years or so, bonds can become really cheap.  I probably will receive a lot of flak on that statement depending on what kind of bonds are being bought.  But as most pundits will even admit, the compensation for holding “junk bonds” has gotten as cheap as levels close to 2008-09.  As has been disclaimed in previous writings, my expertise is found mostly in municipal finance, but the ideas I put forth are time-honored for nearly all credits—sovereign, corporate or municipal.  So how do you choose which ones to buy?

 Bond Funds

If you want to play it safe you can always buy a bond fund which will invest in several bonds and fundholders receive the benefit of the aggregate cash flows and any capital gains after fees and expenses [for the fund are taken out].  Arguably the greatest benefit of mutual fund (bond or otherwise) investing is diversification.  This takes the importance out of credit selection and places it onmanager selection.  With longer and mostly positive track records garnering the most attention and money flow.  However, what happens when everyone piles onto the best fund manager investment?  The law of supply and demand takes over and the fund becomes expensive.  As many times is the case, investors may be left with little yield after fund fees and expenses.

 Individual Bonds

On the other hand, you could take a foray into building a bond portfolio of various maturities and payment schedules.  The primary concern usually becomes liquidity (especially for smaller portfolios).  That is to say when you want to buy or sell, could you find a willing partner?  Unlike stocks, bonds are not “exchange-traded” and are primarily traded in an auction-like format.  This is the foundation for my advice to any investor wanting to buy individual bonds:  use a buy and hold strategy.  The time and expense an individual investor would consume as opposed to an investment professional trading individual bonds becomes astronomical in comparison.

 The How

In either case you should be aware of the 3 C’s of credit selection:

  •         Cash flow and ability to pay.  Not enough can be said about cash flow.  Any enterprise worth investing in should be able to demonstrate cash levels appropriate for daily operations.  In the hundreds of credits I’ve researched, this is my primary focus.   Balance sheets and income statements are often idolized when in fact an enterprise’s cash flow statement ties the two together and presents the most accurate picture of true solvency.  It is beyond the scope of this piece, but suffice it to say, becoming intimately knowledgeable of the inter-workings of financial statement interdependence is paramount.
  •         Covenant strength.  When or if things go bad (i.e.  missed interest payments, bankruptcy, etc.) bond holders are protected by bond covenants.  Within the bond covenant lies the legal remedy for bond holders to pursue recourse for violations by the borrower.  However, investors should be aware that the legalese found in most bond documents is byzantine and ironically enough written by bond counsel which represents the issuer of the bonds.
  •         Collateral.  What backs the principal and interest payments?  Real assets are usually pledged in this instance. First and exclusive right to gross revenue is also common.  However, these pledges may often be divided among senior and junior debt holders, the latter having a lesser claim.  When considering real estate as collateral I advise investors to look for recent appraisals for determining value as opposed to relying on book value.

Naturally, investment in either bond funds or individuals involve investors weighing the risk-reward trade off.  But as always, with extra effort you can be handsomely rewarded with a gem of an investment opportunity.

Invest Wisely!

Don’t Believe the Hype

This week I spent a lot of time speaking with clients that had fear that “the market” would continue to hand out irrecoverable losses.  This fear was motivating them to take pre-emptive action.  In a sort of Part 2 of what was discussed last week, I thought I would explore what may have driven that fear.  I think it came from two sources:  what they heard and what they saw.  Now you may say that, a legitimate cause of fear from previous circumstances drove their panic.  I will not disagree, but often as a disciplined investor you have to ignore triggers that remind you of past mistakes and experiences if you want to invest successfully.  Finding the opportunity in chaos is a lesson that will not only serve you well investing, but in life altogether.  What were some of the headlines stoking the fires of panic?  I am sure you heard or read some of them, so let’s cover a couple of them.


On the front page of this week’s edition of Barron’s was “Election follies rattle market“.  Here’s an excerpt of the article:


Sentient viewers must become numb to the political messages as they meld into the parade of pitches for local auto dealers and cures for maladies you’d rather not explain to the kids. But it seems that the financial markets may be becoming more sensitive to the presidential cage match.

With the global financial markets in free fall at midweek, politics seemed to be added to the list of usual suspects battering stocks and speculative-grade debt: corporate-earnings disappointments, China, and the ongoing collapse in oil and other commodities.

What strikes me as an interesting phrase is “politics seemed to be added to the list…”  For me, there are two things that drive market sentiment:  fear and greed.  As far as market fundamentals are concerned though, company earnings should be the overriding factor (see my article from last week for more on this).  However, if you just read this headline you may get the impression that the uncertainty around which candidate will lead the US in its economic turnaround has a very tangible effect on the performance of the market.  I doubt it does and long-term investors should focus on fundamentals.

They should ask a few questions:

  • Is the company making money (e.g. revenue)?
  • If they are, are they profitable (e.g. earnings)?
  • Are they growing both revenue and earnings consistently?
  • Do they have a competitive advantage in their sector or industry?

“Yes” answers to the preceding would indicate an investment that won’t likely be influenced by a presidential race.

Ok.  One more.  On Bloomberg, I found this headline:  “Are We Headed for Recession?”  First, let me say I cannot really argue with the content of this article because the author does a great job of exploring multiple perspectives of this question.  I will only refer to the sensationalism of the headline.  Because at this point, most articles with recession in the title will get read if they are written.  But let’s just briefly explore the notion of US GDP being negative for 2 consecutive quarters (recession defined).  What is GDP?  Gross domestic product consists of the value of all goods and services produced in an economy.  It is easiest to remember with this equation:  C + I + G + (X-M)

  • C = consumer spending
  • I = capital investment (or business spending)
  • G = government spending
  • X = exports of goods/services
  • M = imports of goods/services

Consumer spending makes up about two-thirds of the total number.  I believe consumer spending is the bedrock of GDP not just because it is such a large part, but it also drives business spending.  And as the article states, many positives exist in the economy to keep this number strong.  Maybe the most important is the relatively low cost of credit.  When it is cheaper to borrow, people spend more.  Spending leads to revenues and profits for businesses and when businesses have profits they spend.  Currently, there are not many signs to show that this is coming to an end anytime soon.  Higher interest rates may start to slow spending, but since they are so low now it may be a while before we see spending decrease because of them.  I think the other thing to keep in mind is that economic growth will not always correlate to market performance.  In a perfect world they probably should as this would make sense that profitable companies warrant higher valuations.  However, a down market should not make investors think we are headed towards recession.

I have recently been reading commentary by Howard Marks and he had a wonderful Benjamin Graham quote the other day:  “the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment.  I think the quote is pretty self-explanatory and demonstrates that focusing on the short-term volatility of the market is not consistent with investing based on market fundamentals.

No meaningful progress can be made towards investment goals by paying attention to headlines that instill fear, anxiety and panic.  Imagine trying to run a race while looking up into the sky waiting for rain or into the stands to see who is watching.  What would happen to you?  At best, you will likely lose the race, but at worse you may run into someone else’s lane causing injury to yourself and others.

Invest wisely!






Let’s Look at the Facts

  • Investor sentiment has driven the stock market to new lows in 2016.  However, investor sentiment is rarely reflective of market fundamentals (e.g. revenue and earnings growth).  I calculate an increase of nearly 64% for the S&P between the period of Jan 2011 to July 2015.  However over the same 4-year period corporate earnings have only increased by 25%.  Even worse, from the beginning of 2009 the S&P has returned 186% whereas corporate earnings have increased only 49%.  What gives?  I’d be the first to admit these two metrics don’t move in lock-step by the same amount, however if earnings growth drives returns, why has the market gone up by so much more than earnings growth?
  • Let’s explore what I would call an unusual divergence by looking at the market multiple.  In the last 10 years, the market was probably its cheapest right after the recession where the P/E ratio (measured by Case-Shiller) was 15x.  At the beginning of 2015, this same ratio stood at 26x.  This meant that since the Great Recession, investors were willing to pay 73% more to own shares of the S&P than they were back then.  Really?  Have corporate earnings warranted that great of a premium since then beginning of the recovery?  Possibly, but it doesn’t seem likely or logical once you consider our lackluster economic performance since that time.  It has been better than other developed economies (e.g. Europe, Japan), but by no means worthy of a multiple greater than 25x!  So if you consider all of that, possibly the question worth exploring for further evaluation is if the current hysteria around the latest market collapse should be getting this type of attention?  Could it be that the market has been overpriced all along and what we are currently experiencing is a normal market correction?  After all, weren’t we due?

 What really drives the economy? 

I suggest you view an incredible explanation of how the economy works by Ray Dalio because the following explanation deserves more time than I have here.  But think of what drives the economy–spending. Companies sell their goods and services and generate revenues. These revenues are use to expand through investment (also known as CAPEX) in fixed assets and human capital.  These investments are funded with cash or credit in order to result in greater production of goods and services.  Two-thirds of the US economy is driven by consumers who purchase these goods and services with cash or credit which then drive revenue which drives earnings–so on and so on.  By GDP standards, this cycle has been chugging along at a fairly pedestrian pace.  Corporate earnings are a part of GDP.  The stock market is separate from GDP and only really reflects investor sentiment about the machine I just described.

What could cause the market to go up so much more than corporate earnings?

Consider that monetary policy, until recently, has been “accommodative”.  This is proven by ultra low interest rates and even more dramatically, asset purchases.  These tools encourage something that could have harmful effects.  Low interest rates encourage spending because the cost of borrowing is cheap.  Asset purchasing puts cash in the hands of banks that can then use that cash to make loans to consumers.  The collateral affect is the “psychological effect” on investors to assume more risk relative to what they would normally assume.  An increase in the proportion of risky assets in an investor’s portfolio was encouraged because interest rate sensitive assets pay much lower returns comparatively. This “demand” for return found in risky assets pushes the overall level of asset prices up.  This is why I believe the S&P P/E ratio inflated so much during the time period of 2009 to 2015.

What happens when you remove the elixir?

I liken this to caffeine fast.  For all you coffee drinkers, you will appreciate the analogy.  I would like to suggest that the US economy is now being weaned off of the elixir of easy monetary policy. The reversal of monetary policy prior to an economy stable enough to repeat the cycle above on its own (without assistance) is potential disaster.  The US economy has to be slowly weaned off its dependence on easy credit and low interest rates to purchase goods and services.  The reality of the cost of future debt obligations in a higher rate environment starts to fuel unrest for the borrower and thus decreases consumer demand for those same goods and services.  This results in a pullback in capital spending by businesses looking to “soften” the blow of anticipated decreased revenues, and ultimately slows (or stops) job creation.  This creates a drag on GDP and if no growth happens for two consecutive quarters it is called a recession.

Let me be clear, in my opinion, I do not believe the US has yet reached this last stage.  However, I do believe there is plenty of evidence to show the US stock market was due for a correction to put market valuations more in line with reality.  Since, 1920 the market has averaged a P/E ratio in the mid-teens (call it 15x), so unless corporate earnings increase by a large measure or the market falls further stay tuned for continued volatility.  This is hardly a bad thing though as the universe of bargains is increasing with each market downturn.  Wise investors will do well to take a deep breath and circle the wagons.  The most prudent investors I’m working with currently have been making deposits for bargain purchases.  During the Depression, Sir John Templeton purchased 100 shares of all the NYSE listed stocks trading at less than $1 each to help catapult him to his fortunes.  Investors should consider that chaos creates opportunity.

Invest Wisely!

Suggested Reading to turn emotion into understanding:

Investment Ideas for 2016

Failing to plan is indeed planning to fail.  This is a quote we’ve all heard before and of course its implications are widely applicable.  In attempting to remove the cliché aspect from this post, I was faced with compromising a belief that I have that most success does come from proper planning.  The methodology [of planning] extends to virtually all aspects of life and can literally pay dividends for investors that survey the landscape for opportunities that will prove fruitful with a properly executed strategy.

What ideas will be best for 2016 and beyond?

Fallen Angels – Oil has fallen more than 50% over the last twelve months.  Companies that spent millions of dollars in infrastructure building (CAPEX) to dig wells, find oil and bring it to market are now hemorrhaging financially.  2015 was a year that saw relatively few bankruptcies and restructurings, however 2016-17 should be ripe with more of the same.  These fallen angels will present opportunities to investors that have a longer horizon to withstand the “bottom” in oil prices and ride it back to a point of stability.  Of particular note, have been oil refiners and pipeline companies that have performed although oil prices have declined.

Emerging Markets – Developing economies which are dependent on heavy commodity exporting were happy to see 2015 go.  My thoughts are that the underlying assets in this category may experience more pain in the interim, but are poised for big gains for longer holding periods.  Investors must remember that most markets are cyclical.  China’s growth over the last decade plus must be brought into equilibrium with other developed economies.  As growth slows in China, its trading partners will also experience slower growth until equilibrium of supply and demand are reached.  As this unfolds, emerging markets with strong political leadership and weak currencies stimulating domestic output will look to take advantage of the carnage from this most recent commodity decline and position themselves for future growth.

US Stocks – Bellwether mega cap companies with diversified operations are not currently cheap, but with continued volatility will look quite attractive.  As an example, technology companies like Apple have experienced selling pressure due to the slowdown in China specifically, but for a company with a 1/2 trillion dollar market cap and $41 billion of cash & cash equivalents on its balance sheet it has the luxury of waiting out this storm.  US corporations flush with cash have the option of using stock price pressures to increase their dividends or announce share buybacks.  Investors should remember that cash is king, and companies that produce a lot of it can represent good long term holds in any portfolio.

Municipal Bonds – If you have read any of my previous posts, you may have noticed my “soft spot” for municipal bonds.  This asset class is dear to me because of the relatively ease it presents for patient investors to accumulate safe total returns.  First, if you end up paying more than 25% in taxes in any given year, you should consider municipal bonds.  Most are exempt from federal income tax so you earn tax free income which on a tax equivalent basis gives you a boost.  Next, they usually offer better yields than US treasury bonds and similarly rated corporate bonds.  So for the diligent investor that dedicates a portion of their portfolio to this asset class, tax free investment returns can be used to accelerate net cash flow in the portfolio over a longer time horizon.

These are just a few ideas investors should be considering as investments for their portfolios.  However, remember that the planning process–not just the ideas—is a crucial step in any investment strategy.

Invest Wisely!

Using a Market Collapse to Benefit Your Portfolio

Finding opportunity in chaos is one timeless investment strategy that has been used by many saavy investors.  Recent events in the market prove that recent chaos is just as good an opportunity to benefit as any other time past.  Divergent monetary policy, commodity price implosions, mutual fund liquidations, and the list continues.  How could you position yourself to benefit from these events?  Let’s take a look:

Q.  What type of an event should I look out for?

A. An immediate or systematic liquidations of mutual funds.  The freezing of Third Avenue Management’s (“TAM”) high-yield fund and subsequent liquidation represents the constraint firms like that can experience during volatility.  Essentially, assets owned by the fund could not be sold for more than what they were supposed to be worth.  Since mutual funds are required to meet daily redemptions this situation posed a problem.  Some firms have increased their liquidity and cash on hand to meet investor redemption requests.  But in no uncertain terms is this a good trend for investors. First, you have the risk of loss of investment capital along with the opportunity cost of not being able to invest while the firm is liquidating. The lesson to be learned here is to know what you are investing in.  Investors with a shorter investing horizon and lower risk tolerance should avoid funds that place bets on the high yield sector or any other with limited liquidity. Decreased liquidity or loss of investment capital could always occur.  On the other hand, investors with longer investment horizons and increased risk tolerance could take advantage of these trends by accumulating assets like the ones TAM invests in as they would be “on sale” (more about this below).  You never know when you may be subject to a fund “freezing”, so owning the individual assets in a diversified portfolio is not that bad an idea.  As always, this should be done after prudent research and analysis or with a trusted professional.

Q. What is the best investment approach?

A.  Strategic or  tactical asset allocations.  There are essentially two investment strategies when it comes to the “how” of investing:  passive or active.  My purpose in this writing is not to espouse one or the other, but to explore the merits of each under a market collapse.  First, let’s explore passive or “strategic asset allocation”.  It is passive because the goal is to earn the return of the overall market.  One example would be buying a fund that mirrors the S&P 500 index (there are a number of funds that do this).  Your expected return would be no more or less than the return of the index.  Taking this a step further, suppose you own a fund that invests in an index that reflects the return of the entire high yield market.  That means you will get exposure to all sectors of that market without any over exposure in any one in particular.  Of note, will be the frequency of rebalancing or “turnover” inside of that fund’s portfolio.  Typically, this process is done to keep the fund from over-weighting any sector among other things.  If this were not done, winning positions would be in greater proportion than losing positions in comparison to the fund’s total market value.  However in the process of rebalancing, the winners can be sold and the fund manager is forced to buy more fairly priced assets.  This is the conundrum with passive investing.  On the other hand, active or “tactical asset allocations” allow for the over-weighting of a particularly favorable strategy to exploit opportunities and earn extra return above the index or benchmark.  This is what is referred to as “alpha“.  In an actively managed strategy, rebalancing won’t force the sale of winning positions.  The caveat of course being that you may become “out of balance” or “over-exposed” in one or more sectors.

Lastly, I’ll mention that focusing on total investment return is key.  Most investors primarily focus on change in value (“buy low, sell high”).  This is important, but it is not the easiest to guarantee.  Historically, it takes investors long periods of time (10 years or more) to have remarkable success with strategies that focus primarily on this component of total return.  This is usually the case because markets usually run in cycles of 7-10 years.  A broader perspective would take into account change in value as well as the income generated by investments.  This can be taken a step further to include the income generated from the income.  Or more simply put:


Consider if you buy a stock and it goes up 5% in year 1, you cannot reinvest the 5% the stock made without selling the stock.  However, if the stock paid a 5% dividend, you could reinvest the dividend to buy shares that would then also earn a dividend.  You could indefinitely repeat this process to increase your total return on the stock regardless if the stock’s price.  Quite ironically, if the stock’s price decreased you could presumably buy more shares, increasing the amount of dividend income you earned.  The caveat is that the price would have some level that it could not fall to and still realistically pay a dividend.  My point in saying all this, is to illustrate the power of compounding.  If an investor focused on a sector or sectors of the market that are fairly priced that paid current income that could be systematically reinvested, this would be an excellent strategy to take advantage of a market collapse.

Happy Investing & Merry Christmas!

Five Keys to Great Portfolio Construction

What are the keys to great portfolio construction? I believe despite the following list, there are still ways to construct a portfolio that will outperform:

-Fear of the FED raising rates?
-Fear of the Chinese economy entering recession?
-Fear of the price of oil dropping so far it tanks the economy?
-Fear that the strong dollar slows down US GDP?

My thoughts are that the “FEAR” of (fill in the blank) can be overcome with proper portfolio construction. Here’s a step-by-step process to accomplish just that.

1. Formulate a return objective. I have written about creating an Investment Policy Statement (IPS) in previous writings and this is where the concept originates from. Everything starts with a return objective in goal-based planning. Simply put, how much do you want to make? An accompanying “why” you require this level of return helps, but is not necessary. Let’s start with this following:

Investable assets: $1,000,000
Annual after-tax income needed: $70,000
Tax Rate: 25%

Therefore, $70,000/$1,000,000 = 7% (after-tax) or,

7%/ (1-.25) = 9.333% (before-tax)

Therefore, 9.33% is the annual rate of return (before taxes) you would need to earn in order to achieve your return objective.

2. Assess risk tolerance. Risk assessments can come in all types of shapes and sizes, but the two important things are measuring both your ability to assume risk and your willingness to take risk. The former is more of a quantitative assessment and will take into account your net worth, income and those kind of factors. The latter is more of a qualitative assessment and has to do with your behavior and how your mind thinks about risk. Usually, a risk tolerance questionnaire is used to assess a person’s willingness to take risk. Here is a link to one that is really good (in my opinion!)

2. Set investment constraints. (Bear with me, we will get to the fun stuff!) Constraints are also very important because they set boundaries around your investment process. Many investors find themselves uncomfortable with portfolio investment choices well after they are made because this step is often missed or not even discussed. Will there be tax considerations to take into account? How much liquidity should the portfolio maintain? How long is the time horizon? Is this a single or multi-stage investment plan? Should the investments be socially responsible? Will there be a wealth transfer that involves gifting to heirs? As you can see the questions can go on and on as well as be complex. These should be explored with a qualified professional.

3. Create an asset allocation. Here is the part that most plans “skip” straight to. Now of course, the plan must include assets, but what mix is appropriate? Well luckily by now you have taken the time to go through the previous three steps making this process much less elusive. Let’s see what data we’ve collected so far:

Investable assets: $1,000,000
Annual after-tax income needed: $70,000
Tax Rate: 25%
Required return: 9.333%
Risk Tolerance: High
Current Age: 35
Time Horizon 25 years until retirement, then 30 years until death

From here, we can narrow down the asset classes we should choose from. For example, we know with such a long time horizon (25 years) this investor should have a large portion of “equity-like” (i.e. stocks) in the portfolio for growth. Also, from the risk assessment we see that equities as an asset class are appropriate. We could even diversify further between domestic, international and emerging equities. Next, we see that the tax bracket of 25%, would make municipal bonds more appropriate than government bonds and maybe even corporate bonds depending on the rates of return. However, we already know that bonds as an asset class will comprise a lesser portion of the portfolio due to the relatively high rate of return needed (9.33% per year).

5. Create a system to monitor results. Set it and forget it has rarely worked as a strategy. Portfolio winners must be eventually sold off as they will begin to become a bigger percentage of the overall portfolio. Losers may need to be sold in tax loss harvesting strategies or if they are just weak performers. The trimming of each, represent necessary portfolio rebalancing at regular intervals. The frequency of the intervals will most likely be a function of transaction costs.  Additionally, you will want to know how close you are coming to your return objective.  From the above example, approximately 0.78% must be earned each month to achieve the annual return objective of 9.33%.  This can be tracked by the monthly statements generated by your brokerage firm or investment advisor.

Invest wisely!

Higher Interest Rates…So What’s the Problem?Part 2

Last post I spent some time discussing the impact of higher interest rates on portfolio strategy for investors.  I thought that it might make sense to discuss possible global effects as opposed to individual portfolios.  There are many implications for how a given economy may respond to moves in key interest rates that has various portfolio implications

  •         Higher interest rates = higher borrowing rates = declining trend in purchasing habits.  If you consider there are only two ways to purchase goods–credit or cash.  Cash purchases are largely unaffected by interest rates.  I mean if you have cash in your pocket to pay for a good you just do it.  However, credit purchases (which also tend to be larger purchases) are affected by interest rates.  The takeaway is that as interest rates increase, the cost of borrowing also increases which (in theory) should negatively impact credit purchases.  This is intuitive since the FED will lower interest rates in economic expansion and raise interest rates in order to slow economy.

Implication in portfolio strategy–> Sectors that involve lending would be favorable.  One example of this could be financial services, in that banks can increase the “spread” they pocket by charging higher rates on loans over time.

  •         Higher interest rates = more foreign investment .  If you lived in any country you essentially have two choices for investment–domestic or foreign.  In this simplified world, you would prefer to place your invested capital in the investment with the highest possible return (ignoring risk for now).  All else being equal, invested capital seeks its highest return.  So let’s now include the discussion of risk.  Any country’s risk-free rate is basically the rate you would earn on a cash deposit.  Given this, we can now establish that you would rather earn a higher return on your cash deposit than a lower one even if you had to deposit your cash into another country’s bank.  This is the intuition behind why higher US interest rates will pull capital out of lower interest rate countries into higher interest rate countries for the extra return. Adjusting for the risk of default, according to current central bank rates, the US seems to be one of the best choices for cash investment currently.  (Assuming you don’t want to make a cash deposit into Brazil or Russia!)

Implication in portfolio strategy–>Debt obligations of sovereigns with favorable economic outlooks would be favorable.  One example could be US bonds (e.g. government, corporate, municipal).  Specifically, longer maturities assuming portfolio construction includes bond laddering.

  •         Higher interest rates = stronger domestic currency.  This next notion probably will not be as intuitive given the current state of the global economy, since ultra low interest rates in the US have seen the US dollar as strong as it’s ever been.  Theoretically speaking, lower interest rates should weaken a currency given our previous argument because of capital “outflows” to find higher paying currencies (see the following discussion for more detail).  Suffice to say, this phenomenon is rare and is due to a myriad of other factors that are not within the scope of this discussion.  (Hint: One possible factor is that the US dollar as the reserve currency of the world attracts capital when the fear of global recession exists regardless of the level of interest rates.)  So, consider that foreign capital seeking higher returns will  buy dollars.  This demand for dollars will only increase its value relative to the currency being sold (in order to buy it).  Next, consider what happens on the other side of the equation, as capital leaves the foreign country (to buy USD), the foreign currency being sold will weaken.  Ultimately the price of goods in that foreign country will fall (relative to the US dollar).  This is what you are seeing in copper and other soft metals markets.  It is a multi-fold effect in that the country that exports the good receives less of their domestic currency (when they sell) and thus have less to pay back loans, thus deepening the debt cycle.

Implication in portfolio strategy–> Most commodities (e.g. metals, energy) investments, and the weaker emerging markets economies would be unfavorable.  For example, metals like copper have experienced multi-year lows as of this writing as demand has weakened and the copper producing nations have accumulated deficits.

Invest wisely!