The following is a guest post by Rob Bennett.  I’m pleased to announce that Rob will be sharing his thoughts with us here in a monthly column. Thanks Rob!

Gene Mauch was the manager of the Phillies baseball team when I was a boy growing up in Philadelphia. He once said something in an interview that has stuck with me ever since.

Mauch said that, when his team was on a winning streak, his job was to pop holes in the inflated egos of his players. When players are winning, they start thinking that they are so awesome that they can never be beat. They get sloppy. They stop doing sit-ups. They stop backing up throws. They’ve got it. They’re hot. Mauch would yell at the Phillies at such times. It was his job to bring them back to earth.

His job changed when the team was on a losing streak. The same guys who were so full of themselves a week before would now be down on themselves, certain that they would never again find the groove. They so lacked confidence that they were afraid to swing the bat with authority, afraid to take chances on the basepaths, afraid to take control of a game. At these times, Mauch would not yell, no matter how many strikeouts or errors he saw. At these times, it was his job to remind his players how great they had to have been to have made the team in the first place.

I believe in the Gene Mauch rule. It’s easy to yell at people when they mess up. Easy and dumb. People are never as incompetent as they appear to be when they are making mistakes.

And its easy to cheer people on when they are turning up aces. That’s dumb too. No one needs to be reminded of how great he is when the entire world is busy telling him how great he is. People are never so awesome as they appear to be when they are hitting all line drives.

I am a critic of Buy-and-Hold. I advocate Valuation-Informed Indexing instead. Why? Valuation-Informed Indexing is rooted in a belief in the Gene Mauch rule.

Bull markets are the stock market’s equivalent to baseball winning streaks. During bull markets, the temptation is to get overly excited about stocks, to count the phony and temporary bull market gains as permanent. Gene Mauch would not approve.

Gene Mauch would be yelling at investors who took the numbers on their portfolio statements seriously in the late 1990s. Stocks were priced at three times fair value in the late 1990s. That means that stock investors should have been expecting to see a loss of two-thirds of their accumulated wealth of a lifetime as stock prices worked their way back down to fair value in the coming years. But how many investors knew that? How many of the “experts” in this field reminded them?

Gene Mauch would have reminded them. He understood that believing in your own press releases when things are going good leads to laziness and arrogance and that laziness and arrogance lead to losses, both in baseball and in investing. We didn’t need to hear financial planners telling us how smart we were to invest in stocks in the late 1990s. We needed them to bust our bubble. If Gene Mauch had been around, he would have given a few of us a kick in the bottom.

He wouldn’t be doing that today, however.

We don’t need to be brought down a few pegs today. We need to be reassured that we are not the losers that we are coming to believe we are. Mauch would be pointing out to the investors of today that, while prices remain too high today for us to realistically expect good long-term returns just yet, things are certainly moving in the right direction. Afer the next stock crash, prices will be where they need to be for stocks to represent a strong long-term value proposition. Today’s investor should be getting prepared, not depressed.

Buy-and-Holders are like the baseball managers who are thrilled with their teams as long as they are winning and are punching lockers when they experience a losing streak. Buy-and-Holders are the Billy Martins of the investing world, getting excited over the phony profits of bull markets and looking for a place to place the blame when the phoniness inevitably takes things to a bad place. Have you noticed that the same Buy-and-Holders who praised their own genius during the bull years do not accept personal blame for the losses they have seen over the past 12 years? Wins are their doing. Losses are the fault of a bad economy.

Mauch understood that winning streaks and losing streaks are rooted in the same thing — human emotion. When things are going well, we feel confident and our performance goes up a notch. When things are going poorly, we are afraid to show our faces in public and our fears cause us to underperform. You don’t want players becoming too full of themselves during winning streaks. Those that get caught up in a phenomenon that is rooted in luck will feel all the worse when lucks turns the other way. You want your players to achieve emotional balance, to know that they are good enough to win but not good enough to win without working it hard.

So it is with investing. Valuation-Informed Indexers don’t count the phony gains of bull markets as real. When stocks are priced at three times fair value, we divide the number reported on our portfolio statement by three so that we know the real and lasting value of our portfolios. We don’t want to experience panic when things turn bad. The way to avoid panic when things turn bad is not to buy into the nonsense being told when things are going good.

Gene Mauch understood that managing a baseball team is not primarily about mastering the mechanics of hitting or pitching or fielding or running. Baseball teams are comprised of human players with human emotions. The first job of a manager is to help those humans avoid the emotional ups and downs that plague teams lacking managers as smart as Mauch.

Strategies come and go in the stock field. There’s always a new craze. Today it is Buy-and-Hold, tomorrow it will be for something else.

Emotionally balanced investing is not a craze. Valuation-Informed Indexing is the only strategy I know of that never once would have let you down over the 140 years for which we have records of stock performance. Gene Mauch was a genius.

Rob Bennett argues that IBonds are cash, new and improved! His bio is here.

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Youth is when you’re allowed to stay up late on New Year’s Eve. Middle age is when you’re forced to.

~Bill Vaughn

2011 has now passed into the annals of history. How did the financial world fare? What did we learn in the process?

2011 By the Numbers

Let’s start with a short report card on the 2011 performance of a few key indices: (You can click on each index to see the chart.)

TSX: -11.1%

S&P 500: No Change

CRB Commodity Index: -8.3%

Gold: +13.9%

Oil: +6.4%

Canadian Financials (XFN): -4.4%

U.S. Financials (XLF): -17.1%

Bonds (XBB): +9.3%

Canadian Dollar: -2.1%

Shanghai Composite: -22.6%

You can see that, although commodities in general were down for the year, gold and oil still rose. Copper was down over 20%, commensurate with the “global growth is slowing” thesis.

In general, the markets painted a picture of the quintessential secular bear market in 2011. Specifically, the S&P 500 chart maps the volatile road to nowhere that characterizes secular bears. “While the $SPX finished where it started (1257), it swung about 3238 points over the course of the year to do it.” (via @TBPInvictus)

How Did 2011 Predictions Do?

In my overview of 2011 What Ifs, I noted that sentiment was largely bullish to start the year. We had experienced quite the stock market rally off the March 2009 lows and many were anticipating a strong economic recovery and continued support from central banks and governments.

Whether you were a bull or a bear to start 2011, you could probably claim some kind of victory, for the overwhelming trend of the year seemed to be increased volatility. We regularly saw multiple percentage point moves intraday in just about every global index. Precipitous downdrafts seemed to be followed by rocket rides higher with almost alarming frequency as most traders and investors developed a chronic case of headline whiplash.

Bifurcation

I picked bifurcation as my dominant theme for 2011. Based on the underlying biflation thesis I’ve carried for the past few years, I thought we would continue to see a rising cost of living coupled with slow economic and employment growth. I also thought the U.S. housing market would remain stagnant and that we would see a growing divide between the prosperity of high and low income households.

Commodities had risen a lot since the 2008 lows and we had not yet seen the full effects of those increases at the grocery store yet. If you bought groceries in 2011, you no doubt noticed that just about everything has gone up in price by a significant margin. Energy prices remained elevated as well, adding to the strain on the average to low income consumer. Many predict that these high food prices are here for an extended stay.

I also mentioned the bifurcation we’ve witnessed between wealthier and highly indebted sovereign nations. This dichotomy came to a full boil in 2011 as the European debt crisis seemed to be in the financial headlines daily and was regularly mentioned as the one issue that could send markets tumbling or soaring depending on the headline du jour.

Interestingly, the crisis in Europe is rooted in problems caused by economic bifurcation in the Eurozone. Nations with lower debt loads are trying to figure out how to get debt-laden countries to strengthen their balance sheets without taking down the European (and global) economy or asking their own taxpayers to foot the bill in the process – no small dilemma.

Occupy & Steve Jobs

The bifurcation theme is fittingly captured by the juxtaposition of two of the major financial headline-grabbers of 2011: the Occupy movement and the passing of Apple CEO Steve Jobs. The Occupy Wall Street movement grew out of a frustration with the burgeoning divide between the ultra-rich and the not-so-rich. People seemed to have had it with watching financial scandals affect their livelihood and then witnessing the instigators of these crises walk away with multimillion dollar parting gifts rather than orange jump suits and handcuffs.

Very shortly, however, an anti-Occupy meme seemed to erupt wherein the message of the movement was misinterpreted as a wealth-hating, anti-capitalist, anti-success, and (gasp!) anti-American sentiment enounced by jealous whiners. Jamie Dimon’s “stop picking on billionaires” statements were alternately met with applause and derision depending on which side of the Occupy debate you reside. For the record, I’m with The Reformed Broker.

Compare this divisive backdrop with the unanimous grief with which the passing of Steve Jobs was met. Steve Jobs was pretty rich. And yet his loss was sincerely mourned by those who profited from Apple’s zooming stock price as well as those who could barely afford their latest devices – but wanted to buy them anyway.

Although I’ve read a few less-than-flattering articles on Mr. Jobs’ aggressive pursuit of his goals, I can’t help but think that the company he founded may be one of the last bastions of true capitalism. You see, Apple actually makes stuff – really cool gadgets that people find extremely useful in their everyday lives – at home and at work. Nobody seems to mind paying a little more for them and nobody that I know ever said Steve Jobs didn’t deserve to be very wealthy.

Contrast that with the manner in which some members of the financial elite came upon their wealth. Many have derived tremendous income from the creation of derivatives like the CDOs that sunk the subprime market or the CDS that will either protect or implode the financial system, depending on whom you ask. When these things do blow up, the financial elites escape accountability and happily leave others (taxpayers) to clean up the mess. While the financial sector is a vital component of our economy, it has become too large and too powerful. It contributes too little to the real economy and siphons too much capital for itself.

Let’s hope that the capitalist vision of a company that exists for the purpose of, and derives profits from useful contributions to society did not die along with Steve Jobs. Let’s hope that the bifurcation of 2011 someday gives way to the kind of unity engendered by the accomplishments of Mr. Jobs. Real capitalism is alive and well. We just need to cultivate it a little more and get serious about pulling those weeds. These are some of the lessons I’m taking away from 2011.

What did you learn in 2011 that you’re taking with you in 2012?

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You don’t get harmony when everybody sings the same note.

~Doug Floyd

Every so often I like to write about what the bulls are saying versus what the bears are saying. Usually, both make a pretty good case. That doesn’t make it any easier for investors to make decisions, but it does offer them some balanced information which they can then use in any way they like. Today’s bull vs. bear debate zeroes in on a few specific factors rather than presenting a comprehensive overview.

I recently  came across two differing takes on the market heading into the end of the year. The fourth quarter is often pivotal for portfolio managers as it’s their last chance to meet or beat their benchmark. Like it or not, that’s the nature of the game and it can affect markets as investors jump on trends in an attempt to cross the December 31st finish line ahead of the competition.

The Bull

Barry Ritholtz is hardly a permabull, but he began to put more cash to work around the third week in October. He explains several reasons for his Tactical Shift in Portfolios:

1. Seasonality: November and December are typically the months of the year when the stock market performs best. They kick off the seasonally best 6 months of the year, which usually run from November to April.
2. Sentiment: Excessive bearish sentiment exhibited in extremely high short interest had many hedge fund managers poorly positioned for a snap-back rally. Short-covering can ignite and propel a rally even in the absence of strong fundamental underpinnings.
3. Market History: The type of “buying panic” by investors at the beginning of October has few historical precedents. In just 5 trading days the S&P 500 shot up 11.4%. On the relatively few occasions this has happened in the past, markets experienced healthy gains in the following weeks more often than not.

But . . . Ritholtz is careful to point out that he is still a subscriber to the secular bear market thesis. He thinks “a recession is more likely than most economists expect” and that markets will eventually head lower. For the next few quarters, however, factors like seasonality and sentiment may trump economic fundamentals.

The Bear

I recently came across an interesting article that offered a compelling technical analogy between the current market environment and the one that preceded the 2008 crash. According to Short Takes, Stocks Dropped 54% After a Similar Point in 2008. If you’re into charts, this post has a few that may help to remind us that seasonality, sentiment, and history work some of the time, but that they all go by the wayside when markets truly break.

On the other hand, the fact that the charts are setting up in a similar way to those of 2008 does not make another crash a foregone conclusion. It’s just another data point to put in your arsenal for consideration. The reality is that markets can and will move in either direction over any given period of time and the only way to navigate that kind of capriciousness is to have a rigorous risk management discipline in place.

And the Winner Is . . .

Just kidding, of course. You know there’s no winner. 2011 has been a poster child for the type of volatility we would expect to see in a secular bear market. Both bulls and bears can get repeatedly whipsawed and many investors are left with a serious case of motion sickness. Neither bulls nor bears can claim a clear victory.

In this type of market, those with a solid plan and a thorough understanding of their personal risk tolerance will thrive. They will not cling to either bullish or bearish expectations, but having a pretty good understanding of the kind of ride they’re stepping onto, take appropriate precautionary measures.

Those measures may include reducing equity exposure, setting prudent stop loss levels, or buying when valuations become attractive. Investors may choose to implement any or all of the above to manage risk. In this kind of secular bear market, it’s more important to understand the investment context and perhaps more importantly, yourself than it is to track every news headline that crosses the wire.

How are you handling the volatility of 2011? Are you more optimistic heading into year end?

(Photo Credit: Shutterstock)

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Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

~ Sigmund Freud

November started out much the same as October. Global markets plunged. By October 4th, however, most indices had bottomed and proceeded to embark on a historic month-long rally in anticipation of some kind of tangible action to quell the Eurozone debt crisis. As of October 30th, Toronto’s TSX was up about 7.7% on the month while the S&P 500 was up a whopping 13.5%. Those gains moderated somewhat to 5.5% and just shy of 11% respectively because of the Halloween dip.

So what caused the October bounce and subsequent fall from grace? Perhaps there were just enough rumours of a Eurozone debt solution throughout October to float some hope and squeeze some shorts. Perhaps it was the improved U.S. GDP stats and hopeful earnings reports by some large U.S. corporations. Perhaps it was the prospect of China coming to the rescue with their big bag of reserves. Perhaps it was all of the above and more.

What then, caused the rather sudden Halloween reversal? The European debt framework was announced very early Thursday morning and kicked off a “face-ripping” rally across the globe. That enthusiasm had already subsided by Friday and headed decidedly in the opposite direction on Monday and Tuesday.

Why the Rally Fizzled Fast

• Voluntary Haircuts: The European debt deal supposedly included voluntary debt reductions of 50% for institutional holders of Greek bonds. Many have begun to realize that this does not mean that public bondholders like governments will offer the same haircut. Some will stick with the original 21% offer and others won’t take any haircut at all. Details are sketchy, to say the least.
• Capital-Raising Reality Check: As part of the agreement, European banks would be expected to raise capital to shore up their balance sheets. With many of their share prices having already experienced haircuts of their own, this may be easier said than done. Confidence in European banks isn’t exactly flowing freely among potential investors.
• Defining Default: If you offered to pay the bank $100,000 of your $200,000 mortgage and call it a day, would they consider your loan to be in default? You bet. It’s still unclear whether the ISDA is going to call a 50% haircut on Greek debt a default. The semantic sticking point is the word “voluntary.” I guess if banks volunteer to take the hit it’s somehow not a default?
• Credit Default Swaps: It seems like every discussion of the debt crisis comes back to those pesky, opaque, unregulated CDS. The ISDA (International Swaps and Derivatives Association) treatment of the Greek haircut reminds us of the reality that the financial system is still being held hostage by these WMDs. If the ISDA deems Greece to be in default, the CDS on those bonds will be triggered, creating a chain reaction that no one seems to truly comprehend. If they decide that Greece is not in default, then we have to ask what CDS are really good for anyway.
• Where’s My Haircut? Suppose your neighbour got away with the $100,000 discount on her mortgage. Would you maybe like to get the same deal? That’s what many are hoping Spain, Italy, Portugal, Ireland and others won’t do. It’s clear that neither the troika, the taxpayers nor the financial system can support haircuts and bailouts for all.
• China to the Rescue: Much of the market euphoria had to do with hopes that China might come to the table with a lot of money to help stem the crisis. Some think China has enough problems of its own to deal with at the moment. China itself has said that they are willing to help, but that the real responsibility for cleaning up the mess rests in Europe. The fact that China reported weaker than expected PMI data didn’t help either.
• Greek Referendum: On Monday, rumours began circulating that Greece would hold a referendum on whether or not to accept the terms of the proposed bailout. Markets didn’t like this.
• MF’s Monumental Failure: MF Global, a large brokerage and primary dealer filed for bankruptcy protection on Monday, exacerbating market fears about European contagion. With reports circulating that MF Global failed to segregate client collateral and the small matter of a missing $700 million, this news did little to help investor confidence. Don’t worry about CEO Jon Corzine though. The former Goldman Sachs CEO and New Jersey governor will reportedly receive $12 million for his stellar performance over the 19 months he headed MF Global. (And we wonder what those Occupy kids are so upset about.)

 Freudian Markets

It is often said that the bond market is a lot smarter than the stock market. Last week, when stock markets were giddy about the prospects for any kind of Euro debt fix, credit markets were still expressing skepticism. Perhaps they are once again playing superego to the stock market’s id.

The secular bear market that began in 2000 has seen its share of extreme moves both to the upside and to the downside. There have been scary declines that suddenly turn to short-killing rallies. There have also been hope-induced rocket-rides that terminate in disappointing reversals. Heck, we’ve seen all of that just in the past month.

So if we’re in the middle of a quick move lower, what could lead to the next whipsaw higher? For one thing, rumours that Greece is backtracking on the much-hated referendum idea are hitting the wires as I write this and markets, though still negative, have rallied back a little on the news. For another, the Fed could whisper QE3 again – possibly soon.

More Fed action could clobber some newly-minted short positions and light a fire under the gold price. It would be a triumph of the financial id. Hmmm … I wonder what the superego will have to say?

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Eat, drink and be scary.

~Author Unknown

I’ve got a little Halloween-themed Friday Food for Thought for you here today. I came across this article On Market Timing and Whiskey on Twitter via Rob Bennett. Basically, the author takes a 1952 quote about the pros and cons of whiskey and superimposes on it his own take on market timing.

As with any debate, defining the terms is key. Market timing, in some circles, has come to take on a foreboding tone. It is seen as an investment vice, garnering a level of disdain similar to that of whiskey during the days of prohibition. For some, it’s the strategy that shall not be named – the Voldemort of the investment world if you will. As we prepare to celebrate All Hallows’ Eve, I thought it might be interesting to look at whether market timing is really all that spooky.

On Market Timing

For greatest effect, I recommend that you go to Value Restoration Project and read the whole piece. For convenience, I’ll just reproduce the crux of the market timing portion here:

“All right, here is how I feel about market timing: If when you say market timing you mean the loser’s game, the fool’s errand, the speculator’s effort that separates savers from their capital, turns investors into gamblers, lines the greedy pockets of brokers, strategists, and newsletter writers, challenges the irrefutable logic of efficient markets, yea, literally plunders the wealth from widows and retirees; if you mean the evil action that disrupts the well counseled man and woman from the pinnacle of appropriate strategic asset allocation, balanced objectives, long-term orientation into the bottomless pit of fear, and greed, and meaningless noise, high expenses, and tax inefficiency, and short-termism, then certainly I am against it.

But, if when you say market timing, you mean assessing fundamental value compared to price, favoring undervalued assets while avoiding overvalued ones, always demanding a margin of safety and being in cash when none exists; if you mean being opportunistic and forward looking, buying low and selling high; if you mean the activity which saves investors from catastrophic and permanent losses of capital, achieving positive absolute returns, the endeavor that avoids following the herd up the mountain of excess and over the cliff of despair, favoring instead consistent compounding of modest returns, and the ability to sleep well at night; if you mean that undertaking which has provided capital as the gasoline for the engines of economic growth and prosperity, protected purchasing power and met future liabilities, funded robust retirements, sustainable wealth transfer, and philanthropic endowments, then certainly I am for it.“

~ JJ Abodeely, 2011

How Market Timing Is Like Whiskey

It seems perceptions about market timing and whiskey share several common characteristics:

• Used in excess, they can cause real damage to our lives.
• Used in an educated, responsible manner, they can enhance the quality of life for some people.
• Some folks choose not to use them because they don’t appeal to them.
• Some have learned through painful experiences of loss that they are not able to use them effectively, so they choose to abstain.
• Some take a puritanical approach, looking down on those who choose to partake, and advocating for abolition.
• Some use statistics to prove that they are safe for use when employed wisely.
• Some use statistics to prove that they are a danger to the average person.
• Some use them without fully understanding the risks and rewards.

I’m sure you could come up with many more parallels. Feel free to share them in the comments section below.

Everyone’s a Market Timer

For most, market timing means any attempt to strategically move in or out of a given stock, sector, or asset class. Passive investors acknowledge that there’s no way to predict market movements, so many choose to set an asset allocation and rebalance periodically. Many feel market timing is a waste of time.

While I agree that market timing in the sense of strategic, active investing may not be the best way for the average person to invest, I don’t think it’s something we need to lobby against, fear, or avoid altogether. For any investor, there are really only two things that will determine short or long-term returns:

1. The price when you buy.
2. The price when you sell.

In this sense, everyone’s a market timer. Your results depend on when you buy and when you sell. Some may transact more often than others, but we all time the market in one way or another. If you think about it, the whole reason for investing is ostensibly to create a retirement fund for the years when we’re no longer earning income. That fact alone makes investing time sensitive.

For the Record

On Whiskey: I know some folks who know a lot about it, truly enjoy it and understand that moderation is imperative if they are to keep enjoying it. I also know a few people who are no longer able to enjoy it because it became a liability for them. As for me, I don’t like whiskey, so I don’t drink it. I prefer a glass of red wine with a nice meal, but I wouldn’t presume to tell others whether they should or should not partake in any particular libation.

On Market Timing: I know some folks who know a lot about different market timing strategies. They take full responsibility for their results and enjoy the art of investing. I know others who just don’t care to put the time or effort into it or simply prefer a less active strategy. As for me, I prefer a hybrid approach, but I wouldn’t presume to tell others which strategy is right for them.

Live and let live. That pretty much sums up my 2 cents on whiskey and market timing. Both can have scary consequences, but they don’t have to.

What are your thoughts on whiskey and market timing?

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There is no hiding from the fact that the current economic climate is as bad as it has been for most of the last one hundred years. Savers are being hit by a combination of low interest rates and high inflation, and there aren’t many places to put your money. However, some economies around the world are continuing to boom, so some banks like Legal and General offer customers the chance to invest in emerging markets in the expectation of a better return.

However, is sending your money to the other side of the world really safe? And is it a good thing to do?

Answering the first question is easy enough, even though certain financial institutions haven’t had an easy ride in the press lately, they are still safe to invest with, particularly institutions who have always had a good record with safe investing.

As far as whether investing in emerging markets is a good thing to do, in one sense the answer is undeniably “yes”. The BRICS (Brazil, Russia, India, China and South Africa) all continue to perform well, China is by far the best known, but Brazil is also experiencing an astonishing economic boom that looks set to continue for some time yet.

Therefore, putting your money into these types of markets can earn fantastic returns, much better than you would ever achieve by staying in the UK or Europe.

On the other hand, there is a certain element of uncertainty that goes with investing abroad, even with the best investors around it’s sometimes hard to tell what is going to happen in the not too distant future. There’s no denying that investing in any market is riskier than putting your money into a cash ISA, so if you’re extremely risk averse, it might not be for you.

However, if you are looking for a good return on your investment, and you’re willing to accept a small proportion of risk, then emerging markets are the perfect place to put your money. Further, the best place to invest is always the places that are growing, and as we all know, pretty much nowhere in western Europe currently has a growing economy.

If you’re looking for a better rate of interest, or for more interesting investment opportunities, it may well be worth thinking about investing abroad.

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Every exit is an entrance somewhere else.

~Tom Stoppard

So the markets have really taken it on the chin lately. I read a blog post via Twitter a week ago that said it was a great time to be greedy. It was widely retweeted by many in the personal finance blogosphere. It’s just the kind of confirmation they wanted to hear, but that advice hasn’t worked out too well – at least for now.

I’ve seen plenty of folks chomping at the bit to buy more stocks as prices plummet. Those dividend yields get a lot juicier as the price of the underlying stocks drop! Of course, there’s also room for them to get even more attractive, or to be cut if the economy continues to sputter.

Given the tremendous diversity of opinions out there, I thought it might be a good time to do another Bulls vs. Bears wrap-up. Let’s take a look at the case for buying vs. selling stocks. Most of you already know that I believe we’re in a secular bear market, but I’ll throw that out there in advance so that new readers know that I’m not without my own bias.

The Bear Case

Commodities Collapse: Oil, gold, coal and especially copper have taken a real beating as we’ve entered a new bear market in Canada and the U.S. as well as many other parts of the globe. Many point to the commodities collapse as a sign of economic weakness and problems in China. More on those below.

China Worries: Jim Chanos and many others have been warning that China’s real estate market is a bubble waiting to burst for quite some time. They argue that there’s a lot of debt hidden at the local government level in China. So while the world is fretting over the sovereign debt of Eurpean PIIGS, another time bomb is ticking further to the East.

Recession Is Here: The ECRI (Economic Cycle Research Institute) just announced that the U.S. Economy Is Tipping into Recession. Some would say this is just a continuation of the balance sheet recession we’ve been in since the financial crisis of 2007 – 2009.

Valuations Are Not Attractive Enough Yet: Doug Short looks at the P/E10 ratio and observes the following:

“the latest P/E10 ratio is approximately at the 75th percentile. A more cautionary observation is that when the P/E10 has fallen from the top to the second quintile, it has eventually declined to the first quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its eleventh year.”

Governments Will Act: The presumption among bears is that the political bureaucracy will try to look like it’s doing something, but will just keep doing the same things it’s been doing so far – which obviously have not worked and have likely made things worse. This toxic combination of prolonged ineptitude and impotence may give rise to more civil unrest as it dawns on average citizens that the trillions of dollars of relief they gave to the banks in the last crisis fixed nothing. (If you still don’t understand how this happened, please take a look at The Great Bank Robbery or Banking’s Self Inflicted Wounds.)

The Bull Case

Sentiment Too Bearish: Obviously, the most glaring case for buying right now is simply the amount by which prices have already fallen. Yesterday’s sharp turnaround from deeply oversold levels had the feeling of a market that had just gone too far too fast.

Valuations are Attractive: Some see the recent fall in prices as a great reason to buy more. They view stocks as “on sale” and just like their favourite discounted cereal, they’re going to buy more. Given Doug Short’s commentary, I’m guessing the bulls are using different metrics.

Companies Are Flush with Cash: The market concerns are centered around sovereign and bank balance sheets. That doesn’t mean that companies who are executing their strategies well can’t thrive. The best companies will be insulated and many of them raised a lot of cash in the last crisis.

Governments Will Act: Bulls aren’t sure exactly what kind of rabbit governments will pull out of their hats, but they know that when the announcement comes, shorts will run for cover and buyers will run over each other trying to get back into the market. Again, yesterday’s late day rally seemed to arise from a rumour that a coordinated plan to recapitalize European banks was on the way.

China Will Save Us: Chinese growth may slow, but will pick up at some point, leading commodities and markets higher.

My 2 Cents

I can understand why many investors might be confused and frustrated at having to deal with another cyclical bear market so soon after the last one. Then again, that’s what happens in a secular bear market. It’s interesting to note that bulls and bears share some of the same bullet points, but have very different takes on them. A bull would look at the image for today’s article and see someone running toward the entrance. A bear would probably see someone heading toward the exit. I guess it depends on the context and on your own perspective.

It’s theoretically possible for both the bulls and the bears to be right. It all depends on your time frame. China may indeed slow down. Markets may crash. But even if they do, those with a very long term bullish thesis on China may be willing to deal with that.

Business Insider posted a chart on Tuesday For Those Who Don’t Believe History Repeats Itself. It shows that the S&P 500 close on October 3rd of this year was identical to the close on October 3rd of 2008. There were many calls to be greedy at that time as well. As most of you know, the S&P subsequently fell to 666 in March of 2009 before roaring back to its most recent peak around 1370.

So is it time to buy or not? The bottom line is that the answer to that question is always the same: It depends. It depends on where you’re at with your personal investment plan. Your plan should be based on your age, risk tolerance, debt levels, ability to set aside extra income and how much money you already have invested.

You may have a passive plan that says you stay invested no matter what because you believe markets will be higher by the time you need to retire. You may have very little allocated to stocks because you’re just beginning to save or because you lost confidence in the markets after the last crash. At this point, you may feel like need to make a call on whether you want to enter or re-enter the stock market – or not. That’s not an easy call to make. Next time I’ll tell you about how I’m handling it.

How are you handling the market volatility?

Related posts:

1. Personal Finance in a Secular Bear Market
2. You’re Young. The Economy is Bad. Time to Invest in the Stock Market?
3. China: The Bear Case

The following is a guest post by Rob Bennett. Thanks for sharing your views Rob!

I am a critic of Buy-and-Hold and an advocate of Valuation-Informed Indexing. The one difference between the two strategies is that Buy-and-Holders say that it is not necessary to time the market while Valuation-Informed Indexers believe it is imperative to change your stock allocation in response to big valuation shifts so as to keep your risk profile roughly constant over time. I wrote two earlier guest blogs here describing the practicalities of Valuation-Informed Indexing (The How to of Valuation-Informed Indexing: Part One and The How-To of Valuation-Informed Indexing: Part Two).

The purpose of this post is to describe and comment on Vanguard Founder John Bogle’s views on Valuation-Informed Indexing. Bogle is widely recognized as the primary advocate of Buy-and-Hold alive on Planet Earth today, as I am the primary advocate of Valuation-Informed Indexing. The surprising truth is that, despite common misperceptions, the two of us are not all that far apart in our investing views!

Here are Bogle’s words on Valuation-Informed Indexing: “Big moves out of stocks should not be done at all. Tactical asset allocation — I should say strategic asset allocation rather than tactical — can be done at very rare times, so rare and so difficult to observe, maybe six times in an investor’s lifetime, three times when the market is stupidly high and three times when stupidly low.”

“Big moves should not be done at all.”

This is the one comment that suggests hostility on Bogle’s part towards Valuation-Informed Indexing. The most likely annualized 10-year return for stocks when they are selling at the prices that applied in 1982 is 15 percent real. In 2000, the number was a negative 1 percent. That justifies a big allocation change, perhaps from a 90 percent allocation in 1982 to a 30 percent allocation in 2000. A change from a 90 percent allocation to a 30 percent allocation is a big change and Bogle is here rejecting that possibility out of hand.

Still, I believe that his other words suggest an openness to the concept. I believe that, if Bogle developed a deeper understanding of how Valuation-Informed Indexing really works, he would be less dismissive.

For example, the ordinary procedure would be to go from a 90 percent allocation to a 60 percent allocation at one point and then only years later go to 30 percent stocks. In that event, there would never be an allocation shift of more than 30 percentage points made at a single time. Is a 30 percent allocation shift too big in Bogle’s eyes? Perhaps. But perhaps not.

“I should say strategic asset allocation rather than tactical.”

It made me very happy to hear Bogle say these words. I have had discussions about VII with many experts in the field. Even those who are supportive often refer to the allocation shifts that must be made as being “tactical” in nature. No! There is nothing “tactical” about getting your stock allocation percentage right. There is no decision that an investor makes that is more important than his choice of a stock allocation. The allocation shifts made by Valuation-Informed Indexers are strategic in nature.

“Maybe six times in an investor’s lifetime, three times when the market is stupidly high and three times when stupidly low.”

This statement gets it precisely correct. Some have the misperception that Valuation-Informed Indexers need to check P/E10 values daily or make allocation changes monthly. Nothing could be further from the truth. As Bogle says, allocation shifts should be made about once every 10 years on average.

“Can be done at very rare times”

I don’t entirely agree with Bogle’s characterization that a change made six times in an investor’s lifetime is a “very rare” change.

I don’t agree even a tiny bit with any hint of a suggestion that may be heard in these words that it is not of critical importance to make the infrequent allocation shifts (Where Bogle uses the word “can,” I would use the word “must”). The academic research shows that those six changes will permit the investor to obtain far higher returns at greatly diminished risk, delivering enough benefits in the typical case to permit the investor to retire five to ten years earlier than his Buy-and-Hold counterpart. That’s no small thing.

“So difficult to observe”

This language points to the course of Bogle’s confusion about this strategy, in my assessment. The suggestion is that investors will not know when they need to make the allocation shifts. But there is nothing even a tiny bit difficult involved in knowing when an allocation shift is needed.

The historical data shows that stocks are virtually a risk-free asset class when selling at fair value or less and are insanely dangerous when selling at two times fair value. Is there anyone who is not capable of understanding why he or she should be going with a lower stock allocation when the asset class is insanely dangerous than when it is virtually risk-free?

The other possibility is that Bogle is pointing here to the reality that the investor cannot know when prices will peak and then start heading downward. If that is the concern, the remark is entirely correct but betrays a misunderstanding of how Valuation-Informed Indexing works.

Valuation-Informed Indexers do not engage in short-term timing. We do not know when prices are likely to turn and we do not pretend to know. The fundamental principle that makes Valuation-Informed Indexing so powerful a strategy is that there is no need for investors to be able to time price shifts to be able to take advantage of the benefits obtained by investing more heavily in stocks when the long-term value proposition is strong and less heavily when the long-term value proposition is weak.

Bogle is not a Valuation-Informed Indexer. But I do not view him as being entirely unsympathetic to the concept. I believe that we will win Bogle over in time and that he will provide a huge help in promoting the strategy to millions of middle-class investors. I certainly hope that it turns out that way!

Rob Bennett thinks that John Bogle is an investing genius who made one big mistake. His bio is here.

What are your thoughts?

Related posts:

1. How to Use Valuation-Informed Indexing — Part Two
2. How to Use Valuation-Informed Indexing — Part One
3. Couch Potato Rebuttals

Continuity gives us roots; change gives us branches, letting us stretch and grow and reach new heights.

~Pauline R. Kezer

My computer will be packed and we will probably be en route for stage one of the move by the time you read this. It’s unfortunate that this geographical move is coinciding with more historical economic and market moves. I wish I could follow it all a little more closely. Alas, life happens.

The good news is that if you’ve been reading BJ for the past year or so, you weren’t lulled into complacency by the 2009-2011 rally. To borrow a metaphor from David Rosenberg, you knew that the rally was a house of straw rather than bricks. Hopefully, you managed risk accordingly.

Besides the market, I’ve been short on time, sleep, and as a result, brain power. So I’ll use today’s post to share some ideas from a few folks I respect a great deal. I’d be happy to hear your reflections on their work, but I likely won’t be able to respond for a bit.

• Barry Ritholtz had a great explanation of How the Fed Got Itself Boxed In. This basically goes along with my previously stated thesis that the Fed (under both Greenspan and Bernanke) has used monetary easing like Windex (My Big Fat Greek Wedding reference).
• In Danger: Children at Play Jeremy Grantham chides the U.S. government and the Fed for allowing the financial sector to collect the lion’s share of income gains over the past few decades. He sees this inequality as a destabilizing force in the global economy and society at large. A value investor, Grantham sees the S&P 500 as worth “no more than 950.”
• David Rosenberg shares an installment of Breakfast with Dave via John Mauldin and Barry Ritholtz wherein he reiterates his recession call and elucidates the current global economic situation: “This is not a replay of mid-2010. The global economy is slowing down much faster than was the case then and the problems surrounding sovereign government debt are far more acute. While the Fed may be forced at some point into more easing action, there is more reason to be skeptical of any success now than before.”
• Prem Watsa, the CEO of Fairfax Financial Holdings and one of the more astute investors in the world, sees Dirty Thirties Pain Ahead. He’s worried about the U.S. and Europe as well as a Chinese property bubble. Again, it’s all about the debt.

Any one of these articles would make for great reading, but I heartily recommend all of them. If you’re looking to try to understand the current chaos in the markets, these folks tell it like it is and offer a lot of great details. I always say that investing and life are all about context and all of these articles deliver on that metric.

I’m not sure when I’ll be able to write again, but it would be great if we could get this whole financial sector cancer/systemic risk/derivative Ponzi/economic dysfunction thing solved. You’ll take care of that while I’m out, right?

Seriously, what are your thoughts? How do we get out of this mess? Can we even agree on what the real problems are?

Related posts:

1. A Dozen Good Reasons to Move to Canada

Poetry is nearer to vital truth than history.

~Plato

In our recent discussions about the Couch Potato style of investing, I mentioned that this strategy relies on historical market returns. I pointed out that including a component that reflects valuations might improve the strategy. This is basically the Valuation Informed Indexing approach about which Rob Bennett often writes.

I mentioned in my last post that I like to look at historical data regarding market performance and valuations, but that I didn’t want to rely on it completely. I’ll explain my thinking here and you guys can let me know what you think.

Past Performance Is Not Indicative of Future Results

“History is a vast early warning system.”
~Norman Cousins

One of the things about the financial services industry that always gives me a chuckle is that most advisors and fund managers will try to get you to buy their products by showing you those 100-year charts of the major indices, which of course look like they only ever go up. In the fine print of every prospectus, however, is the standard CYA phrase “Past performance is not indicative of future results.” Translation: “You need to pile into stocks because they’ve risen for 100 years, but we can’t guarantee they won’t go down after you buy. If they do, you’re on your own. (Oh – and by the way, we’ll still get paid.)”

Now I know that neither the Potato investors nor the Valuation Informed Index investors would claim that history will repeat itself exactly. They’re just using it to determine investment probabilities. That’s how I use historical data too. But I also like to incorporate a few other variables, which others may or may not find useful, but have served me well so far:

• Macroeconomic Context: I look at the economy on several levels: 1) What is happening now? 2) What’s happened over the past 10 – 20 years? 3) Where are we in the big, big picture? These are only rough time frames, but the first one might equate to the cyclical economic trend, the second, to the secular trend, and the third to much larger generational factors.
• Technical Factors: I look at technical analysis for various markets. I consider myself a novice, and I’m still refining my skills in this area. Still, when I look at a chart today, I see a lot more information than I did 10 years ago and I’ve learned to trust the charts more than the fundamentals at times. Markets reflect collective psychology and charts are the Rorschach test that maps that psychology. Interpreting them is an art, not a science.

When I look at historical data, I don’t only include market returns or valuations. I will look at charts and macroeconomic factors on multiple time frames as well. This doesn’t mean I catch every market move, get every trade right or accurately predict the future. Far from it. But I’ve managed my risk based on these factors and avoided all of the market carnage of the recent financial crises. I’ve also missed out on some of the gains. I’m OK with that because my portfolio is in the black.

Waiting for Spring

“Each time history repeats itself, the price goes up.“
~Author Unknown

In an article called Get Me Through December, I went through generational cycles based on the Kondratieff seasons. A lot of people think this is bunk, but if you actually read what’s involved in the cycles you might recognize that current economic events look very much like those in a Kondratieff winter. Check out some of the charts and see what you think.

On financial crises: Have you noticed that they’re coming with more frequency and severity? (It’s sort of like labour contractions.) This is actually in line with the idea of a Kondratieff winter and I would expect (hope?) that once “spring” arrives, we will be able to enjoy the birth of a new economic model. This one’s broken.

When I look at the balance sheet problems facing countries worldwide, I can’t help but get much more cautious with my investing approach. That’s one reason I’ve avoided investing very much in the markets for several years now. The bailouts that sparked the 2009-2011 rally did not get at the root causes of the crisis. They only served to transfer the toxic debt from bank balance sheets onto sovereign/taxpayer balance sheets.

Here’s where knowing some macroeconomic history can help our interpretation of real time events. Reinhart and Rogoff looked at “Eight Centuries of Financial Folly” in their book This Time Is Different and found that banking crises are usually followed by sovereign debt crises. I think it’s safe to say we’re there.

While you can’t anticipate every market-moving event, some are pretty obvious well in advance if you take the time to inform yourself. The recent/ongoing crises are perfect examples. It’s a little baffling that those who do the macro research necessary to anticipate these events are often called lucky when they actually come to pass. Those who were looking at a limited set of other factors and missed it feel like they (and their portfolios) were victims of collective misfortune.

Why History Only Rhymes

Mark Twain said “History doesn’t repeat itself, but it does rhyme.” So we can indeed use historical patterns as an early warning signal, but we need to remember that history cannot repeat itself exactly. Why? Because each new historical development affects the next. There are market forces that exist today that did not exist during the historical period that the data cover.

I’ll give you just a few examples of the ones I think will have the most effect on the markets in the near to medium term:

• Derivatives: If I had to choose the single biggest game-changer for how markets play out, this might be the one. Credit default swaps and other derivative products did not exist for most historically documented market periods. Many are aware that if a number of CDS were triggered, there isn’t enough cash in the system to back them. This ticking time bomb is the reason the EU officials were so intent on making sure the “partial default” by Greece was not considered a credit event. That would have triggered the CDS and a cascade of counter party risk that could bring the financial system down – again.
• The European Union: Here’s what I wrote on the topic back in May of 2010: “The European Union wasn’t established until 1993. The mechanics of 27 distinct countries operating under a single monetary policy are complicated. What if one member has run up huge debts and can’t pay them back? Should the healthier nations be obliged to rescue them?” This is one of the factors contributing to the most recent market meltdown.
• Computerized Trading: Many large financial institutions use sophisticated computer models to trade using technical analysis. This can cause a lot of extreme “risk on” and “risk off” moves in the market as similar computer models execute trades at the same time.

 Diversify Your Context

While I love to use history as a guide, I’m careful not to ignore the information coming from other sources. We can’t understand every variable affecting markets at any given moment. Nor can we know the future. It’s human nature to use prior experiences as a context for future decisions and there’s nothing wrong with that. But, to borrow from an article I highlighted in 20 Cents from July, You Are Not an Equation. I’ll reproduce the money quote for you:

“In finance, people built models that use mathematics to describe markets and to describe people and the participants in the markets. And it becomes tempting for them to believe  that the mathematics is a theory and forget that it’s actually an analogy [i.e. model] that  only has limited extension.”

We can look at data and study history and calculate returns as much as we like, but in the end we need to try to take in as much of the whole picture as we can. Reliance on studies, statistics, and mathematics can only take you so far when you’re dealing with matters of psychology. Markets are collective psychology. That’s why trying to interpret them can often feel more like art than science and why science alone probably won’t make you a better investor. Mixing in some new contexts and a dash of common sense can help.

To what extent do you rely on historical data to make your investment decisions? Do you consider the economic context of your portfolio?

Related posts:

1. Book Review: This Time Is Different
2. Financial Spilled Milk: Macbeth Meets Ponzi
3. Investor Sentiment Survey: Marc’s Response

It was widely rumoured around trading desks on Friday that S&P would downgrade the U.S. credit rating, stripping its coveted AAA status. Many dismissed the rumour. After the markets closed, it happened. Now what?

I have no idea what will happen when markets open tomorrow morning. It seems like there’s a pretty good chance of another major sell-off, although the market seems a lot more concerned about the situation in Italy than the U.S. debt downgrade. So far, Middle Eastern markets have opened down sharply, but they weren’t open on Friday, so they could just be playing catch-up.

On the optimistic side, it’s possible that the ECB will come up with something that (at least temporarily) calms the market’s concerns about the European debt crisis. According to some, there’s even a chance that markets could enjoy a kind of “sell the news” rally in the wake of the downgrade – the premise being that the news is priced in.

Also, the Fed’s meeting is this week. If they say something about QE3, that could support markets again. If they do hint at QE3 and the markets don’t have their usual Pavlovian reaction, then it would seem all bets are off.

Here’s a selection of articles I’ve been reading this morning:

Why the Wild Stock Ride? or the print headline: Man the Lifeboats: This Is Not a Drill! ~ Barry Ritholtz in The Washington Post

China Tells U.S. ‘Good Old Days’ of Borrowing Over ~ CNBC

Read China’s Lips ~ Stephen Roach

U.S. Downgrade to Hit Commodity Prices, Panic Unlikely ~ Reuters

This Is What Happens After a U.S. Downgrade ~ Business Insider

Just How Bad Is Bad? ~ Interview with Nouriel Roubini & Ian Bremmer

Debt Crises Trigger Emergency Talks ~ CBC News

ECB Eyes Decision on Italy Bond Purchase to Ease Debt ~ Reuters

S&P Debt Downgrade: Could This Spark a Major Relief Rally? ~ Rougemont on Seeking Alpha

Dollar to Drop on S&P Move ~ Reuters

The newsflow will likely change throughout the day. We probably won’t know much until this evening when Asian markets open or even tomorrow morning when North American exchanges open. I hope you found these articles informative. For real time updates you can follow me on Twitter @BalanceJunkie. Enjoy the rest of your Sunday!

Related posts:

1. History Only Rhymes

I know what I have given you. I do not know what you have received.

~Antonio Porchia, Voces, 1943, translated from Spanish by W.S. Merwin

Well, it took about two weeks, but the Couch Potato cabal piled on all at once in response to my post on Why This Is No Market for Couch Potatoes. Unfortunately, they did so on the day I was out of town with my son for his follow-up surgery so I wasn’t (and to some extent still am not) in the best condition to comment. I’m still busy with post-op pain management and preparing to move, so I’ll have to make this quick, and therefore less thorough than I’d like.

While some fine points were made, I was fascinated by the number of people who commented and attributed a point of view to me that I didn’t think I had put forth. I congratulate Dan Bortolotti (The Canadian Couch Potato) for keeping the discussion more or less “constructive” in his article. Whenever I get email questions from people wanting to learn more about passive investing, I usually tell them that an all-passive approach is not for me, and then I recommend Dan’s site for more information on the details of the approach.

Two Rebuttals, One Day

Two Money Sense bloggers posted rebuttals to my article: Canadian Couch Potato and Canadian Capitalist wrote about it on the same day. You can read both articles and decide for yourself where you stand on the debate and to what extent they addressed the issues I raised.

The Canadian Capitalist article quoted the crux of my argument on how secular cycles could account for the lower than expected Potato returns over the past ten years. Then he described how not all Potato investors are 100% invested in stocks, which is not a claim I made in my article. He went on (in the comments section) to suggest I was “smoking” something in reference to my follow up post in response to a reader question.

For the record: 1) I don’t smoke – anything. 2) It was not my intention to “beat up on” anyone, nor do I think that characterization captures the true tenor of my article. 3) The options I outlined in the follow-up article were not meant to be blanket recommendations, but ideas to consider once valuations come in – and they came in pretty nicely on Wednesday. The point of that second article was to control your risk by controlling your exposure to various asset classes – not to instruct readers on where to put their money at this moment. I’m sorry if that wasn’t clear.

I saw nothing in the CC article to address the data on secular cycles. Rather, Mr. Capitalist cautioned that Potatoes should expect some years of modest returns and suggested that those who outperform the market are just lucky.

The Couch Potato article, which I thought was quite well done, hinted that I thought CP investors were lazy. That’s not true. The intent of my article was to show that Couch Potato investing can be a good strategy, but that it’s wise to fully understand its limitations before employing it.

On Secular Cycles

For those who are interested in learning the facts about secular cycles, please take some time and check out the information on the Crestmont Research site. There are charts, data, and detailed explanations on what a secular cycle is and how valuations affect subsequent investment returns. While there is ample historical data to support the type of ultra-long term returns Potatoes hope to garner, there is also plenty of data to show that taking valuations into consideration can help boost those returns further. Standing aside (even if only partially) when markets are overvalued is another approach that makes sense.

You can also take a look at some of Robert Shiller’s work, which Rob Bennett recently summarized very nicely in a post at Out of Your Rut. It runs along the same lines and is backed by Shiller’s empirical evidence. These are not fortune tellers. These are people using the same rationale (historical data) as Potatoes to invest – with a different twist. For the record, I am somewhat more skeptical of the reliance on historical data than either the Potatoes or the valuation-informed investing contingent for reasons that I can hopefully outline in a future post, but which are at least partially articulated in the quote contained in the next section.

Where We Agree

I agree with Potato arguments that we can’t predict future market direction accurately and that we need a probability-based approach as a result of that. I guess the difference is in which data we look at to arrive at our probabilities, and perhaps in the probabilities we arrive at after we examine the data.

I don’t think all Potatoes are lazy, dim-witted or Pollyana-ish. In fact, I admire the discipline that goes hand in hand with the strategy. I do think that some of them can be very dogmatic. Trying to make something that is essentially an art into a science seems unproductive, and dismissing every other approach as ridiculous is somewhere between inaccurate and arrogant.

It’s easy for novice investors to stumble on the Couch Potato approach and swallow it whole without fully digesting its limitations. One comment summed up some of the challenges and critiques pretty well:

“I think that it is ironic that CCP says: “we cannot predict the future”, but then goes ahead and predicts it by saying that the future is rosier with passive index investing then anything else based on empirical evidence from the past! I think that CCP correctly indicates that one’s investment strategy must be based on determination of personal risk. I think that the risk of expecting the future to unfold like it has in the past is the major weakness of the couch potato passive investment strategy and requires incredible faith! When you are young this type of faith is easier but when you are older you will have found that evidence based research is only valid for today and may not hold for tomorrow which may unfold differently. Many of us believe that the market has changed significantly and that older studies looking at passive index investing may now no longer be valid going forward necessitating a valuation investing strategy.”

I am one of those who believe that the market has changed. Clearly, some agree with me on that, and some don’t. That’s what makes a market.

What’s the Alternative?

A lot of the critiques of my article went along the lines of the following: “Do you think you can do any better?” “What’s the alternative strategy?” If you’ve read this blog for very long, you know that I don’t like to advocate one particular approach over another. There are lots of ways to make money in (and out!) of the market. Not all styles fit for all people.

My aim here is to showcase investment and macroeconomic information that I find compelling and let readers make informed choices for themselves. If your choice is the Potato philosophy, I hope you find it satisfactory. If it’s not, I wish you well with that too.

I think the incorporation of other tools like technical analysis and macroeconomic information can be helpful as part of your overall strategy – if you have the time/inclination to stay informed. In terms of the active vs. passive debate, I still don’t understand why it has to be one or the other. It’s perfectly valid to choose both if that suits your age, risk tolerance and knowledge level.

As for the question Dan put back to me regarding “What if you’re wrong?” I can see that he’s not a regular BJ reader. I ask that question all the time here and I’m never ever sure I’m right. That’s why I like to look at lots of options and let people make their own choices.

For those who are only interested in one side of the story, there are plenty of blogs out there that deliver just that on a daily basis. I try to make this blog a place for discussion rather than instruction. As I’ve said before, I don’t have all the answers, but I try to ask the important questions.

Your comments are welcome.

Related posts:

1. Why This Is No Market for Couch Potatoes
2. Ignorance Makes You a Better Investor & Other Money-Losing Fallacies
3. Passive Investing: Mixed Feelings

If I had a formula for bypassing trouble, I would not pass it round. Trouble creates a capacity to handle it. I don’t embrace trouble; that’s as bad as treating it as an enemy. But I do say meet it as a friend, for you’ll see a lot of it and had better be on speaking terms with it.

~Oliver Wendell Holmes

When I wrote about Why This Is No Market for Couch Potatoes, it sounded like I was saying that there’s elevated risk in both the stock and bond markets at this moment in history. I was. That begs the question then: Where can we invest? If not stocks or bonds, where? Gold? Real estate?

An astute reader posed that exact question and I said I would address it in a future article. So here we go. I presume that all of you already realize that I don’t have any more idea what will happen next in the market than anyone else. The following ideas do not represent investment advice in any way, shape or form. This article is just me thinking out loud, sharing it with you, and hoping you’ll think out loud right back.

On Gold

Gold has been a bit of a nemesis for me for quite a few years. It’s kind of a microcosm of all of the investing mistakes I’ve made over the past decade. First, I read and understood the rationale for all of the gold bug arguments:

• The global debt bubble will force governments to print money in one way or another.
• Global currencies are now fiat money and don’t represent a real store of value. Gold does.
• The serial financial crises caused by the debt bubble will cause a loss of confidence in fiat money and a flight to hard assets like gold.
• Whether we get inflation, deflation or both, capital will run to gold for shelter.

After I read about all of this, I can remember talking it over with a few people and observing that gold might be the buy of the decade. It was trading around $300 at the time. Wow. Was I ever right. The problem is, I never did buy gold. I really believed that we would see a series of financial crises, but I felt like gold might get dragged down with all of the other asset classes if that happened.

Actually, gold did fall for a while during the worst of the 2008 crisis. But I think we all know that it’s considerably above $300 now, having just breached the $1600 mark. I didn’t profit from that run-up at all.

So what can we learn from all of this besides the fact that you might want to take my ideas on gold with a grain of salt? There’s a decent case for it to hit $2000 or much higher if global authorities keep kicking the can down the road. But I can also see why some are uncomfortable investing in a metal that has no real industrial purpose other than the bull market in bling.

If you buy the gold bugs’ argument, you can try to buy gold on dips. Just make sure you have an exit plan. At what point will you take profits? When will you cut losses? If you’re one of the skeptics, put your money elsewhere. There are lots of other options.

How About Real Estate?

Again, it depends on where you live and how you want to invest. If you live in the U.S., property prices have already fallen a lot. That doesn’t mean they can’t fall more, but it seems like prices in the States are getting closer to attractive valuations than those here in Canada, especially with respect to Vancouver and Toronto – location, location, location!

When you’re talking about buying real estate, there’s a big difference between buying a property for investment purposes and buying a personal residence. I don’t necessarily look at our home as an investment, although I wouldn’t want to see the value of the home we just bought fall by a great deal – just in case we need to move again. (Yikes, I hope that doesn’t happen. I’m already sick of packing and we’ve only just begun!)

You can invest in real estate via rental properties, but then you either have to pay a property manager or handle those duties yourself. Some people (myself included) just don’t want the headaches. An alternative might be to look at buying some REITs (Real Estate Investment Trusts). You can buy them individually or through an ETF like the iShares XRE product. It offers a decent yield and it now pays monthly. U.S. investors have even more choice when it comes to real estate ETFs. Again, you can control your risk by controlling your position size.

What If Nothing on the Menu Looks Good?

Given that I’ve also written about the unattractive qualities of bonds, it seems as though nothing on the investment menu jumps out as extremely appetizing. If you feel the same, you have a few choices:

• Skip the restaurant and eat at home. Translation: go to 100% cash and invest in savings accounts and GICs, accepting the boring cuisine as the price of safety.
• Order a combo platter. Translation: choose a few investments that appeal to you and just buy less of them than you normally would.

Suppose you’re worried about the global debt situation and the explosive derivatives that are wired to all of that debt. But maybe you’ve been worried for quite some time and noticed that the market has still risen by over 90% over the past 2 years. You’re not sure how long that can continue, but wouldn’t mind achieving a little more than the 3% or so that 5-year GICs are offering. What do you do?

Again, I can’t tell you what’s best for you, but here are a few ETF options for Canadian investors:

XTR: This ETF is sort of like investing in a balanced mutual fund with about 55% stocks and 45% bonds. It yields around 6% and carries a management fee of 0.55%. Basically, it holds a lot of other ETFs. If you’re looking for a one-stop option, you’re new to investing, or you have only a small amount to invest, this is worth a look.

XUT: This is the new iShares utility ETF. Utilities are usually less volatile, especially in tough economic times and they typically pay a decent distribution.

XEI: This all-stock ETF invests in individual companies rather than ETFs. It pays a monthly distribution and offers exposure to 75 of Canada’s dividend paying companies.

HIX: This is the single inverse ETF for the TSX – no leverage here. It goes up each day by the same percentage the TSX goes down. You can use it as a hedge against one of those mornings where you wake up to red screens across the globe, or just as a way to insure against that debt bomb blowing up your portfolio. (Disclosure: I own a very small bit of this that I trade around occasionally.)

XCB: Another reader said he was shifting out of XIU (TSX 60 equities) into XCB (corporate bonds). This is another option. You can collect the distributions from the bonds of large, stable corporations without incurring the presumably higher risks of owning their stocks.

I wrote in more detail about these three ETFs recently, so you can check out those articles for more detail: 3 New ETFs for Canadians and Income Investing for Canadians. Obviously, your investment options don’t end there. I just wanted to point out that you can still own equities and/or bonds if you want to, that there are ways to generate decent income from some of them, and that you can limit your risk by lowering your exposure. It seems George Soros is taking the same approach with some of his funds, having gone to 75% cash in at least one of them and later announcing that he was exiting the hedge fund business altogether.

Although investing may not be as easy as flopping on the couch with a bag of Cheetos, keeping it simple is always a good idea. There are lots of choices on the menu. You can choose only the ones that suit you, or nothing at all.

Do you have any good strategies for reducing risk?

Related posts:

1. Where Is the Stock Market Headed Next? Part II
2. Where Is the Stock Market Headed Next? Part I
3. What Is a Balanced Portfolio?

The conventional view serves to protect us from the painful job of thinking.

~J.K. Galbraith

A recent article in the Globe and Mail delivered the following advice to investors: Don’t Let a Fear of Bonds Infect Your Healthy Portfolio. The implications are clear:

1. Concerns about ultra-low interest rates eventually turning higher are overblown.

2. If you succumb to the paranoid people who think interest rates can actually rise above 0% – 3%, your portfolio will be unhealthy, damaged, infected. (The image with the article showed people in protective masks.)

3. And my personal favourite: Long term investors need not concern themselves with shorter term market movements because markets always rise over the long term – whenever that is.

So there you go. “Stop worrying so much about bonds.” All you have to do is put your desired allocation in bond mutual funds or ETFs for a long period of time and you’ll be good to go once retirement arrives. So says the analyst of one of the big 5 banks interviewed for this article.

But what if that doesn’t happen? What if all of those crazy people who think markets can move down as well as up, especially after a 30-year secular bull run, are right? What if owning bonds (rather than the fear of owning them) actually becomes the noxious agent in your portfolio? Well, if that happens, you’re bond funds will fall in price and the banks who run them will still have collected their fees from you for the entire period of time you owned them. Happy retirement.

Reasons to Stick with Bonds

Ok, so I’m being a little facetious. Let’s look at both sides of the debate. The bank analyst makes the following points:

• Bonds are a low volatility investment, meaning prices don’t swing as widely as they do for stocks.
• He looked at bonds over the past 61 years and found that “”the downside risk for them is contained.”
• “Now, with interest rates expected to rise when economic growth firms and inflation creeping into the economy from high oil and food prices, there’s growing concern that bonds are going to be a money-losing investment looking ahead. Maybe so. But getting rid of your bonds or bond funds is the wrong approach.”
• ‘“Bonds are an essential element of a diversified portfolio . . . You cannot live without bonds.”’

It’s true that bonds have historically acted as volatility stabilizers for investment portfolios, as they often rise in price (fall in yield) when stock prices fall. Still, the bond market has its own secular cycles and the reality is that it has been in a secular bull market for the last 30 years, aided and abetted over the past decade by monetary policy that has kept short term rates at or near the zero bound. How likely is it that this bull market will continue another 10 or more years?

I don’t know the answer to that, but neither does the bank analyst – or anyone else for that matter. What I do know is that secular bond bull markets can last for decades, but that they don’t go on forever. The laws of probability say that bond prices are more likely to stay the same or fall at some point over the next decade. Common sense says the same. After all, if rates are near zero, how much lower can they go?

Using 61 years of data to conclude that the downside risk for bonds is “contained” seems like the same logic Ben Bernanke and company used to tell us that the risks posed by subprime mortgages were contained because U.S. housing prices had never experienced annual declines before. That didn’t turn out so well.

It’s interesting that the analyst acknowledges that bonds could lose money, but that we must remain invested in them anyway. I’m not seeing the logic there. “You cannot live without bonds.” Really? I think I can.

The Bond Alternative

Regular readers already know what I’m going to say. I think GICs are a realistic alternative to bonds. (For American readers, GICs are the Canadian version of CDs.) In short, they provide the reduced volatility of bonds without the capital risk.

Given the fact that the bond bull is very long in the tooth (although I do think it will remain in place for a couple more years) I’m happy to be out of bonds, collect similar interest rates with 5-year GICs, and rest easy knowing that my capital is safe. I’m not saying you must do the same. It’s just a viable alternative that might appeal to some investors.

Note that if you still want to keep some of your portfolio in bonds, bond ETFs and mutual funds will fall in price if the bond market falls, but those declines can be somewhat mitigated as the manager rolls over maturing bonds and buys new, lower-priced issues. If you hold individual bonds (not that easy for individual investors) you’ll still collect your principal at maturity as long as the issuer doesn’t default. In that case, you don’t have to worry about falling bond prices.

Another alternative is to turn the possibility of increasing bond market volatility in your favour. If you have the knowledge and experience to trade, you can capitalize on market moves using regular and inverse bond ETFs. I don’t feel like I have the acumen to do that, so I opt for the GIC alternative instead.

Absolutes and pedantic pronouncements are dangerous both in investing and in life. Understanding the risk-reward proposition is essential to each decision. No one knows what will happen next in the markets, but each of us can make educated choices based on the probabilities as we see them and our own investment time frame. In the end, it’s your money and only you can take responsibility for the results of your investment decisions.

Do you think you can live without bonds?

Related posts:

1. Are GICs a Good Substitute for Bonds?
2. Questrade Offering Bonds and GICs with No Commission
3. Inflation Protection: Are Real Return Bonds or TIPS the Answer?

Never accept the proposition that just because a solution satisfies a problem, that it must be the only solution.

~Raymond E. Feist

Update: This article was featured in the Totally Money Carnival at Family Money Values. Thanks!

A recent article in Money Sense magazine offered some data on investment returns for the publication’s preferred investment indexing method: the Global Couch Potato portfolio. It’s a simple, low-cost way to invest in a set allocation of stocks and bonds with limited effort on the part of investors. The rise of ETFs over the past decade has turned this strategy from a questionable alternative to mutual funds to a near standard in the DIY investment space. Many personal finance and investing sites promote it as the best way for individual investors to manage their portfolios.

The strategy grew out of a desire to circumvent the high fees built into mutual funds – the investment fad of the previous decade. It was also a great way to address the reams of data that showed that active managers rarely beat the returns of their benchmark indices. These are very rational goals, and to some extent, the Couch Potato approach accomplishes both of them.

Potato Performance Anxiety

“Don’t think you’re on the right road just because it’s a well-beaten path.”

~Author Unknown

It seems the data shows that this Couch Potato strategy returned 4% per year over the last 10 years. That’s better than nothing, and it’s better than some of the indices. But it’s not much better what you could have achieved with a CDIC-backed 5-year GIC ladder. The fact that many active managers performed worse would be little consolation for many investors. 4% just isn’t as impressive as it was supposed to be.

The explanation for the less-than-average market returns goes like this:

“During the last 85 years, portfolios with a mix of 60% stocks and 40% bonds have averaged well over 8% a year before costs. But during the period I looked at, from 2001 through 2010, market returns were nowhere near that. Canadian equities and bonds did reasonably well, with both delivering more than 6%. But U.S. and international stocks were a train wreck: both had negative returns during that period (as measured in Canadian dollars).”

This type of reliance on broad-based historical data ignores the fact that markets experience both cyclical and secular trends over the long term. It’s fine to allow the averages to smooth out shorter-term cyclical periods, but secular cycles that last 15-20 years can have a meaningful impact on your portfolio. That 15-20 year period could fall within your prime saving/investing years. While the market may average 8% per year over an 85-year time frame, it can and does have long periods of time where returns are nowhere near that level. Those are called secular bear markets.

I have written over and over again that we are in a secular bear market that began in 2000. If you took that into account, you wouldn’t be at all surprised to see below-average returns for the Couch Potato portfolio over the last decade. The 20-year period before 2000 was a secular bull market. The Couch Potato approach would have worked beautifully during that time period, but it won’t be effective in a secular bear market.

Dressing for the Wrong Type of Weather

“The only man I know who behaves sensibly is my tailor; he takes my measurements anew each time he sees me. The rest go on with their old measurements and expect me to fit them.”

~George Bernard Shaw

I have no problem with using historical data to help formulate an investment strategy. But you have to use the right context. Using an 85-year context for a 25-year investment time frame probably won’t be very effective. Not too many of us invest for 85 years of our lives. It’s sort of like stepping outside in a bathing suit. It may work in July, but it probably won’t feel great in January – unless you live in Australia.

The same goes for economic expectations. Many economists have been telling investors that the economy has recovered just like it has in every other cyclical downturn over the past 100 years. Again, they are using the wrong context for comparison. There’s more than one type of recession and each requires a different investing mindset.

David Rosenberg has been arguing for years that we are recovering from a balance sheet recession and not a recession triggered by the normal business cycle. If you’re investing for the wrong type of environment, it’s more likely you’ll get hurt. Barry Ritholtz spelled it out for us in a recent Washington Post article: Wall Street Analysts and Economists Have This Recession Recovery Wrong.

Ritholtz also mentions the Reinhart & Rogoff book This Time Is Different. I reviewed the book last year, with the follow observation:

“the economic trajectory after a crisis-induced recession is very different from the one we might see following a normal business cycle-induced recession. Therefore, “standard macroeconomic models calibrated to statistically “normal” growth periods may be of little use.” In that sense, this time is different. It differs from normal cyclical economic activity, but not from what usually happens following a financial crisis.”

So one reason for the lacklustre Couch Potato performance might be choosing the wrong context. Perhaps another is the fact that “Couch Potato investors accept market returns, minus only small costs.” Within that premise is the expectation that markets will provide a pretty good return. I gather that 4% is less than expected, and I would personally like to see it higher relative to the risks inherent in stocks.

Perhaps it’s because I learned about investing outside traditional channels, but I’ve never been able to swallow the idea that I should be aiming for “market returns” or even that I should try to beat the market. The market is not my benchmark. My benchmark is zero. The further from zero I can get on the plus side, the better I’m doing. If the market return is -6% and mine is -4%, I’m not going to celebrate.

And yes, I’m willing to accept more moderate rewards in return for lower risk. The goal of investing, at least for me, is not to meet or beat the market, but to find the right balance between risk and reward. I want to achieve the highest possible reward with the smallest possible risk. There’s nothing easy about that.

Cheetos Aren’t So Healthy

The Money Sense article described the Couch Potato strategy as “the investing equivalent of flopping in front of the TV with a bag of Cheetos.” It’s definitely easier than learning about the stock market and the macroeconomic environment in which we live. On the “easy” metric, the portfolio delivered. The investment returns it generated over the past 10 years, however, were somewhat lower than advertised.

So does this mean we should throw the Couch Potato strategy into the dust bin with all of the other investment fads? Not necessarily. It’s just a reminder that there’s no “easy button” for investing, and there’s more than one way to save for retirement. It’s like those commercials for sugary cereals:  They’re “part of a nutritious breakfast” but if they constitute your entire meal, that’s not so healthy.

You can’t be an ostrich. You still need to use your head. Sitting on the couch with a bag of Cheetos is fine – once in a while. But if that’s your primary modus operandi, you’re probably going to run into trouble at some point.

 Were you surprised by the Couch Potato results? Do you think it’s a good investment strategy?

Related posts:

1. Couch Potato Rebuttals
2. Portfolio Options for a Risky Market
3. On the Evils of Market Timing