Smith: I have no issue with paying taxes and whatever needs to be done for my country to grow. I believe very firmly that my ability to sit here—I'm a black man who didn't go to college, yet I get to travel around the world and sell my movies, and I believe very firmly that America is the only place on Earth that I could exist. So I will pay anything that I need to pay to keep my country growing. . . .

Interviewer: Do you know how much in France you would have to pay on earnings above one million euros [under new French President Francois Hollande's proposal]? Not 30%. 75%.

Smith: 75?! Yeah, that's different, that's different. Yeah, 75. Well, you know, God bless America.

In today's Wall Street Journal, Rich Karlgaard contrasts the hype of the upcoming Facebook IPO with the much more important trends in U.S. manufacturing and energy technology.

Excerpt:

The modern-day code rockers are not mere nerds, either. They form an Algorithmic Army of slightly surreal folks like, well, Mr. Zuckerberg. They seem to be pale men with oddly flat voices and faraway gazes who prefer to hide out in the bathroom during the IPO roadshow. When finally coaxed onto the stage to face investors, the great Zuckerberg appeared in a hoodie.

That can't be America's future, can it?

Read more here (The Wall Street Journal, May 17, 2012)

Economics is not called the dismal science for nothing. Many professional economists go to great lengths to obscure simple truths inconvenient to their political masters. The media then promote these obfuscations, which are designed to appeal to a misinformed electorate. And that is the truly dismal part.

Much of the economics politicians peddle – and voters think they know – is pure bunk. For a different perspective, here are 10 common sense propositions I challenge political economists to refute.

Read more here…

Justice may be blind, but who works overtime to make it deaf, dumb, and stupid?

Which would you imagine might attract more aggressive enforcement from the Justice Department: the theft of $1.2 billion from supposedly segregated customer brokerage funds, or lying about an alleged incident of whistling to attract the attention of a whale so that whale watchers could get a better peep? If you said the latter, then you appreciate the extent to which federal law enforcement priorities have run off the rails.

Read more of "Corzine Steals Billions Sans Charges, Errant Whale Watcher Faces Prison" here.

Dear investor,

In line with the rest of our industry we are making some changes to the language we use in our marketing and communications. We are writing this letter so we can explain these changes properly. Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.

We know we used to promise “absolute returns” (ie, that you would make money regardless of market conditions) but this pledge has proved impossible to honour. Instead we’re going to give you “risk-adjusted” returns or, failing that, “relative” returns. In years like 2011, when we delivered much less than the S&P 500, you may find that we don’t talk about returns at all.

It is also time to move on from the concept of delivering “alpha”, the skill you’ve paid us such fat fees for. Upon reflection, we have decided that we’re actually much better at giving you “smart beta”. This term is already being touted at industry conferences and we hope shortly to be able to explain what it means. Like our peers we have also started talking a lot about how we are “multi-strategy” and “capital-structure agnostic”, and boasting about the benefits of our “unconstrained” investment approach. This is better than saying we don’t really understand what’s going on.

Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry’s shorthand for 2% management fees and 20% performance fees. It is, we’re sure you’ll agree, important to keep up some traditions. Thank you for your continued partnership.

Zilch Capital LLC

Well, unfortunately, we’re watching active fund managers behave badly once again. This time, they can’t resist Apple’s stock after it climbed to new highs and is now the biggest company in the world.

Apple Inc.'s surging shares have prompted hundreds of mutual funds to buy the stock—including many that aren't expected to invest in a giant, U.S.-based technology company that pays no dividends.

At least 50 small-cap and midcap mutual funds—which focus on small and midsize companies—own Apple, the world's largest company by market value, according to analyses for The Wall Street Journal by market-data firms Morningstar Inc. and Ipreo Holdings LLC. Non-U.S.-focused funds also own it. Apple doesn't pay a dividend, but about 40 dividend-focused funds hold its stock. And Apple shares can be found even in one high-yield bond fund.

Read more here…

TODAY is my last day at Goldman Sachs. After almost 12 years at the firm — first as a summer intern while at Stanford, then in New York for 10 years, and now in London — I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it.

Read more in the New York Times here.

Goldman Sachs Group Inc., the frequent target of criticism for its aggressive pursuit of profits, again found itself in a harsh spotlight Wednesday when a London-based executive resigned from the firm in a New York Times opinion piece that assailed the firm's culture as "toxic and destructive."

Read more in The Wall Street Journal here.

By now, it has been well established that Corzine’s former firm, MF Global, committed the sin of sins for a broker-dealer. In late October, during the final, desperate days before it entered bankruptcy proceedings, its executives took money from segregated customer accounts — money that belonged not to MF Global but to the farmers and commodities traders that were its clients — and used it to prop up its rapidly collapsing business. Nor was this petty cash: of the $6.9 billion in customer assets that MF Global held, a stunning $1.6 billion is missing. There is virtually no chance that the full amount will ever be recovered.

The New York Times, March 12, 2012. Read more here.

The decline of the English-speaking world has been greatly exaggerated.

It’s indisputable that the Anglosphere no longer enjoys the overwhelming global dominance that it once had. What was once a globe-spanning empire is now best understood as a union of language, culture, and shared values. Yet what declinists overlook is that despite its current economic problems, the Anglosphere’s fundamental assets—economic, political, demographic, and cultural—are likely to drive its continued global leadership. The Anglosphere future is brighter than commonly believed.

Read more in City Journal here.

Back in the spring of 2009 I was approached by a middle-class investor in a panic. She had dumped all her stocks in the fall of 2008, following the Lehman Brothers collapse. She just couldn't stand watching her life's savings evaporate before her eyes. By the time we spoke, the stock market had already rallied sharply, but she was too afraid to jump back in. She just didn't trust it. I couldn't coax her. She was terrified.

It's a typical story, and the results are plain to see. Last week, the Dow Jones Industrial Average hit 13000 for the first time since the crash. It has recovered most of the ground lost from the peak. When you include dividends, someone who invested on the day before Lehman collapsed is now up a remarkable 18%. If they invested at the lows three years ago, they have doubled their money.

Read more in SmartMoney here.

Warren Buffett: Baptist and Bootlegger

Peter Schweizer, reason.com

During the financial crisis in the fall of 2008, Buffett became an important symbol on television. He filled the role of fiscal adult, a responsible father figure in the midst of irresponsible Wall Street speculators. While pushing for calm and advocating specific market interventions in both public and private, however, he was also investing (sometimes quietly) so he could profit once his policy advice was implemented. This put Buffett in the position of being both Baptist and bootlegger, praised for his moral character while shaking his finger all the way to the bank.

Read more…

Lost in the intense scrutiny of the 15 percent tax rate that Mitt Romney paid on his capital gains and dividend income is the fact that capital gains and dividend taxes are a second layer of tax on corporate profits. In other words, before a company distributes $1 of profits to its shareholders, it must pay the 35 percent federal income tax on that profit. Individual shareholders, then, must pay the 15 percent personal tax rate on that dividend income.  

When both of these taxes are added together, along with state-level taxes, the U.S. currently has the fourth-highest overall tax rate on dividend income among the leading economies at 52.1 percent, according to the OECD. As the table below indicates, this is actually an improvement over 10 years ago when the U.S. had the second-highest dividend rate at 67.3 percent. The improvement is the result of the Bush-era tax cuts that lowered the tax rate on dividends from 39.6 percent – equal to the top individual tax rate in 2000 – to 15 percent, equal to the tax rate on capital gains.

Full story

Swindling people who trust you is more prevalent than you might think

MISTRUST of mainstream finance is all the rage. But lean economic times also make get-rich-quick schemes more tempting, and desperation breeds gullibility. As investors in Bernie Madoff's funds found out to their cost, frauds are more prone to exposure in a weak economy—when it becomes clear who has been swimming naked. The FBI is currently probing 1,000 cases of investment fraud, more than double the number in 2008. Meanwhile America's Securities and Exchange Commission filed more than twice as many Ponzi cases in 2010 as in 2008.

The asset class mutual funds of Dimensional Fund Advisors (DFA) are available only to investors of approved investment advisors. The discipline and long-term focus of these advisors and their clients are evident in this graphic. Old-school Wall Street continues to promote emotion-based, short-term speculation as long-term investing, and millions of advisors and investors blindly follow its lead like lemmings off a cliff. For the enlightened few, there is a better way.

JT

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional's figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor's Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.

The private equity business has taken a pounding in the mainstream press, from both sides of the political spectrum, because of Mitt Romney's history with Bain Capital. The degree of misinformation, biased reporting, and outright ignorance on this topic does not surprise us–most of what we read on economics, finance, and investments in the mainstream press (and now the blogosphere) is shamefully shallow and devoid of facts–so it's nice to come across an article worth a read. Steve Kaplan, the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, has written such an article in The American this month.

We're not endorsing private equity as an investment due to liquidity, risk, cost, and other factors, and we believe a globally diversified asset class portfolio of public securities is a better choice for long-term investors. In fact, it should be pointed out that Kaplan's statement that "On average, every dollar invested in a private equity fund delivered at least 20 percent more than a dollar invested in the S&P 500" isn't that impressive when one considers that an index of small value stocks* delivered 35% more return than the S&P 500 over the past 84 years.

JT

*DFA US Small Value index, 13.0%; S&P 500 9.6%;1928-11/2011. Source: Dimensional Fund Advisors 

 Vice President, Dimensional Fund Advisors

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller’s most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron’s included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as “one of the greatest investors of our time.” A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to “think about thinking” suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller’s bold and concentrated investment style would never be confused with a “closet index” approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller’s overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund’s expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund’s performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion’s share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has “lost his touch” or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, “As William James would say, we can’t really draw any final conclusions about anything.” Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

REFERENCES

Andy Serwer, “Will the Streak Be Unbroken,” Fortune, November 27, 2006.

Edward Wyatt, “To Beat the Market, Hire a Philosopher,” New York Times, January 10, 1999.

Tom Sullivan, “It’s Miller Time,” Barron’s, October 12, 2009.

Diana B. Henriques, “Legg Mason Luminary Shifts Role,” New York Times, November 18, 2011.

Standard & Poor’s

Morningstar Inc.

Excerpt:

All the same, we think there are some profound, if obvious, lessons here — mostly about hero worship in the investment world and how we fail to understand, or try to avoid understanding, the role of luck in our lives and in the lives of those we emulate.

It’s a behavioural quirk that we feel the need to explain what we don’t really understand, and because we’re not good at understanding randomness, we tend to think that excellent outcomes are mostly the result of great decisions made by wise individuals — even in situations where we can’t verify if that’s the case.

That won’t change, and we’re a forgetful species. Eventually — maybe not for years, but eventually — the economy and the markets will be healed, and new fund managers will grace multiple Barron’s covers and be elevated in the minds of their peers to plains higher than what is justified or reasonable.

The cautionary tale of Bill Miller will be soon forgotten. Given the way his tenure as head of the Legg Mason Value Trust has ended, perhaps he can take solace in that.

More…

The fact that these “stars” are a statistical certainty (just like the one “talented” orangutan out of a thousand that can flip ten heads in a row in a coin tossing contest) and no one is able to predict “stars” in advance and ”stars” always flame out eventually (or get fired or die) is totally lost on the star-gazing advisors and their unfortunate clients.

The rise and fall of Legg Mason’s star manager, Bill Miller, is a case in point, as Jason Zweig in the video below explains (iPad, iPhone, and iPod users should click the link to The Wall Street Journal web site below).

The video was posted on The Wall Street Journal web site here.

More about this programme: http://www.bbc.co.uk/programmes/b00wgq0l

We do not engage in market timing in any form at Equius Partners, given that strategy’s abysmal track record. But we do try to guide investor expectations by reviewing short-term returns and the accounting fundamentals of asset classes relative to historical levels. In the August 2010 Asset Class newsletter article titled “Value Investing 2.0,” we reviewed the price-to-book ratios of the S&P 500 and several of the value-tilted DFA funds. Our primary emphasis was on pointing out the wide valuation swings of the S&P 500 index compared to passively-managed, well-structured, and value oriented asset class funds. We attribute this to the fact that the S&P 500 index is essentially a “roach motel”: stocks check in, but they seldom check out (until they’re near death). The phrase isn’t in reference to the quality of the names in general.

In contrast, value-tilted asset class funds, like DFA’s, select stocks based on strict price-to-book ratio rules (relative, not absolute) and sell stocks that rise in price to the point where they no longer meet the criteria and buy stocks when they do. This tends to keep average valuations more constant (and drives the performance of these funds in a classic buy-low, sell-high fashion). Of course, as the old saying goes, a rising tide lifts all boats. So we expect average valuations for value stocks in general–large and small–to rise with a generally rising market. Here is a recent historical perspective to consider.

The first chart shows the change in price-to-book ratios and performance from late 2000, near the market peak, to September 2002, a market bottom. Note the dramatic change in the S&P 500 valuation relative to the asset class funds.

This second chart shows the change from the market bottom to June 2007, that cycle’s market high. Here we see a pretty substantial change in the valuations of the large and small value funds.

The third chart shows the change in valuations that occurred during the global financial crisis. Note in particular how far value stocks declined relative to the large growth stocks that dominate the S&P 500 index. Yes, Virginia, value stocks are riskier.

The fourth charts shows the recovery of valuations and returns since March 2009, the most recent market low.

Finally, we compare valuations today with those in late 2002–the beginning of the recovery from the Internet boom-gone-bust. Notice the similarities in price-to-book ratios for the value-based asset class funds.

We are not presenting this data to suggest a certain rate of return on large and small value stocks going forward. No system has been developed that can predict returns based on changes in fundamental accounting ratios. But the information might be useful in “seeing a light at the end of the tunnel” and believing it portends higher expected returns instead of another oncoming freight train.

JT

Source: Dimensional Fund Advisors

Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This blog entry is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

From John Tamny at RealClearMarkets.com

Dissembling about the capital destruction debacle that was his Administration’s loan guarantee to bankrupt green-energy firm Solyndra, President Obama told ABC News last week that “if we want to compete with China, which is pouring hundreds of billions of dollars into this space…we’ve got to make sure that our guys here in the United States of America at least have a shot.”

Of course if the president were better schooled in basic economics, he would well understand that “our guys” do have a shot to compete in this space thanks to U.S. capital markets being the deepest in the world. Thanks to angel financing, venture capital, PIPEs, convertible bonds, bonds themselves, and stock issuance, those with a good idea have myriad options when it comes to marrying their innovation with capital.

And there lies the obvious problem with Solyndra. Unable to raise needed operating funds in the private markets, it was forced to go to the federal government to get what our markets would not provide.

The implications for our economy are similarly obvious. Though $535 million is presently a laughable sum to a government that knows no limits, and which doles out a great deal more to support the waste that increasingly symbolizes Washington, there’s an unseen quality to this.

Full article…

“Social Security is structured from the point of view of the recipients as if it were an ordinary retirement plan: what you get out depends on what you put in. So it does not look like a redistributionist scheme. In practice it has turned out to be strongly redistributionist, but only because of its Ponzi game aspect, in which each generation takes more out than it put in. Well, the Ponzi game will soon be over, thanks to changing demographics, so that the typical recipient henceforth will get only about as much as he or she put in (and today’s young may well get less than they put in).”

JT

Source: December 1996/January 1997 issue of Boston Review

The Equius Team is pleased to announce the launching of our new Apple iPad app, Asset Class. It is currently available free and can be found by typing “asset class” in the App Store search box on your device or iTunes on your computer. A preview can also be found here.

The current version of the app features the most recent Asset Class newsletter, all of the past issues posted on our web site, our Equius Blog, and an “About Equius” section that includes our six core web site videos and a link to our web site. Our goal in developing the app was to provide the quickest and easiest delivery of an electronic copy of Asset Class to our clients, prospective clients, business associates, and others. As new issues of Asset Class and new blog postings are added to our website, the Asset Class app will be updated automatically.

We encourage you to share the availability of the Asset Class iPad app with family and friends who you believe may benefit from our investment insights. As you know, our goal with the Asset Class newsletter is to promote sound investing principles; warn of the pitfalls, myths, and charlatans of our industry; and increase confidence and reinforce the importance of discipline and structure to the success of a long-term asset class strategy. Those without an iPad can still access all of the content via our equiuspartners.com web site.

We look forward to adding new features to the app as time goes on. As always, we welcome your input and opinions. Once you have had a chance to review the app, please take a moment to add your comments in the Apple App store. Please keep comments/opinions/suggestions specific to the app and asset class investing in general, however, since the SEC strictly forbids testimonials about our services or team.

Thank you.
The Equius Team

The Government and the Great Depression (PDF)

JT

Even if you are among the enlightened who invests in index funds or structured asset class funds (like DFA’s), the book might serve as excellent reinforcement of principles and a reminder of how and why “Wall Street” is so corrupt and destructive when it comes to building meaningful wealth for the vast majority of individual investors.

I write often in Asset Class about “Wall Street.” Ron does a nice job describing what we mean by this term in the first chapter of his book. Please click on the link below for a PDF copy of the chapter:

Wall Street: The Greatest Obstacle to Your Financial Peace of Mind

The book can be purchased at Amazon here.

The “Distinct portfolios only” value eliminates all the multiple share classes of the same funds. Then we eliminate index funds, but, unfortunately, M* doesn’t consider all of DFA’s funds as index funds. Then we make sure they all have 15-year track records. Finally, we eliminate master/feeder funds (those that own other funds as their holdings). The GMO fund still shows up, so we have to eliminate it as well.

We used a 60/40 mix of the Russell 1000 Value and Russell 2000 Value funds to compare to the actively managed fund survivors because that mix of large and small value stocks is our default mix for client portfolios. Of course, we use the DFA funds in portfolios.

JT

Christina Romer, the University of California at Berkeley economics professor and President Obama’s first chief economist, once relayed the old joke that “there are two kinds of students: those who hate economics and those who really hate economics.” She doesn’t believe that, but it’s true. I’m surprised how many students tell me economics is their least favorite subject. Why? Because too often economic theories defy common sense. Alas, the policies of this administration haven’t boosted the profession’s reputation.

Consider what happened last week when Laura Meckler of this newspaper dared to ask White House Press Secretary Jay Carney how increasing unemployment insurance “creates jobs.” She received this slap down: “I would expect a reporter from The Wall Street Journal would know this as part of the entrance exam just to get on the paper.”

Mr. Carney explained that unemployment insurance “is one of the most direct ways to infuse money into the economy because people who are unemployed and obviously aren’t earning a paycheck are going to spend the money that they get . . . and that creates growth and income for businesses that then lead them to making decisions about jobs—more hiring.”

That’s a perfect Keynesian answer, and also perfectly nonsensical. What the White House is telling us is that the more unemployed people we can pay for not working, the more people will work. Only someone with a Ph.D. in economics from an elite university would believe this.

Full article…

1. Read almost anything written by Ben Graham and make critical adjustments it for the modern era (e.g., elaborate stock picking techniques no longer work in markets made super-efficient due to high speed computers, the Internet and thousands of other information sources, and billions of securities transactions.)

2. Listen to ego-maniacs, especially one who made one really good mega-transaction, talk about how smart they are. Then do the opposite.

So, please, do yourself a favor and watch this video of Mr. T-Shirt & Jeans who owns a basketball team tell you how to invest. Then go back to your broadly diversified, buy-and-hold-with-periodic-rebalancing asset class strategy with complete confidence that you are smarter than at least one billionaire. Now, if the class warfare crew can just figure out how to redistribute his wealth…

(Sorry, iPad users. The video is flash, so you’ll have to watch it on your iMac.)

JT

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.

So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.

It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

– Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.

– Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.

– Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

– Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.

– Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving.¹ A globally diversified portfolio takes account of these shifts.

– Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

———————————

1. World Economic Outlook, IMF, April 2011.

Full story…

Sovereign Debt and the Equity Investor

When the Financial Crisis Inquiry Commission (FCIC) reported in January that the 2008 crisis was caused by lax regulation, greed on Wall Street and faulty risk management at banks and other financial firms, few were surprised.

That, after all, was the narrative propagated by government sources since 2008 and widely accepted in the media, in numerous books, and by many commentators. Writing in the New York Times on June 30, for example, Pro-Publica reporter Jesse Eisinger complained that bankers’ concerns about excessive regulation under the Dodd-Frank Act did not take account of “the staggering costs of the crisis that the banks led us into.”

The notion that the “banks led us into” the financial crisis echoes the narrative of the FCIC’s Democratic majority, which placed the blame for the financial crisis on the private sector and dismissed the idea that government housing policy could have been responsible.

According to the FCIC majority report, the government’s housing policies—led by the Department of Housing and Urban Development and the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—contributed only “marginally” to the crisis. Moreover, Fannie and Freddie “followed rather than led Wall Street and other lenders” into the subprime and other risky mortgage lending that ultimately caused the financial crisis.

With the publication of “Reckless Endangerment,” a new book about the causes of the crisis, this story is beginning to unravel. The authors, Gretchen Morgenson, a business reporter and commentator for the New York Times, and Josh Rosner, a financial analyst, make clear that it was Fannie Mae and the government housing policies it supported, pursued and exploited that brought the financial system to a halt in 2008.

Read more at wsj.com (registration required)

“Wealthy Americans may simply be experiencing investor fatigue, prompting them to pull back and allow their advisors to take the lead in managing their assets,” said George H. Walper Jr., Spectrem Group president. This was after “they underwent a period of intense vigilance and participation during the financial crisis.”

Full article here.

By WALTER RUSSELL MEAD

It is, the pundits keep telling us, a time of American decline, of a post-American world. The 21st century will belong to someone else. Crippled by debt at home, hammered by the aftermath of a financial crisis, bloodied by long wars in the Middle East, the American Atlas can no longer hold up the sky. Like Britain before us, America is headed into an assisted-living facility for retired global powers.

This fashionable chatter could not be more wrong. Sure, America has big problems. Trillions of dollars in national debt and uncounted trillions more in off-the-books liabilities will give anyone pause. Rising powers are also challenging the international order even as our key Cold War allies sink deeper into decline.

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For the twelve-month period ending May 31, 2011, equity investors around the world enjoyed the equivalent of blue skies and bright sunshine while the economic news was partly cloudy at best. Among forty-five developed and emerging-country stock markets tracked by MSCI, all but four had double-digit total returns (in US dollar terms), and twenty-six had returns of 30% or more.

If someone had told us a year ago that global markets would stage such a broad-based rally, we would have been inclined to think that trends in employment, housing, and financial distress were about to take a pronounced turn for the better. It seems hard to argue they have done anything of the sort. Somehow, despite gloomy financial page news that keeps repeating itself, equity prices marched substantially higher.

The moral of the story? Investors should be skeptical of their ability to predict future events and even more skeptical of their ability to predict how other investors will react to them.

Past performance is no guarantee of future results.

If you have any doubts about why the current recovery is so anemic, listen to one of our politicians lecture us on economic theory.

Good for Steve Jobs (rich guy)? How about the success of Apple stores versus Borders?

Sadly, our president made the same kind of reference recently. In an NBC News interview he stated:. … “There are some structural issues with our economy where a lot of businesses have learned to become much more efficient with a lot fewer workers. You see it when you go to a bank and you use an ATM, you don’t go to a bank teller, or you go to the airport and you’re using a kiosk instead of checking in at the gate.” The comment was in reference to a lack of job creation in the current economic environment.

Philip Klein of the Washington Examiner followed the president’s interview with this:

Obama may think automated teller machines are bad for the U.S. job market, but don’t tell that to the thousands of employees of Diebold Inc.

Founded in 1859 by German immigrant Carl Diebold, the company shared a similar history over the next century with its rival, Mosler. Both companies were based in Ohio and built successful businesses making safes and other security products. But their paths began diverging in the early 1970s, when Diebold dabbled in the nascent ATM business.

Four decades later, ATMs account for roughly 75 percent of Diebold’s business, which reported $2.8 billion in sales last year. Diebold is the nation’s largest ATM producer, with most of its 7,000 U.S. employees working in the ATM division — making the machines at their plant in Greensboro, N.C., servicing, maintaining and marketing them.

Mosler never got into ATMs. After 134 years in business, they declared bankruptcy in 2001. Diebold spokesman Mike Jacobsen told me that Diebold could have shared its fate, if not for the new technology.

This kind of economic progress has been described as “creative destruction” by both Karl Marx and Austrian-American economist Joseph Schumpeter. I’ll leave it to the reader to assume which version Rep. Jackson and President Obama subscribe to. By the way, Rep. Jackson owns an iPad and according to another article stated last month that the iPad was “revolutionizing the country” and that it would “fundamentally alter how we will educate our children.” He also suggested that there should be an “iPad for every student in the nation.”

There are now around 500,000 apps for the iPhone, iTouch, and iPad today. Thousands, if not millions, of people around the world are competing with each other to develop the best apps to entertain, teach, inform, and assist end users who are willing to pay for the value delivered. People of all ages, color, culture, educational level, and business experience have started or are employed by new companies developing these apps. Established companies have added or expanded divisions to meet the demand.

Some will make great incomes, some will hit home runs, and many will fail. This is an exciting new phase of American business history, driven by innovation, creativity, hard work, and ambition. Rather than fear this change and try to control it (particularly if you’re a career politician or activist with no business experience) by diverting capital elsewhere because you think you’re smarter than the market, try allowing free people to make free, unsubsidized decisions with their money.

We need to unleash the private sector, not bash it, if we’re to climb out of this economic mess anytime soon.

JT

First, the 1981 recession was significantly worse than this one, so it was the worst since the Great Depression. Second, just like significant drops in the stocks market, steep drops in economic activity are almost always followed by steep recoveries. So the correct narrative should be:

This is the worst economy since 1981 and the worst recovery since the Great Depression.

For a good perspective on this topic and the different approaches used by the government to help the economic recoveries, see Peter Ferrara’s article in Forbes magazine here (registration with Forbes might be required).

JT

Chinese business people have apparently taken a while to get the hang of stock fraud. When a technique known as the Chinese “reverse takeover” first surfaced, it was nearly 20 years ago in Hong Kong.

Back then, the son of one of Mao’s Long Marchers had hauled up in town to establish a local affiliate of communist China’s showpiece Shougang Steel Works. He promptly acquired a moribund local company listed on the Hong Kong stock exchange and, to the surprise and delight of anyone holding the stock, began stuffing it with mainland properties at suspiciously friendly prices.

The stock soared 700%, enriching the company’s shareholders overnight—at least until Zhou Beifang, the princeling in question, was recalled to Beijing and jailed for corruption.

JT

I’ve been waiting a decade to use Exhibit 1. It shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000.

For the article, they used this lead: “Admit it, you still have nightmares about the ones that got away. The Microsofts, the Ciscos, the Intels. They’re the top holdings in your ultimate ‘coulda, woulda, shoulda’ portfolio. Oh, what might have been, you tell yourself, had you ignored all the naysayers back in 1990 and plopped a modest $5,000 into, say, both Dell and EMC and then closed your eyes for the next ten years. That’s $8.4 million you didn’t make.

“Now, hold on a minute. This is no time for mea culpas. Okay, so you didn’t buy the fastest growers of the past decade. Get over it. This is a new era – a new millennium, in fact – and the time for licking old wounds has passed. Indeed, the importance of stocks like Dell and EMC is no longer their potential as investments (which, though still lofty, is unlikely to compare with the previous decade’s run). It’s in their ability to teach us some valuable lessons about investing from here on out.”

Rather than sticking with these “has been” stocks, Fortune put together a list of ten stocks that they described as “Ten Stocks to Last the Decade” – a buy and forget portfolio. Well, had you bought the portfolio, you almost certainly would wish that you could forget about it. The ten stocks were Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley, and Genentech. The average P/E at purchase for this basket was well into triple figures. If you had invested $100 in an equally weighted portfolio of these stocks, 10 years later you would have had just $30 left! That, dear reader, is the permanent impairment of capital, which can result when you invest with no margin of safety.

Exhibit 1: Fortune Magazine’s Ten Stocks to Last the Decade

Source: Investors.com

Video courtesy of Dimensional Fund Advisors.

Note: David Booth’s thoughts on the market aftershocks were recorded late last year before the earthquakes in New Zealand and Japan. In no way were they meant to refer to those tragic events. Having posted the day before the Japan earthquake, we have since renamed the video “The Current Market Aftershock” to clarify.

The reason? “…years of strong performance and inflows from institutional investors.”

What’s going on is that money managers who specialize in emerging markets are finding fewer opportunities in which to invest. There are only so many emerging markets, and only so many stocks within those markets. And prices have risen substantially. We don’t try to predict market tops or bottoms, but when money managers start turning away more assets and more fees, well… ya gotta wonder.

And wonder I did as I flipped through to page 24 and found another article with an emerging markets theme. James Wilbanks, the executive director of the $10 billion Oklahoma Teachers Retirement System, has decided that he’s not happy that his international stock managers are not at their 30% “ceiling” for emerging markets investments. So he’s considering hiring an emerging markets specialist as a result.

High past emerging markets returns = Increase your emerging markets allocation now.

And we wonder why we have a retirement crisis brewing in this country? Good luck, Oklahoma teachers. You’ll need it with that kind of thinking from your retirement executives.

JT

What are the chances they will succeed?

The survivorship-biased Morningstar mutual fund database gives us a very conservative clue. Before we do a screen, let’s set our bar at the Vanguard 500 index fund’s 15-year performance of 6.75% annually. So we want funds that returned 9.75% or more over that period.

Screening for all domestic (U.S.-only) stocks funds that have survived for fifteen years, we find 4,231 funds. Of those, 603 funds provided an annual return of 9.75% or better. That works out to 14.25%. So making your decision just on that screen alone, you have about a 1 in 7 chance of beating an unmanaged value stock index. Good luck, you’ll need it.

But let’s dig even deeper. First, enlightened investors know that there are three dimensions to stock returns, or, in other words, three risk factors that determine almost all of a portfolio’s return over time. They are the “market” (stocks in general are riskier than bonds and therefore should provide a higher return over time); size (small company stocks are riskier than large company stocks); and value (low-priced value stocks are riskier than higher-priced growth stocks). There are no better funds to capture these “risk premiums” than very style-specific DFA index funds. Here’s what we find looking at the past fifteen years:

S&P 500 6.8%
DFA US Large Value fund 8.4%
DFA US Small Cap fund 9.6%
DFA US Micro Cap fund 10.0%
DFA US Small Value fund 11.7%

Clearly, the small cap and value premiums were alive and well over these last fifteen years. Any advisor (indexer or stock picker) who tilted portfolios toward these risk factors should have captured at least some of the extra return.

Note that the DFA US Small Cap index fund almost met the 3% return premium target the 603 stock pickers attained. The DFA US Micro Cap and US Small Value funds exceeded it (the latter by almost 5%!).

So let’s look at the 603 “winners’ more critically. When we screen for investment style (using the Morningstar Category field), we find that all but 64 funds were either concentrated in one sector or industry (e.g., energy, health, natural resources, real estate) or had a style bias to smaller and/or more value-oriented stocks. So taking these advantageous, higher risk biases away leaves just 1.5% of the database who are true winners on a risk-adjusted basis (setting aside luck versus skill).

Now consider survivorship bias. Standard & Poor’s, in their March 2010 SPIVA report, points out that 29% of domestic equity funds left the databases over the past five years due to merger or liquidation. It’s a very reasonable assumption that funds disappear for performance reasons. And no fund company in its right mind would effectively wipe out the performance of a fund that beat the market, whether by 0.3% or 3% per year! So now those 14.75%and 1.5% numbers look high by about 30%.

In any event, what investor in their right mind would gamble their long-term, serious, retirement money on an investment philosophy (stock picking) that fails to beat a much more diversified, unmanaged index almost 100% of the time?

JT

My mentor, a very successful international investor, recently challenged me to name the world’s greatest emerging market. Knowing of my on-the-ground experience and career-long interest in emerging markets, he paused with a smile as I considered the logical answers — China, India, Brazil and Russia. Or perhaps he had in mind a “frontier market” of Sub-Saharan Africa or South-East Asia. But his answer surprised me — the USA.

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Video courtesy of Dimensional Fund Advisors.