Slower Traffic Keep Right - Published in the Santa Barbara News Press in June of 2011

In Texas, there are a lot of highways that have just two lanes of traffic in each direction, just like the 101 traveling through Montecito.  It is very common to see signs along these highways that read; “Slower Traffic Keep Right.”  These signs alert drivers of the need to stay in the right lane unless they are passing someone.  This helps speed the flow of traffic and avoid traffic jams that occur when drivers sit in the left-hand lane blocking faster traffic.  (By the way, this is a huge pet peeve of mine, and I wish California would use the same signs.)  While this message is intended for commuters, I think it applied equally well to investors, especially these days, with such extreme market volatility.

Recently 60 Minutes aired a show on high-frequency trading.  High-frequency trading, in simple terms, involves computer programs that look for certain indicators or inaccuracies in securities trading markets, and, when they find one, blast-off orders for a huge number of shares, getting in and out in seconds, trying to profit only by pennies per share traded.  These pennies add-up when we are talking about millions of shares traded, and can be highly lucrative.  However, the trades also increase volatility dramatically, both for the individual security traded, and for the market overall, especially if you have many high-frequency traders all trading at the same time, based on the same or similar indicators.

The problem of high-frequency trading, and the reason it is so controversial, is that, when we have periods of trading where the market moves down significantly over a short period of time, high-frequency traders identify opportunities to participate in that downside by throwing a massive amount of volume at the market, essentially kicking it while it is down.  Often this accelerates the downward move in the market (or an individual security), which can cause wide spread panic, resulting in even more selling pressure.

There have been some who have called for eliminating high-frequency trading, and all program-based trading for that matter.  We saw a similar reaction to the 1987 stock market crash, which initially was blamed on program trading, although this particular type of program trading was insurance-based and not speculative—programs had been developed that were supposed to protect large institutional portfolios from downside risk beyond certain parameters by automatically selling securities if the market fell by a certain percentage or by a certain amount, or by buying put options on indexes, such as the S&P 500, to provide a hedge against further losses.  When the stock market crashed, these programs were triggered, resulting in even more selling and greater losses overall for the stock market. 

My feeling is that markets should be allowed to trade freely, regardless of volatility.  Since I consider myself to be an investor, as opposed to a speculator or trader, I am not so concerned with daily fluctuations, other than when they present opportunities for me to purchase securities at attractive prices.  Volatility is not a bad thing, per se, although it can serve to confuse some investors, and can create a lot of “white noise” meaning that the longer-term trend can sometime be obscured by the day-to-day action of the markets. 

A true long-term investor should not be swayed by daily volatility.  Instead, each investor should have a well thought-out investment strategy based on their true, long-term objectives and risk tolerance, which should not change, based on short-term fluctuations in the market.  If followed, this long-term strategy should keep the investor focused on their long-term goals, and should prevent them from making rash decisions or panicking, based on any short-term declines that may be caused by speculators, high-frequency traders, et al.  Easier said than done!

I realize that, in the heat of battle, sometimes it is difficult to understand whether the volatility we are experiencing day-to-day is a consequence of short-term speculation, or is an indicator of a more significant economic or financial market trend that will have long-term, negative implications for portfolios.  Herein lies the rub.  How can we accurately determine whether a short-term downward move in the markets is just that, a short-term event, or if it is the beginning of a significant market correction or bear market? 

This is a complex question with no right or wrong answer and no single right answer.  I can only comment on what I do to address this challenge, although there are many experts out there that have varying ways of doing so.  I rely on my analysis of the current and future trends I see developing within the U.S. and world economies, and the U.S. and world financial markets.  That is a really broad and general answer to a very specific problem, I know!

More specifically, I conduct a lot of research on what is happening within the U.S. economy and financial markets primarily, and additional research on how foreign economies and markets will affect the U.S. economy and financial markets.  What I attempt to determine is where we are now, in terms of the economic cycle, and then, based on my analysis of the current and future situation, and adding to that what typically happened during similar economic times in the past, where the economy is heading over the next 3 to 5 years.  From that general overview, I then try to identify those sectors of the economy that I feel will perform best, given my analysis and forecast for the economy.  I also look at each sector to see how it has performed historically, at similar times in the economic cycle, with similar commodity prices, similar interest rates, similar political environments, etc., etc.  This is, of course, not always possible, since there may not be a comparable situation for each of these variables.

Once I have completed all analyses and comparisons, I develop my strategy by deciding what percentage of a portfolio, based on the investor’s objectives and ability to assume risk, should be invested in the various asset classes—their appropriate asset allocation.  Once this has been determined, I then decide how I want to divide-up the assets into sub-categories, based on my expectations for the future performance of the U.S. economy and the various sectors within the economy.  Those sectors I believe will outperform in the coming environment will be over-weighted as compared to their historical averages, while those economic sectors that I believe will not perform well will be underweighted or not weighted at all.

Once the overall strategy has been defined and the initial investments have been made according to my determinations for the economy, etc., I then monitor the performance of portfolios against my expectations and the changing investing environment.  When changes are required, I update portfolios to accurately reflect those changes, always maintaining proper alignment with the investor’s stated objectives and risk tolerance.

There are many strategies available to investors, and what I have described above is a simplified explanation of what I do on a daily basis for my clients.  The important point is that each investor needs to identify the most appropriate strategy for their portfolio that not only makes sense to them, but also has at least the potential to generate the kind of returns that are commensurate with the risks taken.  Most importantly, a well-conceived and executed investment strategy can be the one thing that keeps the investor focused during short-term declines, and prevents he or she from panicking at the worst possible time.  My best advice to true investors is “Slower Traffic Keep Right”—let those who wish to speculate have the fast lane and pass you by.  We will see most of them stranded on the side of the road after they run out of gas.

Armageddon or Opportunity?

The Dow gave up another 62 point today, after yesterday's 199 point plunge.  Uncertainty surrounding the debt ceiling vote, or lack there of, is driving investors and speculators to sell stocks.  I would hope that lawmakers will do the right thing to avoid default and at least pass some kind of short-term measure, but they are already posturing for the 2012 election, so it would not surprise me if they let good sense and prudence take a back seat to politics (again).

If they do pass something, I would expect stocks to rally smartly, which is why I am looking to put some of my cash to work.  We closed right at 1,300 on the S&P 500 today, so we have dropped roughly 50 points over the past few sessions.  If I can get the S&P 500 down below 1,275, I will probably invest some cash with the expectation that Congress will take action to avoid a default.  If they stall, and we default, stocks will likely get hit hard.  If that happens, I will look to put a lot more cash into stocks, once we crash.

Playing Chicken with the World Economy

Stock futures have actually rebounded a bit, as European markets react to the possibility of U.S. default.  It appears that traders are fairly confident that there will be an eleventh hour deal to avoid a U.S. default, with John Boehner and Harry Reid both working on separate short-term debt ceiling solutions.  August 2nd is the deadline, so we still have some time, but time is running out.

The other economic news on the international front is the Moody's downgrade of Greece to Ca.  S&P and Fitch already have dropped their ratings on Greek debt, and with the recent EU bailout, Greece is basically in default, with Moody's now saying their is virtually 100% certainty that they will default on their sovereign debt.  They also stated that this sets a bad precedent for the other troubled countries - namely Portugal and Ireland, showing these countries that they can access capital even when they exhibit horrendous fiscal irresponsibility.

U.S. Stock futures have rebounded from their lows, and are not down about 90 to 100 points for the S&P 500.  We will have to watch the first hour or so of trading to see how traders and investors react to the news of the failure of Congress to reach an agreement on the debt ceiling and on Greece.  So far we are not seeing wide spread panic, but many probably have not heard this news as of yet, so we may be in for a roller coaster ride today and this week.

Failure to reach agreement threatens global markets

Congress has failed to reach any agreement of raising the debt ceiling, forcing a powerful sell-off in the futures markets.  We will open down hard in the morning, unless an agreement is reached overnight, which is unlikely.  The President has called an emergency meeting with Congressional leaders to try to find a short-term solution to raise the debt ceiling by a small amount, to avoid default.  I think we will get the band-aid solution, but the bigger issue will be whether or not Congress can agree on a real solution that includes a balanced budget requirement, which Republicans are demanding.

Muni Madness: What’s next for municipal bonds? - Published in the Santa Barbara News Press in June of 2011

Not too long ago I wrote about municipal bonds and my feeling that specific revenue bonds were more risky in the current environment than GO’s, or general obligation bonds.  Revenue bonds are only supported by the revenues generated by the stated source of that revenue.  For example, a water district bond will be supported by the income the municipality receives from consumers paying their water bill.  By contrast, a GO is a state obligation that is supported collectively by all revenues received by that state.  This means that if one state revenue source falls short, the state will not necessarily need to default on the GO bond, whereas if the revenue bond’s source falls short, the municipality will need to restructure at a minimum, which typically will have a devastating impact on the value of the bond. 

Of significant concern is the fact that the total amount of investor money held in revenue bonds ($2.7 trillion) completely dwarfs the amount in GO’s ($1.4 trillion).  Some states are at even greater risk.  In Florida for example, which was pounded economically by the real estate bubble collapsing, about 90% of all its municipal bonds outstanding are revenue bonds. 

Meredith Whitney, who is best known as a top banking analyst who predicted much of the bank and real estate market problems that we experienced in 2008 up to the present, made a highly controversial call on the municipal bond market last year.  Her report was extremely bearish on municipal bonds and on the municipalities that issue them, citing the glaring realities of the massive budget deficits many states are running, and their very limited number of viable options to address these deficits.  In the report, she predicted between 50 and 100 municipalities would default in 2011, resulting in hundreds of billions of dollars in municipal bond defaults over the coming five years.

Whitney stated in an interview with Fortune Magazine; "I never intended on framing the scale of defaults as a precise estimate, but I continue to believe that degree of municipal defaults will be borne out over the cycle. I meant to point out that the state debt problem is a massive headwind for the U.S. economy, second in importance only to housing."

Just this week, Whitney released a fresh report that is, if this is even possible, even more negative on municipalities and muni bonds.  In this report, she concludes that the future state budget deficits that need to be closed, either by new taxes or massive cuts in social services, are far bigger than the official numbers show, and that debt levels, when all liabilities are counted, vastly exceed the official estimates.  States have generally relied on federal aid, rainy day funds and general obligation bonds to balance their budgets. However, they suffer from the same issues as the federal government in that they have massive future liabilities such as unfunded pensions that generally do not appear on their books.

In her latest report, Whitney examines 25 of the largest states, adding ten new ones to the list as compared with her previous report, including Arizona, Nevada, Connecticut, and Wisconsin. Her data shows that since 2003, state governments have raised annual outlays from $1.5 trillion to almost $2.2 trillion, or $700 billion, but tax receipts have risen only $400 billion ($300 billion less), to $1.4 trillion. In fact, spending continued to grow throughout the recession, while income from sales, income taxes and corporate taxes flattened out in 2007, and in most cases have declined since.

In her report, Whitney cites three major problems, none of which have a viable solution.  First, 46 of the 50 states are obligated to balance their budgets each year. Even with tax increases on many income sources, tax revenues are still falling in most states because of high unemployment and lower overall spending by consumers.  To bridge the gap, she states are getting that extra money from three sources:

·       The federal government has increased aid to the states dramatically through the stimulus - the American Recovery and Reinvestment Act.  Since 2009, the ARRA has sent $480 billion in grants and contracts to states, which has offset over one-third of states’ combined deficits. Unfortunately, the last stimulus dollars will go out this month.

·       States have increased their issuance of GO’s to fund operating expenses, essentially matching long-term debt with short-term cash needs. Those securities are backed exclusively by state tax revenue.  The issuance of GO’s has grown from $67 billion in 2000 to $148 billion in 2010.  Although interest rates are historically very low, this massive increase in outstanding GO’s means that states will be spending more and more servicing this debt, which leaves less money for services.  Today, debt service absorbs half of Nevada's budget, and 40% of Michigan's. In Arizona, California, Connecticut, Ohio and Illinois, the share now exceeds 20%.

·       The third and by far most significant problem is pension costs.  Pension liabilities are referred to as “off-balance sheet debt” because, unlike GO’s, states do not report these obligations on their balance sheets.  Pension liabilities are far larger than GO’s, amounting to roughly $2 trillion today.  The unfunded portion of these liabilities has increase by 50% over just this past year.  Pension funding costs are rising far faster than states’ abilities to fund them.  This means that, at some point, taxes will have to be raised significantly to meet this funding liability (or the stats will be forced to default on their pension liabilities).  This situation is not stable, it is getting worse, and the longer states wait to address pension liabilities, the more severe the consequences.  Worst of all, states are not fully disclosing the extent of their pension liabilities, either current or future—either they don’t want us to know, or they don’t know themselves.  Which is worse?  States are systematically underfunding their pensions as well. Today, states are only covering, on average, 77% of their future liabilities versus 103% in 2000. To fully fund their annual pension costs, states would need to increase spending by over $700 billion a year, or over 40% of their current level of spending.

To plug these ever-widening gaps, states are tapping their “rainy day” funds—money accumulated over the years for emergencies.  While I think we can all agree that, from a financial perspective, it is definitely raining, once these funds are spent, there is no source to replace them.  In 2010, states used about $9 billion from their rainy day funds. 

To add even more uncertainly to the municipal bond picture, the federal government is once again looking for ways to remove the tax advantage municipalities now enjoy on the interest they pay on their bonds.  At present, Munis are not taxable at the federal or state level, making them highly attractive to investors in high tax brackets.  Since 1918, there have been 125 attempts to either diminish or completely do away with this tax advantage. 

The President recently put together a bipartisan commission (The National Commission on Fiscal Responsibility and Reform (NCFRR)), tasked with “bringing the federal budget into primary balance by 2015 and to meaningfully improve the long run fiscal outlook.”  After eight months of deliberations, the Commission released a six-part plan in December 2010.  The key element of the recommendations of the Commission that could impact muni bonds is there recommendation to tax interest on state and local municipal bonds as income for newly issued bonds.  This could actually benefit current bond prices because these bonds that are “grandfathered”—not subject to taxation, would be highly valued in the marketplace.  It would make it really difficult for states to sell new bonds, however, and those new bonds that they sell would need to pay a much higher rate of interest to entice investors to buy them, since they would not have the same attractive tax status.  These new bonds would (theoretically) only be taxed at the federal level (would still be state tax-free), but would still be less desirable.

 

The NCFRR report is just one of several initiatives that are currently circulating in Washington, but it is clear that the federal government is actively seeking to take away the federal tax exemption for municipal bonds. 

Given the current political and economic environment, municipal bond investors need to actively review each bond position held, and make some tough decisions about the true risks in their bond portfolios. 

Credentials Matter - Published in the Santa Barbara News Press in June of 2011

In any business, acquiring the knowledge, experience and expertise necessary to perform well for clients or customers is critical to success.  In the investment arena, this is especially true because the financial markets are highly complex, and because so much is at stake.  With your life savings on the line, understanding the background of the advisor you are working with could make all the difference.

Early in my career, I realized that to do a good job for my clients, I would need to do everything possible to understand the markets and the multitude of investment vehicles available to investors.  I started in the business in 1990 with Lehman Brothers after completing a degree in Finance and passed the series 7 and 63 licensing tests, after about 4 months with the firm.  Soon after I also passed my commodities licensing test—the series 3.  I worked for Lehman in Houston for about 3 years before taking a position with Sutro & Company in La Jolla.  I immediately began studying for the CFA, or Chartered Financial Analyst designation, and secured my CFA in 1997.  I went on to get my CFP and CIMA designations, along with my series 24, 8, and 65, as well as my insurance license (all of my licenses except for the 65 are now inactive—I just don’t need them anymore).

I have always believed in educating myself.  From a purely business perspective, the financial world is highly competitive, so having the right credentials is critical to success.  On a much more important level, doing all one can to be the best they can be at their job, to do the best job possible for their clients, is paramount.

While I would not go so far as to say that professionals in the investment arena cannot do their jobs without having credentials, I will say that, at least in my opinion, those who do not put forth the effort to educate themselves to the best of their ability, do not exhibit the level of passion, responsibility, and initiative that I would demand as a client.  With that said, there is no substitute for experience. Those advisors who have been in the business for twenty, thirty, forty years and more, certainly have a lot to offer.  However, gaining those key credentials can only add value to that experience.

It is important to understand the requirements of the most recognized credentials in the investment business, to get a sense of what it takes to obtain them, and how they help the advisor do a better job for their clients.  For investment management, the CFA is the top designation, period.  There are certainly many others, but nothing even comes close.  Anyone calling themselves a “Portfolio Manager” or “Investment Manager” should have a CFA, and if they don’t, as a client, I would want to know why they do not have it.  To complete the CFA program and receive a CFA Charter, the applicant must first meet the minimum initial requirements.

To sit for the CFA exams, the applicant must:

• Have a Bachelor's (or equivalent) degree

Ø  or be in the final year of their bachelor's degree program at the time of registration

Ø  or have four years of qualified, professional work experience

Ø  or have a combination of work and college experience that totals at least four years (Note: Summer, part-time, and internship positions do not qualify)

• Understand the professional conduct requirements (they will be asked to sign the Professional Conduct Statement and Candidate Responsibility Statement)

Once the initial requirements have been met, the candidate can then sit for the exams.  There are three levels of the CFA exam—Level I, II, and III.  Level I is given in June and December each year.  Levels II and III are only given once per year, in June.  This means that it takes a minimum of 2 ½ years to complete the program, assuming the candidate passes each Level the first time, and that they take Level I in December, and then immediately take Level II the following June.  (I have never personally known anyone to do this.)

The CFA exams cover the following topics:

• Ethical and Professional Standards
• Quantitative Methods
• Economics
• Financial Reporting and Analysis
• Corporate Finance
•  Equity Investments
• Fixed Income
• Derivatives
• Alternative Investments
• Portfolio Management and Wealth Planning

The CFA exam process is by far the toughest series of tests I have ever taken.  Nothing else comes close.  Anyone who has successfully completed the CFA program and has been awarded their CFA Charter has demonstrated a significant commitment to their career as an investment professional, as well as a strong commitment to ethical conduct in all that they do.

The CFP (Certified Financial Planner) is the top credential for financial planning professionals.  As with the CFA, I would say that anyone offering financial planning services absolutely must have the CFP certification.  The CFP also has stringent requirements for candidates:

• Completing the Education Requirement
• Pass the test—The CFP® Certification Examination tests the candidate’s ability to apply financial planning knowledge to client situations. The 10-hour exam is divided into three separate sessions. Because of the integrated nature of financial planning, however, each session may cover all topic areas. All questions are multiple choice, including those questions related to case problems.  The exam is administered three times a year - generally on the third Friday and Saturday of March, July and November - at about 50 domestic locations.
• Experience Requirement—At least three years of qualifying full-time work experience are required for certification. Qualifying experience includes work that can be categorized into one of the six primary elements of the personal financial planning process. Experience can be gained in a number of ways including:
•  The delivery of all, or of any portion, of the personal financial planning process to a client.
• The direct support or supervision of individuals who deliver all, or any portion, of the personal financial planning process to a client.
• Teaching all, or any portion, of the personal financial planning process   
• Applicants must also pass the Fitness Standards for Candidates and Registrants and a Background Check and pay their certification fees. 

The CIMA (Certified Investment Management Analyst) designation is the top credential for investment management consulting.  The CIMA professional integrates a complex body of investment knowledge to provide objective investment advice and guidance to individuals and institutions. That knowledge is applied systematically and ethically to assist clients in making prudent investment decisions. The CIMA certification program requires that candidates meet all eligibility requirements, including experience, education, examination, and ethics.

There are many other high-quality credentials available to investment professionals.  I have written about those that I have because I know them well and because I believe them to be the best.  What is more important, however, is the level of commitment it takes for professionals to invest their time, energy, and money into the process of acquiring these and other credentials.  As a client, I would want and expect to see this level of commitment from my financial professional, and if I did not see it, I would be concerned.  There are far too many inexperienced “advisors” hired by banks and investment firms, who do not possess either the commitment or capabilities to manage the hard-earned assets of their clients.  I believe most clients assume that these firms require their financial professionals to obtain education and credentials.  

Unfortunately, this is not the case.  Many “advisors” do not have college degrees, much less advanced degrees, certifications, or designations.  The responsibility ultimately lies with the client to ensure that their financial professional is qualified.

Time to sell Gold!

Okay, I know there are a lot of "Gold Bugs" out there they say you should always have some gold in your portfolio.  Fair enough, but it's the "some" that I would debate.  Gold closed at a record high today, pushed higher by almost $19 per ounce to $1,568 by the continued uncertainty surrounding the debt crisis in Europe.  To me, everything bad that could possibly happen that would push gold up has already happened, short of World War III.  Yes one of these European countries could default (they are already in structural default anyway), yes inflation could get out of control (gold is already trading as if it is out of control)... we can go through the list of possible catastrophes, but the reality is that gold has already priced-in the worst case scenario.

Some think gold could go to $2,000 per ounce.  Yes, it could.  But you have to think - what else is going to happen that is so terrible that gold will advance another 30%+?  I just don't see it.  My call, right now, right here, today, is to sell gold.

Future pummeled on jobs report

After yesterday's ADP report, investors were bullish and continued to run stocks up.  Unfortunately, the government's employment data showed only 18,000 jobs added, versus the ADP report showing 157,000.  Stock futures are getting spanked hard, with Dow futures down 137 points at the moment.

I sold positions yesterday, both for clients and in my model portfolio.  My model is available on my website (www.craigdallen.com).  Google also was downgraded by Morgan Stanley, which is not helping tech stocks or the NASDAQ.

It's going to be an interesting day!  I remain cautious, and continue to hold significant cash balances.  Check out my model portfolio to see what I own currently and the amount of cash I am holding.

Market slides after best week in two years

After a 5.4% gain last week, the strongest weekly performance since the week ending July 17, 2009, we are seeing stocks sell-off a bit this morning.  The S&P 500 has rallied from a recent intraday low of 1,263 to 1,339 at the end of last week, which is a 6% gain.  The problem I see is that investors still believe that the economy is recovering robustly, based on the previous (and some remaining current) economists and analysts overly optimistic growth estimates.  Based on this incorrect assessment, anytime stocks sell-off, investors, again believing they are cheap based on these aggressive growth estimates, jump in, buying stocks back up.  They seem to forget everything that is wrong with the world economy, as if it has simply disappeared.  Unfortunately, these problems persist.  More importantly, the growth estimates that investors are basing their purchase decisions upon , are, in my opinion, grossly over-optimistic.  Since the earnings expectations for stocks are in part based on the growth expectations for the economy, earnings estimates are also grossly overoptimistic.

As we enter the second half of 2011, I believe analysts and company management teams, will be forced to lower their lofty earnings expectations, to more accurately reflect the real growth in the economy.  This will force a realignment of stock valuations, bringing stock prices down.  Given the volatility in the markets of late, we will very likely see stocks sell-off very hard, once the investing public realizes how overvalued the markets are at present.  Investor overreaction will likely push stock valuations far below fair value, causing even more selling as investors panic out of stocks.  While this action in the market will probably shake investor confidence, it will also offer an attractive buying opportunity for those with cash reserves and a well-conceived game plan.

The News Press and I part ways

Sadly, after over two years, I have decided not to write my column for the News Press any longer.  After repeated requests that the editors stop changing the titles of my articles and other content without my approval were ignored, I finally decided that, with regret, I would stop writing for the paper.   I have left the door open with Don Katich, stating that I would be willing to resume my column, if he agreed to at least inform me of any changes before printing my articles.  To-date, he has refused this request, so it appears that my relationship with the News Press is at an end.

I welcome the break, and will have more time to devote to my blog as a result.  I will certainly also pursue other writing opportunities with other local publications, website, blogs, etc., and will post any developments in this regard.

My thanks to everyone who has been a reader of my column over the years.  I appreciate your interest and I look forward to providing the same quality content both here on my blog and elsewhere int eh future!