Yearly Archives: 2013

Not Another Outlook Report

Tis the Season!  Not just for cheery holiday greetings, warm fires surrounded by families and friends, thoughts of peace on earth, the joy of giving and reflections on the last 12 months, but it’s the season for market forecasts!  As you may recall, I don’t make predictions.  I spend all of my research and analysis effort on trying to measure value, and identifying those stocks trading well below my estimate of their fair value.  This approach has been successful over the years, and is a perfect fit to my temperament and proclivity.

Nonetheless, I sometimes reflect back on my days as an equity market strategist and wonder how it would be to make some predictions again.  Would I be credible?  Could I be “correct” in my prognostications?  Should anyone care what I think about the future?

The good news is that these moments of fancy flee quickly, and I snap back to the reality that almost no one can make accurate predictions consistently enough to make you money.  The best way to make money in investing, in my view, is to find an investment approach that works for you, and stick with it.  In my experience, the people who struggle most with their investments are those who feel the need to “do something” in response to the latest news.  Or forecast…

So, I was reading an outlook report this week that caught my eye.  I read a lot of reports each week, and many of them say the same thing.  I mostly read them to understand what the consensus expectations are.  That way, I can usually assess how each new development fits into this consensus model.  Sometimes things happen that surprise everyone.

This report was entitled, “Top 10 Risks for 2014.”  Now I am not the most “glass is full” guy around, but this title seemed overly pessimistic, even to me.  Are we still carrying deep scars from the 2008-2009 global financial crisis that require constant vitamin E rubdowns from reports like this?  Do investors really think that defining risks is the best way to make money in the coming year?

As a counterpoint to whatever negativity you may find out there as we approach the New Year, let me offer my “Top 5 Opportunities for 2014” (wishes, mind you, not forecasts!).

1)   The U.S. Federal Reserve learns how to reduce bond buying without crashing the market.  This was the big fear earlier in the year:  that the Fed would be tightening monetary policy simply by reducing its monthly bond purchases.  The idea behind this fear is that the stock market has been grossly inflated by easy money, and that reducing this easy money policy would “take away the punch bowl.”  At that time, I argued that tapering was not a move from “easy” to “tight,” but from “super-duper easy” to “super easy.” The stock market’s action this week may be a harbinger of additional good news from the Fed in 2014.

2)   Individual investors will stop worrying about “crashes” and begin to invest in stocks with optimistic long-term expectations.  This does not mean investors become blinded by greed (like in the tech bubble), but it means they will come to understand the true nature of stocks, and embrace the notion that equities still represent the best long-term, easily tradable investment available to all investors.  I understand that some people are still troubled by what happened in 2008-09. I understand that we had a “lost decade” for stock investors.  Despite tons of commentary to the contrary, these events did not alter the true nature of stocks – they always go up over time.

3)   The U.S. Government will address the nation’s entitlement programs and debt level in a mature and forwarding-looking way.  I suspect that most serious investors would applaud any progress on these fronts.  I understand that politics may make progress in these matters difficult, but I think the markets would absolutely cheer thoughtful action here.  You may say I’m a dreamer, but I’m not the only one…

4)    The ingenuity and risk taking of global entrepreneurs will bring forth really cool new products for us to enjoy.  Capitalism works as well as it does exactly because people can take risks and get rewarded for it.  They can also fail; that’s the “risk” element of the formula.  Without venturing out into places unknown, without trying something that no one else has, we can see no progress, no innovation and no fun.

5)   Global economic growth and corporate earnings growth will extend the bull market’s lifespan.  Analysts are expecting about 10% earnings growth for the S&P 500 next year.  Economists see the U.S. growing by roughly 2.5% and the world posting something like 3.5% growth.  One could easily conclude that these growth numbers would be positive for the stock market.  The average bull market lasts about 4 years.  Our current one is approaching its 5th year anniversary.  Unless, one considers the huge “correction” of 2011 as a real “bear market”- the S&P 500 was down over 20% (the classic definition of a bear market), intraday, during August of that year.  If so, one could argue that the current bull market is only 2.5 years old and has longer to run and higher to fly.

Long may you run.  And may you always fly like an eagle.

Here’s to another great year in 2014!

Another Excellent Prediction!

Anyone who has read my blog over the years knows that I don’t make predictions.  Trying to guess where the market might be in a few quarters is about as useful as forecasting the weather out a few months.  I read lots of commentary about the market, and always have to chuckle when I see a truly outrageous forecast.  By the way, if you want to appear on television as a “market guru” be sure to bring a few outrageous forecasts with you.  They are the most “newsworthy” ones.  No one wants to hear your middle of pack predictions…

Anyway, I chuckle at these wild forecasts mostly because the people spouting them usually are not professional investors.  And even if they are, no one is likely to remember their incorrect forecast (most are incorrect, no?), and if by some small chance they are correct, the upside might be huge (I have known people on Wall Street who made a career out of being right once…)

So, let’s go back in time to February 2012.  We had just finished a very volatile year (2011) and people were debating which way the U.S. stock might be headed.  I always think a better question than “Where do you think the market is going?” is “How is your portfolio invested right now?”  To my surprise, Barron’s cover for its February 13, 2012 edition (see above) made the bold prediction that the Dow Jones Industrial Average would reach the 15,000 level by the end of 2013.  At the time, it did seem like a very brash forecast.  The DJIA was about 12,500 at the time.

I had a number of issues with this cover.  First of all, almost no professional investor measures performance against the DJIA.  It’s only 30 stocks, it’s price weighted (that is stock with higher prices have more influence on the index than lower-priced ones) and it’s comprised of only big-cap, blue-chip stocks.  Second, any strategist worth his or her salt does not give both level and time frame for a forecast.  Hence, “The DJIA will reach 15,000” is a “good” forecast.  Equally fine would be “The DJIA will trend higher by next summer.”  To say “The DJIA will be at 15,000 by the end of 2013” is way too specific to be credible.   The third and final issue I had was that the forecast, despite what I thought at first glance, was not really that bold.  It represented only a 20% increase in a period of almost two years. That averages out to be about the long-term average for stocks.  Not exactly swinging for the fence on this one…

Nonetheless, I was somewhat impressed at Barron’s moxie to print such a lead story.  We discussed this idea a bit at our Investment Policy Committee meetings, reaching as we usually do, no meaningful consensus about “the market.”  We spend more time figuring out which undervalued stocks to buy.  For some reason, I cut out the center panel of the cover, and with a black sharpie crossed out the 5 in “15,000” and with a red pen wrote a “6” next to it.  Thus was born a rare forecast from yours truly.  I pinned the modified cover on the big map that adorns my office wall. See photo below.

In the name of full disclosure, this forecast was never mentioned outside our firm.  No bets were made; no consideration ever offered or given.  In true Wall Street fashion, I did not specify the time frame for my “forecast.”  I simply stated that the DJIA will reach 16,000.  Well, miracle of miracles, wonder of wonders, the DJIA hit the 16,000 market last week – near the end of the year.  One could argue that because I used the Barron’s cover, the implied time frame for my forecast was the end of 2013.  One could possibly conclude that I made one of the best calls of the last two years, predicting the level and time frame for the most popular and widely quoted stock index!


That said, my “success” with this forecast underscores how useless most predictions are.  No one made any money based on this forecast.  I did not buy more stocks because of this forecast (I was fully invested in stocks at the time anyway).  I was not quoted in the media.  My level of fame has not changed since I nailed this forecast (my Q Score has hovered around zero for about 30 years now…).  None of my IPC colleagues talked about it to anyone else.  They did not adjust their portfolio based on it.  Almost no one knew about it (those who did probably forgot about it a week later…).  Most importantly, had it been wrong, nobody (including myself) would bother even mentioning it. Herein lies the biggest risk of listening and acting on forecasts – the forecasters tend to remember and highlight the correct ones and ignore, rationalize or blithely dismiss the wrong ones.


So, where do I think the DJIA is going from here?  I predict that it will display volatility, both now and into the future.   And that is one prediction I can stand behind with confidence…  =)


Bullish in Orlando

Last weekend I enjoyed the company of 1,100 retail investors at the biennial conference of the American Association of Individual Investors (AAII) held (this year) in Orlando, Florida.  The non-profit AAII has been around since 1978, and does a great job, in my view, educating individual investors regarding stock market portfolios, financial planning and retirement accounts.  The conference featured some high-profile keynote speakers (Nobel Prize winning economist Robert Shiller, for example), useful advice from professional investors, lots of nuts and bolts presentations, and the latest tools (software, etc.) to help investors get their portfolios and financial houses in order.

The range of expertise of the attendees is incredibly wide – from true neophytes taking their first baby steps into the capital markets to grizzled veterans who clearly knew what they were doing.  As is common with most distributions, the majority of the folks there were somewhere in the middle.  A lot of the people I met seemed to like passive investments (index ETFs, etc.), but most seemed fond of some sort of active management.  The mood was quite positive, and more people were bullish than bearish, but I still sensed a quiet tension about the future in many.  I met a few dizzy day-traders (yes, they’re still out there!), one of whom mentioned that she had lost a ton of money in the late 1990s, a bunch more in 2008, and told me that she’d “better get her act together sometime…”

As colorful and friendly as the attendees were, the presenters were actually quite helpful and user-friendly.  It is beyond the scope of this note to mention all the highlights, but a few quotes and anecdotes may help the reader get a feel for the conference.

One oft-repeated theme was that investors need to find a style that fits them and stick with it.  One person suggested that investors write down how they want to invest during a time when they feel calm and rational.  They then should refer to this document (and follow it) in those times when they are stressed, and especially when they feel “this time is different.”  Do-it-yourself investors are notorious for being bad market timers and prone to “sell low” and “buy high” (I’ve seen tons of data supporting this notion).  Listening to the advice of the AAII presenters could help avoid this tendency.

One person observed that many investors feel a great need to “do something” with their portfolios, especially in times of stress.  One person had some great quotes that I really agreed with:  – “The short-term is absolutely meaningless.” “It is human nature to look at the short term.”  “Focus on the facts.” “A great company is not always a great stock.” “A disciplined, unemotional approach is better than anything else.”

I heard a funny story about how many people pick stocks based on image, brand name or a vague feeling about the company (without doing any real analytical work concerning valuation, earnings, cash flow, etc.).  Imagine that you walk into a doctor’s office. The doctor looks at you and without doing any tests or asking you how you feel, says “I think I will prescribe for you the yellow pill.”  You protest, saying that how in the world does he know the yellow pill will be right for you or how does he even know what’s wrong with you.  He counters with something that we’ve all heard people say about a stock they like:  “I have a good feeling about the yellow pill…”  Classic.

One presenter spoke at great length about Benjamin Graham, arguably the best investor of the 20th century – he was Warren Buffett’s mentor!  Graham suggests that the “intelligent investor” (which is the title of his perhaps most famous book) is one not with a high IQ, perfect SAT scores, or fancy degrees from Ivy League schools, but one who possessed patience, independent thinking, discipline, an eagerness to learn and self-control.  These traits of character were, in his view, more important than smarts.

Overall, it was a very enjoyable experience for me. It’s encouraging that someone is trying to help people be smarter about their money and finances amid all the commercial voices simply trying to sell them something. Bravo, AAII!

Mixed Signals

Sometimes I really am confused about the macro picture.  In these times, I am grateful to be a “bottom up” investor, focused on individual company fundamentals and valuation, and not on what the Fed might do, what the economy looks like or other such big imponderables.

I read a lot of the commentary about the markets, the economy, and investment strategies (aka “sales pitches”), but rarely do I find truth in them.  These days I see a large divergence of opinions among stock market strategists.  One group sees the stock market as a fragile bubble, inflated to dangerous levels by the hyper-aggressive easy money policies of the U.S. Federal Reserve, abetted by nearly every other Central Bank that matters.  The other camp has begun to speak of the rarest of market phenomenon – the “melt-up.”

We all know what a “melt down” is – that’s what happened in 2008.  A “melt-up” (don’t you just love all of the clever jargon Wall Street dreams up?) is when the market moves suddenly and surprisingly upward.  This “melt-up” (if it were to happen) would be fueled by rising investor confidence, strong funds flows into the equity market, and perhaps stronger economy data.  One could argue that much of the economic data from the market’s low point in 2009 has been mixed.

The pace of the current economic recovery has been tepid in comparison to the past ones.  The unemployment rate remains much higher than it was at similar points in past recoveries.  Also, policy actions (tax increases, sequestrations, government shut down, etc.) may have dampened economic growth or at least disguised the true underlying strength of the economy.  I was a bit surprised that few people commented on the strong U.S. third quarter (+2.8%) as something important.  This figure was the best showing for the economy since Q1 2012.  It was also the fourth quarter of consecutive growth.  Granted, I am a firm believer that the stock market and U.S. economic growth are not highly correlated, but a stronger economy is rarely a bad thing for share prices.  Sentiment is improving, the U.S. economy is growing at a faster pace and money is flowing into the stock market – what’s not to like?

So, which is it going to be – a correction or a melt up?  Again, I’m thankful that I don’t have to answer this question in any meaningful way for myself or my clients.  One of these two camps may prove to be “right” in the short run.  To me, more important than being “right” about macro forecasts is investing in securities that will make money for my clients and me.

I do believe that we are still in a bull market (I am fully invested in equities in my own retirement accounts).  I don’t think we are on the eve of a recession.  I suspect that the current economic cycle has further room to run and may actually surprise us with its duration and eventual strength.  From where I sit, cash seems like the worst “investment” out there (cash holdings for “rainy days” are not considered “investments” in my opinion).  Most importantly, I can still find good quality stocks trading at a considerable discount to my estimate of fair value.  All of this points to a continuation of the bull market which began in March of 2009.

‘Tis a Puzzlement!

Harper’s magazine occasionally publishes something called “Harper’s Index,” which cleverly compares various data points in order to make a point or illuminate some of the irony that exists in our funny old world.  Here are a few examples from the June 2013 edition:

  • Percentage change in the past 25 years in the Consumer Price Index: +41%
  • In the price of beer:  +40%
  • Of books:  -1%
  • Percentage increase in per-student spending at major public U.S. colleges since 2005:  23
  • In per-student spending on college athletes:  61

Clearly, the editors have a point of view in all of this, but I really enjoy reading this part of the magazine because of its focus on data.  I’m willing to listen to anyone’s point of view if it’s backed up by clear data.

A number of seemingly incongruent data points this week caught my eye:

  • The Dow Jones Industrial Average hit an all-time high
  • According to Real Clear Politics poll, the approval ratings for Congress and Mr. Obama hit five-year lows.
  • The American Association of Individual Investors sentiment survey shows bullishness at 49%, the highest level since 2010.
  • A UBS poll shows investors holding 23% of their portfolios in cash, the highest level since 2010.

These data only underscore the challenge of making sense of investing looking at “big picture” or macro factors.  Why is the stock market at this level, when there remains a palpable malaise in many parts of the country and the world?  How can the government be so disliked, but the stock market can be enjoying its fifth year of a bull market?  How can individual investors be bullish about the market and at the same time raise cash? I will admit that I cannot always make sense of the data out there.  This is why I spend very little of my mental effort and research time on the macro stuff.

Here is what I know:

  • It is still pretty easy to find stocks trading well below their intrinsic value
  • Pockets of pessimism persist aplenty – poor sentiment is usually a positive for stock prices
  • Interest rates are likely to remain low for a while
  • Corporate cash flow remains strong and cash on balance sheets remains near an all-time high – this condition usually coincides with the start of a business cycle rather than the end
  • Traditional excesses warning of a possible recession are nearly non-existent

All the macro puzzlement aside, what I know leads me to believe that the bull market in stocks is more likely to continue than to end abruptly.  Corrections within a bull market are normal and unsurprising.  Some pause in stock appreciation after a big rise (like we’ve seen this year) is also normal and to be expected.  Yet, I continue to think that the biggest risk for investors is to be out of the market.  Cash returns are well below inflation at this point, and investors holding cash are probably hurting themselves while at the same time believing they are “safe.”

Life Imitates Art

One of the few regrets I have in life is never attending a performance of Kabuki.  I did see a Noh play once, and it was as slow and as confusing as people said it would be.  I think its pace and complexity was by design.  Kabuki, as I as understand it, is perhaps more interesting, but maybe just as confusing.

For the uninitiated, Kabuki is a form of classical Japanese theatre in which elaborately costumed male performers use stylized movements, dances, and songs in order to enact tragedies and comedies.

What this has to do with the current state of affairs in the United States will be left to the imagination of the reader.

That is all…

What’s in a Number?

As I worked on my graduate degree at Columbia, I would often stop and silently thank my high school math teachers for the solid foundation they gave me in numbers.  My finance and stats classes didn’t use “hard-core” math (as some would call it), but understanding derivatives, distributions and derivations came in very handy.  Even now, I find myself using a lot of the math I learned in high school.

Everywhere we turn we are surrounded by numbers.  In most cases, the number you see means exactly what you think it does.  The $5 price on your morning cup of fancy java means you need to give the barista a five-spot.  The vast majority of numbers we think about each day – the interest rate you pay on your mortgage, the speed limit on a highway, your blood pressure, your weight (!?), and so on – all tend to mean exactly what we think they do.  However, this normal and rational experience with numbers tends to unravel when we consider the capital markets and investing.

Sure, a lot of the numbers we see in the investment world (interest rates, stock prices, economic figures, etc.) sort of mean what we think they do, but many of them are much more complicated than casual consideration can ascertain.  Take the S&P 500 index for example.  In reality, there is no such physical entity as the S&P 500 index.  It is a fanciful construct consisting of the share prices of 500 different and independent companies.  So the number you see quoted for this index is not so much one number (although it is daily presented as such), but the net result of all investors’ opinions (reflected through daily buying and selling) of all 500 of the underlying stocks.  The one number we see in the price quote of the S&P 500 is literally the sum of millions of daily decisions by investors of all sorts. Every other index could be viewed in a similar fashion.

Then we come to forecasts, predictions and price targets.  There is something deep inside us that craves certainty and order.  The grand irony here is that the more complex a system is, the more we want a simple, whole-number answer.  This innate desire for a simple number to describe a complex function (the capital markets for example) I believe drives market strategists and equity analysts to derive and publish price targets and forecasts.  Yet, when a strategist “predicts” the market to be at some level by year end or when an analyst publishes a single number price target, they know without a shadow of a doubt, in my opinion, that their published numbers represent a midpoint in some, possibly wide, range.  As a former strategist and analyst, I know this to be true.

Professional investors understand this and use analysts’ price targets with a grain of salt.  To them, the price target is a measure of an analyst’s enthusiasm for a stock and little else.  But, a published number can get the individual investor into trouble.  Too often, I will hear someone get excited about a stock because “some analyst has a price target up 30% (or whatever) from the current price.”  You can almost see the gears turning inside this person’s head figuring out how to spend this almost certain 30% (or whatever) windfall.  Individual investors should think like a professional, and consider any forecasted number they see with a big grain of salt.  In a like fashion, one should never make an investment based on a price target or a market forecast.

In my own work with equities, I am constantly analyzing companies and trying to determine a “fair value” or price target, if you will, for a given stock.  For me to say with any degree of certainty that the stock will definitely reach my target is way too arrogant for my understanding of the capital markets.  I understand that my price target can be influenced by many factors – the company’s earnings growth, interest rates, the economy and sentiment about all of the above.  When fundamentals change, I often need to reassess my targets and my opinions about each stock I follow.  It is quite complicated, but I am aided in my efforts by my training during decades of experience as a professional investor.

Bottom line – to be a better investor one should learn to view simple one-number forecasts with a skeptical eye.

The Merits of Balance and Rebalance

My Uncle Roy loved to tell (and retell) the following joke:  “Two birds were sitting on a fence.  One was named ‘Pete;’ the other ‘Re-Pete.’  ‘Pete’ flew away.  Who was left?”  We’d answer “Re-Pete (repeat).”  Then he would say, “Two birds were sitting on a fence…”  And so on and on as long as we would answer him.  Even now I have to chuckle at that one.

I am a firm believer in the benefits of repetition.  I truly appreciate when the people I respect take the time to remind me of best practices, be they health habits, exercise, interpersonal relationships, communication styles, and yes, even basic investment principles.

I think most people understand at some level the basic investment notions of diversification, risk management, valuation and so forth.  And yet, I often see otherwise highly-intelligent people with less-than-highly intelligent portfolios.  Sometimes the portfolio is simply unfocused – a smattering of well-known names, probably selected due to the company’s high profile, attractive products or good standing in the corporate world.  Sometimes the portfolio will be focused on one single idea, such as high-dividend-yield stocks, energy stocks or the biggest names from one overseas country.  Sometimes I meet the hyper-indexed portfolio, put together by someone who thinks 1) the market is efficient and 2) outperforming the market is impossible (both of which are subject to debate).  Where one broad index fund might be sufficient, the hyper-indexer will own 20 – “just to be safe.”  Sometimes, I meet a portfolio with a handful of stocks, one of which represents about 60% of the total. This investor may think the portfolio is diversified (Hey, I own 7 stocks!), but this kind of portfolio may be the riskiest of all the sub-optimal portfolios I see.

For the most part, these kinds of portfolios are underbalanced, undermanaged, and under-diversified, characteristics that often lead to underperformance and can undermine one’s long-term financial plans.

In order to be truly balanced, a portfolio needs a number of key elements.  First is a fixed asset allocation.  Many will debate this point with me, but I think asset allocation should be based on a person’s risk tolerance, not on how he or she feels about the markets.  One’s asset allocation may vary over a lifetime, as core risk tolerance changes, but it should not be changed during a market cycle.  The second key element is adequate diversification.  A mutual fund portfolio with as few as 8 funds may offer sufficient diversification.  An individual equity portfolio should have at least 30 names to reduce non-systemic risk.  Owning a whole lot more than 30 names rarely provides additional meaningful risk reduction.  The third element of a portfolio in balance is some kind of rebalancing regime.  For example, when one asset class becomes a higher percentage of one’s portfolio than the target allocation calls for, one should sell a portion of it, and put the proceeds into the other assets classes.  In an individual stock portfolio, when one stock becomes much larger (through outperformance – yay!) than others in the portfolio, what should one do?  A disciplined rebalancing routine would have one sell a portion of that stock and deploy the profits elsewhere among existing stocks or even into new names.

This rebalancing may seem a bit contrary to some of the old “rules of thumb” we hear sometimes about investing, such as “let your winners run,” or “cut losses on your losers.”  In my view, there are so many such “rules” that following all of them would be nearly impossible.  Sometimes they might apply to short-term traders, but not to long-term investors.  Following the guidelines I’ve suggested will more often result in “buying low and selling high,” something we can all agree is a good thing.

But what about all those capital gains generated by “selling high?”  Well, as my good friend Scott Bush often would say, “No one ever went bankrupt by paying capital gains taxes!”  The good news with realization of capital gains is that you are making money!  The better news is that the U.S. IRS taxes long-term capital gains at a lower rate than ordinary income.  As painful as paying capital gains taxes may be (I would argue this is less pain than losing money!), not rebalancing will often lead to a portfolio that is less balanced, and hence potentially much riskier than the investor would like.

To paraphrase an old saying, “The market giveth and the market taketh away…”  Sometimes it’s wise to take profits when the market offers them to us.

Some Thoughts on Bad News

No normal person likes bad news.

A quick scan of any media source will result in any number of bits of bad news.  A wildfire here, an earthquake there – wars, rumors of wars, plagues and pestilences of all shapes and sizes fill our daily sphere of consciousness.

Some of this bad news appears to affect the capital markets.  An earnings report below expectations can weigh heavily on an individual stock. A disappointing employment number or GDP figure can put pressure on the overall market.  Fears of Western military intervention in Syria took down the S&P 500 by 1.5% in one day earlier this week.

In spite of the bad news we see often, the stock market stands just below its all-time high.  Ultimately, stock prices are not determined by the balance of good news versus bad.  Fundamental factors such as corporate earnings (both level and growth rate), interest rates (level and trajectory), funds flows, cash levels and sentiment are, in my view, much more important to the markets than the daily news flow.  I would submit that stock prices are where they are because fundamentals are quite positive.  I would also suggest that they are supported to an important extent by the ton of bad news out there.

Let me explain.  There has been only one period in my career where bad news was hard to find – the late 1990s.  Business was booming, the era represented a “paradigm shift” and the stock market was a one-way bet.  I knew people who would use cash advances from credit cards to day trade.  I once saw a colleague, who had never invested in the stock market before, plunk down $100,000 on one stock (he made tons money on this stock, but that is beside the point…). Those were heady times.  The dearth of bad news created a euphoric aura around the stock market – everyone “knew” that stocks were a “sure bet,” a “riskless investment” and “the only game in town.”  This kind of universally positive sentiment always accompanies the peak of the market.  The bear market following the tech bubble was not pretty, and was caused in part by the lack of bad news.

I sometimes hear from a client or a colleague something like, “If we could only get some better news on ____ (fill in the blank), I think stock prices could move higher.”  This statement supposes that the lack of good news is the only thing keeping stocks from moving higher. I might argue that when all bad news is gone, that is the time to get cautious.  As long as we have much to fear, things are probably going to be alright.

In closing, let me share some data I got from Liz Ann Saunders, the equity strategist at Charles Schwab.  From March 31, 1960 to December 31, 2012, when the year-over-year change for GDP was less than 0.5%, the annual returns on stocks was 10.5%.  When year-over-year GDP was between 0.5% and 6.0%, the annual return was 7.2%.  When GDP grew more than 6% (this has to be good news right?), the annual return on stocks averaged -4.6%.

So, whenever you catch yourself bemoaning all the bad news out there, stop and think about how it might actually be helping your portfolio in the long run.

Making Sense of the Notion of Yield

Every now and then I meet someone who says something like “If I could just get a steady return of 6% on my investments, I’d be happy.”  I suspect that this idea comes from something read about, seen or experienced in the past.  There was a time when the yield on a super-safe U.S. bond was over 6%.  That would look like a “steady return” vehicle.  Nowadays, with the yield on cash close to zero and the 10-year U.S. Treasury bond offering 2.7%, getting a “steady return of 6%” looks highly problematic.

Yet, there are a larger number of “investment products” out there which purport to offer something like a “steady return of 6%” or even more.  The first question one should ask when presented with a product like this is “Why does it yield so much?”  The answer one is likely to hear will contain fancy words like “option pricing models” or will involve a bevy of math PhDs cranking out proprietary algorithms or some such like.  Rare would be the answer that simply states “I get a huge commission for selling this thing” or, in my view the best answer, “It’s really, really risky!”

The (mostly) linear relationship between risk and return represents the best weapon against being sold something that looks attractive, but may be unquantifiably risky.  If the yield on the U.S. 10-year bond is 2.7% (arguably the most “steady” bond yield one could hope for), then anything with a higher yield is, by definition more risky.  Something yielding 5.4% would likely be twice as risky as the 10-year; a yield of 8.1% would be three times as risky and so forth.

But “risk” is also something people tend to struggle to define, especially in useful, practical terms.  If someone gambles on something that has a low probability of payoff (a lottery ticket for example) and they WIN – would they consider that investment “risky?”  Perhaps not.  Quite often, when a risky investment works out (that is, makes you money), the investor mentally adjusts the “risk” to zero, exactly because the investment did not lose money.  This mentality (which is probably very normal and common) can lead rational and intelligent people to engage in very risky investment behavior.

Analyzing and quantifying the risk of every asset claiming a “steady return of 6% or higher” is well beyond the scope of this note.  Let me simply offer a few “rules of thumb” that might help when approached by something that looks very attractive.

1)     If it looks too good to be true, it probably is.  The economics 101 axiom “there is no such thing as a free lunch” applies here.

2)     Compare the asset to other similar ones.  All else held equal, higher yield always implies higher risk.  If one 10-year bond yields 6% when the U.S. T-bond is yielding 2.7%, it contains more risk.  High-dividend yield stocks also may have more risk than is obvious to the casual observer.

3)     Get the details on the fees, commissions, sales incentives and so forth.  The financial services industry is highly regulated and many of the rules are designed to protect the individual investor from getting burned.  Sometimes the fees are paid to the sales person directly by the company offering the product, so it looks like a “no-fee” investment to the investor, yet the sales person may have a considerable incentive to offer this product, regardless of its investment merits.

4)     Complexity is sometimes a clever marketing tool.  I have seen many products that offer what looks like a reasonable return, but only in a very narrow range of possible outcomes.  Never invest in something you don’t really understand.

5)     Read the fine print.  It may explain the true riskiness of the product.

Let me close by quoting Donald Cassidy, who used to work as an analyst at Lipper.  “The market, while not reliably efficient, is not dependably stupid.  Income vehicles trading at higher yields within their asset class do so because of great risk – of reduced income payments and the underlying asset price… Always avoid yield chasing.”