Willow Ridge Capital Advisors

But It Feels Soooo Good!

2008-08-06T16:24:00.000-07:00

We're in the middle of an election year and the political rhetoric is creating an intoxicating elixir that sounds attractive to voters, but could prove to be toxic to our frail economy. The economy is attempting to recover, banks are failing, Americans are feeling the pinch of higher gasoline prices, home values are down and unemployment is rising. Given the depressed mood of voters it's easy to look to our country's leaders for solutions. Unfortunately, the wrong solutions will compound our economic problems instead of fixing them. Fortunately, there is research that can help us see through the rhetoric.

At the heart of the issue is whether government solutions will increase the tax burden for individuals and corporations. The issue of taxes in this country has been debated for centuries and significant research was conducted throughout the 20th century, providing time-tested facts upon which we can judge political jockeying.

In 1998, Alan Reynolds, senior fellow and director of research at the Hudson Institute, a non-partisan think tank, published research titled The International Importance of Low Tax Rates. I've included a link to the research below, but I'll publish his conclusion to save you the time:

"Although good tax policy alone does not ensure a good economy, world history offers no examples of economies that prospered with punitive tax rates. Governments, like companies, must compete in producing the most value at the lowest possible cost. Countries in which the marginal cost of government is relatively high find it more difficult to attract and retain physical capital, financial capital and human capital. Just as so-called "tax havens" attract investment and skilled immigrants, countries with punitive tax systems face chronic capital flight and brain drain.

In some countries in the top part of the table, taxes on trade (tariffs) were reduced. In others, such as Argentina, the monetary regime was changed. In still others, Social Security was privatized and the payroll tax burdens on employment thus were eased. But the one thing all of the fastest-growing economies of the past two decades have had in common is this: they either had very low tax rates to begin with or moved rapidly in that direction."

Simply said, a country can never tax its way to prosperity. Countries with higher tax rates lose jobs and have slower economies than countries with falling tax rates.

Given this simple truth, let's be careful about listening to political rhetoric. Home prices will rise again, but it will take time. Gasoline prices have come down, but we need to deliver real solutions inside of three years. The credit mess will work its way through the balance sheets of financial companies and then banks will moderate their underwriting standards, although we won't see the irresponsible lending that got us into this mess. New jobs will be created, but we need an environment where companies can thrive.

But a sure way to send more jobs and investment capital overseas is to increase taxes at a time when corporate profit margins and personal incomes are getting squeezed. Presidential campaign proposals to "fix" the economy must be viewed with careful scrutiny to make sure they can actually work, and not based simply on if they make us feel good.

Here is the original source article: http://www.ncpa.org/ba/ba283.html

Moving Beyond Fear

2008-07-08T11:53:00.000-07:00

Investing can be emotional, especially during 2008. This makes it a perfect time to review how following our emotions can lead to bad investment decisions, sapping long-term portfolio performance.

Behavioral finance studies the psychology of investing and one of the early pioneers in this field is Hersh Shefrin of Santa Clara University. By studying how people think about financial decisions, Shefrin and other researchers discovered important principles that help individual and institutional investors avoid making mistakes that may seem logical, but can ultimately be detrimental to their portfolio performance. Fear, greed and overconfidence are powerful emotions that cloud rational thinking. Here are just a few mistakes researchers have consistently found that most investors make:

Herd mentality. Investors often follow what they read in the media. This certainly sounds like logical behavior, but it can work against you. As an example, John has been watching stocks outperform his bond portfolio during the recent market rally. His friends at work share stories of how much money they made on various stocks, so he decides to "invest" some of his own money in stocks. (Actually John thinks he is investing, but as you will see, he is really just speculating.) Over the course of the next couple years, John will likely see a market downturn. He doesn't worry too much about it until his portfolio falls 10 percent below where he bought it. Soon all the media is reporting how bad the stock market is, and the future is bleak. John's friends finally let on that they started dumping their stocks 3 months ago. In a panic, John logs onto the internet and sells his stock. What did John just do? He bought high and sold low, a recipe for losing money every time. John is frustrated with the stock market.

If herd mentality was an isolated problem it wouldn't matter to us. The reality is that there is empirical evidence that this problem abounds -- by looking at mutual fund cash flows. Numerous studies have found that mutual funds experience a net in-flow of cash after the stock market has been rising, and a net out-flow after the market has fallen. Aside from short-term cash needs, an investor is far better off with a buy-and-hold strategy than trying to time the market. Herd mentality causes people to buy near the top and to sell near the bottom.

Loss Aversion. For most investors losing 10 percent is much more painful than the joy and excitement of earning 10 percent. This causes people to become more conservative in their portfolios as their portfolio declines. However, the best returns come early in a market rebound and missing just a few days in the rebound results in significantly diminished returns. For example, if Sarah invested $1,000 in an S&P 500 index fund on January 1, 1970 and held it until December 31, 2007 it would be worth $54,118 for an annualized compound return of 11.07 percent. However, if during this same 38 year time period Sarah missed just the fifteen best days in the market, her $1,000 investment would be worth a mere $25,217 with an annualized compound return of 8.86%. The single best day during this 38 year time horizon was a 9.1 percent return on October 21, 1987, just two days after the October 19th crash. How many investors who bailed on Monday October 19 would have been ready to buy back the very next day? Probably none. Actually, this example underestimates the problem because it doesn't take into account having to pay capital gains taxes when selling. While investors who have an aversion to losses think they can beat the market by getting out of the stock market when it's going down, and jumping back in when it's rising, research shows otherwise.

Loss aversion also leads people to hold onto losing stocks in individual companies longer than they should. Sometimes a company is a bad investment, but taking a loss is often felt as having made a bad decision and is a blow to the ego. Selling admits defeat, while holding on is a sign of confidence in the original decision to buy that stock. Even though the right thing to do may be to sell that company, accept the loss, and re-invest in another company, most people avoid selling at a loss.

Chasing Hot Performance and Overconcentration. Some investors look for the most recent hot investments and put the bulk of their money into that one asset, whether it's real estate or energy stocks. They look at recent performance and extrapolate that to future performance. We've witnessed this in the recent real estate market crash, after speculators saw rapidly rising real estate prices and easy money. Many thought real estate prices would continue their meteoric price rise based on their performance since 2002. Of course reality is setting in -- the average U.S. home prices plummeted 7.0 percent from May 2005 through April 2008, and prices are still falling. In California prices fell by 23 percent! Meanwhile, stock prices rose 26.78 percent during this period. Similar behavior was seen during the tech boom and tech wreck, and we may yet see a crash in the oil market with the recent runup in prices. Chasing hot performance can lead to a very unhappy ending when the runup is over.

So if all of these seemingly logical behaviors are indeed detrimental how should we invest? By making strategic, long-term allocations to a broadly diversified set of high-quality assets and riding through the ups and downs of each cycle, along with scheduled rebalancing. This produces the most consistent returns with the lowest tax consequences and turnover costs. By working with us to personalize your strategic allocation we can build a wealth portfolio that helps you meet your financial goals and helps you sleep better at night.

For more information on behavioral finance see http://en.wikipedia.org/wiki/Behavioral_economics

Summer of Capitulation

2008-06-26T14:34:00.000-07:00

When I was a new bond trader working for the capital markets division of First Interstate Bank, Charlie, a wizened old trader assigned to be my mentor, told me repeatedly: "Remember, you make your money when blood is running in the street." I was sitting next to him on Black Monday, October 19, 1987. He smiled and chain-smoked his way through the day. In the midst of the carnage he went to work setting his bond positions. He made a ton of money.

That image of Charlie calmly smoking his way through what seemed to me to be the end of the world has stayed with me for over twenty years. I have found it to be very reassuring as I have tried to guide clients and investors through every major financial debacle since then. Some have been willing to ride out the storms; some have not. But I can honestly say that those who patiently stayed the course have come out alright.

We call it a "capitulation" when the market melts down and there seem to be no buyers left on the planet. They are periods of raw fear. They are unreasoning and unrelenting and they can try even the hardiest of souls. Yet they can also produce some of the most compelling buying opportunities. Sometimes capitulations happen like Black Monday, cascading in ever increasing volume over a very short period of time. Such capitulations are dramatic and very rare. More typically, capitulations happen over a period of weeks or months, gradually wearing down investor resolve and picking up momentum as they roll along.

We are in the latter type of capitulation right now. Between rising oil prices and the ongoing credit crisis, there is plenty for investors to worry about. I cringe every time I pull into a gas station or stop by the grocery store. Yet stocks are cheap! If you take company-by-company earnings projections for every stock in the S&P 500 for the next 12 months and compare them to the current level of the S&P 500 (which closed just below 1,300 today), the stock market is close to its cheapest levels of the last 20 years. In fact, you would have to cut the latest earnings projections by another 30% before you would get the P/E ratio back to the average level of the past 20 years!

At times like this I like to ask myself what Charlie would do. I'm sure he would be buying.

U.S. Stocks are UNDERVALUED: Morningstar

2008-06-20T07:30:00.000-07:00

Morningstar publishes an interesting chart on market valuation. Every day they calculate what they consider to be the "fair" price of every publicly-traded stock in the U.S. and compare that to each stock's actual market price. If the market price is below the fair price, the stock is undervalued. Conversely, if the market price is above the fair price, the stock is overvalued. Morningstar aggregates these individual valuation measures into an index that measures the market's overall relative value.

Morningstar currently sees stocks as undervalued (see the chart above.) While this indicator is not meant to be a trading signal, it is one more piece of evidence supporting our decision to hold steady despite the market's frustrating ambivalence.

You can access Morningstar's valuation index directly at: http://www.morningstar.com/cover/pfvgraph.html

Housing Market: Near the Bottom?

2008-06-19T08:52:00.000-07:00

The financial press has done a good job reporting the bad news on the housing market over the past year or so, but they may have gone too far. I'm beginning to see news articles that have pockets of good news buried within them that tell me we may be nearing the bottom of the housing market correction. Looking at the various statistics together brings more optimism.

On May 23rd, CNN headlines read "Home sales dip; prices fall sharply," based on the news report from the National Association of Realtors that existing home sales dropped 17 percent from April 2007. An analyst quoted in the article said "this was the latest in a long string of disappointing results." Median home prices were down 8.5 percent since April 2007. By the tone of the article, everything was gloom and doom, leaving readers wondering when the massive bleeding would stop.

Yet the raw data from the NAR clearly show that existing home sales have stabilized around 4.9 million units (seasonally adjusted) since December of 2007, a fact buried by the author. Are home sales down compared to the unrealistic days of lax underwriting standards? Of course! But a five-month trend of stable home sales is a comforting statistic to me, especially compared to the drops of 4.5 percent in August and 7.1 percent in September.

Then on June 9th, CNN reported "Pending sales up 6.3 percent; prices seen falling." Again the author had a hard time containing his pessimism by claiming the report gave "mixed signals." This week the U.S. Census Bureau announced that construction of new homes fell 3.3 percent in May, but in the Northeast new home construction jumped 61 percent over April, the highest number since October.

Taken individually, these statistics do not yet indicate trends and they are lost amidst the gloomy tone of the news articles. Yet taken in aggregate, they may be signaling that we are at or near the bottom of the housing market. Absent a major crisis in the credit markets or oil rising above the expected $150 per barrel, I expect the media will turn more optimistic in September or October, as we get further away from last year's housing collapse. Then, in November, we will elect a new president who has the leadership to restore our hope and confidence.

All of this is good news for the financial markets, too. Less fear and greater optimism in the economy will help to settle the nervous stock and bond markets.

Gas at $5/gallon?

2008-06-13T07:38:00.000-07:00

I've been conducting a (very) informal poll for the past couple of weeks. I've been asking people this question: If you could enter into an agreement that would lock in your price of gasoline for the next year at $5 per gallon, would you do it? The responses have been mostly negative, but the question has sparked some very interesting discussions.

The answer to this question interests me because it reveals the degree to which the recent acceleration in gasoline prices have affected a person's expectations for further price gains. The mostly negative response to my question tells me that inflation expectations have not yet become deeply entrenched (at least among my clients and friends) and this is very important. Inflation does its greatest damage when expectations for high inflation get baked into general perceptions about the future. When that happens, it becomes very difficult and painful to wring inflation expectations out of the economy.

As a case in point, consider the U.S. experience in the 70's after the 1974 oil embargo. At that time, year-over-year core inflation (or, inflation excluding food and energy) averaged 7.9 percent. Beginning in 1979 and continuing through the early 80's, it took the Fed's "tough love" approach--including 18 percent interest rates and a very nasty recession--to finally squelch those expectations. The impact of that "tough love" lingered for many years. In 1988, when I bought my first house, my mortgage rate was 9.375% and I thought it was a great interest rate.

With gasoline now at close to $4.50 per gallon, a rise above $5 per gallon is very possible. Some pundits claim we will see it breach that level and go much higher. Whether they do or not is anybody's guess. But the thing I will be watching is how those price gains effect general inflation expectations.

Coping with the Oil Crisis

2008-05-31T06:17:00.001-07:00

After paying $4.41 per gallon in San Jose the other day, I decided to take action. For $500 I reserved a production slot (#2,366 to be precise) for the new Aptera hybrid vehicle being developed in Carlsbad, California. When delivered sometime in 2010, this vehicle will cost about $30,000, get over 200 miles per gallon and will have a top speed of about 85 miles per hour. Plus, it looks cool. Check it out at www.aptera.com.

Oil & the Urge to "Do Something"

2008-05-30T14:56:00.000-07:00

There is a very interesting story on the front page of today's Wall Street Journal. Under a headline reading "Regulators Step Up Probes of Trading in Oil Markets" the article describes efforts by a newly-invigorated Commodity Futures Trading Commission* (CFTC) to get tough on alleged manipulations in the energy futures market.

While the article provides an interesting look at the latest effort by politicians to "do something" about the rise in oil prices, I think is important to understand that the massive run up in oil and gasoline prices probably has very little to do with chicanery or fraud or manipulation (though bubbles always bring out the worst of these sorts of things.) It is much more likely that the ballooning price of energy is simply a product of the same dynamics that caused the other bubbles in recent memory: big money, small market, and no diversity of opinion. When these factors are in place, you can bet there will be a bubble.

These three factors appear to be in full force in the oil market right now. As I discussed in my last post, the influx of levered financial players into the oil market has resulted in huge increases in demand for oil futures. While oil is hardly a "small" market, it has traditionally been narrow, meaning it was typically dominated by oil industry players with a few intrepid speculators mixed in. In recent years, however, large financial players have moved into the oil patch. Pension funds, hedge funds, and mutual funds have devoted very large portfolios to oil. Even non-specialty funds have moved into oil and other commodities to broaden out their asset allocation. The new financial players in the oil market do not bring a balanced set of opinions about oil. They are in oil only because they believe prices are going higher.

With this being the case, I'm not sure how effective the CFTC's latest actions will be at curbing the spiraling price of oil. In fact, if history is any guide, political efforts to tamper with markets are more likely to cause a host of unintended consequences much worse than the problem they were trying to solve. Remember the Nixon-era price controls?

A better approach is to let the market run its course. In time, the high price of oil will do three things: 1) it will make alternative energy sources look that much more attractive; 2) it will draw more oil supply onto the market; 3) it will encourage the development of new technologies that help us better use our existing resources.

As these three effects begin to take root and the price of oil stops going up, financial investors will likely decide it is time to move on. After all, oil produces no dividend and earns no interest. The only return a financial investor can expect comes from rising prices. Financial investors can be very fickle and impatient. They are driven by expectations about the future and when expectations for excess returns from oil evaporate, so will their demand for oil.

*The CFTC is the government regulatory watch dog commissioned with the the task of making sure that futures markets function properly and are free from fraud and manipulation.

Oil -- The Latest Bubble?

2008-05-01T19:53:00.000-07:00

Perhaps I am in denial, but I have mistrusted the surge in oil prices almost from the beginning. To me, the magnitude of the rise in oil prices is as suspicious as the rally in tech stocks in the late 1990's and the rise in home prices since the tech sector crashed.

I understand--and agree with--most of the arguments in favor of rising in oil prices: China has emerged as a huge consumer of oil just as political disruptions have pinched oil supplies. Still, I have a hard time believing that these events justify a 433% increase in prices since the end of 2000 or a 76% surge in the past 12 months. In my view, this rally looks like another bubble.

According to the U.S. Department of Energy, world demand for oil has increased at an average rate of about 1.6% each year for the past 7 years. This is in line with past growth rates (and past estimates of future growth rates) so it can hardly be considered a "surprise development." At the same time, the growth in the supply of oil has slowed slightly from about 1.6% per year to 1.5%. This mismatch in growth rates is certainly grounds for some upward pressure on prices, but it hardly seems to warrant the magnitude of price increases we have experienced.

In my mind, a much more plausible explanation for the rapid rise in oil prices is the increased involvement in this sector by "non-traditional" players such as hedge funds, pension funds, mutual funds and individual speculators. As a group, these investors control trillions of dollars. Even a small allocation into oil by these portfolios would account for tens of billions of dollars of marginal demand for "paper barrels" - a huge influx for a narrow market for commodities like oil. And while the price of a futures contract is usually thought to be a derivative of the spot price of the underlying commodity, the algebra that governs the relationship between the two could just as easily allow the spot price to be driven by the value of a futures contract--at least in the short term.

The chart at the top plots the spot price of oil along side the number of outstanding contracts for oil futures. I think it is telling that they rise in near lockstep with each other. While statisticians would argue that a tight correlation hardly proves a causal relationship, I contend that the strong interrelationship between the two is hardly coincidental.

As with most bubbles, there are plenty of people who refuse to see it. Some think the rising price of oil is a sign of the end of the world as we know it. Others believe it is a product of rising inflation expectations and a falling dollar. Many believe oil is a one-way trade, that it must go up over time. Often, they argue that prices aren't in a bubble because they keep going higher - a circular form of reasoning that seems to defy gravity.

My feelings are just the opposite. After the d0t.com crash and the real estate debacle, I think we should all be a little smarter about bubbles. Bubbles have a tendency to pop and when they do, the bottom can be a long way down.

Happy Tax Day!

2008-04-15T07:46:00.000-07:00

Happy Tax Day!

Of course I mean that ironically. Most of us approach April 15th with either a sense of dread or a sense of relief, but very few of us see it as a day for celebration. Even my most politically liberal clients (and I am pleased that I have clients and friends from just about every possible political persuasion), cringe when the tax man calls.

Although most of us do not like paying taxes, most of us also recognize that it is inevitable. We want a government that helps to build and protect a society where our values can flourish. Such a government needs revenue to function and and so we pay taxes. But we also want taxes to be levied and enforced in a fair and just manner. This is a principle that cuts across party lines and ideology. In this spirit, I want to recommend an editorial in today's Wall Street Journal entitled "The Loophole Factory."

(http://online.wsj.com/article/SB120821609494914471.html?mod=opinion_main_review_and_outlooks)

The editorial is a criticism of the current Congress which, the editorial claims, is becoming "a tax loophole production factory for the powerful." As case in point, the authors point to the "Foreclosure Prevention Act" passed by the Senate last week. This bill and versions of it being considered by the House include:

$25 billion in tax subsidies for homebuilders and "other industry interests hurt by the crunch";
A $7,000 tax credit for those who buy foreclosed property;
A $7,500 tax credit for first time middle income home buyers;
$6 billion in tax deductions for renewable energy producers (on top of the $10 billion included in the energy bill.)

The Wall Street Journal tries to make this sound like a problem driven by Democrats. In fact, the Journal goes so far to claim that the Democratic strategy is to raise overall tax rates so they can then give special tax breaks to their political friends. As my conservative friends read this they probably nod in vigorous agreement. But in making that statement, I believe the Journal completely misses the seminal point.

The seminal point, in my view, is that neither part has shown any ability to act responsibly with regard to public finance. Spending is out of control and the most galling aspect of this behavior is that it is ubiquitous. It is not an issue of Republican versus Democrat. Rather it is simply another example of Congress pandering to the powerful. The Republicans have spent the past eight years doing the exact same thing.

The chart at the top of my post makes my point. It plots government revenue (red) and spending (blue) since 1993. The solid lines are the actual dollars of revenue and spending as reported by the Congressional Budget Office and the dashed blue line is the spending that would have occurred if the Bush administration has maintained the rate of spending growth set by the Clinton administration. (This graph does not include the cost of the war in Iraq.) As the chart shows, had Clinton-era spending discipline been maintained, we would have a healthy surplus right now.

Economic Stimulus Tax Rebates

2008-04-09T09:03:00.000-07:00

More details have been released regarding the economic stimulus tax rebates announced in February, otherwise known as the Economic Stimulus Act of 2008.

If you file a 2007 federal income tax return and have $3,000 or more of income (including Social Security and cerain veterans' benefits), you may qualify for the rebate. The rebate phases out if your income exceeds $150,000 if you're married and file a joint return ($75,000 as a single filer). The rebates can be as much as $1,200 for married couples ($600 singles) plus $300 for each qualifying child under age 17.

Payment Schedules
This is the year to file your taxes on time. Individuals who normally would not file a tax return must do so this year in order to receive the rebate. If you provide direct deposit information on your 2007 income tax return, your payments will be processed first, beginning May 2nd.

The actual timing will be based on the last two digits of your Social Security Number as follows:

More information can be found on the IRS website at:
http://www.irs.gov/newsroom/article/0,,id=177937,00.html

The Wisdom of Crowds--A Compelling Read from James Surowieki

2008-04-03T07:22:00.000-07:00

It has been a long time since I last wrote a book review. In fact, the last one I can remember was in Mr. Meyerhoff's English class during my junior year in high school. However, I was so taken by James Surowieki's book, The Wisdom of Crowds (Random House, 2004) that I wanted to share it with you.

The premise of The Wisdom of Crowds is that large groups of people can be surprisingly good at making decisions. In fact, when certain conditions are met, the collective judgment of the crowd is consistently and significantly better than the best "expert" in the crowd. In support of his premise, Surowieki's writing takes us from a livestock judging contest at an English country fair to space shuttle missions and almost every conceivable stop in between.

I know the idea of an "intelligent" crowd sounds counterintuitive to most of us. We like the idea that experts have the answers and we are generally skeptical (and rightly so!) of uninformed opinions. Most of us seem to believe what the Tommy Lee Jones character in Men in Black stated so eloquently: "A person is smart; people are dumb." But Surowiecki's book makes a convincing case that given the right conditions, groups of people have important things to say.

The key phrase, of course, is "given the right conditions." According to Surowiecki, groups are wisest when their members are independent, diverse, and decentralized. Group members are independent when their input is based on their own thinking and judgment; they are diverse when they possess different knowledge and skill sets; they are decentralized when members can act without having to conform to a controlling hierarchical bureaucracy.

I was particularly interested in what the author had to say about markets. To the extent the three preconditions are met, financial markets do a pretty good job at assigning value to a particular security and rationing risk among investors. Market prices may not always be "right"--after all, we never know if a stock price is correct until many years down the road--but the markets are very good at giving us a "best estimate" based on all that is currently known about a stock.

However, sometimes the necessary preconditions fail and the markets fail. For example, markets can suffer from what Surowiecki calls an "information cascade" which is another term for the bandwagon effect. This happens when investors pile onto a stock because everybody else is piling on. Their actions cause the stock price to rise which in turn pulls others onto the bandwagon. In this circumstance, members of the group are no longer independent and the judgments they render about the value of the stock have less to do with the stock itself and more to do with what they think others think about the stock. This dynamic causes the price to expand until someone or something causes the sentiment to shift and the bubble pops.

According to Surowiecki, the financial media plays an important role in this process. Citing a study conducted by economists Jeffrey Busse and T. Clifton Green on how the market reacted when CNBC ran a positive report on a particular stock, Surowiecki writes:

Busse and Green showed that prices reacted almost instantly to the news, moving higher in the 15 seconds after the segment appeared. More strikingly, the number of stock trades sextupled in the first minute after the segment. The speed of the reaction testifies, on the one hand, to the market's efficiency at incorporating new information. But what the study also shows is that investors were not reacting to the content of the report. Fifteen seconds is hardly enough time to decide whether what CNBC is saying makes sense or not.

Surowiecki discusses other evidence on the impact of financial "news" on market behavior including an experiment in the late 1980's by psychologist Paul Andreassen at MIT. In Andreassen's experiment, students were divided into two groups. Each group selected a portfolio of stocks and knew enough about each stock to come up with an estimate of that stock's fair value. The groups were then allowed to buy and sell their stocks over a period of time. The first group was allowed to only see the changes in the price of their stocks. The second group was allowed a steady stream of financial news that supposedly explained what was going on. Surprisingly, the less well-informed group did far better than the group that was given all the news.

As Surowiecki explains:

The reason suggested by Andreassen was that news reports tend to overplay the importance of any particular piece of information. When a stock fell, for instance, its fall was typically portrayed as a sign that further trouble lay in wait, while a stock that was on the rise seemed to promise nothing but blue skies ahead. As a result, students who had access to the news overreacted. They bought and sold far more frequently than the people who were just looking at the price, because they took each piece of information as excessively meaningful. The students who could look only at the stock's price had no choice but to concentrate on the fundamentals that they had used to pick their stocks to begin with.

According to Surowiecki, "CNBC magnified the dependent nature of the stock market because it bombarded investors with news about what other investors were thinking." In extreme situations like the late 1990 stock market or the real estate market earlier in this decade, these self-reinforcing information cycles caused a convergence in expectations and bubbles were born. Surowiecki concludes:

And the media does play a role that process. During boom times, it's rare to hear a discordant voice suggesting that disaster is nigh, while when things are going bad, it's hard to find someone who suggest that panic is a mistake. In this way, the media often exacerbates-though it doesn't cause-the feedback loop that gets going during a bubble. It's already hard enough for investors to be independent of each other. During a bubble, it become practically impossible. A market, in other words, becomes a mob.

Financial markets are only one small part of Surowiecki's very wide ranging discussion. In other segments the author looks at the disastrous breakdown in decision making that led to the Space Shuttle Columbia explosion, the attempts to moderate traffic problems in central London, the impact of Nielson ratings on television programming, politics and and on and on. It is a fascinating book, entertaining and compelling. I recommend it to anyone who is interested in gaining a better understanding about the world we live in and who is open to some interesting ideas on how to address some of the challenging problems we face.

IRA Rollovers: Watch out for Net Unrealized Appreciation!

2008-03-25T20:08:00.000-07:00

As clients approach retirement, they often ask what they should do with the assets in their 401(k) plan. Usually, we advise them to roll their plan assets into an Individual Retirement Account (IRA). IRA's generally provide greater flexibility, more investment options and lower overall costs. But there are exceptions. One of the most important exceptions arises if your employer allows you to buy employer stock in your 401(k) plan.

Highly-appreciated employer stock in a 401(k) plan is eligible for special tax treatment called net unrealized appreciation or NUA. Under IRS regulations, taxable distributions of NUA stock are taxed in two steps. The first step occurs at the time of distribution when you pay tax on the cost-basis of the distributed employer stock as if it were ordinary income. The second step occurs when the stock is actually sold. At that time the difference between the sales price and the cost basis is recognized as a long-term capital gain. Without NUA treatment, distributions from a 401(k) plan are all taxed at the higher ordinary income tax rate.

The following example will help clarify the situation:

Tom has worked for X-Tech for the past 15 years. Over the years, he has accumulated a significant amount of X-Tech stock in his 401(k) plan. His cost basis in X-Tech is $150,000; it is currently worth $2 million.

With retirement fast approaching, Tom has to decide what to do with his 401(k) plan. His brother-in-law encourages him to roll it over into an IRA and get it diversified. After all, if something were to happen to X-Tech stock, Tom would lose a significant part of his retirement savings. No taxes will be paid at the time of the rollover, but down the road, when Tom eventually takes any withdrawal, he will have to pay taxes on those withdrawals as if they were ordinary income. At a 35% tax rate, this means Tom will eventually pay $700,000 in taxes on his $2 million worth of X-Tech stock.

Fortunately, before rolling it over, Tom hears about net unrealized appreciation. Based on NUA tax treatment, Tom realizes he would be better of taking his X-Tech stock as a taxable distribution and then selling the stock. In this case he pays $52,500 in ordinary income tax (his cost basis of $150,000 times his marginal tax rate of 35%) plus $277,500 in long term capital gains taxes (his unrealized appreciation of $1.85 million times the long-term capital gains tax rate of 15%.) With NUA, Tom's total tax bill on X-Tech is $330,000--less than half of what it would have been had he rolled it over into an IRA. Of course, Tom could also leave it in the 401(k) plan and defer all taxes until some point in the future.

The net effect of NUA is to significantly reduce the tax burden associated with employer stock in an employer sponsored retirement plan. But it is critical to understand that if the employer stock is rolled into an IRA, that tax advantage is lost. While IRA's are a powerful tool for retirement planning, they have to be used carefully.

10 Amazing Days

2008-03-22T21:34:00.000-07:00

It has been an amazing 10 days. I have never seen anything like it and I hope we never need to repeat it. Consider for a moment all that has happened. In a dramatic effort to head off the spreading liquidity crisis, the Federal Reserve has:

Allowed investment banks direct access to the Fed's discount window - something not done since the 1930's.
Offered to lend $100 billion in cash to commercial banks and $200 billion in U.S. treasury bonds to investment banks. As collateral for these loans, borrowers are able to post mortgage-backed securities, the very assets at the center of the current crisis.
Cut the interest rate at the discount window to 3.25 percent.
Arranged for emergency funding to keep Bear Stearns afloat.
Engineered the fire-sale of Bear Stearns to JP Morgan.
Lowered the Federal Funds rate by 0.75 percent to 2.25 percent.

While the magnitude of these actions may be difficult to fathom for those who don't spend their lives watching the Fed, trust me when I tell you that all of these steps taken together in such a short period of time is nothing less than heroic. It is certainly the most vigorous response by the Fed to any crisis in my lifetime and probably the most dramatic since the Great Depression. Treasury Secretary Henry Paulson was not exaggerating when he said we are in uncharted territory.

It is too early to tell whether these events mark a turning point for the financial system or a bottom for the market. I tend to think we have more struggles ahead of us. Hopefully the mavens on Wall Street will begin taking the painful but necessary steps to get their businesses back on track.

In my view, a workout scheme analogous to the strategy that got us through the savings & loan crisis in the late 1980's is likely necessary to fix this one. Financial institutions will need to segregate their bad loans into a separate entity that would be spun off to shareholders while the good assets would stay in the parent company. We may even need to set up an institution akin to the Resolution Trust Company to facilitate the sale of failed or failing firms.

This strategy, known as "good bank/bad bank" would be very painful for shareholders and I'm sure they will resist it. However, if the Fed's approach to Bear Stearns is any indication of its current mood, shareholders may not have a choice.

A Deal You Can't Refuse

2008-03-18T09:03:00.000-07:00

By now I'm sure you have all seen the news on the "sale" of Bear Stearns. I put the term sale in quotation marks because sales are usually voluntary transactions entered into by two willing parties. From what I have been reading, this deal was what Don Corleone in The Godfather would have called "a deal you can't refuse." You could hear the howls from Wall Street all the way out here on the Monterey Peninsula.

According to the Wall Street Journal, JP Morgan magnanimously agreed to buy Bear Stearns for $2 per share. When I first read that report I thought surely the article had it wrong . Didn't they really mean $20? I was wrong. Although the price of Bear Stearns closed at $30 per share on Friday, JP Morgan smelled blood in the water and, with the help of the Fed's muscle, the deal was closed at $2 per share.

JP Morgan comes away from this transaction with two crown jewels, each worth far more than the $236 million price tag they paid. The first is Bear Stearns' prime brokerage business which is a leading provider of services to hedge funds. The second is Bear Stearns' headquarters building in mid-town Manhattan. According to estimates published on Bloomberg, this 47 story building built in 2000 is worth between $1 and 1.5 billion.

I believe this is a very positive development (unless you are a shareholder in Bear Stearns.) It is the clearest sign yet that the Fed is getting serious about pushing Wall Street to clean house. You can bet that discussions in board rooms up and down Wall Street have taken on a renewed sense of urgency. Nobody wants to suffer the fate of Bear Stearns.

Bear Stearns & the Credit Crisis

2008-03-15T15:47:00.000-07:00

Brokerage firms, money center banks, and hedge funds have been slowly circling each other for months trying to assess each other's credit worthiness. The fear that one or more of them would fail in their commitments to the others (a risk known as counterparty risk) has been simmering below the surface for months. With the Bear Stearns action yesterday and the implosion of Carlyle Capital earlier in the week, this fear erupted into a full boil.

In this morning's Wall Street Journal, a bond-fund manager explained the essence of the problem: "The nature of financial companies is that they are pretty much a black box. If people start to worry about what's in the box, there's not much firms can do to demonstrate that they are not as weak as they appear to be. (WSJ, 1/15/08) In other words, confidence is king on Wall Street. Without confidence, the entire system grinds to a halt.

One of the Federal Reserve's most vital functions is to help maintain confidence in the financial markets. If a major financial firm gets in trouble, they sometimes step in to help organize an orderly transition. This is exactly what happened yesterday with Bear Stearns. Working in concert with JPMorgan Chase, the Fed extended loans to the erstwhile Wall Street titan to help make sure it could meet its obligations to other financial firms. This financial lifeline buys time for the markets to figure out a longer-term solution, which will likely entail the sale of the firm to a stronger entity. This is probably the first of other Wall Street restructurings. I would not be surprised to see other firms follow in Bear Stearns' footsteps.

What does this mean for the rest of us? In the near term, I expect further pressure on stocks and the dollar. The pressure on stocks will come from the continuing uncertainty about how far this credit crisis will go before it bottoms out. The pressure on the dollar will come from lower interest rates on government debt. But don't expect the lower interest rates on government debt to lead to lower rates for you and me. The same crisis of confidence that made financial institutions shy away from Bear Stearns as a counterparty will also make them nervous about the rest of us, at least until a sense of normalcy returns to the markets.

I don't know how long it will take for the markets to get back to normal. These things take time. The emerging market crunch of 1998 lasted 12 months; the dot-com debacle of 2000 lasted three years. But no matter how long this crunch takes, it is important to stay focused on relative value in the market. Right now, relative value is in U.S. stocks. We urge you to hold steady and stay the course.

Another test of resolve

2008-03-07T15:32:00.001-08:00

It never ceases to amaze me how thoroughly markets test the resolve of those who participate in them. It really doesn't matter which market we are talking about: stocks, bonds, commodities, foreign exchange. Even real estate. After all, those who thought real estate was a "sure bet", are certainly having their resolve tested right now. By the number of for sale signs I see going up in my town, I would say that many are flunking the test.

The stock market is presenting us with a similar test. In the past 9 days, the broad market averages have dropped 6.3%. Year-to-date, the S&P 500 is down almost 12%. I am very proud to report that our clients are passing this test with flying colors and you are to be commended. I have had the opportunity to speak with most of you by now and almost to a person, you have been steady in the face of the maelstrom and I have full confidence that your steadiness will be handsomely rewarded. Of course, the rewards for holding won't be immediate. I believe we will pass through more challenges before the current credit crisis is resolved.

Last fall I attended a conference where Steve Wynn, the Las Vegas casino mogul, spoke to a packed house. He said the key to running a successful casino is understanding that human beings crave instant gratification. Steve has built a huge gaming empire based on satisfying that human longing. I think it is telling that the profits of his empire are based on the losses of his patrons. Seeking instant gratification is rarely the path to financial success.

Which brings me back to my discussion of the current market environment. This human craving for instant gratification usually leads investors to disastrous outcomes. When it seems like the market is coming unglued, the urge to cut and run--to seek instant relief--can be almost overwhelming. And, trust me, in the moment of relief, it feels very good. But that sense of relief can be very beguiling. Like that girl mother always warned you about, it will lead you wrong--causing you to sell when you should be buying (or at least holding on.) Even worse, it sets you up for an even thornier dilemma: when do you get back in? The anxiety around this second dilemma can be just as perplexing as the original problem. Seeking relief from that anxiety will almost always lead you to buy at the worst possible moment.

For me, the better path in most situations is to put in place a sound strategy, implement that strategy with high quality investments and hold steady.

Welcome

2008-03-07T15:01:00.001-08:00

Welcome to our new blog! Gary and I have discussed writing a blog for a long time and just never got around to it. The market's volatility since last fall finally gave us the push we needed to get it up and rolling. We hope you find it interesting and informative.

Our goal in creating this blog is to open a more direct line of communication with our clients. For the past five years we have published a monthly report covering issues ranging from the economy to our views on the market to issues in personal finance. Our monthly reports have always contained 100% original material because our intent has been to provide you with a unimpeded view into our thinking. This blog will follow that same pattern.

We expect to post new articles on a very regular basis. In order to get the most out this blog, we encourage you to subscribe to our RSS feed. A link can be found our our blog home page. As we learn more about the process of blogging we will look for ways to enhance your experience by providing more interactivity and more media rich content. Stay tuned!