A final seminar

There is a time for everything, and a season for everything under the heavens.

~Ecclesiastes Chap. 3:1

I started the Investment Seminar with the first article published in the May 2009 Log. My reason was I believed it could be helpful for many who had the responsibility of managing their financial affairs , but were not very knowledgeable about such matters. As it turned out, I believe I was the primary beneficiary; I not only enjoyed composing the articles, I believe it made me a more disciplined investor. I hope at least some of you enjoyed reading and perhaps benefiting from the articles as much as I did writing them. This is my last one.

For those of you who enjoyed or benefited from them, I am pleased to tell you, there is a much better option available: the Berkshire Hathaway Annual Report to shareholders by Warren Buffett, generally recognized as the greatest investor of the 20th century and still going strong.

The entire report is over 100 pages, but the most interesting part to most investors is the Chairman’s Letter- usually about 20 pages. Unlike many annual reports which are mostly a PR effort, it is an interesting combination of wit and wisdom.

You can get the report delivered in the mail every April by calling your broker with a buy order. You will probably prefer the B stock which is currently (10/12/2015) selling in the 130s rather than the A stock around 200,000. If you think the price is too high, the important thing is the value. Is it currently a good value? Warren Buffett is on record as saying he would be an aggressive buyer below a premium of 20% over book value. Its book value on 12/31/2014 was $98.62. At the current price, it is not below Buffett’s buy point but closer to this year’s low of 125.50 than its high of 152.94. If the no dividend policy bothers you, what dividend would you like? Just sell the appropriate amount of stock to meet your reasonable dividend desires and pay taxes at the long term capital gains rate instead of the rate for income. If you still don’t want to buy it, just google it at berkshirehathaway.com where the last 20 years of annual and quarterly dividends are available. You will find it to be a treasure trove of valuable information.

A creative approach to reducing income inequality: competition

We have all been numbed to some degree by the continuing steady flow of bad news: global warming, failing inner city schools, ISIS, the unsustainable increase in entitlements, the unwillingness or inability of our leaders in Washington to put the country ahead of their careers, the bleak outlook for improvement in 2016 with the four leading candidates for leader of the free world including one who, according to Pew Research, is not trusted by the majority, an avowed socialist, an egomaniac, and one with no experience in politics, and the increasing income gap between the top 1% and the middle class. I am reminded of a popular song of the 1960s, “There is something going on here, what it is, ain’t clear”.

An article in the September 1 issue of Fortune gives hope for alleviating the last of the above problems, the income gap. Paul Tudor Jones, while not a household name, is well known on Wall Street as a successful hedge fund investor. In the hope of reducing the income gap, he has the idea of ranking the top 1000 companies based not on what Wall Street values – profits – but rather on what Main Street wants. Fortune says, “If the list caught on, he reasoned, companies might someday vie to be ranked higher than their rivals. And to do so they would have to pay workers more fairly, make products more sustainably, and give more back to the community. To put his plan into action, Jones earlier this year created a nonprofit called Just Capital. The mission is to research what it is that makes people like or dislike corporations and then to create an annual list – which will debut in the fall of 2016 – tentatively called the Just 1000.” Mr. Jones promises it will be unbiased and hopes it will drive corporate behavior. He plans to provide most of the funding to get the plan going, but hopes it will eventually be self-sustaining.

Is Jones doing this out of idealism rather than self-interest? Hardly. He claims history tells us inequality is eliminated by one of three ways, war, revolution, or higher taxes. He hopes his plan will avoid this. Fortune concludes the article with a thought from Adam Smith’s The Theory of Moral Sentiments: capitalism had to have a moral foundation to be sustainable. Otherwise, the rift between the rich and the poor would lead to “the highest degree of disorder.”

Donald Trump may have been unpredictable, but what isn’t?

Through-out most of human history, life was, as James Hobbs said, nasty, brutish, and short. Things started to change with the start of the industrial revolution (about 1760), and change continued to accelerate ever since. With change came a dramatic improvement in man’s condition. Not so with his ability to predict the future. A few examples:

“Heavier than air flying machines are impossible” ~Lord Kelvin, President, Royal Society.

“Everything that can be invented has been invented” ~Charles Duell, Director, U. S. Patent Office 1899. In 1899, 70,075 patents were issued. In 2014 the figure was 1,107,650. IBM as it has for many years, headed the list with 7,534. Second was Samsung with 4,952.

“Sensible and responsible women do not want to vote” ~Grover Cleveland, 1905

“There is no likelihood man can ever tap the atom” ~Robert Millikan, Nobel Prize in Physics, 1923

“Who the hell wants to hear actors talk?” ~Harry M. Warner, Warner Bros. Pictures 1927

I believe we all agree, during our life time innovation has come at an accelerating rate. To take just one example of progress, since 1900, the average life span in this country has increased 30 years, averaging one additional year in every four. I don’t know what the future holds, but I am certain surprises will continue to come at an accelerating rate. A recent example, at least to me, was to see Donald Trump leading in the polls (as of this date 8/7) to become the Republican candidate for president. My first reaction was this country is not yet ready for democracy. My second reaction was – hey, maybe a lot of people are fed up with what’s going on in Washington. My third reaction was, is there any truth to the rumor that it was all a plot by Big Mac-iavelli Bill Clinton to put Hillary in the White House according to an article in the August 10th edition of Barron’s by Randall Forsyth? After all, the Donald made a large contribution to the Clinton Foundation, and the Clintons attended his last wedding. The Big Mac reference was to Bill’s propensity to stop at McDonalds when jogging at the White House before his heart surgery.

Going back to the above quotes, which were intended to remind us that even the experts have difficulty predicting the future, I couldn’t help wondering if Netflix was really worth its 8/7 close of 123.52, a mere 374 times over estimated 2016 earnings, while IBM was selling at less than 10 times estimated 2016 earnings at 155.12. Hmmmm.

7-year bull market may be getting long in the tooth

There is an old Wall Street saying, “They don’t ring a bell at the top”. Although it is impossible to consistently time the market, there are plenty of signs this bull market is getting long in the tooth.

Since the end of World War 2 there have been 13 market cycles with an average life of 5.4 years. This bull market is well into its seventh year.

For the past several months the S&P 500 has sold for over 20 times earnings, a traditional caution sign. Mergers and acquisitions have recently been at record levels, and new issues, the last time I looked, had over 100 potential new issues with an estimated market value of over $ 1 billion, presumably waiting in the wings for the appropriate time to go public. Fortune magazine refers to billion dollar new issues as unicorns because, until recently, they were considered a term of myth. Currently at least eight of them are decacorns.

For a little perspective, in the late seventies and early eighties the total value of all U. S. publicly owned stocks was about 2 trillion. In addition, the 10-year U. S. Treasury bond has recently increased from 1.7% to 2.4%. Does this indicate the end of the long bull market in bonds or just another blip? If the answer is in the affirmative, it will certainly create a head wind for stocks.

Last but not least, Nobel Laureate Robert Shiller’s market research suggests the market is clearly on the high side relative to historical earnings. I am not predicting the end of the bull market is imminent – I have no special expertise for timing the market – but there are many caution signs. Alan Greenspan, who had the huge resources of the Federal Reserve at his disposal, was seven years early with his warning of irrational exuberance in 1993.

Barron’s, for many years has featured a group of Wall Street seers they call their Roundtable. The current number is ten. Twice a year they each offer their predictions on the overall market and individual securities. While their opinions vary, particularly on individual recommendations, they have a total of 46 recommendations, some of them shorts. On balance, their feelings on the market are muted: by year end a 5% increase, at most.

Emerging markets may offer good long-term value

As the bull market continues into its seventh year, the market, as measured by the S&P 500, is high by historical standards. Even higher, by the same standards, are sovereign bonds of developed countries. U.S. Treasuries, the gold standard for riskless investments, may be riskless so far as getting your money back when they mature, but are far from riskless so far as retaining their buying power when they mature. With today’s benign inflation, it is easy to forget the double digit inflation of the ‘70s and early ‘80s which may someday return.

While good long-term values are becoming more and more difficult to find, it may be worthwhile to look at emerging markets. While many emerging market countries have serious problems with corruption, property rights, and individual freedom, did you know the IMF says they had 50.4% of world GDP in 2013 vs. 31% in 1980? This was accomplished by averaging an increase of their share of world GDP .6 % a year since 1980. Further, the IMF forecasts an increase of .7% a year to 2019 to reach 54.5%. In spite of the above, their equity markets have underperformed our markets for the past several years, and at current prices, their values on average, I believe are considerably better than ours.

Most portfolios are grossly underweighted in emerging markets. With world GDP at $77.6 trillion vs. U.S. at $17.7 trillion, we represent only 23% of world GDP, far less than the total for emerging markets. I am not suggesting you adjust your portfolio to a weighting comparable to the world weighting of emerging markets, but you may want to consider moving in that direction. You don’t have to buy individual stocks.

There are many options available via low-cost index mutual funds or ETFs. For whatever it’s worth I currently own Vanguard FTSE Emerging Markets (VWO) with an annual expense ratio of .15% of its capitalization. I also have commented favorably in the past on Wisdom Tree Emerging Markets Equity Income Fund (DEM) with an annual expense ratio of .67%. The Wisdom Tree family of funds has Jeremy Siegel as a consultant who is a long time professor at the Wharton School and has written a number of books on investing. Caution: As I said above, emerging markets have underperformed ours for several years. Don’t expect them to catch on fire as soon as you buy. They may continue to underperform for another year or more. But if you are looking for value, I believe that’s a good place to look.

The May 11 edition of Barron’s has a special section on emerging markets with many recommendations.

Negative interest rates: why it might make sense to pay someone to borrow your money

Several months ago, there was, so far as I know, a truly unique occurrence in the financial world – negative interest rates. It started in Germany, and since has spread to several other euro zone nations.

Instead of paying someone to borrow your money, you might wonder why not put it under your mattress or in your lock box. The American Investment Services explains why it is not necessarily an irrational decision. Global risk is arguably very high, they say. The fate of Greek debt remains in doubt, and fears persist about the sovereign debt of Spain and Italy. Investors who prize safety face limited options. Holding large sums under the mattress is impractical and unsafe, while holding a currency in a bank vault is subject to the limits of depository insurance.

In this environment, German bonds which bear a very low risk of default, may be perceived as safer than other alternatives in the euro world, even if it means paying .2 % to own them. It is possible that buyers of these negative yield bonds could make money if the negative yields increase, thereby pushing outstanding bond higher. If price deflation were to unexpectedly materialize at a higher rate than .2 %, bond holders would experience a higher real return. Foreigners could also come out ahead if the euro were to strengthen relative to their home currency.

Regarding the implications for U. S. interest rates, with negative interest rates in the sovereign debt of several European countries, a case can be made that interest rates will continue to be low here and perhaps go even lower, thus continuing the bullish low interest rate environment for the stock market.

However, the economy is far from a one dimensional event. If the dollar continues to strengthen relative to other major currencies as it has recently, this will increase the cost of our exports on world markets and negatively affect many of our largest corporations.

As the market continues to fluctuate, the prudent approach, I believe, is to maintain a constant ratio of your investable funds in equities vs. fixed income.

The case for municipal bonds

Recently there have been numerous signs that the market is getting toppy. Nobel Laureate Robert Shiller’s current Cyclically Adjusted Price/Earnings Ratio (CAPE) has been exceeded only by the 1999-2000 tech top, dividend yields, price/sales ratios, price/book ratios, and price/earnings ratios are all at levels exceeding most previous market highs. Mergers, acquisitions and new issues are all heating up.

While predicting bull market highs is notoriously difficult, if you have followed the advice of Ben Graham and many other financial advisors, you have been rebalancing your portfolio by selling stocks and buying bonds or other fixed income securities as the market goes up.

What is the best way to buy bonds? If you are in a tax bracket that makes municipal bonds a logical choice, the following long ago experience of mine may be helpful. I used to buy individual municipal bonds after researching their ratings, maturity dates, call and sinking fund features etc. Invariably the next brokerage statement would show a loss from my purchase price. Usually I kept the bonds until they matured or were called, so the unrealized short term loss seemed to be of no great consequence. Still, I decided there must be a better way.

Most municipal bonds are held to maturity. Consequently they have inactive markets. Securities that have inactive markets tend to have a big “spread” – the difference between the bid and offered price. When you buy a bond, you pay the offered price. When you sell, you sell at the bid price. When you look at your brokerage statement, it shows the bid price, hence the loss. Because municipals tend to have smaller issues than corporate issues and are often held to maturity, the above does not apply as much to corporate issues, especially large corporations whose bonds are traded more actively.

A professional municipal bond manager will often have a large block of inactively traded municipal bonds shown to him at a price below the quoted bid. It is reasonable to assume he will also have a better “feel” for the municipal market than the “jack of all trades” investor. In addition, a mutual fund can be bought or sold at the same price, thus eliminating the “spread”. It is for the above reasons, for many years all my bond investments have been in mutual funds, usually Vanguard funds, because of the low management fees.

Financial illiteracy comes at a high price

I started this column in May 2009 because I believed there was a shocking lack of knowledge on investing by many Cypress Village residents. Last January 20th, Mary Shapiro, former head of the SEC gave a talk in Jacksonville in which she bemoaned the lack of financial literacy, stating the American public doesn’t even have a fundamental understanding of financial terms.

On January 24, Jason Zweig had an article in the Wall Street Journal about a lady who opened a brokerage account at Merrill Lynch in the 1970s. Her last trade was made in 1987 when she sold her stock and invested $240,000 in a Putnum U. S. government bond fund. Four or five years ago she says a broker at Merrill Lynch told her she apparently borrowed $3,525 in margin around 1987, but she didn’t understand the implications.

Last December she got a letter from Merrill informing her she owed $65,094.50 in margin debt. Her interest rate charges were as high as 11% in the late 1980s. Her margin interest for 2014 alone was $4,330.63 at a rate of 7%. Her statements showed the debt balance periodically with a dr after the debt amount but she didn’t know that the letters dr meant debit balance. Fortunately for her, the debit balance was erased after an inquiry from the Wall Street Journal.

Several larger questions remain. Why did Merrill Lynch open a margin account for an obviously unsophisticated client? Why would Merrill recommend going on margin for an investment in government bonds when the margin interest was surely more than the interest on the government bond fund? Why didn’t her broker call her before four or five years ago and advise her it made no sense to have a margin bond investment that cost a higher rate of interest than her investment paid? Why would a broker recommend buying a U. S. government bond fund? If she wanted to invest in U. S. government bonds, why not invest in them directly and avoid the “management” fee and possibly a load fee? Could a load fee have anything to do with the broker’s recommendation? What is the reason U. S. Treasury bond funds exist at all? All U. S. Treasury bonds are supposedly riskless. The only difference is the maturity dates. Why not just pick the maturity date or dates you want and save the “management” fee?

The moral of the above story: look at your brokerage statement; if you don’t understand it, ask your broker to explain it. Also, when your broker makes a recommendation, consider if it makes sense to you. If not, ask the reason for his recommendation.

CAPE: A long-term measure of stock value

Nobel Laureate Robert Shiller predicted the collapse of the technology-stock bubble in 2000, and later, the real estate boom in the late 2000s. He also developed a measure of long-term stock valuation that many professional investors rely on. Known as the “cyclically adjusted price/earnings ratio” or CAPE,

Professor Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the last ten years, both adjusted for inflation. A recent reading puts it at 26, well above the long term average of 16, thus suggesting it might be time to sell, or at least lighten up. “If only things were that simple”, Shiller said in a recent interview.

“The market is supposed to estimate the value of (future) earnings, but the value of earnings depends on people’s perceptions of what they can sell it again for to other investors. So the long term average (of CAPE) is highly psychological,” he says.

Even though the CAPE measures go back to 1871, predating the S&P 500, it is unstable. Over the 30 years ending in 1910, it averaged 17; over the next 30, 12.7; over the following 30, 15.7; for the past 30, 23.4. “Today’s level might be high relative to history, but how do we know history hasn’t changed?” says Professor Shiller. He argues today’s level isn’t extreme enough to justify a strong conclusion. Cape was 32 in September 1929, just before the great depression, 44 in December 1999, just before the technology bubble burst, and it sank to below 7 in the summer of 1982, just before the explosive start of the 18 year 1982-2000 (not counting the 1 day 1987 bear market) longest bull market in history.

I suggest an important factor not included in Shiller’s deliberations is bond interest rates vs stock dividend yields and bond interest rate changes. For example, in late 1980, long term US Treasuries increased to double digits and peaked at 14.5% in September 1981. While they stayed in double digits through 1985, by August of 1982 investors correctly assumed the long bear market in bonds was over. In mid- August the bull market in stocks began with hitherto unknown daily volumes of 100 million+ followed by 200 million+ shares trading on the NYSE. Today’s volumes are measured in the billions.

In recent years bond interest rates have been at historically lower than average yields. More important is the spread between interest rates and stock yields. Although stock yields are also historically low, the historic spread between the two suggests stocks are relatively more attractive than bonds. I believe this should be taken into consideration when evaluating current CAPE measures.

Why has it taken so long to recover from this recession? Plus, lessons from Bao Bao the Panda

The economy continues to make slow but steady progress since the great recession was officially declared over in June 2009. The improvement has been slower than any of the other ten recessions since the end of World War II. Why?

In a speech in July at the Cato Institute, Richard Kovacevich, Chairman Emeritus and former CEO of Wells Fargo discusses the reasons. As the Berkshire Hathaway 2013 Annual Report lists Wells Fargo as the largest investment of any publicly traded stock ($21+ billion) in its’ portfolio, Warren Buffett obviously regards the Wells Fargo management highly. Mr. Kovacevich starts by noting the publicity surrounding Bao Bao, the new panda cub at the Smithsonian National Zoo. He suggests Bao Bao should fit in well in Washington: she costs a fortune, she has no useful skills, and she’s always on TV.

He then mentions TARP, the Troubled Asset Relief Program, Which he believes to be one of the worst pieces of legislation ever passed by Congress, by forcing all banks, whether they needed it or not, to take TARP funds. He argues only those banks that were still solvent-but had temporary liquidity problems- should have been given that choice. Forcing all banks to take funds destroyed the publics’ confidence in the entire financial industry causing the Dow Jones Industrial Averages to drop another 40% and financial stocks by 80%, he says.

He claims TARP contributed to an unnecessary panic in the market and required an unprecedented $29 trillion of intervention by the Federal Reserve and Treasury, twice the then annual GDP of the United States. Because of TARP and the anger it fomented, Congress had an excuse to burden the financial industry with the largest increase in bank regulations in history.

Soon after, Congress enacted the 2500 page Dodd-Frank legislation. This will produce more than 25,000 pages of new regulation from the same regulators that presided over the last three major financial crises. Four years after its passage, regulators have still completed only 52% of its 398 rules. He contends Dodd-Frank is a political response that does nothing to address the real causes of the crisis which he said was regulatory failures. Among the real causes was Congress’s failure to rein in Fannie Mae and Freddie Mac, who had been repeatedly warned over many years, operated at excessive leverage, and are still operating today, six years after the crisis. He also claims only about 20 financial institutions perpetrated the crisis. They should be punished severely. Instead, 6000 commercial banks are being punished in the same way as the guilty parties.

Space restrictions limit further comment, but for those interested, the entire speech is in our Library in a folder marked “The Financial Crisis: Why the Conventional Wisdom is Wrong”