Tuesday, September 30, 2008

When Buyers Meet Sellers

Jim Parker, Regional Director, DFA Australia Limited

"Sellers were out in force on the market today after negative news on the economy." So say the talking heads on television each night. But have you ever wondered if there are so many sellers out there, who is buying?

The notion that in bear markets sellers outnumber buyers just doesn't make sense. What the newscasters should say, of course, is that there were not enough people willing to buy shares at the prices the sellers were seeking.

What happens in such a case is either the would-be sellers sit on their shares or prices adjust lower until supply and demand come into balance. This is when transactions occur and is described by economists as "equilibrium".

But equilibrium isn't a permanent state. That's because new information continually is coming into the marketplace, forcing would-be sellers and would-be buyers to constantly adjust their expectations.

That new information might be company-specific news like an earnings warning. It might be news that has implications for an entire industry—like a spike in oil prices forcing airline stocks lower. Or it might be an economic development that affects the entire market, like a change in interest rates.

Given this constant flux in news and information flows and the forever changing expectations of participants, individual securities and the market itself are said to be always moving toward equilibrium.

When markets are going down, it can be reassuring to remember that at some point supply and demand must come into balance. Buyers eventually will see value in the market and will invest if the prices are low enough.

Trying to time these inflexion points is a fool's game, by the way. That's because prices tend move in a random way. So it is next to impossible to predict with any consistency what the market will do next.

This in turn reflects the difficulty of successfully forecasting the future. That doesn't stop many people from trying, mind you. And sometimes they get it right. But that's usually down to good guesswork, not scientific method.

But during times like these, investors can comfort themselves in the knowledge that in a market economy, over the long term, there is a return on capital. If there wasn't, capitalism would no longer work.

They should also recall that when companies' share prices are low relative to their fundamental values, their cost of capital is going up. In other words, investors are being offered a higher expected return.

So rest assured, there are still plenty of buyers out there. The market is doing its job and the rewards will be there if you remain disciplined and diversified.

A shock from the House

From Economist.com

The House of Representatives rejects the $700 billion bail-out plan

IT WOULD have been one of the most unpleasant laws that Congress had found itself writing so close to an election. Devoting $700 billion of taxpayers’ money to rescuing the country’s least popular industry was clearly not a vote winner. That Democratic and Republican congressional leaders held their noses this weekend and came up with the Emergency Economic Stabilisation Act was encouraging evidence that they appreciate the gravity of the financial crisis. But with a vote of 228 to 205, the House rejected it. World stockmarkets promptly slumped...


Note to Investors: Don't Play Games with Asset Allocation

Published: September 17, 2008 at http://knowledge.wharton.upenn.edu

For investors, 2008 has been a nightmare. The most widely followed market barometer, the Standard & Poor's 500, is down more than 16%, shrinking the holdings of millions of ordinary people who have put their faith into index-style investing.

Other major U.S. stock indexes have been hammered as well. And although many investors had bet on foreign stocks, hoping that international diversification would soften the ups and downs of their U.S. portfolios, most foreign stocks are down dramatically, too. And a recent rebound in the U.S. dollar, while it boosts Americans' buying power, has undermined their foreign holdings even further.

What are small investors to do in such a climate? Have the rules of the game changed in some fundamental way?

Stocks are still the best bet for long-term investors, offering better returns than bonds or cash, says Wharton finance professor Jeremy Siegel. But with all the turmoil in the financial services industry, he's not betting on quick gains in the S&P 500. "I don't think it will be up this year," he says, adding, however, that the market "is searching for a bottom. All we need is a few weeks of calm to return and I think we will have a very good base for a rally in the market."

Much of the damage to the S&P 500 can be traced to financial stocks. If one were to remove them from the list, then the ratio between share prices and corporate earnings would be a healthy 14 to one -- less than half the level reached during the stock bubble early in the decade. He calls those levels "really very reasonable."

"Nine of the 10 [S&P 500] sectors have higher earnings to date in 2008 than they had in 2007," Siegel says. Moreover, the international economic slowdown has caused prices of oil and many other commodities to fall, reducing the risk of serious inflation. "I really don't' think that's a concern anymore, and that's really important."

Small Investors Should Sit Tight

As in most crises, small investors will do better sticking with their long-term plan rather than pulling money out in a downturn, says Wharton finance professor Richard Marston, who adds that it's just too hard to spot the market's high and low points except in hindsight. He believes the credit crunch could continue to drive stocks down but that investors who move to the sidelines would risk waiting too long to get back in, missing the rebound.

If one plans a long-term asset allocation of, for example, 60% stocks, 30% bonds and 10% cash, the best strategy is to stick with it through thick and thin, he says. That means putting money into stocks when that portion of the portfolio falls below the target, as it has this year for many people. "The most important strategy is to make sure that the long-run allocation is kept intact during market downturns like we are experiencing," according to Marston.

Franklin Allen, also a finance professor at Wharton, says investors should steer clear of illiquid assets right now, otherwise they might not be able to get their money out if those investments turn out badly. That obviously includes real estate, which he thinks may fall another 10% to 20%. Even some generally sound holdings, such as municipal bonds, look too risky now because panic in the credit markets could undermine prices or mean a dearth of buyers if one needs to unload.

"If you think you are going to need cash, be careful that you hold liquid assets," Allen says, adding that the traditional rule of thumb still holds: Money should not be held in stocks unless it can be tied up for at least five years. Bank savings are a good place for cash, he notes. But given the risk of bank collapses, investors should not keep more than $100,000 at any single bank, since that's the maximum federal deposit insurance.

Some market followers have argued that popular investment strategies, such as indexing, are not as appealing as they once were. Mutual funds and exchange-traded funds that follow indexing strategies simply buy and hold stocks in an underlying index like the S&P 500, seeking to match the market's gains rather than beat it. Low costs and taxes help boost their returns.
Late in the summer, Dan Wiener, publisher of the Independent Adviser for Vanguard Investors, a newsletter for shareholders in Vanguard Group mutual funds, told his readers this had been a "lost decade" for those holding shares in the firm's S&P 500 index fund, one of the nation's largest funds. In August, the index was at its early-2000 level, leaving annualized returns near zero for the decade.

Wiener, who charges subscribers a fee for his advice on getting the most out of Vanguard funds, argued that index investors had been ill-served by the strategy. Specialized Vanguard funds that focus on energy, mining, real estate and some other sectors had trounced the S&P 500, returning over 10% a year during the decade, he pointed out.

But Siegel believes the index-investing strategy remains sound. In an early-September interview, he noted that at the start of 2000 the market was near its peak at the tail end of the dot-com bubble. Comparing today's level to that bloated peak is misleading, he said.

Results look much better if one starts at the post-bubble bottom in October 2002. From then through the end of August the S&P 500 was up about 9% a year. Add dividends and investors made 10.5% to 11% total annual return. "That's a pretty good return," Siegel notes.

In real life, not many investors put all their cash into a single investment on a single date, either the peak or trough, he says. Instead, they add money gradually over time. With steady investing known as "dollar cost averaging," a given sum buys more shares when prices are lower than when they are high, helping to reduce the per-share cost as a holding accumulates. Over time, an investor is likely to do better this way than by trying to judge the best moments to move money in or out of the market.

Siegel points out that the S&P 500 was at 600 in 1995, while it is over 1100 today. Investors who stuck with the index rather than bailing out during the dot-com crisis early in this decade or in the turmoil of the past year enjoyed handsome gains, he notes.

Beware of 'Economic Patterns'

According to Marston, economic patterns are an unreliable guide for those who want to bet on the stock market's peaks and troughs. "In the nine recessions since 1950, the market, measured by the S&P 500, rose at least 30% in the first 12 months once the market reached bottom. In eight of the nine recoveries, the market reached bottom before the end of the recession."

The problem, he says, is that the end of the recession can only be spotted in hindsight -- often many months later. So investors who waited on the sidelines for that signal would have missed the rebound.

And the relationship between the economy and the market doesn't always hold. The most recent recession ended in November 2001, but the S&P 500 did not bottom out until October 2002. Those who used the recession's end as a signal to buy -- assuming they could identify the end as it occurred and not later -- would have lost money over the subsequent 11 months.

"The lessons from this are... don't play games with the asset allocation because you will inevitably be out of the market long after the rally begins...and it will be difficult to know when to increase equity positions," Marston says.

Many investors cannot resist the temptation to play the peaks and troughs, Marston concedes, though it's best to try this with only a small portion of one's holdings. Those investors might find some bargains today in classes of stocks that have been badly hammered: foreign stocks in general, especially emerging-market stocks, and small-company stocks.

"Many Americans are significantly underweighted in foreign industrial country and emerging-market stocks, so they should consider adding to those positions," he says. "But be aware that some foreign economies such as Germany and Japan are deteriorating faster than ours, so expect some bumps in the near future."

Siegel, too, believes most American investors don't own enough foreign stocks, which can be purchased most easily through mutual funds or exchange-traded funds. He argues that as much as 40% of an American investor's stock portfolio should be in foreign issues, allowing one to match global stock returns. This very broad diversification can soften the downturns, and global returns may be boosted from the higher growth potential of developing countries, though these returns can be volatile. He also cautions against piling into stocks in regions that have enjoyed big gains in recent years, such as China.

While stocks always pose risks, the dangers may be worse in some other investments, Marston says. Real Estate Investment Trusts, which are like mutual funds that own real estate, "don't seem to have fully priced in the tightening of credit" and may lag stocks in the next recovery. Credit investments such as high-yield bonds, known as "junk" bonds, "are still deteriorating," he says. "Only the very brave are going into distressed assets at this time."

High oil prices have been a key issue in the past year, helping to drive inflation up and threatening to undermine consumer spending, which is key to the U.S. economy and stock performance. Now that oil has fallen below $100 a barrel and gasoline below $4 a gallon, this threat is easing, Siegel says. That leaves trouble in the housing market as the key factor in the economy, and it is not clear when this crisis will end, he adds.

Allen worries that rising unemployment could help to undermine housing prices as more homeowners default on their mortgages -- not a good sign for the stock market because people who feel poorer spend less.

While he, too, would stick with a long-term plan, maintaining the desired mix of stocks, bonds and cash, Allen warns that there is "huge uncertainty" in today's markets. "I think you have to be conservative at the moment, because there are a lot of very difficult times coming up."

Jeremy Siegel on the Resilience of American Finance

From The Wall Street Journal, 16 September 2008

The turmoil in the financial markets will reorganize the financial landscape. But this does not mean the financial industry will shrink dramatically. In fact the current crisis could well lead to an increase in the demand for financial services, as the world grapples with the need for new financial instruments, new risk management techniques, and the increasing complexity of the financial world.

There is no doubt that some of the most hallowed names in the industry, such as Bear Stearns, Merrill, Lehman and others will disappear as separate entities. Their demise was caused by bad risk management, and a failure to understand the high risks of an overheated real-estate market, the root cause of our current problems.

We can argue about who was responsible for the overleveraging of the financial industry and the poor to nonexistent credit standards that prevailed in real estate. Certainly the regulatory agencies, including the Federal Reserve, should have sounded a warning. But the lion's share of the blame must go to the heads of the financial firms that issued and held these flawed credit instruments and then, in many cases, "doubled down" by buying more when their price was falling.

Overleveraging has been the cause of many past financial crises, and will undoubtedly be the cause of those in the future. It was the cause of the 1998 blowup of Long Term Capital Management, where the Fed also intervened to prevent a crisis. Then two years later the tech and Internet boom burst. If banks would have been allowed to buy on leverage these stocks during the bubble, they would have been in even more trouble than now.

But few were willing to admit that subprime real-estate loans could be as risky as stocks. It was just too profitable to issue these mortgages. So eyes were closed and the money kept pouring in. Groupthink prevailed. To paraphrase John Maynard Keynes, it is much easier for a man to fail conventionally than to stand against the crowd and speak the truth.

There is no doubt in my mind that if we didn't have a proactive Federal Reserve and deposit insurance, we would have been following the same course as we did in the 1930s, when the bursting of the stock bubble and fear of loan defaults led to thousands of bank failures and ushered in the Great Depression.

That will not happen this time. The rapid provisions of liquidity by the Fed will prevent any full scale downturn. In fact, I take it as a mark of confidence in our financial system that the Fed did not feel compelled to bail out Lehman Brothers as they did last March when they folded Bear Stearns into J.P. Morgan. Certainly politics played a role in this election year, as critics (and some Congressmen) criticized the government for bailing out the big boys, while letting homeowners twist in the wind.

Despite the recent turmoil, there is good evidence that the worst is over, especially for the commercial banks with access to Federal Reserve credit. Despite yesterday's severe sell-off, most are significantly higher than their July 15 low, and some such as Wells Fargo and UBS are up over 50%.

Nevertheless, the current crisis will change the financial landscape. Certainly Bear, Merrill, Lehman and others will disappear as separate corporate entitles. But other institutions, specifically the commercial banks that absorb these firms, and who have direct access to Federal Reserve credit, will become larger.

The demand for financial services will in no way disappear as the automobile pushed out the horse and buggy a century ago. Although unemployment on Wall Street will undoubtedly rise, many workers will be reabsorbed elsewhere in the industry. The current financial crisis calls out for new products and services as well as more, not less, information about what is safe and profitable in the future environment.

It is easy to be pessimistic about the future of financial services in the current climate. But objective facts indicate that the future demand for these services will be high. Looking beyond past losses, the demand for financial services, especially internationally, has been strong. The growth of the developing countries, combined with the aging in the developed countries, will lead to huge international capital flows that will be facilitated by new and existing financial intermediaries.

It is shocking that firms that withstood the Great Depression are now failing in what economists might not even call a recession. But their failure was not caused by lack of demand for their services. It was caused by management's unwillingness to understand and face the risks of the investments they made. The names of the players will change, but the future growth of the financial services industry is assured.

Mr. Siegel, a professor of finance at the University of Pennsylvania's Wharton School, is the author of "Stocks for the Long Run," now in its 4th edition from McGraw-Hill.

Friday, September 19, 2008

When sharemarkets and the real world collide

from Smart Investing with Robin Bowerman

The relationship between the real world and the stockmarket can sometimes seem tenuous.

The rout on financial markets is inescapable yet people are still going to work earning money, going to the supermarket or the pub to spend it, buying fridges, TVs and even luxury cars. Spring is in the air and football finals fever is building. In short life goes on.

So reconciling what is happening with sharemarkets around the globe and trying to comprehend the mind-bending numbers that are tossed up regularly in the media about the size of losses or asset writedowns is far from a straightforward exercise.
For the person on the street it is not surprising if the problems besetting Wall Street investment banks seem a long way from real-life in downtown Australia. With the obvious exception of the bank employees who have dramatically lost their jobs the gyrations of the sharemarket can appear strangely disconnected from everyday business.

With words like crisis, panic and financial contagion bombarding us via newspapers, websites and nightly TV radio and news broadcasts it is no surprise that consumer and investor confidence has taken a battering and for the first time in 20 years bank term deposits top the rankings in consumer surveys as the wisest place to invest.

So the need for context - and a clear head - has never been more important. We know from previous market corrections/crashes that making emotional decisions in the heat of short-term events can simply turn bad to worse.

So a critical issue is whether you believe the financial market gyrations are a portent of bad things to come in the real world economy or that over time as confidence returns in company earnings that the sharemarket will return to realistic valuations based on the long-term growth in both our economy and more broadly the global economy.

There is no doubt the financial sector - notably US investment banks - have done a spectacularly good job at distancing themselves from the real world. Amazing profit growth within what has been dubbed the "shadow banking system" in recent years has been exposed for what it is - increasing amounts of poor grade debt bundled up in a way that disguised or at least obscured the true level of risk.

Now the default risk is there for all to see suddenly we are faced with a system that is seizing up on itself. It's akin to driving a car with a fine engine but a gearbox that is struggling to engage the right gear. Repairs - be it via regulation or markets forcing mergers and takeovers - will clearly be required.

Yet there is plenty of good news around on the economic front: oil and food prices are down from their mid-year highs; the US economy seems surprisingly strong (the US economy had the strongest growth of the G7 countries for the June quarter) while unemployment rates - a critical economic indicator - both here and in the US are at low levels.

In the Australian economy the Reserve Bank governor Glenn Stevens reported to Parliament this week that domestic demand in Australia rose 4% in the first six months of this year - down from about 5.5% last year. That is in itself good news because it takes the pressure off inflation from the Reserve Bank's perspective and in turn gives them the flexibility to lower interest rates.

So the economic scorecard paints a much more positive picture than the daily gyrations of sharemarkets. But for investors who are receiving super fund statements or checking account balances online that will be cold comfort. And there are lessons - albeit painful ones - to be learned from extraordinary periods like these.

With all the market activity swirling around us the hardest thing can be to sit still and do nothing. Now if you are young and you are invested in a diversified portfolio in your super fund it should be easy to file the statement and write yourself a note to check back around the same time next year. If you are older, perhaps approaching or in retirement the challenge may seem several orders of difficulty higher.

But at times like these diversification - spreading your money across a range of investments, a number of asset classes and over time - is the best way to handle the risk.

Australian shares - as measured by Vanguard's Australian shares index fund is down 14.7% for the 12 months to the end of August. In contrast the diversified balanced index fund is down a much more modest -4.7% for the same period. No-one likes negative numbers but that really shows the power of having a portfolio that has a good level of exposure to fixed interest and bonds as your defensive asset mix.
The other perspective is to remind yourself that when you are investing in the sharemarket - and particularly with super - you are investing for the long-term. Looking over five years the Australian share market index fund has grown 14.3% a year to the end of August. If someone had told you that was the return you would get five years ago most people would have signed up happily.

When it comes to what happens next in the short-term your guess is as good as the next person's. What a review of financial crises and crashes back to the 1929 Wall St crash does tell us though is that they are typically caused by some speculative build up which is where markets and the real world economy tend to part company. After the bubble - and the seemingly inevitable hangover - the real world economic value can again be seen more clearly and normal cyclical service is resumed.

Tuesday, September 16, 2008

Memo to the Uneasy Investor: Be Strong

This article was written by RON LIEBER (NEW YORK TIMES, NYTIMES.COM)

It’s pretty hard to stick with a long-term plan for your money when the financial world seems to be unraveling around you.

You were probably already uneasy about home prices, job stability and inflation. Then the government took over Fannie Mae and Freddie Mac, Lehman Brothers scrambled for a buyer and the stock of Washington Mutual fell below $3 amid concerns about its own shaky standing — and that’s just in the last week.

The temptation is to climb under the covers, money safely in the mattress, and hide from a world that has surely changed forever.

“The big question that people ask during these things: ‘Is it different this time?’ ” says J. Mark Joseph, of Sentinel Wealth Management in Reston, Va.

And is it? Well, no, not really. And as with any market disruption, you need to start by staring down the volatility and putting it in context. Then, face up to whatever fears led you to stop investing money or to move everything into safer vehicles — or to seriously ponder those alternatives.

Finally, resolve to be brave (and well diversified).


Thursday, September 11, 2008

Lessons from a Theme Park

Jim Parker, Regional Director, DFA Australia Limited
(reprinted with permission.)

Have you ever watched people exiting those nausea-inducing rollercoaster rides at theme parks? Some stumble down the steps as they try to regather their balance, others look deathly pale, the worst are physically sick.

Yet other rollercoaster riders seem to retain their sense of equilibrium amid the unpredictable twists and turns. Some avoid motion sickness by focusing on a distant point on the horizon and reminding themselves that even the scariest ride, however terrifying, is finite.

This is an approach that investors would be well advised to take at a time of extreme volatility in the financial markets, as we have seen in the past year.

To be sure, the daily churn of the indices can feel destabilising if you focus on it too closely. But if you keep in mind that these extreme ups and downs will pass, if you stay focused on your long-term investment goals and if you keep your emotions in check, the volatility can be a lot easier to stomach.

These two charts of the S&P/ASX-200 index, Australia's equity benchmark, might help. The first looks back on a particularly rocky period—from around the middle of 2001 to the end of the first quarter of 2003. If you cast your mind back, this was a period when investors were buffeted by the tech wreck, US recession fears, the 9/11 attacks, the Enron and WorldCom accounting scandals and the build-up to the Iraq war.

This was a volatile, stomach-churning time and you could have been forgiven for calling out 'stop the ride, I want to get off'!

Now take a look at the second chart, which shows the same index over a seven-year period from mid-2001 until the present day. The shaded area represents the 21-month period shown in the previous chart.

You see what a difference a bit of distance makes? (I've used the Australian benchmark index here, but if you charted the S&P-500 or the FTSE-100 or the S&P/TSX Composite, you would see something similar.)

This is not to downplay the momentous nature of the geopolitical, economic and corporate events of that time or the real suffering they caused. But this example does serve to show that if you want to secure the returns of capital markets, you need to keep your nerve through volatile times like these.

The fact is that markets, like economies, go through up and down cycles. We have been in a downward cycle since late 2007. We do not know when this rough ride will end. We do know that it will not last forever.

Tuesday, September 02, 2008

New Vanguard Index Chart (to 30 June 2008)


Lessons from the Credit Crisis

Stephen J. Garth, Portfolio Manager, DFA Australia Limited

Benign financial conditions encouraged excessive risk-taking in fixed interest markets in recent years. But as the tide of cheap credit and plentiful liquidity receded, many investors have seen their portfolios washed up on the rocks. In this presentation, Steve Garth charts an all-weather approach to fixed interest and its proper role in a diversified portfolio. (Running time: 22:57)