The more things change...

If you read the Time magazine article reference in my last post you can skip this paragraph right now and move on to the next. For those that didn't get around to reading the full article, the punch line is that despite sounding very much like something written in September 2009 with its references to high unemployment, credit problems, and the economy in a profound, once-in-a-lifetime state of turmoil, the article was in fact written in September 1992.

I would venture to guess that not many readers really remember the disastrous recession of '91, just like the crash of '01-02 is becoming an ever distant memory. Rest assured that the great debacle of '08-09 will take on a similar hazy recollection down the road.

But as the Time article reminds, it is in fact scary when we are in the midst of the downward part of the cycle that regenerates growth. Much like a destructive fire ultimately regenerates the forest, we need to remember that market declines are a natural and necessary part of capitalism.

Currently many major publications are talking about the 'new normal' economy. Rest again assured that today is not any more a new paradigm than when Japan was going to take over the world in the 80's, or when technology signaled the new economy in the 90's, or when stocks were dead in the late 70's.

The more things change, the more they indeed do remain the same.

The State of the Economy

As you may have surmised from my slightly sarcastic posts last week, I find little of real educational value regarding financial topics in most consumer publications. But Time had an article 'The Long Haul: the U.S. Economy" which provides spectacular perspective on how to view our current economic situation. Here are some compelling excerpts:

If America's economic landscape seems suddenly alien and hostile to many citizens, there is good reason: they have never seen anything like it. Nothing in memory has prepared consumers for such turbulent, epochal change, the sort of upheaval that happens once in 50 years.

The outward sign of the change is an economy that stubbornly refuses to recover from the ... recession. Unemployment is still high; real wages are declining. The current slump already ranks as the longest period of sustained weakness since the Great Depression.

That was the last time the economy staggered under as many "structural" burdens, as opposed to the familiar "cyclical" problems that create temporary recessions once or twice a decade. The structural faults ... represent once-in-a-lifetime dislocations that will take years to work out. Among them: the job drought, the debt hangover, ... the real estate depression, the health-care cost explosion and the runaway federal deficit. "This is a sick economy that won't respond to traditional remedies," said the chief economist at Pittsburgh's Mellon Bank. "There's going to be a lot of trauma before it's over."

The U.S. workplace is "in a profound, historic state of turmoil that for millions of individuals is approaching panic," according to labor consultant Dan Lacey, publisher of the newsletter Workplace Trends.

Bank regulators clamped down on lenders, while borrowers either swore off the credit habit or were deemed bad risks. The result was a credit crunch that has severely hurt businesses, especially small ones.

I hope that you will read this entire article and consider what it means for us going forward.

No, Wait - We 're Headed Down Again

After being confused about whether the market was going to to up or down, I read The Dow Will Hit 10,000 Soon. So What? in the Wall Street Journal which clarified that the market was likely to surge up in the fourth quarter, but then drop again heading into 2010. Here is some excerpts:

A fund manager I know suggested this week we might see a big run-up in the fourth quarter. The market, he said, might be forced higher as more people come off the sidelines—most likely at the worst possible moment. Institutional investors have been too cautious through the rally of the last six months. That's true for the public, too; they sold through the crash, and the latest data shows they were still selling shares in August.

Yet even if the market's rise attracts more investors, stocks are becoming less attractive long-term investments. Shares don't get better as they go higher. They get worse. A share is just a claim on future dividends. The more you pay, the worse the deal.

And a rising stock market does not necessarily mean the economy will keep getting better. The current rally ignores some ominous economic trends. Bank lending has slumped, and so, too, have long-term Treasury yields. Neither is a happy omen. And of course, in the real economy, the pain continues. Unemployment has risen to 9.7%, even as Wall Street has rallied.

So instead of the 4th quarter drop followed by better times as per BusinessWeek we should expect a 4th quarter runup followed by worse times.

Or something like that.

The Case for Optimism by Gloomy Fund Managers

Wait a minute, I think I'm getting my stories confused...

A special report from BusinessWeek in August touted The Case for Optimism with headlines such as 'Why It's Smart To Be Optimistic', 'Signposts That Point to the Positive', 'The Vibrant Promise of Cities', 'Why the Statistics Point Toward Progress', and 'Keeping the Faith in Silicon Valley'.

There's even a video of CEO's from Dow Corning, Eastman Kodak, Intuit and others opining that beyond the issues facing the global economy currently, there are many underlying positives such as the power of technology and the recovery of the housing markets that give cause for optimism over the next few years.

There was also an article in the October 1 BusinessWeek that highlighted 'prominent fund managers' who are preparing their portfolios for a fourth quarter stock sell-off. Included are quotes such as:

I'm concerned we've put a Band-Aid over an infection.

The market's rally was driven by sentiment, and the fundamentals hadn't improved enough to justify those gains. There is still too much debt on corporate balance sheets, with around $2 trillion - or 65% - coming due in the next four years.

(in reference to the beginning of 2009) The world looked like it was going to end. And there's no point investing in an end-of-world scenario.

I guess in the magazine business it makes sense to take a stand as both a bear and a bull. No one will connect the dots when the articles are published two months apart, and then whatever happens in the future you can say that you were writing about that outcome months before it happened.

Have you read your brokerage agreement?

Dan Solin of the Huffington Post had a great blog post titled 'Why Don't You Just Give Your Broker a Gun and Tell Him to Shoot You?' It's 12 short paragraphs, and truly shines a light on the creepy, crawly corners of working with a broker as opposed to a fiduciary.

My favorite line is this (after explaining some of the provisions in the brokerage firm contract he reviewed):

"Why would you entrust your assets to a firm that tells you it does not have to act in your best interests and further that it may have conflicts of interest with you which it will resolve in its favor?"

There's not much for me to add to his posting - you should read it.

Read more at: http://www.huffingtonpost.com/dan-solin/why-dont-you-just-give-yo_b_230578.html

Reduction in 401(k) limits possible

One of the good things to come from the current recession is that inflation has been virtually non-existent and we've even seen a reduction in the cost of living depending on the time frame measured. Through September 2008 inflation was just under 5% due to energy costs, but we've had deflation since March 2009. While this is good on the pocketbook, the IRS may be forced to reduce the maximum contribution from its current $16,500 (plus $5,500 for those over age 50) because the 401(k) law bases contribution limit increases on the Consumer Price Index's measure of inflation.

The law is a bit gray in this area, as this has never happened before. But with the average 401(k) plan balance down over 25% in 2008, a reduction in the contribution limit could hinder the ability to buy more shares at lower prices - cutting at the heart of dollar cost averaging.

A five-minute email to your representatives in Washington can help the opposition to this possibility.

Pitt, David. “401k contribution limits face potential fall.” Atlanta Journal Constitution, September 4, 2009.

Block, Sandra. “In 2010 IRS could cut 401(k) contribution limit to $16,000.” USA Today, August 28, 2009.

True Investor Returns, Pt II

After writing the last post, I was curious about the actual results of previous studies and decided to do a little digging about the history of the DALBAR anlaysis of investor vs. fund returns. My gut agreed with Nick Murray's contention that the underperformance of investors vs. funds remained fairly constant (in all the time I can remember seeing the survey results since I started in the financial business in 1994 that seemed to be the case), but I wanted to verify that. I did some googling and found these excerpts taken from the public pages of DALBAR's website, proving that this is not a new phenomenon.

From the 2001 update page

QAIB (Quantitative Analysis of Investor Behavior) examines real investor returns from equity, fixed income and money market mutual funds from January 1984 through December 2000. The study was originally conducted by DALBAR, Inc. in 1994 and was the first to investigate how mutual fund investors' behavior affects the returns they actually earn.

The following annualized returns for investors, whose average fund retention was 2.6 years in 2000 (down from 2.8 in 1999, but up from 1.7 after the stock-market crash in 1987), compared to corresponding indexes, clearly illustrate the benefit of buy-and-hold strategies:

• The average fixed-income investor realized an annualized return of 6.08%, compared to 11.83% for the long-term Government Bond Index;
• The average equity-fund investor realized an annualized return of 5.32%, compared to 16.29% for the S&P 500 Index; and,
• The average money-market fund investor realized an annualized return of 2.29%, compared to 5.82% for Treasury Bills and 3.23% for inflation. Money-market fund investors lose money after inflation.

From 2003

Motivated by fear and greed, investors pour money into equity funds on market upswings and are quick to sell on downturns. Most investors are unable to profitably time the market and are left with equity fund returns lower than inflation.

• The average equity investor earned a paltry 2.57% annually; compared to inflation of 3.14% and the 12.22% the S & P 500 index earned annually for the last 19 years.
• The average fixed income investor earned 4.24% annually; compared to the long-term government bond index of 11.70%.

From 2004

It is widely believed that rapid fire trading produces huge profits for traders at the expense of the average investor. But the latest DALBAR study shows that market timers actually lose money instead of making healthy profits.

Examining the flows into and out of mutual funds for the last 20 years, the DALBAR study of investor behavior found that market timers in stock mutual funds lost 3.29% per year on average. Over a period when the S&P grew by 12.98%, the average investor earned only 3.51%.

“This finding is consistent with the well known behavior of investors to brag about their gains, but remain silent about losses” said Lou Harvey, DALBAR President. “The occasional money makers create the illusion that all timers are winners all the time. The fact is that most timers lose money most often and this data now confirms it.”

The study for the 20 years ending 12-31-2008 didn't have a public page, but the updated results showed equity investor annual returns of 1.87% versus S&P 500 index returns of 8.35% and fixed income annual investor returns of 0.77% versus the Barclays Aggregate Bond index returns of 7.43%.