The Rush to Safety

We have been talking about this dynamic for over a year now. The public usually rushes into an investment class at precisely the wrong time. For the tail end of 2008 and 2009, that asset class was fixed income.

Bond fund inflows reached record levels in 2009. The story is here.

Full-year inflows to bond funds in 2009, including traditional mutual funds and ETFs, reached a record high of $396 billion, according to a report by research firm Strategic Insight.

Long-term mutual funds, including stocks, bond funds and ETFs, experienced net inflows of $425 billion last year, according to the report.

Taxable bond funds had the highest net inflows in 2009, at $324 billion, followed by equity funds with $75 billion and U.S. equity funds with $6 billion.

Emerging markets saw net inflows of $55 billion; ETFs, $114 billion; and traditional index funds, $54 billion.

“There was a lot of demand for bond mutual funds last year,” Avi Nachmany, Strategic Insight director of research, said in a conference call, noting that the total return for bond funds averaged 17% in 2009.

Returns for the asset class were very good last year as the interest rate environment turned out to be very supportive. This year, not so much so. Rates are rising. I expect them to eventually rise much further. When? As soon as the deflationary forces abate. When will we see that? When credit contraction stops and an economic recovery unfolds. Does that exist now? No way.

Investors hated equities in 2008. They will hate bonds at some point too.

Of Two Disconnects: The Economy and Portfolio Performance

I usually try to refrain from commentary strictly on economics and this post-- while close-- is no exception. There's a huge disconnect between Main Street and Wall Street that exists today and it isn't getting any better. For us to overcome this financial crisis these two sides must meet. We can't long exist in a dichotomous society. From Bloomberg:

Americans are down on the economy and the markets even as stocks and growth indicators are up.

By an almost 2-to-1 margin Americans believe the economy has worsened rather than improved during the past year, according to a Bloomberg National Poll conducted March 19-22. Among those who own stocks, bonds or mutual funds, only three of 10 people say the value of their portfolio has risen since a year ago.

During that period, a bull market has driven up the benchmark Standard & Poor’s 500 Index more than 73 percent since its low on March 9, 2009. The economy grew at a 5.9 percent annual pace during last year’s fourth quarter.

“It’s very difficult to turn perceptions around once you’ve been through the proverbial economic wringer,” says Mark Zandi, chief economist for Moody’s Economy.com. “Everything is colored by the fact that unemployment is near 10 percent. It doesn’t really matter what you ask, you’re going to get the same answer.”

Zandi says the poor performance people report on their investments “is very telling. It’s just a fact that everyone’s stock portfolio is up, or nearly everyone’s.”

Even among investors with annual incomes exceeding $100,000, and who might be expected to follow their financial holdings’ performance, more say they have lost money compared with a year ago than say they have made money.

J. Ann Selzer, president of Selzer & Co., a Des Moines, Iowa-based company that conducted the survey, says the disconnect is typical of the way Americans think about the economy.

‘Everyday Life’ Indicators

“Economists look at their indicators and the American people see indicators in their everyday life,” she says. “It is hard to argue with what people observe in their own communities.”

The poll also finds that Americans remain skeptical about the health-care overhaul even after the U.S. House passed the legislation March 21, with fewer than 40 percent of respondents saying they favor the plan. While most say the government should play a role in ensuring everyone has access to affordable care, a majority say health care is a private matter and consider the new rules approved by Congress to be a government takeover.

Wrong Track

A sense of despair pervades perceptions of the economy and nation. Barely one-in-three Americans say the country is on the right track. Fewer than one in 10 say they believe the economy will be strong again within a year. Just 4 percent of Americans who cut back on spending during the recession now say they are confident enough to open their wallets, according to the poll, which has a margin of error of plus or minus 3.1 percentage points.

Poll respondent Lynn Heath, 31, a Belleville, Illinois, stay-at-home mom with four children whose husband lost his job 18 months ago and since has only been able to find part-time work, says her family has nearly depleted its savings.

“We don’t have cable. We don’t have internet. I just learned how to make laundry soap. For $4, I can make two-and- half gallons,” Heath says.

The Obama Administration has made no progress over the past three months convincing the public that the $787 billion stimulus package passed last year either helped the economy or prevented greater deterioration. Only 37 percent of the public say they see positive effects, the same portion who said so in a December poll.

Economic Deterioration

Asked about a range of economic measures, people say they have seen deterioration over the past year: 54 percent say the condition of businesses in their community has worsened and 56 percent say the value of homes in their community dropped during the period.

Poll respondent Jim Buyer, 47, an electric utility lineman from Syracuse, Indiana, says that his impression of a worsening economy comes from cutbacks in overtime on his job and his observations as he drives to and from work along an industrial road that services home suppliers, toolmakers and recreational- vehicle manufacturers. Media reporting on the economy may be “slanted,” he says, and what he sees has greater credibility.

“We see the traffic in front of where we work,” Buyer says. “A couple of years ago it was hard to pull out at quitting time. Now you almost don’t even have to look because the traffic is so slim.”

Most Important Issue

Half of Americans say they believe the economy or unemployment is the most important issue facing the country. Health care was cited by 22 percent, followed by 20 percent who cite the federal deficit and government spending. Just 5 percent say the war in Afghanistan.

Unemployment in February was 9.7 percent. Payrolls in the U.S. have dropped every month except one since December 2007. Economists expect job growth to turn around in March, with a median forecast that payrolls will rise by 192,000.

Poll respondents rate persistently high unemployment the greatest threat to the economy over the next two years, with 75 percent calling it a high threat. Chronically high budget deficits are cited as a high threat by 70 percent, followed by homeowners who can’t pay their mortgages, which is cited by 58 percent. Higher taxes are deemed a high threat by 57 percent.

Nine of 10 Americans believe that cutting the deficit, which is projected to reach a record $1.5 trillion this year, will require sacrifices from middle-class Americans. Still, when asked about a range of potential tax increases and spending cuts to address the problem, the large majorities of Americans favor tax increases that only affect the wealthy.

More than three of four Americans say deficit-cutters should consider removing the cap on earnings covered by the Social Security tax, currently set at just under $107,000. More than two-thirds say repealing the tax cuts for wealthy Americans enacted by President George W. Bush should be considered.

Smaller majorities favor considering three other options: a reduction in annual cost of living increases for Social Security recipients, which 52 percent say should be considered; cuts in spending on public works, which 54 percent say should be considered; and a penny-an-ounce tax on sugar-sweetened drinks amounting to 12 cents on a 12-ounce can of soda, which 57 percent say should be considered.

Majorities say other options shouldn’t even be on the table. Among them are higher out-of-pocket payments for Medicare services beyond basic care, an increase in the eligibility age for Medicare, a 2 percent increase in income-tax rates on middle-class Americans, and elimination of the home-mortgage interest deduction.

What Hath the Rally Wrought?

This rally in financial assets is relentless. Perhaps the non-professional doesn't appreciate just how extraordinary it has been but friend Barry Ritholtz of The Big Picture blog has ranked it in terms of return over time and it's in the upper 1% of rallies.

Everyone needs to assess their risk tolerance. This has been a risky market since the Lehman Brothers blowup (and really for some time before that) and it's a risky market now. The difference has been that this is a risky market that's rising at an incredible pace whereas in Fall of 2008 it was a risky market that was falling at an incredible pace. Nimble traders LOVE these kinds of markets.

I don't pen my thoughts in this area for traders. I do it for investors. Big difference. Traders can trade ANYTHING. Investors look at what is possible over their relevant timeframe and allocate capital or decide not to.

What is one of my favorite sources of long term valuation (Smithers & Co.) saying about this market? Take a look:


US CAPE and q chart

With the publication of the Flow of Funds data up to the end of 2009 (on 11th March 2010) we have updated our calculations for q and CAPE, which show very little change from our previous calculations.

Non-financial companies, including both quoted and unquoted, were 52% overvalued according to q at the end of 2009. Net worth is virtually unchanged from Q3 to Q4. Domestic net worth fell through dividends ($83 bn.) plus net equity buy-backs ($95 bn.) being greater than net domestic profits after tax ($164 bn.), but this was offset by some small upward revisions to asset values. There was a small increase in the value of US foreign investment abroad ($27bn.), but this was less than the amount of foreign earnings retained abroad, probably due to currency adjustments.

The listed companies in the S&P 500 index, which include financials, were 50% overvalued according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website.

Can you make money in overvalued markets? Absolutely. These conditions can persist for years just as they did in the period 1995-1999 and 2004-2007. Investors who were out of the market in those years due to overvaluation concerns missed some very nice returns. They also missed some horrendous subsequent declines. Those declines have the unfortunate effect of shaking a lot of investors out of their positions in the market. They then miss the subsequent gains. We have spoken of this before.

I am just sharing a valuable source of information. That being said, I am constructively long here with a good deal of risk management in place. It will be interesting to see how this resolves itself.

Happy Tax Day!

"I'm proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money." -Arthur Godfrey

It's that blessed (blasted?) day again. Here's hoping your returns get filed early and the rest of the day is for, well, REST. I am heading to the tennis courts to have my brains beaten in by some young pro. Should be just as fulfilling as filing returns.

Tax Day Approaches!

"The expenses of government, having for their object the interest of all, should be borne by everyone, and the more a man enjoys the advantages of society, the more he ought to hold himself honored in contributing to those expenses." -Anne Robert Jacques Turgot


I think Anne Robert Jacques Turgot needs to: a) seriously consider shortening that name, and b) have a gander at the modern tax system and reconsider her statement. Just my opinion.


Timely Reminders

As April 15th approaches, a few items to keep in mind. April 15th is the deadline for funding an individual retirement account, whether traditional or Roth. It's also the deadline for funding a health savings account for 2009. But what if you aren't certain if a Roth or Traditional IRA is right for you? Well, as long as you fund the IRA by April 15th and file an extension, the IRS will give you until October 15th to re-characterize the nature of your IRA contribution.

Some Relief

Choosing to file an extension provides you with additional time to file your actual 1040 and to fund a SEP-IRA. Note: You actually have to request an extension by sending Form 4868 to the IRS.

What Can You Expect?

Regular readers know that I have very particular views about how and when to invest in the stock market. I don't rant or rave about them but try to get you, dear reader, to consider these views and to do your own research and to come up with your own views about probable returns and investment (not speculative) merit.

Pierre du Plessis of Investment Postcards from Capetown has recently written an excellent article on starting valuations and probable returns that I think is a must read for all investors. The entire article can be found here. But for a sneak peak as to what can be expected from investments in the S&P 500 at these levels, I give you this chart:




The chart gives the expected RANGE of returns given starting valuation of the market. Low starting valuations (low price to earnings ratios) are at the left. High valuations are at the right. The chart has a definite downward skew from left to right and shows that NEGATIVE RETURNS are quite possible some time ten years forward from any starting valuation over 12! What does du Plessis calculate as the present starting valuation? 20.3! Read the entire article. I leave you to conclude whether a buy and hold allocation to the general market makes sense at these levels FOR YOU. Yesterday's dyed eggs may be a more pleasant experience.

Happy Easter!

We have small children in this family. For them, Easter is a lot about the above. Easter egg hunts, baskets and candy. It's also about family and friends and Easter dinners. We'll have all of that today and it will be a great one. Hope yours is too.