More evidence on the dangers of modern-day "wealth management"

In our previous post, we cited two recent articles giving evidence from the current bear market that backs up the core assertions we have made for years about the financial services industry -- specifically, that the idea of "wealth management" from an advisor who rotates his clients amongst varying investment strategies is not a sound model.

We have previously cited studies that we think make that case very clearly. The articles cited in Monday's post can be seen as supporting that case with more recent evidence from the past twelve months.

One detail we cited from Monday's Wall Street Journal article deserves greater examination, and that is the fact that, "following the advice of investment pros" investors had moved heavily into international funds, which are now down an average of 10% more than even the hard-hit US funds.

We believe in the ownership of individual companies, rather than funds (we explain why in this post from December, among other places). But those who rushed to buy international stocks have been similarly hurt.

We have long disagreed with the idea of "international" as an "asset class" that all investors must have. For starters, the idea has its roots in Modern Portfolio Theory, which has taken over the "wealth management" industry (and which it is, in fact, largely responsible for creating) and which we largely oppose, for reasons explained in this post from March.

The Modern Portfolio Theory idea is that owning international funds adds to your diversification. Further, it was seen as a "non-correlated asset" that would potentially go up when domestic stocks were going down. Until the recent crisis, there was much talk of "de-coupling," wherein the other economies of the world supposedly "de-coupled" from the US and therefore provide a level of greater diversification and non-correlation to portfolios.

The recent financial crisis, however, has exploded that notion.

Our other disagreement with the rush to own international investments is the fact that we have always seen them as unavoidably levered to currency bets -- if you invest in a company that reports earnings in another currency, its performance will be boosted when that currency is going up versus the dollar, and depressed when that currency is falling relative to the dollar.

Thus, international investing becomes a form of foreign exchange speculation. "Wealth managers" and "financial advisors" tell their clients "it's time to get into (or out of) international" just as they tell clients that it is time to switch from value to growth, or from small-cap to large-cap, or from biotech to consumer staples. This entire investment philosophy of timing rotation from one sector or capitalization category or country to another is a form of speculation, as we explained in "The drawbacks of sector rotation."

The graph above shows how dangerous such an investment philosophy can be. It is a graph of the US Dollar Index, often referred to as the "USDX," from June 05, 2007 to November 05, 2008.

The index measures the relative strength of the dollar against a basket of six other currencies (the British pound, the euro, the Swiss franc, the Japanese yen, the Canadian dollar, and the Swedish krona). It was set at 100 in 1973, so that values under 100 mean the dollar has declined relative to other currencies since that time, and values above 100 represent relative dollar appreciation since that time.

While the dollar had been on a multi-year slide (hence the steady rise in interest in international investing from investors and their intermediary advisors), actions by the Federal Reserve in the later stages of the crisis, combined with an international rush to hold dollar-denominated securities (particularly Treasuries) when everything else in the world started to look like a bad credit risk, turned that slide around dramatically.

The enormous dollar-rally shown in the dollar index graph translated into severe losses for international funds. An article in today's Investors Business Daily reports that Latin America funds are down 50.57% year-to-date, China region funds are down 56.30% for the year, Pacific ex-Japan funds are down 52.65% for the year, and that MSCI-Barra data indicate that some emerging market funds focused on Hungary, Argentina, Indonesia, Peru, and Russia dropped between 35% and 43% in October alone.

These topics underscore the importance of investing with a time-tested discipline, and one that is based upon fundamental business characteristics rather than speculative calls about this or that sector, market, interest rate, commodity price, or currency.

For later posts dealing with this same subject, see also:

• "Beware of the witch doctors of modern finance" 12/15/2008.

• "The bonfire of the intermediaries" 01/29/2009.
  

• "Professor Amar Bhide and his Praise of More Primitive Finance" 02/23/2009.

• "If portfolios were parachutes" 03/09/2009.

• "The best defense is a good offense!" 12/03/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "March 9 anniversary" 03/09/2010.

• "Another black swan?" 05/13/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

• "It's all about the thought process" 07/29/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

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The intermediary trap and the current bear market

October 2008 has come to a close, and it was one of the worst on record for the stock market.

Even worse, however, is the fact that during volatile times such as these, many investors themselves experience more damaging rates of return due to poor decisions. A recent article on the Morningstar website reports that, according to Morningstar's Market Intelligence research, investors have been selling their mutual fund investments in record numbers.

Morningstar reports that "a net amount of $49 billion left mutual funds in September alone. We've been tracking redemption data since January 2000, and that's the largest one-month outflow that we've seen to date. Yet, it looks like October is on pace to beat it."

As we have noted many times in the past, this type of behavior has led to the results found in the Dalbar studies which for many years have shown that over long periods of time, "the average investor earned significantly less than mutual fund performance reports would suggest."

In other words, the long-term track record of an investment vehicle is better than the track record of those who jump into it and jump out of it, especially because they often jump out of it at the worst times. The Dalbar studies have also demonstrated that "investors make most mistakes after downturns," and graphs from the 2000-2002 bear market support that assertion, such as those we posted in this previous piece.

This problem highlights a glaring deficiency in the current financial services industry, one that does a huge disservice to individual investors, whether they are small investors or very wealthy families. As we have pointed out, the data in these studies indicates that these well-documented investment mistakes are generally made by investors who are receiving professional advice from "financial advisors", "wealth managers" or "financial planners."

The Wall Street Journal today published an article entitled "No Place to Hide" that points out that, as bad as the returns have been year-to-date for the US market indexes, "The average international-stock fund is down 44.6% so far this year, according to Lipper, 10 percentage points worse than the average U.S.-stock fund." The article also correctly points out that "Following the advice of investment pros, mutual-fund investors had also moved heavily into overseas funds in the past few years."

As we explained in a whitepaper entitled "The Intermediary Trap" that we published in February, 2008, the "investment pros" that the Journal is talking about in today's article were not deliberately trying to sabotage their clients' returns (far from it), but "rather out of good intentions which end up creating long-term damage."

In fact, we went on, "because these professional intermediaries have access to more performance data and more information about new management styles and investment trends, they may be even more prone to chasing performance or switching to a different form of investment than nonprofessionals would be."

This behavior is exactly what the Journal article chronicles when they point out that "Many investors may be tempted to make up for losses by jumping into whatever stock-fund category emerges as the next hot thing, as some were doing with commodities funds earlier this year -- before commodities prices plunged." How many of those investors who flocked into commodities funds when they were going up do you think did so on the advice of financial professionals?

Many nonprofessional investors would not have even known about the latest crop of commodities investment vehicles if they hadn't been introduced to them by the intermediaries. The fact that those intermediaries were "just trying to help" is little comfort to those who were burned by the collapse of commodities and international funds.

Compounding this problem is the fact that intermediaries, because they are not investment managers themselves, often use vehicles such as mutual funds in order to obtain investment management for their clients. As we pointed out in "Some drawbacks of mutual funds" back in May, the pooled nature of mutual funds comes with significant disadvantages. One of these comes when investors panic and sell during a serious bear market, creating a problem for the portfolio manager and for investors who are left in the fund (see the diagram above).

The Morningstar article cited earlier explains, funds typically do not have cash on hand for such mass redemptions so their managers are forced to sell into weak markets, and are prevented by lack of cash from buying even when bargains are plentiful. "If those redemptions force the fund manager to sell securities at lower prices, the investor who redeemed doesn't bear the cost. Rather, it is spread across the entire pool of investors still in the fund."

Clearly, these two problems are related -- the problem of investors selling that Dalbar has chronicled, and the drawbacks of mutual funds which are exacerbated by that selling, which Morningstar describes.

We have long advised investors to avoid the pitfalls of financial intermediaries, and (if possible) mutual funds as well. Sadly, as the recent articles from the Wall Street Journal and Morningstar indicate, the real dangers of such "intermediary" investing are most evident in a bear market environment.

For later posts dealing with this same topic, see also:

• "The bonfire of the intermediaries" 01/29/2009.

• "Investor Behavior or Advisor Behavior -- 2009" 06/26/2009.

• "Some lessons from 2009" 12/28/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "March 9 anniversary" 03/09/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

• "The dance of the hippos" 08/10/2010.

• "Investors fleeing equity funds for bond funds" 08/25/2010.

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Lessons from volatility, October 2008

This month's tumultuous trading has set records for volatility. The enormous swings in the market threaten to "desensitize" investors in the same way that numbing levels of graphic violence in film and video can desensitize viewers.

Until recently, a three percent move in the stock market in one day (in either direction) would have been a significant move. Now, with moves of five percent, six percent, seven percent and even larger percentages following each other in staggering succession, such moves seem to almost lose their power to shock investors.

Above is a chart showing the trading of the Dow Jones Industrial Average during the month of October, so far (click for a larger diagram to see detail). Each vertical bar depicts one day of trading, with the opening value depicted by a horizontal bar to the left, and the closing value depicted by a horizontal bar to the right. The five up days of October are in green -- all the red days represent down days. During the entire month, there have been no back-to-back positive days for the market to date.

Some particularly volatile swings are shown with greater detail in the small boxes that depict the values for the high, the low, the open and the close.

On October 9, for example, the Dow traded up 2.01% from its open before dropping to close down for a loss of 7.37% from the open (a closing level that was down a total of 9.20% from the high of the session).

On October 10, the high was up 3.88% from the open, the low was 8.01% below the open -- a total of 11.45% below the high of the session.

On October 13, a positive day, the high of the session was 11.41% above the open, and the close was up 11.08% from the open.

These stunning one-day swings are driven by many factors -- forced selling driven by margin calls, mass redemptions from hedge funds that are closing their doors, large sales from mutual funds to meet redemptions by investors, and short-sellers who have been enabled to drive stocks downward more easily due to the unexplainable removal of the long-standing uptick requirement last year. Tremendous increases in computer-driven trading and the decrease of the role of the specialist on the floor of the exchange may also play a factor.

Investors are understandably dismayed by this barrage of unprecedented trading movement and volatility. How can they possibly expect to compete with short-sellers and hedge-fund redemptions?

The answer is that they cannot. In the short run, powerful forces can move stocks around the way hurricane winds toss debris. Short sellers can tear down the price of a company regardless of how solid the long-term business prospects of that company.

But investors do have one advantage over such "fast money" -- the ability to wait. Short sellers and other players who rely on leverage and borrowing (such as hedge funds) cannot sell a company short for years on end -- the nature of such trading is necessarily short-term.

It is obvious that during such a flurry of wild market swings as we have seen this month, the only possible response for an owner of shares in a company he believes in is to hold on to those shares and wait for the madness to pass.

This observation underscores what we have always argued and which we wrote about in this previous post: that it is critical to invest with a philosophy of holding good businesses through cycles, rather than trying to time them.

As T. Rowe Price wrote in 1973, the majority of those who made their fortune in the country did so by owning shares in businesses for many years. He observed that "They did not attempt to sell out and buy back again their ownerships of the businesses through the ups and downs of the business and stock market cycles" (emphasis in the original).

Investors should take the giant swings of this month as a great object lesson. It is obvious that trying to time such moves is impossible, and that investing through them is the best course.

This is what we have believed all along, and applies to other temporary cycles as well.


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Another important article from George Gilder

The latest Forbes magazine (cover date of November 10, 2008) contains an important article from George Gilder entitled "The Coming Creativity Boom."

In it, the author highlights the critical role that creativity plays in a successful economy. Creativity is the heart of entrepreneurship, and entrepreneurship is at the heart of the economic success America has enjoyed for over two centuries.

Chris Anderson of Wired magazine recently wrote a post in the Wired blog which shows just how insightful George Gilder has been for over two decades in his vision and his articulation of the direction technology is going and the impact it will have on every area of our lives.

This blog has also called attention to the importance of George Gilder's insights, such as his discussion of "The Exaflood" back in February of this year.

In this most recent article, George points out that "the current crisis is mostly confined to the boondoggles of finance." The important thing to keep in mind is that "The real source of all growth is human creativity and entrepreneurship, which always comes as a surprise to us, especially in the worst of times."

To back up this last assertion, that surprises are often developed by creative individuals and companies during "the worst of times," he links to another excellent post written by Rich Karlgaard last week, which details some of the innovative firms that sprouted during the 1970s.

These things are important for investors to understand, especially at a time when few are focusing on them.

For later posts dealing with the same subject, see also:

• "The Unstoppable Wave" 01/12/2009.
  

• "Schumpeter, Creative Destruction, and your portfolio recovery plan" 01/27/2009.
  

• "Clayton Christensen, disruptive technology, and your portfolio recovery plan" 02/04/2009.

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "Exaflood update" 06/01/2010.

• "Have you heard of this company? HITT" 07/06/2010.

• "Have you heard of this company? IIVI" 08/05/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "Another wake-up call" 11/29/2010.

• "Have you heard of this company? EZCH" 12/09/2010.

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"Great Depression" Update: iPhones selling like hotcakes

The news media is full of stories blaming the latest wild market swings on Wall Street acquiring "recession fears" and fretting about "weak earnings." The New York Times, for example, published a story entitled "Stocks Dive as Crisis Erodes Earnings" and cited weak earnings from Wachovia, Boeing and Merck as "major businesses across a range of industries."*

Few if any are the voices which point out that we have reached a state of irrational pessimism, in which nothing can possibly be good news and everything is interpreted from the viewpoint of certain Armageddon.

It is important to view the current state of the economy accurately. The current credit crisis did not arise because the economy was slowing down. The fall of companies like Bear Stearns and Lehman Brothers did not result from spreading economic malaise in the country which caused home foreclosures to rise and thus drive Bear and Lehman out of business.* Bear and Lehman were brought down by their inability to get lending, due to problematic balance sheets and a death spiral exacerbated by mark-to-market accounting regulations and the removal of the short-selling uptick rule, among other reasons which we have noted in the blog.

This is important. If the chaos caused by the problems in the financial sector actually does eventually receive the "recession" label from the National Bureau of Economic Research (NBER), then you should realize that the direction of the disease was from Wall Street to the broader economy, rather than from the broader economy onto Wall Street. Thus, we believe that the continued dire predictions of "the worst recession since the Great Depression" just around the corner are overblown. In fact, there are hints in the earnings reports coming out this week which bear out this analysis.

Certainly, financial companies in deep distress, such as Wachovia, are going to have bad earnings results. But Boeing's earnings woes stem directly from a machinists' strike and are not symptomatic of the overall economy, the way the New York Times would have you believe.

On the other hand, Apple yesterday released earnings that beat analysts' estimates by three cents a share, and which included Apple iPhone sales numbers that one analyst described as "jaw-dropping."* Apple's Peter Oppenheimer said that they sold nearly 6.9 million iPhones in the September quarter, exceeding the 6.1 million units shipped over the entire lifetime of the first generation iPhone. That was in one quarter. If we are in the Great Depression, it isn't stopping too many people from needing to get their new 3G iPhone.

Elsewhere in the third quarter, Amazon* reported that sales were up 31%! Major League Baseball had record revenues in the just-completed season -- an all-time high of $6.5 billion, and attendance just 1% off from the previous record set the season before, according to this Bloomberg News story.

But of course, the spin on all these stories is how negative things are about to be. Many companies (including Apple and Amazon) issued very gloomy outlooks in their forecasts for the upcoming quarter. Can you blame them, with a regulatory environment in which CEOs are frightened by what might happen to them if optimistic guidance turns out to be wrong? In the Apple story linked above, an astute analyst notes that Apple's low-key sales forecast for the upcoming quarter calls for results that are flat from a year ago and ignores the obvious demand for the latest iPhone. He calls the forecast "comical" and says "It's almost mathematically impossible."

Our advice to investors is, first and foremost, to avoid investment strategies that try to predict economic cycles, as we have explained in previous posts. We advise ownership of good companies through economic cycles -- the same way most of the great fortunes in America have always been made.

Secondly, while we don't try to predict economic cycles, we would advise a healthy dose of skepticism about the current calls for the worst recession since the Great Depression. If we do dip into recession, we believe it will be brief and that recovery will be rapid, mainly because we believe it is clear that the current problems came from the financial sector and not from an economy-wide disease, an important distinction.

When everyone is ignoring any good news and are convinced that all news is bad, it is irrational, just as it is irrational when everyone was ignoring any bad news and convinced that the market would go up forever (a situation that seems like a distant memory, but it really did happen once). We are in such an irrationally negative situation now.


* The principals of Taylor Frigon Capital Management do not own securities issued by Wachovia (WB), Boeing (BA), Merck (MRK), Bear Stearns (BS), Lehman Brothers (LEH), Apple (AAPL), or Amazon (AMZN).

For later posts dealing with this same issue, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.

• "Repeal what remains of the misguided stimulus" 09/01/2009.

• "The Consumer" 10/19/2009.

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