Long-term outlook a no-brainer

I once suggested what I thought was a great idea to my attorney who countered with, “Steve, that’s not a good idea. You don’t understand. You’re in the system now, and the system defies logical thinking.” To twist the knife, he added, “It’s always dangerous when the client begins to think.”

I’m reminded of that interchange when I pull a dusty copy of “Stock Market Logic” by Norm Fosback off the shelf. I subscribe to his newsletter, which he initiated in 1975, and have found his “Fosback’s Fund Forecaster” to serve up a modicum of logical thinking with respect to financial markets. Could it be dangerous when the investor begins to think?

I wrote about Norm back in June of 2004, and at the time he predicted that the market would rise by 36 percent over the coming five years. Former Treasury Secretary George Shultz was famous for saying that you can make a prediction of how much the market is going to rise and when it will rise, but you should never offer both pieces of information at the same time. Norm ignores that advice.

A 36 percent rise in value over five years represents a 6.3 percent annual compound rate of return. Back in 2004, Warren Buffett was saying that he expected market returns to be about 6 percent for the next 10 years. Adding reinvested dividends of 1.5 percent to Norm’s number brings us to about 8 percent. In fact, the market rose 40 percent in just 3½ years from the time of that 2004 prediction, but we all know what happened after October of 2007. What Norm failed to anticipate, of course, was the black swan event of a major collapse of the financial markets — but hey, nobody’s perfect.

So, what does Norm predict now? In his latest May 25th letter, he suggests that the market will rise by 37 percent over the next 12 months and 121 percent in the next five years. That 37 percent increase will have put him almost at where he originally estimated — but about one year later — in six years instead of five. If he turns out to be right from this point forward, the stock market will have turned out a decent return with the bonus of immediate gratification — especially when considering the alternatives of cash and real estate.

The Fosback Fund Forecaster places heavy influence on the amount of excess cash in the hands of money managers that they don’t need to meet routine liquidity needs. In this case, that amount of cash is off the charts by any historical measurement, and what is more astounding is that this is true even when cash is essentially earning nothing. If history means anything, this amount of cash will flood the market to fuel that 37 percent rise (on top of what we’ve recently enjoyed) that we can look forward to in the coming 12 months.

In terms of where in the market to be, it looks as if foreign stocks are some of the best contenders, with international stocks outperforming domestic stocks over the past few months. Of those foreign funds, the emerging markets sector has proved to have offered the best results this year, but only because they lost less in the earlier months.

The Pacific Stock Index and European Index lost more in the year’s earlier downturn, but all three are now enjoying a strong recovery. These international funds have also shown no hesitation and have continued to rise during the time our domestic stocks have paused to absorb the astounding gains of March and April and May.

It’s a good bet that markets will return to a pattern that will allow some productive rebalancing from year to year. Different fund types and investment styles tend to be inversely correlated to some extent with small company funds typically leading a stock market advance. This time it was different.

The downdraft in the market took everything with it. Going forward, stay diversified for now with a number of different fund types, but be prepared a year from now to take some chips off the table from a few funds that will have shot beyond their portfolio mates. Add those chips to your losers for the year, and the net effect of this practice over time is one of buying low and selling high.

Analysts like Norm Fosback can help us adopt the long view which, in turn, contributes to a healthy dose of optimism. This heady mix of the long view coupled with optimism amount to an investor’s equivalent of Prozac.

The soothing result relieves the investor of having to think; and thinking, we should recall, is dangerous because what may seem like logic can lead to panic.

Corporate ‘right-sizing’ means profits

A picture in the New York Times showed an empty General Motors office building that recently housed over 10,000 engineers.  Think about what that means beyond the 20,000 Hush Puppy shoes and pen protectors.

It’s as many people as we had in the whole town of Springfield, Vermont where I grew up.   It’s hard to imagine how that many engineers could have found enough work to do considering how little in product development was happening at GM — compared to its competitors.  By comparison, all it took to develop the Ford Mustang, according to Lee Iacocca biographies, was a handful of engineers who used to meet secretly at Lee’s house.

The hopelessly bureaucratic institution which was once the world’s largest company is symbolized by that empty building, but the current recession is smoking out much of the non-productive side of corporate America. 

A number of financial analysts have pointed out that about a third of everyone employed by the financial services industry were in what are described as “fluff” jobs — management positions that could easily be abandoned.  When times are good, management positions get created to reward superior employees with higher pay. 

As the Peter Principle has it, these folks often get promoted to their “level of incompetence.”  When forced to leave through down-sizing, the costs of these managers’ salaries and benefits drop right to the bottom line.   Management effectiveness increases thanks to the fact that there is nobody to get in the way of employees who already know what they need to do. 

In industries like payroll services, for example, there is a major effort at consolidation today as small companies lay off a few employees and decide to handle their own payrolls. This prompts the payroll industry to re-juggle sales territories so that fewer sales people handle a larger client base.  Service may suffer, but it’s a soft-dollar cost.  Meanwhile, the people kept on are, hopefully, the best service and sales people who were capable of handling a lot more anyway.  A general rule in selling is that 80 percent of the business is brought in by 20 percent of the marketing field force.     

Some of the most successful companies in history have achieved that distinction by adopting creative management and compensation tools.

 I’m familiar with Tyco Industries, which, in the twenty years prior to the Dennis Koslowski era, managed to create a steady march of profits and growth by buying rustbelt companies, throwing out the employee manuals and adopting an accountability and bonus structure.  Typically, one quarter of the employees would walk out the door.  The next twenty-five percent would be on the fence and half of those would leave in the next 12 months. 

The roughly two thirds who remained would be making 50 percent more money, and what was once a sleepy company in decline was now a money-making machine contributing to Tyco’s extraordinary growth from 4,000 to over 250,000 people.  

What this sea change means for investors is that companies will come out of this period with income statements, balance sheets and operating practices that are scrubbed clean.   It’s no surprise that ten major banks are begging to pay back the TARP money.   With thirty percent fewer employees, how can they not be making money on an operating basis?  Their continuing profits will dwarf their troubled loans.

The spectacular stock market gains of the ‘90’s were fueled by increases in productivity.  Better communication thanks to the internet and more enlightened management techniques created companies that were more profitable.  Greater productivity allows people to make increasing amounts of money without creating inflation. 

This time out, increased profitability will undoubtedly come from companies having been pressured to “right-size” to reflect economic realities.  In what is now predicted to be a “job-less” recovery, the profits of companies should increase dramatically when they generate more sales with the same number of people they have today.  

People still working will see salary increases even during the recession if history repeats itself.  For those of us waiting for our mutual funds to rise in value, these inevitable developments will contribute to a smug sense of satisfaction — sooner or later.   

‘Valley after the rally’ looming?

What next? While the stock market may be taking a breather, could another shoe be dropping soon?

Pick your poison — the next round of resetting adjustable-rate mortgages, a credit card default wave, small banks with mortgages on empty commercial property, still-rising unemployment — there’s plenty of bad news if you just look hard enough.

Meanwhile, what’s so is that every substantial rise in the stock market has been followed by at least some testing of the lows. It’s the market saying, “Is this for real?”

Turning to some tea leaves, we can start with a look at history. The “Valley after the Rally,” as pointed out by Paul Lim in The New York Times, has seen a lot of variation over the years. A rally after a bear market low always retests the low sooner or later. The market typically declines for awhile as part of a natural digestive process after gorging on a substantial gain. Practically speaking, it can be an exercise of profit-taking by investors who have had enough and who have been waiting to be made at least partially whole before throwing in the towel.

The easy money has already been made over the past eight weeks. Now comes the heavy lifting as the market lurches forward and possibly retests the market low. Regardless of what happens over the “summer doldrums” when a thinly-traded market traditionally slumps, we have history on our side. After any 10-year period when the market ended with a return of less than 5 percent, the following 10-year period saw average returns of anywhere from 7 percent to 13 percent. We are teeing ourselves up for a modicum of success by any historical standards. Money compounding at 10 percent doubles every 7.2 years, if that’s any consolation; but even at a modest 7 percent return, your current account balance stands to double in about 10 years.

For crystal ball purposes, the VIX (Volatility Index) and the Baltic Dry Index (don’t ask) are two forward indicators that can give us some idea as to how we might fare in the months ahead. The VIX is a measure of the amount of volatility in the options markets and it reflects the level of uncertainty on the part of professional investors.

A high VIX (at 80) like we had last fall is usually followed by a decline in stock prices. Today the VIX is around 40. The VIX was at 20 during the rise in 2002.

Apart from the VIX is the Baltic Dry Index. This is the index that reflects the amount of shipping trade in the immediate future around the world. It is a measure of how much raw material is about to be shipped, and this, in turn, offers a glimpse into how much in the way of goods will be produced worldwide — presumably to be sold at a profit. For what it may be worth, the Baltic Dry Index has quadrupled in value over the past few months. In lock step, Dreyfus Greater China fund has doubled since March 4th. Another 100 percent gain since March has been enjoyed at T. Rowe Price Emerging Markets Stock fund.

We don’t need to torture ourselves by wondering why we didn’t act more aggressively back in March when the world was going to hell in a hand basket. It takes nerves of steel to consider investing s in a plunging market — it’s like trying to catch a falling knife.

However, the more risk we can accept, the greater the rewards will tend to be. Over time, the invisible hand of economic forces produces a “risk premium” that generates higher returns for investors who can live with more volatility. It stands to reason that human nature would behave this way, because otherwise there would be no money ever available for smaller companies or for promising ventures in the world’s banana republics.

Considering that some of our retirement money will still be in play when we die, we can take the long-term view for at least some portion of our investments. If the renowned “valley after the rally” becomes a reality over the next few months, some of us might consider it an opportunity to shift a small portion of assets into something more entertaining and dramatic than the usual collection of bonds and blue chip stocks. At the reading of the will someday, our heirs will be amazed at our foresight.

Time to get back on the horse

Now that we can bear to open our retirement plan statements again, it might be a good idea to revisit some investment fundamentals. Otherwise, the next bull market will just lead us by the nose to another feeding trough of irrational exuberance.

Of course, the market rises “on a wall of worry” and there are many events that could stand in the way of investment satisfaction, but on the whole, there is reason for optimism. The economy’s attempt to achieve some gains may amount to a very slow march, but the plus side of a slow recovery is that interest rates will stay lower than they would if things heated up. Meanwhile, I find it reassuring to read that Treasury Secretary Tim Geithner, speaks fluent Chinese. That may come in handy in dealing with our biggest non-U.S. creditor.

But first, to get our bearings, the market is off about 40 percent from its high of 2007, but dividends reinvested since then reduce the loss to about 35 percent. For people with about a third of their money in bonds, the loss has been about 25 percent, but dividends and bond interest payments have reduced that loss to a little less than 20 percent. In October of 2007, the account balances we all enjoyed represented an annual rate of return of around 10 percent assuming we had been saving regularly for 20 years.

Where we are today represents about a 7 percent rate of return over the same time period. Not good, but far better than any risk-free money market during the same period.

Another 30-plus percent burst like we’ve seen in the past two months could put us back within striking distance of our expected 10 percent average annual return. Then we would be back on track.

For those who own a part of the $9 trillion in cash sitting on the sidelines, this would be a good time to dollar-cost-average back into the market on a regular installment basis.

If we have another downdraft over the summer months (triggered by the “summer doldrums”) it may be the last time to pick up shares at relative bargain prices.

If your psychological makeup just can’t handle a second drop to the lows we experienced back in March, consider getting into both the stock and bond markets with regular investments in both stock and bond funds. You can see from the figures above how a bond component can blunt the effect of a crash.

It’s impossible for anyone to second guess these enormously complex influences on market results, so the only constructive approach is to diversify, reduce investment costs as much as possible, and periodically rebalance.

Diversification should include some money in small-company funds and foreign funds with the bulk of the holdings in large-company value oriented funds that pay dividends.

For older investors, at least some bond component can make sense, but don’t forget that home equity should be considered to be a “bond-equivalent” asset if you’re wondering what the proportions should be.

When it comes to selecting financial services, remember that in most investment tools, you have “silent partners” that include taxes and fees. For retirement plan money, the taxes are nonexistent, and fees are largely out of your control until you roll your money out into an IRA. For taxable assets, it’s a different story.

On taxable investment money — investments generated from savings, the sale of a house, an inheritance, etc. — the taxes and fees on a mutual fund can take up 40 percent of what otherwise would have been your profit over the years.

As fund managers buy and sell stocks, short-term and long-term realized gains are reported each year for tax-calculation and payment purposes.

For any meaningful performance analysis, these costs must be subtracted from reported performance figures.

Most of this drag can be avoided by using index funds.

These so called “passively-managed” investments offer plenty of opportunity for gains and diversification without triggering the annual tax obligation and management fees that take such a huge bite out of actively managed account balances.

There are currently more than 200 index funds that track a wide variety of different investment styles and types.

They charge about one-fifth the annual cost of most mutual funds.

Their stock turnover is usually less than 10 percent per year, so realized taxable income is kept to a minimum.

For those who bailed out of the market and for those who stayed fully exposed, the advice is the same. It’s time to get back on the horse.

Use the experience to reassess the quality of your investments and the extent to which they make sense as part of a larger plan. In other words, “Don’t let that crisis go to waste.” Recognize the last 18 month period for what it has been — a powerful learning experience.