Banks not paying back AIG money

I saw the Johnny Depp movie “Public Enemy” about John Dillinger just days after learning that the average wage this year at Goldman Sachs will be $700,000. What made Dillinger a popular folk hero during the height of the Great Depression was that he robbed what people thought of as the culprit causing the nation’s malaise.

Nobody today would think that robbing banks would be a good idea, but it sure makes sense to do a better job of controlling them until every speck of government money is repaid with interest.

With respect to Goldman Sachs, they may have repaid the $6 billion we lent them to keep them afloat, but they have not paid a cent of the $18 billion they effectively received from AIG to insure their ridiculous bets. No one can explain to me why that money has just dropped into a black hole. We’re pretending that a bankrupt AIG is the only party we can turn to for getting our government money back.

To me, it’s no different from the “claw-back” provisions that will plague Bernie Madoff investors who took their profits out at the expense of others. Until Goldman pays the government the entire $18 billion of AIG money that reputedly disappeared into the Goldman maw, it would appear to me that those $700,000 average annual salaries should be more like $100,000 — or less. This is a huge rip-off of public money.

If we taxpayers had not made that money available to all the banks that were benefiting from AIG’s insurance, they would all be history today. Why are we pretending that the bank’s obligation ends with the amount we loaned them directly?

As financial writer and former bond trader Michael Lewis writes in Vanity Fair magazine, it has been a full year and nobody from the government has bothered to go to Connecticut yet to ferret out the workings of AIG trading department that threatened the world financial system.

All we know is that we loaned them a huge amount of money primarily to protect the institutions that had benefited from the AIG charade. AIG is history. Liquidating what’s left will never make up for $187 billion we are owed. We need a Melvin Purvis (the FBI agent that tracked down and killed Dillinger) to go to Connecticut and claw back that money from firms that were saved by our tax dollars.

Meanwhile, lurking right in the administration is a nest of investment bank sympathizers. We can start with administration official Larry Summers, who gamely tried to make the case that paying secret bonuses to AIG executives was acceptable because “we were contractually obligated.”

Apparently no legal mind was handy to tell him that there are all sorts of legal options for breaking contracts under extenuating circumstances — such as a collapse of the world financial system. A recent New York Times editorial, “Sharks Circle in Congress” pointed out the dismal failure of regulators to apply the laws they had at their disposal. These are the people testifying to the effect that current regulatory bodies are just fine.

Those of us saving for retirement deserve better treatment and more protection. We need an army of Melvin Purvis types who are true public servants. No misplaced hero worship should be lost on today’s John Dillingers, because that’s our money in the financial system they are looting.

October turnaround in the cards

Cheer up. The depth of our despair, from an economic standpoint, is scheduled to take place on or about October of this year.

The balance of the summer will be rough with lots of bad news on the economic front, but behind the obfuscating veil created by the news media, things are already looking better. How do I know this? Because I spend most of what I earn from writing this column to access monthly information from the Institute for Trend Research — the latter being a think tank of economists located in a backwater of New Hampshire. Headed by twin brothers, Alan and Brian Beaulieu, the institute publishes charts and graphs and distills them into a computerized brew that has been remarkably accurate at predicting future economic events over many years.

In a recent speech in San Francisco, Alan Beaulieu pointed out that we were approaching the economy’s nadir, as the financial services sector, the first of several leading indicators, was starting to show signs of a turnaround. It doesn’t take a genius to recognize that the stock market is making a comeback, and the bond markets are firming up as well. Traditionally, financial markets lead the economy by about six months — and small companies lead the overall market by an additional three months. Both are right on schedule to predict an October turnaround.

The second of eight major benchmarks is housing, and that market appears to have hit some version of a bottom. For every homeowner sadly walking away from a foreclosure, there is someone else now ecstatic at being able to find an affordable home.

Retail sales are still falling and have yet to hit bottom, as is also true with the level of new orders and production of goods. This is why October is the still the earliest we can safely say that the economy will have entered its recovery stage. Retail sales need to start an upward trajectory before we have any serious resurgence, and this category generally lags the housing and financial indicators by several months. Prices will continue to fall for several more months, and then start rising sometime in mid-2010. The consensus is that the real force of the recovery will be felt in 2010, but the seeds will be planted as early as October of this year. We might as well start crossing off the days on our calendar.

Meanwhile, the trend research indicates that the stock market, for example, will not achieve its 2007 high water mark until as late as 2020. That’s not to say that retirement savers won’t make money between now and then. There will be dividends reinvested during the next 10 years and there will be market declines offering opportunities to dollar cost average. The latter reduce the average price of all shares by buying at least some on a regular basis while the market implodes. Anyone curious about inflation might be interested to know that it will be 1.5 percent in 2009; 3-4 percent in 2010; and 8 percent in 2011.

And that’s not all. So far, only $125 billion of the $480 billion earmarked for the stimulus has been spent. The balance when disbursed will further strengthen 2010’s economy. About the time the rest of the stimulus is paid out, the banks will be paying back the money we lent them. Is this a great country or what?

Health care reform needs common sense

On a seven-mile hike up Flat Top mountain in North Carolina with my nephew, a young family physician, he shared what his experience is like in an emergency room practice in a medium-sized southern town.

He and his partners staff the hospital and serve a patient population that is one-third insured, one-third on Medicare and one-third uninsured. With the few exceptions of those who can afford to pay at least something before pleading bankruptcy, the cost of treatment for the uninsured has to be built into what is charged for the insured people. This is what everyone has been saying all along, but my nephew just confirmed that it wasn’t some urban myth.

So, if we manage to insure all those uninsured people through some form of payroll tax or mandatory coverage, then the cost should remain the same. We’re already paying for them with costs that are built into the existing premium structure. We can be assured that somebody is paying for the uninsured, or my nephew, with three small children, would not be working as a doctor.

The government will have to adopt a payment format (taxes or mandatory premiums) to cover the currently uninsured, and the rest of us should see our health insurance premiums drop as our taxes go up to cover the cost of the program — like taking a bucket of water from the shallow end of the pool and pouring it into the deep end. Ultimately, it becomes a “wash” transaction but with the advantage that everyone, technically, can say they are insured. Uninsured or partially-insured health problems will no longer be the nation’s No. 1 cause of personal bankruptcy.

Reducing costs overall should easily start with the cost of drugs. There are three drug industry lobbyists for every congressman today, and the industry spent $100 million to successfully ban the right of Medicare to negotiate for the price of drugs they provide.

I wish it were legal to point out to the drug industry that, for example, those eye drops that cost $15 per bottle amount to nothing more than 99 percent water and 1 percent diluted Vaseline. According to a retired patent attorney who knows these things, the cost of the eye drop product is approximately.001 percent of its retail cost. Doing the math illustrates that the cost of what’s actually in the bottle has been marked up by 1.5 million times its cost.

Overall, the ability to negotiate drug prices in behalf of the nation’s Medicare patients would have a huge impact on cost reductions. Those $15 eye drops might reasonably cost just $1.50 for packaging and shelf space. All over the world, starting with Canada, negotiating prices is the norm, but the toxic mix of campaign finance practices and career politicians makes it impossible in the United States.

Why on earth do we now allow full page ads aimed at consumers that promote prescription drugs? It used to be illegal to advertise anything beyond over-the-counter medicine. Now, all these ads are creating a nation of obnoxious hypochondriacs (the “worried well”) who are equipped to start telling their doctors what they think they need. With the cost of advertising built into the price of drugs, some of us, for example, are actually paying to be continually reminded that Levitra, Cialis and Viagra can improve quality control? It’s just nuts.

Bonding could protect investors

The Bernie Madoff fiasco prompts me to wonder if the ubiquitous “Member of the Security Investors Protection Corporation” (SIPC) means very much right now for those of us who were never given the chance to invest with Bernie.

Could it be that the $164 million paid out to Madoff victims thus far is just the beginning of the tsunami that will wipe out SIPC’s coffers? How on earth will the brokerage industry’s self-styled umbrella of protection round up enough money to replace tens of billions in stolen assets?

Why does SIPC even need to exist? Why wouldn’t just routine bonding insurance protect against theft? Answer: Because when you allow your stocks to be owned “in street name” at your brokerage firm instead of having certificates actually delivered to you for safe keeping, the brokerage firm can borrow for its own account using those assets as collateral. That’s not theft. It’s just risk that bonding can’t cover.

Brokerage companies can borrow as much as 15 times the value of your shares. Read the fine print of the contract you actually signed when you set up your account. On the firms’ own money — actual profits that they have made over the years and that remain as retained earnings — the brokerage industry (since 2004) has been allowed to borrow as much as 30 times their net worth.

Like a needle in the arm, we now know that with the narcotic of this much leverage, brokerage firms like Merrill Lynch and Lehman Brothers can go right down the tubes, and our money can go with them.

What may have been only an academic interest in the small-print reference to SIPC membership at the bottom of our brokers’ correspondence suddenly takes on new meaning.

SIPC protects basically small investors up to a maximum of $500,000. It has been rare for any brokerage firm to go out of business. If your money is in mutual funds, you can relax because the fund companies know what they’re doing. They write their own agreements with the brokerage industry that protect fund assets from possible exposure.

To illustrate how extensive and creative are the mysteries behind the veil of the brokerage industry, I recall reading not long ago that an estimated 25 percent of Charles Schwab profits were derived from interest earned on loans of customer securities for short sale purposes. This is probably true industrywide.

The next few months will determine whether or not our SIPC protection is worth anything. It’s to their credit that SIPC has paid out as much as they have so far.

It may be reassuring to know that we have at least $500,000 worth of safety net, but the question to ask is why we tolerate a system that requires it at all. We must be slow learners. During the Reagan-era deregulation of savings and loans, greed-fueled institutions failed when wild bets on real estate went bad. Fortune magazine ran an article at the time that pictured about 350 S&L executives that had been sent to jail — a two-page spread of tiny portraits that resembled those insurance ads picturing the year’s leading salesmen. Jail sentences may be satisfying at some level, but they are too little too late.

In the end, we’re alone with our money. Read the fine print and avoid anything that looks too good to be true.

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.

Time to stand back and reassess

With the market falling off five percent after a thirty-seven percent surge, we ought to be wondering:  “What’s going on?”  For the optimists, this is basically a bull market taking a breather.  For pessimists, the rise of the last eight weeks was just another “dead cat bounce” of a market doomed to reflect lower corporate profits — sooner or later.

The “Me Generation” should be asking what either of the above answers means from an individual strategy standpoint.  To the well-balanced investor, the answer to the question should be “both of the above. “  It shouldn’t matter.   If you aren’t well-balanced, at least from a financial standpoint, today’s market level might be offering a window of opportunity to do some course correcting.

What we have just experienced is the strongest market rise since the 41 percent rise during a similar time period back in 1933.  Anyone who has stayed the course and ridden the market down to its March 9th bottom has now recovered at least some of what has been lost over the past few years.  It would have been foolish to sell at the bottom, and you didn’t, but now you find yourself thinking that it’s nice to be back — at least part way.  However, you’re also probably thinking, “I’m too old for this.”

A market recovery sets the stage for some investment course-correcting.  The past eight weeks have lifted us out of the catatonic state brought on by the stock market’s perilous journey.  We can think a little more clearly now that we have seen history repeat itself.  We know intellectually, that a plunging market will be followed by an equivalent upward snap, but there is always that nagging suspicion that maybe “this time, it’s different.”

Because this past downdraft was precipitated by a deleveraging of the financial markets, all stock of virtually all types of companies was affected.  True, some industries like automobiles were hit harder than others, but this was not a typical market decline with more pronounced losses in just one or two major sectors.  For a more common version of a crash, the dot-com boom comes to mind, and before that was the plunge in the ‘70’s of the “nifty fifty” (Xerox, IBM, Litton, etc.)  This time out, it was a deleveraging of the financial sector that brought everyone down with it.  It wasn’t funny at the time, but it amuses me now to watch an industry that limits its customers to borrowing only 50 percent of what they invest in stocks.  Anything more would be too risky.  Meanwhile, in 2004, the same industry  succeeded with the deregulation that allowed it to borrow 97 percent of what they invested, and that ridiculous thirty-to-one leverage did them in. 

Going forward, it could make sense to rearrange the deckchairs in the stock portion of a portfolio so we could relax a little more if those nattering nabobs of negatism turn out to be right.  A higher proportion of money in bonds could help protect against a further downdraft, but the question becomes, “What kind of bonds and how much?”

While it may sound blasphemous, I like the possibilities presented by high-yield corporate bonds which have lost about twenty percent of their value based on current high-yield mutual fund price performance, but they still own the underlying bonds that they can hold to maturity, and the yield at the moment is about 8-13 percent depending upon the fund.  Most of the more conservative of these funds, like Vanguard’s for example, have low fees and very few actual defaults.  The current reduced share price means that steady interest payments amount to a relatively high annual percentage return which is referred to as the yield.  Bill Gross, the bond guru running PIMCO, recommends high quality (as opposed to high yield) corporate bonds, but we would expect him to say that.  The important consideration is that these high yield corporate funds involve some short-term (as in seven -year) capital risk but they deliver immediate gratification in the form of reinvested dividends at a rate that is not that far below Bernie Madoff’s one percent per month.      

The sweet spot for bonds is to occupy one-third of a portfolio.  This is the point at which they reduce the downside of a stock market crash by about one-third while only penalizing the potential upside by one percent.  In other words, if an all-stock portfolio is expected to gain at a rate of 10 percent per year, having one-third in bonds will reduce that expectation to an annual 9 percent.  However, if the market drops by 17 percent, that bond component will reduce the overall loss to just 12 percent.  A higher percentage of bonds offers more protection, but at a much higher earnings penalty.

So, here we are with an opportunity to take breather and think rationally for a moment.  Even if we decide to do nothing, that should be the consequence of an informed decision.  The biggest obstacle is what behavioral economists have termed, “the status quo bias” — otherwise known as “shoulda, coulda, woulda.”

Dividends, buy-backs key elements

Some readers tell me they sleep at the end of their driveways on Sunday nights so they don’t waste a minute getting to my column early Monday morning. My friend, Mike Doyle, says that if he ever detects a hint of pessimism on my part, he wants to know as soon as possible so he can bail out of the markets and sell short to beat the crowd.

Shouldering this level of responsibility, I spent four hours last week listening to economist Alan Beaulieu who, based on his past track record, is remarkably prescient when it comes to offering a glimpse into our economic futures. He points out the fallacy of consumer sentiment, for example, by pointing out that when people are at their gloomiest, almost all other economic indicators rise. The stock market’s last eight weeks offer a good example of that counterintuitive disconnect. The only economic statistic that tracks consumer sentiment is the sale of used boats.

Beaulieu had some depressing news for us as he said that we are heading for a long grinding road to economic recovery and that the stock market would not rise to its September 2007 high water mark until the year 2020. Now then, on the surface that would strike some people as being really depressing news. Not me. I actually just bought a used 1967 boat. Moreover, simple analysis indicates that a long, dry period could be terrific for long-term buy and hold investors who are dollar-cost-averaging with steady contributions into retirement plans. The best thing that could happen to us over the next 10 years would be to contribute with despair into mutual funds that go nowhere quarter after quarter and that then finally double in value starting in about 2018 — exactly what happened at the end of the 1990s.

Peering under the hood of a market that goes nowhere, we can see a far more promising story if we consider the dividends and stock buybacks that are sure to be reinvested during that 10-year period.

Those quarterly statements reflecting reinvested earnings will tell an entirely different story than persistent headlines that keep comparing an in-the-tank Dow Jones average with that fondly-remembered 14,600 Dow of Sept. 31st 2007 — that quarterly statement we wish we’d framed.

This month’s AAII Journal (American Association of Individual Investors) points out the extent to which dividend-paying companies actually grow faster than the so-called growth companies that reinvest all profits. Enough convincing research now makes the case that the companies with strong dividend payout rates are actually the ones whose stock appreciates the most over the years. Setting aside the early wonders like Microsoft and Oracle, most mature companies struggling to maintain growth by avoiding dividends just don’t rise as much as value stocks over time.

Dividend payout rates for the S&P 500 were averaging about 3.7% a few months ago when share prices were at rock bottom. With a 37% rise in share values, those payout rates will have been reduced to just under 3%, assuming the dividends per share remain the same — which most do.

Besides dividends, however, are stock buybacks. In the years from 2005 through 2007, the largest 500 companies bought $2 worth of their own stock for every dividend dollar they paid out. When a company buys back its stock from the public and retires that stock, all of the remaining stockholders just received an increase in the value of the stock that remains. Why? Because the entire company and its profits are now split between fewer shares of stock. In a simple example, if five partners in a business use company profits to buy out one of the partners, the remaining four owners go from owning a 20 percent share to owning a 25 percent share — a 25 percent increase in their ownership — otherwise known as “profit.” This is how many public companies have elected to spend their profits rather than paying the money out in dividends.

Going forward, if the total earnings between dividends and buybacks adds up to 6 percent total per year — as was the case from 2005 through 2007, then $1,000 invested today will compound to $2,000 by around 2020 even if the market itself remains flat. If our current, depressed stock market actually returns to 2007 values because of a healthier economy and higher price earnings ratios, what will then be $2,000 will double to $4,000.

The lesson is to remember that companies still make money regardless of their stock prices. Staying invested and capitalizing on reinvested earnings — both dividends and stock buybacks — will always be rewarding. For entertainment, we can just sit back and watch the market do its thing.