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Steve Cook on Disciplined Investing

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The Market
    
    Technical

    I am not going to re-set the trends of the Averages (DJIA 10779, S&P 1165) the night before a quadruple witching Friday and the weekend in which we may get the healthcare vote.  But under my time and distance discipline, today will mark sufficient time and current price levels mark sufficient distance that both Averages should be re-set to new revised up trends off the March lows.  The new boundaries would be defined by 10319-12751, 1100-1416.  Additional resistance would exist at 11811, 1311 (indeed there is virtually no visible resistance between current levels and 11811, 1311). More important for me, given my negative fundamental perspective, would be the former resistance turned support levels of 10725 and 1150.  The indices need to hold above these levels over the short term to confirm the up trends.
   
    Volume yesterday was poor as usual; breadth was surprisingly weak; the dollar (which bounced back above the lower boundary of its short term up trend) was up (scoreboard: stocks mixed, gold up and oil down)--potentially bad news for stocks?; the VIX broke its support level. Granted it needs time and distance to confirm the down trend; but should it occur, that would be potentially positive news for stocks.

    Bottom line:  my technical discipline tells me that I need to recognize that the Averages are breaking to the upside.  However, I really want to get past quadruple witch and the healthcare vote; plus there is still sufficient confusion in the supporting data to  cloud the issue.  Therefore, I am going to wait and re-visit this decision on Monday.
 
    The congressional affect (medium):
    http://www.minyanville.com/businessmarkets/articles/congressional-effect-stocks-uncertainty/3/15/2010/id/27274

    The latest from Fusion IQ (short):
    http://www.investmentpostcards.com/2010/03/19/technical-talk-one-last-move-up/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+wordpress%2FVYxj+%28Investment+Postcards+from+Cape+Town%29&utm_content=Yahoo!+Mail

   Fundamental
        
    The bull case (medium)
    http://blogs.wsj.com/financial-adviser/2010/03/16/the-bears-are-dead-wrong/tab/print/

    Headlines

    The congressional budget office announced its scoring of the house version of the healthcare bill and the bill was officially posted yesterday which sets the time table for a vote Sunday afternoon.  I am assuming that Ms. Pelosi would not post the bill if she didn’t think that she had the votes for passage.  That not only makes me wrong on my call that it wouldn’t pass; but forces me to re-evaluate our economic forecast and the assumptions in the Valuation Model.  In a nutshell, I think that if enacted (1) it will contribute additional headwinds to the recovery and could well lead to a decline in economic activity over the next 12-18 months and (2) raise our Valuation Model’s assumptions on inflation [interest rates, discount factor] and lower them on corporate profits. 

    Now that we have the official version, here are a few highlights:

(1)    it includes all the old Senate deals [Louisiana, Nebraska, Connecticut] and adds a few new ones,

(2)    it claims to cut total healthcare spending in first ten years by $138 billion; for perspective purposes that is about 60% of last month’s budget deficit,

(3)    one of the ways it gets to this modest savings is that the first ten years are loaded with tax increases, while most of the benefits of the plan don’t kick in till the second ten years,

(4)    further, it imposes a 3.8% tax on dividends and capital gains, which will come on top of the increases resulting from the expiration of the Bush tax cuts.  This is not good for capital formation,

    Of course, part of the problem, is that we can’t even control the costs of the entitlement programs already on the books:
    http://www.american.com/archive/2010/march/mediscare-our-government-administered-insurance-looks-into-the-abyss

    Bottom line:  If the In trade bet is to be believed, at the close last night, the odds of passage of the healthcare bill were 73%; and yet stocks just shrugged it off.  I keep asking myself, ‘what am I missing?’ and I still can’t come up with an answer. It gives me a headache thinking about havoc this bill will wreak on the economy.  And if that isn’t enough, what happens if the dems get jiggy with their success and re-introduce cap and trade, card check and amnesty?  The real investment issue here if passage occurs is not whether to draw down cash and buy stocks; but how much to increase our total Portfolio exposure to gold and foreign ETFs.

    Thoughts on Investing--the Critical Factor in Portfolio Returns from Capital Spectator

If you could only make one decision in your investment strategy, what would it be? Would you concentrate on picking the best securities? The best ETFs or mutual funds? Would you focus exclusively on trying to time your asset allocation/rebalancing choices? Or maybe you'd spend a lot of time deciding if Asian stocks would beat European equities in the foreseeable future. Or how about managing the risk, however defined, like a hawk? In any case, the question is simply this: Which variable in the money game is likely to have the most influence on the end result of performance?

Depending on the investor, answers are likely to be all over the map. And perhaps that's reasonable, since we left out a critical piece of information for answering intelligently: time horizon.

What's the single-most important investment decision driving return? We can't respond shrewdly unless we know the length of time we'll be investing. If we're managing money with an end point of, say, next year, or even a few years down the road, the critical variable may be different (is likely to be different) than if you're investing for results 20 years on.

This isn't terribly surprising, although the time horizon distinction is often minimized, if not ignored in discussions of everything from security selection to asset allocation. Part of the problem is that in theory we're all long-term investors but we're destined to make the journey on a tick-by-tick, daily basis. Even the self-proclaimed day trader has a horizon beyond the next 24 hours. A 35-year-old who trades furiously during the day still wants a comfortable retirement 40 years hence. Perhaps the only investors with truly short, or shorter time horizons are older folks, although even that's debatable, depending on your estimate for longevity.

In any case, back to our question: What's the single-most important variable that influences portfolio return? If we're investing with an eye on maximizing return 20 years from now, the answer is one of basic asset allocation: stocks vs. bonds vs. cash. Assuming some reasonable level of diversification in stocks and bonds, choosing individual securities will have a minimal impact, if any. And it probably won't matter much if you overweight U.S. stocks vs. foreign stocks, or vice versa.

Consider, for instance, a few statistics. For the period 1970-2008, the annualized total return for domestic stocks (S&P 500) was 9.5% vs. 9.7% for foreign stocks (MSCI EAFE), according to the Ibbotson SBBI Classic Yearbook. Not a huge difference for that 38-year stretch. The future's always uncertain, of course, but generally over long periods it's likely that regional differences in equity beta will be minimal relative to the global stock market beta.

In the shorter term, however, it's a different story. Looking at returns by decade for the S&P 500 and MSCI EAFE shows a wider array of results. For the 10 years through 2008, EAFE gained an annualized 1.2% vs. a 1.4% annualized loss for the S&P 500. In the 1990s, the relative performance tables were turned, with a much bigger divergence. U.S. stocks earned an annualized 18.2% for the decade through the end of 1999, more than double the annualized rise for MSCI EAFE, which gained 7.3% during the 1990s on an annual basis. (For a slightly more technical analysis of this trend, see William Bernstein's 1997 treatment of this topic.)

Meantime, we can also show that bond returns over time tend to be quite modest relative to stocks. Again, no big surprise. What's more, assuming reasonable diversification, your choices on short vs. long term bonds, or domestic vs. foreign, probably isn't going to matter so much. Yes, there's the foreign currency factor to consider, particularly when it comes to bonds. But over time, the capacity for forex to add or subtract from equity and bond returns tends to be a wash (i.e., the expected return for currencies proper is zero). In the short run, however, lots of forex volatility, and therefore lots of risk, which may or may not be helpful, depending on the investor and the strategy.

What's the lesson in all of this? Your overall stock/bond/cash allocation is where the action will be over the long haul. But there's a glitch. Although we're all long-term investors, at least in theory, the long-run future arrives one day at a time. In fact, almost no one builds a portfolio today and lets it roll on, unattended, over the next 20 years. That's true even for foundations, which theoretically have an infinite time horizon. Actually, a passive strategy that's broadly diversified would probably fare quite well over time, assuming we chose a reasonable mix of stocks and bonds, such as 60% equities/40% fixed income.

But the set-it-and-forget mentality is hard to do. We're all constantly buffeted by the daily barrage of headlines and other mental matters that compel us to act. For those with discipline and an above-average level of financial analytical abilities, short-term trading can be productive. But adding value over the long haul is rare by way of short term trading, especially after deducting for taxes, commissions and other frictions. In other words, most of us will end up with middling results. The problem is that everyone thinks they're above average when it comes to money.

So what's the big-picture message here? First, don't lose sight of the fact that in the long run, your overall stock/bond/cash mix will perform the heavy lifting for generating performance results, for good or ill. (We might add in REITs and commodities, if we're inclined to embrace a bit more nuance for matters of portfolio design). But getting from here to there is complicated, which is to say that you'll be faced with numerous tactical decisions. There'll be opportunities to add as well as subtract value from your end result, and so we must proceed cautiously on a day-to-day basis.

The good news is that there are some things to do that are likely to add some value, even if you're no financial wizard, starting with rebalancing and owning multiple asset classes. Beyond these two factors, however, things get messy, at least for most investors, and that includes the issue of time horizon. In effect, we're all short term traders with a long-term horizon. This is the original sin that comes prepackaged with investing. We can't escape it, but neither can we fully solve for it.

Balancing the short and long term is a key element in the art of investing—the intertemporal risk for asset allocation, as it's known in the literature. Robert Merton formally identified this risk in the early 1970s in a series of seminal papers and financial economists have been grappling with the related challenges ever since. So, too, have investors, for that matter, even if they don't recognize the risk on those terms.

Yes, we've picked up a few clues in the game of managing money for the long run while juggling short-term risk. We know, for instance, that expected returns vary, and so reversion to the mean is likely, even though the reasons are hotly debated (i.e., market efficiency vs. irrational investing decisions). But there's still no hard and fast solution beyond some general rules of thumb, such as own a broad mix of stocks and bonds, perhaps with some cash and so-called alternative betas. There's also compelling evidence that active management won't help much over the long sweep of time.

The debate, however, is a Wild West show for the short term. Or, as J.P. Morgan, once said, prices fluctuate, proving, if nothing else, that there's at least one concept in finance that's universally accepted.

Economics

   This Week’s Data

    February’s leading economic indicators rose 0.1% versus expectations of up 0.2%.
    http://mjperry.blogspot.com/2010/03/leading-index-increases-for-11th.html

    The March Philadelphia Fed index of general business conditions came in at 18.9 versus forecasts of 18.0 and February’s 17.6 reading.
   
   Other

    The relationship between employment and energy production (chart):
    http://www.businessinsider.com/chart-of-the-day-america-has-now-passed-the-china-test-2010-3?utm_source=Triggermail&utm_medium=email&utm_campaign=CS_COTD_0318100

    More on the nonsense of currency revaluation (long):
    http://article.nationalreview.com/428171/china-and-currency-valuation/daniel-ikenson

    And Morgan Stanley’s Stephen Roach on the revaluation of the yuan (short):
    http://www.zerohedge.com/article/stephen-roach-says-its-time-take-out-baseball-bat-paul-krugman











Posted 03-19-2010 7:31 AM by Steve Cook
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