Bolen | Dodson & Associates

Dear Clients, Friends and Associates,

A few weeks ago I summarized the first part of a particularly useful section in Warren Buffett’s recently released annual letter to shareholders entitled “The Basic Choices for Investors and the One We Strongly Prefer.” The bottom line of that email is to properly define your risks when investing and the biggest risk to investors is loss of purchasing power over the anticipated time horizon of the investment. Short term volatility is not necessarily risky if your time frame is expressed in years or even decades.

Buffett goes on to describe three major categories of investments: 1) Investments denominated in a given currency, such as money markets, CDs, bonds, etc; 2) Non-producing investments, such as precious metals; and 3) investments in productive assets such as businesses, farms or real estate.

Investments denominated in a given currency, such as money markets, CDs or bonds are often thought of as “safe” because they are not very volatile, but Buffett warns us that “In truth they are among the most dangerous of assets.” He is notably concerned with negative impact of inflation on purchasing power over time. He notes that it “takes no less than $7 today to buy what $1 did in 1965.” For tax-paying investors, U.S. Treasury bills produced an average of 5.7% annually. Subtracting an average 25% tax burden leaves a 4.3% after-tax return, which according to Mr. Buffett, was evaporated by inflation over that time frame. So although investors still have their account balances in tact, they had no real return to show for 47 years of effort. At current interest rate levels, “real” returns (after inflation) are in some cases negative. This is a tax on savers as real as any tax. Buffett quotes Shelby Davis as saying “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” Given that bonds are offering yields at 30 year lows, this is serious food for thought. Clearly, there is a place for fixed income investments for shorter term goals. The point is though, to be sensitive to other forms of risk besides volatility and understand what your real return expectations are over time.  

The second major category of investments produces nothing. It is purchased in the buyer’s hope that someone else will pay more for them in the future. We are talking about precious metals, most notably gold. Gold neither has much use nor is it procreative. It relies on ever increasing demand by the ranks of the fearful. Buffett notes that “if you own one ounce of gold for an eternity, you will still own one ounce at its end.” While the self fulfilling nature of rising prices creating its own demand works for a while, it eventually succumbs to reality. Note the Internet and housings bubbles. According to Buffett, the market must absorb around $160 billion in annual production just to maintain equilibrium at present prices. Buffett suggests strongly that rather than buying gold, investors purchase a productive asset, such as businesses or farm land. Businesses and farm land throw off handsome cash flow, or wheat, corn, cotton or other crops year after year. Yet gold owners will still just own their ounce of gold. Buffett’s thoughts really put the current raging bull market for gold in perspective.

The first two investment categories enjoy maximum popularity at peaks of fear. Buffett’s own preference, widely expected, is the third category of investing in productive assets, whether businesses, farms or real estate. Buffett maintains that “Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.” He points to farms, real estate and businesses such as Coca-Cola, IBM and See’s Candy as meeting that double-barreled test. Utilities require capital investment to grow earnings, but even so, “these investments are superior to nonproductive or currency-based assets.” The value of businesses, farms or real estate will be determined but by the medium of exchange, but rather by their capacity to deliver goods and services demanded by the masses. Buffett maintains appropriately that over any extended period of time, this category of investing will prove to be the runaway winner among the three alternatives he’s examined and more importantly, it will be by far the safest.

 Thank you, Mr. Buffett for your insightful commentary. Well said.

Warren Buffett’s annual letter to Berkshire Hathaway’s shareholders is well known for its pithy and often poignant commentary and this year’s letter is no exception. Tucked between detailed commentary of his many businesses and important information for attendees of the upcoming May 5 annual meeting in Omaha are three pages of analysis that all investors would find beneficial. The title of this section is “The Basic Choices for Investors and the One We Strongly Prefer.”

Mr. Buffett starts this section with the generally accepted definition of investing as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire, they take a more demanding approach, defining investing as “forgoing consumption now in order to have the ability to consume more at a later date, net of taxes and inflation.” Notice the emphasis on consumption is in terms of purchasing power rather than money per se, because inflation is important element in the equation.

He goes on to state the “riskiness of an investment in not measured by market volatility (beta), but by the reasoned probability of an investment causing its owner a loss of purchasing-power over the contemplated holding period.” His point is that assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.

This emphasis on expected holding period is a key to investing well and is the basis of Bolen Dodson & Associates “Goals-based Investing” approach. You need cash for spending. Fixed income is best used for spending over the next few years. Bonds are not very volatile, but they do not produce returns net of taxes much if at all in excess of inflation either.

Equities are meant for longer term goals of 5-7+ years and beyond. Equity investments are volatile over the shorter term, but are quite predictable over the longer term. Knowing when you plan on using the funds is an important element to successfully investing in equities. Being afraid of short term volatility is a recipe for failure.

In a subsequent blog, I’ll summarize Buffett’s investment choices and his preference. One guess on what he prefers.

Last week’s market action was downright ugly. I’ve reviewed my basic impressions of market fundamentals and technicals and observe the following:

•  Economic and corporate indicators continue to point to modest economic growth. Leading economic indicators rose again in August. Prices are undervalued.
• Markets discount a Greece default on its debt obligations. Concern of “contagion” is a major cause of U.S. equity declines. However, Greece appears dedicated to not letting this happen. If it does, markets will be chaotic for a spell and likely create a further buying opportunity.
• Consumer sentiment is very poor. While this could induce the first ever confidence led recession, odds are it is setting the stage for capitulation and a rebound.
• A recession is priced into the equity markets yet the odds of a renewed recession are only 25%-30%. This is bullish.
• Market trends are decidedly down, but selling during a market decline has not proven to be a winning strategy. Markets always eventually rebound and they can turn very fast, often when things look bleakest.
• The best course of action is to maintain liquidity for spending purposes and rebalance portfolios, buying equities to take advantage of the market pullback.

While the media was fixated on the looming debt ceiling/default date of August 2, several not-so-well covered news releases painted a glum economic picture. So even though Congress and the President came through with a last minute deal (as expected), investors immediately turned their attention to economic activity and didn’t like what they were seeing and knocked another several percent off the market averages.  

On July 29^th, the Bureau of Economic Analysis released its initial estimate for the 2^nd quarter “real” GDP growth (Gross Domestic Product) of a weak 1.3%. More notably, the BEA revised downward 1^st quarter growth from an already weak 1.9% to a paltry 0.4%. What this means is the economy is growing very slowly and not enough to create jobs in any meaningful way. The BEA also revised downward GDP growth data from 2003, which of course included the “great recession” of 2008-2009. The 4^th quarter, 2008 contraction was changed from -6.8% to -8.9% and the 1^st quarter, 2009 was lowered from -4.9% to -6.7%. The cumulative decline from the 4^th quarter 2007 peak to the 2^nd quarter 2009 trough in real GDP was revised downward almost 50 basis points (0.5%) to -5.1%. These are huge negative revisions and indicative of how severe this recession was, and how far we have to climb to get back to where we were.  

Then on August 1, the Institute of Supply Management released its July manufacturing report, which showed growth in manufacturing, but at a slower pace then June and below expectations. The question in my mind is how much of this slowdown was caused by Congressional inaction on the debt ceiling debate. When consumers are uncertain about the future, they hold on to their cash and quit spending.

As well, the drum beat of potential further European Union credit defaults continues. The European Central Bank is in talks with Italy, Spain and others in efforts to contain the potential for Greece like defaults. While this could clearly get messier, systemic failure of the banking system seems highly unlikely.

Global economic activity throughout most of the first decade of the 21^st century was helped in no small measure by easy credit and overuse of leverage, by both the consumer and world governments. This is now unwinding. Asset bubbles have burst and easy credit is gone. This process will not be rushed. We cannot push on a string.

 Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and formerly chief economist at the IMF has written an excellent article that reframes the issues of the day. He suggests that rather than having come through a Great Recession, we are going through the second Great Contraction. This makes complete sense to me. See the article here: http://www.project-syndicate.org/commentary/rogoff83/English.

The consumer is now retrenching. Savings and debt reduction is in vogue more so than over spending. We hope this continues as it is very bullish for the economy longer term. For its part, the Federal Government is now talking about actual deficit reductions. The debt deal earlier this week is hardly a down payment on what must be more substantive talks on our Government, and its people, living within its means.  

The market is a discounting mechanism so responds to changes in expectations. You are seeing this up close and personal this week. Adjustments happen quickly to reflect the new information. The best guess of the “appropriate” market levels that reflect all the positives and negatives of the day, are the current prices. That is today, tomorrow and every day hence. Regardless of the current dislocations in the economy and in the markets, investors are well served by adhering to their strategic asset allocations while maintaining cash for this year’s spending needs. We will rebalance portfolios when appropriate to buy the underweighted asset class and sell the over-weighted asset class. Without fail, markets always resolve corrections to the upside….sometimes quickly….sometimes slowly….but always. Today’s employment release was a fundamental step in the right direction, but the market is not quite ready to agree…yet.

We are cognizant of human behavior and recognize that people get concerned when their nest eggs are rattled. But markets regularly correct and then once again move higher. I’m sure we are all suffering from some PTSD from the 2008-2009 “Great Contraction”. However, there is nothing remotely similar to the current situation and that series of events.  

While currently the market is focused on the slow down in the economy and the potential for European contageon, there are several reasons to be optimistic. Corporate earnings are strong; oil is down 10% from its recent high; there are no major dislocations in credit markets; inflation is benign; interest rates are low; consumers are saving (allowing for future investment); Congress is serious about reducing our deficits; equity valuations are quite compelling; fear is running high (a contrary indicator); and the market is already down 11% since July 22.

We are available for questions, to provide additional commentary or to hear your concerns.

The stock market was down again today, adding to a string of five consecutive weekly losses. A weak jobs report on Friday capped evidence of a slowing economy seen from various reports these last several weeks. Softening US economic data coupled with renewed concern with international debt issues have made investors nervous and quick to move to the sideline. The S&P 500 is down about 5.5% since the end of April, erasing most of the 6.2% return seen year to date prior to this pullback. Notably (according to the talking heads), this is the worst 5 week showing since mid 2004. The question is, at this juncture, should we buy, hold or sell strategic positions? What can we discern from this recent action that is usable to make decisions that will benefit us going forward?

I received an MBA in finance in 1986 and started my investment career that year. As such, I have been in the investment business for about 25 years and counting. As a student, I learned about efficient markets and the cons of trying to outsmart or outguess the market, but then I was hired as a securities analyst and was paid for my opinion. In the bull market years of the 1990’s, we picked winning stocks with impunity. Interestingly enough, it got a lot harder to pick winners in the early 2000’s. Looking back, I see that the market’s underlying direction had a lot to do with our perceived skill or lack thereof, rather than much in the way of unique insights.

These last nine years, I have been managing portfolios for individuals and small company profit sharing plans. I have worked hard to add value by moving securities around the asset allocation board, either to generate incremental returns or in an effort to mitigate loss. Sometimes moving around helped, but other times it didn’t. As a Registered Investment Advisor, I owe my client’s a fiduciary responsibility to act in their best interest. Last year I decided it was time to review the body of evidence and refresh my opinion on the age old debate between Market Efficiency and Market Timing. While the debate rages on, the data indicates there is no debate.

The body of evidence strongly suggests that markets very quickly discount new information and which way the market is going to go next depends on the next piece of information, and so on and so on. Guessing which way the market is going to go next is well, guesswork. We can only know whether or not we should respond to this current 5.5% pullback by buying or selling with hindsight as a guide. Undoubtedly some market “professional” will guess correctly that person will be paraded out on all the talk show to tout their market prowess, until the next prognosticator comes along. But they in all likelihood just got lucky. Statistically, it takes 63 years to separate skill from luck at the 95^th percentile.

Surely, some people are sharp enough to add value over a “buy and hold” strategy, but the key is to add value net of fees, transaction costs and taxes. Many peer reviewed studies show that “time in the market” actually outperforms “timing the market”, net of costs. The only observation that is statistically noteworthy (using multi-linear regression for you geeks out there) is that over the longer term (1927-2010) the stock market outperforms the Treasury bond market by about 8.0% per year, on average. Beyond that, small capitalization stocks outperform large capitalization stocks by an average of 3.75% per year and value (low price to book) stocks outperform growth (high price to book) stocks by an average of 4.9% per year. This phenomenon has persisted over all 20 year periods and over the vast majority of 10 year periods.

Beyond these investment “risk factors”, there is NO statistical evidence that professionals, much less average investors add value by moving pieces around the board. In numerous academic studies, no more top decile performers in any 3, 5 or 10 year periods were again top decile performers in subsequent 3, 5 or 10 year periods than would be expected by pure chance.

The reason professional money managers continue to try to beat the market in spite of all the evidence that it is a loser’s game boils down to one reason and one reason only. They are paid to play the game by individual and institutional investors. Hope springs eternal. Wouldn’t it be great to pick the winners and avoid the losers. It is everyone’s greatest hope. It has surely been mine. However, honest reflection begs to differ.

What we know with certainty is that fees, transaction costs and taxes are drags on performance. Rather than view the market as an enemy to conquer, the smart money says we should view the market as a friend, to be embraced and ridden for all it is worth. Establish your strategic asset allocation that is consistent with your goals, time horizon and ability to sleep at night. Invest based on your personal goals. That is, based on when you expect to spend the money: Long term investing for long term needs. When markets invariably tumble and your allocation percentages stray, rebalance and buy more of the asset classes that have fallen. When the market invariably recovers (and it always does), rebalance and sell the asset classes that rose.

Leave the market timing to those that don’t need their money. You’ve worked too hard for yours.

David Lockhart, CEO of the Atlanta Federal Reserve, spoke at the Nashville CFA Society on last Thursday. He believes current commodity inflation will prove transitory (but prices will remain elevated), GDP growth will improve sequentially during the year, not falter, and that the market will absorb QE2 wind down without a major hiccup. All three observations, if they prove accurate, are bullish for the markets.

Price rises have to be broad based before inflation becomes persistent. When just one or two items in a basket rise, consumers tend to trade off one purchase for another. That is, they will tend to buy gas and drive less, or spend more on food stuffs, but eat out less often. Relative price changes are not general inflation. General inflation occurs when expected price changes get passed along into higher wages, such as occurred in the early 1980’s. With high unemployment, excess capacity and cheap wages overseas, general inflation is unlikely.

GDP growth for Q1 is likely in the 2% level, down from earlier expectations of around 4%. A long winter, harsh storms, Middle East and Northern Africa tensions, the potential shutdown of the government, and the Japan earthquake/tsunami/nuclear meltdown have all worked to lower consumer confidence and thus output. However, with an improving jobs outlook, a moderation of world tensions, lenders supporting durable goods purchases (cars, appliances, etc), and progress on the deficit, confidence is expected to rebound into the back half of the year and beyond.

Mr. Lockhart argued that the Federal Reserve has been very clear that Quantitative Easing II is set to wind down by June 30 and the bar is set very high for a QE3. He observes that markets tend to be disrupted by unforeseen events, not expected events and that the end of QE2 has been telegraphed and is expected.

On other topics, Mr. Lockhart observes that the weak U.S. dollar has helped exports and U.S. manufacturing. Home prices continue remain the weak link and are being watched carefully.

Markets are interesting in that they seem to consternate most of the people most of the time. A dear client called me last month to inform me that “the bottom is getting ready to fall out of the market” and to “get him out of harms way”. We had a good conversation about what his goals were for his money and over what time frame. I explained to him how difficult it is to move out of the market before a decline and get back in after a decline (assuming you were right the first time).

Typically, things look bad when markets decline and I have found it difficult at best for investors to buy when things look bad. Of course, that is exactly what one should do. Even so, if you had a 60% probability of being right on the call to get out and a 60% probability of being right on the decision to get back in, there is only a 36% chance of getting both decisions right (60% x 60%). It was this problem of back to back correct decisions along with the negative drag from transaction costs and taxes that has caused me to forgo tactical asset allocation and rather use the market to my advantage rather than attempt to use it as my adversary. The stock market rises about 10% per year on average, but tends to do that in fits and starts, rising, then falling, then rising. The best course of action is to rebalance portfolios when holdings move beyond a certain band, say 10% or 20% from the strategic allocation. That way, one is forced to buy low and sell high.

My client did not need most his money to live on for several years, so he had decided to stay put. Of course, he was saying “I told you so” earlier this month when the tensions in the Middle East and the earthquake/tsunami/nuclear meltdown in Japan caused a rapid decline mid March. From February 18 (the recent market high) through March 16, the S&P 500 fell 5.4%. However, it then immediately turned around and now sits right where it was in mid February. Nothing much as improved except we see that the world is not falling apart, at least not yet, but the market has recovered. Focus on the long term results, not on the shorter term drama of the day. Focusing on short term drama is a great tool when you are driving, but not when you are investing.

The U.S. markets are down again today on continued uncertainty around the economic impact of Japan’s earthquake/tsunami/nuclear meltdown/radiation leak. According to news reports, Prime Minister Naoto Kan warned of “substantial” radiation leaks.  

No one knows how much or what effect the earthquake/tsunami/nuclear meltdown/radiation leak will have on the global economy, but hedge funds and market traders are acting in typical fashion with their “ready, shoot, aim” mentality. What we do know is that markets react to sudden exogenous shocks and then always come back. This bears repeating. There has never been an event that caused the market to decline where time, talent and resources hasn’t healed the event’s wounds, causing the market to ultimately work its way back higher. World War One and Two, the Chernobyl disaster and 9/11 are notable examples. Even man made disasters such as the Tech Bubble and most recently the 2008 financial melt down have “resolved to the upside.”

This is not to say the pain and damage from the current disaster is over. But guessing how far and how fast a market will correct in the heat of the emotional moment is always difficult. What we do know is that longer term, the world will survive and adjust and expand and grow again, pulling the market kicking and screaming along for the bumpy ride. Average stock market returns are in the 10% per year range in spite of the issues that plague our globe with resounding regularity. These issues cause volatility, but it is this volatility that makes the 10% average return feasible. Lower risk would cause lower return.

We believe the best course of action for long term investing is to use periods of temporary decline to rebalance portfolios and buy the declining asset class on weakness. This forces a buy low mentality. Investors should always have enough cash available for current needs and enough fixed income for 5-7 years of spending needs. Longer term spending goals beyond 8 years or so can (and depending on your risk tolerance likely should) be in longer term assets such as equities. Younger clients with years until retirement have no retirement account spending needs.

We will maintain vigilance and are regularly reviewing asset allocations. Portfolios are conservatively managed and are well diversified. Please give us a call to discuss your specific situation and concerns and let us answer any questions you may have.