December 30, 2010

Top Five Portfolio News Stories of 2010: AdvisorOne

Why the “new normal” debate, bond market rout, flash crash, European debt crisis and metals mania garnered advisors' attention

The biggest investment stories of the year were not merely sets of interesting data but tapped into reservoirs of anxiety and doubt about the world we live in. These stories have not resolved those issues, but they have fueled useful thought about them.

The “New Normal” Debate

Generating the most traffic on AdvisorOne was money manager Ken Fisher’s disparagement of Pimco bond manager Bill Gross’ famous, or infamous, “new normal” concept. 

“We are chimpanzees with no memory,” Fisher said in response to Gross’ view that we are living in times of reduced economic expectations. “The next 10 years are going to be just as good as the 1990s. The problems in this current environment we think are so different, and so new and so unique. It’s the same stupid old normal we’ve always had. We’ve got a great future.”

If Fisher hadn’t made those remarks back in September, someone would have to have done so. After all, the U.S market has had a pretty good year and lots of companies are more profitable than ever.

Not so long ago, in the midst of the market’s downward thrusts in 2008 and 2009, classic “buy and hold” investing was repeatedly pronounced dead. Yet those who maintained fealty to that much maligned strategy have experienced gratifying recoveries, and have not had to struggle with the question of when to get back into a rebounding market.

Lesson: The return of “the same stupid old normal we’ve always had” — and the struggle panicked investors have had determining whether to get back in the market — should teach us all a little humility. No one has ever been able to consistently time the market. We should simply steel ourselves for a ride that will be bumpy but worth the journey.

Death of the Bull Market in Bonds

A second story generating inordinate web traffic also involved Pimco manager Bill Gross — namely, the world’s biggest bond manager’s declaration that the great 30-year bull market in bonds was over.

The story was linked to the Fed’s announcement of a second round of “quantitative easing” — specifically, a plan to purchase $600 billion in Treasury bonds. The Fed’s plan was aimed at keeping interest rates low, thus propping up a shaky real estate market and unleashing the animal spirits of equity investors, which would create a wealth effect.

The Fed’s bond buying, said Gross, “raises bond prices to create the illusion of high annual returns, but ultimately it reaches a dead-end where those prices can no longer go up. Having arrived at its destination, the market then offers near zero percent returns and a picking of the creditor’s pocket via inflation and negative real interest rates.”

Gross’ declaration of defeat — and the bond market’s selloff confirms his view — is a fresh reminder of all the strikes against bond investing.

Inflation is always crouching in the corner ready to take away whatever meager yields are being offered, and government fiscal and monetary policies are the key determinants of how your investment will perform. In other words, credit quality matters — and the bond market has judged Uncle Sam to be tinkering abusively with its national balance sheet.

Whether you agree with Ken Fisher or Bill Gross, it’s pretty clear why — from Gross’ perspective — we’re living in a “new normal.” There is no good news out there — or prospect of any — for bond investors.

Lesson: Investors in Treasuries, who have always had to worry about inflation risk, duration risk and taxes, could always rely on the absence of political risk; the full faith and credit of the United States Treasury was something the whole world banked on.

As bond vigilantes, gold bugs and the Chinese now constantly remind us, America and credit quality are no longer synonymous. Where once our word was our bond, our bonds are no longer expected to be worth tomorrow what they are today.

The Flash Crash

The “flash crash” of May 6 had every financial advisor’s attention. The story drew wide attention to what are normally technical issues about capital markets functionality with a gripping drama of the Dow plunging about 700 points within just 20 minutes.

A single, $4.1 billion computer-initiated trade seems to have triggered the precipitous decline, and there has been much gnashing of teeth about high-frequency computerized trading and even the role played by the proliferation of ETFs in less liquid areas of the market.

Should investors fear financial Armageddon — or buy like crazy — if another apparent flash crash occurs? Probably both reactions, in good measure and at different times, are called for.

Sometimes bad things occur rather unexpectedly and their consequences also surprise. The Great Chicago Fire was one of the biggest U.S. disasters of the 19th century, yet it is credited with spurring the rapid development of Chicago as one of America’s and the world’s great economic centers.

The “flash crash” that kicked that event into occurring is said to be a kick of a lantern by a cow in Mrs. O’Leary’s barn, according to urban legend. The true cause has never been established.

But Chicago’s rapid-fire destruction and Phoenix-like recovery is telling. Many people lost their lives in the fire, just as many got rich in the re-building.

Lesson: Know that “black swan” events occur and have disparate impact. Waddell & Reed, whose trade brought about the flash crash, was extremely adversely affected whereas all those investors who had gotten out of the market because of the credit crisis crash were completely unaffected.

There’s no more reason to worry about the next flash crash than about a “dirty bomb,” a rogue trader or the sudden collapse of a large European market like Spain’s. Broad asset-class diversification will help investors going into a crisis and opportunistic buying will help them recover and maybe even thrive.

European Woes

The sovereign debt crisis in Europe was the first significant dampener in the 2010 bull market’s march toward recovery.  Worries about a host of problems, beginning with Greek bonds of diminishing credibility, then moving to Ireland’s failed banks and a national budget ill equipped to bail them out, have tested Europe’s incipient euro-based credit union.

While Greece was the story in 2009, the Irish troubles roiled markets in April and May and worries about the soundness of Portugal, Spain, Italy and Belgium loom darkly behind debates of how the eurozone can adapt its economically unbalanced economic sphere.

In all likelihood, the crisis and its impact should only grow in the new year. Greece and Ireland are among the smaller EU countries. The debts of a large European economy like Spain are far harder for EU’s money centers to cover, and the assets on the books of Spanish banks are no better and maybe worse than the CDOs that nearly took down the U.S. economy.

Europe lacks the bedrock harmony, strained as it is, that the U.S. possesses. Germans do not feel a kinship with Mediterranean peoples, and are therefore more perturbed, if possible, than the U.S. public on the subject of bailouts.

Individual European countries are also divided internally on a host of problems, especially immigration, but also broad economic questions such as the proper age of retirement; societal expectations of a state-supported easy life are greater there than in the U.S. and thus economic realities will hit the average citizen harder. In short, Europe and economic and societal crisis are a bad mix, a precursor to war historically.

Lesson: Just as political risk in U.S. Treasuries is a negative “new normal,” we take a stable and peaceful Europe for granted at our peril. The first and most important rule of investing is diversification, and that includes geographic diversification.

There are many sound globally-oriented European companies that will do well whether or not the countries in which they are domiciled are experiencing problems; and there are other companies that could be more affected by, say, work stoppages amid domestic unrest. Be wary of poor credit quality among European debt securities, and spread your risk far and wide among equities.

Metals Mania

The best news for investors in 2010 may be the magic in metals. Not just gold, but silver, copper, platinum, even recycled scrap metal, have gone up, up, up. Mining companies have also brought eye-popping returns. But this story is just the flip side of all the bad news that has worried investors in 2010.

Metals generate no cash flow, add no value, create no wealth. As SoGen analyst Dylan Grice wrote in an attention-getting recent report:

“A bushel of wheat, a lump of iron-ore or an ingot of silver today is identical to a bushel of wheat, lump of iron-ore or ingot of silver produced one thousand years ago. The only difference is that they’re generally cheaper to produce because over time, human innovation has lowered the cost of production. When you buy commodities, you’re selling human ingenuity.”

But they’re real assets that store value in a world where the value of things we once depended on are in undeniable decline. When the credit quality of U.S. Treasuries, of all things, is permanently impaired; when computerized technical glitches can cause plunging values; when the economies of sizable European nations become a house of cards; and in the broader economy more generally where land is more like quicksand — people are attracted to values that are tangible.

As Ken Fisher pointed out, economic woes of this kind are part of the normal human condition, and to that end those who invested confidently as he did in the U.S. stock market were happy campers this year.

Still, it should worry us that metals and mining were among the top gainers, and one hopes that innovation of the kind that has propelled tablets, smart phones and mobile web applications to 2010’s biggest investment winners will be dominant themes in 2011.

Lesson: The market aphorism that “the trend is your friend” is certainly true. Oodles of money were to be made in every direction emanating from the initial thrust into gold and beyond to miners, other precious metals and the whole lot of industrial metals.

But many investors arrived late to each of those parties, missing the biggest gains. Rather than eat the appetizers, they ate their hearts out. There’s something to the old idea of investing in a broadly diversified portfolio including growth stocks, dividend-paying equities and commodities, and turning attention to friends, families and hobbies that bring joy to life rather than worrying about the price of rhodium.

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