March 22, 2011

The Most Expensive Mistake Investors Make
and How to Protect Yourself.

The Investment View from Prescott, Arizona

“A little knowledge can be a dangerous thing” is especially true in the investment world.

For over 20 years I have been telling readers that history shows that there is much more money lost to well meaning but naïve financial advice than has ever been lost to crooks-even counting Bernie Madoff.

In the past I have focused this comment on advisers who were good mutual fund or annuity salesmen, but had no clue about what really made the markets tick.   Usually they just repeat what someone else tells them, but haven’t yet developed the capacity to really think things through to logical conclusions.

Most will point to Morningstar ratings and sell funds or annuities with the most stars.  Of course ratings are usually based on past performance and as the disclaimers all say, that has no bearing on whether you will make money going forward.

To give you an idea why listening to brokers say “this one has done really well” is a really poor way to invest, let’s look at the performance of top rated “5 Star” funds versus below average “2 Star” funds. 

On June 30, 2000 Morningstar listed 192 Five Star growth funds.  Over the next two years those 192 funds returned average losses of 52%.   Ouch!

On the same date, Morningstar listed 218 Two Star growth funds which over the next two years produced gains of 11%.  These results are completely backwards from what one would expect from the ratings.

Clearly, selling investments based upon past performance ratings does not work, yet this is the way most investments are sold.

But rookies need to make a living, so how does an investor protect themselves from rookie advice?

I would suggest you always look at a manager that has been through – and had his clients survive – several up and down cycles.  Ignore the 1990’s.  That was a different world for investors and it will be a long time before we get back to it.  Find out how they have done since 2000-a period that includes two bear markets.  Ask to see a track record of all their recommendations since then.

This holds true for active managers, as well.

David Moenning of TopStockPortfiolios.com recently wrote an article published (ironically) on Morningstar.com that reported on the Inside ETF conference in Hollywood, FL, where my friend and current NAAIM president, Ian Naismith, was addressing over 400 financial advisers. 

Naismith asked the group how many used technical analysis (charts and graphs) or were active managers.  “At least 75% raised their hands,” the article stated.  Then he asked how many had been doing it for more than 3 years (before the 2008 bear market) “and half the hands lowered.”

When he asked how many had been using these methods for 10 years or longer, only a half dozen or so hands remained up. 

What this means to investors is that you will be running into more and more advisers who claim to be active managers, but have little experience at it.

There is no substitute for experience when managing money.  If you don’t have it, hire someone who does.  But don’t be fooled into thinking their quoting from someone else’s newsletter or website equates to knowing what they are doing.

Look for someone who has systems in place and doesn’t just fly by the seat of their pants.  Ask to see their track record.  Good managers will have one.   And if you are hiring experience, why not demand at least 10 years of it. That is certainly enough time to separate the wheat from the chaff.

Slice of Life

At this writing (Saturday evening) I just returned from a week off down in Phoenix.  I use the term “off” loosely because I am in touch with the office daily, run a brief analysis of client holdings everyday and often do trading on the road too. 

But it was a great vacation.  I finished two good books and started a third, played golf three times, saw the Diamondbacks lose twice (it may be a long season unless they get some help in the bullpen), rode my bike almost every day and even spent some time by the swimming pool.

A highlight was on St. Patrick’s Day at Glendale Stadium where the Dodgers were playing the Diamondbacks.  The national anthem was performed by one of the little people, dressed appropriately as a Leprechaun.  At about 3′ 6″ he was perfect for the role.  Except he could not sing.   Not a lick.  It was really painful to listen to.  And then he forgot the words!

The Leprechaun quickly whipped out a card with the words, but before he could take a breath and resume the entire crowd just picked it up and started singing “And the rocket’s red glare . . . ” with – or maybe for – him.  I ended up with tears running down my cheeks and I’m still not sure if they were caused by a surge of patriotism or the display of humanity as the crowd spontaneously picked the little guy up and carried him through the ordeal, or just that the whole thing was so darned funny.   I am chuckling now just thinking about it.

Mental Floss:

Q: What object has keys that open no locks, space but no room, and you can enter but not go in?

A: A computer keyboard.

What’s Happening in the Market.

Inflation: Coming to a Store near You Soon.

Earth tremors reverberated through the financial markets last week.  The fighting in the Middle East and Africa combined with nuclear fallout from Japan managed to shake the world stock markets.

Bond markets reversed their slide over the past few weeks as investors sold stocks and had to find another place to put their money. 

An underlying concern may also be inflation, which seems to be getting traction thanks to rising food and energy prices.  I had to pay $3.85 for diesel in Prescott this week. Yikes! 

US Consumer Price Index (CPI) data released last Wednesday by the Bureau of Labor Statistics shows inflation at the retail level at 2.1% for the year ending February 2011, with January and February inflation the strongest in several years.  Although inflation at the consumer level is still moderate, the trend has clearly turned up. 

The Producer Price Index (PPI) measures inflation at the wholesale level and can give us a glimpse into what is coming at the retail level as corporations pass their cost increases along to us in the form of higher prices.

PPI data shows a worrisome 5.6% increase over the past 12 months.  Even that eyebrow-raiser may be understated because most of that increase has come in the last 6 months.  If the next six months show similar price increases, we will be staring down the barrel of double digit price increases at the wholesale level-something not seen since the high inflation days of the early 1980’s.

Bernanke and the Federal Reserve have been trying to create inflation to ward off deflation and it appears that they may be succeeding.  The question now becomes: Will they be able to put the inflation genie back in the bottle after deflation is whipped?

The cynic in me sees high inflation as government’s preferred means to deal with the federal debt.  Governments don’t go bankrupt.  They inflate the money supply to pay off earlier debts and promises (like pensions and social security) with newly printed money – just what Greece did until last year when no one would take their money any longer.

The US is on that same path right now, and we seem to be turning a corner in the inflation making process.

Those living on a fixed income or with dollar denominated investments (savings and money market funds, CDs, bonds, mortgages, and fixed rate annuities) are most at risk and may find their lifestyles increasingly threatened by inflation.  I would suggest they take steps to protect themselves from inflation, which looks to be building up steam. 

If you know someone in this category, do them a favor.  Forward this newsletter to them and ask them to call me for a free consultation.

What’s Going On In Your Portfolio?

Our Careful Growth* model is only 40% invested, and all of those investments are in hard assets, meaning things you can touch and feel, like gold and silver and oil stocks.

Our 60% cash position means our risk is very low as the stock market sorts itself out.

Our Flexible Income* model remains close to fully invested with gold, silver, four different kinds of bond funds and one high yield stock.

Our investment in hard assets across both strategies reflects my concerns about impending inflation as these investment categories typically do well during inflationary times.  I have done this to protect you if inflation continues to rise.

The stock market struggles since February 18th feel like a garden variety correction that should not do serious damage to the average stock, so I am not hedging portfolios, but merely allowing my predetermined exit signals to work for each holding.  This keeps our risk low if the decline continues.  In addition, the strongest stocks in a new up-leg will often be different than the leaders in the past, so this tactic frees up cash to buy the new leaders once they show themselves.

Tech stocks seem to be taking the hardest hit after Japanese stocks.  I am glad to report that our Careful Growth* model sold the Japan and tech holdings back on February 22nd, just two trading days after the market’s peak. 

I would like to see the stock market’s bounce at the end of last week continue, signaling that the correction is behind us, but as of this writing on Sunday, March 20th, it is too early to tell, so I will be patient and continue to hold a lot of cash.

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.