The Blue Money Report - Current - Financial Commentary about Money, Investing, and Washington

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Today's Commentary: 06.25.03
Quick Questions
I was asked by numerous readers to revive an older idea I used in the early days of the column. Once called Two Quick Questions, now a regular feature on my other site, the idea was to grab several financial topics and answer the burning question, 'how does it affect me?'.

Will today's Federal Reserve rate cut of a quarter point mean anything to me?

Depends on who you are. If you are a borrower, then in all likelihood you will rejoice at Greenspan and company as they chase something lurking in the shadows of the economy. Alan Greenspan, the Federal Reserve Chairman has been very active on the talk circuit lately and what he has suggested both in the way of encouragement and caution was that just because the economy appears well on the road to recovery, you probably are not looking at the big picture. Or at least the one the F.O.M.C. is looking to for guidance.

These financial appearances can be deceiving to the untrained eye. The harsh reality that the Fed Board lives with is simple. A healthy uptick of the inflation index would be good at this point in terms of pricing power. Deflation however is an evil once unleashed can not be so easily reversed. The main problem dealing with this kind of a situation is experience. This country has relatively few instances in its economic past on which the Chairman can draw for reference. With the conomy becoming a creature of its own making, learning as you go can be expensive and possibly damaging. Although the cut amounted to only a quarter point, the amount is actually negligible.

A borrower would see the biggest help come from any open equity line of credit they might own. Tied to the prime rate, the interest on these lines would fall and in a relatively quick way. Eventually some of this cut would filter into longer term loans as Mr. Greenspan has done more than suggested he would like to have happen. Credit cards might have the opposite reaction to the thirteenth whack at the overnight lending rate. Recent reports have suggested that rates for cards are starting to climb. The reason is simple. So many folks have tapped the equity in their homes, that card companies are actually beginning to challenge your credit worthiness. Worried that many Americans have overextended themselves, card companies are attempting to cover the possible new risk to their business.

Savers on the other will be forced to look longingly at days gone by when money markets yields of 6% and sometimes more were comonplace. Barely two and a half years later, those same funds are barley getting 0.7%. Even with the current low inflation, this pittance of a return becomes negative rather quickly.

So if it seems that for the average Dick and Jane, the rate cut may tend to have a negative effect either way. The borrowers get in deeper debt and the savers get nothing for their efforts. So why would they lower rates again in the first place?

Mr. Greenspan sees shadows. Shadows are not it seems part of the scenario of a recovery. Referring to the lack of light in certain areas as an incomplete process of recovery, he believes

Leading Economic Indicators May 2003

Average work week, production/manufacturing +0.05%

New orders for consumer goods +0.01%

New building permits +0.07%

Index of stock prices +0.16%

Money Supply +0.38%

Spread on Treasury notes compared to federal funds -0.13

Index of consumer expectations +0.27%

that by cutting rates again, he would do two things. One he and and his other Fed governors hope to stop the possible demon of deflation from taking root in the process. These folks know that they are close to a rate cut bottom. Once at zero, money supply would not have any short term effect on the recovery.

And secondly recoveries that are meaningful do not usually begin with the stop and start fits we have witnessed of late. A certain amount of smoothness in the numbers would indicate that the imbalances in the economy would have been taken out.

The F.O.M.C. understands that despite the sustained run-up in the stock market, despite the core inflation number (the one that excludes food and energy) rise to 3.2%, add to that the second consecutive monthly increase in the Conference Board survey and a slight drop-off in initial unemployment claims, more stability is needed.

Even though many of these numbers ar being interpreted as a sign that there is some sort of recovery afoot along with Mr. Greenspan, Ken Goldstein of the Conference Board was quoted as saying that "...the dangers in the first five months of the year have not disappeared completely". When looked at in the manner as the Fed Chairman, even unemployment doesn't seem as bad. Mr. Greenspan never really worried about a pool of available workers. He was more concerned that businesses had no faith in the operating climate and laid workers off as a result of that lack of commitment. To get the economy running at full tilt again, that pool of workers currently collecting unemployment needs to exist.

Are we still in a bear market or is this a new bull market?
Interesting question that is more a inquiry about your personal investment style than an actual marketplace. The hardest part about the three year downturn that has admittedly fried a few portfolios but may also be over, was finding the opportunities.

There was a study done recently by Charles Schwab that found that black investors have not returned to the markets in the same way white Americans have remained in the market. The outcome of this reversal of faith in equities is due largely in part to a misunderstanding of how the markets operate rather than a racial mindset. During the late nineties, many investors came to the markets in the hopes of attaining all of the riches being touted by the headlines. Understanding the markets wasn't a necessity in those days. Involvement was all that was really required.

Without reviewing too many of the details again, those new investors, many of who were African American, felt the sting of the decline harder than investors who had been in the market longer. Those long term investors knew that time would heal those wounds even as they lost heaping mounds of newly made wealth.

Markets are not about timing as much as they are about time itself. The opportunity presented by the bear market will fully manifest itself in the new bull market if you have been dollar cost averaging your way through it. Shares bought at bargain basement prices in index funds who had fallen from those historic highs and doing so consistently may have been costly from a loss (taxes, capital gains, and loss of principle) but when this market gets on the footing it needs sometime early in 2004, all of those contributions will be what long term investors smile about.

Is there any truth that rich guys invest better?
Maybe not better but the rich colleges may be the guide to the way we should allocate our investments. You may not have known this, but Yale University has had a consistent run at the markets over the last four years allocating their money in the Yale Endowment Fund.

While we don't always have the assets available to chase these types investments, it might alter the way you view how you allocate your money. This goupr has had returns of 12.2% in 1999, 41% in 2000, 9.2% in 2001 and 0.7% in 2001. For the period ending June 2002, the university was invested in equities (U.S 15.4%, foreign 12.8%, and private 14.4%), bonds (10%), hedge funds (referred to in the report as absolute return, 26.5%), real assets (20.5% such as real estate and even timber) while parking only one percent in cash.

Now you probably don't have access to a hedge fund. You probably consider your house a real estate investment, which by the way, it is not. It may appreciate but it is only an investment if you don't need a place to live. Otherwise, you invest in a home, it is not an investment. The question is how can you allocate your investment money to best mimic their returns.

Allocation is a tricky thing and is based on many factors. Many folks have been easing out of the bond market and into large cap funds as a way to capitalize on the recent tax cuts. Dividend paying stocks tend to be well capitalized companies. This of course doesn't explain why the NASDAQ has moved so rapidly. I believe that the small and mid cap companies and the funds that invest in them will lead us out of this bear market in a big way. If I were to allocate this group in a portfolio they would comfortably occupy 85%. This by way of disclaimer is not a recommendation. The remainder of the portfolio would be left with the risk of the high yield or junk bond market. Sure the yields are off their October highs of 13%, but they still allow a decent amount of return for the risk. What risk remains should be seen well in advance if those bonds are nestled in the arms of a good bond fund.

If I remain in bonds and bond funds, won't I do better over the long term as this market finds its voice?
I have been worried about bonds for quite some time. I am more worried now. The price on bonds is still too high to warrant running there for safety. The risk, while less is more in the risk of no return that the risk of loss of principle. Treasuries have an after tax yield of 2% or less. With that in mind, calculating your return should be easy. A decade's worth of waiting for a return on your investment will net you next to nothing for the effort. Keep in mind that Treasury yields are low because their prices are high. Should those prices drop and that is always a distinct possibility at these high levels, years worth of income could be wiped out.

Is there a balance between saving and debt?
There certainly should be although the balance is hard to define. When I took my kids trick or treating when they were very young they got enormous amounts of candy for two reasons: they were cute, and dad loves the idea of getting candy for just dressing up and begging for a handout. As they gathered candy into their bags and headed to the next house, I understood that carrying all of those goodies would slow them down and tire them out.

Imagine the candy going into the bag as debt. This debt would be the money used to buy cars and appliances, and to remodel homes. This money amounted to 66% of the credit used last year but only increased 4.5% in the first quarter of this year.

Now imagine me walking behind these costumed youngster taking candy out of the bag. This might be considered retirement of debt. By removing the money to pay off that car or that contractor, the bag stays relatively the same weight.

Why that seems like we have less money in savings is more directly tied to how much more or less we are making. Recent stats have shown that we are making more per hour but as a work week total, the amount has dropped. This shows that spending has been modest. In order for savings to significantly increase, spending would not only have to slow but salaries would have to rise substantially. In other words, my kids would need to be the only kids out on Halloween night and me with a wheelbarrow. Only then we will have a clear picture of whether we are saving less, spending more, or earning enough to do either.

Today's Commentary: 06.24.03
Active Management and the Bear Market Myth
Once again, I'd like to thank Larry Swedroe for this contribution. Larry is the author of "What Wall Street Doesn't Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," and "Successful Investing Today: 14 Simple Truths You Must Know." Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor

One of the more persistent myths perpetuated by the Wall Street Establishment is that active managers will protect you from bear markets. The following is a perfect example. In 1997, Susan Byrne, of the Westwood Equity fund, when asked by Fortune magazine about index funds responded: "An index fundŠ doesn't have a conscience (?). It doesn't think. That's how you get overvalued stocksŠ. The reason index funds are beating everybody is that the market has been going straight up. When we are not in a straight-up market everyone will beat them. Let's look at the historical record to see if Susan Byrne was right and that active managers actually protect investors in bear markets. You will see that accountability ruins the game.

Just prior to the second worst (at the time it was the worst) bear market in the postwar era (1973-74), mutual fund cash reserves stood at only 4 percent. Cash positions reached about 12 percent at the ensuing low.

In the market correction of mid-1990 when the S&P 500 Index fell 14.7 percent, actively managed funds fell an average of 17.9 percent.

In 1994, when the S&P 500 Index posted a tiny 1.3 percent gain, the active managers lost 1.4 percent. vIn mid-1998, when the Asian Contagion bear market arrived, cash reserves were just 5 percent. Compare this to the 13 percent level reached at the market low in 1990, just prior to beginning the longest bull market in history. In the bear market of July 16 - August 31, 1998, the average equity fund lost 22.2 percent. This compares to losses of just 20.7 percent and 19.0 percent for a Wilshire 5000 Index fund and an S&P 500 Index fund, respectively.

The S&P 500, S&P Mid Cap 400, and S&P Small Cap 600 Indices outperformed 54 percent of large-cap funds, 77 percent of mid-cap funds, and 72 percent of small-cap funds, respectively, during 2000 - 02 -the worst three-year bear market in the post Depression era.

In 2002 alone, the S&P 500, S&P Mid Cap 400 and S&P Small Cap 600 Indices outperformed 61 percent of large-cap funds, 70 percent of mid-cap funds, and 74 percent of small-cap funds, respectively.

Lipper Analytical Services studied the six market corrections (defined as a drop of at least 10 percent) from August 31, 1978, to October 11, 1990, and found that while the average loss for the S&P was 15.12 percent, the average loss for large-cap growth funds was 17.04 percent.

It seems that not only was Susan Byrne proven wrong, but that fund managers are very good at executing a buy high and sell low strategy. Byrne got one other thing wrong: What investors need protection from is active managers - and, of course, myths. Susan Dziubinski, editor of Morningstar's FundInvestor newsletter, put it this way: "The average fund can't keep up with its index when it's sunny or rainy. "