Thursday, August 21, 2014

A Letter to the SEC

Earlier this week, Richard A. Fleming, the Investor Advocate at the Securities and Exchange Commission gave a speech to the 38th Annual Southwest Securities Conference, Dallas, Texas.  The title of the speech was The Case for User Fees. For those unaware, the SEC is charged with, among other things regulating financial advisors. Just as the IRS only audits a tiny fraction of tax returns, the SEC audits a small percentage of financial advisors. The primary reason given for this by the SEC is budget constraints. Since Congress is unlikely to give the SEC the necessary funding, there have been proposals to have the SEC charge a fee for every registered advisor (or firm). The Investor Advocate was making the case this week.

I think he is unaware of some serious concerns raised by user fees. I outline them below. 

Full Disclosure: I work for a registered advisory firm, so these fees would impact me and my firm. 

Dear Sir,
In your speech on The Case for User Fees on August 19th, you noted "the main objection to a user fee is a philosophical resistance to growing the government."  While that is a valid criticism of user fees, I think it is not the strongest argument against user fees.
One significant problem of putting the burden of higher SEC funding on advisors, is that higher costs will drive marginal firms out of business, as there will be no corresponding rise in income. This will happen either as firms shutter or consolidate. The end result will be a landscape of fewer, larger firms serving the investing public. As history has shown, most recently with the banking crises, a system of fewer, larger firms is less robust than one consisting of more and diverse entities. User fees would make the investment advisory industry more fragile, less robust.
User fees also present a potential conflict of interest for the regulators. If regulators find evidence sufficient to prevent a firm from further operations, proceeding in the best interest of the public will cause them to reduce their own budget. Regulators could face the prospect of sanctioning the very firms that pay their salaries. This seems like a terrible burden to place on the SEC employees. In the investment industry, current laws and regulations bestow fiduciary status (and responsibility) on those advisors who align their interests with the investing public. I suggest the same should be true of regulators. Regulators are to serve the public, and thus should be paid by them. For regulators to be paid by a third party, the one they are tasked with monitoring, is not in the best interest of the public.
Russ Wood


The experiment continues. I read a random tweet.

Wednesday, August 20, 2014

Daily Twitter Reading

Here's a neat feature I am trying out. I record my reading of a random tweet.

Wednesday, August 6, 2014

Apple Pie

Rotary Wednesday means desert.
For me, that means pie.

Thinking it Real

Broadly speaking, I think inflation is an easy concept. I presume most people have a basic understanding of the potential for prices to change over time due to a decline in the value of the currency. The mechanism, the measurement, the theory can be quite complex, but I think most understand there is a difference between nominal value and real value.

Part of the challenge is to monitor the divergences in a timely manner, as they are best seen through long swaths of historical data. We don't think in real terms on a daily basis.

The financial media was buzzing about the record highs for the stock markets throughout the month of July. Even the Federal Reserve Chairwoman took notice. There seems to be a general sense that stocks have risen significantly and the bull market is long in the tooth.

Only in nominal terms.  If you can think it real, you know the market hasn't done much.

Consider this chart (click for a more real image).

The chart shows an inflation adjusted history of the S&P500 since 2007. In this case, the inflation measure is the price of gold, so the chart shows the price of one share of the S&P500 priced not in dollars but in ounces of gold.  The far left shows the large decline during the great recession. Then from 2009-2012 the stock market was flat in real terms. There has been a nice recovery since early 2013 when the Fed signaled the end of their QE programs, but stocks remain well below levels at the start of the 2007 recession. The bull market many see as getting old and tired, in real terms, has only begun. A longer term chart shows stock values are quite low in real terms, relative to the 1990s, 2000s, and 1960s (not shown).

Thursday, July 31, 2014

When the Bough Breaks

At the mid point of 2014, it is looking like another good year for investors. Every major asset class has positive returns year to date.  In fact, the U.S. stock market indexes have posted gains for five consecutive years and now sit at all time highs. Given the slow, tepid pace of economic growth, the stock market appreciation seems excessive to some. Many market pundits (and investors) are asking “should I continue to invest money at these high levels?” It is a reasonable question, one we’ll discuss shortly, but not the most important one. Of greater importance for investors, at all times and under all market conditions, is to have an answer to the question “what will I do if the market declines?” How should one prepare for when the bough breaks?

Investors who stress over current market highs are echoing the research of Professor and now Nobel Laureate Robert Shiller. His findings can be paraphrased as stock markets have a normal range, and when prices get beyond that normal range, investors should be cautious (i.e. stay out of stocks).  Today, the valuation metric attributed to Dr. Shiller is quite high, indicating markets are overvalued and investor exposure should be low or nil. Ironically, the same day Dr. Shiller earned the Nobel prize, it was also awarded to Dr. Eugene Fama. Fama is famous, and earned his Nobel prize, for the idea markets are efficient. Fama teaches us there is little or no value gained from Shiller’s warning, as everyone knows the state of the market and one cannot benefit from it. In fact, Fama is correct, at least on the point that Shiller’s warnings are of little practical use. Stock markets have been “expensive” many times in history, and they often remain in that condition for months or years. Historically, concerns over valuation offer no predictable value as a signal for exiting the market. (As an aside, even if valuation gave a great tip on when to sell, it would be of zero value without an equally predictable signal on when to buy back in.)  Investors who follow a valuation sell signal such as Dr. Shiller’s, might take comfort in the fact they avoided losses by selling. However, this is a hollow victory as one can always avoid losses by not investing, regardless of the market valuation. Anyone who chooses to invest, and identifies themselves as an investor, does not have this opportunity. What remains is to prepare one’s portfolio for the inevitable downswings regardless of their cause or the market valuation when they occur.

Robust portfolios are those which can withstand not only the instances of high valuations but more importantly the inevitable surprises such as terror attacks or  tsunamis.  In general terms, one might build robustness with two simple components: portfolio construction and tactical rebalancing. Neither of these can promise to avoid losses, but they offer the potential of a prudent level of risk management.

Portfolio construction is a complex process but for purposes of this discussion, consider the importance of multi-layered diversification. The first layer consists of being diversified among the major asset classes such as stocks, bonds, real estate, etc. If one is concerned that a particular asset class is overpriced, exposure to the other asset classes is a form of risk management. Interestingly, in today’s environment stocks do appear expensive by some measures, but so do bonds. In fact, one of our valuation tools indicates U.S. stocks are in the top 20% most expensive valuations since 1950, while bonds are in the top 5% most expensive valuations. In short, the typical safe haven for investors selling stocks due to valuation concerns carries even more valuation risk than stocks. In situations like this, the second level of diversification, diversification among investment styles within an asset class, is vital. Within an asset class, there are ways to reduce risk while remaining invested. Consider two such styles within equities. One approach involves maintaining exposure to stocks but managing the risk via the use of hedges. Options, futures, and short-selling are all techniques used by some managers to limit the downside risk of holding equities when prices seem extended. These risk management techniques come at a cost, but that cost may be preferable to the possibility of a sharp market downturn. A second approach involves active management based on valuation. Here, Shiller and Fama tend to agree. Market valuations are generally calculated on stock indexes. Yet even when indexes are hitting new highs and valuations seem rich, this is not true of every stock. Some managers adhere to a strict valuation style, which invests only in the stocks below certain valuation metrics. Of course, these active decisions come at the cost of potential underperformance to their benchmark, but they can offer some level of risk reduction for an investor concerned about high prices. A truly diversified portfolio will have access to various risk management styles as well as index exposure for every major asset class.

Portfolio rebalancing is also part of a simple approach to risk reduction. Strategic rebalancing refers to a regular process of selling assets which have appreciated and now comprise too large a share of the portfolio combined with purchasing assets which have declined and now comprise too small a share of the portfolio. This is a traditional buy low, sell high technique used broadly in the industry. Tactical rebalancing involves similar buying and selling on a more dynamic timeframe in response to valuations, policy changes, or other macroeconomic variables. For an investor concerned with stock valuations, tactical rebalancing might help reduce risk. Consider a simple portfolio where the allocation to stocks was invested 100% in index funds. When valuation measures become alarming the investor might reallocate the equities one-third to index funds, one-third to hedged strategies, and one-third to value style managers. The investor addresses his concerns about valuation risk without rebalancing to bonds (with higher valuations) or going to all cash (and ceasing to be an investor). 

Saturday, July 26, 2014

Review: Battery Sticks

In the course of attending charity dinners, you often collect small tokens. Most of mine are given straight to my young children and never used as intended. However, this year the hot new swag is portable battery sticks. These devices are small, yet powerful, and usually able to fully or nearly fully recharge a typical cell phone. I have two.

The first looks like this:

I had this one with me during my trip to Vegas for the WSOP. When Carlos final tabled one of the Aria daily tournaments, we were on the rail for twelve hours. My Galaxy S3 didn't last that long on one charge, given all the texting and tweetng of his updates. But this stick, which is small enough to fit in your pocket (it is the size of a classic Bic cigarette lighter), helped me get through the event. It easily plugged into my phone and restored an almost full charge. It will typically fully charge my phone if I charge while the phone is off or idle. It will provide mostly a full charge when I charge while using the phone.

My other charger, also a charity dinner gift, is more versatile.

This version charges faster, and has a greater capacity. We put it to work on the beach during a recent vacation. With the wife's iphone 4s synched to a bluetooth speaker, we were the annoying Americans playing our music on the beach (actually, we were quite discreet). When the phone dropped below 10%, we connected to this charger. We continued to play the music and run bluetooth, and the device provided a full charge. This has a larger shape, kind of like a small cell phone itself, but it is very light and thin. 

If you depend on your phone for just about everything when you travel, a cheap, portable batter stick is a great addition to your travel gear.

Tuesday, July 8, 2014

The Hockey Stick of Human Prosperity

As a follow up to this post, here's more on Adam Smith and the wealth of nations. No mention of energy independence here, just specialization and comparative advantage.

Friday, July 4, 2014

A New Declaration of Independence?

Happy Independence Day!

Last week, in anticipation of Independence Day, the local paper printed this letter from a local educator. The letter reflects on the original Declaration of Independence and argues America today needs a declaration of energy independence. This, of course, is nonsense. Everything great about America flows from our openness to trade. It engages us with other people and cultures. It is directly linked to individual freedom, and it has made our nation tremendously rich. A movement to become energy independent would be a disaster for our liberty and our economy. Or so I tried to argue in this letter (so far, unpublished) called "Energy Independence Isn't Free":

Dear Editor,
Wednesday's MDJ included an impassioned plea from a life-long public servant for a new Declaration of Energy Independence. Retired Cobb elementary school teacher and Army Lieutenant Colonel Bob Lanzotti joins a long line of liberal environmentalists and conservative protectionists calling for America to return to the economic malaise of the 18th century.
Ironically, the American Declaration of Independence referenced by LTC Lanzotti was written the same year Adam Smith published his economic masterpiece, An Inquiry Into the Nature and Causes of the Wealth of Nations. Smith's fundamental insight was in regard to what separated wealthy and poor nations. Those nations which shunned imports and exports and tried to be "independent' were invariably the poorest. As economists have verified time and again over the following 238 years, self-sufficiency is a road to poverty, not prosperity. 
Luckily for us, America followed Smith's advice. Today the U.S. is the wealthiest nation on earth, yet remains dependent on others for many crucial goods and services. We are dependent on other nations, which are often controlled by bad people, for coffee, cocoa, televisions, and tee-shirts, to name a few. There is nothing special or important about our reliance on others for energy commodities, it is merely a result of our comparative advantage in other areas. If America were to dedicate more people and resources toward energy production, it would leave less available for our current endeavors. Diverting resources from the highly valuable areas of technology, pharmaceuticals, and finance to employ them in the relatively low value areas of energy production would reduce American wealth and competitiveness. (Wise parents encourage their children to be graphic designers and biochemists, not oil rig operators.)
LTC Lanzotti is concerned our dependence on foreign oil has lead us into a long war on terror with Arabs, but several facts cast doubt on his thesis. First, America's largest suppliers of foreign oil are Canada and Mexico. Second, China is much more dependent than America on foreign oil, and much of China's oil is supplied by the Middle East. Yet, the decade long war on terror is an American creation, with China a mere spectator. This suggests the war on terror LTC Lanzotti laments is more a result of poor American political leadership than the fact we import some energy from the Middle East.
LTC Lanzotti has served our nation as an Army officer and our community as an educator. We owe him much. I'd like to suggest he wander across the halls of Kennesaw State where he's an adjunct professor to the offices of J.C. Bradbury or any of the fine economics professors on that campus. I'm confident the time it takes to consume a cup of coffee would be sufficient to convince the colonel of the silliness of energy independence.
Russ Wood
Powder Springs, GA