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If you buy a bond from, say, General Motors (GM), you are lending them money for a set interest rate for a specified length of time. You face two sets of risks in doing so. The first is that they go bankrupt and don't pay you back. The second is that interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw). With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up. This is just like how a Life Insurance company has to have enough cash on had to pay off on your policy in case you die. However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas. In that case, if GM did go belly up, you would just plain be out of luck. In the case of life insurance, there are strict limits on who can take out a policy on you. You can take out a policy on your own life, and on close family members. In some circumstances you can take out a policy on your business partner, but beyond that there are not many people you can take out a policy on. You have to have what is called an insurable interest; you can't just wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them. This is not true for the CDS market. You are perfectly free to take out a "life insurance policy" on GM, GE (GE) or any other firm that issues a bond, and you do not have to be holding the bond. You can even take out a "life insurance policy" on the synthetic garbage the Wall Street has been pumping out. This ability to buy insurance on things that you have no insurable interest in transformed this market into a huge casino. It is totally unregulated, and even the new steps by the New York State Insurance Commissioner, Eric Dinnallo, only covers the least egregious part of the market, where people actually have an insurable interest (i.e. hold the underlying bond). Regulation of this market was specifically prohibited under the Commodity Futures Modernization Act of 2001. That provision was slipped into the bill in the dead of night by our old friend Senator Phil Gramm of Texas -- now Vice Chairman of UBS. People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit. For example (NOTE: figures are made up here, not a reflection of the actual creditworthiness of GE), the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GE defaults sometime in the next five years. Then after a few months, GE raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GE will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GE survives or not. However, suppose that the person who they made the bet with goes bankrupt themselves and can't pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of "cascading cross defaults" comes in. All this is to say that the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 trillion, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system. When the dust settles from all the current mess, bringing this market under control has to be high on the agenda. I would suggest that the contracts be standardized and that they be traded on an exchange, where the exchange itself acts as the counter-party for each trade (this is how the commodity exchanges work). It might also make sense to require that any party buying a CDS have an insurable interest in the underlying bond (i.e. that they are using it to hedge, not speculate). This however, is work for the next Congress and Administration. First we have to put out the fire with a well crafted and responsible bailout bill to prevent these cascading cross defaults from occurring. The original Paulson proposal was not well crafted, yet Congress doesn't appear likely to make significant improvements to the bill.
With shares of banks, brokerages and insurers soaring in response to government rescue plans, it may look like it. But many fundamental problems remain. While Treasury Secretary Henry Paulson has proposed that the government buy hundreds of billions of dollars’ worth of distressed mortgage securities, many details need to be worked out, notably the price that would be paid for them. As a result, few market watchers are confident that financial stocks have already reached a bottom. “Maybe we are getting closer to a low point,” said Standard & Poor’s chief investment strategist, Sam Stovall. It doesn’t take a genius to see that financial stocks have taken an awful beating. In the recent downturn, measured against the last six major market declines, going back to the late ’60s, financial shares in the Standard & Poor’s 500-stock index registered their worst losses in recent memory. The question is whether the carnage is, for the most part, over. Since the market peaked last October, financial stocks — now the second-largest segment [15%] of the S&P500 — had fallen 49% at their close on Wednesday. That’s worse than the 36% decline for the sector in 1990, in the heart of the savings and loan crisis. That earlier crisis was worse by some other measures, however. Between 1989 and 1991, for example, 1,187 banks and S.& L.’s went under, representing more than $454 billion in assets, according to the FDIC. So far this year, there have been 11 failures of these institutions, representing total assets of around $40 billion. Of course, Washington Mutual is exploring a sale and there are, no doubt, more failures coming. That isn’t an encouraging picture. T. Timothy Ryan, president and chief executive of the Securities Industry and Financial Markets Association, served as director of the Office of Thrift Supervision during the savings and loan cleanup in the early 1990s. He said that despite the bleak headlines, savings institutions “are in much better financial shape” today than they were between 1989 and 1993. But at this point, savings institutions may be the least of the financial sector’s problems. This time around, we’re not dealing just with insured deposits at banks and thrifts, but with a range of financial institutions and credit instruments whose implosion could have serious and unforeseen consequences. The American International Group, which the government last week agreed to bail out for $85 billion, is one of the world’s biggest insurers. A failure of its global web of credit derivatives might have severely damaged many other institutions, which is apparently why the Federal Reserve took emergency action to help prop up an insurance company. Merrill Lynch, which agreed last week to be sold to Bank of America, and Lehman Brothers, which filed for bankruptcy on Monday, are among the nation’s biggest investment banks and brokerages. And it doesn’t stop there. Morgan Stanley is considering a merger with Wachovia or other institutions. For all of these firms there is continuing uncertainty about the value of the mortgage-related instruments in their portfolios, and about the extent of government help that may be forthcoming. If its deal goes through, Merrill will continue to operate as part of Bank of America. And when you take a long view of market history, it’s not unheard of for brokerage firms like Lehman to file for bankruptcy, said James W. Paulsen, chief investment strategist for Wells Capital Management in Minneapolis. He pointed out that Drexel Burnham Lambert, for example, which popularized junk bonds in the 1980s, filed for bankruptcy in 1990. “But you’d swear from listening to the coverage that this was the first time people had ever seen a broker fail,” Mr. Paulsen said. Mr. Stovall added that many past brokerage failures came at or near market bottoms. Drexel filed for bankruptcy on Feb. 13, 1990, and eight months later, the market rebounded from a major downturn. This time around, the circumstances are unusual, to say the least. The catalyst for the rebound for financial stocks has already occurred. It is clearly the promise of a massive government rescue. Yet with the terms of possible further assistance not spelled out, there is no guarantee that the upturn in the stock market will continue. What is more, especially in an election year, there is a real possibility of a reaction against the “moral hazard” that may be implicit in government assistance for institutions that invested recklessly. Little is certain except that more pain is coming for at least some of the financial companies.
The world has changed, and so too must investors, says Jeffrey Applegate, chief investment officer of Citigroup's Global Wealth Management unit. "The primary engines of growth have shifted away from the United States," he says. "Investors need to position themselves to take advantage of global opportunities." For the typical mutual-fund investor, who holds 12% to 15% in foreign stocks -- or half that in a 401(k) -- holding 55% in foreign stocks would seem like a massive overweighting toward overseas markets. But in fact, mirroring the world markets is a neutral position on the markets because it places no bets on either domestic or foreign stocks, says Peter Bernstein, a Wall Street risk expert. Indeed, investors' toe-dipping approach to foreign stocks leaves them more vulnerable to big swings in the value of the U.S. markets, and will likely underperform a world-weighted approach over the long run, Mr. Bernstein says. Why change now? For many investment pros, the logic for loading up on foreign stocks is simple: U.S. stocks aren't as important as they used to be. American stocks represented 66% of the world's market value in 1970 and have been declining bumpily since then, primarily as a result of the growth in emerging markets, according to Russell Investments, which uses Russell and Morgan Stanley Capital International, or MSCI, indexes in its analysis. Foreign stocks surpassed U.S. shares in 2005, based on the number of shares routinely available for trading, according to Dow Jones Indexes, and the Dow Jones Wilshire 5000 Index of U.S. stocks currently represents 43% of the Dow Jones Wilshire Global Total Market Index. Emerging-markets shares total 8.4% of the global index, roughly four times where they stood just four years ago. Still, it's not surprising investors are confused about how much to put into foreign stocks. Stock pros give widely varying recommendations -- usually anywhere from 20% to 40%. Those with lower allocations to overseas shares cite concerns about currency risk, a higher volatility of foreign shares and lax oversight of foreign companies. But supporters of a world market-weighted portfolio argue that these concerns are either not relevant to long-term investors or are remnants of an older economy. Rene Stulz, an economics professor at Ohio State University, says it's fine for small investors with a long time horizon to ignore currency movements. He says worrying about currency risk could prompt individual investors to try to time the currency markets and result in harmful transaction costs as they move money in and out. As for the idea that a foreign portfolio is riskier than a domestic one, "the numbers don't back that up over the long term," says Christopher Davis, a fund analyst at Morningstar. The standard deviation -- in the mutual-fund world, a measure of how much a fund's returns have bounced around its average return over time -- of the total U.S. stock market was 15.4 for the past 10 years, compared with 15.5 for foreign stocks, including those of emerging markets. Of course, that's an average figure, so some foreign markets were indeed more volatile than the U.S. But a diversified portfolio of overseas investments will smooth out that risk, experts say, and present no greater volatility than U.S. stocks. Some pros argue that a diversified portfolio also can ease concerns about lax accounting standards and securities regulation in overseas markets. They think such fears are overblown, but if you spread your money around the overseas sector, your exposure to any such risky situations is limited, Morningstar's Mr. Davis says. And Mr. Stulz of Ohio State University notes that any lax oversight practices are already reflected in stock prices. One final concern is timing. Some experts aren't convinced that investors should move large sums abroad immediately, arguing that the problems plaguing the U.S. -- tight credit conditions, falling home prices and rising unemployment -- have yet to fully play out in overseas economies, meaning more declines could be ahead. David Darst, Morgan Stanley's chief investment officer, notes that matching the world's market capitalization skews a portfolio toward the troubled financial sector and away from health-care stocks, which are a defensive play. "The U.S. market currently has 16% financial stocks, while Europe and emerging markets have 22% to 24%," he says. "We believe that longer term you do want to gradually increase the weighting [in your stock portfolio] to about 40% or more [foreign stocks], but there isn't any rush to buy into these markets, because you still have some rockiness and uncertainty ahead," he says. He wants to see earnings estimates begin to improve and inflationary pressures ease in foreign markets before expanding exposure to them. Of course, any argument to boost overseas allocations would have been easier to sell to performance-chasing investors last year, when foreign stocks were outpacing U.S. shares for the fifth consecutive year. Between Dec. 31, 2002, and Dec. 31, 2007, the average annual return of the Dow Jones Wilshire Emerging Markets Index was 46.5%, and the Dow Jones Wilshire Developed Markets, excluding the U.S., averaged 23.3% a year, in U.S. dollars. By contrast, the Standard & Poor's 500 returned an average annual 12.8%, while the Dow Jones Wilshire 5000 returned 14% a year. The figures include reinvested dividends. For the first eight months of 2008, though, the emerging-markets index was down 22.7%, and the index of developed nations declined 17%, while in the U.S. the S&P 500 index held up somewhat better, returning a negative 11.4%, and the Dow Jones Wilshire 5000 lost 10.3%. Still, if you want to increase your foreign-stock allocation, financial advisers say not to spend too much time worrying about the timing. "This shouldn't be a tactical decision if you're going to hold your portfolio for 10 or 20 years," says Matt McGrath, an investment adviser at Evensky & Katz. By trickling money into a larger foreign-stock allocation, "today is as good a day as any to get in for the long term." What's more, says Citigroup's Mr. Applegate, foreign stocks are likely to outperform domestic stocks in coming years, and emerging markets will be particularly strong. And, strategists note, it's easier than ever to invest overseas. While investors once faced limited and often costly access to foreign markets, most are now easily accessible through mutual funds with modest annual fees. Morningstar recently counted 747 stock funds that invest outside the U.S., compared with 3,213 U.S. stock funds. While the average expense ratio for the foreign funds is slightly higher than domestic ones -- 1.52% compared with 1.36% -- 30% of the foreign funds have expenses equal to or below the domestic group's average. While a global approach makes sense intellectually, there is a huge psychological component that may make some U.S. investors reluctant to commit so much to foreign stocks, says Harold Evensky, a founder of Evensky & Katz. "It's hard to get investors to make big changes -- and there is a natural bias toward investing in companies they hear about in the news, even if they are investing in mutual funds and their risk is diversified." For this reason, Citigroup will keep in place its traditional U.S.-centric asset-allocation model -- 70% in U.S. stocks and 30% in foreign -- as an alternative. "If you agree with our best thinking, the global-centric portfolio is the way to go," Mr. Applegate says. "But getting investors there is going to be a work in progress," and some will choose to stay in their comfort zones and overweight U.S. stocks. The fact is, most investors have so little foreign exposure that they could benefit from beginning to expand it. "They could do a bit at a time, to suit their comfort levels," Mr. Evensky says.
Though share prices are off by about 20% since the market peaked on Oct. 9, 2007, corporate earnings — the “E” in the P/E ratio — have fallen even further. In the first quarter this year, earnings of the S&P500 sank 17.5%, according to Thomson Financial. But the index, excluding dividends, itself declined 9.9%. And in the second quarter, corporate profits declined by an estimated 22% while stock prices fell by a much more modest 3.2%. Christopher N. Orndorff, head of equity strategy at Payden & Rygel, said, “the lack of P/E compression has created a headwind” for stocks. Historically, bull markets emerge from bear markets after stocks sink to attractive levels for investors. Since 1938, the average P/E for the S&P500 at the start of new bull markets has been 13, according to Standard & Poor’s Equity Research. That’s considerably lower than the current level of 24. To be sure, at the start of the most recent bull market, on Oct. 9, 2002, the market’s P/E was a lofty 27. But this was after the tech bubble of the late 1990s, a bubble that distorted valuations altogether. Moreover, a multiple of 27 still represented a deep discount to where the market was trading earlier in the decade. Why does any of this matter? Mr. Orndorff says the P/E ratio shows that the stock market still has serious problems. “I would consider the expansion in P/E’s in the current environment to be another indication that we are still in a bear market,” he said, “and that the current rally is just a bear-market rally rather than a change in direction.” Based purely on the raw data, P/E ratios appear too high to start a new bull market, said James B. Stack, editor of the InvesTech Market Analyst newsletter. But Mr. Stack and others argue that investors also need to weigh several other factors. For starters, he noted that corporate earnings were being distorted by troubles in just one sector: the financials. According to S.& P., earnings for financial companies are expected to drop about 70% this year versus 2007. That accounts for most of the profit drop for the overall market. And just as there has been no drop in P/E’s so far in this bear market, there was no expansion of them in the previous bull market. In fact, from October 2002 to October 2007, the ratio gradually fell, to around 19 from 27. Therefore, valuations might not need to fall as much during this downturn. Also, corporate earnings have been shrinking since last summer. When earnings decline this way, P/E ratios can be volatile — and even misleading, said Duncan W. Richardson, chief equity investment officer at Eaton Vance. The last time profits were in decline — at the beginning of this decade — P/E ratios kept climbing even as stock prices fell during the bear market of 2000 to 2002. Eventually, though, that trend reversed. Jeffrey N. Kleintop, chief market strategist at LPL Financial, also noted that based on “forward earnings” — projected profits, as opposed to actual results — the market P/E is already quite modest. Consensus earnings forecasts from Wall Street analysts for 2009 work out to a forward P/E of around 12 for the S&P500. Of course, Wall Street earnings projections have been way too optimistic in recent quarters, and David A. Rosenberg, the Merrill Lynch economist, thinks that they may still be too rosy. In a recent economic commentary, he says Merrill is expecting S&P500 earnings to continue to decline through 2009. In fact, he says he thinks profits of the S&P index will come in at around $63 a share next year. That’s down from the $68 he is forecasting for this year, and a far cry from the $100 that Wall Street is expecting for 2009. Using his projection, the market’s forward P/E would be nearly 20, not 13. If he’s right about earnings, it may be a while before a new bull can emerge.
The American Association of Individual Investors (AAII) is famous among those who track sentiment for their weekly survey. But they also keep track of several other key data points. Among them is the allocation ratio of their members between cash, bonds and stocks. From the latest data, AAII respondents have said that they have increased their cash positions to almost a third of their portfolio value. This is the highest cash levels since late 2005 and 2002. To raise the cash allocation, retail investors have sold their equity holdings. In comparison to the summer of 2007 when the allocation for equities was almost 70%, today it is just above 50%. To find similar levels we’d have to go back to November 2005, summer of 2002 and May of 2003. Each of those instances were great buy points with a long-term time horizon. But remember, this is as reported by the membership of the AAII. There is no way for them to verify if indeed what their members are reporting about their allocations is true. So let’s take a look at actual fund flow data. According to AMD Data, July’s money market funds reports net cash inflows totaling $44.402 billion! That is a very large amount for one month. Back in April, [there was a] massive exodus from money market funds to the tune of almost $80 billion. Since then the average mutual fund investor has consistently increased their cash position - which would tend to lend credence to the AAII survey results. {But] the market always throws curve-balls to keep things unpredictable and exciting. So remember, retail traders are not always wrong.
There are three basic ways to do this. You can give each biller permission to pull the full amount from your bank account. You can use the online bill system at your bank to push payments out automatically each month. Or you can charge every bill to your credit card and give only that card company permission to pull money from your bank account when the credit card bill is due. Each of these methods has its potential shortcomings, which will become clear as we march through the hiccups that can occur when automating your payments. Errors Some people fear giving companies the ability to draw money from their bank accounts because they worry about mistakes. If a biller takes thousands of dollars more from their account than they should, it could lead to overdraft fees and a huge hassle trying to get the money back. So how often does this happen? Nacha — the Electronic Payments Association, a nonprofit association that oversees the network that automated payments travel on, says the error rate is 38 for every 100,000 bill payments. This figure counts mistakes that banks report but doesn’t include problems that consumers solve directly through the billers. (Nacha once stood for National Automated Clearing House Association; automated bill payments are one of many kinds of A.C.H. transactions.) If an error occurs, according to Elliott C. McEntee, Nacha’s chief executive, the association’s rules, which all banks that deal in A.C.H. payments follow, require banks to automatically credit customer accounts for the mistake. Consumers get the credit as long as they inform the bank of the problem within 15 days of receiving the bank statement with the error on it. People who miss that deadline still have recourse under federal rules, which give consumers 60 days to report the error, but the credit could be provisional at that point until the bank determines who’s responsible for the error. Are customers quickly made whole all of the time? Probably not, because banks may neglect to follow the rules and their customers may not read their bank statements quickly or carefully. But if there’s a problem, go to your bank first and request a credit before you complain to the biller. Mr. McEntee suggests calling your bank rather than talking to a teller, because phone representatives should have scripts that prompt them to issue the credit. If you’re charging every possible bill to your credit card, you’ll have an opportunity to catch the mistakes on the monthly card statement before you pay the bill. Then, you’re vulnerable only to the card company itself pulling the wrong amount of money out of your bank account. Also, you can earn lots of rewards from the card company. Just be sure to pay the bill in full each month, lest interest wipe out the value of the freebies. One other thing to keep in mind: While billers make plenty of errors, consumers probably make even more. People forget to pay, pay late or pay the wrong amount. Part of the point of automation is to protect the mistake-prone from themselves. Service That Won’t End For months after John Wald, now a finance professor at the University of Texas, San Antonio, moved, his local phone company in Pennsylvania kept drawing money out of his bank account, even though he had canceled the service. His bank was able to put a stop to the withdrawals but did not issue any temporary credit for the money that was already gone. It took a year to get the money back from the phone company, and now he steers clear of automated payments. Stopping the automated payment, at least, may be easier if you’ve set it up through your bank’s online bill-paying system. “Rather than authorizing a biller to take money out and losing total control, we give you that control back,” said Mary Beth Lawson, director of product management for CheckFree, a provider of online bill payment systems. Customers sign up on the bank’s Web site, not CheckFree’s. CheckFree sometimes handles customer service for banks, too, and can get the biller on a conference call with a customer to try to resolve refund requests and other mix-ups. Expired Credit Cards One potential problem with using credit cards to pay your bills each month is that they expire. Terry Perkins, an information technology consultant, ran into this problem with Verizon two years ago. She said that she hadn’t noticed the lack of a charge on her credit card statement and that the company hadn’t sent any bill, warning or reminder that it needed the new date until a notice turned up in the mail saying her phone was about to be cut off. “You get this really cold, intemperate letter where you can just infer from it that you must be a dirtbag,” she said. “I finally just said forget it, you guys are never going to have this privilege again, where you have access to my credit card.” Bob Elek, a Verizon spokesman, said he couldn’t comment on Ms. Perkins’ situation but that the company can now get the new expiration date without a customer’s help 90% of the time. Otherwise, the company calls the person’s home and sends e-mail messages to try to get it. Visa and MasterCard have programs that allow participating card companies and merchants to get new expiration dates automatically so they can continue customers’ automatic bill payments. Here’s hoping that becomes standard operating procedure. Until it does, you should put in a round of calls to billers around expiration time to make sure they have the new expiration date. Security Are you risking identity theft or other problems by giving so many companies access to your credit card numbers or bank accounts each month? Bruce Cundiff, director of payments research and consulting for Javelin Strategy and Research, says the nonautomated approach is more problematic. If you’re paying bills one by one each month via your bank’s Web site, you need to worry about whether anyone has installed software on your computer that would capture user names and passwords. And not having paper statements and checks floating around that could be stolen from the mail is a plus as well. Complacency If you’re not careful, automated bill paying can easily lull you into believing that everything is taken care of and no vigilance is needed. Scott Cole, a television editor for CBS, said that his almost daily ritual of checking Quicken and then pushing the button to pay the bills once each month keeps him aware of each payment. It also forces him to think about whether the cost for any particular service has gotten unreasonably high. Mr. McEntee, of Nacha, does have 17 automatic deductions taken from his bank account each month, but he keeps a list of them handy and then checks them off one by one with his bank statement each month. I still think it’s possible to achieve Mr. Cole’s level of awareness while having Mr. McEntee’s volume of automated payments. Keep a cushion of cash in your checking account if at all possible to avoid unexpected overdrafts and jump on any errors if you’re unlucky enough to experience them. In essence, the first principle of the automated payment is this: If you simply set it and forget it, you’ll probably regret it.
Already this year, 21 blue-chip financial companies have cut their payouts by $16.2 billion, a total reduction of more than 20%, according to Standard & Poor’s. That’s up from just five that cut their dividends last year, and only one in 2006. Moreover, as a result of the huge sell-off in the financial sector — which accounts for roughly a quarter of the income thrown off by the S&P500 — dividend-paying stocks have lagged of late. From last Oct. 1 to Aug. 15 this year, dividend-paying stocks in the index lost 13.4%, on average, versus a 12.6% decline for the stocks that didn’t pay dividends. And it doesn’t look as if the situation will change anytime soon. Since mid-March, there has been a major divergence in the market, with growth stocks — shares of companies whose earnings are growing faster than the market as a whole — posting positive returns, and dividend-paying value stocks falling. Still, when it comes to dividends, investors should look at time frames significantly longer than a single year. Historically, dividend income has represented around 40% of the market’s total returns. But in the 1980s, that fell to 28%, according to S&P. And in the 1990s, it shrank to just 16%. But guess what? Since the end of the 1990s, dividends have accounted for all of the market’s gains. In fact, without dividends, you would have lost money by investing in blue-chip stocks, based on the S&P500. Indeed, a $1,000 investment in the index on Dec. 31, 1999, would have fallen in value to $871 by the end of June this year, according to an analysis by T. Rowe Price. That’s why many investors refer to the current period as the “lost decade,” as equity investments have lost ground. But had you reinvested your dividends from that original $1,000, your portfolio would have grown, though ever so slightly, to around $1,005. It shows that dividends provide “defensive protection in adverse market environments,” said Brian C. Rogers, the T. Rowe Price chairman and fund manager. Step back even further, and you begin to appreciate how a steady, consistent dividend stream can gradually grow into a surprisingly large source of gains, even though the yield of the S&P is now a modest 2.2%. “Two percent may not sound like a lot, since stocks can move up or down more than that in a single day without getting written up in the papers,” said Howard Silverblatt, senior index analyst at S&P. But over time, two percentage points make a huge difference. Since 1979, dividend-paying stocks have outperformed nondividend payers by 2.16 percentage points a year, based on total return. Had you invested $10,000 in 1979 in the dividend payers — and reinvested the income along the way — you would have wound up with $406,825 by Aug. 15 this year. That same $10,000 in nondividend paying stocks would have grown to just $243,385 — a difference of more than $163,000. “That’s real money,” Mr. Silverblatt said. A separate analysis by T. Rowe Price showed that over the past 27 years — a period marked by generally falling payouts — reinvested dividends accounted for more than 50% of the gains in the S&P500, thanks to the long-term effects of compounding gains. Of course, this doesn’t solve one problem. Financial stocks represent a disproportionate share of dividend-paying stocks, and you may not want to make a big bet right now on struggling banks and brokers. Yet by focusing on companies that don’t just pay dividends, but consistently increase them, dividend investors can reduce their exposure to this still-volatile sector. The Vanguard Dividend Growth fund, which invests in companies with a history of increasing their dividends and enough cash flow and earnings growth to keep doing so, recently held only 10% of its assets in financials. By comparison, financial shares make up nearly 15% of the market capitalization of the S&P500. Or you might consider a fund that embraces financials — but only those banks and brokers that haven’t cut their payouts. The SPDR S&P Dividend exchange-traded fund, for example, tracks the S.& P. High-Yield Dividend Aristocrats index, which is made up of the 50 highest-yielding stocks that have raised their dividend payouts every year for the past quarter-century. Since the start of July, the fund is up 9%, while the S&P500 is up only 1%. Perhaps it’s an early sign of better days to come for dividend investors.
Individual and professional investors alike struggle with selling. Berkeley finance professor Terrance Odean has found that investors are at least 50% more likely to sell their winners than their losers. Among the money managers surveyed by Cabot Research, a Boston consulting firm, fewer than 30% base their sell decisions on "extensive research." The rest concede they basically sell by the seat of their pants. The longer you've owned a stock and the more you've lost on it, the harder it can be to sell. "Once you start thinking about how much pain a stock has caused you," says Columbia University psychologist Eric Johnson, "that emotion blocks you from thinking about the advantages you could get from selling." You may think you own a stock, but the stock may own you. Then there's the haunting belief that your portfolio is ruled by a version of Murphy's Law: Whatever can go up will go up, but only after you sell it. Cornell University psychologist Thomas Gilovich explains, "People tell themselves, 'If I sell, and it goes up, I know I'll kick myself,' because it's so easy to imagine having hung on to it instead." Over the years, I've heard dozens of fund managers say they made a stock go up just by selling it. Fortunately, there are techniques that can take some of the emotion out of selling at a loss. Use stop-look orders. I am not a fan of stop-loss orders, which automatically sell you out of a stock when it drops below a preset limit -- and tend to fill both your portfolio, and your broker's pocket, with cash. But I do believe in what I call "stop look" orders: Whenever a stock drops, say, 25% below what you paid, automatically review your original top three reasons for buying to see whether they are still valid. That will prevent you from selling without thinking first. Don't go far afield. Minimize your risk of future regret by replacing what you sell with something similar. If, for instance, you want to unload Beazer Homes because you underestimated how risky its inventory was, you could move the proceeds into SPDR S&P Homebuilders ETF or iShares Dow Jones U.S. Home Construction Index Fund. Shop before you drop. Ask yourself: Which stock or fund would I most like to own? Then view your losers as a source of funding to reduce the amount of cash you would otherwise need to raise. "Thinking about possibilities instead of pain," says Prof. Johnson of Columbia, "will make selling a lot easier." (Remember, too, that once you sell, you can deduct up to $3,000 of your losses from your taxable income.) Get over it. Robin Hogarth, a management professor at Pompeu Fabra University in Barcelona, advises changing the log-on for your brokerage account to something like "dumpmylosers." Repeatedly typing such a phrase will soften your resistance to selling. Reprice it. Let's say you bought Citigroup three years ago for 43.50. Divide your original purchase price by 10. Imagining that you paid 4.35 should help you see today's price (around 17) in a new light. If you can't justify why Citigroup is still cheap after quadrupling from what you "paid" for it, you should sell. Follow your sales. Using an online portfolio tracker, monitor the returns of all the stocks you sell after you sell them. Studying the aftermath of your mistakes will enable you to learn which you sold too soon and which too late. You cannot improve what you do not measure.
The Federal Reserve is divided between hawks who worry inflation is getting out of control and doves who fear further weakness in the economy. For the moment, they have reached a tenuous truce, more or less agreeing that the economy's problems are too big to risk raising interest rates right now. But there are still some, at the Fed and elsewhere, who worry that with the federal-funds rate at 2% and the consumer-price index recently clocking in at 5.6%, the "real" target rate is negative. That suggests the Fed is flooding the system with cash and inviting runaway prices. That, in turn, has some still crowing that rates need to rise. But a less-famous tenet of Mr. Friedman's was that the absolute level of interest rates matters less to inflation than the flow of cash in the financial system, notes Northern Trust chief economist Paul Kasriel. On that front, there seems little to fear. Arguably the most important money measure, the monetary base -- all the currency and bank reserves in the system -- was up just 2.1% year over year in July, compared with its long-term average of 6.4%. It remains near a low seen only three times since the Fed started keeping track 40 years ago. Other money gauges are similarly weak. All this could be interpreted to suggest the Fed's policy is too tight. It is doubtful the Fed sees things that way, but it still has little reason to heed calls for higher rates.
With inflation at 6 percent, for example, a dollar of profit that a company will earn a year from now is worth only 94 cents in today’s dollars. But if inflation were just 1 percent, as it was in early 2002, that dollar earned a year from now would be worth 99 cents today. Such differences add up, especially as investors consider a company’s earning power over many years. Put a different way, if other things are equal, the value of a company’s future earnings will be lower to the extent that inflation is higher. That would make the company’s stock less valuable, and if investors went no further in their analysis, stock prices would deserve to decline. But other things are not equal when it comes to stocks and inflation. Over the last eight decades, corporate profits have tended to grow faster when inflation is higher. In such periods, companies have been able to pass along higher costs to their customers. As a result, even though higher inflation leads to a greater discounting of future years’ earnings, those earnings tend to be bigger than they would have been otherwise. The net result is that the current value of a company’s future earnings remains relatively stable in the face of rising inflation. This was the strong conclusion of a study conducted five years ago by John Campbell and Tuomo Vuolteenaho, both economics professors at Harvard at the time. (Mr. Campbell is still at Harvard; Mr. Vuolteenaho is not. Both are now partners at Arrowstreet Capital, a money management firm based in Boston.) Their study, “Inflation Illusion and Stock Prices,” was in the May 2004 issue of the American Economic Review. In an interview, Professor Campbell emphasized that their study does not mean investors are wrong to worry about developments like high oil prices, which may be damaging the economy in specific ways while also contributing to inflation. But, he said, “inflation should not be an additional source of concern above and beyond those other developments.” Of course, investors suffering from money illusion could knock down stock prices further than they deserve to be. Historically, this has sometimes occurred as inflation has begun to heat up, as investors extrapolate too low a growth rate for corporate profits into the future. One of the best-known illustrations occurred during the high-inflation 1970s. For the 10 years through 1979, the Standard & Poor’s 500-stock index had an annualized gain of just 1.6 percent, a far cry from the historical average of close to 10%. That dismal performance helped to lower the index’s price-to-earnings ratio to a low of 6.8 by the end of that decade, according to data from Robert J. Shiller, the Yale finance professor. The comparable ratio today is around 20. Franco Modigliani, who in the late 1970s was a finance professor at the Massachusetts Institute of Technology, realized that money illusion was a major factor in the market’s dismal performance in that decade. In a 1979 article written with Richard A. Cohn, then also an M.I.T. professor, he argued that stocks, in fact, were a good long-term hedge against inflation and that the stock market was therefore significantly undervalued. The strong bull market of the 1980s and 1990s vindicated their argument, and in 1985 Professor Modigliani was the Nobel laureate in economics. (Both men are now deceased.) There’s no way to know, of course, whether investors will make the same mistake in the next few years as they did in the 1970s, pushing stock prices down to unjustifiably low levels. But even if they did, it doesn’t necessarily mean stocks deserve to be cheaper when inflation is high. As Clifford S. Asness, managing principal at AQR Capital Management, a hedge fund firm, put it in an e-mail message, “It is a strange leap to observe that investors consistently make an error, and then recommend that error to current investors based on precedent.” In any case, if inflation keeps heating up and investors fall victim to money illusion, stocks may well decline for a while. But if history is any guide, such weakness would signal an excellent long-term buying opportunity.
Asset allocation — or how much you invest in stocks versus bonds — is probably the biggest determinant of the risk and returns you can expect from your portfolio. But in just 10 months, a declining stock market may have already undone some of your plans. How so? If you started with a portfolio that was 60 percent stocks and 40 percent bonds at the market peak last October, chances are that it’s now closer to a 50-50 mix, as stocks have sunk and bonds have risen. Depending on your age, this mix may be far too conservative to meet your long-term needs — that is, unless you rebalance. But be careful. Although rebalancing seems a simple concept — periodically booking some profits in assets that are up in order to replenish your stake in those that are down — it’s far more complicated in practice. If you rebalanced right now, for example, you might sell some shares of a bond fund while picking up a few more shares of a broad market stock portfolio, like the Vanguard 500 Index fund, which tracks the Standard & Poor’s 500-stock index. Well, thanks to several years of market-beating gains, energy stocks now make up 14 percent of the S&P500, up from 6% in 2000. This means that by rebalancing back into equity funds, you’ll probably be adding to an already disproportionate weighting in a frothy sector. Such issues are rarely considered, financial planners say, because few investors rebalance regularly. When times are good, investors neglect doing so because it means having to sell stocks that are soaring — and who likes to sell a winner? And when times are bad, rebalancing means having the courage to buy stocks as prices are tumbling, which few investors are willing to do. But with the market off about 17% from its recent peak, despite Friday’s rally, now is a great time to think about rebalancing. Following are a few suggestions: Rebalance Within Your Stocks “Rebalancing isn’t just about your stocks versus your bonds,” said James A. Shambo, a financial planner in Colorado Springs. “It’s also about your small stocks versus your midcap stocks versus your large-cap stocks.” And, for that matter, it’s also about your domestic stocks versus your international ones. Say you put 10% of your equity portfolio into volatile emerging-market shares at the start of 2005. If you failed to rebalance for the next three years, you would have entered 2008 with more than 17 percent of your money in places like China and India — just in time to see those markets tank. Since the start of this year, the Indian stock market has fallen 34%, in dollar terms, while the Chinese market is off more than 29 percent, also in dollars. Set the Triggers Many investors adjust their holdings once a year, on a specific date like June 30 or Dec. 31. But if you wait until an arbitrary date to rebalance, sizable gains or losses in your portfolio may have already self-corrected. Consider the October 1987 market crash, when the Dow Jones industrial average lost more than 22% in a single day. If you waited until the midway point of the next year to adjust your portfolio, you would have waited too long: The Dow recovered all but about 100 points of its losses by June 30, 1988. A better strategy is to rebalance whenever your underlying allocations shift by a certain amount — say, 5 percent. If you think your appropriate exposure to stocks is 70%, but your stock weighting falls to, say, 65%, consider rebalancing. Use Common Sense Be realistic when it comes to rebalancing, said Ronald W. Rogé, a financial planner in Bohemia, N.Y. If you have a small portfolio and rebalancing means selling or buying slivers in positions of $5,000 or less, “then it might not make sense to rebalance too frequently,” Mr. Rogé said. Why not? “Because the transaction fees might erode such a sizable percentage of your portfolio, it would defeat the purpose of rebalancing,” he said. If you owned $5,000 in small-cap stocks and that position shifted 5%, you might incur $25 in commissions and taxes to sell just $250 worth of shares. Don't Drown in Company Stock Over the last five years, the weighting of the typical 401(k) investor in his employer’s stock has fallen to around 15 percent from 25 percent. Does this mean it’s time to rebalance into more shares of your own company? Absolutely not, said Mike Scarborough, president of Scarborough Capital Management, a 401(k) investment advisory firm in Annapolis, Md. Even though the allocation has been dropping, 15% is still too big a stake to own in a single company — especially when it’s your own employer. “If they’re rebalancing toward more company stock, that would bring me to tears,” he said. “If anything, I would hope they would rebalance away from it even more.” If you don’t agree, Mr. Scarborough says, you need only ask employees at companies like Bear Stearns or Enron who tied the bulk of their retirement security to company shares.
First, consider the technical evidence. Compared with the initial rallies after previous bear-market bottoms, the rally that began in mid-July has been disturbingly weak. In fact, during the first days of the climb, a relatively large number of stocks actually fell. That has led many analysts to conclude that the upward trend is likely to fizzle. Take note of one particular indicator — based on the proportion of shares trading on the New York Stock Exchange that rise in price in a given session. If July 15 were the bear-market low, according to many technical analysts, there should have been at least one trading session in the subsequent rally in which at least 90% of total trading volume was from shares rising in price. Martin Zweig, president of Zweig-DiMenna Associates, a hedge fund firm in New York, calls such days “9-to-1 up days.” In his 1986 book, “Winning on Wall Street,” Mr. Zweig wrote that “every bull market in history, and many good intermediate advances, have been launched with a buying stampede that included one or more 9-to-1 up days.” The market’s rally over the last three weeks hasn’t satisfied this precondition. This may seem surprising, because there have been three days — July 16, 17 and 29 — when the Dow Jones industrial average has risen by well more than 200 points. But the volume of rising shares on the Big Board never exceeded 82% on any of those days; on one of the three, July 17, it reached just 71%. Now consider the stock market’s fundamental foundation: stocks are still not cheap, at least in relation to corporate earnings. On the contrary, the market remains more expensive than it has been at most other times in recent decades. This is well illustrated by the price-to-earnings ratio for stocks in the Standard & Poor’s 500 index. It is now at 20.0 when calculated on the basis of trailing 12-month earnings, according to Clifford S. Asness, managing principal at AQR Capital Management, a hedge fund firm in Greenwich, Conn.; that is higher than 73% of the readings dating back to 1965. To be sure, corporate earnings are typically depressed during bear markets, thus inflating the P/E ratio. But even when taking this tendency into account, the market’s current ratio is well above historical norms. This is demonstrated by the ratio of price to an average of inflation-adjusted earnings over the trailing 10-year period. Such a metric was proposed more than a decade ago by Robert J. Shiller, the Yale economics and finance professor, and John Y. Campbell, the Harvard economics professor, in part to sidestep the complexities caused by artificially high P/E ratios at bear-market bottoms. Using that 10-year measure for the S&P500, the ratio is now 21.8, or higher than 66 percent of comparable readings back to 1965, Mr. Asness said. Clearly, stocks are not as overvalued today as they were in early 2000, just before the Internet bubble burst and the bear market of 2000 to 2002 began. Nevertheless, the market remains far closer to the expensive than to the cheap end of the valuation spectrum. Investor sentiment is the one arena that provides strong support for a new bull market. Investment advisers are now more pessimistic than they have been since early 1995, according to Michael Burke and John Gray, editors of Investors Intelligence, a newsletter based in Larchmont, N.Y. This is an encouraging sign, they wrote to subscribers in late July, because market bottoms are typically accompanied by exceptionally high levels of despair. Sentiment alone, however, is not a strong foundation for a bull market. History suggests that when this bear market hits bottom — whenever that may be — stocks will have more attractive valuations and the subsequent market rally will be broader than the recent surge.
Except in bad times, selling is a topic that long-term investors rarely consider. In fact, classic buy-and-hold investing calls for investors not to sell stocks now, but rather to add to their distressed holdings in a process called rebalancing. By booking some gains in, say, your bonds and commodity-related investments, and using the money to buy more beaten-down stocks, you’ll make sure that you sell high and buy low. If you don’t think you have the intestinal fortitude to buy more stocks now, you may need to reassess your risk tolerance, financial planners say. You may come to realize that your appetite for risk has changed since the end of the last bear market, more than five years ago. Or maybe you have never factored in certain market risks — like the possibility that major financial institutions like Fannie Mae or Freddie Mac might one day find themselves in need of government assistance. Be aware, though, that you are taking a risk by being out of the market. Measured by overall price movements, the S&P500 barely budged from 1966 to 1982. But within that 17-year span, there were nine separate bull and bear markets, according to S.& P. Each lasted roughly a year or two. Because these market cycles can be rather brief, you can miss out on most of the gains if you’re out of stocks and holding cash for the first few months of each new bull cycle. This doesn’t mean you should never sell. Russel Kinnel, director of mutual fund research at Morningstar, said, “It always makes sense to continually monitor your investments and make sure they’re still good ones.” You might decide that it’s time to sell specific stocks or funds because they’ve underperformed their intended goals for a long period, not because you want to be out of the market. How can you tell if it’s time to sell? In some instances, the decision is straightforward. For example, if you bought a mutual fund precisely because you wanted something in your portfolio to perform well in difficult times — and your fund simply hasn’t kept pace with its peers over the last decade —you may want to reconsider. On the other hand, if you bought an investment as a core long-term holding for the next 20 years, there are a few questions to ask. If you hold individual stocks, have the underlying reasons for buying them changed? “What makes a stock worth something is its projected earnings growth — which gets reflected ultimately in its price — and its dividend stream,” said Sam Stovall, S.& P.’s chief investment strategist. If your expectations about the profits or dividends of a company have changed drastically, it may be time to reassess. If you’re a mutual fund investor, ask yourself how your funds have performed over the long term — and specifically against their peers. For example, over the past three years, the Vanguard Value Index fund has gained a paltry 1.9% a year. Time to sell? Probably not. When you consider that the average large-cap value fund has returned just 1.3% a year, Vanguard Value Index’s performance looks relatively good. Moreover, don’t look only at a fund’s 5- or 10-year performance figures. Sometimes, those numbers mask what’s really going on. Consider the Oakmark fund. In the last five-year period, this fund finished in the bottom 17% of its large-cap peers. But most of its bad numbers were attributable to a terrible 2007, when the fund trailed the S&P500 by more than nine percentage points. In four of the previous six calendar years, the fund outperformed the S.& P. You have to allow managers, especially those with great long-term track records, a chance to make up for a few bad years. If you’re on the fence about a losing investment, it may make sense to err on the side of selling — that is, when it comes to your taxable investments. By selling and booking a capital loss, you’ll make sure that the federal government shares in your pain. Whatever path you take, look to the future, not the past, Mr. Kinnel said: “You have to recognize that as bad as the past 10 years have been, you need to build a plan for the next 10 and 20 years — not one based on things you wished you would have owned in the prior decade.” How Fund Categories Fared WSJ 7-02-2008
A new study builds on this research by applying a sensitive statistical test borrowed from outside the investment world. It comes to a rather sad conclusion: There was once a small number of fund managers with genuine market-beating abilities, as judged by having past performance so good that their records could not be attributed to luck alone. But virtually none remain today. Index funds are the only rational alternative for almost all mutual fund investors, according to the study’s findings. The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas” [by Laurent Barras, a visiting researcher at Imperial College’s Tanaka Business School in London; Olivier Scaillet, a professor of financial econometrics at the University of Geneva and the Swiss Finance Institute; and Russ Wermers, a finance professor at the University of Maryland] uses a statistical test known as the “False Discovery Rate”. It used in fields as diverse as computational biology and astronomy. In effect, the method is designed to simultaneously avoid false positives and false negatives — in other words, conclusions that something is statistically significant when it is entirely random, and the reverse. Both of those problems have plagued previous studies of mutual funds, Professor Wermers said. The researchers applied the method to a database of actively managed domestic equity mutual funds from the beginning of 1975 through 2006. To ensure that their results were not biased by excluding funds that have gone out of business over the years, they included both active and defunct funds. They excluded any fund with less than five years of performance history. All told, the database contained almost 2,100 funds. The researchers found a marked decline over the last two decades in the number of fund managers able to pass the False Discovery Rate test. If they had focused only on managers running funds in 1990 and their records through that year, for example, the researchers would have concluded that 14.4% of managers had genuine stock-picking ability. But when analyzing their entire fund sample, with records through 2006, this proportion was just 0.6% — statistically indistinguishable from zero, according to the researchers. This doesn’t mean that no mutual funds have beaten the market in recent years, Professor Wermers said. Some have done so repeatedly over periods as short as a year or two. But, he added, “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives” — just lucky, in other words. Professor Wermers says he was surprised by how rare stock-picking skill has become. He had “generally been positive about the existence of fund manager ability,” he said, but these new results have been a “real shocker.” Why the decline? One is high fees and expenses. The researchers’ tests found that, on a pre-expense basis, 9.6% of mutual fund managers in 2006 showed genuine market-beating ability — far higher than the 0.6% after expenses were taken into account. This suggests that one in 10 managers may still have market-beating ability. It’s just that they can’t come out ahead after all their funds’ fees and expenses are paid. Another possible factor is that many skilled managers have gone to the hedge fund world. Yet a third potential reason is that the market has become more efficient, so it’s harder to identify undervalued or overvalued stocks. Whatever the causes, the investment implications of the study are the same: buy and hold an index fund benchmarked to the broad stock market. Professor Wermers says his advice has evolved significantly as a result of this study. Until now, he says, he wouldn’t have tried to discourage a sophisticated investor from trying to pick a mutual fund that would outperform the market. Now, he says, “it seems almost hopeless.”
Most individual investors don’t invest all their money in stocks. They put a portion of it into bonds, in part to stabilize their portfolios in a market storm. This old-fashioned diversification has demonstrated its value. From the start of October 2007 — around the peak of the domestic stock market — to the end of June, a portfolio of 70% stocks and 30% bonds fell just 9%, according to the research firm Morningstar. The stock portion mirrored the Standard & Poor’s 500-stock index, while the domestic bond allocation was based on the Lehman Brothers Aggregate Bond index. You would have fared even better if you had been gradually putting money into the stock market, a strategy known as dollar-cost averaging. In a falling market, this offers another form of ballast: it means that investors are buying new shares at ever-lower prices, thereby averaging out the returns they earn on each pot of new money. “Times like these should remind people of the importance of the basics — like having a long-term asset-allocation strategy,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. Investors might also want to remind themselves of the following three basic rules: Don't Panic Downturns like this one may be painful, but “they’re a normal part of the market,” Mr. Ritter said. Generally, the market has experienced a 20%-plus pullback every five years or so since 1900, according to James B. Stack, editor of the InvesTech Market Analyst newsletter. Some market strategists, including Ms. Sonders, say they think this downturn won’t be as severe as the bear market of March 2000 to October 2002, which cut the Standard & Poor’s 500 in half and erased nearly 80% of the value of the Nasdaq index. That bear was marked by sky-high stock valuations amid weak corporate fundamentals. This time around, corporate balance sheets — with the exception of financial companies — are in decent shape and price-to-earnings ratios are generally in line with historical standards, Ms. Sonders said. “So I don’t think we’re necessarily going to suffer the same type of market pain as the last time,” she said. Stay Properly Diversified This means not only owning different types of stocks, but also committing a permanent portion of your portfolio to fixed-income investments. Why? Bonds can be a remarkably valuable part of a portfolio when stock prices decline. Peng Chen, president and chief investment officer of the investment advisory firm Ibbotson Associates, recently studied the diversification benefits of various assets under different market conditions. He found that when domestic stocks went south, there was a tendency for many other investments to follow suit. In a recent article in the journal of the CFA Society of the United Kingdom, “Re-evaluating Asset Allocation in a One-Basket World,” he found that correlations between the S&P500 and foreign stocks increased in periods when the American index declined. By contrast, the correlation between American bonds and stocks fell to virtually zero in months when the stock market declined, according to Ibbotson. That makes bonds, as an asset class, an extremely effective buffer when the stock market is shaky. Stay the Course “Sticking to the original plan is the best course of action,” said Alison Borland, the defined-contribution consulting practice leader for Hewitt Associates. History certainly bears this out. Say you were dollar-cost averaging $1,000 a month — with 70 percent going into S&P500 stocks and 30% into a diversified basket of bonds — during the bear market from 2000 to 2002. While the market slide reduced the value of the stocks around 50%, the value of the new investments you made during that period would have fallen about 14% during this stretch, according to Morningstar. Moreover, by continuing to invest through the bad times, investors set themselves up to bask in the long bull market that started in October 2002.
The challenge for individual investors is in deciding how to go about adding commodity investments to their portfolios. Whereas just a few years ago, they had few choices, there are now about 160 commodity funds in Morningstar's database. The difficulty is choosing from among the many options, especially considering the volatile nature of these investments and the wide differences in fund strategies and performance. In the past 18 months, more than two dozen commodity ETFs have opened for business, and nearly three dozen of their cousins, known as exchange-traded notes, have hit the market, each with its own twist on tracking commodities. Traditional natural-resources mutual funds also have expanded in number, with more than a dozen launched since the start of 2007, according to Morningstar. But having more choices means more homework for investors. Mutual funds run by stock pickers can have very different strategies, while the indexes tracked by ETFs and ETNs can have vastly different exposures to different commodities, most notably energy. That can lead to very wide differences in performance. For example, the iShares S&P GSCI Commodity Indexed Trust, an ETF, was up 73.7% for the 12 months through June 30, compared with a 17.8% gain for Putnam Global Natural Resources Fund, which invests in the stocks of commodity producers. When considering adding commodities to a portfolio, the first thing investors salivating over the past year's double-digit returns need to remember is that commodities often have exceptionally wide price swings. Wheat prices, for example, more than doubled between last summer and this past spring, and then slid 40% before bouncing back 15% since late May. For those who can't sleep at night knowing a slice of their portfolio is down 20% or more, commodities may not be the best investment. In addition, now could be an especially risky time to put money to work in commodities. After huge rallies, driven at least partly by booming demand for raw materials from China and other fast-developing economies, some argue that prices -- especially on energy -- are due for a fall. Others say that the commodity boom is being driven by speculation and not real demand, raising the potential for a sharp drop in prices, as well as drawing scrutiny from Congress and regulators. "On a stand-alone basis, commodities are a pretty risky asset class," says Thomas Idzorek, director of research at asset-allocation specialists Ibbotson Associates. But as part of a broader portfolio, the benefit is that "they're not moving up and down at the same time as your other investments." A decision about how much of a portfolio to put in commodities depends on whether there are other investments in the portfolio aimed at hedging against inflation, such as Treasury Inflation-Protected Securities or real estate -- which, despite the current market, usually performs well in times of inflation. "An investor shouldn't be afraid of a 3% allocation to commodities - and on a more aggressive side, they may want to take that allocation up to 10%," says Mr. Idzorek. Until just a few years ago, investors wanting to add commodities to their mix had few choices. For many, the commodities futures markets weren't an option. And by law, mutual funds are prohibited from directly owning commodities. The only viable option for most investors was a mutual fund investing in the stocks of companies in the commodities business, such as oil producers or miners. While that provides some diversification to a portfolio, the results aren't nearly as meaningful as a direct investment in commodities, because the stocks may rise and fall more in step with the broad stock market than with commodities prices. Funds focused on a broad range of natural-resources stocks were up, on average, about 19% for the year's first half, according to Morningstar. Crude oil, meanwhile, was up about 46%. Betting on a High Oil Weighting Via ETFs & ETNs For many years, institutional investors such as pension funds and endowments invested in commodities via complex financial derivatives that track prices on a basket of commodities. With the advent of ETFs and ETNs, this approach has become accessible to the smaller investor. The key is to understand the indexes the funds are designed to track. One of the most widely followed commodity indexes is the Standard & Poor's GSCI index. Created by Goldman Sachs in 1991, it tracks 24 commodities, such as copper, wheat and cattle. The weightings of commodities within the index are based on the dollar value of their production around the globe. Over time, that has led to a greater weighting of energy, which today comprises 78% of the index. An additional 12% is in agriculture products such as wheat, 6% is in industrial metals, such as copper, and the rest is in livestock and precious metals. Critics say that investors putting money in a fund that tracks the S&P GSCI are basically making a bet on oil. The index's fans say that the big weighting in energy is simply an accurate reflection of the world's commodity markets, and that given the impact energy costs have on the economy, it makes the perfect offset in a portfolio. They point to the events of this year: As energy prices have soared, fueling a 41.4% advance in the S&P GSCI, stocks have fallen. Should energy prices fall sharply, the GSCI would take a big hit, but stocks likely would enjoy a substantial rebound. David Burkart, portfolio manager at Barclays PLC's Barclays Global Investors unit, says the oil concentration does make the index -- and thus funds like the firm's iShares S&P GSCI Commodity Indexed Trust -- more volatile. But people looking for broad commodity exposure as part of a diversified portfolio "should favor a GSCI-type of approach because that high volatility makes the most out of the low correlation" between commodities and other investments, he says. The iShares ETF had net assets of $1.11 billion as of July 1. A different approach is taken with another widely tracked index, the Dow Jones-AIG Commodity Index. Tracked by Barclays's $3.89 billon iPath Dow Jones-AIG Commodity Index Total Return ETN, it is partly based on the liquidity of the commodity markets -- the more tradable, the bigger a commodity's position -- as well as on levels of global production of 19 different commodities. But unlike the S&P GSCI, there is an annual rebalancing intended to make sure that no group of commodities -- such as energy, which can include natural gas, as well as different crude-oil products -- can make up more than 33% of the index for very long. But over the course of the year, market movements can affect the weightings. Currently, energy is above the cap at 40%, while base metals are at 17% and agriculture at 28%. The DJ-AIG index was up 26% in the first half. Competitors say the caps are arbitrary limits that prevent investors from getting a true representation of commodity markets. But Jamie Farmer, director of global index operations at News Corp.'s Dow Jones unit, says the idea is to provide exposure to a broad array of commodities while avoiding the "excessive influence" of any one component. "We think we strike a good balance," he says. The result is an index that is less volatile than the S&P GSCI and that may be more palatable to conservative investors. As commodity markets have boomed, more firms are creating indexes that can be tracked by exchange-traded products. UBS AG, for example, in April launched its E-Tracs UBS Bloomberg commodities exchange-traded notes, designed to track the performance of indexes created by UBS. The broad UBS index follows an approach that considers the level of production and consumption of commodities, in addition to trading volumes. As of mid-June, it had 33% in energy, while industrial metals and agricultural products each accounted for 29%. The Stock Pickers - Mutual Funds In addition to index-tracking funds, investors can gain exposure to commodities through traditional mutual funds run by stock pickers. One of the oldest such funds is Oppenheimer Commodity Strategy Total Return, which at its core is designed to mirror the S&P GSCI index. But managers of the fund, which was launched in 1997, also try to take advantage of trading opportunities across the futures market to boost returns. "We argue that the commodities markets are pretty inefficient and provide some opportunities," says Kevin Baum, one of the managers. The managers also seek to boost income by investing in short-term securities. Over the past five years, the fund has beaten the GSCI by about two percentage points a year. In the first half, it was almost two percentage points ahead, with a 43% gain. Another mutual fund, DWS Commodity Securities Fund, aims to take advantage of the whole spectrum of investment options in commodities. The DWS fund invests in exchange-traded portfolios, futures contracts and stocks of commodity producers, depending on what seems the most attractive. Co-manager Theresa Gusman thinks a good way to play the boom in agriculture is via stocks of fertilizer and seed companies, rather than investing in the actual commodities. But when she was bullish earlier in the year on gold, she loaded up on an exchange-traded note that directly held the metal, rather than stocks of the producers. The fund returned 24% in the first half. Quick Facts, Stats & Opinions Studies show that when losses pass the 20 to 25 percent range, even buy-and-hold style investors start to get itchy feet. The temptation is to control risk by getting rid of it, but that's wrongheaded thinking because risk is ever present. Sidestep one risk and you put yourself in harm's way for another. Sidestep market or principle risk — the potential for your investment to lose ground in the stock market — and you run smack dab into purchasing-power risk, which is the chance that your money won't keep pace with inflation. (Chuck Jaffe, MarketWatch 9-28) According to S&P, 25 financial companies have reduced dividend payments since the fourth quarter of last year, compared with seven in the previous five years. Standard & Poor's in July cut its forecast for dividend growth this year among the 500 largest U.S. stocks. S&P projects a 4% dividend rise, lowered from 9.3%. That would be the smallest dividend increase since 2002. (Christopher Condon, Bloomberg 9-28) Yields on speculative-grade bonds rose to distressed levels for the first time since 2002 as the turmoil sweeping Wall Street led investors to shun all but the safest government bonds. Investors demand 10.25 percentage points more in yield to own junk-rated securities than Treasuries, according to Merrill Lynch's U.S. High Yield Master II index. Bonds that trade at a so-called spread of 10 percentage points or more are considered distressed. The last time spreads were so wide was in the aftermath of Enron's collapse. Now, a slowing economy and failures of some of the largest U.S. financial institutions are driving investors away. Distressed bonds default within one year 22% of the time, compared with 1% for non-distressed junk bonds, according to Fridson Investment Advisors. The default rate among high-yield, high-risk, non-financial borrowers may rise to 23.2% by 2010, the highest since 1981, S&P said in a report Sept. 25. The `worst-case scenario' estimate suggests 353 junk-rated borrowers outside the financial sector may default in the next two years, S&P said. High-yield new issuance this month has fallen to $845 million, from $5.9 billion in the same month last year, according to data compiled by Bloomberg. Yields over benchmark rates on investment-grade bonds also widened yesterday, climbing 23 basis points to a record 459 basis points, according to Merrill's U.S. Corporate Master index. (Goldstein & Keogh, Bloomberg 9-27) There have been just 54 initial public offerings so far this year, which is the lowest number through September of any year since at least 1991. The second lowest was during the dot com hangover of 2001, when there were 66 through September. After a decent amount of 15 offerings in January, we saw 8 in February, 5 in March, 5 in April, 8 in May, 4 in June, July and August, and just 1 so far in September. (Bespoke Investment Group Sept 08) It has yet to be determined whether the U.S. economy is in a recession, but the stock market has sure acted like it. The average recession sees the S&P500 index drop 25.6% from peak to trough, according to Citi Investment Research. So far this downturn, the index has fallen 26.5% from its Oct. 9 closing high through Wednesday. (AP 9-21) The Paradox of Deleveraging The paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow. Once the double bubbles in housing valuation and housing debt burst a little over a year ago, every levered financial institution decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense. At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. (Paul McCulley, Pimco July 2008) Senator John McCain wants to maintain the current tax rate of 15% on dividends (while cutting the corporate tax), but it is a good bet that if Senator McCain is elected president, while Congress remains Democratic, Congress won’t give the Republican president what he wants. They would instead let the Bush tax cuts expire, returning the dividend tax for high-income taxpayers to about 40%. By contrast, if Mr. Obama is elected, Congressional Democrats will be less likely to balk at his proposed 20% dividend tax rate and thus embarrass the new president from their own party. This leads to one of the great ironies of the political season. On the issue of dividend taxation, Barack Obama may be the candidate with the best chance of preserving George Bush’s legacy. (N. Gregory Mankiw, NY Times 9-06) Individual ownership of US stocks has fallen to a record low, underscoring the increasing importance of institutional investors in domestic equity markets. Retail investors owned 34% of all shares and 24% of stock in the top 1,000 companies at the end of 2006, the last year for which figures are available, said the Conference Board, an industry group. Both numbers are record lows. By contrast, individual investors owned 94% of all stocks in 1950 and 63% of all shares in 1980, the group’s 2008 Institutional Investment Report said. Institutions – defined as pension funds, investment companies, insurance companies, banks and foundations – held 76% of the shares in the biggest 1,000 companies, up from 61% in 2000, the report said. The 66 per cent share of all stocks held by institutions was up from 63% two years before. (Deborah Brewster, Financial Times 9-01) Need a loan? In today's lousy credit environment, securing one may not be much fun. It may not even be possible (at least at reasonable rates) -- unless you have access to an untapped home equity line of credit. If not, I've got a solution for anyone who earns money from something other than a salary. Simply postpone some federal income tax payments that you would otherwise make to the IRS via estimated tax installments. You don't need the government's permission. You just do it and then make up the difference later. The IRS will charge interest on the difference between what you should have paid in for each installment and what you actually paid. However, the current interest rate is only 5% annually. While the rate can potentially change each quarter, it will probably remain at a reasonable level for a while. Borrowing from the IRS in this fashion is only a short-term fix. By no later than April 15th of next year, you must catch up for any estimated tax payment shortfalls for the 2008 tax year. If you don't, the IRS will start charging additional interest of half a percent per month on the shortfall--which equates to a 6% annual rate. That 6% is on top of the "regular" interest charge, which is currently 5%. So you could be looking at a rate of 11% or maybe more. (Bill Bischoff, Smart Money 8-20) Wages and salaries in the euro zone were 3.4% higher in Q1-08 than in Q1-07, matching the Q1 annual inflation rate. It was the steepest wage increase in the 15 countries that share the currency in nearly six years. Inflation in the euro zone hit 4% in July, and many economists expect wages to keep rising this year. In the U.S., where unions are weaker and wages aren't often indexed to inflation, workers fell behind. Consumer prices were 4.1% higher in the first quarter than in the year-earlier period, but workers' wages and benefits increased 3.3% over the same period. Inflation has risen further since the first quarter, hitting 5.6% in July, while compensation growth has slowed. What's good for Europe's workers could prove costly to its economy. As European wages rise, employers come under pressure to increase prices to cover labor costs. The added danger in countries where wages are formally indexed to inflation is an inflationary spiral that's hard to tamp down. Sharp wage increases could prompt European companies to lay off workers or move more jobs to countries where labor is cheaper. Timing accounts for some of the difference between wage growth in the U.S. and Europe. The U.S. economy started slumping last year, well before Europe's did. (Perry & Reddy, WSJ 8-22) The Conference Board’s measure of Leading Economic Indicators fell 0.7% in July, its worst monthly decline since August of 2007. It also experienced a 3.3% year-over-year decline, the worst since April 2001, and most of the drop can be specifically linked to the malaise in the housing market. While housing starts continue to fall on a month-over-month basis (even though the rate of decline seems to have slowed), the economic outlook remains relatively bleak, despite the recent respite from higher oil prices. Jack Ablin, chief investment officer at Harris Bank, notes that the stock market tends to follow the LEI index reasonably closely. “This morning’s number is another nail in the coffin for stocks in the near term,” Mr. Ablin writes. “U.S. equities need a catalyst, like tightening credit spreads, lower crude oil prices or a stronger dollar, to move higher.” (David Gaffen, WSJ 8-21) Strategists at Merrill Lynch have noticed so far that if there’s any one sector that can be considered boring and predictable in today’s market, it’s technology. Technology, according to Brian Belski, U.S. sector strategist at Merrill, is “exhibiting the lowest standard deviation of earnings growth over the past five years of any sector within the S&P 500.” Basically, that means that this sector has experienced less volatility in its earnings from quarter-to-quarter and year-to-year, unlike the financials, which now have all the dependability of Lotto tickets. He notes that between the end of 2007 and July 17, the overall growth rate for the S&P 500 declined by 18 percentage points — but expectations for tech fell by just 9 percentage points. (David Gaffen, WSJ 7-21) It was natural gas — not crude oil — that was the best-performing commodity for the first half. With an astounding gain of 74.5%, it was enough to make oil look dull, which was up 49.9%, according to Standard & Poor’s. Its strong performance was partly attributed to the move to clean energies, as many new power plants are embracing gas instead of dirty coal. (David Gaffen, WSJ 7-17) Fans of the basic materials sector would be wise to focus on the industrial and capital-goods companies (like Eaton, Deere and GM) for trends. Those companies, analysts say, are cutting back business investment and capital spending as a result of tight financial markets reducing the available capital to invest. In April, about 55% of the nation’s banks reported tighter lending standards for commercial and industrial loans to large and middle-market firms. That’s up from 30% in January and represents a constraint on businesses. Raw materials companies will find the market for their goods diminished as a result of the pullback in the industrial names. “If I’m producing less goods I don’t need as much steel, I don’t need as much nickel, I don’t need as much copper,” says Tobias Levkovich, chief investment strategist at Citigroup. “If my trucks aren’t moving around and moving this material, I need less energy.” (David Gaffen, WSJ 7-17) Home Page Previous Factoid Top Sites
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