Bogue's Blog

My last entry discussed how investment asset classes and sub-classes go through long term upward or downward trends called secular cycles. Within a secular bear market like we are currently experiencing now in the stock market, there are two key characteristics you need to understand and accept to be able to effectively navigate through this market environment. I appropriately call these characteristics “The Two V’s.” In this entry, I will discuss the first predominant characteristic: Volatility.

A secular bear cycle typically results in flat cumulative returns when you look at the market indices levels from beginning to end. However the path of a secular bear cycle isn’t in the least bit smooth and subtle. Secular bear markets are roller coaster rides with extreme levels of upside and downside volatility. Below is a chart depicting how the Dow Jones Industrial Average fluctuated during our last full secular bear cycle, which occurred from 1965 to 1981:

Graph Copyright ©2012, www.CrestmontResearch.com

The market action of the last secular bear market is eerily similar to the current one. The cyclical bear markets with the greatest drops in this chart could easily been mistaken for 2001-2002 and 2008-2009. The largest cyclical bull runs that followed are similar to what we experienced in late 2002-2007 and early 2009 to early last spring. I’m not suggesting that the current secular bear market will pan out exactly like the one depicted above as each secular cycle will have its unique course of action. But I would continue to expect similar market action over the course of the cycle.

The main takeaway from this is that volatility is normal market behavior in this type of regime. The more than you are able to understand and accept this, the more you can use volatility to your advantage rather than falling victim to it. In my next entry, I will discuss the second of “The Two V’s.”

Most people are relying on the stock market to provide for their retirement and other long term goals. However, the stock market has been nothing but disappointing for most people over the past decade. To be a successful investor, one important key is to understand the current secular cycle.

Secular market cycles are generally defined as a long term trend in which a particular asset class or sub-class is trending upward (bull) or downward (bear). Within the prevailing secular trend there is short term bull and bear markets action called cyclical cycles. Secular bulls have the higher number and more acute level of cyclical bull markets within it while secular bear markets have a higher number and more acute level of cyclical bears cycles.

Below is a graph showing the secular trends in the U.S. stock market since 1900. Over this time period we’ve had nine secular periods with four secular bull markets and five secular bear markets. Currently we are within a secular bear cycle that began in the early part of 2001.

Graph Copyright ©2012, www.CrestmontResearch.com

Secular cycles usually last from five to twenty years. If the secular bear market follows the historical norm, we are looking at a reversal in the latter part of this decade. Secular bear markets tend to begin when a particular asset class is excessively overpriced from a historical perspective and is usually coupled with some tipping point where a change in geopolitical and/or economic climate usually does not support the asset class in question. For example, our current secular bear market began with stock values at historical highs and since then we’ve experienced several recessions, sovereign debt concerns and an arguable lack of political leadership. Secular bull markets tend to begin when a particular asset class is excessively underpriced from a historical perspective with a tipping point where change in geopolitical and/or economic climate is usually positive to the asset class involved. Our last secular bull market started in 1981 when stock prices were at historically low valuations and was followed by a period of political stability, deregulation, technological innovation, inflation was tamed and the Cold War came to an end.

Why is understanding the secular cycle so important? It’s because certain strategies can be effective in one secular cycle and be less effective in another. In my next blog posting I will discuss what to expect and how to invest in difficult market environments like we are currently experiencing.

To protect yourself against identity theft, I recommend that you periodically check your credit reports. Every year you are entitled to a free credit report from each of the three credit reporting bureaus (TransUnion, Equifax and Experian). To take advantage of the free credit reports and monitor your credit in the shortest amount of intervals, I recommend getting your credit report once every four months, rotating this between the credit bureaus accordingly. About four months ago I wrote a blog about how to obtain your credit report from Experian. This time I will provide instructions on how to check your credit report from TransUnion. Here is the process:

1. Go to www.annualcreditreport.com
2. Select your state and click “request report”
3. Fill in your personal information, security characters from picture, and click “continue”
4. Select TransUnion and click “next”
5. Click “next” again
6. Once at the TransUnion site, follow the prompts (skip all the extras they try to sell you unless you want your credit score)
7. Answer the verification questions
8. View and print report

Check your report and contact the agency immediately if you find a problem. I will send you a note in 4 months to remind you to obtain your Equifax report.

The two biggest factors influencing how much money you will accumulate for your goals is time and the amount that you will save over this time; this far outpaces the influence investment returns have on portfolio values. For those saving for their retirement goals, the recent market decline provides a great opportunity to fully fund your retirement accounts for 2011. Rather than waiting until the tax deadline in April of 2012 to fund their Roth or Traditional IRA now may be a more opportune time to take care of this.

For those who participate in an employer sponsored retirement plan and want to maximize their contributions, this is a good time to determine if you are on target. Not only to optimize contributions for this year, but also to determine what deferral percentage you will need to maximize contributions for next year. This month, the IRS will announce if any changes will be made as employee contribution limits are adjusted over time with inflation. We haven’t had any changes over the past couple of years so I suspect that we will see some sort of increase for 2012.

Also for those who participate in an employer provided plan where the employer has matching contributions, in most cases you want to make sure you stretch out your employee deferrals throughout the year. By doing so, it optimizes the dollar amount of the employer match. Often times I will see people maximize their employee deferrals way before year end. They think they are doing the right thing, but unfortunately they end up leaving employer provided money on the table. Employees who are subject to large bonuses and/or commission have the most trouble with this as it’s hard to predict incoming earnings. Some employers are now offering programs where they will assume you are making deferrals throughout the year – providing a full match even if you maximize your contributions before year end. You usually have to sign up for this so I would take advantage of this if your employer offers this.

Finally, don’t forget about Roth Conversions. In an off-hand way, the taxes that are paid from the conversion could be considered an additional contribution. Again, with the recent drop in the market, this makes this strategy more attractive and if the market continues to drop throughout next year, you always can re-characterize the conversion before October 15th. Roth conversions usually only makes sense if you have the cash outside the IRA to pay the tax. Just keep in mind that conversions don’t make sense in all scenarios so be careful and fully think this through before executing.

Meeting goals in a low return environment requires one to save more – simple but true. In the long run it’s a lot better to employ strategies that you can control rather than relying on things outside our control (like the financial markets). If any of my clients would like to fully fund their retirement accounts or explore their options, please feel free to call or e-mail.

The more popular articles you see periodically from the financial media tend to focus on how you should invest based on the current state of the market. Please do yourself a favor and don’t read these unless you are speculating (and if you a speculator, this blog isn’t for you). Switching gears in your investment approach in concert to any change in the current mood of “Mr. Market” is a sure way to lose a lot of wealth over time. The trick to a great investment strategy for the long haul is having a well thought out strategy before you encounter euphoric or panic in the markets and sticking to that game plan. These are the three key elements that should be well thought out before you implement your strategy:

Will Your Strategy Create the Required Rate of Return Needed to Meet Your Need?

Every investment strategy that is designed to fund a determined goal has needs a certain rate of return to be able to accomplish the task. This is dependent on how much you save, your time horizon and other financial factors of your life. Combined, this translates into the level of risk that you need to take in your strategy and accordingly translates into your asset allocation and the underlying mix of stocks, bonds, cash and other asset classes/sub-classes within your portfolio.

Is the Strategy within Your Risk Profile?

Often investors fail to align their investment strategy with the level of risk they can absorb. If they are taking less risk than they can deal with, but their required rate of return in their portfolio is satisfied, this isn’t an issue. However, a lot of investors take on more risk than they can handle and they don’t realize it until its too late. Ultimately the investor sells in a panic at absolutely the wrong time. Also, many investors risk more than they can afford to lose. Often people fail in keeping an adequate emergency fund or earmarking funds for short term needs in investments that have a low risk of principal loss. A good plan should address these issues and if the required rate of return provides a level of risk that the investor simply can’t stomach, then they should lower the risk and adjust elsewhere such as saving more or extending the target date of the goal.

Does Your Strategy Outline How You Will Monitor and Make Adjustments?

You should have a systematic process that dictates when you take action within your portfolio and how you will do it. If you periodically keep track of the progress towards your financial goals, then you can incorporate a game plan to increase or lower portfolio risk accordingly if you find yourself ahead or lagging in your progress. You should also outline when you will rebalance your portfolio whether this is on static time intervals, due to your asset allocation breaching certain parameters, during deposits and withdrawals and/or due to dramatic changes in the market. How should you rebalance (back to target allocation or to over or under-allocate depending on valuations and market momentum) is another consideration. Should you rebalance using current holdings or adjust periodic investments if you have a ongoing deposit plan like a 401(k)? Should you and when would you use tax loss harvesting measures? The key to successfully doing this is twofold. First, you have to take a proactive approach that acts on your goals, not to the markets and things you can’t control. Second, rather than making ad hoc decisions during times of market flux – document your process and adhere to it in a disciplined way. The more this game plan is documented and structured before turbulent times of greed or fear, this will take more of the emotional element out of the picture and create a disciplined process that help you stay on course with your strategy over time.

If you have these three elements in place, you have a solid foundation for an investment strategy that will give you a better chance of meeting your lifetime goals over time. How do you go about documenting your process? The elements stated above and other refined details of your predetermined investment strategy are often components of an Investment Policy Statement. Many investment advisors use Investment Policy Statements as a standard operational procedure with their clients, but the individual investor can do this as well. Morningstar has a template that you can use and can be found at: Creating your investment policy statement. In the end, setting up a predefined strategy is a whole lot better than flying by the seat of your pants.

For those who hold a current mortgage, just a quick note that interest rates for conventional fixed rate mortgages have dropped again to historically low levels. As a result you should compare your current mortgage with other alternatives available to see if it makes sense to refinance.

How can you tell if it makes sense to refinance? The way I approach this is to determine the net present value of the current mortgage payments over the remaining lifetime of the loan. Then I calculate the net present value of the mortgage payments if you refinanced. If you pay the closing costs out of pocket (these are costs outside of escrow items such as insurance and real estate taxes that you would need to pay anyway in the future), then you add this dollar value to the net present value of the refinanced mortgage payment. Whatever payment has the lowest net present value is the option that you should choose. Of course if it favors the refinance, but the difference is not material in nature, then it may not be worth the time and aggravation to refinance.

The traps I tend to find is when people only take the closing costs and divide it by the monthly savings to determine a breakeven point to make the decision on whether to refinance. This isn’t a trap by itself, but it is a trap if they extend their mortgage and fail to take into account the extension of payments beyond their current mortgage that they now have to pay. Also it doesn’t tend to pay off if you plan to move within five years.

On Friday, Standard & Poor’s lowered the credit ranking of the United States from its most creditworthy status of AAA to AA+. This is the first time in history the United States has been lowered. As a result, the stock market tumbled with the S&P 500 down roughly 6.7% for the day. Here are my thoughts on the situation:

• The announcement of the downgrade by Standard & Poor’s simply reflects what is already known. The creditworthiness of the United States is still strong, but we have structural issues with our fiscal policy that need to be addressed. The only new news was the announcement. This created no surprise to me.

• The ramifications of a downgrade would suggest that interest rates would increase as buyers of United States bonds would require a higher interest rate as compensation for more risk. Ultimately the market would decide this, but given the weak economic conditions around the world, I doubt that rates will rise quickly in the near future. Japan was downgraded earlier this year and no one flinched.

• The other concern would be the loss of the dollar as the reserve currency of the world. But it begs to ask, what would replace the dollar? The only remaining “real” AAA rated countries are too small to handle the volume or do not want to assume this implied leadership. The Chinese want our dollar strong so they can continue to sell stuff to us at affordable prices. The Euro is worse off and there is not enough gold in the world. The United States economy is weak, but it is still the largest and strongest economy in the world and our largest companies are still quite profitable. Ironically Treasuries rose yesterday because they are still the safe haven of the world.

• The real risk is uncertainty. The announcement of the downgrade was nothing within itself. However, the consequences of the announcement and combination of reactions could potentially create a tipping point or Black Swan event, creating capitulation similar to the fall of 2008. We won’t know if this will create a tipping point or if this is a tipping point until we are looking back at this in the future. The risk of these events is always present in both good and bad times.

• Keep in mind that a country with a sovereign debt issue that can control its currency can never fall into actual default. When you control your currency, all you need to do is start printing currency and devalue the debt away. Unfortunately the cost of this is high inflation.

• A political silver lining? I think our elected officials thought they were going to get off easy last week. They thought they could do some political posturing, defend their ideology and make a last minute deal to avoid chaos and save face. Ironically it backfired because as their inability to address our debt problem in the long term created a ripple in an already fragile global economy. It’s time to address the situation rather than kick the can down the road – remember – we are the ones that vote them into office.

• The ratings agencies don’t have a great track record. A few years ago, Standard & Poor’s gave solid credit ratings to Lehman Brothers, AIG and plenty of those toxic mortgage backed securities. None of these exist anymore. Billionaire Warren Buffett, the world’s most successful investor, said S&P erred and the U.S. should be rated “quadruple-A.” I don’t know about you, but I’d trust Buffett more than Standard & Poor’s. Moody’s today also rebuked S&P’s downgrade.

• Unless there is some unforeseen tipping point as discussed above, I believe the reaction of the markets were more emotion and animal spirits than based on fundamentals. And the financial press does not help quell that fear because sound investing principals don’t generate great ratings. As discussed the other day, if the market continues to give you trouble, one of the best things that you can do is periodically rebalance your portfolio. This is nothing sexy, but rebalancing forces you to buy low and sell high.

Finally, no matter how scary it might seem, this is atypical market behavior. If you allow yourself to be swept away by Mr. Market every time a blip occurs, you will not be very successful over time. If you allow yourself to work with the things that you can control and be opportunistic of what the market brings you, a contrarian investment strategy can be very rewarding.

Four months ago, I suggested you request a free credit report from Equifax. In order to take full advantage of your free credit reports, I suggest that you request a free report every 4 months from the different credit agencies. This time I’m detailing the process to request a free credit report from Experian

Here are the steps necessary:

1. go to https://www.annualcreditreport.com/cra/index.jsp
2. select your state and click “request report”
3. fill in your personal information, security characters from picture, and click “continue”
4. select Experian and click “next”
5. click “next” again
6. enter last four digits of your social security number and click “submit”
7. choose extras if you want to pay, I never do, click “annual credit report” at the bottom in gray.
8. check “I have read and agree to Experian’s Terms & Conditions, etc” if you accept them, click “Submit”
9. answer the “identity verification” questions and click continue.
10. click “print report” in upper right section of page.
11. print report

If you find there is something amiss, contact that agency immediately. You can contact Experian at 866-397-3742. In 4 months I will remind you to get another report from TransUnion.

This is the question that clients, friends and colleagues having been asking me over the past several weeks. Here is my take on the subject:

Will They Reach a Deal? At this point, I feel that the likelihood of a technical default is low and that some sort of reconciliation will be made prior to August 2nd. The one thing that I can count on is politicians wanting to stay employed. I suspect the only reason the politicians have been posturing so long is because the financial markets haven’t over-reacted to this point. There is a sense of caution out there, but it is definitely not panic. If Washington felt votes were on the line, this would be a done deal.

Will There Be Panic if Congress Fails to Make a Deal? There have been some catastrophic predictions of what would happen if we failed to raise the debt ceiling. Most notably, Bill Gross of the PIMCO funds in a recent letter stated: “default would still be a huge negative for the U.S. and global financial markets, introducing fear and unnecessary volatility into the economy and global trade. The market situation might resemble what happened after Lehman Brothers collapsed in 2008.” A post Lehman situation is always a possibility, but I would think it would take a combination of negative events like more trouble from the Euro zone or sudden weakness in China’s economy along with a technical default to set off a contagion like event. Just keep in mind that the probability of a “Black Swan” event is always a possibility and usually comes out of the blue from some combination of catalysts that nobody can foresee. Given there has been quite a bit of doomsday talk about what would happen here, I’m skeptical that contagion would be created solely from technical default; there would have to be more out there.

The Long Run: My main concern focuses on the long run implications of what will happen if we don’t get our financial house in order. The U.S. federal debt to GDP ratio is closing in on the 100% level. Once we go beyond this mark, it begins to have a detrimental effect on economic growth. If the confidence of buyers of U.S. debt wanes, this would erode our status as the reserve currency of the world. With more perceived risk in us meeting our obligations, this would result in higher interest rates, inflationary pressure and would undermine our ability to grow economically. Although it wouldn’t be pleasant, I would even accept some short term anxiety if action was taken to fix the problem in the long term. The days of kicking the can down the road should end.

The Reality of It All: Our problem is far from being unfixable. However it won’t be fixed overnight either so I think it’s absolutely silly for our politicians to be dangling the debt ceiling and deadlines as a bargaining chip. In the big picture the reality is that the plan will take years of gradual implementation to eventually right the ship, while not blowing up the economy in the process. Both sides are going to have to compromise. If a politician discusses deficit reductions without talking about entitlement reform, they will never fix the problem. The same thing goes for those that think that permanent changes in our tax system are not a necessity. Everyone will have to experience some pain in the form of paying more or getting less. It should not be “us versus them” in this debate. In reality it’s just us. I would rather be able to address the problem while it is still manageable, rather than creating a crisis that probably my kids would need to fix. Greece is now stuck and has no easy choices anymore. We don’t want Greece’s problem to be our problem as well.

On May 15th I was quoted in the Sunday Boston Globe concerning my thoughts on Boston mutual fund company Putnam Investments. Putnam was a mutual fund darling during the late 90’s, but fell from grace when growth stocks fell out of favor and were tarnished by the mutual fund scandal in the early part of last decade. In Putnam’s Progress, the article discusses management changes, new product offerings and improvement among some of their mutual funds, but as you will see, I remain skeptical.