Contents: Prepped for next crash? GIC guarantees not all the same, regaining clients’ trust, condo ‘reversions’, Florida house affordability down , signs of a bleak retirement, misleading 401(k) numbers, boomers ripping off generation X/Y/Z, what matters to charitable givers, smart(?) beta, Nobel winners on equity bubbles: apparent disagreement might just be reinforcing that passive/indexed approach is the best.

Note: The next blog post is planned toward the end of the week of November 4…in the meantime…gone fishing! 

Personal Finance and Investments

In the WSJ’s “Are you prepared for the next crash?” Mark Hulbert, “on this 26^th anniversary of the 1987 stock market crash, the worst one-day drop in U.S. history”, discusses the probability of recurrence of such a 20%+ one-day drop and its potential impact. According some researchers, on the average a daily drop of 20%, 15% and 10% will occur once every 100 years, 50 years, and 15 years, respectively. The lesson is that “Because crashes are both inevitable and unpredictable, you need to permanently insulate your portfolio against them, unless you have a very long investment horizon and the discipline to stick with your strategies even in the wake of a crash.” There are no cushions (e.g. foreign stocks, gold) which will help; only “cash-like instruments, such as money-market funds, and short-term bonds are the primary options for conservative investors wanting to protect themselves against a crash. Hulbert studied advisors who came through losing less than half of the market drop during such a crash, and they were those who allocated on the average 40% to cash and short-term bonds, with the exception of one who was ”fully invested in high dividend yielding blue chips”. (Not sure if the high-divided strategy would work as well today after the past few years’ stampede in to such stocks.) Referring to the high cash-like allocation Hulbert suggests that “Even if such an allocation causes you to trail the market, it could be a small price to pay for a strategy you can live with through thick and thin.”

In the Globe and Mail’s “Five things GIC investors need to know” you might find of interest Carrick’s reminder that “Not all deposit insurance plans are created equal”. The CDIC “is a federal Crown corporation that protects member bank and trust company deposits for up to $100,000, including GICs with terms of five years or less” while “Credit unions have their own provincial deposit insurance plans and they vary in how they operate”. For example Manitoba’s DGCM “exceeds CDIC by providing unlimited protection of deposits at credit unions and their online banking divisions. But because DGCM is not part of the Manitoba government, the strength of the protection it offers is not quite at the level of the federally backed CDIC.” Still as credit unions offering more than 0.5% more interest than banks, their share of the GIC business is growing as banks are not competing on rates.

In the Financial Post’s “How advisors can win back investors’ trust” Martin Pelletier writes that “Currently, only 52% of investors “in the U.S., U.K., Hong Kong, Canada and Australia trust investment firms to do what is right,” according to the recent CFA Institute & Edelman Investor Trust Study”. He also discusses Charles Ellis’s view on what advisors need to do to regain investors’ trust: don’t exaggerate ability to forecast and/or beat the market, provide custom-tailored solutions to clients, “fairer and aligned fee structure”, transparent fee structure, stop focus on “beating the market” and instead “spend time understanding a client’s needs and then custom tailoring a portfolio that meets those particular needs”.

Real Estate

In WSJ’s “Condos are going back up for sale” Conor Dougherty reports unsellable condo developments coming to market five years ago were instead kept going as rentals, but since then are coming back on the market in LA, San Francisco and South Florida; even new condo construction is starting again. These “reversions” (condo-to-rental-to-condo) are driven at least in part by “a supply shortage in the single-family-home market, which has sent prices upward”. As of mid October South Florida condo/townhouse inventory at 21,000 units was 66% down from Q4’2008, but up 14% from June 2013.

The other factor driving condo buyers appears to be lower affordability of single family homes. In the Sun-Sentinel’s “Buyers finding fewer affordable homes in South Florida” Paul Owers reports with a Palm Beach County median income of $51,000, only 58% of the area’s homes are affordable compared to 64% a year ago. While this affordability is still considered very good “prices are rising faster than incomes, and mortgage rates are higher than they were a year ago.”

Pensions and Retirement Income

In the Financial Post’s “Here are some sure signs that your retirement is going to be bleak”  Fred Vettese writes that the real retirement crisis will be had by 3% of the Canadian retirees who after having had “low employment income and then suffered another drop in consumption of 25% or more in retirement”. This group is characterized by several of factors such as: “spotty work history with long periods of low earnings” (i.e. very low CPP), “virtually no retirement income from RRSP or pension plans”, “no home and never had children (i.e. were used to spending most of their work life income on themselves), singles (typically cost for a couple is 1.6x that for single), new Canadians not meeting residency requirement for full OAS/GIS, living in a large/expensive city.

Floyd Norris in a NYT Economix blog post “Misleading numbers on 401(k)s” notes that you must pay attention to what you read if you don’t want to be mislead by factually true but otherwise misleading reports. He quotes a news release example which indicates that between 2007 and 2011 401(k) accounts for “consistent participants” increased 5.4% a year while the market essentially “broke even”. The implicit caveats in this statistic include: “consistent participants” (e.g. excluded those who lost their jobs and stopped contributing for a while means that they were making), how much of the gain came from contributions vs. investment profits? The authors of the study had no clue about these subtle questions either. Such a “news release that compares two completely incomparable figures — the change in stock prices and the change in balance in an investment account that gets constant contributions — to falsely imply that 401(k) plans have been outstanding performers.”

Things to Ponder

In a WSJ Opinion piece “Stanley Druckenmiller: How Washington really redistributes income” James Freeman  explains the billionaire class warrior’s view that boomers are ripping off generations X,Y and Z with the “federal entitlements like Medicare and Social Security”. Mr. Druckenmiller is on a tour of college campuses explaining the “generational theft” under way. While he thought that the Republican strategy to tie the debt limit to ObamaCare was crazy, but he adds that he “did not think it would be nutty to tie entitlements to the debt ceiling because there’s a massive long-term problem… (and) he argues that major reform to protect future generations would be worth a short period of market turbulence.” He further argues that the boomer generation paid obscenely low taxes during their working lives while the US debt ballooned to such an extent that unless something is done about it now, by the time the boomers move through the system “by the 2040s the debt itself and its gargantuan interest payments become bigger problems than entitlements”. His solutions include: raising taxes on capital gains and dividends, eliminating corporate tax, means testing Social Security and Medicare. In case you are interested in the US national debt Bloomberg BusinessWeek shows “How U.S. debt per capita has changed under every President since JFK”

In NYT’s “With giving season in full force, seeking to understand donors” Paul Sullivan discusses charitable giving: reasons why they are giving (concentrated giving is more rewarding than giving a little money to every group”), considerations which are not important to donors (tax rates, worries about running out of money before they die) and superior mechanisms for giving (donor advised funds, giving appreciated stock rather than proceeds of the sale of such stock is better for both donor and charity.)

In IndexUniverse’s “Smart Beta equals factor tilts” Larry Swedroe writes that according to a study “Using data on the 1,000 largest stocks from 1968-2011, Andrew Clare, Nick Motson and Steve Thomas, authors of the study “An Evaluation of Alternative Equity Indices,” compared and contrasted the performance of a set of alternative indexing approaches… The bottom line is that if you want to outperform the market with a diversified portfolio, the best way to do so might be to increase exposure to the common factors that we know explain returns: size, value, momentum and now, profitability.” For those interested in the subject you might also want to look at the Cinthia Murphy interview with Craig Lazzara in IndexUniverse’s  “Measured about smart beta” where he discusses: three generations of indexes, we are living in a cap-weighted world, rule based definition of indices, transparency of independent vs. self-indexing, “The arithmetic of active management”, factor indexes.

And finally, in the Financial Times’ “The Nobel Laureates on equity bubbles” Gavyn Davies discusses (what appears to be diametrically opposite) views of two of this year’s Nobel Prize winners in economics, Fama and Shiller, on bubbles. Fama (provocatively?) states that he doesn’t understand what bubbles are or how they can exist. A bubble is when the “asset price has deviated sharply from the level defined by fundamentals” and “for the equity market, the price is justified by fundamentals is given by the expected future flow of dividend payments, discounted by the required future return on the asset. The required return is equal to the risk free rate, plus the equity risk premium.” But Shiller argues that asset price volatility cannot be explained by fundamentals, except if one allows for large variations in equity risk premium, which in turn are driven by changes in risk appetite. Fama argues that that the market is always in equilibrium and there is no opportunity to beat the market “given the risk appetite prevailing at any point in time. Shiller counters that that it is impossible for risk appetite to fluctuate that much so it must be a result of behavioral factors of investors which in turn lead to “irrational bubbles”. So at market peaks, Fama argues that rational investors are increasingly bearish and bet against the market nudging prices down to more appropriate levels, whereas Shiller would argue that irrational investors at peaks would be bullish continuing to drive the price further into bubble territory. (Could it be that they are both (partly) right, and that’s why the only sustainable long-term strategy for most investors is a passive approach? Since most of the time markets are “efficient” and when they are not, it is difficult/impossible to tell if/when and to what extent they deviate from “equilibrium” plus the cost (fees/transaction/taxes) of identifying and acting on that exceeds the likely benefits. This does not deny the assertion that in retrospect performance outcomes tended to be superior when the investment occurred at times when markets were much cheaper rather than much more expensive based on fundamentals. Interestingly John Authers in the Financial Times’ “Combining opposites produces a clear plan for investing” in which he writes that “So the work of neither man is perfect. However, they have produced insights on which all can agree and which leave us with a far better idea of how to invest.” Here he reaches the same conclusion about indexing, and adds that for those who really have done their homework and have the conviction of their beliefs a few concentrated bets and even “smart beta” might make sense. The Financial Times’  James Mackintosh also weighs into the Nobel economics fray in ”Searching for a Nobel for common sense” arguing that the Nobel prize in economics “should be treated like those for literature or peace”, just as a guide to who is most famous today. On the investment front he also suggests a diversified portfolio rebalanced periodically. (For the average investor good luck with other than a passively implemented balanced portfolio with periodic rebalancing; but than most investors are way above average J!)