Politics and Stocks

In this murky soup of American politics, we try to place blame on one politician or another for his or her influence over policies that may or may not directly affect the enormous capitalist economy that we have. People often ask, “Is it better for the stock market when there is a Democratic President/Congress or a Republican one?

According to Crandall, Pierce & Co., the Dow Jones Industrial Average had the following results. This is for the 1945-2009 time period.

Circumstance Average DJIA Annual Return
   
Who is the President?  
Democratic President    9.43%
Republican President    6.81%
   
What happens when parties line-up for President and Congress?  
Democratic President, Senate & House 7.43%
Republican President, Senate & House 14.06%
   
What is the best historical scenario for the stock market?   
Democratic President and Republican Senate & House 14.67%
   
*Since 1945 there has not been a line up of the current situation: Democratic President, Democratic Senate and Republican House.  

Notably, all returns are positive, pointing to the fact that on average annual stock returns are positive regardless of politics. The dispersion of returns is large enough however that knowing the average return does not give you much insight into what stock returns will be in any given year. Since you can’t really use this information to your benefit, it is best to keep a long-term perspective with a well-diversified portfolio.

It is my opinion that so many factors affect the stock market that this is no true indicator of stock market performance. The market is affected by past policy and present decisions, as well as investor expectations. It is affected by a global economy and enormous world-wide demographics. Nevertheless, we do get asked the question fairly often, so here are the statistics – but you may want to take them with a grain of salt.

Harli L. Palme, CFP®

Financial Advisor

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Charitable Giving Tips

I recently read a study by The Center on Philanthropy at Indiana University.  “The 2008 Study of High Net Worth Philanthropy,” sponsored by Bank of America, found that over 90 percent of households surveyed planned to make donations using cash and checks in the near future.  A little over 30 percent planned to donate securities.  

As you probably know, donating appreciated securities has tax advantages.  Sure, it is not as easy as writing a check.  With proper planning and some paperwork, you can lower your tax burden while providing the donation amount you already planned to give.  

It is important to consider the option this year if you had a major tax event.  Perhaps you converted from a traditional IRA to a Roth IRA.  Maybe you have a capital gain from a stock sale.  Donating appreciated securities could minimize the resulting tax burden.      

Such donations can also become part of long-term estate planning.  Do you want to provide a legacy for the charity or charities of your choice?  Do you want to donate a fixed sum every year?  Would you like for your children to be involved in charitable giving decisions? 

Your investment advisor can assist you with both your short-term and long-term charitable giving strategies.  If you are interested in donating securities this tax year, I urge you to contact your advisor soon.  It is best to submit securities donations as early as possible to ensure processing before December 31. 

Cristy Freeman, AAMS
Senior Operations Associate

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What’s the Score?

In some ways, mutual funds are more difficult to evaluate than individual stocks. It’s harder to drill down when there’s so far to go (kind of like deepwater drilling as opposed to land drilling – you have to get past all the water first). We rely primarily on Morningstar for our mutual fund research, and the data is updated monthly. We used to review a section of the mutual fund buy list each week (large caps one week, mid caps the next, and so on), but it took too long to rotate through the list, and we wanted to increase our review frequency to match the Morningstar updates. But how do we sift through that mountain of data monthly? I have no objection to hard work, but I like to spend my time wisely, so we came up with a scoring system.

In short, I load a selection of the new Morningstar data into our buy list spreadsheet each month. We look at total return (for the trailing 12 months, 3, 5, and 10 years), the fund’s percentile rank in its peer category, manager tenure, Sharpe ratio, alpha and beta to the best fit index, 3 and 5 year standard deviation, turnover ratio, gross expense ratio, trailing 12 month yield, and correlation (R2) to the best fit index. The spreadsheet extracts some of that data (3 and 5 year category rank, expense ratio, alpha, beta, Sharpe ratio, and manager tenure) and scores it. For example, if a fund’s category rank is in the 50th percentile or higher, it gets 0 points in that column. If it falls between 25th and 50th, it gets half a point, and if it falls in the 1st to 25th percentile, it gets a full point. There are 7 metrics on which a fund is scored, so the highest point value possible is 7, and the lowest is 0. Funds that score between a 5 and 7 are buys, between 2.5 to 4.5 are neutrals, and 2 and below are sells.

This is just a starting point, however. Once the data is entered and the scores are tallied, I spy with my little eye any calculated scores that don’t jive with the current IPC rating. These are analyzed further to see if an IPC review and vote are necessary. Sometimes, a fund can fall from a buy to a high neutral based on a slight decrease in the alpha, for example; further inspection will show that the alpha (though lower) is still positive, the fund’s long-term record is attractive and all the other fundamentals measure up. In a case like that, we might choose to leave the fund a buy. The scoring system really functions as a first pass, a way to flag changes in the funds from month to month and help focus attention on funds that need more in-depth review.

Sarah DerGarabedian, Research and Trading Associate

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Positive Thoughts on the Stock Market

Eighteen months ago, in early March of 2009, the stock market reached its low point with the S&P 500 at 667.  Currently it is 1,045, + 57%.  Then the economy was sinking; now it’s growing.  Jobs were being lost, now they are being created.  Inflation is very low.  Interest rates are at an all time low.  Corporate profits are rising rapidly; corporate cash accumulation exceeds $1.8 trillion!

Why is everyone so worried?  Higher taxes coming on a weak economy?  Maybe, maybe not.  They have been much higher before.  Weak housing?  With 4,000,000 young Americans turning 30 each year, how long does anyone really think new housing starts will stay below 500,000 with 4.5% mortgage rates available?  Low job creation?  Expectations are for 1,000,000 – 1,500,000 more jobs this year and more than that next year.  True, 1,200,000 more only holds the unemployment rate level, but at least jobs are being created!

Everyone worries about a surprise decline, and there is always some new worry that could send it down.  Avian flu?  Worried about that pandemic now?  Probably not.  Greece? Worried about that now?  Probably not.  China’s growth rate could decline from 10% to 9%.   Is that really something to worry about?  The Taliban.  Criminal thugs.  From 1910 – 1950 the world suffered WWI with 40,000,000 deaths and then WWII with 60,000,000.  Allied deaths in the Iraq and Afghanistan Wars are very low in comparison, numbering less than 10,000.  Of course we all wish it was -0-; my son Eric is a 2nd lieutenant in the Army and will probably be in Afghanistan next year.   Sadly, there will be more wars and incursions to come.  Thankfully, for the first time in world history there is no super power confrontation.  Britain, France, Germany, Russia, China, Japan and the USA are all pretty friendly and economically cooperative! Each has too much to lose by going to war with another.

Instead of a surprise decline, how about a surprise and massive advance?  It happened 18 months ago, now + 57% from that level.  Estimates for earnings on the S&P 500 for 2011 are $93.  That puts the Price Earnings Ratio (P/E) at 11.2.  The average over the last 100 years is 15-16, with a low of 10 and a high of 20.  When do we get a 20 P/E?  When inflation is low, interest rates are low, and corporate profits and the economy are growing.  Check, check, check and check.  The overall level of GDP will likely be at an all time high in the first quarter of 2011. 

The 3rd year of the Presidential cycle has historically been the best year of the four year cycle, and has been positive every time all the way back to 1939, averaging + 21.6%.  For the 30 years from 1926 – 1955, including the Great Depression, WWII and the Korean War, the compounded annual return on large stocks was + 10.2%, on small stocks was +10%.  Over the last 30 years, even with the terrible 2000 – 2009 decade, annual compounded returns on large stocks were +11.2% and +12.3% on small stocks.  You could buy a 30 year Treasury bond today with a 3.65% yield.    But this is likely to be a very poor investment compared to alternatives.

Where will the market be in early March of 2012, 18 months from now?  We’re mindful that it could easily go down before it goes up, but over the full 18 months we at Parsec are going to predict up.  Maybe WAY up.  A 15 P/E on $105 of S&P 500 earnings in 2012 would be 1,575 on the S&P 500, + 51% from here.  Markets fluctuate, but historically over the longer term they go WAY up.  + 51% over the next 18 months?  It may appear unlikely right now, but more than that happened over the last 18 months.  We’ll keep you posted.

Bart Boyer, CFP

Chairman and CEO

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SDG Market Indicator: Future Nobel Prize Winner?

Every day, it seems someone has a new model that claims to predict the next stock market meltdown or boom.  Two of my colleagues, Mark Lewis and Sarah DerGarabedian, and I had a stock market theory we tested a couple of years ago.  We called it the “SDG Market Indicator.”  

At the time, Sarah’s almost one-year-old son was having some difficulties sleeping through the night.  Whenever she did not get a good night’s sleep, we noticed on most of those days the stock market dropped.  Over a 48-day period, we compared her sleep cycle against the market’s performance.  If she slept well the night before, the market increased 42 percent of the time.  The market was either flat or declined 58 percent of the time when she had an average to bad night’s rest.  

You are probably saying to yourself, “This is the stupidest thing I have ever heard.”  You are right.  Some people accept far-fetched theories like the SDG Market Indicator as sound market guidance, though.  As they chase the next theory’s prediction, they risk losing more than they could potentially gain.  

Market timing statistically does not work.  A study by Morningstar highlights the dangers of market timing.  This study shows that, during the period 1926 – 2009, an investor who invested $1 in stocks would now have $2,592.  The study also shows that if that investor missed the 37 best months during this time frame, but was otherwise invested in stocks, the investment would only be worth $19.66 at the end of 2009. 

At Parsec, we prefer to take the long-term view when evaluating the market.  It is impossible to predict on a day-to-day basis what the market will do.  However, as studies have shown, the market will eventually recover from declines.  It is all part of the cyclical nature of financial markets.  

The next time you see a hot new theory, just think of the SDG Market Indicator.  Now, I am off to force feed Sarah a turkey sandwich and slip an Ambien in her tea.  It is time for a few positive days in the market.

Cristy Freeman, AAMS
Senior Operations Associate

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Too Much Information?

Too much information running through my brain
Too much information driving me insane
–The Police

The more you trade, the worse you do. This has been demonstrated in repeated academic studies over various time frames. Why does it work this way? Because the human brain is wired to do exactly the wrong thing at the wrong time in the stock market.

As our clients know, a core part of our investment philosophy is keeping a long-term perspective. When we purchase a stock, we intend to hold it. While it is difficult to calculate exactly, our average holding period is probably in the 4-6 year range.

Earlier this year, I chuckled when I saw there is now an iPhone application for mobile trading. As I have told some of my friends, do you really need to be able to place trades from your child’s soccer game? And shouldn’t you be watching the game anyway? Is this the type of logical, well-thought out investment decision that will enable you to select and hold a diversified portfolio of assets to help accomplish your financial goals? No! It caters to short-term thinking, which is often destructive.

So imagine my horror when I saw a commercial last week on CNBC for automated trading. Now you don’t even need to initiate the trade from the soccer field. You can select some strategy from a menu, set up your trades, and then go off to work. When you come home, your email inbox will have your trade confirmations and you can see how you did. While you’re at it, why not add some leverage by way of margin to help get wiped out sooner?

As I see it, the underlying problem is the constant media barrage of information telling us that we need to do something. You can watch financial news 24/7 these days, and every channel is urging some sort of action. But these experts are not talking about things like risk tolerance, what mix of assets is appropriate for a particular situation, how much you need to save in order to retire, and how much you can spend from your portfolio in retirement. Your financial plan is at least as important as your specific investment strategy, and perhaps more so.

There are many strategies out there, some good and some bad. But being able to liquidate your portfolio poolside, or trying to trade your way to riches without knowing anything about the companies you are buying sounds like a disaster waiting to happen.

Bill Hansen, CFA
August 13, 2010

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Financial Industry Reform

The banking overhaul bill has passed!  To quote the Kiplinger Letter, “The regulatory revamping cuts a wide swath, giving broad power to Uncle Sam to protect consumers and discourage banks from engaging in risky behavior.”  The main goal of the law is to prevent a crisis like the one experienced in 2008.  Let’s hope the law will act as a warning system when greed and fear creep into decisions being made by financial institutions.  One of the key components is that the Fed now has the authority to seize big financial firms and banks before panic sets in.  The largest of banks will increase their reserves so that they are less likely to crash in economic down turns.  Harry Reid was quoted saying, “Now no bank is too big to fail.”  However, there will always be financial giants that would cause disaster in world markets if they failed.  The new higher capital requirements of the big banks will make lending standards more demanding, which will have a slight drag on the recovering economy.  GDP is expected to be 3-3.5% in 2010.  The big banks will also be required to hold 5% of the loans they underwrite in their own portfolio.  Smaller banks have less capital requirements then big banks, but they could be affected by the reduction in certain fees that can be charged to consumers.  The bill does permanently increase the FDIC insurance to $250,000 per account.  The SEC also gains authority to force corporations to let shareholders nominate candidates for boards.  The bill was not intended to provide investor protection.  However, increased transparency and disclosure by financial firms that could help prevent a meltdown will be good news to investors.

Gregory D. James, CFP®

Partner

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Recovery Phase is Over? Now What?

There is plenty to be worried about these days. Outside of Europe, Iran, China and taxes, it appears we are now faced with a slowing economy. Over the past few weeks, we have seen economic and earnings data disappoint versus expectations. Although it appears that the economy is slowing, it can be beneficial to understand the economic cycle to better understand what is truly happening.

The typical economic cycle lasts between 5-7 years. The textbook definition of a business cycle includes four stages: Expansion, Prosperity, Contraction and Recession. Although I may not be textbook in my thinking, I like to divide economic cycles into 7 stages: Peak, Contraction (or Recession), Trough, Recovery, Expansion, Euphoria (then Peak again).

During the Recovery phase, we typically see companies experience significant growth, not because the economy is completely healed, but rather because the growth is being compared to extreme lows (the Trough). Although this growth is welcomed by both individuals and the market, it is typically unsustainable. For example, for the last several quarters we have seen many large cap companies grow earnings by 25 – 50%. During a Recovery, the majority of this growth is achieved by extreme cost cutting and margin expansion combined with a moderate amount of revenue growth.

As the economy begins to heal, we begin to transition to the Expansion phase of an economic cycle. Although less exciting, this is typically the longest phase of an economic cycle. During this period we typically experience earnings growth, but at a slower pace. This is the phase we believe the market is now entering.

Quite often, the transition from Recovery to Expansion is met with much pessimistic volatility. While this transition is taking place, investors still have vivid memories of the past contraction. As the recovery slows, skeptics are able to pinpoint leading indicators that are showing signs of weakness. These factors help to create the “Wall of Worry” that the markets so typically climb.

The good news for our clients is that high-quality, dividend paying stocks will often outperform during an expansionary phase. This occurrence is typically due to earnings growth, dividend yield and rising interest rates, which can harm the weaker, over-leveraged companies. It is also common for high-quality fixed income to underperform during the expansionary period, again due to rising interest rates.

Although the negatives continue to grow by the day, we continue to believe the “double dip” is unlikely. We feel the positive sloping yield curve, absence of inflation, pristine corporate balance sheets and strong corporate earnings growth will provide for a normal, albeit bumpy, transition from Recovery to Expansion.

Michael Ziemer, CFP®
Partner

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The “Flash-Crash” and Stop-Loss Orders

We occasionally get questions from clients regarding stop-loss orders and why we do not use them on some or all of the positions in client accounts. I believe there is much misunderstanding about these types of orders and how they work. I will briefly try to highlight how this type of order works, and use the recent “flash-crash” as an example of its potential pitfalls.

On May 6, the Dow Jones Industrial Average lost 565 points in 7 minutes between 2:40pm and 2:47pm, and then gained 590 points in the next 10 minutes. Some stocks, such as Accenture (which opened that day at $41.94 and closed at $41.09), traded for pennies for a few seconds. Long-term investors who do not concern themselves with intraday price movements probably would not have even noticed this strange fluctuation. When we buy a stock, we intend to hold it for at least 4-5 years and possibly even longer. From our perspective, while this type of intraday fluctuation was puzzling, it did not reflect anything adverse about that particular company or its earnings prospects.

A stop-loss order is a sell order entered at some price below the current market. When the stop price is hit, the order becomes a market order. It is then automatically submitted and filled at the current bid price for that security. Let’s take an example: Say Accenture is trading at $40 and you decide you are willing to lose no more than 20% of this value, so you enter a $32 stop-loss order. If the stock trades at $32 or below on any particular day, your stop is triggered. The order is sent to the NYSE where it is filled at the current bid price. In most cases, this is reasonably close to the stop price unless it is a fast-moving market that day. But what happens in a fast market?

On the day of the flash-crash there were not enough bids on the NYSE for many securities, therefore these orders were routed to other electronic exchanges that do not have the same circuit breakers. By the time your $32 stop was routed and filled (within seconds), you could have ended up with a fill price of $1 or less. The exchanges later cancelled trades that were 60% or more away from the 2:40pm price, but that would not help you if you got filled at $20 for your Accenture shares (you would have been down about 50%, so the trade would have been honored). Then the stock ends up closing at $41.09 an hour or so later, so the stop-loss order did nothing to protect you from downside risk and got you out at an abnormally low price. The crucial thing to remember about a stop-loss order is that it is not a guarantee to get you out at a specific price!

The exact causes of the flash-crash are still being investigated and may never be completely revealed. New regulations are being proposed by the SEC to slow down or stop trading in individual stocks with large price movements during most of the trading day. Whether these regulations will be successful in reducing intraday volatility is uncertain. We remain focused on earnings and dividend growth as the drivers of stock prices over longer time periods, rather than short-term price movements.

Bill Hansen, CFA
June 18, 2010

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What is the Real Cost of the Gulf Oil Spill?

Many years ago, and on a regular basis ever since then, we reviewed BP and decided to rate the stock a “buy” and purchase it for many of our clients. We bought Transocean stock for many clients as well. When it became clear that the Gulf oil spill was a devastating disaster, we decided to sell BP and keep Transocean. The reason for this apparent contradiction is that as it stands now, BP, who operated the oil rig, is responsible for the spill and will be financially liable for the majority of the clean-up. Currently Transocean, who owns the rig and leased it to BP, has limited liability for the clean-up. In light of this, and a significant back-log of revenue for their 140+ rigs, we see Transocean as over-sold and have decided not to sell the security at its current depressed price.

What is the Cost?

Financial analysis involves valuing a company based on estimated variables. One way we value a company is to discount future dividends using estimated growth rates. We also take the consensus earnings growth rate and estimate how that translates into a future stock price. We look at many other factors, such as the market value of the company’s debt and equity, or the present value of future earnings.

All of these factors are estimates and variable but they are known. By known, I mean they are conceivable factors. We could not have conceived of an oil spill this large, that would happen at this time, and that would be attributable to BP with any reasonable certainty. And because the estimated probability of something like that would have been so small, it would not have affected any analyst’s valuation metrics. This makes the case for portfolio diversification. In order to protect against company-specific and industry-specific risks, we put 40-50 company stocks in a portfolio, at about a 2% weighting.

Our sell/hold decision on BP/Transocean was based on the spill’s potential impact on the companies’ earnings, and thus the value of the companies. But what if we had made our decision based on the true economic impact of the spill? What if we could quantify the entire economic impact of the spill and attribute that to the companies’ earnings and value? Once we considered the injury to the livelihood of the shrimp fishers, the effect on the Gulf States’ tourism, and the government expense to clean the wetlands and beaches, would there be any earnings left at all? But this is not the charge of our Investment Policy Committee and of course, the impact could never truly be quantified.

What is the Solution?

Some of our clients have requested that we make investments for them in clean energy stocks. It seems like a simple proposition – these emerging technologies are on the cutting edge and will surely be profitable. However, that is often not the case. New industries and technologies face high costs, high barriers to entry, tough competition, and the simple risk that their technology may not be the technology that prevails in the end (think Betamax versus the VCR). For these reasons emerging industries are considerably more difficult to evaluate than established industries, and thus we have opted to buy an index of clean energy companies for those clients who have requested it, rather than invest in a single company.

There is considerable technological ability, capital, expertise and intelligence among those developing technology in the oil industry. They have developed a way to locate the presence of pockets of oil that reside miles under water and thousands of feet further underground, get major machinery down to that spot and drill down to access this reservoir, then pump the oil back up through miles of water and into vessels above the surface. With this type of might and capability, theses companies could put substantially more focus on developing alternate energy technologies. The economics of that development may show it as not yet profitable enough at first glance. But if we calculated the real costs and risks of energy production, perhaps they would see the benefit. I hope that out of this terrible environmental disaster we see an improvement in the collective understanding of the importance of clean energy.

Harli L. Palme, CFP®
Financial Advisor

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