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®


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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®

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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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The Market

Obviously, we are going through a difficult time – again – in the market and investors fear there will be another drop similar to the last one. I read the following in an AP article on the web this morning: “Don’t panic. Think long-term. Corrections are normal.”

The idea to get out of the market when it starts to go down and get back in when it goes up just does not work. The reason it doesn’t work is that despite all the predictions you read and hear out there, no one knows when the market hits the bottom or when it will turn around. Long term investors should not be concerned about short term volatility. You should always keep enough cash for emergencies and have the proper allocation for your situation. You need a long-term plan and you also need to resist the temptation to succumb to the fear that the media generates.

I received a newsletter this week where the title concerned another bubble that is about to explode. They predict that the average $100,000 portfolio will be worth $48,000 at the end. However, if you would only take the bold steps outlined in the report you could turn that $100,000 into $2.4 million. The report is 20 pages long and outlines some compelling evidence and I can see why people would be influenced by reports such as this. If it was so easy to make so much money why is the author writing a newsletter? There are also books – that are best sellers – that are predicting dire things for the economy. There are also books that give a more balanced historical perspective, such as “Manias, Panics, and Crashes” (fifth edition) by Charles Kindleberger and Robert Aliber. While we usually hear “this time is different” the truth is that every time is different, yet surprisingly the same.

Barbara Gray, CFP®

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Question: what does alpha have to do with an ox? Answer: as far as investing goes, nothing. But I did find an interesting nugget on Wikipedia when I Googled “alpha” this morning. In Moralia, Plutarch discussed why alpha should be the first letter of the Greek alphabet. The story goes that Cadmus, a Phoenician, put alpha at the beginning because it was the Phoenician word for ox, and the Phoenicians considered oxen a primary necessity. Plutarch, who was not a Phoenician, tended to side with his grandfather, who noted that the “a” sound is the easiest sound to make, and thus the first sound children make when learning to talk.

As much as I’d like to continue in this random vein, I’m afraid I must come back to investing, since this is the Parsec blog. Fortunately for me, alpha does have meaning in our world, too. Most often, it is used as a way to measure a portfolio manager’s skill – you may have heard it mentioned in conjunction with mutual fund performance. Well, here’s the Morningstar definition: “Alpha is a measure of the difference between a portfolio’s actual returns and its expected performance, given its level of risk as measured by beta.”

Crystal clear now, isn’t it? As Inigo says in The Princess Bride, let me ‘splain…no, there is too much – let me sum up. Let’s say you have a large cap mutual fund, and you want to know how it performed compared to the S&P 500 index. First, you look at the fund’s beta relative to the benchmark (the S&P, in this example). I’ve discussed beta before, so I won’t revisit the topic here, but basically if the beta is over 1 (let’s say it’s 1.10) you would expect the fund to return 10% over the S&P. If it does as expected, then the fund manager didn’t add any value – the fund performed as expected given its level of risk and its alpha is 0. However, if the fund returned 12% over the S&P, the fund’s alpha is 2%, meaning that it performed better than expected given its level of risk – the manager added value. Of course, this is assuming that the only risk is market risk (beta), and that the chosen benchmark is an accurate comparison for the fund in question.

Enough tedious financial arcana – get outside and enjoy the beautiful spring weather. Seriously, what are you doing reading this? Begone!

Sarah DerGarabedian
Research and Trading Associate

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To Convert or Not to Convert?

I hate paying taxes. I know, I know. The government needs money to provide services and secure the national defense. I just hate paying taxes. You probably share my sentiments.

You will be surprised to know I am actually considering an option that would require me to pay more taxes over the next two years. For 2010, the IRS has changed the rules for conversions of traditional IRAs to Roth IRAs.

In the past, if you converted, you must pay taxes on the value of the distribution when you prepared your tax return the following year. However, for conversions processed in 2010, you can spread the tax liability over two years.

So, why would anyone want to do this? Distributions from traditional IRA accounts are taken at ordinary income tax rates. If you think you will be in a higher tax bracket in retirement, it might make sense to pay taxes now.

Presumably, you would pay less tax now than at retirement, when your IRA account has (hopefully) appreciated in value, and tax rates may be higher. Keep in mind that Roth distributions are tax free if you have had the Roth for at least five years and are over 59 ½.

There are other reasons to consider a conversion:

• Individuals who were previously ineligible to convert to a Roth because of income limits can now take advantage of the conversion option.
• You are not required to take minimum distributions from a Roth account.
• Distributions will be made income tax free to your heirs over their lifetimes.

Still, it may not be the right decision. If you think your tax bracket will be lower in retirement, then why pay more taxes now? If you have a short time horizon to retirement, it might not be worth the tax liability. Do you have cash available to pay the taxes? Using funds from the IRA you are converting or selling taxable assets to raise funds might be defeating the purpose.

Confused?  Your financial advisor would be glad to review your situation and determine if a Roth conversion is the right step for you.  Please give him or her a call.

Cristy Freeman, AAMS
Senior Operations Associate

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Do December Job Losses Mean “Double Dip”?

This morning we received a disappointing jobs report from the Department of Labor indicating that U.S. employers cut 85,000 jobs during the month of December. Since the consensus of analysts was expecting a loss of only 10,000 jobs, one can only wonder if this disappointing news means the end of positive jobs data.

As we move into this economic recovery we must remember that one piece of data does not a trend make. In fact, we have seen most indicators (leading, coincidental and lagging) improve over the last 6-9 months. When reviewing economic data, it is very difficult to make any conclusion from a single piece of data. Instead, it can be more important to follow the trend of data to get a sense of whether the economy is improving or weakening. During 2009, monthly job losses moderated substantially. Employment losses in the first quarter of 2009 averaged 691,000 per month, compared with an average loss of 69,000 per month in the fourth quarter. In following the recent trend, it is clear that the economy is strengthening.

We must remember that it is the job of the news people to shock us in order to ensure that we “tune in” tomorrow. Buried in today’s headlines, we learned that the US Labor market actually added 4,000 jobs in November rather than losing 11,000 as initially reported. This marked the first job growth in two years. This is excellent news that, along with the current trend, should indicate job growth for quarters to come.

In the early 1980’s we experienced what some call a “double dip” recession. This double dip recession was actually two recessions (Jan. 1980-July 1980 & July 1981-November 1982) separated by a period of rapid economic growth. In fact, the economy recovered so strongly from the 1980 recession that inflation forced the Fed Reserve to increase interest rates to a point that forced the economy into the second recession of 1981-1982. Let’s not forget that the economic period after the recession of 1981-1982 was arguably the strongest period of sustained economic growth in history.

This lesson in history teaches us that a slow and steady recovery may be more sustainable than a quick, inflation driven recovery. Although the trend to economic growth remains intact, the reasonable rate of change may allow the Fed to remain accommodative. This freedom could allow the Fed to raise rates when it feels the economy is stable enough to handle a tighter money supply.

Each and every one of us has either been directly affected or had a friend or family member who has been affected by the worst recession since the 1930’s. Their pain and suffering make us wish for a sharp economic recovery and strong job growth. However, we must not forget that before you can run you must first learn to walk. As long as the trends remain positive we will be running in no time.

Michael J. Ziemer

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When Mutual Funds Make Sense

The best thing about mutual funds is that they are an easy way to hold a diversified investment.  The difficult thing about mutual funds is that many mutual funds underperform the broader market, they can be expensive, and there are so many options available that picking among them can be daunting.  But it is possible to pick high quality, low expense mutual funds that are suited to you, and it is important to determine when a portfolio calls for them.

It is our philosophy that in large portfolios, mutual funds are best used to get exposure to international, small-cap, and some mid-cap companies.  This is because the universe of international and small companies is so large, it is best to rely on an active manager who specializes in those areas.  Also, research and financial data is not as readily available on international and small-cap stocks, making active managers all the more important. 

We do believe, however, that we can create a well-diversified portfolio of large-cap, domestic (S&P 500) companies by buying individual stocks.  There is a plethora of research available on these companies, making financial data transparent and easy to obtain.  The trading costs on individual stocks is low enough that this is a more cost effective way to get exposure to this area if your portfolio is large enough to fit 30-50 individual positions of a reasonable size.

In smaller portfolios it becomes less cost effective to buy individual stocks.  To get 40 individual stocks in a portfolio that already encompasses bonds, international and small-cap funds, we would need to resort to very small position sizes.  The smaller the position size, the larger the transaction cost as a percentage of the holding.  Therefore, we believe that depending on the size and the number of accounts within a portfolio, mutual funds may be the best option.

When we choose mutual funds we look for those of the highest quality.  We focus on long-term performance track records, various risk measures associated with the funds, and low-cost investments.  We routinely assess the quality of the funds we hold, and screen for new additions to our fund buy list.  If a fund no longer meets our criteria, we will replace it with a fund we view as better.

To what extent a client has mutual funds in their portfolio is determined on a case-by-case basis.  Sometimes this comes down to client comfort level and perspective.  Other times it is a function of the type and size of accounts in a portfolio.  We work with clients to determine what makes the most sense for their particular situation.

Harli L. Palme, CFP®

Financial Advisor

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