Thursday, February 21, 2008

Timely Technicals

At times of uncertainty it often helps to look at a picture to understand where we've been and where we are. Too often the use of technical trading tools is either over used or too quickly dismissed. I once had a client who would always call charts suspect because they were nothing more than self fulfilling voodoo. Self-fulfilling seems pretty good to me. To avoid the identifying trends and changes in money flows simply because it is a picture rather than a talking head on network televisionis simply silly. They are looking at charts too.

The S&P 500 chart below shows a broad market that has clearly entered a new trend, breaking the 200 day moving average decisively. The triangle pattern is tightening and indecisive. From a technicians perspective, a triangle is a known as a continuation pattern and generally will break out from the apex in the direction of the prevailing pattern. If it breaks downward on significant volume investors should take measured but defensive action.

The surrent oversold condition gives some hope that there could be a counter trend rally back to the trend line about 100 points or 7% higher than today's close, but the developing pattern does not bode particularly well for equity purchases.

Clients continue to be in relatively defensive positions for wealth preservation rather than capital growth. Against the backdrop of steadily deteriorating economic news and the technical bearishness, we will use counter trend rallies as sales points and resist the seduction of bargain hunting on drops. This is a trader's quick or dead market which is not our longer term strategy so until technical and fundamental indicators show a new upward trend, we remain diversified preservationists.

John F. Barnyak AIFA® 2/21/08
Stonehouse Asset Management

Safe Harbor or Rough Seas for 401(k)

It is not often lately that all nine justices on the Supreme Court agree. It would be hard to imagine a more polarized duo than Justice Stevens and Justice Scalia. But yesterday they agreed and the judgment has potential ramifications many companies and retirement plan participants should pay attention to. Earlier this week I wrote about the impending unwinding of the West Virginia teachers defined contribution retirement plan. This week in a unanimous decision by the highest court, another shot was fired across the bow of sponsors and administrators of 401(k) plans.

Since the inception of 401(k) plans employers have taken refuge from liability and found comfort in the safe harbor aspects of ERISA law. Yesterday the Court ruled that the employer has fiduciary liability not merely at the plan level, but also at the individual participant level.

Previous rulings have taken the position that the concept of fiduciary responsibility was confined to the plan as a whole. The court argued that previous rulings were appropriate and intended in a world of defined benefit pension plans but that the new norm of defined contribution plans turns those rulings on their head. Plan sponsors beware.

The specific case dealt with an administrator’s failure to carry out a change in investments as directed by the participant. The participant sued for opportunity lost and his “depleted” interest in the plan. 401(k) plan sponsors should be reviewing procedures that could impact not only the plans ERISA compliance and tax position, but also keep in mind the possibility of actions taken by individuals who find or even perceive they have a grievance. Even defending and winning a case can be a burdensome legal expense.

Systems and procedures that document intents as well as actions of employee participants can provide the framework to quickly verify that the plan administrator is doing the right thing. Any instructions that the participant gives should have a designated procedure and confirmation process that catches missteps quickly. In the event that a minor does miscue it can be quickly corrected, avoiding the kind of expense of the LaRue v DeWolff et al case. In the case the employer alleged that the administrator did not carry out instructions to change investment strategy in 2001 and 2002. He finally filed the lawsuit in 2004 for damages of $150,000. Obviously time does not heal all wounds.

A consultation with fiduciary analyst and review can help avoid problems easily remedied with the right processes and diligence.

John F. Barnyak AIFA® 2/21/08
Stonehouse Asset Management

Wednesday, February 20, 2008

The Black Swan (when pigs fly)

Overlooking the Grand Place in Brussels, Belgium is an elegant and famous restaurant named, La Maison du Cygne, the house of the swan. In this former guild hall of butchers, Karl Marx wrote his Communist Manifesto. I suspect he would have looked askance at the very non-socialist prices on today’s menu.
During my time living in Brussels I ate only once at that opulent eatery after being taken aback by the very Belgian habit of taking one’s dog to dinner. Laying at the feet of a diner about two feet away was a huge black Bouvier des Flanders, one of the larger and hairier hounds on the planet. I am not a fussy eater, but where I find a $100 entrée, I do not expect to find even the best behaved sheepdog.

In the investment community there is a recent book that is becoming the years “must read” titled, The Black Swan. Like the Bouvier dog in the Maison du Cygne, a Black Swan is a rare, unpredictable event of high impact. I didn’t expect it and I never ate there again. Who would have predicted weeks ago that the U.K. government would nationalize a bank? Who predicted 9/11? Even looking back into the near past many of the events that shape the markets have been precisely those NOT predicted by most highly honed minds.

In 1998, a group of Nobel Prize winners got together to form the hedge fund, Long Term Capital Partners. The premise of their tireless computational style was to invest huge amounts of capital for very small and very frequent certain returns. They called it picking up nickels. Lots of people gave lots of their money to the Noble laureates because what could be more certain? They had written the book on risk. One certain nickel at a time and they and their clients would become even richer. Then they nearly brought the global financial system to its knees when they failed. Russia defaulted, the Asian tigers collapsed and the entire thing unraveled. The book When Genius Failed, is important reading for people who manage money and a strong reminder that certainty is anything but.

More recently, the discovery that one could borrow money in Japan for essentially free and then leverage mortgage securities in the United States to the hilt was a sure thing. All over the world pensions, investors, banks and funds of every ilk stepped in, assured that the US national residential real estate market simply never goes down. Treasury Secretary Paulson went to China to convince the Chinese they should get more innovative with their investments. It’s the new sure thing. More recently the Chinese brought needed capital and ownership of a slice of Morgan Stanley when innovation went awry. Playing with loaded dice is a good idea, until somebody switches the dice and you keep on throwing.

If the most meaningful events are unpredictable how one does find profit and protection from these Black Swans that occur not only unexpectedly but fly against the voices of reason? You diversify, you diversify, and you diversify and you do not confuse diversification with variety.
When will real estate return as a meaningfully profitable asset class? No one knows, but it is an asset that should be in the portfolio, even if only minimally. Commodities, same story. Gold, agricultural products, emerging market debt. The list goes on. None should be taken off the radar screen.

What about bond allocations. As we bounce along at historically low interest rates with greater and greater evidence of inflation pressures lurking how should you invest in fixed income as a diversifier. Heavy bond allocations found typically for older investors could have serious consequences if not immunized against inflation, or if structured with higher risk in the search of higher returns.

With all eyes on the economic risks to growth and possible recession, could the next Black Swan be the other side of that coin, inflation? Inflation has historically been the greatest risk to investors and savers. Like high blood pressure it is silent and deadly. If in a year or two that sleeping giant is again making headlines as it has not in twenty-five years are you ready?
John Barnyak

Tuesday, February 19, 2008

Country Roads Take Me Home....

Last month the state of West Virginia announced a proposal to allow state teachers to return to the Teacher’s Pension Plan after many were encouraged to participate in the 401(k) style defined contribution plan. Oops! The reason cited was the “poorer performing 401(k) retirement plan.”

Presently it appears that many West Virginia teachers won’t be retiring anytime soon despite approaching typical retirement age. After being encouraged and opting to move from an ailing pension plan in 1991 and thereafter, it now seems they jumped from frying pan to fire. In a plan that may be a precursor of things to come elsewhere in the U.S., if the Governor’s proposal is approved, the state will be picking up at least some of the pieces after teachers who chose the “safe” investment route have found the savings and outcome to be completely inadequate.

The demise of defined benefit (pension) plans and replacement with 401(k) style defined contribution plans moved responsibility for investment performance to the participant from professional managers and sponsors. The failure of the outcome will be debated for years to come with enough blame to go around. The companies and entities that stripped out “excess” contributions in the good times and made entirely inappropriate return assumptions get a portion. The retail investment industry who inferred that if the red headed office geek could make a fortune in the market, well, who couldn’t, gets a slice. Of course the ultimate buck, or lack thereof, stops with the employee.

Employers were relieved of any responsibility for the future well being of employees. Many of those employees went into the financial equivalent of the fetal position, investing in guaranteed return products or leaving their contributions in money market where the only real guarantee was a continual loss to inflation. The confluence of a responsible party who is effectively unable to manage one’s own investments joined the fast moving current of investment industry marketing and sales with a predictable outcome.

To cite a “poorer performing 401(k)” plan, as a reason for this failure misses the point. The poor performance was the inevitable outcome of the decision made by policy makers to cede responsibility for managing investments to those ill equipped to handle it. There is a reason we don’t allow children to drive cars. They are not sufficiently experienced to make the judgments necessary to assure a positive outcome. While I know people who have managed their retirement plans themselves with good results, I know at least as many who have not.

Negative outcomes have a ripple effect beyond a single individual. Our society will be likely be required to attend to these negative outcomes and those ripples. The decisions may be driven by ethics, morals, economics or a host of other aspects of societal sensitivity as the determination will be made of how people will live out their lives after their economic contributions to society have faded. The West Virginia taxpayer may well be picking up $75 Million of the tab of the shortfall between personal responsibility and dignity. It is always more expensive to provide for a patient in the emergency room than to provide ongoing preventative care.

There are modest efforts to provide some semblance of fiduciary responsibility for investment management in the realm of retirement plans, but the results are nowhere near sweeping enough for individual plans. Even now, I see many individuals in “safe” investments for retirement who are likely guaranteeing failure by inflation.

The underpinning principal of Stonehouse client management is to provide the degree of fiduciary care that rests on firm investment practices, legal principals of responsibility and constant monitoring of risk, performance and expenses. Putting the “cork on the fork,” as one wit called it. If you miss the mouth occasionally, at least you won’t lose an eye. The time is approaching then I expect the state will also be forced to step in to mandate steps to ensure long term economic outcome even if it flies in the face of “personal responsibility.” Or, they won’t; in which case everyone should be running their personal retirement plan like the investment managers they used to have.

John F. Barnyak
Stonehouse Asset Management

Monday, February 18, 2008

Boys with Toys

January 18, 2008

My wife, who designs landscapes with an artist’s eye, used to lament that much of her time was spent undoing the efforts of those who had preceded her at a client’s home with backhoes and bobcats. Sweeping power in the end turns out often to be no match for care and nuance in producing an end result to live with. In the investment landscape and now the economy as a whole the same is holding true.

I am afraid we now need to undo the damage of kids with calculators who have been long on cleverness and short on wisdom. The sheer pleasure of creating an investment that is constructed using mathematical models and derivatives cannot be overestimated. Add to that the financial benefit of selling it as the perfect investment to institutions large and small and you’ve got a potent mixture. In investment speak we are now dealing with a “long tail event.” That is, one statistically unlikely and in often uncharted waters. I recently read the comment, “it is the dumbest people and the smartest people who lose the most money.” Like the 1998 Longterm Capital hedge fund collapse that nearly unraveled the global financial system, we are seeing a similar event unfolding. That collapse led by several Nobel Prize winners inspired the book, When Genius Fails.

The idea that housing values could fall on a national basis was deemed so unlikely that an entire country based its economy on the inevitable rise of real estate. Teaser loans that could be refinanced with the increased equity in a home drew any and all into the great American dream of homeownership. Political and central bank policies encouraged it and until the past few weeks cautionary signals were ignored by those who were entrusted with the roles of leadership.

In the past few weeks we have seen a seismic shift in the global economy. Many won’t notice for years to come, but it seems that national economies are on a path to irrelevance. Look at the names of companies that have become part of a growing list of internationally owned institutions as firms desperate for capital infusions scoured the globe; Morgan Stanley, Merrill Lynch, Citibank, Standard Bank. These are the names of the bulwarks of global capital creation. Names now further immersed in the global needs of sovereign nations like Singapore, China, Saudi Arabia and the United Arab Emirates as those investors substantially increased holdings and influence in these financial titans.

What does it mean for the United States? No one really knows yet. But as investors, we need to be sifting through the wreckage for the beneficiaries and watching as the powers that be seek solutions to problems often of their own making. Already policy moves are beginning to invoke the law of unintended consequences in other areas.

Where the opportunities will arise from the ashes of the subprime mortgage debacle isn’t yet clear. However in another area, I believe investors should be exploring. In December, President Bush signed into law the new energy bill. Among the various aspects of the law are massive changes which have not yet been fully felt and have the potential to reverberate strongly through the economy.

In 2005 14% of the corn crop was dedicated to ethanol. For 2008 that figure will increase to 32%. The amount of US agricultural land employed for energy production will increase from 10 million acres to 26 million acres. These are jaw dropping long term changes in the balances within our economy.

Grains have been rising steadily and beef cattle ranchers are feeling pain already, in many cases culling herds because the expense of feed has become prohibitive. As the price movements work their way through the protein chain, watch for additional effects on price and availability of agricultural produce and products. Consider some the investment options available to profit and diversify within that sector as our clients have.

John F. Barnyak

All Whine, No Cheese

It looks like the Fed has thrown a party and no one has bothered to come. No RSVP, no regrets, just nobody at the punch bowl. The double barreled 1.25% decrease in interest rates last month was the fastest since the Fed Funds Rate become the principal policy tool in 1990. Still, the cost of credit has increased for companies and households in the past few weeks.

As financial companies have struggled with the uncertainty of underlying asset values, they have increased the spread they require to lend even to the most solvent of customers. The fed funds interest rate may be lower, but the risk premium has soared to offset any benefit. The market has been tightening credit as fast as the fed has been loosening. The net result is a credit system in lock up.

The failure of monetary policy has led now to the fiscal stimulus package of some $168 Billion intended to prime the pump. Until the checks actually get into individual hands later this year, the debate will rage over the effectiveness. The last time such a package was used, about two thirds actually went to consumption stimulus. How much this time will be added to GNP enhancing consumer appetites and how much will be used to pay down debt is an open question.

A recent poll indicates 19% of recipients intend to spend the rebate, 45% will pay debt and 32% will invest the rebate. What will then be effectively a $32 Billion dollar injection to the economy is only slightly less than the current losses declared by Merrill Lynch and Citibank, just two of many banks with toxic debt on the books. The package looks more like a political inoculation for congress than a serious effort to set the economy back on a steady course.

The next administration, Republican or Democrat, will be facing decisions likely to be politically untenable but necessary, at least ultimately. Decisions about national priorities cannot be put off much longer. As a nation the debate will rage on such issues as whether the greater and more likely terroristic threat is an unexpected and unaffordable illness or an unexpected attack by misguided religious zealots.

The nature of national risk perception is no different than investment risk. Catastrophic risk is often given greater credence than more common risk. Many of us will not travel by air yet step without hesitation into the shower, even though the shower is the riskier proposition. Likewise investors look at risk of losing money in an investment as inherently greater than the near certainty of risk to purchasing power from inflation.

At a time when the risk constellation for investors is particularly muddled, there is no clear answer to the question of the “right” investment. Now more than usual, having a widely diversified portfolio balanced to strategic allocations is the best tactical approach. US Stocks, Foreign Stocks, Gold, Commodities, Bonds, Large Cap, Small Cap, Real Estate, Municipal Bonds, hedged, leveraged, cash? Regardless of the fact that the airwaves are full of predictions, it’s largely noise in a confused financial world. The past few years have muddled the historical correlations, and in some cases stretched valuations. Now is the time for patience. We will let the market tell us how and when the next boom or bubble will appear and in the meantime try to select the best choices for cost and risk within a wide diversity of investments.

As clients know, we are strategically adding to several asset classes and paring back on several others as we try to both look beyond the horizon and watch that we don’t step in anything nearer.

John F. Barnyak
Stonehouse Asset Management

Tuesday, February 12, 2008

Hair of the Dog

Moral hazard is a term many investors are not familiar with but recently I am seeing an economic world rife with it. In the insurance industry it is a particularly relevant concept as an insured will undertake riskier activity than normal if some part of the risk has been transferred. People who have life insurance are more apt to skydive and those with medical coverage will ski a bit more aggressively than the uninsured.

The financial markets are similar. In recent years we heard of the “Greenspan put” which was the understanding that if the markets faltered the Fed would cut interest rates and bail us out. Bernanke has trumped that with emergency rate cuts only one week before the Fed’s scheduled meeting. As Morgan Stanley’s Steve Roach opined in an interview, “I thought someone had put a virus or a joke in my computer when I read the headline.”

The compensation structure for financial executives have led to excessive risk taking on behalf of investors by the financial engineers who would not be penalized for egregious errors of judgement. The departing CEO's of major investment banks have walked away with ten's of millions of dollars despite costing shareholders billions.

The ambitious willingness to lend to anyone with a pulse and a house may ultimately create the greatest confluence of effects of moral hazard we have seen in many years. Looking at the structure of credit creation we see the grouping of the hazards of unregulated “banking.”
The complexity of securitization and the inclusion of multiple incentivized participants is a prime example of the disguising and enhancement of risk rather than management.
With the stimulus package one would argue it is, “hair of the dog,” policy. If bigger deficits, negative real interest rates and incentives for lenders to lend and borrowers to borrow can be rekindled we might just avoid this recession – by digging the hole deeper.

As investors there will be opportunity when fear peaks, but the longer term problems are deep and will require a much more flexibility than the past generation has been accustomed to.

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
Arthur SchopenhauerGerman philosopher (1788 - 1860)

Tuesday, February 5, 2008

Musings Anew

Everyday it seems a new technology arises to help us communicate with each other, or conversely, overwhelm us with information without context or usefulness. As Stonehouse Asset Management grows and changes, we continually look at how best to communicate with our clients and friends.

The stamped letter has become often just another piece of paper amongst the pizza and dry cleaning coupons. Now it seems email has increasingly been added to the growing list unwanted pleas for attention.

I have decided to put a toe into the blogosphere. Where clients, friends and perhaps future clients can stop by and at their leisure gather what will hopefully be some clarity and analysis in a world of noise. If there were certainty in the economy and markets CNBC and The Wall Street Journal would have long ago closed shop. Discussion and dissent from readers is invited. Questions you might raise can lead us to other areas of dialogue and keep the discussion not simply a self indulgent exercise, but hopefully of value to readers.

Daily missives will hopefully make it a place for you to land occasionally, and the "edit" function should help me correct content and tone before it becomes etched in permanence to haunt me forever.

"The market can remain irrational longer than I can remain solvent", John Maynard Keynes

A Cat Amongst the Mice

Most of my life I have been a dog owner; big lumbering hulks that could grab a loaf of bread off a table and never break stride or dig a trench in a birthday cake in the two seconds when a back turned. More recently a cat adopted us when he wandered in and found a bowl of mice in the kitchen. (Don’t ask, we live on a farm.) In any case, this is a different animal which calls for different attitudes.

One of the attributes of these sleeker more aloof creatures is the habit of regularly leaving a reminder that just because it was running away doesn’t mean he should have eaten it. For all the grace and apparent effortless meandering, there is often evidence all is not well, something like the economy at the moment? The current thrashing around with interest rates, stimulus packages, and political cliché, sounds like the precursor of a financial hairball. It can’t always be identified, but it’s always ugly.

The principal driver of the U.S. economy is the U.S. consumer. On average over twenty-five years before 2000, consumer spending accounted for around 67% of GDP. In recent years this has grown to 72%. This growth in the portion of GDP from consumer spending has come on the back of sub-par income growth driven by income extraction from equity (principally from home equity) and free and easy credit.

The previous equity bubble was caused by capital spending and deteriorating corporate balance sheets. Capital spending made up about 13% of GDP at the time of the uproar of seven years ago. What happens when the deflating bubble is six times as big?

What happens when unemployment increases and income falls, when the value of the house that acted as an ATM through home equity loans falls and when credit availability tightens? These factors are coming together. No doubt there will be solutions provided to keep the economic animal spirits of the country alive. But the cures won’t necessarily be painless. Likely the solution will be an attempt to expand another bubble, if the world cooperates. Our job as investors is to protect what we have and find the new opportunities.

Last week Countrywide sent out 122,000 letters to customers freezing credit lines because debt now exceeded property value. Chase lowered the borrowable percentage of home value from 90% to 70% in California, effectively closing the window. Even the apparent low rates on mortgage, below 5% are not clear, as “points” have been raised where none were before.

These are uncertain times for investors, and call for greater attention to preservation than the past several years. I am looking at more defensive investments for my clients and negative correlation to protect gains of the bull market through diversification and risk abatement.
When in doubt, zoom out. Look at the big picture. Every time I turn on another purported expert the recurrent theme is, “we just don’t know.” We don’t know the size of the problem; we don’t know the effect it will have on the consumer; we don’t know how many shoes are left to drop. Forget most of what you thought you learned about the stock market from 1981 to 2000 and don’t be afraid to try new tools but keep it simple.