Small Cap Stocks are Rockin’ – But Steady the Course

Posted May 3, 2012 by thomas

The gains come on the heels of a huge move in October of 2011, when the Russell 2000 rocketed up 15 percent. Things bumped around in November and December, then took off again in January (+7 percent) and February (+2 percent), for a total change of 15 percent in the last six months.

Traditionally, small cap stocks have been extremely sensitive to economic cycles. They take the biggest bruising when the economy slows down – but they also tend to come back strong when the economy begins to recover.

Investors are beginning to notice: Net inflows to small-cap funds and ETFs were north of $1.8 billion in February.

Does that mean we’re backing up the truck to buy all the small-cap shares in the Russel 2000 index?

No. We don’t quite work that way. If anything, the opposite is true: If you bought a bunch of small cap stocks back at the beginning of October, when the Russell 2000 Index was taking a bruising, your portfolio may have been thrown out of whack by the rise in small cap stocks.

If the rally continues, it may be prudent to balance things out a bit. After all, economic cycles come and go. Just as the great Pete Seeger song “Turn, Turn, Turn” implies, there is a time for bulls and a time for bears, a time you may purchase small caps, and a time to gather bonds together.

We’re still pretty early in the economic recovery, so we’re not too concerned about small-caps taking it on the chin just yet. Although they’re not exactly cheap at current valuations (the average P/E is about 17) have room to run. But no one knows the future for certain. We don’t like our clients to make gambles they can’t afford to lose.

Strategy Trumps Tactics

Batters keep their eye on the ball; hitters keep their eyes on the game. Take a look at your portfolio as a whole. If you are willing to accept risk at all (and that’s not a given!), then you should probably maintain a healthy split between small caps and large cap stocks – as well as U.S. and overseas stocks. You should also maintain a healthy diversification across industries, as well.

What does that mean? It’s a little different for everyone.

The easiest way to do that for most people is to use index funds, or their close cousins, ETFs.

The execution: Keep things balanced. Investing is like flying a multi-engine airplane: You want to keep an eye on all the dials. You want to keep engine output as balanced as possible. When one engine begins to overheat, or is pulling too much of the load, it will begin to become inefficient – and at an elevated risk of a flame out. So you back off the throttle a bit, and distribute the workload among the remaining engines.

The same with investing: At some point, you’re going to want to back off of small-caps, or back off of gold and precious metals. You start with a target allocation, and when any one asset category takes up too much of your portfolio, back it off some.

In our view, the time is long past to back off long-term bonds, including long-term treasury bonds. Those yields have gotten miniscule, compared to the risk you incur when a long bond collides with a rise in interest rates. It’s not pretty.

Corporations are not People (They’re “Persons.”)

Posted May 1, 2012 by thomas

Contrary to what some people are arguing, no one is seriously positing that corporations are, in fact, people. What is undoubtedly true, however, is that corporations are persons.

See, the law has to deal with more diverse economic units than just individuals. So when legislators craft a law imposing something even as mundane as, say, the requirement to take out workers compensation insurance to protect laborers, they have to craft it to apply to more than just individuals. It is, in every jurisdiction I know of, illegal for corporations and individuals alike to employ a laborer to work on a roof without having first taken out workers compensation.

How do they do it? By defining the term “person” under the law, to include not just individuals, but also corporations, trusts and estates (and labor unions, for that matter).

There are a lot of reasons for this: Any of the above entities – a corporation, a trust or an estate – can and frequently do enter into contracts. A corporation, trust or estate may, through a direction of their trustees or executors, enter into a contract for services from an individual, such as an attorney, for example. We regard corporations as “persons” for a very good reason – to include them in the long tradition of contract law, to make agreements they enter into enforceable. Otherwise, an attorney (or financial planner, for that matter!) could put in hundreds of hours of time into the account – only to find out that the executor, trustee or officer of the corporation who physically signed the contract got fired, quit or died.

The doctrine of corporate personhood allows the individual or other person who rendered goods or services to enforce the terms of the contract, regardless of personnel changes at the corporation, and regardless of whether ownership of the corporation changed hands in the meantime. The new stockholder has responsibility for all the inherited obligations and debts of the corporation. You can enter into a contract with a corporation secure in the knowledge that the contract is legally enforceable, precisely because we consider the corporation a separate legal entity from the people running it.

This is part and parcel with the doctrine of limited liability. Few people can take personal responsibility for the obligations a large corporation must enter into routinely. If a middle manager at Boeing thought that having signed a contract for delivery of a 747 jumbo jet to an airliner in three years’ time thought the courts would hold him personally responsible for a $100 million dollar airplane on his salary of $150,000 per year – and threaten to strip him of everything he owned and his children’s college if there were a snafu with the delivery beyond his control, he would find another job. And if the contract were not enforceable after he quit, no one would enter into a forward contract for a large capital investment anyway. The result: Boeing doesn’t function, planes don’t get bought or sold, and nobody travels.

The doctrine of limited liability, of course, extends specifically to shareholders: Stockholders in C publicly traded corporations stand to lose their entire investment in every stock they own – but unless they buy on margin, they can’t be sued for more than that. If people who owned a single stock in Boeing could realistically get pursued and held jointly and severally liable for a judgment after a company declares bankruptcy, it would be exceedingly difficult to raise money for the next corporation. The result: Again, planes don’t get built, jobs don’t get created, and nobody flies.

You cannot have limited liability without considering corporations to be a separate legal entity. That doesn’t mean that corporations are people, though some, like Bill Press, are working hard to obfuscate the definition. It means that corporations have obligations under the law, and with those obligations come rights, as well.

Citizens United

In a landmark Supreme Court Case from a few years back, called Citizens United, the Supreme Court held 5-4 that laws abridging the freedom of speech were unconstitutional, even when applied to U.S. corporations (Citizens United had just made a move critical of the Clinton response to the gathering Al Qaeda threat, and prominent Democrats were moving to suppress it.)

This would seem to be a 7-0 decision, simply on the basis of a plain reading of the first amendment’s text:

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

There is no provision, allowance or carveout for exempting legal entities other than individuals from the protections of the 1^st amendment.  Indeed, even a moment’s thought renders the notion absurd:

If we grant government the authority to suppress the freedom of the press on the grounds that corporations such as Citizens United are not entitled to 1^st amendment protection of freedom of expression, then we would have to apply that law evenly to include The New York Times Corporation, The Washington Post Corporation, ABC, NBC, CBS, the Tribune Corporation, Gannett, FOX, Time Warner, which owns CNN, and thousands of others, including your hometown newspaper.

All of these organizations that we rely on to hold government accountable could exist only at the mercy of the government, which could shut them down as soon as they viewed coverage to be unfavorable.

We would also have to extend the ruling to labor unions, which are themselves 501(c)(3) corporations, as are churches and synagogues. (Contrary to popular belief, they are not prohibited from making political statements or participating in campaigns. They only risk losing tax exempt status because of it. They risk no other sanction, absent any fraud, other than being treated like everyone else under the tax code.)

Advocates of a restrictive policy, abridging 1rst amendment protections for non-individuals, must address the troublesome question: If I have a 1^st amendment right as an individual to express myself via advertising, why is it that I lose those protections if I band together with other likeminded individuals in an association?

Yes, Mitt Romney is on record saying “corporations are people.” And democrats and republicans like Ron Paul pounced on him, alike, making the obvious points – that are only obvious if you don’t think about them too hard.

But in a legal context, Romney was referring to the fact that corporations are, in fact, associations of individuals with a common purpose – and that any taxes collected from corporations ultimately come from the pockets of individuals, for they can only be paid by reducing shareholder dividends or (as is common with gasoline), by raising the price the individual pays for goods and services to account for the higher tax.

There may be a legitimate state interest in placing some restrictions on corporations spending money on political advertising – though the constitution should properly place a very heavy burden on those seeking to abridge the first amendment to do so. But the effort to go beyond that, by mounting a withering attack on the doctrine of corporate personhood in its entirety, are throwing the baby out with the bathwater.

Why DIY investors don’t make it!

Posted April 24, 2012 by thomas

If you look at the stock market over the past 30 years or so, things look pretty good. Stocks have, in theory, created a lot of wealth for investors, in the aggregate – at least if you just look at share price increases. During the 20 year period from 1991-2011, the Standard & Poor’s 500 index of U.S. large cap stocks returned an annualized 7.81 percent.

But  how much of that wealth did individual investors actually realize? After all, unsophisticated DIY retail investors – the ones that watch those stock-picking shows on TV and call into Cramer asking for his advice off the top of his head – are motivated by fear and greed. And they tend to get fearful and greedy just when everyone else is, too.

As a result, the typical DIY investor buys after stocks have already risen substantially – and sells after they’ve already declined. We know this by interviewing investors, monitoring cash flows into and out of mutual funds. Buy low and sell high is not as easy as it sounds eh?

DALBAR has just published its much-anticipated Quantitative Analysis of Investor Behavior – an annual report that monitors the difference between market returns, and the cash-flow adjusted returns that the average individual retail investor actually realizes.

What did the average investor see? Just 3.49 percent.  That’s right: Over 50 percent of the wealth that should have been generated by stock price increases and dividends simply vanished, as far as the individual investor is concerned. It was eaten up by fees, commissions, and money that sophisticated investors and institutions earned, using Main Street dupes as counterparties. Every share the unwashed masses bought at the wrong time was sold by someone – likely a professional or institution, selling at the right time.

That has profound implications for the DIY investor and his/her retirement plans. Those numbers mean that DIY stock investors took all the risks of equity-holders, but achieved results worse than bond-holders had a right to expect. They got hurt worse by bear markets (in 2000 and again in 2008) and benefited less from bull markets. And those numbers reflect the difference between clobbering inflation and barely keeping pace.  And they reflect the difference between a secure retirement with piece of mind and one of sacrifice and worry.

What hurt investors in 2011? A lot of them got discouraged by lousy markets in the summer and fall, and gave up. They pulled out of the market before a year-end recovery, and missed out. Incidentally, they pulled out into one of the lowest interest-rate environments on record for safe vehicles like CDs, money markets and fixed annuities! So for 2011, even though the S&P posted a small gain of 2.12 percent for the year, the average equity mutual fund investor actually lost money that year – posting a loss of 5.73 percent.

The 2012 DALBAR study validates our investment approach here at Vaerdi. As usual. Specifically, it’s clear that the investor who buys and holds a broad index fund – mostly ignoring the ups and downs of the market, while keeping expenses low, in the aggregate, outperforms the typical unassisted, unsophisticated retail investor, year in and year out.

The problem: So few people even know about index funds – or the fact that some online brokers don’t even charge a commission on trades using their exchange-traded funds – the index funds you can buy and sell during the day like a stock.

That doesn’t mean index funds are the end-all-be-all of investing. They aren’t great risk management tools, for example, and come with no guarantees. But if you’re looking to capture the full effect of the wealth generated by American capital markets, they can’t be beat.

The study also reinforces the value of guarantees for the average American: The less likely an actual investor is to at least approximate market returns in his own portfolio, the more valuable we see that traditional, defined benefit pensions are, and the more value we see in annuities, which come with at least some guarantees, depending on the contract.