Top 5 Things An Investor Should Know...#1

Over the coming weeks, I’ll unpack what I’ll call my “Top 5 Things An Investor Should Know”. Hope you find it insightful and interesting…

This week starts with #1:

Unregulated capitalism is a bad thing.

Don’t get me wrong, I’m a capitalist. I believe in profit taking. I also lean much more to the free market economy side than to Keynesian economics (see this for more on free markets vs. Keynesianism). But, unregulated and unchecked capitalism has resulted in the “Wall Street Gone Wild” situation that we’ve experienced over the past decade - from dot com bubbles, to exorbitant profits, to a global meltdown, to exorbitant profits at the expense of the taxpayer (bailouts), to exorbitant profits, to exorbitant profits, to exorbitant profits.

While I don’t want to get too much into politics, it’s important to understand how politics and regulation affect the markets…I’ll try to keep this simple.

Let’s begin in the 90s when the Clinton administration thought it would be a nice idea that more people in America owned homes. I believe the exact words were: "Every American deserves to live the American dream". Well, most everyone that could afford to own homes already did in the booming economy. But what about those that couldn’t own homes (because they couldn’t afford them)? Well, the administration put pressure on the financial institutions and Fannie Mae and Freddy Mac to relax lending standards to those that didn’t and couldn’t own homes. Enter subprime mortgages and ARMs (Adjustable Rate Mortgages) - instruments considered “creative financing”. People (that normally would be turned down for a home loan) could now get loans and realize their American dream of home ownership. Hurray for the American dream, right? It sounded good…

Fast forward to 1999. An important piece of legislation known as the “Glass Steagall Act” was repealed. For understanding, Glass Steagall was put in place after the events of the Great Depression occurred. It in essence built a wall between any crisis Wall Street might have and “Main Street” not allowing a spillover effect – and was in effect for 65 years. Add in the “Commodities Futures Modernization Act of 2000” that kept financial derivatives from regulatory oversight and required no money down of the issuer in reserves to back up the derivatives, and we had massive deregulation and now the seeds for economic destruction. Financial institutions (Goldman Sachs, Lehman Brothers, Bear Stearns, e.g.) and insurance companies (AIG anyone?) got bigger and bigger.

At the same time, these financial institutions were piling more and more into creative financing and financial engineering. For example, consider mortgage backed securities (MBS): taking mortgages, bundling them together, and selling them in packages or slices. The problem, as we’ve discovered, was that many of those MBS packages had subprime mortgages in them…some even comprised of most all subprime mortgages!

Now what happened in 2007? You have people with a home loan that couldn’t normally afford it, a recessing economy, and a dash of job loss. That resulted in loan defaults. People couldn’t afford to make their home payments anymore. What happened to those mortgage backed securities that were grounded in the assumption that people would make their home payments? All the big institutions issuing those seemingly good investments (which were actually junk) and getting them rated as good (I’ll have more to say about ratings agencies in another post) began having cash problems because they couldn’t cover the defaults (because they weren’t required to have money in reserve).

Wall Street took risky bets, peddled junk, and got caught. Now, a true hardcore free market and capitalistic approach would have been to let the companies fail and send a clear message to any institution wanting to gamble with other people’s money. Economist Allan Meltzer puts it like this:

“Capitalism without failure is like religion without sin – it just doesn’t work.”

And how about a proverb:

“He who oppresses the poor to increase his wealth and he who gives gifts to the rich – both come to poverty” (Proverbs 22:16).

Apparently this isn’t the case in America any more. Instead, these institutions were labeled “too big to fail” and received a bailout - billed to the American taxpayer (thank you George W.). After all, the Washington elites had buddies on Wall Street that needed to maintain their quality of life, right? It might strike some as strange that such reforms benefitting these companies also happened with former Goldman Sachs elites at the helm of some key administrative positions (e.g., Robert Rubin, Secretary of the Treasury under Clinton and 26 year veteran of GS; Henry Paulson, Secretary of the Treasury under George W. and former CEO of GS). You might also find the article in this link interesting, if not upsetting at the least. Evidence of more crony capitalism? But I digress…

So in hindsight was making the American dream available to all worth it? Was deregulation worth it? It’s a nice political tactic, but in hindsight it cost us a lot. There is a reason that some people get turned down for mortgages – they can’t afford them. No matter how creative institutions got in their financing, the bottom line is that those mortgages should never have been handed out because the recipients couldn’t afford it. Financial institutions knew this, but the government prodded them along. They acquiesced like good boys and girls, then saw the deregulation gap open up and took the car for a joy ride while their proverbial government parents were asleep.

Consider this: the Dow Jones Industrial Average (commonly referred to as “the Dow”) first crossed the 10,000 level in 1999 and it finally crossed back over 10,000 this last month (as of this writing, the Dow is around 10,750). After including dividend income on stocks, the Dow has returned approximately 15% since 2000 – that’s about 1.5% per year. Investors could've done better holding bank certificates of deposit. Five-year Certificate of Deposits (CDs) were yielding 7% in 2000 and 4% in 2005 -- which would've returned 5.5% per year over the same period (and a total return of 71%). CDs are certainly not giving off those returns anymore. But most of us “sheep” owned investments in the stock market and between 2000 and 2010 Wall Street lost 20% of our retirement playing the stock market.

The real winners here in all of this? Wall Street. Over that same period, Wall Street pocketed hundreds of billions for themselves. Wall Street bonuses, even during the crisis, barely slowed or retracted. For example, the U.S. Treasury Department’s “pay czar” reported in July that 17 banks gave executive $1.6 billion while receiving billions in bailout money at the same time. Keep in mind, that’s only 17 of the 419 companies that took bailout money! When the crisis hit in 2008, these institutions off-loaded trillions of debt on taxpayers and received taxpayer money. Average Wall Street bonuses for 2009 were up 17 percent when compared with 2008. For those that didn’t fail (err, were left to fail like Lehman Brothers) they emerged even stronger and more wealthy. In May 2010, Goldman Sachs reported making money on in-house trading and investments every trading day in the year’s first quarter – even though only seven of nine of their “recommended” trades for investors like you and I paid off. In the second quarter, they only had ten days of in-house trading losses. They win, we lose. See how this works? The rest of the economy is in shambles, many people are out of work, and many unfortunate folks who took the bait and signed up for a subprime mortgage also have no home now. Wall Street wins, we lose.

But before we get too worked up bashing Wall Street, here’s the deal. Even though it peeves many on “Main Street” (me included), we have to understand that Wall Street played within the boundaries of what they were allowed to do. At first blush, it seems as though they are acting unethically (I wouldn’t disagree), but with an increasingly deregulated market, more opportunities are available and capitalism says that there will be profit takers. In the face of deregulation and relaxed lending standards (thank you Clinton and Bush administrations) within a capitalistic system, Wall Street moved in and did what it does best: take profits.

Thus the old adage is true and can be applied to deregulation: “give them an inch and they’ll take a mile.” This is why regulation is so important in a capitalistic system. Without some regulation and boundaries in place to keep the playing field relatively level, the hedonists in the market are further unleashed and eat everything in sight.

Bad news, good news...

To stray off the investment topic for a post, I couldn’t help but post this (I’ll return to investing next week). I came across a handful of charts on a blog that I follow called “Calculated Risk” and wanted to pass along for your observation (FYI – Calculated Risk is an excellent blog for any of you economics/finance nerds out there…it daily posts economic/finance data and indicators. For you non-economic/finance types, I dare say you’ll find it boring!). The following four graphs tell an incredible story about unemployment and the current state of the economy. Employment is always a huge factor in the “health of our economy” equation. It is also a factor that helps pull our economy out of the hole and back on solid footing…after all, the more people are employed, the more of their paychecks get pumped into the economy, right?

Keep in mind, the unemployment numbers are based on data from the government – the Bureau of Labor Statistics (BLS) – so I might venture to say the situation is actually worse than the charts below might indicate. However, we’ll take their data at face value for now. One day I might post about the BLS and how they conveniently falsify determine their unemployment numbers.

Anyway, I always like to get the bad news out of the way first so here you go…

What do these last two charts mean? Basically, it’s going to take the economy a lot longer to recover than it has in the past.

And now for some good news:

Despite high unemployment and a prolonged economic downturn, people are increasing savings and paying down debt. Have a look at the following two charts. The second shows “revolving consumer credit” - if you recall the post from Debt Happy, revolving consumer credit is credit card debt.

Of course, as has been noted before, people who pay off debt and save more are in effect not pumping money into the consumer machine and propping up businesses. But as I've also proposed, we’ve been living with an overinflated economy based on wants, not needs. More individual saving and less individual debt will help purge and deflate the economy to a healthy level. I consider this good news.

“No discipline seems pleasant at the time, but painful. Later on, however, it produces a harvest of righteousness for those who have been trained by it.” - Hebrews 12:11

Some beginning thoughts on investing...

I think I’ve been beating up on debt long enough in my posts. I hope everyone reading realizes how bad of a situation we are in as a country. I hope it’s also caused you to question your own life and how you spend money and consume.

I’m going to start to transition into some information on investing. Being in business school during this economic downturn has been interesting, to say the least, and has been like a having prime seats at a movie, sporting event, or play. More like a play probably (ha!). I hope my observations are helpful as I begin to unfold some thoughts on investing and the financial aspects of our economy.

So…

Up until this economic downturn, why do people invest in the stock market? Historically, the main reason is that one could earn more in stocks than they could with holding cash or investing in bonds. The “risk premium” is the amount that one is supposed to earn in interest by taking the additional risk of owning a certain investment. If one doesn’t get paid a premium for taking the risk, they should look elsewhere to put money.

Now, over the last 120 years investors were paid approximately 2.0-2.5% more each year (on average) to invest in stocks than in bonds. Not bad, but problems exist. Depending on what investment a person is in, risk premiums can be higher than 2.0-2.5% or well below it (especially in economic downturns). Also not in this factor is something called "selection bias", meaning that funds or investments that ultimately failed over the selected time period weren't included in the calculations. This starts to get real ugly, though, when we have to face up to the fact that we have no idea when economic downturns will occur – or how long they will last.

So what does that mean? Earning a 2.0-2.5% risk premium is based on picking the right investment and also on timing. Well, that’s not very comfortable to me because it’s not something that can be controlled nor can it be predicted…more like random luck than investing. Heck, we might as well take cash to a casino instead and play, right?

Now, I’m not saying we should just give up and not do anything, nor am I saying we should sell all our investments and stop investing, or even take it to the casino. What I’m trying to get at though, is that we grossly underestimate risk.

We’ve been sold a bill of goods that says, “put your money in the stock market and you’ll make a fortune.” While that might have been more true during the developing dot com bubble (where even a monkey picking stocks off a page could have made money), it is not the case today. The markets are extremely volatile and we don’t understand risk. Putting money in equities (stock related investments) exposes you to the possibility that you could lose it all, some, or none. How many brokers tell you that at the outset of investing your money, hmmm?

Here’s a statement worth time to ponder: “Past performance is not an indication of future performance.” Meaning, just because an investment has had a decade of positive returns, doesn’t mean it will have another decade of such returns. Anyone heard of a little oil company by the name of British Petroleum (BP) that had a little problem in the Gulf of Mexico? Yeah, they had a stock that gained in value for years. Since the spill, their stock price has been pummeled. Think anyone saw that coming?

Gone are the days of “easy” investing…we all need to get comfortable with that fact.

R I S K. It has to be considered. It has to be understood. It’s more of a factor than we think.

A good quote...

I came across this quote from Tony Blair’s new memoir “A Journey”, out this week, and couldn’t help but find it incredibly insightful and to the point.

Regarding stimulus, Keynesianism and re-regulation, Mr. Blair writes:

"Ultimately the recovery will be led not by governments but by industry, business, and the creativity, ingenuity and enterprise of people. If the measures you take in responding to the crisis diminish their incentives, curb their entrepreneurship, make them feel unsure about the climate in which they are working, the recovery becomes uncertain."

Worth some thought…