She Toddles!

This past week, my fifteen month-old, Finley, started taking her first steps. She’s been a solid climber for months (we frequently find her on top of the dining room table or in the dishwasher) but she’s been a bit more hesitant to walk. So, in an effort to be pushy parents, our new favorite after-dinner activity is for all four of us (Millie, three year-old Grayson, Finley and me) to sit on our kitchen floor and unashamedly make Finley walk from person to person.

And she really loves it…at first. We stand her up and she’ll stumble her way to the next person six feet away, ultimately landing in their lap with a squeal and a giggle. Of course, walking in our house isn’t easy. For starters, Finley has a big sister with the wingspan of a basketball player and the excitement of a cheerleader. Grayson frequently gets technical fouls for “excessive celebration” involving neck hugs that are a little too tight. Then there’s the 8 year-old lab mutt with a licking tongue and wagging tail who is all too excited that we’re all on her level. Worst of all, Millie and I are those parents that scoot back as the toddler nears us; hoping to get a couple extra steps out of her.

I’m astounded at how much of a pounding little Finley can take. She keeps toddling and falling, toddling and falling. Invariably though, all our “training sessions” seem to end with Finley crying, pouting and/or just flat-out refusing to put her feet on the floor when one of us tries, one last time, to stand her up. She’s a resilient kid, but she can only take so much before she is “open tears” as Grayson says.

The Obstacles We’re Toddling Through

Over the last quarter, we’ve seen the same sort of “resiliency” in the economy and in the investment markets. The economic and political environments look a lot like our toddling baby: taking a step, falling, taking a step, falling. Some of our data points suggest that investors are predicting the toddler actually won’t fall again, but rather she’ll break into a full sprint any minute now. We have been more skeptical (see our last few market commentaries) and while we believe that she will indeed learn to walk, she’s likely to have more falls, more bruises, and “Ms. Market” is likely to “pitch a fit” or two before running at full speed again.

  • Middle East/ Northern Africa: It’s hard to recall a quarter that has seen so much widespread, diverse geopolitical turmoil. Starting in January, riots and uprising in Tunisia migrated to Egypt and ultimately Libya culminating in a UN sanctioned attack on the reigning regime. Even Syria, which looked to be “civil unrest-proof” is in its third week of protests and uprising.
  • Japan Earthquake: In March, Japan experienced a massive earthquake. Though we’re still assessing the damage of the earthquake, the longer lasting variable is the lingering radiation from the Fukushima Daiichi Powerplant. Japan is an integral link in the supply chain for so many goods; this will only drive prices upward. I think it’s easy to say that a nuclear accident wasn’t high on many investors lists of potential risks.
  • Employment: We’ve seen some surprisingly good employment data recently, although as we like to say, the news is rarely as good or as bad as it seems. The unemployment rate has dropped below 9% – the effect chiefly of two factors: 1) large numbers of people giving up on finding a job (thus not being counted) and 2) rising government hiring (which some argue shouldn’t even be counted since we have to borrow to pay these wages). Fed Chairman Ben Bernanke observed that “this gain was barely sufficient to accommodate…recent graduates and other new entrants…and therefore, not enough to significantly erode the wide margin of slack that remains in our labor market.”
  • Federal Debt: The Federal Debt held by the public is around $9 trillion today. This is the amount our government is paying interest payments on (and in a historically rock-bottom rate environment, those payments are artificially low). Note that this doesn’t include the present value (money needed in the bank today) to pay for projected future demographic needs. That staggering sum is over $65 trillion and consists of $7.9 trillion for Social Security, $22.8 trillion for Medicare, and $35.3 trillion for Medicaid. Unfunded liabilities are not in themselves a problem, rather the problem lies in how likely someone will be able to fund them in the future.  For example, I have an unfunded retirement liability; meaning I still need to make contributions to my IRA to be able to retire decades down the road. If I continually ran a deficit, I would never be able to close in on my unfunded retirement liability. I need to live within my means today while setting aside money for tomorrow. If the US is running a yearly deficit on top of a large debt load, how will they contribute to their “IRA”?[1]
  • Inflation: The Core Consumer Price Index (Core CPI) measures inflation without Energy and Food taken into account. This is the inflation rate that the Fed keeps an eye on and it hasn’t been wildly out of control. The problem is that most of us need to drive….to the grocery store…often. This trip costs about 15-30% more than it did a year ago. Additionally, the Producer Price Index (PPI), a measure of the cost to make things, was up 1.6% just for the month of February! This would translate into nearly a 21% increase annually in the cost to make goods, after an increase of nearly 6% in 2010! We’re kidding ourselves if we think that won’t show up on our Target receipts in the near future.
  • Interest Rates: With Quantitative Easing 2 (QE2) the Fed agreed six months ago to buy $600 billion in treasuries through June of 2011. This provided the economy will loads of liquidity; but what happens when it runs out in two months? The Fed has a job to provide both stable employment and stable prices – but given a choice, they’ll likely choose employment. This could very well mean the Fed implements QE3. And with the inflation effects of QE2 not even showing up yet in the inflation numbers (it usually take 9-15 months), the implications of QE3 along with a possibly slowing economy will be even harder to stomach.

At any point in history we’ve always had some or all of these “obstacles” in the world economy and have “toddled” through one way or another. The point to realize is that some of the old tools we had at our disposal are no longer available. Most of the young parents that Millie and I know have an ample supply of foam pads to cover the corners of coffee tables, hearths, and anything else pointy and at toddler head level. Those foam pads are, in a sense, “tools” that lessen the risk of injury in the toddler stage. With our deficit sky high, home equity severely reduced, interest rates historically minimal, and more liquidity already in the system than ever in history, we are running dangerously low on fiscal and monetary versions of those foam pads to cushion the fall.

Pumpkins and Mice

Yet in all this, the S&P 500 was up more than 5% this quarter (all of it coming in the final two weeks). The largest contributors to this quarterly gain were areas we thought were the most overvalued at the beginning of the quarter (Small/Mid Caps, Low Quality Large Caps, and Real Estate). Their record performances were the results of one part speculation and one part unsustainably high profit margins – both part being fueled by this soon-to-dry-up excess liquidity. To us, these don’t look (and didn’t look) like areas with great prospects for future returns. Rather, they look like Cinderellas still dancing too close to midnight. While it’s never fun to stand on the outskirts, watching someone else dance the night away (and, for the interim, earn a higher return) it’s better than looking down and suddenly realizing you’re waltzing in dirty rags. As investors, we’d prefer to sit nearer the door rather than try to catch that last dance with the “handsome prince” (forgive my references; my 3 year-old is apparently sponsored by Disney®).

Interestingly enough, we still see some bright spots and we’ve tilted our portfolios to reflect where we see appealing risk/reward opportunities. These are mostly in the unloved or lesser-loved areas like: High Quality Equities (across all market caps but mostly in the Large Cap space), Emerging Markets, and Higher Risk Bonds (such as Corporate and Municipals). We’ve also been seeing good returns and further potential values in certain Commodities, driven by the demands both for their use (oil and food) and demand as a storehouse for wealth (silver and gold). Lastly, we’ve seen value in holding Cash. The latter idea sure won’t sell ads on CNBC, but it will certainly buy another dance or two when other investments turn to pumpkins and mice.

Justin W. Smith CFA®, CFP®

Financial Advisor

April 15, 2011

[1] For more, see Bloomberg Businessweek’s article “USA, Inc.” here: and the more in-depth analyst report here:

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Dog takes the pill but Cat takes the cake

I’m not immune from behavioral biases. Really, no one is. There’s no cure, either; the best you can hope for is to #1 understand how behavioral quirks effect us, #2 recognize them when they show up and #3 don’t let our biases interfere with our decision making. Number three is a lot harder to pull off than we think. What works for me is having a few trusted colleagues and friends to whom I’ve given authority to speak truth into my life when, as Dan Ariely puts it, I’m Predictably Irrational, or as Meir Statman says ever-so effortlessly, I’m Normal Stupid.

Long before the recent financial crisis, Ariely wrote about how we humans prize keeping all our options open, how forfeiting an option is painful and the high price we’ll pay to “prevent” incurring the emotional cost when we’re in danger of losing one of our options.

If your travels need an overnight in Asheville, you can surely spend more money but you won’t find nicer accommodations, better breakfasts and more delightful proprietors than at Sweet Biscuit Inn. While behavioral quirks in Asheville abound (everywhere, bumper stickers fulfill the prophecy: Asheville – Where Weird is Normal), you won’t find behavioral finance illustrated half so clearly than in Robert and Angela’s kitchen, headquarters to one fine chow-poodle mix named Otto and one cat named Daisy.  The cat is trouble.

Otto recently had surgery to repair one torn Ruptured Anterior Cruciate Ligament, or

Otto in cone

ACL. Otto was still feeling a little punky when we were there, partly due to his Elizabethan collar, to keep him from pulling out his staples.  Otto had learned to navigate the 1915 home and, much to his (and his owners’ delights) discovered he had a reverse gear, which is helpful if you walk around on all fours and wear a lampshade about your neck. So when Robert and Angela told me how they finally got him to swallow his pain pills, I perked up.   You never know when you, like Angela and Robert, will need to know the finer points on how to give an uncooperative dog 5 pills a day, without taking down your whole day or running your customers off.

So Angela and Robert popped a pill in Otto’s mouth. The pill went splat on the kitchen floor.  They tried wrapping the pill in a blanket of sliced ham, with the ends tucked in like an egg roll. Yum. Otto took the bait, swallowed. So far so good. Next dose, wrapped another ham slice around another pill.  Otto must have thought, “Fool me once, shame on you, fool me twice, shame on me.”  “Nah,” gestured Otto, “no pill going down my throat.”   Angela and Robert tried again. Ham roll went in, out flew the pill. “Let’s roll it up and put it at his feet and see if he takes it, one of them said, and so they did. Otto looked down, and then, as only a dog can do, looked utterly and completely disinterested.  Disinterested, that is, until Daisy the cat sashayed over to see what was shaking.  Figuring if Otto the dog was dumb enough to pass up a perfectly good slice of ham, they both didn’t have to be stupid and so Daisy tiptoed up to the trick ham slice like it was found money. “Not in my house,” grunted Otto to himself and upon seeing his treat about to disappear, lunged wide-eyed, open-jawed, past Daisy, Elizabethan collar and all, straight at the ham-roll, and gulped down his dose of deception in one bite.  Mission accomplished. Angela updated me  –

“We just had Otto’s staples removed today, so he is finally healing well. Pills are still no fun, although we are down to only 3 a day from 5 a day! Progress! Our cat Daisy was the great pill motivator for that one session. Butter is the lure device presently, but now Robert is worried about Otto’s cholesterol! You just can’t win!

In 2008, Ariely wrote about how winning looks and feels to contestants when they start seeing their precious options disappear.  Not too different from what Otto experienced. They pounce, even when it’s in their best interests to stand still.

“Closing a door on an option is experienced as a loss, and people are willing to pay a price to avoid the emotion of loss,” Dr. Ariely says. In the experiment, the price was easy to measure in lost cash. In life, the costs are less obvious — wasted time, missed opportunities. If you are afraid to drop any project at the office, you pay for it at home.”

You can read the full article here, and you can even try your hand at how a guinea pig feels to be in one of Ariely’s experiments.  If you see or hear iterations of Dog takes the pill but Cat takes the cake, drop us a line.

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Stability Breeds Instability

Playing at the sand and water table

Two summers ago, Justin’s oldest daughter, three year-old Grayson, discovered the Fisher Price Sand and Water Table and life hasn’t looked the same since. This little 2′ x 4′ table, as the name implies, has sand on one side and water on the other (though usually not for very long) and has been the source of hours upon hours of delight. She pours, she digs, she builds, she tears down, she repeats. In this commentary, we explore how three physicists at a computerized version of a sand and water table have informed the way we think about complacency, market stability, and the road ahead.

In Ubiquity, Why Catastrophes Happen, Mark Buchanan wrote that in trying to discover the underlying cause of a vast range of tumultuous events, no better archetype of simplicity stands out than that of the sandpile game[1]. “Imagine dropping grains of sand one by one onto a table and watching the pile grow. A grain falls accidentally here or there, and then in time the pile grows over it, freezing it in place . . . And so it was in 1987 when physicists Per Bak, Chao Tang and Kurt Wiesenfeld began playing [a computerized version of] this sandpile game in an office at Brookhaven National Laboratory, in New York…The researchers ran a huge number of tests, counting the grains in millions of avalanches in thousands of sandpiles, looking for the typical number involved. There was no typical number. Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur.”

Grayson unknowingly creating "Fingers of Instability."

So, the three physicists tweaked their computer program to show the sandpiles colored according to their steepness. Steeply piled “ready to topple over” sand grains were colored red, and stable, flat grains of sand were colored green. At the outset, of course, everything was green, but flip the switch and let the randomized sand sprinkling begin, and green sand piling up became red. They peered closer. One red pile threaded itself through sandy green plains to another red pile, and another, and another. These networks, later known as “Fingers of Instability”, seemed to map themselves effortlessly and complacently into place. If the next avalanche-inducing grain fell onto a red pile sparsely connected to other red piles, the damage was minimal and contained. However, if the next avalanche-inducing grain fell onto a red pile connected by dense networks to other red piles, it could set off a chain reaction, flattening the entire sand pile.

In other words . . . actually in the words of Economics Nobel Laureate Hyman Minsky, “stability breeds instability.” What we call complacency, Minsky called his Financial Instability Hypothesis, which goes something like this: when times are good, investors take on risk. The longer times stay good, the more risk they take on, until they’ve taken on too much and reach a point where the cash generated by their assets is insufficient to payoff the mountains of debt they took on to acquire them in the first place. Losses on such speculative assets prompt lenders to call in their loans. Cash strapped investors sell off even their less-speculative holdings to make good on their loans, leading to a wholesale collapse of asset values. And to think that Minsky (1919-1996) died 11 years before the real estate bubble.

Stability Breeds Instability

In real life, sand piles don’t change color to highlight areas of instability. No, from the outside, the pile of sand on my table probably looks the same as the pile on yours. It’s only in computerized models that the lights start flashing red and green. The following are some of the “red sands” (or the “stability that breeds instability”) that we see piling up. They might not seem to spell trouble; but that’s exactly Minsky’s point.

  • Investor Sentiment Positive and Increasing – The American Association of Individual Investors’ (AAII) bullish investor sentiment (a survey of the optimism of individual investors) has been this high only 17 weeks out of 1232 weeks (1.38% of the time). Also AAII’s bearish investor sentiment (a survey of the pessimism of individual investors) has been this low only 76 weeks out of 1232 weeks (6.17% of the time).
  • Market Pessimism and Volatility Low and Falling – Our own pessimism and volatility indexes have returned to the lows of 2004-mid 2007 and of April 2010, times that preceded market swoons.
  • Personal Hedging Activity Absent, Commercial Hedging Present – Patrick J. O’Hare, Briefing’s Chief Market Analyst, notes that the currently low CBOE Put/Call ratio is a sign of complacency (there’s little need to buy insurance). Conversely, he notes that the Commitment of Traders report shows commercial hedgers have a large net short position, which frequently precedes a dramatic shift in the current trend.
  • Riskier Assets Outperforming – Obviously stocks have outperformed bonds, and high yield bonds have outperformed high quality bonds, but more subtly, Morningstar’s “high uncertainty” risk universe has outperformed the “low uncertainty” risk universe since the July 2010 lows by a margin of 2.3.
  • “Smart Money/Dumb Money” Confidence Spread Falling – Sentiment Trader’s ratio of “smart money”indicators (indicators which typically “correctly” predict the market movements) to “dumb money” indicators (those that tend to get it wrong) is 0.458, markedly outside the normal range.
  • Mutual Fund Flows Shifting – Following 24 months of steady inflows to bond funds, retail investors have started pulling money out of bond funds and begun buying stock funds.
  • Drought of “Worst Days” Getting Longer – We keep a running list of the market’s 150 worst days since 1928. For some context, we had 13 in 2008 and 4 in 2009, but it’s been nearly two years since we’ve had a “worst” day. Unfortunately, we think investors have forgotten what those “worst days” really feel like.

Living in Red Sandville

Grayson "rebalancing" Her Cups

In spite of the above, we think fundamental reasons for owning high quality stocks in balanced portfolios remain: shares of low uncertainty risk, wide-moat, dividend paying companies are available at prices below fair value. Our emphasis on companies that pay rising and sustainable cash dividends makes accepting a world of uncertainties tolerable. However, a stock market up 16% since the end of August 2010, with red grains piling up on the sand and water table, raises the likelihood for an unexpected market setback of some degree and requires a plan.

Since each of our clients and their situations is unique, we think and behave in Red Sandville in different ways for each of them. For some, in addition to our shift to quality, we’re tackling it with minor rebalancing out of overrun assets into better valued assets. For others, we’re accumulating a much larger than normal cash position. This is where knowing the amount of risk that our clients’ stomachs and wallets can bear is so important. While our timing won’t be perfect and we might not experience a sand avalanche for some time, we are not going to forget the words of fellow advisor Charles Knott, “[Investment] opportunities come again and again, but our clients’ principal comes but once.”

Jonathan Smith
Managing Partner

BACK TO POST [1]We’d like to thank John Mauldin for helping us connect the dots between Minsky, Sand Piles, and Fingers of Instability in his weekly newsletter “Thoughts from the Frontline”, which can be found at

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What Investors Really Want

Jonathan here.

“What led you to write this book,” I asked Meir Statman,

Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University and Visiting Professor at Tilburg University in the Netherlands, referring to his gem of a book, What Investors Really Want.   Professor Statman, who learned resilience as a child raised by “holocaust survivors who persevered to make a life for themselves and their three children,” shared his thoughts about this and other questions.   Our conversation of December 10, 2010 follows:

JS: What Investors Really Want is a fascinating and powerful book; after reading it, I want to change the name of my company from Jonathan Smith & Co. Investment Counsel to Jonathan Smith & Co. Investor Counsel. What led you to write this book?

MS: I wanted to share my knowledge with investors. I serve as a lab of myself and gain many insights by introspection. Some aspects of my behavior make little sense, and I ask myself whether my behavior is unique to me or common to all people. For example, am I unique in finding it difficult to manage my spending and saving such that I don’t overdo either of them? This introspection leads me to studies of self-control in saving and spending and to the conclusion that financial advisors must manage the behavior of their clients as much as they manage their investments.   There is no shame in our need to be guided, taught, and managed.

JS: It’s very interesting that you mentioned no shame. We want, as you wrote, to nurture hope for riches and banish fear of poverty. How can we balance the two?

MS: It is difficult to find the right balance between desire for protection from poverty and hope for riches. Today fear prompts us to focus on the desire not to be poor as we see portfolios that have shriveled and an economy in great trouble. We have lost much hope. We say “I would rather keep what I have rather than aspire to more.” So we pile into bonds or they pile into gold, as they perceive a world that is collapsing. This is where science comes in, where knowledge of the behavior of markets and our own behavior is especially important. We know from science that fear is causing us to see moderately sized risk as giant risk, and so we become more risk averse. Knowing the effect of misleading emotions on us is the first line of defense against them. I say to myself, “I know that I’m scared, and I know how fear affects me.” I can then apply reason to moderate the effect of fear. I say to myself: “The world is not coming to an end. Stocks go down, and stocks go up. I shouldn’t overload my portfolio with stocks and I shouldn’t leverage them, but I also shouldn’t hide my entire portfolio in gold and bonds.

JS:  The marriage of science and finance can be enormously helpful.  You’ve written, and rightly so, “We want three kinds of benefits from our investments: Utilitarian, expressive, and emotional.”  We want our cake and eat it too.  We also want, I think, three other kinds of benefits from our investments, I believe, and from our cars, from our plumbers, and from anything else our money can buy: we want speed, price, and quality.  We want all three, but in reality, we get to choose any two out of three.  Only on rare occasions can we have all three.  In your opinion, is it possible to have full buckets of utilitarian, expressive, and emotional benefits from our investments or will we have to settle for two out of the three?

MS: We cannot have it all in life or investments. We always face trade-offs between utilitarian, expressive and emotional benefits. But we should not deny that investors care about benefits beyond the utilitarian benefits of investment returns. Yes, investors who trade often sacrifice some returns, but they enjoy the expressive and emotional benefits of trading in the same way that we enjoy video games. Trade if you enjoy it, as long as trading does not undermine important goals such as retirement income and savings for your children.

JS: You’ve said, “We do not have computers for brains and we want benefits computers cannot even comprehend.”

MS: Sometimes we describe people who do not have computers for brains as irrational. By that definition, I’m irrational and I imagine you’re irrational too.  We pay extra for a Lexus when a Toyota does the same utilitarian job of getting us from home to work and back. But it doesn’t mean that everyone who buys a Lexus is an idiot.  We want cars that are beautiful in our eyes; we want cars that show that we are rich enough to afford them.  We should be tolerant of one another and allow for differences in taste rather than say that people who have different tastes from us are idiots.

JS: We have become intolerant, it’s so true.  “We want profits higher than risks, we have thoughts some erroneous, we have emotions some misleading.”  The Web is creating a constant and heightened awareness of our holdings, how they make us feel, and what they say to others and ourselves about us, to say nothing about what the Web is doing to raise our awareness to an increasingly unstable world and time, for millions of investors, is running out, precisely when our earning potential and our intellect might have peaked.  As an advisor, I worry that investors and advisors are caving in, calming investors’ fears instead of rebalancing their portfolios and buying lower yielding, and lower yielding investments, leaving us exposed to inflation and increasing dependence on a paternalistic government, exposing us to the threat of higher taxes.  How can we possibly turn this around?

MS:  Advisors should know financial markets and human nature if they are to guide clients. A 40-year old client might say, “I’m going to put my entire portfolio in bonds.” You, as an advisor, can point out to them that if indeed they put it all in bonds they are likely to live on very little in retirement, a sure little, but still very little. All of life involves risks, and we are foolish to try to avoid all of them. Think about the risk in getting married. If you want more risk, have children. We take risk when we choose a profession. We take risk when we move from one place to another. The risk in our portfolios is just one of many risks in life. Yes, a portfolio containing some stocks is likely to bite you hard from time to time, but it might give you a better chance to reach your goals than a portfolio that is entirely in Treasury bills.

JS: I think advisors need to learn how to step up, and to be respectfully tolerant with their clients and, as you say, to lead and guide them, perhaps by their own examples, as you’ve done, into understanding the trade-offs.

MS: I think that advisors should think of themselves as financial physicians, knowing and applying the science of investments and the science of human behavior. Too often financial advisors think about themselves as investment managers and display no patience as clients describe family quarrels and jealousies. Good advisors place themselves in their clients’ shoes. An advisor might think that leaving money to the kids is fine only if clients have portfolios fat enough for ample retirement income. But some clients consider leaving money for their kids more important than ample retirement income. Good advisors listen to what clients want and help them make the distinction between what they want that is reasonable and what they want that is not. This is very hard work for advisors. But this is the great value they provide.

JS: Meir, I will take that as a call to arms from you.  Thank you.  Decades ago, when your father asked to tap his pension fund to build an extra room to his home for his growing family, the managers of the fund turned him down, and at the time he was sad, but he was grateful for them in retirement.  Today we live in a society that is highly skilled in acquisitive ways, if someone tells us “no” we’ll keep on trying until we get a “yes.” How do we learn to say no to ourselves and accept that no?

MS: Being able to say “no” to ourselves is part of growing up. Toddlers aren’t very good at saying no to themselves, so you can see them scream in supermarkets aisles because they want the candy on the shelf. They need their moms to say, “No, you cannot have it.” But as we grow up, we hear our parents’ voices inside us. There is still the voice of a child in us who says, “I want that candy, I want that new car, I want to build this extra room,” and there is the voice of the parent in us who says, “no you cannot buy that car now because if you do you will not have enough for retirement.” Sometimes we need the help of others, such as financial advisors, to do what is right. My Dad understood years later that the pension managers who denied his request for money were smarter than he was, or at least more cool-headed.  They considered the trade-off between spending now and having enough in retirement, and they’ve done him a favor by denying him the money.

JS: your Blog tour is a wonderful concept and I’m sure it’s stretched you in many ways. Is there a question along the way that you had hoped you’d be asked but that you haven’t been?

MS: The issues of values did not come up as much as I hoped and issues of children did not come up as much as I hoped. These are central for advisors because they answer the question “What is the money for?” Sometimes advisors speak about clients as if clients are kind of machines that accumulate money for ourselves during working years and spend it on ourselves in retirement. But what about families? What about children? Some children are disabled. Some children need help beyond age 21 or 22.  We have to answer the question of “what is the money for” because money is only a vehicle for happiness. Financial advisors have a very important role in guiding clients away from decisions such as leaving money to one kid but not to another, which might feel right at the moment but destroy families later.

JS: I have a friend, 30 years old who has a note written on a sticky pad that he has placed on the dashboard of his car, which reads. “Comparison is the thief of all joy,”

MS: That is right. I think that it is very important to restrain our competitive instinct and direct it well. The competitive instinct was immensely important for our ancestors in the African Savannah when there was not enough food for everyone, and it’s still important for us today, because competition and ambition promote achievement. But if we let our ambitions run way ahead of us, we will always be frustrated.  It is sad when we are unhappy with $50 million because Joe has $75 million.  Learning to say “enough” is a banal lesson, but it is a true and useful lesson.

JS: I am profoundly grateful for your time and your thoughts today, for your book, and for your commitment to investors worldwide, and to the investment profession.

MS: Thank you Jonathan, it was a pleasure to speak with you.

Endnote: If investing for you feels like a losing game of Whack-A-Banker, put down that hammer, get a copy of Meir’s What Investors Really Want, and learn how asking yourself some new and different questions could make a difference in your investing.

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The great lane change-up

(Originally published October 15, 2010)

One Friday in October, I drove down to Charlotte with Anne and a dear friend to attend a black tie dinner celebrating the 25th anniversary of the Western Carolina Chapter of the Alzheimer’s Association. Having seen my mother and a number of our clients’ lives devastated by the disease, I have volunteered to chair Greensboro’s 2011 Memory Walk and the dinner only cemented my commitment to the cause. (If you’d like to help fight this disease, you know how to find me.) The highlight of the evening was getting to meet Vera Guise, the woman from Cullowhee, NC, who 25 years ago, while caring for two Alzheimer’s afflicted parents, single-handedly founded the chapter that today provides help and hope to 50,000 families in 49 counties in western North Carolina.

The only ‘lowlight’ of the rather memorable evening was the ride down. After twenty minutes of smooth sailing, we met screeching stops, bad-tempered drivers, and hyped up kamikaze motorcycles weaving through traffic at speeds approaching the sound barrier. What should have been a pleasant hour-and-a-half trip turned into a three-hour trek. Had it not been for the good traveling company, it would have been unbearable. The interesting thing about being in a traffic jam is that there is always a tendency to pick the lane that seems to be traveling the fastest. Sometimes you’ll luck out and move along better, but more often than not, you aren’t the only driver to have that brilliant idea and the fast lane quickly grinds to a halt.

Somewhere between Salisbury and Kannapolis, I realized that the financial markets are much like a never-ending traffic jam. While one asset class moves along, others stand still. At times, all lanes move along at breakneck speed and at other times, an overturned tractor-trailer stretches across all five lanes. In the last 21 months, we’ve seen unprecedented cash flow into bond mutual funds and out of stock mutual funds. While we’ve seen plenty of lane-shifting in the past (into technology in the 90’s and real estate in the 00’s), much of that shifting was out of one fast-moving lane into another even faster lane.

The thing that makes today’s “Great Lane Change” into bonds unique is that we’re seeing “drivers” move from both the slow lane (Money Markets) and the fast lane (Stocks) into the middle lane of Bonds. The investors in Money Markets and CDs are fed up with near-zero returns and the investors in Stocks are happily taking money off the table that has seen a nice return over the last 18 months. Combine this with the great past returns of bonds (that are still, as the saying goes, no sign of future returns) and you can see the traffic patterns pretty easily.

The problem we see with continuing to add to bond positions (even, and especially, in the “safest” of these, the U.S. Treasury) is three-fold: the retail investor is rarely right, the bond lane seems to have a flashing “Road Work Ahead” sign squarely in the road, and we think high-quality dividend-paying stocks have many bond-like qualities without the same interest rate risk.

The Investor is Rarely Right

These flows show, for the most part, the decisions of retail mutual fund investors, who have been known, as a group, to buy and sell the wrong things at the wrong times. A recent study from DALBAR shows that for the last 20 years, equity returns for the S&P 500 index have been 8.35% annualized versus just 1.87% for the average investor. On the bond side, the results have been much the same; Barclay’s Bond Index rose 7.43% annually versus the average bond investor’s return of 0.77%. In other words, Joe and Jan Investor’s timing has been far from impeccable and this “Great Lane Shift” makes us suspicious.

Source: Riverfront Investment Group

Road Work Ahead

The chart above shows 10-year U.S. bond yields since 1798. Note that in only two other periods in our country’s history have we experienced yields this low (once in a lifetime!) It is important to remember that in the seesaw bond world, rising yields result in falling prices. If U.S. bond yields revert to 4% (where they were just 6 short months ago in April 2010!), bonds could lose nearly 10% in price, the equivalent of the next four years’ interest payments. Investors’ thirst for high quality bonds could turn out to be a very expensive form of insurance just to hedge the pain of prolonged uncertainty.

Bond-like Stocks

So, if the bond lane looks congested with Road Work Ahead, is there an alternate route? Let’s look at an example. Today, we can buy a Johnson & Johnson (JNJ) 10-year bond paying 2.83% yield to maturity and whose bond payments are guaranteed to grow 0% over that time. Alternatively, we could own JNJ common stock, whose latest quarterly dividend of 54 cents per share equals a 3.4% annualized yield. If the company continues to raise the dividend at just half the rate we expect, the “rent” will likely more than outpace inflation.

And while we know as well as anyone that stocks like JNJ can (and will) go down sometime in the future, we’re at a point where buying bonds at today’s prices carries near-equal risk with nowhere-near the incremental return. If inflation and interest rates revert to trend levels, an investment in JNJ bonds could impair our capital and result in diminished future purchasing power (that 10% drop mentioned above) while the stock dividends could have growth potential.

Meflation is What Matters

Last month, The Wall Street Journal’s Jason Zweig penned a piece about “Meflation”. He noted that investors put so much effort into figuring out whether we’ll see inflation or deflation and picking the right course based on the research. His thoughts were refreshing: don’t invest according to what you think will happen, rather invest according to what will affect you personally (“me”). This is the same approach we take with Bonds versus Stocks. While we’ve laid out reasons to think about not swerving broadside into the bond lane, it doesn’t mean we are avoiding the tangible safety and predictable returns of bonds. The trick is to make a sound judgment about the trip ahead and then chart an appropriate course.

The most important thing about our drive to Charlotte last Friday was not that our trip was pleasant or that we arrived before anyone else. Rather, the most important thing was that we got there safely, and after experiencing a wonderful evening, we arrived safely back home. Some terrified drivers pulled over and waited for traffic to clear. Others took the first available exit off the interstate or made a u-turn, causing us to wonder if they knew where they were going. And some switched lanes incessantly, unaware they lost about a car length with every change. Our Suburban held it in the road, adjusted to changing conditions, and we did our best to enjoy the ride.

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NPR’s Adam Davidson and Alex Blumberg put the cookies on the bottom shelf in their demystification of Quantitative Easing, “really one of the more impressive financial phrases out there, impressive for the distance between how boring it sounds and how dramatic it actually is.”

The right question to ask, in my view, isn’t whether QE2 will work or won’t work, the right question to ask is, “are the assets I own priced correctly, given the full range of possible outcomes?” The right asset, but at the wrong price, will eventually deliver its consequences. If you’re going to consider anything, you have to consider everything.

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Why Three Top Bond Managers Like Equities

Why Three Top Bond Managers Like Equities.

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“Investors Think Insurance Agents, Brokers are Fiduciaries”

I read an interesting article from this morning (full article here).  In case you wondered, other people who are not fiduciaries include, but are not limited to: my dentist, my plumber, and the drive-thru worker who asks if I want to supersize my combo meal. It doesn’t mean they are bad people (in fact, I’m more than happy with their service), they just aren’t required to put my interests first. Excerpt below:

But there is still a lot of confusion about who is actually held to a fiduciary standard, the survey found. Three out of five U.S. investors think insurance agents do. Two out of three U.S. investors think stockbrokers do. And 76 percent of investors think that all financial advisors (a term used to describe brokerage firm salespeople) do. Meanwhile, 75 percent think that financial planners are held to a fiduciary standard and 77 percent say investment advisers are.

Only 29% understand that the primary function of stockbrokers is to buy and sell investments to clients, and only present limited advice.

So, here are some questions to ask an advisor, insurance agent, dentist, or drive-thru worker (in that order): How and what are you paid in our relationship? Are you required by law or oath to put my interests first? Do I really need a tooth-colored crown on a tooth that only my spouse will see? Take a look at me, do you really think I should supersize my combo?

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Opportunity Arriving Daily

Sir John Templeton, Jonathan Smith, and William H. Barnhardt
Douglas Airport, Charlotte, NC sometime in August 1987
Photographer: J. David Barnhardt

During the 1980’s, I had the unalloyed privilege of managing some money for the late Sir John Templeton. Every now and again, I pause to consider that one of the world’s wisest investors mentored me, with his money and on his dime, and I am profoundly grateful.

His wisdom was vast, his insights were unconventional, and his generosity knew no bounds. Sir John was always a learner and never a knower. Learners keep flexible and open-minded; knowers are brittle. When naysayers challenged his view that life continually offered wonderful opportunities, he countered that opportunities were not all gone, what was missing was preparation. Wisdom like this takes years to sink in. Some do not ever get it.

This summer, a Chattanooga friend who knows Lauren Templeton, the founder of the investment firm bearing her name, told her that years ago I managed some money for Sir John. Lauren is the wife of Scott Phillips, a principal and portfolio manager at Lauren Templeton Capital Management, LLC and the great-niece of Sir John Templeton. We three connected and talked for over an hour, a joy that reminded me of many conversations with John Templeton himself. This week, I shared my recollection of Sir John’s views on opportunity and preparation with Scott. He reminded me that Sir John once said that the very reason he went to the trouble to save half of his income was so he would have the necessary funds ready to take advantage of future opportunities, since opportunities often appear when least expected. This Scott knows, as is evidenced throughout his latest book, Buying at the Point of Maximum Pessimism, Six Value Trends From China to Oil to Agriculture.

At Jonathan Smith & Co., Investment Counsel, we recognize volatility in financial markets is high and is likely to remain high. Our experience is that volatility can be unbearably unsettling to investors, leading them to sell good companies for wrong reasons. Volatility can also paralyze investors, preventing them from taking steps that historically, over the long haul, have been in their best interests: buying quality investments whose margins of safety are high. Investors are not the only ones who must manage volatility successfully if they want to survive; read how hard pilots have it when their outlooks are horribly pessimistic:

“There’s an exercise that some pilots go through late in their flight training. The student pilot gets the plane airborne, at cruising altitude. Then the instructor places a loose-fitting, thick-woven sack over the student’s head, so the student can see nothing. The instructor takes the controls and starts stunt-piloting. He loops the loop. He pushes the plane, Turkish-headache-style, skyward, then flips belly-up and swoops earthward. He rollicks and spirals, careens and nosedives, tailspins and wing-tilts. He gets the student utter discombobulated. Then he puts the plane in a suicide dive, plucks the bag off the student’s head, and hands him the controls. His job: to get the plane back under control.” (Mark Buchanan, The Rest of God, Restoring your Soul by Restoring Sabbath, page 37)

Getting investors’ “financial planes” back under control is the JSCO Way, yet so many investors are still utterly discombobulated, their planes in suicide dives. If the instructor has plucked the bag off your head, handed you the controls, and if it feels like you are approaching earth at 17,333 feet per second, give us a call, we can put your nosedive on hold for as long as it takes to have a conversation about getting your financial plane back under control.  And if you do not want to, we will hand you back the controls while our parachutes still have time to open.

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Looking at Investing Through the Eyes of a Landlord

It seemed like a really great idea at first. And it actually was, but somewhere along the way, it turned bad, really bad. I’m not quite sure when, but it was either before or after a tenant started breeding Pit Bulls in the back bedroom . . . well, now that I say that, it was probably before. The story starts a good six years before the Pit Bulls. I was just finishing my freshman year in college. Four friends and I were looking for an apartment that would rent to five college kids, but no one would go above four (that should have been my first hint). So I hatched an idea and floated it past Jonathan (side note: I quit referring to him as “Dad” after my first day of work here). I proposed that we use my first-time homebuyer status to get a cheap loan, then buy a four bedroom condo, cover our mortgage with the rent from my four roommates, and on graduation day we’d easily sell it and voila, three years of rent free living. I was, as we say, very bullish.

It worked well for the first three years. In addition to the rent working out as planned, I happened to meet my wife, Millie, who was living in the building next door (I later learned she had made the same proposal to her Mom and they owned her condo also – the serendipity!) Three years later, my roommates became my groomsmen when Millie and I married a month after graduation and, even though we couldn’t sell the condo right away, we found some decent tenants to tide us over for “just a few months.”

That first batch of tenants sent their checks in on time and didn’t scuff up the walls too badly. But as we continued to rent it out while looking for a buyer, we discovered each group of tenants brought new troubles. Our costs went up: carpets had to be cleaned after each tenant, washers broke, and rooms were painted black. And our emotional expense went up as well: lost sleep over dealing with missed rents and worry over our exit price. All the while our potential liabilities piled up: the smoke detectors went unattended, the 3rd floor porch railing was removed for an impromptu golf driving range, and of course the aforementioned Pit Bull husbandry. Thankfully, the world is full of enterprising young men with four friends who want to live together – we were lucky enough to sell our place to one such “investor” well before the housing market collapsed.

The Tenants or “You’re Going to Let Who Stay in Our Hotel?!?”

Arabic Numbers: Where the 4’s look like backwards 3’s

We have a good friend who refers to monthly statements and the flashing data on CNBC as “Arabic Numbers” because they have no real significance without someone willing to interpret and apply them to a specific investor’s situation. One of the “interpretation” tools we use is to view our investment portfolio through the eyes of a Landlord.

As far as we’re concerned, every investor, from the parents saving for college to Warren Buffett himself, is the Owner and de facto Landlord of a 100 room hotel. Each room represents 1% of their portfolio and each Landlord has the choice to rent out each room to a variety of tenants with various quirks. We’d like to introduce the tenants and shed light on how this framework helps us see and navigate the current environment.

Bonds: We have a wide spectrum, but let’s start with our average Bond. We’ll call him James Bond and he agrees to pay us a stated rent and even shows us his estimated payment schedule. In addition, if we let him stay and don’t evict him before the term of his lease is up (if we don’t sell our Bond before maturity), then James promises to leave the room in the same condition he found it. At one end of the spectrum, we have our safest Bond, a US Treasury, who we’ll call T. Bill Bond. Bill has never missed a payment in over 200 years and is pretty well regarded globally. He won’t pay us as much rent as James, but we usually sleep well at night with him in our rooms. At the other end is the riskier High Yield Bonds, we’ll call Barry Bond. Barry has high hopes and offers big promises. He owes a lot of money to his lenders and doesn’t have the best track record of paying his rent. The only reason we let him set foot in one of our rooms is because he promises to give us a large rent check . . . and, like all Bonds, we have a legal contract we can enforce in case he backs out.

Stocks: We have a very curious relationship with our Stock tenants. It really couldn’t look more different from Bonds. In most cases, we allow Stocks to stay with no promise or expectation of a monthly rent. Why? Well, our proposal to Stocks goes like this: we let them stay rent free with no lease agreement in hopes that when we kick them out (sell them), they’ll pay us all their “back rent” in one lump sum payment. It sounds pretty preposterous, but history shows that over long stretches of time, Stocks pay a pretty decent rent. It’s like they are so thankful for a place to “live” while they sell their iThings, Microthings, and Googlethings that they are happy to share in the profits when they move out.

Of course, there are plenty of times when Stocks don’t pay rent when they move out. The best outcome in that situation is that they leave the hotel room the way they found it and we can just rent it out again to whoever we choose (we have no loss on our position). The worst outcome is when we rent a room (or worse, multiple rooms) to someone like those Lehman Brothers or someone who will go unnamed but whose initials are AIG. They not only stiffed their Landlords, but they stole bathrobes, set the drapes on fire, and got the hotel room permanently condemned.

Dividend Stocks: A subset of the Stock tenants is the Dividend Paying Stocks. These Dividenders say they’ll pay a monthly rent, but they give no legal promise. In fact, all that the Landlord has to go on is the Dividender’s history, their word, and their deeds. This can leave the unsuspecting Landlord open for much disappointment. We’ve seen it plenty of times (and even been tricked ourselves); some Dividenders say they’ll pay rent but end up over-promising and under-delivering. Inevitably they don’t pay the advertised rent, or even a fraction of it. When the Landlord gets fed up with their broken promises and kicks them out, they find a hotel room that looks like it was inhabited by an ‘80’s Rock Band. This is why our “screening” process for these Dividenders goes far beyond looking at last month’s rent check. As we’ve mentioned in prior commentaries, we look at their rental history, “job security”, other financial obligations, and, most importantly, their ability and willingness to increase their rent payments.

Third floor Driving Range
Note: Do Not Try This At Home

Gold: Just when it seems that we couldn’t get much different than the above mentioned cast of characters, we meet the most unusual fellow of all: Gold. On the surface, he seems like the last person we’d want to rent to: he has no job, no real prospects for employment, he promises no monthly rent and his only redeeming attribute is that he’s a snazzy dresser . . . and, or course, he’s always been a hit with the ladies. The only way that I, as a Landlord, can make a profit by renting to Gold is by pawning him off on the next Landlord who pays me a premium. Today, Landlords are clamoring for Gold – they’re paying close to historical highs to prior Landlords just for the opportunity to let him in their rooms. This isn’t to say he’s a bad guy. He has a long history of being the go-to tenant in times of uncertainty and fear – it’s just important to know what we’re getting into. Warren Buffett agrees when he says about Gold, “It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Cash: After all these instances of skipping rent and trashing rooms (it feels like I’m watching Tom Hanks in The Money Pit ), one doesn’t have to explain the appeal of Cash. In effect, owning Cash is the equivalent of putting a “No Vacancy” sign on any number of doors. While we won’t collect any rent, we’re guaranteed to have our room in the condition we left it – chocolates still on the pillows and the toilet-paper roll still folded into a point. Of course, an empty room provides little comfort when costs inflate.

The Landscape or “Where’s the Rent Coming From This Month?”

That’s a lot of words spent on setting the stage, so we’ll get right to the point, which is what we see happening in the markets. Recession, Inflation, Deflation, and Interest Rates seem to be on everyone’s mind, so we’ll spend the rest of our time there.

The Money Pit tagline is eerily appropriate:
“For everyone who’s ever been deeply in
Love or deeply in Debt”

Recession impacts our Stock tenants just like it would any real-life tenant. If Joe Stock’s income is squeezed, he has less money to spend on rent. Same goes for the Dividenders, if they aren’t committed to sending their monthly rent check, they will either reduce or eliminate it all together. We think the probability of another recession (or just continuing the one we may not have ever really exited) is about 50/50. Add in the possibility of large tax increases in 2011 which bring a “negative multiplier” effect (it hurts growth 2-3x more than it helps tax revenues) and a recession gets more certain. The key to renting to Stocks when the shadow of recession is in view, is to only offer rooms to those tenants with secure jobs and predictable salaries, and to have realistically low expectations for “exit rent” that would still make it worthwhile to the Landlord.

Inflation is the silent killer of the hotel business; most evidently in our Cash and Bond rooms. We see it in our hotel’s rising prices of utility bills, staff health insurance and pool maintenance. While our Stocks have jobs that will likely pay them more in times of inflation (thus passing that along to the Landlord) our Bonds have contracted a set amount of monthly rent and our Cash is paying us nothing. While we think it’s a near certainty that we’ll have some period of rapid inflation in the US, the question is “When?” We, for one, do not want to be holding a massive amount of Bonds when inflation returns, forcing interest rates to shoot up, and we’re stuck with an undesirable tenant.

Deflation, a decline in prices, is the flipside of inflation. It’s easy enough to see that this has the opposite effects of inflation and, from where we sit, this seems to be a likely short-term scenario. Even though the Fed is printing money and injecting stimulus, if banks and consumers are holding on to funds at an even faster clip, the end result is that money is being taken out of the economy, prices quit going up, and interest rates go lower. In our Portfolio Hotel, deflation will favor Bond holdings (because we’re happy to collect their now relatively high monthly rents) and favor the Quality, Dividend-Paying Stocks over the Non-Paying Stocks (again, due to the rent coming in). If and when we see deflation, we don’t think it will be a long period and we’re not ones to want to stake long-term assets on a short-term event. So, while we have adequate Bond exposure, we’ve stopped short of overweighting this short-term scenario. Rather, we’re choosing to “bet” on deflation by being more certain that our clients have adequate personal reserves and are paying off any expensive debts. In other words, we’re less inclined to rent out rooms that we might want to live in over the next couple years.

Mr. Buffett reminds us, “Be fearful when others are greedy and be greedy only when others are fearful.” We’d rephrase that for our hotel analogy to say, “Rent out your rooms when other Landlords lock their doors, and light up your ‘No Vacancy’ sign when others swing the doors open wide.” While we expect overall returns going forward to be lower than historical averages, we are by no means disappointed with the tenants we’ve opened our doors to. Rest assured that we, as the Landlords of our clients’ Hotels, have filled our rooms with a mix of renters that we fully expect to help our clients reach their goals regardless of the larger macroeconomic outcome.

Justin Smith, CFA®, CFP®
Financial Advisor

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