Archive for August, 2011

Is it 2008 again?

It seems like 2008 all over again. Not counting the snapback today, for the last month, S&P 500 is down 17%, close to “official” bear market territory. The index fell an astounding 11% in just three days. The fear indicator is at the yearly high, and headlines about “market turmoil” dominate the news.

All of that is indeed very frightening. But we have been through similar turmoil before. Events in 1987, 1991, 1998, 2000-2002, and, of course, 2008, were very frightening indeed. But markets recovered each and every time. So my take on this is as it has always been – I remind myself that I am a long term investor, that sharp market drops have occurred and will occur in the future, and that it is crucial to stay calm and not make emotional decisions. And this approach proved itself over the years – since 2004, those of you who invested alongside with me saw your portfolios grow 40% compared to 13% for S&P 500.

Now, what happened to the markets this time around? Three major concerns were brewing for the last several months. First, a number of reports pointing to slowing U.S. economy. Second, worsening debt problems in South European countries. Finally, debt ceiling drama here at home. These concerns were brought to investors’ attention during the last week, especially after questions were raised (again) about debt burden of Spain and Italy. Add to that first ever U.S. rating downgrade (which seems to be politically motivated), and you have a recipe for full-fledged market panic. But once again, some perspective — the correction so far is only one percentage point greater than the one last year (after which markets climbed some 30%). But it happened a lot faster this time, and so it seems a lot scarier.

But here are some good news. The earnings season was, once again, excellent, with vast majority of firms exceeding estimates and many offering higher forward guidance. So, there seems to be a disconnect between great earnings reports and poor economic indicators. There are several explanations for this discrepancy:

– higher worker productivity creates higher profitability (unemployment remains high).
– major corporations are multi-national, deriving a huge part of revenue from overseas (no help to domestic economy).
– weak dollar helps both top and bottom line.

No one knows for sure what is going to happen with debt problems in Europe (at least, now that debt ceiling deal in U.S. has been reached, no default here until 2012) or with the economy. It has been my long-standing belief that it is far more productive to concentrate on the companies I invest in, rather than on macroeconomic issues. After all, it is the earnings, not economic reports, that ultimately drive stock performance. Unlike countries themselves, many companies are in excellent financial shape, they have huge cash hoards that allow them to weather any downturns. Being a partial owner of such companies will, as always, be rewarded.

August 10, 2011 at 12:26 am 1 comment

Is the Bull Market Over?

This is the headline that appeared today on CNN Money.  Putting on my contrarian hat, I actually like seeing headlines like this, as they are more likely to appear near market bottoms.  So what happened?  Despite the fact that the debt ceiling deal was passed, an expected market relief rally didn’t take place.  Instead, investors focused on deteriorating economic conditions, and kept selling for eight straight days, bringing S&P 500 down for the year.  Here are some of the recent statistics that illustrates weakening economy:

– Second quarter GDP growth was estimated at 1.3%, while first quarter was revised to 0.4%, forcing many economists to revise down growth projections for the rest of the year;

– Durable goods orders fell 2.1%;

– Manufacturing activity was weaker than expected.

However, there were some pieces of good news that went unnoticed during the selloff.  Consumer confidence rose in July to a better than expected reading, and, more importantly, first-time unemployment claims declined to 398,000.  The 400,000 is considered an important threshold for job creation.  We will see if Friday payroll report confirms this trend.

Meanwhile, the second quarter earnings season is drawing to the end, and similarly to many previous quarters, the results are quite good.  This time, both earnings and revenues rose by over 13% compared to one year ago, due, among other things, to weak U.S. dollar and stock buybacks.  I would like to point out that while markets will certainly fluctuate, long-term performance is driven only by corporate profits, not politics or economic reports!  So far, there haven’t been any hiccups on the earnings front.

It has been my long-standing belief that it is futile to worry about overall direction of the economy, as no one, including President Obama or Fed Chairman Ben Bernanke, can predict it.  I certainly can’t.  Instead, it is far more productive to concentrate on the stocks in my portfolio.  I don’t know the answer to the subject of this letter, but there is always a bull market somewhere.

On a separate note, please take a look at a series of four postings regarding portfolio performance on my blog.  The links are below:




Option Strategies

August 2, 2011 at 11:28 pm Leave a comment

Musings on Performance – Options Strategies (Part 4)

In this final part of Performance series, I would like to briefly touch on two strategies that can increase performance. Or not.

Both strategies involve selling options.  In Covered Calls Strategy, you can sell call options on the stocks already in your portfolio, thus generating extra income.  For example, if you have $40 stock, you can sell a call option with a strike of $45, for, say $1.  If the stock stays below $45 before expiration, you simply keep $1 as extra income.  If, however, the stock advances above $45, you will be forced to sell it at $45.

Selling covered calls is a conservative strategy in the sense that you are trading cash upfront for future potential gains.  In most cases, out-of-the-money options will expire worthless, thus generating extra income for you.  However, a single large upward move in one of the stocks (for example, as a result of a good earnings report) can more than compensate for options premiums collected for all other stocks.  If in our example, that stock soars to $60 and you are forced to sell at $45, you’d wish you never knew about covered calls.

In the Selling Puts Strategy, you sell put options.  In the example above, you could sell $35 put for $1.  Then, you keep the premium if the stock stays above $35, but if it drops below, you will be forced to buy it at $35.  Unlike Covered Calls Strategy, this approach generates extra income while keeping your upside unlimited, seemingly the best of both worlds.  But there is no free lunch.  While it is also true that most options will expire worthless, allowing you to keep extra income, a big drop in stock price could wipe out all of your option income, and then some.  If that stock drops to $20, you will be a proud owner at $35.  In the event of a large-scale market decline or a black swan event, depending on how many options you sold, you may receive a margin call and your whole portfolio could be in jeopardy.

Both strategies are, in a sense, anti-lottery.  A likely outcome is that you are going to keep options premiums, earning you extra income, which will make your performance look better.  You have to recognize the risks, however, especially when selling puts, and use these strategies very carefully.  A single unexpected event, which in financial markets can happen quite frequently, could wipe out all of your gains and cause large portfolio losses.

August 2, 2011 at 10:41 pm 1 comment

Musings on Performance – Measurement (Part 3)

In this part of the performance series, I would like to address the question of performance measurement.  From the first glance, it might seem like a very simple question.  For example, if you started with $100K and ended with $110K, the performance was 10%.

The calculation is indeed very simple, but only in the case there were no cash flows in or out of your investment account.  In real life, however, these cash flows occur frequently, as we deposit or pull the funds from an account.  Some brokerage firms, such as e-trade, provide performance calculations on their clients’ portfolios.  But I would strongly advise to find out exactly how the performance is calculated — the final results could vary dramatically.

Here’s a very simple example.  You started with $100K portfolio, which stayed absolutely flat during the year.  You also deposited $20K during that year, ending with $120K.  So your performance should be zero (not 20%).  Does your broker or some other software you may be using give the correct answer?

Now, a more complicated example.  Again, you start with $100K portfolio, and deposit additional $100K during the year.  You end up with $220K.  What is your performance?  Answer – it depends.  If you deposited your funds at the very beginning of the year, you effectively started with $200K, so your performance is 10%.  However, if you put in the funds at the very end of the year, then the original $100K was responsible for the $20K gain, giving 20% result.  And if you made your deposit in the middle of the year, or in stages, the performance will be somewhere in between 10% and 20%.  Does your broker or your software handle this situation correctly?

So, make sure exactly how your performance is calculated before comparing it to others or to an index.  For my portfolio, I do the math myself.

August 2, 2011 at 9:31 pm 1 comment

Musings on Performance – Don’t Forget Taxes (Part 2)

On many occasions, I have expressed my belief that market timing and associated short-term trading is counter-productive and hurts performance in the long term.  But there is another reason that penalizes a short-term trader even more — taxes.

All performance calculations are made before taking taxes into consideration.  This makes sense for general benchmarking and reporting purposes — every individual has a unique tax situation.  So reporting an after-tax performance of a mutual fund is not even possible.  However, taxes make a huge difference and have to be considered by each investor.

Here’s an example.  Suppose we have investors A and B, who achieve identical before-tax returns and are in the same tax bracket.  We will even assume that short term and long term capital gains taxes are the same.  The only difference is, investor A pays taxes on gains each year, while investor B pays them once at the end of investment period.  Who will have more at the end?

The answer is, investor B, and depending on rate of return, tax bracket, and the length of investment period, by quite a lot.  For example, assuming generous annual return of 15%, tax rate of 40% and 20 year investment period, investor A will grow $100K portfolio to approximately $560,000.  Not too bad.  Investor B, however, will have $1,021,000, nearly twice as much!  In real life investor B will pay smaller long-term capital gains taxes: if they are 20%, then he will end up with $1,329,000.

So, taxes should definitely be a part of overall performance measurement.  Don’t ignore them!  Taxes are a huge drag on performance for a short term trader — another powerful reason to be in the market for the long term.

August 2, 2011 at 9:28 pm 1 comment

Musings on Performance – Benchmarking (Part 1)

In this 4-part series, I would like to address some issues and misconceptions regarding evaluating equity portfolio performance.  The first question is, how do you know if your portfolio is performing well (or not)?

The widely acceptable practice in the industry is to compare your portfolio performance to a relevant industry benchmark.  For example, a well diversified portfolio can be compared to performance of S&P 500 index.  Many other indices exist, tailored to specific industries, geographic regions, company sizes, etc.  But for simplicity we’ll accept S&P 500 as a benchmark.

Here’s a case study.  An investment portfolio that I manage for clients beat S&P 500 index by 3 percentage points annually, since its inception 8 years ago.  From the first glance, a few percentage points per year certainly doesn’t seem exciting.  I certainly thought so at the beginning of my investing career.  I didn’t want 3 percentage points, I wanted 30 points of out-performance!

It took me many years to realize that simply beating the index is, in fact, a very respectable goal.  Depending on who you ask, 70% to 90% of all fund managers actually underperform the index!  And this is not due to the fact that these managers are not competent or corrupt; it is because out-performing S&P 500 is actually very hard.  If you think about it, all the mutual funds taken together are the market, and so it stands to reason that an average manager will match the performance of the index.  However, managers have expenses — trading costs, administrative costs, and, of course, management fees — and so the net performance of this average manager drops below the index.

So in my case, I am quite happy with 3% out-performance.  But don’t take my word for it.  Ask any financial industry specialist — fund manager, wealth manager, financial planner — what he or she thinks about consistently beating the market by a “few” percentage points.

So, set your expectations accordingly.  30% of out-performance is not going to happen, even if you are Peter Lynch or Warren Buffett.

August 2, 2011 at 8:47 pm 1 comment

Blog Author

Leon Shirman's long-term investment philosophy is summarized in his book, “42 Rules for Sensible Investing”, also available from Amazon.


Recent Posts