The recent article in the Sunday Times by Gretchen Morgenson titled “Red Flags that Muni Investors Can’t See“  provides a reason to bring out the old’ “sunlight is the best disinfectant” quote from U.S. Supreme Court Justice Louis Brandeis.

The article details the lack of transparency in the muni market between the quality of the bonds that are bought and sold to unsuspecting investors.

Points that merit attention:

1) Cities, hospitals, and states borrow money from investors through munis and are required to file basic reports outlining their conditions. Unfortunately, many fail to make such filings. Out of the 65,000 issuers of these securities:

1 in 2 is more than a year late in filing

1 in 4 is chronically delinquent, by three years or more

How would stock investors react if 1 in 4 public companies did not bother to provide an annual report and half of all companies were a year late in filing?

2) 1 in 4 issuers had issued distressed notices, an indication of significant financial problems

3)  More alarming was that many of these “distressed issues” were purchased by individual investors at par value- which means they were purchased by investors as if the underlying entity was financially health.

Of the 9,643 distressed muni sales that were sold to customers, more than half of them, 5,798, were bought at par value or higher.

41% of these purchases were made by the small investor, as indicated by the size of each trade - $50,000 or less.

Essentially, the individual investor overpaid for the distressed securities and the dealer pocketed the difference.

There is nothing inherently wrong with municipal securities. They serve an effective purpose in the economy and in one’s tax efficient portfolio. But when there is such obfuscation in simply buying and selling a security, it seems all the economic benefits can be lost to the investor and surreptitiously conveyed to the selling party.

With a 22% trading increase of municipal securities this past year, it seems many investors flocked to the safety of bonds to avoid the risk inherent in distressed positions. Based on the most recent research, many did not really receive that safety and were a victim of the Wall Street assembly line.

I came across the following chart in a recent article, “The Fateful Message of Cash” by Nick Murray.

Essentially there is one dollar in a money market fund for every two dollars of  equity common stock in the marketplace. As you can see from the chart, 10 cents for every dollar is a more reasoned expectation.

This strikes me as extreme fear in the market and while fear can be the emotion of choice for a while, it will pass.  When it does, there will be an “immense river of cash building up behind an earthen dam of fear. The cash is a force of nature; the fear is a human emotion. The cash must move-it cannot remain where it is, earning no return- while the emotion, like all nearly unanimous emotions, must eventually give way.”

Nick goes on to write that “This is not a call on the market. It is a cry from the heart: eschew unanimity. The mob is never right, other than momentarily. And history may yet show that it was never more wrong than in the days when it was holding a dollar in cash for every two dollars of common stock in America.”

I agree with his sentiments.

With last weeks rally, many of us may be eagerly awaiting to find out if this is the bottom.  Please view these clips before making this determination based on expert opinion.

Remarkably, it is a very sobering piece by the Comedy Channel’s Jon Stewart as he interviews a humbled Jim Cramer.

Are we well positioned from an investment strategy standpoint for the next market stage?

There are essentially two forms of investment management. Active managers are those that try and find under-valued securities and insist that the stock is mispriced. They will profit from their purchase when market participants eventually come to their senses and provide a higher value to that stock relative to the overall value of the stock market. These active investors also take into consideration macro level events and surmise that the markets have or have not reflected these events properly in their prices and hence take anticipatory market positions.

A passive or structured investment approach takes a completely different position. It is based on the premise that all known information is already reflected in a stock’s price and even though new/unforeseen events may recalibrate the stock’s price significantly (i.e., volatility) an investor cannot take the known information and consistently use it to outperform another investor. We embrace this approach.

Recently, the NY Times highlighted a published study in Economics & Portfolio Strategy by Mark Kritzman. The study supports the standard conclusion that investing in index funds provide better net returns than hedge funds and actively managed mutual funds. This strategy is reflected in the structured, multiple-asset class approach that we follow.

Taking into consideration variables such as taxes, premium fees, turnover, and transaction costs that are significantly more onerous in hedge funds and active managers, an active mutual fund would have to return 13.5% a year and a hedge fund 19% a year to simply keep pace with an annualized passive return of 10%.

What are the odds of finding a manager that can outperform the markets by such an extreme margin? According to Russell Wermers, a finance professor out of the University if Maryland, “next to zero.” He also concludes that it was “exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone.”

Kritzman concludes that “it is very hard, if not impossible to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And those that attempt this are “deluding themselves.” What about in a tax-sheltered accounts? “Even in a tax-sheltered account, the odds of beating the index fund are still quite poor.”

So are we positioned from an investment philosophy standpoint for the next stage in the markets? The evidence indicates as much.

A Wall Street Journal article recently devoted a front page story to the only active manager out of 8200 diversified US stock mutual fund managers that ended 2008 with a positive return. This manager, Thomas Forester, of the $70 million dollar Forester Value Fund, returned .4% for the year. (Interesting side story is that his wife wanted him to close his fund last year if he couldn’t improve his returns from previous years.)

While some readers of the Journal may have thought, “Wow how do I get in on that?” What is of more interest to me is that if there was ever a year where market forecasting could have come in handy, it would have been in 2008. No other fund came in above zero and unfortunately, the average US fund lost -39% last year compared to a US market drop of -37%.

What are the odds that only one out of the 8200 self-proclaimed markets beaters was essentially flat for 2008? By chance alone, you would have thought some other fund manager could have been out in front of this tsunami.

 Why is it again that we listen to these managers when they are guests on CNBC for their best investment ideas or their views on what is going to happen next?

Here is a great 4 minute interview with David Swensen on NPR.  Swensen manages the Yale Endowment which has frequently been recognized as the most successful endowment portfolio over the last twenty years.

You will find strong parallels with with our approach and his view of the markets and ultimate investing  conclusion .

Click here for the interview: David Swensen Interview.

With cash serving as the latest investment fad in what is looking like a fright to quality, who would have thought that the mattress industry would be suffering? Simmons Bedding Co., the country’s second largest mattress maker has hired bankruptcy lawyers as it looks for new backers. In this environment, the strategy of keeping your money under mattresses would require the purchases of many more mattresses. Unfortunately for Simmons, this mattress stuffing strategy isn’t as attractive as money market funds-although both alternatives are basically providing the same return.

With the current spate of scary news combined with rapidly declining portfolio values many investors contemplate getting out of equities in advance of further anticipated losses. An investors risk preferences can change, but a change to the portfolio should only be considered once there is a clear understanding of the trade-offs and corresponding risks of such an action.

A comprehensive wealth management solution addresses the multiple risks spanning the entire planning horizon and determining the trade-offs associated with reducing or eliminating some risks at the expense of increasing or taking others. These include:

1) Market risk - the risk that stock prices will decline.

2) Inflation risk - the risk of losing long-term purchasing power.

3) Longevity risk - the risk of outliving your money.

Getting out of equities conveys a desire to eliminate market risk, or the chance of further declines in the value of the portfolio. However, this action will magnify the risk of losing purchasing power, as a market-risk-free investment is almost guaranteed to lose money after tax and inflation. This loss of purchasing power could increase the chances that a client will outlive his money, especially if he maintains a high level of spending relative to assets.

Sound advice is indispensable in this situation, as there is no “right” set of trade-offs. For example, an older investor with substantial assets relative to spending might never outlive his money, even if he invests in cash equivalents and accepts more inflation risk. His trade-off may be to give up the potential for philanthropy and/or the upside of a substantial estate for heirs in exchange for lower market risk. This may be a perfectly rational decision.

Another investor with a longer time horizon and/or higher spending relative to assets may also choose to eliminate market risk. However, he may have to offset higher inflation and longevity risks by accepting other trade-offs, such as working longer and/or significantly reducing long-term lifestyle expectations. Once again, this could be a rational choice.

In contrast, it is more likely for individuals expressing a desire to get out of equities to regard their potential action as a temporary move to the sidelines rather than as a long-term or permanent decision. Their proposed strategy may be to ride out the storm until the weather improves.

There are obvious problems with this attempt to time the market. Once a client decides to get out, the next question is when to get back in. He may feel it is more prudent to wait for stabilization or strengthening of the economy as a sign the market will recover. However, a recovery in the equity market will tend to lead a recovery in the economy. In this example, by the time the weather appears clear from the harbor, the tide may have already gone out.

When we ignore taxes and transaction costs, buying stocks and continuing to hold them are basically the same decision, and one should view the function of their allocation on a forward basis to assure that their portfolio is properly position to provide for future and or continuing outlays.

Although the mattress approach to investing may be a rational choice for some investors willing to trade market risk for other risks. The table below shows the approximate number of years to recoup a 45% decline assuming various rates of expected return.

No one can predict the future-and stock prices may decline further before they recover-but if long-term investors want to flee the market, it will be likely that they will not reach their previous highs within the next 30 years!

The decline in stock prices has certainly been dramatic and painful. The following considerations can better frame for you the ongoing decision making process:

1) Risk is multi-dimensional: Eliminating one risk may magnify another.

2) Stock prices and the business cycle: A recovery in stock prices tends to lead a recovery in economic conditions, and there is no evidence that risk premiums become reliably negative during recessions.

3) Stock returns and economic conditions: Market returns tend to be countercyclical (i.e., lower when economic conditions are strong and higher when they are weak).

4) Prices reflect all current information: More bad news will not necessarily cause further stock price declines; it is news relative to expectations that matters.

5) Payback time: Weigh the upside of higher expected returns against the probability that equity markets will not reach previous highs within the payback period associated with a market-risk-free investment.

The Washington Post’s Weekend Outlook section recently contained a much needed article that was a revelation in self-reflection. I would like to take a moment to thank financial writer Joel Lovell, who pens a monthly column for GQ magazine titled “Men + Money,” (I am curious, however, to know what “Men + Money” equal). In his contribution for the Post, he wrote What Do They Know?- True Confessions Of a Conflicted Money Guru.

It is an honest appraisal about the lack of ability for anyone to accurately forecast the markets even though this is precisely what individuals want. But because individuals crave this ability then “the more terrifying and destabilizing the news, the more the financial news sages seem to commit themselves to dispensing advice with unblinking certitude.” In essence, his message is they (financial gurus) don’t really know what they are talking about and they are equally as surprised that you think they do and continue listening and acting on their advice.

We don’t pretend to know all or any of the answers of what is going to happen next. We don’t think that is a very good use of our time or your investment allocation. I could provide a laundry list of examples of how expert opinion, such as those offered by Joel Lovell or the Jim Cramer’s of the world, was spectacularly wrong over the past year but it wouldn’t get us anywhere. This article provides such a laundry list of examples.

To achieve investment success we need to focus on the things we can control. Those factors are deploying your capital across asset classes with long-term expected rates of return, allocating across these asset classes in a diversified manner, maintaining contribution levels needed to achieving an objective, and maintaining sensible distributions that allow a portfolio to pace inflation and perhaps achieve secondary and tertiary objectives.

None of these concepts are groundbreaking but things of significance rarely are. It is the manner in which you apply them that requires strength and discipline.

One benefits of this blog is to pass on useful information. A client sent me the following link which she felt provided one of the best explanations of the current crisis. I agree and here it is:

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

Although our clients have come to realize that we have a disciplined view a successful investment strategy supported by strong empirical research, we have also come to realize that you are bombarded with different types of investment advice in your social circles, on your doorstep every morning, and in your cable box.

Though prevalent, this is rife with misinformation that many times run counter to your long-term best interest.  Although I don’t have a television channel or the inclination to provide a minute by minute counter point, there are many times I wish I had a direct line to your ears and eyes.

In times of extreme uncertainty when every one has an opinion on the current market or latest investment chase, understanding why and how you are invested is many times the most significant foundation to your future success.

This blog represents my effort to respond to or provide you with information I feel will help you filter out the noise from the investment community and focus on what is important for success - the “signal.”