Book Review: The Age of Turbulence

The Age of Turbulence: Adventures in a New World





In September, I was fortunate enough to see one of my favorite people live at my graduate school alma mater George Washington University’s Lisner Auditorium. The “Maestro”, Alan Greenspan, was promoting his new book, The Age of Turbulence. At 81, Greenspan is hardly in need of money to support his modest lifestyle. However, having been virtually silent for the past 18 years at the Federal Reserve, he is literally bursting to express his opinions, both political and economic, as well as providing us with some insight and history for future generations. I believe this book, and the controversy surrounding it, may have a significant positive impact on the future economic success of the US economy.

Greenspan explained that the Fed was weaker today than in years past due to the “global forces” beyond its control. These “forces” are part of the “Conundrum” mentioned in one of his famous speeches about the Fed’s inability to affect long-term interest rates in 2004. In a light moment during his speech, Greenspan said he received over 10 bottles of the famous Caymus Conundrum wine. When asked how it was, he said he never touched it because of the name, “Conundrum, by its very nature is unknown. Why would I want to drink that?” he explained.

Greenspan, often referred to as a Right Wing Libertarian Republican, took the time to correct this mistake. “I am not right wing. [I am] far from it.” He explained how he felt that the Republican Party has moved too far away from its fiscally conservative roots, and how this shift allowed the Democrats to take control the house in 2006 and possibly the presidency in 2008. There are many other political issues mentioned in his speech and in the book, including issues relating to Greenspan’s disappointment with the Bush administration and his admiration for Mr. Clinton’s fiscal restraint.

What keeps the Maestro up at night? He mentioned 5 topics:

• US dependence on oil


• The growing U.S. deficit


• Lack of government funding for future Medicare requirements


• Inequity of income in the US


• The need to clarify the rules of intellectual property.

Greenspan was reluctant to talk about current Fed actions and the short term outlook for the economy. When pressed, Greenspan jokingly offered a highly precise a prediction of 42.5% chance of recession, up from the 30% chance he predicted in February.

Real Estate Corner: Catch a Falling Knife? Not Yet...

There are several indices that aim to measure the value of residential real estate in this country. The most accurate and least biased is the S&P 500/Case Shiller Home Price Index. I decided to test the accuracy of this index by comparing it to my own purchases of homes in the Washington DC area.

I purchased my first home, a townhouse near Fair Oaks Hospital, in Fairfax, VA in October of 1989. My timing was impeccable. When I compared it to the Index, the value of Washington single family homes was at an all time high. The Index peaked just 4 months later before falling like a rock until it reached the bottom in February of 1992. It was at this point I abruptly sold the house at the bottom of the market. According to the index value my home should have dropped about 5%. In reality, the property had dropped 10% and after selling commissions I owed more than it was worth.

The 10% I had put down was gone and I was now underwater by about $10,000. The index, which peaked in the Washington area in April of 1990, did not reach that peak again until February of 1999, nearly 10 years later.

I was recently in Tampa, Florida visiting a client when the S&P 500/Case-Schiller Home Price Index for July of 2007 was released. The report showed that the worst real estate markets in the country were Detroit, Tampa, and Washington. I asked my client about the local market to check to see if this rang true. He told me about two completed condo projects with no owners and one large condo project with just one family living in it. The scariest thing about this is that the Index does not include condos!!!!

Most people consider the value of their homes to be whatever the highest value ever paid in the neighborhood. Nationwide, I believe home prices have now moved down to their October 2005 values. In Washington, these values are down to the May 2005 values. The index shows a drop of 4% year over year nationally and a drop of 7.2% in the Washington MSA.

In my April 2005 Newsletter, I predicted a 10% market drop nationwide. It appears as of July of this year, we are nearly halfway there on a national basis and 75% there in the Washington MSA. Let’s take a look at the housing data to see just how bad it might get. Most of this data comes from Greg Weldon’s website http://www.weldononline.com/ and John Mouldin’s Weekly E-Letter.

Existing home inventories have increased by more than 1,000,000 homes since March 2007 and have doubled since 2005. In January of this year, there was a supply of homes for sale of about 6.6 months on the market. This figure has moved up to 10 months. There are now over 500,000 homes in the process of foreclosure and this number is increasing at an alarming rate. New home sales in August saw the largest decline in 30 years. Mean new home prices are down 11% in the last five months. Expensive homes, those above $750,000 are down over 35% from last year.

Many of the loan products, which helped people buy homes the last few years, are now gone. This includes not only sub-prime and Alt-A loan products, but the every day jumbo variety as well. The impact of this mortgage credit crunch will not be felt until the forth quarter of this year. As a result, I still believe we have a significant drop ahead. Washington MSA may experience a 15% drop from the 2006 high; nationwide I am still sticking to my 10% drop prediction.

While this may seem bearish, the market will bounce back. There will be some terrific buying opportunities in 2008. A significant amount of patience, however, will be required.

Asset Allocation: Going Green

In case you haven’t noticed, just about everyone, even the Nation’s capital, is going “green”. In December of 2006, Washington DC became the first city in the nation to pass legislation requiring not only government-owned office buildings larger than 50,000 square feet to adhere to green building standards, but privately owned buildings as well.

How can you make a positive impact on the environment and capitalize on the “green” phenomenon?

Take Steps Towards Becoming Carbon Neutral

The concept of becoming carbon neutral can be debated by many as is global warming in general. However, for the purpose of this article, I will assume we all want to make a positive impact on our environment. You can start by taking steps to move your household towards carbon neutrality. I took the test at http://www.carboncounter.com/ and learned that I generated 4 times the carbon of the average US citizen! Thus, according to the calculations on the web site, I need to donate $576 to “offset” my carbon emissions and become “carbon neutral”. The donation goes to the Climate Trust, a 501 (c) (3) working towards a more stable climate.

According to the website, offsets are used to:

• Increase energy efficiency in buildings, factories, or transportation,


• Generate electricity from renewables such as wind or solar,


• Modify a power plant or factory to use fuels,


• Put wasted energy to work via cogeneration,


• Capture carbon dioxide in forests and agricultural soils.

Practice Energy Efficiency
Next time you buy a new appliance, remodel your home or buy a new one, factor energy efficiency into your decision-making process. According to the US Green Building Council, http://www.usgbc.org/, 10% of all carbon dioxide emissions in the country come from our homes. Typical American homes lack energy-efficient appliances, windows and insulation, thus consume extra energy to compensate for loss of heat and air conditioning. The up front costs of improvements will be recouped in the long run.

Recycle and Buy Recycled Products
Most people today recycle bottles, plastic and newspapers in their homes. However, few of us use recycled products. Using recycled materials, especially if they are locally made, can have a huge impact on the environment. Many of today’s building materials come from recycled waste. If you are in the Washington area, check out Eco-Green Living. Eco-Green Living, is the premier green, organic, and fair trade store in the Washington, D.C. metro region for lifestyle, home remodeling, and personal care products. You can find out more at http://www.eco-greenliving.com/

Invest in “Green” technology
The following is a list of funds that invest in various forms of “Green” technologies:

PowerShares Water Resources Fund (PHO) is based on the Palisades Water Index™. This Index seeks to identify a group of companies that focus on the provision of potable water, the treatment of water, and the technology and services that are directly related to water consumption.

PowerShares Global Water Fund (PIO) is based on the Palisades Global Water Index™. This Index seeks to identify a group of global companies that focus on the provision of potable water, the treatment of water and the technology and services that are directly related to global water consumption.

PowerShares Global Clean Energy Fund (PBD) is based on the WilderHill New Energy Global Innovation Index. The Index seeks to deliver capital appreciation and is composed of companies that focus on greener and generally renewable sources of energy and technologies facilitating cleaner energy.

PowerShares WilderHill Clean Energy Portfolio (PBW) seeks to replicate, before fees and expenses, the WilderHill Clean Energy Index, which is designed to deliver capital appreciation through the selection of companies that focus on greener and generally renewable sources of energy and technologies that facilitate cleaner energy.

PowerShares WilderHill Progressive Energy Portfolio Fund (PUW) is based on the WilderHill Progressive Energy Index. The Index is comprised of U.S.-listed companies that are significantly involved in transitional energy bridge technologies, with an emphasis on improving the use of fossil fuels.

The Spectra Green Fund (SPEGX) is a mutual fund that seeks long-term capital appreciation by investing at least 80% of its net assets in equity securities of companies of any size that, in the opinion of the Fund's management, conduct their business in an environmentally sustainable manner, while demonstrating promising growth potential.

By doing your part in the “Green” movement, you can feel good about the choices you make for a better world for you and your children.

Book Review: The 4-Hour Work Week

The 4-Hour Workweek: Escape 9-5, Live Anywhere, and Join the New Rich

By Timothy Ferriss

What do you do? Tim Ferriss has trouble answering the question. Depending on when you ask this controversial Princeton University guest lecturer, he might answer:

“I race motorcycles in Europe.”

“I ski in the Andes.”

“I scuba dive in Panama.”

“I dance tango in Buenos Aires.”

He has spent more than five years learning the secrets of the New Rich, a fast-growing subculture who has abandoned the “deferred-life plan” and instead mastered the new currencies—time and mobility—to create luxury lifestyles in the here and now.

Whether you are an overworked employee or an entrepreneur trapped in your own business, this book is the compass for a new and revolutionary world.

Join Tim Ferriss as he teaches you:

• How to outsource your life to overseas virtual assistants for $5 per hour and do whatever you want

• How blue-chip escape artists travel the world without quitting their jobs

• How to eliminate 50% of your work in 48 hours using the principles of a forgotten Italian economist

• How to trade a long-haul career for short work bursts and freuent "mini-retirements"

• What the crucial difference is between absolute and relative income

• How to train your boss to value performance over presence, or kill your job (or company) if it’s beyond repair

• What automated cash-flow “muses” are and how to create one in 2 to 4 weeks

• How to cultivate selective ignorance—and create time—with a low-information diet

• What the management secrets of Remote Control CEOs are

• How to get free housing worldwide and airfare at 50–80% off

• How to fill the void and create a meaningful life after removing work and the office

You can have it all—really.

Mortgage Update

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Sector Performance Report 9/30/07

In 2007, the industry sectors that are dominated by large cap multinational companies have out-performed all others. As noted by economist Michael Albert on his blog http://www.leadlag.com/, the sectors of the S&P 500 with the highest multinational cap weighting, like energy, industrials, materials and technology, significantly outperformed the domestically dominated sectors such as financials, consumer discretionary and consumer staples.

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Bad Economic News…Good for the Stock Market?!

The mortgage industry melts down, credit markets tighten, home prices plummet, the dollar falls and oil prices reach a record high of nearly $84 a barrel. Naturally, the stock market was up for the quarter -- go figure. After the Federal Reserve cut rates 50 basis points, the equity markets rallied and erased their previous losses posted in July.

The S&P 500 was up 1.6% for the third quarter and 7.6% (excluding dividends) year-to-date. International markets, as measured by the MSCI EAFE Index, were basically flat for the third quarter and are up 10.9% year-to-date.

Here is the good news; the futures market has currently priced in two more Fed cuts by the end of the year. This would leave the WSJ Prime Rate, currently at 7.75%, somewhere around 7% at the close of the year.

Pre-election Years May be Good for the U.S. Stock Markets

Since 1950, pre-election years like 2007 have produced an average return in the S&P 500 in excess of 19%. Thus we may be looking at a positive 4th quarter, even with a potential recession looming in 2008.

Now the bad news; inflation fears spooked the bond markets causing long-term rates to rise and the dollar to fall. According to economist John Mouldin, “The last three times the Fed initiated a new easing cycle, 10 year bond yields dropped 20 basis points or more in the next five days. This time they rose 20 basis points. Since mortgage rates are typically geared off the yield of the ten year Treasury bond, this is a cut that has not helped the consumer as of yet.”

Book Review: The Support Economy

The Support Economy: Why Corporations Are Failing Individuals and The Next Episode of Capitalism

By Shoshana Zuboff and James Maxmin

This husband-and-wife team Zuboff's a Harvard professor and author of In the Age of the Smart Machine, and Maxmin's the former CEO of Volvo and Laura Ashley give socialist utopians of yesteryear stiff competition with their manifesto for a more personalized capitalism. They strive for the pop socioeconomics of a David Brooks or a Malcolm Gladwell, but their heavy academic style may disenchant some readers before their thesis's more radical parts kick in.

Over the last two centuries, they argue, an increasingly efficient economy, coupled with a rise in democratic thinking and growing access to information, has opened up life's possibilities to increasing numbers of people. Because participation in the consumption-based economy is unavoidable, the general public looks to markets to provide "deep support" in their quest for individualization, but "are routinely punished for being complex psychological individuals in a world still fitted out for the old mass order." This macroeconomic structure treats people as either employees or consumers and inevitably hurts their feelings. Zuboff and Maxmin would eliminate the "little murders" of customer service interaction by replacing the current transaction-based model with a form of "distributed capitalism" based on a customer-supplier relationship, so semi-anonymous customer service reps will be replaced by "advocates" fully emotionally involved in their clients' needs.

It's not clear how society will make its way to the authors' dream of a fully automated lifestyle, or what life will be like for blue-collar workers and manual laborers. Pundits who celebrated the Internet's potential to thoroughly revolutionize the economy, however, will no doubt rally behind these impractical visions.

Credit: Publisher's Weekly

Retirement Matters: Is Your 401(k) Working For You?

Eighty percent of our retirement income will come from our savings in retirement plans and other after tax savings accounts. The bulk of this money will come directly or indirectly from employer sponsored 401 (k) accounts. However, most Americans pay little attention to this most important portion of savings. Many of us are guilty of spending very little time analyzing our 401 (k) investment allocations and fund selections, very few people actually review the plan costs with their sponsors and some do not even attempt to maximize their contributions to the plan. As participants in any retirement plan, you have the right to have quality investment selections in nearly every asset class at a reasonable cost.

Your 401(k) can be one of the best investments you will ever make. And if your employer is matching, it is a real “no brainer” When an employer offers 401k matching, they are guaranteeing that they will match a certain percentage of your contributions. A common match is 50 cents on the dollar. That means if you put one dollar into your 401k plan, they will match your contribution by putting 50 cents in. You just made 50% on your investment!

Now you see why it is important to maximize your contributions. The 2007 maximum contribution is $15,500 and if you are age 50 or older, you can make an additional catch up contribution of $5,000. Perhaps one of the biggest mistakes investors make is to pull back on their 401 (k) contributions because the market or their portfolio is doing poorly. However, every time the investor puts money into their 401(k), they are making a guaranteed profit up front. Besides, when the market goes down, most investors benefit because you begin buying assets at a lower cost!

I must disclose one important detail about this wonderful investment: Some companies do not have quality investment selections, while others do not have the appropriate asset classes covered. As an example, Fidelity 401(k)s are limited to mediocre funds (most have new managers) in a single fund family. And there are some plans and investment vehicles that charge very expensive fees to participate. If you fall under any of these, talk to your Plan Administrator and ask them to look into new plan options. They have a fiduciary requirement to provide you with quality plan investments at a reasonable price.

1st Portfolio, Inc. offers a retirement plan consulting service designed to bring professional, unbiased plan consulting combined with competent objective investment advice to the trustees and the participants of the plan.

Book Review: Leadership

Leadership By Rudolph W. Giuliani

I read this book back in 2002, but decided to pull it out again in light of the 2008 presidential elections. It makes for an excellent read from a historical perspective and also provides some insight on the author. -MR

From Publishers WeeklyNew York's celebrated former mayor explains how he used specific management strategies to run the city and handle crises in this captivating memoir. Giuliani's minute-by-minute account of his actions on September 11-trying to coordinate rescue efforts and reassure the populace while reeling from the deaths of firefighter friends he'd spoken to just minutes before-is harrowing. Other anecdotes are equally forceful, as when Yasser Arafat arrived uninvited to Giuliani's U.N. anniversary celebration, and Giuliani insisted on making Arafat leave while attempting to avoid an international scandal. Giuliani's main advice to leaders: surround oneself with talented people, hold daily meetings to keep everyone on track, define the core mission and make sure procedures and policies serve that mission efficiently, demand accountability from everyone (including oneself), show loyalty to employees and become knowledgeable about all subjects related to one's organization or business.

Federal Reserve Update

The Fed met in late March and decided to keep interest rates unchanged at 5.25%. This was expected and the market read the statement to mean that the Fed is no longer biased towards hiking interest rates. Subsequent to the announcement future interest rate cuts were priced into the fed funds market. This reinforced the notion that the Fed would keep the U.S. economy out of recession. The notion of an easier Fed policy diminished, though, when the full minutes from the recent meeting were released. The minutes revealed that the Fed Governors still believe inflation risk remains and could even require additional rate increases.

The strong employment report in early April seems to confirm the Fed’s inflation wariness and subsequent to the release of the minutes the likelihood of a Fed rate cut occurring declined significantly in the future’s markets. Currently, economists are debating as to whether the economy is in a mid-cycle slowdown or on its way to recession. The current market volatility is caused by this uncertainty. Stocks typically do well during mid-cycle slowdowns (which we are at the very least experiencing now), as a refreshing pullback in demand relaxes inflation pressures and allows for lower interest rates. However, history shows us that stocks don't fare so well if the economy doesn’t just slow down, but actually contracts.

Estate Tax Summary

Here is a quick summary of current federal estate tax rates. Be sure to consult your attorney before taking any recommendations listed below. If you have not updated your will and estate plan within the past 3 years, make an appointment with your attorney today!

Current tax laws concerning federal estate taxes provide an applicable exclusion amount of $2,000,000 per person. Don’t forget about your life insurance policy! This means that each person can give away during life up to $1,000,000.00 or at death a combined total of $2,000,000.00 worth of property, without any taxes being due and payable.

On May 26, 2001, Congress passed “The Economic Growth and Tax Relief Reconciliation Act of 2001,” which provides for the applicable exclusion amount to increase over time as follows:

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Additionally, current federal tax law provides for an unlimited marital deduction. This means that you may transfer an unlimited amount of property between you and your spouse without incurring any federal estate taxes. Combining the applicable exclusion amount with the unlimited marital deduction means that a married couple can have a combined estate of $4,000,000.00, which passes tax-free at the death of the second spouse. The tax rate on any amount in excess of $4,000,000.00 starts at forty-six percent (46%). To ensure utilization of the $2,000,000.00 applicable exclusion amount, both of you should have property worth at least $2,000,000.00 held in your own names or revocable trusts and not with rights of survivorship.

A typical plan to fully utilize both $2,000,000.00 applicable exclusion amounts for a married couple is to place $2,000,000.00 in a bypass trust at the death of the first spouse. The bypass trust typically provides that all income is payable to the surviving spouse and the Trustee may invade principal for the spouse’s health, support, maintenance and education. Upon the spouse’s
death, the principal is payable to the children outright or in continuing trust, free of any estate tax even on the appreciation of the assets in the credit shelter trust. The balance of the estate in excess of $2,000,000.00 is given outright to the surviving spouse and the surviving spouse, at his or her election, may place this additional inherited amount into his or her own revocable trust. Alternatively, the balance may be held in further trust. Upon the death of the surviving spouse, all of the survivor’s property is passed on to the children, either outright or in a continuing trust. The $2,000,000.00 in the bypass trust created upon the first spouse’s death, together with all appreciation therein, is not taxable again in the surviving spouse’s estate.

Warren Buffet on International Investing

Each year I look forward to reading Warren Buffet’s annual report to the shareholders of Berkshire Hathaway. The 76 year old Buffet is the Chairman of Berkshire Hathaway, a holding company that owns a diverse group of subsidiaries.

With an estimated net worth of $28 billion, Buffet is one of the ten richest men in the world and considered by many to be the best investment analyst ever. In the past, he has stuck primarily with US investments, but as he says in his report to shareholders, things are changing.

In reference to the $2.2 billion dollars he made on currency exchanges and the nearly $3 billion earned on his investment in PetroChina, Buffet said, “As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. . . the U.S. had $.76 trillion of pseudo-trade last year - imports for which we exchanged no goods or services (only money).” By doing this, Buffet said, “the US necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy, but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.”

Buffet continued, ”The ‘investment income’ account of our country – positive in every year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card.

And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay for ever-increasing amounts of interest on interest.” In addition to our trade imbalance, non-U.S. companies are gaining ground in areas traditionally considered U.S. based businesses. As an example, the world’s largest producer of steel and the largest supplier of beer are US Steel and Anheuser Bush, right? Wrong. Mittal Steel, owned by an Indian and headquartered in the Netherlands, is the world’s largest steel producer. U. S. Steel is the 7th largest producer of steel behind six other non-U.S. companies. InBev, the result of a merger of a Brazilian company AmBev and a Belgium company, Interbrew, is the largest producer of beer in the world. Anheuser Bush is the third largest, behind InBev and SAB/Miller, a South African company.

The world’s best companies continue to make huge investments outside the U.S. We must follow their example and do the same. Over the past 5 years, the EAFE Index, has had an annualized compounded return of 16% compared to a return of just 7% for the S & P 500. A balanced investment portfolio must include a heavy dose of non-U.S. investments.

Buffet summarized his thoughts on this issue by stating, “It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future, U.S. workers and voters will find this annual “tribute” so onerous that their will be a severe political backlash. How that will play out in the markets is impossible to predict – but to expect a “soft landing” is wishful thinking.”

Sector Performance Report 3-31-07

The utilities sector posted the strongest 12 month trailing return of nearly 28%, followed closely by the telecom sector at 24% annual return. The worst performing US sector in the past 12 months was the IT sector at just under a 3% total return.

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Market Summary

A recent Wall Street Journal article depicted investors riding on a rollercoaster called the “Volatiler”. Quite appropriate, since the S&P 500, like most roller coasters, ended in the same location it started. The first quarter of 2007 moved up over 2% and down over 3%, more than a 5% delta, much like the “Volatiler”. In contrast the EAFE Index (a market value weighted index of the largest companies in Europe, Australia, and the Far East designed to measure overall conditions of overseas markets) posted another excellent quarter, up 3.5%. Over the past 12 months, the S&P 500 and the EAFE were up 11.8% and 20% respectively.

Going forward, the market is likely to remain quite choppy. The housing market slowdown, which may be worsened by the growing debacle in the sub-prime mortgage market and tighter lending standards, is of chief concern to the market. Warnings by homebuilders and new federal investigations into lending practices have the market on edge as do concerns that these problems may spread into the broader economy. Further, a spike in oil prices amid growing Iranian tensions is adding fuel to the fire. These inflationary pressures are likely to keep the Federal Reserve in limbo in the short run but may allow for a drop in rates by the end of the year.

Volatility in the market creates ideal conditions for portfolio rebalancing. Make sure you do not have all your eggs in one basket or you may find yourself in the hole!

Book Review: The Black Swan

The Black Swan: The Impact of the Highly Improbable
By Nassim Nicholas Taleb

Four hundred years ago, Francis Bacon warned that our minds are wired to deceive us. "Beware the fallacies into which undisciplined thinkers most easily fall--they are the real distorting prisms of human nature." Chief among them: "Assuming more order than exists in chaotic nature." Now consider the typical stock market report: "Today investors bid shares down out of concern over Iranian oil production." Sigh. We're still doing it.

Our brains are wired for narrative, not statistical uncertainty. And so we tell ourselves simple stories to explain complex thing we don't--and, most importantly, can't--know. The truth is that we have no idea why stock markets go up or down on any given day, and whatever reason we give is sure to be grossly simplified, if not flat out wrong.

Nassim Nicholas Taleb first made this argument in Fooled by Randomness, an engaging look at the history and reasons for our predilection for self-deception when it comes to statistics. Now, in The Black Swan: the Impact of the Highly Improbable, he focuses on that most dismal of sciences, predicting the future. Forecasting is not just at the heart of Wall Street, but it’s something each of us does every time we make an insurance payment or strap on a seat belt.

The problem, Nassim explains, is that we place too much weight on the odds that past events will repeat (diligently trying to follow the path of the "millionaire next door," when unrepeatable chance is a better explanation). Instead, the really important events are rare and unpredictable. He calls them Black Swans, which is a reference to a 17th century philosophical thought experiment. In Europe all anyone had ever seen were white swans; indeed, "all swans are white" had long been used as the standard example of a scientific truth. So what was the chance of seeing a black one? Impossible to calculate, or at least they were until 1697, when explorers found Cygnus atratus in Australia.

Nassim argues that most of the really big events in our world are rare and unpredictable, and thus trying to extract generalizable stories to explain them may be emotionally satisfying, but it's practically useless. September 11th is one such example, and stock market crashes are another. Or, as he puts it, "History does not crawl, it jumps." Our assumptions grow out of the bell-curve predictability of what he calls "Mediocristan," while our world is really shaped by the wild powerlaw swings of "Extremistan."

In full disclosure, I'm a long admirer of Taleb's work and a few of my comments on drafts found their way into the book. I, too, look at the world through the powerlaw lens, and I too find that it reveals how many of our assumptions are wrong. But Taleb takes this to a new level with a delightful romp through history, economics, and the frailties of human nature.

Credit: Chris Anderson

Asset Allocation: Avoid Picking Individual Stocks

I recently attended an economic presentation by Dr. Gene Fama of the University of Chicago, the leading champion of the efficient market theory and a favorite to win the Nobel Peace prize one day. Dr. Fama stated, “I’d compare stock pickers to astrologists, but I do not want to bad-mouth astrologists.”

One of the biggest mistakes individual investors make is following the advice of the media, a stock broker or money manager on individual stock picking. Why is it that every year Money Magazine selects its top stocks to beat the market and never reports on how they performed the next? Why does Fortune Magazine list different “top money managers” each year and forgets to tell you about their selections of previous years. Why does CNBC run experts with differing opinions 14 hours per day and never tracks their recommendations? The reason is that it sells magazines and ad space!

Let’s look at some of Fortune Magazine’s “All Star” stock picks in their July 2000 edition:

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In the January 2000 issue of Time Magazine, Amazon founder Jeff Bezos was declared man of the year. If you purchased Amazon in January of 2000, your stock lost 75% of its value within a year. This year’s person of the year is “you”! The ramifications of this prediction are a little scary. This phenomenon is not limited to just stock picking either. Money Magazine’s “timely” June 2005 issue touted the virtues of buying residential real estate and denied the existence of any housing bubble. According to the magazine, “These days, everybody knows someone who has made money in real estate, and rising prices have become a national preoccupation. We are a wealthier country than we have ever been, so it makes sense that we would spend more on real estate, pushing prices to new highs. After a l l , F e d e r a l R e s e r ve Chief Alan Greenspan complained of "irrational exuberance" in 1996, more than three years before the stock boom ended in tears.”

I feel truly sorry for those that followed that advice. Once a financial trend hits the main stream, it’s generally time to get out. Over the past 20 years, money managers failed to beat their market bench marks over 80% of the time. This leaves just 20% of money managers or stock pickers beating the market on an annual basis. The problem is that different managers beat the market each year.

There is very little consistency with these managers beating the market from year to year. On the occasion that one of these star managers floats to the top, so much money flows into their portfolio that it creates a drag on future investment performance. Maybe if we can locate these emerging managers, we can beat the market more consistently. So how do we find these guys? When Peter Lynch, arguably one of the best stock pickers ever, retired from his job as manager of Fidelity Magellan, he and the executives at Fidelity spent an enormous amount of time and money scouring the investment world for the best money manager. Three money managers later, Fidelity Magellan has underperformed its bench mark index by exactly the management
fee it charges. What makes us think we can pick a good portfolio manager when Peter Lynch and Fidelity cannot?

What about the great stock picker Warren Buffet? According to Buffet, he may find 2 or 3 good stock ideas every couple of years. Mutual fund companies typically hold 150 to 250 stocks. How does a mutual fund manager find 200 good ideas? I guess they simply select 2 good ideas and 198 average ideas. Buffet also inserts himself into the management of the good ideas he selects, a likely boon to his returns. This does not happen in the traditional portfolio managementindustry. So, if we can’t pick stocks that consistently beat the market and we can’t pick managers that consistently beat the market, what should investors do? Stop trying to beat the markets! Put your savings to work and earn a market rate of return. As investors, we are entitled to the market return. Anything less is our own mistake. How do we get this?

In order to answer this, we need to understand some basic facts about what the “market” is and risk. Here is a table showing the typical market asset classes and their performance over the previous ten years.

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As you can see, different asset classes perform differently from year to year. Many times one year’s winner is the next year’s loser. By diversifying among these asset classes in such a way that meets your individual risk tolerance, you can obtain market returns with an appropriate amount of risk. This can be done by purchasing index funds and exchange funds that mirror the asset classes. Now, if we simply select the asset mix that meets risk and return profiles, we can earn the market return and go play golf!

If you need help, don’t hesitate to call. This is our specialty!!!

Real Estate Corner

The real estate market softened considerably during 2006. There have been pockets of depreciation in certain parts of the country and in the higher priced homes. I have seen drops of as much as 15% from recent peaks in the same markets. However, the overall market seems to have stabilized. We have not as yet experienced a significant broad based drop in home prices.

The Mortgage Bankers Association referred to 2006 as “A Normalization of the Housing Market”. In the aggregate, residential real estate seems to have remained roughly the same as a year ago. Home sales were lower by 10%, with new homes falling by 17% and existing homes falling by 8%. (This excludes data from December 2006, which will not be released until the end of January).

According to the Office of Federal Housing Enterprise Oversight, “US Home prices rose in the 3rd quarter, but the rate of appreciation declined significantly and some areas experienced declines. Nationally, home prices were 7.73% higher in the third quarter of 2006 than they were a year earlier.” Idaho topped the list of states with an annual increase of 17.5%, while Michigan, home of Ford and GM, was at the bottom with a slight price decline.

In our local market, the average sales prices of homes in Northern Virginia declined 4% in November compared to a year ago. Homes are also taking longer to sell, averaging 85 days on the market compared to just 35 days a year ago. There were also 30% fewer home sales than a year ago. One of the most interesting phenomenons is the switch from a seller’s market to a buyer’s market. Over the past 5 years, buyers have been paying on average 2% less than the listed price. However, in 2006, this number has increased to 7%.

I expect 2007 to be a true buyers market with sellers willing to provide handsome concessions and lower prices to entice buyers. If rates move north of 6.75%, there may be some true housing depreciation. Most economists however, are still expecting a soft real estate landing with a flat market over the next 2 years.

Sector Performance Report 12/31/06

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Market Summary

2006 turned out to be a terrific year for most investors. Stocks rose more than Wall Street analysts predicted after the Fed. halted 2 years of interest rate increases while energy prices fell 22% from their high in July. The S & P 500 was up 14%, the Dow Jones Industrial Average was up 16% and the NASDAQ moved up 9% for the year. Overall, the equities market performed remarkably well in spite of pressures from higher interest rates and energy prices.

In writing this newsletter, I reviewed my predictions from last year and would like to report the results. I suggested large cap stocks with high dividends or “value stocks” would have a big year. In fact, this asset class was up 23%. I also suggested the Fed would stop raising rates after another 1/2% increase. The Fed did stop, but not until after raising short-term rates another 1%. I suggested the energy and real estate sectors were due for a correction. I was way off here. The energy sector posted a strong 21% return beating the S & P 500 by 7%.

The real estate market was mixed. Commercial real estate continued to post excellent returns while residential real estate fell considerably. As for mortgage rates, I predicted a 1/2 % increase in rates. As predicted, 30 year fixed rates mortgages did increase from 6.25% to 6.75%; however, they came back down to 6.25% ending the year where they started.

For the record, my predictions are done mainly for sport. Predicting short term economic trends is more luck than skill and my predictions should not be acted upon at home. Market timing should never be substituted for sound asset allocation and rebalancing strategies.

Expectations for 2007 That thought in mind, let’s see what may be in store for 2007. As the current economic cycle matures, I expect larger stocks to perform better. This sector has been an underperformer since the late 90’s and is due for a good year. 2007 may be the year the S&P 500 and Large Cap growth stocks out perform all other asset classes. I also expect Healthcare and Financials to be in the top US sectors. As for rates, the market is pointing to a 50 basis point drop by the Fed and mortgage rates to lower by about 1/2%