Archive for November, 2010

“Buy and Hold” Is NOT “Still A Winner”

Thursday, November 18th, 2010

Investors are being advised by Princeton Professor Burton G. Malkiel (“ ‘Buy and Hold’ Is Still A Winner”) to hang in there, even when the market drops 60% of its value, as it did during 2008-2009.

But Professor Malkiel clearly has little understanding of active investment management, a valid alternative to “buy and hold” investing, which he equates to market timing.

Active investment managers use technical and fundamental research to drive their decision making.  Active managers aim to reduce volatility and draw downs by using proven techniques such as hedging and stop-loss orders, as well as some of the techniques he advocates in his column – diversification, dollar-cost averaging.

The big difference is that active managers sell off when they see trouble coming.  Advising my clients to sell in the summer of 2008 saved them a great deal of money that they would have lost if they followed the “buy and hold” strategy (see The Wall Street Journal, Feb. 12, 2009 for an example from Wenning Investments).

Professor Malkiel advises individual investors to keep their money in index funds and ignore the ups and downs of the market.  He cites respected investors Warren Buffett and Yale’s David Swenson, who give the same advice.

But if investing in index funds is such a great idea, why don’t Mr. Buffett and Mr. Swenson follow their own advice?  Active investment managers believe individual investors should benefit from many of the same techniques that these investment experts use.  If we’ve learned anything from the past decade, we should have learned that investing in index funds is too risky.

QE2: Will Investors Buy Higher Prices?

Monday, November 15th, 2010

The chief role of the Federal Reserve used to be to fight inflation.  It was a role the Fed played well, generally holding inflation in check since the 1980s.

With the launch of a second round of quantitative easting (QE2), the Fed is switching direction and is seeking to increase inflation.

Why would we want higher prices – especially at a time when we need more consumer spending?

Because, the Fed believes a little more inflation is needed to stimulate the economy.  For some time now, the Fed has feared deflation. When prices drop, profits decrease, stock prices drop, and unemployment and bankruptcies increase.  Consumers put off purchases and wait for prices to fall further, which contributes to even further deflation.

So the Fed announced QE2, which involves printing more money that will be used by the government to buy bonds.  Pumping $600 billion into the economy is supposed to stimulate spending.

But more money will also further devalue the weak dollar, making American goods cheaper abroad.  While the impact on trade would be welcome, there are already grumblings about a trade war brewing with China, which is taking steps to slow its economy down.

With the purchase of bonds, QE2 was also seen as a way to bring interest rates even lower, even though they are already close to zero.

So how will QE2 turn out?

When plans for QE2 were announced, stock prices rose.  On Friday, though – the first day of QE2 – prices dropped.  Investors were selling bonds as the government was buying them, canceling the impact of the government’s action to some extent.

We’ll see what happens next, but there is no certainty that QE2 will stimulate inflation (QE1 didn’t).  And there is also a chance that it will cause too sharp of an increase in inflation.  The current rate of inflation is under 1% and the Fed would like to see inflation rise to 2%.

Note to Fed Chair Ben Bernanke: Be careful what you wish for.

When Good News Is Bad News

Friday, November 12th, 2010

Sometimes investment managers live in Bizzaro world, the place in the old Superman comics where everything is the opposite of what logic would dictate.

A case in point is the recent investor optimism.  Investors have been returning to the stock market, where inflows are finally exceeding outflows.  The American Association of Individual Investors recently found that 48% of investors are bullish on stocks, the highest level since February 2007, while only 27% are bearish, which is the lowest level since January 2006.

So shouldn’t we all be euphoric that investors are finally following our advice and returning to the market?

Not really.  The en masse return of the individual investor is a sign that stocks are overbought and overpriced, and could be destined for a fall.

There are plenty of other factors to consider – some positive and some negative – but the more confident individual investors become in the market, the less confident investment managers become.