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Bob's Journal 
What's this?______________________________________________ March 29, 2007 2:45 p.m. Lessons from a Law Firm Meltdown You might have noticed in the news that a major law firm, Jenkins & Gilchrist, reached a settlement with the government this week and will be going out of business. The firm once was widely-respected; a few of my classmates from law school started there after graduation. J&G was doomed by its involvement with some tax shelter strategies that allegedly enabled clients to shield large capital gains from the sale of stock in the late 1990s. There are a few lessons from these events for all of us: ▪ Aggressive tax reduction rarely pays. There are many ways to reduce taxes that we should use. But complicated, aggressive strategies usually stretch the law and count on the IRS either not finding out about them or deciding they are too difficult to understand them. It might take the IRS a while to find the strategy and penalize it, but often it does. When the day of reckoning comes, the interest and penalties far exceed the initial taxes. In these cases, the use of aggressive strategies was less than logical because the taxpayers were trying to avoid the long-term capital gains rate of 15% or 20%. ▪ The way people think about money can cause bad decisions. In this case, the clients were victims of something called anchoring. Once their stocks were valued, the clients had those values fixed in their minds. After they learned how much the capital gains tax would reduce those values, they wanted ways to get back to the original value. This same mindset keeps people from selling losing positions early; they want to get their original investments back. So, they watch the investments decline further rather than sell. Investors need to fight anchoring; it leads to poor decisions. ▪ Accounting firms, investment banks, individuals, and companies all paid the price for accounting fraud and scandals in the early 2000s. Lawyers and law firms faced almost no penalties and in many cases reaped fees after the scandals became known. In this case, the courts did not allow attorney-client privilege to protect the documents and other communications of the lawyers. Rather than protecting clients or third parties, the attorney-client privilege often protects lawyers who knew about and frequently approved the actions. March 29, 2007 1:07 p.m. Facts About Subprime Mortgages The subprime mortgage market is the big news in the financial world. The major debate is over whether the damage will be contained within that market or will spread to the rest of the mortgage market and perhaps even beyond. The most bearish case is that the losses will lead to tighter lending standards across the board and less cash available for businesses and consumers, ultimately triggering a recession. A good source for information about all mortgages is Trust Company of the West (TCW) and its crack mortgage group headed by Jeffrey Gundlach. TCW has been one of the biggest and best investors in mortgages. They manage money for the pension fund I oversee and have one of the better bond mutual funds, TCW Core Fixed Income. TCW saw problems developing with subprime mortgages several years ago. In response it tightened its own investment standards and avoided mortgages issued by certain firms and by firms that did not follow certain lending standards. Only lately did the Wall Street investment banks that were providing financing for these lenders follow suit. TCW believes that the loss estimates making the headlines are worst case scenarios that are unlikely to be realized. Subprime mortgages are a fairly small part of the market. In addition, continuing economic growth, stable interest rates, and high consumer confidence give subprime borrowers incentives to continue making their payments. The big risk is that housing prices continue to decline for an extended period. Having little or no home equity is a disincentive for struggling homeowners to continue making high payments. Most of the questionable loans were made in 2005 and early 2006. It takes about 24 months for a homeowner to go from missing payments to default and foreclosure. The mortgages that are making headlines today primarily were issued in 2003 and 2004. We won’t know for a while yet how many from 2005-2006 will default. If interest rates remain relatively low and credit is available for a number of homeowners to refinance, the worst case scenarios can be avoided. It often is a good idea to learn the views of someone who has been in the midst of a market and saw potential problems long before others. This view of the mortgage group at TCW is far more valuable than reports from economists and analysts who are viewing the market from afar and making assumptions. Absent a surge in interest rates or drop in economic growth, the problems in subprime mortgages should be limited. This does not mean smooth sailing is guaranteed in the economy. Business capital investment is less than robust, and there is talk of tax hikes in Congress. These and other factors are why we are maintaining cautious, hedged portfolios. March 27, 2007 12:40 p.m. Fed and Investors: All in a Box Investors cheered the statement that accompanied the Fed’s interest rate decision last week. This was a puzzle to me, because it didn’t seem that investors were reading the statement too closely or understanding its implications. Today, with Fed Chairman Ben Bernanke’s testimony on Capitol Hill, the picture is becoming clearer to many investors. The results are that stocks soared last week with the Fed statement and are falling today with Bernanke’s testimony. Here is the conundrum in a nutshell: The Fed sees economic growth declining. So far, the economy looks in good shape. It still is growing, and the growth rate is one that can be sustained for some time. A slightly higher rate is preferable over the long term, but the recent rate of 2% or so won’t cause problems for a while. Unemployment is low, and wages are rising. Profit growth still is good, and profit margins are at historic levels. Unfortunately, there are factors that could cause economic growth to decline further. The decline in housing could reduce consumer spending. The problems in the subprime mortgage market could spread to the rest of the economy, with the biggest risk being that lending standards will be tightened across the board. Credit crunches generally lead to recessions. Another negative factor is that capital spending by businesses has been sluggish for several years and recent slowed. Normally, this picture would cause the Fed to reduce interest rates or at least be prepared to, and that is the posture many investors saw in last week’s Fed statement. Yet, inflation still is above the Fed’s comfort level. Despite assertions that the Fed expects inflation to decline soon, that hasn’t happened yet and might not happen. So, the Fed is in a box. Economic growth is slowing, and there are factors that could cause it to fall more rapidly. Yet, inflation is too high. Cutting interest rates to stabilize the economy could make inflation worse. If inflation continues to rise, the Fed has to give serious thought to raising interest rates further regardless of what the economy is doing. I don’t have a strong opinion about how events will unfold. I have believed that the economy is stronger than most people believe and that inflation is more of a concern. The ideal result is that inflation does decline below 2%. That would give the Fed some reason to act or not act depending on how the economy performs. Expect volatility in the markets as some investors take the economy-and-inflation-fall scenario while others believe inflation and interest rates will rise. That is why we will continue with our portfolios that are positioned for different scenarios. March 21, 2007 9:30 a.m. Behind the Blackstone Deal Formed only 22 years ago, Blackstone Group plans to sell 10% of the company in a public offering. This is considered ironic, since Blackstone is one of the premier private equity firms. It raises money to buy companies. Sometimes it buys public companies and takes them private or buys divisions of public companies. Other times it buys companies that already are private. In all cases, Blackstone touts the advantages of running a private company instead of one subject to public shareholders and the rules of public companies. Is the Blackstone offering a warning sign? Is this a case of the smart money sensing a market peak and selling to the public while there still is money to be made? I don’t think so. If the Blackstone offering is followed by a stock decline, that would just be a coincidence. The debate over taking Blackstone public has raged behind the scenes for some time. It is not a case of market timing. In addition, if the firm thought the public markets were peaking, it would not still be buying a lot of companies. It would be trying to bring its portfolio of companies public as fast as it could. Bringing Blackstone public has some disadvantages for its current owners and management, but it also has advantages. It helps with the estate planning and cash flow needs of the founders. Being public also makes it easier for the company to hire quality employees by rewarding them with equity compensation that is more liquid than private ownership interests. There could be two warning signs in the public issuance that not many observers are noticing. One possibility is that the Blackstone Group sees an end to ready, low-cost cash through its traditional financing sources. In other words it could see the global liquidity boom shrinking at least a bit. Blackstone also might believe that it has fully tapped its traditional investor base of institutional investors and believes access to public market capital is necessary to keep growing. I think the public offering means that the practice of taking public companies private is likely to continue, and individual investors will face a shrinking market of stocks in which to invest. March 20, 2007 11:30 a.m. Is the Coast Clear? Is yesterday’s sizeable gain in the major stock indexes the end of the correction? If so, it was a very shallow correction. The technical factors of the market, however, do not indicate that a new market rally is under way. The media and many analysts focus on the price movements of the market indexes. I believe, however, that it also is important to examine the intensity behind the market. We can do that by examining trading volume and comparing that with the volume on recent days. When trading volume is high, that indicates a majority of big investors (such as mutual funds) are joining in the move. When trading volume is not heavy, that indicates a relatively small percentage of investors and probably individual investors are influencing the prices. In the steep decline of Feb. 27, trading volume was the highest level in more than a year. That signals a correction. In the ensuing days when the market rose, volume rose nowhere near the level of Feb. 27. In yesterday’s big rally of around 1% in the indexes, trading volume was very low. An easy way to track trading volume is at www.BigCharts.com. Enter the ticker symbol DIA or SPY and compare the trading volume in the bottom of the chart. There was a lot of conviction when stock prices declined Feb. 27, but there has not been any conviction on days when the market indexes rose. It still is a time to be cautious and wary of the risks in the markets. Some investors are itching to load up on stocks in hopes of finding the market bottom and riding all of the next rally. The problem with that is you risk getting caught in the next leg down of the market. It is better to let the market confirm a bottom with a rally in high trading volume. March 13, 2007 12:10 p.m. The Looming Disasters The housing downturn (especially the fate of subprime lenders) and China dominate a lot of market analysis. The housing situation is said to be the tip of the iceberg of looming financial disasters to come. China is considered to be a potential trigger. It could sell treasury bonds, revalue its currency, stifle its economic growth, or make some other policy mistake. The sharp market decline of Feb. 27 began after China’ stock market declined after talk from a Chinese official. Before analyzing the potential for harm from these and other sources, it is wise to consider why the other crisis of recent years did not trigger the big crisis. In a short term the economy has been resilient through the terrorist attacks of 2001, the Iraq War, 17 interest rate increases, sharply higher oil and commodity prices, a decline in the dollar, Hurricane Katrina, falling home prices, and more. In the past, any one of these would have led to a sharp economic dislocation for at least a brief period. Yet, only the 2001 terrorist attacks had a significant effect on the economy and markets. Instead of spending time analyzing housing and China, investors should analyze why these small disasters did not lead to a big disaster. Here are some points to consider: ? Lack of correlation. Changes in the global economy have made events less correlated. There are more sources of financing for businesses. Lenders and investors are better able to diversify. Central bankers also have learned more. Freer trade allows economies to grow without being dependent on one economy or industry. ? The service economy. As the influence of manufacturing on the U.S. economy has declined, the economy has become more stable. Service businesses generally are less cyclical than manufacturing. That is a big reason why the last few recessions in the U.S. have been rather shallow. ? Housing’s lag. A key argument these days is that the lost wealth in housing will result in lower consumer spending and an economic contraction. We will find that there is a lag in this effect. In addition, some Federal Reserve statistics indicate that a sizeable part of the money taken out of home equity was invested, not spent on consumer items. That will make the reduction in consumer spending less than analysts anticipate. ? Global capital flows. The U.S. trade deficit exists because of policies in China, Japan, and Europe, not a lack of competitiveness in the U.S. The money that flows into those countries is reinvested in the capital markets. It is keeping interest rates low, liquidity strong, and economies growing. Until an analyst is able to explain why the crises of the last few years did not result in an extended or deep economic decline, forecasts of the next economic crisis shouldn’t carry much weight. March 6, 2007 12:10 p.m. Our Portfolios Updated The funds in our portfolios withstood yesterday’s fresh decline in the indexes well. Here’s a summary. Sector and Balanced Managed: There still are no changes here. ProFunds Ultra Bull came closest to triggering a sell signal. Its recent high was $74.64, making the sell signal $65.68. It closed at $65.98 yesterday, just missing a sell signal. Needham Growth had a recent high of $40.30, for a sell signal of $37.48. It is comfortably above that. Hussman Strategic Growth continues to rise when other funds decline. IWW Classic Mutual Funds: REITs have been among the leading decliners in this correction, and this portfolio had two REIT funds. We sold Cohen & Steers Realty Shares from this portfolio last week. Price Real Estate finally fell below its sell signal on Friday and was sold from the model portfolio on Monday. Its recent high was $28.44, giving it a sell signal of $26.45. The portfolio should stay in money market funds until the April issue of Retirement Watch is published. IWW ETF: We sold Mexico iShares last week and continued to hold Spain iShares. That fund has fallen through its sell signal and should be sold. This portfolio also will remain in money market funds until the April issue is published. IWW ProFunds: We sold Real Estate last week. Yesterday Ultra OTC fell through its sell signal and should be sold. The portfolio should remain in money market funds. IWW Rydex: We sold Real Estate last week and held on to Dynamic S&P 500. RYTNX had a recent high of $50.02 for a sell signal of $44.02. It just barely avoided a sell signal yesterday with a close of $44.24, so it stays in the portfolio for at least another day. The proceeds from funds sold stay in money market funds until the new rankings come out in the April issue of Retirement Watch. March 6, 2007 12:15 p.m. How to Avoid Risk Investors are re-learning some important lessons in the current market pull back. These lessons are a major part of my next book, which is due out in July. One lesson is that risk should be managed and reduced whenever possible, because we don’t know what will cause markets to head south. In addition, the markets can turn suddenly. It is not prudent to own an investment long after historic risk measures have been surpassed simply because it continues to rise. Another lesson is the difference between traditional diversification and true diversification. Many people think they have diversified portfolios because they have a range of different stocks or stock funds. But most traditional investments tend to move together in times of market stress. We saw that in last week’s major decline. All 30 stocks in the Dow declined. All but two stocks in the S&P 500 fell. And only two of the 51 country stock markets around the world followed by MSCI Barra did not lose value. Emerging markets and high yield bonds lost value, and real estate investment trusts were among the stocks leading the markets down. True diversification means a portfolio holds assets that have low correlations with each other. In particular, that lack of correlation should hold in times of extreme market moves. A good example of a truly diversified asset to hold in a portfolio is Hussman Strategic Growth. Because it viewed the stock markets as overvalued it was hedging its portfolio. This fund rose while the traditional funds were declining. To reduce risk a portfolio needs assets that are genuinely uncorrelated with each other. You give up some gains in the short-term during periods when almost all assets are rising, which was the case from July until the end of February. But you avoid the big losses in market declines and have solid returns with low risk over the long term.
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The web site and web journal of the editor of Retirement Watch, covering all the financial aspects of retirement and retirement planning, with a few odds and ends thrown in.
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