Double K’s Quarterly – Winter Edition
"We will open the book. Its pages are blank. We are going to put words on them ourselves. The book is
called Opportunity and its first chapter is New Year's Day." ~ Edith Lovejoy Pierce
Happy New Year!
What a year! Volatility was the name of the game in 2011 for bi-polar markets that
made even the heartiest of Portfolio Managers somewhat sea-sick. Well… “Happy New
Year!” Out with the old and in with the new. A clean slate and a world of possibility lie
before us. The weather has turned colder and the markets may be warming up. This is
a lengthy Quarterly due to the “On The Markets” piece where we review several 2012
market predictions and I defend my own, so you may want to consume this in pieces.
After the epic “Markets” bit, we’ve got some fun stuff about famous predictions and
market indicators. But first, a question…
In This Issue:
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Feature Article: Are You A Business Owner Interested In Potentially Reducing Taxes?
On The Markets… Past, Present and Future
The Myth of the Super Bowl Indicator (and then some)
Odd-endums and Factoids
Are You A Business Owner Interested in Potentially Reducing Taxes?
If you are a Partner in a professional practice, or a business owner with a high income
and taxes that make you cringe, you may be able to take some of those tax dollars and
put them into your own pocket through creative Retirement Plan design. Professional
Practice and Small Business retirement plans have become a core focus for me
because those types of business owners are generally the people for whom I manage
money. And it’s often true that a significant amount of their investable assets are in
the company plan. One benefit I’m able to offer these owners is simply picking up the
entire plan and bringing it in-house at Morgan Stanley Smith Barney. This allows us
to remove them from a restricted, mutual fund-only program and offer professional
money management to the owners, while offering all participants a much larger
investment selection.
There are many types of company retirement plans, including Simple IRAs, SEPs,
401(k)s, Profit Sharing, Defined Benefit Plans, Pensions and more. And within those
types of plans are many plan design alternatives, such as Matching, Non-Matching,
Safe Harbor, Age-Weighted, New Comparability, and on and on. While for most
companies a fairly straight forward and simple plan design is appropriate,
professionals and business owners who have a high income and the desire and ability
to put away more and seek to reduce their tax burden, may benefit greatly from a
more advanced plan design. Most financial advisors will work with retirement plans
when they come across the opportunity, and many work on and implement the more
advanced plans (often some form of Defined Benefit Plan combined with a 401(k)
and/or Profit Sharing Plan) but I have noticed that it is extremely rare to find
financial advisors, even those who are currently servicing such plans, who really
understand how to help clients manage their plans and take full advantage of the
endless nuances these plans offer. Such plans often require custom-design, and most
financial advisors offer cookie-cutter plans. Even in the custom-plan world, among
the actuaries whose job it is to slice and dice the numbers until they discover the most
beneficial formula, it can be difficult to find those that are really exceptional at it.
If you find yourself wishing you could protect more of your income, even if you’ve
already explored different plan designs but couldn’t find a better one that made
financial sense, give me a call. There are often some very clever plan options that you
just haven’t been presented.
(Note: The previous comments are the opinion of the author (as are all comments in Double K’s
Quarterly). Morgan Stanley Smith Barney, its affiliates and Financial Advisors do not give tax advice.
Please see full disclaimer below.)
On The Markets… Past, Present and Future
It’s a new year and in the financial world that means everyone and their
grandmothers has an opinion about the markets in the year ahead. Well, I’m no
different! We’ll look at some notable viewpoints being put out and I’ll give you my
own as well but first, we should take a look back and reflect.
The entire year was relentlessly volatile. It started well enough with the S&P 5001
climbing about 6% (Reuters) through February before crashing back down to where
it had begun the year by the time March was half over. It climbed again to a more
than 8% gain (Reuters) on the year in May, but crashed back down to its starting
point once again in June. It attempted another brief rally in July but got serious
about crashing in August when it dropped 19.4% from its May high (BTN Research).
20% would have indicated that we weren’t just having a correction but had entered a
Bear Market. Talk about a close call! Tack on another climb, another fall, and a last
minute December gift to get us… right back where we started. The S&P 5002 started
the year at 1257.6 and after all the drama and gyrations, ended the year at exactly
1257.6. Unbelievable. It’s now the first week of January and the markets seem
content to drift upward. The volatility index has even come down considerably, but I
don’t trust it for a moment. I think we’re in for more dramatic gyrations! Before I
give you my own thoughts though, let’s take a look at what some other people are
saying.
Over at UBS the guys were fairly cautious, saying "We recommend entering 2012
with a modest defensive bias with under-weights to global equities and commodities
and corresponding over-weights to bonds and cash. We continue to avoid euro-zone
exposure, and instead prefer the U.S. and emerging-market equities. We also
maintain our focus on both quality growth stocks and income-generating
investments amid choppy and range-bound markets." (Mike Ryan, CFA®, Chief
Investment Strategist and Stephen Freedman, CFA®, Head, Investment Strategy,
UBS) Even more pessimistic was Nouriel Roubini, Chief Economist at Roubini
Global Economics. That’s not surprising since he’s famously known as “Dr. Doom”
for stridently and repeatedly predicting that a financial meltdown was coming in
2007… and then, of course, being right. He says "The outlook for the global economy
in 2012 is clear, but it isn't pretty: recession in Europe, anemic growth in the United
1
An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading
indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
2
An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading
indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
States, and a sharp slowdown in China and most emerging-market economies.”
Ouch. T. Rowe Price wrote, "As of this writing, our base-case scenario envisions the
economy expanding by 2% in 2012. Nevertheless, we acknowledge several downside
risks to our outlook, including a worsening of the eurozone crisis, deepening fiscal
austerity in the U.S. (whether intended or not), and a hard landing for the Chinese
economy." (Alan Levenson, Chief Economist, “Commentary”) That doesn’t sound so
good either. Best we move on. How about Laszlo Birinyi, the President of Birinyi
Associates? He’s a world famous market forecaster. Laszlo Birinyi has refused to
make a 2012 forecast, given the uncertainties. Hmmm. Well, they’re a little more
intrepid over at Lancz Global. They say, "The smart investors should capitalize on
the more economically sensitive, cyclical leaders that have been sold off due to global
economic concerns. After two years of following the trials and tribulations of Europe,
it seems the concerns are becoming overblown. Europe will take a long time to get
their house in order, but over the next year or two, many select, economically
sensitive companies should show impressive recoveries in share prices." (Alan Lancz,
President) That’s a little better. I left a lonely bull, Richard Bernstein, for last. He’s
going to tell us why stocks are going higher this year. "If fundamentals rule, then we
think 2012 will be another year of U.S. asset outperformance. This remains a very
out-of-consensus view, but as we have repeatedly pointed out, the U.S. dollar index
(DXY) troughed in April of 2008, and the S&P 500 has been outperforming the
SMCI BRIC index for four years.” There’s a reason I left Bernstein for last. It’s
because I believe he’s the one who got it right.
Yep... call me DeNiro ‘cause I’m a raging bull! I think stocks could go significantly
higher this year provided we don’t have a full blown recession. Why? Part of the
reason is that so many other people don’t seem to believe it. If they were all touting
the wonderful stock market we are in for this year, I’d be worried. You really can’t
have a lasting bull market when everyone thinks it’s a bull market. Everyone would
already have their money in and there would be no new money to push the market
higher. This pessimism dynamic is just a piece of the puzzle though. It only works if
things are going fundamentally well with the things that make the market run.
Luckily, they appear to be.
This week we got another upside surprise in the employment numbers. In fact, over
the last year the unemployment figure has come down from 9.5% to 8.5%. That’s
significant improvement and a sign that the economy is getting better, even if slowly.
The economy doesn’t just run on the employment figures though. There’s a whole
slew of economic indicators that can sometimes be pointing in different directions.
That’s why there’s an Economic Indicator Diffusion Index. It subtracts the bad
economic release data from the good release data, as reported over the past 50 days,
and plots the difference (known as the diffusion). It sits at a 6 month high right now,
meaning things appear to be getting better and better. Even more telling for me is
the ongoing stream of good corporate earnings. It’s been going on for two years and
they seem to just keep improving (which is exactly why unemployment keeps going
down). The thing is, companies are selling more and doing it more profitably, but
their valuations haven’t changed that much (It took us a whole year to get back to
“Start” on the S&P 500). That can’t continue. There is pressure mounting on stock
valuations and they seem to want to rise like they’re filled with helium. The problem
has been that European messes and natural disasters seem to keep coming along and
tying them down with lead. That also can’t continue. If Europe blows up and the
euro comes crashing down, I’m going to be wrong. But I don’t think that happens. If
it did happen I’m not sure that it would come this year anyway, but I think they
figure it out and soldier on. Many of those economies are going to be sucking wind
for awhile, but I don’t think the contagion brings us down and instead, we get a
slowly improving economy and a potential bull market. Now that I’ve said it, I’ll
bring you back to my first expectation for 2012. It’s going to be crazy volatile (again)!
So yes, equities may be the place to be, but only if you’ve got a strong stomach and/or
a portfolio manager working his butt off to help reduce risk and dampen volatility
(Hey, come to think of it, I do know this guy…).
The Myth of the Super Bowl Indicator (and then some)
The Playoffs are here! A good excuse to explore some of the more interesting marketperformance indicators that have surfaced over the years, as one of the most famous is
the Super Bowl Indicator. Someone years ago (I don’t know who) found a correlation
between an NFC team winning the Super Bowl and the stock market rising for the
remainder of the year. Conversely, the market is supposed to fall if the winning team
is from the AFC. Followers of this “indicator” claim it has an 80% success rate. That
seems pretty interesting, right? I mean, it doesn’t make any sense, but it would sure
make my job a lot easier is I could just watch the Super Bowl and then go all in or
hedge the heck out of my positions based on the outcome of the game! Another easy
(and easy on the eyes) indicator concerns the Sports Illustrated Swimsuit Edition.
Apparently, if there is an American model on the cover, the stock market rises doubledigits. I’m not sure how that makes any sense either but hey, my clients depend on
me so after I finish watching some football I’m going to have to get down to some
serious research with the Swimsuit Issue. It’s also good to know that if a horse wins
the Triple Crown, the stock market will tank. There have only been 11 such horses in
125 years so I’m not convinced we have a statistically significant sample here, but I’ll
probably bet against the Derby winner from now on. And did you know that when the
economy is good, hem-lines go up? It’s true, but that’s what we call a “lagging
indicator” and they’re not so useful for stock investing. So let’s see… so far we have
football, scantily clad women and horse racing as our indicators. The only thing
“indicated” to me is that men still dominate the financial markets! Aren’t there any
real, scientifically proven indicators out there? Actually, yes. Back in the 90’s some
super-geek-quant-computer guy ran some numbers through his super-geek-quantcomputer and found that there is a high positive correlation between butter
production in Bangladesh and the direction of the S&P 500. Seriously. The computer
proved it and everything! Ice cream production also has a strong positive correlation,
as does U.S. cheese production. And just fyi… if you’re trading on any of these
“indicators”, you’re as nutty as a cheese ball. These are excellent examples of
statistical anomalies that appear to “prove” something to be true, but in reality are
nothing more than happenstance. For instance, the geek who ran the Bangladeshi
butter numbers did a regression analysis (backward looking) of the 10 year period
from 1983 to 1993, and everyone was shocked that the numbers could be such an
accurate predictor for 10 whole years. People started coming up with all sorts of
logical explanations for why this correlation existed. The only problem was… it didn’t.
Just a year or two later the whole thing fell apart and the “indicator” suddenly stopped
working. It was just a coincidence all along. In fact, I misused the word “anomaly”
above. An anomaly is a departure from the norm, but this sort of statistical
happenstance can be found all over the place all the time. The harder part is figuring
out which correlations actually mean something. We’d be wise to remember that
although it’s said that statistics never lie, they are exceptionally good at misleading us!
Well, I’m off to do some of that important research we discussed. Until next time…
Cheers!
KK
Contact the Editor
Kent Keith
Portfolio Manager
Financial Advisor
MorganStanleySmithBarney
1787 Sentry Prkwy West, Blue Bell, PA 19422
Toll Free: 800-648-4584 • Office: 215-274-2561 • Fax: 215-540-0788
[email protected]
www.KentKeith.com
Odd-endums and Factoids – The Famous Predictions Edition
♦ Glad he was wrong - Radio host Harold Camping, 90 years old, predicted that “Judgment Day”
(i.e., the final annihilation of the earth) would occur on 10/21/11 (source: USA Today).
♦ I wish! - Forecasters at the 1893 Chicago World’s Fair (i.e., 119 years ago) predicted that by the
year 2000, Americans would work no more than 3 hours a day (source: Wall Street Journal).
♦ We all wish! - President George Bush predicted on 1/03/07 (i.e., 5 years ago) that the US
government would reduce its annual budget deficit to zero by fiscal year 2012 (source: White
House).
♦ Smart guy - Microsoft founder Bill Gates predicted in a 1/08/02 interview (i.e., 10 years ago
yesterday) that the upcoming 10 years would be the “digital decade” and that consumers will come
to “take computer capabilities for granted the way we take electricity or water for granted today”
(source: Consumer Electronics Show).
♦ Oops - Treasury Secretary Tim Geithner was asked on 2/07/10 whether the USA could ever lose
its top credit rating. Geithner responded “that will never happen to this country.” S&P downgraded
the United States from AAA to AA+ on 8/05/11. The USA had been AAA-rated for 70 years (source:
ABC News).
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