Brinker/Swedroe: Bob began the interview by noting that this is an election year and one of the ways to get elected is to bash the economy and say things have never been worse. Larry agreed and said it is very difficult for people to deal with the emotions of bear markets and people tend to panic and sell and end up with lousy returns. Larry said one of his favorite sayings is that bear markets are the mechanism by which money is transferred from those with weak stomachs and no plan to those with strong stomachs and well thought out plans. We have all this bad news, but if you look back to 2003, if you had a crystal ball everyone would have been shorting stocks. At that time, we had the SARS virus, the Iraq invasion, mutual fund scandals, global deflation threat, etc., and yet stocks had a great year with many asset classes producing returns of 50%, 60% and even 70% in some of the international markets. Stock markets are forward looking. They already include all of the bad information we could possibly know about the market and therefore it is too late to do anything about the bad news.
EC: I can almost hear Bob's thinking process as Larry is talking. For starters, Bob would dispute Larry that we have had a bear market. Bob defines a bear market using the S&P 500 on a closing basis, and so far, the max it has declined is around 16%. Larry may have been speaking in terms of other asset classes, and even some stock indices other than the S&P 500. There are certainly some bear markets out there, just not the benchmark that Bob tracks. The second thing Bob was probably wanting to say is that his crystal ball allowed him to buy back in on March 11, 2003, which just about marked the retest of the bear market lows to the day. But then he might have to add that he was still long the QQQQs with a sizable chunk of the portfolio. In any event, Larry didn't give him a chance, and his next comment seemed to grab even Bob's attention.
Swedroe: Larry said that even if you could perfectly time recessions and your crystal ball allowed you to get out of the market before the recession began and then get back into the market the day after the recession ended, there have been 11 recessions in the post-war era and the stock market has actually gone up an average of 7% during those recessions and that would have outperformed risk free Treasury bills. Thus, it is very difficult to out-fox the market.
EC: That is an amazing statistic and one I didn't know. It certainly is something all investors should be aware of. Incidentally, the average duration of recessions since World War II excluding the 2001 recession is eleven months. If you want to read how the National Bureau of Economic Research's Business Cycle Dating Committee determines recessions, go to this url:
Brinker/Swedroe: Bob said we have not had a bear market as the S&P 500 is only down 15% so the stock market is solidly in correction territory and got as high as just 16% on January 10th. (I told you Bob was thinking that!). Bob asked Larry how it could be with all of the bad news out there, including the credit markets being in complete shambles and the recession talk, that the market is just down 15%? Larry said that is the great mystery and if anyone could answer that question they would be much richer. Larry went on to say that NOBODY has shown any great ability to forecast the stock market.
EC: Uh oh. Dem's fighting words. Does Larry not realize he is talking to the world's most famous self-appointed market timing guru? Did not the call screener tell Larry that putting down market timing is anathema on Moneytalk? Oh, the humanity!
EC#2: Joking aside, Bob's question tells a lot about why he remains bullish at this juncture. Bob has always discussed how the stock market discounts the futures by 6 months at a minimum. Bob is right that the news has been terrible, and at least so far the market's worse showing was a 16% decline. In fact, the market is now right at the level which Bob most recently gave an outright buy signal.
Swedroe: Larry said a lot of people will point to hedge funds to support the view that some geniuses can successfully predict the market. Well, if you look at hedge funds, the academic research shows that even they have had a difficult time keeping up with Treasury bill returns when you take into account for the risk that they take and the biases in the data. There are so many unexpected events, it is impossible for anyone to guess where the market is going. For that reason, Larry said the most prudent strategy is to anticipate bad markets. We have had two horrible bear markets where we saw 50% declines, the last time in 2000-2002 and then in 1973-1974. Build that possibility into your financial plan. If you are in the accumulation phase, you should be rooting for bear markets so that you can buy cheap. It is only in the withdrawal phase that bear markets are painful and if you panic and sell into weakness, that can really take a toll.
EC: As you know, Bob's newsletter is called Marketimer. During one broadcast, where Bob was being asked specifically about his market timing efforts, Bob said what he does is "anticipatory market timing" which he acknowledged, in a moment of candor, to be one of the most difficult things to do. Bob's market timing efforts in recent years have been good, although it depends on whether you include all of his timing efforts, such as the QQQQ trade. If you go back to the inception of his model portfolios, you have two problems. First, Bob reset the beginning date of his model portfolios. And then, when his timing model failed in the late 1980s, he said he changed his timing model to where it is today. If you go back to the beginning, according to Mark Hulbert, Bob's timing efforts have led to underperformance which would support Larry's view. If you start tracking Bob's timing efforts since 1991, well then he has done much better although it bears pointing out that he has only made a few timing calls since then and that other than the 2000 tactical asset allocation move (followed by the QQQQ trade), and back into the market in 2003, Bob's portfolios have been very similar to a buy and hold position. In a secular bull market, that can work. If we are headed for a bear and Bob stays fully invested, well..., let's not get ahead of ourselves right now.
Brinker/Swedroe: Bob said individual investors tend to do so much worse than an index funds because they do sell out when they see huge declines. Larry said investors buy yesterday's winners and therefore buy high, and yesterday's losers cause you to sell. The key to successful investing is to restore your asset allocation and rebalance by selling into strength and buying into weakness. Every study done has shown that the average investor significantly underperforms the very mutual funds they invest in because they chase winners. There was only one fund family that was able to outperform and that was Dimensional Fund Advisors (DFA) and their outperformance has nothing to do with the funds they selected. It was because DFA requires you use an approved advisor and they keep their clients disciplined.
EC: On my list of topics to cover in a future newsletter is to provide a primer on Dimensional Fund Advisors. It is a unique shop for sure. Here is a link to their web site:
Brinker/Swedroe: With the credit market in turmoil, what is your impression of what is going on? Larry said he thinks it is a classic mistake of investors, particularly the hedge funds which treat the unlikely as if it is impossible. When you purchase high risk securities, one of the risks you undertake is illiquidity and when that shows up, you can get slaughtered. That is why investors should be very careful in the fixed income side of their portfolio. The fixed income side of your portfolio should be invested in securities that allow you to sleep while you take the risk on the equity side of your portfolio. Therefore, you should only be invested in the safest fixed income securities, such as U.S. Treasury bills and Treasury Inflation Protected Securities which are great and only the highest grade corporate bonds if you are going to go that route. Larry said he would avoid hybrid securities such as preferred stock, convertible bonds, and junk bonds which are the worst of the asset classes. Larry said he would even avoid emerging market bonds even though they have some diversification benefits. If you want to take risk, take it on the equity side where you can invest in a much more tax efficient manner.
EC: I agree with Larry and his view that the fixed income side should have the highest quality whereas you take the risk on the equity side. That is one of the premises of how my partners and I constructed our Model Portfolios for those in retirement in our Retirement Advisor Newsletter. (see, http://www.theretirementadvisor.net/)
Brinker/Swedroe: There has been incredible volatility in the municipal bond market and a lot of the municipal bonds funds have been hurt. Bob said it obviously is not because of rising rates, so it must be credit concerns. Larry said that was not correct. In this case, the municipal bond market, once seen as a boring market, became the target of hedge funds who were trying to take advantage of the steep yield curve in the muni market. They would buying longer municipal bonds and taking big positions and leveraging them. The hedge funds were getting margin calls because the banks did not want to put up the money anymore in this type of environment which forced the hedge funds to sell in a distressed environment. As a result, the prices were collapsing because there is not enough buyers. This is really a liquidity crises and creates a wonderful buying opportunity for individual investors to take advantage of the pain suffered by the hedge funds. You might not want to go to long out because of inflation concerns, but at least now you are getting compensated justly. This is not a credit story, it is a liquidity story. All instruments, even if they are very safe, are being priced for liquidity risk. That risk is always there, it just doesn't show up often.
EC: Great points by Larry. The Los Angeles Times has an article out this weekend entitled, "Credit-market mess poses opportunity in muni bonds." If you are in the market for a municipal bond, you should definitely check out this article:
Caller: One of the fears that everyone has is the price of oil going through the roof. What is driving the price of oil? Is it fundamentals, or hedge funds manipulating the price? Larry said he is not an expert on oil and it might be a combination of things, but it is irrelevant unless the price of oil impacts your portfolio. Larry said what he recommends to hedge against such an outcome is having a small allocation in your portfolio devoted to commodities. Larry says he specifically recommends PIMCO's Commodity Real Return Fund because it acts as portfolio insurance. Commodities tend to have their best returns when stocks or bonds are doing poorly. For example, during the eight bear markets or eight years of negative stock returns since 1970, commodities have returned an average of 23% and in the nine years of negative bond returns, commodities have returned an average of 30% a year! The main reason for this is that commodities are positively correlated to inflation whereas stocks and bonds are negatively correlated to inflation. Thus, Larry thinks you should own 5-10% of your equity allocation in this type of investment. Thus, if your allocation was 70% equities and 30% fixed income, you should own somewhere between 4-7% in commodities as a way to hedge your risk against the kinds of events that could drive oil through the roof.
EC: PIMCO's Commodity Real Return Fund (symbol: PCRAX) is a no load fund with an expense ratio of 1.24%. It has an impressive rate of return in recent years as commodity prices have surged. Here is a link to the fund's profile on Morningstar:
Caller: Is now a good time to purchase zero coupon bonds? Larry said you have to always consider how the addition asset will impact the entire risk profile of your portfolio. Zero coupon bonds are generally very long term maturities which means you will take inflation risk by owning it, but it will also provide a hedge against deflation situations like recession when interest rates fall. You also have to consider your human capital. If your potential for work fluctuates widely with the economy, then maybe its a good thing that you have a long term bond because if you get laid off in a recession, that long term bond will help you. On the other hand, if you are a retiree, and you are subject to inflation risks then the zero coupon might be a bad investment. Larry said he doesn't believe in trying to predict interest rates, so it gets back to where does it fit in your portfolio and how does it fit with the other assets of your portfolio.
Brinker/Swedroe: There has been a lot of angst over bond insurers lately. How much weight do you put in that? Larry said in his view you should never make an investment based on the bond insurer's credit rating. People think that all single A rated bonds are the same. Not true. A single A municipal bond that is uninsured is 95% less likely to default than a single A rated corporate bond. If you are buying municipal bonds, you should look at the underlying credit rating of the bond without regard to insurance and the minimum rating you should look for is A, maybe AA or even AAA. Larry said he wouldn't purchase any municipal bond that had less than a single A rating for its underlying credit rating whether it had insurance or not.
Swedroe: Larry said he has a general rule about financial products that are offered. The more complex the product, the more you should avoid it because it is more likely that it was designed to be sold instead of bought. Certainly, you don't need it in the fixed income side of your portfolio where something like Treasury Inflation Protected Securities are all you need for your taxable dollars. If you want something to help out with taxes, and you are going into the municipal bond market, stick to AAA and AA. In a shorter maturity, you could go to an A rating. But beyond that, you don't need to get fancy. Larry said he has looked at all of the different asset classes and how they all mix, and you can do a more efficient portfolio and ignore junk bonds, convertable bonds, etc. which are totally unnecessary.
EC: Learn about Treasury Inflation Protected Securities in depth at this url:
Brinker/Swedroe: Bob said people have been hurt chasing yield going back many years. Larry agreed and said it can also be an illusion. For example, take the Vanguard High Yield Bond Fund which is really not a junk bond, but generally at the higher end of the bonds that are non-investment grade. That fund has only provided a 50 basis point higher return than 5-year Treasuries despite the fact that yields on the funds are much higher than the yields on Treasuries. Most of that yield is illusionary because of call risk. If you need a little more return in your portfolio, take the extra risk on the equity side of your portfolio, not the fixed income side. Historically, you have done much better. Moreover, these types of junk bonds tend to do worse when stocks are cratering which is just the time you need to feel good about the fixed income side of your portfolio.
EC: Interesting. I thought Bob might have taken the other side of this argument because for some time now, Bob has held the Vanguard High Yield Corporate fund (VWEHX) in his fixed-income portfolio, allocating 15% of the portfolio to that fund. I suspect that Bob would say that since that portfolio has no weighting in stocks, he feels that you can take some extra risk by owning the high yield fund.
Caller: This GM employee asked Larry what he thought of GM Demand notes paying 5% which he owns. Larry said don't confuse what is familiar with what is safe. Larry said if it were him, he would sell it. Larry said he only invests in the safest instruments on the fixed income side of his portfolio which is your safety net to allow you to take risk on the equity side of your portfolio knowing that you will get the return of your principal back. GM is a risky company and there is always a chance you won't get your money back. Bob said for 5% yield, you were taking a ton of risk, including your principal, when you could earn just a little bit less in something like the Vanguard Prime Money Market fund and not have to worry about losing your principal. Larry said some of the best investments right now are FDIC-insured CDs. Do not confuse familiarity with safety. This often occurs with people who work for a company and take the risk of owning a lot of shares of that company when they also have the added risk of human capital in that they work for the company. Many people have been hurt over the years by companies they worked for.
EC: More good points by both Larry and Bob. There is no guarantee that GM will be in business long enough to pay back its notes. Sure, it is a blue chip company that has been around for years. But so was Xerox and Enron and MCI right? Sure, they are offering 5% yield, but if you want that yield, you can purchase 7-year FDIC insured CD from PenFed and sleep knowing your principal is not at risk.
Brinker/Swedroe: What kind of grade would you give Ben Bernanke? Larry said Ben has it tough. He is faced with rising inflation, a weakening dollar and a real credit crises. He really doesn't have a choice but to ease interest rates to avoid a liquidity crises. The real trick will come if inflation keeps going up. At some point if that happens, he will have to raise interest rates. Larry complimented Greenspan for the job he did until the last few years when he didn't do enough about the bubble, and as a result the current conditions aren't really of Ben's making.
Brinker/Swedroe: What is your reaction to the stimulus package that Congress passed and Bush signed? Larry said he didn't like it and thought it was a bad package. There is nothing long term in the package. If you want to stimulate the economy the best thing to do is give an immediate write-off to corporations on investments. They should cut the corporate tax rate to keep more jobs here in the U.S. Larry said he feels this package is spending oriented instead of incentive oriented and being a free market economist, Larry thinks they should have created stimulus. Larry said the evidence shows that people spend money on projected income they will receive over the long term, not a one time check for a few hundred dollars.
EC: Great interview! Larry Swedroe is one of the best. Larry was also a guest on Moneytalk in 2005 and 2006 and I did a full summary of those interviews as well. If any subscriber would like me to e-mail them the past interviews, I am going to consolidate all three interviews into one e-mail and would be happy to send it to you. Just let me know.
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