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In This Issue: Fed Is No Wizard Of Retiree Oz Think Like A Raider For Value Stocks
Fed Is No Wizard Of Retiree Oz A new book by Bob Woodward entitled "Maestro" chronicles the activities and thought processes of Alan Greenspan, the chairman of our Federal Reserve Board. It is an important book, but not for the reasons one might think. A consensus suggests that the government (i.e. Greenspan) can control interest rates and therefore make stock markets and economies come in for soft landings if they have to land at all. The theory is based on the notion that interest rates are the single most important factor in the movements of the economy, and as long as someone can control interest rates, then, by extension, they can control the economy. What makes the book interesting to me is the extent to which it illustrates how powerless the Federal Reserve can be in face of human behavior and external events that determine economic outcome. Periodic stock market plunges remind us of how fragile the economy can be. Yet, we want to believe that the government is capable of somehow shielding us from economic discomfort. At the first sign of distress, the temptation is to blame the Federal Reserve. George Bush Sr. provided one of the more memorable examples when he blamed Alan Greenspan and high interest rates for his failed presidential bid in 1992. In a way, we believe in the "Fed" for the same reasons that Americans condoned Wall Street manipulators in the 1920s. The public in those days felt that it was good for the market to be manipulated by the "Big Money on Wall Street" because if the market could be controlled by anyone, why would that someone ever let it plunge. The Fed is admittedly powerful. It raised interest rates to 19 percent back in the early '80s to try to stop runaway inflation. The economy booms when interest rates are low and it cools off when interest rates are high. Inflation is a hardship for voters with fixed incomes or for the holders of long-term bonds, so the government takes steps to control it. Since the Vietnam War, a little inflation has been considered to be a good thing. President Reagan, who lowered taxes but tripled our nation's debt, operated on the basis that inflation would just reduce the cost of eventually paying off the debt. In theory, we all resort to this practice to some extent when we pay off a 30-year mortgage with inflation-prone dollars that become less valuable and therefore cheaper as the years go by. How does the Fed actually try to control interest rates? It does so by adjusting the rate it charges banks for overnight money they borrow or by buying government bonds from the banks. Banks start by loaning money that their customers deposit in savings accounts or provide through the purchase of CDs. However, there is a mysterious phenomenon called the "money multiplier" that allows banks, as a whole, to actually loan a lot more than they have in deposits. Banks are actually highly leveraged in this sense. What the government charges for interest and the amount it will loan as a multiple of the banks' own customer deposits determines the amount of money in the system and therefore the available credit to our economy. This financial alchemy is so complex with such a huge matrix of variables that nobody, including Alan Greenspan, fully understands it. In theory, our government can loan an infinite amount of money to the banking system if we thought it would end a depression, because we have the power to print our own money. Historically, this has happened in various banana republics as well as in Germany in the 1930s. The practice leads to hyperinflation and general chaos but strikes many countries as a better alternative than a depression. In 1992, President Clinton listened carefully to Alan Greenspan when jump-starting the economy called for either a tax cut or a paying down of the deficit. Clinton resisted the tax cut and went instead with the deficit reduction. This had the effect of increasing confidence in the nation's resolve to solve its Reagan-era debt problems, and as it did so, the interest rates in the bond markets came down. Interest rates stay up when bond investors think that inflation will eat away the relative value of their principal. Greenspan argued that paying down the deficit would reduce bond interest rates. The resulting easing of credit would do far more than a tax cut as a stimulant to any future boom. As a society, we spend more money on a new car or a house when interest rates drop. By comparison to the tens of thousands spent on a major purchase, how much stimulation would we offer the economy by spending the $150 to $1,500 saved by a tax cut? So what has he done for us lately? Here we are at what looks like the tail end of a boom and a looming recession. In theory, we shouldn't have any inflation, but tell that to people like me who have seen recent college graduates demand almost 50 percent more salary than they would have been happy with two years ago. The last time I filled my tank with gas, it was almost $35 versus $25 last year. Apartment rents are routinely $1,500 that were only $800-$900 in 1999. I thought this was just a California phenomenon until I was shocked to hear that a sister company in Cleveland was having the same problem on the same scale. I look at my personal Consumer Price Index and it seems to be rising at a rate of 10 percent or more. It just isn't showing up on the government radar screen for some reason, and Greenspan himself voices the same complaint about the government's inability to generate timely data. My grass roots experience of hyper-inflation coupled with a recession feels to me like the "stagflation" of the President Ford era. So what's the point? We can't let ourselves be lulled into a false sense of security by believing that the banking system and the government actually have the power to control the economy. Alan Greenspan says, "Anyone who has a great conviction at this stage about what the economy is doing or what proper policy is, I think, is under a mild state of delusion." Interestingly enough, the role of Alan Greenspan is not new. In the early 1800s when vast amounts of money moved between England and America to fund the building of cities and railroads, all the same mechanisms had to be in place. British banks loaned hundreds of millions of dollars in this country at a variety of changing interest rates. The accounting was done by men with green eyeshades sitting at row upon row of desks. Again, there was one man who played the role Alan Greenspan enjoys today. For many years, it was J.P Morgan. In Great Britain, for 24 years, it was Montague Norman. Hitler had Dr. Hjalmar Horace Greeley Schacht, the evil genius of Nazi finance. In the end, no single person has ever been able to predict interest rates, much less control them. It is a mistake to think that anyone can do so now. The descriptions of Alan Greenspan, Paul Volker his predecessor and their counterparts from other countries are remarkably similar. All can be described as intelligent, somber, elder statesmen personifying the economic confidence of their respective generations. Alan Greenspan represents what Bob Woodward describes as the "confidence wing of the American personality." In this sense, these men become larger than life and assume a mantle of royalty in the same way that Princess Diana evoked an emotional response from people around the world. Meanwhile,
as keepers of the flame beneath our retirement money, we need
to recognize such people for what they are. They are figureheads
with limitations. In the end, a prudent balance of investment
mix should take into consideration the fact that the economy
could experience a hard landing that the Fed will be powerless
to correct. In other words, we cannot count on the Federal Reserve
to say, "we are the government and we're here to help you."
On the one hand, today's market turbulence should not be an
excuse for the long-term investor to try timing the market.
On the other hand, anyone who is within a few years of tapping
their retirement nest egg should not assume that the government
will be effective at protecting its current value.
Think Like A Raider For Value Stocks Is there a safe haven for people with a long way until retirement but whose supply of Pepto-Bismol won't last through more downdrafts like we had during 2000? In the face of a broad market sell-off, how did a fund such as Van Kampen Comstock rack up a 30 percent gain in 2000? Like the "plastics" advice in the movie "The Graduate," the answer is one word: "Value." Within the single year 2000 we witnessed an entire spectrum of market forces at work. Large growth, large value, small growth and small value -- the four corners of the style box -- all had an opportunity to shine. In the first quarter, growth stocks continued their headlong climb, only to collapse in April. Meanwhile, beginning in early March, value stocks began their steady march to prominence. Let's review our definitions. Value stocks are those whose underlying assets and regular earnings support the value of the shares. Growth stocks, by comparison, are those whose prices are supported by the expectation of a prosperous future, coupled with a phenomenon called "the greater fool theory." The latter means that regardless of what you pay for something today, there will always be someone who will pay more tomorrow. A good way to understand value stocks is to appreciate that someone can come in and buy the entire company for the value of its outstanding stock. Then, assuming they bought at a reasonable value, they can sell the assets the company owns for significantly more than what they paid for all of the stock. To be an effective value investor yourself, it pays to think like a corporate raider. For example, say a raider offers to buy all shareholders' stock for 30 percent more than its current listed price. The directors of the company, representing the stockholders, have to vote to sell the company, or they will get sued by the stockholders for turning down such a sweet deal -- that instant 30 percent gain. All stockholders benefit, from the teenager who owns a few shares to mutual funds with millions of shares. The takeovers done in recent years by Pacific Lumber are one of California's purest expressions of this type of financial opportunism. Remember, the total value of a company's stock held by investors can be much higher or much lower than the independently appraised value of the company itself. Warren Buffett points out that there can be wide swings in the value of securities that depend on markets governed by hysteria, interest rates and hundreds of other factors. We should never confuse the total value of a company's publicly held stock with the value of the company itself. "Market inefficiency" is the term that describes the degree to which a stock price is not coinciding with a company's true value. Corporate raiders are very smart people. If they are in the business at all, they are making millions, and in some cases, billions of dollars a year. They use computerized screens to keep track of the assets of companies and compare the value of those assets with the total value of the stock. When the planets line up, they pounce. In a simple example, imagine a company whose assets are appraised at a worth of $2 billion if they were broken up and sold piecemeal. If that company's stock price is so low today that the value of all outstanding shares is only $660 million, the buyout company could offer $1 billion to current shareholders. Shareholders would be happy with a nice premium, and the raiders would still double their money if they were later successful at selling off everything for $2 billion. Why is this example important? Because to understand value investing, we need to understand the fundamentals. We can talk about value all day long, but if good values don't have a cause and effect relationship to higher stock prices, it's like the proverbial tree falling in the forest with no one to hear its sound. Fortunately, we don't have to wait until the threat of a purchase becomes reality. Takeover rumors usually drive the stock price up. On Wall Street, the axiom says, "Buy on the rumor, sell on the news." By the time the deal actually is announced, the stock has already risen, at least partially, to meet the expectation created by the rumor. Meanwhile, value investors are looking for stocks with a stock price of only two to three times cash flow, because these companies can make money for investors sooner or later. Often, these companies with low multipliers are ugly. Philip Morris was a huge winner this past year, and Waste Management was another example of a stock nobody wanted. By the time a stock becomes real lovable, like Wal-Mart, it can be too late, because everyone else has bid the price up out of value range. If a former value stock keeps climbing, it becomes a growth stock--and we should start praying that the greater fool theory will kick in. There is also a self-fulfilling prophecy operating here. As value investing gains publicity, there will be more money managers and investors moving toward value-oriented stocks. Demand will prompt an increase in prices. The Dogs of the Dow will rise again (these are the 10 stocks of the Dow Jones industrial average that have the highest percentage dividend pay-outs relative to their stock prices.) When choosing value investments, there's a distinction between your retirement and non-retirements accounts. Value-styled mutual funds are fine in a retirement program, but a money manager may be a better candidate for after-tax money. Why? Because tax considerations and controlling when you sell will have a major impact on results. Also, a visit with an older value manager who was in the business through several up and down cycles can offer insight into how the downside can be minimized. People in their late 20s and early 30s managing, say, the Fidelity funds may not have a clue as to what makes sense in current markets. Most were in junior high school during the Crash of '87, and the collective effort of these people can't compensate for a lack of experience and instinct. Who could
have guessed what last year wrought? Why didn't it happen the
year before, or even back in 1998? Since no one has a crystal
ball, the best alternative for most of us is to spread our assets
over a mix of different fund types and rebalance periodically.
Anyone whose growth-oriented funds had done well at the end
of 1999 would have enjoyed great results if they'd rebalanced
at the start of 2000 to an even mix of value and growth. This
kind of rebalancing takes discipline and will power, but it
is essential for strong long-term performance. Like the ads
say, "Just Do It."
Don’t Forget About Your FSA’s When You File Your Taxes! While it is true that any portion of your salary that you deferred through your company’s Section 125 Plan is completely tax free to you—you may still need to address those amounts on your tax return. MSAs vs. Medical FSAs Many “off-the-shelf” tax preparation programs ask if you have an MSA (and then go on to ask you about various reporting requirements, 1099s issued etc.). If you were enrolled in your company’s Section 125 Medical Reimbursement Plan—the answer to the MSA question is NO! They are two different plans trying to accomplish a similar objective. MSAs are for small companies, or individuals, who have high deductible health plans or no health coverage at all. These accounts are set up with a trustee or custodian (usually a bank or insurance company) and are tax favored but require additional reporting on the individual’s tax return. Medical FSAs are sponsored by your employer and do not require any reporting on your personal tax return. Form 2441 for Dependent Daycare Accounts If you had salary deferrals for a Dependent Daycare Reimbursement Account last year, you should notice that the total amount of your deferrals appears in box 10 of your W-2 (although it should not be included in your gross wages). You will need to complete a Form 2441 with your individual tax return to report to whom these funds were paid and what (if anything) you may have forfeited (left unclaimed in your account). Form 2441 is fairly simple to complete and most “off-the-shelf” tax preparation products will walk you through the process. If you have your taxes prepared by a professional, they should complete this form for you, but it is your responsibility to make sure it is included with your return and that the information is correct. If you had Dependent Daycare deferrals in 2000, yet nothing is reported in box 10 of your W-2, you should notify your employer immediately! Mid-Year Changes To Insurance Coverage There are dynamic changes in the health insurance industry. As a result employers are having to cope with significant increases in premium costs and changes in coverage for their employees. Some employers are coping by either changing insurance plans or changing the amount you, the employee, are responsible to pay toward these premium costs. Be aware that, while Section 125 Plan documents allow for mid-year adjustments to premium deductions, they do not allow changes to Medical Reimbursement Account elections due to these coverage changes. You should also be aware that, if at the beginning of the year you “declined to participate” in any portion of the plan because you had no premiums being deducted, and your employer begins requiring you to contribute toward premium costs mid-year, this will have to be an After-Tax Deduction for you until your Flexible Benefit Plan re-enrolls (January for most plans). Pre-Tax Parking & Commuting Did you know that the IRS has approved legislation to allow for pre-tax salary deferrals for reimbursement of Commuter* and Parking** expenses? If your employer does not already offer this benefit—you should be asking about it! Pension Dynamics Corporation is in the process of putting together an administrative package for these plans and we are looking forward to providing our clients with yet another way to enhance employee benefits. *Public
transit or approved car/van pooling
For those who like slogans, here are a few rules worth following: Tomorrow
never comes. They
who hesitate—can win. A
penny saved is a good beginning. The
experts aren’t. The
stockbroker is not your friend. The
IRS is your friend. Sometimes. Develop
your won’t power. Focus
on the fundamentals. The rest is white noise. Master
your spending habits—save and invest by payroll deduction.
There is a fundamental distinction to be made between an investor and a speculator. Benjamin Graham, whose name has been mentioned before in these pages, says that the speculator is interested in anticipating and profiting from short-term changes in the market—up or down. The famous “day trading” industry is built around just such a speculative approach (and we have all seen recently what the consequences of involvement in this activity can be). On the other hand, the investor has as his primary interest buying and holding “suitable securities at suitable prices”, in anticipation of long-term gain. The speculator buys or sells in anticipation of a market move, while the investor buys or sells because the price level is either low or high relative to the stock’s underlying value. Said differently, the investor who has chosen wisely has the option of acting when he chooses, whereas the speculator acts when forced to do so by the marketplace. Consider the following parable from Graham’s book “The Intelligent Investor”: “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects, as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.” If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.” Through careful study the prudent investor can turn the speculator’s mistakes into his or her good fortune.
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