Tuesday, August 31, 2010

Something is Going on Here...

This morning, The Wall Street Journal highlights the fact that a basket of 18 companies reaching their peaks in the past month are all makers of goods considered necessities should financial calamity hit. The Journal points out that, "the bunker portfolio, while vastly oversimplified, does reflect investors' preference for companies with products that are relatively immune to economic swings, and whose conservative strategies are suited to these uncertain times." Indeed, most of the companies hitting highs are producers of inelastic goods - those whose demand will remain stable even if prices increase.

However, the important thing to note about this group all hitting highs at the same time is not that the underlying companies represent a "Who's Who List of Armageddon Protection Purveyors" (that's a mouthful!). More importantly, it's that they are all true defensive stocks and have histories of paying and increasing their dividends.

As the article hints at, when the economy dips further into recession and the business cycle continues to pound cyclical names, the best area to look at are the steady dividend payers, hence the rise in The Journal's sample portfolio. In fact, the article says that "many of the star performers are steady dividend stocks: At least half of the companies on the list have increased their dividends this year, including Cummins, Dr Pepper Snapple and Airgas." Investors flock to safety when they sense that there's uncertainty in the market and one of the safest places to look among equities for safety are companies that pay a dividend and raise that dividend consistently. Outside of large amounts of free cash flow, a rising dividend is one of the few surefire signs of financial strength at a company.

Interestingly, the only stock on the list that's down year-to-date - JM Smucker - is still up roughly 70% from the bottom it hit during the peak of uncertainty in the financial crisis.

Monday, August 30, 2010

The End of the P/E Ratio? Not so fast

Today, The Wall Street Journal reports on the "Decline of the P/E Ratio", first discussing the reason for the dropping P/E of the overall market (uncertainty) but more importantly, why the P/E is no longer as prominent as it once was. I take exception to the argument that the P/E ratio is no longer relevant and I think the article proves my point. The Journal states that:

"With profit and economic forecasts becoming less reliable, investors are focusing more on global economic events as they make trading decisions, parsing everything from Japanese government-debt statistics to shipping patterns in the Baltic region."

While this trading mentality will no doubt affect short-term prices, the long-term determinant of stock prices remains the earnings that a company can generate. When a company generates earnings over the long-term, it can raise its dividend and it will be a more worthwhile investment.

How do Japanese government debt stats and shipping patterns in the Baltic region affect stock prices over the long-term? They really don't. While markets are becoming more globally-oriented by the day, there is little to no benefit in that information for long-term investors. While short-term investors may be able to exploit such data by trading on that news, the cost of doing so and the lack of expertise most people have in such areas will quickly erase any advantage the trader thinks he has. On the reverse, the long-term investor should be concerned with one thing and one thing only: earnings.

The P/E ratio can be either forward looking (forward P/E based on earnings estimates) or historical (trailing P/E based on EPS in the last 12 months), it holds a wealth of information. After all, with one figure, we are able to gauge both what the market expects a company to earn in the future and how much its willing to pay for $1 of earnings. For example, if XYZ Corp. is trading at a forward P/E of 22, then investors are willing to pay 22x for $1 of XYZ's earnings. Naturally, faster growing companies will have higher P/E ratios than slower growth ones.

The P/E ratio is far from dead. In the end, earnings matter. The P/E ratio is not a means to an end, but it's a good road map because it bridges the gap between a stock's price and earnings expectations based on each trading day.

Friday, August 27, 2010

New GDP Report & Its Trade Data

The revised estimate of Q2 GDP, a broad measure of U.S. economic growth, was released this morning by the Commerce Department. The report was anything but rosy with almost all engines of economic growth either tapering off or growing well below their intended targets. Worse still, because everything from business and consumer spending to the trade imbalance remain weak, it's likely that this will continue to put pressure on the unemployment rate.

The unemployment rate runs countercyclically with a lag, meaning that when the economy is starting to exit a deep recession, the rate can still increase for awhile before it begins to decrease, so we are potentially looking at rates of unemployment near 10%. For some historical perspective, in 1933, in the midst of the Great Depression, unemployment stood at 24.9%! Now, of course, the U.S. economy is a lot larger but this "Great Recession" is indeed still a lingering problem.

However, what worries me the most from the new data is the new, bigger trade imbalance. The trade imbalance (or deficit) occurs when you import more than you export.  Ideally, you would like to export more than you import because goods produced in your country and shipped elsewhere count positively in your nation's GDP report. In Q2, the Yahoo! article points out that, "imports surged 32.4 percent, the most since 1984. That overwhelmed a 9.1 percent increase in exports." This has been the trend for a long time now and likely will continue to be as the U.S. relies less on manufacturing and buys cheaper goods elsewhere. While this is great for international trade, it just means that other areas of the economy will have to make up for this figure in the GDP calculation - that doesn't appear to be happening just yet.

Thursday, August 26, 2010

Investing Bubbles & The Media

Fortune recently highlighted what they view as six separate investing bubbles in the making, including the Chinese economy, gold and U.S. Treasury bonds. All of the talk of bubbles can be particularly scary since the bursting of the housing bubble has been one of the primary causes of "The Great Recession" we're currently in.

While I don't have an official position on each of the bubbles Fortune lists, I do think that any time the euphoria and enthusiasm for a particular investment officially gets "called out" by the financial press, it may be time for a reconsideration of whether or not those investments are fairly valued. After all, you normally see the media write glowing stories about assets as they inflate, inflate, inflate until their bubbles burst. When the financial press begins looking at things more closely and pointing out the inflated valuations of those assets, the end of the run may be near. Caveat emptor!

Wednesday, August 25, 2010

Economics and Investing: Pay Attention to All Data!

Today, the WSJ's Economics Blog has highlighted how an even slower economic recovery would feel. Daily, we are hearing reports of more and more economists who believe that we are going to experience a double-dip recession due to little or no jobs growth, the lack of any real pickup in home buying/construction, reduced consumer confidence & spending and limited business activity. In addition, the blog says that "New orders for non-defense capital goods excluding aircraft plunged 8.0% in July, wiping out the gains of the previous two months." All of this is sure to put a damper on whatever economic optimism is out there.

However, this news is important for Gen Y's because economics is an area that we often overlook, both out of disinterest and the notion of it being boring. After all, why would you want to eagerly follow something that's been labeled the "dismal science"? If there's one thing I have learned from my college econ classes, it's that you have to question all of the data all of the time and you can never believe only one set of numbers.

All of this economics talk helps validate the importance of behavioral economics. I talked about behavioral finance last week but the discipline also applies to economics. It's common for us to overlook or gloss over certain facts or data that's presented to us, either because we're just not interested or it doesn't help validate our case. For example, if we're optimistic seeing that the economy is humming along with GDP growth growing briskly, jobs being added monthly and wages rising then should we necessarily believe that a drop in durable goods orders forecasts a recession? No! But this also hammers home an important point: Never simply look to one data point to validate or invalidate a forecast we may have. You have to look at everything as a whole.

The same is true with investing in stocks - just because one data point (lagging sales growth, for example) might tell us that a stock isn't an attractive investment, it doesn't necessarily mean that this is the case because there's always more to the story. However, when we see multiple data all pointing towards one thing - a further downturn in the case of today's economy - then we should probably take heed.

Tuesday, August 24, 2010

Interest Rates on Credit Cards Rise

Today's blog post is going to be a quick break from the behavioral finance for Gen Y features I've been posting. The Wall Street Journal reports today that as a result of new credit card rules that took effect Sunday, banks are now limited in how much they can charge customers in penalty fees. This has led to a rise in interest rates on cards and in Q2, the average interest rate rose to 14.7%, up from 13.1% in 2008.

This can be interpreted as sobering news for Gen Y since many of us rely on credit cards to help bridge our month to month financial needs. Credit cards are a great way to build good credit but only if managed effectively. For example, only charge something to your credit card when you know you have the cash to pay off the bill when you get it. This way, you won't be forced to scramble for cash and you'll be sure to build an excellent credit rating while remaining disciplined in the process. So while the new rules that are now in effect will certainly raise borrowing costs for many people, if you remain a disciplined Gen Y saver and spender who only uses a credit card to buy something when you have the cash to pay off the bill, you won't have to worry about any interest charges.

Monday, August 23, 2010

Behavioral Finance for Gen Y: Part 2

I'm back at college for senior year and beginning to think of more and more investing biases that are particularly prevalent among Gen Y - and what you can do to avoid them!

Last week, I highlighted the self-serving bias, where we tend to give ourselves credit for having investing skills when a stock pick goes up, but avoid responsibility for buying it and instead blame bad luck when it goes down. Today, I'm going to highlight risk aversion. Basically, risk aversion is exactly what the term implies: When an investor is given the choice between a risky investment (growth stock) or a less-risky choice (domestic stock index fund), he/she will choose the less risky investment. This is very normal behavior for some people who simply do not recognize the fact that high risk investments can mean high reward, when the possibility for high loss is also understood.

So, if I advocate index funds, why am I highlighting risk aversion here as an investing bias? Ultimately, as Gen Y's, we have a longer investment horizon than Baby Boomers and Gen Xers. As a result, while a balanced allocation of index funds (60%+ of total asset allocation) is ideal, it's rational to own a diversified portfolio of dividend-paying stocks as part of the rest of the allocation, keeping in mind that the individual stock exposure should always be less than the total index fund exposure. With this approach, any bumps from purely buying risky investments (which will lead to risk aversion tendencies should they go down) will be mitigated by the large allocation to index funds. Even better, a diversified basket of stocks in different industries will be less correlated to each other, further lessening risk.

We are lucky in that our time horizon enables us to recover from any particularly poor-performing investment. However, if we diversify well enough and invest in companies that have a long-term history of paying a consistent dividend, the issues that arise because of risk aversion become smaller as the companies we are buying aren't as risky as some of their counterparts. Then, the benefits of this approach are especially notable because of the potential for higher returns in the individual stocks we own, provided we reinvest their dividends. Couple this fact along with the fact that we own a nice portfolio of index funds, and Generation WI$E will be all set.

Friday, August 20, 2010

Gen Y Beware: Fidelity Says 401(k) Hardship Withdrawals Up

Taking a short break from my posts on behavioral finance for Gen Y, I wanted to highlight an article I found regarding a study to be published by mutual fund giant Fidelity Investments today. The study says that during the second quarter, workers both increased hardship withdrawals from their 401(k) retirement accounts, and borrowed money from those accounts at a 10-year high.

What are hardship withdrawals? As the name suggests, the IRS allows you to take a distribution from a 401(k) retirement account before your mandatory disbursement age of 59 1/2 if certain circumstances arise. Unfortunately, this does not occur without penalty as you incur both income tax on the withdrawal and are subject to a 10% withdrawal penalty you must forfeit if you are not at least 59 1/2. Circumstances upon which you can take a hardship distribution include: certain medical expenses, payments to prevent home eviction or foreclosure, repairing damage to a primary residence and purchase of a primary residence, among a few others.

Secondly, the pitfalls of too much credit card debt are well documented. You don't need me to tell you why borrowing from a retirement account just isn't a sound investing strategy.

This study is particularly important for Gen Y because it proves just how important proper planning is. After all, if people need to tap their retirement accounts before their disbursement age and know that they will incur a 10% penalty in the process, it's likely that they simply didn't plan ahead well enough. As Gen Y's, we are young enough where we can still learn from the mistakes of others. A 401(k) is for retirement, not for dealing with day to day living expenses.

Thursday, August 19, 2010

Behavioral Finance for Gen Y: Part 1

Today is the first part in a series of posts where I'm going to talk about behavioral finance for Gen Y, and then highlight certain investing biases that are especially prevalent among Gen Y investors. If you really take time to think about the behavior I will discuss and to understand the biases inherent in the mindset of most all investors, you will save yourself plenty of money and aggravation as you get older! 

First, I need to give a brief definition of behavioral finance, the study through which all investing biases flow from. In its purest form, behavioral finance is the study of how human emotions, interactions, and behavior all impact investment and financial decisions. Basically, the idea is that the human element, particularly our emotions and how we think and process information, plays a large part in impacting investment decisions.

Proof of this is readily available.

An Example of the Human Element in Investing

You've owned a stock for 5 years and during that time, it's gone up a split-adjusted 1,000% (hey, we can dream)! Now, the rational thing to do would be to evaluate your overall financial situation and if it warrants so, sell some of your holding and invest it elsewhere. Instead, what many investors tend to do (and it's not only Gen Y's who are guilty of this) is "fall in love with their stock".

In essence, we attribute the 1,000% price jump to our skill in stock picking and it pains us to sell the stock because we believe its success lends credence to our intelligence and superior stock picking skills. Before you say to yourself something to the effect of, "Well, I researched the stock and loved its fundamentals so I judged it to be a great investment", consider this scenario instead: 

Over the 5 year holding period, your stock is down 99% and the company is on the verge of bankruptcy. What do you think about your stock picking skills in this scenario? If you're like most investors, you'll probably blame bad luck for the extreme drop in stock price! This is what's termed a self-serving bias because you believe your stock picking skill led you to buy a big winner, but if it turns out to be a loser, you'll blame bad luck.

Wednesday, August 18, 2010

Gen Y Rejoice: Vanguard Opens 2055 Target Retirement Fund

I woke up to some very interesting news this morning on Vanguard.com - the mutual fund giant is launching a 2055 Target Retirement Fund. Yes, that's 45 years away! This fund is designed for the youngest Gen Y investors, those between the ages of 18-22. The goal behind this offering is for the fund to be a one stop shop for young investors who want much-needed diversification in their portfolios, but are unsure of how to get there. The fund doesn't own individual stocks outright. Instead, as a "fund of funds", it owns five other Vanguard index funds with the largest percentage of fund assets allocated to the Vanguard Total Stock Market Index (VTSMX) at 71.8%. The fund also has bond and international exposure.

As the "Target Retirement" date of 2055 nears, the fund continues to lessen exposure to riskier assets like international equities and moves a higher percentage of assets into relatively safer areas like bonds. Vanguard states that  the fund, "begins annually reducing stocks and increasing bonds around 2031." This should make the fund a favorite among many younger investors who would like to diversify, but aren't quite sure where to start because most of the work of diversification and rebalancing is done for them. This new offering signals the first time that a "Life-Cycle" fund has been marketed to 18-22 year old investors by a fund company as large as Vanguard.

While I'm not specifically endorsing this fund, I think its creation is an outstanding development for two reasons: 1). The largest financial players are now recognizing the importance of marketing their offerings to Generation Y - in this case, the youngest Gen Y's out there 2). The 0.19% expense ratio of the fund is very low and will certainly draw other Gen Y's into indexing as they realize it's the most cost effective way to build wealth over the long-term

Tuesday, August 17, 2010

Bryce Harper is $10 Million Richer

At midnight EST this morning, Major League Baseball's signing deadline came and went for players drafted in the June MLB Draft. The first overall pick of the draft by the Washington Nationals was Bryce Harper, a 17 year old from Las Vegas who has already graced the cover of Sports Illustrated and drawn comparisons to basketball star LeBron James as both are athletic prodigies. He signed a contract worth $9.9 million over 5 years which includes a $6.25 million signing bonus; yes, he's only 17.

By all accounts, Harper is the real deal. Tremendously gifted, he has amazing bat speed and intangibles and with the majority of scouts projecting him as the top overall pick in the 2010 MLB Draft if he were to drop out of high school two years before graduation and become eligible. Harper did just that and subsequently got his GED and attended the College of Southern Nevada. There, he wound up hitting 31 home runs in 66 games and hit .443...with a wooden bat! Who was the last .400 hitter in the Majors? Yes, it was none other than Hall of Famer Ted Williams in 1941. He is also known for hitting the longest home run in Tropicana Field - home to the Major League Tampa Bay Rays - at 502 feet. In short, Bryce Harper is kind of a baseball freak of nature and today, he's $9.9 million richer.

From an athletics and marketing perspective, the 17 year old Harper is part of a new breed of rich, young elites. In Kanye West's remix of his song "Diamonds from Sierra Leone", rap mogul Jay-Z says that he's not a "businessman" but a "business, man". Welcome to the new world of Bryce Harper - I hope he's as good at picking a quality financial adviser as he is at playing baseball. Bryce, if you read this, consider joining Generation WI$E!

Monday, August 16, 2010

Recession Changes Gen Y Attitudes

Over the weekend, the Miami Herald had an interesting piece on the changing attitudes of Gen Y workers who are dealing with the inevitable job cuts and pay reductions that come with a recession. After reading the article, I can't help but note how important it is for Gen Y's to understand and accept the fact that we are not invincible. As strange as that sounds, corporations who need to cut costs in a recession will begin to cut their workforce first and many times will cut new hires as opposed to company veterans. Sadly, this was the exact situation new Bear Stearns employees were faced with in 2008, many of whom were just out of college.

There aren't many companies out there that are completely immune from recessions. So how should Gen Y's prepare for recessions and general downturns in business that occur? First, accept the fact that most companies view you as a number. It's an unfortunate fact that most companies disregard your personal situation when it comes time to cut jobs. With that said, be prepared! When you sense that an economic downturn is coming or business conditions within your industry are worsening, be sure to sock away more and more money to your emergency cash reserve and any retirement plans you may have.

Even though this is a topic I talked about on here last week, I can't stress enough the important role liquidity plays for Gen Y's who don't yet have vast wealth to tap should they be let go or see their salaries cut. Instead, plan ahead. When you see conditions in your business worsen, increase the percentage of money taken out of your paycheck that will go into your emergency cash reserve, whether it be a money market or an interest bearing checking account. Having enough cash to cover three months of anticipated living expenses is a sensible place to start. When you do this, you won't be caught flat footed should a worst case scenario occur and will have some much-needed liquidity to tap as you look for a new job opportunity.

Sunday, August 15, 2010

My College Advice: Two Recommendations

For Generation WI$E readers who are in college (or recently graduated), Karen Blumenthal's college survival guide published in the weekend Journal will be a very interesting read because it touches upon so many different areas - money management, health care and other important issues like buying insurance and dealing with costly textbook purchases.

As a college senior, I have personally experienced many of the hardships in going away to school - especially since I travel over 1,300 miles from home to school each year. Besides the fact that college teaches newly-minted Gen Y's the importance of being responsible, perhaps no other event in life outside of marriage and leaving home for good acts as a springboard towards personal financial independence (or disaster!). The temptations in college to spend frivolously are vast. After all, how many of your friends or family members succumbed to the temptations of independence and spent their semesters staying up late and partying constantly? While the number of college students who party wildly grows each year, the collective financial IQ of the Gen Y's who are going off to college keeps dropping due to a lack of financial education in schools. It's pretty sad, really!

With that said, there are two things I recommend all Gen Y's do when going away to college for the first time in order to teach financial responsibility and discipline:

1). Pay for your education with your own money (at least partially) 2). Work, work, work!

Paying for your own education ensures the necessary buy-in that will make your experience in undergrad a lot more worthwhile. After all, when you own something, you tend to take care of it - the same goes for your education. Secondly, if you get a job while at college, so as long as it doesn't conflict with your studies, you will have money to help pay for school, to spend on whatever you desire after all of your necessary expenses are dealt with, as well as a solid work commitment that will help you learn time management and be prepared for life in the real world. It's said that "there's a time and a place of everything and that place is college!" This is indeed true. The little stepping stones college - educational buy-in, time management and the like - that college offers you are also great ways to prepare you for what's ahead once you graduate and begin your career.

Thursday, August 12, 2010

Gen Y's Job Struggles & Liquidity

Given the "Great Recession" that the U.S. economy is still working its way out of, it's no surprise that young people are still having a very difficult time finding jobs. Today, the International Labor Organization (ILO) said that 81 million of the 630 million 15-24 year old in the worldwide labor force are unemployed. This staggering number means that the global youth unemployment rate is nearing 13% with 7.8 million more youths unemployed than in 2007.

What does this mean for American Gen Y's? For one, the labor market has not yet turned the corner and if today's weekly jobs report is any indication, we have a long way to go. If you're lucky enough to have a job in this downturn, it would be a great idea to establish an emergency cash fund should a worst-case scenario arise such as the loss of a job or a severe reduction in income.

Sadly, nobody is immune from the effects of this ongoing crisis as all classes of workers have been hit with job cuts and reductions in pay. This makes it all the more important to create an emergency cash fund where you set aside a percentage of your income that you are comfortable with, say, 5% of your net discretionary income into a savings or money market account. Another interesting idea to help build this fund but at a smaller level is by taking out all of your change and $1 bills from your wallet daily and depositing that into your fund. At the end of the month, you will be amazed at how much you accumulated! Better yet, at the end of the year, your emergency cash reserve will be significantly higher and it may even be possible to lower the amount you take out from your income.

With this fund, you will have the liquidity that you need in a cash fund should you find yourself facing a worst-case scenario like millions of other Gen Y's are right now.

Wednesday, August 11, 2010

"Flash Crash" Meeting Helps Prove a Point

Today, executives from large money management firms like BlackRock and Invesco are set to meet with finance academics at the Commodity Futures Trading Commission to discuss the implications that the "flash crash" of May 6th, 2010 has for investors.

The "Flash Crash" was an event on May 6th, 2010 in which the major stock averages plunged dramatically in a span of a few minutes (the Dow was down 700+) and took a severe toll on investor confidence when it was revealed that the causes of the huge decline were unknown.While it may be a few days before we hear the results of the symposium, the meeting helps to prove an important point every Gen Y investor needs to hear: stop watching daily market movements!

This may sound somewhat silly when the media is constantly bombarding us with news of what the Dow and NASDAQ did that day but many investors who were watching the tape on May 6th were  scared into selling off key long-term investments for fear a collapse was coming. After all, many investors still think that if the so-called "Smart Money" on Wall Street is making a move, then they should be too.

On the other hand, the long-term investor who paid little attention to the market's gyrations and maybe only heard about the "flash crash" as an afterthought months later (if at all) was no doubt more disciplined in sticking to their investment plan. Ultimately, you save a lot of time, money and worry by simply turning off your TV sets and doing something else - regardless of what today's symposium determines.

Tuesday, August 10, 2010

Welcome Gen Y Investors!

Hi everyone, please allow me to introduce myself. My name is Tim Olsen, I'm 21 years old and a senior at Louisiana State University in Baton Rouge, LA where I'm majoring in finance with a minor in history. I have long been interested in investing (I bought my first stock at 8) and when I was 13, McGraw-Hill published my investment primer for teenagers: The Teenage Investor: How to Start Early, Invest Often and Build Wealth. Aside from that experience, I have interned for 5 years at a hedge fund in New York City where I worked in equity research of transportation companies.

Now, 8 years later, I've matured a lot and seen the financial markets change drastically as we were faced with a meltdown of the financial system from late 2007 into 2008 brought on by the bursting of the housing bubble, excessively easy credit and lax lending policies (among other things). Now more than ever it's important for Generation Y investors - those born between the mid-1970s and early 2000s - to learn the importance of understanding not only their own finances, but the global financial system. It may sound complicated and boring but it's really not.

By reading this blog, I hope to give you key tips, insight and some much-needed perspective to help you navigate the ever-changing financial markets. By checking this blog out daily, you'll get to hear my thoughts on how daily events in the financial markets will impact you, the Gen Y investor. The best part is, you will receive this information straight from a fellow Gen Y who knows exactly what you're going through! While reading this, I hope that you will ultimately notice a personal transformation: the Generation Y investor in you will become the Generation WI$E investor!