Peggy Noonan’s Perspective on America

Whether you agree with her or not, Peggy Noonan, a columnist for The Wall Street Journal, simply writes beautifully. I found this week end’s column Who We (Still) Are to be both realistic and optimistic.

It is obvious that the United States has many problems, and it is easy to focus solely on them. A short list would include regulatory failures, bank failures, and failures of foresight and leadership at many levels. Referring to “the age of the empty suit” Noonan writes, “Those who were supposed to be watching things, making the whole edifice run, keeping it up and operating, just somehow weren’t there.”

Concerning the Bernard Madoff scandal, she writes:

That’s the big thing at the heart of the great collapse, a strong sense of absence. Who was in charge? Who was in authority? The biggest swindle in all financial history, if the figure of $50 billion is to be believed, and nobody knew about it, supposedly, but the swindler himself. The government didn’t notice, just as it didn’t notice the prevalence of bad debts that would bring down America’s great investment banks.

All this has hastened and added to the real decline in faith—the collapse in faith—the past few years in our institutions. Not only in Wall Street but in our entire economy, and in government.

On the other hand, she writes of the past achievements and the innate ability and good sense of the American people.

This is a good time to remember who we are, or rather just a few small facts of who we are. We are the largest and most technologically powerful economy in the world, the leading industrial power of the world, and the wealthiest nation in the world. … We are the oldest continuing democracy in the world, operating, since March 4, 1789, under a vibrant and enduring constitution that was formed by geniuses and is revered, still, coast to coast. We don’t make refugees, we admit them. When the rich of the world get sick, they come here to be treated, and when their children come of age, they send them here to our universities. We have a supple political system open to reform, and a wildly diverse culture that has moments of stress but plenty of give.

The point is not to say rah-rah, paint our faces blue and bray “We’re No. 1.” The point is that while terrible challenges face us—improving a sick public education system, ending the easy-money culture, rebuilding the economy—we are building from an extraordinary, brilliant and enduring base.

The other day I called former Secretary of State George Shultz, because he is wise and experienced and takes the long view. I asked if he thought we should be optimistic about our country’s fortunes and future. “Absolutely,” he said, there is “every reason to have confidence.”

Mr. Shultz laid out some particulars of his own optimism. There is “the ingenuity, the flexibility, the strengths of the national economy.” The labor force: “We are so blessed with human talent and resources.” And the American people themselves. “They have intelligence, integrity and honor.”

We should experience “the current crisis” as “a gigantic wake-up call.” We’ve been living beyond our means, both governmentally and personally. “We have to be willing to face up to our problems. But we have a capacity to roll up our sleeves and get down to work together.”

Realistic to the core, she concludes

What a task President-elect Obama has ahead. He ran on a theme of change we can believe in, but already that seems old. Only six weeks after his election he faces a need more consequential and immediate. In January, in his inaugural, he may find himself addressing something bigger, and that is: Belief we can believe in. The return of confidence. The end of absence. The return of the suit inhabited by a person. The return of the person who will take responsibility, and lead.

Financial Planners’ Reflections on 2008

I recently attended a meeting of financial planners in Northern New Jersey. Ordinarily, we meet once a month to listen to presentations given by experts on a variety of topics such as insurance, portfolio management and estate planning. This time, though, our group met specifically to discuss the recent upheaval of the stock markets and how that has affected, not just our clients, but us. (It’s been a very stressful year for planners.)

The members of our group are very experienced, individually and collectively, and they take financial planning and investment management very seriously. The consensus was that almost everyone has been adversely affected in some way or another by this year’s stock market decline. “It’s been a humbling experience,” said one planner.

Some members of the group expressed dissatisfaction with various mutual fund managers. Others revealed that they have revised their asset allocation recommendations, according to their changed outlook for various asset classes.

Here are some observations of general interest:

A great many people are genuinely frightened about the current economic situation, perhaps because the media continuously emphasizes the bad news. Some clients believe, rightly or wrongly, that the bad news will likely continue and things will probably get worse.

As various Wall Street industry icons went out of business, some clients became concerned about the financial stability of their custodians and Money Market accounts. Fortunately, planners were able to reassure their respective clients about these issues.

Planners are referring to 2008 as a “black swan” event, a comparison drawn from the book, The Black Swan: The Impact of the Highly Improbable  by Nassim Taleb.

While diversification is a valuable strategy in a typical year, 2008 has been anything but typical. As one participant said, “Diversification works over time, but not every time.”

While 2008 was a very difficult year, it was not totally unprecedented. Planners with long memories looked back to 1973 – 1974 and 1987 for some solace. Those were also difficult times, but we got through them.

All planners agreed that it was time to revisit their clients’ Investment Policy Statements and their personal financial plans.

One planner admitted to being right about one issue (investing in commodities), but not necessarily for the right reasons. (It was that kind of year.)

Naturally, the Benard Madoff mess came up. Providentially, the clients of only one manager were affected, and then, only by a very small amount. In this particular case, diversification definitely paid off.

Special concern was expressed for those individuals who have recently retired or are just about to retire. The markets may not recover in time enough for these people to fully and thoroughly enjoy what is supposed to be their golden years. As these retirees draw down funds, they will have less and less available to keep invested for the eventual rebound which most people expect. Various strategies were discussed for retirees.

Some technical issues were discussed such as Roth conversions, tax loss harvesting and the best strategies for rebalancing, when markets are volatile and people are worried.

One planner expressed concern about municipal bonds, since many states are under heavy fiscal and financial pressure.

The group consensus was this: We will all be very relieved to say goodbye to 2008.

Lessons from the Bernard L. Madoff Fiasco

“Many aspects of the Madoff affair are depressingly familiar: the lure of high returns with little risk, glowing testimonials from early investors, the sense of membership in a special club for those fortunate enough to be ‘in the know,’ the trust in the promoter due to religious or social affiliation, the vague documentation of investment strategy, the skimpy accounting, and the speed of the ultimate collapse.” – Weston J. Wellington.

There has been much written about Bernard L. Madoff, who is accused of running the largest financial fraud scheme in history, and all of it sordid and sad. The sorry tale raises serious questions and concerns about how well (or how poorly) the Securities and Exchange Commission, the so-called watchdog of the U.S. securities sector, did its job. It also makes you wonder how it was that so many “sophisticated” investors could have been so thoroughly fooled.

A recent New York Times column, Be Smart, but Don’t Think That You’re Special  by Ron Lieber and Tara Siegel Bernard, summarizes the debacle as follows: “When wealthy investors are willing to hand over a sizable sum to a single money manager they heard about at the country club, certain first principles of investing bear repeating.”

Here are some useful quotes from the article:

… scores of people made outsize bets on his prowess without taking the time to fully understand what they were investing in.

All investors, but especially those with a high net worth, need to maintain a healthy sense of humility about their level of ignorance. Alternative investments, whether they are hedge funds or venture capital or private equity, can be complicated. They contain unpredictable levels of risk. But all too often, people are willing to overlook those risks because, well, everyone else is doing it. Or they simply place too much trust in too few hands.

Humility

Investing, in general, requires humility. Few people have enough of it. It is the reason so few people put most of their money in index funds, which track various asset classes rather than trying to pick the winners in each.

One problem with hedge funds is that they appeal to all the wrong instincts. They are for the privileged. Investors need to have a minimum net worth to qualify. In the case of the money managed by Mr. Madoff, many people seemed to have gotten in on it by belonging to the right country club.

“He was dealing with extremely wealthy individuals,” said Harold Evensky, president of Evensky & Katz, a financial planning firm in Coral Gables, Fla. “All too often, they make relatively easy marks because the pitch is, ‘You’re special, you can get something that other people can’t get.’ ”

But you are probably not special. Bill Gates is special, and he is the beneficiary of the best investment opportunities from the smartest people in the business. The Ford Foundation is special. The people who run Harvard and Stanford and Yale’s endowments are special.

You, however, are probably hearing about the second- or third- or fourth-tier ideas in the world of alternative investments. That does not mean the managers pitching them cannot make them work. But be honest with yourself: if you are in on them, how special could they really be, given the enormous demand for truly unique investment opportunities?

Smarts

You may be rich and you may be smart. But smart about this sort of investing? Not so much.

There is no shame in not understanding Mr. Madoff’s split strike conversion strategy. Admit your ignorance, question your investment adviser’s certainty and seek a plain English explanation of the opportunity that is in front of you.

Secrets

One hard part about investing in hedge funds is that some of the most successful ones will not say much about how they work. If they disclose too much about their tactics, others will copy them and their investors will be hurt. (So will the managers’ take-home pay.)

While Mr. Madoff’s supposed returns were fully available to all, investment advisers were less successful in understanding how he did what he did. “I knew that their returns were always good, but I knew that nobody could explain how they made their money,” said Mr. Weinberg. “In our attempts to look under the hood, it was impossible to ascertain what they were doing.”

Conclusion

Let’s review some of the “red flags.”

Madoff had complete control of his clients’ investment funds. This is absolutely contrary to the recommended procedure of having your funds held separately, in custody, at a broker-dealer firm which is regulated by the Financial Industry Regulatory Authority and backed by the Securities Investor Protection Corporation. As an investor, you should be receiving copies of your statements directly from the (independent) custodian, not from your investment manager.

You need to understand the investment strategy that your investment manager is recommending. Avoid the “black box” approach to investing; look for investments that are clear and transparent.

Question any investment record that looks too steady over the long term. All investments have some risk, no investment is a “sure thing.” (Bear in mind that other investment managers could not duplicate Madoff’s investment performance, using similar strategies, so what “magic” did he possess that others did not?)

As the saying goes, “If it seems too good to be true, it probably is.”

Bubbles and Wall Street, Part 2

“From time to time, for reasons that are poorly understood, investors stop pricing businesses rationally. Rising prices take on a life of their own and a bubble ensues.” – William Bernstein.

When a bubble occurs, Wall Street executives may reinforce it through rational self-interest. The previous post included this quote from Henry Blodget:

“In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.”

Blodget expands on this notion.

This tension between investment risk and career or business risk comes into play in other areas of Wall Street too. It was at the center of the decisions made in the past few years by half a dozen seemingly brilliant CEOs whose firms no longer exist.

Why did Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, and the rest of an ever-growing Wall Street hall of shame take so much risk that they ended up blowing their firms to kingdom come? Because in a bull market, when you borrow and bet $30 for every $1 you have in capital, as many firms did, you can do mind-bogglingly well. And when your competitors are betting the same $30 for every $1, and your shareholders are demanding that you do better, and your bonus is tied to how much money your firm makes—not over the long term, but this year, before December 31—the downside to refusing to ride the bull market comes into sharp relief. And when naysayers have been so wrong for so long, and your risk-management people assure you that you’re in good shape unless we have another Great Depression (which we won’t, of course, because it’s different this time), well, you can easily convince yourself that disaster is a possibility so remote that it’s not even worth thinking about.

It’s easy to lay the destruction of Wall Street at the feet of the CEOs and directors, and the bulk of the responsibility does lie with them. But some of it lies with shareholders and the whole model of public ownership. Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results. When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward—when what you’re really doing is betting the firm.

As we work our way through the wreckage of this latest colossal bust, our government—at our urging—will go to great lengths to try to make sure such a bust never happens again. We will “fix” the “problems” that we decide caused the debacle; we will create new regulatory requirements and systems; we will throw a lot of people in jail. We will do whatever we must to assure ourselves that it will be different next time. And as long as the searing memory of this disaster is fresh in the public mind, it will be different. But as the bust recedes into the past, our priorities will slowly change, and we will begin to set ourselves up for the next great boom.

A few decades hence, when the Great Crash of 2008 is a distant memory and the economy is humming along again, our government—at our urging—will begin to weaken many of the regulatory requirements and systems we put in place now. Why? To make our economy more competitive and to unleash the power of our free-market system. We will tell ourselves it’s different, and in many ways, it will be. But the cycle will start all over again.

What can we learn from this bubble?

First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.

Conclusion

A number of things must come together to cause a bubble. One of them is an ignorance of history. We forget that markets can be cyclical. During the boom years, many of us conveniently forget (or didn’t even consider) the possibility of a bust.

It typically takes 30 years for a new group of potential believers to arrive.  Inexperienced investors make it possible for price increases (success) to lead to more price increases (excess).

The old adage, “What goes up must come down” is overwhelmed by “it’s different this time.”

Don’t expect your typical Wall Street messenger to warn you about the danger. Wall Street executives are typically concerned about career risk.  Moreover, in the last bubble, they did a very bad job of managing risk for their own firms.

Bubbles and Wall Street, Part 1

“Bubbles occur whenever investors begin buying stocks simply because they have been going up. This process feeds on itself, like a bonfire, until all the fuel is exhausted, and it finally collapses.” – William Bernstein.

Why Wall Street Always Blows It  by Henry Blodget appeared in the December issue of The Atlantic. The article offers interesting observations on how powerful incentives have compelled Wall Street executives to play musical chairs with their clients’ money, until the music finally stopped.

Here’s what Blodget has to say (emphasis added).

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

Everyone …bears some responsibility too. But … it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone …acted just the way you would expect them to act under the circumstances.

That’s especially true for the professionals on Wall Street, who’ve come in for more criticism than anyone in recent months, and understandably so. It was Wall Street, after all, that chose not only to feed the housing bubble, but ultimately to bet so heavily on it as to put the entire financial system at risk. How did the experts who are paid to obsess about the direction of the market—allegedly the most financially sophisticated among us—get it so badly wrong? The answer is that the typical financial professional is a lot more like our hypothetical home buyer than anyone on Wall Street would care to admit. Given the intersection of experience, uncertainty, and self-interest within the finance industry, it should be no surprise that Wall Street blew it—or that it will do so again.

Since Wall Street replenishes itself with a new crop of fresh faces every year—many of the professionals at the elite firms either flame out or retire by age 40—most of the industry doesn’t usually have experience with both booms and busts. In the 1990s, I and thousands of young Wall Street analysts and investors like me hadn’t seen anything but a 15-year bull market. The only market shocks that we knew much about—the 1987 crash, say, or Mexico’s 1994 financial crisis—had immediately been followed by strong recoveries (and exhortations to “buy the dip”).

By 1996, when Greenspan made his famous “irrational exuberance” remark, the stock market’s valuation was nearing its peak from prior bull markets, making some veteran investors nervous. Over the next few years, however, despite confident predictions of doom, stocks just kept going up. And eventually, inevitably, this led to assertions that no peak was in sight, much less a crash—you see, it was “different this time.”

Those are said to be the most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the 1920s, the “differences” were said to be the miraculous new technologies (phones, cars, planes) that would speed the economy, as well as Prohibition, which was supposed to produce an ultra-efficient, ultra-responsible workforce. (Don’t laugh: one of the most respected economists of the era, Irving Fisher of Yale University, believed that one.) In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Of course, as …was crystal clear to most Wall Street executives at the time—being bullish in a bull market is undeniably good for business. When the market is rising, no one wants to work with a bear.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

This does not make the participants villains or morons. It does, however, illustrate another critical component of boom-time decision-making: the difference between investment risk and career or business risk.

Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.

If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won’t call Fidelity and say, “Thank you.” Instead, you’ll probably call and say, “What am I paying you people for, anyway?” (Or at least that’s what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.

On the other hand, if your Fidelity fund declines in value but the market drops even more, you’ll probably stick with the fund for a while (“Hey, at least I didn’t lose as much as all those suckers in index funds”). That is, until the market drops so much that you can’t take it anymore and you sell everything, which is what a lot of people did in October, when the Dow plunged below 9,000.

In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.

The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.

In the late 1990s, while I was trying to figure out whether it was different this time, some of the most legendary fund managers in the industry were struggling. Since 1995, any fund managers who had been bearish had not been viewed as “wise” or “prudent”; they had been viewed as “wrong.” And because being wrong meant underperforming, many had been shown the door.

It doesn’t take very many of these firings to wake other financial professionals up to the fact that being bearish and wrong is at least as risky as being bullish and wrong. The ultimate judge of who is “right” and “wrong” on Wall Street, moreover, is the market, which posts its verdict day after day, month after month, year after year. So over time, in a long bull market, most of the bears get weeded out, through either attrition or capitulation.

By mid-1999, with mountains of money being made in tech stocks, fund owners were more impatient than ever: their friends were getting rich in Cisco, so their fund manager had better own Cisco—or he or she was an idiot. And if the fund manager thought Cisco was overvalued and was eventually going to crash? Well, in those years, fund managers usually approached this type of problem in of one of three ways: they refused to play; they played and tried to win; or they split the difference.

Conclusion

When stocks (or house prices) are going up, it is very easy to be optimistic or at least go along with the crowd. There are always many reasons to explain why “the sky is the limit.” That’s how the phrase “it’s different this time” gains currency.

If you work on Wall Street, it’s bad business to be prematurely negative, because you may miss out on the “easy money.” And it can be bad for your career to be pessimistic or even doubtful of the new paradigm.

“Everyone was doing it” may not be a defense for a child’s behavior, but it seems to apply to investment managers who are willing to take on additional risk to attempt outperformance.

Instead of reining in over-optimism and greed, Wall Street executives became enablers for their clients. The timing could not have been worse.

Note that a conservative diversified portfolio will underperform in a bubble but will typically avoid a steep decline when the market turns. This approach is not perfect, but it sure beats chasing performance when everyone says, “this time it’s different.”

To be continued …

Lessons Learned from the Housing Bubble, Part 2

In my previous post, I started with Henry Blodget’s belief that we are all to be blamed for the housing boom and bust.

It was purely greed, or to put it more kindly, as we shall read – self interest.

Here’s where we left off:

How on Earth did we get into this mess?

The exact answer is different in every case, of course. But let’s round up the usual suspects:

• The predatory mortgage broker? Well, we’re certainly not happy with the bastard, given that he sold us a loan that is now a ticking time bomb. But we did ask him to show us a range of options, and he didn’t make us pick this one. We picked it because it had the lowest payment.

• Our sleazy real-estate agent? We’re not speaking to her anymore, either (and we’re secretly stoked that her BMW just got repossessed), but again, she didn’t lie to us. She just kept saying that houses are usually a good investment. And she is, after all, a saleswoman; that was never very hard to figure out.

• Wall Street fat cats? Boy, do we hate those guys, especially now that our tax dollars are bailing them out. But we didn’t complain when our lender asked for such a small down payment without bothering to check how much money we made. At the time, we thought that was pretty great.

• The SEC? We’re furious that our government let this happen to us, and we’re sure someone is to blame. We’re not really sure who that someone is, though. Whoever is responsible for making sure that something like this never happens to us, we guess.

• Alan “The Maestro” Greenspan? We’re pissed at him too. If he hadn’t been out there saying everything was fine, we might have believed that economist who said it wasn’t.

• Bad advice? Hell, yes, we got bad advice. Our real-estate agent. That mortgage guy. Our neighbor. Greenspan. The media. They all gave us horrendous advice. We should have just waited for the market to crash. But everyone said it was different this time.

Still, except in cases involving outright fraud—a small minority—the buck stops with us. Not knowing that the market would crash isn’t an excuse. No one knew the market would crash, even the analysts who predicted that it would. (Just as important, no one knew when prices would go down, or how fast.) And for years, most of the skeptics looked—and felt—like fools.

Everyone else on that list above bears some responsibility too. But in the case I have described, it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone on that list acted just the way you would expect them to act under the circumstances.

The most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

In my example from the housing boom, for instance, each participant’s job was not to predict what the housing market would do but to accomplish a more concrete aim. The buyer wanted to buy a house; the real-estate agent wanted to earn a commission; the mortgage broker wanted to sell a loan; Wall Street wanted to buy loans so it could package and resell them as “mortgage-backed securities”; Alan Greenspan wanted to keep American prosperity alive; members of Congress wanted to get reelected. None of these participants, it is important to note, was paid to predict the likely future movements of the housing market. In every case (except, perhaps, the buyer’s), that was, at best, a minor concern.

Conclusion

When everyone is under the (mis)conception that housing prices can move in only one direction, namely up, it’s not unexpected that people react in a way that seems perfectly rational. Of course, it is only later that we see the folly of that reaction.  Indeed, the most expensive words in the English language are “it’s different this time.”

Next up: How Wall Street was swept along in the “bubble” mentality and how incentives shaped the behavior of its executives.

photo credit: laurgasms

Lessons Learned from the Housing Bubble, Part 1

“We got greedy; we went nuts; we heard what we wanted to hear.” – Henry Blodget.

In the December issue of The Atlantic, Why Wall Street Always Blows It  by Henry Blodget provides a thought provoking view on what went wrong with the housing market. Blodget has two simple arguments to underscore what went wrong: (1) We are all to be blamed, and (2) Wall Street had powerful incentives which compelled it to keep playing musical chairs until the music eventually stopped.

How are we all to blame? According to Blodget, in a word: Greed.

Here’s what Blodget has to say on that point.

Well, we did it again. Only eight years after the last big financial boom ended in disaster, we’re now in the migraine hangover of an even bigger one—a global housing and debt bubble whose bursting has wiped out tens of trillions of dollars of wealth and brought the world to the edge of a second Great Depression.

Millions have lost their houses. Millions more have lost their retirement savings. Tens of millions have had their portfolios smashed. And the carnage in the “real economy” has only just begun.

What the hell happened? After decades of increasing financial sophistication, weren’t we supposed to be done with these things? Weren’t we supposed to know better?

Yes, of course. Every time this happens, we think it will be the last time. But it never will be.

I experienced the (housing) bubble differently—as a journalist and homeowner. Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early. Figuring that the roaring housing market was just another tech-stock bubble in the making, I rushed to sell my house in 2003—only to watch its price nearly double over the next three years. I also predicted the demise of the Manhattan real-estate market on the cover of New York magazine in 2005. Prices are finally falling now, in 2008, but they’re still well above where they were then.

Live through enough bubbles, though, and you do eventually learn something of value. For example, I’ve learned that although getting out too early hurts, it hurts less than getting out too late. More important, I’ve learned that most of the common wisdom about financial bubbles is wrong.

Who’s to blame for the current crisis? As usually happens after a crash, the search for scapegoats has been intense, and many contenders have emerged: Wall Street swindled us; predatory lenders sold us loans we couldn’t afford; the Securities and Exchange Commission fell asleep at the switch; Alan Greenspan kept interest rates low for too long; short-sellers spread negative rumors; “experts” gave us bad advice. More-introspective folks will add other explanations: we got greedy; we went nuts; we heard what we wanted to hear.

All of these explanations have some truth to them. Predatory lenders did bamboozle some people into loans and houses they couldn’t afford. The SEC and other regulators did miss opportunities to curb some of the more egregious behavior. Alan Greenspan did keep interest rates too low for too long (and if you’re looking for the single biggest cause of the housing bubble, this is it). Some short-sellers did spread negative rumors. And, Lord knows, many of us got greedy, checked our brains at the door, and heard what we wanted to hear.

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

House prices, we are told by our helpful neighborhood real-estate agent, almost never go down. This sounds right, and they certainly didn’t go down in the stock-market crash. In fact, for as long as we can remember—about 10 years, in most cases—house prices haven’t gone down. (Wait, maybe there was a slight dip, after the 1987 stock-market crash, but looming larger in our memories is what’s happened since; everyone we know who’s bought a house since the early 1990s has made gobs of money.)

We consider following our agent’s advice, but then we decide against it. House prices have doubled since the mid-1990s; we’re not going to get burned again by buying at the top. So we decide to just stay in our rent-stabilized rabbit warren and wait for house prices to collapse.

Unfortunately, they don’t. A year later, they’ve risen at least another 10 percent. By 2006, we’re walking past neighborhood houses that we could have bought for about half as much four years ago; we wave to happy new neighbors who are already deep in the money. One neighbor has “unlocked the value in his house” by taking out a cheap home-equity loan, and he’s using the proceeds to build a swimming pool. He is also doing well, along with two visionary friends, by buying and flipping other houses—so well, in fact, that he’s considering quitting his job and becoming a full-time real-estate developer. After four years of resistance, we finally concede—houses might be a good investment after all—and call our neighborhood real-estate agent. She’s jammed (and driving a new BMW), but she agrees to fit us in.

We see five houses: two were on the market two years ago for 30 percent less (we just can’t handle the pain of that); two are dumps; and the fifth, which we love, is listed at a positively ridiculous price. The agent tells us to hurry—if we don’t bid now, we’ll lose the house. But we’re still hesitant: last week, we read an article in which some economist was predicting a housing crash, and that made us nervous. (Our agent counters that Greenspan says the housing market’s in good shape, and he isn’t known as “The Maestro” for nothing.)

When we get home, we call our neighborhood mortgage broker, who gives us a surprisingly reasonable quote—with a surprisingly small down payment. It’s a new kind of loan, he says, called an adjustable-rate mortgage, which is the same kind our neighbor has. The payments will “reset” in three years, but, as the mortgage broker suggests, we’ll probably have moved up to a bigger house by then. We discuss the house during dinner and breakfast. We review our finances to make sure we can afford it. Then, the next afternoon, we call the agent to place a bid. And the house is already gone—at 10 percent above the asking price.

By the spring of 2007, we’ve finally caught up to the market reality, and our luck finally changes: We make an instant, aggressive bid on a huge house, with almost no money down. And we get it! We’re finally members of the ownership society.

You know the rest. Eighteen months later, our down payment has been wiped out and we owe more on the house than it’s worth. We’re still able to make the payments, but our mortgage rate is about to reset. And we’ve already heard rumors about coming layoffs at our jobs. How on Earth did we get into this mess?

To be continued …

photo credit: Joe Shlabotnik

Investment Guru Predicted Crash

“There will always be someone predicting disaster and someone predicting great fortune. At one time or another, each will be closer to correct than the other. But it won’t matter to you if you understand this and have invested responsibly. You have a long-term plan; stick with it.” Peter Lynch.

In my previous post, one of the individuals quoted was Jeremy Grantham, a very successful money manager, who has been getting a great deal of media attention lately. He was among the “Fortune Tellers” featured in New York Magazine’s December 7th article, Oracles of Doom.

In addition, late last month, Grantham was the sole guest on PBS’s popular investment program, Consuelo Mack: WealthTrack. She described him as a modern-day “Cassandra,” noting that he predicted today’s depressed stock prices a decade ago.

I might be in the minority here but, in my opinion, being pessimistic 10 years in advance isn’t all that useful.

Now, don’t get me wrong, I think Grantham is very intelligent and quite eloquent. He’s also very convincing. The problem I have with him is that he has been bearish for so long, that eventually, he had to be right.

You can read more about his prophesies in Here Comes the Crash, an article published in the November 15, 2004 Fortune magazine.

Talk to Jeremy Grantham about the stock market, and you get the impression the sky is about to fall. For years the chairman and chief strategist of money-management firm Grantham Mayo Van Otterloo has been gleefully rattling listeners’ nerves with his claim that the excesses of the dot-com bubble still haven’t been unwound and that the market is headed for another precipitous drop. About a year ago his prediction became alarmingly specific. Shortly after this year’s election, he says, the market will sink into a “black hole,” losing about a third of its value over the next two to three years. He sounded this warning most publicly at the annual Morningstar investment conference in July. In late October, speaking from his elegant Boston townhouse, he told FORTUNE, “We’re still in the unraveling of the greatest bull market in American history.”

To be fair, from what was printed in the Fortune article, he has been right:

Using GMO’s computer models, he has made several well-timed calls. In 1982, with stocks selling at fire-sale prices and the economy recovering, he predicted the market was ripe for a “major rally.” That year the U.S. market kicked off its longest bull run ever. He also called the top of the Japanese bubble in 1989, the resurgence of U.S. large caps in 1991, and the rallies in U.S. small-cap and value stocks in 2000.

But, he has also been wrong:

He turned bearish on U.S. equities in the mid-1990s, prompting clients to shift money to other firms.

His prediction in 2004 was that “The low will come two or three years from now, at a level below 700 on the S&P.” That’s not what happened at all. In fact, the S& P 500 went up in 2003, 2004, 2005, 2006 and 2007. Finally, in 2008, his pessimism paid off.

A web site from CXO Advisory Group rates investment “gurus.” According to them:

Jeremy Grantham has been persistently very negative about the prospects for U.S. equities (apparently since 1994), but not for international equities.

Based on subsequent stock market performance and our judgments about his forecasts for overall stock market direction, Jeremy Grantham’s forecast accuracy rate is 48%, which is about average. His forecast sample size is very small, as is our confidence in this score.

Note that carefully: 48%. One could argue that an accuracy rate of 48% is not dissimilar from simply using a coin tossed in the air to determine your prediction.

Finally, if the stock market had gone up this year, I doubt that Jeremy Grantham would be getting this much favorable press.

Experts Who Predicted Recession

“The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith.

I took a look back through my files to see which market economists or analysts correctly predicted that we would eventually have such an awful recession and horrendous stock market decline. In his article, Last Christmas Before Next Recession, Paul B. Farrell of MarketWatch quotes economists and investment gurus who did not pull their punches. You won’t find a “on the one hand this and on the other hand that” quote among the lot.

Of course, this particular group is always making predictions. So please read the entire post, before you decide how “helpful” their predictions actually were.

The quotes are very slightly shortened (for dramatic effect).

Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co

“Everyone agrees that there are extreme imbalances in the U.S. and the global economy … The bulls believe that all will work out … The bears believe that sooner or later these imbalances will come home to roost. … The probable winning bet [is] a very mean reversal … for the next few years.”

Gary Shilling, economist

“A bursting of the housing bubble will probably be the expansion ender. Signs of the bubble’s demise are accumulating, making a … recession probable.”

Bill Gross of Pimco

“Now after 300 basis points and 17 months of tightening — which by the way is typical of prior bear cycles as well — it should only be logical to expect a slower economy …”

Alan Greenspan

“Our budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken. The consequences for the U.S. economy of doing nothing could be severe.”

Farrell goes on to recommend extreme steps to prepare for the bear market and recession.
“You need a wake up call: Total shift of consciousness, an extreme mental makeover, a massive attitude adjustment. … This is real war.”

He ends with this question, “Are you prepared to survive the recession and bear market likely to hit in 2006?”

Yup. You read that right. That’s 2006. The article was posted on December 12, 2005. Had the article been posted on December 12, 2007 that would have been really impressive. Frankly, being two years early in calling a recession is not at all useful. In point of fact, the S&P 500 had returns of 15.8% in 2006 and 5.5% in 2007.

So, what do you call people who are right, but two years early?

“Wrong.”

Choosing a Financial Advisor, Part 4

When shopping for a financial advisor, just how do you ensure that he or she has the “right” experience and training?

A recent article in Money Magazine, Don’t Judge an Adviser by His Title, by Walter Updegrave, warns that “you should be on guard” against “unscrupulous salespeople posing as trustworthy advisers” who are using “dubious retirement credentials.”

Earlier this year, state insurance and securities regulators approved model regulations that will prevent advisers from implying they have expertise about retirement planning that they don’t actually have.

The new regs will make it illegal for advisers to tout made-up or self-conferred designations, or credentials that are real but granted by organizations that don’t set rigorous standards.

That said, it may take well into 2009 before most states adopt them. And no regulations can totally eliminate abuses. You still have to exercise caution when you seek retirement advice. Here’s how.

Don’t be awed by a string of initials.

Given the dozens of official-sounding titles floating around, it’s virtually impossible to know which are marketing gimmicks, which are legitimate and which fall in between. I’d view any credential that contains words like senior or retirement with skepticism.

Earlier this year, a reader e-mailed me to say he’d met with an adviser with a Wharton Certificate in Retirement Planning. How much credence should he give it?

What I found is that the certificate is available only to advisers affiliated with the insurer AXA who attend a five-day program at the Wharton School. There’s no final exam, no grade. I don’t want to suggest that the program is a sham. It is taught by Wharton professors, and AXA sends only experienced advisers. Then again, it’s not exactly a Wharton M.B.A.

When a designation does connote a special skill, consider how relevant that expertise is. The Certified Senior Advisor designation, while legit, is largely meaningless as a gauge of retirement planning proficiency.

Why? Its purpose is to increase awareness of the aging process. It requires no special financial training.

Do a background check.

Even if an adviser’s credentials are beyond reproach, his or her integrity may not be. Before signing on with an adviser, check with your state securities commission (nasaa.org) and state insurance department (naic.org) to see if he or she has a history of disciplinary problems or consumer complaints.

Plus, don’t attend free-lunch seminars that target retirees – they are often nothing more than a way for sales-people to peddle high-fee investments. Instead, screen for a planner who concentrates on retirement at the Financial Planning Association’s site (fpanet.org).

Be wary of safety claims.

Older investors are understandably worried about retirement today. Unfortunately, advisers who misrepresent themselves with misleading credentials may also see this as a perfect opportunity to prey on those fears.

Insurance commissioners in several states have recently warned that some advisers are using concerns about the health of insurer AIG to persuade annuity owners to switch into a new annuity.

Such a move can be a great deal for the adviser, who earns a fat commission. But it may not be a wise decision for the investor, since a transfer may trigger early-withdrawal penalties, not to mention start the clock on a new set of surrender charges.

It’s during uncertain times like these that you’re most likely to seek financial advice. Just make sure you end up with a real adviser, not a salesman with a fancy title posing as one.

Conclusion

This article is useful regarding what to avoid in looking for a financial planner, but you need more information to be successful in finding the right person for you.

I have written before about the importance of having a financial advisor who puts your interests first, i.e. a fiduciary. Fee-only planners, who are members of NAPFA, all agree to act as fiduciaries and sign a fiduciary oath.

Aside from the very important issue of the manner in which your financial advisor is compensated, keep in mind that different planners have different areas of expertise. Knowing this may help you choose the individual who best suits your needs. To a large extent, the best financial advisor for you will largely depend on the kind of advice you are seeking. A brief rundown of the alphabet soup of designations, which follow the name of a financial advisor, will help you sort it out.

Designations

The following designations have rigorous standards and are widely recognized and respected. One could debate whether the course requirements are comprehensive enough and just how difficult the tests are.

Nevertheless, if you are working with someone who has one or more of these designations, you know that the planner is serious enough about the craft of financial planning to meet the requirements. It’s not an ironclad guarantee of competence, but it is a good indicator.  In all cases, there are continuing education requirements.

Certified Financial Planner (CFP®) – The CFP® designation requires a minimum of three years of experience and the passing of a rigorous two-day exam. Certified Financial Planners should be able to provide a broad range of financial advice.

Certified Public Accountant (CPA) – A CPA is an experienced accountant who has met strict education and licensing requirements. A CPA is a good choice for tax issues.

Personal Financial Specialist (PFS) – CPAs, who undergo additional financial planning education and pass an exam, can use the PFS designation.

Chartered Financial Consultant (ChFC) – Insurance professionals, who specialize in some aspects of financial planning by meeting additional education requirements in economics and investments, can use the ChFC designation.

To be continued …

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