Fagan Associates Archive for May, 2011

Readers of our column, listeners to our radio show and those close to us know that we are huge sport fans.  We are especially fond of baseball, specifically the routine, symmetry and the fact that there is always hope due to the lack of a time clock.  That said, the start of baseball season usually provides us with a lot of anxiety as we are fans of the New York Mets and ask ourselves why we couldn’t have been brought up Yankee fans.  Ironically, some of the terminology utilized in baseball works well in formulating investment philosophies.  We note some of them below.

DON”T SWING FOR THE FENCES!  So many investors (especially younger ones) are looking for the home run.  They want to day trade their way to financial freedom and are constantly looking for the next Google or Microsoft.  Reality is that most baseball rallies are built one single at a time and that solid financial portfolios are built through diligence and discipline.  Home runs can occur but mostly they come while you are swinging level and not trying to hit one.  It is also important to recognize that some of the most prolific home run hitters also strike out the most.

SACRIFICE.  In baseball many wins are constructed through the sacrifice bunt (especially in the National League which doesn’t utilize a designated hitter).  Likewise, most investors are best served by making sacrifices and contributing on an ongoing basis to 401(k) plans and to Individual Retirement Accounts.  These dollar cost averaging techniques take the market timing aspect and emotion out of the process and help investors build solid financial futures.

CURVE BALL.  A prudent investment strategy requires a plan of action should your investment choice go down in value rather than up, as you had planned.  What if the stock market or your investment throws you a “curve ball?”  What are you going to do?  How will you respond?  Do you have a plan of action to rebalance your portfolio at a specific level or on a periodic schedule?  Always expect the unexpected.

GOOD PITCHING ALWAYS BEATS GOOD HITTING.  As we have witnessed over the past several years, sometimes the stock market goes nowhere.  Sometimes there are limited opportunities.  During these period of times, don’t lose hope.  Keep your nose to the grindstone.  Keep your eyes on the ball and over time, this will pay off.

THE THIRD BASE COACH.  OK, this might be a stretch, but runners rounding third base are always looking for help and advice from the third base coach.  Likewise, frequently investors are wise to get professional help especially when facing difficult decisions.  The learning curve can be steep and costly should you try to invest on your own.  As we have stated time and time again, experienced investors have a better chance at differentiating between an opportunity and danger.  They tend to have a better feel for when to act rationally and when to act irrationally.  We use the example of buying low and selling high.  That flies in the face of rational thinking.  Why would anybody move toward something that is down and out.  The answer regarding investing is quite simple – investors should always try to buy potential and sell a lack of potential.

PINCH HITTER.  Many investors tend to evaluate their investment portfolios during regular intervals.  For instance at the end of every calendar quarter.  The problem with this is that your investments know no calendar.  They go up and down in reaction to different types of data, including that which pertains to the economy, corporate profits, geopolitical events, monetary policy, etc….  Investing is not a static situation.  Rather it is evolutionary and sometimes revolutionary.  Therefore, you need to be ready to act when the situation dictates.  For individual securities, this may be at a moment’s notice.  For mutual funds, this is most likely in response to an accumulation of data that would cause one to act.  Either way, the calendar does not dictate when changes are warranted, among other criteria, the investing environment does.

THE FINAL SCORE.  You’re the batter.  You’re the investor.  One way or another a pitch is going to be thrown.  You have a decision to make.  Do I swing at the pitch?  Do I make the investment?  If you choose to make an investment have a plan on what to do if it doesn’t work out.  It you decide not to swing, always remember that unlike baseball, when investing you can pass on as many pitches as you want and only swing at those you think you can make effective contact with.  There are no balls or strikes.

HOME PLATE.  OK, you’ve reached your goals.  You’ve achieved your objectives.  Now, don’t go back.  Try to protect your principal and remove some risk.  Stocks have nearly doubled off their first quarter 2009 lows and now may perhaps be the time to scale back a bit of risk, especially if you will be in need of the principal over the near term.

An article was recently published in AARP, The Magazine that detailed the trials and tribulations of a particular investor who, looking a “safe investment for his 86-year-old mother and his mentally disabled brother” committed a grievous investment error.  Through the advice of the broker, a friend he had known since he was nine, this individual invested “about a third of his savings” in a structured product.  Unfortunately, what the investor did not realize was that the principal of the structured product, described by the broker as a “low-risk, high-yield investment called a principal-protected note” was guaranteed by Lehman Brothers, the investment firm that collapsed during the Fall of 2008.  Prior to following the article along to determine the mistakes that were made as well as some other revelations regarding the financial industry, for the purpose of this article, let us first define a structured note as an investment whose return is determined by a underlying pool of securities and whose principal is either partially or completely guaranteed by the issuer.

As we assume the reader is a regular to our weekly columns, we trust you picked up on the first major mistake the investor committed, which was to invest one-third of the money into any one vehicle.  Prior to making an investment into a particular security, ask yourself “what happens to my financial well-being if this does not turn out as intended.”  If the answer is calamity, then either don’t make the investment or scale back the commitment.  This gentleman broke the cardinal rule of putting too many eggs in one basket.

The second mistake, the clue to which was outlined in paragraph one of this column, was committed mostly by the broker and Lehman brothers as they described the investment as a “principal protected note” implying little or no risk to the investor.  That said, the individual is also at fault as he assumed that this principal protection meant no risk to him.  What he failed to realize or didn’t want to realize due to the allure of perhaps high returns was that the principal was not protected by the FDIC or other government entity, but rather by an investment company, which was on shaky financial ground.  Know whether or not there are guarantees and if so, who is the guarantor.

Despite the inherent but not-so-obvious risk, according to the article in AARP Magazine, “sales of structured products keep rising.  In 2010 Wall Street firms and major banks sold a record-breaking $51.86 billion of the investments to U.S. consumers.  Their pitch:  low risk to principal, and high yield.  Their favorite customers:  older Americans who are scared of outliving their money if it remains parked in low-yielding CDs and bonds – and are often desperate to find a safe, better-paying alternative.”  Our response, “Wall Street is a marketing machine, continually developing both core and fringe products that take advantage of the current environment.  In this case, the period of low interest rates is pushing some conservative investors out into an arena in which they are unfamiliar and ill-equipped in which to compete.  Caveat emptor.” 

Why then if these products are difficult to comprehend and carry unforeseen risk are sales skyrocketing.  According to the magazine article, “structured products are extremely profitable for sellers.  For buyers, not so much.  At best, you pay high fees for an illiquid investment with limited potential gain….What’s more brokers are highly motivated to sell them.  The sales commissions on structured products range from three to ten percent.”  What most investors don’t know is that despite its’ efforts, the financial industry remains one of high commissions, creating either a real or perceived conflict of interest.  With this in mind, always ask your broker, what commissions for your firm and you are generated should I purchase this product.  (By the way, Fagan Associates, is 100% fee-driven earning 0% from commission.)

The article notes that these investments are also illiquid and that “most aren’t traded or listed on exchanges.  If you want out of your investment, your only option may be to sell it back to your broker at a loss.”  Generally speaking, never invest in anything that is not registered in your name at a reputable brokerage firm or where you are unable to calculate the value on a daily basis during the course of a business day.  This limits negative surprises.

Finally, a section of the article in AARP Magazine is entitled “How Brokers Sucker You.”  The article notes that “a sales pitch for a structured product often starts like this:  A bank customer complains to the teller about the awful yield on CDs and savings accounts.  The sympathetic teller refers the customer to a securities broker right there in the bank, who enthusiastically describes a product he or she claims is a secure alternative.”  Close your eyes and think of the bank.  What comes to your mind?  Safety and security are two images that come to ours.  However, keep in mind that although this is true for the side that is insured by the Federal Deposit Insurance Corporation (FDIC), there is a side to the bank that is no different from Wall Street, one in where there is substantial, non-guaranteed risk to principal.

Unfortunately, within one year the individual who invested one-third of his savings into this structured product lost everything within a year.  We hope that our attention to this unfortunate occurrence will prevent any of our readers from experiencing this type of life-altering event.

This past week, Standard & Poor’s (S&P), perhaps the country’s premier rating services agency, reduced its outlook on direct debt of the United States Government.  In a lengthy release S&P stated that “it affirmed its ‘AAA’ long-term and ‘A-1+’ short-term sovereign credit ratings on the U.S.  Standard & Poor’s also said that it revised its outlook on the long-term rating of the U.S. sovereign to negative from stable.”

S&P elaborated on the reason behind the change to negative from stable, the first such change ever for the United States.  “Our ratings o the U.S. rest on its high-income, highly diversified, and flexible economy.  It is backed by a strong track record of prudent and credible monetary policy, evidenced to us by its ability to support growth while containing inflationary pressures.  The ratings also reflect our view of the unique advantages stemming from the dollar’s preeminent place among world currencies.”

“Although we believe these strengths currently outweigh what we consider to be the U.S.’s meaningful economic and fiscal risks and large external debtor position, we now believe that they might not fully offset the credit risks over the next two years at the ‘AAA’ level.”

“More than two years after the beginning of the recent crisis, U.S. policy makers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures,” this according to S&P credit analyst Nikola G. Swann.

What could this shot across the bow mean?  Well, most likely nothing for now.  However, should our elected officials not get the country’s fiscal house in order, Americans might expect a continuation of the decline in the dollar and inflation in the form of higher interest rates.

Like it or not, however we believe for the good, the financial markets will most likely determine how quickly our politicians respond to this pending crisis.  For example, just this past week the Euro rose to a fifteen month high relative to the dollar.  Despite the fact that a weakening dollar is good for exports, too much so makes imports (see oil) more expensive and is thus inflationary.  Furthermore, also this past week, the ultimate safe haven, gold, crossed over the $1,500 per ounce mark as debt concerns surrounding the United States as well as the countries of Western Europe has sparked interest in not only this precious metals, but semi-precious metals, industrial metals and commodities, as well.  In fact, in addition to tensions in the Middle East and global demand, many analysts believe that oil would be some $30/bbl lower if it not for the falling greenback.

All the while our Congressmen fiddle as Washington burns.  S&P’s Swann also stated that “our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years.  The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.”

In response to S&P, U.S. Treasury Secretary Timothy Geithner said this past Tuesday that there was “no risk” that the United States would lose its ‘AAA’ credit rating noting that “the President recognizes and the leadership in the Congress recognize that we have to start to bring these deficits down.”  In our opinion that is easier said than done as America must guard against forfeiting its reputation as the “land of opportunity” for one as the “land of entitlements.”

Standard & Poor’s has effectively managed to heighten the increasingly contentious debate between Republicans and Democrats, one which came to the attention of most Americans with the publishing of the recommendations on how to deal with our budget deficit by White House Fiscal Commission co-chairs Alan Simpson and Erskine Bowles and may only end with what may be one of the most important elections of our collective lifetimes, the 2012 Presidential Election.

THE BOTTOM LINE – America and Americans, including our elected officials, respond best in a time of crisis.  Make no mistake about it.  If we do not get the U.S. budget deficit under control, a crisis will occur.  Perhaps Standard & Poor’s, which by the way many believe is itself not without fault for the way it did or more accurately did not dispense accurate ratings information during the recent financial mess, has, by way of its ratings outlook revision from stable to negative, in a roundabout way issued a challenge to our President and Congress.  “Fix it.  Get us on the right track.”  Unfortunately, we believe that “fixing it” will include spending cuts by all municipalities, Federal, State and Local; tax hikes and changes to entitlement programs, including Social Security and Medicare.  If this is what it takes to right the ship, we’re all for all of the above and we believe so are the financial markets.