DempseyTV

A fitting title as we begin Mar. 2009. Equity markets have been down six straight months. The Dow Jones was down 15 of the last 17 weeks.

There is a very strong tendency for people to exaggerate the importance of recent events and recent performance. It is human nature. You turn on the t.v., read a paper and whatever is on seems more important at the time than in retrospect. Probably the greatest mistake in investing is exaggerating the importance of, and extrapolating, what happened lately. What has happened over the last 3 and six months has substantially changed the psychology of a lot of people in the direction of betting these recent conditions will continue.

Floyd B. Odlum made a fortune in the Great Depression

So, I’d like to introduce you to Floyd B. Odlum, who died in 1976. He was an investor by profession, CEO of Atlas corp. Functionally he was an opportunist. He made a fortune in the Great Depression by buying up the deeply discounted shares of publicly traded investment trusts, the toxic assets of his day. We can have no finer role model in this, our Great Recession.

None of us can know the future, but like Odlum, we can make the best of a sometimes unappetizing present.

Let us travel back in time to 1930, the first time full year of the great slump. Nobody knew there would be a second such year, let alone a third. They were as much in the dark about the future as we are. In August 1933, the New Yorker magazine ran a profile of Odlum. “His cheerful behavior during this period was a recurring source of wonder and irritation to his friends.”

At one of the most painful moments in the country’s financial history, he was saying “I believe there’s a better chance to make money now than ever before.” As investors we are always so conflicted. We seek out bargains at the mall but shun them with our investment dollars. We loved internet stocks in 1999 at sky high prices, then hated them at $2 per share. Long term U.S. bonds are snapped up today at 3% yields but despised at 14% and more in the early 1980’s.

Odlum’s big idea was to buy dollar bills for 50¢.

Buying Dollar Bills for Fifty Cents

Great investors, world class opportunists, adapt to the times. What makes Odlum a guide and beacon for 2009 is that he saw across the valley of despair. Quoting from a Fortune magazine article about him from 1935: “He has no great faith in the immediate future of the market, whereas he was willing to bet his fortune on the market’s eventual future.” Odlum was bullish on America, as many of us are and should be. But he put money at risk only when the odds seemed right – when the investment has a price tag low enough to afford a margin of safety.

The silver lining of the Great Depression was of course, the prevalence of low price tags. Thankfully, to a lesser degree, it is the silver lining of our Great Recession.

Well, here we are, in the beginning of March 2009, and again in the grip of financial panic and fear. So many of you have spoken to me about what “they” say–”they” being what we all read and hear. And of course, none of us are immune to what “they” say… The “they” being media, experts and our own intelligent and informed friends. In no way does this minimize the obviously serious issues the global economy faces; however, it had me thinking about how those predictions have turned out…

Some Predictions

Let’s start in the late 1990’s with the internet boom and dot com stocks… remember that? No one would leave their house, we would all be “telecommuters.” We all know how that ended. But, in 1999, gold was $250 an ounce and oil was $10 a barrel. Did they talk about that? Gold recently hit $1,000 an ounce and oil hit $150 per barrel during summer 2008.

Then came Sept. 11th and the subsequent anthrax scare. Everyone said we would have multiple terror attacks coming and I’m sure a few of you bought duct tape and cipro for the coming biological/anthrax attack.

Next up was the ongoing bear market in stocks, that started in March 2000 and ended around March 2003. By that Spring, everyone knew stocks would keep going down and bonds/money market were the best investments… stock markets doubled from there!

Let’s see what’s next? Oh, of course, real estate! Remember all the t.v. shows, flip that house, etc. lines of people camped out overnight in Miami and Las Vegas, to get a ticket for the privilege of paying over asking price for a house/apartment…

Well, how about summer 2008 and oil hit $150 per barrel and gas $4 per gallon… they knew oil would be $300 and gas, $8! Remember that? Remember the Hybrid Toyota Prius, people waiting months and paying thousands over list price to get one… dealer lots are full of them. As recently as the beginning of this year, oil touched $25…

So, that brings us to today’s fear, panic and “end of days” talk, all of it with urgent certainty… hmmm let’s see….

Remember… no hard landing, and emerging markets will “decouple”? Remember the idea of what we call a soft landing–the economy will have a soft landing, and not a hard landing? Much of this analysis is just a sales pitch. Those are my thoughts on “they.” Thank you.

The title of this memo, as investors, says it all! It is audacious to be hopeful, these days, for anything. However, this is exactly why we must begin to adjust our thinking.

While we can’t know what will happen we can at least observe. With that in mind, we’ll observe the period from 11/20/1998 to 11/20/2008. The total return for that period matches the period from late 1928 to 1938! An annual compound loss of (2.58) or a cumulative loss of 23%; dividends included. By this calculation and observation, the stock market may have already discounted a 1929 –1933 type depression.

It is hard, even in our media-hyped fear mongering modern world, to envision that future circumstances would produce a depression with a total earnings wipeout and unemployment soaring to 25%.

Compare the current financial crisis to the war years: 1938-1942

Keeping in mind that the stock market deals with the future and what might happen while the news deals with what has happened, let’s look at the war years 1938 to 1942.

From the time global war was visible in 1938 to the blackest days of 1942, when the risk of losing the war was the greatest, the U.S. stock market fell 60%. This compares to a 52% top to bottom decline 10/09/2007 to 11/20/2008.

Some facts:

• 430,000 American lives were lost in that war.
• Between 50 and 72 million civilians/combatants were killed in that war.
• From 1939 through 1942, Germany and Japan were winning the war, perhaps soon to occupy and control the Pacific Rim, Europe and the Americas, including the U.S.
• In Europe, only England and Russia were not occupied and London was being bombed nightly.

From the actual start of the war in the Fall of 1939 thorough the critical turning point in 1942, the U.S. stock market fell 44% compared to the recent 52% decline. Now, some perspective, does this imply the risk of life, fortune, freedom, future prosperity and well being is greater now than it was back then? I think not.

• Is there any real risk of being ruled by foreign despots?
• Is there now the real risk of total confiscation of personal assets and wealth?
• Are our very lives now at risk?

To say today’s stock market risk factors are the greatest since the depression is absurd.

As a model for the current crisis the great depression does not stand up to even a cursory examination.

Catastrophic policy mistakes following the 1929 stock market crash

Two catastrophic policy mistakes transformed a severe economic downturn following the 1929 stock market crash into a deflation depression:

• General adoption of aggressive trade protectionism – There are no significant pressures now
• Federal Reserve allowed both widespread bank failures and a severe contraction in money supply, exacerbated by the gold standard.

It is clear from the speed, scale and radicalism of the Fed’s ongoing response to the “credit crunch” that they intend to not repeat that mistake. Clearly, they have learned something; with a different set of consequences that we’ll cover in 2009.

Other differences between the current financial crisis and that of the 1930s

There are other crucial differences with the 1930’s. Most bank deposits are now federally insured. Government spending forms a much larger part of the economy and significant components of it automatically rise if the economy declines. These “automatic fiscal stabilizers” are much larger than they were then. Furthermore these factors are replicated across the global as fiscal stabilizers exist in every economy now and bank deposits are widely protected.

Looking beyond

So this leaves us, like the stock market, looking forward to 2009 and beyond, looking to the “audacity of hope” and what can surprise us.

• The new president and leadership from Washington
• So far, crisis responses have been monetary. For 2009 they will be fiscal; evidenced by the President elects plan to create 2.5 million jobs. This is been repeated around the world.
• A plan to end the Iraq war
• Much lower interest rates
• Much lower fuel prices

While 2009 will have news headlines almost too unbearable to read, as investors, I am hopeful we have much to be optimistic for.

Today we are going to speak about what has been going on in the stock and bond markets here in October and November of 2008. What is going on is what I call liquidation sales.

When a store (or any other business) closes its doors and all assets are sold/auctioned off; it is called a liquidation sale.

These sales, sad for the seller, create opportunity for the buyer. Seasoned shoppers – those who are knowledgeable about what the merchandise being liquidated ‘usually’ costs – become excited about finding and buying good, quality items at deeply discounted prices.

Rarely does someone else’s liquidation sale prompt us as consumers to liquidate our own holdings even if we might have paid more for the same or similar assets in the recent past.

Quite the opposite – If we have the cash, we buy more. Liquidation sales are always for cash.

Investors join the selling frenzy

These recent weeks have witnessed many investors having exactly the opposite reaction to liquidation sales of financial assets. They are drawn to join the selling frenzy, rather than look for bargains to buy. Irrational behavior at its most obvious.

The liquidation sales have been made by various holders of financial assets – Investment banks, banks, hedge funds, investment funds, etc…

These holders are either going out of business due to excessive debt or forced to shrink the size of their portfolios due to customer defections.

Forced sellers must sell, usually at any price!

“Real money” investors are never forced sellers

All Pension Partners LLC clients are what I consider “real money” investors.

A “real money” investor:

• Owns the investments outright, without debt
• Has a longer-term time horizon
• Has good liquidity (cash) in the portfolio.

The above ensures that you are never a “forced seller” or forced into a liquidation sale.

It is strange to observe that many investors who hold diversified portfolios of financial assets suddenly feel a need to compete with the forced sellers in a crowded marketplace – thereby forcing prices even lower!

But that is exactly what happened in early October through November of 2008.

Bulk of the decline likely behind us

Many of you have asked me, “Is it over yet?”

Though there are no shortages of opinions about this, nobody really knows the answer.

I do know that the top to bottom decline of the S&P 500 from the 10/09/2007 peak to the 10/27/2008 recent low was about – 46%. This ranks the decline as the third biggest decline in the post WWII era.

No decline has been greater than 50% in the last 65 years. Not one.

This suggests that the bulk of the decline is behind us, not in front of us.

Central banks and governments around the globe are fighting the financial crisis and in January, the country will have new leadership.

It is not the time to join panicky sellers.

Eventually, fears subside, and the focus shifts back to fundamentals and values.

What else do we know?

Risk assets in the U.S. and throughout the world are cheaper than usual, because prices have declined so sharply during 2008.

By virtue of this cheapness, we believe the probabilities of favorable financial outcomes for today’s buyers of financial assets are much improved compared to most times.

We have the same belief for current holders of financial assets.

I appreciate your time - and in our next segment, we will be speaking about the “Lost Decade,” the decade from 1998 to 2008.

Today’s topic is Role Reversal: It’s my belief that 21st Century Income will require new ways of thinking, new ways of positioning and organizing investments… and many “Old Rules” will be discarded or even turned inside out.

New rules are reversal of old ones

One of these is the idea that as you approach retirement, you assign an increasing percentage of assets to fixed income or cash-like investments. This idea has been outmoded for years. Almost everything that made it work has changed and the changes have created a new, significantly different reality. The new formulas will be a reversal of the old ones.

Three generations ago, “retirement” was a fairly exotic concept. For the last generation (those in retirement today), retirement became an expectation. Social security and corporate pension plans combined in a new system for supporting retirees.

Personal investments were a distant third as a source of retirement income. With life’s basic needs provided for, protection and predictable income took precedence over growth in personal portfolios.

Most factors that drove that conservative process have changed. As people today approach retirement, institutional sources of retirement income are diminishing to insignificance!

To heighten the rate of change, life expectancy is extending the number of years that require retirement assets. The cost of living well—especially the cost of quality healthcare—continues to escalate.

Individuals must be own pension fund managers

So, what’s the new truth about funding retirement? In a role reversal, individuals must now assume the responsibility for providing the bulk of retirement assets. They must be their own pension fund managers and pursue returns via the same strategies used by institutional investors.

This means multiple income drivers…a fancy way of saying income from many sources… interest, dividends, rents, oil, gas, etc.—all non-correlated, all diversified, and many having built-in inflation protection.

You’ll need to provide a consistent growth rate that is substantially higher than the rate of inflation to protect against outliving your money.

How do we do this? By thinking in units of currency, as opposed to Dollars, “New Money” in the 21st century. That is our next discussion.

Hi. Thanks for tuning in to 21st Century Income. Today I’d like to speak about the falling dollar and the possible coming re-valuation of the Chinese currency called the yuan. Let’s talk about those as they relate to generating income. If you are at retirement age and you have built up a sum of money and you are now going to try and turn that money into income, how does that affect you?

We have the dollar falling in international markets. It’s falling in international markets because of many complex reasons, but at least the closest cause is a lot of what’s going on with sub-prime mortgages and financial issues in the US. That had caused the Federal Reserve to make its first interest rate cut last month. The consensus is that the Federal Reserve will have to continue to cut rates to assist the economy in healing all the various mortgage issues. That, of course, does not bode well for the value of the dollar internationally and that’s why the dollar’s falling.

How does that affect savers?

Now, when the Federal Reserve cuts rates, it affects the most—let’s talk about income, if, again, you are at retirement age or in retirement and you’re generating income when the Fed cuts rates. Most people are savers and most savers live on what’s called the short end of the yield curve. For us that means money markets, CDs, checking accounts, things like that, bonds. Those instruments are most affected when the Federal Reserve cuts rates. The effect of that is when you go forward you will earn less interest income.

Falling dollar leads to higher inflation

The falling dollar, also, in international markets has other implication, one of which is that China, whom we import a large amount of goods from, may be revaluing their currency upwards to the United States. That means, of course, that those imported goods will now become more expensive. You can see imported goods becoming more expensive in things like oil, whose price has gone up simply because we import so much oil. As the dollar goes down, the people who export the oil have to be paid more just so they can be paid the same.

You have these twin jaws: lower interest income, higher inflation. It is effectively a war on savers—again, savers being people who live on savings accounts, CDs, checking accounts, short term bonds. In the 21st century, or in terms of generating 21st century income—what it’s going to be about is, how do you profit from these? How do you make profit from these changes? These are major structural changes that are going on both inside and outside the United States. Our job, as people who generate income in the 21st century, is to make a profit from that.

How do you manage your money in light of the falling dollar?

Generating this income, I think, in the future is going to be less about how much you have and more about how you actually manage it. In the old days you could have a certain amount of money. You used to be able to go the bank and, maybe, make eight or nine percent on that money—there was a time, even ten percent—and not take any risk. So now, of course, that’s not the case. You can’t make that. You can only make, maybe, three or four percent and this is going down, while inflation is going up, which means the amount of goods and services that money buys is getting less, becoming less.

The challenge is going to be to take those old rules, things like rules about risk, rules about time horizons, and rules about how you properly manage an account or how you manage your money for income, and to disregard them. Those rules don’t apply anymore. In fact, they are dangerous if followed. It is kind of like how there was a time when people thought the earth was flat. Well, now we know that it’s not flat. What I’m saying is that in the 21st century, how you manage the money you have for income and how you generate the income will be more important than exactly how much you have. Thank you for tuning in.

Hi. Thank you for tuning into 21st Century Income. Today we are talking about what we hear in the news called the subprime “mess,” the subprime “fiasco,” mortgage “meltdown,” and the many fixes that you are seeing on TV, put forth by the president or Treasury Secretary Paulson. So without taking too much of our time talking about how we got to this place, suffice it to say that the simplistic reason is that for the first time on any grand scale, you have the people who lend money being separated from the people who are actually going to pay that money back.

Securitization allows banks to disregard repayment of loans

In previous times, when a bank lent money, the bank cared deeply about whether they were repaid or not. Today, in the modern world, we have something called—a process—that’s called securitization. Securitization means that the bank makes the loan and then the bank sells that loan off, packages it up with other loans and sells it off to investors. When the bank completes that sell, they have now been paid back. What actually happens to that loan—and whether the borrower can actually afford it or not—is really not of consequence to the bank, certainly at the time they made the loan. What we are learning now is that it may in fact have consequences for them.

How can we be opportunistic?

What I want us to focus on, as 21st century investors: how can we be opportunistic? What’s obvious is that we live in a time of great turbulence, financial turbulence, and a time of many financial excesses. As a result of those excesses and the turbulence that comes from them, it creates opportunities and it creates chances for good investors to be opportunistic.

If you recall and you go back and look at some of my previous blogs, if you are a 21st century investor, what that means is that you have to think in terms of decades. You have to think in terms of, how do I build a stream of income that is going to last me for many years into the future—what might be decades.

Think like a ‘real money investor’

That immediately makes you start to think, or should make you start to think, like what we call a ‘real money investor’. What’s a ‘real money investor’? A big pension fund, insurance companies, endowments, people like Warren Buffet. It means people who are not buying with borrowed money. People who are buying with long-term time horizons. As a result of this turbulence, there are great investments to be made right now that will bear fruit three years from now, five years from now. That’s how a real money investor thinks. That’s how a big insurance company or a big pension fund thinks.

In the 21st century, generating 21st century income means, you have to be opportunistic; it means you have to have very flexible thinking. And it also means that you need to think a little bit differently. By thinking differently, it means—when you have a very long term time horizon, you can make opportunistic investments.

Portfolio lenders do not engage in securitization

So there are very, very interesting finance companies, interesting banks, small banks (Banks that were doing this whole securitization were many of the big banks, the household names that you know.) But the smaller banks, the banks you might see in your local town, small community banks, which are called portfolio lenders—being portfolio lender means that they don’t actually sell those loans. They keep those loans on the books. Kind of the old-fashioned way, so to speak.

Investing in portfolio lenders is great way to generate income for future years

Now, one of the consequences is that as everyone has become scared of subprime, scared of CDO (Collateralized Debt Obligation), all these acronyms, they of course have sold all the stocks of all the banks. Many of the smaller, regional banks have very good dividends, dividends in the range of four, five, six percent with a history of increasing dividends. Remember, 21st century income—you have to generate ever-increasing income for years out into the future. Well, what a great way to do that—by opportunistically buying very, very conservative, well-run banks that have a history of increasing their dividends, whose stock prices have been absolutely decimated because we live in a very fast-paced world, where as soon as there are any of these disturbances, pretty much everything gets sold immediately.

Cost of money for portfolio lenders will decrease

Let me go back to being opportunistic and thinking. One of the consequences of this whole subprime, CDO dislocation, for lack of a better word, is going to be, rightly or wrongly, a lowering of interest rates. A lowering of interest rates means that what’s called the yield curve—shorter rates versus the longer rates—becomes more positively sloped; it looks sort of like a hockey stick. Banks lend money long term, and their cost of money is a short term rate. So what is going to happen is as the short term rates go down, the banks are going to be able to make more money going forward. If you think about some of these smaller banks we are talking about, these regional banks, they are going to have a lower cost of money in the future, in the very near future. Their cost of money is going to go down. The rate that they are going to charge is going to either stay the same or perhaps even go up because some of the bigger banks might be pulling back in some of these various mortgage-lending areas. It’s a great way for portfolio lenders to step in and provide loans, provide liquidity.

So being a 21st century investor, thinking like a real money investor, you can think opportunistically about acquiring some of these companies at what I believe, three or five years from now, are going to look like bargain basement prices. These are companies, banks that have a history of increasing dividends, that are conservatively run. You can put them in your portfolio and enjoy those dividends for many, many years to come. That’s one example [of strategies to generate retirement income]. We will be back with more. Thank you.

Hello and welcome to 21st Century TV. I thought for today’s talk we’d have a history lesson. The history lesson is this: There is a woman named Ida Mae Fuller of Vermont. She was the very first Social Security recipient—she received check 001. This was in 1940 and it was for about twenty two dollars per month. Ms. Fuller lived to be one hundred years old so she collected Social Security until the age of one hundred. Now, why a little history lesson today?

First baby boomer takes social security

Because something very important occurred about three or four weeks ago. Three or four weeks ago, a woman who is considered to be the very first baby boomer—I know some of you might be laughing that someone actually has that distinction but she is considered to be the first baby boomer—she took her Social Security. She qualified; she applied for it, at age 62.

Think about this. Ms. Fuller, who retired in 1940, lived to be age hundred, and now we have the first baby boomer. There are tens of millions of baby boomers. The first one took Social Security at age 62.

This is important because there is this huge demographic tsunami. All of these people are now going to begin to take Social Security. It has, of course, lots of implications for things like inflation, interest rates, etc. But what we are really focused on here today is, how does this relate to managing money and managing money in the 21st century? Someone like Ms. Fuller who retired in 1940 likely had her money in a bank account and just lived off of the interest.

Living off interest doesn’t cut it anymore

Today those old rules not only don’t work, because—think about if a bank account pays four or five percent. That means that every million dollars generates, maybe, forty or fifty thousand dollars of income. So, the old rules not only don’t work but, in fact, in many ways hurt people.

Because preparing for a 21st century retirement means that you have to prepare the money to deliver income for decades—for, literally, decades you have to have a growing stream of income—it’s going to require a very, very different point of view. It’s going to require different ways looking at old rules and different ways of assessing risk, one of those risks being that the income is going to have to provide for many decades. It’s going to be not only as much about how much money you actually have but, I think, in ways it’ll be more about how do you actually manage that money. How do you actually manage income from the money that you have? That’s something that we are very much focused on here at 21st Century Income.

Thank you for tuning into 21st Century Income TV. What I want to talk about today—I read a very interesting editorial in this week’s Barron’s. The editorial spoke about extending Social Security benefits—meaning taking Social Security at the last possible moment as opposed to taking it at the first chance, which is at age 62. I’m going to relate that to a product people often hear about called annuities. So, let me explain.

Often, we hear about annuities, buying deferred annuities. The argument for buying a deferred annuity is that the income that you earn is tax-deferred while you are working or until age 59 and a half. But what it’s really presented as is a way to convert the balance into lifetime income from the insurance company.

So what really happens when you buy an annuity?

What happens when you buy an annuity is you are saying to the insurance company, “Here is my money,” and you are giving up control of that money in exchange for the insurance company paying you at some future date a sum of money for as long as you live. That’s actually quite similar to Social Security: Social Security pays you an income for as long as you live.

So why buy an annuity?

So one of the things we have been thinking about is that these annuities, deferred annuities, are, of course, quite expensive. There are quite a number of various fees built into them. You are giving your money to the insurance company in exchange for getting this lifetime income; the cost of that is quite a lot of fees.

We’re thinking here, in working with clients, that maybe you need to restructure or rethink your personal investments so that when you retire—let’s assume you retire at age 62—so at age 62, your personal investments are structured in a way that will give you the level of income you require to not take your Social Security. Doing so, you are able to hold off taking Social Security until the last possible moment. The benefits could be as much as a third higher than if you retire at age 62. So by doing that, you are increasing your retirement benefit later.

If you recall, one of the things we always talk about here on 21st Century Income is dangers, strengths and opportunities of living in retirement in the 21st century. The biggest danger is that you may live for many, many decades and you are going to need a very high sustainable source of income that goes out well into the future.

A way to do that in a cost-effective manner could be to delay taking Social Security until the last possible moments. That requires you, of course, to rethink your investment program between the age of 62 and the age you take those social security benefits. Thank you.

Hello, and welcome to 21st Century TV at 21stcenturyincome.com. The topic today that I am speaking about is the definition of risk. Whose definition of risk—the mutual fund manager’s or yours?

So oftentimes when I am out lecturing and speaking to clients or pension plan clients, I’m talking about “21st century income.” “21st century income” means that you have to generate income from your investments for many years out into the future. Many years out into the future has many dangers, many strengths and many opportunities.

A mutual fund manager’s definition of risk:
Deviating from the benchmark

One of those dangers is this disconnect between the person who has the money—you—and the person who is managing the money—either a mutual fund manager, an investment manager, or an investment advisor—and how they are defining risk compared to how you are defining risk. Let’s talk about a mutual fund.

How does a mutual fund define risk?

Let’s say that you have a four- or five-star mutual fund. Four or five stars would mean that it has very good performance—has a very good past performance. That manager is going to be judged against what’s called a benchmark or an index. For golfing, we would call it par. That’s how they will be judged.

If that manager should decide that they need to deviate from the index or they want to deviate from the index perhaps because investment conditions might dictate that, they have a risk. The risk is that they may underperform the benchmark, underperform the index. If they do that, all sorts of mostly bad things happen. The fund could perhaps lose some of its stars. If it loses its stars, it may lose assets. Assets equal paychecks for people who are managing the funds. The marketing department of the fund will come to that manager and say, “You really can’t do this because this is not what we are out promising our investors.”

An individual’s definition of risk: Losing money

The mutual fund manager when considering risk lives in a very different world than the world of the individual. The individual—and we have many years experience working with clients and I think I can say for all of them—defines risk as losing money, as losing significant amounts of money. When you are in the income mode, or “disinvesting” mode, as opposed to accumulation mode, significant losses of principal have really catastrophic effects on the amount of income you can generate in those future years.

It is a really, really important topic to understand who has what risk and who is defining what risk is for yourself and, of course, for the mutual fund manager or the investment advisor. If you ask pretty much any mutual fund manager, or call up the fund or look at their reports, you’ll see that there are lots of charts, lots of things that discuss risk, but none of them really discuss the real risk of losing money. And the real risk of losing money also from unforeseen events. That’s going to be a future subject called black swans and white rhinos. Thank you.