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James R Derrick CFA Archives - Page 4 of 4 -

“The Most Powerful Force in the Universe”

By | 2013, Newsletter, Viewpoint | No Comments

Those who understand interest, receive it. Those who don’t, pay it. As investors, we believe this and we strive to go one step further. We seek to get paid interest on our interest. We call this compounding interest.

Albert Einstein called compounding interest “the most powerful force in the universe” and “the eighth wonder of the world.”

It is this mathematical force that has driven the Dow Jones Index to new highs and to over 15,000 this year.

Like everything in life there is a catch. It takes time to achieve compounding interest and it involves uncertainty.

Time

One of the first questions we ask investors is “What is your time horizon?” In other words, “When do you plan to spend this money?”

This is critical because it may take some time to realize the benefits of compounding interest. On June 30, 1993 the S&P 500 was at 450. Fast forward one year and the return was negative 1 percent. Move forward ten years and the total return was 116 percent. Twenty years later, in 2013, the total return was 256 percent!

It pays to be patient with investments. It pays to keep a long-term perspective.

Uncertainty

The stock and bond markets do not travel in straight lines.  There are days when they rise and there are days when they fall. If we don’t accept the uncertainty, then why would we expect to receive a reward.

As investors, we must accept some risk and we believe that over long periods of time, these markets will reward us.

In the last 50 years, the S&P 500 has gained 2,215 percent. Despite this fact, the market was positive only 42 percent of the months. That sounds like a frightening outcome, but the average return for all months was still a positive 0.6 percent.

The good news is that the longer the time period, the more likely an investor is to achieve growth. Positive returns occurred in 53 percent of the years, in 60 percent of 5-year periods, in 80 percent of 10-year periods, and in 100 percent of 20-year periods.

What can we expect in the future?

I believe there is still room for growth. I believe potential for improvement in technology, housing, energy, and employment could fuel this growth.

I expect that the further we look in the future, the more likely we are going to see opportunities to compound returns.

I believe the Dow Jones Index, which currently is flirting with the 15,000 level, is likely to reach 30,000. In my mind it is not a matter of if, but when.

What does all this mean? As we like to say at SFS, “Now is always the best time to invest.”

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Lessons of the Bitcoin

By | 2013, Executive Message, Money Moxie, Newsletter, Viewpoint | No Comments

Bitcoin is a new form of money. It is 100 percent electronic and it just exploded in popularity. In just 6 weeks a Bitcoin went from $25 to $250. What an exciting time for Bitcoin speculators. Why even question it? This is a new electronic age and the possibilities are endless.

Not so fast! On April 10, 2013, the Bitcoin imploded. In just a few hours the value of a Bitcoin fell from $266 to $76.

What is the problem with Bitcoins? Where do we begin? The synthetic currency has no intrinsic value. It represents ownership of nothing. It is not backed by any government. It is not a commonly accepted form of payment. Its owners could be hacked and robbed, or it could be replaced by a more popular made-up currency. The Bitcoin mania may turn out to be one of the most spectacular bubbles of all time.

The term bubble was first used in the early 1700s to refer to wild price fluctuations associated with the “South Sea Bubble.” Another famous episode was the Dutch tulip mania of 1637. In recent history, we have survived the dot com bubble, the real estate bubble, the oil bubble, and possibly the gold bubble.

Why are we so prone to pricing bubbles? Will they ever end?

Greed: The idea that $100 could turn into $150 tomorrow creates fans. That excitement leads them to forget that it is one of the most volatile ways to gamble. Given that it has no real value, it may be more likely to fall 50 percent than rise 50 percent.

Conformity: When opinions converge on an incorrect idea, we call it groupthink or herd mentality. When money is involved, we call these bubbles, and they are dangerous because they can be costly.What should we watch for when trying to detect a bubble?

(1) Insane predictions (with or without good explanation)

(2) Excessive attention as too many people discuss and act like experts

(3) Repeated use of the phrase “this time is different”

(4) Deviation from normal supply and demand because of manipulation

The U.S. stock market has had a string of new highs over the last few months. This in and of itself is no cause for alarm. Hitting new highs is exactly what stocks are supposed to do. That is how investors make money. (Read “Patience is a Rewarding Virtue” from the  previous issue of the Money Moxie.)

How do we know if stocks are in the process of forming a bubble? There are a few simple reasons why investors should not be overly concerned at this point.

(1) Stocks represent ownership of real companies that have value and can grow in value

(2) Valuations of companies compared to earnings are near historical averages

(3) Fundamental improvements in the economy are taking place that support a rise in the market

Bubbles involve a high degree of risk. One way to avoid unnecessary risk is to watch out for investments that don’t have real value or have deviated too far from their true value. Those values are derived from how much the next person is willing to pay.

On the other hand, stocks market gains can benefit everyone who participates. Stocks represent ownership of something real. Time has shown that carefully investing in a diversified portfolio can yield positive results over time.

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Patience is a Rewarding Virtue

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What 50 Years of New Highs Looks Like

We have all been taught that the way to make money investing is to “buy low and sell high.” This makes perfect sense, but it is so much easier said than done. The danger in “buy low and sell high” is that it encourages investors to take active risk that may be contrary to their long-term goals. Most investors would do better following a more patient mantra.

Consider the recent highs in the market. On March 5th, 2013, the Dow index closed at a record level: 14,253. The S&P 500 index hit its high on March 28th, 2013, with a close at 1,569. These highs are only exciting to those participating in the growth of the market.

Some may see new highs as a signal to increase risk, others as a reason to decrease it. Keeping in mind that past performance does not guarantee future results, here are some answers to questions asked by the media when such events occur.

Do the new highs matter?
Yes! How else will investors make money? Making new highs is exactly what the market is supposed to do. Sure it doesn’t happen every day or even every year. It took these stock indexes 5½ years to reach their previous highs set on October 9, 2007.

Over the last 50 years, the S&P 500 hit new highs 714 times. It falls frequently, but the long-term trend is up and that is the way it should be.

Can we say that what goes up must come down?
There is always a reason for a rising market, and so a new high is often followed by more highs. The positive momentum and good news often have continued. The average return following a new high is positive for 1, 2, 3, 6, and even 12 months following the high.

Is this time different?
The current bull market is celebrating a birthday this month. (The current bull market began on March 9th, 2009.) It is turning four, which is a long time for a bull to run on Wall Street without interruption.

What could stop the bull?
Consumers are once again financing spending through debt. Their savings have fallen to just 2.6 percent of their income. (See cover story for details.)

Low savings equate to high spending. This is only good over short periods of time. A market rise that goes with it cannot be sustained forever. Eventually, consumers will reach a limit on how much they can borrow and spend.

Human nature is also a constant in the investment world, and it often leads to an over-inflated market as investors become overly optimistic. If it leads to inflation, the Federal Reserve may choose to send interest rates higher on debt.

Are there signs of overheating?
Consumer spending trends may be headed in the wrong direction right now, but they seem far from overextended. In fact, household debt is at historically good levels—the best in over 25 years.

Inflation could become a major concern, but it isn’t right now. North America is on its way to energy independence, possibly by 2020. Take a look at the price of natural gas on your winter heating bills. Prices have been low for energy.

Everyone is beginning to love stocks again. This is a good sign and a reason for caution. Just remember, patience is a rare virtue in the market, and if you have it then you should expect to do better than average. Of course, there are no guarantees.

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Elections Over. Fiscal Cliff in Focus.

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Stocks started 2012 with solid gains and then added to them during the year. Most major asset classes made money during the year.
Despite being three years into the current economic recovery, stocks and many other risky assets started 2013 with a bang. Small cap stocks, international stocks, and high yield bonds have been particularly good thus far. Resolution of the Fiscal Cliff was clearly the initial factor, but there are other fundamental contributors to current optimism as well.  The following data points are available from the Federal Reserve Bank of St. Louis.
• Oil production continues to grow within the United States thanks to hydraulic fracturing or “fracking.” Natural gas production, which is growing from the same process, is also likely to continue at its elevated levels. This industry has provided jobs to approximately 50,000 workers in the last three years and is still increasing its employment numbers at a rate of 6.5 percent.
• The growth in the supply of natural gas and oil has also provided lower energy costs for consumers and manufacturing. After 10 straight years of job losses in manufacturing, this industry is now experiencing three years of employment growth around 2 percent.
• Consumers are in a better position to increase spending and saving. Household debt is 10.5% of disposable income, which is the best level since the early 1980s.
• The housing market is improving. Prices of existing homes rose over 4% (Case-Shiller 20 City Index) in the last year. Housing starts and permits are each up 20%.
• Even after the recovery began in 2009, state and local governments were reducing their work force. This placed a short-term drag on the economy by reducing consumer confidence and spending. Half a million workers lost their jobs. Now it appears that many of these governments have their fiscal house in order.
The hemorrhaging may have run its course. The negative factors may now turn positive.
• Inflation, measured by CPI, is just below 2 percent. This will provide the Federal Reserve the flexibility to continue to focus on stimulating the economy in order to create more jobs. The efforts of the Federal Reserve are certainly a large part of the current recovery and will likely continue to play a role in 2013.
Of course, all this opportunity for growth comes with a price. Investors don’t have to love risk, but they do have to live with it. It is a tool to be managed carefully in order to participate in the long-term benefits of investing.
Many of the positive factors that drove the market upward last year are still in place this year. Indeed, the current year started off with a similar jump as that in 2012. While history will not repeat itself exactly, hopefully it will rhyme.
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Celebrating 100 Years of Taxes!

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Dear Valued Clients,

Motivating the citizens of the United States to pay their Federal Income Tax has always been a struggle. Various strategies have been implemented over the years to improve tax collection. Some meant to force tax payers and others to encourage them.

The first income tax in our nation was enacted by Congress in 1862 to help support the Civil War. (Blockades against the ports of the North limited supplies and cut off tariffs.) President Lincoln himself paid $1,296 in 1864 for his income tax. In order to encourage ordinary citizens to pay the government made tax returns public. Americans were encouraged to turn in those they suspected of not paying their fair share.

This Civil War Era income tax was removed ten years after it began, only to be brought back in 1894 until the Supreme Court voted in 1895 that it was unconstitutional.

In 1913, Congress passed the 16th amendment of the U.S. Constitution. This new law created the first permanent income tax in our country. At that time, the highest rate was 7 percent. Five years later the top bracket was at 77 percent. (See the full history of the top brackets in the graphics on pages 3 and 4.)

By the time World War II came, the nation had a serious problem with deficits. Congress was not about to make tax returns public. Instead, the nation turned to Donald Duck who explained to Americans their duty to pay the government: “Taxes to bury the Axis.”

Today, most of us might relate more to Arthur Godfrey who said, “As an American I am proud to pay my taxes. But I’d be just as proud for half as much.” Nevertheless, our nation needs us and so, taxes are here to stay. I hope you enjoy this issue of the Money Moxie® as we “celebrate” the 100th anniversary of the U.S. Income Tax.

James R. Derrick
SFS Chief Investment Strategist

Source: David Kestenbaum, “From Abe Lincoln to Donald Duck: History of the Income Tax,” NPR, 3/22/2012.

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