"A Foolish Consistency is the Hobgoblin of Little Minds" - Ralph Waldo Emerson

Psychologists have uncovered a fascinating phenomenon about people at the racetrack. The moment after placing their bet on a horse they become much more confident of their horse’s chances of winning than they were immediately before placing their bet. Is it possible that the very same thing happens the moment we invest in a stock or a mutual fund?  

In his book entitled Influence, Robert Cialdini says that the need for consistency “lies deep within us directing our actions with quiet power.” It is quite simply our nearly obsessive desire to be (and to appear) consistent with what we have already done. Once we have made a choice and taken a stand we will encounter personal and interpersonal pressures to behave consistently with that commitment.” 

In this increasingly busy, networked world, information could easily overwhelm us if not for automated responses. They offer us “shortcuts through the density of modern life” according to Cialdini. “Once we have made up our minds about an issue, stubborn consistency allows us a very appealing luxury: We really don’t have to think hard about the issue anymore. . . . We need only believe, say, or do whatever is consistent with our earlier decision.” Sir Joshua Reynolds put it this way, “There is no expedient to which man will not resort to avoid the real labor of thinking.” 

But even more troubling according to Dr. Cialdini is the second and more perverse attraction to mechanical consistency. “Sometimes it is the cursedly clear and unwelcome set of answers provided by straight thinking that makes us mental slackers. There are certain disturbing things we simply would rather not realize.” He goes on to say that preprogrammed, mindless automatic consistency can effectively barricade us from the sieges of reason and reality we don’t want to face.

Last Sunday there was a fascinating article in the Wall Street Journal on a phenomenon which occurs among stocks that could be explained by the theory of automatic consistency. The article by Russell Pearlman, entitled Dead Stocks Walking illustrates the surprisingly large number of large company stocks that have provided no returns (or losses) for their investors over a full decade despite fundamentally good earnings performance. Blue-chip companies like WalMart, Cisco, General Electric, Pfizer, Merck, Amgen, Medtronic, Intel, Microsoft, Ford, Dell, and Time Warner. These are industry-leading companies long held by widows and orphans and hundreds of mutual funds. Pearlman adds up the market capitalizations of the 30 worst performers to find that a staggering $2 trillion has gone nowhere in a decade.

Pearlman attempts to explain why individuals and professional portfolio managers alike would tolerate such lousy performance for such a long time. One reason he thinks is the old buy-and-hold strategy, proven effective by experience. From 1980 to 2000, the average annual return for the 100 biggest U.S. stocks was 62%. Pearlman says “that wasn't a fluke of the calendar, either. Indeed, during any 20-year period from 1970 to 2010, investors saw large-cap stocks' average annual return rise 13%. Managers interviewed by Pearlman said they have no intention of changing their buy-and-hold strategy. They say “investors get into trouble when they change their stripes or discipline.”

Wall Street analysts consistently like the big guys too. Pearlman notes that as many as “13 pros had buy ratings on [WalMart] in 2004, and a near-equal enthusiasm can be found among securities analysts in virtually every quarter since. (Only one of them, during this stretch, has slapped a SELL on the stock, according to Zacks Investment Research, and even then, the rating lasted a mere two months.”

Another reason cited by Pearlman is that the large-cap category of managers “have no choice but to buy these stocks: There are only so many large-cap equities. Adding smaller names carries a risk, managers say: having their fund no longer classified as a ‘large cap’ fund by Morningstar, Lipper or another ratings firm. These classifications might not matter to individual investors, but they do to financial planners and pension plan administrators looking for a particular type of asset mix.” Hear Mr. Emerson whispering ‘foolish consistency’ yet?  

Still another reason cited by Pearlman is intellectual discipline. Value investors want to buy stocks that seem undervalued relative to its growing earnings and shrinking stock price. As the stock keeps falling they simply buy more (automatically and consistently).  

Take Abbott Labs for instance. Since 2001, Abbott has more than doubled its annual profits, yet its stock price, while outpacing the broad market since then, has essentially remained flat. Rather than being disgusted, though, Robert Zagunis of Portland, Ore. actually likes that he can continually buy the stock. ‘Investors would love to be able to buy a private company that was increasing profits like that,’ he says. But since Abbott is public, ‘you get a weekly, daily, even hourly reminder of what other people think,’ which makes the task of sticking to one's guns ‘more difficult.’  

Whether one justifies behavior with ‘buy-and-hold,’ ‘analyst favorite,’ ‘large-cap allocation,’ or ‘value’ the outcome for the last eleven years has been inarguably painful. Automatic consistency has quite literally stolen wealth, and lifestyle from a huge majority of investors for nearly one fifth of their investing lifetime.

What’s the alternative?  

Change the focus and energy of your life from selecting (or endlessly holding) stocks, mutual funds, and active managers to setting goals and continually evaluating your confidence of reaching and exceeding them. You know your goals and dreams, we can help you marshal your resources (including, but not just your investments) to confidently achieve those dreams.

Using sophisticated probability analysis, we continually stress test plans to determine, based on the latest information, whether they are properly, under- or over-funded to meet their objectives. While we can quantify goals and their timing, we cannot know with certainty what impact the capital markets will have on our assets as we plan to save and spend over our lifetimes. But we can measure the uncertainty and manage it to an acceptable level of confidence, enough for comfort and not so much that you sacrifice today for future wealth you have said you will not need in your lifetime.

We use exchange traded funds which efficiently and effectively capture the broad and diverse capital markets. We allocate stocks and bonds appropriately for each client’s plan to provide sufficient future wealth, with no more risk than is required to maintain sufficient confidence of meeting or exceeding their goals. Our portfolios virtually eliminate the risk of underperforming markets as did the ‘dead stocks walking.’ We also eliminate the risks added by active managers who make outsized bets on under-diversified selections. 

Active managers increase uncertainty in your portfolio, which quite simply translates into reduced lifestyle; working longer, saving more, taking more risk, or enjoying fewer financial rewards in your future. Why risk your future trying to improve on the already sufficient returns of the capital markets? Over the last decade the allocation we use for our Growth model has returned 3.9% per year, while our most conservative portfolio has yielded 5.23% annually, comparing favorably to the ten-year average for the S&P of 2.9%.

We generally value and approve of consistency. But no one wants to consistently do the wrong thing, or even wonder consistently if they are doing the right thing. We help our clients consistently re-evaluate where they are relative to their goals and objectives by controlling what we can in costs and underperformance and by quantifying and managing uncertainty through sophisticated planning. 

Consistency by any other name would be foolish.

“We’ve Never Seen Anything Like This Before”

How many times and in how many situations lately have we heard the familiar refrain we’ve never seen anything like this? Whether the subject is politics, housing, jobs, stocks, sovereign debt, corporate ethics, or American wars, experts find themselves unable to find comparison or remedy. Having no historical frame of reference makes us anxious. We naturally prefer familiarity over the unfamiliarity. We like trends and historical context on which to base our projections. We do not like unproven ideas.

Wednesday, America and the world lost a man who lived his life showing us what we had never seen before. He did not shrink from lack of historical context or supporting trends. Steve Jobs saw beyond uncertainty and the doubt of those around him countless times as he, in large measure singlehandedly, created the world’s second most valuable company. He created completely new product paradigms and he persuaded millions of people to try them, even though they had never seen anything like them before.

President Obama said “Steve was among the greatest of American innovators: brave enough to think differently, bold enough to believe he could change the world, and talented enough to do it. By building one of the planet’s most successful companies from his garage, he exemplified the spirit of American ingenuity. By making computers personal and putting the Internet in our pockets, he made the information revolution not only accessible, but intuitive and fun. And by turning his talents to storytelling, he has brought joy to millions of children and grownups alike. Steve was fond of saying that he lived every day like it was his last. Because he did, he transformed our lives, redefined entire industries, and achieved one of the rarest feats in human history: he changed the way each of us sees the world. The world has lost a visionary. And there may be no greater tribute to Steve’s success than the fact that much of the world learned of his passing on a device he invented.”

George Lucas said, “The magic of Steve was that while others simply accepted the status quo, he saw the true potential in everything he touched and never compromised on that vision.”

As we consider the pervasiveness of Steve Jobs’ legacy, we Americans would do well to adopt his spirit of innovative boldness as we tackle the significant challenges confronting this great nation. Years of economic malaise offer glaring proof that re-treaded ideas born of the status-quo simply aren’t working.

The “spirit of American ingenuity” of which Mr. Obama speaks so proudly, is nowhere more absent than in Washington DC. The century-old ideological war between bigger government and smaller government continues with few signs of innovative thinking. But just as Apple grew to brilliance (twice) under Steve Jobs, it is possible that our country’s leadership will turn toward innovative ideas to spring this economy out of its morass. As voters we should be particularly attuned to those politicians who offer bold new ideas which are uncommon, untested, and apolitical.

A very simple government innovation is this: Replace the 2,500-page US tax code with a one-page simple flat tax that a bright ten-year old can understand. It would remove the ability of Congress to do back room deals with supporters that unfairly re-distribute billions of dollars of tax breaks, it would improve collections and timeliness, it would increase tax revenues as loopholes would be eliminated, and it would free 5.4 BILLION hours of Americans’ time. That time slice equals an entire year of productivity and innovation in the US Information industry. Just one silly little vote guys and you can give us back close to 5.4 billion hours freeing time for life, innovation, productivity, and consumption.

While we continue to innovate incredible new technologies in this country, we build less and less of it here. We have allowed our industry to migrate to countries that offer better deals to our manufacturers. With some creative thinking, government could easily offer sufficient incentives to businesses to keep their manufacturing at home. They don’t’ leave just because labor is cheaper. For instance, the percentage of labor cost in a car is roughly 10%, according to the UAW. Still, that 10% takes a great deal of management time and expense compared to foreign competitors. When total benefits (including pensions and health care for workers, retirees and their spouses) is factored in, GM's total hourly labor costs is about $69, while Toyota's is about $48 according to a report by CBS News.

A service centered economy collapses faster and comes back more slowly than an industrial economy. Consider this; Americans eat 4.8 meals a week in restaurants. If they eliminated just one meal per week at full-service restaurants as many as 1 million restaurant workers could lose their jobs, or 7% of the 14 million people currently unemployed in the US.

Manufacturing jobs in a general sense are less fragile. Things like cars, refrigerators, cellphones, computers, and televisions eventually break or become outmoded and must be replaced. They may not be as easy to give up as a meal out a week. And businesses are not likely to walk away from expensive plants and equipment. Do we really want China to make our best and most innovative technology?

A number of things have to happen to bring manufacturing back to this country and they will require innovation and cooperation on the part of government, business, and labor. Government can consider new and less burdensome regulations as well as incentives that are fair to taxpayers and beneficial for the economy. Businesses can and should make commitments to the communities in which they open plants and form close relationships among workers, schools, and local governments. Unions likewise must commit and cooperate locally, basing negotiations on the local and state economy’s demographics, not irrelevant national data.

This week saw a refreshing change in direction, though modest. Job growth improved more than expected in September by 103,000 following a revised 57,000 rise in August. The ISM Manufacturing index showed that both employment and production picked up while orders in the manufacturing sector were flat. Construction came back in August, mostly from public sector spending, but private components also gained. And the ISM Non-Manufacturing index showed monthly growth in orders with employment contracting.

Steve Jobs leaves behind a rich legacy of creating “bicycles for the mind.” He showed us that humans could go further and faster than ever before if we used our imaginations to find whole new ways of solving problems. Steve Jobs’ life and accomplishments are getting the attention they truly deserve in this troubled time. His story reminds us how important thinking differently has been throughout our history and how vital it is to a better future.

Thank you Steve.

Optimists Could Use Some Good News

There was scant positive news this week offering hope to those still optimistic the US and global economies can avoid a recession. The government’s third and final revision of economic growth (GDP) for the second quarter was revised up to 1.3% from 1%, however still quite anemic. German lawmakers quelled short-term fears by approving an expansion of the euro-area rescue fund which allows European policy makers to focus on next to blunt their debt crisis. They will likely leverage the fund as the US did in its own crisis in 2008. 

But as some hold out hope of averting recession, the darker chorus grows louder. Lakshman Achuthan of Economic Cycle Research said there’s “a wildfire among the leading indicators across the board. Non-financial services plunging, manufacturing plunging, exports plunging.” He went on to say the combination of trends points to at least a couple of worsening quarters ahead.  

Equity markets which look to the future by a quarter or two may be suggesting the same. US stocks attempted rallies each day this week, but finished down three of the last four. The MSCI US Broad Market Index rallied by as much as 6.8% this week on the good news at home and in Europe, but gave up those gains over the past three days as negative data an sentiment seem to be winning out.

 In an historic retreat, according to the Wall Street Journal, investors world-wide during the three months through August pulled some $92 billion out of stock funds in the developed markets, more than reversing the total amount of money investors put into those funds since stocks bottomed in 2009. The withdrawals matched the worst three-month period during the depths of the financial crisis. Last week the Dow Jones Industrial Average suffered its worst one-week decline since October 2008. It is down 16% from its late-April peak.

Bond markets typically look much further than quarters. The bulk of bond buyers are not traders, but investors who are making commitments for years into the future. They carefully assess long-term risks such as inflation and credit quality in their due diligence. The US Treasury market has long been a safe haven for those fleeing the increased risks associated with stocks and has generally been a very good barometer of investor sentiment toward economic growth. Bond prices rise on increasing demand when investors think the economy (and inflation along with it) will slow.  

This time, however, the Federal Reserve in efforts to stimulate the economy and improve employment has dramatically impacted the behavior US Treasuries with its unprecedented purchases of the government’s debt. The first efforts QE1 and QE2 were focused on the short end - 0 to 5 years and the latest known as “operation twist” sells their short term bonds to buy bonds maturing between 6 and 30 years. The Fed’s balance sheet has expanded to the unprecedented level of $2.88 trillion.  

So if Treasuries don’t currently represent true investor sentiment on the economy, the next best thing is municipal bonds. Municipals are like Treasuries in that they are guaranteed by a state or municipality, not a corporation. If investors are worried about the economy, they by association worry more about corporations (stocks) than they do entities able to raise taxes to pay their debts.  

Despite problems at the city and state levels, investors are buying municipal bonds. According to Bloomberg, the $2.9 trillion municipal bond market is headed toward its sixth-straight month of positive total returns, the longest winning streak since 2002. Still, sales are well off of last year’s pace, so it may be difficult to draw much inference from the trend. This year’s municipal sales totaled $165 billion as of Sept. 23^rd, down about 40% from the period in 2010. The fact that Treasury yields are down so much (due in large part to Fed intervention) the tax-free yields of municipals are now all the more attractive by comparison. 

The week’s economic data was not very helpful for the optimistic case. New home sales remain at a nine-month low of a 295,000 annualized rate in August vs. 302,000 in July and 303,000 in June. New home prices dropped in August by 8.7% for both the median ($209,100) and the average ($246,000). On an annualized basis prices had been showing some slight growth, but new data show them down 7.7% at the median 8.5% on average.

The S&P Case-Shiller index is a broader index measuring all home prices across the nation. It showed prices holding steady for the third month through July, but summer is a traditionally strong period for housing demand. The index will likely be negatively impacted by the steep price contractions in new homes for August.  

Amidst declining stock and home prices as well as continued high unemployment, the consumer got some more bad news this week. Wages and salaries declined 0.2% in August after a 0.3% increase in July. Weakness was led by private services while the government component posted a modest rise.

Not surprisingly, consumer confidence is low and declining. According to the Conference Board, fifty percent of the sample say jobs are currently hard to get up 1.5% from August and compares with 44.8% in July and 43.2% in June. Same time, the Bloomberg Consumer Comfort Index dropped to its second-lowest level on record to minus 53 in the period ended Sept. 25^th from minus 52.1 the prior week. Ninety-three percent of those surveyed had a negative opinion of the economy as companies remain reluctant to hire and wages fail to keep pace with inflation according to Bloomberg. 

Worse, confidence in leadership is barreling downward. Global investor confidence in President Obama’s leadership now stands at 57% unfavorable, compared to 55% favorable last May. Perceptions of European leaders including German Chancellor Angela Merkel and French President Nicolas Sarkozy have also turned sharply negative. Scott Troxel, of the Tradition Group in Lausanne, Switzerland, summed it up well when he said “President Obama must get in front of the problems by taking real risk in achieving a bipartisan solution to long-term debt reduction, credible short-term job stimulus, and tax reform that is more clear and thoughtful than a tax on billionaires.” 

Bloomberg recently conducted a poll of 34 economists to determine their thoughts on the possible success of President Obama’s $447 billion jobs plan. On average they think it will help, but considerably less than Treasury Secretary Geithner and President Obama hope. Geithner estimates that the bill will increase GDP by 1.5%, and significantly lower the unemployment rate. According to the survey results, economists predict a median 0.6% growth in GDP next year, and 0.2% growth in 2013, should the bill pass. Median job creation predictions for the bill clock in at 275,000 next year, and 13,000 in 2013.  

A coalition led by Apple, Google, and Cisco Systems is lobbying for a tax holiday on more than $1 trillion in offshore profits. The one-time tax break is estimated to cost the US government $78.7 billion over the next decade, but proponents say the flood of cash has the potential to boost the faltering US economy. However, independent studies found that the last time the tax break was tried, in 2004, the repatriated offshore profits did little to spur hiring or domestic investment. Most of the money was used to buy back stock. Still, with some creative requirements, the idea might be worth a try. A trillion of fuel today for a cost of only $78 billion over 10 years sounds like a good investment to me. 

Barring a surprise from Europe, the next big thing happens on Capitol Hill when the president and Congress spar over the best ways to stimulate the faltering economy. Whether we wind up with the president’s bill, the House’s bill or the group of six’s stopgap bill, chances appear small that credible long-term remedies will result. With confidence low and uncertainty high, Mr. Obama and Congress could do infinitely more to boost this economy if they would turn their focus to reforming old, tired and bad habits, rather than continuing to waste billions or trillions of dollars in short term spending and tax breaks. Can a ‘problem’ fix itself?