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Myers CPA Investment Letters

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MYERSCPA INVESTMENT LETTERS

invest2022-DEC.pdf

Contribution limits: IRA $6,500 (50+) or $5,500 (<50) for 2014 due by 4/15/2015.

Best advice. “For now, avoid over-commitment, don’t be greedy and accept that money will be left on the table. Try steady rebalancing, which involves buying emerging markets and selling the US. This will not be the best option, but it will be among the best.” (John Authers, FT 1/3/2015)

Recommendations for your IRA or other self-directed investment accounts

Wellington Fund (fund #0021). The blinking yellow light is on! The stock market is above its long-term trend line. The Wellington Fund consists of the 100 US blue chip stocks (65%) and a portfolio of quality corporate bonds (35%).
Vanguard S&P 500 Index Fund (fund #0040). This is the big workhorse and will benefit from the US economy being the strongest of the high-valued added economies in the world. Also available as an ETF.
Vanguard World Fund (fund # 0628). This fund is 55% North America; 22% Europe; 14% Pacific; 9 % emerging markets. (This is a good destination fund for a rebalancing strategy away from US equities.)
Vanguard GNMA Bond Fund (fund #0036). Yielding about 2.31% on an intermediate term bond fund (and is closer to short-term). Safe and sane for people who want to tread water for a while!
NOTE: The trend line of 6.3% comes from Andrew Smithers’ FT blog and is the US equity rate of return since 1801 and he shows that this rate has been remarkably consistent over 30- to 50-year time frames ever since.

Market recap. The stock market closed at 2059, a new ANNUAL high. The S&P 500 index is up 13.7% (dividends reinvested) for the year, the third consecutive year the index has risen by more than 10 percent.

Figure 1 S&P 500 index for 2014. Wow! What more needs to be said? (from the NYT)

The world economy

The above chart wins “best picture of the year award” for describing the 2014 economy. Two points: the drop in energy prices is like a big worldwide tax cuts—the most efficient and effective economies will be the biggest winners. Second, the lower oil prices will put downward pressure on price indices and therefore the Fed and other central banks may be slower to raise interest rates in the 2015-2018 time frame. In the US the Fed can get to higher levels of employment before having “to take away the punch bowl.” (As famously described by a former Fed chairman over a half-century ago.)

Interest rates. Gavin Davies on his FT blog indicates—based on superb analyses of Fed information—that the Federal Funds rate will increase from today’s .25% to 3.75% by the end of 2017. That implies mortgage interest rates of 6.5 to 7%, for example. That will (1) slow house price appreciation in the US, (2) create winners and lots of losers in the emerging market world, and a host of other effects. It will also make owning an intermediate term corporate bond fund like the 35% of the Wellington fund a more remunerative proposition in the future—the “balanced” fund will actually have more balance!

Notice – the current market assessment of interest rates—the red dashed line—is below the projection that represents the consensus of the Fed governors! Some market surprises surely are on the way!

Longer term trends

Global climate change is real and will result in a worldwide infrastructure boom centered upon improving energy efficiency over the next two to three decades. The head of a big French power equipment company described the future as 4X meaning a doubling of energy consumption while cutting emissions by half through improved efficiency over the next 30 years. The natural gas boom helps this process as power plants retro-fit from coal to gas.
Worldwide big companies will lead because these firms are the R&D engines for the next two to three decades. Participate in this through both the Wellington fund and the Vanguard World fund.
Emerging Markets and other international markets measured by relative value are cheap compared to high-priced US equity. Fly business class with the Vanguard World Fund. A good rebalancing pick.

Market overview. The market seems to be re-pricing itself around (1) improving and sustainable growth in the US and (2) probably too much pessimism about overall world growth. Expectations about somewhat higher future interest rates act will act as a brake on exuberance. High P/E ratios (see below) indicate possibly stronger economic growth ahead (otherwise the stock market is overpriced).

Relative Market Valuation Metrics

Some big ideas.

· Wealth inequality debate—some unexpected outcomes

Gavin Davies, the FT economics blogger, makes some fascinating points about the wealth and income inequality debate (created by the Thomas Piketty book).

o The future returns on equity will probably stay high. The “revert to the mean” argument is overdone, he says.

o Wealth inequality is going to continue to increase. This is the historical norm (the mid-20^th century “middle class” prosperity was an exception to history because of the destruction of capital in the two world wars).

§ More new wealth goes to existing wealth holders rather than new wealth holders. Wealth to new wealth holders primarily comes from increases in housing wealth (which is why the broad-based housing programs in the US after World War II built American middle class wealth).

o If the total rate of return on financial assets is 4 percent. And if the real rate on bonds is zero, then the overall rate of return on equities has to be about 8 percent. (Stocks and bonds half and half of total financial assets.)

o These firms are “Wellington-like” which helps explain the Wellington Fund’s excellent long-term, low-risk rates of return. Internationally, the Vanguard Developed Markets Index fund captures the big international companies headquartered outside the US.

Other thoughts – how about letting professionals “run” your money?

Answer: managed funds are not coming anywhere close to beating the Vanguard S&P 500 index fund.

Money poured out of high management fee and commission-paying mutual funds during 2014 and into Vanguard (our own local PIMCO fund family in Newport Beach had record outflows as investors fled in droves—“… leaving the world’s largest fixed income mutual fund half the size it was at its 2013 peak.” FT 1/2/2015).

Hedge fund and private equity fund performance

· Macro hedge funds made 5.6 percent thru November; equity hedge funds 2.4 percent. In contrast, the Vanguard S&P 500 earned 14 percent. Someone’s not earning their fees!

· “Historically, private equity funds have been stellar performers. But in recent years, their performance has dimmed; over the last five years, on average, they have lagged the returns of the broad stock averages. Amid this decline, some investors have raised concerns about hidden fees levied by private equity funds.” (NYT 12/27/14)

Vanguard Funds

Some great advice. “There are many problems in the economy and in the markets, certainly. But the answer for a long-term investor isn’t to avoid risk. It is to be extremely diversified – and to invest in equities. You’re likely to do much better that way than if you stay out of the markets.” (David P Kelly, chief global strategist at J.P. Morgan Funds, NYT 8/31/13)

· “Money management has been a profession involving a lot of fakery – people saying they can beat the market and they really can’t.” Robert Schiller, 2013 Nobelist in Economics in NYT 10/20/13.

· “During the past five years…it has been a bad time to try to beat the market by running an active fund, and a great time to run money passively, tied to an index.” John Authers, FT, 10/25/13.

Yes, the US Market is high.

The Schiller P/E ratio is currently at 27, historical mean of 16, or 68% above the long-term average (the Schiller P/E ratio is an average of the 10 years past earnings adjusted for inflation and is regarded as an indicator of potential market overvaluation—the bubble).
The S&P500 current P/E ratio is 20 compared to a long-term average of 16 for a potential 25% overvaluation.
One commentator in the FT wrote: “For die-hard bulls, this [a high Cape] is an inconvenient truth. I calculate that this level of valuation is consistent with annualised real returns on US large-cap shares over the next decade of minus 3.4 per cent.”
More for the rebalancing argument: “Rather than wondering whether buying low Cape stocks will succeed [next year] , the critical question for me is how to square the healthy returns implied by the low Capes in the eurozone with the poor returns signaled by the same indicator in the world’s most influential market, the US.” (FT 11/21/13)

MYERSCPA INVESTMENT LETTER FOR 2014

January 1, 2014

Summary to expanded investment letter—four key points.

A solid core retirement portfolio should consist of the Wellington Fund (a superior risk-return balanced fund), the Vanguard S&P 500 Index Fund (US equity growth), and the Vanguard World Fund (US, Europe, Pacific, Emerging Markets all in one harmonious whole!).
Global warming is real and will result in a large worldwide infrastructure boom centered upon dramatically improving energy efficiency over the next two to three decades as the world adapts to higher temperatures. (Alternative and green energy will play a small role; electric cars and other panaceas almost none.)
Worldwide big companies will lead because they are the R&D engines for the next two to three decades.
Emerging Markets measured by relative value are cheap compared to high-priced US equity. Enjoy a bumpy ride to higher future returns! Or fly business class with the Vanguard World Fund.

Market recap. The stock market closed at 1848, a new all-time new high. The S&P 500 index fund is up 30% for the year.

Adjusted for inflation the S&P 500 is still about10 percent below its peak in the year 2000 and that the subsectors of Finance, Information Technology, and Telecoms are still about 50 percent below their peak—the creative gale of destruction hit these “very smart” investments touted by Wall Street very hard. (Floyd Norris in NYT 11/23/13.)

Figure 1 S&P 500 index for 2013. Wow! What more needs to be said? (from the NYT)

Market overview. The market seems to be re-pricing itself around (1) improving and sustainable growth in the US and (2) slightly better overall world growth. Somewhat higher interest rates act as a brake on exuberance (interest rates were always going to revert towards the mean!). High P/E ratios (see below) indicate possibly stronger economic growth ahead (otherwise the stock market is overpriced).

Relative Market Valuation Metrics

Time to buy Emerging Markets? On the buy low-sell high game plan, Emerging Markets are low on relative valuation to US markets (much lower PE ratio than US markets), have higher returns on equity and growth rates. They that about a 50 percent higher rate of return over the past decade—and that’s what really counts! So, why is Mr Market offering us this great deal? Well volatility is almost twice the level in Emerging Markets than the stable US Market. So it is a bumpy ride. Right now, the EM markets seem to be priced unusually low compared to the US market. (And there are plenty of worries out there—but there almost always are!). Best bet for 2014 still might be to go broadly international through the Vanguard Total World fund.

Emerging Markets—the conclusion. So “you’d be better off heading for the chaos of cheaper emerging markets than the seeming calm of the US.” (FT 8/30/13)

Yes, the US Market is high.

The Schiller P/E ratio is currently at 25, historical mean of 16, or 56% above the long-term average (the Schiller P/E ratio is an average of the 10 years past earnings adjusted for inflation and is regarded as an indicator of potential market overvaluation—the bubble).
The S&P500 current P/E ratio is 20 compared to a long-term average of 16 for a potential 25% overvaluation.
The Cape for the S&P 500 is currently 24.4, more than one standard deviation above the long-run average of 16.5. One commentator in the FT wrote: “For die-hard bulls, this is an inconvenient truth. I calculate that this level of valuation is consistent with annualised real returns on US large-cap shares over the next decade of minus 3.4 per cent.”
Continuing: “Rather than wondering whether buying low Cape stocks will succeed in 2014, the critical question for me is how to square the healthy returns implied by the low Capes in the eurozone with the poor returns signaled by the same indicator in the world’s most influential market, the US.” (FT 11/21/13)
My conclusion: economic growth and profits will be higher and stronger than current stock market valuations indicate. The media screams “Gridlock!” The markets love future stability!

Vanguard mutual funds and ETFs are the lowest cost “best way” to achieve worldwide diversification in equities.

Some big ideas.

· Globally dominant companies best! Martin Wolf on the role of globally dominant companies: “one hundred giant firms, all from the high-income countries, account for over three-fifths of the total R&D expenditure among the world’s top 1,400 companies. They are the foundation of the world’s technical progress in the era of capitalist globalization…These companies have invested hugely across borders.” (FT 7/9/2013)

o These firms will dominate economic growth worldwide over the next couple of decades.

Other thoughts.

· John Authers points out that the biggest and most successful of the “alternative investment” funds—the Yale Endowment—trailed the S&P 500 13% to 21% since the financial crisis and that over the past 5 years Yale has trailed a simple 60-40 percent balanced index portfolio (like Wellington and the Vanguard Balanced Index fund). CALPERS, the big public pension fund, has made large, often disastrous investments in politically connected real estate ventures and other “alternatives” over the past 10 years. The people who peddle these investments make big commissions and fees.

This chart (from Hedge Fund Research) from the Financial Times tells it all (FT 12/18/13). Short-term marketing considerations (get the performance up!) destroy long-term performance. (The FT calls these funds “the zombies.”)

The FT story continues: “Your $100 would be worth $220 if you lodged it with Vanguard — while the Long-Short industrial complex would have turned it into $155 (after taking at least $25 in fees).”

Climate change is going to have large impacts on our economies in the future. You will hear more and more about it, witness these statements by Financial Times economics editor Martin Wolf.

· “On the present course…all the discussions of mitigating the risks of catastrophic climate change have turned out to be empty words…when the concentrations were last this high [estimates of the current trajectory]…the world was a very different place. (Martin Wolf FT 5/14/13)

· “The attempt to shift our choices away from the ones now driving ever-rising emissions has failed. It will, for now, continue to fail. The reasons for this failure are deep-seated. Only the threat of more imminent disaster is likely to change this and, by then, it may well be too late. This is a depressing truth. It may also prove a damning failure. (Martin Wolf 5/21/13)

· “Sea levels could conceivably rise by more than three feet by the end of the century …from a draft report from a UN scientific panel (that won the Nobel Peace Prize in 2007) and that average worldwide temperatures could increase from 2.7 to 5.0 degrees F. (NYT 8/19/13) The investments in adaptation will be huge!

How to invest in an era when the world economy might start to respond to climate change? Schneider Electric CEO has a simple 4X rule: over the next 30 years, demand for energy will double, while greenhouse emissions must be cut in half. So a fourfold increase in efficiency is required. This implies a substantial rebuilding and retrofitting of the world’s energy infrastructure in the coming decades. I would suggest three interrelated investment thoughts:

· Efficiency: industrial and basic living processes must get much more efficient an deliver more output for less factor inputs including energy. Look for carbon taxes to further incentivize this process. Most likely the 100 big integrator firms will lead the way. Stay with broad-based international index funds.

· Infrastructure. Adaptation to changing conditions will create increased investment in infrastructure. Look at the iShare Emerging Markets Infrastructure (EMIF) which pays about 3.4% dividend.

· Clean energy. Be very careful here. Lots of false friends. Dabble in iShare Global Clean Energy fund (ICLN) and paying 2.4% dividend. Mostly energy efficient international utility companies. (This ETF started at $50, fell to $5, and is back to about $10—this is a true Fallen Angel!)

New! Core retirement account portfolio. These three funds held in equal proportion should be at the core of a long-term portfolio held for capital appreciation.

Vanguard Fund picks

· Dividend appreciation index – add this fund for retirement accounts

· Wellington Fund – single best fund to hold for long-term return in a risky world (65% blue chip stocks; 35% bonds)

· Stock value – Vanguard Small Cap Value Index Fund

· International – Emerging Markets Select Stock

· Fixed income – GNMA bond fund and ST Investment Grade Bond

MYERSCPA INVESTMENT LETTER FOR 2013

January 1, 2013

Market recap and overview. The stock market closed at 1426, less than 100 points below its all-time high of 1504 reached in year 2000. It advanced 13% in 2012, near the upper end of last year’s guess-estimate of 5-15% in this letter.

Broad diversification works! (from the most recent edition of Burton Malkiel’s A Random Walk Down Wall Street) For the 10 years ended December 31, 2010, the US stock index was ZERO! Over the same period, a portfolio of 5 Vanguard funds from stock, real estate, bonds, and international DOUBLED! So broadly diversifying across markets, not “beating” the US market, works! This is the most important investment insight I have read in the past 10 years!

Total Bond Market Index 33%

US Total Stock Index 27%

Developed Mkts Index (foreign) 14%

Emerging Mkts Index 14%

US REIT Index (real estate) 12%

Bonds and interest rates. A lot of commentary that the 30-year bull market in bonds centered on ever-decreasing interest rates is at an end. When? This year or next? Holding bonds or bond funds with maturities more than 4 or 5 years out seems unwise.

For 2013 (same forecast as last year!). Economic growth in the 2-3% range in the US with possible upside surprise. Stock market advances 5 to 15 percent. The future: look for a breakout to higher economic growth with US growth around 4 percent; international growth at 6+ percent.

Vanguard Fund picks

· NEW – Global ex-US Real Estate Index – great diversification fund

· Fixed income – GNMA bond fund and ST Investment Grade Bond

· Stock – Wellington Fund

· Stock value – Vanguard Small Cap Value Index Fund

· International – Emerging Markets Select Stock

Global ex-US Real Estate Index. Invests in REITS outside the US. Pacific (including Hong Kong and China) 55%; Europe 20%; Emerging Markets 20%, everywhere else 5%.

Short-term investment grade bond fund. At 1.14% yield, this fund is a short-term parking lot. But GNMA at 2.2% looks better for a 3-5 year time horizon.

Wellington – 10-year rate of return of 8.20% versus 7.1% for the S&P 500. Current yield of 2.33% looks good against almost all alternatives. A very good long-term capital builder.

Small Cap Value Index – 11% for the past 10 years, well above the S&P 500 and Wellington. This fund works well over periods of time when small cap firms exceed big company dominated indices, often when economic growth is increasing.

Emerging Market Stock Index has earned 16.2% over the past 10 years. This year’s selection is an actively managed fund in the emerging markets area, a near cousin of the stock index fund. Commentators suggest emerging market stocks are undervalued.