Nearly two years ago we blogged about the nature of secular bear markets.  If anything, we are even more convinced today that we remain mired in a secular bear market, for who only knows how much longer.

Secular bear markets are comprised of short-term – or cyclical – trends.  This big old secular bear that began in 2000 is comprised of a cyclical bear that ran from 2000 to 2002, a bull that ran from 2002 to 2007, a bear from 2007 to 2009 and the current bull that started in 2009.  We have seen some pretty good equity returns since 2009, just as we saw good returns from 2002 to 2007.  However, since 2000 until now, the market has moved more or less sideways, only with a great deal of ups and downs over that 12 year period.

Valuations are the truest measure of when a secular market begins and ends.  Bull markets begin with below average P/E ratios; bear markets begin with above average P/E ratios.  This secular bear began in 2000 with P/E’s around 42; the average is around 16.  Today, P/E’s are around 22, still relatively high.  As investors, we will start to feel much more bullish when we see P/E’s well below 16 – at maybe 10 or 12.  When P/E’s are at 10, don’t expect CNBC to be broadcasting happy headlines.

Until that point, we will remain cautious investors, mindful of the nature of secular bear markets.

The Chinese consumer is starting to spend some of the money they have earned.  According to Jim O’Neill of Goldman Sachs, twenty percent of Apple’s astonishing revenues (total of $46.33 billion for the 3 months) came from sales to Chinese consumers.   Apple’s own statement alluded to the remarkable opportunity afforded by sales to China, and suggested many other companies could benefit dramatically too.

Much has been written about the role consumers in China and other emerging countries would play in global growth.  No one seemed to know exactly when this would occur or what the extent of it would be.  If Apple’s numbers are any indication, the time is now and the amount is large and growing. 

We are all familiar with identity theft, but let me offer you my definition: it is allowing a criminal to make financial decisions that will benefit him or her, using your money and credit. According to the Bureau of Justice Statistics, 7% of US households experienced identity theft victimization in 2010. That is approximately 8.6 million households per year.

So what can you do? There is a fantastic book called “Stealing Your Life: The Ultimate Identity Theft Prevention Plan” by Frank Abagnale. Yes, the Frank Abagnale played by Leonardo DiCaprio in the movie “Catch Me If You Can.” After being imprisoned for five years, Mr. Abagnale turned his life around and has been consulting with the FBI and other institutions for over 35 years. Mr. Abagnale’s book is full of great ideas and he includes a complete twenty step program you can follow to protect your identity.

Following are 8 of the best ideas I have found in Mr. Abagnale’s book and other sources that you can take to proactively protect your identity.

1. Buy top of the line antivirus software for your computers and make sure the software is running and being updated regularly.

2. Err on the side of shredding just about everything.

3. Be very suspicious of unexpected contact including in-person encounters, calls, letters, and emails. We want to be polite and we are curious about who this person is that is contacting us, but it is just not worth it. Never give out any information of any kind unless you initiate the contact.

4. Write as few checks as possible. Whenever you write a check, in a nice neat little package, you have given a criminal more than enough information to steal your identity including your name, home address, bank, account number, and signature.

5. Use credit cards as often as possible and not debit cards. Why? So you can use the credit card company’s money and not your own. In the case of fraud, Federal law limits your liability to $50 per card. With debit cards, you are using your money and have much less protection in place.

6. Instead of signing the back of your credit cards, write in big bold letters- ASK FOR ID and then make it a point to thank every person who asks to see your license during a transaction. I have been doing this for years and it has worked very well.

7. Check your credit reports at least once a year. By law, you can do this for free at AnnualCreditReport.com

8. Stop getting financial paper statements of all kinds. Set it up to access them securely online instead. Please note, if you are still receiving paper statements from TCI, you can stop us from sending them and gain access to your account statements securely online simply by calling your advisor.

Lastly, here is some information about our online statements:
– They are available on the third business day after the end of each reporting period.
– You are notified by email when a new statement is available.
– Online access will give you immediate access to the three most recent years of statements. We keep all of your statements and you can access them without expiration by contacting your advisor.
– Our secure login is protected by VeriSign, a globally recognized leader using SSL encryption technology.

You will go a long time before reading anything as entertaining as Jim Grant’s speech before the New York Fed, wherein he launched a pointed and amusing attack on his hosts.  Grant’s ultimate solution to rein in feckless central bankers is a return to the gold standard.

When it comes to monetary policy, we find ourselves neither with the goldbugs aching to do away with fiat currency, nor amongst the latter day William Jennings Bryans declaring, “You shall not crucify mankind upon a cross of gold!”  Our place on the long arc between those two poles is defined by dread of the short-term pain certain to be caused by substantially shrinking the money supply, coupled with recognition that we are on dangerous ground, never before trod by central bankers. 

Though we generally eschew predicting the future, we do believe that there are identifiable secular trends.  That policymakers will be dealing with the effects of the credit crisis for years to come is one of them.

Chained CPI: The Bipartisan Deficit Fix?

How do we begin to tackle the mountain of debt in the U.S. has been a source of debate on both sides? In a recent article, Bloomberg suggests changing the Consumer Price Index to a more accurate gauge of inflation would save the U.S. a bundle. 

Depending on which expert you talk to, the current measure of inflation, the consumer price index (CPI), contains several biases that cause it to overstate inflation by anywhere from 0.3% to 0.8%.

This overstatement is significant because CPI is used to determine several aspects of the federal budget.  CPI is the benchmark that determines cost-of-living adjustments for various government programs, including social security and federal employee pensions.  Additionally, CPI is used to peg income tax brackets, exemptions, deductions and credits.

The chained CPI is a measure that the Bureau of Labor Statistics has been tracking since 2002 and is a more exact measure that accounts for the substitutions consumers make when a product’s price goes up.  This alternative method chains together two consecutive months of price data and adjusts the weights to account for a decrease in purchases of the more expensive item and increased purchases of the lower-cost substitute.  Whereas, the standard CPI largely maintains the same basket of goods regardless of price changes.  On average, the chained CPI has been 0.25% to 0.35% lower than the standard CPI measure.

Estimates project that using an alternate method of calculating CPI would produce savings in federal spending and interest payments on debt, help shore up Social Security and put the economy on firmer ground.    The adoption of the chained CPI has been an element of every serious deficit-reduction plan of recent years.  It seems this change might be one both sides are in agreement on.  

Click here to read the full article.   

Bill Gross of PIMCo writes his Investment Outlook newsletter each month.  TCI provides a link to this newsletter at www.trustcoil.com.   We find Bill’s April 2012 Outlook to be particularly incisive.  

Bill discusses the vital role leverage has played since the abandonment of gold and the embracement of dollar based credit in the early 1970’s.    The private sector was more than willing to aggressively use more debt and policymakers did a ‘great’ job of supporting this system.  That is until 2008, when leverage reached its limits.  Today we are left in an environment where low interest rates and quantitative easing have pushed up the price of risky assets and reduced the future returns for all financial assets.

So what does Bill recommend?  First, high quality, shorter term bonds and inflation protected bonds.  Second, stocks of developing countries versus developed and dividend paying stocks as opposed to growth stocks.  Third, inflation sensitive, supply constrained commodities.  He also recommends being wary of leveraged strategies that promise double digit returns. 

TCI’s asset allocation is largely consistent with Bill’s thoughts.  I highly recommend you read the entire newsletter. 

Most clients for whom we allocate assets have more than one account with us.  A typical married couple might have four – two investment agency accounts titled in the name of each spouse’s revocable living trust and two IRA accounts.  As is becoming more common, they may even have a Roth IRA or two as well.

The different taxable natures of those accounts offer us an opportunity to minimize the clients’ tax bill and allow them to keep a greater percentage of their investment earnings. 

A first step in the process is understanding the type of tax liabaility a mutual fund is likely to generate.  Funds that generate mostly long-term capital gains and qualified dividends (which are taxed at favorable rates) are most appropriate for taxable accounts, like investment agencies.  Funds that generate interest income (which is taxed like ordinary income) are more appropriate for tax-deferred or tax exempt accounts, like traditional and Roth IRA’s.

Beyond return, we must also include considerations of risk in locating assets.  Variations in return for taxable accounts affect two parties – the investor and the governement, as the government will take a share of the return in taxes.  Consequently, an investor effectively has lower risk in a taxable account than he would in a tax deferred or tax exempt account.  (Though the investor will eventually pay taxes on distributions from a tax deferred account, the variations of return will no longer be a factor.)

In conclusion, we generally favor taxable accounts for holding risky assets that generate long term capital gains and qualified dividends.  We favor tax deferred and tax exempt accounts for holding lower risk assets that generate interest income.

Whenever the stock market backs up a little, I get questions about what we are doing about it.  Perhaps I am misinterpreting the question, but I always get the feeling people are looking for new thinking for this new situation.  The truth, of course, is the stock market goes up and down almost as certainly as the sun—just not as consistently.  So there is no need for brilliance—we have a plan.

While the recent decline of almost 5% is a poor excuse for blogging on this subject there is no way of knowing how far this little decline will go.  Will we have a 20% correction like last summer?  After yesterday’s market increase, will this ‘correction’ be forgotten before May arrives?  We don’t know. So what is the plan?

There are two parts.  First, if our portfolio becomes sufficiently out-of-balance because the equity sector declines and the stable sector remains (for lack of a better term) stable, we buy enough equities and sell enough stable assets and/or alternative investments to get back in balance.  How can you not like an automatic program that buys low and sells high?

Second, if the market declines enough, equity valuations will become sufficiently attractive that the TCI Investment Committee is willing to change our allocations to buy more undervalued equities.   Once again buy low and sell high.

The hard part, of course, is we are bucking the trend.    

We hold these truths to be, if not self-evident, at least observable:

1. Human behavior plays an outsized role in markets, particularly in the short term. Knowing the outcome of collective human behavior is not possible. Ergo, the direction of the market, particularly in the short-term, is unknowable.

2. Modern Portfolio Theory statistical measurements of risk, i.e. variance, standard deviation and covariance, do not have the same constancy as atomic weight and atomic number. They are measurements of past behavior and vary drastically depending on in which timeframe they are measured. Therefore, the best measurement of risk for investors is the probability of the permanent loss of capital. Avoiding permanent loss is utterly dependent on creating an investment discipline and sticking to it.

3. Valuations matter. Human emotions and momentum (but we repeat ourselves) will drive prices far above and below fair value for extended periods of time, but eventually, the gravity like pull of mean reversion will pull the asset back to equilibrium. So, investors should buy more assets that will be pulled up and fewer assets that will be pulled down.

4. There are two types of people in the world: those who buy gold and value investors. Gold provides no cash flows. It costs money to store. It is of relatively little use in industry. And yet, if you bought some in 2002, you have made more money in the last decade than stock investors. We congratulate you. But if we cannot value an asset (like gold), we will not own it.

5. “There is a mysterious cycle in human events. To some generations much is given. Of other generations much is expected. This generation of Americans has a rendezvous with destiny.” – Franklin Delano Roosevelt, 1936. The mysterious cycle applies to markets and the economy as well. No trend will continue forever, whether up or down. Those in the 1970’s bemoaning the death of equities discovered this to be so, as did those in the late 1990’s heralding the end of the business cycle.

6. It is much more fun to claim to be a contrarian than it is to be one. Warren Buffet’s maxim, “Be greedy when others are fearful and fearful when others are greedy” has less resonance when you’re trailing the benchmark in a bull market.

7. The two most important virtues to have as an investor are patience and humility. The two least common traits among investors (particularly professional investors!) are patience and humility.