Tuesday, August 31, 2010

Rating Agencies

Rating agencies were back in the news last week. The Finance Minister of Canada wasn't too happy that Standard & Poors downgraded Ireland's debt. As quoted in the Globe and Mail, “You know, the rating agencies, quite frankly, were part of the problem that caused the crisis,” Mr. Flaherty said. “I’m not a big fan of Moody’s and Standard & Poor’s and so on when they start to pontificate on certain issues.”

Neither should you. The system of ratings is a deeply flawed system. Ratings are paid for by the debt issuers. In order to do a bond issue, I have to pay the rating agency to provide a rating for it. Of course, the better the rating I get for my bond, for example, the more demand I generate. There is too much incentive for me to "bonus" the rating agency in return for the rating I desire.

In defense of the rating agencies, one could argue that leading up to the recent market crash they were not able to fully comprehend the nuances of modern derivative products. To that, I would say, that didn't stop them from issuing a rating and pocketing the cheque for doing so. They say the ratings are "point in time", meaning as factors change, so do the ratings. So why didn't they? Incompetence is a poor defense of ignorance!

To make matters worse, there is no regulatory agency responsible for ratings. Instead, products need to be rated by two of the three large "quasi-regulatory" companies. The biggest firms hire their own ratings staff. Where do you think the best talent goes - to ratings agencies like Standard & Poors, or the big, high paying firms?

The other argument used to defend the actions of ratings agencies has been customers should never invest in things they don't understand. I couldn't agree more. So what is the purpose of the rating?!?

Again, it is the little guy who doesn't have access to a research staff who is most at risk. This is a case of damned if you don't, and damned if you do! I can't tell you what to do, but I ignore ratings. I do my homework. I stay away from derivatives and products we are not meant to understand. I invest in bonds using bond ETF's. I compare the advice of a really, really, good advisor to what I think I should do. Lastly, I listen to my gut. Even when everybody else is doing it, you can still end up losing your shirt!

Friday, August 27, 2010

Believing Is Seeing

Have you ever heard another person describing an event which you attended? Did they describe it the way you remembered it? Probably not. Why the difference? When two people focus on different aspects of the same event, it is like they are seeing two separate events. If I am frustrated by my inability to connect with an old friend, and at the same time you were having the time of your life dancing, we will both remember the event differently because of what we were focused on at the time.

Or, perhaps we both witnessed the same thing, but our perceptions of what we just saw were different. You may have thought the guy was, perhaps, distinguished. I, on the other hand, may have thought he was way too big on himself.

This is what happened to the markets, on Wednesday. American new home starts were near a record low, and oil inventories were higher than expected. Did the markets go lower? Yes, at the start, but then they quickly rebounded. Buyers came to the rescue seeing their opportunity to buy things on sale, rather than selling their losers.

Events do not drive the markets - perceptions do. Sure, events can generate a reaction in the markets, but the market trend is set by the overall perception of market participants. Perception is determined by sentiment. When we believe it we see it. If I am feeling like the luckiest person on the planet, it is because I have numerous references to back it up. I choose the references, and I choose what they mean. In any given day the media sees the markets are up, so they look for the good news that caused it. They wouldn't even begin to look for the bad news that explains what just happened! Likewise for bad days.

As goes the optimism or the pessimism of the herd, so goes the markets.

Thursday, August 26, 2010

My Agenda

I am searching for a better method of making money from the stock markets - the Toronto Stock Exchange in particular. Notice I did not say 'invest' in the stock markets. Right away we can debate the difference between investing and trading. I don't like using either word because of all the preconceived notions each invokes. Investors have a long time horizon; traders do not. Says who?!? Investors are loyal; traders might just as well be spelled 'traitors'. Who cares?!?

If you get your information from the Financial Services industry, you are in a lot of trouble. Buy and Hold is a marketing strategy - not an investing (there's that word again!) strategy. There is no shortage of information, and opinions on that information, when it comes to stocks, stock markets and strategies. The real key is to identify the useful information. Too much of what we hear in the media is just a smoke-screen. Too much of what we get from advisors is what their company wants us to hear. This goes double for small clients. Ask your advisor if they are rich. If the answer is no, then ask the question, "Why not?" Isn't that the advice we are seeking?

I don't claim to have all the answers. What I have learned is different times call for different measures. It took me some time to realize that in the current market volatility I needed to shorten my time horizon, and reduce the size of my positions. One method will not work all of the time. I can pretty much guarantee the top ten mutual funds from the past year will not be five years from now. Situations change - we need to change with them. Today, a passive investing strategy using Exchange Traded Funds (ETF's) is working great, but I wouldn't recommend starting one today. The risk of the market going lower from here is a lot greater than the chances of it going much higher. Even if I am wrong, how much can you lose? I plowed a pile of money into a mutual fund in early 1998. I proceeded to lose about 25 percent of my funds by the end of the summer. Nobody warned me the market was about to correct!

As a matter of disclosure, I should tell you about 80 percent of my personal portfolio is currently in inverse ETF's (the ones that make money as the market goes down). I do not recommend betting on the down-side unless one is actively managing their portfolio every day. Despite what the advisors say, there are better times than others to enter the market, and this is not the time. I am reminded of a Dilbert cartoon I read on the weekend. Perhaps you saw it. Dilbert is in a meeting with his manager and the product safety engineer. The engineer is completely wrapped in bandages from head to toe - including their face. The manager asks for an opinion on the company's product. The reply is totally muffled, so the manager turns to Dilbert and asks, "Did that sound like SHIP to you?"

What I am suggesting is despite the industry's desire to get more people into their funds, the stock market is not ship-shape, at the moment. My personal agenda is a little different from that of the financial services industry in that I want to make more than what they say is "realistic". More than that, I actually want to help as many others as possible to do the same.