The immediate crisis is passing ... what the future must look like ...

Yes, the immediate crisis is now in the process of passing, with all the extraordinary measures taken to assure the financial system remains liquid. There will still be, perhaps, moments of further high-wire acts over the next 12-24 months, but these now appear less likely to take down the entire financial system, given the exceptional world-wide commitment to blitzkrieg measures as necessary.

I think that, given the unbelievable bungling by companies, CEOs , and boards in the banking and insurance sectors, a round of applause is due to central banks, and governments, world-wide in managing the crisis. This isn't the same as saying that they took measures to prevent the crisis from arising but, once it was upon us, took appropriate measures to make sure this didn't become "The Great Depression, II".

Given the enormous failure of systemic corporate foresight and governance on an individualized corporate basis, governments must now take steps to regulate systemic strength and redundancy into both the banking and insurance sectors. The government must also reform obscene and excessive-risk-encouraging executive pay schemes, since boards have clearly failed to perform their duties to protect shareholders in particular and, as a group, their actions have endangered society in particular.

Here's some quick thoughts on what some of this regulation can and should look like (by the way, corporate boards, take some notes in case this doesn't get legislated, as it's still solid corporate practice: good and prudent governance, if you will):

Banking:
Never again allow the total disconnect between the lender and borrower to occur, by mandating that any pools of capital moved "off balance sheet" (i.e. sold to hapless investors), have some significant portion retained by the originating institution. Whether that amount is 15%, 25% or 50% should be thought about carefully, with the two competing objectives of robustness of system, and efficiency of capital, duly and thoughtfully considered.

The FDIC and similar institutions need to consider "100 year events" in pricing their deposit insurance, as secular increases or declines playing out over a couple of decades can hide fundamental flaws in this type of insurance pricing (i.e. the current scenario). The pricing needs to properly reflect the risk of the loan book of a particular institution - in other words, those playing in areas of the pool with no lifeguard, need to have appropriately steep insurance costs to discourage the most egregious type of risk-taking - or alternatively, to protect the general public when the inevitable failures occur. More highly levered institutions also need to pay higher premiums.

Insurance/Banking:
Anything that looks or smells like some sort of insurance scheme is appropriately reserved. This means that pretty much anything that is insurance against some other event, and involves a trade (swap) of potential event happenings, or pricings etc. It doesn't take a financial genius to recognize that things that are "insurance" aren't always called "insurance". Here's some keywords for regulators, boards and investors to think as insurance: "hedge", "swap", "obligation" (in certain contexts), "derivatives", and so on. No longer should these be allowed to be unreserved. They are all some type of insurance, and need appropriate regulation and reserving to recognize those risks.

Pay schemes:
Federally regulated industries need to have banned, outright, stock option grants. Options encourage excessive risk taking, without the offsetting consideration to downside risk. A winner take all mentality, if you will. This must be discouraged, as it produces unacceptable systemic risk.

In fact, had boards collectively produced proper and appropriate compensation schemes, I argue that much of these systemic excesses may never have happened. For further thoughts on executive pay reform, go here. (In fact, I'd now go one step further and say that the CEO should have to own stock equivalent to at least two years base pay during his entire tenure + eighteen months, as CEO).



JW

The Confused Capitalist

Thinking Ahead: Ten Years Out

One of the themes I've tried to engage readers in here, is that by playing some fairly obvious trends, and coupling those with reasonable valuations, is a relatively easy way to outperform the market.

One theme I've pounded on over the past one-and-a-half years is the emerging market theme. It doesn't take too much heavy lifting in the thinking department to realize that with soaring GDP growth rates of 8-12% annually in some of these countries, expecting their stock valuations to follow isn't much too much of a mental stretch, even for weak thinkers like me.

So, thinking ahead, and about 10 years out is a good target, it becomes much easier to think that an overweighted emerging markets position is likely to be both prudent, and very profitable. Now, the graphic above showing firestroms in California (currently displacing one million people) obviously suggests that this posting isn't about emerging markets.

That's correct - this is about alternative energy production. While climate change and global warming have been warned about and was easily readable in the popular media 20 years ago(Time Magazine, for instance, awarded Planet Earth as "Man of the Year" in 1989, due primarily to concerns about global warming), it's only recently that most people are finally waking up to the severity of the problem.

As the problem continues to grow in the public mind, so too will the demand for solutions. These will be invoked on a political and individual basis. As the negative consequences of inaction become more and more and more visible and the predictions more dire, many will begin making personal change AND demanding societal change. This is inevitable.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!)

What is also inevitable is major changes to our type of energy consumption and to the pattern of use. For instance, emerging economies will begin to use far more energy than in the past. This is good for them, but not good for the planet. The energy hogs of the planet - that's us in the western world - will finally begin to reduce consumption outright - not just on GDP weighted basis. Since we were "first in" to this pattern of inefficient energy use, it also is right that we strive to be "first out" of the pattern.

This brings us to our investment opportunity. Looking ten years, does anyone see a world in which the general populace isn't pressuring the politicians to fund alternative energy, to create incentives/disincentives to change energy use, and possibly even to restrict certain types of energy use? Perhaps rationing, a popular method for "spreading the pain" and acknowledging that we're all in this together, will become popular.

In any case, I personally cannot envision a world in 10 years where alternative energy isn't a significantly larger economic sector than it is today.

Of course, my much beloved ETFs provide a way to play this trend while avoiding single company risk. The recent launch of three ETFs targeting this sector might lead some to utter the usual cliques and say that this is a clear sign that this market segment has "topped". Yet the reasonable valuations, societal trends, and my common sense, tell me "no", that is not the case at all. And that is why I am willing to significantly overweight my portfolio to this segment.

While I do not pretend this is a comprehensive list, here are three ETF names in this sector:

Market Vectors Global Alternative Energy ETF (GEX) started trading on the New York Stock exchange. The fund, tracks the Ardour Global index (Extra Liquid), which is comprised of stocks in 30 publicly traded companies engaged in alternative energy production. These stocks are selected from a stable of 250 companies in this space. At least 30% of the names are not US-domiciled companies, and may therefore be attractive to those wishing some diversification out of the US currency. It is however, a relatively concentrated ETF, with 60% of the value being held in the top ten positions. Yahoo Finance shows the current PE as ~30.

Power Shares Global Clean Energy Fund (PBD) is based on the WilderHill New Energy Global Innovation Index. The Index seeks to deliver capital appreciation and is composed of companies that focus on greener and generally renewable sources of energy and technologies facilitating cleaner energy. The modified equal weighted portfolio is rebalanced and reconstituted quarterly. It currently holds 84 positions. It also has limited exposure to US companies, with only 26% of the ETF having US domiciled companies. Yahoo Finance shows the current PE as ~26, while information from PowerShares says the PE is ~42.

Finally, an all US domiciled companies is the First Trust NASDAQ Clean Edge ETF (QCLN)which started trading in February, covers five sub-sectors of the alternative energy industry: renewable power generation, renewable fuels, energy storage and conversion, energy intelligence, and advanced energy-related materials. The investment has above average concentration, with the top ten positions holding 55% of the value. It seeks to track the NASDAQ Clean Edge U.S. Liquid Series Index. Yahoo Finance reports the PE as ~25.

One caution with all of these ETFs is that they are presently quite small, none having assets of more than $100 million. But I predict that will change dramatically by the time 2017 has rolled around. Clean energy - a future whose time is now for the investor.



JW

The Confused Capitalist

Fear is Your Friend: Embrace It!

The other day I entitled an article “Fear: an Investors Biggest Friend & Worst Enemy” and it occurred to me that I’d said why it was an enemy, but didn’t say why it was a friend. The reason is, if you learn to use your fear – which generally occurs after an extended market decline – as a contra-indicator.

In other words, you recognize the fear, but also recognize that a market decline generally represents an excellent opportunity to increase your long-term rate of return. I’d read that an analysis determined that if you added 10% to your stock portfolio after every 20% market decline (an opportunity that admittedly doesn’t happen very often), that you would increase your overall rate of return by 2% annually.

While 2% doesn’t sound like a lot, it has large implications over a long investment horizon. For instance, if you think your return rate is likely to mirror the long-term average of the stock market (large stocks: 10% or so), then increasing your return by 2% annually means this over a 25 year period:

Instead of a $100,000 portfolio being worth under $1.1 million in 25 years, it is instead worth over $1.7 million. What a huge difference when using fear to your advantage.

So this is how to turn fear to your advantage – by using the Warren Buffett saying … “We seek to be greedy when others are fearful, and fearful when others are greedy.”

Fear – your best friend.


JW

The Confused Capitalist

Levered Stocks - Aye, Volatility Ahead Captain!

There's also a different type of leverage than simply going out and borrowing money to invest in the market, like I've written (favorably) about recently. There's also the ability to buy a number of stocks and mutual funds whose returns are geared to, or levered on, a particular underlying stock, or index.

However, since they are "geared", that means they'll experience more rapid increases and decreases as that particular stock/index burps and belches over time. Which can be darned uncomfortable to watch during a market "correction", since the changes are magnified. However, on the other side of the coin, when the market is moving these stocks or indexes upward, it adds a wonderful upward profile onto your portfolio. But if you don't sleep well in "stormy seas", then this type of investment isn't for you.

However, if you can live comfortably with the underlying volatility and are reasonably confident that you aren't entering the market at a high valuation point, and have a long enough investment horizon, then these levered or geared investments can get you a better return - get you to where your going sooner. Later, we'll look at a few of these levered investments ...

JW

The Confused Capitalist

Fear: An Investors Biggest Friend & Worst Enemy

Although I've laid out a very conservative and creditable plan for using leverage (see the Leverage Series, just completed) to help an older couple with poor retirement prospects significantly improve their future, many people will see the same plan and completely pass it by.

Why? The reason is usually fear. However, many people won't admit to that; they'll talk about the market at a peak (although they might know very little about the market), or use some other justification to avoid changing their situation. Many great investors have said that managing one's own emotions is the largest hurdle to becoming a successful long-term investor.

In this way, you can avoid selling when "the market" has declined in value (and in fact look to BUY at that time), and not panic and sell your own investments (or "rebalance" from a position of emotional weaknesses) during a market downturn. Managing your own emotions also allows you to avoid chasing a hot market or sector, as many people did (like I did, too!) during the NASDAQ rocket ride in 1999 - only to be shortly followed by the crash thereafter.

Being emotionally balanced and remaining committed to the long-term, despite the markets burps and belches, is the best way to have the success in the long run.

JW

The Confused Capitalist