Pick One: Global Warming or Peak Oil

I had an interesting exchange with some church folks about global warming and/or peak oil. This message from a fellow congregant started the whole thing...

In this week’s edition of his chronicles, Jim Kunstler says we should stop griping about Bush, even though he says Bush is an a*hole, as he calls all presidents after JFK. Kerry, for example, has done nothing or said nothing about improving our rail system, and it has deteriorated, meaning that the only major interstate transportation network we have is the Interstate System (I-64, I-90, and so forth). He cites the hypermedia for airing a show saying that the tar sands of Alberta will solve our energy needs. It is interesting reading, and it is at:

http://www.kunstler.com/mags_diary16.html

I checked-out the link and found a foul-mouthed peak-oil fanatic. Here's my response...

I would like to get Kunstler and the Global Warming talking-heads together in a room and let them figure-out which approach they are going to use to try to slow down economic growth. They have two mutually exclusive choices:

1. they can claim that our continued use of fossil fuels will create massive global warming; or
2. they can claim that we're on the verge of running out of oil and industrial / suburban life as we know it will cease to exist.

Both of these cannot be true at the same time... proposition number 2 solves number 1.

The response to my message was stunning (not in a good way)...

Economic growth is not desirable. If you take a number and multiply it by a number greater than 1 over and over again, it will get larger and larger and larger without limit. If this number is monetary worth, this could be because of inflation – one day we will be exchanging quadrillion-dollar bills over the future version of a cash register. If it is real growth, then there is no way that can happen. The Earth is finite, and growth CANNOT happen forever.

Economic decline is just as undesirable. If the number you multiply by is less than 1, then it will shrink and shrink and approach zero. Eventually, essentially nothing will be left.

The only acceptable growth is zero growth. This is the only way we will have something without exceeding Earth’s limits.

Number 2 does solve number 1. That’s the problem in the years ahead.

Bush gives his state of the union talk tomorrow. I hope he acknowledges that the reason for the War in Iraq was oil, that we need to conserve on all types of energy, and that Congress needs to pass a big tax on fuels, including gasoline. Bush needs to come up with a talk similar to Jimmy Carter’s.

Jimmy Carter!!! This is what I deal with when I engage my fellow UU congregants in economic discussions. Here's my response...

oh my gosh... where to start...

Real economic growth in the last 300 years is the sole reason we're not all peasants barely surviving on subsistence farming. Economic growth is the ONLY empirically proven way to bring large amounts of people out of poverty (try telling your zero growth story to sub-Saharan Africa).

The Earth, as a lump of matter, is indeed finite. Human potential and technological progress, however, is growing exponentially (check out http://singularity.com/kain.php/ ) and I doubt the earth's physical resources we ever constrain our development. Our approach to development will, of course, be shaped by the availability of resources, but human invention has always stayed many steps in front of our physical constraints. Just think about computers... we take earth-given sand & human know-how and make multi-teraflop computer
processors. Energy... once science can make an efficient solar cell, oil will be an non-issue.

The Earth has been in a state of flux much longer than humans have been around. Could global warming make weather more extreme? Sure. Could oil become very expensive and change the way we live? You bet. Will humanity suffer? Maybe a bit... but any future suffering will pale in comparison to historical levels of diseases
and death due to extreme poverty and the lack of scientific progress.

Here's my point... everything in life has trade-offs. If I had to choose between a stable global temperature and the scientific / economic progress made in the last 100 years, I'll take progress every time.

I ended this last response with one of my favorite quotes... it's from Calvin Coolidge in 1932:

Nothing in the world can take the place of Persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and Determination alone are omnipotent. The slogan “Press On”, has solved and will always solve the problems of the human race.

Hussman Weekly Market Commen

Here's a link to the latest Hussman commentary:Hussman Funds - Weekly Market Comment: January 30, 2006 - Where Else are Investors Going to Go?

"The S&P 500 currently trades at 19.3 times peak earnings (trailing GAAP basis), compared with a historical average for the
price/peak earnings ratio of about 14, and if we only look at points where earnings were actually at fresh peaks, a historical average closer to 12. Suppose that earnings, currently right at the robust 6% trendline connecting S&P 500 earnings peaks from economic cycle to cycle across history, continue to grow along the peak of that historical channel over the next 5 years, and that the price/peak earnings ratio at that point touches, merely touches, a level of 16 - still well above historical norms. Given a current dividend yield of 1.84%, the resulting 5-year total return would be:

(1.06)(16/19.3)^(1/5) + .0184(19.3/16+1)/2 - 1 = 4.13%
... which is about what you can expect from money market funds.

This isn't a timing argument, because the quality of market action is at worst mixed, and investors may very well have some
speculation left in them. Unfortunately, speculation at this point will simply cause further deterioration in the long-term returns that stocks are priced to deliver. It's not necessary for investors to actually shift from stocks to money market funds (in fact, it's impossible for them to do so, in aggregate). All that's required for a "bear market" is for investors to recognize how unsatisfactory the long-term returns are likely to be from prevailing valuations. Investors could discover this with simple algebra, and historically reliable algebra at that, but hope springs eternal."

IndexInvestor.com: Best $25 Spent

Still don't believe that index investing is the way to go? Do you want to stay on top of all the latest academic research on passive investing? Do you need impartial analyses of different index mutual funds and ETFs? Do you need statistically optimized asset allocation models to get the best return with the lowest multi-year standard deviation?

Trust me and spend some time (and $25) exploring IndexInvestor.com. This site is very content rich and had a ton of indexing and asset allocation information. There is a decent amount of free content, but the subscriber information is great.

There are a bunch of persistent articles and research papers that cover a range of index investing topics. Additionally, they publish a large (44 pages this month) monthly journal that contains a 10-12 articles (sometimes pretty technical) and an update of their model asset allocations.

The authors take special care to approach each topic with intellectual honesty... they site available research, present opposing views without twisting meanings and their rigorous approaches to asset allocation (they list their optimization methodology and give alternative allocations based on different methodologies) gives readers many options. Since their only desire is to sell more subscriptions (ridiculously under-priced), they don't have any vested interest in mutual fund selection, brokerage preferences, or whether you need to invest with a 'professional' to achieve investing success.

Check it out and let me know what you think.

Check Your 1099-DIV

E*Trade just made my 2005 tax documents available and I went ahead and downloaded my main broker account 1099 and my 2 kiddie tax account 1099's. The kiddie accounts look great... (almost) tax free income of over $1700!

I start looking over my 1099 and noticed that my non-qualified dividend (i.e. the dividends that get taxed at my marginal rate) amount looks pretty large. I do have a fair number of REITs, but it still looks big. I go ahead and download the detail income report and start looking over where all the non-qualified income comes from.

Here are the big sources of my non-qualified dividends...
- BDV - $1,080 - this is a surprise... it's not a REIT
- FFC - $759 - this is a preferred security closed-end fund
- HRP - $336 - this is a REIT
- SFI - $915 - this is an MREIT... but I know this is wrong
- NFI - $1050 - another MREIT

Now, I look for tax-related press releases for each of these companies and I find something pretty disturbing...
- BDV - 100% qualified - $140 error
- FFC - 30% qualified - $30 error
- HRP - 32% return of capital - $30 error
- SFI - 12.5% qualified & 21% return of capital - $69 error
- NFI - 100% non-qualified - $0 error

Only 1 out of 5 of these were reported properly by E*Trade!!

If I hadn't checked, this error could have cost me $269 in extra taxes. If your 1099 shows any non-qualified dividends, do yourself a favor and verify the information yourself. Let me know if you have any success stories and I'll post them on the blog.

Common-Sense Religion

The Chronicle has a thought provoking article about critically evaluating your faith:The Chronicle: 1/20/2006: Common-Sense Religion.

Here's a quote:

That's why those who have an unquestioning faith in the correctness of the moral teachings of their religion are a problem: If they
haven't conscientiously considered, on their own, whether their pastors or priests or rabbis or imams are worthy of such delegated authority over their lives, then they are taking a personally immoral stand.

That is perhaps the most shocking implication of my inquiry into the role religion plays in our lives, and I do not shrink from it,
even though it may offend many who think of themselves as deeply moral. It is commonly supposed that it is entirely exemplary to adopt the moral teachings of one's own religion without question because — to put it simply — it is the word of God (as interpreted, always, by the specialists to whom one has delegated authority). I am urging, on the contrary, that anybody who professes that a particular point of moral conviction is not discussable, not debatable, not negotiable, simply because it is the word of God, or because the Bible says so, or because "that is what all Muslims (Hindus, Sikhs...) believe, and I am a Muslim (Hindu, Sikh...)" should be seen to be making it impossible for the rest of us to take their views seriously, excusing themselves from the moral conversation, inadvertently acknowledging that their own views are not conscientiously maintained and deserve no further hearing.

Read the whole article.

Employee Stock Purchase Plan Taxation

Here's a link that explains ESPP taxation...Employee Stock Purchase Plans.

The bottom line is that if you immediately sell your shares when they are deposited in your account, the vast majority of your gains will be reported through your W2. Your W2 will reflect the difference between the buy price and the market price as reported by your company at the time you get the shares. Any difference between the reported market price and what you actually sell it at, is reported as a short-term capital gain or loss.

Investment Risk & Indexing

I have scoured IFA's website for the past week and I repeat my prior claim that this is one of the better index investing sites in existence. Much like Swensen, their focus is on convincing us that index investing your best bet.

One of the more interesting tidbits I discovered was their discussion of investment risk and return (which is step 8 of their 12 step active management recovery program), including research findings from French and Fama.

One of modern finance's key pillars is the CAPM model -- CAPM says that your investment return should be the risk free rate plus some percentage of the return of the market based on your exposure to the market. Sharpe created a ratio that purports to measure how well a portfolio performs as compared to what the CAPM model predicts. If the Sharpe ratio is less than 1, you would claim that the portfolio's return does not justify the risk. If the Sharp ratio exceeds 1, you would conclude that the portfolio manager 'beat the market'.

If you believe in efficient markets, Sharp ratios exceeding 1 should not exist. Well, they do exist and many proponents of actively managed investing point to this fact to sell there stock picking services.

French and Fama discovered that the CAPM model only 'predicts' 70% of a given portfolio's return. The active traders believe the remaining 30% is manager skill - French and Fama show it was simply model error. Their research expanded the CAPM model to include additional factors in addition to market risk. They added a factor for the weighted market capitalization of a given portfolio and for the growth/value tilt of the portfolio. This new, expanded model predicts 95% of a given portfolio's return - an 83% reduction in tracking error.

French and Fama both work/consult for an index mutual fund company called DFA. DFA manages $84 billion in index mutual funds for private and institutional investors. Their funds take advantage of all three risk factors that French and Fama discovered and they have some truly unique offerings. IFA's model portfolios are based on DFA's funds. In fact, I've taken their risk survey and I've identified the portfolio I want to model my holdings after. There's just one catch - DFA funds are only available through selected financial advisers. Although there are advisers who will grant you access to the funds for relatively small fees (20 basis points), I plan to try to construct my portfolio based on freely available mutual funds and EFTs.

I'll let you know how it turns out.

Hussman Strategic Growth - The Latest ER Investment

I have decided to get my portfolio much closer to the allocation models mentioned by Swensen and IFA by putting 10% of my portfolio into HSGFX. Hussman's Strategic Growth Fund (here is a chart comparing HSGFX to the S&P 500) is a large-cap blend fund that , based on market valuation and market action, is sometimes hedged or leveraged. Their hedging protects the fund against downward market moves when valuations are deemed too high and it's leveraged (up to 150%) when the market is deemed undervalued.

Here's what I like about this fund:

• Performance: their 5 year performance is top notch for large cap funds (this is a key period to look at because it includes both bear and bull markets.
• Loss Aversion: the worst quarter for this fund has been -2.39% and their worst 12 month period has been 1.9%.
• Co-Investment by Manager: John Hussman (the fund manager) has 100% of his net worth in his two funds.
• Ethical Attitude toward the Market: I'm sure Swensen would approve of the fact that Hussman charges no loads, 12-1b fees, inflated commissions. Additionally, to discourage short-term trading, the fund charges a 1.5% surcharge if you sell within 6 months of purchasing. Here's the neat part - the 1.5% is added to the fund's assets and not the manager's pocket. Additionally, they have a record of reducing their fees as they attain economies of scale through asset growth.
• The Manager: Hussman is a well educated economist (PhD from Stanford) who understands and believes in the efficient market hypothesis. He believes, however, that the market can be, at times, overvalued or undervalued. His weekly commentaries are thoughtful and the show a consistency of thought that I really appreciate.

The bottom line for me is that I can sleep at night with this investment. Their hedging strategy fits well with my loss aversion and I still get a good exposure to market upside.

Unconventional Success - An ER Book Review

David F. Swensen is the manager of Yale's endowment. It's one of the largest in the world and, more importantly, it is considered the best run endowment. His ten year record of 16.8% for a fully diversified portfolio is unmatched.

Thankfully for us, he decided to write a book about personal investing. It's uninspiring cover art and uncreative title, Unconventional Success: A Fundamental Approach to Personal Investment, are it's two most glaring issues (I really think the cover and title are testaments to Swenson's un-flashiness and lack of gimmickry).


The book lays-out the following argument:

1. Most investors rely on money managers (brokers, mutual funds, etc.) whose compensation systems are in conflict the the investor's objectives.
2. Academic and real-world studied have shown that diversification, low fees and rigorous re-balancing are the three keys to investment success.
3. Stock picking, market timing and chasing last year's 'hot hand' do not produce consistent results.
4. There are six core asset classes that every investor should be exposed to in their portfolios: US equities, foreign developed equities, foreign emerging equities, real estate, US treasury bonds, US treasury inflation protected securities (TIPS).
5. Every other available asset class (muni's, corporate bonds, mortgage bonds) are simply combinations (from a risk perspective) of the 6 core assets.
6. You should use very low cost and tax-efficient ETF's or mutual funds to invest in the core asset classes.
7. It is critical to re-balance (sell a portion of winners to invest in losers) to ensure you do not get too much exposure to a single asset class (think about the 2000 tech collapse).
8. The vast majority (95%+) of mutual funds and some ETF's are a total scam. High fees, poor after-tax performance and a core misalignment of interests make actively managed mutual funds a loosing proposition for individual investors (he presents a ton of evidence supporting these claims).
9. Vanguard and TIAA-CREF are non-profits and investors' best bets for ethical business practices w/ investors. He also mentions Long Leaf Partners and Numeric Investors as highly ethical mutual fund companies - I would add Hussman to that list.

This is a game changer for me. I've always known that I should have more of my portfolio in passive and diversified index funds, but nobody with Swenson's 'street cred' has built such a convincing case. I think I'll always play some stocks, I just need to segregate the vast majority of my portfolio to the side for a true asset allocation.

Read this book. It's a bit dry, but you'll be a better steward of your money for reading it. I'll leave you with one paragraph from the book where Swenson 'let loose' on full-service brokers:

The full service offered by full-service brokers generally impairs the investor's odds of success. Full service includes demonstrably worthless research. Full service encompasses clearly irrelevant broker advice. Full service costs materially more than other trading alternatives. Investors who employ full-service brokers pay a very real something for an extremely costly nothing.

Kiddie Tax for 2006

One of my first and most popular posts was about using custodial accounts for your kids to shelter tax on non qualified dividends and interest. Here is an updated version for the 2006 tax year.


If you have young dependent kids and significant unearned income (interest, dividends, etc.), you can convert a portion of that high taxed income to tax free with a few clicks of a mouse. Here's why: your children can earn up to $850 per year of interest and dividends tax free and another $850 taxed at only 10%. Anything over $1,700 will be taxed at your rate.

Here's what I did:

1. I created a custodial account for each of my children @ E*Trade (all of my accounts are with E*Trade)
2. My wife and I made tax free gifts to each of their accounts - each kid got a total of $15k
3. I invested their new found money into high dividend stocks such as FRO, SFI, ACAS (no need to put the money into stocks that are entitled to the 15% dividend tax - I went for maximum gross dividends)
4. At tax time, I simply file a IRS Form 8615 for each kid on my return and the income gets tax at the reduced rate.
5. With 2 kids @ $1700 of income per child, I'll save $782 in taxes just this year! (My marginal rate is 28%)

Words of caution:

• Always consult a tax adviser if you are unsure of how this would impact you
• When you give your children money, it's theirs... it can only be used to their benefit or you risk losing the tax benefit
• Just because it works for me, doesn't mean it will work for you.

UPDATE: Political Calculations has built another wonderful calculator based on this post.

Index Investing - Fantastic Resource

I've been wanting to write a post on active versus passive investing and, in doing my research, I ran across a truly wonderful and FREE web resource. It's IFA's 12 Step Program: Active Investors Anonymous.

Clever art, great analytics, and sound advice... what more could you ask for.

Another Favorite Investment - iStar Financial

iStar Financial (SFI) is a MREIT that specializes in complex corporate real estate lending. I've owned it for several years and it's been a great investment (both capital appreciation of 44% and my cost-based yield of 11.5%). Although I have discussed in the past that you should hold REITS and MREITS in tax deferred, tax free or kiddie tax accounts, this happens to be in my taxable account.

I have always assumed that the taxes on the dividends from iStar would get smacked with my marginal income tax rate (28% federal). Not so... based on the latest press release from iStar:

During 2005, taxable dividends for iStar Financial's common stock were $2.93000 per share. For tax reporting purposes, the 2005 taxable dividend will be classified as follows: $1.90554 as ordinary income, $0.37271 as 15% capital gain, $0.03419 as 5% capital gain, and $0.61756 as return of capital.

I had no idea that an MREIT had different levels of taxation from their dividends. This is definitely good news and it somewhat impacts my thinking about whether they should be put in tax-deferred accounts.

I took the iStar dividend numbers into excel and calculated my my true tax rate on the 2005 dividends. It turns out that at a 28% marginal tax rate, iStar would be taxed at 20%. This moves my after-tax, cost-based yield from 8.2% to 9.1%... a full 90 basis points!

It will be interesting to see if E*Trade properly reports this on my 1099.

Religion & Politics

I'm a bit of an oddity. I'm a politically conservative Unitarian Universalist. No one really knows how many of us exist, but we're surely on the endangered UU species list.

Our Board of Directors recently passed a resolution that stated that our Church has taken a formal stand against a proposed amendment to Virginia's Constitution that bans same-sex marriage or any legal approximation thereof. It's a poorly written amendment and, I believe it is bad law: it limits private contracts. The Board resolution, however, had several debatable findings of fact (like equating same-sex marriage to the civil rights struggles of the 50s and 60s).

I don't want to write about same-sex marriage... I doubt I can come up with any position or argument that hasn't already been made. Rather, I want to discuss the wisdom of individual Churches and Denominations taking 'official' stands on divisive issues.

This topic was bantered back and forth yesterday on my Church's discussion board and I have a few choice quotes to share.

It all started when one member simply asked, "How many individuals at church actually voted to oppose HJR 585?" Seems like a valid question since the Board resolution states that 'the Church' opposed the amendment.

Next, there were some clarifications that the Board unanimously voted for the resolution, and that the Church had voted overwhelmingly to become a welcoming congregation. I made the observation that I didn't like when our Church or Denomination makes 'Single Voice' pronouncements about divisive issues and, if we do, we should offer opponents the chance to offer their dissenting opinion. Well... that opened-up the flood gates of comments from other members:

What is a legitimate 'dissenting view' on this issue?

...true forces of darkness, having lost the ability to persecute people on the basis of religion (for the most part) or skin color still feel safe in persecuting homosexuals.

But do we offer a justification of racism -- to prove our intellectual diversity -- or justification of economic exploitation and coercion of the poor when speaking on other social justice issues? I hope not. Similarly, I don't see the need to offer the "other" view on homosexual marriage.

And what does it say about our ability to be a moral force in a world in which right-wing fundamentalists (whether Christian or Muslim or Jewish versions) feel no limitations on their action in the public arena and are actively working to take over governments and kill off the opposition?

Wow! I think I touched a nerve. I offered the following:

I have no problem, what so ever, with a group of concerned UUs aggressively lobbying for social change. I struggle with those people using the Church (the church that I consider a second home for me and my family) as their communication vehicle. I think the family analogy is a good one. How you you feel if you disagreed with 90+% of your family on a given issue and your family made a public statement that said, "Our family believes x". Would you feel welcome in your own family? This family estrangement is what many UUs feel when the Association or individual Churches make sweeping pronouncements concerning divisive issues whether it be political or theological (remember when Sinkford made his god comments a while back? How did that make humanists and atheists feel?).

If you don't want dissenters in the family, do what other religions do and proclaim that you have discovered the One Truth. If you want dissenters in the family, encourage members to organize in the larger community to fight for what they feel is important - always knowing that they can come home and be with their family.

Then, my friend offers:

You are faced with the a common dilemma, one that most everyone faces at one time or another ... if they are involved in a pluralistic organization or society. You disagree with a position, or policy, or a statement made by that group. Everyone in this situation must then ask themselves if this problem is significant enough to require that they no longer be associated with the group. If it is, they leave, but if they can live with it, they either choose to accept things and let go and/or they fight to change the group.

Great point. This is what I have been doing for the last four years when I'm in the minority at Church. I, however, came up with, in my un-humble opinion, a convincing counter argument:

The group also has a decision to make. Which is more important: making a statement as the group on an issue that does not have unanimous support and risk alienating some members of the group -- or -- refrain from making 'group' comments and encourage sub-group and/or individual comments.

In a business or political party setting, I would certainly choose the former due to the need for a single, strong voice.

In a family, religious or social situation, I would choose the latter - family and friends (for me, at least) trump economic, political and policy issues every time.

Let me know your thoughts on the matter.

PS - I'm 90% recovered from my illness and the regular posting schedule has resumed.

More Wal-Mart

Check out Arnold Kling's response to the Maryland Wal-Mart law...TCS Daily - Liberals Should Know Better.

Here's the 2nd paragraph - it hit's close to home for me with my friends in UU-land:

Most of my friends are liberals. This series is the conversation I wish that I could have with them. I wish they would let me finish my train of thought before
interrupting. I wish that they would consider my arguments, rather than try to bury them in rhetorical put-downs.

Don't worry, it's not an attack on 'liberals'... it deals with the unintended consequences of government meddling in market (in this case, the labor market) dynamics.

Overvalued, Overbought, Overbullish

Here is Hussman's weekly commentary... Hussman Funds - Weekly Market Comment: January 16, 2006 - Overvalued, Overbought, Overbullish

And the 'money' quote:

On average, this set of overvalued, overbought and overbullish conditions has historically produced tepid results even when the broad quality of market action has been favorable on the measures we use, and has been downright mean when the internal quality of market action is unfavorable (such periods include February 1962, December 1972, and August 1987, all which shortly preceded violent declines). Given current conditions, the quality of market action is best described as either tenuously unfavorable or neutral, so in any event, market risk hardly appears worth taking at present.

Early Riser - Down For The Count

Loyal Readers,

I've been sick all weekend and I'm still under the weather. I'll be back tomorrow (hopefully) with some sort of moderately interesting post.

ER

Maryland Is Now A Province Of Red China

I cannot believe the short-sighted legislation that Maryland just passed. The bill forces any employer that has more than 10,000 employees in Maryland to spend 8% of their payroll expense on health-care for their employees. It just so happens that Wal-Mart is the only employer in MD that has over 10,000 employees. What a coincidence!

Here are some choice quotes from the liberal brain trust:

"Don't dump your employees that you refuse to insure into our Medicaid system," said the bill's sponsor, Sen. Gloria Lawlah.

In the House, Delegate Anne Healey compared Wal-Mart to a schoolyard bully. "We're here to tell this bully to change his behavior," she said.

And the minority voice of reason:

House Republican Leader George Edwards called the measure an unwarranted intrusion into private enterprise. "If you don't want to work for Wal-Mart, no one's twisting your arms. Go somewhere else and work," Edwards said.

Wait... you mean Wal-Mart employees aren't indentured servants!?! I didn't know they had a choice of where to work!

If I was Wal-Mart, I would immediately close enough facilities to get under 10,000 employees in MD (they currently have 17,000). Then I would open distribution centers & technology centers just on the other side of the MD state line in each of the neighboring states.

An alternate strategy would be to contribute the money to health care expenses that directly help Wal-Mart's bottom line... smoking secession programs, weight loss programs, etc.

If Maryland is really committed to employers providing health-care, they should pass a law that requires every employer to provide health-care. This won't happen, however, because it would create more unemployment and, therefore, more folks on the Medicare rolls. That being said, I never underestimate the lack of economic literacy of politicians. Time will tell if idiot-legislators from other states will try to crater their economies with similar bills.

Update: Go read Don Luskin's column over at The Conspiracy.

Employee Stock Option Diversification - A Different View

I posted a series of articles a few weeks ago that dealt with analyzing Employee Stock Options (Part 1, Part 2, Part 3, Part 4). As my company’s stock has continued to appreciate, I have sold about 30% of my vested options (much to the dismay of my tax preparer - me).

I have written about the desire to diversify my risk by reducing my exposure to my company’s stock. Currently, my options’ exercise value is about 21% of my net worth (excluding my house). Not too bad, but I really don’t want any single investment to be more than 5% of my net worth.

I was trolling through Quicken last night and I had a bit of a revelation: comparing a highly leveraged investment to non-leveraged net worth, may incorrectly minimize your over-concentration risk. What if we valued the ‘in the money’ options as if we held the underlying stock? My 21% would grow to 51%. Yikes!

I think the 51% is the best way to understand how the movement of your company’s stock impacts your overall portfolio. This means that a 10% decline in my company’s stock would reduce the total value of my portfolio by 5%.

I think I’m going to sell some more options today.

Hussman Weekly Market Comment - Do P/E Ratios Expand Once the Fed is Done?

Here's a link to the latest Hussman market commentary: Do P/E Ratios Expand Once the Fed is Done?

And the money quote:

If we restrict valuations to a price/peak earnings multiple of 16 or higher (the current multiple is 19), we find that on average, S&P 500 earnings declined by -8.6% over the 18 months after the final rate-hike. Yet despite this decline in earnings (which would normally raise the raw P/E ratio if prices were to remain constant), the raw P/E ratio actually declined as well, by an average of -1.3%. The result was an average loss, including dividends, of -6.5% over the 18 month period (an annualized loss of -4.4%).

TRFX - The Latest Early Riser Investment

I purchased some shares of Traffix (TRFX) at $5.90 yesterday. Traffix is an on-line advertising firm. It's also a Prudent Speculator pick.

You say, "Why did you buy some third-string online advertiser?"

I say, "I'm glad you asked."

• Any Prudent Speculator pick is, in my book, pre-qualified for my investment dollars due to my record with their picks.
• Gross Margins of 50%+
• $35M of cash and equivalents on their balance sheet (that's more than $2 per share)
• An annual dividend of $0.32 or 5.4% (15% taxation)

I have decided to post all of my trades from this point forward to give my readership an idea of my personal finance ideas in action. I'll keep you updated on TRFX.

Note: I'm always looking for good topics to write about. Please don't hesitate to leave your personal finance questions as comments to my posts and I promise to write an article about your topic of choice.

SinceSlicedBread.com

Instapundit has an ad link to SinceSlicedBread.com. The site supposedly contains 21 great ideas to make the country stronger and we're allowed to vote for our favorites. Sounds pretty compelling, huh?

Nope... it's a lame collection (with a few exceptions) of socialist rantings - very few of which are actually new ideas. Here are some of the fascinating ideas:

Medicare As A Single payer - Hillary-care!

Massive Public Works Projects

Civil Works Corps - more spending, again!

Blanket The US With Wireless Access - for free, of course

Universal Health Care - again

Extend Social Security Tax Beyond $90k - more taxes.... Hurray!

Ownership of Retirement Assets - uhhh... I guest they have never heard of 401ks and IRAs

These idea sounded a bit suspicious to me so I scrolled down to see who runs the site. At the bottom there is a logo that says SEIU with the tag line - "Stronger Together". Sounds like some left-leaning think tank.

I click on the logo... ohh... it's the Service Employees International Union. I guess it now makes sense.

There are a few reasonable, non-socialist ideas like teaching Personal Money Management to High School students that I voted for. Everyone should visit the site and try to only vote for the ideas that don't further the interest of the union.

I love dividends

First, a favorite quote...

The handout and the spokesman threaten our diligence, our ingenuity, our skepticism, our zeal. For zealots we must be. Not for a cause. For facts and for truth—and all of the truth.
Frank H Bartholomew, President, United Press 1958

I'm going to start offering my favorite quotes so my blog posts seem classier.

Allow me to count the ways I love dividend paying stocks...

• At it's core, a company's stock price should be the net present value of it's future dividends. Companies that pay dividends today are, by this definition, more valuable than non-dividend paying stocks.
• They are less risky. Most companies that pay dividends have profits that exceed their dividend rate.
• Favorable tax treatment - sometimes. Other than REITS (Real Estate Investment Trusts) and MREITS (Mortgage Trusts), dividends are taxed at 15%. REITS & MREITS are taxed at your marginal tax rate. You can mitigate the impact of REIT taxation by placing them in an IRA or a KIDDIE TAX account.
• Regular, no-work-required, passive income. For all you RDPDs (Rich Dad, Poor Dad) fanatics, you'll understand the draw of a monthly or quarterly check.
• Your yield on your investment can increase significantly based on earnings growth of the company.

Here are a few of my favorite holdings, their current dividend rate, my dividend yield based on my cost basis and the tax treatment:

• Washington Mutual (WM) - 4.3% current yield - 4.9% for me - 15% taxation
• Ameren (AEE) - 4.9% current yield - 5.8% for me - 15% taxation
• Hospitality Reality Trust (HPT) - 7% current yield - 10% for me - REIT taxation
• JP Morgan (JPM) - 3.4 % current yield - 5.1% for me - 15% taxation
• UST (UST) - 5.3% current yield - 7.9% for me - 15% taxation

I got all of these picks from The Prudent Speculator.

The Danger of Cash Flow Thinking

I have a friend at work - let's call him Don (the name has been changed to protect the foolish). After many white board sessions, my friends and I convinced him to put a full 15% of his salary into our company's Employee Stock Purchase Plan(ESPP). As I have discussed before, if your plan is set-up properly and you can sell your shares immediately, participating in a ESPP is a financial slam dunk.

Now, Don wants to buy a house... "Great!" I say - a house is one of the best net worth growers in existence. I heard through the grapevine, however, that he plans on ceasing his ESPP contribution so that he can afford the house payments. What!?! You are no longer going to participate in a plan that generates an annualized return on your investment of over 100% almost risk-free.

Looks like we're going to need another white-board session. I'm afraid Don is viewing the ESPP payroll deduction as an expense and not as an investment. He has a good handle on his cash flow (most people do) but he's missing the net worth boat.

When you are faced with a cash flow shortfall you need to ask yourself a few questions:

• Is this shortfall permanent or temporary? - If you make some fundamental change (like buying a house) that hurts your cash flow, you need to take a step back and re-evaluate all of your savings, debt and spending.
• What is the opportunity cost of reducing my savings / investment rate and how does that compare to my debt costs? - This is the analysis that Don needs to do. His ESPP investment has an annualized return of over 120%. A HELOC or good credit card has an annual cost of 7-15%... any questions?

The bottom line is that Don needs to look for alternate ways to shore-up his cash flow crunch. Eliminating his ESPP participation is a cash flow positive move that comes with a severe net worth cost.

Investment Newsletter Review: Prudent Speculator

My father has received the Prudent Speculator investment newsletter for over 10 years. In that time, I have peaked over his shoulder and taken many of Prudent's picks and purchased stock. Based on my first investment newsletter review, I'll discuss Prudent in terms of the Early Riser Rules.

A one-year subscription costs $295 and has a 100% money-back guarantee. Additionally, the employees of the company 'eat their own cooking' and invest in the newsletter's related mutual fund (as do I). Therefore, Prudent passes Rule 1 & 2...

Newsletter Rule #1: Low risk purchase
Newsletter Rule #2: Publisher must stand behind the quality of the newsletter

According to Hulbert, The Prudent Speculator is the #1 ranked investment newsletter for 10, 15 and 25 year returns. It's important to note that this ranking does not factor-in risk of the suggested investments, rather it's just the total return. Once risk is taken into account, Prudent drops to just being in the top 5... still, not too bad.

Their investment philosophy is basic value investing (looking for undervalued companies) coupled with an almost extreme buy & hold strategy. The now-deceased founder, Al Frank, calls this investment patience 'benevolent neglect'. In fact, they recently examined how their returns would have looked with 10, 15 and 25% trailing stops. They found that their returns would have been lower with the stops versus with their benign neglect.

There's nothing special about value investing. Prudent's devotion and patience with their value picks is, however, unique enough to generate leading returns. In my book, they satisfy Rule #3...

Newsletter Rule #3: Author must have unique knowledge or skill that cannot easily found in the market.

Every month the newsletter contains a 'Pick of the Month' article, a selection of 10 'Portfolio Builder' stocks (a list of buys that follows some theme) and a listing of all currently recommended stocks. This listing is my favorite destination. It lists over 100 stocks that meet their stock screening criteria and that are trading below the newsletter's 'buy-limit'. Every other month, I find myself making a few trades based on this page.

The newsletter also has a web site that has 'Flash Updates' every few days and a listing of the buy and sell limits for all stock that have been recommended in the past and are trading below their sell limit (it's a really big list). The site and the newsletter are timely and well designed, satisfying rule #4...

Newsletter rule #4: Newsletter must provide timely and actionable information

For the last 4 years, I've been buying (and selling) their stock picks. I've had several home-runs (stock & buy-price):

• MO at $25
• VCLK at $2 (sold @10)
• UST @ $30
• and many (15+) others

and a few strike-outs including zoom @ $9 (I sold at $5). There have also been a few instances where I prematurely sold, Prudent held and I missed-out of big upside. The bottom line is that their advice has been very profitable for me and I'll continue to take their picks.

Unfortunately, it has not been profitable for my dad. His investment style is much more aggressive than mine. Where I tend to make more frequent, smaller buys, he tends to make a few, large trades and holds them (well actually... he sells his winners too soon and holds his losers indefinitely). His big bets have been on the wrong stocks and he cannot stand to recognize his losses.

Newsletter Rule #5: The newsletter must produce uniquely good results for me.

This is the most important rule and in the case of The Prudent Speculator and me - the answer is an unqualified yes. For my dad, the answer is no. Your mileage may vary.

Intellectual Honesty

As much as I respect my devout friends and family, one of the biggest challenges I have with most very devout folks is their lack of intellectual honesty when dealing with issues that cross over between faith and the material world.

Intellectual Honesty is an attribute of a good argument...

• Acknowledging the limits and weaknesses of your argument
• Directly answering your critics questions
• Avoiding common argument fallacies (from Sagan's Demon Haunted World)

This is not intended to imply that these folks are not intellectuals or honest, because they are really smart and honest. I'm really talking about a general tendency that faithful people have when they discuss their faith. Maybe that's the point... faith is above discussion for many people. When their faith, however, impacts material world issues, it's not enough to simply disengage and claim that faith is not debatable.

A few examples...

• Intelligent Design - if you want to criticize evolution, great... scientific progress is fueled by objective, peer reviewed critiques of current scientific thinking. Most people who push ID, however, start with the underlying position that God created humans and they look for any shed of evidence that supports the claim. Most are not seeking objective truth... there is no amount of evidence that would cause them to support evolution.
• Religion in the 'Public Square' - I'm always surprised when very religious and socially conservative folks want prayer in public schools or in government. If I were them, I would only want to hear god-talk from people that I was in complete theological agreement with. For most conservative Christians, I highly doubt that public school teachers would be parents' first choice for religious education. I'm not really sure why they want prayer in public schools, but I'm pretty sure it's not to replace the role that parents and churches to play in religious education.
• Abortion - this is an issue where the religious pro-life position is much more intellectually honest than the pro-choice folks. The central issue of abortion is: when does life begin? The pro-lifers' argument centers around this question and their answer is that life begins at conception. You may disagree, but at least they are taking a stand. The pro-choice argument avoids the topic of the beginning of life because their position (life begins at birth) is really indefensible. They, instead, focus on 'Rights' and 'Privacy'. Until the hard-c0re, pro-choice organizations (NARAL, NOW, etc.) honestly addresses the definition of life, the two sides will never be able to have a thoughtful discussion. (Full Disclosure - I believe life begins at the quickening.)

ER Book Review: Heaven on Earth

The road to hell is paved with good intentions.

Joshua Muravchik has written a compelling history of the rise and fall of socialism. He traces it's roots from French revolutionaries, through English Utopians, the USSR, and Communist China.

Each chapter moves us through one attempt after another to establish a well intended idealistic socialist society. We meet the leaders, we understand what motivated them to embrace socialism and we see the disastrous impacts of what Hayek predicted. When you seek to centrally control economic activity, necessity will demand that you try to centrally control all activity. This is because human nature is in direct conflict with the central operating principle of socialism. Human nature drives us to expend the most effort to support those closest to us. Socialism forces us to expend effort to support society as a whole and there is no connection between my effort expended and the benefit to my family.

Here is Thomas Sowell's review from Amazon:

Socialism is a wonderful idea. It is only as a reality that it has been disastrous. Among people of every race, color, and creed, all around the world, socialism has led to hunger in countries that used to have surplus food to export.

Its economic disasters have afflicted virtually every industry. In its Communist version, it killed far more innocent civilians in peacetime than Hitler killed in his death camps during World War II.

Nevertheless, for many of those who deal primarily in ideas, socialism remains an attractive idea -- in fact, seductive. Its every failure is explained away as due to the inadequacies of particular leaders.

Many of the intelligentsia remain convinced that if only there had been better leaders -- people like themselves, for example -- it would all have worked out fine, according to plan.

A remarkable new book makes the history of socialism come alive. Its title is "Heaven on Earth: The Rise and Fall of Socialism." Its author, Joshua Muravchik, is a scholar at the American Enterprise Institute, a leading think tank in Washington. It is hard to find a book on the history of socialism that is either readable or accurate, so it is especially remarkable to find one that is both. The story told in "Heaven on Earth" is so dramatic and compelling that the author finds no need to gild the lily with rhetoric or hype. It is a great read.

This history of socialism begins more than two centuries ago, at the time of the French Revolution, with the radical conspirator Babeuf, who wanted to carry the revolutionary ideas of the times even farther, to a communist society.

It ends with current British Prime Minister Tony Blair, who brought the Labour Party back to power by dropping the core of its socialist agenda and putting distance between himself and previous Labour Party governments, whose socialist policies had so backfired that the party lost four consecutive national elections.

In between, there are stories of small communal societies, such as that founded in the 19th century by Robert Owen, the man who coined the word "socialism," as well as stories of huge nations like China and the empire that was known as the Soviet Union.

In all these very different societies around the world, the story of socialism has been a story of high hopes and bitter disappointments. Attempts to redistribute wealth repeatedly led to the redistribution of poverty.

Attempts to free ordinary people from oppression repeatedly led to what Mikhail Gorbachev frankly called "servility" to new despots. How and why are spelled out with both facts and brilliant insights expressed in plain words.

Human nature has been at the heart of the failures of socialism to produce the results it sought, even when socialist leaders were idealists like Julius Nyerere in Tanzania or Pandit Nehru in India.

Nowhere have people been willing to work as well for the common good as they do for their own benefit. Perhaps in some other galaxy there are creatures who would, but the track record of socialism among human beings on earth shows that this is not the place.

Worst of all, the concentration of political power necessary to try to reduce economic inequalities has allowed tyrants like Stalin, Mao and Pol Pot to impose their notions and caprices on millions of others -- draining them economically or slaughtering them en masse or exploiting them sexually.

Mao Zedong, for example, had harems of young girls -- and occasionally boys -- for his pleasure in various parts of China.

There is no point blaming the tragedies of socialism on the flaws or corruption of particular leaders. Any system which allows some people to exercise unbridled power over other people is an open invitation to abuse, whether that system is called slavery or socialism or something else.

Socialism has long sought to create a heaven on earth but an even older philosophy pointed out that the road to hell is paved with good intentions.

Buy it.

Hussman's Market Commentary

I recently purchased Hussman's Strategic Growth mutual fund (HSGFX) because I began reading and really enjoying John Hussman's weekly market commentary. This guy is really smart and thoughtful (two qualities that rarely find themselves together in great quantities).

Here's a sample from this week's commentary:

USA Today ran a piece noting that the historical average return on stocks has been 10.4%, with various analysts voicing the opinion that, basically, last year's sub-par return increases the odds that future market performance will revert higher. That's the “gambler's fallacy” if I've ever heard it – the notion that a string of bad rolls raises the probability of a good one.

Unfortunately, in stocks, the things that produce above average returns are a) below average valuation or b) a propensity of investors to accept increasing amounts of risk, which can be largely read out of the quality of market action. Presently, we have neither. That's not to say that 2006 is destined to remain in this particularly negative Climate, but here and now, there's little to suggest the probability of above average returns until the evidence changes.

The fact is that the 10.4% historical return on stocks breaks into three simple pieces: an average earnings growth rate (measured from peak-to-peak across market cycles) of about 6%, a mild secular uptrend in price/earnings ratios over the past century, which added about a half percent to annualized returns, and an average dividend yield of just under 4%. Those pieces, by the way, are exhaustive. Mathematically, you can fully characterize the total return on stocks with a) earnings growth, b) changes in the P/E multiple, and c) the dividend yield. Note in particular that factors such as stock buybacks are already taken into account in the calculation of index fundamentals such as earnings and dividends for the S&P 500. The three factors above really are exhaustive.

Given a durable, robust historical peak-to-peak earnings growth rate of 6%, a current dividend yield of 1.8%, and a starting price/peak earnings multiple of
19, stocks are currently priced to deliver long-term returns of 7.8% annually provided that price/earnings multiples stay at a “permanently high plateau” indefinitely. Allow that multiple to contract to anywhere close to historical norms (historically, when trailing net earnings on the S&P 500 have been at a new high, the P/E ratio has averaged just 12), and stock returns have the capacity to be very unsatisfactory even over periods of 5-10 years or more. Suffice it to say that 10.4% returns are not inherent in stock ownership. Rather, long-term returns are, and always have been, a function of initial valuations (and as a tautology, ending valuations).

This is great stuff and you should make Hussman's site a weekly destination.

(Mostly) Really Deep Thoughts

If you asked the top 100 thinkers...

WHAT IS YOUR DANGEROUS IDEA?
The history of science is replete with discoveries that were considered socially, morally, or emotionally dangerous in their time; the Copernican and Darwinian revolutions are the most obvious. What is your dangerous idea? An idea you think about (not necessarily one you originated) that is dangerous not because it is assumed to be false, but because it might be true?

... what would you get? Some pretty compelling reading. This is what the Edge Foundation recently did and the results can be found here.

A few observations:

• When scientists and researchers write about their area of expertise, they really excel.
• When they talk about an area outside their sphere of knowledge, they often take rather silly positions.
• I don't understand modern physics. There are several posts about string theory, dark matter and multiverses that I just cannot comprehend.

Best Responses

Craig Venter writes about the sociatial impact of people realizing that much of our personality and behavior is dictated by our genetics.

Paul Ewald tells us about the golden age of medicine.

Oliver Morton writes about how our planet is NOT in peril... the human race, maybe... but not the planet.

Worst Responses

David Bodanis thinks that Western civilization is declining.

Geoffery Miller says that runaway consumerism is the reason why E.T.'s haven't reached-out and said hello.

Simon Baron-Cohen thinks our governing bodies should be more empathetic and not so manly.

Mihalyi Csikszentmihalyi doesn't believe the market system is enough.

Risk Assumption & Insurance

As we go through life, we are faced with many risks of loss... your house burning down, a premature death, losing an engagement ring, your stereo breaking before you expected it and so on. The frequency of these events can be measured by insurance companies and you can buy insurance to recoup the costs of each of these events.

When a financial planner works with you to plan your insurance purchases, they may tell you that you shouldn't buy some types of insurance such as: children's life insurance, extended warranties for consumer electronics, or disease-specific coverage (eg. cancer insurance). What they are really telling you is that you can afford to assume the risk of some perils. In other words:

You should only buy insurance for potential losses you cannot afford.

To explain, let's look at a few examples:

• Life Insurance for a Child - beyond the fact that I find the whole idea quite distasteful, a child's death is rarely a financial burden on the family. It's certainly one of the worst things that can happen to a family... it's not, however, a financial risk
• Extended Warranties - this is one of the best money-making products that retailers sell and it's almost always a bad deal for consumers. If you can't afford the loss of your new TV breaking two years from now, you probably shouldn't be buying it.
• Engagement Ring Insurance Riders - you need to understand the replacement value of your ring as compared to your net worth. My wife's ring could be replaced for less than 1% of my net worth. Would it suck to have to replace it? Absolutely. Would it hurt our finances? Not materially.

The ring example adds one additional dimension to the risk assumption statement above:

You should only buy insurance for potential losses you cannot afford or don't want to afford.

If the thought of financing your own risk of loss makes you worry and adds stress to your life, you should consider purchasing insurance coverage for those emotional perils.

Can you trust your insurance agent?

One of my favorite shows on TV is 'Entourage'. The main character, Eric, is his best friend's (Vince) Hollywood agent. Eric is always looking-out for Vince and he's trying to do what is best for him. He battles with the studios, co-stars and Vince's other friends - all for Vince. Sure, he get 10% of Vince's earnings and Vince could fire him if he doesn't like his performance. They both know, however, that their future fortunes are strongly linked together.

Quick quiz: when it comes to your Insurance Agent, are you Vince?

Answer: not unless you own the insurance company.

Here's the deal - insurance agents are acting as agents for the insurance companies, not you. This means that their legal and moral obligation is to maximize profits for the insurance company, not necessarily to give you the best value for your insurance dollar.

Are there honest agents who serve consumers very well? Absolutely.

Are there agents who sell consumers over-priced policies that they don't really need? Absolutely.

What's a consumer to do? Well, if you really trust your agent, go ahead and stay with them. Just make sure you shop your policies around to make sure you're not spending too much.

If you're a financial do-it-yourselfer (like me), learn as much as you can (I just completed an insurance course at The American College) and use the internet to find the best policies.

If you don't understand insurance and have no desire to understand insurance, find yourself an insurance broker. Unlike agents, insurance brokers have a fiduciary responsibility to serve your best interests. Brokers have access to many insurance companies and can help you navigate the complexity of the insurance business. They still may want to sell you more insurance than you really need, so be on guard and ask questions.

Better yet, find yourself a fee-only Certified Financial Planner to help you through your insurance decisions.