A Positive Step by Regulators

Posted on May 1, 2014 | Investor Update

The Financial Industry Regulatory Authority (FINRA) took a positive step last week by proposing mandatory background checks on brokers. The proposal requires firms to verify the accuracy and completeness of the information contained in an applicant’s Form U4 (the Uniform Application for Securities Industry Registration or Transfer). Firms would also be required to search public records to ensure the data is correct.

In essence, when a person applies to work for a brokerage firm, either as a new employee or as a transfer from another firm, the hiring company would have to confirm that the job candidate is not misrepresenting himself. This confirmation process would include checking to see if the candidate is hiding any past criminal activity.

FINRA further proposes searching all publicly available criminal records for any registered individuals who have not been fingerprinted in the last five years. The regulatory body then intends to conduct periodic reviews to ensure the information provided to the public is accurate. FINRA operates the BrokerCheck website, which allows individuals to do a background check of a broker. The database has been the subject of criticism for omitting red flags about brokers.

The majority of brokers and advisers are honest, but, as is the case with any field, there are also some who are malfeasant. The difference between a fraudulent broker and, say, a fraudulent car mechanic is the magnitude of the financial damage they can inflict. A mechanic out to rip off his customers might cost you hundreds or perhaps even a few thousand dollars. A broker out to rip off his clients can cost you a far larger sum. In both cases, the bad apples are in the minority, but it does not take a very large percentage of unethical professionals to give an industry a bad name or to create a long list of unfortunate victims. Thus, it is important that you ask questions and do background research.

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How I Analyze Earnings Reports

Posted on April 24, 2014 | Investor Update

On Tuesday, I had a triple serving of earnings reports. Two of the stocks I follow for AAII Dividend Investing, Travelers (TRV) and AT&T (T), announced their quarterly results. Skyworks Solutions (SWKS), which I personally own, also released earnings. Compounding matters, the May issue of the AAII Journal was due to the printer. Needless to say, I had quite a bit on my plate.

Fortunately, I’ve learned techniques from years of analyzing earnings releases to streamline the process. It’s not a completely formulaic process since every company has different divisions and statistics. Some even release different documents. AT&T particularly bogs down the process by issuing a press release, two sets of presentation slides and several spreadsheets. Still, there are generalities of what to look for that apply to most companies.

Hone in on Revenue, Earnings per Share and Net Income—The very first thing to do is to determine the rate at which revenues, earnings per share (EPS) and net income have changed. Have they grown or decreased from the same period a year ago? How do the growth rates for each line item compare to the other two? If profits grew faster than sales, the company’s margins widened. If sales grew faster, margins shrank. If EPS grew faster than net income, then EPS was boosted by a reduction in the share count. Depending on how the earnings release is formatted, it can be easier to simply calculate the growth rates yourself.

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Don’t Fret Over the Market’s Recent Volatility

Posted on April 17, 2014 | Investor Update

It certainly feels as if Mr. Market has reverted back to being a toddler: happy one minute and cranky the next. Those who own highly valued momentum stocks such as Netflix (NFLX) and Facebook (FB) have certainly felt the impact of the volatility.

Though some stocks have been whipsawing, the markets overall have been less volatile than they feel or some headlines suggest. As of last Friday’s close, the S&P was just 3.9% below its record high closing. The large-cap index has also only ended up or down by 1.5% or more four times this year. The action feels more volatile because the recent decline has occurred quickly, as downward moves typically do. Plus, last year was a calm one. I counted just eight days with a closing price change of 1.5% or greater and only four days with a closing price change of greater than 2% for all of 2013. Depending on what stocks are in your portfolio, you may have experienced more or less volatility than the S&P 500 has this year.

As to whether the recent decline is a precursor of a market correction, I couldn’t tell you. The same holds true for all market forecasters. We are about to enter what has historically been the worst six-month period for stock prices (May through October). On the other hand, optimism in the AAII Sentiment Survey is at a level that has historically been followed by above average S&P 500 returns. Neither indicator has a perfect record, so we might have better accuracy trying to predict who is going to win this year’s World Series.

What can I say is those who stayed invested in stocks all of last year have a nice profit cushion to ride out any retracement that occurs this year. Even if a painful correction of 15% were to occur (and I’m NOT saying it will), a sizeable profit will still exist for an investor who bought an S&P 500 index fund at the start of 2013.

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The 200-Day Moving Average’s Record as a Timing Indicator

Posted on April 10, 2014 | Investor Update

One strategy I have heard people discuss from time to time is using the 200-day moving average as a timing indicator. Stocks are purchased when a broad market benchmark is above its 200-day moving average, and stocks are sold when the market benchmark falls below its 200-day moving average. Though there are variations in the type of the moving average used, the basic premise is the same: Own stocks when the market is above the indicator and sell stocks when the market is below it.

In his new fifth edition of “Stocks for the Long Run” (McGraw-Hill, 2014), Jeremy Siegel looked at whether this strategy is beneficial. He ran the numbers from 1886 through 2012 using the Dow Jones industrial average. He applied a 1% band, meaning the Dow had to be at least 1% above its 200-day moving average to trigger a buy signal or at least 1% below its 200-day moving average to trigger a sell signal. The band is important because it reduced the number of transactions. Without it, an investor would be frequently jumping in and out, driving up transaction costs in the process. Siegel also assumed end-of-day prices were used.

Following the 200-day moving average timing strategy would have kept an investor out of the worst market downturns. Specifically, the investor would have avoided the large losses endured during both Black Tuesday (October 29, 1929) and Black Monday (October 19, 1987). The strategy would have also helped the investor avoid the 2007-2009 bear market.

Commenting on the results, Siegel observed, “The timing strategist participates in most bull markets and avoids bear markets, but the losses suffered when the market fluctuates with little trend are significant.” He added, “The timing strategy involves a large number of small losses that come from moving in and out of the market.”
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How to Beat High-Frequency Traders

Posted on April 3, 2014 | Investor Update

Author Michael Lewis ignited a debate within the financial community with his appearance on “60 Minutes” last Sunday. Lewis, the author of “Flash Boys: A Wall Street Revolt” (W. W. Norton & Co., 2014), called the stock market “rigged.” His reasoning? High-frequency traders are seeing what trades are being placed, jumping in line ahead of those investors who placed the trades and profiting at the expense of everyone else.

Brad Katsuyama, the man whose story Lewis tells in his book, used an analogy of buying tickets. Katsuyama described to “60 Minutes” a situation of placing an order to buy concert tickets for four adjacent seats on ticket exchange StubHub at $20 a ticket. A confirmation comes back saying only two tickets have been purchased. At the same time, the price of the other two adjacent seats has risen to $25.

The jump in prices described by Katsuyama, 20%, is a big exaggeration, but it clearly explains the allegation he trying to make: High-frequency traders are getting ahead of investors and are profiting as a result. High-frequency traders and their proponents counter that trading costs are being driven down and liquidity is being improved in the process.

Where’s the truth? The five-year 21.7% annualized return for the iShares Russell 3000 fund (IWV) as of March 31, 2014, shows good returns could have easily been realized by an individual investor who merely tracked the broad market’s performance. (A big reward for participating in the so-called “rigged” market.) Self-described long-term institutional investors Clifford Asness and Michael Mendelson of AQR Capital Management claimed in a Wall Street Journal op-ed that high-frequency trading is reducing their costs. On the other hand, if high-frequency trading firms weren’t making money, they certainly would change their approach.

It’s hard to discuss this subject without igniting emotions. It’s even more difficult to separate the facts from the hyperbole. What’s lost in the conversation is a focus on the market’s complexity. The digital structure underlying the market has become so complex, there isn’t a clear answer as what actual impact high-frequency traders are having on all other investors. Even Asness and Mendelson admitted not being “100% sure” as to whether high-frequency trading is actually reducing their costs. What we do know is that complexity not only can lead to problems such as the flash crash, but it can create anomalies and opportunities for malfeasance (legal, ethical or perceived).
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New Tax Rules for IRAs and Bitcoin

Posted on March 27, 2014 | Investor Update

The Internal Revenue Service (IRS) recently issued announcements regarding individual retirement accounts (IRAs) and bitcoin. Since more of you have retirement savings than bitcoins, I’ll start with IRAs.

In the April AAII Journal, which will be on AAII.com early next week, we introduce you to Alvan and Elisa Bobrow. This couple is responsible for promoting a change in the rules regarding when you can and cannot rollover IRA. The rollover rules allow you withdraw and redeposit funds from a traditional IRA on a tax-free basis as long as you do so within a 60-day window. Patrick Gutierrez, a specialist in employee plans at the IRS, told me some people try to take advantage of this window to get what is in effect a free, temporary loan.

I can’t speak to the Bobrows’ reasons for doing what they did, but here is the short version of the events. Between April and September 2008, the couple moved money in and out of three IRAs. The IRS, which currently allows one rollover per IRA account per year, said the Bobrows violated the rollover rules with their actions. The tax court not only ruled in favor of the IRS, but further said the tax code limits aggregate IRA rollovers to one per a 12-month period.

I hope you read that last paragraph carefully. Currently, IRS Publication 590 says if you roll over funds from existing IRA #1 to new IRA #3, you cannot make any other rollovers from these accounts during a 12-month period. You can, however, make a rollover from existing IRA #2 to new IRA #4 at any time. Just after the April AAII Journal went to press, the IRS issued a new bulletin saying that in light of Bobrow v. Commissioner, IRA rollovers will be limited to one per person per year. The new rule will apply regardless of how many retirement savings accounts a person owns. It’s not certain when the new rule will take effect, but the tax agency’s current intention is to have it take effect on January 1, 2015.

The new rollover rule will not apply to trustee-to-trustee transfers. Both Sally Schreiber, the senior tax editor at the Journal of Accountancy, and Mark Luscombe, a principal analyst at CCH Tax & Accounting, confirmed that this means you can move your IRA accounts to as many brokers as you would like over the course of a 12-month period. The key is that you move the actual account, and don’t move funds from one IRA to another. (If that sounds like a technicality, realize it is a big one.)
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Coping with Randomness

Posted on March 20, 2014 | Investor Update


I found myself struggling with my NCAA Basketball Tournament picks more this year than in the past. Partially it’s because of the parity that has evolved in men’s college basketball. Partially it’s because there are teams whose chances are tough to assess (e.g. North Carolina, Michigan State, my Kansas Jayhawks, etc.). Then there is the sheer randomness of the event that wrecks bracket picks.

The statistical odds of the tournament favor going with the top-ranked seeds, but upsets can and do happen. Fourth-seeded teams have lost during the first full round of play (now technically the second round of the tournament) more than 20% of the time since 1985. Seventh-seeded teams face nearly a 40% chance of not making it to the round of 32. Top-seeded teams may look invincible with a perfect record during the round of 64, but it’s only a matter of time one is beaten by a 16th seed. (For those of you who don’t follow college basketball, the NCAA tournament has seven single-elimination rounds, whittling a field of 68 teams to just two.)

As the tournament goes on, unexpected teams gain momentum and win more games than anyone predicted. Wichita State, Butler, VCU and George Mason all surprised expectations and busted tournament brackets by making it to the Final Four in past years. I don’t recall any of the major college basketball commentators advising to take a chance on any of those teams. (This year, Wichita State is a #1 seed and is certainly not an underdog. The Las Vegas Sun listed the school’s odds of winning the national championship as 4-to-1.)

No amount of analysis can help you pick the correct outcome of every game. This is why Quicken Loans is able to run a contest with a $1 billion prize; the chances of picking a perfect bracket are astronomical. USA Today cited DePaul University mathematician Jeff Bergen as calculating the odds to be one in 9,223,372,036,854,775,808. Yet many have scrutinized their picks this week, including myself, in hopes of getting them right. It’s a reflection of our inability to cope with random events.

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The Challenge of Deciding When to Retire

Posted on March 13, 2014 | Investor Update

One of the biggest decisions a person will make is when he or she will voluntarily retire. Though a great deal of emphasis has been made to encourage saving for retirement, arguably not enough emphasis has been placed on determining the “optimal” date for retirement or considering what one’s retirement lifestyle will be.

Two recent analyses looked at retirement date decisions and uncovered two different insights. The first, a poll by Gallup, found that finances play a significant role. The second, a study by the Michigan Retirement Research Center at the University of Michigan, said cognitive abilities play a role. Both considered different data and sought to answer different questions, which explains some of the difference between the conclusions.

Gallup surveyed over 85,000 working adults. The research firm found that nearly 50% of working baby boomers (those born between 1946 and 1964) do not plan to retire until at least age 66. One out of 10 predicted that they will never retire. Not surprisingly, those who strongly believe they have enough saved plan to retire earlier (age 66) than those who strongly believe they have not (age 73). Job satisfaction also played a small, but not significant, role in the desire to retire later rather than earlier.

The Michigan Retirement Research Center analyzed data from the American Life Panel (ALP). The ALP is run by RAND and the University of Southern California. It surveys more than 6,000 adults age 18 and older. These researchers found a link between cognitive scores and retirement expectations. Higher cognitive scores were associated with later projected retirement dates and more coherent retirement expectations. The Michigan researchers also found a correlation between longer expected longevity and postponing retirement.

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The Bull Market’s 5th Anniversary

Posted on March 6, 2014 | Investor Update


This Monday, be sure to say “happy birthday, bull” as the current bull market will turn five years old. Since bottoming on March 9, 2009, the S&P 500 has gained nearly 200% on a total return basis. This is quite the reward for someone who braved the fear and pessimism that was occurring back then and bought a stock index fund, such the SPDR S&P 500 (SPY).

Also take time on Monday to reflect on your emotions, portfolio decisions and tolerance for risk during the last bear market. Yes, I realize it was a dark period you’d as soon forget, but this is a useful exercise. The level of pessimism and fear was very high: Bearishness in our weekly Sentiment Survey reached a record level of 70.3%. Banks were failing left and right, credit was extremely tight, and well-known financial firms were imploding. There was even speculation about General Electric (GE) going bankrupt.

What was your reaction to the negativity? Did you pull out of stocks and equity funds completely? Partially? Were you concerned the economy was about to fall into the abyss? Did you think further stock market losses were coming? Or did you open your wallet and start buying stocks?

If you were terrified, don’t feel alone. Many people were. A key problem with many economic theories is the assumption that humans are rational, profit-maximizing individuals. As behavioral science shows, we’re emotional, impulsive and overly focused on the short term. Our minds are programmed for survival, not Mr. Market’s ever-changing moods.

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Make Your Investment Expenses Count

Posted on February 27, 2014 | Investor Update


Over the years, various surveys have shown that investors aren’t aware of what expenses their portfolios are incurring. Compounding matters, I’ve observed situations throughout my career where investors are focused on comparatively small costs without giving much consideration to the potential benefits that can be realized from incurring them. It’s important to be aware of both.

I’m bringing this subject up because in our March Stock Superstars Report, which will be published tomorrow, we discuss the costs of tender offers, offers to purchase some or all of shareholders’ stock in a company. If asked, I doubt many investors could articulate them. Yet, Helen of Troy (HELE) shareholders could be looking at a double-whammy of selling at a price below the current market value and incurring higher commissions. (Fidelity charges $38 for participating in a tender offer versus $7.95 for a traditional, open market trade). Granted, tender offers are not frequently made, but they do provide a good example of why it is important to pay attention to costs.

A far more commonly incurred cost is fund fees. Within the large-cap category of our 2014 mutual fund guide, one of the cheapest funds is Vanguard Total Stock Index (VTSMX). This fund has an annual expense ratio of 0.17%. In contrast, Marsico Flexible Capital (MFCFX) ranks among the most expensive funds with an annual expense ratio of 1.44%. This 1.27% difference equates to $127 extra per year for every $10,000 invested with MFCFX instead of VTSMX. That amount adds up. On a $100,000 investment, an investor will pay Marsico $1,270 per year more than he would pay Vanguard.

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