PHIL TOWN

GARRETT - RAMSEY'S ASSUMPTIONS ABOUT STOCKS ARE WRONG

Rulers, The following is from Dave Fisser, a retired pilot that sits on our Southwest Pilot's 401K committee. Dave wrote an article titled "Retirement Planning: Not Average Math" I copied some excerpts for you to consider. In particular, Dave Fisser took notice to some of the very things I had previously posted regarding Dave Ramsey's retirement advice. Again, I think Mr. Ramsey is excellent at personal finance. However, I believe he's doing a disservice to his followers regarding stock market expectations for retirement planning. I just think Mr. Ramsey and I need to meet so I can set him straight on some facts and introduce him to Rule #1 Investing! Here's some of Dave Fisser's article:

"AAII Journal quoted that a healthy 65-year-old had a 36.9 percent probability of reaching age 90 and a 17.6 percent probability of reaching age 95. But an Associated Press newspaper article quoted that for a healthy 65-year-old couple, chances are 63 percent that one would live until age 90 and there was a 36 percent chance of one of them living until age 95. In the Sunday Dallas Morning News business section, June 19, 2011, Dave Ramsey advised a reader, “Build a nest egg that you can live off about 8 percent of. If you have $500,000 stashed away, then that would mean about $40,000 a year.” He justified that by saying, “Throughout the history of the stock market, the Standard & Poor’s 500 has averaged between 11 percent and 12 percent.” He then stated, “But if inflation runs about 3 or 4 percent, and you’re making 11 to 12 percent, you can pull out 8 percent and still leave enough in there to give yourself an inflation raise every year and not touch your nest egg.” Unfortunately, Dave Ramsey doesn’t offer any research to support his advice.

Consider the historical periods of poor annualized compound performance for the S&P 500 and the corresponding inflation rates: 1929-1948 S&P 3.1 percent and inflation of 1.7 percent; 1966-1981 S&P 6.0 percent and inflation of 7.0 percent; and the most recent period from 06/30/1996 to 06/30/2011 (Morningstar data) S&P 6.42 percent and inflation of 2.44 percent. One can see that the 8 percent spread between returns and inflation doesn’t always happen for long periods of time. What Ramsey may also have stated was arithmetic average returns rather than geometric or compounded returns. When I add the calendar year performances from 1926 to 2008 and the divide by 83, I get close to 12 percent. The differences are huge. Take $100 and subtract $50 and then add $50, the arithmetic sum is $100. Then take the same $100, lose 50 percent and then gain 50 percent and you’re left with $75, a notable difference due to compound math!

Another dubious assumption is that a retiree would have 100 percent of a retirement portfolio in stocks. Just think of the stress because of the volatility in August and September of this year, let alone most of 2000-2002 and the last half of 2008. For a second opinion, I consulted a recent update to the original Trinity Study, which used actual stock and bond calendar year returns (not averages) from 1926 through 2009. It showed a 100 percent stock portfolio, assuming an initial 8 percent withdrawal rate, and withdrawals adjusted for inflation had a 44 percent chance of lasting 30 years. So using averages says that the 8 percent withdrawal may work, but reality says it doesn’t always and who wants to be a part of the 56 percent who’ll run out of money? The Trinity study also stated that a 50 percent stock and 50 percent bond portfolio with a 4 percent initial withdrawal, increased for inflation, had a 96 percent chance of surviving 30 years. I’ll opt for the more conservative odds, with less volatility.

There are many critics of the 4 percent withdrawal rule as well, one being its attempt to support non-volatile spending with volatile investing. In other words, if the markets do real well, you may die with a whole bunch of money you could have spent somewhere early on. But who knows when emergencies may arise that call for the use of “reserve” funds and who can predict market returns? I think the idea of “non-volatile spending” is a misnomer as well. Can anyone, with any certainty, quote future heath care costs? It would also be nice to avoid volatile investing, but guarantees come at their own price as well.

This whole discussion is just the beginning of things to think about. It’s not to disparage Dave Ramsey or any other advisor, but retirees need to understand the assumptions of any retirement plan, whether the assumptions are reasonable, and then do the math as part of your homework. Average numbers don’t represent the worst-case scenarios. Effort spent now will make the retirement flight that much more enjoyable and stress free."

--------------- To Your Wealth! Garrett Hey...Read this: I am not an adviser. I am not licensed. I am not offering advice because I have no idea what might be right for you and I'm not trained in any way to know what is right for you. Anything I post is for my own general education and is probably not appropriate for you.

JJ RAMBERG IN THE HOUSE WITH 'ITS YOUR BUSINESS'

A good friend of mine, JJ Ramberg, the host of MSNBC’s hit show, Your Business, just released her new book, Its Your Business and I just finished reading it.
If you have any interest in starting and operating your own business, this book is a must read. Here’s the link to get it on Kindle.  You guys know I don’t just blurb any old thing on this site. This is a good book that comes from the TV show. I do the TV show pretty regularly. I must have done a few dozen of them now that we’re in our 7th year. The show is funded by American Express and they put most of it on their website, Open Forum. Here’s a recent show I did with JJ and Carol Roth.  

The show is done in quick segments. We get right to the answers without a lot of messing around and, naturally enough, the show host’s book does the same thing. What I love about JJ’s great book is that it’s tight. She puts the information I need to max out my small business into 183 Tips. Every one of the Tips is written with no air at all. Just bang-bang here’s what you need to know. JJ sent me a copy a few days ago. Melissa went to bed early right after I did a webinar for y’all, but I was still too jacked to go to sleep so I headed for the kitchen to crank up a tuna sandwich. The book was waiting for me on the counter and I flipped to one of the tips and immediately got hooked. These TIP things are awesome. Here’s a tip from me that JJ was kind enough to use. It’s one of my ‘tough love’ concepts:

TIP #47 Fire quickly

This is admittedly the easiest piece of advice to give and the hardest to act upon. In a small company, it’s usually obvious early on if you’ve made a hiring mistake. If that happens, immediately fire that employee. While that may sound harsh, Phil Town, investment advisor and author of Payback Time, says it is the right thing to do. You must hire only A-caliber people because they will also hire A people. B people will kill you and your company because they are afraid to hire A’s so they hire Cs, and pretty soon you have a company that literally doesn’t work. So if you find that a recent hire is just not performing at the A level, give them a dose of tough love and let them go. It’s the best way for them to move on in their journey of becoming an A in another setting.

 

That’s it. That’s a page on Kindle. I zipped through this thing before I’d eaten the chips I added to the late night snack. Truth is, the book is so spell-binding for a guy like me that I added to the meal to make sure I didn’t run out of food before I ran out of pages. This book goes on my bookshelf where I can get my hands on it when I need advice for my own business, Rule #1 Investing, LLC. If a small business is your thing, get this. Here’s the link again: http://www.amazon.com/Its-Your-Business-Essential-ebook/dp/B0076DD71S/ref=tmm_kin_title_0?ie=UTF8&qid=1350522687&sr=8-1

 

Now go play!

AUSTRIAN V KEYNESIAN ECONOMICS - BY STEPHAN HALLER

This post is from Stephan Haller.  

Rulers,

Phil was so kind to allow me to write more on economic issues.  I try to make the economic theory relevant to Rule#1 investing.  The first issue I wanna talk about is Austrian Economics vs. Keynesian Economics.

Keynesian Economics

 Lord John Maynard Keynes (1883-1946) was the most influential economist of the 20th Century. Modern representatives of Keynesian Economics are Paul Krugman, Alan Greenspan, Ben Bernanke and a lot of others. His book “The General Theory of Employment, Interest and Money“ was for decades the most influential book on macroeconomics.

 

The most important issue in Keynesian Economics is fiscal policy. Confronted with the problems of the Great Depression, Keynes saw the under-consumption and sticky wages during a recession as the biggest obstacle on the road out of a depression back to economic growth.  In his view, there are several problems which make a recession worse and can lead to a depression:

1. Prices and Wages:  When an economy is in a recession, prices fall because of a lack of demand for goods and services. Because of strong unions and/or minimum wage laws, wages can‘t fall at the same rate as prices do (Keynes argues that there is also a problem if wages decrease, because with lower wages the propensity to consume is shrinking).  When demand for goods and services is low, prices are falling, but wages stay too high, businesses have to lay off workers in order to stay profitable. Therefore Keynes favors a decrease in real wages, caused by rising prices (inflation), because a reduction in nominal wages would be resisted by unions/workers.
2. Excessive Saving:  During a recession, people spend less and save more, because they are in fear of losing their job. The lack of spending worsens the recession and more workers get laid off, because more savings  lead to a decrease in aggregate demand.
3. Animal Spirits:  With the term Animal Spirits Keynes describes the irrational behavior of humans, which can lead to economic fluctuations. The animal spirits can boost a boom or worsen a bust. 
4. Liquidity Trap:  Usually the economy grows when the Fed lowers interest rates. But when people hoard cash, because they are in fear of a depression and money isn‘t invested or spent, lower interest rates don‘t lead to more economic output.
5. Slow down of the Circular Flow of Money:  When a person spends money, the money becomes another person‘s income. In a recession this Circular Flow slows down, because of less spending and more saving. Therefore the economy can‘t run on full speed. If the Circular Flow is slowed down, unemployment rises.

In order to solve the problems causing a recession and to prevent the economy from falling into a depression, Keynes advises that government fight the recession by lowering interest rates (reducing interest rates to the point where full employment is achieved), lower taxes and provide deficit spending.

“Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better....If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.“ (Quoted from: “The General Theory of Employment, Interest and Money“, Page 128,129)

This sounds weird but a former Federal Reserve Chairman had a similar idea to solve the housing crisis:  The government should buy and destroy the surplus houses.

Let’s stop here and ask some important questions:

 

What makes a society grow wealthier? More goods and services or more money and higher asset prices?  Are we really better off if we destroy already existing houses, so that the prices of the remaining houses rise?  Is cash for clunkers really such a good idea?

 

Keynes argues that it is a good idea because he believed there is a multiplier effect.  If the government spends 10 million dollars on the construction of a bridge, construction businesses get paid and with the money they pay their workers and buy new machines. This enables the businesses that build the machines to hire more workers. The new hired workers spend their money on housing and cars.  This is the multiplier effect.  In Keynes opinion the economic output added to the GDP will be quite a lot greater than 10 million dollars invested in the bridge because of this effect.

Once, in the judgment of the central bank enough stimulus has been applied, according to Keynes, the central bank should then counter inflationary influences by reducing spending, paying back the debt and raising interest rates. 

 

These economic theories have been applied liberally by the US Federal Reserve for the last 80 years with the result that the dollar has lost 95% of its buying power, we have a huge national debt, we seem to go from one asset bubble to the next and today we have high unemployment although interest rates are near zero percent. 

To sum up, Keynesian theory says the following:

1. If there is inflation, it is caused by excessive spending by the public. To cure inflation government should step in and take away the excess purchasing power by higher taxation.
2. If there is a recession, under-consumption and excessive saving is to blame. To cure a recession, government should increase its own spending, by running deficits. The central bank should lower interest rates to provide an incentive for entrepreneurs to invest more.

 

Keynesian theory is criticized by the Austrian School of Economics, in particular by Mises, Hayek and Rothbard.

 

Austrian Business Cycle Theory

 

The ABCT describes why we have continuous booms and busts in the economy.  The ABCT was developed by Ludwig van Mises in 1912 in his book “Theory of Money and Credit“ and further elaborated by Murray N. Rothbard and Friedrich August von Hayek, who received a Nobel Prize for economic science in 1974 amongst many other “Austrians” who are still alive such as Hans-Hermann Hoppe, Joerg Guido Huelsmann, Thorsten Polleit, Phillip Bagus, Joseph T. Salerno and Jesús Huerta de Soto.

 

ABCT disagrees with Keynesian theory.  According to ABCT when governments attempt to steer the economy it leads to asset bubbles, devaluation of the currency and boom/bust cycles. When a central bank lowers interest rates, the commercial banks are able to expand the money supply significantly.  Lower interest rates artificially stimulate economic activity.  In this artificial environment new projects are undertaken that in a normal economy wouldn’t have been profitable.  New economic activity increases demand for labor. With the increased demand for labor, wages rise and hence prices increase. This creates a boom.  The housing boom is an example of this effect.  Because of rising prices and wages, domestic goods lose their competitiveness with the products of foreign nations. This results in a trade deficit.

 

Another problem is that the economy adapts very fast to the new rate of inflation. Like a heroin addict who needs higher and higher doses to get high, in order to stimulate more growth you need a higher rate of inflation every year.  When people soon become aware that there is no reason to expect an end to increasing inflation and increasing prices, they get rid of their fiat money by buying hard goods.  This creates real goods inflation and results in rising commodity prices and a decrease in the exchange rate for domestic money. 

 

ABCT says that to prevent a collapse of the currency, the central banks need to step on the brakes by raising interest rates. When the central banks did this in the early 80’s, the 30 Year Treasury Bond yielded about 16%.  When interest rates are artificially low, numerous people exercise poor judgment and create mal-investments.  Those investments that once appeared profitable due to artificially low interest rates eventually cease to be profitable. Companies cut down their operations or close down.  Workers get laid off.  Prices collapse. Depression ensues.

 

ABCT argues that the longer the period of credit expansion lasts and the longer the central banks stick to their policy of low interest rates, the worse the impending crash becomes.    

 

So what should the government do to solve our current problems according to the Austrians?

 

According to ABCT the government must immediately stop re-flating the economy. This will bring the inflationary boom to an end. The economy can readjust, liquidate mal-investments and reestablish truly desired proportions between investment and consumption. This will be a painful process because prices and wages need to fall and unemployment will rise for some time. But if this painful cure is allowed to take place, it won’t last long and the economy will grow again. If government and the central banks stay out of the game, the growth will be more sound and future recessions will be much shorter and less severe.

 

How would this business cycle look in an Austrian world?

In a truly free market economy without a central bank and with a 100% gold standard, there is no way for banks to expand credit and lower interest rates without a simultaneous rise in deposits.

 

Imagine yourself standing at a roulette table in Las Vegas. How much would you risk?  All your savings?  Your house? Your kids’ college savings fund?  Probably not.

 

Now imagine the same situation with Bernanke and Geithner standing behind you, whispering:  “No fear! We back you up. We will cover your losses and bail you out because we can print all the money we want.”

 

You would take on much more risk.

 

This is what the commercial banks are supposed to do with the central bank standing behind them.

 

Without central banks and government interventions the interest rates (the price for money) will adapt to supply and demand. If the savings rate is high (the demand for money is low) interest rates will fall.  Entrepreneurs will borrow money in order to invest because the low interest rates give them the signal that money is available.

 

In this ABCT world we would have slower but healthier growth, fewer and smaller recessions and no inflation (price deflation is more likely because of technological progress).

 

ABCT argues that our economic problems are not the fault of capitalism and free markets, but the consequence of continuous inflating of the money supply, artificially low interest rates and government market interventions.

 

In the next lesson I will try to find out what this all means to us as Rule#1 investors and how we can profit from all these economic booms and busts created by the government and the central banks.

 

-- Stephan Haller

 

PHIL’S COMMENTS:  Thank you, Stephan.  In your next post, would you address this question?  ABCT says government intervention should create inflation.  However, Bernanke argues that he is reflating the economy, pouring billions into a hole created by the trillions of dollars of asset losses in the real estate melt-down and that without doing so, the economy would have gone into a depression.  He points to a lack of significant inflation as proof that he hasn’t gone too far.  Is he right in this case?

 

 

 

 

BP COMMENTARY JULY 2, 2010

I wrote this for my 'Phil Town Live' students on FRIDAY, JULY 2, 2010.  I'd just loaded up at $27 but I think what I wrote is worth reading for a lesson on what to look for when everyone is afraid to buy the stock because Jim Cramer is saying its going to go under.

 

IS BP GOING BANKRUPT?

 

Since I’ve taken a long position in BP (meaning I own the stock and will make money if the stock goes up), I thought I’d discuss the possibility of total disaster for my investment – BP goes bankrupt.

 

Unless you’ve been hiding under a rock, you know BP had one of their Gulf of Mexico deep drilling rigs catch fire and kill 11 guys.  The platform then sank and when it did the mile long drilling pipe hanging off the bottom of the platform snapped off and the pent-up pressure in the hole gushed oil into the Gulf of Mexico.  Initially BP reported the gusher was about 1000 barrels of oil per day but now they think it may be as high as 60,000 barrels a day.  They are working on containment with robots at 5000 feet below the surface and have partially contained the well.  Within 6 weeks they will have completed two wells that will take the pressure off this broken pipe and end the flow.   Oil has washed ashore on Gulf Coast states beaches and some environmentalists are calling this spill the biggest environmental disaster in US history.  In addition, people have been killed and injured and jobs and investments have been lost.  Estimates of damages runs from billions to trillions and over 300 lawsuits have been filed against BP.  Cramer thinks the lawsuits will force the company into bankruptcy.

 

Why would anyone invest?  In particular, why did I invest at $27?

 

Here’s why:

1. BP will not go bankrupt.  It has $100 billion in equity it can pull on to pay off damages.  It will invoke the maritime law limit on disasters not caused by ‘gross negligence’ at $75 million.  Congress will not be able to raise the limit post disaster and force BP to pay more.  The lawsuits will go on for years and it will be found that it is nearly impossible to nail BP for more than the $20 billion they are already willing to pay.  And no reasonable judge will believe that BP is worth more dead than alive.  It will survive.
2. BP makes $18 billion a year profit.  $6 per share.  It owns the rights to over a trillion dollars of oil in the ground.  It can pay its way out of this mess.
3. At $6 per share, the price I bought in at represents a Payback Time of 4.5 assuming zero growth. 
4. Using a growth rate based on Book Value growth, the business price is also at an attractive MOS.
5. It hit a nice Floor at $27.
6. Active portfolio management may mitigate a great deal of the risk of the $27 price.

 

These are all my opinions.  I could be wrong and Cramer could be right.  Either way, for sure, this is not an investment for an amateur.  This investment is going to have to be closely watched.  But I do believe I like the way this looks very much.

 

Reports are starting to come in that the spill isn’t going to turn the corner and move up the east coast.  Oil is being absorbed in deep water and may not affect much of anything more than it already has.  The impact to the Gulf States is major but well within BP’s ability to pay the damages and may not be as bad as originally projected.  In other words, right now things are starting to look better. 

 

Is it too late to get in?  No.  I think, if you do the 4Ms on this business and you decide you like it, you may find the price right now just about as attractive as it was at $27.  But do not buy this without a plan.  In the Tuesday and Thursday night investing Talks I will be discussing ways of mitigating my risk on this investment as it unfolds.

 

Now go play.

 

Phil