The Value in Art

The value in ART as an Investment

The last line in a thoughtful book by Melanie Gerlis, Art as an Investment?, does not do her work justice, “Those looking at art purely as an investment might first consider looking elsewhere.” In fact, she makes a cautious case for those interested in fine art who also have an interest in investing. But first, full disclosure since I am biased. Both fine art and antiquities constitute a meaningful portion of my investment portfolio. As I write this note, works by Max Beckmann, Chuck Close and Sol Lewitt surround me. A visit to the San Antonio Museum of Art will find a dozen Egyptian antiquities from our collection on display.

Another quote to provide some context for the following conversation comes from another great read, The Value of Art by Michael Findlay, “A collector has one of three motives for collecting; a genuine love of art, the investment possibilities, or its social promise” (quote by Emily Hall Tremaine). Anyone not meeting all three criteria is unlikely to enjoy the rest of this note.

Gerlis undertakes a laudable enterprise by comparing artwork acquired for investment purposes with other asset classes. An editor for The Art Newspaper, she is a knowledgeable commentator on the business of art. Her book makes one-on-one comparisons of fine art to; equity markets, gold, wine, real estate, hedge funds and, intriguingly, luxury goods such as jewelry and watches. By defining each investment’s attributes – such as market transparency, liquidity, market makers, and valuation metrics – she creates a context useful in determining the differences between these investment options.

We’ll focus on the world of fine art starting from a time around 1850. However, a caveat is in order here since the art market is a complicated subject and rather than try to qualify remarks that obviously have exceptions (most of them), let’s just assume that all comments below are, “generally speaking.”

The quick and the dead in art.

Following Gerlis, it seems appropriate to use metaphors taken from the world of investing herein. Conceptually there are two distinct markets with an important overlap. On the one hand are dead artists, the majority of which have some standing in the cannons of art history and criticism. Then there are the living artists whose reputations will evolve for better and worse, as should their artistic output, over a lifetime. In between are the few long-living artists who have achieved accolades likely ensuring their place in history. This can be viewed similarly to that of value and momentum stocks, assuming a gray zone here as well.

The Card Players, by Paul Cézanne www.metmuseum.org

The Card Players, by Paul Cézanne www.metmuseum.org

Value artists would include names like Cezanne, Pollock, Warhol and, of course, Picasso. Like a big established multinational corporation, the price of the art will fluctuate over time, but there is an expectation of enduring intrinsic value. Both the equity and art markets experience good and bad times, but the trend over long periods is upwards. Categories having demonstrated value over time include Old Master and Impressionist works. The place of post-WW II abstract expressionists also appears to have been firmly established, with Pop Art probably not too far behind. However, much like gold, art tends to maintain value over time, also contributing to the value in art. Paintings, in particular, have a curious tangential value as insurance. During times of crisis, paintings can be quietly transported across borders, their value not being linked to any particular currency, unlike real estate or some equities.

Momentum artists, on the other hand, remain an unknown entity as far as their long-term valuations are concerned. A look at the dot-com stock era is a good context for thinking about contemporary art – where hopes and dreams intersect with savvy marketing to create the “next big thing.” Or not. As one professional dealer put it, the worry is whether a work of art is even worth displaying five years from now.

With the rise of mega-dealers like Gagosian and Zwirner, who make a lot more money than many of the artists they represent, the hype is an ever-present danger. We hear about the unknown artist who finds their work suddenly fetching high prices at auction, but not their peers watching prices drop in the same market space. The books listed at the end of this essay give many examples of just how far a new superstar can fall. And how fast. There is a difference between a fad and a trend. Fads come and go, often with little in the way of residue. Trends are indicative of long-term shifts in taste or behavior. People generally tend to “get” Impressionist paintings. Not so much with “video art.” With contemporary art, the winner can more often be the dealers rather than the artists.

Banksys-"Supporting Calais", www.widewalls.ch

Banksys-“Supporting Calais”, www.widewalls.ch

Currently, there is much conversation – and sales activity – being defined by issues unrelated to the value in art. Contemporary art originating in the Middle East and Latin America are hot art commodities right now even if their shelf life is unclear. A decade ago contemporary Chinese art was a market darling, just as the Aboriginal art of Australia had been twenty years before that. On the cutting edge in trendy art markets like New York is work by the alternative lifestyle crowd who now enjoy accolades instead of opprobrium for being LGBTQ. There is also a geographic risk when discussing a “local” artist as these tend to more often be about the person instead of their art.

So, what is the value in art?

I’ll suggest that what makes great art is an ability to engage people over time and space, by embracing our shared humanity. This leaves doubt as to the long-term viability of art focused on a place or personality. Art tied to political protest (think of the French Revolution as well as Kent State) have not tended to endure. Like comedy, art linked to a specific context, ages quickly. The humor of the Marx Brothers and Lenny Bruce can be mostly lost on Millennials. Yet the works of Chaucer and Shakespeare are routinely remade for contemporary consumption because the underlying humor is based on human foibles that don’t change much over time.

A friend once proudly pointed out that he had paid over $17,000 for a painting bought from a local art gallery dealing in local artists. Setting aside the temptation to judge the work on artistic merit, it is noteworthy that considerations regarding the placement of the painting (colors and textures already in the room) played a prominent role in its selection. The likelihood of reselling the painting at any time in the future for even a few hundred dollars is non-existent. The best that can be hoped for is to pass along an item of sentimental value to the kids.

The case can easily be made that the same dollar amount spent on a respected, post-war artist could have found a work fully meeting the decorative criteria. With a little care in selecting art from an important period of an artist’s oeuvre (granted, most likely to be a drawing or print instead of a painting), the likelihood of selling the work near the price paid improves dramatically. And from personal experience, I can say that as our tastes evolve, being able to sell one work to purchase another is an additional benefit of being mindful when thinking about what’s hanging on your walls. As with any endeavor, there is a lot of work to be done in negotiating the vagaries of the fine art market. Frankly, most people would likely be as happy with handsomely framed museum posters of their favorite paintings.

Personal value in art. “Pilate Washing His Hands”, -Albrecht Dürer

“Pilate Washing His Hands”, -Albrecht Dürer

One final consideration is that important works of art, properly prepared for display and cared for, endure across time. As a kid, I was hypnotized by a book with the complete engravings of German artist Albrecht Dürer. One in particular, “Pilate Washing His Hands” from 1512 informed many of my early drawings. Today an original of that engraving, likely printed around 1514, enjoys a place of prominence in my office. Even after looking at that image for fifty-years it still fills me with endless delight.

At some point, the Dürer engraving will find new owners who also appreciate the master’s skill. Not only will I have been lucky enough to enjoy Dürer’s art up close and personal, I will be part of a group of collectors stretching across 500-years intent on ensuring others also get a chance to see the real thing instead of as a page in a book. Monetary value is not solely what defines the value in art.

A brief bibliography for someone thinking about art as an investment:

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What is the definition of wealth?

The idea that being a part-time investor is going to bring you wealth and make you rich enough anytime soon to retire and enjoy the life of as a country squire, tending grapes at your chateau in France is delusional. Better to assume that your efforts as an individual investor will leave you in a position “down the road of life” to enjoy long stretches of time doing things you enjoy. Maybe even months or years pursuing interests for their own sake, regardless of whether you get paid or not. I’m a big fan of the notion we should be able to take time to pursue activities simply because we want to – without worrying about any financial ramifications. That’s the point of this blog, to help ensure you have the means to create and enjoy a full life.

Creating Wealth John Train Money Masters of Our Time|Ask yourself, is it the wealth, or what you can do with the money, that interests you most? I’m a big fan of the notion that we should be able to take time to enjoy ourselves without worrying about financial constraints; as money simply represents the potential of what can be achieved by spending it.|

The wealth of Croesus isn’t waiting for anyone diddling in the markets, or looking to make a fast buck off of gold or real estate. If you want to make the Big Money, then you had better be prepared to put the fun stuff on hold and get busy doing Big Work. Do you really believe that you can play competitively on the same court as any of the 491 players currently in the NBA? What this meant for an individual investor really hit home for me many years ago, after reading John Train’s book Money Masters of Our Times.

A collection of interviews with 17 of the best investors alive, including the usual suspects like Buffett and Soros, the relentless drive, and focus of these individuals is breathtaking. And their idea of fun is to be relentlessly driven to focus on wealth accumulation. When one of the billionaires Train interviewed is asked about his very pedestrian lifestyle he replied that money was the scorecard. If he actually spent money, his score would go down. Ask yourself the tough question; is it the money, or what you can do with the money, that interests you?

The luck of the few

Origin of Wealth written by Eric D. BeinhockerCircumstances beyond our control (often called “luck”) will likely be a major factor in our personal pursuit of wealth. Eric Beinhocker, in The Origin of Wealth, satisfyingly demonstrates that wealth tends to clump even without external influences. The winners in the contest for asset accumulation are more likely to be people in the right place at the right time, rather than master rainmakers.

Money, Blood and Revolution by George CooperMoney, Blood and Revolution by George Cooper, further suggests that democracy is a key driver of economic growth for most people lucky enough to be living in one, but also a guarantee that income disparity will inevitably persist. Which in turn suggests inequality is not a problem to solve, but a fact to be lived with (personally, I’d suggest the issue is primarily defined by education, but let’s save that conversation for another time).

Yet another point Cooper drives home in his book is the importance of dealing with the world as it actually is, not as we wish it to be. In the final analysis, one of the biggest influencers of creating wealth is luck. So, when luck arrives, avoid assuming you had anything to do with your success and proceed to save and invest humbly.  Also, be mindful of the distinction between the need for creating wealth, and the need to keep what you have. Worse than never having the chance to achieve a meaningful level of net worth is arriving at success but then letting ego and hubris make it all disappear. At some point, preservation becomes more important than getting more.

I’ve always understood that money simply represents the potential of what can be achieved by spending it. Further, most of us are trading the (very limited) time we have on this mortal coil to acquire that money. I’ll suggest the accumulation of things (the biggest house, the fanciest car, the most expensive watch) is far less valuable than a trip to Egypt with your kids or knowing you can leave a job no longer offering the satisfaction of doing meaningful work without putting your financial well-being, and that of your family, at risk.

Now ask yourself again, “is it the money, or what you can do with money, that matters?” With all the talk here at Invest-notes about “having a plan” for investing, please don’t lose sight of having a purpose for what the successful implementation of that plan really means. When the time comes and you cash out the winnings from your investments, what will you do with the proceeds?

We’re all in this together

And finally, remember that your investment portfolio should include not-for-profit and charitable service organizations. Both our time and money need to be directed toward helping rectify the inequality in our own communities. The day we forget what an outsized impact luck has had on our lives is the day we begin to lose our humanity. If we can be smart enough, and lucky enough, to put ourselves on the winning side of creating wealth, then we have both the privilege and obligation to earn the dividends of helping those less fortunate than we are.

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Ch-ch-ch-changes

This will be the last Invest-Notes in its current iteration. Actually, there’s only been one version of the Invest-Notes blog since my friend Rob set it up as a birthday gift in 2011. Your next visit will still find thoughts on investing and economics – including the full archive – but will be easier to navigate and better share the spotlight with music and art. Hoping you will enjoy the changes.

Of Banks and Buildings

There’s another, bigger change coming soon, and this one will affect the equity indexes, and thus the benchmarks for a lot exchange-traded funds. Individual stocks of major companies will find that the description of what business they are in will change. This matters because the Big Daddies of indices, S&P Dow Jones and MSCI, use the GICS stock classifications to determine things like whether Home Depot should be identified as a Consumer Staple, or a Consumer Discretionary stock. In their turn, the Big Daddies of funds, Blackrock and Vanguard, use the stocks in the S&P 500 and MSCI to decide what stocks will be included in the ETFs that individual investors are buying in ever increasing amounts.

First a quick review of the Global Industry Classification Standard (GICS), a worldwide standard for stock classification. Established in 1999 with ten sectors, the GICS consisted of: Consumer Discretionary; Consumer Staples; Energy; Financials; Health Care; Industrials; Technology; Materials; Telecom; and, Utilities. With the equity holdings of hundreds of ETFs and mutual funds based on the composition of these sectors, definitions are important. So, Phillip Morris (PM), a maker of tobacco products is a Staple and Home Depot (HD) is a Discretionary. Clear as mud, right? Cigarettes are something everyone needs, but the ability to affect repairs to your home or apartment isn’t so necessary? But I digress.

On August 31, 2016, the first ever change to the original Big Ten took place when the Financial Services Sector became bifurcated, creating a new sector, the Real Estate Sector. At the time of the split, real estate companies made up around 20% of the Financial Services Sector. REITs are a major component, with those and other entities involved with real estate related investments often paying sizeable dividends. These include shopping malls and strip centers, home builders, office buildings, holders of actual mortgages, industrial warehouses, apartment complexes, long-term care facilities, property management firms, timberland and now buildings occupied by computers that make-up “The Cloud.” Real estate stocks, particularly real estate investment trusts (REIT), have typically been considered niche investments.

http://www.invest-notes.com/2016/07/23/the-difference-between-banks-and-buildings/

Since the time of that first change to the GICS, banks have done well, REITs not so much so. In retrospect (also known as Monday Morning Quarterbacking) the headwinds were building for the real estate sector at the same time banks were beginning a genuine recovery from the financial mayhem of 2009. The upcoming change to the Telecom Services Sector will likely be more seismic since there will be three sectors involved and much larger ones at that. If you own any sector funds, now is a good time start thinking about what these changes might mean for your portfolio.

Communications Services Sector

The transition taking place on September 30, 2018 will see three sectors face major changes in their composition. Telecom Services will be renamed as Communications Services. The smallest of the eleven sectors composed of the stocks in the S&P 500, when Telecom becomes Communications it will grow from 2% of the index to 10%. More challenging for investors is determining what to do with current sector holdings when the biggest stocks in the S&P get shuffled around. Google, Verizon and Disney are not niche investments.

Now, what happens to the Information Technology Sector when Google, Facebook and other heavy hitters are no longer part of Technology ETFs and become components in the new Communication Services Sector? Or the Consumer Discretionary Sector (a sizable ETF holding in my personal account), Netflix, Disney and other big companies will be moving out. And is it time to go ahead and add one of the big Telecom ETFs – IYZ or VOX – in advance of the reshuffle? A tough call to make since the logic underpinning the changes is hard to understand.

Skeletons Walk Where Questions Begin

Disney and Netflix are currently the fourth and fifth largest holding in the Vanguard Consumer Discretionary ETF (VCR) and account for 9% of the total holdings. In the Information Technology ETF (VGT) Facebook and Google make up 15% of the fund, holding the third, fourth and fifth positions (Google, now known as Alphabet, has two classes of stock, each traded independently). As for Telecoms (VOX), 50% of the total holdings are the top two stocks, Verizon and AT&T, with the ETF offering a yield just north of 4%.

One incorrect assumption when banks and real estate divorced was the big dividend being paid by the real estate stocks would make it a more attractive offering. Yet the high yield was not able to offset a drop in the value of the underlying equities. Facebook, Netflix and Google don’t pay a dividend which would suggest that a sector known for its generous payout won’t be anymore. Frankly, it is not clear to me what connects these businesses. Netflix and Verizon? Disney and Facebook? Google and AT&T?

Finally, for those of us invested in S&P 500 cap weighted index funds – SPY or VOO – it turns out that Facebook, Google, AT&T and Verizon are also top holding. Due to the size of the largest holdings, it is possible that the new Communications Services funds really won’t offer anything other than a focused version of the biggest stocks in the S&P 500 ETFs. Maybe, it’s time to pull back a bit from diversification through sector funds since that seems to be the last thing being achieved by grouping really big companies in ever smaller index sectors.

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Market Drops

Market drop image

After an explosive move up in January, we were subsequently reminded that stocks (and indexes) can still go down. This is a time when it is especially important to avoid emotional reactions and focus on intelligent decision-making. Here are a few investment thoughts, offered up once before, that might be worth considering.

Simplify

1. Don’t make more predictions than your data can support. A collection of just four or five exchange-traded funds (ETF) is all most people need for a successful retirement account. If you own individual equities then understand the basics: what does the company do, how does it make money from that and what does it do with the profits? Beyond this, short of being a member of the company’s management team, there’s not much else you can know for sure. Assume nothing and avoid the temptation to believe a business is holding a winning lottery ticket. As Warren Buffett once noted, “You should invest in a business that even a fool can run, because someday a fool will.”

Focus on the not-too-distant future

2. Near-term forecasts are more certain than 10-year projections. Remember all of the investment analysts who were predicting a big drop in February with an immediate rebound? Me neither. The future has always been hard to predict and this fact is unlikely to change just because investors wish it would. Always be suspicious of undue emphasis on the long-term, especially when the short-term isn’t looking so good.

Understand your assumptions

3. Be aware of the weakest links in your argument. Without doing this, it is pretty much impossible to know when it is time to exit an investment position. When a key assumption changes, or more likely proves incorrect, it may be best to exit the investment and move on to the next good idea. Put another way, keep a lookout for what you didn’t think about when entering an investment.

Be wary of precision

4. It is better to be vaguely right than precisely wrong. Too much detail gives a false sense of security. This explains why successful panhandlers always ask for an exact handout, like sixty-three cents. It’s just human nature to think someone predicting that earnings for the S&P in 2012 will be $107.63 must know more than someone who simply suggests that earnings will be less than $100. Yet a prediction of a range – less than $100 – can prove more helpful in understanding the underlying assumptions, such that the S&P will struggle to achieve growing earnings.

Leave yourself an intellectual paper trail

5. By definition, our memories are terribly biased. During my 13-month experiment as a day trader (using a Scottrade account specifically for this purpose), I kept a spreadsheet documenting every trade, the cost to trade and the profit or loss on every position. While I ended up with about an 8% return (this was way back in 2007, when it was pretty hard to lose money in the markets), the amount of work involved as well as some of the risks assumed, made it obvious that market timing isn’t a good strategy. Being able to revisit the actual data has been a valuable reminder for staying focused on what works for me. I keep remembering how wildly successful I was, a notion difficult to reconcile with the actual data.

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Coin of the realm

Bitcoin

That Bitcoin, and its ilk, are experiencing a “Netscape Moment” should serve as a cautionary note on many levels to investors. The practical similarities between the web browser Netscape Navigator as an investment, and Bitcoin as an investment are obvious. Netscape made using the World Wide Web practical for the average computer user. Bitcoin is the first application to make blockchain technology accessible for the average computer user. But with technology stocks, it does not usually payoff to be the first person at the party. So, it should come as no surprise if the “Bitcoin Moment” ends badly.

How the web was like blockchain

The World Wide Web was for much of its early years an intriguing idea without any widespread application beyond the military and academia. It took the creation of a universal access tool, initially Netscape Navigator, to make a sprawling, but difficult to access network something everyone could find a use for. Navigator made it possible for anyone to get aboard what is now called the Internet and communicate (email), connect (Facebook), share information (Google) and offer a platform for commerce (Amazon).

Netscape Navigator 1994 IPOLong story short: Navigator launched in late 1994 with an IPO in late 1995 being one of the most successful ever, up to that time. Additionally, Netscape set what many investors would still consider a bad precedent by also being unprofitable when it went public. Long story short, by 1997 Microsoft’s Internet Explorer was the hand’s down winner in the so-called “browser wars” and Netscape never recovered. In 1998 AOL acquired Netscape. Its fate was the canary in the dot.com coal mine.

For our conversation today, let’s sum up the browser analogy this way. When Netscape opened up access to the Internet, few people were thinking about e-commerce or online bullying. The evolution of the Internet browser was trial-and-error in its purest form. Where blockchain ultimately ends up taking us remains unknown and we are still very early on a long journey.

So, what’s up with the futures exchanges?

What grabbed my attention was the announcement of the two Chicago options exchanges now offering futures contracts on Bitcoin. And there is some irony to the fact the contracts can only be bought and sold using dollars – you can’t actually short your Bitcoin collection,BITCOIN-EXCHANGES-RISKS just gamble on its price variations. Yet the speed with which the options exchanges embraced the blockchain left me baffled until reading about a couple of projects MIT is working on in collaboration with two very different consortiums.              Herein might be the next phase of blockchain implementation with the potential for serious impact on the global financial system.

One powerful application of blockchain is to create a viable currency to be shared among fringe economies. Think of Eastern bloc countries like Bulgaria, Romania, Albania and Hungary creating a shared currency for use on par with the Euro and Ruble. Or of the many marginal countries in central Africa, also challenged by failed economies. In theory, the open nature of blockchain ledgers would make it possible for everyone – both inside and outside of the currency network – to see when a government is, for lack of a better term, cheating the system and exclude just their blocks from commercial use. Here, the transparency of an open ledger creates value and stability, making allies of adversaries.

Global Blockchain NetworkAnother interesting idea is using blockchain to create a cryptocurrency tied to physical commodities like gold, oil, sugar or wheat. This would eliminate the necessity of having to price commodities in dollars, Euros or rubles, reducing the amount of friction and cost in transactions by moving toward a true barter system. For international trade, this would be a huge shift in the balance of power away from the major currencies. To my mind, this scenario provides a perfect explanation for the rush to embrace blockchain by the futures exchanges.

Blockchains and Blockheads

First, while not qualified to discuss the intricacies of the blockchain, I do have a firm grasp of the concept. Bitcoin will be discussed here only as an example of how blockchain technology works. However, blockchain is the engine for all of the recent wave of “initial coin offerings” (ICO) and Bitcoin competitors like Ethereum and Ripple. Though ICOs have now been banned in China, the government of Argentina has proposed an ICO to replace its own now worthless currency. And for the truly gullible, many shady companies are using ICOs to raise capital, bypassing any credible oversight and making fraud easy.

Which brings us to a second point which is counter-intuitive. Bitcoins are money. In the final analysis, the goal is to have a currency accepted worldwide that is not regulated and cannot, in theory, be manipulated by governments or central banks. Unlike dollars, Euros, renminbi and yen, there is, in theory, a permanent, public record of every time a Bitcoin is used in a financial transaction. Which can also make its widespread use for illegal and nefarious purposes hard to understand. And if the use of cryptocurrencies for transactions actually takes hold, imagine how big a blockchain could become to manage.

Now, let me make my bias clear. While appreciating the argument of why we should not trust “fiat money” like dollars, Euros and yuan, cryptocurrencies take this concept to an extreme. Because the dollar is no longer backed by a physical commodity – gold – doesn’t mean there are no assets of the United States government to support a value for our currency. Just one example, the value of 52-million acres of national parks on the auction block is worth a lot more than whatever is in Fort Knox. Most cryptocurrencies are backed by no one and nothing. This is what makes the blockchain work of MIT and the futures exchanges so interesting.

Perhaps the most accessible conversations about cryptocurrencies and their potential future are described in the January 2018 issue of Scientific American. 

Gaming the system

The metal found in a dime may not be worth ten cents when melted down,  and the paper a Euro is printed on has no value,Bitcoin Wallet but both are widely accepted and easily used for commercial transactions. To spend a Bitcoin you have to have both electricity and Internet access while still relying on an exchange (like the currency kiosk in international airports) to facilitate a transaction. The word “coin” couldn’t be more incongruous as a descriptor in this instance. That cryptocurrencies are “mined” is an even more egregious misuse of a word to give gravitas to the idea of digital money having some physicality.

So, it works like this. Massive amounts of computing power are necessary to solve cryptographic number puzzles (yeah, it’s a computer game). The prize for solving one of these number puzzles is a unique, one-of-a-kind “block” that is subsequently entered into a massive digital database. Each block becomes a Bitcoin, or whatever the blockchain owner decides – like a share of “stock” in a bogus enterprise. Bitcoins are created and verified solely by raw number crunching. In Siberia (a hotbed of Bitcoin “mining”) you can now buy a home heated by the computers being used to “generate currency”.

The digital ledgers (or databases) belonging to each cryptocurrency are open for anyone with the right equipment to access. When it comes time to make a purchase, or perhaps trade cryptocurrency for old-fashioned dollars, computers work to verify the legitimacy of the block(s) and add this latest transaction to the block’s history without any centralized authority being involved. In theory, blockchains cannot be altered and will exist forever. Massive fraud has recently seen hundreds of millions of dollars-worth of cryptocurrencies disappear making this “fact” suspect as a reality. Assuming your counterparty in a transaction will accept Bitcoin for payment you can pay for a car or illegal narcotics. The average transaction fee of around $30 making buying things like a latte or sandwich impractical. And some vendors won’t accept Bitcoins whose history includes the creation of, or use by, entities known for their involvement in criminal activities.

Finally, if you decide to join the cryptocurrency crowd, all it takes is opening an account online (cash up front) with a Bitcoin exchange and you are given a “digital wallet” for making transactions – pretty much the same way as using a mobile phone payment system. Best guess is that around $8-billion was spent using credit cards to open Bitcoin accounts in the 4th quarter of 2017. It just couldn’t be easier to set yourself up to be fleeced.

What could possibly go wrong with cryptocurrencies?

Quite a lot, actually.

On a practical note, recently one of the Bitcoin exchanges (Bitstamp) saw the value of one Bitcoin go from $17,000 to $19,000 to $15,000 in less than half an hour. One explanation attributed the wild swings to traders in Asia, where it has been suggested that on any given day up to 20% of all Bitcoin transactions are taking place in South Korea. A coin exchange went bankrupt a few of weeks ago in South Korea after being hacked. There is no legal recourse for account holders, they are simply wiped out. And tell me again how you’d feel about paying $30 to use a Bitcoin ATM to get some fast cash?

Perhaps most scary, and telling, is this quote, “A survey of over 200 board-level British executives recently found that while over half of businesses sampled are planning Blockchain initiatives, more than 40% of non-IT/data senior executives admit to not fully understanding Blockchain technology.” In other words, we have no idea what this is, but we want some. APNIC: Don’t Get Caught Up in Blockchain Hype

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Oh time, thy pyramids

Let’s start with a reminder that equities and fixed income instruments don’t respect the Gregorian calendar. Why should it? At what point does the fact that a year consists of about 356 days, and further divided into twelve months of more or less 30 days each, be considered a reason for selling stocks? This is not a concept of particular interest to Mr. Market. It is also a concept that should remain off the radar of investors, especially those with retirement accounts.

A brief history of time for investors

Conceptually, we call the time it takes for the earth to complete a full rotation on its axis a “Day.” The time it takes for the earth to complete a full rotation around the sun is called a “Year” during which period almost 365 days occur. The actual starting point of this cycle began around four billion years ago and as such remains a bit of a mystery.

Retirement not accountable to Egyptian Calendars

That this idea of a year being divided into twelve-month segments that have some kind of significance can be blamed squarely on ancient Egypt. Not only were the Egyptians responsible for the calendar as we understand it, they also suggested a start and finish to the year for help with planning around the annual flooding of the Nile. But they also invented tax collection, another questionable practice (as a side note, they also invented beer as we know it, and I’ve long been suspicious there’s a connection between this simultaneous appearance of beer and taxes). Today, as a recent article in National Geographic demonstrated, religion can also play a role in setting the start and finish of a year; March for Hindus, September for Jews and Muslims.

To tax, or not to tax

In tax-deferred and retirement accounts, no changes should be made just because the calendar says it is December. Or March, or September. Long-term investments are as oblivious to a twelve-month calendar as Mr. Market. As for investment transactions made in taxable accounts, there might be reasons for things like selling stocks to “harvest tax losses” but this often has the feel of market timing. Yes, you can sell a stock for a loss on December 30 and use that credit to avoid paying some taxes on profitable equity trades you’ve made. But why would you sell a stock with long-term potential for a short-term benefit? And if it was a crummy investment, why wait until year-end to sell? Unlike the Ancient Egyptians, you can “tax harvest” at any time. 

The first page of the papal bull "Inter Gravissimas" by which Pope Gregory XIII introduced his calendar.

“Inter Gravissimas”

So please don’t make a bunch of trades in your IRA or 401K retirement accounts because it’s the holiday season. Or because of decisions made by an Italian pope named Gregory in 1582 that subsequently provided the U.S. Internal Revenue Service with a framework for how to start taxing incomes to pay for the U.S. Civil War. Of course, we all know that taxing incomes in 1862 was just a temporary action initiated by Congress that couldn’t possibly endure since so many citizens were opposed to the idea.

What about stock markets next year?

Now, having said all of the above, let’s ruminate on S&P 500 returns for the year that was, and the year ahead. Knowing now that an artifice like the Gregorian calendar doesn’t have any relevance you can confidently declare a better reason for all those December sales of stocks in your retirement account. Everyone knows that after a big year like 2017 – likely to finish the year up around 20% – the next year will likely be not so good. This could be an unfortunate assumption.

As clearly demonstrated by the Boys at Bespoke (highly recommended), the performance of equity markets over time has about the same predictable correlation as flipping a coin; none. In fact, comparing index performance year-over-year is falling victim to the same bias; that Mr. Market has an internal clock and a memory. Comparing 12-month results from December to December will vary dramatically from comparing results from August to August. The S&P 500 had a very good year in 2016, up almost 12%, with most of the gains coming in the 4th quarter. Certainly, a signal to sell going into 2017, right?

As for next year, well, if you’ve built a well-diversified portfolio of indexed funds anchored around a core holding like the S&P 500, your returns are likely to benefit from the fact that markets tend to rise more than they fall. In the final analysis, it’s about building wealth over time, not market timing to get rich quick.

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Foreign Affairs

Invest-Notes has always been a big advocate of investing in enterprises operating beyond the borders of the United States. And while the world has not turned out to be quite as flat as predicted during the close of the last millennium, this increasingly volatile terrain remains a viable place to look for foreign investment opportunities. Almost a quarter of my personal retirement accounts are invested in stocks and bonds from non-U.S. companies.

Emerging Markets

Among the sectors that can be found across international equities, the most (in)famous is likely Emerging Markets. The most popular exchange-traded fund (ETF) proxy for this sector is EEM, iShares MSCI Emerging Markets. Up around 35% since the regime change in Washington, DC a year ago, this remains a scary place for many individual investors. Crushed during the market mayhem in 2008-2009, EEM has taken a longer, more volatile route back to a solid uptrend. Which might just make this a time for those without exposure in this space to consider adding some international flavor.

A quick comment before we do some analysis. Early on Emerging Markets was a catchphrase for the BRIC counties – Brazil, Russia, India and China.

Foreign Investment - BRIC Nations Brazil, Russia, India and China

BRIC countries- Brazil, Russia, India and China.

These days Mexico, South Africa and Taiwan also play supporting roles with walk-ons from countries like Turkey, Thailand and the Philippines. All-in, most Emerging Market indexes offer up around 10% of total world equity capitalization making this suitable only as a small part of your total foreign investment portfolio. In my case, 6% is invested in a competitor to EEM, Vanguard’s VWO. Today we’ll compare and contrast these two ETFs with an eye to the future based on some recent events.

EEM vs. VWO

While the biggest difference between EEM and VWO is the number of stocks included in their respective portfolios, a quick comparison points up a couple of points to consider:

EEM – iShares Emerging Markets

  • MSCI index
  • 900 stocks with around 9% turnover annually
  • 1.25% yield
  • 27% of the index value is in the top ten stocks, seven of which are Chinese

VWO – Vanguard Emerging Markets

  • FTSE index
  • 4,000 stocks with around 13% turnover annually
  • 2.25% yield
  • 17% of the index value is in the top ten stocks, five of which are Chinese

Is VWO the Better Option?

In summary, EEM is far more concentrated, more exposed to China and offering a smaller yield. All of which makes VWO a more attractive holding using the metrics preferred here at Invest-Notes. But more significant, perhaps, is what the results of the 19th National Congress of the Communist Party of China could mean for investors holding Chinese stocks. The quick take is that President Xi Jinping has centralized his power, and that of the Communist Party, to an extent not seen since Chairman Mao.

Any notion that Xi would embrace free market concepts to advance the Chinese economy has been laid to rest, despite his time decades ago as an exchange student in Iowa. Ever-tightening control of the Internet, silencing of the press and political dissidents, along with stricter top-down management of the economy open up the possibility for government meddling in some of the world’s largest companies. Especially vulnerable are the two major Chinese-based Internet players Tencent Holdings (TCEHY), the largest holding of both EEM and VWO, and Alibaba (BABA) a top ten holding in both ETFs, that could potentially find themselves with a new major investor – the Chinese government. While not inevitable, it is also not an outlier event based on current trends in China. So, if you determine to add some Emerging Market holdings to your retirement accounts it might make sense to limit exposure to Chinese equities by going with VWO.

Low Risk Additions for Your Foreign Investment Portfolio

Finally, for those interested in adding some foreign investment exposure but with less risk, a good choice might be Vanguard’s VEU (8% of my IRA). Sporting familiar names like Nestle, Toyota and Novartis in the top ten holdings, it more closely resembles an international version of the S&P 500 and delivered solid, but less impressive returns this year than EEM or VWO:

VEU – Vanguard All-World ex-US Index Fund

  • FTSE index
  • 2,400 stocks with around 5% turnover annually
  • 2.5% yield
  • 8% of the index value is in the top ten stocks, only one of which is Chinese – yes, Tencent

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Train keeps a-rollin’

10-29-17

With market valuations at nosebleed levels and market sectors like technology going parabolic, it is easy to make a case that a correction must be immanent. This is not a good bet. The current bull market started in October of 2009 and is now the second longest rally in the last one hundred years. Just to be clear, a bull market is a period without any 20% declines. Now lasting almost 3,200 days, we only need this bull to run for about another THREE YEARS to become the longest of all time. Using financial management language, what we have here is a failure to understand Momentum.

In a nod to one of my favorite economists, newly minted Nobel Prize winner Richard Thaler, this current state of affairs shouldn’t be such a surprise. One of the biases he observed is called the “recency effect.” Simply put, we tend to think the future will look like the immediate past. So an assumption that after one of the worst financial crisis in U.S. history people should be fearful of stock markets makes intuitive sense. It would also be wrong. That this bull run has long been called “the most hated rally in history” tells us more about human behavior than how to successfully invest our money. Just ask the folks who have been waiting since 2010 for a market correction to start investing in stocks again.

Okay, then what do we do now? Think about diversification outside of indexed funds like ETFs, even as they remain our preference as the primary investment choice for individual investors here at Invest-Notes. As discussed previously, the idea that ETFs are in a bubble, or will lead to weird price distortions or even a market collapse are just wrong-headed. But history has demonstrated pretty impressively that buying equities when valuations are high tend to mean subpar returns over time. This is where the idea of adding some individual stocks or narrowly focused ETFs might make sense for adventurous investors.

That there are specialty ETFs almost sure to fail spectacularly shouldn’t be a surprise. There are ETFs holding the stocks of Nigeria or Egypt that have lost a quarter of their value over the last three years. And if you bet on gold miners or master limited partnerships (MLP) during this same timeframe there are ETFs sitting on losses of up to 90%. Of course anyone reading this blog should know better than to even think about an ETF called ProShares UltraPro Short Financial Select Sector (FINZ), down over 40% so far this year, just as in many past years. Conversely the plain-Jane financial services indexes (like XLF or VHF) are up over 15% year to date.

Which makes for a nice segue to offer an observation about a possible investment opportunity. In August of 2016, a change was made to indexed financial services ETFs, like XLF and VHF, for the first time since 1999. No longer included with banks and their ilk, Real Estate Investment Trusts (REIT) now have their own index. A detailed explanation can be found here:

“The Difference Between Banks and Buildings”

The quick take is that previously about 20% of financial index funds were composed of REITs that provided the bulk of the dividend income generated by these ETFs. The assumption at the time was that bank-only ETFs would offer lower dividends and more volatility when the REITs were spun off. As it turns out, 2017 has proven a challenging one for REIT-themed ETFs, like VNQ or ICF. Despite a big spread between the dividend yields (REIT = 4.5% while Banks = 1.5%) the REIT ETFs are mostly lower than at the start of the year, underperforming bank ETFs by a significant margin since their Independence Day.

Another curious result of this separation of banks and buildings is their seemingly inexplicable lack of correlation. As the Boys at Bespoke have discussed recently (https://www.bespokepremium.com, highly recommended), there are asset classes that move in tandem and others that move in opposite directions. A quick example of this is the impact of rising interest rates on two asset groups that wouldn’t normally be thought of as behaving similarly. Yet both utility company stocks and long-term bonds lose value as interest rates go up. So when (not if) interest rates finally start climbing, having invested in these types of stocks and bonds will provide very little safety despite the diversification normally associated with a stock/bond mix.

When comparing a list of 18 popular asset groups (bonds and indexed ETFs, but also oil, gold and Bitcoin), the two assets most likely to go in opposite directions on most days are the REIT and Financial Services indexed funds. As noted by Bespoke, just a year ago they were traded as one asset. This suggests that REITs could provide some valuable diversification if financial equities begin to lose some of their recent altitude. The caveat here being that rising interest rates tend to boost bank stocks while often pressuring REITs.

However, it is just possible that recent headlines about the death of physical retail outlets – versus the online variety – is greatly exaggerated. This red herring obfuscates the fact that most income-producing real estate is not shopping malls – office spaces, warehouses, data centers, apartment buildings, manufacturing facilities, hotels, gas stations and convenience stores – suggesting that the recent underperformance of REIT ETFs might be an opportunity to add both value and income (the 4.5% dividend) to a portfolio at decent valuations.

While I don’t currently own any REIT ETFs, VNQ is on my radar and starting to look interesting. As a side note, over 10% of my personal IRA is in individual REIT stocks that I have owned for over a decade. That the bulk of my personal assets are real estate investments also explains why I have not been in any hurry to add real estate exposure through these new ETFs. But that might be changing.

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A Happy Anniversary

10-16-17

Ten years ago today the first Investnotes was sent by email to a handful of family and friends. In 2010 my good friend Rob Simons gave me a WordPress blog site, set-up and ready to go, as a birthday gift. There has since been over 400 postings on investing, jazz and art.

Here for all to see are my missteps, misguided trades and boneheaded commentary. But also a few solid suggestions and nuanced observations that when embraced by readers delivered real value for the time spent reading these musings.

Thank you for choosing to join me on this journey of discovery, as well as for your many comments both good and justly critical. Below is the first missive to appear as what is now Invest-Notes. Leaving this post unedited has been the most difficult task of the last ten years.

10/16/07 #1

Investing is not a zero-sum game. All the talk about “beating” the averages serves only to distract from the point, which is to generate a meaningful return on your investments while minimizing any risk of significant loss. What someone else makes is irrelevant as long as you can achieve the goals you’ve set based on your needs and circumstances. You don’t have to “beat” anything over time to create wealth. It is also a fallacy that someone else must lose money for you to profit. So what that someone sells you a stock that then goes up. What if that investor had been holding the stock for years and finally cashed-in for big, long-term capital gains? In this scenario one person has exited a position profitably as another enters the same position favorably.

In his otherwise excellent new book “A Demon of Our Own Design” Richard Bookstaber makes the assertion that when hedge funds win, it is because someone else loses. But he then contradicts himself during a fascinating discussion about the primary purpose of the market being to provide liquidity. Equities, for example, are bought and sold not because of economic news (the Efficient Market Hypothesis), but because someone needs money to take a vacation or buy a new home. Conversely, investment firms and mutual funds receive money that must be invested in a timely fashion. This idea of the market as an entity intended to monetize investments means that as long as the reasons for ownership of an equity are influenced by matters not pertaining to the business of the enterprise then it is impossible to assume that an investor has either won or lost in any given transaction.

Whatever your financial goals, follow your own instincts, not those of people who might view the world differently than you do. And don’t get distracted by what other people claim to be achieving. The only thing that really matters is the value of your assets when you need them.

ck

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The Jazz of Investing

Frankly, it’s a fool’s errand to try and decide when is a good time to buy or sell equities based on movements in the stock market. Yes, valuations appear stretched and the recent, relentless upward trend in most market indexes would argue for caution. But this same comment could have been made repeatedly since the market bottom in 2009. A tired old quote is worth a revisit, “The market can remain irrational longer than you can remain solvent.” Or, put more bluntly, nobody has any real insight into what the market is going to do next. The only sensible choice is always to stick with your original investment plan. And if you don’t have a plan, then don’t do anything until you commit to one.

Almost a decade ago Lewis Sanders of investment firm AllianceBernstein made an intriguing observation, “The principal dynamics in the world’s capital markets revolve around a tug-of-war between feeling secure and making money. In the end, the feelings generally win out.” Around the same time a hedge fund manager (whose name is not in my notes) said in a Bloomberg interview that his only trades consistently making money were the painful ones. Buying stocks that are out of favor, avoiding the “hot investments” of the moment and having a plan that you stick with is not just difficult, but is indeed painful.

Looking back to 2000 there were many competent fund managers and investment professionals who underperformed the market during the dot-com bubble. Warren Buffett in particular came under withering criticism for being too old to understand the value of technology stocks. Yet it was the investors, like Buffett, that stuck to what they knew and had the discipline to execute on their strategies, even in the face of public ridicule, that avoided being burned in the subsequent crash. Probably worth noting that Berkshire Hathaway (BRK.A) hit a dot-com bottom of $44,000 per share in February of 2000. It closed yesterday at $278,670 per share.

For those of us who saw our 401K plans become 201K plans during the market mayhem of 2009-2010 the pain lingers. But a refusal to panic enabled disciplined investors to subsequently enjoy one of the biggest bull market runs in U.S. history. If you were buying stocks in the summer of 2009 you were considered an idiot. Today you are a genius for being so insightful at that time.

So all this helps to explain the tendency for emotion to win the day rather than reason. Research has demonstrated time and time again that most investors tend to sell their winners too early (because it feels good to make a profit, any profit) and then hold on to losers (because to sell is to admit that we were wrong, and no one likes being wrong). Having the conviction to avoid these common, painful mistakes requires discipline and the work necessary to fully understand not just what you own, but why you bought it in the first place.

Yet the Big Decision each of us must ultimately make is whether or not to be an equity investor at all. There is no shame in admitting that any loss is too much to bear. Or, that having to make decisions about how and where to invest money we have worked very hard to earn is just too painful, even with professional help. Let’s face it, most investors are not particularly successful anyway. There is nothing wrong with simply socking money away in bank CDs or U.S. Treasuries (the “but what about inflation” caveat notwithstanding, or particularly relevant recently). For most of us, that we routinely spend less than we earn will be the driving factor in creating wealth over time.

Finally, a quick thought about investing strategies derived from the musings of jazz great Miles Davis. Don’t laugh, Davis was making over $200K annually back in the 1960’s when that was a lot of money (his New York City brownstone, Maserati and full-length snakeskin coats weren’t paid for with credit cards). Davis once said that, “If you play a note you didn’t intend to play, what determines whether it sounds like a mistake or a moment of inspiration is the note you play after it.”

Buy a stock; hold the stock, sell the stock or buy more of the stock? Only with study and practice can we become good enough investors to know what note to play next.

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