The Fed Holds The Line

by David Gimpel

Traders on the floors of exchanges across the country collectively "BOOOOed!" today's choice by the Federal Reserve to hold interest rates constant at 2%. The Fed finally gave equal billing to economic growth and inflation. Tha market response was a meaningful, but measured jump of about 90 points. This measured response is primarily due to the fact that the pressing issue weighing on the market is the potential bailout of AIG.

You all know I don't like CNBC's Jim Cramer, but he hit it right on the head when he said (paraphrased) "The Fed could raise rates for all I care as long as they take care of AIG."

Readers of this blog should also note that I am not a fan of bailouts, but I completely agree with Cramer inasmuch as the market cares way more about AIG than the fed funds target rate. It will be interesting to see how things work out over the next few days. In my mind, the best possible outcome is a privately funded bailout of AIG by peers, not by the Federal Government.

We shall see.

It's Amazing We Save Any Money At All

A recent New York University study and subsequent Money magazine article recently asked and answered a simple question: Given the choice between $20 now or a larger amount later, how much would people demand to make it worth waiting?

The answer was expected; the magnitude of it was not. From the article:

“…to the typical person, $20 now is better than $23 three weeks from now, $40 three months from now or $47 six months from now…In short, for your brain to be willing to wait a mere three weeks for a higher payout, that $20 would have to grow at an annualized rate of roughly 4800%.”

Wow.

Remember, our brains are hardwired to make this kind of ridiculous and seemingly irrational decision. Imagine a similar situation hundreds of thousands of years ago when the choice wasn’t about investing, it was all about food. In order for our brain to accept the idea of delaying or missing a meal in order to potentially reap a bigger food reward in the future, the potential payoffs would have to be absurdly high to justify the risk.

Our brains evolved, it seems, to keep us alive, not make us money.

It’s a good thing that Rational Capital Management has evolved to pick up the slack.

Fannie and Freddie, Conservatorship and Stupidity

Fannie and Freddie, Conservatorship and Stupidity

The market is up roughly 290 (2.6%) points today, September 8^th, 2008.

I start with that fact because when I was in junior high, I learned that it’s best to address my opponent’s rebuttal before they have a chance to. So there it is. Big Brother bailed out the two financial giants, and in unison the markets cheered, excited about the idea that this move is a light at the end of the tunnel for the current credit crunch and related housing slump.

Big Whoop.

In previous posts I have discussed at length the importance incentives play in functioning markets. In short, the sense of risks and the potential for painful financial losses keeps firms from taking on too much risk. Remove the potential from loss from the equation, and you remove the incentive for firms to behave well.

Are you getting this? Bailouts beget bailouts because they cause firms to lose their sense of risk when making decisions. “Even if we become totally insolvent, Uncle Sam will come to the rescue!” they say. My blood pressure is rising with every word I type.

So here is my “fire and brimstone” thought of the day for everyone who can’t see past today’s market performance. The endgame of Federal intervention into public markets can only lead to two potential outcomes. The first, as I described above, is firms taking more risks, leading to more volatility, failures, and yes, bailouts.

The second, even more dire outcome, takes us down the road to socialism. After all, when the Feds bail out a firm or an industry, that money often comes with strings attached. It may not be like Chavez unilaterally nationalizing companies, but every additional government intervention and every additional layer of oversight and beaurocracy only inhibits the natural progress of capitalism.

Yes, the markets sometimes cause acute pain, but it’s nothing compared to the chronic, destructive ramifications of bailouts.

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

Why Economic Stimulus Checks Suck

by David Gimpel

Let's talk about political reality versus actual reality.

In crazy political world, you recently received an economic stimulus check. The check seemed like manna from heaven. It felt like Uncle Sam was really looking out for you and your family. You took that check, and did good things for the economy. And you probably, though begrudgingly, felt OK about the Federal Government...even if it was just for a moment.

That was the government's idea, of course. To make you feel happy. I know this because the economic stimulus checks can not serve any other purpose. So let's get real...

In economics there is a concept called "Ricardian equivalence." The theory says that governments need money to operate and execute policies, and such funds can only come from two places. First, the government can tax citizens now. Alternatively, the government can borrow from the public by selling bonds. Of course, these bonds must be repayed in the future, and those payments can only come from - you guessed it - taxes. So, the choice actually boils down to this: tax now or tax later.

Your economic stimulus check is a masked form of "tax later." Certainly, the government is not going to change their spending habits, so if they are sending out checks to individuals, those checks must be financed by future tax hikes.

Let's go one more step. A rational citizen, realizing this, should do one of two things - save/invest the money or pay off debts to free up cash flow for inevitable future tax hikes. Evidence suggests that many people do just this, particularly in regards to debts. In this case, stimulus checks doled out to private citizens are essentially a direct transfer of funds to hard-luck lending firms, paid for by future tax hikes to private citizens.

Are you still thrilled to receive your check?

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

Active ETFs

by Dave Gimpel

It's official - actively managed exchange traded funds (ETFs) are a reality. In late February, the the SEC granted permission to four ETF providers to develop and launch the first actively managed ETFs. This new generation of ETFs will awkwardly bridge the gap between traditional, actively managed mutual funds and passively managed, index-based ETFs.

Let me jump right into my bold predictions:

1.) Actively managed mutual funds are officially dead. As the variety of active ETFs grows, I can see very little reason for investors to stay with traditional mutual funds. Fees for these new ETFs will certainly be higher than their passive cousins, but they still won't be as high as comparable mutual funds. On top of that, active ETFs will retain some of their tax efficiency since they are traded like single stocks (the effect will be diminished, however, due to higher internal turnover). For these reasons, traditional mutual funds as a product will eventually go the way of the dodo.

2.) Active ETFs will not be the overnight sensation index ETFs were. First, index ETFs had a pre-existing demand. Investors were practically begging for a way to trade baskets of stocks like a single stock. No such demand exists for active ETFs. In fact, one recent article in a prominent trade journal on the topic stated "The greatest boosters of active ETFs are their creators, who are looking for the next big thing. Whether investors will buy active ETFs comes down to how they perform." Which leads me directly to my final prediction:

3.) Active ETFs will generally underperform their passive cousins. I base this on the simple fact that in an average year, most (over 75%) mutual funds underperform their relative benchmarks. What reason is there to believe that the statistics will be any different for active ETFs? Investors who believe in the investment thesis of indexing tend to be at odds with those who believe in active management. For this reason, I expect most of the new business for active ETFs to come from the mutual fund world, not the passive ETF world.

I am not very encouraged by this new investment tool, but I do applaud the innovation. Who knows what new options this step will open up in the future? That is the only thing that I can get excited about because, in case you missed it, I expect active ETFs to be underwhelming.

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

Dollar Cost Averaging

By: David Gimpel

As most of you already know, dollar cost averaging (DCA) is the practice of investing the same amount of money consistently over equal intervals. There are two ideas behind this practice. First, when process are higher, we purchase less of the investment and when prices are lower we buy more. If markets are volatile, but generally rise in the long term, the practice of DCA leads to a lower average cost than the market price of an investment. This is a good thing – the difference between the cost of the investment and it’s current market price is the investor’s capital gain. Second, DCA helps us sleep better at night because we avoid making a lump-sum investment in the market that is poorly timed.

The question to answer, however, isn’t whether dollar cost averaging is a reasonable practice. It is. The question is whether or not it is optimal. There are many potential strategies about how to invest money over specific intervals. For the sake of contrast, let us choose two at the very opposite ends of the spectrum: DCA and lump sum investing.

Let's begin with the well established fact that over the long term, roughly two out of every three years the market will rise. Knowing this fact alone, we can make the common-sense assumption that two out of three times, investing a lump sum will outperform a DCA strategy since the DCA has cash sitting on the sidelines.

Of course, is the real world that simple?

Obviously, this is a loaded question since people disagree on how predictable markets are. If you believe in the random walk theory, which largely insists that stock movements are completely random, I would suggest lump-sum investing, if you can stomach it. Again, if the markets behave completely randomly, two-out-of-three times, you are going to be better off using the lump sum strategy.

If, on the other hand, you believe that markets are even somewhat predictable (as I do), then you might take a more tempered approach. On extremely rare occasions, it is clear to competent financial advisors that the market is due for a correction. I say extremely rare because most advisors are subject to the same cognitive hindsight bias as individual investors; essentially people believe they "should have seen it coming." Only in rare extremes would this actually be the case, and such an extreme is the only time DCA should even be considered.

In my professional life, there was only one time that I would have endorsed DCA - the tech bubble. Given the extended life of the bubble, the insane valuations on companies (the broad market approached a p/e of 50!) that were unprofitable, and the non-existent equity risk premium (in 2000, under.5%), it was clear the the fundamentals of the market were historically unfavorable and unsustainable. Even the 1987 "Black Monday" crash was largely unforeseeable based on fundamental information - its causes are debated to this day.

Don't get caught up in the details - the bottom line is that in just about every market, including volatile and unpredictable markets such as the one we find ourselves in, lump sum investing will typically yield a better result than DCA. It may not help you sleep at night, but if you can stomach the risk of jumping in, it will usually be the smart choice.

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

All Hail Volitility

By: David Gimpel

If you don’t know who Nick Murray is, learn to love him. I had the pleasure of seeing him in person years ago when I was first embarking on my journey as an investment advisor. To say that his speaking style is direct is an injustice both in understating his style and more important the clarity of his message.

In the April 2008 issue of Financial Advisor Magazine, Murray has a feature article entitled “The V Word,” which discusses how investors and the media deal with volatility. It’s best I let Mr. Murray speak for himself…

“The mob – and journalism, which functions, for the crowd, as an alternative to an adult brain – say 'volatility' when what they mean is 'a market that is going down a lot in a quick hurry.' But that’s not quite the word’s precise meaning.”

Amen.

Volatility actual relates to both up and down movements in the price of an investment. Of course, when investments suddenly and sharply go up in price, investors do not have the negative association with volatility that they have in a declining market – even though volatility can be just as high in a bull market as a bear market. Recently, volatility has been historically high – this is true. What this actually means is that the number of sudden moves – both up and down – have been larger and occurring more frequently than would be expected based on historical averages.

But here is where Murray elevates himself from a straight shooter to a guru to other advisors. In his article, he continues to thank the market gods for volatility. See, volatility is specifically what earns equity investors excess returns over fixed income investors over the long term. Because equity investors risk large sudden losses, they must be compensated by having more upside opportunity.

If that downside volatility were suddenly not to exist, you better believe that your upside would disappear right along with it.

The purpose of this post is two-fold. First, it was intended to pay homage to Nick Murray. I may not agree with him on every point, but as a professional he is what I aspire to be. On the topic of volatility, however, I am completely with him.

Volatility is our friend, but only if we really understand what the word actually means.

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

Random Thought on Gas Prices

by Dave Gimpel

From time to time I am struck by questions that are particularly interesting because I don't know the answer. My most recent question occurred recently while I was filling my car with $3.59/gallon regular fuel. Chicago, it turns out, consistently has the highest fuel prices in the country, making the following question more interesting and more important. Here it is:

How much of the financial "pain at the pump" can be mitigated by owning oil (in any securitized form)?

The easy answer is this - almost all. Industries that are most affected by changes in oil prices such as airlines and auto manufacturers have come up with effective hedging strategies that mitigate the risks of rising oil prices. Such strategies cost money to initiate and maintain, but firms view those costs the same way individuals view an insurance premium - as an unfortunate yet necessary expense that helps everyone sleep better at night. The problem is that often these strategies are outside the scope of an individual investor's capability and comfort zone.

But that doesn't mean that there aren't hedges available to regular investors. Simply owning shares of stock in an oil company like Exxon Mobil (ticker:XOM) mitigates some of these costs. How effective is this hedge? Time for some simple math...

1.) In the past 5 years, the price of gas at my local pump has risen from $1.63 to $3.59, or 17.1% per year.
2.) Over the same time, XOM stock has risen from $34.26 to $84.58, or 19.8% per year.
3.) Let's further assume that I consume 400 gallons of gas per year and I start off owning 100 shares of XOM 5 years ago. How painful is the gas pump really?

Had gas prices stayed constant at $1.63, I would have paid $3,260 over the past 5 years. Over the same period, due to inflated gas prices, I have paid slightly more than $6,000 to fuel my car. This is an increase of $2,730. Over the same time the 100 shares of XOM would have risen from $3,400 to over $8,400, a gain of over $5,000. What this means is that over the past 5 years, owning 100 shares of XOM would have MORE THAN made up for increases in gas prices.

It's not a perfect hedge, but I think the idea here is clear. Most of the time, when consumers face rising costs, those dollars are feeding a company's bottom line. Owning the company (or better yet, the industry the company is in) is sometimes a prudent hedge. If you consume a lot of gas, owning stock in an oil company can be a simple hedge that works in both directions. When gas prices are rising, it's a good bet that the value of the stock is, too. You take a hit at the pump, but you get a boost in your brokerage account. When gas prices are falling, you save money filling up your car, but the value of your oil stock is probably falling, too.

The most interesting part of this is the nature of hedging for individual investors. The most common reason investors hedge is to control the risk in their portfolio. If you believe that an asset is going to lose value you might purchase a put option. This happens all the time.

"Pain at the pump," however, has nothing to do with your portfolio, it has to do with your daily life. How many people have ever considered hedging the cost of that?

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

Credit Crunch 101: Why Incentives Matter

By David Gimpel

I follow the news just the right amount. My goal is to try and understand the issue without getting bogged down in the details. The recent news regarding investment bank Bear Stearns is what finally put me over the edge, but I have been fuming about incentive structures since the beginning of the credit crisis.

Every parent and every child has an innate sense that incentives matter. From the child's perspective, the decision to behave or misbehave is largely predicated on the potential punishment to be handed down from the parent. Parents conversely understand that not punishing misbehavior invariably leads to more of it, but feel guilty administering penalties. Because of this, families develop a natural equilibrium regarding behavioral standards that are based on the balance between the incentives for the children and the parents. The same simple theory applies to the interplay between the Federal Reserve Bank and Congress, and distressed financial institutions and borrowers.

It is always difficult dealing with a situation like this. Every few years it seems that some Fortune 500 firm collapses for causes that could have been easily avoided. On the one hand we have blameless employees whose lives are potentially destroyed. On the other hand, we have the natural process of capitalism, which routinely bears out the weaknesses of firms and enables progress through creative destruction. The question everyone has to answer is this – what is more important?

The humanist in us all feels for people who lose their jobs, benefits, and potentially life savings through no fault of their own. But the economist must understand what incentives a bailout creates. If companies begin operating under the presumption that they literally cannot go bankrupt because the Fed or Congress will bail them out, they will only take more risks. It's like a child whose parent refuses to punish them.

The recent credit crisis had many complex causes, but they generally fell into two categories. First, individual borrowers lived beyond their means and accumulated too much debt that they couldn't pay off. When the rates adjusted higher, many borrowers couldn't make the higher payments. Furthermore, decreasing home prices created a situation where many homeowners who put little or no down payment on their homes (and thus had little or no equity) had mortgage balances that were higher than the value of the home mortgaged. Second, the firms who both originated the loans and the firms that used the derivative packaged mortgage securities were injured by taking too much risk in their lending practices and in poorly managing their balance sheets.

I truly feel for the innocent people at Bear Stearns. But I cannot escape the greater fear that if we don't allow individuals and institutions to fail, we eliminate all the incentives for them behave. The Fed's behavior in dealing with Bear Stearns and the entire financial system may have averted an unprecedented financial collapse, but when firms and investors lose their fear of failure, they only step closer to the edge of the cliff.

Allowing failure and punishing misbehavior isn't callous. Parents have another phrase for it - tough love.

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

The Uselessness of the RAND Report

By David Gimpel

If the RAND Corporation got it right in their recently released report on Investment Advisers and Broker/Dealers, I can confidently say two things about you.

1.) You don't understand the difference between an investment advisers and a broker/dealer

2.) You don't really care about #1.

It isn't surprising that you don't know the difference since, increasingly, all financial services providers are converging in terms of services offerings. Think about how many people are buying mutual funds from their life insurance agent, and conversely how many people are buying life insurance from their stock broker. Everyone wants to be everything to everyone.

So let's make it very easy - investment advisers are fiduciaries while brokers are not. What this means is that investment advisers get paid for their advice, and as such are held to the highest legal standard (the fiduciary standard) when making recommendations. Brokers, on the other hand, are paid commissions to process transactions and are only supposed to give advice that is "incidental" to the transaction. As such, brokers are not held to the fiduciary standard, they are held to the lower "suitability standard" since brokers should not be giving advice in the first place. That's why you should care.

Of course, you probably don't. The second major finding of the RAND report is that despite the confusion regarding the nature of financial professionals, clients report high levels of satisfaction with their chosen professional. Brokers have gotten a rotten deal over the past few years, but the truth is that there is nothing wrong working with a "professional" (investment adviser) or a "salesman" (broker/dealer). Both are honorable careers.

However, it doesn't seem right that two people who provide the same services yet have different titles on their business card aren't subject to the same ethical and legal standards. It's for your (the client's) protection, which is why despite the RAND report's findings, you should care.

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David Gimpel is the President and Founder of Rational Capital Management. To learn more about the firm, please visit www.RationalCapitalManagement.com.

Open For Business!

Thank you for taking the time to read Rational Capital Management's blog. My name is David Gimpel, President and Founder of the firm.

In speaking with friends and colleagues, I received much feedback about how to best use this blog. Much of the feedback, not surprisingly, warned me against speaking my mind. The important issues of the day tend to have several points of view and as a businessperson, it is often easier to have no opinion than one which offends. I understand this point of view and wholeheartedly disagree.

In a general sense, people should not be ashamed of their principles. Our country is founded on ideals of diversity, and nothing is more diverse than opinions. On a more related, professional level, clients should know who they are working with. As such, this blog will cover a very wide range of topics, including:

1.) Behavioral Science

2.) Politics

3.) Economics

4.) And from time to time, we might even talk about investments and markets.

The idea here is to be interesting and entertaining. The idea is to express what we think and why it matters. The idea here is to let you know who we are.

Firm to Launch Mid-March

Please check back soon.