Monday, March 11, 2013 - When to Hold Them

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When to Hold Them

By Sinclair Noe

DOW + 50 = 14,447
SPX + 5 = 1556
NAS + 8 = 3252
10 YR YLD + .01 = 2.06
OIL + .11 = 92.06
GOLD + 2.60 = 1582.80
SILV - .01 = 29.09

So, the Dow industrial Average hit another high, the S&P 500 is within 10 points of a record high. Capitalism is doing well under this socialist regime.

Let's imagine you actually participated in this rebound. Let's work on the idea that you have an automatic investment plan, such as a 401k or a SEP or an IRA, and you are invested. What now? Do you continue to invest? Do you rebalance? And the answer is yes, if that is part of your investment plan. The record highs do not change the plan.

What if you got out and did not participate in the rally? Again, we go back to your plan. Why did you get out? Was it part of the plan? If you have a plan and you don't follow it, that is like not having a plan. If you don't have a plan and you're wondering what to do; the first order of business is to get a plan.

What if you have a bad plan? And if you have ever been stuck in a bad plan, you know what I'm talking about. If you are in a bad plan, the first order of business is to get a good plan, and then you can follow that plan to tell you whether to get out of certain investments.

If you are starting to see a pattern, it is simple. Develop a solid investment plan and have discipline. This doesn’t mean that you sit back and take losses in a downturn because your have great fortitude and unwavering discipline. If you're taking big losses in a downturn, it means you have a bad plan. Get a good plan, appropriate for your age and risk tolerance, then and only then should you be disciplined.

Discipline is the Holy Grail of investing.

I understand that it’s hard, and that it feels like we should be doing something. But it’s important for us to understand that when we make important financial decisions based on a false assumption, it can lead to scary results.

So the next time (or even this time) the noise implies that you should be doing something — because the markets are doing something —  it’s time to check your assumptions. The noise probably doesn’t apply to you.

Where are interest rates headed? Well, a few months ago I tossed out the idea that the Federal Reserve just might take all those bonds and mortgage backed securities they were buying, and they might just hold them. And then when Fed Chairman Bernanke delivered his testimony to Congress, he tossed out the idea.

The Fed isn’t planning an immediate exit and continues to add to its stimulus, buying $85 billion of mortgage-backed securities and Treasuries each month. It has left the duration and size of the program open-ended. Then, the thinking is that QE has to end at some point, and that raises the question of how the Fed could stop buying bonds and sell what they have on their balance sheet without seeing interest rates and inflation rise.

If the Fed doesn’t withdraw quickly enough, there’s a risk of overshooting. If the Fed gets rates back to a typical level and the economy is back to what’s regarded as normal, does having an expanded balance sheet have a notable effect on the economy, on asset markets, even once rates are normalized? We haven’t really had that situation in the US before.

Under the current exit strategy, the Fed would cease reinvesting some or all principal payments from its securities, revise its interest-rate outlook, raise the federal funds rate and then start selling housing debt to eliminate it from its holdings in three to five years. But then Bernanke raised another option. Bernanke told lawmakers: “The one thing we could do differently” is “hold some of the securities longer... We could even just let them run off.”

Not all policy makers are convinced that holding the bonds to maturity is a viable strategy. Philadelphia Fed President Charles Plosser says it’s too soon to know whether the Fed can withdraw its easing this way. Plosser said: “I don’t know how we can commit to never selling. We don’t know the answer to that, so it’s hard to pre-commit, to say we can’t sell assets even in the face of rising inflation.”

What we will probably see is the Fed will go ahead with sales at a gradual pace and any sales will be well communicated in advance. Market response will determine if the Fed dumps bonds or it they are forced to hold to maturity. With the chance of large asset sales receding, the yield on 10-year Treasuries probably will remain between 1.8 percent and 2.25 percent this year.

Of course, there's more to this story. Without the actions of the Federal Reserve, the 10-year Treasury note would most likely have a yield closer to 3.5%; the Fed is the 800 pound gorilla in the market; they run the show, but economic growth also factors into the equation. The Fed is more like a two-ton monster in the mortgage backed securities market. The next 6 months will be a potential turning point for the Fed; that will allow enough time to feel the negative effects of the payroll tax hike and the sequester. If the economy shows strength in the third quarter, despite the fiscal restraints, then the Fed may finally start hinting at easing off QE. If the economy sags, the Fed will continue with QE to infinity.

Every time an IPO has a big pop on its opening day, we have to ask: did the investment banks leading the deal rip off the company raising equity capital? Joe Nocera, who had a great column this weekend, where he uncovers a bunch of documents in a securities lawsuits against Goldman Sachs. The documents should have been sealed; they weren’t. And now, thanks to Nocera, we can all see exactly where Goldman makes its money, when it comes to IPOs.

The lawsuit in question concerns the IPO of eToys, back in 1999. The company sold 8.2 million shares, raising $164 million; Goldman’s 7% fee on that amount comes to $11.5 million. If Goldman had sold the shares at $37 rather than $20, it would have received an extra $10 million — and what bank would willingly leave $10 million on the table? It was a big pop IPO, which finished it's first day of trading at $77 a share.

What Nocera has discovered, however, is that Goldman was not leaving $10 million on the table. Instead, it was making more than that — much more — in kickbacks from the clients to whom it allocated hot eToys stock. Lawyers representing eToys’ creditors’ committee sued Goldman Sachs over that I.P.O. That lawsuit, believe it or not, is still going on. Indeed, it has taken on an importance that transcends the rise and fall of one small company during the first Internet craze.

The plaintiffs charge that Goldman Sachs had a fiduciary duty to maximize eToys’ take from the I.P.O. Instead, Goldman purposely set an artificially low price, so that its real clients, the institutional investors clamoring for the stock, could pocket that first-day run-up. According to the suit, Goldman then demanded that some of those easy profits be kicked back to the firm. Part of their evidence for the calculated underpricing of eToys, according to the plaintiffs’ complaint, was that Lawton Fitt, the Goldman executive who headed the underwriting team and was thus best positioned to gauge the market demand, actually made a bet with several of her colleagues that the price would hit $80 at the opening.

So, Nocera uncovered some documents on the case. What they clearly show is that Goldman knew exactly what it was doing when it underpriced the eToys I.P.O. — and many others as well.

Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the numbers in something it called a trade-up report, the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O.’s and demand that they reward Goldman with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50 percent of the first-day profits be returned to Goldman via commissions.

In one e-mail, a Goldman Sachs executive described hot I.P.O. deals as “a currency.” He asked, “How should we allocate between the various Firm businesses to maximize value to GS?”

Goldman Sachs denies it was involved in quid pro quos for giving preferred clients access to hot IPOs.

Goldman supporters also point out that it was hardly the only underwriter to allocate shares of Internet public offerings based on what it would get in return. In the aftermath of the bubble, Goldman wound up paying fines to the Securities and Exchange Commission for I.P.O. excesses. But so did a lot of other firms. None of the government’s allegations, by the way, were related to the kind of practices alleged in the eToys lawsuit. As for the litigation itself, Goldman has argued that, contrary to popular belief, underwriters do not have a fiduciary duty to the companies they are underwriting.

Incredible but true.