It’s never easy. But rarely have I seen as big a disconnect as the one I read about in the current issue of Business Week (August 16-29, 2010).

First, the seemingly good news. A Bloomberg-compiled report, done in early August, studied the stock market forecasts of 12 major investment banks. The consensus results said, “the fastest annual earnings increase in 22 years will push the S&P Index up 20 percent in the last six months of 2010.”

At the same time, the article notes, many of the economists at the same banks are increasingly becoming more pessimistic about the economy.

Can the stock market rally while the economy slumps? Yes. We’ve seen it many times. In the past it’s been referred to as the market “climbing a wall of worry.”

In the current situation, record low interest rates are one of the main factors for optimism. But another propellant for the expected rally is growth of earnings. Corporate earnings are looking robust right now, and going forward seem poised to beat earlier estimates. Cash at companies in the S&P 500 has risen for six straight quarters, partly a result of firing workers by the thousands and partly from reducing capital spending. That stinks for the now unemployed workers, but it helps the firms’ bottom line. Hence the rosy forecast for corporate earnings, and the expectation of higher stock prices.

While a 20 percent jump from current levels seems extreme – and since the 20 percent figure was the consensus number, some forecasts had to be even higher – both Jack Bowers and I have been projecting a rally into the closing months of the year.  Time will tell.

Whether for home repair, medical needs or legal advice, the person or firm that specializes is more likely to give satisfaction than the jack-of-all trades.

It’s the same in my profession.

Here’s an on-line ad I came across.  I’ve seen similar ads many times, in many places, and you have too.

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If you require assistance or would simply like more information on the following services, please contact me at the address above to set up a consultation:

-Life insurance,
-health insurance,
-long term care,
-disability,
-auto insurance
-401(k) / IRA rollover,
-annuities,
-life-time income annuities,
-mutual funds,
-college savings,
-retirement concepts,
-mortgages,
-realtor services, and
-homeowners insurance

We offer personalized and reliable service to all of our clients and offer ideas on how to earn money in a down market. Please contact us today.

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Each one of those bullet points represents a wide field of study. While some services, such as certain insurance needs, can safely be lumped together, I would be wary of selling my home (“realtor services”) or setting up a 401(k)  through the same person who sold me my life insurance. And I certainly would question the expertise of this person when it comes to crafting a portfolio of mutual funds.

Yet most full-service insurance firms offer mutual funds, so we can safely assume a very large number of Americans have bought funds from these firms. After all, the average person is intimidated by financial topics, and so the person with any expertise at all is seen as, well, the expert.

But  …

Will the insurance broker do a thorough and competent assessment of the current and future financial needs of each client? Will he or she be fully versed in the makeup and behavior of the hundreds of different types of mutual funds?  Will the recommended funds be the best for the client, or will the commission paid to the broker influence the decision? Will the broker provide on-going oversight of the portfolio?

Take a guess.

Each is a legitimate cause for concern. But for those of us who take the long view, the outlook is becoming rosier.

You don’t become a successful investor by buying when everyone else is buying, or selling when the world is dumping stocks. The smart way to buy low and sell high is to see what the crowd is doing, and then do the opposite.

So what is the crowd doing lately? Here’s part of a chart from the Investment Company Institute:

Estimated Flows to Long-Term Mutual Funds
Millions of dollars 

Take a look at the figures in the “Domestic” line. What they show is that in the week ending 7/21/10, investors pulled $1.52 Billion out of U.S. stock mutual funds, and about twice that much the week before. This trend of money leaving U.S. stock funds has been happening since May of 2007, and as the chart clearly demonstrates, the outbound flood has not abated.

Are you sitting it out, waiting for some special signal to move back into the US stock market? If yes, you are clearly not alone. But now may be a perfect time to reevaluate your strategy.

Good luck. You are an amateur up against professionals.

The first thing you need to accept when it comes to financial seminars for the public is that they are designed to sell financial products and services. Period. You may walk out better informed than when you entered, but educating you is not the primary goal of the presenters. That’s why you see hot-button words in the invitation:

“Act now!”
“If you are over 60, you cannot afford to miss this seminar”
“Seating is Limited!”
“Reservations an Absolute Must!”
“This is a time-sensitive offer!”
“There is a financial storm brewing”
“If You Own a Mutual Fund You Must Attend!”
“Startling presentation reveals costly mistakes that can ruin your finances.”

To get you to lower your guard, the invitation may also use words like “educational,” and “nothing will be sold at this workshop.” Yes, that may be technically true, because the real sales job comes over the next few days.

A 2007 study of financial seminars, done in part by the SEC, found that more than half of the firms presenting these sessions, “used advertising and sales materials that may have been misleading or exaggerated.” http://www.nasaa.org/content/Files/Seniors_Report.final.pdf

A few juicy examples from the report: “Immediately add $100,000 to your net worth,” “How to receive a 13.3% return,” and “How $100K can pay 1 Million Dollars to Your Heirs.”

I would agree labeling those claims “misleading or exaggerated” is accurate!

To be sure, ethical investment firms do offer seminars, so don’t let me dissuade you from attending a particular seminar that appeals to you.  Just be aware that many of the products being touted are the ones that have the highest fees and those fees are almost always cleverly hidden.

And never sign anything while still at the seminar! Wait a few days, discuss what you “learned” with your spouse or, if possible, with at least one other trusted advisor, and only then consider buying whatever it was they were selling.

I don’t know anyone who has done well, long-term, in the options market.

Nonetheless, there seems to be a rush towards these lesser-known investment vehicles. (I am loath to call them investments.) From 2004 to 2009, the volume of options trades done by individuals increased an astounding fivefold at Fidelity Investments.

Options are a class of “derivatives” contracts that give buyers the right, but not the obligation, to buy or sell a security, a commodity, or an index’s cash value at a set price by a specific date. There are two basic kinds of options: call and put. A call option confers the right to buy the underlying asset in the future at a specific strike price, while the put option gives you the right to sell.

Before you can do any options trading, you must provide details of your finances and trading experience to a broker, and you need to sign a document saying you received and read “Characteristics and Risks of Standardized Options” from the Options Clearing Corp. In other words, the people who know options from the inside recognize that these things have the potential to be riskier than traditional investments in, say, mutual funds, where no such document is required to be signed.

Nothing sums up my feelings about options better than this quote from Whitney R. Tilson, founder of the T2 Partners hedge fund: “Trading options is one of the all-time sucker’s bets…Most experienced professionals lose money doing it.” (Business Week, 6/ 7/10)

If that is true, what chance does the non-professional have? Not much, in my opinion.

Still, there is money to be made in this field; you make money by teaching others how to trade options. E*Trade Financial reports a 600% increase in attendance last year at its training events, with fees ranging from free to thousands of dollars.

I concede that in the short term, money can be made using options – assuming you have done intensive study. But if you have a long-term horizon, stick with a disciplined and patient approach using no-load mutual funds, and you will probably be far better off.

Still not convinced? In the section of Wikipedia that explains options, you will find this:

As with all securities, trading options entails the risk of the option’s value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlier (the underlying security – KW) and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.

The risks “are more complicated to understand and predict.” The next time you see an offer to teach you how to make big bucks from options, please re-read those words.

But to my mind, other villains deserve equal scorn. Or more.

The major credit ratings firms – Moody’s, Standard & Poor’s, and Fitch – all gave their stamp of approval to smelly piles of toxic crap.

Those three are big names in the industry. They are powerful, profitable and protected. But they got so much wrong, for so very long. In case after sorry case, they gave their triple-A blessings to sub-prime junk, and that, in great part, set up the financial chasm of 2008.

But what especially riles me is the fact that in most cases the banks and companies that issued the securities that need to be rated, pay for the rating! It’s as if MGM and Warner Brothers paid Time magazine to review their movies!

If that were the case, wouldn’t the movie studies shift their business to those reviewers who gave them the best reviews? Doesn’t that seem like a conflict of interest?

Of course it does!

The credit raters deny having their judgment skewed by those payments.

Of course they do.

From our perspective, it would be as if Morningstar got paid by mutual funds for the star ratings it awards.  That would be immediately shouted down by the investing public, because mutual funds live in an open tank. Not so the world of the big three rating agencies.  Transparency is not part of their business model.

There are several good proposals in Congress that aim to fix this self-serving rating problem. One interesting idea is for an impartial unit to arbitrarily, and somewhat randomly, assign different agencies to rate new issues.

Open and fair markets need objective, untainted advice. Let’s hope some of those proposals pass.

The evidence is overwhelming and stretches back through our history, from Charles Ponzi to Bernard Madoff, to the current allegations against “financial advisor to the stars” Kenneth Starr.

This Starr case (he’s accused of running a $30 million investment fraud) is especially exasperating, coming as it does while the stench from the Madoff disaster is still rank in the air. Starr’s clients include bold face names from the worlds of entertainment (Martin Scorsese, Uma Thurman, Wesley Snipes, Sylvestor Stallone), politics (Henry Kissinger, Caroline Kennedy) and media (Steven Brill).

These celebrities, you might assume, would be wise enough to avoid becoming ensnared in questionable business practices. Yet aside from the successes they have achieved, they are not necessarily any more financially astute than average folks. Of course, they likely are used to delegating what they would consider mundane tasks. That might have been the core of the problem.

Regardless of the outcome of this particular case, we know that far too many investors rely on little more than a friend’s recommendation as a green light for signing on with a broker or investment manager.

From our perspective it is frustrating because, in the eyes of some, all financial professionals get tarred with the same brush when these stories hit the headlines.

Admittedly, there is no short cut to vetting your investment professional. As a start, you need to grasp the fundamental strategies and philosophies the advisor uses. Are there commissions involved? If yes, be sure you understand them fully, and where every penny of your investment goes.

And if possible, ask to see some sort of track record – on paper, not a verbal assertion.

Be wary of any obvious red flags, such as an advisor who refuses to keep your money in a custodial account at a major brokerage firm. All good advisors keep a wall between themselves and their client’s money.

Personally, I like it when prospective clients have done their homework about Weber Asset Management. They have an appreciation for the complexities involved in the decisions we make for their accounts.

So that reflects what you, the mutual fund investor, would have made, right?

Probably not.

Morningstar calculates what it calls “investor returns,” which reveal how much real world investors actually gained or lost. The difference can be startling, and it stems from how the two types of returns are calculated.

The mutual fund takes a hypothetical starting amount and tracks it over time, assuming no contributions or withdrawals. Morningstar, on the other hand, uses a “dollar-weighted” formula which tracks cash flows into and out of the funds. And as we see all too often here at Weber Asset Management, mutual fund investors rush into funds after big gains have been posted, and sell after the fund drops.

It’s human nature to jump on a bandwagon, to follow the crowd, to follow the trend.

The Summer 2010 issue of U.S. News & World Report presents a few all-too-typical examples of what this means. They start with the popular, but highly volatile CGM Focus Fund. It can trumpet its impressive 18% annualized gain over the ten years ending April 16, 2010. But when Morningstar calculated how money sloshed in and out of the fund, it says, “the average investor lost about 11% in that time period.”

Ouch.

Then U.S. News goes on to show other sobering examples of how the average mutual fund investor fared poorly despite buying funds with top-notch performance figures.

Is that you?

Do you rush into hot funds? Do you sell after the hot fund has given back the lion’s share of its gains?  Obviously, if you do, you are not alone.

So yes, this could be a long hot summer. But let’s keep four key factors in mind.

First, the global economy went into this latest period of market volatility in much better shape than in early 2009. The strength of the economic recovery during the past year, particularly in the United States and Asia, has continually surprised on the upside. While that momentum will undoubtedly slow, it does not automatically mean a reversal back to global doom.

Second, while the stock market correction so far has been abrupt and painful, it actually has been fairly typical of what might have been expected to happen given historical patterns. It’s been about 14 months since the current bull market began on March 9, 2009, which is in the neighborhood of the average length of time that has passed from the start of prior bull markets to a first correction (17 months, on average).

Third, the S&P 500 Index gained 84% from its low on March 9, 2009 to its peak on April 23, 2010. Historically, the first correction in a new bull market has come after average gains of 57%, so again, it can be stated quite reasonably that the market was long overdue for a breather.

And fourth, as Barron’s reported last week (5-17-10) in its “Stronger Than Ever” cover story, “Corporate America is sitting on piles of cash, ready to be spent on things like share repurchases and acquisitions.” Meaning US firms are in an enviable position to withstand gloomy news from abroad.

Again, the market is decidedly weak right now. But there are good reasons to think this downturn will be nothing like what we saw in 2008.

And for Weber Asset Management clients, be assured that we, for some time now, have greatly reduced our exposure to foreign stock markets in client accounts.

Which raises the question – what is a realistic expectation for short-term performance?  How does one follow the oft-told advice to stay the course?

Here’s some perspective.

The May, 2010, issue of the Hulbert Financial Digest took a look at the performance of the 20% of newsletters that had the best performance over the past ten years. The results showed something I had expected, but had never seen so clearly expressed.

Hulbert showed that the best, smartest minds in the financial newsletter world lag the overall stock market “in an average of 3 of 10 calendar years.”

That’s right. The best will disappoint you roughly one third of the time.

In the same article Hulbert cited a 2007 academic study that looked at underperformance in the mutual fund world. Once again, it was clear that weak short term results are commonplace as well for leading mutual fund portfolio managers. The authors of that study found that among those mutual funds that outperformed 90% of their peers during the previous decade, every single one was “in the bottom half for performance in at least one 12-month period.”

Even more startling was the finding that 75% of those same leading mutual funds “were in the bottom 10% during at least one 12-month period.” Going further, the study showed those same funds, on average, “lagged the S&P 500 by 19.5% in their worst one-year periods.”

Would you have had the strength of mind to withstand being nearly 20% behind the market for a full year? (It kind of puts our 7% lag in a new light, don’t you think?)

The lessons are clear:

1. Everyone falters now and then.
2. If you want superior long-term performance, you will have to grin-and-bear it with some regularity.
3. To help get you over the inevitable short-term potholes, stick with strategies that have demonstrated proven long-term success. That will help give you the mental fortitude to not change strategies at the wrong time.

Patience and discipline – I know of no successful investor who lacks those two qualities.