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Top 2 Investing Rules…

Kirk SpanoRule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.  

Warren Buffett

The most important aspect of financial planning is having an investment approach that protects you from permanent loss and gives you an opportunity to make money over the long-term. Industry statistics demonstrate that most financial people fail in both regards. Your financial representative should understand investing at its core, not just be able to show you a pie chart, use industry jargon and provide deceptive mutual fund ratings.

At Bluemound Asset Management we focus on Buffett’s top two rules daily. My name is Kirk Spano and I am the founder of the firm. I am easy to follow online. Please read some of my articles and notes to help filter the noise in the markets and verify the sound advice I have given over the years. When you are ready, contact me to discuss building a better plan and securing your future.

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2008 Review: A Whale of a Year

January 22009 

2008 Review: A Whale of a Year

Mortgage Related Securities, Credit Default Swaps (huh?), Leverage, Bank Failures, Stock Market Crash (grrrr), Bailouts, TARP, Bernie Madoff.

These are just a few of the things we got to hear about on the nightly news this year on an all too regular basis.  It sounds horrible.  And it has been.  The vast majority of investors in the United States have lost money this year.  Many folks, I have heard, are not even opening up their statements anymore.  I suppose in a strange way that is good, because maybe they will wait for things to get better, rather than randomly selling assets (certainly some assets should be sold, but better investments should be bought in their place).

Read on to find out why things might not be so bad going forward.  And remember, I’m the guy who has been cautiously pessimistic for the better part of a decade now, to the point where some of my colleagues call me a Perma-Bear (a name for somebody who thinks the markets won’t go up for a long time– like from 1999 to 2008).

What Really Happened? The Shorthand Version

I have been asked how things got to be as they are now about two hundred times the past few months, so I now have a great short answer.  What is even more impressive is that it is basically right.  If you want the long version you will have to meet up with me late some Friday afternoon (the only time I try the long version) and bring a bottle of wine.  Remember, as we go through this, what has happened is not as important as what can happen.

Beginning in 1999 and culminating in 2006, credit became very easy to attain.  Credit had in fact been pretty easy by historical standards since the middle 1980s, but in 1999 became very easy, and eventually, easy to the point of being silly in 2005 and 2006 (there is a story to this if you would like to hear it, but it does in fact require the wine I mentioned earlier).  Suffice to say, there is enough blame to go around as to why credit loosened up to the point of absurdity, but in general it was the politicians, banks, investment banks, shadow banks and the Federal Reserve who are mostly at fault. 

As you may know or suspect, or at least have heard, when credit gets too easy, a lot of loans are likely to go bad at some point.  Since early 2007 that has in fact been the case.  Mortgage foreclosures are setting records right now and don’t promise to fall back to a normal range until at the earliest mid-2012.  Here it is important to get some perspective on who is defaulting.  In dollar terms, it is primarily investors, those with non-owner occupied properties and those with more than one home who account for the majority of the default crisis.  While ma and pa are having a tough time, owner occupied homes are only defaulting by a few percentage points higher rate than historical averages.  In addition to the mortgage issues, beginning recently is a rash of unpaid other sorts of bills, such as credit cards, student loans and car loans.  This will get worse until unemployment stops rising, hopefully by early 2010.

All banks and credit issuers expect losses of some sort and are generally prepared for tough times like recessions.  In a more normal environment banks can handle up to about 8%, and sometimes higher, in defaults before actually losing money.  Well, thanks to the wonderful world of exotic investments called derivatives– brought to us by various investment banks, hedge funds, structured investment vehicles and private equity firms around the world, the commercial banks got caught in a pickle they couldn’t swallow.  In short, many commercial banks (the kind that make loans and take deposits) issued mortgages based on easy money brought to them by the issuers of exotic investments.  As a result of having so much money being poured on them, the banks and a new breed of lender called a mortgage lender made millions of loans which did not conform to usual credit standards. The risk was off the charts. 

There is a very misunderstood concept at play called leverage.  Leverage, in short is when an institution is exposed to the change in value of an investment position more than the amount that it paid for the position and/or has more in assets loaned than capital.  In English, and put much more simply in a way similar to how our grandfathers spoke– the investment banks, private equity firms and hedge funds made deals their checkbooks could not cover if they were ever asked to cover those deals.  Well, as mortgages defaulted, some ungracious investors became nervous and asked to be paid out.  Terrible people, asking for their own money!  As a result, a lot more deals went bad up and down the domino chain, and traditional financial umbrellas could not handle the downpour when tougher times hit.

Empirically, the banks 8% (or so) cushion we mentioned earlier shrunk down to about 23% due to losses on exotic securities, just as defaults shot past the historical default rate of the 23% range to 810%.  The result is that banks are actually shrinking due to losing a large hunk of their capital.  In simplistic terms, this is why lending has dried up and the economy is in recession.  Not only is it the commercial banks not lending, many of the mortgage companies simply don’t exist anymore and there is little to no offshore investment money pouring in.  Because our economy had been running on credit with very low cash requirements, the lack of cash and credit has major implications. 

Because of this unvirtuous circle, we are in the middle of a serious contraction.  Right now, because such a deep hole was dug with borrowed and often times imaginary money, the government is trying to fill that hole by printing money and buying defective debt off the market.  These actions spread the risk to the entire population, and while probably somewhat necessary to avoid further collapse, will come with a large price down the road. 

Hopefully, although I doubt it, the economy can grow fast enough in the future where the return on the borrowing we are doing is worthwhile.  Simplistically, we will at some point in the next decade need to have growth rates that exceed the interest rate on our debt, at least over 4% to 5%, which would be a super-boom in such a developed economy.  The only thing I can think of that will provide such growth will be a massive restructuring and rebuilding of our energy, transportation and utility infrastructure to take advantage of alternative energy, improved concepts in transportation, water resource preservation and environmental concerns. There will be many entrenched interests that will need to be overcome and appeased to do this.  I hope we have the strength and foresight to move forward.

What is happening now, called deleveraging, an environment where more cash is needed to make deals, is I believe more severe than what many realize, and will last at least two or three years.

Fixing the Problems and All About Whales

Whales are majestic creatures.  Usually weighing well into the tons, these beasts can submerge a mile into the deep blue sea and not come up for hours to take a breath.  Their power is enormous with the ability to tip boats and small ships.  Their speed is breath taking as they often move their massive bodies gracefully at over 30 miles per hour. Whales have saved men’s lives.  Whales have taken men’s lives.  Novels have been written about whales thought to be immortal.  And although these mammals appear resilient in ancient and mystical ways, they can certainly be killed through malice or ignorance.

The American economy is a whale. 

Right now, this whale has lost its way and washed up on a beach. 

When a whale washes up on a beach, there are two things likely to happen.  Either the whale dies because it dries up and it becomes weak which allows its weight to crush it, or it manages to stay wet and strong enough to survive until the tide comes in and it can swim away. 

While I have heard person after person ask why we must bail out the banks, insurance companies and car companies, as well as, other businesses, I keep coming back to the whale on the beach for an answer.

Just as the whale will die if it sits on the beach for too long drying out and eventually crushing itself, the American economy, left untended, could, and probably would, dry up and crush us all in a viscous collapse of the type not seen since 1932

Caring for the economy in the short run, until international and then domestic growth reignites, requires that we pour money onto it.  While I won’t argue that the money that is being poured today is being poured one hundred percent correctly, I can argue that pouring money on the economy is as necessary as the water that people trying to save the whale on the beach pour on it.

You will have heard reference to systemic risks to the economy if the Federal Reserve and U.S. Treasury do not pump money into the system.  They are right from everything I can surmise.  There is a gigantic risk of massive unemployment and financial collapse if we do not pour money on top of the economy.  I certainly understand people’s suspicion that bailing out AIG or GM or Citigroup or whoever, is throwing good money after bad.  Some of the money is being wasted and stolen, there is no doubt. 

Ultimately however, what we fear the most is the loss of freedom that a collapsed economy could bring us all.  So while printing and tossing around money to stave off a depression will certainly have bad side-effects like any strong medicine does, in some form or another, creating more money and spreading it around is the correct triage treatment.  And just as the volunteers who keep the whale wet allow it to survive until the tide pulls it back out to sea, pouring money on the economy will likely save it until a global economic tide rises again.

Here is where expectations are important.  When the whale gets back into the water, there is no guarantee it is just going to swim back out into the deep water.  It will likely flounder as it gets its senses back.  It might swim in a few circles.  It may even end up on the beach again and require saving more than once. 

In the long run, the U.S. economic whale can regain its strength by building from the bottom up.  Top down economic building, while illogical in any other construct, though strangely touted the past few decades by certain ideologues, has finally proven to be poor philosophy in matters of national well being and socioeconomic order. 

As a nation, we need to make sure that people are willing and able to work.  That means for the time being some extra government involvement as a way to jump start employment.  Longer term we need a renewed national focus on education and skills.  We will need a new commitment to the ideal that hard work can and will support us.  Ultimately, individual industriousness and entrepreneurial spirit must, and I am certain will, take over again as the ethical leaders of our economy.  We will then find a balance between greed and the socioeconomic requirements of a great nation that will support us for generations, just as we found that balance after World War II.  

During the next decade there will be many opportunities, not only for those who choose to work, but those who choose to invest.  While I understand the feelings of fear and depression that comes with losing invested money, I also understand the opportunity of beaten down markets.  I enjoin you to not miss your opportunities.  There are several opportunities emerging as we save the whale right now (remember that medicine has side-effects), consider those opportunities.  Have the gumption to make good decisions and follow through.

Side Effects of Medicine

Let’s discuss what I believe will be the side-effects of pouring money on our current problems for a paragraph. The main side-effect will likely be inflation in the next decade (after this round of deflation is finished sometime in the next year or two).  Unfortunately, I’m not sure we can avoid that inflation given the enormous money creation around the world.  There is a possibility the world needs some of the new money as emerging economies grow.  So, we might indeed find some balance or at least have a less severe inflation than what could notionally be feared.  Regardless, expect inflation in the next decade and plan accordingly.

Here I will name toss.  Warren Buffet, perhaps the biggest investment whale ever, made most of his best investments during the 1970s during and between two recessions, before the economy turned up in the 1980s and 1990s.  I believe that younger investors– who I define as more than fifteen years from retirement– are seeing the opportunity of a lifetime to invest over the next few years.  Those within a decade or so of retirement or already retired also have very interesting opportunities to buy low by doing some investment re-balancing to try to grow their nest eggs in anticipation of long life.

Finally, remember that whales are strong, resilient and faster than you would expect by looking at them.

Welcoming the New Year.

Kirk Spano

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Kirk Spano at MarketWatch

Kirk Spano’s views have been recognized and sought after nationally. He writes for MarketWatch of the Wall Street Journal network, has appeared on television — including Fox Business, is a regular radio guest, has authored articles for multiple publications and has two books in development. He also publishes the American Resource Boom Letter.

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