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Basics of Personal Financial Planning Money Management

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					The Sicilian Expedition


    Ancient Philosophy
      The Sicilian Expedition
• 18.26 With this Nicias concluded, thinking
  that he should either disgust the Athenians
  by the magnitude of the undertaking, or, if
  obliged to sail on the expedition, would
  thus do so in the safest way possible.
      The Sicilian Expedition
• The Athenians, however, far from having
  their taste for the voyage taken away by
  the burdensomeness of the preparations,
  became more eager for it than ever; and
  just the contrary took place of what Nicias
  had thought, as it was held that he had
  given good advice, and that the expedition
  would be the safest in the world.
        The Sicilian Expedition
• All alike fell in love with the enterprise. The older
  men thought that they would either subdue the
  places against which they were to sail, or at all
  events, with so large a force, meet with no
  disaster; those in the prime of life felt a longing
  for foreign sights and spectacles, and had no
  doubt that they should come safe home again;
  while the idea of the common people and the
  soldiery was to earn wages at the moment, and
  make conquests that would supply a never-
  ending fund of pay for the future.
          Sicilian Expedition
• With this enthusiasm of the majority, the
  few that liked it not, feared to appear
  unpatriotic by holding up their hands
  against it, and so kept quiet.
        The Icarus Paradox
• The 'Icarus Paradox' was coined by Danny
  Miller who observed that great success
  often precedes severe decline.
• The Greek word for this was hubris, or
  pride.
         The Icarus Paradox
• Icarus attached wings made of wax and
  feathers to his shoulders and flew up into
  the sky. He flew higher and higher, until he
  came close to the sun, which melted the
  wax and Icarus fell to his death in the
  Aegean sea. What made him soar was the
  very reason for his decline.
         The Icarus Paradox
• The same happens to organizations.
  Successful organizations tend to give
  more funding, support and status to the
  people they perceive as the basis of their
  success (for instance, a technology
  department).
        The Icarus Paradox
• People with other ideas, from other
  departments, lose funding and status and
  decrease in number, making the
  organization more homogenous, 'simple',
  and inert.
        The Icarus Paradox
• The organization loses its sense of
  urgency and becomes blind to
  opportunities and threats from a changing
  environment.
        The Icarus Paradox
• Eventually, performance declines, at which
  time the alerted organization begins
  watching the environment again only to
  find out that it is too late and dramatic
  restructuring is needed to get back on
  track.
Secular bear market underway


The history of stock markets is one of long
bull markets and long bear markets.

We believe that U.S. stocks are in a secular
bear market - one that could last years,
rather than months.
Bull and bear market cycles
  Here’s a quick overview of the last 100 years:

    • 1909 - 1921: Stocks entered the 1900s trending higher, and
        rose 35% in less than three years. But stocks swung wildly,
        peaking in 1909. By August 1921, the broad market was 40%
        lower.
    • 1921-1929: In the famous bull market of the Roaring ‘20s,
        stocks returned more than 400%.
    •   1929 - 1948: Stocks plunged, recovered significantly by 1937,
        but by 1948, stocks were down more than 50% from the ’29
        peak.
Bull and bear market cycles…

    •   1948 - 1973: Stocks prices produced a six-fold increase,
        culminating in the Nifty-Fifty market of 1972.
    •   1973 - 1982: The S&P 500 was lower in August 1982 than in
        January 1973. Adjusted for inflation, the results were far
        worse.
    •   1982 - 1999: The S&P 500 index rose by a factor of 12. The
        NASDAQ ended the 90s at 21 times its 1982 level.
Most stock returns come from secular
bull markets

Annual price change for 1900 - 1999         5.6%
Long term compound annual price            13.8%
change from Secular Bull periods only
(last century)
              Excludes: 1900-20,
              1929-48, 1966-81
Compound annual price change,               -1.1%
no Secular Bulls                        (Simple ave. +2.1%)
              Excludes: 1921-28,
              1949-66, 1982-99

 Based on S&P Composite 1900-1999, dividends not included
Periods following secular bull markets can
produce dismal returns
1929:                                       1966:
The next decade saw the 2 most              The next decade saw the most
severe bear markets* in the first half of   severe bear markets* in the last
this century:                               half of this century:
1929 peak –                                        1969-70: -34%
1932 trough: -86%                                  1973-74: -47%

1937 peak –                                 (Between December 1968 and
1938 trough:       -54%                     December 1974, the
                                            unweighted Value Line Index of
                                            1700 stocks lost more than
 ’29 peak to ’38 trough: -73%               74%)

               *Based on S&P Composite, dividends excluded
Secular Bear Markets can devastate
             investors

 $1,000       Year Initial    # of
  Invested at Investment      Years to
  Peak of     Recovered       Recover

 1929           1953            24
 1966            1993           27

   Inflation adjusted recovery period, excluding dividends
           We can conclude:

Secular Bear Markets usually parallel the Secular Bull
  markets that precede them
Bear follows bull - another view:

                  100 Years of Stock Market History
                                S&P Composite (log scale)
10,000




 1,000
                                                                             Bull


                                                              Bear
  100
                                           Bull
                                  Bear
                    Bull
           Bear
   10




    1
    1900   1909   1918   1927    1936    1945   1954   1963    1972   1981    1990   1999
The ‘90s stock market certainly resembled
other stock manias of the 20th century

   625      260 week run to peak for '29 Dow, '89 Nikkei
                    and '00 S&P 500, Nasdaq
   550                   (Indexed to 100 at week 260)

   475                                                      '00
                                                        NASDAQ
   400                                                             '29 Dow

   325

                             '89 Nikkei
   250                                                             '00 S&P

   175


   100
      260   237   214   191 168   145   122   99   76    53   30   7
                             Weeks from peak
Sound familiar?
In his book, “A Short History of Financial Euphoria,” Economist John Kenneth
Galbraith outlines common features of a market mania. See if any of these
sound familiar:


Brevity of financial memory, disaster is quickly forgotten (S&L debacle, junk
bonds, Japanese bubble, Mexico collapse, Orange County, Asian collapse,
LTCM)

Association of money with intelligence (Derision of those who question New Era
market, elevation in status of CEOs, financial commentators, money managers)


Arrival, development of something new (Internet, telecom and myth of
increased productivity)

Claims of financial innovation (Increased use of derivatives, Internet trading,
home equity loans, minimum payment mortgages)
Credit fueled our recent mania
           $ Billions of private nonfinancial borrowing
            & borrowing to change in GDP (left scale)                      $ Bill
$4.00                                                                        1800

$3.50                    Borrowing/change in GDP:                            1600
                         More and more borrowing required for
                         a dollar of GDP growth                              1400
$3.00
         Non-federal Borrowing                                               1200
$2.50
                                                                             1000
$2.00
                                                                             800
$1.50
                                                                             600
$1.00
                                                                             400
$0.50                                                                        200

$0.00                                                                        0
        66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

                                    Source: Fed's Z-1, Bureau of Economic Analysis
The credit surge, another view

            Total Credit Market Debt Outstanding
                          1985 - 2004 ($Billions)
37,000


32,000


27,000


22,000


17,000


12,000


 7,000
         85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
                                             Source: Federal Reserve Z-1
And another view

                  Total Debt Outstanding to GDP
                                 1964 - 2004
  2.10

  2.00

  1.90

  1.80

  1.70

  1.60

  1.50

  1.40

  1.30
         64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

           www.prudentbear.com                  Source: BEA, Federal Reserve Z-1
Credit fueled our recent mania

Credit flooded the corporate sector in the late ’90s, supplying
financing to too many marginal companies and credit excess
capacity, particularly in telecom.
When credit growth slowed in these sectors, the Federal Reserve
tried to buoy the economy by easing monetary and credit
conditions further. The result was a middling economy and a
bubble in the home mortgage sector. For the first time in memory,
rather than retrenching, consumers took on more debt during the
recession.
Telecom helped business borrowings explode
in the late ’90s

850
                    Business Sector Borrowing
                 Quarterly borrowings at annual rate, Q1 '70 - Q4 '04
750

650

550

450

350

250

150

 50

-50
   Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep-
    70   72   75   77   80   82   85   87   90   92   95   97   00   02

                                                              Source: Federal Reserve
When business borrowing collapsed, the
mortgage sector more than made up for it
$Billions

 1600       Mortgage & Business Sector Borrowing
                 Quarterly borrowings at annual rate, Q1 '70 - Q4 '04
 1400

 1200                           Household Mortgage Borrowing

 1000
            Business Sector Borrowing
   800

   600

   400

   200

     0
      Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep-
       70   72   75   77   80   82   85   87   90   92   95   97   00   02

                                                               Source: Federal Reserve
Cash-out refis were key to the surprising strength in
consumer spending
                  More lending = more spending
           Cash out volume for prime conventional loans ($bill.)
  $160

  $140

  $120

  $100

   $80

   $60

   $40

   $20

    $0
         1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
                                                                 (e)  (e)

                                                       Source: Freddie Mac
When the refi boom faded…


                  Mortgage Bankers Association
                Mortgage Refinancing Index

10000


 8000


 6000


 4000


 2000


    0
     Jan- Oct- Jul- Apr- Jan- Oct- Jul- Apr- Jan- Oct- Jul- Apr- Jan- Oct-
      95 95 96 97 98 98 99 00 01 01 02 03 04 04
… home equity lending surged

                 Home Equity Borrowing
250



200



150



100



 50



  0
      98    99      00       01     02        03         04
                     * Annualized   Source: Federal Reserve, Z-1
…enabling the mortgage finance bubble to keep going



 $ Billions
                      Total Mortgage Borrowing
   800.00

   700.00
                   All Other
   600.00
                   Home Equity Borrowing
   500.00

   400.00

   300.00

   200.00

   100.00

     0.00
              98       99       00         01   02   03   04
The physical evidence of the bubble is obvious

                    New & Existing Home Sales
                              1969 - 2004
Millions of Units

   8.00
                                                     Bubble!
   7.00

   6.00

   5.00

   4.00

   3.00

   2.00

   1.00
          69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03
                                               Source: Nat'l Assoc. of Realtors
For another view of the mortgage bubble, consider the
dollars involved

   2000

              Transaction Value of New & Existing Home Sales
   1800
                                    ($billions, thru Jan. '05)
   1600              Annualized new + existing home sales x mean sales price

   1400

   1200

   1000
              New Homes Sales
   800
              Existing Home Sales

   600

   400

   200
     Jan-90     Oct-91   Jul-93    Apr-95     Jan-97    Oct-98     Jul-00    Apr-02   Jan-04

                         Source data: National Assoc. of Realtors, Census Bureau
Meanwhile, the mortgage bubble squeezes consumer
income

           Fed's Financial Obligation Ratio - Homeowners
 17
                        March '80 - Sept. '04


 16       Fed's estimate of debt service to disposable income


 15
                                                           Refi booms: a
                                                           help, not a cure
 14



 13
   Mar-   May-   Jul-   Sep-   Nov-   Jan-   Mar-   May-   Jul-   Sep-   Nov-    Jan-
    80     82     84     86     88     91     93     95     97     99     01      04

                           Includes consumer and mortgage debt. Source: Federal Reserve
And balance sheets bear the burden of excess
                       Household Debt as % of GDP

 85%

 80%

 75%

 70%

 65%

 60%

 55%

 50%

 45%

 40%
       70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04*

         *Q3 2004 debt, 2004 GDP   Source: Federal Reserve Z-1, Bureau of Economic Analysis
Despite credit-induced ‘wealth creation’ consumers are
more leveraged to housing than ever
  %
          Home Equity as Percent of Home Market Value
  75
                             1965 - Q3 2004

  70



  65



  60



  55



  50
       65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03
                                                        Source: Fed's Z-1
From the previous pages it’s clear that the credit bubble
is ongoing. The Fed’s aggressive posture simply shifted
the stock bubble to new sectors. Asset price inflation,
which is dependent on credit, continued and has crept
back into the stock market as well.


What happens when the credit bubble bursts?
What will drive the economy once the desire to save
returns?
                                 Savings Rate
%                 Savings as % of disposable income, Q1 '90 - Q4 '04
8




6




4




2




0
Mar-90   Dec-91   Sep-93    Jun-95   Mar-97   Dec-98   Sep-00    Jun-02    Mar-04
                                                  Source: Bureau of Economic Analysis
Greenspan once had it right about how
credit booms can distort an economy:
“The excess credit which the Fed pumped into the economy
 spilled over into the stock market - triggering a fantastic
 speculative boom. Belatedly, Federal Reserve officials
 attempted to sop up the excess reserves and finally
 succeeded in braking the boom. But it was too late: by 1929
 the speculative imbalances had become so overwhelming
 that the attempt precipitated a sharp retrenching and a
 constant demoralizing of business confidence.”

    Alan Greenspan, Gold and Economic Freedom, 1966
Have we had our bear market?


    Valuations never reached “bear
    market” levels
    The following charts reveal that stocks remain
    expensive by a number of measures.
Dividend yields unattractive

             S&P Composite Dividend Yield (%)
                           1871 - 2004
10
 9
 8
 7
 6
 5
 4
 3
 2
 1
 0
  1871 1883 1895 1907 1919 1931 1943 1955 1967 1979 1991 2003
                                    Source: Global Financial Data
Stocks look pricey relative to gold

                             Dow to Gold
            Dow Jones Industrials divided by Gold Price
                                1920 - 2004
$40.00

$35.00
                                              Stock mania
$30.00

$25.00
                       Stock mania
$20.00

$15.00

$10.00

 $5.00
                                 Gold mania
 $0.00
         1920 1928 1936 1944 1952 1960 1968 1976 1984 1992 2000
S&P Industrials price to book value
                                                            We are
                                                            here!




                                                                 This chart combines price-
                                                                 to-book with dividend yield




                                                 Source: Elliott Wave International
                                      Bond yield/stock yield
       Even over long periods, high PEs
       result in sub-par returns
                      20-Year Rolling Returns of the Dow,
                         1919-2003, Ranked by Decile
                                    Range of        Ave. Return Ave. PE
      Poorest       Decile        Total Returns     For Decile  at Start
      return decile      1         1.20%      4.50%       3.20%        19
      burdened by        2         4.50%      5.20%       4.90%        18
      periods with       3         5.20%      5.40%       5.30%        13
      high starting      4         5.40%      5.80%       5.50%        12
      P-Es
                         5         5.90%      7.20%       6.50%        15
                         6         7.20%      8.80%       8.10%        16
                         7         9.00%      9.30%       9.20%        16
                         8         9.40%     10.80%      10.20%        12
                         9        11.00%     11.90%      11.70%        12
                        10        11.90%     15.00%      13.40%        10

S&P 500 PE = 20 as of Mar. 2005          Source: Crestmont Research
Still no capitulation that typically
follows a Super Bull

        Net Cash Flows into U.S. domestic
        equity mutual funds:

        1995 – 2001:    +$1,256 billion
        2002:           -$28 billion
        2003:           +$152 billion
        2004:           +$177 billion




                         Source: Investment Company Institute
History has taught us:

    Long bear markets are a natural outgrowth of long
    bull markets
    Stocks remain expensive. Even if earnings grow at
    historic rates, stocks could provide poor returns over
    the next 5-10 years.
    Credit is the driver of speculative manias.
    Historically, once credit becomes less available,
    asset prices suffer.
   The Bubble Trouble Remains

“Since early 2000, the US has gone through a mild recession
and the most anemic recovery on record. Over that same
period, America’s net national saving rate has plunged to a
record low, the household sector debt ratio has risen to an
all-time high, and the US current account has gone deeper
into deficit than ever. All this smacks of a US economy that is
living far beyond its means, as those means are delineated
by domestic income generation. Far from purging the
excesses of the late 1990s, the United States has upped the
ante on structural imbalances as never before.”

Stephen Roach, Morgan Stanley 9/2/03

				
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