GMO Capital Jeremy Grantham latest newsletter once again is very insightful especially how he explained some of the basic concepts in the investing. He cleverly used Polonius a character in Shakespeare’s play Hamlet for describing and giving these investment advice. For those of you like me who don’t recall your days in high school English Polonius in the beginning of the play came across as an inept advisor to the king who tended to give his advice in a wordy and long winded manner and thus in the beginning was portrayed as a loser, however by the end Shakespeare made most of his dull advice actually useful. Here are some of the excerpts from Grantham’s newsletter in what ironically he titled it as The Longest Quarterly Letter Ever:

Believe in history. In investing Santayana is right: history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away. You absolutely must ignore the vested interests of the industry and the inevitable cheerleaders who will assure you that this time it’s a new high plateau or a permanently higher level of productivity, even if that view comes from the Federal Reserve itself.

Don’t put all of your treasure in one boat. This is about as obvious as any investment advice could be. It was learned by merchants literally thousands of years ago. Several different investments, the more the merrier, will give your portfolio resilience, the ability to withstand shocks.

Be patient and focus on the long term. Wait for the good cards. If you’ve waited and waited some more until finally a very cheap market appears, this will be your margin of safety. Now all you have to do is withstand the pain as the very good investment becomes exceptional. Individual stocks usually recover, entire markets always do. If you’ve followed the previous rules, you will outlast the bad news.

Recognize your advantages over the professionals. By far the biggest problem for professionals in investing is dealing with career and business risk: protecting your own job as an agent. The second curse of professional investing is over-management caused by the need to be seen to be busy, to be earning your keep. The individual is far better-positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals.

Try to contain natural optimism. Optimism has probably been a positive survival characteristic. Our species is optimistic, and successful people are probably more optimistic than average. Some societies are also more optimistic than others: the U.S. and Australia are my two picks. I’m sure (but I’m glad I don’t have to prove it) that it has a lot to do with their economic success. The U.S. in particular encourages risk-taking: failed entrepreneurs are valued, not shunned. While 800 internet start-ups in the U.S. rather than Germany’s more modest 80 are likely to lose a lot more money, a few of those 800 turn out to be today’s Amazons and Facebooks. You don’t have to be better; the laws of averages will look after it for you. But optimism comes with a downside, especially for investors: optimists don’t like to hear bad news. Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III. Been there, done that! And in a real stock bubble like that of 2000, bearish news in the U.S. will be greeted like news of the bubonic plague; bearish professionals will be fired just to avoid the dissonance of hearing the bear case, and this is an example where the better the case is made, the more unpleasantness it will elicit. Here again it is easier for an individual to stay cool than it is for a professional who is surrounded by hot news all day long (and sometimes irate clients too). Not easy, but easier.

But on rare occasions, try hard to be brave. You can make bigger bets than professionals can when extreme opportunities present themselves because, for them, the biggest risk that comes from temporary setbacks – extreme loss of clients and business – does not exist for you. So, if the numbers tell you it’s a real outlier of a mispriced market, grit your teeth and go for it.

Resist the crowd: cherish numbers only. We can agree that in real life as opposed to theoretical life, this is the hardest advice to take: the enthusiasm of a crowd is hard to resist. Watching neighbors get rich at the end of a bubble while you sit it out patiently is pure torture. The best way to resist is to do your own simple measurements of value, or find a reliable source (and check their calculations from time to time). Then hero-worship the numbers and try to ignore everything else. Ignore especially short-term news: the ebb and flow of economic and political news is irrelevant. Stock values are based on their entire future value of dividends and earnings going out many decades into the future. Shorter-term economic dips have no appreciable long-term effect on individual companies, let alone the broad asset classes that you should concentrate on. Leave those complexities to the professionals, who will on average lose money trying to decipher them.

The idea of one day travelling, doing the hobbies you always enjoyed and spending time with the family all without having to go to work, is the retirement many people look forward to having one day.

Unfortunately though for some especially those that identify themselves with their jobs; when they reach this new stage in their lives they begin feeling bored, unfullfiled or unproductive.  To some extent this may explain the growing mental health challenges such as depression, addiction, and suicides that has become prevelant among people age 65 and over.

Although many people do end up going through the various financial planning process to prepare themselves from a dollar and cents perspective, but by viewing retirement mainly as a financial event and not devoting enough time in visualizing what they want in their retirement they are increasing the likelihood of facing many of the challenges that occurs in everyday life of a retiree.

One of the ways to help identify what’s truly important about retirement is to go through answering the famous three questions George Kinder shed light on that has become standard conversation starters in life planning:

• Imagine that you have enough money to take care of your needs, now and in the future. How would you live your life? Would you change anything?
• Imagine that your doctor says you have only five to 10 years to live. You won’t feel sick, but you’ll never know when death will come. What will you do? Will you change your life? How?
• Now imagine that your doctor says you have only one day left to live. Ask yourself: What did I miss? What did I not get to be or do?

In addition some have also suggested formulating a list of things that you would like to explore further at some point in retirement that involves staying mentally and physically healthy, while remaining socially active.

As always like all planning processes it is best that these processes are explicit and written and are discussed with one’s partner or if single with a friend or family member.  This conversation is especially important for couples that may have different time lines for when they want to retire, or may want to pursue different paths.  Some of the topics that it would be helpful for couples to discuss would be for example where they want to live, their relationship with rest of the family members, their time together and time apart, or their changing roles and identities as retirees.

If you missed it S&P 500 index closed the year at 1257 exactly where it had closed one year earlier in 2010!  Setting aside having identical closes two years in a row which was a statistically low probability event; the meager performance on its own wasn’t too surprising considering earnings for S&P 500 companies were up just 3.2% over the last 12 months.

Other indexes like Nasdaq ended up down 1.8% for the year while the Dow Jones Index ended the year up 5.5% thanks mainly to performance of just three of the 30 companies in the index.  Bonds once again did well as yields continued to go down with the 10 year U.S. Treasury ending the year at 1.88%.  Meanwhile gold which for the past several years has replaced real estate as the investment du-jour for dinner gatherings ended the year up again this time by 10% even after having a 22% fall after hitting all time highs in early September.

Stock markets in U.S. started out strong. By the end of January last year S&P had moved up by 2% and by the end of April it was up by more than 8%. However by summer market’s globally began reversing and S&P was down by 11% for the year in mid summer. The reversal in the markets was highly correlated among various asset classes while being extremely volatile.  The macro themes that attributed to this volatility included ending of the Fed’s QE2 program, the ongoing Eurozone sovereign debt crisis, the Middle East & North Africa uprisings, the aftereffects of earthquake in Japan, and debilitating debt ceiling negotiations in the U.S. that preceded to downgrade the U.S. debt rating from AAA to AA+.

The new year is once again bringing with it many forecasts and predictions, not to mention the usual best and worst investments lists. Needless to say being in the investment profession does involve to some extent predicting future events based on their likelihood, however whenever I come across such forecasts or lists I remember what Chinese poet Lao Tzu supposedly had said: “Those who have knowledge don’t predict. Those who predict don’t have knowledge.”

That said given the magnitude of the European situation even Tzu may go out on the limb to suggest that the biggest market risk for 2012 is how the Eurozone countries deal with their debt problems and its potential effects on the global economy. Of course even if Eurozone countries can resolve their debt problems soon, they probably will not be able to escape having a recession.  Although in Fall many economists and analysts were predicting a recession in U.S. in 2012, however because of some recent data albeit some of them are lagging or at best coincedental indicators have reduced those chances.  That said until some leading indicators such as those put out by ECRI begin to reverse the risk of U.S. recession in 2012 is still high.

Other variables that should have a significant impact on the markets will be the trajectory of economies in emerging markets specifically China, Brazil and India; and to some extent the less discussed Japanese sovereign debt problem.  Needless to say U.S. presidential elections and geopolitical events will again play a role in how traders and investors react.

As of now S&P 500 companies are expected to produce about $107 in earnings per share an approximate 9-10% growth rate for 2012.  Although it is not a stellar growth rate, and as always those earnings are susceptible to shocks from major events; however with the S&P trading in the mid 1200′s or perhaps in the event of an overreaction to news from Europe or geopolitical events it could go down to mid or low 1100′s it does make U.S. markets an attractive place to invest in 2012 when using price to earnings multiples which in the low teens make them at a historically low level.

Whether President Obama’s recent job plan aka fiscal stimulus plan will be passed in its entirety or passed partially is still not certain, but what is certain and factually supported given the work of Reinhart and Rogoff is that solving or getting out of this malaise or hangover from our recent credit bubble will take more than just several years.  Along this point here is a very telling excerpt from one of John Hussman’s recent letters:

“In game theory, there is a concept known as ‘Nash equilibrium’ (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, ‘I drive on the right / you drive on the right’ is a Nash equilibrium, and so is ‘I drive on the left / you drive on the left.’ Other choices are fatal.

“Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.

“We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring. While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about ‘global financial meltdown.’ But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.”

With countries like Portugal, Ireland, Italy, Greece and Spain facing a burdensome amount of public (government) debt the risk of having a sovereign debt default or restructuring which are fancy ways of saying bondholders will lose all or good portion of their money seems increasingly likely … especially in the case of Greece.

As it was mentioned in an earlier post here given the interconnectedness of global markets the effects of a default or even restructuring news in Europe will more than likely have an impact in U.S. markets. Not so much because U.S. financial institutions and/or U.S. citizens are big holders of these European bonds. Rather because as we saw in the 2008 subprime mortgage crisis, investors holding those bonds were not the only ones that were effected. In fact most of the damage was done to providers of default insurance or commonly referred to as Credit Default Swap (CDS).

So for example in the case of Greece the majority of their debt issued is directly owned by European banks (90%+), however through the CDS market they are only responsible for approximately 45% of it in the event of a default. Whereas the remaining 55% is the responsibility of American banks!

Now to this risk add the U.S. debt ceiling debate and potential consequences of politicians pullying another stunt as they did when TARP bill was first voted down, the slowdown in American economy, US AAA rating status, end of Fed’s QE program, and China’s attempt to bring down inflation by slowing down its economy. This is why many are worried about what some would refer to as a tail risk event or depending on your information level a Black Swan event. This is an event that has a low probability but if it does happen it would have a great impact on the markets … just like how the relative small U.S. subprime mortgage market effected the global financial markets in 2008.

So to protect a portfolio against such events one really has three options. The oldest and easiest way is to hold cash. Another way is to use the option market to hedge positions or even ‘massively’ capitalize on a tail risk event with minimal capital. Last is to construct a portfolio usually a long/short portfolio which will have a negative correlation again to an event with a low probability but huge impact.

The first option that is holding cash is very underrated, very cheap and not at all glamorous and given today’s rates will yield only around 0.25%. The other two especially the third option can be very costly to construct, however if the right instruments are picked up then should the event happens the profits will be substantial.

The financial crisis in 2008 effected many different facets of global economy one of which was to increase the uncertainty and risk in various investment decisions.

This is not to suggest that prior to last crisis there were no uncertainties, but as a result of the huge impact the crisis had on the balance sheets of both individuals as well as governments; both the range of outcomes (Black Swan event) has increased in the markets, as well as number of variables and factors one needs to take into consideration for making a prudent investing decision.

Both before as well as post the 2008 crisis in a typical top-down or bottoms-up research model investors had to take into consideration macro factors such as business cycle, as well as “traditional” monetary and fiscal policies to company’s earnings and occasional overseas political/economic turmoil and natural disasters. However as evident by the neurotic ‘risk-on’ vs. ‘risk-off’ daily trading patterns that is now present in stock markets; asset classes like U.S. stocks are now highly correlated not only within various industry sectors within their domestic market, but also with events that effect other markets across the globe.

The volatile swings in currency exchange rates, to rhetorics and viewpoints of regulators and politicians around the world on policies that on the surface may seem its effects should mainly be on their own domestic constituents but in reality in the global world we are in its effects are much broader, is why at this time investing in financial markets has become much different than before.

Here is an excerpt from an excellent article in Institutional Investor magazine written by James Shinn highlighting the four key events that will determine the near term direction in financial markets:

I started exploring the global macro world back in 2005, when the Central Intelligence Agency gave me an informal license to hunt for intelligence insights among macro traders. We thought Washington could learn a lot from the care with which global macro traders built and monitored their reference scenarios, because they have powerful incentives to get it right and lots of money to construct sophisticated early-warning systems. In that article I totted up the political decisions that move these reference scenarios, speculated about which government actions that move markets were becoming more or less opaque (or transparent) from a trading perspective and flagged some methods that smart traders use to get an early-warning jump on these events — or at least avoid being crushed by them.

I found that the reference scenario most broadly held by global macro traders turns on just four key events: U.S. monetary policy, Chinese GDP growth, the European Union sovereign debt crisis and the price of oil. Other uncertainties seize their attention from time to time — Tokyo’s ability to contain the fallout from the Fukushima Daiichi nuclear power plants, the giant traffic jam as thousands of trucks full of Brazilian soybeans fight their way down a single highway to the port of Santos, and Vladimir Putin and Dmitry Medvedev’s shadowboxing over who runs Gazprom and who inherits the Kremlin — but the traders are watching the Big Four like red-tailed hawks. And they have placed their multibillion-dollar bets on the likely outcomes.

These four concerns are critical for the Federal Reserve right now too. At his landmark April 27 press conference, Fed chairman Ben Bernanke admitted that these big-picture events were the major source of uncertainty in the Federal Open Market Committee’s forecasts: “I can say, without too much fear of giving away the secret, that FOMC participants do see quite a bit of uncertainty in the world going forward. And a lot of that uncertainty is coming from global factors. I have already talked about Middle Eastern–North Africa developments, which have affected oil prices, and conditions in emerging markets, which have affected commodity prices and other things. The European situation continues, and we’re watching that very carefully.” Bernanke diplomatically avoided mentioning that sharp disagreement among his Fed colleagues is part of the fourth big event: monetary policy.

Often so many of the news items or opinions we read or hear – especially those with some basic data are fraught with what can be referred to as ‘Round-trip Fallacy’. As Nassim Taleb suggested in his book Black Swan this simply means the reporting or opinions often confuse the absence of an evidence for an unexpected/high impact event that has occured or will occur with ‘evidence of absence of such events’.

Came across an interesting article in an investment advisory trade journal. The author (Bill Bachrach) began by writing about a fictitious event in which a traveler had boarded the wrong flight. Upon hearing the usual destination check that is done by the flight attendants he jumped up and loudly asked to be allowed to get off the plane. The point the author was making was that when faced with the discovery that you are going on a wrong flight the natural reaction is to want to be ‘immediately’ taken off the plane.

His analogy was intended to explain the life’s journey, how sometimes you may be on the right path and sometimes not. The challenge is to be both aware of the destinations as well as the path to reach them As there are many destinations and in most occasions there are no flight attendants to remind us about our chosen path. That said here are some of the destination-check suggestions that he mentioned that might be worth considering:

Personal money: What is your desired personal money destination? This one is easy to start with because money is easy to count. It’s easy to figure out how much you need in order to pay for the present lifestyle you want, to fund your future lifestyle and get your own financial house in order. Getting your own financial house in order means having the right amount of cash reserves, reducing or eliminating your debt, having the right amount of every type of insurance relevant for you and your family, saving and investing enough to be financially independent and fund your other goals, having all the appropriate legal documents (wills, trusts, etc.), and paying your taxes in full and on time. You can dramatically increase your confidence about the future by having a good handle on your personal money destination.

Action Idea: Hire a financial planner to write your financial plan and answer the questions about how much money you need to pay for the present lifestyle you want, get your financial house in order and fund your future goals.

Fitness and health: What is your desired fitness and health destination? This is also easy to measure. You might measure lipids, body fat, body mass, calories consumed, number of workouts per week (strength, cardio, flexibility, balance), etc. Barring some unusual genetic health situation, you don’t end up out of shape and unhealthy by accident. It happens from being on the wrong health and fitness path and choosing (maybe refusing) to get off and get on the right path. What’s the point of being financially successful but not healthy and fit enough to enjoy it?

Action Idea: Get a comprehensive executive physical and ask your doctor, “What are the most important things for me to measure; what should my target number be in each area; what is the best way for me to get that number from where it is now to where it should be?” And consider hiring a personal trainer and/or nutritionist to help you create a fitness and health plan and stay on track.

Relationships: What are your relationship destinations? Some people feel that these are not as easy to measure as money and fitness because different people in your life will have different metrics. This is true. And yet, like most destinations that matter, there are plenty of things within your control that you can do to make them work better.

Action Idea: Make a list of the most important relationships in your life, get together with these people and ask questions like, “How do you know when our relationship is working?” and “What can I do to be a better (spouse, father, brother, sister, friend, aunt, uncle, mentor, boss). The very fact that you ask and listen to their responses will improve your relationships.

You can have similar destination checks regarding your spirituality, your philanthropy, and everything else that is important to you.

Be aware of what’s important to you, engage in some honest reflection, and make a change where and when change is appropriate. There are no secrets to getting off the wrong path and getting on the right path. There are people who do and there are people who don’t. Which type of person you choose to be is up to you.

If you are not on the right path, how long are you going to stay on the metaphorical plane flying you to the wrong destination? Don’t make it long. Be clear about your destination, make the choices to get where you want to go, and be willing to do the work your desired destination requires.

Not that money managers that manage $230 billion can’t make a mistake on their call, but considering the intense investment process and access to quality insight and research that shops like PIMCO have it is only prudent to consider the implications of their recent move. SEC filings made by the fund showed that they cut their U.S Treasury exposure in their flagship Total Return bond fund to the highly unusual amount of 0%.

It is unusual because this fund’s benchmark is the BarCap Aggregate Total Return Index which has an approximate 35% exposure to U.S. Treasuries. Underweighting or overweighting a particular sector in a benchmark is a normal move by any fund manager but not by 35% as they have done!

It does seem they are betting that when QE2 is finally over in June and with the Federal Reserve no longer in the market to purchase U.S. Treasuries the rates will go up sharply. Of course given interest rates relationship in calculating the discounted value of stocks future cash flows and cost of capital higher yields should and ‘could’ have an adverse short term effect on stocks as well.