What to make of this market?

As of writing the DOW-30 is up just shy of 300 points and about 4% higher than the close on Monday, Nov 25. Does this imply that we have seen a bottom? The talking heads have declared that we have seen a 10% move lower in the indexes and now we can get back to our raging bull. I take caution to this. Why is 10% the amount markets need to correct to shake off excess, etc? By trade I use technical analysis in making investment decisions. This includes support, resistance, moving averages, and some various other indicators to help me decide to pull the trigger. What really matters is what happens after I initiate a position. This is what really matters, how you get in a position is meaningless (be it technical analysis, fundamental analysis, or throwing darts at the quotes of the Wall Street Journal). Positions must be entered in a favorable risk to reward ratio. I am willing to give up X dollars in expectations of Y returns. The way I see it currently is there is little more upside potential to be gained versus the likely hood of the markets being at some sort of intermediate top. I could be wrong and the markets might continue higher, I don't know. What I do know is the probabilities and the amount of money I am willing to risk on my decision. Below is what my favorite Blogger, Barry Ritholtz, has to say, via his Blog, The Big Picture.

Market's Back-to-Back Streak

Wednesday, November 28, 2007 | 01:00 PM

Well, the Christmas Rally we discussed on Monday and Tuesday has finally arrived.

Indeed, like the NY Knicks, the Markets have finally pieced together two consecutive winning days.

Since the decline that began on October 30th, the S&P 500 has gone 19 days without having more than one winning session in a row.

I have been following this ever since my friend Paul first asked about what the failure to have two consecutive back-to-back winning days actually means. I was speaking with Mike Panzner about this earlier in the week. Mike noted:

• The longest such streak (since 1999) was the 24-day run that ended on 9/21/01. The second longest streak was 22 days, which ended on 3/21/01. There have been two other streaks of 21 days each, ending on 10/3/00 and 4/29/02, respectively.

• Except for the post 9/11 streak, which marked a climactic V-bottom low in the equity market, other spans seemed to define the first leg of a downdraft that "paused" for anywhere between 4 and 14 days before it resumed.

• Visually speaking, the pattern that developed when those prior one-day-wonder streaks ended was a "flag," which in technical analysis terms, often implies that a move -- in this case, the downtrend -- is about half-way over.

• For what it's worth, the same also holds true for the two shorter streaks of 16 days that ended on 1/28/03 and 4/1/05, respectively.

• Based on past history, then, it seems that once the current streak ends ( i.e., we see two or more winning sessions in a row), the risk is that it won't be long before the market begins another push lower.

I would add one item to Mike's comments: The wild swings in the markets, +/- 2%, with violent up 200 or 300 point days don't typically come in healthy Bull markets -- these spasms are symbolic of Bear markets.

The Evolution of an Investor

This is a very interesting article out of Portfolio.com, following the progression of a stock broker and a look under the hood at the mechanics of some Wall Street firms. The conflicts of interest that are presented in this article are the reason so many advisors are going to fee only. By having a fee only advisor the firm's interests and its client's interest are more closely aligned. This structure forces the firm to actually make the client money to have them retained as an advisor and not just a sales and marketing firm. Always try and ask yourself (and advisor for that matter) how does the other guy make money from this? Money is the score card of Wall Street, always find out how they score and make sure your are along for the ride and not taken for one.

Enjoy the following article and be better informed next time someone asks for your money.

The Evolution of an Investor

Retail round up

Now that we have made it through the first push in Holiday spending we should take a look and see what kind of damage we, as a spending nation, did. I expect the results to continue to be OK from downwardly revised expectations. This is one of my favorite Wall Street tricks: lower expectations then create excitement when the expectations are beat. Despite the shenanigans we are constantly led to believe, these expectations are what create stock's value. Prices will move to account for all known information, as well as expectations (a phrase the efficient market folks leave out). There for beating lowered guidance is a valid excuse to increase share value. I expect too much pessimism has been priced into the retailers going into the holiday season. Longer term I think we will see some weakness, but for the immediate future there are some opportunities out there. Stores are busy for now but the real test will be in the bottom line. Sure sales may be up, but sale will undoubtedly come at the expense of normal margins. This should be just as exciting as unwrapping the gifts themselves, at least for some the retailers.

Without further comment, lets see the spending scorecard.

The New York Times reports...Bargains Draw Crowds, but the Thrill Is Gone

American consumers flooded stores yesterday on the traditional first day of the holiday shopping season, but the irrational exuberance of the Black Fridays of the last five years has been replaced by pragmatic restraint.

With an uncertain economy, a slowdown in the housing market and high gas prices hanging over their heads, consumers flocked to discount chains like Wal-Mart, Target and Best Buy, brandishing bargain-filled fliers.

In a reversal from years past, they largely bypassed more expensive retailers, including such powerhouses as Nordstrom, Coach and Abercrombie & Fitch, according to shoppers and merchants interviewed around the country.

This shift has prompted industry analysts to christen this the “trade down” holiday season......

Return to Sender

Once again folks, there is nothing to see here, we are still in the greatest bull market we have ever seen. Unfortunately, your S&P indexed mutual fund is worth the same as it was on January 1st, 2007, unless you are looking in real trade weighted dollar terms then you would actually be down about 10%. That is really unpleasant. Lets say, "be thankful you aren't traveling outside of the USA." Now, back to your regularly scheduled holiday. Eat up!!!


This might be a good time to review your portfolio strategy. A start would be to review my some of my earlier posts.

-Are you diversified?
-A subprime look at the global economy
-Dear Mr. Poole, you left the money spigot on
-Real effects of inflation

Should we take our Medicine?

While we are enjoying the gluttonous activity that Thanksgiving has become, shoveling turkey, stuffing and anything else that finds its way in the vicinity of our mouth, here is something else to chew on. Is it time to take our medicine and owe up to the excesses we have enjoyed for some time now? One Street.com writer thinks so and I do not disagree. Pain can make us stronger and more disciplined, that I can attest to. It is good for the soul and creates a stronger foundation, of course greed and fear tend to keep us from doing that which we know we should.

Here are 17 reason why we need a recession. Remember that what does not kill you makes you stronger. The key here is you must stay alive, so proceed with caution.

1. Purge the excesses of the housing boom
2. U.S. dollar wake-up call
3. Write-offs
4. Budgeting
5. Overconfidence
6. Ratings
7. China
8. Oil
9. Inflation

10. Moral hazard

11. War costs

12. CEO pay

13. Privatization

14. Entitlements

15. Consumers

16. Regulation

17. Sacrifice

PAUL B. FARRELL

17 reasons America needs a recession

Think positive, this 'slow motion train wreck' is good for the U.S.

But the truth is, not only is a recession coming, America needs a recession. So think positive: Let's focus on 17 benefits from this recession.

To begin with, recession may be an understatement. Jeremy Grantham's GMO firm manages $150 billion. In his midyear report before the credit crisis hit he predicted: "In 5 years I expect that at least one major 'bank' (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private-equity firms in existence today will have simply ceased to exist."

He was "watching a very slow motion train wreck." By October, it was accelerating: "Train hits end of track at full speed."

Also back in August, The Economist took a hard look at the then emerging subprime/credit crisis: "The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be between a mild recession now, and a nastier one later."

However, the publication did admit that "even if a recession were in America's long-term economic interest, it would be political suicide" for Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson to suggest it.

Then The Economist posed the big question: Yes, "central banks must stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether."

How well will comerical real estate hold up?

The commercial real estate market is one sector of the economy no one has really been commenting on. By and large this sector has remained steady and has not felt the same effect the residential sector has felt. How long can this continue? Can commercial real estate remain resilient in light of a deteriorating consumer and economy? I venture to say no. I am a believer that the consumer leads the economy since they represent about 2/3 of our GDP. When the consumer slows so does everything behind it.

Nouriel Roubini, RGE monitor, comments in the article:

The Next Shoe to Drop in the Credit Meltdown: Commercial Real Estate and Its Massive Forthcoming Losses

While everyone’s attention is concentrated on subprime and other residential mortgages, as first reported by this blogger this past July the next shoe to drop - in the mortgage and credit crunch saga - will be commercial real estate (CRE); indeed investors’ worries and panic are now shifting towards CRE and its related securitized products (CMBS and CMBX).

Many of the same excesses that were observed in subprime – poor underwriting standards, loose and excessive lending to marginal projects – are also observed in CRE. For example, as reported by Fitch, since 2005 there has been a very sharp increase in interest rate only mortgages and mortgages with high loan to value ratios. Loans increased to 118 per cent of the value of commercial properties in the last quarter, as reported by Moody’s, suggesting widespread use of reckless negative ammortization mortgages. And while real investment in commercial real estate has been strong in recent months (growing at a SAAR rate above 10% while residential was collapsing at a negative 20% rate) there is now evidence that commercial real estate is also at a tipping point. Actually the bubble in CRE construction – like the bubble in residential construction – will soon turn into a painful bust.

The reasons for this coming bust are clear. Commercial real estate – or more generally non-residential investment in structures - includes two main elements: office buildings, shopping centers/malls; and construction of structures for the manufacturing sectors (i.e. new factories). Both components are now under stress. The reason why we will observe a sharp slowdown in construction of new offices and shopping centers is that, with a lag, commercial real estate follows residential real estate.

Gavekal’s four scenarios for what lies ahead

Without a doubt we are facing some very uncertain times. In times like these various results must be sketched out and then a plan must be designed to allow for fairly smooth passage. I have my own scenario, but also find it important to understand what the majority is betting on. Not because it is right or wrong, but because this will help you understand and react to the crowd correctly. For instance, I have been watching this subprime mess for quite some time. For me to take a short position on real estate at the moment of my discovery would have had adverse results. However, knowing there was a problem, it did make sense for me to take a small stake (test position) at times when the real estate indexes were struggling to make new highs, or as the rumors/news were first coming out. Now that we are in the middle of the crisis, the full reward is minimized in relation to the risk I would have to expose myself to.

FT. Alphaville provides some commentary as to some possible outcomes.

click below for the full commentary and replies, an excerpt is posted below.

Gavekal’s four scenarios for what lies ahead

• Scenario 1: The Fed sticks to its assertion that the risks for inflation and growth are now in balance, does not cut rates any further and the US economy grows past its credit crunch. If this happens, it would be massively bullish for the dollar, massively bearish for gold and potentially bearish for HK and Chinese equities (which are now anticipating more rate cuts). It would also be very bearish for US Treasuries and government bonds around the world. Additionally, we would most likely see a rotation within the stock markets away from commodity producers and deep cyclicals (which have been leading the market higher for years) towards the more traditional “growth” sectors, such as technology, health care, consumer goods, and maybe even Japanese equities.
• Scenario 2: The Fed sticks to its guns, does not cut rates, and the US economy really tanks under the weight of the credit crunch. In essence, the US would move into a Japanese-style “deflationary bust”. In this scenario, equities around the world, commodities, and the dollar would collapse, while government bonds would go through the roof.
• Scenario 3: The Fed ultimately cut rates, but this fails to rejuvenate the system and get growth going again. This would likely mean stagflation. As such, gold and other commodities would do well, while stocks and the US$ would struggle. Excluding bonds, this is increasingly what the market is pricing in today.
• Scenario 4: The Fed ultimately cuts rates, and succeeds in reining in the economy. This would be good news for equity markets, commodity markets, and the dollar, but of course, terrible news for bonds.

Enjoy the ride!

Is the Yen good for anything?

As you know I incorporate currency into my portfolio soup. This article in the WSJ.com sheds some light into the parallels between currencies, the markets, and of course our perception of risk.
At the heart of all this is the carry trade which is effectively selling weak currency (Yen) and buying high yielding currency (Kiwi, AUS dollar, etc). As appetites for risk (greed) begin to run the spreads between this pair trade widen and money is made. As fear (or risk aversion) enters the spread tighten as speculators are forced to sell the higher yielding currency and buy back their low yielding currency. Borrowing money to make more money is always a risky play despite their obviously appealing rewards.

As the Japanese Yen Goes,
So, Too, Do Stocks -- Usually

By JOANNA SLATER
November 14, 2007; Page C1

To understand whether global investors are feeling fearful -- or optimistic -- keep an eye on the Japanese yen.

That's because the yen has become an unexpectedly important barometer of investors' appetite for risk world-wide. If investors get worried, the yen often strengthens. Conversely, when investors are willing to go out on a limb, the yen tends to weaken.

That's what happened yesterday, when U.S. stocks surged amid falling oil prices and hopes that the impact from the subprime-mortgage crisis on banks will be contained. At the same time, the yen weakened against the dollar, with one dollar buying 110.89 yen late in New York, up from 109.67 yen on Monday.

The movements aren't coincidental. They stem from the unusual influence of Japan's super-low interest rates on global markets from New York to New Zealand.

They also explain why the yen, itself a perennially weak currency, has strengthened 11% against the dollar since the end of June. It's not just because investors are discouraged about the U.S. economic outlook. It has a lot to do with the fact that they're reassessing the degree of peril in the market.

The yen is now "sort of like the canary in the mine," says Jerome Abernathy, chief investment officer of Stonebrook Capital Management, a New York currency manager. "It's quite sensitive to risk aversion."

For the complete article go to:

As the Japanese Yen Goes,

So, Too, Do Stocks -- Usually

Plug for Investor's Business Daily

Despite the various opinions about this daily paper, I believe it provides some insight into the current state of the market. For years William O'Neal has kept investor on the right side of the market and up to date on what has been making it tick on a yesterday basis. The information is late for those who need real time (the print version comes in the mail, the day after all the action). IBD also provides its top 100 Stocks each Monday that provide some interesting ideas and opportunities for the "Big Boys" to pick on the dumb money. Any idea has to be taken with a grain of salt and must fit into your own trading/investing strategy. Here is a reprint of this morning's Big Picture.

THE BIG PICTURE Stocks Rebound, But In Weaker Trade BY JONAH KERI INVESTOR'S BUSINESS DAILY The Nasdaq snapped a four-day losing streak Tuesday, but lighter volume pointed to a lack of conviction among big-money investors. The technology-rich Nasdaq composite gapped up at the opening bell. It faded a bit around midday. But instead of swooning, the Nasdaq rallied the rest of the afternoon to score a 3.5% surge. NYSE stocks followed suit. The NYSE composite jumped 3%. The S&P 500 picked up 2.9%. The Dow industrials bounced 2.5%. But volume sank 5% across the board. When viewed in context, Tuesday’s trading levels look even more anemic. Monday was Veterans Day, a bank and bond market holiday that typically suppresses volume levels on Wall Street. Tuesday’s sizable price gains might also lead you to expect a jump in trading volume. But as the past few weeks have made clear, this isn’t a healthy market. For the past several days, the major indexes have notched a series of big down days in well aboveaverage volume, often higher than the day before. Institutional investors — the mutual funds, banks, pension funds and other big boys who controlabout three-quarters of the market’s movement — have done a lot more selling than buying lately. One key sign of trouble is the manner in which leading stocks have tumbled lately. When a top stock runs up for a long time and holds well above its moving averages, then suddenly knifes down through those levels, that’s a bad sign for the stock and ultimately the market. Apple’s recent action is a prime example. The iPod and iPhone maker was one of 2007’s top performers. But last week the stock topped and started falling hard. In just four days, Apple went from red-hot leader to slicing through its 50-day moving average. By way of comparison, it took 10 days — more than twice as long —for Apple to undercut that level during the market’s brief correction in July and August. Chinese search engine giant Baidu.com and other top-rated stocks have shown similarly harsh, rapid declines. The broad indexes also have shown more violent, faster price drops than seen earlier this year. As for Tuesday’s price gains, it’s far too soon to tell if they could lead to something bigger. Don’t put too much stock into one up day — even one as big as Tuesday — especially when it follows a run of nasty sell-offs. We’ll need to see a lot more strength to lift the major indexes off the canvas. Leading stocks will also need to show some strong gains in healthy volume. A big drop in oil prices helped stoke Tuesday’s rally. December crude dropped $3.45 to settle at $91.17 a barrel on the New York Mercantile Exchange. Oil prices skidded after the International Energy Agency cut its monthly forecast for crude demand. A better-than-expected earnings report from Wal-Mart and bounce-backs from beaten-down financials also fueled Tuesday’s rebound.

Keeping an eye on the Consumer

With the consumer excessive spending season (holidays) upon us I wanted to highlight a book I read some time ago. In Ahead of the Curve, by Joseph Ellis, the author develops a very convincing thesis that consumer spending is the real driver of the economy (aka taking a stance and developing it, that the chicken did indeed come before the egg or the likes). Throughout, the book Ellis includes the real leading, coincident, and lagging indicators from a consumer spending view point. Of course all of the information is a bit lagging in that it takes several data points to determine when an actual inflection point occurs, but the information is useful in determining big picture economic health. The book is built around the following graph which describes the nuts and bolts of the economic cycle.For fairly up to date graphs and charts from the book see the Ahead of the Curve website.

Excerpt from Joseph Ellis' web page

How to Read the Signs of Economic Change—Before They Impact Your Business and Investments

Economic and stock-market cycles affect companies in every industry. Unfortunately, the confusing barrage of anecdotal and conflicting indicators we face every day, week, and month render it impossible for managers and investors to see where the economy is heading in time to take corrective action.

Now, a thirty-five-year Wall Street veteran unveils a new forecasting method and working model that puts these indicators into context and will enable managers and investors to understand and predict the economic cycles and related stock-market movements that control their businesses and financial fates. In Ahead of the Curve, Joseph H. Ellis argues that the problem with current forecasting models lies not in the data, but rather in the lack of a clear framework for putting the data in context and reading it correctly.

The book (1) explains critical economic indicators in nontechnical language, (2) identifies and documents the recurring cause-and-effect relationships that consistently predict turning points in the economy, and (3) provides the tools, including highly readable charts, that managers and investors need to position themselves ahead of cyclical upturns and downturns.

This website contains 20 of the key charts from Ahead of the Curve, continually updated, so that readers will be able to apply the book’s key insights to today’s latest reported data.

Economic events are not as random and unpredictable as they seem. This book will help readers recognize and react to signs of change that their rivals don’t see—and win a sizable competitive advantage.

About the Author:
Joseph H. Ellis was a partner of Goldman Sachs and was ranked for eighteen consecutive years by Institutional Investor magazine as Wall Street’s #1 retail-industry analyst.

An early Thanksgiving on Heil Ranch's Wild Turkey Trail

Sunday I took the opportunity for a nice Mt. Bike ride on the newly constructed Wild Turkey Trail loop north of Boulder at Heil Ranch. Despite the usual rocky trail cursing, the Wild Turkey Trail is tons-O-fun and I will raise a glass to those involved in its construction. I would recommend this trail for anyone from the beginner to the expert. It has something for everyone. It is not too technical but excessive speed will send you into the shrubbery if you are not keenly focused. Go check it out on your two wheels or running shoes.

Gold's cover blown?

Once again gold has found its way into the headlines. Last time we were here a contrarian top was essentially called. Are we there again? Seems like it. Rhona O'connell commenting for MineWeb offers as good as commentary as any. Like any analyst or expert they have a good thesis but reality takes little regard for that thesis and generally goes about its business despite what it "should do".

With gold grabbing the headlines in the "lay" press as well as the specialist publications and law-abiding analysts being buttonholed by their mates about whether it's now a "buy", it is perfectly arguable that the market is topping out. While this is unlikely actually to be the case this time, there is clear scope for a correction, as speculative froth needs to be blown off the market. Many market observers expect the spot price to challenge the historical high within a matter of days. The record high fix was $850 on 21st January 1980, although the intraday high was closer to $875.

The reasons behind the moves are obviously well rehearsed, including continued dollar concerns, geopolitical tensions, oil heading towards $100 per barrel, associated inflationary fears and concerns (potentially misplaced, given balance sheet strength) about the banking system, volatile equity markets and underlying financial stability. Perception is all and it is the fears surrounding the banking sector that are exacerbating the problem (the run on Northern Rock in the United Kingdom is a case in point). The sector that may actually have the real problems is the financial insurers, who are likely to incur substantial losses against loan write-downs.

Gold, that other insurance policy, has accordingly gained 28% between the recent intermediate low fix of $653.00 on the morning of the 17th August and the pm fix of $841.10 on 7th November. This increase is in dollar terms rises in a selection of other currencies have been as follows (taking the low pm fix, 21st August, through to the pm fix of 8th November). The gain in yen terms was 26%, while the gain in Australian dollar terms was a mere 10%, as the Australian dollar been benefiting from commodity strength (although the recent hike in Aussie interest rates may also have helped here).

For the complete commentary see: GOLD AND SILVER ANALYSIS

Rinse, Lather, and Repeat

Needless to say, this past week and a half have been tough for a stock market guy. So far so good, this is where active management can make or break. By this I mean that in times of market volatility (either rapid price movement up or down) is the best opportunity for people to make bad decisions. Fear and greed drive the markets to their extremes. At these two extremes are where people to make the wrong decision. One of my main themes is that people act about the same on average. Unfortunately, we all make up the average and that means that when markets are reaching extremes we tend to make the wrong decisions. Whether, selling at the bottom or buying at the top, people tend to all feel the same emotion and act about the same at the same time. This creates the common problem of selling just before the stock turn around. If on average everyone, sells at the same time because they can't take the pain of the loss anymore, there will be no more sellers and only buyers left and the stock will rise. The opposite is also true. As the euphoria of greed kicks in and we chase a stock that is rising higher everyone is feeling the same emotion and is buying at the same time. When this surge of buying dies out the stock will reverse and the sellers take the stock lower because there is a lack of buying to support the higher valuation. Rinse, lather, and repeat over and over again. We see this time and time again.

The question currently in the stock market is where are we going from here? Has all the bad news been priced in or is more blood likely to run? I believe, and have believed for quite sometime that we will test some lower levels. For months the experts have called for a bottom in housing, a bottom in financial, etc. just before more bad news comes out and the sectors take another dive. Despite my opinion, up until recently I found my self extremely long the market and was correct in doing so. The landscape is changing now and I will be reevaluating over the next few weeks. Reevaluating means taking small probing positions and various levels of support, either long or short. I identify the highest reward to risk ratio and enter a position at an area of support the stock is not likely to break. If it does I take a very small loss. Rinse, lather and repeat until a sustainable direction is present.

Who is right; The Bulls or the Bears?

This is an article posted by a good friend, colleague, and mentor, Don Dreyer, who consistently finds himself in the top fraction of a percent in every major online investing contest. When he talks about stock ideas and money management it is a good idea to listen.


Who's Right?
Posted Mon Nov 05, 06:31 pm ET

There are so many experts and opinions in the market, how can you tell who is right? Only the market is right all the time. Any and all opinions need to be checked against the price action. Price must confirm the analysis. If it doesn't, then it is time to go back to the drawing board. This may mean you need to abandon your own elaborately formed opinion on the current state of market or where you think it is going.

No prediction is as valuable as being able to know what to do with what is. When you look at the current price of a stock, do you know whether to buy, hold, sell or sell short? Do you know what to do when that price goes up or down from this point? It doesn't matter what you believe a stock is going to do; you have no control. What you do have control over is what action you will take when the stock moves in the direction you expected or in the opposite direction.

To make money in the market, you need good opportunities. Next, you need to be able to recognize an opportunity when it presents itself, whether that comes from a so-called expert or from your own analysis. You then have to have the conviction to seize the opportunity. More important still is that the market must confirm and validate that you have truly seized an opportunity. If you get confirmation, ride the winner and enjoy the profits. If the market emphatically proves you or the expert market analyst wrong, then change your mind because the market isn't going to change for you or the "expert."

Don't spend time trying to guess who is right in the stock market. Focus rather on aligning yourself with the market because the market is the only one that is right all of the time. Seek to get better at listening to the message of the market instead of the endless opinions all around you. Learning how to take action under every circumstance is far more important than guessing which way the market will wiggle next.

PetroChinia IPO hits market value of $1 Trillion

I am not one to call an absolute top, but are you kidding me? PetroChina hits a market value of $1.1 Trillion. This rings close to a posting last month regarding the market valuation of the Chinese stock market. Remember, stocks are priced, in part, to their expected future cash flows. Can we really believe that China is experiencing an industrial revolution to this scale? What is truly driving this growth? Can the growth priced into this and other Chinese stocks be sustained? For a while this growth is sustainable, unfortunately it will probably end like the late 1920's. This price puts PetroChina as the worlds biggest company, more than double ExxonMobil which is the second biggest company in the world. I am I missing something?
For a more complete story see CNBC's coverage,

PetroChina Shares Nearly Triple in Shanghai Debut

Volatility Gremlins

I had a conversation today and the effects of volatility over the long run was brought up. This is a concept that is very rarely talked about. I suspect not many people (advisors) have this discussion because they don't even know it exists. This topic is one of the main culprits individuals fail to realize the average returns over the long run that is to be expected based off of historical stock market return marketing material. The other culprits are inflation, timing, and making too many decisions. Historically, we have come to believe the stock market will return about 7.2% over the past 100 years or so. At issue is the creating of this figure. Using a geometrical average, which is how Roger Ibbotson who is credited for calculating this figure among others, you will arrive at roughly a 12% return figure. The geometrical average is calculated by simply adding up the number of data points and dividing by the number of data points used. For example the geometrical average of 2%, 5%, 15%, 20%, 7% = 49/5 =9.8%.

This work well as a marketing tool for long run performances. Brokers can always hide behind this widely accepted figure. This simple average is also used in calculating all kinds of forecasting models, pension funding requirements, and so on. However, a geometrical average is not what we experience in reality. Lets use the returns above as a quick example. Beginning with an account size of $100,000 the portfolio using the simple geometric average and return results as demonstrated above would gross $159,592.2. However, in reality you don't actually realize the average return each and every year. For every year you under perform the average you need a return in excess of the difference. Another words, if you start with 100% and lose 50% the next year you will have to have to make 100% to break even in the following year. In our example we saw two year of below average return followed by two years of greater than average returns. The gross return accounting for realized gains is $158,143.86, more than $1000 difference over 5 years. The difference here is relatively small but when you string together several years of under performance and maybe negative year or two and all of the sudden the difference becomes much larger. In the not to distant past, from 1/1966-1/1986 the market returned only 1.9% average. In reality does this volatility make any real difference? Over the same sampling period over the last 100 or so years the actual returns look something like 4.8%. Another words, over the long run, volatility erodes about 2.4% per year. Pretty significant and this is without even mentioning inflation, and when you begin your investment.

For a more detailed look at volatility issues I recommend reading, Bull's Eye Investing by John Mauldin.