2017 Q4

2017 was a banner year for markets.  Rarely in history have the markets displayed such consistent increases.  We first noted the calm in the market in our 2017 Q1 commentary, and that theme continued through the year.   Looking specifically at the S&P 500 through 2017, we can see: 

At no point did the market close at less than 3% of its previously achieved high.   

December 31st marked the 13th consecutive month the S&P posted a gain (the last time this happened was in 1959).  

The highest daily increase in 2017 was 1.38%, one of the lowest on record.  

In prior commentaries, we have explored at length the various factors creating the calm in the market, and honestly, not a lot has changed.  Congress did pass a tax reform bill, but that was already being figured into market expectations.  So, we enter 2018 at the same pace and with the same calm that dominated markets in 2017. 

What will 2018 bring us?  In the past we’ve written about our trepidations with market forecasts and predictions (something about expert forecasting being as accurate as dart throwing chimpanzees).  It is uncertain what will transpire over the coming year and the useful benefits of prediction are limited.  What we do find useful, especially in times where the market calm tempts us to complacency, is to consider where we are.  Markets and economies go through cycles.  Markets move from a state of absolute fear (everyone is selling) to a state of absolute greed (everyone is buying) and then back to fear.   Economies go through cycles of expansion and recession and, while separate, these two cycles are closely related.  When the economy is growing, or shows the prospect of growth, markets tend to perform well.  When economic data points to a recession and a decrease in corporate profits, markets tend to perform poorly. 

Framing our thinking within the paradigm of these cycles is a reminder that things change.  It is especially critical to remember this right now as the length of the current economic expansion and the calm, steady upward climb of the market pushes us into complacency.  It helps us resist resting on our laurels because we remember that things will change.  Thinking in terms of cycles also helps us frame some of our portfolio decision making.  There are certain opportunities and risks commonly associated with the various parts of these cycles.  Having a general idea of where we are helps inform us of how our portfolios should be positioned and what we should be prepared for in the future.  So, let’s get out our road maps and see where we are at. 

Where are we? 

We are going to start with the easier of the two cycles: the economic cycle (oftentimes also called the business cycle).  The chart to the right outlining the business cycle is one that you can find in any Macroeconomics textbook (page 11 of mine).  It is important to remember that economics is not a hard science…economists are basically philosophers with calculators and spreadsheets.  That’s not an insult (or at least isn’t meant as one).  There are far too many variables, and so much of what happens in an economy is up to human behavior.  However, some general trends, like the business cycle, are consistent.  A well-functioning economy will expand, reach a peak, then enter a recession, before it eventually troughs and then goes into expansion.     

We’ve taken the liberty, in the style of a mall map, to indicate roughly where we are in the cycle.  Please don’t read too much into the sizes of peaks and troughs and don’t focus too closely on where the little star is, because I don’t know exactly where we are in the cycle and neither does anyone else.  However, certain characteristics tend to exist in certain parts of the business cycle.  Looking at the data across the board suggests our current business cycle is nearing a peak: unemployment, credit expansion, default rates, businesses growth, and other economic activities are at or nearing places typical of a business cycle that is getting close to a peak. 

This isn’t a call for a recession in 2018.  The recently passed tax reform bill will provide stimulus to the economy.  Companies are already announcing wage increases, special bonuses, increased capital expenditures, and job creation measures that will likely lengthen the cycle.  Even with that being the case, we may see some signs of a slowdown or even deterioration in economic data sometime in the next 12-18 months. 

Determining where we are in the market cycle is less data driven and more inference driven.  Market cycles do not tend to follow the same gradual changes of economic cycles.  Much of that has to do with what is driving market cycles: it is less about reality and more about peoples’ perception of reality.  Knowing exactly where we are is difficult but there are indicators you can look to: measurements of business and investor sentiment that can provide a loose picture of where we are at in the scale of Fear to Greed. 

To the right is a chart I keep and update on a continual basis (it didn’t upload very well into wordpress).  This is not something we came up with.  This is a guide investor Howard Marks uses and outlines in his book, The Most Important Thing. He calls it the “Poor Man’s Guide to Market Assessment” because it does not require a $25,000/year Bloomberg Terminal (has 2-6 computer screens and you can get about any economic/market data set imaginable) to complete.  We like it because of its simplicity and, because it’s generally true. 

Here’s how it works: the two right columns are opposing market characteristics.  You simply work your way down the list and bold which best describes today’s environment (I highlight but the spreadsheet didn’t transfer over well to wordpress). Is today’s economy vibrant or sluggish?  Is the outlook positive or negative?  Are lenders eager or reticent?   The more bold characteristics on the left, the farther in the market cycle we likely are.    

As you can see, most of the descriptors we chose when applying it to the US Stock Market are in the left column: lenders are eager, capital markets are loose, debt terms are easy, interest rates are low, spreads are narrow, markets are crowded, there are few sellers, recent performance has been strong, and asset prices are arguably high, to name a few.  These characteristics are indicative of late market cycles.  Admittedly, there is a lot of subjectivity involved in this chart.  It is not perfect, and neither are we in its application.  Another person may take the opposing viewpoint on some of our selections.  But when looking at market characteristics it appears we may be nearing the end of a market cycle. 

Knowing where we are doesn’t tell us exactly where we are going and when we will get there.  We don’t know what the year will bring.  Our guess is that there will be more volatility in the markets this year.  It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year.  However, just because it is more volatile does not mean it will be worse or better.  But, predictions aside, the most important thing to take from all of this is not to buy into the calm.  It will not last.  The economy appears to be nearing a peak and domestic equity markets are exemplifying the characteristics of an over-priced, over-extended market.  We need to vigilantly work to hold assets that are reasonably priced, limit credit exposure, and be ready for mispricing opportunities that can arise if the market does turn.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2017 Q3

Market Update

As the last quarter of 2017 begins, market sentiment continues to be overwhelmingly positive.  The calm in the markets we wrote about last quarter has proven to be resilient.  It seems nothing will scare off the unicorns grazing on the front lawn of the New York Stock Exchange. Geo-political tensions may rise (North Korea) and the Federal Reserve may tighten monetary policy (increasing interest rates and reducing the assets on their balance sheet), but the market continues its climb.  

The calm is not without some good reason.  A sober look at the details of these notable events reveals very little immediate risk to the economy or businesses. I by no means profess to be a geo-political expert, but conflict in Asia looks unlikely in the near term.  Kim Jong Un seems far too interested in staying in power to make the one decision (starting a war) that would with certainly result in him being removed.  Despite President Trump’s aggressive public stance, the US is unlikely to start another war in Asia unless it is absolutely necessary.  In addition, China has stated that it will not support North Korea if they fire first but will protect North Korea if the US or its allies takes the first action.  It looks like things will need will need more time to percolate before open war starts, if it starts at all. 

As to the monetary tightening, the members of the Federal Reserve Board (FRB) act as if they have taken the Hippocratic Oath: “First, do no harm.”  The board members have no interest in upsetting the current economic recovery.  From 2008 to 2013, the FRB took unprecedented steps to stabilize and stimulate the economy by providing banks and other financial institutions with liquidity through the purchase of treasury securities, mortgage backed loans and other debt instruments.  As the chart to right shows, the FRB increased the Federal Reserve Assets from $600 billion in 2008 to around $4.5 trillion in 2013. That’s an increase of 7.5 times.   This wholesale purchasing of assets allowed banks to bolster their balance sheets (most of the money went back to the Federal Reserve.  See chart on the following page…how convenient) and suppressed interest rates so companies – and households – could restructure their debt at  lower rates. 

Since 2014, the FRB has cautiously withdrawn this stimulus and has now started the process of unwinding it through interest rate increases and outlining a plan to reduce the assets on its balance sheet.  Removing this kind of stimulus from the economy is no small deal.  The FRB has been committed to cautiously making adjustments when they see that the strength of the economy warrants it. They telegraph every move far in advance to give financial markets time to digest their decisions and adjust.  Markets have acclimated and become comfortable with this process. 

There were also positive developments during this last quarter that appear to have further bolstered market sentiment.  Q2 GDP growth was recently revised up to 3.1% annual rate.  This is the first time a 3% growth rate has been achieved since 2015.  In addition, Congress and       the White House have re-centered their focus on tax reform.  While the details have yet to be worked out, the various proposals are favorable to economic growth, at least in the short term. Certain measures – such as the one-time preferred corporate tax rate on repatriated money and the reduction of the corporate tax rate – have the potential to push more cash into the economy, which could stimulate corporate profits and economic growth.

All-in-all, the external backdrop looks favorable for the market.  But risks are still plentiful.  North Korea is a reminder of the geo-political tensions that exist around the world, and although the near-term probability of conflict in that region seems low, things can quickly change.  The Federal Reserve Board can use caution and telegraph their every move, but they are again embarking on an unprecedented operation with unknown consequences.  And we have all seen how well Congress and the White House work together in passing a bill.  Tax reform is in the bag!  Right?  While the immediate backdrop looks calm, we remain mindful of where we’re at: as we have discussed at length in past writings, US markets continue to be at rich valuations, markets are complacent, stability tends to create instability – as the economist Hyman Minsky hypothesized – and we have experienced one of the longest and weakest economic expansions in US history.  All seems calm now but that could change fast. 

Investment Commentary – Return Free Risk

The struggle in a market like this is continuing to find assets that are priced well.  The Federal Reserve’s maneuvering has caused inconsistent price manipulations that have distorted markets and left investors with little option other than to price securities almost solely based on the decisions of the Federal Reserve.  This is clearly the case in bond markets.

In typical market conditions, a bond holder will receive more interest for bonds that mature at later dates. If you have ever purchased a CD at a bank, you have experienced this: a 1-year CD pays more interest than a 6-month CD; a 2-year CD pays more interest than a 1-year CD, etc.  Typically, it works the same in the US treasury market: a 5-year bond will pay a higher interest than a 2-year bond; a 10-year bond will pay more than a 5-year bond, etc.  When you plot these interest rates on a chart, you get what’s called a yield curve.

The chart to the below shows the yield curve as of two dates: The current October 2017 (blue line) and the beginning of year January 2017 (orange line).  What has happened over the last year is that the yield curve has “flattened”.   The interest rate on longer dated bonds – like the 30-year bond – have gone down (the end of the blue line is below the orange line), while the shorter dated bonds – like 1-year – have gone up (the beginning of the blue line is above the orange line).   This is not an abnormal phenomenon.  If fact, it is a normal occurrence in the credit cycle and is typically indicative of deteriorating economic conditions.  

However, other portions of the bond market are behaving in ways indicative of economic growth. Just as investors receive more interest for loaning their money out for longer periods of time, they also receive more interest for loaning money to less “credit-worthy” borrowers.  Companies with poor balance sheets and negative cash flow will have to pay more interest on their loan than Apple, who has $100 billion+ in the bank.  The difference in the rate these two borrowers pay is called the “spread” (I know…a lot of finance terms.  There’s a quiz at the end).  For example, if Apple is paying 2% and Sprint is paying 6%, then the “spread” is 4%.   

The chart below graphs the average spread for the last year of junk rated bonds over US Treasuries.  During this time, the spread has narrowed…the difference between what “safe” bonds are paying and what “risky” bonds are paying has decreased.  This is also not an abnormal occurrence but is indicative of improving economic conditions.  

Under “traditional” interpretations, these markets are giving us conflicting reports.  The Treasury Curve is telling us things are getting worse, and the High Yield Spread is telling us things are getting better.  Why?  I have my speculations on what the tea leaves are trying to tell me, but right now I’m more concerned with how they are making my water taste: with the curve flattening and spreads narrowing, investors are being paid less for increased risk.  That’s not very good tea.  

A good example of this is our recent experience in Senior Secured Floating Rate Bank Notes. In August of 2013, we committed a sizeable percentage (5-10%) of portfolio assets to these securities.  They offered good value relative to the rest of the bond market, the contracts were written with a lot of covenants (covenants are requirements lenders force upon borrowers to manage their risk), they offered interest rate protection, and default rates were low. This past quarter we unwound the positions. When we purchased these securities, we were earning over 5% interest.  That number is now around 3.75%. While that’s been good for us on a total return basis (when bond yields go down, prices go up), it is not much to be paid on loans given out to low credit quality companies.  In contrast, we could buy highly secure companies for 2.2% interest.  If default rates on the Bank Notes were to inch up to historical norms, then we would be receiving almost no additional compensation for the increased risk we were taking.  In addition, loans were being issued with fewer and fewer covenants, which further reduced our protection.  To steal a phrase from another portfolio manager, we were getting return free risk.  Given the changes, we sold the positions this last quarter.  The risk was no longer worth the reward.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2017 Q2

Market Update – The Great Complacency

If no news is good news, then all I have is great news for you today. The first half of this year has seen stock markets across the globe make steady upward climbs.  The indexes in the chart below represent major markets across the world.  As you can see, almost all major markets are in positive territory for the first half of the year.

The markets seem as calm as Hindu cows.  These increases have, for the most part, come steadily without a lot of fanfare or turbulence.  Investors believe this calm will continue at least in the short term.  The VIX, represented in the lower-right chart, is an index developed and maintained by the Chicago Board Options Exchange (CBOE).  Commonly called the “fear gauge,” the VIX is the measurement of the expected volatility (how much the index will change in value) of the S&P 500 over the next 30 days.  As this chart illustrates, the VIX is at the lowest level on record since its development in 1994.  The S&P 500 is not alone in its low realized and expected volatility measures.  European and Asian markets are also at or near historical lows.    

In several markets around the globe, we would argue these market increases are warranted.  We have long held the opinion that Asian and European markets are under-valued, especially from a relative standpoint.  While the US market has continued to increase the last few years, these markets have stagnated until recently. Europe seems to be entering the stage in the economic cycle that the US began in 2009…slow yet steady growth.  Beyond foreign developed markets, emerging markets appear to have come out on the other side of another round of currency pressure in good health. This illustrates an economic resilience that hasn’t been there in the past. 

In contrast, the US economic expansion and bull stock market are getting a little long in the tooth.  The current economic expansion has lasted 96 months, the third longest expansion since 1854.  At almost 100 months long, the current US bull stock market is the second longest on record.  Neither of those facts spells near term doom, but there are other signs of frothy investment markets.  Just to cherry-pick a few:

Traditional valuation metrics are historically high – Total Market Cap to GDP ratio is around 120%, a number surpassed only at the height of the Internet Bubble in 1999/2000.  Shiller CAPE index has now surpassed the level it reached in 2007, just prior to the Great Recession.  In fact, there have been only two other times in history when it has been this high or higher – 1929 and 1999/2000.  When talking about stock markets, those are not good years to be associated with. 

Stock valuation metrics are being ignored – To site a specific stock overvaluation, during the last quarter Tesla, an electric car manufacturer, surpassed Ford in market value.  Tesla has a fraction of the revenue of Ford ($8 billion vs. $151 billion), a fraction of the assets ($22 billion vs $237 billion) and has never posted an annual profit.  This sounds familiar to the internet bubble, when everyone was banking on future revenue that was just supposed to come from somewhere. 

High Margin Debt Level – The New York Stock Exchange publishes monthly margin debt levels (borrowed money to buy stocks[i]).  It is currently the highest on record. When viewed as a relative measure to US Gross Domestic Product (GDP), it is at the same level as it was in 1999 and 2007. 

Low Institutional Investor Cash Holdings – Institutional investors are almost fully invested, with 2.25% of their account holdings in cash. This is the lowest level since 2008.[ii]

Argentina’s Bond Offering – To be fair, this is example isn’t from the US market, but it shows how desperate people are for higher yielding bonds. Just a few weeks ago, Argentina successfully issued $2.75 billion in US denominated bonds that mature in…wait for it….100 years!!!.  This bond issue was oversubscribed…there were 3x more buyers than there were bonds to sell.  This is Argentina, a country that has defaulted or rescheduled payments on external debts 5 times since 1950 (1951, 1956, 1982, 1989, 2001)[iii].  Their most recent external default holds the record for the largest sovereign external default at $95 billion and, for some reason, people think it’s a good idea to lend them money they don’t have to pay back for 100 years.  It befuddles me. 

These factors – steady increases in market value, low volatility, and a general disregard for risk and valuation – are indicative of a complacent market.  Complacency tends to create instability in furthering misallocations of capital. In other words, people feel safe so they ignore risk.  When you add to those factors a very long bull market by historical standards and investors who are fully invested and even leveraged (margin debt) then you have a scenario where things will likely change quickly when they change. 

The timing of the change is impossible to know. Equity markets could continue to go up.  The last time the Shiller CAPE ratio was this high, the market continued to go up for another 2 years.  Economic data continues to be generally positive and corporate earnings are still improving.  These factors could continue to support an overvalued market.  However, with the above risk factors we will maintain our conservative approach to US market exposure. 

Investment Theme – Water

For a midwestern boy, the concept of “water shortage” is completely foreign.  I grew up not far from the Missouri River.  Most of my Saturdays from the time I was 13 until I turned 20 were spent fishing on the large lakes of central Missouri – Truman, Stockton and Pomme de Terre.  As an adult, I’ve spent countless hours fly-fishing in streams.  One of these, Bennett Springs, has a daily flow of over 100,000,000 gallons that, as the name suggests, comes out of a hole in the ground. I’ve spent several weeks fishing in Canada, where you can’t seem to drive 3 minutes without passing a lake.  For the last few years, my family and I have vacationed several times at Lake Michigan.  In my world, water is everywhere and in abundance.

I – and all of you, except our west-of-the-Rockies clients – live in one of the richest water locations in the world.  The Mississippi River Valley stretches from the Appalachians to the Rocky Mountains.  Hundreds of rivers and streams contribute to the system as it meanders its way from as far north as Montana and Minnesota to the Gulf of Mexico. The Amazon and the Congo Rivers are the only river systems in the world with larger drainage basins.

Reality is much murkier in other places in the world, even some places in the US.  The graph to the right illustrates that much of the world is going to be under stress to provide enough water to support their populations[iv].  Global population growth over the last century has placed a lot of stress on water systems.  In most developed parts of the world, water infrastructure has been able to keep up with growth.  For example, during the 20th century, 45,000 dams were built around the world, which increased the world reservoir capacity by 4x, and aquifers were discovered and tapped to supply water to otherwise water poor regions[v].  But the efficiency of those measures is starting to hit their limit.  The number of dams that can be effectively put on a river is limited, and aquifers replenish at a very slow rate. 

In addition, current water infrastructure is aging and will need extensive replacement and repairs in the next 10 to 20 years.  The American Water Works Association (AWA) claims the US is hitting the “Replacement Era” of water systems.  The type of piping used in water infrastructure has changed over the last century, but oddly enough, newer pipes have less longevity than older ones.  In an almost perfect storm, 3 different types of piping will be hitting the end of their “life expectancy” within the next decade.  This same scenario is being played out in other areas across the globe.  For example, Mexico City loses 40% of the city’s potable water through leakage of old pipes every day[vi]

Developing economies face even greater challenges.  Having frantically thrown together water systems to meet the increased demand from industrialization and urbanization, many developing or recently developed countries are facing pollution problems.  It is estimated that half the surface water in China and India is contaminated to an unusable point.  In 2016 a report from the Chinese government, it was stated that 80% of underground well water was unfit for drinking or bathing[vii]

All of these varying issues will need to be solved, and solving them will cost money.  As global populations continue to increase, new systems and technologies will be required to meet demand.  Since water cannot be created, this will have to be done through increased efficiencies in use/reuse and delivery (desalinating ocean water is another potential). As to the aging infrastructure, the AWA estimates that the cost for replacing drinking water systems will be $13,500 per household (sorry…. your water bill is going up)[viii].  To stem the pollution of their waters, developing countries will need to increase regulations on industries on the water they release into the system, which will cost money to implement.

We like the investment opportunity this presents.  Besides oxygen, water is the most basic necessity in life.  People need access to it, and they want it to be clean.  Recent experiences in Flint, Michigan have demonstrated just how important it is to get right.  A lot of money is going to be spent on water over the next 10 to 20 years.  We currently have a small position committed to this area and will be likely be increasing it over the coming months. 

We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.


[i] Data can be viewed here: http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8

[ii] http://www.businessinsider.com/stock-traders-look-dangerously-overconfident-cash-holdings-2017-7

[iii] This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff

[iv] Chart from World Resource Institute http://www.wri.org/resources/charts-graphs/water-stress-country

[v] Water: The Epic Struggle for Wealth, Power, and Civilization by Stephen Solomon

[vi] ibid

[vii] https://www.nytimes.com/2016/04/12/world/asia/china-underground-water-pollution.html?mcubz=0

[viii] Water 4.0: The Past, Present & Future of the World’s Most Vital Resource by David Sedlock

2017 Q1

I don’t know if we could pass a Mother’s Day Resolution right now.

–     Representative Matt Gaetz as quoted in the Wall Street Journal March 25th, 2017

Easier Said than Done

Since the election of Donald Trump to the office of the President of the United States, the US stock market has been on a steady upward climb. From October 11th, a few weeks prior to the election, till March 21st the S&P 500 did not experience a greater than 1% drop on any given day – the longest such streak since 1995. It is always speculation to attribute market movements to a single factor but the relative calm and optimism of the market appears, at least in part, to be due to President Trump’s plan to grow the economy. However, during the week of March 20th the realities of implementing legislative agendas began to set in as the Repeal and Replace bill for the Affordable Care Act (ACA) was to come to a vote.

Repeal and Replace, as it is commonly called, has been on the minds of Republicans for several years. It seems most – if not all – Republican candidates running for election since the passing of the ACA ran on a platform that included its repeal. During the Obama administration, the Republican controlled Congress sent several Repeal bills to the President knowing his veto was a certainty. One would think after so many years of campaigning for the Repeal of the ACA and after passing several bills at the congressional level  to Repeal the ACA that the Republican Party would have a readymade, passable bill. However, now that the vote was for a bill that would become law building consensus became more difficult. The Republican Party fractured and the bill failed.

The Repeal and Replace bill was the first in a set of legislative dominoes to affect change in the US economy. The tax savings achieved through Repeal and Replace would make room for greater adjustments to the tax code which would in turn guide infrastructure spending. These items were intended to stimulate the corporate and economic growth the market has been banking  on. The failure to Repeal and Replace the ACA does not spell certain doom for the other items on the legislative agenda. As Republican Rep. Matt Gaetz’s quote indicates it does demonstrate the difficulty in building consensus in a ruling party.

Building consensus will not get easier as the President and the House move on to the next item in their agenda, tax reform. One of the major pieces of the GOP proposed tax plan (http://abetterway.speaker.gov) is to add a Border Adjustment Tax (BAT…an unfortunate acronym but we’ll go with it). To keep things moving along here we won’t go into the inner workings of a BAT. We’ll just say the intended consequence is to reward US based companies for exporting goods and penalize them for importing goods. Sounds great, right? Well, if a BAT is implemented you will find your next trip to COSTCO quite a bit more expensive. Retail items are largely imported. If importing goods suddenly costs companies more money that extra cost will get passed on to you.

The proponents of a BAT argue this increase in cost to the consumer (you) will eventually be quickly because it will cause the dollar to  strengthen in value relative to  other global currencies  thus making goods  from other  countries cheaper   we are  not  convinced the cause and effect connection is fully there. There are far too many variables impacting the value of the dollar relative to other world currencies to rely on one factor to account for a massive shift in currency valuations.  We are not alone in our skepticism   no fewer than 19 Republican Senators have expressed concern over adding a BAT and several of those are strongly opposed. Even the White House, and President Trump specifically, have expressed concerns regarding implementing a BAT. When you have Senate majority by two seats and vice presidential tie breaker you only have two votes to give up…there is not a lot of wiggle room there to lose votes. As the administration proceeds with its agenda to overhaul the tax code and implement the other changes the market seems to be banking on it finds itself looking up at another set up hurdles while still lying on ground from the last hurdle it just failed  to clear.

Though any tax reform bill is at least 7 months away we remain mindful of the impact tax codes changes can have on financial markets. One such instance, the Tax Reform Act of 1986, caused massive shifts in the real estate market. While the current proposed tax plan does not appear to make any changes that would so directly affect one specific asset class there are a few provisions that will impact markets. The BAT tax discussed above will have drastic impacts on certain market sectors: retail, auto and aviation to name a few.

There are other provisions of the proposed tax code which have the potential of causing major shifts in the markets as well. One provision will allow US based companies to repatriate dollars held overseas at a tax rate of 8.75%. Another provision removes company’s ability to deduct interest expense on money it borrows. While seemingly unrelated the combination of these two provisions would fundamentally change the math behind corporate finance and could cause large shifts in the bond market. Given these potential impacts we will closely monitor the tax bill as it works its way through the legislative process.

Oil Markets Settle into a Range

For years, the oil market has been run by a cartel…the OPEC nations. The price of the commodity shifted based on their production levels. However, their influence over the price of oil appears to be waning. New technology developed over the last decade or two has allowed for oil to be extracted from shale fields which resulted in a large increase in United States oil

production. The Saudis’ recent experiment to slow this growth of US oil production by over-supplying the markets has resulted in a consolidation of the US oil market but not a lessening of capacity. If indeed this was the Saudis’ intent they underestimated the ingenuity of American oil producers. As we stated in our 2016 Q1 Commentary US oil companies have been making money in oil for 150 years in many different environments. Given time they would adjust to the new normal and that’s what has happened. Over the last few years the break-even point for US oil producers operating in shale fields has dropped through technology and innovation.

What this likely means for the oil market going forward is a pricing system more defined by market forces and less by a cartel. OPEC will continue to have influence on oil markets…they’re still the 900 lbs. gorilla. But limiting demand to drive up oil prices, as they have done in the past, will now be met with greater production from US producers. This very scenario has played out over the last year. As oil prices returned to the $40-$50/barrel range US producers picked up production.

The 2015 – 2016 turmoil in the oil markets provided us with some opportunities to over-weight our energy portfolio with assets at reasonable values. In our opinion, the market forces described above would keep the price of oil in the $40 – $60 range for some  time limiting the near-term upside potential in the price of oil. In response, we unwound or reduced some of those positions in January 2017 and shifted our energy portfolio to be more sensitive to oil production levels (which we believe will continue to increase regardless of price) and less sensitive to the price of oil. While this will limit our upside if the price of oil unexpectedly goes up it should also limit our downside should the price return to the low levels we saw in 2015.


The US market is not alone in its relative calm. European and Emerging Market economic data is being read as overwhelmingly positive (there is some good, bad and ugly in emerging markets) and global markets are responding with steady upward climbs. Events that once shook the market – fed interest rate increases, talk of a wind-down of Federal Reserve assets, geopolitical uncertainties – no longer seem to carry the weight they once did. It is during these times of calm when our awareness of risk needs to be at its greatest. Not because risk is inheritably greater in times of calm but because the calm can cause a dangerous sense of ease. We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2016 Q4

President Donald Trump

Does that look right to you yet?  The day after the election I sent a good friend of mine a message….”President Elect Donald J. Trump.  There.  Just had to give it a go and see if it feels more real.”  It didn’t really help.  Whichever side of the election you were on I think everyone can agree the concept of “President Trump” seems strange.  Yet on Friday, January 20th, 2017 Donald J. Trump was sworn in as the 45th president of the United States of America.  

In the weeks leading up to the election the news media was overwhelmingly predicting a Hilary Clinton victory.  Simultaneously, the financial news media was reporting that a Hillary Clinton election would be viewed positively by the financial markets whereas a Donald Trump election was sure to cause market chaos.  The actual results of the election and the subsequent reaction of the stock market were a reminder of how poorly the prognosticators prognosticate. As election night unfolded and the possibility of a Trump election became greater the futures market on the Dow and the S&P sank lower and lower.  But by the end of election week the Dow had posted its best week since 2011.  

By their fruits you will know them

It seems that a good portion of the news these days is spent on what “will” happen instead of what has happened.  Nowhere is this truer than in the financial media.  This time of year is full of forecasts: where the market will be at the end of the year; what direction interest rates will go; what sectors will out-perform, under-perform, etc.  After being an observer of these forecasts for more than a decade I can tell you the vast majority of them turn out wrong.  My favorite from last year: Bloomberg interviewed 65 analysts asking where interest rates would be at the end of 2016.  Every one of them said the yield on the 10 year treasury would be below 2%.  It closed the year out at 2.45%.  65 experts…all wrong.   

Every year I see similar forecasts from the experts and every year they fall short of being right.  When it comes to accurately forecasting the future the experts do not have a good track record.  But don’t just take my word for it…. Philip Tetlock is a professor who authored the book, Superforecasting: The Art and Science of Prediction.  He spent over 20 years interviewing 284 experts while tracking the accuracy of their forecasts along the way.  After compiling 20 years of data, here’s what he found in his own words: “the average expert was roughly as accurate as a dart-throwing chimpanzee.”

To be fair, Dr. Tetlock’s discovery does not disqualify all expert forecasting, as he makes clear in his book. What it does illustrate is the rarity of good forecasters.  Arriving at a correct understanding of current events is hard enough.  Then to take that and extrapolate what will happen next is extremely difficult.  There are always unknowns and there is always a human element, which is impossibly hard to predict – just ask the Baseball Prospectus guys.  Every year they run a simulation based on player and team statistics to predict each major league baseball team’s record.   In 2015, a team the system said would lose 90 games won the World Series (I’m not still bitter about that prediction…really, I’m not).  

In 2016 there was no shortage of incorrect forecasting.  The Presidential election, the Brexit Vote results and the subsequent market reaction from each of those events were all forecasted incorrectly by the vast majority of pundits on TV and the experts in the fields.  This brings us to a stark reality: most of the pundits on TV and the experts do not have a clue what is going to happen whether it regards the economy, politics or financial markets.  At the end of the day, all their running commentary is just a lot of noise.  

As investors, it is important to recognize the limitations on our ability to foresee future events.   We can’t predict with any accuracy where the market will be in six months or how we will get there.  Nor can we predict how one event – like the election – will impact the markets.  Pretending we can will result in making imprudent short-sighted investment decisions.   

However, that does not leave us blind and without a road map.  There are things we can know or have varying degrees of conviction through which we can make good decisions.  We can gather a lot of current factual information: economic growth rates, demographic trends, and government and private sector debt levels just to name a few.   We can have a general sense of where we are.  Economies and financial markets tend to move in cycles.  Economies move from contraction to expansion and vice-versa.  Markets move from euphoria to fear and back again. We cannot identify when a cycle will change but we can have a general idea of where we are. We can identify and evaluate various risks: geopolitical risk, economic risk, market risk, valuation risk, interest rate risk, and many other forms of risk.  

What this information will not do is tell us exactly what will happen over the next few months.  We cannot accurately forecast from this info where the S&P will be at the end of the year or what the yield on the 10 year treasury will be 6 months from now or how First Solar will perform over the next 3 months.  What we can do is use this information to make decisions regarding long term economic trends, current valuation levels, long term growth trends, short-term mispricing opportunities, conviction levels, allocation percentages, hedging needs and many other factors that go into building a diversified investment portfolio.  

Trumps Impact on Investing

As we look ahead to a Donald Trump Presidency the most important question we ask ourselves is not what impact President Trump will have on the stock market.  We don’t know how his presidency will ultimately impact the market and anyone who says they do is not being honest with you or themselves.  The real question to ask is what changes now that Donald Trump is President?  We would argue that the facts largely remain the same: the developed world is mired in too much debt; despite accommodating monetary policy of central banks (low interest rates and Quantitative Easing) economic growth is slow; productivity growth is stalled; the best long term growth opportunities still appear to be overseas; domestic assets – stocks and bonds – are at historically high valuations; and people will continue to eat food, drink water and use oil.  

What we will likely see from President Trump are policies that will have definite short term impacts.  For example, the tax policy proposed by the incoming administration will likely have a short-term benefit to corporations by lifting their profitability.  In addition, the administration is planning on infrastructure spending, which could have a positive impact on the general economy.   His foreign policy looks to be very different from past presidents which will adjust geopolitical risk.  His strong language against current trade policy and, more specifically, China will certainly have impacts on foreign markets.  But will any of these things substantially move the needle on the big picture items I stated above?  Probably not.  In our view, the Trump presidency does not completely change the landscape of investing.  It just shifts the shrubs around a little bit.  

The presidential administration may be changing but our focus on the long term remains the same.  The domestic portion of our portfolios will be conservatively allocated to value oriented portfolio managers or in sectors where we believe long term trends will prove out over short term volatility.  We will allocate positions to geographic areas where we believe there is good relative value, stronger growth potential and less debt.  Portfolios will have low exposure to interest rate risk.  Our focus on having non-correlating assets will also remain the same.  And we will continue to invest in areas where we see value and the greatest potential for long-term growth. 


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2016 Q3 Quarterly Commentary

Interest Rates are Low?  Who Knew?  

The chart below shows the change in the interest rate of the 10 year Treasury bond over the last 34 years.  The early 1980’s were the tail end of a period of high inflation and interest rates.  Many of you probably remember having CD’s paying interest in the double digits.  In 1981 policies were enacted by the Federal Reserve that started a drop in interest rates that, as the chart below shows, has not really ended since.  Earlier this year the interest rate on the 10 year treasury hit a record low…the US has never seen interest rates this low.   In fact, if you put it in a broader historical context the current interest rate environment is the lowest the world has ever seen.  We won’t bore you with the details of Grecian, Roman, Byzantine and British Empire interest rates but it is true – interest rates have never been this low.  

The real effects of this on people’s lives are clearly visible.  On the positive side home, vehicle and unsecured financing is inexpensive.  This has allowed people to free up cash flow by reducing their interest costs and households have been slowly reducing their debt the last few years.  Total household debt relative to US Gross Domestic Product is the lowest it has been in over a decade. 

However, the negative consequences of low interest rates are starting to weigh heavily on investors and the economy.  Our economy is built upon a system of credit and interest and it is becoming apparent this system is impaired in a low rate environment.  Banks rely on the ability to lend money out for more interest than it costs them to hold it (net interest margin).  As interest rates entered into unprecedented lows their margins shrank and now depositors receive little to no interest while paying fees on their accounts.  Similarly, insurance carriers rely on interest payments from a bond portfolio to reduce premium costs and increase profits.  As income received from their investment portfolios have decreased insurance premiums have increased.  Pension funds who had generally counted on – foolishly in our opinion – an 8% annual rate of return to pay future liabilities are now facing a reality where 40% of their portfolio is only earning 2% – or less – interest.  That makes it kind of hard to earn the 8% they – and their pensioners – are counting on.  While low interest rates may have assisted in the avoidance of a total economic collapse if they continue too long our economic system may slowly break down.

What we think is more likely to happen is an attempt to return to normal via central bank raising interest rates. We have been waiting for this for a long time.  Admittedly, this low interest rate environment has lasted far longer and been more extensive, than we expected.  It could continue to go on longer than we expect.  But the commentary among the “economic and political elite” has begun to change.  The US Federal Reserve is receiving a lot of pressure to normalize rates and it appears they may resume that process soon.  

A World with Rising Interest Rates

This creates a very real risk to investors.  There is an inverse relationship between interest rates and the value of a bond.  If interest rates go down – like they steadily have for 30 years – then the value of a current bond goes up.  If interest rates go up then the value of a current bond goes down. Once this process of raising rates begins bond holders will be dealing with something they have not had to deal with in 30+ years – the value of their bonds going down.    

As Jack would remind us, the way people invested when he started as an investment manager 40 years ago this would not matter.   People would purchase a bond by directly lending the US Government or a company $10,000, for example, collect interest for 10 years and then at the end 10 years the entity would give them back their $10,000.  Whatever happened to the price of the bond along the way did not matter.  The investor got their $10,000 back at maturity no matter what the value of the bond did.  

But it does not really work like that anymore.  30 years of decreasing interest rates, an industry “scaling” their business models to maximize profits, and the creation and adoption of Modern Portfolio Theory (the en-vogue investment management theory of the day) have essentially changed how individual investors access the bond market.  Investment products have been designed and built around a bond market that steadily increases in value. The principal protection element of bonds (you get your $10,000 back the end of 10 years) has been at best limited and at worst eliminated through the management style of bond funds.  Bond fund managers rarely (very rarely) hold a bond till maturity.  In fact, the execution of a portfolio following Modern Portfolio Theory results in the creation of divided bond classes grouped by the maturity date of the bond.  This grouping forces the manager to sell their bond holdings prior to maturity, even it has to be sold at a loss. 

With the winds of change upon us we are being forward thinking in how to manage a bond portfolio in a rising interest rate environment.  There are methods to mitigate this risk.  Some strategies have already been implemented in portfolios and others will be implemented as conditions warrant. 


In the 2016 Quarter 1 commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year.  The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing.  We have never quite understood the general consensus of the financial world towards China.  They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar).  But to every one of these arguments there exists fundamental misunderstandings about China.  In the interest of brevity, let’s examine just one…overpriced stock markets.

In the Quarter 1 commentary we addressed the overpriced stock market.  In the Quarter 2 commentary we addressed lower economic growth prospects.  And this quarter we will wrap this up by addressing the misconceptions of China being overextended in debt.  

Wait a minute…there’s actually two sides to a balance sheet?  

During the last decade total debt in China – consisting of corporate, household, government and bank debt – has increased from roughly 150% of China’s Gross Domestic Product (GDP) to over 250% of China’s GDP.  That’s a lot of debt. In fact, when you take into consideration that the denominator in the equation has also increased significantly during that time period the increase in debt gets really big: total debt has gone up 465% in the last decade.  

Our recent experiences in western culture make these numbers very worrisome.  In the US, we have witnessed the danger of an over-leveraged economy: the 2006 housing crisis and the subsequent Great Recession beginning in December 2007.  But to every balance sheet there are two sides: assets (what you own) and liabilities (what you owe).  What is being largely ignored in the case of China is the asset side of the balance sheet.  

Let’s take a look at the household debt burden in China within the context of the real estate market.  In the last few years many pundits have expressed concern of a growing bubble in Chinese home prices.  Home prices have increased roughly 9% – on average – every year for the last 10 years.   In our economy those high increases would be troubling.  But Asian cultures tend to look at savings and debt differently than western culture.  In short, they save more and they go into less debt. A few statistics to consider:

  • Wage increases have averaged roughly 13% per annum for the last 10 years, which outpaces the home price increases.
  • In order to buy a home in China a 20% down payment is required.  That is not a banking standard.  It is a law.  That is if it is your first home.  If you are buying an investment property (second home) 30% is required. 
  • A 2014 study showed that 15% of all real estate purchases were paid with 100% cash.
  • According to a China Household Finance Survey in 2012, average household debt amounted to only 11% of home value; the median household debt was 0%.   
  • The same 2012 survey indicated that if home values fell 50% only 14% of mortgages would be underwater.  

Those stats paint a very different picture than an over-extended, over-leveraged consumer.  And a similar picture could be painted for corporate and government debt: there are assets to support their level of debt.  Even the structure of the debt (state financed in a closed system) makes the debt level more palatable.  While Chinese debt has grown excessively during the last several years it appears to be at manageable levels. 

That is not to say there is no risk here.  In our opinion this increase in debt is going to continue for some time.  China has aspirations for their currency (Yuan) to be used more heavily in international transactions and as a reserve currency.  In order for that to happen there needs to be more volume of Yuan in the market.  In a fiat currency system, money is created and put into circulation through debt.  If China wants more Yuan in circulation then more debt will be required.  Continuing to fuel this debt may put more strain on the Chinese economy.  While we do see long term value in investing in China we will be closely monitoring the situation watching for meaningful economic deterioration. 

As we examine the global landscape, China – and other select Emerging Markets – continue to have the greatest potential for long term growth.  We believe patient investors who endure the volatility often experienced in these markets will see long term gains.  We also see developed markets – such as the US and Europe – struggling to obtain meaningful economic growth.  As central banks and governments make more decisions and businesses and individuals continue to adjust to an economic environment very different than it was a decade ago we believe markets will continue to be volatile.  Throughout these developments we will continue to invest in areas where we see value and the greatest potential for long-term growth.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2016 Q2 Commentary

Please Brexit at the Next Vote

On June 23rd the United Kingdom voted to leave the EU. Prior to the vote polls indicated the populace would vote to remain in the EU but we were all reminded why polls come out with a margin of error. The outcome of the vote caused a degree of panic across markets as people digested the news.

How much actual damage will occur from the Brexit is yet to be seen. Once a member country has notified the EU of its intent to leave they have two years to negotiate the details of the withdrawal…there is still some time before anything will be technically different. But the preparation for withdrawal will be costly to the UK and companies operating in the UK. Over 50% of the UK’s trade goes to countries in the European Union. New trade agreements will be required with each individual country and then businesses will have to comply with each individual agreement. This will increase costs and uncertainties over the next couple of years.

Longer-term consequences are harder to see. Most economists and other outspoken public officials seem to be of the opinion that this will be bad for the UK and for the EU. In reality, it is impossible to know. Not only could there be unknown negative consequences but there could also be unknown positive consequences. For example, British officials have already begun dialogue with Asian and other emerging countries to negotiate new trade agreements. Those officials will have more opportunity to negotiate agreements beneficial to England as opposed to subordinating their interests to that of the EU. A pivot towards trading more with emerging economies that are less debt laden and more room for economic expansion than EU member nations may prove to be a long term boon to the their economy. Only time and decisions will tell.

Where the greatest risk appears to be in this scenario is any contagion effect the Brexit will have on other nations leaving the EU. There are already political parties in several EU member nations pushing for an EU referendum. If viewpoint begins to steamroll – as it did in the UK – than there could be a lot of political and therefor economic turmoil in the EU. We will maintain a close eye on the situation to see if changes to risk warrant adjustments to portfolio positions.


In our last commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year. The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing. We have never quite understood the general consensus of the financial world towards China. They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar). But to every one of these arguments there exists fundamental misunderstandings about China. In the interest of brevity, let’s examine just one…overpriced stock markets.

Let’s consider another one of these misunderstandings…lower economic growth prospects.

How Much Slower is Lower?

China has experienced unprecedented economic growth over the last 2 decades. Looking back over the last 20 years the annual Gross Domestic Product growth rate has ranged from 8% to over 14% on an annual basis and never experienced an economic contaction during that period. In terms of size, total GDP has grown from just under $1 trillion in 1996 to over almost $10 trillion today. That’s an average annual growth rate of over 13%.

What many economic and market pundits find alarming is the trend-line of growth. Looking at the below chart you can easily point out a downward shift in annual percentage GDP growth. Growth peaked in 2007 at around 14% and has steadily declined since. It currently sits in the 6.5% to 7% range and the International Monetary Fund estimates growth to be 6.3% in 2016 and 6% in 2017.


There is no arguing with the numbers and facts – Chinese economic growth as a percentage of GDP is slowing – but we find the worry surrounding this situation to be puzzling for a couple reasons. First, answer this….which would you rather have? 12% of $350,000 or 6% of $1,000,000. I don’t know about you but I want to sign up for the 2nd deal…its $18,000 more. Now, add a few zeros to the equation and you are looking at the GDP growth of China. While the economy is experiencing lower growth on a relative basis it’s current total $ growth still out-paces the higher % growth rate of 5-10 years ago.

Secondly, when did a 6% growth rate become a bad thing? Since 1970, the US has experienced greater than 6% GDP growth in one year (1984) and the US Federal reserve is projecting a growth rate of 2.2% for the US in 2016 and slightly less in 2017, which we feel is optimistic. Admittedly, comparing developed US growth to developing China growth is not an apples to apples comparison but it does help put into perspective reasonable expectations. In the slow growth era the global economy is currently in 6% growth is nothing to shake a stick at.

Over the next several years we do expect a slight continued slowing or – at best – a stabilizing of Chinese economic growth but we do not think it warrants as much concern or worry as many people are giving it. As the numbers above show, even with a slower growth rate than it was once accomplishing China is still experiencing substantial growth at a rate unseen in developed economies and higher than most developing economies. With a growing middle class and an economy in the midst of shifting from being export driven to being consumer driven we believe there is plenty of opportunity for prudent active management to identify and take advantage of growth opportunities.


The Brexit vote does cast another shadow over global growth prospects but only time will tell how long a shadow it casts. We are constantly looking out for risks and also looking for pockets of opportunities where we feel the potential return is commensurate with risk. We feel we have identified some areas but also remain cautious as the global economy continues to work through the challenging environment it has created for itself. We will continue to invest in areas where we see value and the greatest potential for long-term growth.

Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

A $65,000,000 Deceased Eagle? The Subjective Nature of Value

In 2007, an art dealer/collector by the name of Ileana Sonnabend passed away. Within her rather large and valuable art collection – her net worth was estimated at $1 billion – was a piece titled, Canyon. The artist, Robert Rauschenberg, used a combination of paint, sculpture and a stuffed juvenile bald eagle in constructing the piece. When I say a stuffed bald eagle I’m not talking a stuffed animal you’d buy your kid to snuggle with. This was an actual taxidermied eagle.

In the audit of Sonnabend’s estate tax return the IRS noticed this prized piece of art had been valued at $0.00. While that may seem strange it was with good reason. In 1940 congress passed the Bald and Golden Eagle Protection Act making it illegal to possess, sell, purchase, transport, import or export a bald or golden eagle in any condition…dead or alive. Ms. Sonnabend had been granted permission to retain her ownership of the piece as long as it was on display at a public museum but it was illegal for her estate to sell it.

What’s the worth of something you can’t sell? The valuators of the estate argued it was $0.00. The IRS on the other hand came to a valuation of $65,000,000, which came with a $40,000,000 tax and penalties bill (see here for NY Times article).

Two different groups looked at the same set of facts, the same circumstances and came up with valuations that were $65,000,000 apart. How can that happen? Each side had reasons for their figures but let’s not get lost in details. From a big picture standpoint it happened because valuations are subjective. They require assumptions. They require individual opinions.

Take a dental practice valuation for example. There are a number of subjective elements to a dental practice valuation. If the valuator utilizes a cash flow method they have to make decisions on what to include as add-backs to net cash flow. There’s no standard to that (at least not one I can agree with) and what and how much of what gets added back in is up to debate. And that’s only the beginning. How do you figure replacement value? What about the capitalization rate, which is partly a product of intangibles like location.

You may or may not be familiar enough with valuation lingo to know exactly what I’m talking about but I’m sure you see my point…when you look at a practice valuation you see an opinion derived through a lot subjective decision making. Give two different valuators the same info and you are likely to get two different answers. Add a third and I’m sure we could all guess the result…a different number.

That’s not to say valuations are meaningless. They do have value. But the figures shown should not be viewed as sacrosanct and in a merger or acquisition the value figure should not be solely relied on to drive price. What does matter? The answer is dependent on whether you are the seller or the buyer. Let’s start with the seller.

Have you ever watched the Antique Roadshow or at least seen a clip of the show? Ever noticed what the experts say when they are giving a dollar figure to the person who brought in the 18th century Chinese rhinoceros horn cups (really). In this specific instance they state auction value. At other times they state retail value or insurance value. There’s differences in those definitions but all of them revolve around the same concept – how much money someone will pay the owner to part with the item. For the seller of a dental practice, that’s what matters. How much you can get for the practice.

What a buyer should be looking for is the return on investment. The value of dental practices is almost entirely made up in their cash flows. The assets of the business have little value (secondary market equipment value is much much much much much lower than new purchase cost). The “asset” with the greatest value is goodwill but the value of goodwill is usually derived from the cash flow of the business which brings it back around to cash flow being the predominant driver of value. What a buyer needs to be concerned about is what kind of cash flow they will receive from the practice and what risks exist to the sustainability of that cash flow.

Do not get too attached to valuations. If you are selling a practice, use it to assist you in establishing an asking price. If you are a buyer, use it as a starting point to determine what return on your investment you could expect to receive.


The Value of Process

Whenever I’m in a conversation with someone and my job comes up I’m almost invariably asked if part of what I do is help people budget.  Usually I respond with a zealous, NO!!!  I have no interest in telling people what they should be spending on their hobbies or caffeine consumption.  And the good news is my clients do not want me to tell them. We are on the same page.

What I do encourage, and help, my clients to do is to go through the process of backwards budgeting. This is what I like to call the spend what is leftover strategy. The process begins by establishing your financial goals. Typically the goals revolve around retirement but it can also be larger expenditure items.  For example, I’ve walked clients through this planning to prepare for purchasing real estate for their practice.  Whatever the goal, or goals, the process is the same…define how much it is going to cost and what kind of savings it will take to pay for it.

At the end of the process what you have is a number.  This number now becomes sacrosanct.  As long as the income is coming in that amount of money goes towards the goal (or goals).  Then you look at what you have left over. That’s where your personal budgeting can begin.

I’ve simplified the process for illustration purposes.  There are a lot more layers of complexity to this process, or at least there should be.  Accurately defining and prioritizing your financial goals is a process in and of itself.  Maximizing the saving dollars through tax advantaged planning (business owners can really make some money here) and cost benefit analysis on financial products should also be considered.

But the value is the process itself because you have goals and an in-depth knowledge of what you need to do to accomplish them. The planning you have completed now sets parameters for all your other financial decisions.  Everything else flows through the lens of this process.  How much money can we spend on a home?  What about a vacation?  That renovation project?  Those decisions can now all be run through this plan.

In my experience, when people do not go through this process and these parameters are not established than they are setting themselves up to make poor or – at best – inefficient decisions.  Ever seen someone blow through $600,000 of income per year?  I have.  What about a large inheritance…that too.  In all these cases a plan was never developed.

Granted, those are extreme examples but it does speak to the point that if a plan isn’t made than money will not be allocated as effectively.  If you don’t go through this process you may not blow through all your income but decisions will be made haphazardly.  Saving for retirement or college for children will be done as money is available.  When it comes time to make that business investment the cash needed won’t be there.  You may miss years, and thousands of dollars, of tax advantaged planning.  And then years down the road you have less money or you had to settle for a worse deal than if you would have simply taken the time to plan.

Go through the process.   It is worth the time and will payoff immensely years down the road.

A Ski Resort in Florida

In his book, The Most Important Thing, Howard Marks recounts the fictional tale of a man with an insane business idea: open a ski resort in Miami.  Competition would be sparse, to say the least.  The man invested money in the land, infrastructure and ski lifts.  His first season in business a blizzard hit bringing 12 feet of snow to Miami.   The man made a nice profit.

Was his decision to put this resort in Florida a good decision?  He made a lot of money, right?  Then it must have been a good decision.  Well, actually, no.  Any sane person would conclude this man made a terrible decision but was impossibly lucky.

While the story is fiction and the results are exaggerated this scenario plays out all the time.  People have a tendency to judge decisions based on outcome…a decision resulted in a good outcome so it was a good decision or, a decision resulted in a bad outcome so it was a bad decision.  This type of decision making is commonly called outcome bias.  Outcome bias represents one of the most challenging aspects of finance and investment decision making.  Just because something worked does not mean it was a good decision (like our guy in Florida).  And just because something failed does not mean it was a bad decision.  Outcomes alone do not tell the whole story.

When examining results there can be many unseen factors at play and a lot of times things that seem like good decisions can simply be chalked up to a good dose of luck.  That friend of yours who made a lot of money in real estate and is trying to get you to jump in…maybe they got lucky.  They happened to buy the right property at the right time and was able to sell it for hefty penny.  That does not mean it is a good thing for you to do.

If financial and investments decisions can’t be simply made by looking at outcomes how does one go about making good decisions?  Through quality decision making processes – processes that evaluate the merits of the situation.  Do not rely on the outcomes experienced by friends, family members, co-workers or some guy you read on an Internet blog (irony?).  Go through the process of understanding what is involved.  Understand why those people succeeded or failed.  Understand the risks involved.  Understand the consequences if it fails.  Look into the probability of failure.  Ask questions…lots of them.  Do not just assume things will work out (or won’t work out) because they did for someone else.

How do you personally make financial decisions?  Is there a process in place?  The Florida ski resort is a cautionary tale in decision making.  Don’t just look at results.  Dig a little deeper and go through the process of evaluating the situation.  And be honest with yourself about whether you even have the ability to assess the situation.  Humility goes a long way in decision making.  If you don’t know how to make the decision find someone who does.