Inflation in Canada Over-estimated by CPI

Those prone to suspect that the government low-balls inflation estimates can rest a bit easier. What a nice surprise to come across Measurement Bias in the Canadian Consumer Price Index, written in 2005 by Bank of Canada economist James Rossiter. It examines the various biases that affect published CPI numbers and concludes that CPI has over-stated the actual cost of living increase in recent years by about 0.6% per year. In other words, instead of the approx. 2% annual inflation CPI says we have been seeing, the real number is closer to 1.4%. That helps those on fixed budgets.

Of course, CPI is an average and no individual actually buys exactly the basket of goods in CPI, so some caution is in order. The sources of bias cited in the paper can perhaps help one in making an adjustment:

• commodity substitution bias occurs, for example, when a real consumer notices a jump in the price of beef and starts buying pork instead (Michael James noticed a "swine flu special" on pork) but CPI continues to track beef the amount of beef consumed exactly as before. If you think pork and beef are not really equivalent, that such substitution is in effect a loss of real value, then subtract 0.15% from the 0.6% number above.
• outlet substitution happens when you buy the same designer jeans at lower price at the outlet store instead of the high-priced retail store with the loud music. CPI takes a while to catch up to this shift retail patterns. Think part of the pleasure of the jeans is the music? Take away another 0.1%.
• quality change bias might best be characterized by considering quality of the average car of 25 years ago compared to today. I for one prefer today's cars. If you really enjoyed the breakdowns and rust of bygone days, you can say inflation is not really lower by another 0.15% compared to CPI.
• new goods, new services and new brands bias happens when the increased in standard of living resulting from the introduction of such new products and greater choices is not reflected in CPI. If you think such things as microwaves and cell phones have not enhanced your life, then take away 0.2%

The paper mentions on page 22 that estimates in other countries show a similar but slightly higher over-estimation - the USA around 0.8% and the UK 0.35 to 0.8%.

Overall, I am most skeptical about the first bias, commodity substitution, since when I am forced by price to buy downward, it isn't the same value, though I can imagine other substitutions where I would not care. The other biases do ring true enough, so I'm happy to accept that CPI really does over-state inflation.

Self-Regulation by Financial Advisors on Wrong Track

Fellow blogger and former financial advisor Preet Banerjee at WhereDoesAllMyMoneyGo has brought to my attention that financial advisors are threatened by more government regulation as a result of recent scandals and rip-offs by advisors. It is being suggested they self-regulate. Certainly preventing fraud by advisors is a primary concern because the client loses everything when that happens.

Whether it's government regulation or self-regulation, criminal fraud is not the only problem advisors have. The other big, somewhat hidden issue is what might be called abuse of fiduciary duty. Though seemingly not illegal, too many so-called advisors are nothing more than sales people in disguise, who fail in their moral obligation to do best by their clients by investing them in high-MER mutual funds on the basis of trailer fees and who provide little of value in the way of investing or financial advice. Advisors can be extremely beneficial for the investing public, but if the relationship is to be based on trust as the article says, then they need to work in the client's best interest first and not secondarily after their own fee income goals are met.

Stocks and the Long Term - Some Solid Research to Consider

It is a cliché that one should only invest in stocks if one has a long term horizon but often this advice is dispensed with a definition of long term using a number pulled out of the air or even without any number at all! Is long term five years, 10, 15, 20, 25, 30?

Thanks to the fine IndependentInvestor.info website (you will need to register to see content but it's all free and unbiased info) for uncovering some credible answers. As one should expect, there isn't a single number but a sliding scale of declining risk with extension of years invested. How Long is a Long-Term Investment? The 1 in 9 Rule summarizes the paper by economist Pu Shen of the Kansas City Fed, available at How Long is a Long-Term Investment.

Some of Shen's Discoveries

• showing risk on the basis of a one-time investment at the start (the typical "if you had invested $10,000 in Fund X in 1970, it would be worth $ZZZZZ today") understates the chances of losing money; the more realistic scenario, where an investor puts in money gradually over time, which he calls repeated investments, took at least 24 years before a positive real return on stock investments was always achieved. Stocks = the Center for Research in Security Prices Index, an index for the entire U.S. stock market from 1926 to 2002. The one-time method always showed positive returns after only 19 years, a difference of 5 years. The reason is the net effect of two opposite forces - time diversification (which reduces risk) and shorter effective holding periods (which hurts). Check out Shen's chart 2 below
  

• stocks never under-performed bonds (US Government 20 year bonds) after at least 26 years holding period (repeated investment method used), not exactly a mere blink of an eye.
  
• though the risk of stocks declined progressively with longer holding periods, the odd time they did have poor results, and even after 20 years the worst stock vs bond under-performance was still quite a hefty difference - check out Shen's chart 5 below. Sobering data, I'd say.
  

• quote: "Worse than investing in stocks right before a market crash is liquidating stocks shortly after the crash." (He says this in the context of people needing to retire then but of course a retired person does not typically spend all his/her money, or cash everything out, the day of retirement.) The worst possible 20 year holding period for stocks was ending in 1974 but from then on, there was a bumpy but ever-upward recovery. Moral of the story: hang on, don't panic, don't sell everything, try to sell as little stocks as possible after a crash - viz 2008 crash and 2009 recovery to date.
• even after 25 years holding period bond investors only beat inflation 34% of the time!! Now that's what I call risky. Stocks always beat inflation over 25 years and beat bonds 99.8% of the time. Stocks for the long-term indeed.

She shows that it is very misleading and harmful to define the long term for stock investment as five or even ten years, such as this article does. One should also keep in mind that Shen's paper did not factor in the annual fund expense fees and tracking error that an actual investor would face. This would lower returns and extend necessary holding periods.

The TTC - What Is It with Government and Cost Control?

The Toronto Transit Commission is about to raise rates 10% and this Toronto Star article describes how about-to-be-poorer citizens have been accumulating tokens to lessen the impact of the fare increase. The implication is that these people are somehow blameworthy for doing so.

Nowhere does there seem to be a discussion of the justifiability of the rate rise. Why does the TTC history of rate increases going back decades illustrate a long-standing case of inability to keep fares in line with inflation? Look at this graph

taken from a link at TTC, the Costly Way, an interesting account of the TTC experience from a Toronto resident. Using the year 2000 as the base, the TTC's cash fare increase to the 2010 rate has been 4.1% compounded, while the Bank of Canada inflation calculator says CPI has gone up 1.95%. That's more than double the rate of inflation! Since the TTC is a public body, profit gouging cannot be blamed, it must be out-of-control costs, perhaps (?) due to an embedded bureaucracy at a monopoly service. If there's anyone blameworthy, looks like one must also include the TTC and the succession of City Councils that have overseen this chronic mess.

Worthwhile Rule Changes to Ontario Locked-in Retirement Accounts

In what I would call an incremental but still very beneficial improvement, the Financial Services Commission of Ontario announced a few months ago in O.Reg. 209/09 that holders of LRIFs or old and new LIFs will be able, as of January 1, 2010, to unlock up to 50% of the account on a one-time basis. The unlocking can be a straight taxable withdrawal or a tax-free transfer into an RRSP or a RRIF.

O.Reg.209/09 also changes the maximum withdrawal calculation to either the old formula (under which the percentage allowed changes every year and is published in December by the FSCO - e.g. 2009 tables here in Schedule 1.1), or the account's investment return for the previous year, which ever is greater. In good market years with strong returns, that could increase the amount that can be withdrawn or transferred tax-free into a RRSP or RRIF. The annual maximum withdrawal/transfer is separate and additional to the one-time transfer.

These measures add flexibility and control for the investor since more can be withdrawn as needed or put into RRSP/RRIF accounts that are still tax-deferred but which have no limits on withdrawals. It also allows people like me with a number of separate locked-in accounts to consolidate by moving the Ontario plan assets into another existing account.

When one has multiple accounts, portfolio rebalancing gets awkward and complicated. I anticipate being able to reduce my Ontario LIRA, which I will soon convert into a LIF, to the point (in 2008 that point was officially $18,520 according to FSCO's Form 5, which is used to apply for the transfer) where I can ask for the remainder to be transferred into my RRIF under another rule which allows a 100% withdrawal/transfer for those over 55. The small amount rule applies only to the total of Ontario-regulated locked-in accounts so those who also have accounts regulated by other provinces or the federal government (hooray, that's me) are more likely to benefit.

FSCO's L200-302 details all the rules as of May 2008 regarding Ontario locked-in plans, including provisions for early withdrawal due to shortened life expectancy, becoming non-resident of Canada and financial hardship.

Book Review: Yes, You Can Time the Market! by Ben Stein and Phil DeMuth

Market timing is normally not my thing but after reading this book I accept that, Yes, you can time the market with Stein and DeMuth's method. The only thing is the method requires that you have the patience of Job and the lifespan of Methuselah. What investor would be willing to not buy / not invest in the market for 17 years waiting for the buy signal to begin flashing? The book's buy signal test was a red "no-go" for the whole time between 1984 and 2001, a period during which the S&P 500 (used as the US market proxy throughout the book) experienced huge unprecedented gains. Similarly, the twelve years between 1954 and 1966 was another long period for an investor to sit on cash or money market accounts according to Stein and DeMuth . The authors' goal to show conservative investors how to make money in the long run is truly vulnerable to Keynes famous quip that in the long run, we are all dead.

The Yes market timing method works as follows:

• objective - determine when the US market is over-valued, in which case don't buy, or under-valued, in which case buy
• assess over-/under-valuation with four real after-inflation metrics: price, price/earnings, dividend yield, earnings yield vs bond yields, price to sales, price to cash flow and Tobin's Q (a measure of fundamental value of companies; each individual metric works but several simultaneously saying Yes works even better
• the current value of the metric is compared against the trailing 15 year average
• valuation is applied against the market index only - the S&P 500; it is explicitly not proposed to be used for individual stocks
  
• wait ten years or more (the longer you wait, the better, though their testing only goes up to twenty years) to achieve far superior returns than you will get whether investing at random as an average of years or on a continual dollar cost averaging schedule.
• when signals are saying are saying No, it only means don't buy, it doesn't mean sell; you keep whatever stock investment you have and simply wait till the next buy signal.
  

This last point has caused other reviewers (e.g. at Amazon) to accuse the book of not really being about market timing. To be a market timing purist you must be jumping in and out and in etc, it seems. Similarly, the book violates another cliche image of market timing, that it is only about short-term timing in days, months or perhaps year to year, but not decades, which is the case here.

For the most part, the analysis and comparisons make a convincing case for the authors' thesis. Using 100 years of market data, rolling periods and looking at results after 5, 10, 15 or 20 years of holding after purchase builds confidence that the data was properly compiled. There is also economic logic supplied as to why the indicators should work.

Where the argument isn't convincing is the comparison of dollar cost averaging vs their market timing using 1977 as a starting point. In 1977 the buy signals were flashing so the market timer got their money into the game a lot sooner than the DCA investor. With a subsequently rising market, the market timer was bound to win.

It is very useful for the book to contain all the year by year tables of past signals, both buy and don't buy, along with subsequent results of the 5-20 year holding periods. That reveals a key fact - the market timing system did not produce great returns every time it said buy (e.g. buying in 1973 produced only a 251% gain 20 years later) , just as buying in many years when the system said it wasn't propititious to buy produced outstanding returns in subsequent years (e.g. buying in 1982 gave off a gain of 582% after only 15 years). The system appears to produce better returns on average.

Chapter 8 titled Using Market Timing contains a lot of very sensible cautious advice for investors, the antithesis of a get rich quick mentality that one might suppose a book on market timing might present - e.g. "Never make a "bold" investment decision; Don't think big; Don't make any sudden moves".

The book was published in 2003 so the data series stop too soon for us to find out what any reader wants to know - what is the situation today, is the market over or under-priced and is it time to buy? Fear not, the authors have continued to update the metrics on the book website http://www.yesyoucantimethemarket.com/index.html. As of Oct.30th, 2009, it shows for the S&P 500 - Price - Green! BUY!; P/E Ratio Red! Don't Buy!; Dividend Yield - Green! Buy! (They say also that data for several other indicators is no longer available.) That should mean it's a good time to buy.

Stein and DeMuth posit that their method should work on other markets, though they haven't tested. It might/should given its essence is to identify times when a market is clearly under-priced in historical terms. Of course, the method also rests on the assumption that the future will be like the past, that reversion to past means will occur.

My rating: 3.5 out of 5 stars.

Foreign Diversification Cognitive Dissonance

Take a look at this chart and tell me what the heck is going on?

Isn't diversification into foreign equities supposed to reduce portfolio volatility and increase returns through non-correlation and rebalancing? Yet the simple all-Canadian portfolio with 5% T-Bills, 30% All Canadian Bonds and 65% TSX Composite Equities would seem to have done about the same as an international portfolio with the same fixed income but with equity holdings of 25% TSX, 15% S&P 500, 15% MSCI EAFE developed country and 10% Emerging Markets. The cumulative compound return of the two portfolios after 22 years ended up almost identical - the Canadian portfolio at 250% and the International at 256%.

Twenty two years is starting to be a long time waiting for international diversification to help a Canadian investor. Is the data somehow wrong? I used financial advisor and frequent Financial Webring contributor Norbert Schlenker's downloadable time series spreadsheet from his Libra Investment Management website. The data (unique and no doubt compiled with considerable effort) has been adjusted for inflation and converted back into Canadian dollars from unhedged foreign holdings.

This graph goes against the conclusions in such classic books as Roger Gibson's Asset Allocation (my review) to the effect that international diversification helps considerably. Gibson figured things in US dollars instead of the Canadian dollars in this data. Is Canada somehow special and its equity market a mirror of an international portfolio?

Condo Real Estate

Author and speaker Gail Bebee of No Hype-The Straight Goods on Investing Your Money fame yesterday sent out her e-newsletter (just go to her website to sign up) with a link to an excellent guide to condo buying, whether as an investor or an owner-resident, by financial advisor Kurt Rosenstreter. Having once been a condo owner and board member, I can vouch for the sensible advice he gives. If the rental costs don't even cover interest on a mortgage these days, let alone taxes and condo fees, as in one example he cites, then it sure is time to rent rather than own a condo.

Parallels between Love and Investment

Renaissance man Ben Stein ruminates about the similarities between a successful approach to love and to investing in the delightful Lessons in Love, by Way of Economics on the NY Times website.

One thing he forgot to mention is that being good at one does not automatically make you successful at the other!

Time for Portfolio Vaccine against Swine Flu?

Last year it was the banks the precipitated a market crash. This year will it be swine flu?

All of a sudden, swine flu is in the economic news. Today, GlobeInvestor's H1N1 sick days could hamper Canada's fragile recovery notes the potential for swine flu to make the economy sick. At the same time, CBC's headline article A perennial bull turns negative about the pessimistic outlook of market commentator Josef Schacter includes swine flu as a negative point in his outlook.

Perhaps my view is coloured by what I learned during the brief stint I spent in a former job helping to plan for a flu pandemic, but I am a bit worried too for a couple of reasons. First, there is the reality of a pandemic. By definition a pandemic directly makes sick an awful lot of people, up to a third of the population during the peak of an outbreak. Whether its kids or adults falling sick, a lot of people may take time off work to minister help. Whack! Take that, economy and stock market.

As bad as the real effect is, the panic effect could be worse. If stories of food and fuel shortages start appearing in the press, who knows what panicked people might do. Whack again, economy and stock market.

The key to avoiding all this is control of the outbreak. Thankfully, there is a vaccine, whose effectiveness is unknown but it could still work well if enough people are vaccinated according to Swine Flu Vaccine Predictions from the UK National Health Service. Enough people is a huge number - "... only 70% of the population would need to have the vaccine to reduce the impact of the virus to that of a relatively mild seasonal flu epidemic". 70% means about 0.7 x 33 million = 23 million people in Canada need to be vaccinated but the total so far is only 1 million according to the Montreal Gazette. The reference to striking increases in flu activity is alarming. Official statistics on actual infection rates are hard to get. The national Public Health Agency seems to publish only the number of deaths, which thankfully is low, but that doesn't help too much since the main impact of low-mortality rate swine flu is sickness not death. We are left with Google's Flu Trend indicator, which it claims tracks actual cases quite accurately. Below is a screenshot of today November 3, 2009.

Yikes!, an almost vertical upward trend, except for Quebec, which is different as ever and totally blank for some unexplained reason. I've been watching it for the last month as the country turned bright red, not an indicator that the Liberals have finally won an election, but the sign that things have gone as bad as the scale goes.

For an investor, what happens in the USA matters greatly and the Google trend there is pretty high too. The World Health Organisation provides weekly updates on its H1N1 portal for all parts of the world and swine flu seems to be advancing everywhere to differing levels of intensity though the data's usefulness is suspect since many countries have stopped reporting individual cases. The Pan American Health Organisation publishes a very cool inter-active, but useless (due to stale data), map of swine flu.

A portfolio equivalent of vaccine in this case is to use put options on market ETFs such as XIU in Canada and VTI in the USA to shield against a market downturn. That protection can be secured by buying a 90 day put. A flu pandemic might last a few months, it doesn't last forever and since the death rate is low (barring an unpredictable mutation that changes it) for this swine flu, the bad effects also won't last forever either. Is it still worth buying put options?

Given the relatively high likelihood of a temporary flu-induced market sneeze, it is very tempting to play the speculator and really go "whole-swine" into puts. On the other hand, since I expect to be invested in the market for many years hence, the dip will not harm me in the long term.

What to do, what to do ... just accept the discomfort since the chances are low for a fatal infection to my portfolio, or try to make some money predicting the short-term future.