Episode 122 – Comments on Current Financial Affairs with guest Charlie Smith

Episode: 122
Originally Aired: April 22, 2015
Topic: Estate Strategies Deliver Clarity and Peace of Mind with guest Bob Keebler, CPA, MST, AEP

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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Comments on Current Financial Affairs
James Lange, CPA/Attorney

Episode 122

Please note: Some of the events referenced in our audio archives have already passed. Please check www.retiresecure.com for an updated event schedule.

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TOPICS COVERED:

1. Guest Introduction: Charlie Smith
2. Easing Fears about The Stock Market
3. The Equity Premium
4. The Effects of An Aging America
5. Inflation or Deflation Trends
6. Sticking to the Plan
7. The Shortcomings of High Frequency Trading
8. Deflation

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1. Guest Introduction: Charlie Smith

David Bear:  Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks.  I’m David Bear, here in the KQV studio with James Lange, CPA/Attorney and author of Retire Secure!, The Roth Revolution (Pay Taxes Once and Never Again), and his newest book, Retire Secure for Same-Sex Couples.  Turmoil is a constant in investment markets, which is why this week, we’re glad to welcome Charlie Smith back to The Lange Money Hour to provide some perspective on the situation.  Executive Vice President and chief investment officer of the Fort Pitt Capital Group, Charlie and his perspectives on the economy and markets are widely regarded, and he’s appeared on CNBC, The Wall Street Journal and many other financial media.  He’s written and lectured on these subjects over the course of his career, which began in 1983, and has included leadership roles with several regional Pittsburgh investment firms before 1995, when he became founding partner of Fort Pitt Capital.  There are a lot of topics on today’s agenda, and Charlie’s always at his best when he’s answering questions, so listeners, since the show is live, please feel free to call in and join the conversation, KQV, at (412) 333-9385.  And without further ado, I’ll say hello, Jim and welcome back, Charlie.

Jim Lange:  Welcome, Charlie.

Charlie Smith:  Well, thank you!  Good to be here again.

2. Easing Fears about The Stock Market

Jim Lange:  Before we get into the meat of the program, I do feel honor-bound to present open disclosure.  Usually when I have a guest, other than perhaps plugging their book if I like the book, I don’t have any financial interest in the guest or the guest’s company.  That is not true with Charlie Smith and Fort Pitt Capital Group.  I do have an arrangement with Fort Pitt Capital Group where if a client comes to us first, and then our firm does the things that we do, like Roth IRA conversions, how much money can you safely spend, what’s the best Social Security strategy, what’s the best income tax and retirement strategy, what’s the best estate planning strategy, etc., the stuff that we have been doing, and they would use Fort Pitt Capital Group for the actual money management and all of the things that Fort Pitt Capital does so well and they pay a combined fee of one percent or less, depending on how much money is invested, to Fort Pitt, and then Fort Pitt then, in turn, pays me a percentage of that one percent.  So, therefore, if somebody likes what they hear about Charlie and me, and you’re interested in that combination, and you do go through our firm, I do have a financial interest, and I feel it’s only fair to disclose that interest.  So, with that disclosure, I’d like to head into the meat of the program, and more and more, as I’m talking to some cynical clients and prospects, I hear people just don’t have any faith in our President.  They certainly don’t have faith in our Congress.  They’re losing faith in the banks and the Feds and the Treasuries, the auditing department of the big CPA firms, the lack of agency.   So, a lot of people are saying, “Hey, you know, I’m just really uncomfortable investing in the stock market right now.”  Charlie, how would you respond to these concerns?  And particularly, if you add in some of what’s going on in the world with terrorism and climate change and everything else, how would you respond to somebody who’s just very uncomfortable being in the stock market for a major portion of their investments?

Charlie Smith:  Well, Jim, the word that you used in that question, which is key, and really the key to the answer is ‘uncomfortable.’  Successful investing is never about being comfortable.  You can evaluate what’s happening in the world.  You can measure prices.  You can evaluate businesses to try to decide what they’re going to earn.  You can try to decide which way interest rates are going to go.  You can go through all the machinations that get you an answer about what you can rationally expect in the world economy, but when it comes down to putting your money out there at risk, it’s never a question of succeeding because you’re comfortable.  There’s a difference between making a rational decision about what a business is worth and actually finally making the step of putting your money out at risk, because the best time to invest, bar none, is when the people around you, and perhaps you yourself, are most uncomfortable.  We make the assumption that over time, the position of equity ownership, owing a piece of a business, is the best way to build wealth.  And that process takes time.  The process of compounding wealth takes a minimum of three to five years.  So, from our perspective, if you’ve done the work and evaluated the business, it almost doesn’t matter what’s happening around you in terms of whether interest rates are going up at the time, or the stock market is rising or falling at the time, or Congress is in a great big fight over some issue at the time.  If you’ve decided that you’ve got a well run business that you can purchase at a reasonable price, and you can afford to hold onto it for a minimum of three to five years, it almost doesn’t matter what the current investment weather forecast is like, because chances are, if you let your emotions drive the decision and you’re comfortable, you’re going to pay too much for that investment.

3. The Equity Premium

Jim Lange:  Well, this relates back to something that you have always talked about for years, and it would probably be worth listening for the listeners.  You talk about the equity premium.

Charlie Smith:  Yes.

Jim Lange:  Can you tell our listeners what the equity premium is and why they should invest rather than just have money in CDs and fixed income?

Charlie Smith:  Sure.  The equity premium is the additional return that comes to you as an investor for taking the risk of ownership.  You can measure it every day in the marketplace by taking what is viewed as the risk-free rate for a long-term investment, and that benchmark today is the long-term treasury rate.  You can use either a ten-year or a thirty-year treasury.  So, that’s the return you would get, no credit risk for lending your money for an extended period of time.  You’re going to measure that return against the potential return for investing in a business where the returns are not guaranteed in any way.  You can build a portfolio of businesses that ups the odds that your returns are going to be positive over time, and that’s exactly what we do.  We take a blended measure of the expected return from a portfolio of companies and measure that against the risk-free rate.  Subtracting the risk-free rate from the expected rate of return from your portfolio of companies gives you the equity premium, and that equity premium goes up and down over time.  When interest rates are very high, the equity premium is small.  When interest rates are very low (as they are today), the equity premium is higher.  The equity premium rises when stock prices are low.  The equity premium falls when stock prices are high.  So, the equity premium is the additional return you get from taking the risk of owning a business, and, in this case, of owning a portfolio of businesses.

Jim Lange:  All right, and ownership of a business is actually owning stock.

Charlie Smith:  Yes.

Jim Lange:  You’re owning a business…

Charlie Smith:  Yes.

Jim Lange:  …as opposed to a bond or a fixed income when you are basically lending money to a business or a government.

Charlie Smith:  Exactly.  You mentioned CDs earlier.  A CD is simply a loan that you make to a bank.  The bank, in turn, takes the money that you’ve given the bank and lends it out to a business.  Capturing the equity premium is all about simply making an end run around the bank and going directly to the business, giving the business equity capital rather than a loan.  So, you’ve sort of disintermediated the bank when you own a stock.  You’ve cut the bank out of the equation, and therefore, you’re going to earn a higher return.  The returns aren’t guaranteed, but if you’ve built a diverse portfolio of businesses, you’ve created very high odds that your returns are going to be positive.

Jim Lange:  And over a long period of time, it’s just astounding what the difference is.

Charlie Smith:  Well, and think about when you say over a long period of time, our society is literally structured so that the people who take the risk of going into business have to receive a greater return over time.  If they don’t receive a greater return than the risk-free rate, that means interest rates are too high and they’re going to fall.  So, you know, the returns are out there.  You know, millions of people go to work in this country every day to try to add value to their enterprises.  We have very liquid and deep capital markets that allow us to participate as owners in a myriad of companies.  We can build a diverse portfolio of businesses that represent ownership in hundreds of companies, if you want to have that many.  But the point is that you’re going to capture that equity return in a diverse way, and it allows you to sort of make an end run around these other financial intermediaries.

Jim Lange:  And I guess some people might see that as increased risk, but by doing that and getting a higher return over time, you’re also defending against, let’s say, the silent risk of inflation.

Charlie Smith:  Well, that’s partly true.  What are your risks when you put your money out at equity, when you’ve built a portfolio of equities?  The prices are going to move around from day to day, okay?  There’s a chance that some fraction of the businesses that you own are going to fail.  Unless literally our society collapses, you know that not all those businesses are going to collapse, and particularly if you’ve built a portfolio of businesses that have a solid long-term operating history of profitability, you know you’ve upped the odds that a large majority of the companies in your portfolio, over time, are going to earn more than the risk-free rate for you.  So, you’re going to have a positive return that is greater than what you could get if you lent to those companies.  If you lend money to those companies with a corporate bond, you know your return is going to be less than what the company earns on its own equity.  That’s the job of the corporate treasurer, frankly.  If he has bonds outstanding, his job is to pay off those bonds at the lowest rate possible and maximize the return for the equity holders.  There’s no such thing as a bond option.  It’s all about stock options.  The equity returns always earn the highest return, and it’s the job of the treasurer to pay off the bonds at as low a rate as possible.  You need to know what’s behind the piece of paper that you own.

Jim Lange:  All right.  Well, let’s even say that you have, either on your own, or, in your case, with excellent money management skills, picked out the series of different high quality companies, and I know that you like good companies, good brand names with a history of profitability, often with low price earnings ratios.  So, let’s say that you’ve picked out some of these, but the economy changes.

Charlie Smith:  Umm-hmm.

4. The Effects of An Aging America

Jim Lange:  So, you get a futurist like Harry Dent.  And Harry Dent says, “Hey, look at the demographics.  We are an aging country.  We’re going to be like Japan.  We’re going to have all of these old people that need to be supported with Social Security, but there’s not going to be that many young people who are going to be working who are going to be adding value, and we might even be headed for a deflation.”  He talks about the United States that just keeps pumping money into the system with the low-cost rates, and he would probably have you hide your head like an ostrich.  And then, he’s not a total crank, and I guess if you constantly predict doom and gloom, every once in a while, like 2008, you’re going to be right.

Charlie Smith:  Correct.

Jim Lange:  How would you respond to him and his followers?

Charlie Smith:  Well, first of all, he’s an excellent demographer.  To a certain extent, demography is destiny.  You know, the statistics that tell us what age cohorts are largest in the system, you know, trends in terms of how big the labor force is going to be are very useful.  But oftentimes, the future doesn’t quite work out the way you expect because…and the best example of this, the last ten or fifteen years is what we’ve seen with the increasing size of the labor force in China.  I believe we have deflationary forces around the world because we’ve been adding fifteen million new labor force participants just in China alone, each of the last ten to twelve years.  So, the demographics can tell you that the U.S. population and the European population and the Japanese population is aging, and therefore, there’s a chance that a society might not be able to be as productive.  And frankly, that would argue for greater inflation because you’ve got a static demand from all these older folks, but a smaller productive younger cohort at the bottom that’s producing.  So, you know, an aging population, all else equal, would tend to be more inflationary, but we’ve instead had deflation the last ten or fifteen years around the world because we’ve had so many new entrants to the worldwide labor force.  And that’s really the sort of defining trend demographically in the last, you know, ten or fifteen years in the world is this push towards a new and rising middle class and people being more productive in the industrial and technological economy.

Jim Lange:  Well, I know in the past, I’ve heard you talk about the worldwide labor force, and you have made it a big deal that the United States can be a lot more successful if we open our markets…

Charlie Smith:  Umm-hmm.

Jim Lange:  …and other countries open their markets to us.  So, therefore, some of their labor can serve some of our aging population.

Charlie Smith:  Sure.  Yes.

Jim Lange:  And one of your fears was, in effect, that the United States would go into an isolation mode…

Charlie Smith:  Yes.

Jim Lange:  …and kind of, again, use the ostrich approach where they’re not going to be open to other people’s labor and markets.  Have you changed your tune on that, or is that still the same thinking and maybe even more important in our aging demographics?

Charlie Smith:  Well, I really haven’t changed the foundational concept of ‘open markets are good.’  We have seen, in the last ten or twelve years here in the U.S., a stagnation in real wages, partly due to the displacement of U.S., particularly manufacturing, workers by workers overseas.  So, that’s had a depressing effect on wages.  Partly, it’s an arbitrage.  The wages and standards of living of literally billions of people around the world who formerly lived in third world conditions, those standards of living have been rising in an accelerating rate, and part of that benefit has sort of come out of the hide, so to speak, of U.S. manufacturing workers.  But if you take the entire system, in terms of the standard of living of the average person within the entire system, it’s been elevated.  So, there is a net benefit to the entire system from these open markets.

David Bear:  But there’s another issue here which, you know, is not just new people entering the workforce.  We also have robotics…

Charlie Smith:  Yes.

David Bear:  …and different kinds of systems that don’t require as many people to accomplish the same or more than they used to.  So, how does that figure in?

Charlie Smith:  Well, that’s really sort of the ace in the hole for the entire world’s population.  When we implement systems and software, robotics, you know, automated trading is one example.  When all this automation gets implemented and we’re basically taking human labor out of the system, the entire system becomes that much more productive, and that is a net benefit to the entire system.  But unfortunately, initially, when this process is first implemented, the benefits flow disproportionately to the people doing the implementing.

David Bear:  Umm-hmm.

Charlie Smith:  We’ll talk later a little bit about high frequency trading and how some of the benefits of the new automated trading system, which drove down the cost of trading securities immensely.  The benefits initially flow to the people who build the system, which is proper.  There should be incentives for people to build these new devices and systems which make the world better off and more productive.

David Bear:  Well, this is probably a good time to take a break.

BREAK ONE

David Bear:  And welcome back to the Lange Money Hour with Charlie Smith and Jim Lange, and before we get back into the show, I just wanted to congratulate you, Jim.  I know that Retire Secure for Same-Sex Couples is now just about out the door, and you sent out a press release earlier this week and it got picked up by 175 outlets.  That’s pretty significant.  So, we know there’s going to be a lot of good things coming, but I just wanted to share with listeners one of the other high quality promos and blurbs you’ve gotten recently about the book: Jane Bryant Quinn, who, as we know, is a guest on the show, but more importantly, a syndicated personal financial journalist, wrote, “Jim Lange has written another wonderful book for all committed couples, same-sex or opposite sex, who are considering marriage.  Once you reach retirement age, marriage becomes the best way of preserving income and wealth for the partner who survives.”  Pretty high praise!

5. Inflation or Deflation Trends

Jim Lange:  Well, you can’t get much higher than Jane Bryant Quinn and Ed Slott.  But anyway, thank you.  So, continuing on, Charlie, you were one of the few people who was saying, “Hey, there isn’t going to be wild inflation.”  Everybody else was going to say, “Hey, with our economy today, we’re spending so much money that we don’t have.  The only way we’re going to ever pay for it is to just print a lot more of it, which means that there’s going to be inflation.”  And that’s what I kept hearing again and again and again, and then I would hear you talk, and you said, “Well, I’m not too worried about inflation.”  And, at least up to now, certainly in the last, let’s say, six years, you have certainly been vindicated.  Could you say why you didn’t think there was going to be a significant inflation, and what your projection for inflation or, as Harry Dent thinks, we are going to have a deflation in the future?

Charlie Smith:  Sure.  I’ll comment at the end a little bit about why deflation can actually be a good thing for an economy, but on the inflation question, we weren’t sure that we weren’t going to have inflation.  Back in the latter part of ’08 and early 2009, when the Fed was really aggressively beginning the QE1 (Quantitative Easing) and aggressively cranking money into the system, we were actually concerned that we could have inflation.  But in the latter part of 2010-early 2011, we saw the credit statistics, which showed that the vast majority of the money that the Fed was cranking into the system wasn’t leaving the banks.  It was being held as reserves at the banks.  So, in early 2011, latter part of 2011, the monetary velocity, which is the number of times a dollar turns over in the economy, the lending statistics were all indicating that this money was trapped at the banks.  It really wasn’t being lent out into the economy, and to have inflation, you need to have credit growth.  And if you look at the consolidated balance sheet of the twenty-five largest banks in this country today, the line on the balance sheet marked ‘loans and leases’ is still smaller than it was the quarter that Lehman Brothers failed.  So, the banks have been taking in all these excess reserves from the Fed and not lending them out.  It’s as if the Fed is gunning the engine and the banks can’t find the gearshift.

David Bear:  They kept their foot on the brake.

Charlie Smith:  Or even worse!  Right, exactly.  So, the point being that when we first saw the Fed aggressively trying to stimulate with all this money creation, we thought, “Okay, there’s a risk of inflation,” and that’s really when gold took off in the latter part of ’07 and ’08.  And so, we said, “Okay, we need to monitor these statistics,” and then, a couple years after that, we began to see that it just wasn’t working.  And so, all the credit creation wasn’t happening, so we said we’re not going to have inflation.  And I think the gold market, it finally began to recognize it.  You know, in the last couple years, we’ve seen gold prices fall off by a third.

Jim Lange:  Well, it must be sweet vindication for you to go against the grain and have history prove you right.

Charlie Smith:  Well, you know, we really had no idea until the statistics told us.  I mean, it’s hard to know how a brand new policy…QE had never been tried before.  It was tried to the tune of over a trillion dollars within the first eighteen months after the crash, and we didn’t know, and most people would tell you they didn’t have any idea what this new policy would do.

David Bear:  Well, looking forward, they’re talking about easing the policy.  So, what’s that going to do?

Charlie Smith:  Tapering, right.

David Bear:  Tapering.

Charlie Smith:  Reversing it.

David Bear:  Right.

Charlie Smith:  Well, from our perspective, the process of reducing the amount of quantitative easing month by month…

David Bear:  Umm-hmm.

Charlie Smith:  …and the increments are ten billion a month, and first of all, these numbers are numbers that the average person has no concept of.  You know, back last year, the Fed was cranking $85 billion a month into the banking system, and the average person has no idea how much money that is.  We tried to frame it in a way that people could understand it, and it’s still difficult.  Boeing announced a large contract to sell 200 wide body aircraft in the Middle East over the next ten years, and those 200 aircraft delivered over the next ten years were going to cost $100 billion.  Last year, the Fed was cranking $85 billion every month…

David Bear:  Umm-hmm.

Charlie Smith:  …into the system.  So, the magnitude of the amount of money the Fed has cranked into the system over the last five years is beyond anyone’s comprehension.

David Bear:  Is that all debt now?

Charlie Smith:  Well, what has happened, the Fed has purchased from the banks mortgage bonds and treasury bonds.  They’ve been sort of helping finance the federal deficit, and also sort of taking off the market a lot of the old mortgage debt that had failed as a result of the previous boom collapsing.  So, the Fed has parked a lot of these bonds, both treasury bonds and mortgage bonds, on its own balance sheet, and the question we’re trying to answer is okay, once they stop buying bonds, at some point, are they going to have to begin to sell these bonds back into the marketplace?

David Bear:  Umm-hmm.

Charlie Smith:  And potentially, that would drive up interest rates considerably, because when a whole new giant supply of bonds comes on the marketplace, that drives the prices of the bonds down and drives the interest rates on the bonds up.  So, we have a concern that if the Fed does begin to reverse QE, and then start selling these bonds back into the system, we could have a problem with interest rates.  There are some people who believe the Fed will never do that.  They will simply hold onto these bonds to maturity, keep them on their balance sheet for the next ten, twelve, fifteen, twenty years.  That may happen, as well.

Jim Lange:  Well, could I ask a related question?  Because a lot of people right now think because of everything that’s going on, that the market is very high.

Charlie Smith:  Umm-hmm.

Jim Lange:  Other people say no, the market’s going to go up even higher, and I know that you’ve always liked to talk about the price earnings ratios.

Charlie Smith:  Umm-hmm.

Jim Lange:  Can you talk a little bit about what you think whether the market is ‘high’ and how that relates to price earnings ratios and whether using traditional price earnings ratios, the market is, right now, high…

Charlie Smith:  Umm-hmm.

Jim Lange:  …low, or…

Charlie Smith:  In between.

Jim Lange:  …in between, which is somehow I suspect what you’re going to say.

Charlie Smith:  Yeah.  We’re in between right now.  The way that you value a business, and the way you value a market is by a multiple of earnings.  How much am I paying for a dollar’s worth of earnings?  And the multiple that you’re willing to pay, historically, has correlated inversely backwards with inflation.  That is, at low inflation rates, PE multiples tend to be much higher.  At high inflation rates, PE multiples tend to be lower.  So, there is an inverse correlation between PE and inflation.  Today, we have about a two percent inflation rate.  Historically, in the U.S. markets, a two percent inflation rate has correlated with a PE ratio in the seventeen to eighteen range.  So, in the PE today, for the S&P 500, it is about sixteen-and-a-half.  So, we’re slightly undervalued given historical PE ratios in a two percent inflation environment.

Jim Lange:  So, some of the people who say, “Whoa!  The market’s just so overvalued, and I’m going to wait until it simmers down before I get back in…”

Charlie Smith:  Right.  I think most of those people are making the argument that profit margins are at forty-year highs.  You know, if you’ve been following the markets the last few years, you know that corporate America has been doing very well.  Labor and other constituencies in the economy haven’t been doing as well.  We talked earlier about how wages have been stagnant for years.  Corporate America’s been doing very, very well.  Corporations, in terms of the S&P 500 as our benchmark, profit margins on the S&P 500 are at forty-year highs.  And the people who say the market’s overvalued are saying those margins can’t go any higher, and, in fact, they’re set for a fall, so that if profits fall, that means the ‘E’ in that equation, the PE, is going to be falling, and typically, when E is falling, price follows.  So, the people that are saying the market is overvalued are generally making the argument that earnings have peaked and are set for a fall, and therefore, prices will follow.

Jim Lange:  All right.  Well, a lot of people, let’s say, make a lot of decisions based on gut instinct and what they think is going on.  And one of the things that I saw Fort Pitt Capital do (and I thought that you guys were literally amazing), in 2008, and I’m not going to say you didn’t lose money because you certainly did, but one of the things that you did is you kept your clients in the market.  So, when everybody was complaining and saying, “Oh my God, the sky’s falling.  I want to turn to bonds.  I want to turn to bonds.”  Through some combination of personal attention, and I know that you guys were on the phones all the time, at least for the people that we work with with you, virtually all those people stayed in the market and were rewarded very well in 2009 and subsequent years, and most of them are actually doing better than they were then, even given a reasonable rate of return.  How do you keep people in the market, and how do you keep people from doing stupid things?

Charlie Smith:  Jim, you’ve come probably to the core reason that folks like myself have a job.  You know, there’s an old saying: if you’re being chased by a bear and you’re with someone else, you don’t have to outrun the bear.  You just have to outrun the other person.  Well, in the investing world, things sort of work the same way.  The vast majority of retail investors either don’t have the temperament or the emotional makeup to invest successfully, because people want to be part of the herd.  People are social and they want to behave like their compatriots are behaving.  In the investing world, the ability to say okay, this is what the market’s worth, this is what the current policy set given, you know, monetary and fiscal policy in the political background, this is what the current environment says the market should be worth.  We need to stick to our discipline.  That mindset is what builds the entirety of our business as money managers.  People want to do the wrong thing at the wrong time, and it’s because they’re getting advice from all the people around them that really have not taken the time to understand how the world works, and therefore, are going off their gut feel or their emotion, and that’s really a sorry way to invest.  So, we get paid, I like to say, for our stomachs more than our heads, oftentimes.  The ability to stick to our plan, recognize that the market is going to move from undervalued to overvalued cyclically, and being able to stick to the plan when it appears like the world is really going haywire.  That’s where we earn our money.

6. Sticking to the Plan

Jim Lange:  Well, you talk about sticking to your discipline, and you do that so well because I know a lot of firms have literally changed their discipline midstream and it hasn’t worked out so well for them.  So, for example, your discipline is, if you’re rebalancing, when something, or a particular sector, does particularly badly, instead of running away and getting out, you buy more.

Charlie Smith:  Sure.

Jim Lange:  Or if something is doing well, instead of buying more, you sell.

Charlie Smith:  Right.  Well, again, price is the final determinant of value.  We assume that, over time, we own decent quality.  We own businesses that are well run.  We own companies that are going to generate a steady stream of cash flow.  But we also know that the market is going to choose to price those businesses all over the lot.  From day to day, Mr. Market is manic-depressive, and we can take advantage of that.  We can take advantage of the inability of the vast number of players in the marketplace to rationally price their asset.  They’re going to price it irrationally, and we’re going to get a chance, at some point, to buy well-run businesses at a price which makes them a good investment for us.

David Bear:  With buy and hold.

Charlie Smith:  Well, it is, but it’s wait and buy and hold, really, essentially.

Jim Lange:  Yeah.  Actually, that relates to another question that I had, because most money managers, when you go from either managing money for yourself, or you switch to a money manager, most money managers are going to say, “Okay, You’re coming in with all these different stocks and mutual funds, etc., and on day one, we’re going to sell everything.  And then, we’re going to put you in what we like, and that way, we can just follow what we like.”

Charlie Smith:  Umm-hmm.

Jim Lange:  And you, you’re the exact opposite.  In fact, I’ve heard people criticize you for not doing anything…

Charlie Smith:  Right.

Jim Lange:  …because you just keep what they had for a while.

Charlie Smith:  Right.

Jim Lange:  And that’s just so contrary to what every money management firm I know does.

Charlie Smith:  Sure.

Jim Lange:  Can you comment on why you do that and what is the thinking behind keeping some things that people already have?

Charlie Smith:  Well, let’s sort of separate the argument between the taxable and the non-taxable accounts because in a taxable portfolio, if someone comes along with thirty stocks that they’ve owned for twenty-five years, chances are that they’ve got some gains built up in that portfolio that if I blitz out the entire portfolio day one, they’re going to have a gigantic tax bill.  And remember, investing is all about after-tax total return.  How much money can you put in your pocket at the end of the day?  You know, some of it’s going to go to the IRS.  Some of it’s going to go for trading and costs.  Some of it’s going to go for my fee, frankly.  But how much can you put in your pocket after taxes is the focus.  And so, when I see a portfolio, particularly a tax paying portfolio, if it’s got thirty names in it, typically a third of those names are names that we, as investors, believe are good businesses.  So, it doesn’t make sense for us to, sort of, just take a cookie cutter and blitz out all those stocks.  Chances are, we’re going to be buying back a few of them at some point.

David Bear:  Umm-hmm.

Charlie Smith:  So, it generally comes down to a third, a third, a third.  A third are the names we’re perfectly comfortable with and we may even add to.  A third in the middle, we’re on the fence.  We need to do some research on those.  We don’t necessarily follow that business closely.  We need to understand what that business is all about.  So, in five, six, eight, ten months, over time, we’ll figure out whether we want to keep that business, and we’ll keep some and get rid of the rest.  Then, the other third, we’re going to get rid of, but even then, we don’t get rid of them necessarily day one.  Our first initial screen on a portfolio is for financial risk and operating risk.  If we see an operating risk in a business or too much leverage, chances are we’re going to chop that business out fairly quickly.  But it’s not a cookie cutter approach, and particularly in accounts that pay taxes, that can save people a lot of tax money.

Jim Lange:  Well, I just had a client who did switch money managers, and they did this exact thing, which is they sold basically highly appreciated assets in a taxable account, generating a lot of taxes, and we had a very, very unhappy client.

Charlie Smith:  Well, oftentimes, for the new manager, that’s the easy way to do things, and, you know, frankly, there are risks involved, particularly if it’s a big position.  We have many clients who come along who’ve worked for a local Pittsburgh company, perhaps, for twenty or thirty years, and they have a big position, maybe 15% or 20% or their net worth, in PPG, or Matthews, or Bank New York Mellon, or PNC, and they’ve got a huge appreciation here, and we have to manage our way out of that position, and that can involve using options to create a collar on the position where we’ve, sort of, hedged around the risk of any one big position blowing up.  It can involve gradually moving out of the position over a period of years.  But the point is that we need to manage it.  We need to take the responsibility of managing that position, rather than simply blitzing it out and making the big tax bill the client’s responsibility.

Jim Lange:  Well, you do keep going back to taxes, and, you know, we just finished a pretty brutal tax season.

Charlie Smith:  Yes.

David Bear:  April 16th!

Jim Lange:  But one of the things that we notice as preparers is that there are less capital gains in portfolios that you guys are managing, and it’s not because you’re not making money.

Charlie Smith:  Umm-hmm.

Jim Lange:  It’s just because you just don’t trade as much.

Charlie Smith:  True.  We don’t.  We will, most certainly, in a taxable portfolio between, say, the first of November and the end of the year, always go in and harvest losses to offset gains we’ve taken previously during the year so that the net number in terms of gains at the end of the year is as small as possible.  But, you know, again, it’s all about after-tax total return.  We’re not going to let the tax question, you know, the tax tail wag the investment dog, so to speak, but we are always going to be conscious of it.

Jim Lange:  Well, by the way, that’s another area that I want to compliment your firm on because you, more than any firm that I know, do a wonderful job of, what we’ll call, tax loss harvesting.

Charlie Smith:  Umm-hmm.

Jim Lange:  So, you’re always interested in where people are in terms of their capital gains, and not just with money that you manage because sometimes people have some, either other money managers or money that they’re managing on their own.  You always try to get an inventory of where you are and what can be done to save taxes because, like you said, in the end, it’s really not necessarily what you earn, but what you keep after taxes and fees.

Charlie Smith:  Right.  And that’s really…from our perspective as money managers, that’s not the hard part.  That’s sort of a rote routine procedure you can just run through at the end of the year.  That’s simple mathematics.  The art of managing money is way harder in understanding risk, and understanding how the world works.  That’s the hard part.  Doing the basic service components of harvesting tax losses, I mean, everybody should be able to do that.  That’s not that hard.

Jim Lange:  Well, they should be, but very few do.

Charlie Smith:  Well…

Jim Lange:  And I will compliment your team because even if a client doesn’t say anything, it’s not like the client has to call you and say, “Oh, I had this big gain in Apple this year, so what are you going to sell to offset it?”

Charlie Smith:  No, we’re proactive.

Jim Lange:  Yeah.  They just sit there and do nothing.  All of a sudden, they magically get tax loss harvesting benefits.

David Bear:  Well, let’s take a break right now.

BREAK TWO

David Bear:  And welcome back to the Lange Money Hour with Jim Lange and Charlie Smith of Fort Pitt Capital.

7. The Shortcomings of High Frequency Trading

Jim Lange:  Before we get into the last leg of the show, I do feel honor bound to repeat a disclaimer I made earlier.  Usually, my guests are independent and I have no financial stake in their success, or whether people work with them or if they don’t.  That isn’t the case with Charlie Smith and Fort Pitt Capital Group.  I have an arrangement with them whereby if somebody comes to me first, and our firm does things like big picture planning, how much you could spend, Roth IRA conversions, Social Security, tax planning, estate planning, etc. and then, they also work with, and I bring them to, Fort Pitt Capital Group, who actually manages the money and does everything that we are talking about, that they pay Fort Pitt a fee, and then I share a percentage of that fee.  So, I am not financially independent to Charlie Smith and Fort Pitt Capital, and wanted to repeat that disclosure.  So, anyway, one of the things that’s in the news these days is high frequency trading, and you read about books where people are making all this kind of money by selling and buying, literally, in microseconds before everybody else, and the reaction that a lot of people have is, “Oh my goodness, you have all these people making huge amounts of money, and it’s at my expense.  That is, little old me, the buy and hold investor, is getting killed by all these people who are just reaping profits by this microsecond trading.”  Could you comment on whether these kinds of trading vehicles are hurting the average investor?

Charlie Smith:  Sure.  Essentially, answer the statement that Michael Lewis, who wrote Flash Boys, the book about high frequency trading, his statement was ‘the market is rigged.’  He came on 60 Minutes a few weeks ago to promote his book and basically said, flat out, the stock market is rigged, and the assumption being on the part of individual investors, that every time they trade, they’re getting ripped off in no matter how small a way.  The answer to the question is yes, the market in a microcosm is rigged, but I think you need to put that in the perspective of the last forty years.  And so, let me lay out my argument that it’s rigged, but it doesn’t really matter.

Forty years ago, to trade $100,000 worth of stock on the New York Stock Exchange, the American Stock Exchange, it would’ve cost you between $800 and $1,000.  Today, to trade a million dollars worth of stock, it costs about eight dollars.  So, we have seen a 99% decline in the cost of trading stock in the U.S. over the last forty years.  These benefits have all come from the automation, basically, the substitution of computers for people as intermediaries in the process of trading equities.  And then they’re actually growing into the other markets, as well: foreign currency, bonds, and pretty soon, we’re going to have automated trading everywhere.  But in the stock market, they have cut the cost of trading 99% over the last forty years.  So, there’s been a tremendous benefit to everybody who’s ever been an investor over the last forty years.  What we’re arguing about when we’re discussing high frequency trading is that last one percent.  The folks that built the system, the people that, you know, the investment banks, the exchanges, the traders, the regulators, the folks that built this system are the ones who know the quirks.  They know the aspects of the system that are capable of being exploited, and they have taken advantage of that.  They’ve given us tremendous trading advantages through automation.  They’ve cut the cost 99%, but there’s one percent still left in the system that we need to perfect it, and it involves, basically, the physical positioning of the exchanges and how fast data can travel between them.

You can get an advantage if you position your computer closer to the New York Stock Exchange, for example.  You can get an advantage, as Michael Lewis wrote about in the book, if you build a fiber optic line between Chicago and New York to try to speed the rate at which data flows between Chicago Merck and the New York Stock Exchange.  But those are all, sort of, fallout from the fact that we’ve automated the trading system, and the benefits that come from trading in microseconds, not human trading, by the way.  It’s all done by algorithm, all done by computer, and it sort of runs by itself, which is what created the flash crash several years ago.  But the point is that we’re talking about the final one percent of the benefit that’s come from automating trading.  And yes, if I trade a lot today, the high frequency traders are scalping some tiny fraction of every penny that I’m trading with, but particularly, if I’m a buy and hold investor and I make three or four trades a year, even if I have a million dollar portfolio, it’s not costing me more than a couple bucks.

David Bear:  Umm-hmm.

Jim Lange:  Well, that’s something that’s very important, and when you say one percent, you’re not talking about one percent of the entire investment, you’re talking one percent of the trading cost.

Charlie Smith:  Right, and I’m saying that when we started with an $800 charge to trade $100,000 worth of stock forty years ago, that charge for that same trade is now eight dollars.  So, that’s a 99% decline in the cost of making a trade.  So, we’ve got another one percent to go, and actually, that’s not the best way to frame it because potentially, the cost cuts are infinite.  We could find new ways to get, you know, this last…

David Bear:  You cut them in half right now.

Charlie Smith:  Right.  We could find new ways to get this last little bit of friction out of the system.  You know, the ability of the software jockeys to write code to take advantage of the speed differences of today versus forty years ago, I have to give them credit.  That’s an amazing skill.  We’ve all benefited from their ability to do that because they built the system that was this fast and this automated.

David Bear:  Does it impact the price of the share?

Charlie Smith:  No, no.  If I’m a big institutional trader and I’m trading millions of shares, it does have an effect because the way the system is gamed in some ways allows certain traders to get a look at what a big investor wants to do before he does it.  It’s front running, essentially.  Again, it’s detailed in the book.

David Bear:  Read tomorrow’s news today.

Charlie Smith:  Yeah, exactly.  Get tomorrow’s newspaper today because you have a technology advantage.  But the point is that the big institutions that are potentially being harmed by that, they recognize the problem, and one of the heroes of the book, a trader from RBC, has now built an exchange, the IEX, which is gaining favor day after day.  In fact, they reported today their highest volume day in their history, which is designed to remove any speed advantages.  So, the big institutions that are potentially being nicked, you know, if you trade hundreds of millions of shares everyday, and, you know, there’s a hundredth of a penny being taken out of each share, yeah, it’s going to matter to you.  But from the perspective of the small investor who doesn’t trade very much, the benefits we’ve seen over the last forty years far outweigh any of the costs that we’re paying today because we haven’t quite gotten to perfection.

8. Deflation

Jim Lange:  Well, that is a good thing to hear, and probably again going against the grain, which you seem quite comfortable doing.  And speaking about going against the grain, and unfortunately, I think this is going to be the last subject for today’s show, you mention that deflation isn’t really such a horrible thing to be feared.  Where Harry Dent was going to try to scare the bejeevers out of us, you seem a little bit relaxed about the concept of deflation.  Could you tell us why you’re not afraid that that might happen, and if that did happen, what the impact would be for individual investors?

Charlie Smith:  Certainly.  Another way to define deflation is progress.  In the modern U.S. economy, we’ve had a couple of periods of steady price deflation.  Most of them happened in the latter part of the nineteenth century, between 1850 and 1900.  We had a very volatile economy during that period, but we also had some of the most amazing technological advances, standard of living advances, in our history during that period.  And it’s because we saw the prices of so many goods and services falling because we were becoming so much more productive.  Well, after World War II in this economy, we built a financial system which really sort of took over the rest of the economy, and if there’s one entity in the economy that cannot stand deflation, it’s the banks, because they’ve lent out money historically, and if they’ve lent against assets, you know, you’re a lender, you lend against a house or you lend against a car, as a security for your loan.  Well, if the value of that house falls, or the value of that car falls, you, as a lender, are no longer secure in your loan.  So, deflation for a banker in an economy where we’ve made the financial sector such a big part of our economy is a potential problem.  So, the banks fear inflation, but the average working person, the average person who’s trying to get by on the average wage, deflation is a good thing.  They look for deflation every week when they go to Wal-Mart.  That would benefit them.  Real wages rise when prices fall.  But we have this system today where the banks are so powerful that they really don’t have the ability to withstand deflation.  The government doesn’t, as well.  Tax revenues depend to a certain extent on nominal growth, inflation within the economy.  So, banks and government are the two big enemies of deflation, but deflation represents progress in many ways.  More goods produced at lower prices benefiting more consumers, and the best measure of an economy is how it treats consumers, and we need to have a certain amount of deflation in the system to benefit the average wage earner.  Otherwise, we’re going to continue to see this wealth inequality and income inequality continue and expand.

David Bear:  Well, on that note, we should quit for today.  I want to say thanks to Charlie Smith.  You can reach him directly at his firm’s website, www.fortpittcapital.com.  Thanks also to Dan Weinberg, our in-studio producer, and Lange Financial Group coordinator Amanda Cassady-Schweinsberg.  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can also access the audio archive of past programs, including written transcripts, at the Lange Financial Group website, www.paytaxeslater.com under ‘Radio Show.’  You can also call the Lange offices directly at (412) 521-2732.  Finally, mark your calendar for Wednesday, May 7th at 7:05 and the next new edition of the Lange Money Hour, when Jim will welcome Bob Keebler to the show.

END

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