AAII Investor Update: Financial Foul Play

Thursday, August 9, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Details on how your orders get executed.

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Common tactics companies use to misstate performance.

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  1. “Revised Model Fund Portfolio: Combining Mutual Funds and ETFs”
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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 36.5%, up 6.0 points
  Neutral: 36.2%, up 1.5 points
  Bearish: 27.4%, down 7.6 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

The financial sector sure seems to be ignoring the memo about the need to rebuild the public’s trust. Just look at the following headlines, all of which have been written since summer started on June 20, 2012:
  • “LIBOR Manipulation? Done for You, Big Boy,” Financial Times Alphaville Blog, June 27
  • “MF Global Redux as Regulator Says PFGBest Client Funds Missing,” Reuters, July 10
  • “Error by Knight Capital Rips Through Stock Market,” Reuters, August 1
  • “UK bank Accused of Iran Money Laundering Scheme,” The Wall Street Journal, August 6
Each of these events was a separate, unrelated incident. Three are the actions of a small number of rogue professionals, though the scope of the LIBOR scandal is not fully known. The impact on the financial sector’s reputation, however, is far larger. The headlines imply the financial sector has yet to embrace its fiduciary duty to shareholders or show a commitment to rebuilding the public’s trust. I’m angry, as likely are many of the other honest professionals who work in finance.

But, it’s one thing to be angry and another thing to disengage. Despite the actions of the bad players, investing in stocks and bonds—either directly or through funds—remains the best way to build wealth and provide a stream of income in retirement. Those who are waiting for signs that the shenanigans have ended will unfortunately be waiting a long time. The history of the financial markets is soiled by the actions of bad players. In the 19th century, investors were sold shares of railroads that didn’t exist, nor were ever intended to exist. In 1934, Franklin Roosevelt appointed Joseph Kennedy to head the then new Securities and Exchange Commission in part because he wanted someone who knew how speculators worked to defraud investors. In the late 1990s, some brokerage analysts were telling investors to buy technology and Internet stocks that they knew were lousy investments.

Yet—and this is important—honest investors who took a long-term view toward investing still made money. Did some people lose money because of malfeasance? Absolutely, but the headlines don’t talk about all the people who saved, managed their portfolios well and quietly built wealth for themselves.

Articles about money managers and advisers who help their clients achieve their long-term goals don’t sell newspapers. Scandals, on the other hand, make for great headlines, even though they usually impact a relatively small number of people. Add up all the people who lost wealth due to Bernie Madoff, Allen Stanford, allegedly Russell Wasendorf, the flash crash and Knight Capital, and the group will be dwarfed in size by the total number of investors participating in the financial markets.

There is no doubt that more needs to be done to stop ongoing financial foul play as much as reasonably possible. But, even with all the bad characters that have participated over the history of the financial industry, large-cap stocks have still returned 9.8% on an annualized basis. It is still very possible to win on Wall Street if you take a long-term focus and are proactive in managing your portfolio.

A Note About Knight Capital

Knight Capital Group (KCG) is one of the many firms that provide buy-and-sell quotes to help facilitate trades in stocks. Based on the details released so far, a new software program used by the firm sent a flurry of buy and sell orders on approximately 150 stocks to the New York Stock Exchange last week. This in turn caused a large amount of volatility in those stocks.

Electronic trading has helped to lower transaction prices for individual investors and accelerate the rate at which orders are filled, both of which are positives. The downside is that as trading systems become more complex, the potential for problems increases.

Discount brokerage firms check a variety of exchanges, seeking the best price for their clients trades. When Knight Capital’s glitch happened last week, many orders were quickly rerouted elsewhere. In addition, procedures to halt trading if prices show too much volatility in a short period of time have been implemented since the flash crash occurred in 2010.

The best way to protect yourself is to use limit orders when placing an order to buy or sell a stock or an exchange-traded fund. Look at the bid-ask spread and set your price limit at the bid for selling a stock and at the ask for buying a stock. You can go a little outside of this range if the stock is moving, has low volume or you anticipate volatility and want to ensure your order is filled. If the spread is wider than a few cents, you can also set the price limit somewhere in the middle, though at the risk of not getting the order filled.

More on AAII.com

The Week Ahead

Approximately 20 members of the S&P 500 will report earnings next week. Included in this group will be Dow components The Home Depot (HD) on Tuesday, Cisco Systems (CSCO) on Wednesday and Wal-Mart Stores (WMT) on Thursday.

The week’s first economic reports will be the July Producer Price Index (PPI), July retail sales and June business inventories, all of which will be published on Tuesday. Wednesday will feature the July Consumer Price Index (CPI), the August Empire State manufacturing survey, July industrial production and capacity utilization, and the August National Association of Home Builders housing market index. July housing starts and building permits and the August Philadelphia Fed survey will be published on Thursday. Friday will feature the preliminary University of Michigan consumer confidence survey and the July leading indicators index.

Minneapolis Federal Reserve Bank President Naryana Kocherlakota will speak on Wednesday and Thursday.

August stock options will expire on Friday.

AAII Sentiment Survey

The percentage of AAII members describing themselves as bullish topped those describing themselves as bearish for the first time since May 3, 2012, according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 6.0 percentage points to 36.5%. This is the highest level of optimism registered by the survey since April 5, 2012. Even with the increase, bullish sentiment is below its historical average of 39% for the 19th consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.5 percentage points to 36.2%. This is the highest neutral sentiment has been since December 22, 2011. It is also the fifth time in six weeks that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 7.6 percentage points to 27.4%. Pessimism was last lower on March 29, 2012. This is the first time in 14 weeks and just the second time in 18 weeks that bearish sentiment is below its historical average of 30%.

The ongoing rise in stock prices is giving some AAII members hope about the short-term direction of stock prices and is curtailing short-term fears for others. The optimism is cautious, however, as concerns about slowing global economic growth, Washington politics, the European sovereign debt crisis and further market volatility remain very much front and center. The ongoing streak of below-average bullish sentiment is the longest since a 29-week period between April 2, 1993, and October 15, 1993.

This week’s special question asked AAII members whether the recent statements by European Central Bank (ECB) President Mario Draghi, including his intent to do whatever it takes to preserve the euro, have impacted their sentiment. Slightly more than half of respondents said Draghi’s words have not impacted their sentiment. Many of these individual investors perceive Draghi as simply adding to the ongoing chatter, instead of offering a solution. A sizeable minority said Draghi’s comments have made them more optimistic. A smaller minority said they have become more pessimistic.

Here is a sampling of the responses:

  • “Draghi’s comments—like an elevator’s close button or Congress—are there, but are of no use.”
  • “Draghi has made me even more suspect about the depth of European leaders’ willingness to admit the severity of their financial situation.”
  • “He is managing the perception of certain investors, but needs to bring action before he changes my feelings.”
  • “They had a positive impact on my sentiment, but I want to see what European leaders actually do before committing additional funds to the international market.”
  • “It makes me feel the ECB will be proactive in saving the euro.”
  • “I’m even more bearish now. More talk, less action means the day of reckoning is yet to come.”

» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor