We were very fortunate to have Ken Volpert, of the Vanguard Funds, visit our offices last week.

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Behavioral finance is one of the most exciting areas of finance today.  Unlike traditional financial theories that assume that all people are perfectly rational, behavioral finance looks at impact of human emotion on financial decision-making.

This article marks the second in our series on behavioral finance and reviews Representative Bias, the over-concentration on data sets that are too small and anecdotal evidence.

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Each month, I publish a "Spotlight Stock" that describes a company that we own and why we like it.  The purpose isn't to provide a 'hot tip' or promote a particular company or stock, but to help investors understand our investment philosophy.

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U.S. stocks once again dismissed poor economic data to push higher – even the day’s best economic release showed consumer confidence remains stuck at a low level.  For the week, the broad market posted its fourth-straight weekly decline; although, the bounce since Wednesday kept the losses to a minimum. 

Basic materials, financials and tech led the broad market higher.  Health care and utilities were the losers for a second-straight session, but even these groups managed to close higher. 

The CRB Index rallied as 14 of its 19 components rose in price.  Gains in natural gas, sugar, silver, copper and cotton led the rally.  The overall index closed just 4% below the post-crisis high hit on April 29.  This morning commodity prices are up again, led by crude (back to $103/bbl) as traders are talking more QE even before the current round has expired. 

The Dollar Index slipped for a second-straight session.  The old greenback has been crushed by Bernanke but remains meaningfully above the recent low of 72.93 hit on…you guessed it, April 29 (same as the CRB’s cycle peak).  The all-time low of 71.35 was hit in April 2008 – the Dollar Index began in 1967.

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Our QE-world financial markets got a little more bizarre yesterday as the yield on the 10-year Treasury slid to 3.05% even as stocks rallied – and the equity-market rally came out of the blue at 10CDT after beginning the session lower on another day of weak economic data.  

I ran a chart that overlays the S&P 500 and the 10-yr yield going back to 1998; the last time there was this much divergence between stocks and bonds (stocks saying things are fine, bonds say there’ll be hell to pay) was October 2007 – but then such analysis comes into question when the markets are this manipulated.

Consumer discretionary, telecoms and tech led the broad market higher.  Health care and utilities were the losers, but even these sectors closed higher. 

The CRB Index inched lower, which is rare for this environment as there’s a high correlation between stocks and commodities when monetary policy is ultra aggressive. A drop in the prices of cotton, crude and natural gas offset increases in wheat, gasoline and aluminum. 

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U.S. stocks shook off weaker-than-expected durable goods orders number and yet another report on falling home prices to bounce Wednesday, although a late-session slide pared the gains.  Traders also looked beyond another sign that the global economy is in trouble as the latest UK business spending figure plunged 7.1% quarter-over-quarter.

Weak data doesn’t matter like it normally would though, as the market knows Bernanke isn’t going away.  The same so-called dissenters to current policy (Fischer at the Dallas Fed, Plosser at the Philly Fed, and to some extent Kocherlakota at the Minneapolis Fed) keep writing Op/Eds that the FOMC needs to tighten, but their words are vacuous as the votes to keep the current policy stance intact continue to be unanimous.  And the Committee goes through the motions of touching on their strategy to unwind, but they have no willingness or desire to unwind. 

Watch, there will be additional rounds of QE on any meaningful weakness in the stock market as Bernanke is petrified of a negative wealth effect (both stocks and home prices falling), because of the structural weaknesses in this economy – weaknesses that were brought on and exacerbated by the very Fed that kept policy too loose in the prior cycle, engendering a terrible debt problem and a housing bubble.  But we get to a point by which the policy must be reversed as it fosters new problems (specifically the mispricing of risk and higher commodity prices that crush the segment of the population that doesn’t have the resources to participate in the assets that Bernanke has driven higher), and that’s when we find that the underlying economic troubles have not been cured at all, just masked over. 

Energy, basic materials and industrials led the broad market higher.  Consumer staples and telecoms were the losers. 

So stocks bounced after three sessions of decline, but commodities outperformed (as the leading sectors would suggest) as all 19 components of the CRB Index increased in price – silver, sugar, copper, wheat, cattle and crude led the charge.

Yesterday’s 5-yr Treasury note auction was super strong as the bid-to-cover came in at 3.20 (3.2 times more demand than the amount being offered).  According to Bloomberg, this is the highest demand since 1994 – the yield on the 5-yr hit 7.8% in 1994, today it is 1.8%...ok.  

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U.S. stocks began yesterday’s session higher but lost momentum after the latest survey on manufacturing activity was released to show it had moved to contraction mode.  The news kept any alacrity to get the risk trade rolling at bay and the major indices went negative as the session progressed.

Energy, basic materials and telecoms were the only industry groups to close higher.  Industrials, consumer discretionary and tech shares led the losers. 

The Dollar Index weakened slightly after two days of gain (and up 4% since the end of April 29) and the CRB Index bounced back a bit (it’s down 8% over the same period), driven by silver, sugar, OJ and the energy complex. 

Concerns over European debt issues seemed to ease yesterday -- or were they ignored? -- but that doesn’t mean that things look better.  Interest rate spreads for the PIGs continued to new wides.  Borrowing costs for Spain narrowed ever so slightly, but we’ll see how things go as the new regional governments report that the country’s debt situation is even worse than previously believed.   And for an economy that arguably has a larger housing-market overhang than our own and 21.3% unemployment (reportedly over 40% for the younger end of the workforce), Spain is probably going to crack in the not too distant future. 

Is Spain the breaking point for the euro-zone?  It’s too tough for me to even guess.  It could be Spain; it could be a Greece that must leave the zone in order to bring back the drachma just to devalue it and make paying their debts a bit easier; it could be an Italy that has frontloaded its government debt to the extreme and thus must roll 70% of it within 18 months. 

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U.S. stocks fell by the most in a couple of months (since the 1.9% slide on March 16 to be exact) as the European debt crisis received more attention – it’s not that the situation hasn’t been raging again, it’s just been collectively ignored by global equity markets. 

The Dollar Index is in the process of bouncing back from extreme lows, and stocks don’t like that as it’s a clear sign that some move to safety has occured.  (I’m not saying this is the way it should be – to view a rising dollar value as a bad thing for stocks – it’s just the environment we’re in.  When we’ve got a wildly aggressive Fed chairman at the helm, the greenback will only find life when investors flee riskier assets.)

Telecoms, consumer-related and health care shares were the best-performing sectors, but only because everything’s relative – all 10 of the major industry groups lost ground for session.  Tech, energy and industrials were the biggest losers. 

The CRB Index moved back to the near-term low (initially hit last Monday) as 15 of its 19 components declined – the exceptions were natural gas, coffee, gold and aluminum.  Crude fell back to $97.46/bbl (which nearly erases the MENA-related pop) and wholesale gasoline inched lower $2.93/gallon, but essentially unchanged over the past week.   The national average pump price is down to $3.83 – 15 cents off the high hit little more than a week ago, but still a buck higher than the year-ago price. 

The European debt crisis moved to a new level on Monday as the regional elections in Spain resulted in a rout for the majority Socialist party, which (as the WSJ first reported on Friday) will probably lead to the uncovering of a deeper debt problem than was previously acknowledged.   Interest rates spreads moved to new record wides in Greece, Ireland and Portugal, while Spanish and Italian spreads also continue to widen (the cost of borrowing is getting more expensive relative to benchmark German bunds).

There was also pressure coming from Asia as the slowdown we’ve been talking about for some time now appears to be occurring – a result of their tightening campaign as the region is dealing with the inflation that Bernanke exports.  An index of Chinese manufacturing fell to the lowest level in 10 months and is very close to contraction territory.  The Pacific Rim has been a major engine of growth for this global economic cycle and its weakness will be felt in our manufacturing numbers. 

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IRA accounts were an important part of last week's newsletter on where to invest for retirement, but I wanted to take a deeper dive into the differences between Roth and traditional IRAs.

Both options allow for tax-deferred growth on your investments, which means that you will not pay taxes on any dividends, interest, or capital gains while your money is in the account.  The primary difference between a Roth and traditional IRA is when your money is taxed. 

For a traditional IRA, your money is taxed when you make withdrawals, while contributions may be tax-deductible (depending on your income and participation in an employer retirement plan).  For a Roth IRA, contributions are made with after-tax dollars, but withdrawals are tax-free. 

The other major difference is in flexibility.  Traditional IRA owners are required to make minimum distributions (withdrawals) beginning at age 70 ½, whereas Roth IRA owners have no such requirements during the owner's lifetime.  And unlike the traditional IRA, Roth IRAs allow you to continue contributing past the age of 70 ½.  In short, the flexibility of the Roth IRA allows your money to benefit from additional tax-free growth.

Given the Roth's flexibility and ability to make tax-free withdrawals, it is usually the best option, but the decision isn't a no-brainer for everyone.  Ultimately, choosing a suitable IRA depends primarily on an individual's time horizon as well as their current and future tax rates.

Since estimating your future tax rate is very difficult, there are a few general rules of thumb you can apply when choosing an IRA.  If you expect to be in a higher tax bracket or believe that significant tax hikes could be on the horizon, then a Roth IRA allows you to "lock in" your current tax rate - paying taxes on your contributions today and not paying the higher tax rate in the future when you withdraw the money in retirement.  Conversely, if you are in the top tax bracket or believe you will have a lower income tax rate at retirement, then the traditional IRA might make more sense. 

Time horizon is the other big consideration.  Generally a Roth makes more sense for investors that are not near retirement and thus have more time to allow their money to grow tax-free.  This is a particularly important point for someone considering a Roth conversion - a hot topic recently since any investor, regardless of their income, can convert a traditional IRA to a Roth IRA this year (and last year) by paying income taxes on the amount of dollars that are converted.  Investors who are near retirement may not have enough time for the tax-advantages of a Roth to offset the tax hit that comes with a conversion.

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U.S. stocks shook off another spate of European concerns, actually side-stepping the issue quite deftly considering all evidence points to a sovereign debt situation that will rage in time. 

Energy, utility and telecoms gained ground.  The other seven of the 10 major industry groups closed negative, led by financials and industrials. 

The broad market endured the third-straight week of decline, which is the longest stretch since August. But in terms of degree there is no similarity as last summer’s move lower was significantly more pronounced as the S&P 500 was 14% off the near-term peak (today it’s less than 3% from the recent peak), sitting at 1060 and looked headed for the 900 handle until Bernanke turned it all around with his August 27 QE2-is-coming speech. 

Those European debt concerns took center stage on Friday as not only peripheral-economy (Greece, Ireland and Portugal) debt spreads widened but Spain’s did too.  There are concerns that the regional Spanish elections this weekend will result in a rout for the Socialist (which not looks to be the case) and thus the new governments will uncover a debt situation that is worse than has been acknowledged – much like saw occur in Greece. 

The CRB Index gained some ground as 11 of its 19 components saw prices rise.  The prices of agriculture, precious metals and the energy complex (crude settled back to $100/bbl) were the movers. 

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