In investing, it is important to understand what industries the companies in which you invest are in.  There are several reasons for this:

• Companies within an industry tend to face the same cost pressures.
• Companies within an industry tend to face the same revenue drivers.
• Companies within an industry tend to face the same regulators and political pressures.
• Companies within an industry tend to face the same behavior from debt-financers and equity investors.

Now, some companies have competitive advantages that are difficult to replicate, but those are not plentiful.  It is no surprise then that equity performance within industries tends to be tightly correlated.

Now consider ETF activity.  The largest ETFs cover whole stock markets, or sectors containing many industries.  The trading can drive the prices of many stocks regardless of the fundamentals in the short run.  The ETFs allow for simple decisions to be made.  “Financials stink; sell the XLF.”  “Technology stinks; sell the XLK.”  “Energy and materials will do well here, buy the XLE and XLB.”

The thing is, in each of those sectors, there is a lot of variation.  Is there a reason to worry about financial companies that focus on mortgages?  Yes.  Does that have anything to do with insurers?  Aside from mortgage, financial and title insurers, no, it doesn’t.  What do chemicals have to do with base metals?  Not much.  Do refiners and E&P companies benefit similarly from a rise in the price of oil?  No, it is the opposite; one buys oil, the other sells.

ETF trading activity can be a benefit to the fundamental investor.  When your companies come under pressure from ETFs because ETF holders sell indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the selling, it is time to buy a little more.  When your companies rise because ETF buyers buy indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the buying, it is time to sell a little.

ETFs simplify decision-making for many investors.  Sophisticated investors will avoid the simplification and drill down the economics and the industries and companies that they own, leading to greater profits in the long run.

Those that know me well know that I have been following the entitlements issue for over 15 years. I feel that the leadership of the American Academy of Actuaries has blown it royally over this whole period, and before, through and before the Greenspan commission (his worst legacy). We had a chance to warn the nation, and did not do it. We allowed actuaries who could do the math, but didn’t understand the politics, to write in our journals, and talk to Congress, and suggest that everything would be fine.

Well, things are fine now, and they might be fine for the next president, but they won’t be fine by the 2020 election.

I am talking about Medicare/Medicaid. Unless there are significant changes made, there is no way that we can afford the promises that have been made.  The graph from the Wall Street Journal (from this fine article), on the right, depicts spending excluding interest.  Including interest payments makes the graph worse, and more so as time goes on.  In general, Americans don’t like sending more than 20% of GDP to the Federal Government.  By 2020, that will no longer be possible to avoid, unless significant changes are made.

This is the same issue that faces every state in the nation (except Wisconsin) and the Federal Government over their retiree health care programs; they didn’t set aside money for the future payments, but decided to pay-as-it-goes.  Now, what choices are there to remedy the situation?  Not many good ones:

• Raise taxes significantly.
• Raise the age for Medicare eligibility to 75 or so (don’t phase it in).
• Means-test eligibility (lousy incentives there, as it is for Medicaid)
• Eliminate part D now, while there is no imperative to keep it.
• Create a reimbursement system that forces the creation of a two-tier medical system.  For the elderly, it will mean limited help in their waning years.  Treatments for expensive prolonging of life will have to come out of private sources.  Call it the Federal Elderly HMO.

The likely solution will involve all five policy options in some form.  How it works out depends on how much political resistance the elderly Baby Boomers will put up.  Another political hurdle: much as I dislike National Health Care, that is a wild card in this mix.  That could be the de facto way that limits the benefit payments that seniors receive.

I’m not into doom and gloom.  I manage money that is invested in stocks, and I have to look for advantage every day.  But we have put off real reform of entitlements for over 25 years, and we continue to do so.  Which of our six remaining presidential candidates is willing to talk about reforming Medicare?  I haven’t heard any of them go that way; it just loses votes.  But when it is hitting us between the eyes twelve years from now, younger people will be incented to vote in politicians that will curb benefits.

My investment implication is this: don’t rely on Medicare existing in its current form past 2020.  Plan today for the medical care you will need then.  Unless you have a funded private plan behind you, that means saving for the future costs.

No way. If you had asked me two weeks ago whether I would get back in the plus column for 2008, I would have said, “Yes, but in eleven months.” Well, my broad market portfolio is up on the year. Even now, I know that when I write next week, I could be on the other side of the line.

The thing that gives me some degree of confidence at this point relates to what I wrote at RealMoney earlier today:

		David Merkel
		Rebalancing Trade
		2/1/2008 2:56 PM EST

It’s not supposed to work this fast, but I did a rebalancing sale on Alliance Data Systems. Looked really cheap after the merger agreement blew; I guess it was cheap! Hanging onto the balance for more gains. It’s been a weird year so far. On the bright side, I am back to breakeven for 2008, and I have a better, cheaper, more financially sound batch of stocks than I did in mid-2007.

That means something to me. I even think my portfolio has more growth potential than the one I was running with in mid-2007, and I don’t pay up for growth. I do accept it if it is being offered gratis.

There is something different going on in the markets now. It is as if the wind has moved to my back and out of my face. That said, it could just be a bear market rally, or a brief spurt of mid- and small-cap value amid a market favoring growth investing.

Then again, I am grateful to God for the turn; I’ve made a number of good picks and sales lately, and they have paid off more rapidly than normal. With that, I am ready for some retrenchment here, but who knows? My philosophy is to play for maximum advantage; if I have made gains early in the year, I want to play for more. I always hated the idea of indexing if one had a good start to the year. Why cheat your clients? Do your best regardless, and most of the time, it will win.

Hey, I’m just grateful to have made money in 2008. Hope you make money too, and more than me.

Full disclosure: long ADS