Sunday Morning Coffee

A reader asked me to weigh in on the coming election and whether I think it will be market moving.

First a hysterical quote from Alan Ableson's column attributed to Tom Gallagher from ISI;

This, indeed, is an odd election: It pits a candidate who should have been president eight years ago against a candidate who should be president eight years from now.

I don't write too much about politics because my skeptical nature leads me to conclude that election results are never as meaningful as some would have us believe.

I'm a Libertarian so I don't really care for either candidate (have not been of any candidate for quite a long time). They both have flaws galore and they probably each have positives too.

Part of my frustration (not unique) is the fact that very, very few of the "promises" made can actually happen. Candidates often promise things that cannot be passed through congress. They may (or may not) believe in the value of certain policies but still many of them never have a shot in congress and they know this going in.

I find the pandering to be nauseating. I find myself perplexed as some of the ideas that come from candidates that seem to ignore common sense. Regardless of how we got here, the economy stinks. Raising taxes in a lousy economy is a bad idea. Raising them in a mid 1990s economy is far less damaging.

I find there is dishonesty in much of what is said, there is no easy way to find really unbiased analysis of what is being proposed. As an example republicans are critical of raising the capital gains tax to which any dem they can put on TV says they will be below what they were under Ronald Reagan. I'm sure I am being overly critical but I find answering the question of will he raise taxes by saying they will be lower than... to be dishonest at the core.

The drilling in ANWR is another absurd debate. It won't add oil for ten years. If they had started ten years ago we'd have it now. If they started eight years ago prices now might be less with the realization than ANWR would start producing in two years. The land in question is a massive, barren tundra. If you have been reading this site for any length of time you know what sort of animal person I am. With that said, does it make any sense whatsoever that the wildlife that would be displaced or otherwise harmed by commencing drilling ops on a speck of that massive barren tundra is more important than the American economy?

The US needs twenty something million barrels per day. A bunch of new sources of 500,000 to 2 million BPD seems like a good idea to me in conjunction with R&D for alternative energy.

If Barry Obama gets in and can allow the taxes on dividends to sunset or otherwise increase it will create a drag on those sectors that are typically thought of as being dividend payers. Although not talked about much anymore, these sectors got a tailwind when the cuts were enacted.

Allowing gains taxes to sunset or otherwise go up will create a headwind, in general, for equity prices. The cuts helped, increases will hurt. I do not think it will trigger a lot of sales ahead of time to capture the 15% rate but more likely will hurt demand in the future. Not to say stocks can't go up but simply this headwind will be added to the list of others (equities always have headwinds and tailwinds, sometimes the headwinds are more important and sometimes the tailwinds matter more).

Windfall profit taxes are ludicrous. The dems who favor this focus on the absolute numbers. Continuing the ludicrousness out a little bit would it make more sense to set windfall rates based on profit margin? Exxon is a very large holding in every broad domestic index fund, you know the kind of index funds owned one way or another by the very people Obama is pandering to. Every time a dem is asked about this they spin out to something completely off topic. More dishonesty.

McCain, aside from some unlucky quotes, seems to be very middle of the road and Sarah Plain and Tall (has anyone used this yet?) notwithstanding he may have a tough time bringing in a lot of republicans so very little may get done. This sort of gridlock (Barron's talked about this) is not the worst thing in world.

Obama would be worse for capital markets, IMO. I have two friends that are really Obama people. I said to both of them, at different times, that he has doesn't seem to embrace capitalism as much as you'd hope for and both conceded the point.

McCain as a maverick? Will maverick ever equate to loose cannon or unpredictable? Still he is probably better than Obama.

Told you I was a skeptic but what would you expect from a Libertarian who lives in a cabin, on top of a mountain in the Mountain time zone?

The picture is from the trail down to Pololu Valley, where I filmed yesterday's video.
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The Big Picture for the Week of August 31, 2008

The video is shot in Pololu Valley which is a few miles east of Hawi (pronounced Ha-vee) at the end of highway 270.

Here is the list of currency ETFs filed for by WisdomTree according to IndexUniverse;

• WisdomTree Dreyfus Chilean Peso Fund
• WisdomTree Dreyfus Czech Koruna Fund
• WisdomTree Dreyfus Hong Kong Dollar Fund
• WisdomTree Dreyfus Hungarian Forint Fund
• WisdomTree Dreyfus Israeli Shekel Fund
• WisdomTree Dreyfus Icelandic Krona Fund
• WisdomTree Dreyfus Indonesian Rupiah Fund
• WisdomTree Dreyfus Malaysian Ringgit Fund
• WisdomTree Dreyfus Mexican Peso Fund
• WisdomTree Dreyfus Norwegian Krone
• WisdomTree Dreyfus Polish Zloty Fund
• WisdomTree Dreyfus Russian Ruble Fund
• WisdomTree Dreyfus Singapore Dollar Fund
• WisdomTree Dreyfus Swedish Krona
• WisdomTree Dreyfus Swiss Franc Fund
• WisdomTree Dreyfus Taiwan Dollar Fund
• WisdomTree Dreyfus Thai Baht Fund
• WisdomTree Dreyfus Turkish Lira Fund
• WisdomTree Dreyfus BRIC Currency Fund
• WisdomTree Dreyfus Developed Currency Fund
• WisdomTree Dreyfus Emerging Asia Currency Fund
• WisdomTree Dreyfus Emerging Europe Currency Fund
• WisdomTree Dreyfus Emerging Latin America Currency Fund
• WisdomTree Dreyfus Gulf Currency Fund
• WisdomTree Dreyfus Oil Exporters Currency Fund

That is some list.

So as another example of what I saying in the video, if they do actually list the Icelandic krona fund and there is very little interest in the fund the payout stands to be quite high. WT runs into issues with the dividend from the fund not being that close to the index when a lot of assets pour in to that fund.

If they seed the Icelandic krona fund with $X and only one person buys in then the yield is going to be in the teens. Of course the krona could drop in value and if only one person buys in then at some point the fund may close.

It looks like WT filed on August 20. That means the soonest any of these could list is 75 days (my understanding of the process). They didn't file to list none of them but as I said in the video I doubt they will actually list a lot of these.

I can say I would be interested in quite a few of them, they offer interesting potential and would really make the category very thorough. This also makes Taleb's idea of t-bills from around the world with 90% of the portfolio combined with 10% in very risky stuff more easily accessed in a brokerage account.

If they list all of them (again, not what I expect) I would suggest moderation. My idea of going absolutely berserk with these would be to own two of them with modest weightings.
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Ain't Nuthin Working Today

I have this widget on my desktop to quickly see what is happening sector by sector throughout the day.
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What Of GDP?

A reader asked for my take on GDP which printed a better than expected 3.3%! It probably means gray skies are gonna clear up and that all is right in the world. Ahem.

Barry Ritholtz does the heavy lifting of dissecting the report and spelling out why there is less than meets the eye. Ditto Durable Goodies so I won't reinvent the wheel. Mish just invoked the term Occam's Razor which means the simplest answer is the best or most likely answer. I love this idea and believe in it.

So, to the question which I'll broaden a tad to the US economy. Well, housing prices are down a lot in many parts of the country (dare I say places that are economically very significant to the country?). This means that if you had to sell your house you could not get a price you'd be happy with and for many folks this means the proceeds wouldn't pay it off. If you could find a buyer willing to pay a "good" price that buyer might not be able to get financing.

The housing issue is part of the asset deflation story that has unfolded for a while now. The S&P 500 first closed at 1300 (yesterday's closing price) on March 15 1999. People worry about whether this period could turn into the 1970's, it already has. Nine years with no gain in stock prices in nominal terms (maybe things look better if you add in the dividends but then you would need to inflation adjust the whole thing and I'm thinking it still wouldn't look so hot).

At the same time our assets are grappling with deflation many of the things we have to pay for every week or every month have gone up a tremendous amount.

The economic policies of the gubment have left us indebted, needing more debt and needing foreigners to buy an awful lot of that new debt on top of what they are already holding. In order for this to continue it means the US must rely on several things all continuing to go right (they probably will but this reliance exists and is a risk factor).

I haven't even touched on energy, social security or Medicare issues.

So sticking with the issues cited above what is the simplest answer? Thinking about that answer, does it really matter how GDP prints? What matters more, I submit, is that if your house was worth $400,000 a year ago--what could you get for it now if you had to sell? What matters more is whether your financial plan is on track for where it is supposed to be in 2008. What matters more is your ability to meet your obligations. What matters more is the gubment's ability to meet its obligations.

Anyone can take anything they want from the data and probably make it sound plausible. The simple explanation spells out trouble continuing. This is not apocalyptic because certain markets have offered normal returns and people that live beneath their means can weather a poor economy and there is demand for the US' debt.

All this takes me to the same place I have been for several years which is slower growth at home, slightly higher interest rates than we are used and the need to find normal equity returns elsewhere.
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New Zealand Update

Here is a pretty thorough dissection of the challenges faced by New Zealand.
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An Allocation To Ponder

I meant to get to this earlier in the week but the reader question posts and flying on Wednesday got in the way of it.

On Monday on European Closing Bell the guest investor was Juerg Zingg from Q Investments. Mr. Zingg did the interview from the stock exchange in Switzerland so I assume he is Swiss.

He lamented the short term focus people seem to be giving toward technicals and said that most markets have just broken the "last Fibonacci line" and he expects more downside pressure.

In that light his current allocation is 30% in traditional markets, 40% in alternative investments and 30% in real assets. The graphic on the screen indicated that he expects this mix (more specifically his application of this mix) to return 8-14%.

He does not like bonds currently allocating just 10% to bonds as part of the traditional markets portion. Real assets include 20% in commodities and the other 10% includes private equity and wine funds (not sure why these are real assets and not alternative but this is what the graphic said).

The 30% for traditional markets breaks down as US 35%, Asia 25%, Europe 25%, emerging markets 15%. Within equities he prefers materials, drillers and ag stocks. He is warming up to tech. I realize these number don't quite jibe with the bond number above--I am just going by the graphics used but that isn't really the interesting thing.

He has very little equity market exposure. He thinks world growth will be 3% this year and next, compared to about 5% last year which leads him to conclude that demand will be there for the groups mentioned above that he likes.

The sort of growth level implies an equity environment that is not horrible (even if it is not great) but still only 30% in traditional markets. I would read that as a comment on volatility expectations but that is just my read as the question wasn't asked.

I've written a lot of posts that try to explore and create awareness of alternative investments (assume a liberal definition) as I am convinced they can help create different types of effects within a diversified portfolio. Hearing how other people utilize these sorts of things makes for a better understanding for our own use but I would urge caution WRT to a number as big as 40% like Mr. Zingg uses.

While I cannot know his intention or exact opinion going that heavy could be thought of as giving up on the stock market. In my opinion global equity markets are simply enduring a cyclical decline (the US might be a little more serious but is not Japan). If global markets are simply in a cyclical downturn then they will start a new bull market and when that happens the move will be big and most alternative ideas would lag at that time.

Keep in mind that up a lot doesn't happen very often (just one year this decade) and while it is ok to lag those it would be bad to miss them. Market up 26% you up 20% would be a lag. Market up 26% you up 8% being too heavy in alternative assets would be a miss IMO.
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Hoppin Over To Hilo

If you're going to be in the inter-island terminal between noon and 2pm Hawaii time near gate 54 be sure to say hello.
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Reader Question 3

A reader asked me to expand on my thoughts about investing in surplus countries or other types of themes where money appears to be flowing. He says that Laszlo Birini has also mentioned investing along these lines and lastly the reader asks if there are any sites that track this.

First let me say that I cannot vouch that Birini has talked about this or not, certainly the reader says so and I believe him but I have not looked at Ticker Sense to find that info.

As far as sites to track this, I'm not sure what he means exactly. Surplus info is available most of the time on central bank web sites which almost always have an English version (Uruguay is the one exception I know of). One other way to look is to just type "country name budget surplus" into Google which will take you to something that will tell you one way or the other.

Now as for the the theoretical, or maybe philosophical, part of this...I can remember reading various things long before the current phase of my career where very smart people in the field talked in very simplistic terms about trends that were very obvious but seemed to get missed by other people in the business (a forest for the trees type of thing).

Reading this sort of thing over and over made an impression. As I am lazy by nature I am drawn to find the path of least resistance in everything including portfolio construction. If money must flow into some segment for whatever reason it is only logical that prices have a good shot at going up.

Water is an example of this. There are all sorts of ghastly statistics about how many people die because they do not have access to clean drinking water. As the emerging world ascends this issue is either going to be rectified or a ton of money will be spent in failing to rectify the problem. Either way this likely means good things for any company that is part of the solution.

There are several ETFs in the water space and obviously many stocks as well. A given stock or ETF may be the best way in or the worst but money must be spent here and it creates a tailwind for anything associated with the water industry.

There are obviously many other ideas like this that exist, some better and some not as good as water.

As far as surplus countries...it is possible that this decade could be thought of in terms of divergences. Last I checked the US was a deficit country (a little levity). Forgetting everything else about the US for a moment, it is a country whose deficit has become much larger and whose stock market is down slightly for the decade. All of the reasons and opinions notwithstanding these are two facts.

The All Share Index in Norway, which is a surplus country, is up about 150% since early 2001 (as far back as Yahoo Finance can chart on that one). Canada is up 50% this decade. Brazil is up 200%, after what looks like a huge decline on the decade-long chart.

The UK has Budget deficit that appears to be headed in the wrong direction and the FTSE 100 is down on the decade similar to the S&P 500. France has a budget deficit and the CAC 40 is also down on the decade.

I am sure there are examples that work against my point too but a surplus implies a healthier starting point. To be clear I do have some exposure to deficit countries in addition to the US--I am not an all or nothing investor.

If there is anything to what I mention above the question then becomes how long does this last? Bringing in some things that are open to interpretation like how serious are the excesses caused by the credit crisis and what the aftermath will be (credit contraction), maybe this will last for a long time yet. In the mean time the surplus countries seem to be less impacted by this, the ascending countries are still ascending and everyone needs more water.

If any of this makes any sense to you, then you need to ask yourself where is the path of least resistance.
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Reader Question 2

In an ongoing thread there was a question about covered call funds. I used to write about these more. I am a believer in the concept but many of the CEFs have done poorly through the market events of the last year. I have used one CEF (with foreign exposure) for many clients with a very small weight (this is the manner in which I wrote about how to use them; in moderation).

Specifically the reader seems to be asking whether holding a call writing fund in lieu of a broad based fund while the S&P 500 is below its 200 DMA makes sense. I sort of touched on this recently talking about the PowerShares Buy Write ETF (PBP) which I own personally and for a couple of clients.

The bigger macro IMO is that when demand for equities is poor what steps do you think you should take, if any, to look less like the market? Owning the right covered call fund certainly could be part of the solution. Where domestic exposure in this space is concerned I think the ETF might be the better wrapper.

Look at the chart. It compares the market price of the S&P 500 Covered Call Fund (BEP) to the net asset value of that fund and the S&P 500 index.

The NAV appears to have about equaled the index but there have been two dividends of $1 each in the year charted so the NAV has outperformed the index noticeably.

The market price appears to have lagged the index by a meaningful amount, add in the dividend it is a slight beat for BEP. PBP has had a more meaningful albeit less volatile run of outperformance.

And the thing that is difficult is that the next go around BEP could do much better or much worse it just depends. The issue, as I see it, is that changes in fear and greed are what move the CEFs and that issue doesn't really exist with the ETF market.

The effect that I have written about trying to achieve in this context is to look less like the market with the portfolio when demand for equities is unhealthy. Obviously some things will be more volatile than the market, some less but what matters is the overall blend.

Pursuing this becomes easier if you can reasonably predict how various holdings will do. What I mean by that is if you have an industrial stock you can have a good sense whether that stock is typically more or less volatile than the sector in general. In a simplified world if you have one stock for each of the ten S&P sectors and each of those stocks is less volatile than their respective sectors it is a good bet that the overall portfolio will be less volatile than the broad market.

Not everything can be predictable all the time of course but taking on CEFs can reduce the predictability of the portfolio. Some of that will go with the territory but if you take on a CEF and you want a little more predictability in a bear market you may need to offset the CEF with something else.
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Couldn't Agree More

Wise Investing: No Substitute for Saving - Finance Blog - Felix Salmon - Market Movers - Portfolio.com

I've put up a lot of posts on this point. It is crucial to understand.
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Reader Question 1

Several great questions came in over the weekend. I'll tackle one the first one today.

First up, a reader asked a follow up about shipping stocks (mentioned in passing in this past weekend's video). I mentioned in the video that one of the names in this group, Dry Ships (DRYS) as being nuclear hot. I made a joke about seeing the name in the $60's a few months back and ten minutes later it was trading at par ($100).

The reader stumbled across Frontline (FRO) and asked for my take on what to make of the 18% yield. He wonders if buying the name would be considered chasing yield. That he is asking the question means he realizes a crucial point. We are in a 3%, or maybe 4% world. Something that yields 7% or 10% or 12% or as high as you want to go has some sort of risk to it. In the last year FRO has been as high as $72, as low as $34 and is pretty close to the mid point right here.

I don't know the stock but you can glean a fair bit by looking at a chart comparing it to the Energy Sector SPDR (XLE). Yeah yeah it only carries oil and shouldn't move with oil stocks but look back over any decent period of time and you'll see multiple instances of the broader sector getting a cold and FRO getting pneumonia. Maybe it is just a coincidence but in the last two years I count this happening six or seven times--it worked the other way too sometimes. There were also times where they diverged.

The reader wondered how much solace the dividend could offer to a purchase that turned out to be unlucky. The stock hit its high on June 23. A few days later it knifed down to $65. Anyone buying at that point and still holding on has a 15% loss with a dividend coming in September. The last dividend was $2.75 so assuming it is the same next month how much solace is that versus a $10 drop. There can be no right answer.

The risk seems to be one of poor entry into a volatile stock. In the last couple of years there have been times where buying panic was wrong and times where buying strength was wrong. I certainly don't have the answer. No matter how great or lousy someone might think the name is anyone buying in is adding a lot of velocity. This was even the case when oil money was more easily made in the stock market a few years ago.
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Handball Finals

I've been on a team handball jag since before the Olympics started and all the more so when I found out that Iceland was in the mens tournament.

Iceland lost the gold medal match to France 28-23 to get the silver. The team became a media of a media sensation with pub in the NY Times, International Herald Tribune and USA Today.

I tivo'd USA's coverage of the final because of the lousy time slot they gave it. Earlier I compared team handball hockey and basketball but after watching some of the water polo I think that might be a better comparison; they beat the hell out of each other in both sports.

It really was a great story in terms of the excitement on the ground in Iceland and the notion that a country of 300,000 can successfully compete against countries with millions of people--a great underdog story.

On a related Nordic note Norway won the womens tournament.

If you say them play; not too shabby for them by any means.
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Sunday Morning Coffee

A few stray items.

This week's interview in Barron's was with Byron Wien. There were several interesting nuggets including this comment; ...whenever a category in the Standard & Poor's 500 gets to be more than 20%, you should probably pay attention, because a reversal is probably in store.

This is something I have harped on many times before, not that I claim any originality.

It makes sense to pay attention to sector weightings and pay heed to distortions from the norm. The crew at Bespoke usually has good info on this sort of thing. A sector becoming 30% is a clear warning (energy in the early 80's and tech at the start of this decade) but 20% might be a little less clear. Financials historically have been in the mid teens but had been hovering around 20% for several years before the crisis started.

Looking forward with this, energy seems to be one to watch. It has come up quite a bit this decade as you might imagine. I saw it top out around 16% but now is at 13.75%. If it does get to 20% or so I would be inclined to be underweight no matter what I thought of the fundies.

Another item from Barron's is that apparently the Bank of Japan, as in the central bank, is a public company. Barron's said the ticker in Japan is 8301. I found BNJAF for the five letter designator for US trading but it is not clear that it does actually trade. Both the Yahoo Finance and PinkSheets.com pages for the stock give the impression that there has been no trading for months.

Also the Barron's article says the Japanese government owns 55%, and you need its permission to own the shares. I'm not exactly sure what that means. Additionally the dividend is minuscule and the bank doesn't report earnings.

I am in no way advocating that anyone try to buy the central bank in Japan but I find the existence of shares to be fascinating. Central banks are meant to be independent so why not publicly traded? Central banks can fail. I was recently reminded that the current Federal Reserve is actually the third incarnation of a US central bank.

Buying shares in some central bank that presides over some monster surplus and a wealth fund is intriguing on some level.

One thing about ETFs that I did not get to in the video was that IndexUniverse is reporting that there is a Nordic ETF in the works that will mimic the FTSE Nordic 30 Index. The countries represented will be Sweden, Norway, Finland and Denmark. I might expect a lot of banks and a heavy weight in Vestas Wind (VWDRY).

Banks and Vestas is either right or wrong but all four countries have interesting companies and the effect of owning these countries might get blended away depending on what the fund ultimately looks like.

The picture is from the east end of Molokai near what I believe is mile marker 20. We hung out at a beach right across the street from this house.
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The Big Picture for the Week of August 24, 2008

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New Picture

Well, someone figured out how to use the Microsoft Office Picture Manager to make photos smaller to fit blogger's very narrow profile photo requirements.

The old picture was from 2003, the new one is from 2007, four years and I'm no less ugly.

The picture was taken at Bank One Ballpark Chase Field where the Diamondbacks play when the Red Sox were in town.
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Financial House

"I'm not gonna take this! Wormer Freddie? He's a dead man. Marmalard Lehman? Dead! NIEDERMAYER FANNIE? Dead!!"

Sometime yesterday I saw a graphic showing Lehman Brothers down 75% and I thought about the above speech. We also know the drop at Fannie and Freddie is in the 90s.

Everyone knows that the financial sector has problems but the crisis now kind of long in the tooth. That is not a call to go heavy by any means but the crisis is old.

For a little perspective, many folks date the start of this to June 1, 2007 but it actually started much earlier than that. Here is a video I did in December, 2006 (about 5 minutes 38 seconds in) and another one in February 2007 (about 8 minutes 8 seconds in) in which I talk about subprime and actually mention names that were already in trouble and ended up failing one way or another.

Ok, the button to embed a link seems to not be working so the exact dates for the videos are December 23, 2006 and February 10, 2007 for anyone who cares to click through to the archives.

At some point a crisis ends. We all know the financial crisis will end, we don't know when or who the final victims (companies going to zero) will be. It is a good bet that the stocks will turn up, for real, before the uncertainty is over. This is simply how things work as opposed to a commentary on the specifics of this meltdown. Yahoo bottomed at $4.54 (adjusted for splits) on September 24, 2002. Six months later it was at $11.67. One year from that bottom it was at $18.30.

Bounces off the real bottom are big and when the bounce in tech started people were still terrified of the sector. People will be terrified of financials when it turns and for good cause; I would expect some failures to still occur after the bottom.

Just as buying a tech stock in Q3 2002 would have been difficult emotionally to do, so too would buying certain financial stocks be emotionally difficult a few months from now. This makes a good argument for using an ETF, even for folks who usually pick individual stocks. Even if a stock with a 4% weight in an ETF goes poof, the hit absorbed by the fund would not be disastrous to the overall portfolio.

The slightly bigger macro is that after at least 21 months and huge losses I think the most of the risk is now out of prices at the sector level, currently down 45% from the high XLF bottomed out about 55% from the high and could go there again before bottoming. To be clear there will be more carnage at the individual stock level.

You may disagree with the down side estimate or not but the way I view it the down side is what I mentioned above and the upside is the next bull market cycle. For now I am the same underweight I have been for ages, adding more exposure will come, slowly, once the broad market takes back the 200 DMA--whenever that happens. It is a good bet that when that occurs people will still be shunning the sector.
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3000

Today's post is number 3000. This site will be four years old next month.

The picture is to commemorate a great baseball player and person but does not to signify the end of my blogging.

From yesterday's FT Alphaville comes this little nugget from Marc Faber;

From a personal perspective, says Faber, of his total assets, about 5 per cent is in equities, 8 per cent in gold, 8 per cent in real estate and related investments and the rest is split between US and euro fixed-interest securities.

He also mentioned that sooner or later he thinks the entire financial system will blow up. This makes the case for him for holding some equities because he thinks large cash deposits will disappear over night in a "blow up" but equities although down a lot would still have some value.

He cites an opinion from an unnamed economist who thinks that the surpluses built in Asia will shrink in 2009 by 50% (why is spelled out in the link) which if did happen would be devastating for everyone.

Here is a fun fact from Whitney Tilson in a post on Seeking Alpha; prior to this decade, the average American household was able to borrow approximately 3x its pre-tax income to buy a house...As the decade progressed, they (lenders) were willing to lend 9x a household’s income!

I can't vouch for the numbers but we all know that the direction is correct. Regardless of whether 9 is spot on or not the lending standards became absurdly lax.

Is there anyway that Fannie and Freddie's equity survives? Forgetting the day to day news flow for a moment isn't their failing (equity-wise) a foregone conclusion? Am I missing something? Even if I have that wrong their going to zero is well within the realm. This brings up a point I have made (but did not originate) many times before which is that part of the fallout from a major crisis is enormous failures (Enron and Worldcom as recent examples). This has happened before, appears to be happening now and more importantly will happen in the future.

On a more pleasant note there was a snippet in the WSJ about a banker venturing out to start a wine fund, apparently there are ten of these that already exist.

The chart is a wine index that seems to be impervious to cycles (I wish the chart went back to 2000). I don't know anything about wine but some sort of exchange traded something or other would not shock me.

Evolution in this regard would be great; let the end user decide it owning it makes sense.

In going anywhere near something like this I think I would rather own a meat fund, sugar or chocolate. These types of things face new demand from ascending (and bigger) markets as opposed to what might be demand from the same rich people that have always bought expensive wine.
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One Night In Bangkok Shanghai

Last week I disclosed going back into China with a small purchase for most, but not all, clients. Relative to a day or three the timing was poor. The big macro is that at down about 60% from the peak there is a lot of bad news priced in.

Today the Shanghai Composite was up 7.63%. Just as two days was not enough time to be wrong, one week is not enough time to be right. I do not know if a bottom is in or not but I would expect the real and ultimate bottom to be a little quieter than a 7% rally a day or two after "bottoming."

It is very human to have a reaction to appearing to be very right or very wrong soon after making a trade but if you buy something with a long time horizon the first week means nothing (assuming no catastrophe or no buy out).

Iceland won its quarterfinal match against Poland in team handball earlier today, next up is Spain.
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Will This Work?

From the hmm, this might be interesting file...

The chart compares the Double Short Long Bond ETF (TBT) versus the Single Long Long Bond ETF (TLT) since TBT's inception.

I have been in the camp that thinks US interest rates are going up. This call has been wrong or early (take your pick) but I still believe it will be the case. If that turns out to be correct then longer dated bond funds stand to get hit. As a rule of thumb an increase in rates of 100 basis points on long dated paper could be expected to cause an 8% drop in price. With individual issues you do get the par value back at the end but with funds there is no par value that has to be made back.

With about three months of data (not a huge sample, I admit) it looks like TBT is zigging against TLT's zag. Since inception of TBT yields have dropped a little so TBT is down in price.

An investor putting $10,000 into TLT on May 22 (day one for TBT) and $5000 into TBTwould have $14898 at yesterday's close plus two dividends from TLT totaling $73.04. So in this example the net loss was $29 or 0.019% which is pretty good if the position really is hedged and considering that he market went against the position.

One administrative note about TBT is that it too pays a dividend but the dividend should be annual at the end of the year and represent t-bill interest less the expense ratio. If rates do go up, including t-bill rates, then TBT would probably pay much more than it is likely to pay now.

A combo of TLT and TBT where TLT yields 6% and TBT yields 4% and the portfolio is protected from rising rates sounds pretty good to me.

Obviously the idea makes no sense at all for anyone disagreeing with the higher rate scenario. Personally I would need a little more time to be convinced the zig zag will stand up. The objective of TBT is twice the inverse on a daily basis. I think the reason it appears to be working for now is that market captured is much less volatile than equities where the leveraged products are a little less predictable.

If there is any there there then a TLT TBT combo could be thought of as the basic strategic building block. Anyone so inclined to tinker might come up with other ways (meaning other products) to implement some sort of hedged combo. In the context of brainstorming and exploring, anything goes at this point.

Yaz, get well soon. Last night, Red Sox announcer Jerry Remy said that Yaz would be getting bypass surgery at Mass General. Later in the game they reported that the surgery was successful.
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Too Much Supply?

FT.com / Comment & analysis / Comment - Rogoff: The world cannot grow its way out of this slowdown

Part of the above article delves into whether there is too much supply of financial institutions and whether impeding the natural market force that would shrink that supply will have consequences.

I've seen this sort of idea before but the article is worth reading.
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Coffee House Ponderings

Over the last couple of days I stumbled across a way to articulate what might be going on with the US capital market and economy versus what might be going on in foreign markets and economies. I touched on this yesterday in a different context in my greenfaucet post.

In the last little bit, foreign equity markets and currencies have rolled over in varying magnitudes over concerns that these places (most of Western Europe, several emerging markets and Australia as examples) are slowing into a recession.

There is visibility for a global recession and stock markets and currencies seem to be pricing this in at the moment. Global recession may or may not happen, the point I am making is that capital markets are giving that outcome a greater weighting.

If you do a little reading about some of these countries and their current state of affairs you might conclude that they are facing a cyclical event, a normal cyclical event. Maybe the catalyst ties in with the US or maybe not, but cyclical just the same.

The US on the other hand is also facing some systemic issues that play little to no role, that I can glean, in other countries.

Deficits matter, "no country has devalued its way to prosperity," the nature and scale of the Fannie and Freddie situation (bailouts, foreign investors backing away from their debt, raising capital one way or another, the sheer numbers involved) stands to be really big, the US' unhealthy dependence on foreigners funding our deficits and anything else you want to throw in.

Additionally, the deflation in assets prices (Mish has written a lot about deflation) combined with whatever is really happening with higher prices for things we spend money on is a bad mix. And at some point credit contraction becomes a big negative too if it isn't already (concerns about credit is what all those posts about the inverted yield curve were about).

The consequence as I see it and have been writing about for several years now is below normal domestic equity market returns (this has been the case for a while now), a creep up in interest rates (I would have thought rates would have gone up quite a while ago but they have not) and slower GDP growth during the expansionary parts of future cycles.

The investment implications, as I have been chronicling for a long time, are more foreign, more of what ascending countries need and more alternative assets (the focus is over a five or ten year period not the next 6-12 months).

I think the personal implications, this is not new either, are to live below your means, save like hell, plan on working longer and get/stay out of debt.

Maybe none of this is right but it does seem plausible. Just as plausible is that any version of the above will not be as bad as the gloomiest accounts would have us believe.
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A Theory Tweaked

Several times I have mentioned Nassim Nicolas Taleb's idea of putting 90% into a mix of t-bills from around the world and then going berserk (my word not his) with the other 10% in terms of risk taken.

I find the concept intellectually appealing on some level similar to the idea of living in a foreign country. I'm not going to do either one but it is interesting to contemplate.

So the tweak pertains to the 90% but perhaps this is what Taleb had in mind. Instead of putting the 90% into a mish mash of foreign t-bills limit the t-bills to just surplus countries like Singapore, Norway, Canada, Brazil, China, Kazakhstan, Switzerland, Australia (well, budget anyway) and so on.

Investing in a surplus country guarantees nothing and at times deficit countries perform better and at other times a mix of deficit and surplus countries is best but I think it is safe to say that surplus countries are on surer footing and have much larger margins for error.

The mix could obviously also include US exposure with treasures or TIPS or anything else you think fits the bill. There is a risk of course the the US dollar could go up (not my opinion about what will occur but it could happen) so maybe something along the lines of the PowerShares Dollar Up Fund (UUP) which might provide a little bit of hedge for those so inclined.

The upside to this is that if you can spot important trends you can squeeze a lot out of the 10% and the draw down should be much less in bear markets (only 10% is in equities one way or another) even if the 10% goes to zero.

As I mentioned this is more of a contemplation than anything else but it does get you thinking about things like risk budgets and so forth.

On a personal note I decided to give up the investment gig in order to support my wife's coffee art career.

Pictured here is a buffalo in my Sunday morning mocha.
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Sunday Morning Coffee

An interesting, albeit quick, discussion broke out in the comments of yesterday's post about buy and hold, versus the DFA version of buy and hold versus doing something that is not buy and hold.

My basic take was you can glean any conclusion you want from the data (and reasonably support that conclusion). I think it boils down what sort of path you want to take to what is likely going to be a similar long term result regardless of the path you choose.

That is just an opinion, it makes some assumptions, feel free to disagree but that is how I view it.

It got me to thinking about an article I recently wrote for TheStreet.com which was about a portfolio concept for people who just throw in the towel on the stock market as a function of realizing they just cannot stomach bear market volatility despite the very cyclical nature of it.

While I think this idea makes things very difficult on several fronts the fact is some folks are better off emotionally not doing too much in the stock market.

The basic idea was a little buy write fund, a little emerging market bonds (as a proxy for foreign equity exposure), a lot in absolute return, a lot in inflation protected bonds and then save like hell.

I would expect a mix like this to lag a lot but I think it would go down a lot less too. And while particulars may or may not be a good combination the big picture strategy makes sense for some folks. In addition to people that cannot stomach volatility it might also be worthwhile for people who are way ahead of where they need to be.

A building block here is that, in the case of the buy write fund, the US stock market is not forever broken. Average returns may be less than what we're used to but the stock market still works. Assuming that is the case, the market will work higher at some rate and the buy write fund will either lead or lag but be reasonably close. The long term track record of the emerging market bond fund was very strong and long enough to convince me they can keep it up and so on. To be clear I am aware there are gaps galore in the concept.

Assuming you are neither way ahead of where you need to be and can tolerate normal ups and downs it still might make some sense to take a little off the pedal especially if you save a lot. I view this as part of the thought process for managing portfolio volatility which I obviously think at times volatility should be increased and at other times, like now, it should be decreased.

On a different note the Barron's interview is with Eric Sprott and he has some gloomy things to say about energy prices (he says they are going way up).

The picture is the trail down to Kalaupapa on Molokai.
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Nouriel Roubini in the NYTimes Magazine

Dr. Doom - Profile - Nouriel Roubini - Predicting Crisis in the United States Economy - NYTimes.com

A couple of money quotes;

We have a subprime financial system not a subprime mortgage market.

and

This might be the beginning of the end of the American empire.

He recently wrote about the end of the empire on his website.
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The Big Picture For The Week Of August 17, 2008

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Finally A Friday

I don't know about you but I am enjoying the Olympics, well most of it anyway. I'm not a fan of tennis as an Olympic sport because we can see tennis anytime we want as opposed to something like water polo.

Occasionally I get an email touting some sort of small cap stock or more correctly a micro cap stock. I don't write about these for several reasons and I am not about to start now but I had an interesting observation with an email of this ilk that I received yesterday.

Being as vague as humanly possible, the company in question apparently has access and rights to some sort of as yet untapped oil field in a country that is not known for oil production. The idea being that if the oil discovery pans out the company stands to make a lot of money and so the stock should go up a bazillian percent.

I don't know if any of it is true, that is not the point. If there is oil in this country that could become a bit of a game changer for the country in question down the road when, or more likely if, crude starts to flow.

The point is that while the stock being touted in the email is of no use to me some of the news being used as a catalyst is of use. If the whole thing is bogus, so what, this is something that may happen, I know about it and if it does happen then fine. There is no reason to not read a tout you might learn something. Investing in a tout is a different story and hopefully the distinction made here is clear.

IndexUniverse has an article up about TIPS and the corresponding ETFs that capture the space. The article questioned the utility of TIPS relative to other segments of the bond market and also questioned how CPI is calculated. The calculation of CPI does have real problems and I wouldn't suggest going real heavy in any segment of the bond market but the article overlooked (or at least I did not see this) an important piece of information about TIP's payout.

The article correctly notes that the 30 day SEC yield is 1.36% but there is more to the story.

The table is from ETFconnect. The monthly payout has gone up considerably in the last months. The reason for this is that the fund pays out, as part of the fund's dividend, what would be the par value adjustment for the individual issues. I verified this on the phone with them a couple of weeks ago for a TSCM article.

The average monthly payout over the last three months has been $0.8288. TIP closed yesterday at $105.82 giving the fund a 7.8% yield. Pretty good eh?

Well it is pretty good but thinking 7.8% is exactly the wrong way to look at this. The dividend is never the same two months in a row. It has gone up lately because CPI, flawed and understated though it may be, has been going up.

The yield on just about every bond ETF I have ever looked at is a moving target but I think, I say I think, it can remain on the high side for a while as CPI seems destined to stay elevated for a while. The fund is $7 off of its high and seems like it has correlated fairly closely to iShares Lehman 7-10Yr Treasury Bond Fund (IEF) for most of the last couple of years.

This is not a suggestion that anyone buy TIP, which I own for clients, but to realize that although the fund is not perfect it does have quite a bit of utility. If you are going to use ETFs I think it is important to realize that there are drawbacks with all of these funds, hopefully you weigh both the positives and the negatives before diving in.
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Assorted What Nots

This chart from Michael Kahn over at Barron's puts the dollar rally in some perspective, eh?

People are saying the dollar bear market is over but as rallies this decade go it doesn't look that big.

It could extend and turn into something big of course but we have seen this movie before WRT to snap back rallies during this decade.

This applies to charts of other things having violent moves in the other direction from what we have become accustomed.

To me this is a good reminder that these moves, counter trend or the real deal, happen often, do not require a panicked response and make a good argument for moderate exposure.

I was never in the gold $2000 camp, and thought oil could come back down to $120 but as fast as the moves have been I think the best thing would be for the velocity to slow down, let these things (currencies, commodities and anything else on your mind in this context) calm down and find their footing. Very fast moves, IMO, belie a very nervous market--more nervous than usual.

I found this guest article about the iPath Global Carbon ETN (GRN) on IndexUniverse.

The author contended that GRN has had a low correlation to the Oil ETF (USO) noting that from July 31 forward GRN was up 10% and USO was down 10%.

I have written about this fund a couple of times expressing my interest in seeing how this works out and what effect it might deliver to a portfolio as the world trades more carbon credits.

My hope is that things related to carbon trade in their own world, essentially correlating with nothing. A few days ago I expressed some surprise at how much GRN had dropped to which a reader very rightly pointed out that it had dropped with the price of oil.

I think the article missed on the correlation issue. It seems clear to me that so far, the two have been correlated but in reality I think it is too soon to feel very confident either way.

A quick Buy Write ETF (PBP) update; it launched right after the S&P 500 started rolling over into a bear market and I gotta say it seems like it is doing what PowerShares and the CBOE said it would do, at least in a down market.

BigCharts has data for the underlying BXM index going back to early 2002. From that point forward BXM is up what looks like 40% versus about 15% for SPX.

In 2003, the one year this decade that the US market was up a lot, BXM was up about 18% versus 26% for the S&P 500. The next time the market is up a lot BXM and by extension PBP would probably lag then as well but the long term result is compelling. I own PBP personally and in a few client accounts.

The volume thus far in PBP has not been so hot but maybe that will change.

I'm still writing for greenfaucet. The content is different than what I post here, I hope you'll check it out.

Team handball update; Iceland is 2-0 in pool play. Last night on the Red Sox game, announcers Jerry Remy and Don Orsillo were talking about team handball. Apparently some of the players were watching in the clubhouse and it is very popular with the players which I find amusing. It really is a hoot.
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Distortions and Dislocations

Maybe Twin Peaks is a little off topic for this post. Anywhoo...

There are currently a lot of distortions and dislocations in the capital markets these days and it is important to recognize them for what they are.

For example, the dollar rally. From mid July through Monday the dollar, as measured by the Dollar Index, was up close to 7%.

Regardless of whether the oil decline is the reason, weakness in other currencies, other things, all of the above or none of the above, 7% in less than a month should not be expected to be a sustainable move.

Even if July 2008-July 2009 turns out to be another 2005 (the dollar was up that year) the move of the last month is too big for this market and based on how this market works, it should work back down at some point. This is not a dollar bear argument (I am a longer term dollar bear) but is simply meant to point out that moves that occur with extreme velocity (relative to what is normal) often go back the other way even if just temporarily.

Oil is another one. Many have opined that a part of the decline can be attributed to demand destruction. Maybe this is true but the case for demand destruction would be easier to buy into if the oil price had eroded and no one thought the bubble had popped. But instead oil has panicked down in such a manner that it is difficult to think it has accurately captured a change in behavior.

We could talk about a lot of the commodities, ag stocks and currencies in a similar vein but you get the point by now.

The point from me is not to load up on these things, I am a believer in moderate weightings, but to the extent you use any of them to supplement your equity exposure, but to not get shaken out when they hit an occasional air pocket. If you diversify with some alternative stuff (and again I only use a little) you should realize it won't always go up but that does not mean it is all of a sudden a bad idea.

I'm not sure what to tell someone who is 25% commodities.

With regard to why you invest, presumably you want to have enough money for some purpose in the future (like not running out of money after you retire), these things are noise. All of the asset classes mentioned, and ones not mentioned, have all had more puke downs or panics up than we can remember and will have many more in the future.

The big run this decade in resource related themes combined with our decade long round trip to nowhere for domestic stocks has perhaps skewed our thinking but from 30,000 feet, markets work a certain way over long and short periods of time and expecting these sorts of things work out roughly the same way is the better bet the vast, vast majority of the time. And for most folks the short term distortions and dislocations can and should be ignored which is easy to forget if you watch and read too much of the wrong thing.

The long term distortions and dislocations do, as a matter of philosophy, need to be heeded but other folks say no. By long term I mean things like the yield curve or exit strategies and so forth.

We are all confronted by short term noise that we need to filter. A big chunk of the filtering needs to be having a plan, sticking to it and knowing your plan won't the best approach for all times but if it is well thought out, you stick to it and you save properly you have a good shot of getting where you need to be.
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CNBC Video

Someone with very long hair hijacked my appearance on the network today.

A reader was kind enough to leave the link to the video.
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CNBC Appearance

I am scheduled to appear on CNBC around 30 minutes before the US close to talk about dividend stocks.

As a quick preview, I generally like dividends.

Hope you can check it out.

Now hopefully Obama doesn't have a mishap with some McNuggets or McCain doesn't have a ghastly hiccuping episode.
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Mid Morning

A few months ago I wrote a couple of posts about some of the interesting (or odd) income trusts that trade in Canada.

Hydro funds comprise one segment of these vehicles like the Algonquin Power Income Fund which has symbol APF-UN in Canada and is traded in the US on the pinks with ticker AGQNF.

As you no doubt know the many of the foreign currencies are down a lot against the dollar in a very short time which has created some interesting effects in various places.

As you can see from the chart, Algonquin's Canada listing has drifted slightly higher in the last couple of weeks, maybe, but really no big move either way but the US listing is down a noticeable amount as the loonie, as measured by Rydex Canada Currency Shares (FXC) is down by almost 5% in the last that time.

While the loonie, and for that matter all the commodities, commodity currencies and gold, could obviously extend what has been an unusually fast decline it has created a discount of sorts for US based investors for certain things.

I'm not a buyer of Algonquin, I am interested in another one of these (not hydro), that I am not sure I am going to buy or not, and while I would not own more than one of these I know some folks really like to load up on them.
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A Plan Comes Together

I never mentioned this on the blog but many months ago I decided that I would probably get back into China, one way or another, when/if the Shanghai Composite dropped 60% from its high.

Monday morning Shanghai got within a few points of 60% down and I bought in on Monday by swapping out of a mega cap telecom name from Western Europe and going into China Mobile (CHL). Not every client owns China now but many do.

To be clear my net long exposure is the same, save for rounding up or down.

Earlier this summer in a video I said I might go in this summer, that I was mulling three names of which CHL was one. I was also mulling a toll road stock and a broader infrastructure stock listed in Hong Kong. I'm not going to disclose those names as I can see going from what is now about 2% up to 4% (not sure when at this point but talking months) and for now those two would be my best candidates for doing that.

As an administrative note I am aware that CHL is not listed in Shanghai. What I bought is an ADR of a company listed in Hong Kong--but not an H-share. CHL simply has a lot of customers on the mainland.

The thinking for 60% was, not surprisingly, very simple. I have been out of China since Q2 2007 as I thought it was overheating (too early I know) but I have never thought the mania in China was worse than the bubble in tech stocks so I have always felt the decline would be less than 75%. 50% declines don't occur that often and so 60% seems like a reasonable overshoot of cutting in half.

Looking out over any length of time what part of the world seems poised for a lot of growth, regardless of the reasons? Asia probably needs to be in the top two of the answer. This has been true all the way down for China and now the markets are much cheaper than they were, much cheaper.

The market could obviously go lower here, that would be easy but it is down a lot now, it is becoming a center of the universe and, again, it is down a lot. I could easily envision the purchase being uncomfortable for a while but that just goes with the territory with some purchases.

There are plenty of bearish points to make about China and they are probably all true but the market is down 60%.
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Mid Morning

A couple of weeks ago or so I opined in a video that a feel good rally could take the market up to about 1310. So we are here now and who knows whether it will keep going (it feels like it but who isn't a sucker for a good story?). I think I was off by a week or so and probably wavered about the feel good rally too but here it probably is.

There seems to be a lot of glee on TV about this so I'll just roll out my typical reminder that feel good rallies are normal, very normal, events within bear markets.

At some point a rally must be the real thing and this could be it I suppose but I really doubt it. The "worst financial crisis..." leading to a very mild bear market does not seem very likely.
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I Gotta Have More Cowbell Handball

By now you know quite a bit about what is happening between Georgia and Russia. You probably also know that the Russian stock market and the currency have both been hit pretty hard and Konstantin Igropulo (number 35) on the Russian Handball team looks pretty worked up about the whole thing as his team went down to Iceland 33-31.

The Market Vectors Russia (RSX) dropped almost 10% this past week. The dollar went up about 3/4 of a ruble, which is a big move, during the same time period.

This will be a great example to learn from. This is a panic caused by what might be a black swan (anyone know if tensions between Georgia and Russia have been an ongoing thing making this conflict inevitable? if so, then no black swan).

This sort of thing has happened countless times before. Some sort of military something or other that catches the market by surprise causing a swift decline followed by the inevitable snapback.

The reason why this is a great example to learn from is the most people are not going to chase heat in Russia. It is not the ideal destination for most volatility tolerances and so as jumping into something that is not right for you as an investment destination is not smart you can pay close attention and watch it unfold.

This sort of thing, albeit with different particulars, has happened countless times and the result seems to always be the same; big, fast decline followed by a snapback. While any single episode could be different, different doesn't happen very often. This kind of event is likely to happen with something that is suitable for you, it has before, and even if chasing it with more money is the wrong trade for you, knowing that you have seen this movie before might prevent you from a panic sale.

If so, mission accomplished.
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Sunday Morning Coffee

There was a lot of chatter on Friday about oil being in a bear market because it is down 20% from its high.

I think we might want to give that one a whoa-champ.

Bear markets tend to start a little quieter than the manner in which oil, and for that matter all commodities, have declined in the last month or so.

In a month, not even, oil is down 20%. It took equities about ten months to to get down to 1252 (a 20% decline for SPX) and even then it has not spent too much time below that level.

The vast majority of the time fast 20% declines turn out to snap back just as quickly if not faster.

Right here right now this looks like a run of the mill panic down, if it turns out differently fine but how many themes end with a bell ringing as metaphorically happened in mid-July. Themes like this occasionally have big fast declines. Emerging markets have had more than I can remember, other hot niches like uranium or currencies had their puke downs too.

Regardless of what this turns out to be it makes the case for moderation. Anyone who did not see this coming and had 25% in energy is probably pretty bummed out. I expressed concern a couple of times as energy made it up near 15% of the S&P 500. While not an obvious sell signal like 30% might be, any time a sector grow to a much larger weight in the index that is a good time to revisit a few things. This has been useful for many years.

The reason behind my continual harping on moderation is that too many people make bigger bets than they realize they have made and end up getting done in or setting themselves back by several years which is very unnecessary.

Congratulations to Martins Plavins and Aleksandrs Samoilovs from Latvia for upsetting (very big upset) Todd Rogers and Phil Dalhausser in the opening match of Olympic pool play in beach volleyball.

When I was in college I played quite a bit of beach volleyball, quite a bit, but funny I don't remember the game being played that far above the net.

Want to watch a great Olympic sport? Check out team handball. Trust me.
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The Big Picture For The Week Of August 10, 2008

Chart from Bespoke Investment Group
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08/08/08

It looks like Rydex' Sing dollar, Russian ruble and South African rand ETFs will be listing in the next couple of weeks. I am most interested in the Sing dollar. Pairing a low yielding, surplus currency like SGD with a higher yielding commodity currency could make for some good diversification.

Other currencies I'd like to see made into ETFs include the Kazakhstan tenge, Chilean peso and the Norwegian krone.

IndexUniverse reported that ELEMENTS ETNs launched three funds "based on the investment philosophy of Benjamin Graham." There is a large cap fund BVL, a small cap fund BSC (really BSC? so soon? wow) and a total market fund BVT. IndexUniverse said they launched on Thursday but that is not clear by looking at Yahoo Finance. Additionally the ELEMENTS website had no mention of them yet.

FWIW I am not a big fan of the equity strategy ETFs/ETNs. I think the draw for exchange traded products is that they are static (save for rebalances) which allows investors to determine their various exposures.

Old friend Telecom New Zealand took a big hit in the local market overnight as earnings dropped 15% due to competition issues and they are likely to go keep heading lower for a while. For anyone new, I sold the stock a long time ago, it was a fine hold (not great) and I have kept tabs on it in case I ever want to go back in but have not pulled the trigger.

Yesterday financial stocks got clocked on more bad news from several stocks. I have been writing about this sector a fair bit lately. I have been saying I think it makes sense to think about the end of the crisis but that it is too early to move to equal weight or overweight (as a matter of philosophy I don't believe in zero weight). People much smarter than us have been very wrong about this sector. The crisis will end at some point and increasing exposure will make sense at some point but we should expect more bad news and there is no need to be early with this.

Yesterday the WSJ had an article about the Harvard Endowment Fund. Apparently for the 12 months ended June 30 the fund was up 7-9% while the S&P 500 was down 14.8% plus (or should that be less?) dividends. The annual report is not on the HMC site yet but it always makes for a good read.

I feel as though I have been heavily influenced by what HMC and some of the other endowments do in terms of seeking out disparate asset classes to create diversification. A big theme on this site has been that portfolio construction evolves and the endowments seem to be out in front of that concept, point being we should listen when they speak.

The strategies they employ are becoming more easily accessed, not that they are right for everyone and certainly this is not an easier path but people that have the time and interest have a good shot at a better risk adjusted result.

I have been doing a fair bit of writing for greenfaucet, mostly about international investing, I hope you will check it out. I post there every weekday.

Is anyone pumped for the Olympics? The opening ceremony is tonight. I'm not feeling it yet but I'm sure I'll get into it but I really dislike the gymnastics and they spend too much time on the human interest stuff for my tastes.

Lastly the issue that the blog might have been having due to a compatibility between IE 7 and Sitemeter should be resolved. Sitemeter support told me via email to move their little bit of code to a different part of the template which I did and they let me know that the issue was solved. If it is not please let me know.
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A Road Less Certain

Sticking with the road theme, although it is hard to see there is a hiking path in this picture which gets you from Hellnar to Arnastapi in the Iceland countryside.

I had a thought at the gym yesterday as I tried to not get flung off the stairmaster about transitioning from defensive positioning to a more invested position as the market transitions from bear to bull.

Fair warning, this is fuzzy stuff.

Over the years I have touched on the idea of having exposure to more volatility early in a cycle and then as the cycle (or theme) matures, reducing volatility in whatever way makes sense to you.

A simplified example might be owning an oil sands name for your energy exposure then moving to an integrated oil company then to a sector ETF. At some point you will need to go back to the oil sands stock (or whatever you might think of as increasing volatility) as the next bull begins.

There are obvious issues with timing and so on but the big macro is that the time to take on more volatility is toward the start of a bull market and have less at the end or in a bear market.

As is obvious, the stock market is now down a lot and even if it seems too early to increase net exposure it might be time to start thinking about increasing the volatility of the existing exposure. For clarity, if someone has 80% stocks and 20% cash and that 80% has a beta of 0.85, they would keep the same 80/20 but maybe increase the beta to 1.05--just as an example.

Generally speaking this is not something I am likely to do a lot of but if there is a panic somewhere in the market, excluding financials, I would probably take action. Obviously panic is in the eye of the beholder.

I say excluding financials as that sector is at the center of this bear market and similar to tech back in 2001 it makes sense to expect more declines because it is very likely there will be more bad news to come. Unfortunately most of the financials with no fundamental link to the crisis would likely also go down in this context.

One area that seems ripe for a near term panic might be energy. I'm not sure what price would make for a panic but if I think it happens I'll post about it. If it does happen in a way I think I can read I would sell some or all of the ETF I am using for some of my energy exposure and add one or two names in its place (names are chosen but do not want to front run my clients).

The idea behind any of this is that anyone who took some defensive action at some point needs to get less defensive. Keeping the same cash level but increasing the volatility is one way to ease back on to the path of being fully invested.

It doesn't take too many trades to change the volatility characteristic of a portfolio so anyone exploring this concept should keep that in mind.

To be crystal clear I have no plans for meaningful changes until the SPX goes above its 200 DMA.
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The End Of The Road?

All things commodities have come way down in the last few weeks.

PowerShares DB Commodity Index Fund (DBC) is down 17% from its July 2 closing high.

iShares Comex Gold Trust (IAU) is down 10.4% from its recent July 15 closing high.

iShares Brazil (EWZ) is down 25% from its high a couple of months ago.

Unites States Oil (USO) is down 18.6% since July11.

You get the idea.

So it is over? As one reader asked, are we done worrying about inflation? What will become of equities and bonds as a result of this? What about the dollar?

Before we worry about how meaningful this is or isn't the very recent puke down in the related areas is exactly why I preach moderation with exposure to these themes. I have talked repeatedly about 5% or so being, IMO, a good number for commodity exposure. If you put 5% into some commodity proxy and it doubled, that would be enough to add real value to a portfolio. On the other side of the coin a 5% weight in something that cuts in half (I realize that is not where we are) cannot set you back for a year or two and reasonably would not cause undue angst.

I have been as bullish and early as almost anyone but have stressed moderation throughout. The entire resources theme has offered many chances to reduce exposure as prices often got ahead of reality or sentiment just got too carried away (here is one example I wrote about in May).

In the last couple of months, one for a greenfaucet podcast and one for SmartMoney magazine (this was in late June when I was in Boston and have no idea if the magazine actually used my quotes or not) I gave two interviews where we touched on oil. In those interviews I said I could see oil headed to $120-$125 (I may have said $115 but you get the idea).

So if I thought $120 was possible I probably shouldn't be shocked that we are here. Can we go lower might be one question on people's mind but the better question is if it goes down will it stay down? In late 2006/early 2007 oil fell from the mid $60s down to about $50 in what seemed like ten minutes which was a bigger drop than the current decline. The current decline is smaller still when you consider that the drop to $50 started from close to $80 a few months earlier.

Last summer EWZ fell 22% in a month. In the spring of 2006 EWZ fell 24% in about a month. And it had a 22% decline in the spring of 2004.

Many people talked about how over extended all the resource names were and the reaction seemed to universally be oh yeah, we agree they're over done and should pullback. So now they pullback and the bubble has popped? Really?

The fundamental story has not changed in the last couple of weeks. The places using resources are still using them. The long term trajectories for demand growth have not changed. These trajectories never changed in such a way that justified oil going from $88 or whatever up to one forty whatever--that's why people used to say they were over extended.

I don't think this correction or end of the story, whatever it turns out to be, means the end of Fed's vigilance. It might relieve some immediate concerns about inflation however. I would note that I think the asset deflation issues trump the issues with the prices that are rising.

The dollar has had plenty of snap back rallies like the current one in the last few years so I am not sure why this would be different. As far as interest rates go, they have to rise (not talking about the Fed Funds rate) for several reasons but long time readers will know I would have expected this to have started quite awhile ago so I probably don't have a good feel for this aspect of it.

As for equities this is still, IMO, a bear market rally, aka a feel good rally. A couple of weeks ago I said in a video that 1310 might be a place for a rally to go. But in the context of this being a feel good rally in a bear market, that means that I still think normal bear market. Normal means 30% from the peak which works out to SPX 1095. Regardless of whether that is right or wrong I would start to reequitize in a meaningful way when the market takes back its 200 DMA as that has been my plan since long before the bear market started.

More important than any of the above is that if you took a moderate approach to this than you have much less riding on being correct. With a moderate approach you have benefited from the multi year rally without being piggish and this decline hasn't killed you. For that matter none of the previous commodity corrections killed you either.

The reason I am so preachy about the moderation of these things is that the idea of waiting until there is a problem, as depicted on TV, creates unnecessary anguish. Obviously no one can be out in front of everything but pre-planning and discipline can go a long way toward smoothing out the ride.
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Mid Morning

With a hat tip to Bill Luby at Vix and More the volatility family tree as he calls it has grown with the addition of CBOE Gold Volatility Index (GVZ) and CBOE EuroCurrency Volatility Index (EVZ). These are in addition to the recently added CBOE Oil Volatility Index (OVX).

I continue to believe (or maybe hope?) that these sorts of products will eventually evolve into tools that can be used in portfolio construction. I'm not sure if this means used individually to somehow create a hedge or a fund the blends together many different volatility indexes into some sort of absolute strategy or something else.

I'm not too worried about being the guy that figures this out, just hopeful that something happens here. The world seems like it is trying to figure out what to really do with these and it is a good bet that there is a very useful application here.

A different subject; as soon as oil has two up days in a row again will the oil going to $200 guys all get invited back on TV?

Did anyone watch the new personal finance show on CNBC last night? I toggled between Red Sox Royals and CNBC Asia (tivo users know what I'm talking about). If anyone watched and has input please leave it in the comments.
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Looking Down Another Road

As a follow on to yesterday's post about looking down the road, today is another type of road to look down.

As the market flirts with "official," ahem, bear status there are a few truthisms, as my friend Charlie would say, about the current state of affairs.

First is that stocks are down a lot. They may drop more (as I think will be the case) or they may not but they are down a lot.

As we are nine and a half months and 20% from the peak we are obviously that much closer to the real bottom and then the real upturn (which I think will be Q1 2009 using a liberal adaptation of the 2/3 1/3 rule).

The other truthism is that there will be a bottom at some point, maybe when I think it will come or more likely at some other time and then there will be a new bull cycle of some sort.

That we know these are truthisms but not when any of them will come into play it makes sense to think about that next bull cycle and think about what you will do when it comes.

To be clear my trigger point for meaningful reequitization will be when the S&P 500 takes back its 200 DMA which appears to be a long way off.

For now I have a list of stocks, going sector by sector for sectors where I do need add once the bear ends (for clarity, I have been overweight utilities and so as of now not looking to add there).

I have been underweight financials for a long time and will need to add exposure there. As of right now that will mean a publicly traded exchange (these are down a ton and the mortgage crisis doesn't really touch them) and a foreign bank (many of them have fewer moving parts than US banks).

With industrials I will need to increase the volatility, reduce the cap size, increase the foreign exposure and wade further into a couple of themes.

In tech the plan will be to increase exposure, add emerging and introduce a little more single stock exposure.

If energy continues to correct it will make sense to increase volatility within. Over the last couple of years I have disclosed moving to a little less risk and selling down some Statoil a couple of times along the way. At some level (eye of the beholder) ratcheting things back up becomes the right thing to do. Here I might swap some ETF exposure for a service company and more of a theme play.

In telecom I would expect to swap some developed exposure for some emerging market exposure. Over the last couple of years I have taken a little EM exposure off and this is an easy sector to add it back in (plenty of stocks and even a CEF that I have used in the past).

Discretionary has been very underweight for a long time and so it needs to be beefed up a lot. A retailer or two and something that seems like an obvious beneficiary of baby-boomer spending makes the most sense right now.

Staples probably need to come down a little, I'll probably just sell one name.

I think I am ok with healthcare, utilities and materials.

Embedded into the above is the need to add China back in, add several themes that I have been writing about, as touched on above, more emerging markets, reduce the average cap size, increase the volatility, possibly let the yield go down, maybe change the style tilt and remove the double short.

This is just a game plan that obviously (or maybe not, lol) I have thought about a lot and can change if circumstances dictate. I am looking forward to moving ahead with this and reequitizing. The job of managing a portfolio becomes easier when you're just managing exposures and not wondering is the bottom in? How about now? What about right there now? The reequitization question would be off the table because you'd be in (assuming you had a well thought out and disciplined exit strategy and have a well thought out and disciplined reentry point).

My approach of using the 200 DMA means I will not catch the bottom but by never going 100% cash I won't miss it which as I have mentioned more than a few times missing a big bounce off the bottom is far worse than lagging it.

The picture is a road in Iceland between Reykjavik and Hellnar.
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