Better To Stay Away?

This was the conclusion from from Felix Salmon yesterday in an interesting post.

Specifically;

Either you’re a buy-and-hold type who’s convinced about the existence of the equity premium over the long term and who happily ignores all intraday volatility, or else you’re a high-frequency trader who loves to make money on a tick-by-tick basis. Everybody else is liable to get stopped out, or otherwise crushed. And in many ways, the only winning move is not to play.

I am all for exploring different ways to get the job done and have written quite a few posts along these lines but I've never been an advocate of not playing. It is very easy to believe that asset allocation and portfolio construction are each evolving at some rate (you can decide if this evolution is fast or slow) due to current events and advancements in investment products. I do not believe evolution means not playing.

Many articles and TV segments seem to frame the conversation in very narrow terms that I believe are impractical. First if Felix literally means not playing at all, going 100% cash; this is very problematic due to commission drag, possible tax consequences and biggest of all which would be going to cash at literally the worst time possible like maybe March 9, 2009.

It is important to have some context before figuring out the best course for you to take. How did September 29, 2008 permanently change your financial life or the financial life of anyone you know? Without looking, do you even know what happened that day? What about October 27, 1997? On that day in 2008 the Dow fell 778 points, the largest single one day drop in terms of points, and on that day in 1997 the Dow fell 554 points in the Asian Contagion and closed early that day. Do you even remember that in the two weeks after the 778 point decline there were two other days that the Dow fell about 700 points?

How many times do you hear CNBC interviewers ask whether investors should sell now or what sectors they should buy now and it is rare where the answer offers something a little out of the box.

In terms of when to sell I obviously believe in a predetermined exit strategy. I use the 200 DMA but there are many that can achieve the same result. The simplest way to look at this is that if demand for equities shows signs of being unhealthy then doesn't it make sense to have less exposure? As noted there are quite a few ways to assess the health of the demand, it takes very little analytical skill to see whether the 50 DMA has crossed below the 200 DMA (as another example) so then it boils down to having the discipline to stick with a predetermined exit plan.

Often you hear the question on CNBC framed as "what will treat my money the best?" The answer of foreign stocks is not mentioned frequently enough. If you watch sports you will sometimes see stats of two anonymous players put up side in a sort of blind test with the question being which one is more likely to be an all star or hall of famer and often when the names are revealed the player you might have picked ahead of time actually has the inferior numbers.

Well if you did the same thing with the US' economic stats my hunch is that there would be very few countries excluding Big Western Europe and Japan where owning the US made any sense. Someone once said investors are more comfortable losing money in a place they know than making money in a place they don't know or words to that effect. If anyone knows who I am paraphrasing please leave a comment.

Without entirely repeating yesterday's post it is only logical to invest money where it will be "treated best," avoid lousy fundamentals and I think take some defensive action. The Bogleheads would say no to that last one but interestingly, and you may know this, Jack Bogle has made some pretty good calls in his time; very good actually.
Read more!

Economic Depression and Other Plagues

Yesterday there was an article from Paul Krugman predicting a depression, the weekly post from John Hussman had a more strenuous warning about trouble coming and both got a lot of play around the interweb.

As opposed to trying to prove this line of thought right or wrong I think it is more instructive to try to figure out what to do in case Krugman and Hussman are correct. Making a compelling argument as to why they are wrong only for them to turn out to be right would be disastrous but going the other way, mentally preparing for bad times that don't come strikes me as the more conservative route.

First I should say that if Krugman turns out to be correct and we go into something "officially" labeled as a depression it will turn out that the depression started years ago. Anyone capable of even a little rational thought should not be surprised or freak out if they are told a depression started in 2000 (ten years ago) and might last another six or seven. Stocks are where they were in the 1990s, housing prices have imploded, job growth has stunk for many years and US debt loads have been increased massively only to get us to lousy. I'm not real keen on labels but if someone says depression just remember that realistically and with the understanding that it will not be exactly like the Great Depression it already started. The depression Krugman is calling for would linger for quite a while without being as bad as the Great Depression.

If you can accept the idea that if this turns out to get the depression label that it would be dated several years back then the info on global equity market returns for the last decade from Bespoke Investment Group becomes very important. I'm not sure where on their site it is but I kept a copy as a PDF.

No matter when the so called depression will be dated to there are plenty of equity markets globally that thrived in that period. The point is not to look back and buy some country that is now up a lot but to realize that there are countries that can do well as the US does poorly. Not that these other countries would not go down if the US retested its March 2009 low but look at how some countries went down a lot less and are already back to where they were before the financial crisis began.

A comment I have made many times in the last two and half years has been that for many other countries the worst crisis in 80 years would look a lot more like a normal cyclical event than the possibly secular or structural event taking place in the US or Big Western Europe.

A reader pointed out an article from Bill Hester, also from Hussman funds, talking about the importance of country selection. This has been a crucial theme here and will continue to be crucial. I realize I've been saying the same thing here for years now but to the extent you care about my opinion on anything (why would you be reading this otherwise?) that should tell you the value I place on country selection.

If you are not able to buy big cap stocks from the countries you favor in order to capture the effect (either due to comfort level or access) there are plenty of ETFs with more on the way to make it easier for you.

While I'm repeating myself from past posts; as important as I believe country selection is I'll say that saving more money and living below your means are even more important.
Read more!

A Lack Of Critical Thinking and Objective Analysis

Recently I have alluded to some serious problems with the Walker Fire Department and while I am not going to get into specifics until it is over (of course it may never end) there are human behaviors at work that impede success and these behaviors can also impede investment success.

There are certain things in our lives where emotion and ego work to our detriment. Ego has no place on a wildfire. Ego often prevents investors from having the objectivity to recognize when something is wrong be it process, macro opinion or an investment selection.

An incident (fire or medical) is essentially a problem to be solved. Solving means being effective and safe. If the context of investing is some long term goal like retirement, that too is a problem to be solved and solving it means being effective and safe.

The more that emotion, ego and other insecurities encroach on these tasks the greater the likelihood that something will go wrong. One problem at the fire department and in many financial plans is the inability to understand this concept and even more difficult is having the objectivity and introspection to realize when behaviors are counter productive.

I hope to resume normal blogging tomorrow.

The picture is of the Bay Bridge from Telegraph Hill taken with my not-so-smart phone.
Read more!

Sunday Morning Coffee

My brother and I are putting the wraps on a pretty good sports weekend. Two baseball games at AT&T and two futbol games yesterday at Cafe Trieste (Uruguay win, USA loss).

Not much to say today about the stock market, I haven't even looked at Barron's yet, but we had a pretty interesting philosophical discussion in between World Cup games.

First from my friend from Walker who said "you can figure it out now or you can figure it out later but if you can figure it out now you will be much happier."

Larry and I were talking about demographic issues with baby boomers and gen X-ers and the differences between the two. Larry made a point about aging that has never occurred to me. One problem people have with turning 40 can be the sense of getting to that age and lamenting the various things not achieved or other types of failures that some folks can have. These can be monetary and also be tied to not being where you want to be in terms of all sorts of personal issues.

While there won't really be any solutions here, the importance of getting to where you want to be personally will make all the money stuff written about here and on other sites you read much easier to achieve.

FWIW if you wish away the week to get to the weekend then look for a new job. In this economy it might take much longer than you would hope but even the search can be a positive. The other thing I would bring up is some sort of volunteer work. Despite the problems our fire department is having I can't tell you how fulfilling this is in my life. I love the very hard work of trying to fight a wildfire or trying to help someone on a medical call. For me this creates part of what I perceive as my sense of purpose. For you there is likely something else that would do the same thing. Some will already have this in their life and for those who don't I would say to spend time seeking it out.
Read more!

The Big Picture For The Week Of June 27, 2010

James Picerno has a post up exploring what the proper allocation to emerging market equities might be. He explores whether to go by market cap weight which would be 12% or maybe some other measurement that might yield a different number.

Here is a thought; the entire conversation needs to be thrown out and a completely different approach needs to be taken. Perhaps the title 'emerging' needs to be chucked. In going country by country in building a portfolio it seems logical that one would pick countries that have the best economic fundamentals. From there one could take volatility, not risk, characteristics into account in determining weighting and how to blend various countries together.

Based on various measures of indebtedness one could conclude that Brazil is in much better shape than the US or big Western Europe. Historically US based investors are pretty comfortable with 100% in US equities. I doubt too many people would be comfortable with 100% Brazil instead but maybe they should be.

Not really of course but if you believe the fundamental story is better in Brazil than the US then why would you have more US than Brazil? This becomes an interesting question. Not every healthy country is as volatile as Brazil, Norway as an example.

Instead of how much to invest in emerging markets the question should maybe change to how much each country, how much to countries more volatile than the US and how many less volatile (or maybe equally volatile).

The Sox lost last night but it was a good game. It was very cold the entire game but did not get colder as the game went on.
Read more!

The Instability Has Not Stablized

At any given time there are reasons for the stock market to go up and reasons for it to go down. Sometimes the reasons turn out to be very insignificant like in 2002 when CEOs were going to have start signing off on their earnings.

At other times these reasons can be very important. The housing data this week was worse than expected. I'm pretty sure it was no secret that the rebate program was pulling a lot of activity forward but the drop off in the latest round of numbers, the first numbers post tax rebate, were worse than expected.

Like any data point this can be spun in any way someone wants but my take is demand for housing is simply not good and I'm not sure how it gets good anytime soon--extending the rebates will not create real demand that is healthy.

The initial and continuing jobless claims seem unable to budge off of 450,000 and 4.5 million respectively. Aside from this being bad for individuals who are either unemployed or underemployed in terms of paying their bills it is also bad for consumption and even worse for municipalities relying on income taxes for revenue; people tend to be willing to buy an iPod with a credit card but don't pay taxes beyond what is required (obviously).

Housing and jobs are very important building blocks for the US economy and the outlook for both stinks right now. Obviously equities can go up in that backdrop, they went up a lot for about year with that backdrop, but they are now up a lot from the lows and the fundamental picture (weighing the positives versus the negatives) is not good and with some numbers has not improved.

As long as this persists I think it makes sense to be skeptical of rallies and devote more portfolio space to foreign countries excluding big Western Europe and Japan.

Short post this morning, my brother and I are headed to San Francisco to see the Red Sox play the Giants tonight and tomorrow afternoon.
Read more!

Back On D

The S&P 500 closed below its 200 DMA for second day in a row yesterday after having recently going back above the 200 DMA.

We did not buy the ProShares UltraShort SPX ETF (SDS) however, instead we bought ProShares Ultra Short Dow 30 ETF (DXD). The reasons for DXD are pretty simple. We wanted to preserve the small loss taken on the last SDS trade for anyone who would want it, we wanted everyone to own the same ETF and needed a fund with sufficient liquidity.

At times the Dow 30 will look a lot like the S&P 500 and other times not so much. If the SPX were to drop 5% I'm not sure what DXD would do but if the SPX drops 40%, which obviously would be down a lot, then I am quite confident that the Dow 30 would also drop a lot and the DXD position would provide the desired hedge.

As a reminder the desired hedge is to protect client accounts in case the market goes down a lot; philosophically, enduring down a little simply goes with the territory.

When I blogged about the recent SDS trade I noted my gut feel that things were not over and the expectation of going back on defense fairly quickly of course I wish we didn't need to take the action. While I am not certain I think if it goes back above the 200 DMA in very short order again I may give at a week before taking DXD off. While this would not guarantee avoiding another whipsaw it might help. Additionally I would rather hold onto a defensive position a little too long than have no hedge at all for too long.

In the very short term this sort of thing either turns out to be correct or not but the short term is not the objective. As I have been saying for almost six years now the goal is to avoid the full brunt of down a lot when it occurs.
Read more!

Victor Niederhoffer

An interview of Victor Niederhoffer on Slate made the rounds yesterday (I found it through FT Alphaville). It was about the two huge blow ups that Niederhoffer endured, what went wrong, what he learned and his mind set now.

I've read a few other things about him and while this may not have been very different it is useful. There are people in this business, and it seems like he is one of them despite what he says, that are willing to really bet big, face the consequences of a big bet gone wrong and then start over from scratch.

The point clearly seems to be about learning from Niederhoffer's mistakes. From there you incorporate what you learn from him into your own investment philosophy. He seems to have been done in by enormous bets with no counter strategy and presumably misuse of leverage in pursuit of those big bets. These things have done plenty of people in and will do so in the future. Students of market history have seen this story play out countless times.

Philosophically this blog is at the completely opposite end of the spectrum or road in rural Iceland as the case may be. I don't ever want to worry about the stock market, client portfolios or my own. Further I don't want clients to worry about their portfolios either. Everyone has different panic points and the dread that goes with watching portfolios values implode is very predictable and I would think more people would make a priority out of avoiding that feeling. Yet somehow people can not envision this when they are placing the trade or trades that put them at risk for this dread.

I can remember a few years ago after a lottery ticket biotech stock blew up, a reader left a comment disclosing that this now dusted stock had been 25% of his portfolio. While I don't remember what the stock was I remember him saying something about the extent to which he believed in the company and the regret naturally felt. Given that any stock can blow up (Fannie Mae and WaMu were very blue chip) there can be very little justification for the typical person to make the types of go for broke bets that did in the reader above and Niederhoffer.

What would be your reaction to 25% or more of your money disappearing that quickly? Do you even know what your reaction would be? An even better question would be do you ever want to find out? As I said above some people can exist this way but finding out the hard way you are not one of those people would be an awful experience.

There is nothing wrong with buying a lottery ticket biotech, long shot gold miner or the like; these are perfectly valid things to buy but measuring a wipeout's impact on your portfolio is crucial in this context. If you put 2% on what turned out to be a fraudulent Chinese hair growth company (Seinfeld reference) could you live with that consequence? I think most people could. What about 5% or 10%? At some point is your line in the sand or know thyself number.

This is also true of the overall portfolio and the portfolio's volatility budget. You know how to build a portfolio that is more volatile than the market or less volatile than the market. If every stock you pick is more volatile than the corresponding Sector SPDR then your portfolio will obviously be more volatile than the market.

Most people are unlikley to pick the most volatile stock in every sector, instead there would be a blend of volatile and low octane names to create a mix that can be lived with when things in the market are their worst. From there an investor could increase or decrease their overall volatility.

For example an investor could swap out of the Materials Sector SPDR (XLB) into a much more volatile stock like Silver Wheaton (SLW) the silver (sort of) miner. Assuming the stock is not a fraud (I don't own the name but don't believe it is a fraud either) then the decision about adding the name and volatility that goes with it becomes either a good decision or bad decision based on top down factors for the market and the materials sector and bottom up factors based on SLW's situation at the time in question.

Buying SLW at $19 in spring 2008 on the way to $3.45 (assuming no sell discipline) becomes less of a problem at 3% of the portfolio; it simply becomes a lesson learned not a radically altered financial plan.
Read more!

China

The US equity market started Monday by jumping 1% presumably because of news about new Chinese yuan flexibility. Who can say if that is really why the market started higher but clearly the news was buzzworthy as there are implications politically and for global capital markets.

Here is one recap from Mike Shedlock if you'd like to read a little more.

As I read a couple of things about this news I had a very big picture thought about the China story that I have touched on before. All of the problems (apparent and real) pertaining to over capacity, the housing market, the consequence of letting the yuan float, the consequence of of not letting it float and whatever else you want to add on is about properly (or not as the case may be) managing growth and modernization on the way up, so to speak.

The issues in the US, big Western Europe and Japan revolve around trying to prevent economic deterioration caused be excesses born of deep ceded problems that come with maturing, chronic deficit spending and unfavorable demographics.

My thought about China has been the same for a long time believing that China is clearly becoming more relevant in the world economic order but there will be plenty of mistakes made along the way.

It seems pretty clear that the Chinese financial stocks are most at risk should there be mistakes. There are issues with lending, speculation, over indebtedness on the part of municipalities and so on that make the sector very unattractive IMO. I also continue to believe that exporters are another bad way to go as they rely on consumption on the part of people in other countries with plenty of problems of their own.

Another segment I am wary of is recently IPO's Chinese companies traded in the US. I mentioned a company a few weeks ago called China Marine Food Group (CMFO). I noted it was small and probably difficult to follow, as are many of them, and then I made a comment about Barron's writing every so often about scandal with these and that often they are a product of a reverse merger. I made the comment not realizing that CMFO was itself a reverse merger. I thought that was funny.

I would avoid the broadest China ETFs as many are very heavy in financial stocks, obviously I would be more favorably disposed to a broad based China ETF that was light on financials. I think the China sector funds from GlobalX that focus on what the country needs for it's modernization would be worth considering; those being materials, energy or industrials.

For people inclined to pick individual stocks I would research companies that have been around for a long time. That doesn't have to be limited to large cap companies but I believe that the scandal factor is likely to be less at a well known company that has been around for a while.

In addition to the sectors above I think stocks from utilities and telecom play into owning part of the modernization theme.

For now we do not have across the board exposure for China but have owned China Mobile (CHL) in the past and before that Sinopec (SNP).
Read more!

Back On The Farm

Over the weekend a reader left a link to a WSJ article about investing in farmland. This has been a popular theme in the last couple of years as quite a few investment luminaries have made comments on this including Barton Biggs and Marc Faber. Jimmy Rogers says that soon it will be the farmers driving Ferraris not investment bankers.

The article was something of an intro piece to buying actual farmland and leasing it out. The context I've been writing about has been buying a farmland stock of some sort or including the possibility of plantation companies in Asia. This has simply been an exploration on my part in an attempt to try to learn about the space to see if there is any viability within an equity portfolio. For now it is a work in progress but it is intriguing to me.

Farmland stocks, in the context I am thinking, would be part of the more-protein theme and at the sector level could either be thought of as staples or maybe materials companies, this would be in the eye of the end user.

The chart captures two stocks I've written about before; Black Earth Farming (BLERF on the US pinks) which trades in Sweden and Marine Harvest (MNHVF) which is traded in Norway. Black Earth is a farm stock and Marine Harvest is, still a part of the more-protein theme, a fishery.

The two have obviously had much different results in the last two years which doesn't have to be important. For purposes of this post let's assume they are real companies with real assets (I believe they are) and not out and out frauds. From there anyone believing in the more-protein theme would need to assess what they think would be the best way in to the theme, then sort among the choices available and then buy one if there is one that is suitable. There is nothing easy about that of course but that process would yield an addition in a portfolio to one of the above mentioned sectors in such a way as to hopefully add a benefit versus just owning a domestic sector fund.

We know that a fishery ETF has been filed for and something like the also filed for small cap Malaysia or small cap Indonesia could, by virtue of index methodology, be a relevant proxy.

As far as actually buying land, I think that is a completely different form of investment and personally I would not think of it as part of my equity portfolio. For people who understand the undertaking or are willing to pay a management company who does then I am sure there are ways to succeed but I do believe there is a different type of study required.
Read more!

Sunday Morning Coffee

There was a profile in Barron's of a mutual fund manager named Tom Forester. The following passage about his philosophy is very instructive and similar to what I try to do;

A portfolio manager must "watch [his] downside," and he isn't afraid to sit on the sidelines if a rally seems to have weak underpinnings. "My time horizon is three or four years, so what do I care if I'm low for a quarter or two? I'm just trying to win the game. I don't have to win every inning.

I refer to the entire stock market cycle which I think is a little longer than three-four years but it is the same concept.

A point that I think is crucial and worth repeating many times is that the priority is having enough money when you need it, or perhaps more specifically giving yourself the best chance possible to have enough money when you need it.

Clearly it is difficult for folks to view the task from this perspective for several reasons. Most things in print and on TV focus on much shorter time frames like "call the close" which is a ludicrous proposition in terms of being right and even more so in terms of importance for the vast majority of people.

Unfortunately for too many people the key to the best chance possible for having enough money will require an increased savings rate and or lowered expectations about lifestyle if there is anything to the idea of this being year ten of an 18 year sideways to down market.

While this may sound daunting I believe thinking about it now, sort of ahead of time, gives the opportunity to make some changes toward increasing the savings rate. Much as people don't want to hear this there are behavioral solutions to many of the instances of poor savings rates, very low 401k balances and the like. Obviously some folks really are in bad situations but not as many people as it seems.
Read more!

The Big Picture for the Week of June 20, 2010

Interestingly the 200 DMA for the SPX seems like it has been significant for the last few weeks. After going below it in May the index had a difficult time punching through and for now it seems like it is relevant support.

As I say that of course that probably now means it will knife through like it wasn't even there but for the time being the market seems to have calmed down. I've been saying for a while that I think the best long term outcome from here for the foreseeable future would be a very boring tape.

The stats about the largest up days in stock market history having mostly occurred during bear markets belies the extent to which emotion, IE panic, is unhealthy for the market.

GlobalX should be coming out with a mid cap Brazil ETF that will have ticker symbol BRAZ. Similar to the Market Vectors Brazil Small Cap ETF (BRF) it is targeting the story on the ground in Brazil. Clearly the middle class ascension along with the World Cup and Olympics create tailwinds for the country as an investment destination.

In the stuff that GlobalX emailed to me about BRAZ was some limited information about a couple Brazil sector funds, along the lines of of their China sector ETFs, they have filed for. Personally I think the narrow access is better than most broad based country funds. A fund like iShares Belgium (EWK) can be difficult to incorporate into a portfolio built at the sector level given its 35% weight in staples and 28% in financials. Obviously a sector fund makes precise portfolio construction easier to do. There are some "broad" country funds that are so concentrated that they might as well be sector funds; iShares Peru (EPU) comes to mind. BTW one client of ours with a specific mandate owns that one.

Continuing the thought, a Norwegian energy ETF (does not exist), a Singaporean financial ETF (iShares Singapore EWS practically is a financial fund) and EPU for materials and you can see where I am going; balancing the sector weights becomes very easy to do.

So are there any better uniforms at the Wold Cup than the Ivory Coast's orange creamsicle jobs? They would look great with Kevin Durant's shoes.

The second picture is of my newly completed office. I've got a comfy metal folding chair to sit in, some insulation batts to sleep on and all the high tech gadgetry I could ever need; truly the lap of luxury.

Actually Joellyn is getting progressively busier with her animal rescue work and after a one year hiatus as assistant fire chief I have the job again and due to some truly ludicrous antics over the last year or two the job entails many more phone calls than in the previous four years I had the job. One day I'll tell the tale but for now--many phone calls fixing things.

The task of responding to a fire or a medical is still very enjoyable which is why I do it. Last Monday we had a smoke call, got to take out a couple of trucks and go for a little hike; fortunately no fire.
Read more!

200 DMA

Yesterday the S&P 500 closed above its 200 DMA for the second day in a row so consistent with our strategy about defense and asset protection we sold out of our ProShares Ultra Short S&P 500 (SDS) position.

For now the SPX feels like it is flirting with its 200 DMA and it would not be the least bit surprising to see it back below in short order and if it happens (I would wait for a second day as a sort of confirmation as I always do) I will again buy a double short ETF as a first step of defensive action. I should say a double short ETF is the most likely first step, were it to happen in a few months or few years I might have a different idea about how to go.

The possibility of a whipsaw always exists with this strategy but I believe it is a very effective way to avoid the full brunt of down a lot which is a very important objective for us. The possible drag from being "wrong" for a few days or weeks is minuscule compared to the protection should a given breach be the one that leads to down a lot.

I remember one time a reader asked why I don't do something like Jack Ablin talks about which is waiting until the market gets 5% or 10% (I'm not sure which) below the 200 DMA. During a given breach taking action right away as I do might be better than what Ablin does or it might be worse, there is no way to know ahead of time and no way one strategy like this can always be the best of the bunch. If you do something that allows you to go down a lot less than the market when it does something very bad then that is what matters.

For now it seems clear that the event is not over. The many days of panic buying and selling are not signs of health. I continue to believe that the fallout from the entire crisis will be headwind for US markets, more so than quite a few foreign markets, for quite a while to come. For now the portfolio remains less volatile than the broad market.

On an unrelated note the WisdomTree International Energy Fund (DKA) has a large position in BP. As you may have heard BP will not be paying a dividend for a while so per WisdomTree BP will be removed from the fund June 18. I mention this as DKA is a client holding.
Read more!

Sector Building

A reader asks;

Regarding process, when you choose a stock, you have generally limited your exposure to 2-3%, with sector exposure weighed by your themes or projections for where we are in the market cycle.( This is my understanding based on reading your site for several years.) Since an ETF, even a narrow etf range selection, represents a pretty broad selection of holdings, are you willing to use one etf for a 5-10% position in a portfolio?

This might be a follow up to a comment I made yesterday about combining a stock and an ETF to build a sector. I've written many posts about building a portfolio at the sector level. Building a sector within a portfolio (the way I prefer to do it anyway) starts with the decision to overweight, underweight or equalweight that sector against the benchmark index--we use the S&P 500.

Taking the industrial sector as an example; it is currently about 10% of the index. For the sake of our example we want to equalweight the sector and allocate 10% to it. The best way to build the 10% will depend on what we think is going on in the world and what is the right thing for the particulars of the client. If 10% works out to $14,000 it probably doesn't make sense to buy six different things for the sector due to commission drag. If the client has a lower tolerance for volatility then loading up on something like the EG Shares China Infrastructure ETF (CHXX) or the Claymore Global Timer ETF (CUT) may not be the best thing for them.

The most basic way to build the sector would be with the Industrial Sector SPDR (XLI) or the equivalent domestic sector fund from any of the other providers. Another way could be to buy a fund with a little foreign exposure along with domestic like the iShares S&P Global Industrial ETF (EXI). That one is 49% US with the rest obviously being foreign. Another broad fund would be the SPDR International Industrial ETF (IPN) which has no US exposure, it has a lot of Japanese and European exposure.

For an account where one broad (relative to the sector) fund was the best way to go I would have no problem with a fund like those serving as the entire 10%. Obviously picking a fund requires looking under the hood and being comfortable with what you see.

Another way could be a core and explore type of thing with the 10%. In this case some large portion of the 10% could go into a broad (relative to the sector) ETF and then some small portion into a theme or a country or something else. This could include things like wind, defense contractors or the GlobalX China Industrial Sector ETF (CHII).

Or a broad fund can be bypassed altogether in favor of some combo of themes, countries and industries within the sector. In the case of 10% putting 3% into two different things and then 2% into two different things would get it done. At that point the decision becomes what the best way to build it might be. For example this sector would be a good way to add Germany with maybe a stock like Siemens (SI)--this is just an example I want no part of Germany or alternative energy (most of the companies or ETFs focus on industrial companies that make equipment) or infrastructure (ETF or stock) or do some domestic stock picking with something like 3M (MMM)--that is just an example we don't own 3M.

How far you go with countries, themes or the rest is largely dependent on the time available to spend on the portfolio. It is obviously a lot easier to track one very broad sector fund than a Japanese nuclear power plant maker, Korean shipbuilder, Spanish solar company and Brazilian steel company.
Read more!

ETF Proliferate

The other day a reader asked me to weigh in on ALPS filing for an MLP ETF. You can read a little more here from IndexUniverse assuming this is what the reader was asking about. The other ETPs in this space (P standing for products) are exchange traded notes which are (usually unsecured) debt obligations of the issuer and not actual baskets of stocks.

I did not find anything in the filing or on the ALPS website that would give an indication of what would be in the fund so without that it is difficult to say a whole lot other than the ETF format is typically preferable, IMO, and obviously some folks are not comfortable picking individual stocks so those folks will have access to the MLP space now assuming the fund actually lists.

This brings me to a thought I had over the weekend as I was reading the Barron's mid-year round table. Felix Zulauf was going into detail about his outlook and how he was positioning. While what he was doing was not especially interesting the way he was doing it was; almost all ETFs. He disclosed a lot of paired trades and a couple of other ideas using ETFs.

When I first started this site I repeatedly made the obvious observation that ETFs would offer access to increasingly more specialized parts of the market and if you think about the number of ETF only shops, or people like Zulauf getting a lot of what they need out of the space or how specialized some of the funds are there really are a tremendous amount of opportunities for do-it-yourselfers to create very sophisticated portfolios with very little single stock risk.

I can appreciate many people will likely never need corn or small cap stocks from South Korea but I believe that investing has proven itself to have become more complex in the last ten years and I think there is very little chance of it becoming simpler anytime soon.

If you've been reading this site for the last almost-six years you've read a lot of posts about country selection and sector avoidance and from here you can look back to see how simple the analysis has been and can be and how most decisions like this can now be implemented with ETFs. The last sentence is not to imply that the countries that have worked before will work in the future--remember this site is about sharing process.

The funniest part of this is that after all the posts about Norwegian fishery stocks a fishery ETF has been filed for. After the several posts about farmland stocks the small cap Indonesia and small cap Malaysia funds that have been filed for could offer a lot of exposure to plantations and the like (we'll have to see how that plays out).

I know people disagree with this line of thinking and are quite content to stick to the same broad indexes that they have always owned. So I think the ball is in your court as far as where you go from here.

There is nothing insane, for example, of having a large portion of your energy exposure in Exxon Mobil (a name we have never owned, it is just an example) and a small portion of your energy exposure in something like the China Energy ETF from GlobalX or the broader EG Shares Emerging Market Energy ETF as two other examples of funds we don't use for now. A mix like that at times will outperform a broader energy fund like the Sector SPDR (XLE) and at other times lag XLE. It would be your analysis that leads you to conclude whether a mix like that or some other mix could add value versus XLE over some long period of time.
Read more!

The Dumbest Article Ever?

On Saturday a reader left the following comment;

Interesting WSJ article says now is a good time for disciplined investors to take on leverage. Any thoughts?

Without having read it yet I simply said it was a bad idea. Well yesterday I read it and you can read it here. Before getting into this I should disclose that I am very conservative with this sort of thing. I've disclosed before that my parents made some poor financial choices in their 30s and 40s which caused permanent obstacles for them which is impacted how my wife and I manage our finances.

If it is not clear the idea would be to take on debt, most likely mortgage debt, and invest the borrowings into the stock market. The article makes the point that mortgage rates are about at all time lows which is factually correct and does some math about tax rates and returns needed to have it pay off and notes that now could be a great time to do this strategy and there are plenty of financial advisors quoted in the article to explain the merits albeit with a few caveats. There are also examples of people taking mortgages out to beef up their portfolios, make up for lost ground and the like.

I've had a few clients ask me about this. I try to steer clients away from the idea which so far I have been able to do. Now keep in mind that if someone wants to cash out and have us manage the money it obviously means more revenue for our firm. The way I steer clients away is talking a little bit about the numbers and the risks and that it could work but that Joellyn and I have paid off our house awhile ago and there is no chance we will be doing this.

I come at this sort of thing wanting to understand what could go wrong and what the consequence will be if it does go wrong. It seemed like the math from the article lead readers to needing a 5.015% return to break even and if you buy into the idea that you wouldn't do this hoping to net an extra 100 basis points then maybe the targeted return ideally would be 7-8% annually. Anything about 7-8% ring a bell? That is about the same number that is slowly blowing up state pension funds.

A big tenet here has been you can only take what the market gives you. If the next ten years provides an average annual gain of 3% it is very unlikely you will get 8% consistently. Of course you might but have you ever beaten the market in this sort of fashion before? If you have, do have any introspective thoughts about what role luck may have played? Are you willing to bet the equity in your home that you can repeat this?

And what if the market goes down 20% from here and trades between SPX 850 and 950 for a while instead of the current range? I might say down 10% in a down 20% world is a good result but that is still 10% of what was home equity now gone if the market stays in the above range for a while.

The next issue is the payment that would have to be made. A $400,000 loan at 5% requires a $2147 monthly payment. Um isn't there something about a 4% withdrawal rate being sustainable? So maybe the article is aimed at people who are still working. Working or not do you really want to take on an additional $2000 in monthly expenses?

One commenter on the WSJ article talked about the interest paid over the loan. Per the numbers I got from Yahoo Finance the interest over the life of the loan would be $373,000. If you are still working and could take on a new $2000 mortgage payment why not just save an extra $1600 a month which would about be the interest portion on that loan.

In that last paragraph lies a key point. If you need to beef up your portfolio and you can afford a new debt payment well then you can afford to just save more money without taking the risk of incurring more debt.

The article also talked about margin loans. Really? Margin is a good idea?

There are two ways to be rich. One is having a lot of money and the other is having no overhead. Assuming you are not a trustafarian you may end up with a lot of money but this seems less within our control. I believe it is easier to get the overhead down. If all you are paying for each month are utility bills, various insurances, various taxes, groceries (including prescription costs) and gas for your car then $500,000 saved plus social security plus maybe some sort of part time work has the makings for a pretty successful retirement.

A slightly bigger macro here is the idea of not learning from past mistakes. People have blown themselves up many times in the past by misusing leverage. This is guaranteed to happen again to people but it is pretty difficult to misuse debt if you don't have any debt.

The two pictures are from New Zealand.
Read more!

Sunday Morning Coffee

Long time readers will know my interest and curiosity is looking at companies from off the beaten from all sorts of investment destinations. Below is a list of companies that I have either read about before, done a little study on or otherwise checked out.

Many of the names will be unfamiliar but you probably know at least a couple. Marc Faber just mentioned Thai Tap Water this weekend in Barron's but he has mentioned it before. He said it has been doing well and it yields 7%. Unfortunately it trades in the US for pennies so it would be difficult to trade but that does not have to be the point of this exercise.

Financials Bank of Cyprus (BACPY) Cyprus--if you'd ever want to invest in Cyprus this is the big bank

Technology Tieto (TCYBF) Finland-- IT consulting kind of like EDS which was acquired

Healthcare Parkway Holdings (PKWHF) Singapore-- owns hospitals involved with medical tourism

Energy Ecopetrol (EC) Colombia-- big oil in Colombia

Industrials Vestas Wind (VWDRY) Denmark-- you probably know this is a big wind turbine manufacturer

Staples Blue Square (BSI) Israel-- grocery store in Israel

Discretionary Fisher & Paykel (FPAHF) New Zealand-- an appliance company making refrigerators and washers and dryers, at least they did when I visited in 2005

Utilities Thai Tap Water (TTAPF) see above

Materials Kazakhmys (KZMYY) Kazakhstan-- rights to resources in Kazakhstan, primarily listed in London but the story is complex

Telecom Maroc Telecom (MAOTF) Morocco-- this one was also mentioned in Barron's yesterday and previously. The primary listing is actually in Paris.

The point obviously is not to buy any of these but there is a bigger picture point that can tie in to a core and explore type of strategy. Someone out there is an expert on Morocco, so if that is you and you want a narrow based portfolio then why not a telecom ETF combined with Maroc Telecom? Ditto a utility ETF and Thai Tap Water or a toll road from some place or something else.

A portfolio with two or three things like this that have been properly researched and bought in moderation will not destroy anyone. I continue to believe that US based investors will need more exposure to foreign and if the idea of avoiding Big Western Europe and Japan continues to be correct and you don't want to put it all into Australia then maybe one or two of the destinations above need to be added in.

About to go on a long hike so that means a short post.
Read more!

The Big Picture for the Week of June 13, 2010

On the heels of yesterday's post looking a comments about diversification from an investment manager who prefers to hold ten stocks (hat tip to longtime reader Sam for that info) and a week where we've had a lot of Nassim Taleb to digest (Trader Mark provides the video) I thought it might be interesting to think about a combo of concentrated portfolios and Taleb's idea of 80-90% in t-bills from around the world and going berserk with the rest (Taleb doesn't actually use the word berserk).

While this will be far from original maybe it can spark a dialogue. Instead of t-bills the idea would be some large portion (to be determined by the end user) in a few relatively stable dividend stocks and some small portion of the portfolio in a high octane name or two.

I pulled out four dividend names that I keep tabs on for one reason or another that tend to pay a decent yield and are not usually that volatile but of course just because they worked in the last meltdown does not mean they will work in a future panic.

Although I've never owned Public Storage (PSA) I have always been intrigued by it. Obviously the story is properties that rent out storage space for people's crap. The story is not about abandoned leases or empty storefronts, the risk is people who stop paying for the storage (I'm not sure but I can't imagine that selling the contents of someone's locker pays off very often). Revenues for 2011 are estimated to go up modestly and earnings are estimated to go up a little better than modestly. It has more cash than debt and yields about 3.5%. For the last three years the name is up 8% (not including dividends) versus down 38% for the iShares DJ REIT ETF (IYR).

Consolidated Edison (ED) is a name some clients have owned for a long time. It will never be the best performer on the way up or the worst performer on the way down. Over the last three years it is down 7% (not including dividends) compared to down 26% for the iShares Utilities ETF (IDU) which is a name some clients own and down 27% for the S&P 500. ED yields 5.5% and the risk that I think is most important is that a lot of its infrastructure is very old.

Kinder Morgan Partners (KMP) is another name I have owned for some clients for a while. This is one of the mega caps of the pipeline space. If you have ever done any research in this space you have no doubt come across this name. It has done a good job of increasing the dividend over the years. A few years ago there was a broken bit of pipe in the southwest that while short lived did impact the price. Although there is no fundamental link to commodity prices it has correlated to the price of crude a couple of times for short stretches. For the last three years it is up 17% not including dividends.

One last example could be McDonalds (MCD) which yields a little over 3% and it seems as though the recent (or current, depending on how you view it) bear market happened without McDonalds. The growth estimates are not earth shattering but they are not bad either. You obviously know enough about McDonalds to know whether it is worth your time to study it further.

As far as the aggressive tranche, what interests you? Things like smart grid, Chinese agribusiness, beef companies in Brazil, something from Africa could all fit bill along with some faddish tech stock. On a more serious note if you really are inclined to swing the for the fence on something then you have to have reason to believe you really understand the space/theme. There are Chinese seed companies and some folks know this space very well and can succeed in the space. Personally I think this is very difficult.

The names above are just examples pulled together with very little time spent. Putting an overly large portion into low beta dividend payers means getting left behind during certain phases of the market cycle. Also there are times where these types of stocks do poorly. These stocks cannot be left on autopilot either as occasionally stories change and dividends get cut.
Read more!

An Argument Against Diversification

An investment manager named Mariusz Skoniecny wrote a post for Seeking Alpha that was very skeptical about the practice of diversification and the motivations behind it. Throughout the post portfolios with 100 holdings drew his ire but I did not glean what number he thinks is right.

He believes that diversification hides incompetence and does not give an opportunity for meaningful outperformance. Although I do believe in diversification I cannot say Skoniecny's arguments are off base. He talks a lot about reps at brokerage firms whose job it is to sell not analyze stocks which is a point I have made before. He notes that by diversifying you avoid the consequence that a blown up stock can have on a portfolio which I view as a good thing.

The building block here is that a proper savings rate, suitable asset allocation and a normal equity market return should give people a decent shot at having enough money for when they retire. A realistic understanding of one's means doesn't hurt either.

It is this idea that is a foundation for how I navigate cycles. I try to go along for the ride during up-a-lot, up-a-little and down-a-little and try to avoid the full brunt of down-a-lot by taking defensive action when the SPX is below its 200 DMA as it is now. To repeat from above this should give people a decent chance of having enough money when they need it, again assuming reasonable spending habits.

A variable that we are collectively trying to assess is "normal" equity returns. The last decade has not been normal. Actually maybe it has been normal. I would not say I am totally on board with the 18 year cycle concept but there is something to it. Stocks did poorly for a long time in the Great Depression into the 1940s, did very well until about 1968, did badly until the 1982, did great until 2000 and then the last ten years. If there is any meat on this bone then we would be in the neighborhood of halfway through.

That there could be eight more years of sideways trade probably tells you one of two things. On the positive side (the way I choose to look at it) you can commit to yourself to save like hell so that when equity markets (global or domestic) start some sort of up cycle you will have a lot of powder that you can deploy. The negative side is that a do nothing market means your portfolio will probably not do anything.

I am more comfortable articulating this as saying long round trips to nowhere have happened before and then they end and are followed by an up market. We have no control over when this will happen so I prefer not to worry about it and just go along for the ride during up a lot, up a little and down a little and try to avoid the full brunt of down a lot by taking defensive action when the SPX is below its 200 DMA as it is now (repeated for emphasis) because this is more in my control.

If going along for the ride combined with proper asset allocation and the rest is enough to get the job done for many people then adding value can come in the form of simple enhancement of returns (aka smoothing out the ride) and not necessarily making a killing and taking the risks needed to make a killing.

It is not that a 12 stock portfolio (or however many names that Skoniecny owns) is wrong, the correct way to frame it is what is right for you. For me the ideal number is 35-40 holdings. For some folks it will be more and some it will be less. And yes I personally am very motivated to try to avoid portfolio action that causes clients to react emotionally.

Now something of a personal note. A friend who is my age, whom I used to work with, had a heart attack on Saturday. He is ok, he said his prognosis is good. I know nothing about his exercise or dietary habits but he did say his mother died of a heart attack.

This is a good wake up call about priorities. Health comes before money. I don't think too many people disagree with that but it is worth saying. Not going to the gym is the easiest thing in the world. Just like saving properly and investing smartly doesn't guarantee a successful investment plan going to the gym doesn't guarantee successful aging but it gives you a very good chance.

As far as diet goes, the best starting point IMO is to never drink soda.
Read more!

More Corn

Yesterday I mentioned that the Teucrium Corn Fund (CORN) was now trading but I was not exactly right about the combo of futures that it will use to try to mitigate contango issues.

IndexUniverse sets it straight; will track a daily weighted average of closing settlement prices for the second-to-expire CBOT futures contract, weighted at 35 percent; the third-to-expire contract, weighted at 30 percent; and the final 35 percent based on the contract expiring in the December following the expiration of the third-to-expire contract.

I would also note that the fund will charge a 1.71% fee which does not sound cheap. I looked at the futures chain yesterday and there is a fair bit of contango looking ahead on the curve. Obviously there is no way to know whether the contango busting strategy will work although I'm sure they have reason to think it will help.

The chart above compares the corn futures contract to the S&P 500. On the chart, and if you long at a longer time period on BigCharts, you see a fair bit of negative correlation. The correlation is not always negative but it is negative quite frequently but not in the second half of 2008.

I don't know enough about corn to know why it might have a negative correlation so often other than just simply saying it is a commodity but it is interesting. And now that stock market investors have easier access than they've had before maybe some of the effect will go away. I've never thought about corn as a portfolio diverisifier and I seriously doubt I will be buying the fund but it is something to learn more about. Maybe corn will be the holy grail of diversification and if it is then maybe buying some after the fund proves itself will make sense.
Read more!

Corn ETF Is Here

ETFdb is reporting that the Korn Corn ETF is now trading with symbol CORN. A quick glance at the futures chain on Yahoo shows that it is trading with some meaningful contango. The structure of the fund is such that it owns roughly 1/3 of each of the front three months to try to reduce the impact of contango, or backwardation for that matter.

Obviously there is no way to know whether the split between the front three months will smooth it out a little bit so as to be less impacted by the roll than USO and UNG.
Read more!

David Rosenberg's Allocation In ETF Form

Cam Hui from the Humble Student Of The Markets blog had a post recapping David Rosenberg's proposed asset allocation. The allocation as written by Rosenberg;

The name of the game is to focus attention on strategies that:

* Delivers income (including dividend growth, hybrid funds and corporate bonds since company balance sheets are in fine shape);
* Minimize volatility and emphasize on capital preservation in a secular bear market (true long-short “hedge fund” portfolios), and;
* Commodities (precious metals as a “buffer” in a financially unstable world; and industrial commodities to take advantage of (i) the secular growth dynamics in Asia, and (ii) repeated rounds of currency depreciation inevitably lead to trade protectionism and “security of supply” constraints, which tend to benefit basic materials.

I did not see where specific percentages so perhaps each of the three should be targeted at 33% of the portfolio. Finding ETFs that generally fit the bill should not be that difficult.

Looking at 'income' first, dividend growth limits the choices some. A lot of the dividend ETFs simply target the fattest yields. The SPDR S&P Dividend ETF (SDY) targets companies that have raised their dividend for at least 25 years in a row. Since its inception it has soundly outperformed the iShares Dividend Select ETF (DVY) but that outperformance started in late 2008. SDY is heaviest in utilities at 23% followed by staples at 16% and materials at 10%. Perhaps the drubbing in financials in the last couple of years explains the low (compared to other dividend funds) 10% weight.

One form of hybrid security is preferred stocks. There are a couple of ETFs out there in this space including the iShares S&P US Preferred Stock Index Fund (PFF) and the PowerShares Preferred Portfolio (PGX). Both funds are very heavy in financial stocks; 88% and 83% respectively. That would make me uncomfortable.

Obviously just about every ETF provider has corporate bond funds. I'll mention the new Claymore Bulletshares series again and mention that it would make sense for anyone interesting in this type of allocation look for a fund with relatively little financial sector exposure. I recently mentioned that one of the providers (I believe PowerShares) filed for sector bond funds. I'd much rather own bonds from the industrial sector (we own some UPS bonds for some clients) or the healthcare sector (we own some LLY bonds for some clients) than load up on bonds from the financial sector.

For long short exposure there are several funds from IndexIQ, the iShares Diversified Alternatives Trust (ALT) and the ELEMENTS Linked to the S&P Commodity Trends Indicator Total Return (LSC) along with quite a few traditional mutual funds including the merger arbitrage funds mentioned the other day.

There are all sorts of funds to access commodities for both methods; owning the underlying or equities in the respective spaces. A less volatile broad based fund has been the Greenhaven Continuous Commodity Index Fund (GCC). It is less volatile because it equal weights the commodities in the index so it has less exposure to crude oil than most other broad funds like the PowerShares DB Commodity Tracking Index (DBC). Obviously there are many choices for narrower exposures to ag, base metals, energy and so on. I'll mention that iPath is sort of replacing most of its commodity ETNs with funds that are five basis points cheaper and callable by the issuer (remember ETNs are debt obligations).

There are also countless equity funds to choose from like from the big boys like iShares and SPDR and the upstarts like EG Shares, Market Vectors and GlobalX.

So finding funds to choose from is not difficult obviously a proper study needs to be done, I just chose funds semi randomly. There are now over 1000 ETPs and as this is just a blog post and not a client proposal I did not do an in depth study.

That disclaimed it makes sense to understand where this is vulnerable. The concern with the income stuff was alluded to above with the big exposure to financial stocks with the preferreds and the bonds. One other fund to look at is the iShares Barclays Credit Bond Fund (CFT) which is 42% industrial companies. SDY's exposure to financials is quite reasonable.

The issue with long short is that funds that you and I would have access to have no guarantee of "working" in the future. We have had good luck with the Rydex Managed Futures Fund (RYMFX) during the worst of the decline but there is no reliable way to know, beyond faith in the methodology, that it will work again. This does not mean they should be avoided just, repeat point coming, that these are not infallible and too much exposure to one fund could really come back to bite.

Among other attributes commodities are cyclical. Many commodities have struggled lately perhaps over perceptions of a less robust recovery than some were expecting or maybe another reason. If you buy into the cyclicality of this space then they could go down more before again being an inflation hedge of some sort or otherwise storing value.

From a slightly bigger perspective one thing that sometimes gets lost in conversations about asset allocations is that occasionally they need to be changed tactically. The easiest example is my underweighting equities when the S&P 500 goes below its 200 DMA but there are other example as well. The combo of positive data and negative data leads me to think things will be slow for quite a while and if that turns out to be correct then having a lot of commodity exposure will be a bad idea.

Additionally commodities (often) and commodity stocks (almost always) add volatility to a portfolio as opposed to most utilities stocks that you would expect to reduce volatility. In accounts where we use an ETF for mining stock exposure we use the iShares Global Materials ETF (MXI). From its peak in May 2008 it dropped 63% at its worst compared to 50% for the SPX. From the recent peak in April MXI is down 20% versus 12% for the broader market. If this trend continues then a very large exposure (not that Rosenberg is suggesting that) could be very problematic.

Did you see Stephen Strasburg pitch last night? Holy cow. It was his first major league game and he set the single game record for strikeouts for the Natinals (if you are really into baseball then you understand the misspelling) with 14 in just seven innings.

He is the real deal assuming that whatever it is he does to throw a sinker in the 90s doesn't damage his elbow or anything else. I only saw him pitch once for San Diego State (my alma mater) so I don't know much about him but he actually seems like he could be a better pro than a college pitcher.
Read more!

Bond ETF Portfolio (Updated)

Last week I posted a bond ETF portfolio to spark some conversation about how to structure bond portfolios and the role ETFs can or should play in a diversified bond portfolio. Before the virtual ink dried on that one we've had quite a few new bond ETFs come out so I thought it would be interesting to construct a completely different portfolio and see where the discussion goes.

The portfolio from last week was;

iShares TIP Bond Fund (TIP) (client holding)
iShares iBoxx Investment Grade Corp Bond Fund (LQD)
iShares Barclays Intermediate Credit Bond Fund (CIU)
iShares JPMorgan USD Emerging Markets Bond Fund (EMB)
Currency Shares Australia Trust (FXA) (client holding)

For the portfolio this week, I'm mostly targeting the same segments of the bond market but hopefully the funds are different enough to continue the dialogue.

PIMCO 1-5 Year TIPS ETF (STPZ) (I own this one)
Claymore Bulletshares 2013 Corporate Bond ETF (BSCD)
SPDR Barclays Convertible Securities ETF (CWB)
SPDR Barclays Capital International Corporate Bond ETF (IBND)
iShares Diversified Alternatives Trust (ALT)
WisdomTree Dreyfus Brazilian Real Fund (BZF)

So the TIP exposure; obviously I believe in the exposure despite the balance tilting toward deflation these days. The other day a reader left a comment on a different post saying why he liked the iShares 1-3 Year Treasury Bond Fund (SHY). Since STPZ' inception it is up 3.39% versus 0.26% for SHY. The two seem to have the same day to day volatility but STPZ has been inching up as opposed to inching sideways. STPZ has payed a few small dividends but interestingly the dividends are a little bigger (eyeballing the dividends reported on Yahoo finance) than from SHY.

Claymore just (as in yesterday) listed a suite of corporate bond ETFs that each target maturing in a specific year. They run from 2011-2017 and the funds will liquidate on December 31 of the year they are scheduled to mature. They obviously allow for targeting very narrow portfolio elements which is a plus but the yield will still not be constant from the day someone might buy one of the funds. The reason for this is that over time if the funds attract assets then more bonds will have to be bought for the fund and those subsequent purchases will take in the prevailing yield at that time. I think this concept for an ETF is a huge positive because while the yield might move the interest rate sensitivity will be very similar to buying an individual bond with the same maturity. Including BSCD in this portfolio creates awareness for anyone who has not heard about these funds yet.

CWB's chart looks a lot like the chart for the SPDR High Yield Bond ETF (JNK). Since CWB's inception 14 months ago it is up 17.91% versus 12.89% for JNK. CWB was not around in 2008 but in the last few weeks CWB is down 5.38% versus 4..07% for JNK. When times are good CWB is a good bet to party on, relative to bond funds, but it will likely feel plenty of pain during the bad times. The question becomes do you want that sort of attribute in your bond portfolio in the current environment.

IBND is also a new fund. I wrote about it for thestreet.com so the short version is that it is very heavy in euro denominated bonds which is a negative. One point I make in the street article is that for the time being corporate bonds in Europe could be less volatile than sovereigns and as ugly as the euro is right now, it is down a lot from where it was.

ALT is not a bond fund, it is an absolute return vehicle. In its six months it has generally traded like a bond fund minus the yield. The point is not to buy a fund that pays no dividend but to think about the possibility that if interest rates rise some portion of a bond portfolio should possibly be allocated to bond fund substitutes. The Collar Fund (COLLX) bills itself as a bond substitute. If rates do go up in a meaningful way bond funds will go down in varying magnitudes. Finding a couple of things to hold that might pay a little interest but more importantly are less likely to go down a lot if rates go up a lot could be better ways to offset the volatility of an equity portfolio.

The question with BZF, as in the other post with FXA, is whether or not a currency fund can be a bond fund substitute. BZF went down quite a bit less than JNK in 2008 and came back quicker too. It has been much bumpier than the iShares 3-7 Year Treasury ETF (IEI) most of the time but that may not be as useful a comparison as with JNK.

There are increasingly more bond ETFs available making more sophisticated portfolios possible. This space will continue to see new product come making it all the more useful--like maybe single country bond ETFs, the indexes for these already exist. PowerShares (I think it was PowerShares) filed for bond sector funds a while back, it would be nice to see those list as well.
Read more!

Harsh From Hussman

From this week's commentary from John Hussman;

We have failed to address the essential problem faced by the world, which is that we have created more debt than we are able to service.

That cuts to the quick, doesn't it?
Read more!

Social Security As Your Fixed Income Allocation?

MarketWatch posted a sort of recap of some comments made recently by Jack Bogle. Most of it was probably familiar but there was one nugget in there I don't recall seeing from him before.

For example, your Social Security investment, when you're say 60 or 65, has a capitalized value of something like $300,000, and it's going to continue to pay. It may pay a little bit less. I hope we can solve that problem, but it's not going to go away.

"And so, if you have a $100,000 to invest, I don't see why you would not put it all in stocks at that stage of your life. That would be 25% then in equities and 75% in effect fixed income with an inflation hedge [via Social Security]. It's a good investment."

So the sad thing is that most people don't have $100,000 accumulated (depending on what you read the average 401k balance could be as low as $45,000). Also, I am leery of over reliance on social security and medicare. With those two points from me out of the way...the big picture concept is interesting.

If your social security is best thought of as a $300,000 fixed income portfolio (probably more like an annuity) what does that mean for the rest of your financial picture, specifically the allocation of assets you have in brokerage accounts?

The road to answering this question for yourself probably needs to start with understanding why you own fixed income at all. Over long periods of time there is a numerical argument for 100% equities--they grow (the last decade notwithstanding) and bonds mature in the future at their par value. Of course bonds can be used for speculation seeking capital gains, most people probably use bonds for income and offsetting equity volatility.

But if Bogle's premise is correct then investors would need more equity exposure and would need to learn to live with more volatility. Someone who is 55 years old with $350,000 in a brokerage account targeting 60% in equities and 40% in bonds (this mix is well within the realm of normal) presumably has $250,000 in capitalized value from social security would think of their portfolio as being $600,000 targeting $360,000 in equities and $240,000 in fixed income. Since the brokerage account only has $350,000 this person will be slightly under their equity target.

So are you on board? Neither am I. Building a financial plan and investment portfolio requires an understanding of how the numbers should work and then implement an asset mix that lets the person be comfortable enough that they don't panic sell. Since the capitalized value of social security cannot be seen it can be somewhat hazy. All an investor knows is how much their (in the context of this post) 100% equity portfolio is up or down over whatever period of time they care about.

A well constructed $350,000 100% equity portfolio will obviously be more volatile than a well constructed $350,000 60/40 portfolio and at a moment of maximum market puke down this investor is very unlikely to think about the capitalized value of their social security benefit.

Maybe I am wrong but people very rarely think about what it will be like for them during a real market panic which often leads to an emotional response when the panic comes. To the extent this is true, the concept set forth above by Bogle is likely a bad idea for a lot of people. Well unless they have some sort of objective trigger point for taking defensive action but of course he doesn't believe in doing that.
Read more!

The Big Picture for the Week of June 6, 2010

Credit Writedowns hosted a guest post by Frederick Sheehan titled Should Investors Boycott The Stock Market? Candidly the article didn't really focus on that question but it is interesting nonetheless. More interesting perhaps could be to wonder if investors should boycott volatility?

On the Seeking Alpha version of my Put Write post the other day Geoffrey Lordi mentioned the Merger Fund (MERFX). I wrote about this fund in a little bit of detail not quite four years ago. The fund chugs along doing its own thing regardless of what else is going on the (stock market) world. In the last ten years as the S&P 500 has had a wild ride on the way to a 30% decline the Merger Fund has had a much smoother ride to unchanged. Unchanged for a decade may not seem so hot but in a down 30% world I think it is pretty good. The strategy of merger arbitrage lends itself to a smoother ride. While I do not know how good the people running MERFX are I can say that over a similar period of time (the beginning of the chart for ten years did not look right so moved it in a little) the Arbitrage Fund (ARBFX) has had a much better result and also a very smooth ride.

There are other funds and strategies that that accomplish similar results, I've written about quite a few of them over the years. To the extent this site does share process these types of funds help with managing portfolio volatility which is a very important concept. If you've been reading this site for a while you know I am big on reducing volatility at certain times (mostly by using ProShares Ultra Short S&P 500 (SDS)) and I believe now is one of those times and so we have a position on in SDS.

Buying an inverse ETF is more akin to temporarily dampening volatility whereas a portfolio full of different products that try to do the same thing as MERFX or ARBFX would be shunning volatility altogether. Something like a permanent portfolio (25% gold, 25% stocks, 25%long bonds and 25% cash) or Nassim Taleb's portfolio and similarly Zvi Bodie's portfolio (80-90% in things like t-bills or TIPS and the rest seeking a lot of volatility) would be somewhere in between the extremes.

At the very least these sorts of things have intellectual appeal. For anyone interested in doing this, and as declines scare more people more people will consider shunning volatility, there are two practical concerns to address. Not every fund will work as it is supposed to. During late 2008 there were all sorts of funds (and accompanying articles) that went down a lot despite targeting absolute returns, hedging strategies or both (a search for headlines for Schwab Hedged Equity SWHEX will probably lead you to some articles) ended up looking a lot more like the stock market than they "should have."

I would warn that just because a fund "worked" the last time doesn't mean it will work the next time. Rules about not making any large bets certainly applies in this space, same as equities.

The other big concern that comes to mind right away is more behavioral. The emotion that leads a person to chuck the equity market is very likely to create impatience after a massive rally. Pretend for a moment that we are currently in the middle of the scare the hell out them decline I have been writing about; I am positive there are people who sold near the low, realized how much they missed so bought back in close to the top and are currently freaking out poised for more ruinous behavior. While that certainly is an extreme example, there are plenty of people who get impatient and to the extent investing requires patience you can see the point I'm making.

In my opinion the answer is better asset allocation. A few times in the last couple of years I've commented about people learning the hard way they had too much equity exposure. Hopefully it is obvious that in this conversation something has to give. The more equity exposure the more volatility and with less equity exposure comes the need to save more money. So I think the solution for people in this camp is a higher savings rate, innovative thinking with regard to asset allocation and time spent learning about various investment products. Obviously several of the ETF providers have created product for this space and if the demand increases there will be more of them to come and while some may not be helpful many will be.

You probably know that John Wooden passed away last night. What a truly amazing man he was.
Read more!

Bond ETF Portfolio

Yesterday I was trolling around the iShares website and I saw a link for their Fixed Income Portfolio Builder and while I never figured out how to use the tool it did provide a list of all the iShares bond funds along duration and yield information.

Below is a portfolio for you to look at, think about and hopefully weigh in on. I don't have this mix for any client so this is simply an academic study to try to learn from.

The portfolio;

iShares TIP Bond Fund (TIP) 25%
iShares iBoxx Investment Grade Corp Bond Fund (LQD) 20%
iShares Barclays Intermediate Credit Bond Fund (CIU) 20%
iShares JPMorgan USD Emerging Markets Bond Fund (EMB) 15%
Currency Shares Australia Trust (FXA) 20%











TIP and FXA are client holdings and obviously FXA is not from iShares and not a bond fund. Can a currency fund now yielding close to 4% be considered a bond proxy? The chart compares all five funds and the S&P 500. You can click to enlarge it or even better you can plug the symbols into whatever website you use for charts to take a better look.

Above a certain age heavy exposure to TIPS probably doesn't make sense. 'Certain age' is subjective but TIPS for someone in their 80s is probably unnecessary. For now there is very little inflation around and a compelling case for deflation but TIP yields 2.77% and the duration is only 4.08 years which is not too shabby.

LQD and CIU might appear to be the same fund by the description but under the hood they are very different. LQD has a yield of 4.80% ans duration of 7.17 years compared to 3.61% and 4.22 years for CIU. Another big difference is that CIU owns a lot of debt from foreign companies and even some sovereigns that are denominated in US dollars which means there are quite a few things you've likely never heard of. LQD owns a lot of things you have heard of. CIU is heaviest, sector wise, in industrials at 39% followed by financials at 30%. LQD is heaviest in in financials at 33% with the rest of the sectors being much smaller.

During the worst of it for bond funds in the immediate aftermath of the Lehman-weekend LQD did a little worse dropping 20% versus 15% for CIU.

EMB not surprisingly did worse still dropping 35% at its worst but has come back to where it was before then. The bonds in EMB are dollar denominated which has been a positive lately but will be a drawback in terms of opportunity cost if the dollar goes back down. The country exposure is spread around pretty well with a couple of countries around 9% and getting smaller from there. The fund yields 6.24% with a duration of 7 years which is a little long for where yields are these days.

FXA went down a lot before, about 35%, and is down now at $84 down from $94 and the dividend as been moving up as the RBA has been slowly increasing rates.

The yield of the overall mix is a little over 4% but of course that requires a grain of salt. ETF yields fluctuate, which is one of the drawbacks. The duration works out to a little over four years, assuming FXA at zero, which I think is a good overall number for a portfolio in the current environment. I did not intend to chase yield although maybe you would conclude I did.

Some questions I would ask is that for anyone interested in using ETFs exclusively for the fixed income portion of their portfolio. You can see from the chart what they did during one of the worst stretches for financial markets in modern history in terms of panics. One thing that is unknown is what these funds might do in a prolonged period where rates rise. Short dated paper is less sensitive to this but because bond funds have no par value to return to there can be a different dynamic which could hurt investors who are not on the lookout for this.

We do know that a short dated fund will move less than a long dated fund but the move in a short dated fund, depending on how things played out could be worse than the 15% or 20% that LQD and CIU dropped. They obviously snapped back fairly quickly but what was the panic level, if any, for holders as they were spiking down? What would you do if a bond fund you owned with no par value to return to dropped that much? Anecdotally it seems like during the panic people leave comments expressing real fear but after the fact the comments tend to lean toward 'no problem, I knew they'd come back.'

Another thing also is that FXA, relative to bonds, has been a volatile hold and clearly not right for plenty of people even if it makes for a good talking point. I think foreign exposure is important but wanted to add something a little more interesting than the sovereign debt funds that iShares has.

Your turn. What do you find interesting here, what would you do differently? Hopefully this can create a useful dialogue.
Read more!

At Some Point It Will Make Sense To Buy Greece

Of interest yesterday was news that as part of the austerity/bailout/repay package Greece is going to privatize and in some cases list shares in the railway, seaports, airports, real estate, the post office and casinos. The casinos? Don't the odds favor the house?

This article in the Wall Street Journal did not provide much in the way of numbers and while the process should start quickly, especially with the railway, I find this interesting and having potential at some point down the road.

The extent to which Greece has big problems has been documented all over the place. The situation is bad, will probably get worse, last a long time and we don't know if anything now on the table will actually work.

That being said the country won't become a ghost town. People will still need to eat, use the phone and get prescriptions filled.

One thing about Greece that we have learned is that they import almost everything. This won't change, at least where staple items are concerned and these things that they must import will come via rails, seaports and airports.

Were these things to list tomorrow the top down factors would still scream, no, don't do it! I do not know when Greece will make sense again, maybe never but the people aren't leaving and they still need to import the food they eat and the medicine they take. If the time ever comes where this makes sense to look at then I would imagine it would be possible to see how the stuff gets there and choose accordingly; again, if the time ever comes.

I've mentioned other countries in a similar regard. Kazakhstan comes to mind as an example. It has vast resources and vast corruption. If resource demand and prices keep going up and the corruption can come down a notch or two then it becomes an appealing destination but if not then not.

It is useful to keep tabs on these sorts of things. I tend to pay attention to more countries than I invest in (never invested in Kazakhstan but have been following it for several years now) and occasionally it pays off. Obviously this will only be relevant for people willing to invest at the country level as opposed to relying on iShares MSCI EAFE (EFA) for foreign exposure.
Read more!