Sunday Morning Coffee

Arjun Divecha emerging market fund manager at GMO was interviewed in the current issue of Barron's. He had an interesting quote that I sort of touched on conceptually in this week's video.

All the smart clients have been rebalancing. Think about this: If you had 5% of your money in emerging markets in 2003, it has appreciated 450%. You have to be cutting back if you don't want 25% of your overall assets in emerging markets.

A phrase I sorted of stumbled across while writing an article for TheStreet.com is volatility budget or some may prefer to think of it as their risk budget. Each investor can only allocate so much of their portfolio to volatile holdings. That number will vary depending on the person but everyone needs to know how much they can allocate to volatility and then must figure out the best way to access volatility in their account.

The example in the video I gave about allocating 5% to emerging market was just that, an example. I obviously agree with the quote above that 25% in emerging is too much. I would say 20% is too much. I don't believe I have ever allocated more than 10% to emerging, but I think I might have grown into a greater than 10% weight a couple of years ago which I have long since paired back.

Unfortunately there was no mention in the interview about how much emerging market exposure Mr. Divecha thought to be ideal.

Emerging has done so well in the last few years that there are probably quite a few investors (professionals and do-it-yourselfers both) who are confusing a raging bull market with something else. While I do believe the stories behind the price moves are different I would not want to be too exposed to the idea that the stock cycles are different.

Having a moderate allocation means not having to worry. How to define moderate? If your emerging market exposure were have a 50% haircut could you live with the impact on the overall portfolio? So if you have 10% (which is more than what I have) then a 50% hit would take 5% out of your overall account.

Different subject;

I looked at the video I made for 2007 and got a lot of things wrong. My prediction for the stock market will undoubtedly turn out to be wrong; I expected the market to be down a little to 1350-1375. As mentioned in the video I did not expect emerging markets to keep its hot streak going. I thought (maybe I should say hoped?) that the yield curve would have normalized by now with rates going up to something like 6% on the ten year.

I was pretty right, surprisingly, about the Fed cutting rates which was really the only thing I was right about. In the video I said I was right about a few things but, no. I was sort of right about healthcare. I said it would do well and measured by iShares Healthcare ETF (IYH) it was up about 9% YTD through Friday compared to not quite 5% for SPY (neither includes dividends). I say sort of right because even though it did better than the market that 9% pales compared to energy's (XLE) 35% lift, utilities' (XLU) 17% gain and staples' (XLP) 12% gain.

If you think of that as adding all that up to very wrong I could not really out-debate you on the point but, and this is what is important, you will see when I make the video to re-cap the Q4 and full year performance that being this wrong did not hinder results. A point I have been trying to make repeatedly is to not be too levered to your opinion because you could be wrong.

I have been expecting a bear market to start for a while (I think it did start in the last couple of months) but have been plenty invested along the way, though not 100% in, because despite what I thought the market kept going up, until just recently--that is if I turn out to be right about the bear market.

Since BusinessWeek seems to have discontinued it annual survey and replaced with opinions from just eight different strategists (if I missed something here with this someone please let me know) I will have to figure out a different way to make a forecast. For anyone who was not around last year I unoriginally used to take the BusinessWeek annual survey and try to figure whether the consensus was too bullish or too bearish.

The picture is what we used for our holiday card this year; Happy Holidays!