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Dr Doom on stock markets, the Hindenburg Omen and what next
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The 90% Solution

An interesting concept came up on the Consuelo Mack Show over the weekend from Nassim Taleb who wrote the book The Black Swan.

Based on the interview he is very risk adverse and said he doesn't really understand the stock market. I don't know enough about him to know if he is simply being modest.

He said that diversification used to work before people knew about diversification but now it doesn't work because people now know. He is certainly right when it comes to brief declines like we had last week.

His idea for portfolio construction is to put 90% into t-bills from various countries and then with the other 10%, the amount you can stand to lose, you should just let 'er rip. Just go hog wild.

I first heard about this concept, with a different twist, quite a few years ago. The idea as I heard it then while that market was falling was 98% t-bills and 2% short Nikkie futures. The idea is interesting from an academic standpoint, or I should say was interesting as the Nikkei is not quite the one trade it used to be.

I view Taleb's idea as being in that ballpark. The t-bill portfolio might average a 5% yield, which on $90,000 would be $4500 and obviously 4.5% to the entire portfolio. If, and I am conceding this is a big if, the $10,000 which is invested very aggressively could return 50% that would be $5000 which is obviously 5% to the overall pie and the total return in my example would be 9.5% which is almost what the stock market averages with much less risk. So it is interesting.

I see some complications that need to be considered. The first one of course is that the 10% that is aggressively invested could do very badly and so the overall return would be less than that 9.5%. Along the same lines if the 10% averages a beta of 2.00, that is kind of like a 20% exposure, in a manner of speaking.

The other big potential risk is that the dollar goes up against the currencies held in the t-bill portion. Sometimes currency moves can be very large, especially in the context of this being a "riskless" portfolio.

I find exploring topics like this very instructive in trying to learn more about portfolio construction and effects that can be created.

On a separate note we had a little fire here on the mountain yesterday. We have had a lot of thunderstorms lately and the fire was caused by lightening striking a tree. This was the second time I fought a fire in the pouring rain. Rain tends to prevent fire from spreading but doesn't necessarily put it out. It took about three hours which is not long for the typical wildfire but seems a tad long to spray, cut down and again spray a tree, oh well.
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Emerging Market ETFs

Over the weekend I remembered that WisdomTree just listed a dividend weighted emerging market fund, ticker DEM.

This chart compares DEM with the other broad-based emerging market funds, at least the ones I could think of.

WisdomTree says that the dividend weighting should hold up better during declines and while I have not checked all of their funds DEM seems to be passing its first little stress test.

Granted the fund is only ten minutes old and this may not mean anything for the future but the fund is making a good impression out of the blocks which is all a new fund can do.

Barron's had an article over the weekend that opined that after years of great returns some sort of serious correction or reversion to the mean would be coming. I am a huge believer in emerging markets investing but people need to realize that when things do turn there is usually pain involved. A little over a year ago I trimmed an overweight position closer to an equal weight (equalweight being high single digits) and more recently cut back on China to get back to equalweight again.

After a great run I have a tough time thinking overweight is the right allocation but zero weight is a bad idea too as they obviously could keep this run going for years. Clearly though there is no blood in the streets.

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This Could Matter

Shinzo Abe had a rough weekend and the result so far is that the yen is weaker against almost everything and the Nikkei 225 opened about 1% lower.

Yen strength contributes to risk aversion selloffs. If the yen weakens over this political snafu we may see the carry come back into immediate vogue thus opening the door to all the cheer and merriment that markets enjoyed over the last few months since the last yen rally.

It is too early to know what the outcome is but this is the sort of thing that you need to be in touch with if you want to manage your own portfolio.
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Sunday Morning Coffee

A read left a "quick question" as to whether I thought a bear market has started or if this is just a correction. Well the question might be quick but can the answer be quick?

First I would say that my hunch is no. It seems to me that bear markets do not start as dramatically as what just happened last week. I said the same thing about the Q1 dip as that one unfolded too. Anything is possible of course but for now I say no bear market.

I wanted to answer the question concisely up front but I have to say I think it is the wrong question, at least for me it is the wrong question. The way I view it is that demand for stocks is either healthy or it isn't--here I am saying the market above or below the 200 DMA is the tell for how healthy demand is.

If there is a problem with demand it makes sense, to me, to be defensive and when demand is healthy it makes sense to be more invested. BTW demand for stocks is healthy the vast majority of the time.

To be clear there are times where the 200 DMA gets it wrong and there are several other ways that other people gauge market health, I am not saying the 200 DMA is the only way and it may not be the best way.

For you managing your own portfolio it probably is not necessary to worry about animal adjectives to describe the market. I also don't believe it is necessary to outguess the next bear market or correction. If you own stocks you have to be willing to endure down a little. Right now the S&P 500 is not down anywhere close to the 10% that usually defines a correction so still down a little, very little really.

My approach is simply to be invested most of the time, stay reasonably close to the market over time and try to miss a big portion of down a lot. For people that have saved enough this is sufficient and means that unreasonable risk does not need to be taken.

The market goes up enough over time to give people who save properly enough money when they need it so people do not need to take on as much volatility as it seems like they do. Further missing a chunk of one down a lot in your lifetime can add nicely to your average annual return.

This sort of approach or view of the market is difficult for a lot of people to grab on to. Ken Fisher talks about how human beings are not wired for investing and I think this is part of it. People seem to want to make big bets on volatile parts of the market and often do so with poor timing. The building block for this is that if you save properly, stay in equities and never take defensive action you have good chance to having enough money. In that context the things I write about are my effort to simply give clients a smoother ride to that end.

The picture is from the north rim of the Grand Canyon.

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The Big Picture For The Week Of July 29, 2007

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Volatility Down Side

There have been a couple of comments making reference to the use of double short funds to hedge. I do this for most accounts.

One thing about the use of these funds to keep in mind is that as the market goes down the size of the the double short you own gets larger relative to the rest of the portfolio meaning it hedges more and more as the market goes down.

If you take no action into a decline, and this post is not about whether you should or shouldn't, you will become more hedged.

To use a simplified example. An account has $90,000 in SPY and $10,000 in the double short S&P 500 fund (which I own for clients). The market then drops 10%. The SPY is now worth $81,000 and the double short is now worth $12,000.

$12,000 is obviously a much larger percentage of the total account of $93,000 (after the drop) than the $10,000 was of the total $100,000 before the drop.

Keep in mind that this example is very simplified and that there is no guarantee as to what a double short fund will do.
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Hindenburg Omen

Well this is a new one on me; the Hindenburg Omen. Wikipedia has a page on it and Michael Kahn mentioned it in his column yesterday.

Per Wikipedia a divergence of stocks making new highs and stocks making new lows creates a higher probability for a crash.

I was on Capital Connection on CNBC Europe about a week and a half ago and felt quite certain we would be in for more volatility. I was on again last night and said I expect volatility to continue.

From a slightly bigger picture viewpoint all of the things that the worriers have been talking about like the carry trade, threat of an economic slowdown, subprime and so on have all contributed to the selloff.

There has been no shortage of commentary about what these things will mean to stocks so the market action of the last week or so should not be a total shock. The market is always worried about a bunch of things, this is obvious. It makes sense to be cognizant of the market's current fears and make some sort of assessment for yourself about how real the threats are and what is a reasonable bad case scenario.

For example I do not think the fundamentals of the subprime issue will be anywhere near as bad as the doom and gloomers think. However even if the fundamentals aren't so bad (or more aptly so widespread) that does not mean that the pounding thus far in the financial sector won't get worse because it could. The emotions that move the market short term will matter more for the next couple of weeks (or longer?) than whatever the realities of the fundamental story are.
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Decline

You may feel like doing this but the drop today is far from unprecedented, we had a similar (but worse) sell off on February 27.

The market is capable of big declines on any day and when it happens you may be inclined to act on your emotions.

It is days like today why I prattle on so much about picking an exit strategy ahead of time before you might be emotional so all you need to do is stick to your plan, whatever that may be.

My plan calls for some sort of defensive action at 1450 on the S&P (that is roughly where its 200 DMA is).

The market will either get there or it won't and I don't really care. A bad few months (if that is what is starting) will happen over and over in our investing lifetimes. This is one of those times or it isn't, I don't know. Really I don't have to know and neither do you. If you are disciplined over and over you will add value to your returns over the long term even if you don't manage this situation exactly right.

To further stress how unimportant this is, how does the LTCM selloff from 1998 impact you today? It doesn't.

If your exit strategy had you reduce at 1510 or will have you reduce at 1420, it doesn't matter, just stick to whatever your strategy is and don't worry about it being exactly right or exactly wrong. If you are right this time, great but you might be wrong on the next go around and vice-versa.
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The Same But Different

This thing with the delay of $12 billion in Chrysler paper is not good. It may turn out not to matter but it is not a good thing.

In 1989 the unraveling of the UAL LBO came about from the financing falling apart. It caused a mini crash in the US stock market.

I suppose the current news is different enough to be explained away but it is worth knowing a little bit about this sort of history. The turning off of the financing spigot, regardless of the details, is a threat to stock prices.
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All Consuming

There appears to be two of these moving through the world right now. One is in the Tour De France (nice call Linda P, you were exactly right) where the Tour has been destroyed to the point that I seriously wonder whether they might scrap it next year. Too bad there is no way to buy puts on the Versus channel.

A less dramatic storm might be in the currency market. Up until Wednesday the dollar was a one way trade down.

On Tuesday (I think it was Tuesday) the Daily Pfenning newsletter in and amongst all the exclamation points mentioned how strong all the currencies look against the dollar. While this is probably true it is worth remembering that nothing is a one way trade.

It looks like the dollar was very strong overnight against everything I watch except for ISK.

If you do a lot of foreign investing you have benefited from the weak dollar. You are also vulnerable to a dollar rally. At some point the dollar will have to snap back some. This has happened a few times during the last few years and will happen again--at least this is how markets usually work.

I do not think the longer term trend for dollar weakness has changed, I am not going to try to trade around any sort of dollar rally, should one come, but if the dollar does rally and you own a lot of foreign you will lag for a while.

The visibility for this is easy to see. Not easy from the standpoint of trading it because who knows about the timing but one way trades reverse. We have seen this several times with crude oil in both directions and of course stocks. It is the type of pattern that repeats over and over in all markets.

If the dollar rallies I will lag.

Knowing what you are vulnerable to, as I have written about before, is very empowering. It is logical and true thus there is no need to react to something that is logical and true with emotion.
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Just How It Works

So today I have two stocks in the portfolio getting hit very hard. As a result the portfolio has a noticeable lag on the day.

This is a great time to talk about managing sentiment. Days like this are guaranteed to come along every now and then, this is just how the market works. Period.

Any long term portfolio is guaranteed to have days with a lag; months, quarters and years with a lag for that matter too.

Part of managing a portfolio is to simply own the fact that this is how it works, that occasionally it goes the other way as well and that good and bad periods balance themselves out.

The only thing I feel about this is the hope that no clients stress out too much. Trying to calm someone down when they are upset about a bad day is not easy to do. All I can do is try to convey the extent to which one day means nothing.

To repeat this is simply how the stock market works.
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Why Is This An ETN?

You probably have heard a little bit about this new Exchange Traded Note that tracks some sort of index of MLPs from Bear Stearns; the BearLinx Alerian MLP Select ETN (BSR).

I couldn't really find too much on it. Greg Newton has a little but the link to the prospectus from a news release didn't quite work, I saw nothing on the Bear Stearns website and I did not find anything on IndexUniverse either. I'm sure info is out there somewhere but I came up short.

It is safe to assume the backtest is good, but I have not seen it and do not know. But its an index of stocks (MLPs really) that presumably trade on the exchange so why does this need to be an instrument that relies of the health of the firm?

If we truly are in a liquidity bubble or a sub-prime bubble (maybe these would be one in the same?) the bottom will likely include a huge firm failing. This is not a comment about Bear Stearns in particular or any other firm but big bubbles bursting (I am not saying we are in a bubble but if you think we are) usually involve huge financial failures. If this is unfamiliar to you I would suggest finding a book on market history.

In Greg Newton's post on BSR he pokes some good fun at the whole story and he could be correct but all I can say is no thanks. ETNs, to my limited way of thinking strike me as being most useful for things that might be difficult to access in an ETF, which would not include a basket of MLPs, but maybe my thinking is wrong here.

Is the hook that the ETN eliminates the K-1 form? That is a guess do to my not finding any meaty info. If anyone has a link please leave it in the comments. Thank you.
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The Sickly Kiwi...

...is now above $0.80 despite a current account deficit in the neighborhood of 10% and repeated efforts by the RBNZ to talk the Kiwi down and despite recent Kiwi selling by RBNZ.

What does this say about the US dollar?
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The Quest For Yield

A good discussion whipped up about yield after yesterday's post, thanks to everyone who participated.

I'll try to weigh in on some of the comments people left.

MikeC says a 10% return is a 10% return, period. I agree that in taking a reasonable income from a portfolio it does not matter whether it comes from dividends or price appreciation. It will always be a combination of both and the makeup just depends on what is going on in the market and remember the idea is for the account to grow a little faster than the withdrawal need.

One point to add to Mike's comment is that the 10% matters in the context of how much risk one takes to get his 10% or 12% or 8%. This has nothing to do with Mike's point but is relevant to everyone's big picture.

One reader is thinking about increasing yield with Canadian Royalty Trusts and shipping stocks. The reader notes the yields are very high but believes that mixing these types of stock in with other growthier stocks would make for a good mix.

The yields in those two areas are fantastic but anytime you can get 12% in a 5% world you are taking a risk somewhere. Maybe you see it and maybe you don't but it is there.

Fundamentally the trusts and the shippers should not be subject to volatility in the oil patch but I am not sure the fundies matter. I would tell anyone looking at shippers and royalty trusts to check how these stocks did during the last couple of crude oil price declines before buying in. I would further suggest looking at as many names as you can find in this regard to give you a better idea of what might happen the next time energy gets hit.

I specifically don't own shippers or royalty trusts because I believe the volatility is very high. if you want to step in I would urge moderation. Allocating 10% between the two is very likely to cause anguish at some point in the future.

HoosierDaddy lays out a reasonable comment that makes an argument for 80% munis and 20% equities. It might work but that is not an allocation I would ever put someone into without getting them to sign a waiver absolving me of any legal liability.

A comment was left with a link to a Fortune Magazine post with 40 stocks to retire on. I hate articles like this. Just build a diversified portfolio. Use some stocks, use some ETFs, use a couple of CEFs and cover your bases intelligently.

Finally a reader asks about funds that sell covered calls and write puts. A lot of the "call writing" funds also sell puts. The reader is concerned that call writing funds would be vulnerable to a bear market. As the question is about CEFs a fund that just wrote puts (if one even exists) would face the same general decline that call writing funds would face in terms of market price. I don't think the market would sort out any difference. I am a huge huge fan of call writing funds, as I have written many times but most clients only have one fund that takes up about 3% of the portfolio, I make the point of moderation over and over where these funds are concerned.

In adding various things to bring up the overall yield of the portfolio I think it makes sense to draw in different types of products that are vulnerable to different things. For example I have disclosed owning Macquarie Infrastructure (MIC) many times before. At my cost basis for most clients the yield is close to 8%. The call writing fund that most clients own also yields close to 8%.

Beyond interest rate risk these two have nothing to do with each other. If the entire call writing genre blows up as couple of folks think MIC won't realistically be threatened, in fact it may draw some assets that had been in the call writing funds (again assuming some sort of blowup).

Likewise is MIC turns out to be a fraud the call writing funds won't blowup in sympathy, IMO.
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Sunday Morning Coffee

In the ongoing quest to learn about and add yield a reader left a comment about constructing a portfolio to yield 4% so that nothing would ever need to be sold and that the investor could just live off the dividends (the reader assumes a prudent 4% withdrawal rate).

Another reader responded that if reader number one was interested in income and not growth that a muni bond ladder could yield 5%. I do think he does want growth though.

I certainly don't have all the answers but I have opinions and preferences. Constructing a normal equity portfolio to yield 4% is very difficult, even 3.5% would not be easy. When I say normal I mean diversified.

My initial reaction is that in order to get the yield up that high it would require tilting hard to the sectors that yield, at the expense of sectors that don't usually pay much in the way of dividends (like tech which I guarantee will have another day in the sun even if I have no idea when) or it would take loading up on a bunch of leveraged CEFs and at some point too much CEF exposure will bite back hard.

I think the first comment is just framed differently than how I view the issue. In the course of managing a portfolio, dividends come in at some frequency (depending on how you have constructed it) there is also the occasional trade that needs to be placed. If you read that first comment I am responding to you know what I mean as I say it is never so cut and dried and simple as to take in 3% and sell 1%. IMO that just is not how it ever happens.

For someone with the time and inclination maybe they should sell an occasional covered call to enhance yield. If you think about all the people out there selling the idea of 3% a month from call writing maybe that could be toned down to 75 basis points a year? If a portfolio yields 2.75%, which is pretty good, and you occasionally sell a call or two after a big move you could probably add 50 basis points anyway without becoming a junkie who has to have his account constantly re-paired* to determine the option requirements.

*Re-pairing refers to matching up long and short options within an account in such a way as to minimize the amount of cash to secure the position like a credit spread is usually the difference between the strikes and so on. This can be a wildly complex task depending on the number of positions.

The picture is taken from the path down to Hideaways Beach in Princeville on Kauai.
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The Big Picture For The Week Of July 22, 2007

Hectic hectic so no video this week.

I wanted to revisit the Currency Harvest ETF (DBV). This is the one that goes long the high yielding G10 currency and short the low yielders.
It is long Aussie, Kiwi and GBP and it is short yen Swissi and Swedish kroner.

DBV has pretty much kept up with the S&P 500 which, backtest notwithstanding, is a surprise. The short position in the kroner has been a drag and the fund has benefited mightily from yen weakness, and strength from Aussie and Kiwi.

As you can see on the chart DBV will be vulnerable if the yen shows any strength ever again as it did react to the threat of carry trade unwind in the first quarter.

I think anyone in DBV and heavy in Australia or any of the other high yielding destinations needs to realize they will be threatened by a yen rally. This does not mean you have to sell anything but you do need to realize what you are vulnerable to. Every portfolio is vulnerable to something.
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Questioning A Given

Russell Bailyn has a article up at Seeking Alpha about WisdomTree ETFs that is a good read.

In it he makes one comment that we have all heard before many times which is that "as baby-boomers start retiring, portfolio managers will be allocating portfolios towards dividend and other income-oriented products."

The logic is obvious and I can't really argue with it but I do question it whether the outcome can possibly be as expected. Specifically I question whether money allocated to dividend payers in the manner suggested will actually lift prices in some sort of advantageous manner for the people who get in now.

So many people believe it so (it seems) that I don't think it will play out as expected. This strikes as the type of thing that will just turn out to be wrong. I am not saying these types of stocks will do poorly or even be a drag but simply there will be no out of the ordinary excess return.

I do believe in yield but the way I think of it is what is the yield of the entire portfolio in relation to the market. You can add 100 basis points in yield quite easily when you add yield in certain sectors like utilities, telecom, energy and of course financials and then add in one or two things, modestly weighted, that yield 7-8%. One example would be a call writing fund and for anyone new; modestly weighted is 2-3% of the portfolio.

As important as I think dividends are I think it would be a mistake to own nothing but high yielding stocks. You can't be properly diversified owning nothing but yielders.

Now from the Hey Ma, Look category a bunch of blogs got mentioned here in BusinessWeek, including this one, but quite frankly I can't tell if it is just online or made the print edition too but I suspect the former.
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Research - Active Indexer: Offense–Defense, Part I

John Serrapere has a new post up at IndexUniverse that you can click through to above.

His stuff is always a good read.

Way back when I was a trader at Schwab Institutional he called into our desk all the time but I doubt he remembers me.
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Financial Wreckity?

OK, poor follow up for the name of a post after yesterday's Techity Wreckity. Domestic financial stocks have generally been struggling for the last few months or so relative to the broader market.

My position for clients has been the same for several years which has been very little domestic exposure and a lot of foreign exposure netting out to less than the S&P 500's 22%.

Many attribute the weakness to the subprime dealio but I have to wonder if a part of it too was that the slope of the yield curve, which when inverted or flat is a headwind for the sector, finally caught up to it.

Perhaps the slope of the curve contributed to the subprime which then contributed to financial stocks lagging? Maybe, maybe not.

Interestingly the part of the group that has done better than the broad sector has been the more volatile (in my opinion anyway) public exchange stocks and brokerage stocks (ex-Bear Stearns?). I think the reason for this is because as the market has been going higher investors/traders have been willing to take on the type of risk that goes with these two sub-sectors.

This divergence could last a while longer as the trend, much to my surprise, seems to still be intact.

For now I continue to prefer foreign over domestic for financials. Banks and the like are a great way to own foreign countries. Just about every foreign country has one or two big public banks.
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Techity Wreckity

Oof the tech sector.

I was a last minute fill in on Capital Connection last night on CNBC Europe. I talked about how every so often the tech sector shows a glimmer of hope, the promise of a better tomorrow and then whammy; a kick in the stomach.

I used to understand this sector much better than I do now (talking late 1980s and early 1990s not confusing the late 1990s bubble with being smart). I have been underweight for several years as I have disclosed throughout the blog.

I don't know what will really turn it around and I doubt I will catch the turnaround but I have some exposure, about 2/3 the market weight, so when I do miss the turnaround clients won't be horribly impacted.

I think this sort of thing should ring true for every big sector of the market in a diversified portfolio--maintaining at least a little exposure even to thing you hate because at some point all sectors have their day, all of them.

I will be away from the machine most of the day but will have a normal schedule tomorrow.
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A Quick Reminder

The economy minister of Argentina resigned yesterday because she could not explain why there was a satchel in her office that contained the equivalent of $64,000.

The Merval was down almost 2% yesterday but is recovering a bit today.

This serves as a reminder that there is still the potential for corruption to exist in popular, exotic investment destinations. The thesis for Argentina (not a country I own and I don't know the story very well) does not change as a result of this but it serves as a reminder that things that cannot be planned for will still come along every now and then which serves to increase volatility.

This sort of thing thing can happen anywhere. While this not serious another episode in the future could be.
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Just When We Were Feeling Good

A must read for me every Monday is John Hussman's weekly commentary.

This week's was an especially good read. He spelled out a little market history comparing the current state of the market to past, similar periods.

December 1961 (followed by 28% market loss over 6 months)

January 1973 (followed by a 48% collapse over the following 20 months)

August 1987 (followed by a 34% plunge over the following 3 months)

July 1998 (followed abruptly by an 18% loss over the following 3 months)

July 1999 (followed by a 12% loss over the following 3 months)

December 1999 (followed by a 9% loss over the following 2 months)

March 2000 (followed by a 49% collapse in the S&P over the following 30 months)

According to Hussman those periods all share the following with today;

1) price/peak-earnings multiple above 18

2) 4-year high in the S&P 500 index (on a weekly closing basis)

3) S&P 500 8% or more above its 52-week moving average (exponential)

4) rising Treasury and corporate bond yields

Hussman is quick to point out that he is not trying to make a prediction so much as create context for current market events.

This is an important distinction. The market can go any direction at any time for any reason or no reason. The general tone of Hussman's article ties in with what he has been writing for a while but the bullet points sum it up nicely.

Clearly these sorts of obstacles can exist for a long, long time without hurting the market. This is an argument for not making big bets to get out of the market for fear of a correction, bear market, crash or whatever else. I continue to be bearish (have been for a while and have been incorrect) but am so without missing the market. My trigger point for taking action is simple (a breach of the 200 DMA by the S&P 500) and has not been violated so I ride along skeptically thinking a turn will come soon.

Bear markets come so infrequently that guessing on the next one in a meaningful way is like to be the wrong trade. Hussman creates a great background of what stocks must continue to overcome go higher. The things Hussman cites or maybe subprime or maybe the dollar or something else will cause the next bear market at some point but time devoted to trying to nail the top is probably not productive.

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What Don't You Know?

The other day I had a quick post noting that ISK had gone below 60, belying USD weakness against the Icelandic currency. A reader left an even shorter comment saying he did not care. Fair enough.

His comment got me to thinking about what is an important concept in investing even if it does not pertain to this one person which is the idea of not knowing what you don't know.

Every investor has gaps in his knowledge, Warren Buffet claims tech stocks are one of his gaps (I don't think he phrases it this way however) for example. I have gaps and more important to you is that you have knowledge gaps in your investing too. No one can fill all of their gaps, that is not the point nor is it even ideal to try.

What might be more important is an introspective listing of what you don't know. For example I have mentioned many times my not understanding what had been never-ending demand for new homes (maybe this is changing now?). I never understood how all the building of new homes, the supply, wasn't dwarfing the demand. As a result I have never owned a home builder stock personally or for clients. I understood it was me, I wasn't getting it, but because I didn't get it I stayed away. This is an example of knowing what I did not know.

Based on comments on the blog and emails to my Street.com account common gaps have to do with portfolio construction issues specifically pertaining to thinking about and understanding the consequences of what it means to be overweight and how much of an overweight is prudent.

Before the emerging market correction of June, 2006 I heard from a lot of different people sharing the fact that they had 25-30% in that segment. A lot of people also disclosed 20-25% in the Canadian energy trusts. Both of these segments have obviously had big hiccups over the last year and while they may or may not have big hiccups in the future other soon to be popular segments will take big hits and before hand people will have 20-30% there as well.

My entire approach to portfolio construction and management is about the path of least resistance without potentially being undone by a big bet on one theme. Putting 30% in emerging markets is an attempt to have huge portfolio gains. Getting huge gains when the overall market is up modestly means you have taken huge risks. This is a path of a lot of resistance.
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Sunday Morning Coffee

A reader left the following.

"and looked at two of my ETFs, MXI and DBN which together constitute about 1.8% of my total portfolio, but 8.6% of my basic materials holdings. I know it is redundant to hold both, but want to choose "wisely" between the two. I couldn't find the expense numbers for both of them. Which would you choose, and for what reasons?"

MXI is the iShares Global Materials and DBN is WisdomTree International Basic Materials. I own
MXI for a few clients for whom individual stocks in this sector are not ideal for whatever reason.

He notes it is redundant to hold both, well sort of. If the two funds, which are very similar, only total 1.8% then really the only redundancy is with the commission. If you sell one now would you then put that money into the other? So what's better, paying now or paying later when/if you sell. I think the important thing here is that the two added together don't constitute a reckless bet.

The 8.6% number is a little more eyeopening. As I read that I think he is saying his allocation to materials is in the mid-teens. The S&P 500 appears to be 3.17% in materials, the iShares DJ Total Market ETF (IYY) is 3.42%, the iSharesETF (IWB) is 4.68% (I think, it lists it as materials and processing) and the iShares Russell 1000 S&P 1500 (ISI) is 3.58%. Depending on the benchmark used, his number is high. Depending on what else is allocated to the sector this could be volatile and prone to some discomfort if the mega cycle ends abruptly.

As for his question of which I think is better; the seem to be interchangeable. The holdings are very similar to a point. MXI includes the US and DBN does not but the US weight is not huge. I think the more important differentiation is that the domestic materials ETFs don't have much commodities exposure.

The two BHP listings combine to be the largest holding in each fund. Anglo American (AAUK which is a client holding) is number two in MXI and number three in DBN. They each also have Rio Tinto, Bayer, BASF and Arcelor in their top tens.

Performance-wise the two started out tracking very closely but since DBN listed the outperformance looks to be five percentage points. An interesting point is that the entire outperformance appears to come from two periods; a couple of days in late March and maybe around May 1.

While the extra 5% certainly would have been nice I am not sure at this point if it is sustainable or not. I am not saying it isn't just that it is unclear to me.

The top-downist in me would note that the more important decision was made when he decided to buy either one. Since inception, regardless of which one anyone chose, holders are up about 50% while the S&P 500 is up 14%. A 2% allocation at inception has added 100 basis points to the entire portfolio which is not too shabby.

The picture is from Urquhart's Bay in New Zealand.
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The Big Picture For The Week Of July 15, 2007

I think the IndexUniverse article just made a typo in saying DEM lagged at the five year mark.
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ISK!

ISK finally went below 60 today. It seemed like it was destined to happen but still it is wild to see.

The dollar just keeps eroding and no one seems to care.

It is possible it won't matter until it goes down much farther, if ever, but the action does put upward pressure on interest rates which doesn't have to hurt equities but it won't help.
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Questions From Yesterday

A lot of questions came in on yesterday's post that I'll try to answer here.

One reader asked about separately managed accounts from a firm called XTF that the reader says does sector and country rotation along the lines of the funds from Claymore (XRO and CRO). Specifically he wanted to know my take on paying for management versus just buying the funds. Well knowing nothing about XTF makes it difficult to offer too much here but...

My inclination about XRO and CRO is to wonder whether they can offer a slightly different, and better, twist on SPY and EFA for people who use broad-based products and to be clear I don't. XRO may be on its way to proving out to be better and we'll have to see about CRO. If they pan out they are better for the do-it-yourselfer.

The idea behind the separately managed account is probably that the XTF people believe they can add value above and beyond what was out there when they started and probably taking into consideration anything new that comes along. Any active manager (or quasi-active) that can consistently deliver a return (all things considered) that is right for you is will be worth the fee.

One reader is bugged by not being able to determine yield for some of the dividend products out there. For WisdomTree; go to the site, go to the index page for the ETF you care about and it says it right there. However that yield number is for the index. You then need to subtract the fee to get what the fund yields.

There seems to be a quirk with the WisdomTree dividends that I have not about other fund companies having to deal with and I am not sure I can even articulate well. If you look at Exxon Mobil you will see that it $1.40 annually. If you own 100 shares on ex-date you get $0.35 times 100 shares. If you buy another 100 shares after ex-date you still only get $35 in dividends on the paydate. As a function of new money coming in and only getting paid on the first 100 shares some of that funds have been/are paying less that what the index yields minus the fee.

I only use one of their funds as an across the board holdings and for smaller accounts I use a couple of sector funds and DNH and quite candidly the results have been very good compared to competing funds dividend quirks notwithstanding.

The most important thing to me is looking under the hood and making a judgment about whether this mix will be better than other mixes on a total return basis. This is sort of like stock picking in a way.

To get the yield info for Claymore just call them is all I can say.

LindaP asks about tax issues with the Claymore foreign stuff. I don't really know the mechanics here, but my hunch is that this is all netted out in the dividend you receive (this is nothing to due with paying tax here from your 1099). I would say to call and ask them for a better answer than this one.

Someone asked what I could dig up about "those lipper etf funds." What information have you found so far that you can leave here?

One little extra item. Very rarely does the difference between funds boil down to a 20 basis point difference in fees or a quirky tax thing. Often people don't see the forest for the trees (especially in a lot of articles I read) on these things. The back test on the new WisdomTree Earnings 500 ETF (EPS) has outperformed the S&P 500 by 1.89% annualized over the life of the back test (five years). I concede all of the ifs you can possibly think of but if it repeats that over the next five years that extra 19 basis points in fees for EPS over iShares S&P 500 (IVV) becomes the wrong thing to worry about.

Fees matter but they are not the most important thing the vast majority of the time.
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Thursday's Market?

This is all you need to know.














Hopefully we don't get this tomorrow or the next day.
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Market Commentary and a PSA

Yesterday I got a call from the local paper asking for some chatter about about the market (this will be in the Sunday Arizona Republic for anyone in AZ who cares). The general tone of my comment was about increased volatility in stocks coming from increased volatility in the ten year treasury as the market tries to sort out how important the latest subprime news is or is not.

That couldn't be truer today and I think will persist a bit longer. News-wise I can't imagine we have heard the last of this. The fundamental importance and magnitude can be debated but there will be more news and it is bound to scare the market again as it did the other day. Brace yourself for a few more bumps that will probably be forgotten by labor day.

The PSA is for Directv subscribers who are also baseball fans. Directv is starting a free-view of the Extra Innings package today through next Wednesday but there is only one game on schedule for today with a full slate tomorrow, there is a full schedule today.
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New Foreign ETFs

Claymore launched two new ETFs yesterday that on the surface look interesting and one of the two looks very unique while the other one looks like a different twist on on an existing theme.

The first one is the Country Rotation Fund (CRO). The idea is to pick countries, presumably from the EAFE basket as EAFE is the benchmark, that it feels offer a better risk return profile based on some sort of undisclosed process. Then it picks stocks based on some sort of relative value, corporate growth model that is not spelled out very clearly.

The UK is the largest country weight at 25% followed by Australia at 12%, a bunch more between 4.5% and 10% followed by a 0.17% in Ireland. The country selection includes macro economic factors so I am surprised how little weight Ireland has and more surprised that Norway has no weight. I am sure it can be justified just fine but still.

It is easy to be skeptical of a rotation fund but the other fund like this that rotates domestic sectors, ticker XRO, has clocked the S&P 500 since its inception. Its up abut 22% compared to SPX' 15%. It has only been ten months or so but when a "gimmick" fund with a great back test lives up to its own hype it is tough to expect it to do better than great.

The other fund is the International Yield Hog (HGI). It is heaviest in the UK at 18%, US 11%, Canada 8% and plenty of other countries with smaller weights. Like the domestic Yield Hog, which I own for a couple of folks it goes to all sorts of different products to get yield; it owns stocks, CEFs, Canadian Trusts, MLPs and emerging market ADRs.

The hog strategy has worked fairly well since the domestic inception. It has lagged the S&P 500 by about 4% but has beaten DVY, which I own for a few clients, by about 3%. you can decide for yourself whether that equates to success.

The idea of high yielding foreign was first put out there in an ETF from PowerShares with PID. Since then WisdomTree came into being with a bunch of funds and Barclays just listed is EPAC Dividend Fund (IDV). I might be forgetting one or two more.

Neither fund has exposure to Japan which could allow them to pull away from EAFE, if Japan continues to struggle. CRO is very heavy in the financial sector but surprisingly HGI is not.

One weird thing about the release of these funds is that there appears to be no published back test, at least I didn't see one in the spot where they put the back test results for the other funds.

Claymore has cranked out a lot of funds lately and a lot of them strike me as gimmicks but it seems to me that they deliver more often than not which makes thinking of them as gimmicks unfair. Obviously I have no idea how either of these will do, I tend not to buy ETFs right out of the chute and I am holding off here too but these are worth watching.
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Visibility

Part of constructing and then managing your own portfolio is understanding how it will react to certain types of market events, when it will lag and when it will outperform.

On one level, if you are really overweight energy and oil goes down 10% in a week you know your portfolio will have a very bad week and the opposite is also true.

Lately I have noticed that my portfolio does a little better on days the market is down and lags a little if the market is up a lot.

Occasionally on a given day the portfolio will beat by a lot or lag by a lot. Any time this happens there tends to be a catch up effect for a day or three.

Yesterday the portfolio beat by a lot so I know it will lag on the next big up day, obviously I can't know by how much. That I know ahead of time that there will be a lag makes the lag much easier to deal with.

It is the same with the energy example above. Oil has had a nice run of late as have most energy stocks. A normal correction within the group doesn't derail any longterm bullish thesis but it does mean the stocks would go down for a bit.

Got emerging market stocks? Some sort of panic there will hurt whatever you own. Ditto for any other theme.

The point here is not about trading it is about understanding what you are vulnerable to and preparing emotionally for a speed bump. In February the market had a scare over the carry trade and various themes that are vulnerable to the carry trade fared worse than the broad market but now that entire event seems to have been forgotten.

Being out in front of this sort of thing emotionally makes participating in the market much easier for the times that you don't perfectly trade around a correction or dip.

It is a guarantee that something you are vulnerable to will have a bad fill-in-whatever-time-period-you-like. Think about it now so you don't panic later.
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Throw Another Bagette On The Barbie

That is no doubt what Fabian Cancellara is saying to his team car as the euro is hitting a high against the dollar. Or maybe not since Cancellara is Swiss.

But the euro is hitting a high as rates move down today. This has been an ongoing theme for a while and I believe will persist for an extended period.

Even the sickly ISK hasn't been so sickly as the Icelandic is stronger than it has been for quite a long time except for two brief exceptions in 2005.

I think any hint of rate cuts will really take a further bite out of the dollar. That may seem very obvious but I do not think there was ever chance of another hike in this cycle. I think it has always been when will the Fed cut. If that turns out to be correct it will have portfolio implications along the lines of what I have been writing about for a while which is buy more foreign stocks.

I do not think this will devolve into rioting in the streets as some others do.
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Ben Stein

Ben Stein was on Consuelo Mack's PBS show over the weekend in a short interview that had a couple of great, albeit simple, tenets for financial planning.

The nature of the interview was such that Consuelo seemed to cut him off continuously but he got some good big picture stuff out there.

He talked about equilibrating (I had never heard that word before) consumption and income over ones lifetime so you don't "wind up broke."

The other important (to me) point that he made was that "liquid assets equals freedom." He used that phrase several times and then went on to talk about the importance of saving. He quoted his father as saying liquid assets equals security and living beneath your means equals freedom. He also said that every time you buy into a fund (or whatever) you are buying freedom and there is nothing more important than buying freedom.

I have been trying to convey similar ideas since the start of this blog and trying to live this way for even longer. I have only had a couple of occasions to have the live beneath your means conversation professionally (I manage portfolios, I am not a financial planner) and I am no good at compelling people toward understanding this to the point of making better decisions.

One argument that came up in the comments and that came from a client who doesn't read the blog is that people are more active in their 60s when they first retire and slow down as they get older. This makes sense but medical expenses go up a lot as people age too, an awful lot. The notion of slowing down the activity/spending assumes a certain amount of discipline. Some will have the discipline and some will not. Anyone thinking they will spend less on activity when they hit 70 needs to have a long look at themselves in mirror to make sure they can follow through.

My thinking is probably quite limited here but when people talk about being active don't 95% of them mean traveling? I have a couple of thoughts on this that will probably go over poorly. One is to take a couple of trips-of-a-lifetime before you retire while you are still making money.

The other thought is spend a little less when you go. With a little time spent researching you can find great places to stay that are not expensive. A couple of $20,000 cruises a year can be a killer.

As for saving; I have written a couple of times about studies that say people save too much because the brokerage firms scare them into saving more than they need to collect more fees. I'll save less, that'll show them!

If you have no bills to pay (here I mean only one car payment instead of two and having less mortgage than you could otherwise afford), have a lot of money saved, or some combination of both you will be able to weather almost anything which I think is the type of freedom than Stein refers to.
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Metaphor

Its a little difficult to see but there was a huge crash at the end of today's Tour de France that resulted in a massive pile up of riders.

I couldn't find a still but so I paused the video and captured this.

I'm sure there is some sort of investing metaphor with a pile up like this but that seems unlikely to be today.

You can watch the video here.
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"The Price Is Wrong"

Morningstar ETF writer Sonya Morris has an article up called "How To Evaluate New ETFs" that I found via ETF Trends that, like most of what I have ever read by her, I think takes the wrong approach to ETF selection.

It seems that Morningstar tries to apply bottoms up analysis to ETFs and I don't think this makes any sense.

Anyone constructing a portfolio using ETFs (or other types of funds) is specifically not picking stocks. They are either making decisions about the broad market, cap size, style, sector, countries or some combination of the above which I think are more forward looking than bottom up analysis which looks at whether a stock is reasonably valued or not and then assuming that if it is fairly valued it will do well. This makes a lot more sense for a stock than for something like mid cap growth. In her article she picks on some of the new emerging market ETFs from StateStreet because...

... Emerging-markets funds have notched double-digit returns for several years now, and it's hard to see them continuing at the same breakneck pace. Plus, the strong rally has pushed emerging-markets valuations to pricey levels, according to Morningstar's international stock analysts.It wouldn't be surprising to see that market segment cool, which would clearly be an unfavorable development for the new ETFs.

So is she saying investors should have zero in emerging markets? The article never clarifies so we can't know. Emerging markets is a segment of the market. Anyone interested in a diversified portfolio should always have some exposure. At any point in time there should be more or less exposure based on some of the things she mentions but to be clear she should be using those points as reasons for adjusting how much not deciding if.

She specifically questions the timing of SPDR S&P Emerging Markets (GMM) for the reasons stated above. This is the wrong way to look at it. The big point of differentiation with GMM is no South Korea. This will make GMM more attractive more attractive for some people over something like iShares Emerging Market EEM which is heaviest in South Korea.

I think the process needs to be more like do you want to be heavy or light in emerging markets? Then based on various big picture things important to you, what parts of emerging markets do you think are best; commodity based, frontier, manufacturing based and so on? Once that is decided, what is the best way for you to access emerging; broad-based, narrow-based (which includes individual stocks) or some combination of both? Then finally the individual picks.

If you want a broad-based but don't want South Korea then GMM becomes your only choice making the analysis in the article moot.

Another misguided bit of insight is the poo-poohing of the PowerShares DWA Technical Leaders Fund (PDP). Ms. Morris notes that "PDP doesn't look compelling right now from a valuation perspective." She further goes on to note that PDP "smacks of performance chasing, and it completely ignores valuation, which is a core tenet of my investment philosophy. A look at this ETF's price characteristics confirms that valuation is not paramount here."

Are you kidding me?

I have not studied PDP but I am thinking that a fund called Technical Leaders probably employs some sort of technical analysis as opposed to the bottoms up that Morningstar believes in. Further we might glean that PDP does exactly what she says; chases performance and ignores valuation. On some level isn't that exactly what technical analysis is? PDP may or not be a good fund but she is essentially saying "I don't like technical analysis because I don't like technical analysis."

I continue to hold out hope that Morningstar can actually deliver useful ETF content. For now, not yet.
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Sunday Morning Coffee

Barron's has an interview with Thomas Herzfeld, who is all things closed end funds, this week.

This Herzfeld interview gives an inkling of hpw complex investing in CEFs can be when he says they look at 20-30 different things to pick funds.

I went to the Herzfeld website and found a link to a free back-issue of their regular reports that your can subscribe to. While I don't think I am going to subscribe there was a ton of information in the free back-issue.

Included in there toward the end were several portfolios with different objectives including a US Equities Portfolio. I'm not sure if it is OK to republish so I won't but I can share a couple of observations.

The portfolio had 14 different funds. I was surprised that in looking at them on ETFconnect there is very little overlap of holdings within the funds, there is some but not a lot. This is not easy to do. Consistent with the article almost all of the funds were trading at big discounts to NAV. Some of the funds have almost no volume. Of the 12 holdings that Yahoo could chart (there were two it could not) nine lagged the S&P 500, two beat and one had the same return.

I concede that in most instances the S&P 500 is not the best benchmark for this study as some of the funds are smaller in cap size. This lag, though, of the funds means one of two things; either this portfolio lagged badly (not the bet I would make) or they do a lot of trading and get good returns (this would be the way I would lean but I did not see any returns posted, apologies if I missed). For the month of April this portfolio had eight trades which seems active to me. Point being it would be very difficult for most do-it-yourselfers to replicate this on their own.

But this is his approach and I am sure it is successful for him but either you pay them to manage your money, try to do re-create something similar yourself or use closed end funds in a completely different manner. It that last one that I have gravitated to.

For certain segments of the market I think closed end funds work very well but I am not sure plain, domestic equity exposure is one of those segments. I have one call writing CEF as an across the board holding, some clients own one of the India CEFs, literally a couple of clients own a dividend capture fund and that is it on the equity side of the ledger. I do a little more with fixed income CEFs with a convertible bond fund, a foreign bond fund and in some instances a generic bond fund.

Herzfeld has forgotten more about CEFs than I'll ever know and so he can use all-CEF portfolios. Most us should not, including me.

The picture is of a restaurant in Hellnar, Iceland, a couple of hours outside of Reykjavik. Hellnar has a year round population of nine. Yikes.
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The Big Picture For The Week Of July 8, 2007

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NOKy Socks The Dollar

This chart compares USDNOK versus USDEUR (the backwards way of looking at the euro in relation to the greenback).

As you can see, NOK has outperformed the euro dramatically (the chart shows that the dollar is down 4% against NOK and down 1.5% against EUR).

I tend to get preachy about foreign exposure into countries that have different economic makeups than the US with this chart being a microcosm of why. The dollar has had an extreme move of late and exposure to Norway has given a better tailwind than available from a euro-based economy, like the ones that dominate iShares MSCI EAFE (EFA).

In the same time period, the Aussie (another one I prattle on about) has done a touch better than NOK. This guarantees nothing for stock returns as my Norwegian stock has done very well but my Australian stock has lagged slightly YTD but it makes the job of portfolio construction easier.

This is not about gaming a currency swing trade (if those two terms even go together?) but assessing that conditions are generally favorable for a particular currency and that a portfolio could benefit from a modest exposure. This is not very complex but will become very important over the lifetime of anyone's portfolio.
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Future Consideration

One aspect of my approach to portfolio management is to look down the road a few years to think, in big picture terms, what client accounts might look like. I have written many times about Iceland and Vietnam as investment destinations but for now don't have wide exposure for clients but expect I will over the next couple of years.

Kazakhstan is another country that could make it's way into the portfolio over time as well. It is very resource rich, has $22 billion in foreign currency reserves, GDP growth in the neighborhood of 10%, unemployment in the ballpark of 1% and moderate short term interest rates around 5% but they do have a small current account deficit which makes some sense in that I believe there is a need to import a lot of consumer goods.

There is a stock market in Kazakhstan but I could not figure out how get to a page with a chart of the benchmark KASE index and at this point I am not sure how it has done. If anyone can find a chart at that website or elsewhere please leave a link.

If you are a regular reader of FT Alphaville (literally the first thing I read in morning) you have seen several Kazak companies list in the UK. Chances are these are not available now but I think they will be in the next couple of years

One last point is that you can follow the economic goings on at the English version of the National Bank of Kazakhstan website.

I think it makes sense to learn about as many countries as you can. It will make sense to invest in some of them in the future and learning about them ahead of time and following them over a period of a few years will better prepare you to decide which ones you actually buy.
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Currency Moves

This is the list of currencies I have on MyYahoo page.

Of late, and this has gotten some attention, the dollar has sold off in a big way against a lot of other currencies.

This tends to belie a willingness in the market place to take more risk. The AUDCHF, the second from the bottom, which some view similarly to the old TED spread, has moved dramatically in the favor of the Aussie.

A year ago AUDCHF was around 0.92, so it has moved 13% to get to 1.04.

The US dollar is down against all sorts of deficit currencies like the Aussie and kiwi and it has also lost ground to the surplus currencies like the Norwegian krone and Swedish kroner.

The dollar is also down against just about every emerging market currency you can think of too, not all of them but most.

The portfolio implication is unclear in that you can find plenty of smart folks that can lay out a compelling case about how a weaker dollar helps our economy, helps exports and so on but I don't really buy into this idea. I think its more like a weaker dollar is not 100% bad which is a long way from saying it is a good thing.

I heard Peter Schiff on one of the shows on Tuesday (Kudlow?) calling for the same collapse he has been calling for every time I have ever heard him speak. While I don't think much of always predicting the same very extreme outcome the more important part of his message get thrown in as an after thought; buy foreign stocks.

The US market has lagged most other markets in local terms and the outperformance magnifies when you factor in you get an extra 8% from the Aussie dollar and 6% from the Norwegian krone (as two examples of countries I have been writing about for several years).

Being in touch with big macro trends like this makes investing much easier. The simple decision to go foreign has been very important and seems very likely to continue to be very important.
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Fourth Of July

A little fun with the craziest baseball brawl ever.

Baseball Brawl

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Claymore launched a new energy ETF on Tuesday with the Claymore/SWM Canadian Energy Income Fund (ENY). This one has been in the works for a while.

It is supposed to be a blend of oil sands stocks and high yielding trusts. During a "bull phase" the fund will be 70% oil sands stocks and 30% trusts. During "bear phases" it will be the other way around. It appears as though the keepers of the fund view now as a bull phase, not that I disagree.

The fund is 100% Canadian stocks, it is heaviest in mid caps at 45% I would imagine that it is currently tilted to growth and during a bear phase it would switch to value. It only has 29 holdings.

I have written in the past that an oil sands product might be useful for people who do not want to take single stock risk within the sector. Often non-stockpickers are shut out from narrow, but potentially important, themes but not with oil sands anymore.

There is no back test data and I'm not sure there needs to be. If oil goes up how's this fund going to do? The variable is whether it does better than other products which I don't know. Hopefully it goes without saying that during the bull phase this fund will be very volatile relative to other energy funds and during the bear phase the hope is it would be less volatile but sometimes the trusts can be very hot potatoes.
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New Bond ETFs

Although this did not get too much attention, Ameristock listed five new bond ETFs that have been in the works for ages.

Ameristock/Ryan 1 Year (GKA)
Ameristock/Ryan 2 Year (GKB)
Ameristock/Ryan 5 Year (GKC)
Ameristock/Ryan 10 Year(GKD)
Ameristock/Ryan 20 Year(GKE)

These are unique for how they target very specific maturities across the entire curve and I am sure there will be some clever trading strategies with pair trades within the product line, pair trades with these fund combined with bond ETFs from other providers or ways to play changes in the shape of the yield curve.

I am not so sure these have much use for individual investors who want to maintain a bond portfolio. The issue here for me is that the interest will always be equal (give or take) to whatever that maturity is yielding in the market.

If the yield on the ten year was 6% and you thought that was pretty good you risk getting a lower rate with GKD if the yield in the market place goes down. That which might yield 6% today could yield 4% next year. If you buy an individual treasury your yield will be whatever it was when you bought it which I think makes managing this portion of your portfolio much easier.

Treasuries are very easy to trade in terms of access and liquidity. Anyone who can select a fund with a ten year maturity and select a bond with a ten year maturity too.
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The Latest From Jim Rogers

Bloomberg.com: Asia
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Fun With Numbers

I found this table in an article on Yahoo Finance, that is a good read, with all sorts of other related data.

These are the top five Central Bank reserve holdings, although I would note that Russia is now above $400 billion.

The article also has information on how money is allocated within these reserve funds. The current numbers are less important than what happens with future additions to these treasuries. I have been writing for a couple of years about the visibility for the US receiving less of this flow than it has in the past. We have seen several small countries reallocate away from the dollar. A small country can do so without moving the market but the countries listed in the above table would have a hard time doing any meaningful dollar selling without hurting their own interests but they can buy few dollars going forward.

Many people do not believe this will happen or think it won't matter. I would rather plan on it mattering and be wrong than the other way around. My take on the consequence of this is and has been that rates in the US will be a little higher, nothing like the early 1980s though, and there will be a little drag on the economy which could include a normal recession.

Something will cause the next recession and it could be the domino effect from this.
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"I'm Outta Here!"

That is the title of the annual BusinessWeek retirement guide from the current issue. The focus was retiring early.

There were a couple of interesting ideas along with some "building blocks" of retirement planning which included the need for equity exposure well into retirement and to plan on drawing only "4%-6%" out of your nest egg every year.

I would say don't exceed 5%. Lately I have become more aware that very few people are willing to plan for 5% and that very few people are willing to concede that their plan may have to change as a result of what they want to spend.

I am not a financial planner but I have made a couple of good planning decisions for myself. While I always get comments disagreeing... don't plan on drawing X dollars, plan on whatever you got; taking just 5%.

If you're living on $80,000 and you have $1 million the day you retire taking $80,000 has a high probability of leading to failure. If you need $80,000 and you have $1 million you also have a problem in the making. You either need to keep working or spend less money.

Work doesn't need to be the 9-5 you hate it can be something you want to do. I have written in the past about my 75 year old neighbor who does backhoe work for $60 per hour, he can get as much work as wants with his big Tonka Toy. Here in Prescott there are a couple of companies that provide shuttle service to the Phoenix airport (two hours away) and every time I have ever taken it it has been a "retired" person doing the driving.

One "tip" along these lines in most magazine articles is to consult, part time, in your field. I am doubtful this is easily available for people but if this could pertain to you I would start lining up ducks long before you actually retire.

One idea that I don't think I have read anywhere that you make your plan to retire at age X, squirrel away with that in mind, plan whatever it is you need to to make X happen and then stay 12 more months. I have read"work longer" but that always seems vague. This is a specific idea to plan retirement at age X and work until X+1. It doesn't come up much but the number of people that should have worked for 12-24 months more could be quite high. For many people they make their highest income right before retirement and maybe they spend a little less in that last year or two as well.

I'll conclude by saying that I am not trying to be overly harsh about perceived income needs. We all have our various financial blindspots, realizing that you too have blindspots is important and that if you do not yet know what your blindspots are you should take some time to sort it out.
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Sunday Morning Coffee

Ah, the glamor of mopping up. Once the flames are pretty much out the ground gets sprayed and turned over from the perimeter in by some amount, this time we were told 100 feet. The idea is that the ground can still be very hot even if there are no flames making it very easy for the fire to start back up.

I had been working with some guy from the State Land department but he disappeared for a while so here I am with the hose over my right shoulder spraying and I am trying a one-handed raking technique with a McLeod in my left hand.

A reader left a question asking for the basic framework for building the fixed income portion of a portfolio. This came on a post about inflation where I made the comment that from a numbers standpoint bonds don't make a lot of sense but that emotionally speaking everyone needs some exposure.

First thing I would say is that if you are paying someone for bond portfolio advice and they suggest a barbell they are doing no work for you at all.

I view bond portfolio construction the same way as equity portfolio construction which that I want exposure to various segments of the market that when combined offer the change for a zig zag effect within during times of heightened volatility. There is no guarantee of achieving this but the effort can be made and I believe it will work more often than not.

The big picture is an important thing to understand as you make decisions with your bond portfolio. What I mean is that you don't have to be Bill Gross to understand that 4% ten year yields are very low (so prices were high) and 10% ten year yields are very high. Its not a good idea to buy into a market that is already expensive, but it is probably a good idea to buy a market that is cheap relative to its history. It is also not difficult to realize that today's 5.08% is below normal and that there is a good chance that yields will move up into a more normal range in the next couple of years.

The basic framework I think starts with some portion in treasuries or municipal bonds. I use treasuries more than munis but when the mandate is for munis I swap out the treasuries. For the time being I seem to gravitate to 35-40% in treasuries/munis.

I am a big fan of convertible bonds but I think a bond fund makes much more sense as I view convert deals to be very complex and would rather let someone else manage that for me. I use a couple of different CEFs, just about every client has exposure ranging from 10%-20% (of the fixed income portion). The reason for converts is that they can be less rate sensitive because of the chance to convert to stock as the price of the stock rises.

I am also a big fan of foreign bonds too but they are not right for every client. I use a CEF for Australian exposure and own some Norwegian sovereign debt that matures in 2009. There are two reasons to own foreign bonds; they will go up in dollar terms if the dollar gets weaker and both Norway and Australia are at different points in their respective economic cycles which creates visibility for the zig zag effect I mentioned above. Accessing individual bonds is not practical for individuals due to trading minimums but it is a little easier to do when buying for a bunch of people as I obviously do.

I don't do much with corporates these days going instead with preferred stocks. I have found that with corporate bonds sometimes the liquidity is no problem and sometimes getting out can be difficult. If I had to sell and on that day there happened to be no bids, then what? Most preferreds are NYSE listed and I have never had a problem trading them.

Part of this mix stems from yields being low and spreads being thin. Wider spreads and higher yields are a time to take on more risk as opposed to now. When/if yields go up and spreads get wider the mix could be different and I could have different products, like maybe more corporates and maybe some emerging market exposure too but that will depend on what else is going on at the time.
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