Sunday Morning Coffee

A Facebook friend posted a status update that really intrigued me. It was a small news item that I was able to find via Google as follows;

RICHARDTON, N.D. (AP) - A Roman Catholic monastery in North Dakota is putting its ranching operation out to pasture because it lacks monks with cowboy skills.

Abbot Brian Wangler tells The Dickinson Press that ranching has been a part of Assumption Abbey since 1893, when it was in Devil's Lake. He says raising cattle helped make the monastery self-sufficient.

He says two monks now care for 260 cows at the Richardton abbey, but only one has the skills to do it by himself...

Wangler says the abbey will rent its pastures to other ranchers.

Monastic cowboys? On some level, but I'm not sure which one, I find this fascinating. It strikes me not only as multidimensional but dimensions that are radically different from each other.

During the spring I mentioned my involvement with the Prescott Basin Ops Group which does the planning for the big inter-agency training that is conducted every March (this is a Fire Department thing). One of the guys also involved in the Planning Group is a retired law enforcement officer and current volunteer (very actively involved) with another department in the area. A couple of weeks ago we went into town to hear/see the local steel drum band (kind of a big deal here) and there was my colleague from the Planning Group having at it on the steel drums.

Turns out he and his wife (more his wife) founded the group. Retired sheriff and steel drum enthusiast would seem to me to be radically different dimensions which I think is a great thing in terms of living a full life and staying engaged.

While this post is not stock market related I do think time spent on other things can sharpen critical thinking skills that are needed for long term portfolio success.
Read more!

The Big Picture for the Week of July 31, 2011

A reader asks;

Looks like the 3 consecutive months of average 2% declines is upon us...yield curve looks OK, but 200 day MA in play...new bear market or not?

First things first, the 200 DMA is my preferred catalyst for defensive action. I don't really think it matters which trigger is used as no single trigger can be the best for all times but they can be effective which is the priority as I see it. Here effective is simply defined as avoiding the full brunt of a large decline. Aside from my belief in its effectiveness, the 200 DMA is simple to explain and understand.

As far as 2% declines for three months in a row (I know this as originating with Ken Fisher, feel free to comment if you know otherwise), this is reliable insomuch as true bear markets start slowly giving many months to get out as was the case in both 2000 and late 2007 into 2008. Fast declines, or panics typically retrace quickly and are better bought than sold for someone who is a trader.

On April 1st the SPX was at 1363, May 1st 1345, June 1st 1320, July 1st 1300 and now it is at 1292. By my math that does not literally invoke the 2% rule but it is clear sign of a slow rollover. Anything can happen of course but it looks like a rollover which I would use as more of a confirmation of the 200 DMA. In practice this could mean selling two stocks to get started with defensive action instead of one.

As far as the yield curve, I believe in heeding the inverted yield curve for initially reducing financial sector exposure even before a 200 DMA inversion. Currently the curve is very steep but I continue to believe US banks stink so we are still light there with no plans of loading anytime soon. One complicating factor with the yield curve now is that fed rates have been at zero for a couple of years which is IMO distorting the rest of the curve in some manner. My suspicion of the yield curve is not problematic because I am not ignoring an inversion, I simply feel the steepness is artificial which is supported by how poorly the financial sector has done.

As I mentioned in the comments of yesterday's post, I believe the GDP is warning of a recession sooner than most of the experts think. Two quarters below 2% is bad, period. It does not have to mean recession but I think it does even if I don't know how soon. This will influence the type of defensive action I might take in the face of a 200 DMA breach.

It does not make sense to try to sell now before any indicator is triggered because (repeated for emphasis) there may not be a recession. It makes more sense to heed a trigger in the market for defensive action because in addition to it being objective and simple, stocks will turn down before the next recession, whenever that is, as a function of normal market behavior; capital markets turn down before the economy. Also if somehow there was a recession but stocks did not go down there would be no reason to sell.

As far as a "new" bear market, I believe the 200 DMA will tell us the answer, what is more important than guessing correctly is (also repeated for emphasis) having some sort of objective strategy for defensive action that gives a reasonable chance to avoid the full brunt of a large decline. I put the word new in quotes in that previous sentence because it is quite obvious to me that we are still in the same macro economic event as 2008. The crisis from 80 years ago took more than a decade to sort out so the worst crisis since that one could take just as long.

On a more humorous note; although I'm sure it came out wrong, Harry Reid had the quote of the crisis yesterday: the only compromise is mine.
Read more!

Implosion or Erosion?

To hear Nouriel Roubini and Stephen Roach tell it, China is getting apprehensive about it's treasury holdings because of the rampant dysfunction manifesting in the US political system as our "leaders" try to cater to what they think are the interests of their constituents which of course potentially serves their own interests of being reelected.

One point not getting enough attention is the role that the US plays in the world order as a consumer, as a military defender of many other countries (regardless of anyone's opinion on that) and as the world reserve currency (for now anyway). To repeat from past posts (both mine and from other people), this means that the world has a huge vested stake in the US not imploding in a blaze of glory.

The world's vested stake does not spare the US, as an investment destination, from eroding slowly however. I've been making the point that a slow erosion has been going on for years and unfortunately will continue.

To that end David Rosenberg (via Barry Ritholtz) has some ideas about how to structure a portfolio into current events;

1) “High-quality corporates” plus companies with “A-type” balance sheets and “BB-like yields.”

2) Reliable dividend paying Stocks (including preferreds).

3) Low debt-to-equity ratios, high liquid asset ratios, good balance sheets, no heavy debt.

4) Hard assets: Oil and gas royalties, REITs – focus on income stream.

5) Sectors / companies with “low fixed costs, high variable costs, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity.” This includes utilities, consumer staples + health care.

6) Alternative assets that do not rely on “rising equity markets” or are independent of volatility trades.

7) Precious metals. Specifically, he puts a $3,000 target on Gold.

Obviously the list can be implemented with ETFs although anyone actually doing this should stick with individual issues for point number one, high quality corporates.

I think the list is intended to focus on the shorter term. A way to tweak it for the longer term would be to add themes like food and water (a reader at Seeking Alpha called me Malthusian) and exposure to a few countries that seem to have a good chance for long term outperformance either because of resources, emerging middle class, strong fundamentals or a combination of those three.

As a practical matter this could look like the following (corresponds to the list above);

1) Individual corporate notes
2) A dividend ETF like DVY or SDY
3) Here I would prefer individual companies like client holding JNJ, I don't know of any ETFs but maybe Russell will come out with a balance sheet ETF soon?
4) There are all sorts of individual issues and funds in the royalty space but you need to learn the tax implications
5) For utilities, health and staples there are plenty of individual stocks and ETFs which could allow for combinations of higher yielding US blue chips and growthier emerging market sector funds or theme funds.
6) WisdomTree is doing more and more here, there are also a lot of merger arb products and other forms of long short that strive for a somewhat absolute return.
7) I have no idea about $3000 gold but the trends for a weaker USD and stronger gold and other currencies seems like it is here to stay.

Above I mentioned a couple of themes and as for countries, long time readers will know I like Latin America and Scandinavia among others and am working on a way into Africa.

The idea from Rosenberg seems to be trying to sidestep the US-ground zero. I don't think there will be an implosion and I doubt Rosenberg thinks that otherwise I think he'd be suggesting a basket of "safehaven" currencies instead. If there is an implosion then we will take defensive action upon a breach of the 200 DMA.
Read more!

Can It Be? A Toll Road ETF?

ETF provider Global X appears to be cranking up its golly-gee-whiz machine with an ETF filing that is right in the wheelhouse of a lot of my posts over the last couple of years.

The filing consists of the following;

Global X FTSE Toll Roads & Ports ETF
Global X FTSE Railroads ETF
Global X Farmland and Timberland ETF
Global X Cement ETF
Global X Advanced Materials ETF

My primary point of contact at the firm talked about the Cement and Toll Road & Ports as being my ideas which I'm sure is part flattery but if it is true then maybe they'll send me a bag of Quikrete if the cement fund lists (humor attempt).

Zooming out a little bit the utility to these types of funds is in narrow based portfolios where individual stocks might be difficult in terms of feeling comfortable with information available or liquidity or anything else.

That might seem like an obvious statement but what I mean is that it doesn't really take a colossal leap of faith to buy shares of DuPont (DD) from the materials sector. At any given time DD could be a bad hold or a good hold but companies like this tend not to permanently impair capital, they are easy to access, they are widely followed by analysts (you may choose not to heed their opinion but they are sources of information) and you can find a lot of information yourself all over the web.

A stock like DD is going to look a lot like its corresponding sector ETF, in this case iShares Materials (IYM), the vast majority of the time making one a type of proxy for the other. The above is a little different with a group like cement stocks. Getting a lot of information about Cementos Argos (CMTOY) from Colombia would not be as easy. There is an English version of the company website but it is unlikely that you could go to Yahoo Finance to find a bunch of analyst info, get a few pages of results with a search at WSJ, then hop over to Seeking Alpha to get a lot of color although you'd probably have luck looking at the numbers from Businessweek.

While I do not know yet what the index that will underly the cement fund looks like there are cement companies in many emerging markets and, intending to be very obvious, a lot of the stuff that is needed to modernize these countries requires cement. Other than Cemex (CX), which you may recall bought Rinker awhile ago, I am not aware of any emerging market cement companies on the NYSE or Nasdaq and these companies are usually not prominent in ETFs although CMTOY does have a 5% weight in Global X Colombia (GXG). I think the group is a great way to get a little smaller with emerging market exposure and to me there is a clear and obvious need for more cement.

As an example, pairing DuPont, a name we don't own, and it's 3% yield with something thematic like the cement ETF would cover a lot of ground in the materials sector in terms of radically different exposures with in the sector, a reasonable foreign and growthy footprint (probably), different volatility characteristics and a theme whose demand is easy to understand. Not a bad strategy at the sector level.

The other big fund for me in the listing is the Toll Roads & Ports ETF. Generally I think if these as most like utilities but with a little more volatility. I think these are a great way into a lot of countries including China. They play into the aspiration of driving a car which has a very steady demand behind it and with many of them, especially in China, the business also includes various services like rest stops, repair and hotels. The port aspect of this fund (not sure if it will include airports, at one point it was going to) captures the economy for better or for worse as cargo comes and goes.

The Railroad ETF would seem to be similar in that regard although I would expect more cyclicality and volatility with less yield. Farmland and Timberland could be more of play on plantations than the current BARN ETF from Global X and if so I think would be a neat but very volatile exposure.

A quick update, the other day I mentioned Union Agriculture which farms crops and livestock in Uruguay, well they pulled their IPO.
Read more!

What Is The Correct Objective?

Marketwatch had what I would consider an important article that recapped some thoughts from Charlie Ellis. The big thing was having the correct objective with your investing. Long time readers might recall my talking about my primary goal of giving clients the best chance possible to have enough money when they need it. My idea on how to do that is to try to assess when market conditions give a good chance for growth and then going along for the ride and also assessing when market conditions urge for more caution than normal and then focus on protecting assets.

While there are obviously many participants who don't think of their investing goal as in terms of seeking to have enough I do think of that as being the overriding primary objective.

A point Ellis is making is that simply "beating the market" is not congruous with most people's actual objective; objective being defined as what their financial circumstance and psychological make up calls for. I have my own philosophy on things which is what I write about and incorporate into how I do my job. You no doubt have at least some thoughts on your own needs and ideas about how to get there and hopefully what you think you need versus what you really need line up with each other.

I know there will be a couple of comments from people who feel they must try to beat the market and probably just think I am wrong on this point which is fine for them up to a point. This incongruity does not have to have a bad outcome by any means but a misalignment increases the probability of a bad outcome.

To the extent having enough money when you need it is a logical objective the longer term portfolio math that goes along with avoiding large drawdowns is quite compelling and I would also add that people are less likely to panic if they don't have something panic about. That is a semi-snarky comment but the market occasionally cuts in half (twice in less than ten years would seem to be unusual) and it is in the heat of those large declines where people panic. If the full brunt of the decline can be avoided then chances are the emotional panic that goes with the full brunt can also be avoided.

That sort of focus is one way to add long term value over the long term as opposed to beating the market this quarter.
Read more!

This Could Be Interesting

I found a lot of things to tie in to yesterday's post about Investing Where It Rains. Of course choosing to invest where it rains is a theme of sorts, really a subset of a theme. As I've said many times before the big idea here is finding areas where we know money is going to be spent. This can guarantee nothing but money being spent into an area where there is obvious demand creates a good tailwind for long term success.

Tech Crunch had an article about an early stage startup called Motif Investing that is going to offer what it calls motifs for different themes. I had a very similar idea a couple of years ago that I think called exchange traded baskets. There are certain rules about portfolio diversification that makes some ideas impractical for ETFs but the motif might be a way to mitigate the restriction. Yes the diversification rules are there for a reason but buying a basket of five stocks will have less single stock risk than buying one single stock.

Motif is still early days so it remains to be seen how this develops but to the extent themes and niches have been and will continue to be important (I think they will) then this could democratize thematic investing more so than ETFs.

I doubt there will ever be an ETF devoted solely to Chinese toll roads. I think there are about a dozen of them in total and the liquidity for a few, even in the Chinese markets, is pretty thin. I've been writing about this niche for a while now as I think it is a pretty good space for investing in China. Someone who might agree with this idea might not be real eager to buy one toll road but five or six would be a different story--at least it would for some portion of people interested in the space.

On a related note another possible theme for a motif could be publicly traded farms in Latin America. There are a few names I know of like NZ Farming Systems Uruguay (NZFSF), Cresud (CRESY) of which I own a few shares, the recently listed Adecoagro (AGRO) and there will be another one this week with Union Agriculture Group (UAGR) which has farming operations in Uruguay. This article makes it seem like UAGR dominates the market in Uruguay but on an incredibly shaky and risky foundation.

At times these names, or the farming companies traded in Europe with operations in Russia, will move a lot for no reason at all or what seems like no discernible reason in either direction. This can make owning the stocks, individually difficult at times which could be partially mitigated by the motifs or baskets or any other thing that might come along. Hopefully Motif moves forward and their offering is very robust.
Read more!

Invest Where It Rains

Almost since the start of this site I have been talking about how important I think the water investment theme is. There is simply not enough potable water in the world. The near term consequences are tragic for certain countries but the long term reality (I think it is a reality) is the money is going to be spent trying to rectify the situation, at least partially. I do not know how successful it will be but the money will be spent and this means good things for related companies.

The current letter from Jeremy Grantham addresses shortages in things like water, potash and topsoil. The title is Separating the Dangerous from the Merely Serious. To the extent that supply and demand matters (I think it does) it makes sense to invest in spaces where there is visibility for growing demand and questions about whether or not supply can keep up with demand.

This subject points to investing long term in things like water, food, infrastructure and the resources that provide all these things. This is a theme I've been writing about and more importantly implementing for clients for a long time.

The key to this, and stated in the previous paragraph, is thinking long term. We have owned the PowerShares Water Portfolio since that fund started. It is a boring hold yet over it's life time it is up 28% versus 6% for the S&P 500 (neither figure included dividends). Market Vectors Agribusiness ETF (MOO), which is also a client holding, is up 25% since it's inception in 2007 versus an almost 12% decline for the S&P 500. You may draw a different conclusion but I believe these spaces have done better than the market because of the visibility for growing demand and the questions of supply constraints.

Back to the Grantham letter, I had a thought that I am still trying to sort out. Many of the shortages Grantham writes about will come, he believes, from warmer weather and less rain. If countries need rain to grow crops (seed modification and farming efficiencies notwithstanding) then maybe we should invest in places where it rains a lot?

Among other destinations this would include Canada which has a shockingly disproportionate amount of water, New Zealand, several countries in Asia and probably a couple of places in Africa. Here I am focusing on countries where they grow stuff. Does it rain in Tanzania? They grow stuff and just opened a stock market there--that is something to look into. There are of course other places.

If there is anything to this, Canada (for example) won't have to confront the consequences of a meaningful drought, I realize anything this is possible but the idea here is a sort of brainstorming process.

There are obviously plenty of ETFs and individual stocks to express this in a portfolio. Simple country funds would allow for capturing the benefit at the country level for this good fortune, niche funds would be a way to tap more directly into the theme and individual stocks would offer a way in to the narrowest part of the theme that I can think of which is the Asian plantation stocks. I would note that the Global X Farming ETF has at least 10% in small cap Asian plantations.

This is an evolving thought, hopefully more to come.

Congratulations for Cadel Evans for winning the Tour de France.
Read more!

Sunday Morning Coffee

We had a joint training with Native Air which is the local helicopter service for certain medical calls. The first picture is site prep, the second one is of the approach and third one is from driving to the station before the training and I just thought was neat.

Hectic weekend, regular blogging will resume tomorrow.















Read more!

The Big Picture for the Week of July 24, 2011

A reader left the following question for me at Seeking Alpha on my post about one dimensional investing;

I'm assuming that during the Great Recession, you did quite a bit of juggling to minimize paper capital losses. For your retired clients I would understand, but for your own personal portfolio, i wonder what you did.

My reply;

What did I do personally? I am very fortunate to have essentially no overhead (no mortgage, credit cards or car payments), consequently I have a very high savings rate relative to my income and needs. As a result my equity allocation is quite low for someone my age to which I would add I hope to do this work until I am very old--my dad is 85 and remarkably fit. While I do not think I would have an emotional reaction to stock market volatility (which would distract me from my job) I have removed the possibility, I'm 25-30% equities. My view on what my job should be leads me to conclude that I should not be spending a lot of my time trading my account.

If you look at my archive of posts (I don't really expect you to do that) you will see I was very early in recognizing the market was going to have a problem so I bought a levered inverse fund for clients and sold maybe half a dozen stocks out of about 35 holdings before I started buying back in slowly in early 2009 (I did add to our Statoil position in late 2008). Is that "quite a bit of juggling?" You might think it is, I don't know but that is what I did for clients.

Obama's press conference last night at 6pm eastern was fascinating. He was furious, I mean really angry over how the republicans are behaving with these negotiations. To be clear, I am not expressing a judgement on the republicans behavior merely stating that this is what is making him so angry.

I've read criticisms of Obama questioning his leadership, mostly from republicans or people otherwise on the right. This episode has given me the impression that somehow Boehner and company don't have the proper amount of respect for the person occupying the Whitehouse.

On a lighter note Friday's stage of the Tour de France up Alpe d'Huez was fantastic. Congrats to Pierre Rolland for an amazing stage win, tracking down Alberto Contador shortly before the finish.
Read more!

Investing Dimensions

My post from the other day about the 4% rule drew out the usual suspects in the Dividend Zealot crew at Seeking Alpha which surprised me as these guys have come to hate me (maybe a sort of reverse confirmation bias?). As I was reading through the comments a thought occurred to me at a slightly more macro level of the nature of the debate.

As best as I can tell the DZ crew believes that a portfolio should consist of mostly or exclusively (depends who is talking) companies that grow their dividends. This should, they feel, get the portfolio to the point where the yield alone covers the 4% so that no shares ever need be sold to meet the withdrawal need.

If a portfolio last year was at $500,000 and then grew to $550,000 and $20,000 was withdrawn then I don't think it matters how it got to $550,000. Both dividends and gains are taxable or it came out of an IRA so the distribution is taxable. Likewise if a portfolio last year was at $550,000, dropped with the market to $500,000 and $20,000 came out then again I don't think it matters how it got there.

My own preference is a diversified portfolio that includes dividend stocks along with growthier stocks; really having holdings with all sorts of attributes providing a combo of yield, price appreciation and exposure to multiple (repeated for emphasis) attributes. As I read the comments a new term popped into my head that might describe this which is dimensions. Building a portfolio in the manner that I believe the DZ crew is talking about is one dimensional. There are all sorts of single dimensions that work over long periods of time and of course data can be mined to support every single one.

The point is not whether any form of one dimensional investing can work because, again, they all can work so it about the risk taken in betting on one dimension. If they can all work (depending on the person) then they can all fail. The does not mean something is likely to fail in fact DZ philosophy is far less likely to fail than many other single dimensional strategies. I think the big psychological divergence between what I am talking about and defenders of single dimensional investing is not allowing for the possibility that something somehow goes horribly wrong with the strategy. Paraphrasing 0ne of my favorite quotes from the show Deadwood, it is a conversation they cannot hear.

If Seeking Alpha chooses to rerun this post I am sure there will be plenty of comments attacking this line of thought but the post is not for them, it is intended for people less entrenched in one concept to serve as reminder that "obviously great strategies" can foul up for reasons that are not reasonably foreseeable.

Not being able to allow for the possibility that something could go wrong is a behavior that has repeated many times before in investing history. There probably will never be a problem with this particular dimension but that does not make the behavior any different from previous single dimension strategies.
Read more!

Thursday Tidbits

Two quick items this morning.

First up, I find it intriguing that PayPal, the former add-on/logical compliment, seems to be growing into being the primary business at eBay. It's bit early to expect the company to change its name to PayPal just yet but the revenue was just over $1 billion versus $2.76 billion for the entire company and I am quite certain it will change the name in a few years.

Quite a few times I've made the comment that the actual internet has exceeded the hype even if the stocks were not priced correctly. The space has been incredibly unpredictable, I think, in that Google and Amazon appear to rule the world and Yahoo appears to be desperate and on the path to being marginalized.

This makes the newest crop of stocks like LinkedIn, Pandora, Zillow (did you see that drop from $60?) and the potential IPOs of Facebook and Dunkin Doughnuts (just threw that one in to make sure you're paying attention) simply the latest phase of the market trying to figure out what to do with internet stocks.

The other thing to mention is the Bloomberg piece on Michael Burry. He is the former cancer patient with a slight case of Asperger's, former doctor, former hedge fund manager who made his mark shorting the housing market (shortened explanation).

The thing that struck me about his story was his conviction in the thesis, the extreme discomfort it created for his investors and his ability to look out over a period of several years. A multi-year thesis is unlikely to look correct after three months and so the occasional performance lag goes with the territory. Complicating matters is that investors must be able to discern between a lag and a broken theme.
Read more!

Take Your Chances With Inflation?

Bespoke tweeted this article about whether or not it is time to go to cash. The article was so so other than a fascinating premise put forth by James Montier from GMO.

In our view it is better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent impairment of capital.

He went on to note that the current lack of attractively priced stocks is a reason to have a lot of cash now.

The inflation comment is very thought provoking. A building block that offers perspective is that at a 3% annual inflation rate, expenses would be 50% higher in 15 years. This is complicated by the fact the health care expenses have gone up at a much higher average rate and I doubt there is any chance of that changing anytime soon.

Over the last couple of years or so reported inflation has not been that bad compared to the impairment of capital that some have endured up to this point. The notion of permanent impairment is a little fuzzy to me. The SPX is down 15% from its 2007 highwater mark. It is also down 12% from the March 2000 high. I have no doubt that the SPX will take back both those levels, the variable of course is when. If it takes back those levels in 2015 that would certainly be a long time but not permanent.

If he means individual holdings it is still not clear to me. Take a crazy example of the investor who five years ago put 50% into Fannie Mae and 50% into Apple (AAPL). The Fannie Mae position is permanently impaired but the AAPL position has quintupled. $10,000 into each is now worth about $57,000 despite a total wipeout in Fannie.

As a more realistic example, by virtue of luck and having avoided a few things an investor could be up a fair bit from the SPX' 2007 high water mark. This could sill be the case had an investor been unlucky enough to have had Fannie Mae or Freddie Mac at a 3-4% weighting and who then rode it all the way to (almost) zero. I obviously believe in looking that the bottom line of the portfolio as being more important than the individual holdings but someone who believes otherwise would view these examples as permanent.

The interesting part of the comment is preferring to take a chance with inflation than stock market declines (permanent impairment or not) when valuations look poor. I wrote the other day that it is ok to hold cash when market circumstances dictate. One way to take the comment is that Montier is granting permission to consider a radically different asset allocation.

Some people are permanently afraid of stocks now and would consider holding a lot more cash or cash like investments (Soros is currently 75% cash?). There has been a proliferation of merger arbitrage products, inflation linked products, funds like COLLX, currency funds, hedge fund trackers, managed futures and so on which I have referred to in the past as diversifiers.

My opinion remains the same which is that stocks still can work but you may have to look to other countries but some people can no longer tolerate equity market volatility and for these people it may make more sense to have more in products like the ones above that, if they function properly, give a chance to keep cash a little ahead of inflation and then have a much smaller than "normal" allocation to stocks. For people who save a lot this can work but there is no reason someone pursuing this can't still have a properly diversified equity portfolio.

I would also note that the person who makes this change on a reactionary basis is very likely to regret in the face of a large market rally.
Read more!

Common Sense Is Allowed

Two points that have been made here repeatedly resurfaced elsewhere in the last day or two and are worth repeating.

First was an article from theStreet rerun on Yahoo Finance that took on the 4% retirement withdrawal rule. The article cited a study from T Rowe Price that says instead of starting at 4% your first year and then increasing by the rate of inflation that instead less should be taken out during a bear market.

As I read through I gravitated to whatever you got, 4% (more correctly 1% per quarter) which is something I've been writing about for years. It makes no sense to me to start taking $30,000 out of a $750,000 portfolio and then somehow take $30,900 out the following year from a portfolio that shrunk to $680,000 in a down year. A withdrawal rate anchored to some highwater mark combined with a large drop in the market (and presumably the equity portion of a diversified portfolio) would seem like an obvious path to a financial plan-rewrite.

I view this as more of a common sense issue more than anything else. Typical financial planning is important in terms of understanding probabilities and if probabilities and reality end up converging then there should be fewer things to worry about but people cannot ignore when probabilities and reality diverge. A $50,000 withdrawal rate from a portfolio that would seem to allow for only a $40,000 withdrawal has a very high likelihood of leading to serious problems as a matter of common sense.

Denial plays a large role here of course but if reality diverges from the plan in a negative way then something will have to give. If you've got $800,000 then the 4% rule allows for $32,000, if it drops to $700,000 then 4% calls for $28,000. Simple as that.

The other issue is the latest round of US and European bank stock implosions and the lingering of sovereign credit problems. Prices general got hit very hard yesterday and Sean Jones from Egan Jones was all over the place scaring everyone about everywhere.

As I mentioned the other day jobs and housing in the US show no meaningful signs of turning around. Europe is having what looks like a very slow moving contagion on the back of all sorts of fundamental problems. It seems only logical that financial companies would face serious problems against that backdrop. Expectations for the worst crisis in 80 years to wrap up neat and tidy in a year or two (from 2008) have always baffled me.

In terms of simply wanting to avoid the market's worst problems the amount of work to be done here is minimal. For someone who needs to be exactly correct, maybe for shorter term trading purposes, then obviously the work is much greater but for most market participants figuring out what to avoid will go a long way toward long term success in pursuit of the goal of having enough when you need it.

That certain segments of the market are going to have fundamental problems for a long time to come seems like a matter of common sense. I'm sure someone will buy UniCredit at €1.08 and get a great trade but the fundies are a long way from being healthy.

There are plenty of investment destinations not facing their worst financial crisis in 80 years. They may go down in some sort of sympathy in the short run of course but when we look back on this decade in 2020 it will be these markets that had "normal" or better than "normal" decades.
Read more!

Barron's Dissects ETFs and Emerging Markets

Barron's had some interesting stuff on both emerging markets and ETFs.

There was a point counter point about emerging markets with Jim O'Neill from Goldman Sachs as the bull and Richard Bernstein as the bear. First a tip of the hat to O'Neill for making a point I have been making for a while now which is that the term emerging markets is out of date.

It was odd that Barron's did not find another emerging market analyst to make the bear case; Bernstein is more of a strategist and the mutual fund he runs is pretty broad. I took Bernstein's argument to be more of a short term argument and that he thinks emerging markets will lead again in a couple of years or so.

Both pointed to potential issues with inflation in some countries as being problematic, we know that China and Brazil are on the front burner for this issue. Given the global back drop and what appears to be secular problems that are nowhere near being solved for the US, Big Western Europe and Japan the cyclical threats cited in the article about emerging markets are small potatoes. If you are one to trade around cyclical events, of which I am not critical, you need to realize that a downturn is not the same thing as a decade-long roundtrip to nowhere.

The cover story this week was about finding the best yielding ETFs. Unfortunately the article failed to mention that past dividends cannot be counted on in the future. There was a positive mention of client holding iShares TIPS ETF (TIP) because the yield now annualizes out to 4%. TIP is a monthly pay but there have been quite a few months where there has been no payout.

I also thought Murray Coleman's piece on what he called hedge fund strategies was useful although I would have included the Index IQ Multi Strategy Tracker ETF (QAI) which in the context of absolute return has done very well.

An entire portfolio of alternatives would turn out to be a dreadful longterm mistake but as a tool for managing volatility over the course of an entire stock market cycle a modest allocation has been very important before and will be in the future. It is well worth your time understanding the space an incorporating them in from time to time.

We saw this three axled thing in town the other night. I've seen them before of course, very neat looking.
Read more!

The Big Picture for the Week of July 17, 2011

One of the benefits of ETFs, even narrow ones, is that they help investors avoid single stock risk. While stock picking does not have to be unsolvable, black box work many investors, including professionals, would rather not pick stocks. Broad based funds allow for capturing asset class diversification and narrow based funds, depending on how they are used, can replicate many attributes of a portfolio consisting of individual stocks up to a point which is a democratizing force I've mentioned before.

What if an ETF is riskier than holding individual stocks? Is this even possible? I believe it is and no the context is not the structure of a fund like a derivatives based product.

Someone looking to build a portfolio comprised of narrow based funds would, I think, need to make some sort of decision about the financial sector. If you look at most of the financial sector ETFs they all seem to be heaviest in some lousy companies. I continue to believe that banks (the ones that are most likely to be heavy in these funds) in the US, Europe, Japan and China stink. How could someone who agrees with that buy XLF or IPF (as examples)? Obviously some folks think these banks are good investments right here and maybe they'll be right but I think that is a long way off.

Other ETF alternatives in the sector include narrower bank funds which might work for some people, there are a couple of capital markets funds but they have investment banks in them, PowerShares has a small cap fund. One other place to look would be country funds that are heavy in financials. For example iShares Singapore has 44% in financials and there are many other funds with financial weightings in the same ballpark. Whether this type of exposure counts as a proxy is really up to the end user.

So anyone wanting at least some financial exposure but thinking the ETFs are too flawed to own will need to consider individual stocks. Our firm has some accounts that size-wise are ideally suited to one or two holdings per sector with the vast majority being ETFs but for the financial sector I can't really find an ETF I'm comfortable with (iShares Emerging Market Financial (EMFN) has 30% in China and the EG Shares Financial GEMS ETF (FGEM) has 37% in China).

This creates the possibility that individual stocks must be considered as a proxy for financial related ETFs--so to speak.

That I might be negatively disposed to financial ETFs really shouldn't mean much to you but if you are someone who uses ETFs it should underscore the idea that no single wrapper can be ideal for every segment that might be built into a diversified equity portfolio. I would hope that anyone using ETFs would take the time to look under the hood and make a decision or two about what is there. In that context it is possible that for a given fund you will not like what you see and if that is possible then it is also possible that all the funds in a space will be unattractive.

This creates the need for a willingness to consider some individual stocks in a portfolio that is large enough to go narrower than SPY/EFA/IWM.
Read more!

Own Worst Enemy?

Yahoo Finance reran an article from the WSJ that looked at some of the ways that investors are their own worst enemies. The article interviewed a few financial advisors for anecdotes so there was only the one point of view but we all know about various behaviors that people collectively seem to repeat over and over that greatly impedes long term success.

This raises an interesting question about whether people should either go all in in terms of time spent monitoring markets and research investments or go all out and hire someone. The dichotomy is is of course false as there are not enough advisors to accommodate every disinterested 401k investor and one of the behaviors we are talking about is the lack of self awareness by some portion of the population that they are doing a bad job and need to make a change.

That may seem harsh but I think the portion of people who actually do not learn from their mistakes is not that high. What might be higher is the people who learn from their mistakes but the fix turns out to be wrong as well. For example the person who realized they had too much in equities at the wrong time (like early 2009) who then does not simply reduce equity exposure but instead eliminates it.

Every so often I am asked what books someone should read and I always include something that addresses behavioral issues and otherwise teaches how to think effectively. The starting point is probably an understanding that people's fear and greed (or any other emotions) causes bad decisions to be made like buying high when everyone is excited or selling low when everyone is terrified. Also included is forgetting what large declines feel like or forgetting that certain "great" asset classes can sometimes implode--here I might include closed end funds or MLP/royalty trusts as examples.

While it may not realistic to totally overcome every behavioral quirk, awareness of these quirks can help with overcoming some of them or reducing the instances of getting caught succumbing to behavioral quirks.
Read more!

All Star Extravaganza

Tuesday night my brother and I went to the MLB All Star game. We had a great time, the game was well played but the pictures were only so so. In the one posted to the left, Cliff Lee is pitching to David Ortiz in the 3rd inning.

Our conversation during the game mostly covered sports but with a few financial topics too. At one point my brother made a pretty funny comment. He said that one of the things I've been writing about all along has been living below your means (the first post on this was in early 2005), yes I said, "too bad no listened."

It struck me funny and while it is true I tend to think of it from a different angle which is life is simpler and has far less financial stress when you live below your means. While I am a bit of an outlier on this stuff there is nothing that says a married couple must have two car payments at all times. If you can make twelve monthly payments (to make up an example) pay off a kitchen remodel then you could instead make twelve monthly payments to save for the remodel ahead of time and then pay cash for it. The difference being if something unexpected comes along financially (good or bad) it can be absorbed far more easily.

There can be no defense against the idea that going to the All Star game is an extravagance but I believe it is infinitely more extravagant if you're still paying for it six months later.

Short post as I catch up from being out of town.
Read more!

More Signs that the Word "Emerging" Means Nothing

Heidi Moore had a post at Marketplace the other day about mutual fund managers moving more into emerging markets, even going to the extent of removing previous (artificial) limits on how much they could invest in emerging.

Off the top there are two different thoughts here. The first one is whether a move by mutual fund companies to remove these limits could be a bell ringing on the space. A permanent bell seems ridiculous only because many of the countries thought of as emerging have decent fundamental underpinnings and will continue to have decent fundamental underpinnings for many years.

So then a bell ringing could only realistically be cyclical and of course there are almost always markets facing normal cyclical issues. Normal investing and market behavior includes cyclical declines. If we are lucky there might be some warning that would allow for reducing exposure but any great ten year story will still include a couple of large declines.

The other point I see here is one I've been making for a while now which is that term emerging market has lost most or all of its meaning. Each country is its pros, cons and attributes. Building a diversified portfolio can mean assessing the pros, cons and attributes of various countries and blending together different types of pros, cons and attributes to gain exposure to countries that will have different reactions to certain types of cyclical events.

Of course this should not create the illusion that some countries should be expected to completely avoid the occasional panic that comes along. Before the financial crisis I set what turned out to be a proper expectation in this context which is that some countries will turn down later, come back sooner or go down less. As the US market peaked in October 2007 countries like Brazil and Norway kept going up until May and June of 2008. Chile's peak to trough decline was in the thirties, percentage-wise.

This all serves to smooth out the ride which I've written about repeatedly as being a crucial long term goal of what I'm trying to do.
Read more!

Cash Is Not Trash

Barron’s had an article over the weekend about Jim Stack, the money manager and newsletter writer from Montana. I’ve mentioned Stack several over the years, referring to his article from Smart Money Magazine in 1993 where I first bought into the potential significance of the 200 DMA as a defensive strategy. Although I don’t read much from him or about him some of the concepts addressed in the Barron’s interview play a prominent role in client portfolios, and my own.

Stack calls his method Safety First. If this is new to you, the big idea is that over the long term you can outperform the market by avoiding the full consequence of large market declines. In the past I've referred to John Serrapere's strategy of 75/50 which is trying to capture 75% of the upside with only half of the downside, and also John Hussman's targeting results over a full stock market cycle in terms of different ways to come at this idea.

Stack's ways of looking at the market for clues of impending trouble has a lot of moving parts, potentially, so you should read the article if you want more detail. One thing in there that I think is important and have mentioned before is Stack's willingness to have a large cash balance at times. People get impatient with cash and I've never really understood why, not completely anyway. Yes some element of behavior wants money always to be working, trying to earn a return but quite simply there is a balance between risk and reward. This balance changes and understanding it changes is a contributing factor to long term success.

In past posts I've (half) joked that the market is a lot less likely to drop a lot after it has dropped a lot. The point being it doesn't have to be rocket science. The 200 DMA most certainly is not rocket science, it warns of a possible problem. Sometimes the problem is serious and sometimes it is not but occasionally it is serious in when that is the case raising cash, even a lot of cash, would seem to make a lot of sense.
Read more!

Global X Filing Palooza

IndexUniverse reported that Global X filed for 22 ETFs including the following single country funds;

Global X FTSE Portugal 20 ETF
Global X FTSE Ukraine ETF
Global X FTSE Greece 20 ETF
Global X Hungary ETF
Global X Luxembourg ETF
Global X FTSE Morocco 20 ETF
Global X Czech Republic ETF
Global X Slovakia ETF
Global X Qatar ETF
Global X Kuwait ETF
Global X Nigeria ETF
Global X FTSE Bangladesh ETF
Global X FTSE Sri Lanka ETF
Global X Kazakhstan ETF

Beyond the fact that we don't know if they will list or when there are several different angles to address with this.

First up would be if there is any utility to these countries in an investment portfolio. As for Portugal and Greece it is reasonable to think that if Europe ever recovers that it would be the worst hit countries that could snap back the fastest. This would be happening without my money or my clients money but that is the argument. The Luxembourg ETF is a head scratcher as I don't think there are a lot companies doing business there so much as listing there.

Eastern Europe exposure ex-Russia is very interesting to me as a lot of these countries have their acts together and appear to be starting to catch up to the Western countries in terms of prosperity, quality of life and disposable income. The Ukraine has a lot of farming but I am not sure if that will be represented in the fund. I've read some very good things about the Czech Republic and Slovakia.

As far as Nigeria, Mark Mobius likes the banks there, I've mentioned Maroc (as in Morocco) Telecom favorably once or twice but I don't know a lot about these countries. I don't have a lot of interest in the Middle East ex-Israel but Qatar has a lot of natural gas and I am pretty sure the Kuwait fund would be heavy in financials--maybe Qatar too.

Jim Rogers was real big on Sri Lanka for a short while in anticipation of the civil conflict there ending but I have not heard him say much about it since but it is a place I would like to learn about.

I've mentioned Kazakhstan several times in the past; it is very resource rich, will become more globally relevant because of this but has serious corruption issues. A couple of the banks have failed but the mining companies, there are several traded in London, are performing in line with the industry. It has been obvious to me that at some point there will be an ETF for Kazakhstan and now it looks like it is coming to fruition. A Kazakhstan ETF and the proposed Mongolia ETF from Market Vectors could combine to make for a pretty good materials sector allocation.

Another angle here would be one of skepticism. I can hear Herb Greenberg kvetching already but if Big Western Europe and Japan are looking at another lousy decade and you want foreign exposure then what are you going to do? I think the logical answer is look at other countries besides Big Western Europe and Japan. If this is plausible then I don't see where fewer choices would be better.

Assuming the sector issues work out it would be valid to have exposure to four or five different parts of the world with one or two holdings from each region to comprise the foreign portion of the portfolio. Why not Chile, Norway, Slovakia, Kazakhstan, Singapore and New Zealand? That the investment world is getting flatter is a definite positive IMO. If you have any interest in Hungary you were probably looking at either the ma bell telecom company or the big oil company and if the ETF ever lists then you will have another choice. For some would-be buyers of Hungary the telecom company or the big oil company will still be the way to go but for some others the ETF will be best same as any other sector, country or theme.

We had a little fire Saturday night as a lightning strike lit up a dead tree. The ground was soaked from a serious rainstorm earlier in the evening. We had four firefighters on the scene plus the duty officer from the Forest Service. It was up a very steep hill and required quite a few trips so it was a good workout and also a lot of problem solving. It was probably the funnest fire I've ever been on because while we worked very hard there was no reasonable worry about it getting out of control for how wet everything was and obviously the problem solving aspect makes it very fun.
Read more!

Sunday Morning Coffee

We executed a swap for larger accounts over the last couple of weeks. We sold Partner Communications (PTNR) and then replaced it early on Friday with the EG Shares Emerging Market Telecom ETF (TGEM).

PTNR turned out to be a poor proxy for both Israel and telecom as it turned out (maybe this will change in the future) but the massive dividend offset a large portion of the price decline, but not all of it. The stock had a couple of hiccups along the way in terms of missing estimates once or twice, still what I would call very good growth but with certain stocks, earnings misses obviously get punished.

We've been slightly overweight telecom but the PTNR sale left us temporarily underweight which was not going to be the case very long. I was very positive of the concept of the EG Shares sector funds from the outset and when they finally listed the rest of them I liked what I saw under the hood of the telecom fund. Had PTNR worked out as hoped for I doubt I would own TGEM at the point but we did sell, I wanted a replacement and I think TGEM can be a good hold.

From the top down I wanted high yielding foreign exposure that avoids Europe. From the bottom up I think telecom in China (the largest country in the fund) is one of the sectors that can be held and if China Mobile (CHL) ever gets going then this fund will do well. I also like being able to access South Africa in a consumer-ish sector and increase our Brazil exposure. The fund should yield in the high threes after accounting for the fee.
Read more!

The Big Picture for the Week of July 10, 2011

The jobs report printed yesterday and as we all know it stunk. It was bad in every direction.

As a repeat theme the "worst financial crisis in 80 years" should take a long time to work through. Housing still stinks and jobs still stink. From a housing standpoint there was wild excess in terms of supply, extreme risk taking on the part of lenders and extreme risk taking on the part of home buyers both buying more house to live in than could actually be afforded and buying more homes (for speculation) than could actually be carried. While the plummeting of prices is probably over the gradual declines probably are not and there are very few signs of natural demand resuming anytime soon.

On the jobs front the US lost about 8 million jobs and only about 1/4 of the jobs lost have been replaced, so the stats tell us, but even the small retracement is dubious when population growth and underemployment are factored in. The are pockets in the economy of varying size facing structural unemployment; what portion of construction workers will never work in that field again?

Politicians do not know what to do, hopefully that is obvious, but that won't prevent them from continuing to appear to try with various "fixes" that they don't truly understand. I found it amusing that Obama singled out corporate jet owners (this has been widely talked about) and CNBC had a corporate jet executive on yesterday pointing that his industry employs 1.3 million people and increasing taxes will have an impact on that number working in this industry. Obviously the executive has his own agenda too but I think the example does isolate the on the one hand nature of these issues.

All of this negativity and we haven't even gotten to the political wrangling over the debt ceiling and the debt in general. Cullen Roche is big on jumping on anyone who says we are headed for an outcome like Greece branding them as not knowing how the US monetary system works but I am not sure that is correct. To be clear, the idea that because we control the printing press, as opposed to Greece who does not, we will not face the same outcome as Greece is completely correct. The threat is a different bad outcome than Greece's but I'm not sure that the politicians in question don't understand this so much as their constituency doesn't understand and there is some perceived political benefit to them to continue to scare their constituents.

If this seems plausible then it means that the debate is dishonest which further reduces the already microscopic odds that policy can ever help actually start to become effective.

All of this negativity and we haven't even gotten to... a lot of the other issues that make this so complex.

The above is the fundamental case for why the US is not currently an attractive investment destination. This is contradicted by the the fact that the US market has generally done quite well for more than two years now. We are not zero to the US and I'm sure we'll always have some exposure but as a repeat theme it seems only logical to seek out countries that do not have these same obstacles before them.

Simple avoidance (or maybe just underweighting) is an easy way to minimize the personal impact of large declines in the market.
Read more!

Broad Based Indexing Still Requires Work

IndexUniverse reported that Van Eck has filed for a Market Vectors ETF that will be broad based exposure to China. The difference with this fund is that it will offer a combination of access to the A-share market, B-share market, H-share market and red chips.

I am all for fund companies coming out with as many funds as they can afford and I would say the narrower the better as very narrow funds can be a better substitute for an individual stock than a broad sector fund (example; XLE would be a lousy proxy, on a relative basis, for uranium); I was calling for a fishing ETF two or three years before it listed.

This new China fund is very likely to be heaviest in financial stocks as every large cap China ETF is (or so it seems anyway). Assuming that will be the case with this new fund, which is a good bet, then it will probably be better left alone. To repeat something I've said many times, if there is going to be trouble in China the banks will be ground zero which will crush all of these broad based funds that are 30-40%, or more, in financial stocks.

Obviously there are investors for whom broad based funds are the best way to go but that does not mean that these investors should not look under the hood, try to understand what is there and make a decision or two about what to avoid. This will make the task a little more difficult but more difficult is a better outcome than getting hurt if there is a serious consequence to owning, in this case, Chinese banks. I would encourage broad based investors that want to own China to figure another way to do it.

Figuring a couple of things to avoid, even for broad based investors, may not mean you outperform the market but will probably spare some anguish.

Avoid most banks and long dated US treasuries.
Read more!

China Is Burning Down

My first foray into investing in China for clients was in 2003 with Petrochina (PTR) which I later replaced with Sinopec (SNP). When I first started blogging I specifically made two overriding points, one was that China was clearly becoming more important in the world economic order (I obviously was not the first mover here) and that it would be a very complicated investment destination for a long time.

While these observations are obvious they are also very important. Concerns about Chinese debt are growing; there are more articles being written about real estate debt that seems destined to go bad, the debt problems of the municipalities and Temasek is bailing on (not out, on) the Chinese banks. A point I made a long time ago what that there were bound to be mistakes in managing the country's new found prosperity.

This has lead me to have some pretty consistent views on how to invest in the country which is that I think energy, utilities, industrials, materials and consumer stocks make more sense than financials, real estate and exported related companies. Our exposure for clients is low and comes by virtue of China's weight in the Market Vectors Coal ETF (KOL) and iShares Emerging Market Infrastructure ETF (EMIF).

Aside from the debt issues mentioned above there are also concerns with inflation heating up (there are discrepancies between CPI and the deflator) and growth slowing down (it seems like growth has been 9-10% for years with concerns it will drop to 5-6%).

The debt and growing pains issues contribute to the bear case on China. However the Shanghai Composite is down more than 50% from its late 2007 high. The Hang Seng Index is down almost 25% from its highwater mark and the Hang Seng Enterprises Index, aka the H-share market, is down about 35% from its high. Obviously these markets could get crushed from here but the idea that some of the above threats are priced in seems plausible and I think the market will not get hit as hard as some think should those issues come home to roost.

The banks could get annihilated but I think things like energy, utilities and certain industrials would hold up ok or recover reasonably quickly if there is broad selling. Please note that our exposure is small but targeted in areas where I think ongoing business has a high likelihood of not being interrupted.
Read more!

"Can Stocks Be Safer than Bonds?"

Felix Salmon explores this idea in a post and concludes probably not. I would submit that the way the question is posed and addressed are actually framed incorrectly. If we start by proclaiming that bonds are safer than stocks then you'd probably get a lot of shrugs of acceptance. Invoking Karl Popper; it only take one result to refute the theory. I don't think I would get too much push back if I proclaimed that client holding Johnson & Johnson (JNJ) is safer than two year Greek sovereign debt.

Depending on where you look in the bond market you will find issues that are both "safer" and "less safe" than equities. Similarly, depending on where you look in the equity market you will find issues that are both "safer" and "less safe" than bonds.

Once an investor moves past the building block level of learning about investing, the word safe simply becomes the wrong word. Volatility might be a better way to think of it but even that may not be sufficient.

Investors, as opposed to traders, hope for different things from equities versus bonds. With equities investors want to see a combination of price appreciation, dividends and dividend growth with the realization that the trade off should be some amount of risk and volatility. With bonds most investors are looking for a steady interest payment and little to no price volatility. Hopefully the unvolatile bonds will provide some ballast against the "normal" volatility of equities. The ability of a company to make its interest payments will not reasonably be affected if the company earns $0.71 versus an expectation of $0.74 although such a report might hit the equity price very hard.

We know that equities can be either attractively priced or unattractively priced (or fairly prices too). If a bond is unattractively priced at the moment then it should be expected to have more threat of risk or more correctly volatility than something that is attractively priced. Consider a corporate bond due in ten years. If, as a simplistic example, ten year treasury yields are close to all time lows (which they are) and the spread of that corporate bond over the ten year is historically low then the bond is not attractively priced; it is relatively high in price.

This particular bond may stay expensive for a long time or not but it is still expensive, a buyer is buying high. The consequence for this would be a large price decline in the bond if rates go up thus creating volatility in the portfolio. Yes the investor gets his money back at maturity but large price declines tend to cause people to panic sell.

The contrast can be buying equities when they are cheap or thought of differently, after they have gone down a lot. Equities that are already down a lot might go down more of course but the risk of further declines decreases the more the market drops.

Buying something that is expensive is not universally bad as anything that is now expensive can become more expensive and it works the same way with things that are now cheap getting cheaper. Buying a US ten year treasury a few months ago with a 3.4% yield was buying high based in historical standards but turned into a pretty good trade when yields went to 2.9% a week or two ago but I'm not sure it could be considered safe.

Part of Felix' post was a response to a reader who appeared to be making the case for dividend stocks as a proxy for bonds. The argument has never made a lick of sense to me. That JNJ might yield more than a US treasury is not an argument for one over the other even if it is an argument for JNJ to be cheap or for treasuries to be expensive. They have different characteristics and should deliver different things to a diversified portfolio. Echoing a point that Felix made, if JNJ has some sort of problem far worse than what has happened over the last year and the dividend is cut I have no doubt the stock would go dwarf star with no guarantee of a return to the high watermark. If interest rates go from 3% to 6% over night then a ten year note would probably drop about 25% in price simply creating the likelihood of having to wait until maturity to get back the investment but they would get it back in nominal terms.
Read more!

Model Portfolio Dissection

A portfolio manager/blogger named Carlton Chin had an interesting post at Seeking Alpha titled A Well Balanced Portfolio Including Alternative ETF Allocation which might be fun to dissect. This has a sort of Permanent Portfolio feel to it but I may be wrong about that.

Chin's allocation as follows;

15% US stocks
15% Foreign developed stocks
10% Emerging markets
15% Bonds
10% REITs
15% Foreign REITs
20% Commodities

Chin goes on to suggest various ETFs, mostly from Vanguard, for each of the segments. Oddly for commodities he suggests the Elements S&P CTI (LSC) which I would say is more of a proxy for absolute return as opposed to being either a broad or narrow proxy for commodities. If he meant 20% in actual commodities that is a lot more than I would feel comfortable with. Commodities are generally added to this type of portfolio for diversification benefits but they are very volatile at times. At some point (before getting to 20% IMO) that volatility can start to work against an investor who is not looking to actively trade the portfolio. If Chin were to say the volatility is mitigated by choosing LSC I would say that LSC uses commodities to achieve a different type of result.

The exposure to REITs is way more than I would ever consider. The yield comes in handy most of the time of course but the correlation exhibited by the group to the US broad market and US financial sector leaves me thinking that even an aggressive weighting would be well under the 25% Chin suggests.

For equities the only examples given are the broadest of ETFs. There is nothing that says that portfolios like these can only use broad funds. Chin's concept could certainly appeal to someone with investable assets of $700-$800k which would mean $280-$320k in equities. In my opinion, this dollar range should own more than five broad ETFs but I realize not everyone would agree with me on that.

The section on bonds only mentions a couple of domestic treasury ETFs and a total bond market fund. I would urge far more diversification than this, especially some sort of foreign exposure. The ETF market for fixed income has improved dramatically offering access to quite a few segments what were previously very difficult to access.

Exploring these types of alternative portfolio structures is a worthwhile pursuit, not in terms of turning your own portfolio inside out based on what might be a persuasive article but more along the lines of taking little bits of other people's process to make your own. Some folks are well ahead of where they need to be and so really reducing volatility, versus something like a 65% allocation to equities which seems to be a common number, becomes something that should be considered. Chin's portfolio kind of addresses this idea, although I would disagree with him on REITs and commodities

The Tour de France is off to a good start except for Versus' ongoing infatuation with Jonathan Vaughters. The segment yesterday going across the suspension bridge was very neat to see.
Read more!

Sunday Morning Coffee

I wanted to follow up on yesterday's post about portfolio construction at the sector level with a look at some ideas on how to construct each sector, the context being that a portfolio is built at the sector level and benchmarked to the the S&P 500 with decisions about overweighting, underweighting or equalweighting each of that index' ten sectors.

Making decisions about how to weight a sector can come from a combo of knowing a little about market history and assessing the current environment to make a forward looking analysis at least this is how I try to do this.

The obvious way to execute this would be to take a sector, like industrials which is currently 11.2% of the SPX, and allocate 13-15% to it for an overweight or 8-9% to underweight it--or any other numbers you prefer.

Another way to come at this is by increasing or decreasing the volatility. The energy sector provides an easy example. The Energy Sector SPDR (XLE) owns the energy stocks in the S&P 500 and so could be thought of the benchmark of the sector. In the context we are talking about an equalweight to energy would be buying XLE in exact proportion with the S&P 500.

One way to underweight the sector would be to own stocks and or funds in the same proportion as the SPX but with less volatility. A combo of Exxon Mobil (XOM) and a partnership name like Energy Transfer Partners (ETP) will very likely (no guarantee) be far less volatile than XLE. This might be the right type of exposure after some sort of crazy spike in oil prices that brings out many calls for $200 or $300 oil or if the economy appears to be rolling over into a slowdown.

The other side of the spectrum could be a combo along the lines of Global X Uranium (URA) and the PowerShares Small Cap Energy ETF (PSCE). It doesn't take a lot of imagination to see where these two are going to be much more volatile (no guarantee) than XLE. Putting on this type of a combo might make sense after a large drop in the market or a drop in oil prices.

A third possibility is a combo from the two groups for some desired purpose. Something like 75% of the energy allocation into a low vol name like ETP and the rest in something high vol like URA could generally dampen the volatility but allow for growth the next time the volatile holding doubles--at some point things like uranium or some other niche will double leaving XLE in the dust but until then someone could capture some yield with tilt to the low vol name. The above are just examples, we don't own any of the stocks or funds mentioned.

The bigger idea here is to think about how each sector is comprised. It may make sense to go low vol in one sector but high vol in another. Blending sector volatilities can allow for creating a portfolio that is more or less volatile (depending on preference) than the broad index that serves as the benchmark.

This is the type of stuff I have in mind when I talk about creating very specific effects in the portfolio. The narrower you go the more precise you can be.
Read more!

The Big Picture for the Week of July 3, 2011 Special Tour de France Starts Now Edition

The other day I was interviewed for an article about ETFs. Part of the conversation was the way I look under the hood and thinking about an ETF (or individual stock for that matter) as being a proxy for different things or part of the exposure for some some segment.

Succinctly this means taking in to account the sector weightings of a country fund, country weightings of a sector fund and both country and sector weightings in a thematic fund. Failure to do so is how people ended up 50% in tech in 2000 or 40% in financials in 2007.

This only seems logical to me, and something I have been writing about for a long time now, but was new to the interviewer. Of course other people take these things into consideration but maybe the point is that not enough people do.

Fund screening in this context is simple spreadsheet work, or Morningstar can do it for you with their portfolio tool. A portfolio that combines stocks, thematic funds, country funds and sector funds will have some weighting in each sector and some number of countries. What are those weightings, and is that where you want to be positioned?

Taking a simplistic example, a portfolio consisting of iShares Poland ETF (EPOL), Market Vectors Gulf States Index ETF (MES) and EG Shares China Infrastructure ETF (CHXX) would seem to cover a lot of divergent ground. EPOL has 40% in financials, MES has 65% in financials (including real estate) and CHXX has 23% in real estate (which I consider to be part of financials). Obviously if someone wants that much in financials then there is no potential issue of being blindsided (only a potential issue of being wrong).

The lopsided exposures in these funds is not by itself a negative. If MES were 100% financials then a 5% portfolio weight in the fund would obviously be 5% of the portfolios in financials. Someone wanting a total of 15% could compile the other 10% for financials from other funds and/or individual stocks. For someone only using funds it might be difficult to get to each sector target exactly as hoped for but they can get reasonably close. If 10% is the desired weight, I don't think 8% or 12% would be ruinous. Wanting 10% and ending up with 40% might be.
Read more!

The Faces Of Alpha

Cullen Roche had an interesting post about the three sources of alpha. They are better information, better analysis of the same information and recognizing when prices are manifesting an extreme in greed or fear.

Occasionally anyone can stumble across better information (even though they may not realize it) and clearly many will try to regularly access better information but for most of us a method that relies on better information on a consistent basis is probably not realistic.

Better analysis of the same information is multifaceted. For example not many people were able to look at the volume information from Sino Forest and draw skeptical conclusions. The information was there for anyone who sought it out but very few people truly understood it. With individual stocks there are changes in little data points that can warn of a slowdown (talking something far less dramatic than a fraud) or a turn up in business.

Better analysis of the same top down information is much easier. To recycle a joke from past posts, how many times do you have to read that housing and banks in Europe are in a lot of trouble and this is why before you start to think hey, housing and banks in Europe might be in a lot of trouble? In the build up to and the rolling over of the housing/financial crisis in Europe and the US we heard all sorts of arguments as to why everything was just fine ranging from faulty analysis to political lies rhetoric.

Some who may have missed the financial crisis but see in hindsight what the warning signs were in terms of actual data and various indications of sentiment can hopefully apply some of that to whatever the next crisis will be. For example in both 2000 and 2007 we heard why the yield curve inversion didn't matter "this time" or why various metrics of analysis were no longer relevant (tech stocks and then housing) and so on.

Extreme greed or fear can mean recognizing when the price of something is too low or too high. This is easiest in the face of an extreme move in price. If an energy stock you own goes up 100% in six months while the Energy Sector SPDR (XLE) goes up 6% then you probably should take some off the table. Understanding when good news or a scare is overdone comes from really understanding the business and the nature of how the stock trades. "Really understanding" is of course vague and subjective as however well you know a stock you own there are other shareholders who know it much better than you and others who know far less then you.

While no one can be universally correct with these sources of alpha I do believe that the last two are reasonably accessible to do it yourselfers.

Baseball fans, when was the last time you thought about Tippy Martinez?
Read more!