Thinking Loooooooong Term

Last weekend I had a post up that tried to poke holes in the Five Stocks to Hold Forever types of articles. In that post I mentioned in passing that while we don't have to pick five of anything to hold forever, it would make more sense to think about this in terms of countries instead of individual stocks.

An editor at Seeking Alpha asked me to write something up following through on the five country idea which I was not thrilled about doing but then a reader asked the same thing. In thinking about this a little I thought that what this really should be about was five (or any number important to you) top down segments which could include countries but also themes and sectors.

One theme would be things related to food and water. Yes this is a Malthusian argument but it seems very obvious that there is now not enough food and water in many places and a lot of money will be spent trying to solve this problem as the world population continues to grow. Some do not believe in this and so they would have no interest in the theme.

There are plenty of ETFs and individual stocks for this theme taking on all sorts of attributes in terms of countries, volatility and yield.

Another theme but also is about country selection is the Brazilification of other countries. You can probably guess that I mean countries that are likely to become more prosperous and see a middle class emerge/proliferate as they sell resources to other countries. We own Brazil which is relatively mature in this phase but still has a ways to go IMO. We also own Colombia for similar reasons. As I have mentioned before I can see owning Mongolia and Kazakhstan at some point as part of this idea. There are ETFs filed for both countries and we own individual stocks for Brazil and Colombia. At some point I imagine there will be other countries to add to this list like maybe some of the other 'stans or a couple of countries in Africa.

As disclosed in previous posts we have exposure to about a dozen foreign countries and for reasons I've talked about before I guess Chile and Norway would be my two "favorites" but I don't necessarily expect them to be the top performing countries. Both countries are low octane and the fundamentals are very solid which creates a backdrop for ongoing and meaningful outperformance of the US even if they are not the ones that go up 1000% in the next ten years.

Assuming I keep both countries for the next ten years, or even add to their respective weightings, chances are it will be some other country that is the top performer and I obviously don't know which one it would be which is why I believe in owning many countries. In the last decade commodity related countries and small emerging markets seemed to be the best performers and I think that argument is still fully in tact but what if it is some other grouping of countries? What if instead it is the small emerging debtor nations like Hungary and other countries of that ilk? I can't make a fundamental argument for Hungary but that might change.

What about the CIVETS, the N-11 and any other grouping of countries, those could all work out too--or not.

There are other ideas we could also add to the list including natural resources, Africa and some Asian markets where there is really not much of a stock market yet; Laos and Cambodia come to mind. Who's to say that five years from now there won't be a Cambodian cement company with ADRs on the NYSE?

My favorites will be my favorites until they aren't, if you take my meaning.

Unrelated tree house picture.
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The Australian Permanent Portfolio?

The Daily Reckoning had a post up about the Permanent Portfolio (the Harry Browne concept, not he US mutual fund) from an Australian perspective. As a quick reminder the Permanent Portfolio allocates 25% each to cash, equities, long bonds and gold.

The idea of building the Portfolio from the perspective of another country is pretty interesting and is possible with a couple of countries using ETFs including Australia.

The cash portion is simple with the Rydex Currency Shares Australian Dollar Trust (FXA). It captures the movements of the currency and has a yield that is generally inline with rates set by the Reserve Bank of Australia.

With the equity allocation they usually have a broad large cap fund in mind. There are at least a couple of those to choose from with the iShares MSCI Australia Index Fund (EWA) and the WisdomTree Australia Dividend Fund (AUSE). There is no reason though that the equity portion can't take in more than just a single broad based fund. There is small cap exposure via the Index IQ Australia Small Cap ETF (KROO) and you might find a materials ETF out there that might be enough of a proxy for Australia. Of course there are also individual stocks from just about every sector to choose from as well.

For the fixed income portion there is the long standing and client holding Aberdeen Asia Pacific Income Fund (FAX) which is usually heaviest by far in Australian debt and the WisdomTree New Zealand Dollar Fund (BNZ) is due to convert on Monday to the WisdomTree Dreyfus Australia & New Zealand Debt Fund.

As for gold, I believe there are funds in other countries that price gold in other currencies and while I could see a couple of these coming to the US at some point I think any that exist now would be difficult to buy logistically.

This is sort of doable with Canada also with the Global X Canada Preferred ETF (CNPF) as a proxy for the fixed income--we own a few shares of CNPF. It is possible to do this with China now that there are a couple of Dim Sum bond ETFs trading however I would want no part of the Dim Sum bond funds. The concept of foreign Permanent Portfolio will get easier as more foreign fixed income ETFs come to the market.

In the real world there is no reason to be limited to one country and there is no reason not to have a fully diversified equity portfolio instead of just one broad index fund and there is no reason not to have a fully diversified fixed income portfolio instead of just owning something like TLT. And as I have said 25% in gold is way too much for my tastes but obviously some people are comfortable with that much (or at least they were before this big plunge).

That was an insanely clutch homerun by Dan Johnson of the Tampa Bay Rays last night.
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Seriously, How Is This Even Possible?

Over the years I've poked fun and tried to dissect the unraveling of Bill Miller's (from Legg Mason) once sterling reputation. The other day there was this post at Market Beat that dug into the history of his position in Eastman Kodak (EK). I did not know he owned the name until Monday--my interest here is more about what not to do from a big picture behavioral standpoint so I don't keep very close tabs. I probably saw EK listed there but skipped right over it looking at the financial names.

EK is a large holding in the Legg Mason Opportunity Fund (LMNOX) which is the "other" fund. The Market Beat post has this fund down 37% YTD which is an astounding number in a down 8% world. I looked at the holdings on Morningstar (understand they can be dated and changes may have been made since the last disclosure) and the holdings are truly astounding. Aside from EK which was down 55% YTD there is Genworth Financial (GNW) down 61% YTD, MGIC Investment Corp (MTG) down 81%, Monster Worldwide (MWW) down 67%, Boyd Gaming (BYD) down 51% and several others down not quite 50% this year.

Astounding.

While I do not know concretely what is going on here there are a couple of things that seem plausible to me. I've always picked on him for always having such a heavy exposure to financial stocks. The latest from Morningstar has him at 32% in the sector. He essentially went down with the ship on several names a few years ago but the thing that is most baffling is that he appears to not even be a little skeptical of the sector.

I don't know how someone comes through the last few years without being a little skeptical about the sector and that is just generically speaking. When you layer on the pounding his funds took in financials you might think he'd have a little bit of introspection and at the very least lighten up some. Maybe he is less exposed than he used to be but at 32% he is two and half times the S&P 500's weight.

The other thing that I think might be going on is the idea that everything that gets crushed becomes a good value stock. This is referred to as value traps. While the market is not infallible I am inclined to think that a multi year decline from $90 to $20 for a company where it is very easy to envision the extinction of the primary product might be a useful message from the market.

This is what happened with Kodak. It was at $92 in February 1997, it traded between $21 and $34 for many years in the last decade and has since imploded again. I know they have products but when was the last time you bought anything from them? I am pretty sure the last time we used film in a camera was in 2003, we went to Kauai with film and a digital camera. After that digital only.

Everyone gets things wrong, I have in the past and will in the future--so will you and that is ok. I have no idea what his process is but I think a big part of a potentially successful process needs to include mitigating the consequences for when we are wrong. Avoiding 32% in one sector would be a good place to start.
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Someone Else Bashes the Dividend Zealots

This one ought to whip up the dividend zealots; there was an article up at Seeking Alpha titled The Dumb Dividend Idea noting that "the concept of dividend-stock investing is almost worthless, on the face of it."

My general take on this issue has been not to put all your eggs into one strategy-basket. My preference is to have a portfolio comprised of holdings with all sorts of attributes. This makes for better diversification in my opinion by owning various attributes including dividend characteristics, countries, themes and sectors. I view this approach as being moderate but the dividend zealots think I am wrong, or worse.

It was very surprising how few flaming comments there were on the post the last time I looked, my seemingly less inflammatory posts get lit up pretty good; funny stuff.

The author, David Goldman, seems to be saying that the dividend zealots don't care about price appreciation and while I don't know if that is true, as I have sifted through their comments over the last couple of years and capital appreciation seems to be low on the priority list (my interpretation, I'm sure they would say otherwise).

Dividends are crucial to long term investment success. Depending on the period looked at dividends have accounted for 40-50% of total equity market returns. This makes a very simple argument for being cognizant of what your portfolio yields and the way I view things makes the argument for trying to have the portfolio yield a little more than the S&P 500. I think collecting an extra 100 or 125 basis points in yield above the SPX will add meaningfully to a long term result both in nominal terms but also risk adjusted.

The building block here is that over long period of time the stock market averages 9-10% annualized returns (we can debate whether 9-10% stands up anymore in another post). If 3% of that can come from dividends instead of 2% then the rest of the portfolio doesn't have to take on as much volatility, unless you want it to.

The other big point made in the article was that during downturns, dividends don't offer a place to hide. I generally agree with that point. There are a lot of articles in MSM that allude to hiding in dividend stocks. From the recent July 8 peak the S&P 500 is down 14.06% and the SPDR S&P Dividend ETF (SDY) is down 11% so maybe that was a place to hide? Maybe not, that would be a subjective decision. However from the October 2007 peak to the March 2009 low SDY clearly was not a place to hide as it dropped 54.24% versus 50.45% for the S&P 500 (actually this is through March 6, 2009 which was where the chart on Google Finance went to).

Dividends are far from worthless. Their role in a diversified portfolio is pretty clear but a properly diversified portfolio means having exposure to whatever is leading the market, or at least a better chance of that exposure which I believe will lead to a better long term result.
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Interesting Items From Barron's

A little confirmation bias for a couple of long running themes I've been writing about;

First up is a quote from a bond fund manager who is "also allocating some money to bonds from Canada, Australia and Norway, which have triple-A ratings and strong, commodity-backed economies."

We have had across the board exposure to short term sovereign debt issues from Australia and Norway for several years and exposure here and there to Canada. Debt from these countries has become increasingly popular in the last year or two (a mixed blessing) for what I think are obvious reasons -which is that although not trouble-free economies they are on much firmer footing.

There have been plenty of instances where the inferior US dollar has gone up against these currencies and this is always a threat but over the last ten years the Australian dollar is up 100% against the USD, the USD is down 34% against the NOK and the loonie is up 60% against the dollar. All of that but plenty of counter trend moves along the way. Obviously I feel the dollar will continue to encounter long term weakness even if the results over the next ten years are less dramatic than the last ten years.

The other item came from the Asia Trader column. "'The fact that Asian markets have performed worse than U.S. and Europe when the real problem is there, not here, seems a little unfair,' says Markus Rosgen, Asia strategist for Citigroup in Hong Kong" and "...agree with Garner that 'the sell-down in Asia is clearly overdone.' The shares, after all, fell harder than those in Europe or the U.S., which is where all the trouble started."

We'll not worry about the notion of fairness. I've asserted many times that decoupling was never about markets that somehow go up when most other markets go down but at best, more like going down and then recovering on different time tables than the US. The different time table idea worked very well in 2008 (think beyond Europe and Japan) but appear to not be working as well now.

I made a comment the other day about Singaporean banks being on firmer ground than the US banks but that Singapore always seems to get hit harder during these types of downturns. The quotes are signs of frustration over this type of trading but it is not a new phenomenon. In the last decade Singapore was up 9% plus dividends versus a loss of 24% (excluding dividends) for the S&P 500. Obviously 9% for a decade is not good but better than a loss of 24%.

A point I have made in looking at other countries in the decade-long context is that many of these places carried on without us and will continue to do so. Client holding Nike (NKE) just had its earnings report and revenue from emerging markets was up 24%. Our economy stinks and people in other markets are buying a lot more Nike shoes and apparel--as an anecdote.

This will mean little for traders but I think is very encouraging for investors. It takes work to isolate markets likely to benefit in this manner and again they will not go up when other markets are panicking lower--at least this should not be the expectation but I believe the decade long success from other markets can be repeated even if the US does poorly again.
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Sunday Morning Coffee

The other day I saw an article whose title was something about picking five stocks to hold forever for retirement. I'm sure the companies are all fine business but there is more than a little folly to projecting forever.

One of the stocks in the list was Apple (AAPL). Obviously it has been a huge winner for holders of the stock and holders of certain ETFs where the name has a huge position.

I have nothing negative to say about the name. However that is not much different of a description someone might have applied to Cisco (CSCO) ten years ago. In the last ten years however the stock has been a bit of a dog. It is up 34% versus an 82% gain for the Nasdaq. The previous ten years CSCO was up 3800% versus a gain of 190% for the Nasdaq (190% for a decade is outstanding BTW). It would be easy to point to CSCO's inclusion into the Dow 30 as being part of the story but either way, if you were around during the 90s you remember what Cisco was.

Something will change the trajectory for AAPL, I don't know what or when just a matter of pointing out that anyone buying anything might be able to hold forever but if the story does change in a meaningful way you need to be on top of it.

AAPL could easily turn into a dog stock the same way Cisco did. How do I know? because it happened before. In the ten years ending Jan 15, 1999 AAPL was down 3% versus a gain of 510% for the Nasdaq--this came after dramatically outperforming the Nasdaq in the 1980s.

I had a more interesting thought though than the folly of picking a stock forever. If we had to pick something to hold forever (of course we don't) then wouldn't it make more sense to think about countries in this context?

This is of course a top down concept. A country index will sort out the companies that fail for you as opposed to one of the stocks you own failing and if the prospects of a country for whatever reasons you care about look promising (after thorough research) then picking five countries (or some other number) would make more sense than picking five stocks.

To clarify a couple of things, I am not a fan of the premise put forth in the referenced, but unlinked, article but someone who is looking for some holy grail of having a few holdings and never doing anything with it again might want to consider countries instead of stocks.

I am all for holding something forever when possible, we have several names in the portfolio that have been there since 2004 (when I started at the company) but as disclosed before we have not hesitated to sell stocks we thought we could hold forever when something serious changed.

A quick word on Operation Twist; more desperate and extreme measures belying just how much trouble the US is in.
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The Big Picture for the Week of September 25, 2011

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Friday Night Question

A reader asked the following at Seeking Alpha;

Why not stay in cash and wait for the markets to go much lower?
How much lower do you all expect it to go? Some folks though the bottom came in during the week of August 8th and retests were made on 8 19, 9 12 and especially yesterday.

My reply;

100% cash is a huge bet too. What if it doesn't go lower? Anyone can pick a target low 1100? 950? It is unlikely any single prediction would be correct. In the face of panic, buying a little makes sense but it may go lower the next week. In the face of euphoria it makes sense to sell a little but it may go up next week.

I try to mitigate the consequences of the times I am wrong which is why 100% cash is too big of a bet for me.

Just a reminder of a point I have made before.
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The Market is Freaking, But You Should Not

There is a funny thread of sorts among the people I follow on Twitter that makes fun of the Fast Money crew from CNBC because no matter what is going they are all correctly long or short and making money every day. I never watch the afternoon show and often mute the mid day show unless they have a luminary on so I don't know how much this thread is exaggerating.

The reason to bring this up is to talk a little about the psychology that goes with weeks like this one. A big part of what I try to do in client accounts and also write about is defensive action to help avoid the full brunt of large declines in order to smooth out the ride over the course of the entire stock market cycle.

If you've stuck with this blog for a while then I have to think this approach resonates with you on some level. We start defensive action based on an objective trigger (the 200 DMA) but however you take defensive action invariably on days like yesterday you wish you had taken more defensive action and if the S&P 500 goes up 30 points today you will wish you had taken less.

This sort of emotion is one of many that investors will possibly encounter although I would say it would be better to understand where your emotions might go ahead of time and try to mitigate the chances of acting out on your emotion.

If I say to you that "markets correct downward every so often and sometimes these can be fast and quick moves that scare people but markets and the stocks that comprise markets come back at some rate of speed and that the decline will not wipe you out," what would you do with that?

If the S&P 500 was at 1550 and everyone was feeling pretty good then most people would say that "well of course the market goes down 20% now and then, the volatility is just fine." Now as the market feels like it is down a lot people tend to forget the rational voice the knows markets do go down as they are now.

I've drawn some negative comments when I've said this before but the behaviors in the market are not different, the details causing the moves might be. It is the same emotions (various stages of fear, greed and panic) that we are seeing now that we have always seen before. The market will come back, even the S&P 500 will make a new high. The caveat is that it might take much longer than investors would hope necessitating owning other countries (my thesis, anyway).

Caterpillar (CAT) had been a long time hold. We have sold it a couple of times along the way including a few months ago as part of our defensive action. We sold it because it tends to get crushed in recessions which is where I thought we were headed when we sold it (we are probably there now). I sold it on the same logic a few years ago as well. The decline in 2008 was far more than the current 34% decline but the point is that the market behaviors do repeat.
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Big News!!

The following press release was sent out late yesterday;

AdvisorShares Announces Partnership with Roger Nusbaum, CIO of Your Source Financial

Partnership Will Create an Actively Managed ETF That Will Seek to Generate Alpha Across Global Market and Asset Classes

BETHESDA, Md., Sept. 21, 2011 /PRNewswire via COMTEX/ -- AdvisorShares Investments, LLC, a sponsor of actively managed Exchange Traded Funds (ETFs), today announced a partnership with Roger Nusbaum and his colleagues at Your Source Financial, a Phoenix, Arizona investment management firm, to develop an actively-managed ETF. The proposed ETF will take a top down perspective, focusing on global asset allocation and individual security selection utilizing both long and short market exposure.

Chief Investment Officer Roger Nusbaum is a leading expert in ETF analysis and market commentary through his blog at http://randomroger.blogspot.com . Roger will work with AdvisorShares to develop a similar strategy as the one he often writes about and offers to his clients. "What's important to us when constructing portfolios is assessing whether the environment for stocks is positive or negative, assessing big, important themes that could move markets, and assessing where we are in the current stock market and economic cycles. We then take all of these current events, combined with a study of similar periods in market history, to build a forward-looking analysis of what we expect to happen in the market."

Noah Hamman, CEO and Founder of AdvisorShares said, "Many investors know noted market expert Roger Nusbaum for his Random Roger stock market blog and his frequent contribution to media outlets such as CNBC, but more importantly through his analysis of ETFs, and for the transparency he provides to reading of how he manages assets. We look forward to working with Roger and his team in creating a unique ETF solution for investors that provides both broad and targeted investments through his use of individual equities, ADRs, bonds, and ETFs."

To request more information on AdvisorShares, please contact Noah Hamman or Chuck Robertson at 202-657-6383, nh@advisorshares.com or cr@advisorshares.com.

There is still a long road with many tasks to be done in order for the fund to list. It turns out "he seems like a cool dude" isn't quite sufficient (humor attempt). There are a lot of restrictions about what can and cannot be said including strategy and ticker symbol ideas however if you've been reading this site for while then you might have an inkling. We scrapped the idea of a niche fund focusing solely on the greasy wool industry group (another humor attempt).

Needless to say I am beyond thrilled and very grateful to AdvisorShares for giving us the opportunity to do this. I will repeat that there are quite a few steps along the way but I am very optimistic this will come to fruition.

I also need to thank you all for reading my content. That I have built a following over the years with my writing, aside from having always been surprising to me, has contributed to getting this opportunity. I will continue to update the progress as this moves forward and as is allowed.
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More Reader Questions

A commenter on yesterday's post asked;

Not sure where would be the place to invest. Europe is seemingly always in crisis, Japan has problems at least as bad as ours, do you trust the Chinese banks and markets? OK, so what's left? Latin America, where it seems like more countries are installing more statist regimes? What foreign markets, exactly?

I cover this ground a lot but it is important and so worth repeating. The reader has made some observations that I have been talking about for ages. Namely the problems with most of Europe, Japan and Chinese banks.

Countries that we own, have owned and may own in the future with a little bit of color. Invariably I will leave a couple off the list.

Australia; we're out for now but it is commodity based and the cycle is different than the US'

New Zealand; we've been out for years but I expect to get back in, it is agricultural based, the volatility is very low but the trade deficit will always be an issue

China; we are in via the weightings in KOL and EMIF, the banks stink, I like the toll roads which are utility-like, I also like energy (ex-solar), materials and industrials

Mongolia; this is in the future and probably resource oriented (ditto Kazakhstan)

Singapore; we don't own Singapore but there are a lot of very interesting companies, the banks are generally on very solid ground but they seem to always get crushed when the market goes down a lot.

Indonesia and Malaysia; if we get involved with plantation stocks as part of the ag theme I would consider these countries

Israel; we've had exposure here for many years but it has been beaten up very recently

The Mid East; not too much interest here, Qatar has a lot of natural gas but I am not aware of any easy way in

Russia; we owned Russia once for just a few clients and it did not go badly by any means, it seems obvious that oil and resources will bring continued prosperity but something just seems off

The rest of Eastern Europe; the stories on the ground in a couple of places have some promise (Czech Republic, Slovakia, Estonia, Turkey) but we have nothing there for now, they are difficult to access too, Turkey is easier to access

Scandinavia; all four countries are relatively healthy, enduring much more of a cyclical event compared to bigger countries in the euro

UK; we own Diageo (DEO), there are also a lot of foreign companies listed in London that would not be proxies for the UK

Switzerland; I think ex-the banks the country can be owned

Africa; I've been saying we are going to do something there soon but we have not, I have a few things in mind but the timing has not felt right yet

Canada; we have a bank and an energy company

Brazil; there are some issues now with a strong currency and inflation but the world still needs its stuff

Chile; relatively low volatility but the market has been hit lately, great economic and fiscal fundamentals and steady demand for equities thanks to what amounts to privatized social security

Colombia; kind of an earlier stage Brazil (different resources) we own an oil company

Peru; in terms of across the board-- three countries is enough for now but there are a lot of positives going on here and Humala will not be as bad as originally feared

Argentina; this is probably a good destination for farm-related stocks, I read good things about Banco Macro (BMA) but given the issues here I can't wrap my head around the concept that buying an Argentinian bank could be a good idea
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The Uselessness Of SPX Price Targets

The WSJ had an article about SPX price targets from brokerage firm strategists coming under scrutiny, or maybe fire is a better word. You probably heard that BofA bumped its equity strategist about ten minutes (slight exaggeration) after he reaffirmed his year end target of 1400. Some of the usual suspects are also mentioned for either sticking to their guns or giving up the ghost.

Many investors like to hear SPX price targets, so many financial firms oblige. I used to do a little more here myself with picking some number that was away from consensus that tried to incorporate some aspect of where I thought we were in the cycle. I was close to right a couple of times and too pessimistic a couple of times.

The simple issue here is that these forecasts tend to be wrong, a lot. We've gone over some of the dynamics of the perma bulls, the threat they pose and some of the conflicts they may have in "needing" to be bullish so it is somewhat surprising that BofA got rid of someone who appeared to be too bullish.

Price targets notwithstanding, if you zoom out a little, the US is a destination where the sovereign debt was downgraded, there is a demographics problem, the government is not functional, growth is below trend with no visibility for improving, there is too much debt and there might be a serious problem (I think there is a serious problem) with liabilities to retirees and future retirees.

If this description were about another country you would quickly move to research another investment destination.

Anyone capable of being able to think in terms of several years at a time (or even a little longer) would be better served looking to longer term trends that have a reasonable basis for working in the future or continuing to work as they have in the past. Obviously not all previous winners can continue to work out well.

Consider the above issues with the US (and any others you care to add) and ask yourself what is the simplest outcome. My answer to that question is not a Schiffian (as in Peter Schiff) implosion but instead an ongoing muddle where average growth rates are well below what we think of as being normal and being far inferior to many other countries in the world.
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More Incomplete ETF Reporting

Here are three articles I found last night about the UBS scandal calling into question the extent to which ETFs are the next blight on mankind.

UBS' $2b Man Kweku Adoboli And The Perils of ETFs

ETFs Under The Spotlight As Shadow Falls Across UBS' Delta One Operation

Tom Stevenson:ETFs Have Potential to Become The Next Toxic Scandal

These articles pretty much all say the same thing, noting the proliferation (especially in Europe) of ETFs that use derivatives to track whatever it is they are meant to track.

Um, yeah, if you don't want a derivatives based ETF you own to blow up catastrophically due to some unforeseeable failure somewhere in the world then don't use derivatives based ETFs. The articles read like these funds are at great risk of blowing up any minute. Maybe they are but that is a different kettle of fish to the equity backed funds (the ones that just own stocks).

One crucial point not addressed in any of the articles was that UBS and Kweku were not done in by a failed product, they were done in by how he traded. He could have blown up just as spectacularly with any tradable instrument (Nick Leeson). Ditto Jerome Kerviel.

This is similar in a way to options. Selling a call against some stock you own every now and then is not the same thing as maxing out on short puts right before the market cuts in half.

This is also similar to loading up on some lottery ticket biotech stock right before an FDA announcement surprisingly goes against the company.

The point is that people can blow themselves up with anything and they can have success with anything. It should be about how the product is analyzed and then used (or avoided). Did it take Kweku to make the world realize that derivative based funds carry an additional risk that the plain vanillas do not (and again this is not what caused the loss, it was what he did with the product).

We do know that plain vanillas can have problem. Many ETFs freaked out in the flash crash and traded briefly at a penny before getting right side up. If you realized that a basket of stocks that was worth $50 at 2:15 was not then worth a penny 20 minutes later then this event did not blow you up. Plain vanilla bond funds also have trouble now and then as the funds are more liquid then the underlying bonds which causes the market price to trade more dynamically than the IIV.

These types of temporary deviations will probably happen again in some future time of market duress. Equity ETFs we had got caught up in the flash crash and a bond ETF we use had a quick spread between its market price and IIV in the Lehman aftermath and I have to say not only is it not a big deal now as I look back, it wasn't a big deal as it was happening.

None of this might matter to you however. If you disagree with the conclusions I am drawing then obviously you should not use ETFs of any kind but the way the issue is being covered seems to be more about attracting eyeballs, not addressing the actual particulars involving flawed human behavior.
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Sunday Morning Coffee

Barry Ritholtz had a short post about Ray Dalio that included the following exchange between Barry and Dalio;

“I (Barry) find your focus on self-reflection and error correction, on enlightenment refreshing compared to the rest of Wall Street.” or words to that effect.

He swivels around to face me full on, and says “Isn’t that what it is all about? If you don’t understand yourself, how can you ever meet your goals, in life or in investing?”

I like to think this is something I have conveyed through my blog posts. This is about staying on your own mat (a yoga phrase whereby you don't worry about how well the person next to you is doing the poses, you just focus on how you do the poses).

We are all formed by our unique life experiences and while everyone is entitled to their goals there are limits with numbers. Someone who makes and lives a $100,000 lifestyle is not going to be able to live a $200,000 lifestyle (assumes no massive inheritance or winning lottery ticket). More practically it will be difficult for someone accustomed to making $100,000 but living a $115,000 lifestyle to continue on in that fashion. Those numbers are at great risk of not working.

Am important point I think I see in Dalio's comment is understanding what your real goal is. I think that if people think about it, many would realize they just need to focus on having enough when they need it. From there if they can realize that maybe they don't need quite as much stuff as they think then it becomes much easier to have enough when it is needed.
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The Big Picture for the Week of September 18, 2011

An anti-ETF blog post by Terry Smith of Tullet Prebon got a lot of attention yesterday from several MSM sites. While it might make some investors think twice about using the product I think this really needs to be dissected to be put in its proper perspective and utility.

Point number one was that "some ETFs do not hold physical assets of the sort they seek to track. They are "synthetic" and hold derivatives." Smith is based in London and this is more prevalent in ETFs listed in Europe. There are of course ETFs in the US that use derivatives and so obviously face counter party and other risks mentioned by Smith.

It does not take a lot expertise to understand that the more complicated a product is under the hood the more risks there are that have nothing to do with the exposure being sought. If ProShares were to have some sort of problem with its counter parties then SPXU is going to have a problem regardless of what the S&P 500 is doing. This should not be news to anyone and if this possibility is unacceptable to you then you would simply avoid the funds.

Smith's next issue was "ETFs do NOT always match the underlying in the way people expect. Because of daily rebalancing and compounding, you can own a leveraged long ETF and lose money over period when the market goes up but during which there are some sharp falls." We covered this here many times when this was a front burner issue in late 2008.

My own observation is that the narrower the segment covered by an inverse or levered fund the less predictable the fund will be. The broader levered and inverse funds have "worked" over some longer periods of time. Look at a YTD chart comparing client holding SDS and SPY. It "worked" for most of this year. It may have stopped "working" for the last month or so (you can decide for yourself). This all serves to tell us what we should already know, in the future it will work longer terms except for the times that it doesn't. Seriously, there is no way to know whether these will "work" over the longer term, it all depends on the combination of up and down days. This should not be new and like the point above, anyone for whom this in unacceptable would simply not use these types of products. The reason we use it (in moderation) is that if the stock market goes down a lot today then I have full faith that SDS will go up twice the amount of the decline.

Number three was the old chestnut about short interest being larger than the number of authorized shares. The example from before was the SPDR Retail ETF (XRT). IndexUniverse addressed this worry very effectively; only authorized participants can create and redeem shares. Massive short positions have to be closed by trading out of them.

Smith's last point was that fund companies make money trading the derivatives that underlie the funds. If we broaden this to include stocks (which is of course incorrect as the fund companies don't create shares, APs do that) then the issue becomes does the fund do a good enough job tracking the stock basket it is supposed to track. You obviously need to decide for yourself about that.

One point I have made repeatedly about ETFs is that they are merely access. It is up to the end user to decide what the best access for them is for each exposure they want in their portfolio. It is not logical that an ETF can be the best tool for all times and for every single exposure. And for some segments there are no ETFs. Someone wanting Canadian banks or Scandinavian banks must use individual stocks (unless they want very diluted exposure from a broader fund).

ETFs have flaws as do individual stocks as do broad based funds. A huge building block for portfolio success is understanding the potential drawbacks of what you own.
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How Many Stocks or Funds Should You Own?

A reader left the following comment on the Seeking Alpha version of a post from earlier this week;

For the average personal investor, forty stocks is a lot to be owning and constantly rebalancing. Wouldn't one be just as well off buying sector mutual funds (or ETFs) and allocating their percentages?

It is a bit of a short cut to think in terms of the "average investor." The best framing of this conversation is that each of us has a unique capacity for the number of holdings that we can keep track of. This is typically going to be based on time available and the level of interest in the subject. For some people it is also a matter of how much skill they have, harsh as it may sound some people should not use individual stocks (I tend to believe that people with middling skill can still do quite well with individual stocks).

One way to look at this is to think there are three types of products; broad based funds, narrow based funds and individual stocks. To the reader's question some individual investors will clearly be able to handle 60 stocks in their portfolio. Certainly not most people but a capacity for something like 50 or 60 names is would not be so shocking although clearly more than most people.

Also to the reader's question yes, some combo of sector funds makes a lot of sense for a lot of people for a lot reasons. This doesn't have to mean just ten ETFs (one for each sector) but for a larger sector like maybe energy or tech more than one fund (targeting different segments, or a core and explore idea) and for a small sector like utilities perhaps one fund would suffice.

A do-it-yourselfer might be somewhat comfortable for whatever reason with stock selection in four sectors and go with ETFs in the other six. Another framing might be one stock and one ETF for each sector.

Ok, so you get the idea. The important thing with this is figuring out what you can and cannot do. An investor would not be better off doing anything but what they can understand, can live with and plays into their level of time and interest. Any, and I mean any, approach can work. There was an odd comment yesterday or the day before where the reader said the only way to beat the market is... which is of course ridiculous. I am quite sure he has success with his way but as I have said before there are people having legitimate success with every strategy you have ever heard of. That is not to say that you or I would have success with any strategy just that anything can work.

A big part of what I do is figure out what to avoid. It is not relatively time consuming and makes the rest of the task much easier. This is probably not unique to top down investors, not terribly precise but still may not work for you. Time is very well spent figuring out the best way for you to manage your own portfolio. If you chose to hire someone then it is worthwhile to make sure you really understand what the manager is trying to do and make sure you can live with it.
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A Reader Asks, I Answer

An exchange I had with a reader in the comments from Monday's post:

Reader:

You said,
"...if some industry, for example semiconductors, collectively goes down 30% for some reason it is very unlikely that the typical investor will pick the one that somehow goes up."

So why doesn't that reasoning apply to countries? For example, there are 45 countries in the MSCI ACWI. If the market collectively goes down 30% for some reason, isn't it very unlikely that the typical investor will pick the one country that somehow goes up?

My reply:

I addressed that many times before and then during the crisis.

My belief going in was that countries with different fundamental attributes (like commodity based) might be on different economic cycles which might mean they are on different stock market cycles such that there is some zig when the US zags. Also a fundamentally healthier country than the US might also only have a more cyclical event as opposed to secular.

Whether it was by luck or otherwise this is what happened and it happened with the countries I talked about before the crisis.

Brazil and Norway kept going up until June 2008 and Chile only endured a normal cyclical decline dropping a little over 30% as the US was going down 56% and Chile has since gone on to a new high.

I also wrote often about not expecting much real diversification from countries most similar to the US like Big Western Europe.

The work that lead me to these conclusions was far from complicated and involves a fair bit of common sense.

A reader (maybe you, I don't remember) was critical of my taking too simple of an approach to financials but to the extent a lot of the top down stuff I do relies on common sense means that it is doable for the typical investor.

I would add that this does not guarantee any sort of success but there is logic to be applied that has worked before. A country that is fundamentally healthy stands a far better chance for offering "normal" equity returns over some reasonably long period of time with the previous decade as exhibit A.

There is a lot of discussion right now about the extent to which correlations have gone up recently (here and here) but these are very short term observations. A hedge fund manager or the like probably does need to worry about these issues but you managing your own portfolio who presumably cares most about having enough money when you need it do not need to worry about short term correlation issues.
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ETF Innovation Goes Mainstream (sort of)

ETF Trends posted a recap of research from S&P that concludes that certain single country ETFs can be used as proxies for sectors. The examples shared in the ETF Trends post were iShares Canada (EWC) and iShares UK (EWU)--you can look at the funds for yourself to decide whether those particular ETFs are proxies for anything.

One S&P researcher noted that “We think a creative alternative to investing in industry sectors is through country ETF securities. We think this is a way to gain a higher percentage exposure to specific industries or sectors that an investor may favor.”

This is noteworthy for several reasons. The first thing I would point out is that this is something I have been writing about for many years. A big factor in portfolio success over the last ten years (more importantly this will continue into the future) has been the use of narrow based products (specialty funds and individual stocks). The way I've targeted this is building portfolios at the sector level choosing whatever product (or more than one product) I thought made for the best way to capture each sector. The secondary consideration is how to embed themes and countries into the portfolio.

As one example of this, I've mentioned using Vale (VALE) as a proxy for both Brazil and the materials sector.

The IndexIQ Canada Small Cap ETF (CNDA) is about 72% weighted to resource stocks. I would say that this would make CNDA a proxy for natural resources. Over time it may or may not prove out as being a desirable proxy based on return, volatility, maybe yield or a couple of other things that an end user might care about.

The bigger opportunity I see here is that if S&P can finally clue in to the potential application in this context then it may lead to more useful products from fund providers. I saw where iShares filed for six Asian ETFs but it looks like most of them will be broad based funds. That misses the mark. A new broad based fund might be incrementally better than an existing one but won't offer a meaningful improvement. The smaller ETF providers understand this and the bigger ETF providers do offer funds with utility to be sure the referenced filing from iShares is more a waste of time and resources but I think the bigger companies will also head in the direction of more specialized funds which gives do-it-yourselfers who do not want to keep track of 40 individual stocks a better chance for portfolio success.

Congrats to Tim Wakefield for getting win number 200 last night.
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Tuesday Twofer

The chart is a YTD look at the Financial Sector SPDR (XLF) and several European banks. The declines are truly eye popping.

Anyone who is a market participant knows something of what has been going on with US and European financials. The level of knowledge/interest varies but everyone knows there is serious trouble.

This of course leaves many wondering what do about financial stocks in their portfolio, this question is asked dozens of times a day on stock market television and in print. There has been an unprecedented parade of writedowns, crises and questions of simple viability--and if not unprecedented then certainly the vast majority of us have not navigated these waters before.

So what is the answer? What should be done? This question is asked continually (repeated for emphasis) and there aren't too many answers. To steal a line from the very funny show Pardon The Interruption; a special Random Roger Investigation has revealed that the fundamentals for US and European banks stink. They stunk a year ago. The stunk two years ago. They stunk in 2008. They started deteriorating several years before then. Not only that, they are going to stink for several years to come, if not many years.

How do we know they will stink for a long time? Well one clue is the guessing about what all these sovereign defaults that might mean to these banks. How bad is it going to be is a pretty good tell that we are a long way from healthy.

As I have said all along there will be great trades to be had but they will not be good investments for quite a while. A great way to smooth out the ride for a diversified portfolio is figuring out what to avoid and (repeated from many past posts) figuring what to avoid is easier than figuring what to own but it also helps with figuring what to own. I cannot rule out good luck with having figured this out with financials but it has made my job much easier during the ongoing economic/financial event we are still enduring. Ditto, avoiding Japan.

On an unrelated note, a few weeks ago I mentioned that our refrigerator was slowly dying and that we would need a new one soon. Well the patient's condition deteriorated rapidly this weekend so Joellyn hit up the stores on Sunday, bought a new one and it came early Monday morning.

When we were in the tire kicking stage (before things got desperate) one of the sales people told my wife that refrigerators only last six or seven years now. While I take that with a huge grain of salt, it could be true. If it is true then it creates a serious, and relatively frequent, one-off expense. The nature of our doorway and ramp into our cabin is such that we cannot buy a refrigerator that exceeds 20 cubic feet (19.7 is the actual number) so we are not spending a lot (I don't think) on a relative basis. Including the undercoating, I mean extended warranty, it was $1540.

Consider a retired couple in the enviable position of a $5000 monthly lifestyle with $2000 coming from social security and $3000 coming from a $857,000 portfolio (that number assumes a 4.2% withdrawal rate not 4.0%). Obviously one-offs come along every now and then (just about every month as we've talked about before) but $1500 (or more) for a new refrigerator this month, $2000 next month on a transmission for the car, $1200 the month after for some sort of plumbing catastrophe, a $600 veterinary bill one month later and this seemingly enviable retirement situation looks a little shaky.

This stands to turn a lot of plans upside down but I don't think gets enough attention which is why I've written about it so often. There are many ways to address the issue. For some it might mean getting the planned withdrawal rate down to 3%, for others it might mean padding the monthly budget by some dollar figure, yet another answer for some will be continuing to work part time (hopefully something you love and would otherwise do for free), a combo of those three or something altogether different.
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Diversification Evolves?

Jason Zweig had a column up over the weekend that included the following observation;

It thus takes roughly 40 large stocks today to equal the diversification benefit investors got from just 20 stocks in the early 1990s, warns Mr. Sullivan of the Financial Analysts Journal. Anyone who doesn't use index funds should be aware that portfolios of only a handful of stocks are more prone to sharp fluctuations than ever.

It appears that the conclusion above is tied to the proliferation of index funds buying and selling many different stocks at a time but the work behind coming up with 40 being the new 20 was not disclosed and so I cannot vouch for it--based on the article it might simply be an assumption of some sort.

Regardless of the accuracy of the numbers cited the idea is fascinating; does it really take many more holdings today to create diversification than it did 20 years ago and if so how many more stocks does it really require?

This concept is more about the evolution of portfolio construction and markets more than anything else IMO. Top down analysis says the most important decision is whether to be in or out of the market. More practically this means whether to be defensive or not as getting completely out has some logistical issues (taxes, commission drag) along with strategic issues too (what if you're wrong?).

A point about top down analysis I have made several times in the past is that if some industry, for example semiconductors, collectively goes down 30% for some reason it is very unlikely that the typical investor will pick the one that somehow goes up. It is possible to pick the one that goes up but it is not probable.

So in a decade where US markets went down, an overly US-centric portfolio appears to not have much diversification as most of the holdings probably went down but there were no such worries in the 1990s, when everything goes up diversification, in hindsight, becomes less important (obviously this is a psychological issue).

Not isolated in the article is what type of diversification is being sought. A portfolio of 20 holdings each targeted at 5% is not taking unreasonable single stock risk--US financial companies in 2008 notwithstanding the road to $0 is rare and when it happens there is usually plenty of time to see trouble (even if there is no expectation of zero) and get out before $0.

Considering the above, then the issue is correlation and this is mentioned in the article however I would go back to the idea of evolution and point out for the umpteenth time that while the US was going down 24% on a price basis there were plenty of markets that had normal returns and other markets where returns were better than normal. Anyone who has been reading this site for even a little while knows the countries I mean in this context, and anyone reading this site from back in 2004 when I started blogging knows how simple most of the macro analysis was for these places.

I'd love to portray this has having been very complicated and sophisticated but it wasn't. Chances are that if the benchmark index in some country goes up 100% in ten years (that is enough to get the job done) then many of the larger constituents in that index are going to be up about the same amount. Picking a few countries correctly and correctly avoiding a few and pretty soon you've got a return that is close to normal and could be done with 20 holdings.

As it happens, I don't think 20 is ideal for accounts above a certain dollar amount. I've targeted in the mid 30s for a while now but that is just me; 20 may be great for you or you might want 50 or 60. I would submit that what has changed is not the number of stocks needed for diversification but where you go for diversification and when you take protective action in the portfolio.

We had two more lightning caused tree fires over the weekend. We had much shorter hikes this time ( a couple of weeks ago we hiked for two and a half hours to get to a fire). Nine of us responded on Saturday and five on Sunday which are both very good turnouts. I started out as incident commander for both and ceded to the Forest Service when they arrived, both were on Forest Service land.
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Sunday Morning Coffee

The other day Bloomberg did a lengthy profile on Anthony Scaramucci and Felix Salmon immediately took a chainsaw to Scaramucci in a scathing retort of sorts. How scathing? Well Felix' post was titled Anthony Scaramucci's Sleazy Sales Pitch.

Scaramucci has been a regular on CNBC at times for running a shop called SkyBridge which is a fund of hedge funds. Among other things he puts on the SALT Conference that CNBC broadcasted from this year, he also paid for a cameo in the movie Wall Street 2 and oddly was allowed to ask a question to President Obama at a town hall meeting that was televised by CNBC.

There were several things in the Bloomberg post about him that left me scratching my head to be sure and while I don't know enough about him to know whether he is the Antichrist that Felix makes him out to be I have written several times over the years that I don't understand why anyone adds this extra layer of fees to their investment plan. Obviously the fund of fund guys justify their segment of the industry somehow as they exist in the first place and have clients.

I'm a big fan of keeping things as simple as possible. Most of us simply need to have enough money when (if) we retire. We may or may not get succeed but most of us do not need to go out of our way to find more complicated expensive ways to try to get there.

The picture is from the Rupert Fire from earlier this summer; not too shabby for the camera in my phone.

Today is obviously the tenth anniversary of 9/11. We are all getting a lot of 9/11 coverage so I don't feel the need to add to it other than to say it is a day where more than remembering where we were and what we were doing at the time we probably remember the entire day.
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The Big Picture for the Week of September 11, 2011

As you know Bespoke Investment Group cranks up and distributes a tremendous amount of data on all sorts of things. One regular part of their rotation is monthly dividend screens--more of a data and information thing, I don't believe this includes a qualitative component but I might be wrong about that.

I spent a lot of time going through the list, looking at companies I don't know because you never know where a new idea can come from. In addition to names on their list, when you plug a new name into Yahoo Finance and/or Google Finance you also find competitors including some foreign names which again--you never know where a new idea can come from. The other bit of utility here is that sometimes a stock you have an interest in, but lose track of, might pop up for having an unusually high yield. If you decide you believe the yield is sustainable and already know most of the story then you're not starting from scratch.

I saw one name on there that I knew to have a dividend that could not possibly be sustainable; turns out it has been cut. And from the what the what?-file Garmin (GRMN) was on there yielding almost 5%. The PE is about 10, no debt, more than $7 per share in cash, the dividend is very well covered--when did all that happen? I'm not a buyer of the name despite some good stats as smart phones have GPSs in them and I'm pretty sure Garmin is not participating there or I'd expect the estimates for earnings growth to be more robust. Still I gave the name a little bit of a once over and it was worth the time even if I am not a buyer and if someone knows otherwise about GPS devices embedded in smart phones then I would more interested in the name.

There was also a circuit board maker on there with more than a 5% yield and another odd one was Douglas Dynamics (PLOW) which as you can tell from the symbol makes plow blades and other winter equipment. PLOW yields a little less than 6%, the coverage of the dividend is only decent it has a little more debt than you might like to see but there is a clear an obvious need for the equipment, the business will be easier to understand for most folks than a circuit board company and in the face of a "bad" winter I would think the stock would go up a lot.

Both Garmin and PLOW could go on to be lousy holds or great holds but the stories and the numbers were very interesting and in looking through the list (it was very long) there were many other interesting names. For an investor willing to use individual stocks there would no doubt be a name or two compelling enough to buy for anyone spending the time.

A couple of weeks ago I wrote an article for theStreet.com about pairing a high yielding stock with an ETF for each sector as a way capture some meaningful yield, not take single stock risk throughout the entire portfolio, still capture plenty of themes and disparate country exposure and not put all your eggs on one strategy basket. The above offers a pretty good way to do the necessary research for such a concept; the dividend portion anyway.

One funny tweet that Howard Lindzon retweeted (I would link to the original but the user name in Howard's tweet was somehow incorrect): if u r long financial's pls delete your stocktwits act & wire your money to that Nigerian prince who emailed u $$.

That is funny.

One other item that I don't do too often but a brief review of the movie Hanna which just started showing this week on PerPerView on Directv (so it is probably on all the cable systems too). This is the one about the young girl who is trained like an elite, and I mean elite, soldier.

The action was great and the premise was just so odd that we really enjoyed it. The movie however seemed to be poorly structured (or edited) as there were things introduced into the movie that were never explained or resolved. Without giving anything away there were all sorts of things about the Marissa character that they never came back to and they never told us what became of the family--unless we missed it and someone who also saw the movie wants to fill me in. It is still very much worth watching and again, we really enjoyed it.
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It Won't Get Easier

Both the WSJ and Reuters has articles yesterday telling why baby boomers are in trouble financially and even sadder was that the articles were about two different things (sort of). The WSJ wrote about boomers having too much debt and not being able to contribute to their savings at a time when they should have their highest income and savings rate. Reuters wrote about fear becoming a self fulfilling profecy and the extent to which fear is keeping boomers under-invested in stocks.

One thing captured in the WSJ article and something I can attest to on an anecdotal basis is that more and more people nearing the traditional retirement age still have plenty of mortgage left to pay. A married couple who'd been here close to 20 years just had to move out over the weekend after getting foreclosed on and while I don't know it would seem they got in trouble with mortgage equity extractions.

One bit of reality that people are go to have to come to terms with is that nothing related to retirement is going to start getting easier. Anyone who is now facing some trouble as a consequence for living beyond their means (as a function of taking on too much consumer debt) is going to have to face that issue head on one way or another. This might mean paying it, defaulting on it or something else but whatever the case the excessive spending will then (hopefully) have to end.

Navigating stock market cycles for people with investment portfolios is not going to get any easier. One of the pillars of this site has been that the same old same old that worked in the 80s and 90s stopped working a long time ago and I would add is not likely to come back.

People certainly might have more trepidation about investing in equity markets but that is where the growth is even if we are not talking about the US market. Avoiding equities is simply a matter of a tradeoff. If you can't live with the volatility that sometimes goes with owning stocks then you need to make up for it elsewhere (saving, spending less, working longer or a combo of all three).

The government is not going to make it any easier as the debate is on just how unhealthy social security and medicare are. Hopefully no one thinks all is perfectly fine with the programs but there are divergent opinions about how much trouble it is or is not in. I've said many times I expect to get nothing.

As I have said many times this is a challenge for each of us to solve for ourselves--at least I believe the people who view it this way will have a much better chance of having financial success. One of the people quoted in the WSJ was "not quite 50" and had been hoping to retire by 55 but now feels he cannot. I've seen one or two comments from friends from highschool on Facebook about looking forward to retirement.

On a philosophical level I view this as wishing your life away as opposed to focusing on the journey. Also part of my belief system is that some sort of work late into life provides a reason to get up, keeps people engaged, keeps them challenged mentally, keeps them at least a little active and might bring in a little income. I've mentioned my father here every so often. He is 85 and does a bunch of little things that keep him hopping including "helping" people near where he lives with little business ideas they have going. The reason I put helping in quotes is that this is how he has referred to it for the last I don't know how many years but it turns out he gets paid for these gigs, which I did not know until his last visit here a few months ago.

The example of my father checks off all the boxes as does the example of my neighbor with the backhoe whom I've mentioned dozens of times. This is work they each enjoying doing regardless of the pay. Thinking of it in terms of pre-retirement income is the wrong context; the income derived is a part of their individual solutions.

This is a tie in to a point I've made many times about figuring out how to get paid for doing something you love and would otherwise do for free. Too many people confine their thinking of post-retirement work as being forced to do something they think is dreadful (many commenters have mentioned things like being the Walmart greeter) which is not what I have in mind with these posts.

This sort of willingness to innovate will come easier to people who generally like problem solving and planning and will come all the easier to people who not only like problem solving but who also have a little self discipline with their spending and saving.

Pity parties and lament is the wrong combination to bring to the table. This will take planning and a positive attitude.

The picture is of what turned out to be not a serious collision in a practice lap at the recent Indycar race in Baltimore. You can click here for the video but essentially Tony Kanaan's car got airborne and his left wheels got very close to Helio Castroneves' head.
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Another Reason To Avoid Financials

Nassim Taleb and Mark Spitznagel had an article up at CNN offering a different perspective on avoiding bank stocks. The starting point was the reasonably familiar notion that the banks have mostly been bad actors in terms of the risks they've taken, the benefit gleaned by certain bank employees and the bailing out of the banks when the risks blew up on them.

This has been a part of the equation that has made them fundamentally unattractive for so long. I know some think they are fundamentally attractive but the above argument is not new.

The interesting twist that Taleb and Spitznagel take is that investment advisors are violating their fiduciary obligation by investing in companies that so reward employees at these companies that give little to nothing to society (paraphrase). This is an interesting idea to the extent these companies exist to enrich themselves (I'm not sure it is that cut and dried but many certainly believe it is).

They seem to imply that the market should favor the banks, on a relative basis, that take appropriate risks with the implication that this is not already what is happening which I found to be odd. Over the last five years Bank of America (BAC) is down 85% while Banco de Chile (BCH) is up 115% and Bancolombia (CIB) is up 131%. That would appear to be the market's way of sorting out the points made in the article. Obviously the market will occasionally misprice this sort of thing but I think a five year sampling is a form of weighing as opposed to voting.

The argument put forth by Taleb and Spitznagel, whether you agree with them or not, seems a little less solution oriented although there might be more work done in the running of the Universa Fund. I've had good luck in a couple of areas in this sector but given the nature of how fouled up so much of the sector is I think it is crucial that people with narrow based portfolios spend time on studying what to avoid here because most of it is going to be bad for a long time to come. I would also add that I think people with broad based portfolios should consider products that are relatively underweight the financial sector; these funds do exist.
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A Simple Reality

Governments and central banks in many countries have undertaken all sorts of policies and programs in an effort to stimulate both narrow and broad slices of the economy in terms of trying to help consumers and businesses. Some policies have also targeted asset prices.

There was certainly hope for these programs as they came out, and continue to come out but of course they have so far ranged from coming up short, to totally ineffective to having the opposite of the intended result occur. There are going to continue to be programs and policies foisted upon the markets and economy in an attempt to "fix it" but the simple reality is that these are likely to continue to fall short, be totally ineffective or have the opposite of the intended result.

It is certainly possible that some policy somewhere could actually help but I don't think it is prudent to build an investment thesis that relies on a government enacting an effective policy. This has been a slow moving train wreck that I've been writing about for a long time and it will continue to be a slow moving train wreck which creates the challenge for investors of figuring how to invest against a slow deterioration.

Many of the posts here have been about my idea on how to do this (select foreign countries and certain narrow themes) but of course there can be countless ways to have success as the US, Big Western Europe and Japan continue to flounder. If you have been reading this site for a while then you probably have already developed and implemented a couple of ideas along these lines.

I view the entire dilemma as a challenge that needs to be met with an individual solution (hopefully well reasoned) that makes sense for you. One type of solution might be along the lines that I write about (this might be extreme depending on how much time you can and are willing to put in), another type could be putting it all in the TrendPilot ETNs (this would be extreme for obvious reasons) that take defensive action for you or any other strategy you can be comfortable with.

Find your own solution is also true for a retirement strategy and more general life choices we make. In that light it makes no sense to lament how fouled up and unfair things are, instead make more productive use of your time by figuring out the right way for you to work around a new and simple reality.

Last night Twitter and Facebook were blowing up over what is going on in the second picture as Maryland played Miami in college football. Words don't quite do it justice, Maryland's uniform looked like two different uniforms sewed together. Truly an abomination. I wonder if Under Armour is a short on this development?

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Sunday Morning Coffee

John Hempton;

I think what is going on here is a general problem. When someone says something - anything - that is so far from the consensus as to sound outrageous then they will be considered mad, and sometimes they will be considered mad even after they are proven right.

Louise Yamada in Barron's;

Preservation of capital is our prime concern. We would rather be out of the market wishing we were in than in the market wishing we were out.

The picture is of what is called the Grand Canyon of Yellowstone.



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The Big Picture for the Week of September 4, 2011

Earlier in the week someone tweeted a link to this article where a behavioral finance guy chopped down some of what the financial advising business is all about. I believe this can be useful to both financial advisors and do it yourselfers because do it yourselfers are also financial advisors, they simply cater to one client; themselves.

The first thing that Ariely (the behavioral finance guy who wrote the article) attacks is the notion of basing a financial plan on what percentage of pre-retirement income is desired. Ariely believes that the right way to come at this is what type of lifestyle does the person want in retirement? He says that by framing the question that way, that many people will conclude they need much more income post retirement than pre-retirement.

I've covered this before. A goal based on income has never made sense to me. Ariely's idea, as laid out in the article seems incomplete in that if you believe we are collectively financially illiterate then what type of lifestyle do you want will lead to a lot of time wasted targeting exotic and expensive trips, a $150,000 sedan, a $500,000 motorhome and so on.

The starting point should be expenses. Some expenses will go down and some will go up--some will go away altogether. My saying that such and such will be less is futile; we each have our own circumstance and what might go down for you might go up for someone else. Look at your expenses and figure out your own likely outcome. I say likely because at 50 or 55 you can't know with complete certainty what your expenses will be when you are 65 or 70. But you can have an idea what your budget will look like.

From there what pursuits will you devote time to and how much is that likely to cost? If your recreational interests requires things with motors in them then that is going to be somewhat expensive. If a big trip to someplace new (to you) and far from home is a regular part of your preferred routine then that will be expensive. If you do these things then you already have an understanding of the costs involved.

Ok, add it all up and what is the total? Now double the figure you used for health costs. Then inflate the whole thing by some margin of error that upon further reflection seems reasonable and now what is the total? Now divide that number by 0.04 which tells you how big the portfolio needs to be. This assumes the 4% rule so you can use a smaller or bigger number depending on how conservative or aggressive you are.

If the numbers work then you may only need to be on the lookout for changes or threats to your situation. If the numbers don't work then something needs to give (lifestyle, working longer, both). That all sounds reasonable (I think) but at no point touches on a percentage of salary. We all want what we want. We either can afford what we want or we can't. On that basis I think it is a simple equation. Human emotion and behavior is what complicates things.

The other item that Ariely attacks is asking clients to score their risk tolerance on a scale of 1-10. Most people will not have the correct answer until the market drops a lot. I've commented before about people learning after a large decline that they had too much in the wrong (for them) thing.

I think a step closer to usefulness could be quantifying what a large decline would actually do to your portfolio and to try to envision your reaction/emotional state. A portfolio that is $500,000 with a 65/35 split favoring equities might drop by $97,500 if the SPX drops by 30%. This assumes no defensive action, fully invested and merely tracking the market with a couple of broad index funds. Any value that might be added could make drop a little smaller but of course attempts to add value might not work.

Again this seems reasonable (I think) but it can be difficult to take this look in the mirror seriously as far more people say they can tolerate market volatility than can actually tolerate it when it does drop.

The key here is to remember what large declines feel like, the mood and fear they create--this is easier said than done as the 2008 decline scared the hell out of a lot of people despite something similar only a few years prior.

The above is what I would call common sense type things but not a substitute for real financial planning for people with a lot of moving parts in their financial lives. If you don't know whether your financial life has a lot of moving parts then you need to figure that out and either hire some help or learn how to do an adequate job on your own. Complicating factors include having a lot of money, a lot of real estate, large families, a lot of stock options from the company you work for, a successful small business that you own and the list goes on. There are solutions involving insurance products, tax planning, spending hierarchies and other things that I don't know much about, portfolio management is not financial planning. To steal a line from Mohamed El-Erian common sense and sound portfolio strategy are necessary but may not be sufficient to financial success.

The first picture is from the wolf versus bear series (humor attempt) and the wolf has a piece of the buffalo carcass and the second picture is of the arch at the entrance in Gardiner, MT.
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Does the US Need More QE?

This is a complicated question. There is a paradox of what should have been done before versus where the world is now. The first part of the equation is the extent to which poorly thought out policy has made things worse thus prolonging what the natural duration of the financial crisis would have otherwise been.

There is no way to know what would have happened if they'd have let banks fail and only bailed out depositors. What if the I-banks had been forced to take realistic haircuts on AIG instead of being made whole. What if the Fed had not lent so much to the banks? What if they had not executed all the various acronym programs.

I'm generally of the opinion there should have been less protection for the institutions (but again total protection for depositors), fewer desperate measures enacted by the government. My thoughts could easily be incorrect but regardless what anyone's version of should have is, we have only one reality which is what happened and what happened, among other things, is that the Fed bought a lot of US treasury debt which has become to be known as quantitative easing. They've actually done this under two different QE programs and both times it has come up short.

Regardless of whether QE should have been done, it was done at some expense and has not had the desired end result. This raises the question for which I have no answer; if there is no QE3 then were the first two simply a waste of time and money. Put another way, do we have to do QE3 (by that or any other name)? Then do we have to do another one until it finally sticks? Of course what then is the ultimate consequence?

The answer is not about anyone's philosophy it is about the fact that this is what has occurred up to this point (whether we like it or not) so based on what has been done, what makes the most sense. I was much closer to the tear the band aid off camp before but that was not our reality. Our reality was intrusion on markets on what appears to be an unprecedented scale. This intrusion cannot be undone, so in the face of that intrusion should there be more?

You may conclude no but the process that takes you to that answer must be different than how you would have answered the question three years ago.
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Hello Kazakhstan

I get a lot of spammy email from fund companies, management firms, firms offering trading solutions and more. I had one email come in earlier this week about investing in Kazakhstan. Kazakhstan is a country I've been trying to keep tabs on for many years and have mentioned it a few times on the blog. The country is obviously resource rich but appears to not be efficient in allocating capital due to corruption. Of course everything we might find about the country is likely to say things are improving on that point. Other than taking a trip there it will be difficult to suss this out, it would even be difficult to figure it out by going there. The country is still of interest and I can easily see investing there again at some point.  

The email in question shared news that many state owned companies will soon be sold into the market in a similar manner as many of the large Chinese companies, at least that is how I read it. Some companies mentioned were Air Astana, KEGOC which operates the electric grid, KazTransOil an oil pipeline company, KazTransGas a gas pipeline company, Kazmortransflot a shipping company, Samruk-Energo which generates power, Kazakhstan Temir Zholy a railroad operator and Kazatomprom a uranium miner. There are also a few materials companies that have been trading on other markets for a while with Kazakhmys (KZMYF) the one name most likely to be familiar. Kazakh Telecom appears to have a listing in France, but not on the US pinks, but it appears to have not traded since February. Kazmunaigas is also included in the announcement but it has shares trading on the AMEX; they've not done too well.

A few years ago we owned Petro Kazakhstan which was traded primarily in Canada but had an NYSE  listing. The company was taken over and is now part of Petrochina (PTR). 

This process is still a couple of years from starting (if not longer) and will play out over several years (if it ever starts) and the email gives the impression that Citigroup and UBS will be involved but I imagine that if this does happen there will be several other banks also involved. 


Regardless of the email's accuracy it is obvious that many countries that are not now easily accessed will be in the future including Kazakhstan. The big idea here is that Kazakhstan has stuff the world needs, it will become more efficient in delivery that stuff to the countries that need it and this will create prosperity in Kazakhstan. This should help Kazakh stocks, of course there is no guarantee, and I believe that someone has filed for an ETF for the country. 


Out and out fraud at one of these state run companies is not a realistic probability as the government has a vested stake and punishment of corrupt executives would be severe. I think a more realistic threat (but with an extremely low probability) would be some sort of of regime change whereby the government takes a company back and leaves shareholders with nothing. 


If you believe that the government having a finger in the pie would make for a poorly run company, then that would be a reason to avoid these stocks but does not necessarily make an argument for them going to zero. 


Obviously some will think even considering this type of holding would be crazy, obviously I don't. Success in the last decade required a willingness to own markets that previously would have been dismissed like Brazil or Norway. These countries are now not far fetched in the slightest (I don't think they are anyway). That same willingness will be required in this decade too but not by solely relying on last decade's countries.
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