Sunday Morning Coffee

John Hathaway, the manager of the Tocqueville
Gold Fund (TGLDX) had a take in Barron's on why gold can move higher that I don't recall hearing before. Perhaps people have been saying essentially the same thing but still I thought this was interesting.

He said "the disparity between the amount of paper that has been created since 1980 and the amount of gold that has been produced since then is just enormous." So we have had a much larger increase in the supply of money compared to the supply of gold. FWIW, Hathaway thinks gold can go quite a bit higher.

I have been writing about having gold exposure one way or another since I started this site, three years ago yesterday by the way. The idea that it can zig when stocks zag has been tested a little bit of late. I own several things in the mix that I think/hope provide offset to domestic stocks. When the market is roaring I would expect gold to lag but sometimes, like the month just ending, gold does even better than stocks.

Maybe a way to think of it is that gold may not a great hedge for market events but could offer a lot more protection against an external shock like a terror attack. If that line of thought makes sense to you then it may be possible that there will be long periods of time where it does very little as was the case from February of this year until August. Personally I do not think this is a bad thing but some folks will not be patient enough to endure sideways action for that long.

I am no gold bug but I do believe that a diversified portfolio needs to include exposure to something that gets mined or to a company that does mining. The theme has been a huge contributor to gains in the last few years and I think will continue to be very important for the next several years.

A reader asked what currencies I think will rise the most against the dollar and how to invest in them. The thing behind the thing for my currency exposure is not to game the forex market. I believe in foreign exposure to stocks, bonds and cash. The best diversification would probably a currency from either a surplus economy or a commodity based economy. Rydex has eight single country currency ETFs and iShares has three ETNs. Beyond those it gets difficult to access single countries. I use short term government bonds from Norway, but not for everyone, as a proxy for the krone. The minimum buy is $100,000 which is easy if you are buying for a bunch of people, pretty tough for an individual.

Everbank has various products but I personally am not a fan of locking into a CD. I think you can buy $10,000 worth of many single currencies in an account without buying a CD but I do not know the particulars.

I Tivo the Saturday morning Fox shows so I can fast forward through the political commentary (if I wasn't black balled from their channel before I am now, eh?). On this week's Cashin' In I only watched Trapper's picks during the last two minutes and I got a chuckle when he picked the double short ETF that I use and have written about so often of late.

He actually called it a double short fund.

Also from Barron's Trader column, there was a short write up on Smithfield Foods (SFD), apparently the company is having a problem with "swine fever at some of its Romanian hog farms." How many Romanian hog farms do they have? I'm not sure why that cracks me up but it does.

If you have been reading blogs for a while you might recall the blog called Inventing Money, written anonymously by Slash, which as been on hiatus for quite a while. Well he back posting again, stop on by and check it out.

The picture is from New Zealand. They may not quite have their current account where they want it but they are not wanting for scenery.

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The Big Picture For The Week Of September 30, 2007

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Twisting By Bill Poole

Bill Poole just threw a wrench in the works and knocked the market down as he tried to dampen expectations for a rate cut.

As I write this the market snapped back a hair off it low and while the reaction was swift it was not that big--unless the other shoe drops in the last few minutes.

I am torn between the goal of staving off recession and my concern that the dollar decline could move a little faster than the market can handle comfortably.

No answers here just a little conundrum to close out the quarter.
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Reader Question

A long question came in about when to undo a defensive strategy. The reader joked that "I'm right, until I'm wrong" may not be the best plan. Click here to read the whole comment.

I can only try to answer this from the context of how I get defensive, what I have done before to get less defensive and to point out that I have no expectation of being exactly right with what I do. Some of this will also be discussed in this weeks video.

The first thing to mention is that I say at every turn that I do not make big bets. In getting defensive I start small so that if the sentiment gets whipsawed the portfolio won't. Earlier this summer I sold one stock and added about 1.5% to the double short fund with the willingness to do more if the market had deteriorated any further. Last summer I did something similar and my lead versus the benchmark unwound, this year it appears to have increased (details to come in the video) due, I believe, to the snap back in certain parts of the market.

With all of the action that transpired this summer I took very minimal action. The focus was to be disciplined to my defensive strategy while at the same time realizing that the market was in a fast panic and dumping a lot of stock into it, as some readers commented that they had done, would be the wrong trade. I commented countless times this summer that it was a fast decline and that fast declines snap back quickly.

Last year as I held the double short fund and the market snapped back the double short fund got smaller and the rest of the portfolio got bigger so in a way the position reduced itself and along the way, but I did wait a little too long before adding a couple of new names into the portfolio. The decision to add was probably more gut than anything else, so not very scientific.

The result for all of last year was about even with the market while sitting on a lot of cash and a little double short. What I said on the blog then, and this is a cornerstone to my ideas about how manage money and I have written many times, is to not let being wrong bring down your portfolio. I wrote going into last years double short purchase and after the fact the lagging a huge rally is nowhere near as bad as missing one. I lagged for a while to be sure but did not miss it.

It appears as though I am not lagging the current snap back. Going forward, I have talked about adding a financial name when the yield curve normalizes and I also have a couple of other stocks I have learned and will probably buy soon as a way of deploying the above average cash position I have disclosed having.

If this summer had devolved into down a lot, and I should say no matter what emotion you might have felt we were nowhere close to down a lot, getting un-defensive would occur when the market takes back the 200 DMA. This time around the market was down a little and the breach of the 200 DMA was short lived. I don't have an exact answer to Rick's question because the way things have played out, my not making large bets, I have not needed to have one.

I am mostly in, have been mostly in, and have more names to buy but am not sure when I will buy. The action taken this summer has left me underweight volatility and consistent with my opinion that we are very close to the end of the cycle this is where I want to be for now.

In conclusion there is some objective market indicators at work, a belief in moderation and a big picture opinion of what I think is going on. In terms of portfolio execution it has been right so far. It could start being wrong at any time. As I mentioned yesterday, and many times last summer, if the market explodes higher and I leave a few percentage points on the table being cautious (so lagging not missing) I would be thrilled.

I realize not everyone will like the answer but that's what I have.
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PoTAYto PoTAHto

I used that title once before.

A reader commented that he was 80% equities, 20% cash and referred to himself as bullish. I replied that I was similarly allocated but would describe myself as leaning bearish.

I have commented once or twice that that labels such as these, while convenient, tend to be a waste of time. You save and invest for some purpose. You need to stay relatively close to some benchmark over longer periods of time and if you can successfully navigate one down a lot market you will add tremendous value to your long term results.

The media's quest to label any dip, do you think this is a correction or a more serious bear market, is a huge waste of time. A few weeks ago a reader left a series of comments that were "bearish" in nature. His point of view made sense but I perceived a desire and a priority on his part to be right.

This is a much different mind set than what I think is an easier path for making your way through the market. Anyone participating in the capital markets for any length of time is going to be wrong about a lot of things. I view the task of managing money, whether it is yours or someone else, as capturing most of what the market does (a little better sometimes and a little worse other times) over time, not seeking a moral victory for occasionally making a prescient market call.

The types of things I write about are actually about not having to be right in order to have success. Before you get too caught up in big macro calls, the market has an up year 72% of the time. That fact puts the wind in a lot of our sails and does a lot of work for everyone who goes long.

A lot of things can distract us from what we are really trying to do. Personally, I want to have enough money accumulated for when I need it. That's it. I don't remember whether my account beat the market or lagged it in, say, 2003. In a couple of years my result for 2007, personally and for clients, won't matter. The couple of big-ish macro calls I have been right on before don't matter now and neither do the big-ish macro calls I have been wrong about.

My goal for clients is similar to my personal goal with the added hope that I can smooth out the ride for them as market conditions dictate.

If you are going to manage your own money I think you really need to know what you are saving and investing for. If you need to smooth out your own ride (not everyone does) you better learn how to do it.

A short term goal is fine of course but most people are investing for something that is long term. Over the long term you are going to be wrong about many things. You only need to be right a little more often than you are wrong and not allow the things you get wrong take you down, that is to say (repeat really) don't make big bets.
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A Question About Selling

A reader emailed me in my Street.com account lamenting that he has a habit of selling stocks too early and he gave two examples of nice trades but with a lot left on the table.

First thing would be that regardless of your strategy you will not top tick too many stocks on the way out, it just isn't realistic so you have to deal with that sufficiently so that you don't second guess everything you do. This reader is much more of a trader than I am but it seems to me that if you are interested in short time periods for holding a stock you probably should define an exit point above and below the entry price and then stick to it. If you set an upside target of 20% for two months and you get it, I think you just need to it take, be happy, and move on.

It is possible this person is not a trader but gets shaken out when he gets a big move that goes his way. If so then this person needs to change something but I am not sure what. Maybe when they get the urge to sell in this scenario they should only sell half. The two examples he gave do not lend themselves to stop orders very well, IMO, but that could be an option too.

Realistically over a lengthy time period (maybe not that lengthy) most investors would look back at hopefully a lot stock picks that have done fairly well, some that probably have not done much of anything and few that for one reason or another are down. Some could be down because they are counter strategies of some sort, some could be good holds but in the wrong sector and some could be down for the simple fact you got it wrong.

Having stocks that are down for any of these three reasons is normal. If you have too many that are down there might be a problem. The problem could be stock selection but it also could be the result of big bets in the wrong part of the market. For example anyone who has made a big bet on discretionary stocks this year is probably struggling versus the market.

People get hung up when something goes down which I think is a focus on the wrong thing. If a portfolio has a 10% return in a year, some stocks will do better than the 10% and some will lag. You can't know ahead of time which will be the one that goes up 50% which why a diversified portfolio is a relatively easy path.
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Tuesday Tidbits

You probably read that there is a chance that Fannie and Freddie will be allowed to up their respective antes in the not so distant future.

This is a watch out situation in the making. Depending on how (and of course if) it is done it sets up for unintended consequences. If policies and procedures are antiquated I am all for making changes but this seems like a reaction to a crisis which would end up catering too much to the things that caused the crisis as opposed to long term changes that could generally make the agencies better/more relevant/more able to fulfill their primary mandate.

From the good doctor, Hussman that is...

Investors will likely be reminded of how the market has historically performed following two consecutive cuts in the Discount Rate. We've observed 11 instances of this since 1950, with average total returns in the S&P 500 of 6.18% over the following 3 months, 12.48% over the following 6 months, and 21.05% over the following year. The difficulty with these averages is that the cuts almost invariably occurred well into bear markets, where valuations were already depressed.

Rate cuts strikes me as the sort of thing that is subject spin and data mining. Also it is the type of truism (rate cuts=higher equity prices) that can do the opposite of what it "should." If this snapback ends up being a 30% rally over the course of the next year I'd be thrilled to leave 3 or 4% of that on the table being cautious.

Lastly some of the big bad immediate threats to the market seem to have come and gone without real incident. The First Data deal looks like it is going to happen and commercial paper seems to be rolling, for the most part.

One of the biggies still floating out there is the impact of the mortgage resets that have been underway for a while and will be getting bigger every month for the next few months before they start to get smaller again.

The commercial paper thing turned out to be much smaller than some feared and I believe the mortgage reset issue will also be much smaller. It could cause problems but the sky will not fall. The likely worst case scenario is something well within historical norms that will soon be forgotten, like the early 1990s recession.

Stock prices cut in half (or worse) during the great depression, the 1970s and at the start of this decade. I believe there were earlier instances but my knowledge of history only knows when a couple of the older bad times were (the first decade of the 20th century, the 1870s and the 1830s I believe) not the magnitude of them.

It just doesn't happen that often. The reason for this, I believe, is behavioral. Most investors today know the fear of a market cutting in half because it just happened. Enough time needs to pass so that new participants who did not experience a 50% dive first hand can make the same mistakes (albeit with slightly different details) than past generations made.
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Get A Dog

Ben Stein often mentions getting a dog, he is exactly right.

Anyhoo a reader left a question yesterday about volatility of broad-based ETFs. He has observed that they seem to be as volatile as individual stocks. He likes the idea of reducing volatility but maybe is unsure whether ETFs actually do reduce volatility.

I don't think I agree with the general nature of his sentiment that broad-based products are as volatile as he thinks but that is his perception so it becomes his reality.

Obviously there are some stocks that are less volatile than the index to which they belong and also this summer has generally been more volatile than most of the last few years.

That fairly obvious answer aside the question drifts into portfolio construction. I write a lot about increasing or reducing volatility, I am talking about the entire portfolio not the individual components. I do not know the mindset of the person leaving the question but it is common for people to focus on the volatility of the individual holdings as opposed to the volatility of the overall portfolio.

Most of the accounts I manage have 40-45 holdings. There are two reasons why they will not all go up all the time. One reason is that if the do all go up together I would expect they will all go down together (the context here is weeks not on a given day). Secondly, if you buy 40 stocks it is not realistic to expect you will be right about all 40.

The sooner you can recognize an actual mistake and get rid of it the better but not every stock that goes down is a mistake. Back to financials; I expected the group to lag for reasons I have spelled out many times already. So this sector becomes a place to reduce volatility so maybe that means no small caps, no investment banks and no exchanges.

Not having those three sub-sectors allowed for less volatility than I might have otherwise had.

Materials is a sector that I have expected to do well and so adding some volatility seems like a reasonable idea, which is what I have done (this has been disclosed many times as well).

Believing we are close to the end of the cycle and that the chance for corrections is a little higher than normal I have taken steps to reduce the overall volatility even if some of the things I own are volatile. I have a little more cash than normal, I have favored dividends and I maintain a position in the double short fund. In addition to stock selection, these are tools to manage volatility.

The summer was a wild ride but the things outlined here (really what I have been writing about all summer) allowed clients to have a much smoother ride and luckily the places where I do have volatility have had a nice snapback effect (that I have also written about many times), I will detail performance in this weekend's video.

One of the reasons I specifically do not favor broad-based products is because of the fine tuning that is possible with narrower products. As TomK mentioned the other day not everyone has the time to construct a portfolio with so many moving parts--very fair point. An assumption I have made many times before is that the people who are inclined to seek out a blog for stock market commentary are generally more able/likely to spend enough time to come up with more than 80% SPY and 20% EFA.
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Sunday Morning Coffee

Reader BillB left a question about the notion of buying the best within a sector and forgetting about sector ETFs. He says he has heard many talking heads say this matter of factly but he doubts it is as easy as they say.

He further asks me if the stocks I hold are "the best" and do I compare stocks I use to their respective sectors to measure performance.

OK there's a lot here.

"The best" is for me an incomplete description. I think of it more in terms the best way to capture a desired effect or narrow theme. At different points in the cycle the best way to capture certain things will change. Using financials as an example I have disclosed being underweight and own foreign high yielding banks in an effort to reduce volatility in a sector I expect to struggle.

When the yield curve goes right side up the best way to build exposure will change. Adding volatility and more domestic exposure will make sense at that point, whenever it comes.

The market is always changing but it doesn't change so fast that you need major portfolio upheaval every quarter. As it changes slowly over time, the yield curve being a good example, portfolio changes need to be made.

I believe in top down portfolio construction which means that getting the sector right is more important than stock selection. Obviously this won't be the case 100% of the time but it is right often enough for me. So owning a sector ETF as a proxy for a sector (for those that construct their portfolios at the sector level) is not a bad idea. In terms of short term results it seems fairly obvious that at times a stock would be the better choice and at other times the ETF would be better.

There are some stocks that can be bought probably held forever. Anyone think buying an appropriate amount of Johnson & Johnson (client holding) is a reckless idea? It won't always be the best stock but over time it goes up and increases its dividend. There are other stocks like this. If you own a portfolio with a bunch of names like this you still need to pay attention as a couple of them will need to be sold at some point but most will not, I'm sure one time Dow component American Twine was a hold forever type of name.

However if all you own are "best of breed" you probably don't have a properly diversified portfolio. Being diversified has to include small cap, emerging market and perhaps a lottery ticket idea. Maybe this is where ETFs can come in.

As far as measuring performance at the sector level, I'm not sure I have a useful answer. I know what stocks are doing well or are struggling at any given time but struggling does not always mean the same thing. Going back to financials, only one bank that I own is making new highs. The rest, like most of the sector, are struggling. They've bounced some but this is a bad time for the sector. The important decision was made months ago; be underweight the sector.

If I owned an oil stock that was really lagging the sector (I don't, but there must be some) I might consider getting rid of that one. This has been a great few years for energy stocks. A stock that had not participated in that would seem to have something wrong even if I couldn't figure out the problem.

In reading emails and comments, meeting and talking to other money managers and the feedback we have received from clients I have come to learn that my approach to building and managing portfolios has a lot of subtleties embedded which can be difficult to articulate. The subject matter of this post might fall into the difficult to articulate category.

This picture is taken just north of Hilo, looking back toward Hilo.
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The Big Picture For The Week Of September 23, 2007

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One Way Trade

I have been a big believer in the weaker dollar theme (not sky is falling) for a while now. The selling seems to have intensified a little since the Fed cut on Tuesday. Tony Crescenzi from Miller Tabak was quoted saying the dollar's slide has been "rapid and disorderly."

I have a lot of oars in the water on this theme so I removed one by selling the Swedish Krona ETF (FXS), yesterday morning at just a hair above $153. I first bought it a year ago July in the $138s and we also took in a monthly dividend.

I didn't use a stop order because it seems like it moves around $2-$3 at a time pretty easily.

I still have foreign bonds, a foreign bond fund and some folks own the Australian dollar ETF (FXA) and of course the gold ETF.

The idea here is one of reducing exposure to an area that has done very well.

This type of pairing back is something I have done quite a few times in the past. The idea here is maintaining exposure but reducing after a big run that creates a lot of excitement but my opinion about the theme has not changed.

One final point about currency ETFs. I view them more as aggressive cash as opposed to conservative equity. A return in the mid teens is pretty big.

There are schools of thought about selling into strength or weakness. I tend to do a little of both. Some folks swear by one or the other but it seems to me that along with most things in investing, there is no one strategy that can always be best for every situation.
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Hey Now

I found an interesting post from Jim Wiandt in the IndexUniverse blog section about iShares MSCI EAFE Fund (EFA). He was at some sort of ETF conference and he remarked about the buzz created when Steven Schoenfeld said that EAFE was obsolete, and so by extension I take that to mean he thinks EFA is obsolete.

Um, I've kind of been saying the same thing for a couple of years now. The first instance I found in the archives of writing EFA was not a great way to capture foreign diversification was June 28, 2005. There have been many other instances here and once or twice for RealMoney.com. I doubt Jim reads my stuff and I further doubt Steven has ever heard of me but still...

More people have become aware of foreign investing in the last few years and I believe it will become more important as time goes on. But to paraphrase Nassim Teleb, diversification used to work when no one knew about it.

I have never been a fan of EFA, I have preferred stocks mostly or occasionally a country fund and I do use the Wisdom Tree International Energy Fund (DKA) for most clients. The problem as I see it with broad based products is that the benefits of most of the countries get blended away when lumped in with the huge weightings in Japan and the UK.

Certain individual countries, because of their economies, offer the chance for better diversification than others. To the extent there is a fund for a country like that, great, but you may need to be open to the idea of individual stocks as well.

Success in the future will depend on exploring new products and learning about new (to you) destinations. While understanding and accessing Botswana is outside the realm for most folks there countries that should be in the realm if you are going to manage your own portfolio.

Another aspect of this that I have written about a lot is, from the country level, understanding the differences between the various countries owned. A blend of different countries with different attributes provides a chance for diversification without getting crushed if some sort of event happens. For example owning a surplus country and a deficit country is probably a good idea. Or thought of a little differently a carry trade destination country and a funding destination. To be clear I am not saying limit to two countries but do want to point out some of the differences in countries.
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Welcome Back

Welcome back to SPX 1500.

During the decline I had several posts saying that it was a fast decline and that fast declines snap back by some measure before really doing anything else.

I said this was no different than other fast declines and it wasn't.

The point here is not a self back pat because there was no analysis. To repeat what I said before when you think it is different it isn't. Panics, which is what we had, behave the same way even if the magnitude and duration vary.

This is simply how it works.

There are only two outcomes on the table. Either the event is completely over or the market is giving you plenty of time to get out by rolling over slowly. I say slowly because we are down about 1.25% from the high about two months after the high was set.

I tend to lean bearish, but as I have chronicled many times I have not made any extreme bets and while I lagged the huge move yesterday I have participated nicely in the bounce off the bottom.

I am trying to convey a layer of simplicity that can embed into how you manage your portfolio. There was nothing new about anything in this episode and this type of episode will repeat over and over.

Thanks for all the kind words on the Hookie Lau post.
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Going To The Hookie Lau

There were several comments that came in yesterday about the devaluation of the dollar. I have been in the weak dollar camp for ages and still am but I do not buy into the sky is falling idea. We all know the types of things that should do well if the dollar weakens; foreign equities, commodities, foreign currency and foreign bonds.

If you have exposure to these areas and the sky does actually fall you give yourself the chance to offset that type of event. If you are a sky-is-falling person then maybe you need to own more of those things.

My take all along has been that issues raised by the Peter Schiffs of the world will create headwinds and slower growth not chaos. To be clear, exposure to the assets mentioned above mitigates the need to be correct.

A personal item.

Yesterday Joellyn and I closed escrow on a house we bought in Hilo, HI. Owning a house in Hawaii has been 13 years in the making and this summer everything lined up just right.

We are not moving there. For now the plan is to spend about two weeks there every quarter.

It's a three bedroom, two bath new construction with a detached garage on an acre just south of Hilo--Hawaiian Paradise Park for those who know the area.

We sneaked over there for a week in July to look for a place and now it is completed. Our first trip over will be in October. We have no plans to rent it out.

Hilo is a lot like Prescott. Not that many people, a college, Home Depot, Walmart and a lot of hiking trails. Its exactly our speed.

By the way we had no problem whatsoever with the mortgage process.
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Quote of the Day

I listened to it three times to try to be sure but I think Labor Secretary Elaine Chao just told Maria that August is always a "squirrelly kind of month."

Did anyone else hear that? Do I have it wrong?
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Shocking!

Maybe I shouldn't be, but I am shocked that the Fed went fifty on the Fed Funds rate.

Hopefully the tree is a metaphor for interest rates and not the economy (stagflation).

Wow, that one really caught me with my mouth open.
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Fed Day

A few weeks ago a client asked me if I thought the Fed would cut rates. I said I thought yes but I questioned what the consequences would be.

So it seems inevitable that we get a cut of 25 beeps in the Fed Funds rate while the market seems less certain about what will happen with the now relevant discount rate.

Although not an original thought I can't figure how the market can take any Fed outcome positively.

With a 25 basis point cut the Fed might be perceived as being behind the curve. With a 50 basis point cut they raise the question of just how bad is it. Of course as I say no positive reaction seems possible the market could race higher with a resolution to one of the big questions looming out there.

Another reason to think the market cannot rally is the answer we get today will of course raise many new questions, that is just how it works, nothing ever gets resolved.

More important than trying to guess the immediate reaction might be to look a little further down the road at what might be coming. Despite some well reasoned (or not) commentary to the contrary I don't think the dollar can rally off of an easing cycle, but I will concede that anything is possible in the first day or two.

All of what has happened thus far is about some sort of problem in the US that reveals a weakness of some sort. From a common sense stand point the stronger dollar case does not stand up for me.

Owning foreign anything for the last few years has created a nice tailwind which I think is likely to persist.

The longer term theme, even if how long is unclear, is the cutting will eventually lead to a normal yield curve which will change how a lot of bond portfolios are deployed, at least the ones I manage.
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Greenspan and 8%

In the all encompassing Greenspan blitz he made one comment that resonated with me which was that he could see the ten year treasury yielding 8% at some undefined point in time but I think he was talking over the next couple of years.

This is consistent with a point I have been making for a long time (here is one instance I mentioned it but there have been many others) which is that there is visibility for slightly higher rates resulting in a little slower growth and slightly lower equity returns over longer periods of time.

My thoughts were more like the ten year in the sixes but 8% is a number that falls with in the range of historically normal.

The investment impact would be that bonds become more attractive. I don't necessarily know that it means we should own more bonds so much as it become safer to extend maturities. For equities it probably means we need to learn more than we currently know about investing in foreign stocks.
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Barron's on Retirement

Barron's had an article about portfolio issues that potentially confront retirees that was a good read.

Included in the article was this table that gives an idea of what it takes to recover from declines of varying magnitudes.

Understanding the numbers is very important but the article overlooked one aspect of this that I have tried to address before which is the snapback.

Taking a volatile example, the iShares Emerging Market Fund (EEM) hit an intra-day high on July 23 at $144.10. At its low, on Aug 16 it went down to $111.41. It closed Friday at $137.17. At its worst it was down 22%. At the close Friday it was down 4.8%. Someone sold at that low tick in a panic.

This adds a layer of human behavior to the Barron's piece. Whatever is going on right now in the market, I doubt it is panic. Now that the panic is over, if this summer taught you that you have too much in emerging markets, for example, now would be the time to lighten up, now that the panic is over. Someone will add 1+1 to get eleven and think I am saying to sell emerging markets. I am not this is about personal tolerances for volatility.

The thing to keep in mind is that most declines are fast declines, the type that are better not to sell. I'll call 22% down in less than a month a fast decline.

The message here don't panic, don't make extreme moves all at once and just stick to whatever your long term defensive strategy is.

The other big point in the article was about what to do if the market takes a big hit right before or right after you plan to retire.

Two ideas that may not be popular, that were touched on in the article that I agree with; keep working and take less money out.

Keep working doesn't have to be stay in the current job you have it can mean find something that can relieve some of the burden off of your portfolio. If you need and can safely afford $5000 per month in retirement but can bring in $1000-$1500 doing something part time that you enjoy, hello! If this idea appeals to you it probably requires a couple of years of planning.

Take less money out is really about living within, or better yet, below your means. This is a very difficult concept. It touches nerves. If you were making $100,000 when you retired but have only saved $1 million you are not going to be able to live a $100,000 lifestyle. A $60,000 lifestyle is probably beyond your reach as well. You can see where that would touch a nerve but that is the cold hard truth.
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Sunday Morning Coffee

Barron's had a quick reference to the upcoming First Data buyout, the amount of financing needed and whether or not the deal would get done.

Rightly or wrongly some folks are placing a lot of importance on the deal as a proxy for accessing capital.

The Allison Transmission deal was completed last week with some concessions and that might have been viewed as a proxy for getting the First Data deal done.

The Allison deal required a tad of ingenuity to get done but it was done. The First Data deal may also require some fast thinking. It seems like there are some parallels to the UAL deal in 1989. For those who do not know an LBO of UAL fell through in October of 1989 which was a surprise to the market causing a one day 6.1% mini-crash on October 13. The market retraced that crash by January 2, 1990, a little less than three months later.

My hunch is that the First Data deal will get done but if not, the market has dealt with "important" deals falling through before. If it does not happen and if it is as important as some people think it could cause a something fast and nasty.

Something like this, even if this specific deal does go through, has the potential to blind side people.

The bigger threat here is access to capital. I wrote the other day that next week's rolling of commercial paper will not be the seminal event (obviously this is just my opinion) that some fear but this deal failing to happen becomes a symptom of a problem that would take a while to unfold, maybe it started unfolding in July, maybe it started in the spring when New Century went under. This sort of slow rolling over should be of more concern than any short term specific event.

If this has been a multi month rolling over it highlights a point I have made many times, but I am not the one to discover this; bear markets start slowly and give you plenty of time to get out.

Throughout the summer I have talked about the couple of tweaks I have made in keeping with my thoughts about how to get defensive and urged have readers not to get panicky. That is still the message.

The picture is from Sedona.
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The Big Picture For The Week Of September 16, 2007

About two and half minutes into the video I say the word outperform twice when I should have said underperform.
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Special Purpose

I read this news yesterday that options are being added for more volatility products; the new additions are for VXN (Nasdaq 100) and RVX (Russell 2000).

Every so often someone will leave a comment wishing for a VIX ETF. On the surface there seems to be some appeal, but as Adam Warner notes there are a lot of potential flaws with such a product.

We saw with the USO Oil product that not every ETF will work and something as complicated as an ETF to mimic VIX seems like one with a high likelihood to misfire but if it did work I might have an idea of how it could applied in a diversified portfolio, its special purpose so to speak.

I would imagine that this would be one of those funds that was 95% t-bills and 5% futures. In eyeballing any SPX/VIX comparison chart the two appear to have a very low correlation; PortfolioScience puts the three month number at -0.889 so almost a perfect negative correlation.

So is there room in a diversified portfolio for something with a negative correlation to stocks that yields 4-5%? Your answer to that question will determine your level of interest.

A notion I have touched on before is that if the US stock market is evolving to have more volatility and slightly lower returns then having a few different things with some yield that have little to do with the stock market (along with some foreign stocks, currencies and commodities) will make sense.

I would expect that most of the time it would bounce around pretty aggressively within various ranges and during times of panic, like we had this summer, it would go up a lot. I think that anytime it did panic higher it would need to be sold and then it would take patience before buying again.

There is a lot of fear that things are somehow going to be different. While I think that is unlikely, if things are going to be different something like a VIX ETF, should it ever come, could be a good fit in this context.
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Exports

This is a useful graphic from the WSJ.

The other day when I said if you are going manage your own money you should spend some money...WSJ and Barron's is a biggie to get.
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Patience

One aspect of investing that is crucial is patience. I think it is sort implied in some of the things covered here but I am not sure I have specifically written about being patient.

The best way to address this might be an example. For several years bond yields have been very low compared to historical norms.

In addition to low yields the market has not rewarded for going out further in time. With yields on the low side it makes little sense to take a yield for ten years when the same yield can be had for two years.

As this has been the case I have been writing about favoring short dated paper and as a function of spreads being narrow, not taking too much bond market risk.

At some point the curve will normalize, spreads will widen and I will have a different looking fixed income portion of the portfolio than I do now.

More specifically in the last couple of years there have been a couple of times where there have been spikes up in some yields. This was the case two years ago and I bought two year treasuries for a lot of people. Those just came due but now two year yields are very low (keep in mind I do not want to go further out) so the best thing to do is just wait.

Yields are low so prices are high. Buying high is usually not the best trade. Obviously I have exposure to some other fixed income products but for some parts of the market I am waiting, patiently.
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The Hype Machine

Here we see Mr. Peabody and Sherman about to crank up the hype machine for the rolling of commercial paper and adjustable rate mortgage resets.

I don't know if it is "Wall Street," the media, someone else, all of the above but the market often confronts scary events that cause people to get very worried and then these scary events end up being nothing, or close to it.

Going in, these are all "different" but they never are. In the summer of 2002 there was genuine panic because CEO were going to have to certify their earnings. Woooo, that was going to be a bad one. It really turned out to be more of a bottom than a top.

Just recently we had the options expensing thing. This was going to wreak havoc with earnings, hmmmm not so much. I wrote about that one in December 2004, about six months before it was due to start. That one seemed to have zero impact.

I am not sure how many people are paying attention to the commercial paper issue or the mortgage reset issue but neither will matter anywhere near as much as some people fear.

There will be impact here and there no doubt but my hunch is that neither will derail the markets. Invariably there will be a dissenting comment on this but we have seen this movie over and over. The terror caused by the earnings certification was so huge and it was a non event.

The thing that happens with these is that we start hearing about them months ahead of time and so the market prices it in, the surprise factor disappears; who doesn't know there are a ton of mortgage resets coming?

While I am not a 100% efficient market guy these sorts of things tend to have far less bite than bark.

My post yesterday was a bit of a rant about learning how the market works to help remove emotion. Well, this sort of thing is a perfect example. The fear ahead of time is always bigger than the actual thing despite the fact that they are all different.
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66?

Nicole Elliott, technical analyst from Mizuho whose opinion I respect, was just on CNBC Europe calling for the dollar index to hit 66 within the next nine months. Yikes.

She was correct in terms of magnitude about the yield of the ten year US treasury, but I do not recall if her timing was correct or not.

I drew in the thick pick-ish line on the chart, which is similar to what she put up during the interview.

I've been a dollar bear for a long time but this call exceeds my bearishness and if correct would cause a lot of dislocations.

That the chart looks horrible and that the Fed is going to embark on some sort of rate cutting cycle clears a path for more weakness even if 66 ends up being too far.

It makes sense to give a little thought to what you would do if her scenario plays out.
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Take A Step Back

A reader left this troubled comment;

My portfolio is taking a beating. I am about to say good bye to the equity markets for good.
So obviously a lot of emotion in that statement. The other day on the Consuelo Mack show a journalist had pictures of a human brain that "prove" humans are not wired for investing. His take is that emotions impede succeed.

The S&P 500 topped out at 1553.08 (on a closing basis) on July 19. The ride down to 1451 yesterday (not the low in the dip) works out to 6.5% and at 1451 the S&P is up 2.3% plus another 85 beeps for two dividends.

As explored last week some folks are down on the year against that backdrop. While my comments earlier on this were wrong I would ask how much this person is down, why he thinks that amount is such that he is considering giving up on stocks for good. I can't really relate very well to such an emotional response. While I am sorry he feels such anguish there is nothing that has happened this year that has not happened one way or another many times in the past.

The type of step back I am referring to in the title of the post is that constructing and managing does not have to be that complex. I would venture to say that a lot of people that are trailing the market by a significant amount this year are making it more complicated than it needs to be.

All of the rules of thumb I mention that I use in trying to manage money are all very simple, chapter one things. When the curve inverts underweight financials and then just wait until it normalizes. Late in the cycle underweight discretionary. Don't make big bets. These are things I have been writing about for three years now (three year anniversary on September 29) and I think people with some investing experience will recognize them as being incredibly elementary.

These are things that anyone can do.

What may not be so simple is managing emotion. I've tried to address this many times in the past, perhaps to no avail. First I would say that if you are going to manage your own portfolio you need to spend some f&*#ing money on some tools that will teach you how the stock market works. I don't know how many times I have said to buy a Stock Trader's Almanac (no compensation for saying so).

There is nothing that the market can do that it has not done before. Market behaviors repeat over and over. Even after cutting in half a few years ago the S&P 500 came back. The market came back from the crash, the next crash, stagflation, the Iraq war, the next Iraq war, the collapse of the Thai baht, the Bay of Pigs, a few other wars, the Mexican peso, Orange County and so on.

No matter what your fears and anxieties the market will do the same thing in the future. It will go up most of the time and every so often it will go down. Your emotion cannot change that. Ups and downs are metaphysical certitude so what is the point of being emotional? There is no point, that is the point.

To the extent you can add value when the market does go down, all the better.

To get to the point of no emotion took time and study. This is not to say that every decision I make is correct, I do get things wrong, but emotions do not complicate what I do.

The market is going to do what its going to do no matter what is going on in your life. Once you realize this, I mean really come to accept this, you can then move on to an easier time with managing your portfolio.
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What If?

A reader left the following;

Please talk about the deep recession or depression scenario.

As you say, a 100 depression is also "normal" and we are do but you seem to be too "emotional" to take this scenario seriously. It is a very, very real scenario everyone that built financial careers of the last 30 years is ignoring, seems like almost denial and I'd love to hear your macro analysis of that very possible and normal scenario?

I pasted the whole thing because there are parts of it I don't follow but as to the parts I do follow...

First I would say I am not sure why a depression is very possible. From a stock market standpoint down a lot would start out as down a little. So same as anything else have a strategy devised to take defensive action. I have spelled out mine countless times, so far I have tweaked the portfolio and am ready to take more action if the market devolves from here.

According to the Stock Trader's Almanac the Dow Industrials peaked at 381.17 on September 9, 1929. It bottomed on July 8, 1932 at 41.22--about a 90% hit. So that is probably the biggest fear out there, another 90% drop in the market. A couple of things to keep in mind is that the Dow was up 80% in 1933, almost 40% in 1935 but it fell 27% in 1937.

Although the market did not take 381 back until 1954 from the period between 1929-1954 inclusive there were 15 up years and 11 down years. This tells me that a repeat of the 1930s will have some chance for gains but even if you cannot catch any of those up years, discipline to a get-defensive plan could add tremendous long term value. This will make some people groan but down 40% in a down 80% world would be a colossal success.

Unemployment during the depression was, I believe around 25%. That was at a time when more people had manufacturing jobs. Now we have a lot of service jobs. Demand for a lot of services will not wain as much as the need to manufacture big heavy things made of metal.

There would be plenty of jobs lost and I also think people would face taking pay cuts to keep their jobs. So who does this hurt the most? My first thought is people who are over leveraged but this is always true. Regardless of what is going on a couple living beyond their means will be in deep trouble right away if one of them loses their job. If you have a low monthly budget you face an easier time covering the bills with replacement work.

I am not sure a depression and a 90% stock market decline is normal, and I apologize if I ever said it was but it has happened before could happen again at some point. I do not think it is a realistic possibility this decade but if happens it will take a long time to unfold, giving plenty of time to reduce exposure.

Things to own might include equities from countries in their own world, foreign currency and bonds from certain countries and some commodities.

As far as being emotionally complacent; I'm not sure how to answer that. Down a lot, whatever it becomes, starts with down a little; I preach about taking defensive action all the time. Not over extending yourself in life seems to me to be common sense even though many folks are too extended. I can only account for myself; when I first started managing money I had two clients and some savings that I did not want to spend. I spent my afternoons doing things like logging, putting on a roof and building a rock wall for money so I wouldn't have to spend the savings. Point being I was willing to do whatever it took.

If this person is right we may all have to have some sense of whatever it takes. I was not put off by doing it then I won't be in the future, if that is what it takes. To me this is what being enterprising, entrepreneurial and living the American dream is all about. Taking the bull by the horns and doing what needs to be done.

This post really offers no macro analysis because analyzing is it does not benefit my clients. What benefits them is staying disciplined to the defensive strategy I tell them we use and believe in and figuring out what to do if, I think the rest will take care of itself.
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Japan

Japan printed a negative GDP number a few minutes ago at -0.3 for the quarter. The Nikkei is down 2.7% a few minutes into the start of trading. From the recent peak on February 26 the Nikkei is down 14%.
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Sunday Morning Coffee

We had some interesting comments come in on the last couple of posts that are worth mentioning.

"I am losing my shirt in this market, down over 3% on the year and not happy. I was up 12% just a few months ago."

One or two other people jumped on this guy saying he isn't diversified and the like. There is nothing wrong with big bets, un-diversified portfolios and risk taking, it may not be right for a lot of people (me included) but it is right for some people. The thing is not that you shouldn't invest they way we assume this one reader is but understanding that big swings will accompany this approach.

Whatever it was that put this guy up 12% and then took him down 15% from his high will take him back up ahead of the market at some point. Does anyone doubt this? Big swings go hand in hand with big risks. Even if you aren't that experienced I would think this would be common knowledge.

Where I think this person runs into trouble is with the emotion I think he is expressing. Whether he intends it or not, and I think he does, he is living by the sword. You know how the rest goes.

"Screw being well diversified, I want my portfolio to go up and not sideways for ten years because I was too diversified. "

He goes on to stress the importance of beating the market and that diversification prevents that. Ok well I do believe in diversification. If you read the comment his is very preoccupied with beating the market but the what I infer is that he is very focused on the near term. What is more important, being ahead of the market YTD or beating it over some longer period of time that actually ties in with what you are saving for. Quick, did you beat the market or lag it in 1998 and how has that impacted your life since?

In expressing concern about his portfolio going sideways for ten years because of being diversified; well sideways for ten years happens every few decades, that's just how the market works but outside of those rare occasions, and they are rare, just being in is the most important thing.

After watching this week's video a reader left this, "Thanks Roger but I need some good stock picks to get my portfolio out of the red." Well aside from the fact that this site isn't really about stock tips I have talked about several things over the last year (repeated them too often, probably) that could have helped overall.

I have been writing about being underweight financials, shaving emerging markets periodically back to equal weight, generally increasing yield, reducing volatility, buying foreign currency ETFs, being underweight discretionary, being heavy in foreign stocks, adding in some double short fund and warning about the inverted yield curve.

I have been very transparent with all of these things and they have, combined with some luck, made the ride smoother at the time it has needed to be. This site chronicles my ideas about how to catch fish, if you take my meaning.

Further, if you are worried about being in the red then it makes sense to think about how to mitigate that before it happens and while it can happen at any time for any reason, late in the cycle with an inverted curve is probably a good time bring it down a tick, as I have been saying for I don't know how long now.

The picture is from Molokai.
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The Big Picture For The Week Of September 9, 2007

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Fitty Beeps?

So will the Fed cut by 50 basis points on September 18? Maybe sooner?

Well I don't know the answer but this does raise a question that depending on the answer means they will not go 50 basis points.

What happens if they go 50 basis points and then next month they revise today's number up to something like 50,000 job gains, at they same time they revise last month's number back up too and then the fresh number shows some sort of meager gain?

That scenario is plausible, consistent with slowing but might not be as dire as some think it is today.

To be clear I have no answers, just a question or two.
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Stay Classy

Or maybe he would say to "go f*&k yourself" as the jobs number just printed with what appears to be a rotten number and rotten revisions to past months.

While I am glad for Jack Bouroudjian's happiness over the fact that the negative employment number is the best of all worlds, for me the focus is not to try to solve what this means but to think about what to do if this is recessionary.

First if this means that the market is on its way to a normal 25% bear market decline there will be plenty of time to react. Selling too much too soon is a big gamble that is not necessary.

Admit to yourself you will not get out at the top. Then look at past recessions/bear markets on BigCharts.com or in your Trader's Almanac and you will see there was plenty of time to get out.

I do not know at this point if the number will result in a panic in the market but if it does, it will be like every other panic; it will have some snap back before anything else. Again, regardless of the news and the reaction just stick to whatever you devised to take defensive action (if you have been reading this site for a while hopefully you have devised a strategy and are not flying by the seat of your pants).
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De Doo Ron Ron

That is a chart of the US dollar versus the Romanian leu.

Romania is a deficit country that relies on foreign investment, really it is at the mercy of foreign investment. In fact foreign investment is vital throughout the region. The only country nearby that might be in generally rougher shape is Latvia, but the lat, as it is known, has only weakened by about 1% compared to almost 10% for ron.

This article from MarketWatch gives a good recap of what is going on including some detail about a recent report from S&P that says Romania, Latvia, Iceland, Bulgaria, and Turkey are most vulnerable to adverse market conditions. The overnight rate in Romania is 7% and has been heading lower since February.

This may seem like an obscure market, and maybe it is, but (something I have touched on in the past) it is worth being somewhat in touch with substantial currency dislocations going on out there. It could be argued that the risk aversion correction of Q2 2006 started in Iceland, another relatively obscure country.

I am not saying you have to be an expert in these things but simply knowing a thing or two about Romania and having just read the headline of the MarketWatch article puts you in touch that something is going on and knowing a little bit of market history tells you that it could become market moving.

If you own any foreign countries you probably have one that like Romania is a higher yielding deficit country. If Romania dominoes to take down other countries, you might reasonably infer that the country you own has no fundamental link to Romania (assuming of course that it does not) and so if it does go down in sympathy selling it is probably not a good idea.

Giving this no thought might lead to a bad sale if this story does impact other markets.
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Sovereign Wealth Funds

I have written a couple of other posts about sovereign wealth funds (here and here). Nouriel Roubini had a post on the subject the other day that is a good read.

There is an obvious path to something going wrong at one of these funds, and there will be more of them in the future, at some point that will cause a market event. This is not a prediction of when but new market participants with a lot of capital at their disposal will add up to a problem. Realistically these are so new that this is not a threat to worry about now.

These funds come about as a function of prosperity of some sort. It seems like most of them have to do with natural resources but not all (Singapore as an example). A country in the position of having a healthy and growing SWF is probably a good choice for an investment destination for a diversified portfolio.

As I have disclosed, clients own Norway and Australia across the board, I have Russia for a few clients and although I have been out of China for a while I expect to be back in within a year. In the big picture these destinations all have investment merit but in the interest of being really diversified I have exposure to all sorts of countries with different attributes an vulnerabilities.

The deficit countries would seem to be at the opposite end of this spectrum and they too have investment merit. When risk is in vogue these countries have a chance of beating the surplus countries. The deficit countries include New Zealand, Hungary, Turkey and Iceland but there are others.

I think it is very important, for people inclined to pick countries, to have a diverse mix. It might not be much help in a given month of panic but I believe this approach will add a lot of value when there are more serious, slower declines in the US.

UPDATE at 6:54 am

I found this link about Sovereign Wealth Funds on Seeking Alpha from Bloomberg.
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Stop Orders

A reader left a comment about getting whipsawed in the last few weeks because of stop orders set below the market. When the fast decline was followed by a fast snap back it created what he called the STOP-LOSS VEE-SHAPED KNOCK-OUT PUNCH.

I have never thought blanket use of stop orders was a good idea and have also written countless times about fast declines being followed by fast snapbacks. The reader's comment reiterates my beliefs on this subject.

I tend to use stop orders after a stock has had a big move up for a portion of the position. However not every stock lends itself to a stop order. I wrote something for TheStreet.com about this where I looked at Baidu (BIDU). Normal volatility for that stock makes most of the stop loss "rules" very difficult to apply.

This is not to say you should avoid stops altogether or not have some sort of concept to sell a stock but stop orders are wildly flawed and you have to know what the limitations are.

This chart from the other day shows that good companies don't necessarily have to be sold, given the right time horizon.

The context for this comment is that even if you hold onto a stock when it would have been better to sell; time can bail you out, again assumes a certain time horizon. If you manage your own portfolio you clearly could have absorbed the rotten first few months of 2000 for JNJ (client holding) and by now probably forgotten about it.

A 50 year old in good health, with a normal time line for for retirement plus a normal time line during retirement doesn't really need to worry about a great company that cuts in half in a down 15% world when he is 53. This is especially true if no more than 5% is allocated to any one stock.

Anyone selling JNJ at the start of 2000 would have felt good about the trade for a couple of months but since the start of 2000, so including that puke down and one other in 2002, JNJ is up 30% while the S&P 500 is flat.

This is what works against you when you get too heavy into stop orders and assuming you are able to pick stocks that can stay in business.
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Sunday Morning Coffee

A short one this morning.

If you believe the consensus is always wrong, or more like me they have a tough time being correct, then this article in Barron's (sub required) might be a little troubling.

It is a poll of sorts among the chief strategists (or similar titles) from eight different Wall Street firms.

Seven of the eight are calling for the market to end the year higher than it is now, the average of the eight works out to SPX 1568; take out the lone dissenter and the average ticks up to 1582.

Six of the eight list tech as a sector they favor.

We'll see how it plays out but given the potential seriousness of the subprime/liquidity/credit event I think we will still see volatility sticking around for a while. Some will want to trade it and some will not but putting yourself in the frame of mind to expect more big ups and downs will reduce the chance you succumb and end up doing something you regret.

That is a spider under our grill that is almost the size of a golf ball. There is some sort thing about how many spiders people eat in their sleep over their lifetime. I hope this is one no one eats; gives me the heebie jeebies just thinking about it.
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Read This

Count the Days, Not the Years, of Market Pullbacks - New York Times

This article gives another perspective on how market corrections work. It is not very different than what I have been writing about but it is useful read something similar elsewhere.

Here's one snippet;

At the very least, Mr. Stovall said, the speed at which markets historically recover should give investors confidence “not to react so hastily to the current troubles.”
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The Big Picture For The Week Of September 2, 2007

JNJ, BAC and MO are client holdings.
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