The Big Picture For The Week Of February 1, 2009

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Vicks are Trading

One of the VIX ETNs is up and running.

The one month VIX futures ETN has ticker VXX and the five month VIX futures ETN was supposed to have ticker VXY but that is not working on Yahoo or Schwab.

If anyone knows anything about what is supposed to be VXY, please leave a comment.

UPDATE UPDATE

The five month version has ticker VXZ. My bad. VXX (the shorter one) has a lot more volume than VXZ.
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Comment Thread

There was an odd comment thread on on yesterday's rather innocuous post about another blogger's theories about portfolio construction. Seemingly out of nowhere came some anti-financial market, anti-advisor and anti-blogger sentiment.

Some of the comments;

• It seems all you "advisors" have this basic assumption that a "financial portfolio" is needed?

• The "stock market" is a fools game created to steal your money.

• Top down may have worked this time, but has it always?

• Most of these blogs remind me of a daily racing form you get at the horse track... It is gambling!

Wow that is some dourness and I probably resemble some of those remarks (blogger and advisor). First off, after months and months of stock market declines it makes sense to expect that many people will be emotionally weary. Comments like the ones above belie that weariness. The folks leaving those comments might be inclined to tell me to hit the bricks but but for anyone not inclined to compare stock market content to a racing form they might benefit from recognizing the emotion exhibited by other people which in turn might prevent them from letting their own emotions get the best of them.

I was having a conversation with someone on Wednesday and I said the biggest threats to a successful financial plan are poor decisions and poor performance (it only takes one of those to derail a financial plan). People have more control over their decisions than their portfolio results. One source of poor decisions is letting emotion dictate portfolio action as opposed to logic. This is not to say that by remaining logical you will get every decision correct but your chances for success are better if you remain cool, calm and collected.

I've talked about the way I deal with market declines and emotion before but it could be useful now and has helped me along the way. I try to make this as simple as I can. The stock market goes up most of the time but occasionally it goes down and a little less frequently it goes down a lot. These are immutable laws of stock markets. There is no changing this. It will be the case for as long as you invest.

Knowing this ahead of time should make the task of enduring easier. If you look back at blog posts from a couple of years ago, even earlier, I talked about the next bear market and the one after that in very routine fashion as a way of trying to express how matter of fact they are. The current one will end then there will be a bull market again followed by another bear.

To the comment pasted above about top down, the market has tended to warn when the bear phase is starting in fairly consistent ways. Part of that has been that relatively close to peak the market crosses below its 200 DMA. If the goal is to miss a lot of most of the pain of a typical bear market as opposed to trying to get out at the top then a top down exit strategy can be very effective.
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Interesting Blog Post

Over the weekend someone left a link to a blog post from someone named Tom Drake that you can look at here. I don't know much about him but he lives in Arizona and likes baseball so you gotta like that.

The post in question is interesting to me because I think he is drawing some similar conclusions about the future of investing (there are some differences too, as I read the post) but Tom has been learning about markets since the 1960s whereas I only go back to 1984 (worked in the business full time for a year before going to college).

He articulates a case for a completely different type of portfolio construction focusing on varied things with a more active approach than what most folks probably do. He ponders allocating more to commodities because he says it is a commodity era not an equity and bond era (presumably there is context to this line of thought in past posts). He says to forget stocks and standard bonds but use dividend paying stocks as a substitute for bonds and he likes CEFs and royalty trusts.

I've been on board with the idea of portfolio construction evolving for ages so I agree with Tom on this point. My ideas about how to get there are different (have written about this many times before) than Tom's which does not necessarily make either one of us right or wrong but it is good to see other people writing about this and if it turns out that many of the old norms of investing will no longer stand up you need to seek as many perspectives on this as you can.

In terms of differentiation I would suggest more foreign exposure than Tom mentions in his post, more theme investing, more absolute return and making small allocations (which will require more work). This most important thing will be that we never stop trying to learn.
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Hist O Ree

The picture is of WC Hawley and Reed Smoot. Yeah, that Smoot and Hawley. The Smoot and Hawley whose legislation called for an increase on tariffs that was signed into law in 1930.

You have probably heard that the stimulus plan is going to have strong incentives for steel and other materials used in all of the infrastructure projects that are supposed to happen to come from US companies.

Oh, boy.

I'm not going to worry about this until it actually happens, if it happens. If it does happen then, depending on the details, it stands to be something of a game changer and would be a reason to get a little more defensive fairly quickly and maybe more so shortly thereafter. As I write this now I'm not sure if that means selling stock, buying the double short ETF or doing both but probably I'd do both. Again, depending on the details

In terms of managing money, whether you do it for other people or just yourself, the right and wrong of this doesn't matter. Where the portfolio is concerned your job is not to solve the world's problems it is to let the assets grow when that is appropriate and protect them when that is appropriate. This applies to things you perceive as being threats to equity prices. I perceive this sort of protectionism as being a threat to equity prices. I would not make a bunch of trades all at once because I could be wrong but I would take some action very quickly.

I suppose that my thought of a very large bear market rally coming could still pan out but the adoption of this mandate would greatly diminish my confidence of a huge rally occurring.

For now this looms as a problem. What matters is recognition of the threat and the willingness to think about a plan of some sort and then the ability to execute the plan if needed. I've recognized the problem, figuring out what to do if necessary and then just need to stick to it if circumstances dictate.
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Follow Up

Yesterday's post where I ragged on just about everyone was heavily commented on both here on on Seeking Alpha. I realized that I left out an important (to me) point that probably should have gone near the part where I picked on Larry Kudlow, Art Laffer and Brian Westbury.

There seems to be a failure to acknowledge that bear markets are a normal part of the stock market cycle. This failure is common to many people and is beyond me. The stock market goes up most of the time but sometimes it goes down, simple as that. This will repeat over and over because it is normal and just how things work.

As 2007 was winding down the bull market was about five years old. The risk of a bear market is greater after a five year bull market. This conclusion can be drawn without any awareness of the current condition. That would not be sufficient to declare that a bear market was here but in terms of risks, the risk of a decline would be greater after a run up that lasted for five years.

In the early days of this blog long before the bear market and financial crisis started I wrote often about mentally preparing for a bear market. I wrote about how they almost always start. They start slowly and most people do not recognize them for what they are and deny a bear has started which ties in with the perma-bulls somehow forgetting how normal bear markets are to the stock market cycle.

Then sure enough the bear market started slowly back in Q4 2007 and of course most people denied it. The textbook start (I chose the word textbook there because I relied on history to be my guide) to this bear made it, IMO, easier to spot.

If you think about bear markets ahead of time and realize they are simply a part of every cycle then you are less likely to react with emotion, you are more likely to have a plan in place for defense (if that is appropriate for you to do). Then when the time comes you only need to be disciplined enough to execute the plan.

Maybe we can blame the failure of some to even acknowledge ahead of time that bear markets are possible (not even talking about a reasonable prediction, just the acknowledgment that a bear will come one day) on various biases, conflicts and constraints but none of that needs to apply to you. If we are to conclude that your fund manager, for whatever reason, will not protect your assets then you need to take it upon yourself. The next bear market, whenever it comes, will start very similarly to this one and the ones before it.
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Monday Musings

This may come off as an unpleasant rant. Between a couple of articles I found over the weekend and watching the Consuelo Mack show on PBS I came away with a very low regard for the way some folks do things.

First up was an article from Morningstar about what they got wrong in 2008. I have been writing about how worthless the analysis is for as long as I have been writing. They are a bottom up shop and from what I can tell it is a rare day when bottoms up warns of a bear market. Low PEs and other ratios don't matter when the market is going to rollover into a bear. When the market is going up most stocks go up so a good bottoms up might find stocks that go up more than market but being right about the market would seem to be more important. So with that backdrop Morningstar says the learned a bunch of things in 2008. I would wonder what they learned in 2001 and why that seemingly did not help in 2008.

This article from Seeking Alpha contributor Marc Gerstein posits that collectively the crew at Morningstar is just too young. He believes that experience matters a lot when it comes to navigating the market. I find his take interesting because at 42 I am probably in between his definition of too young and experienced. One reader commented that Morningstar has a bullish bias which hurts them. I don't know if that is true or not but there might be something to the youth angle but I do think it is bigger than that. Look at Larry Kudlow who must be close to 60 either way or Art Laffer or even Brian Westbury (I think Brian is older than me) they are all experienced and all missed this coming in hideous fashion, bizarre really.

This gets me to the Connie Mack show which this week featured Brian Rogers from T Rowe Price and Chris Davis from the Davis funds. Brian's fund the T Rowe Price Equity Income Fund lost 35.8% in 2008 which was the worst year for the fund going back to 1985 "by a lot." He said that when there is a severe credit contraction there are very few places to hide. Even safe areas like utilities were "traumatic." Consuelo asked if there was anything he would have done differently or could have done differently and he answered "no I don't think there is." He said they would continue to focus on good quality companies that have struggled, with good balance sheets and valuations. He then said there are things he would have done differently but he didn't say what.

So I guess the next time the market drops 38% his fund will be pretty close either way? Did he really not know that credit contractions cause problems in the markets? That is the entire idea behind the inverted yield curve.

Chris Davis didn't really distinguish himself with anything he said. He admitted completely missing AIG and underestimating the effects of constrained liquidity. For as long as I have been aware of the fund they have had a colossal weighting to financial stocks. I will concede the following is unfair but somehow when he speaks (and he is on this show as often as anyone) I get the feeling he is reciting someone else's thinking. His is a family business started by his grandfather so maybe that is what I think I am hearing but something just never quite seems right there. Very unfair on my part but that is the sense I get.

In past posts I have mentioned that mutual fund managers are not the asset allocators. It is reasonable for a fund manager to invest all of the money in his fund so this post is a bit of a contradiction but I was dismayed by Rogers' comments and to a lesser extent Davis'. So an active fund manager might be all in but these funds can invest at the sector level in any manner they want so they could have underweighted or avoided financial stocks (financials clearly hurt Davis, not sure about Rogers but JPM, GE and WFC show up in his top ten).

I am so critical here because I think well if I saw something bad coming (but did not correctly guess the magnitude) how did these guys miss it so badly? They both are smarter than I am and that is not false modesty. Davis might say something about the capital gains embedded in the positions (a point made on past episodes of the show) so maybe no one should buy the fund going forward but that would also mean he made taxes the priority which will lead to tears more often then not. Taxes should never be the first priority.

In a video a few weeks ago I made a joke about never wanting to say to someone "I just never saw it coming" and while I'm not sure, it seemed like both Rogers and Davis said they never saw it coming. I'm sorry but I find that inexcusable. I feel much better about being able to say I tried to protect your assets and then explain where it did work and where it could have worked better.
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Sunday Morning Coffee

Yesterday on the show Bulls and Bears (God help me I still watch but fast forward through a fair bit of it) there was a conversation about whether nationalizing the banks might actually be the best choice.

As I heard this I had an odd thought. What if that turns out to be the best solution? I am not expressing a preference or a belief I am simply wondering what if the private solution can't get it right and the fastest path ends up going through the government. A private market failure is kind of what has happened already.

However messed up you think the government would be in terms of mismanagement, incentives for the wrong things, unintended consequences and whatever else; I'm right there with you but what if that is the better alternative? What would that say about the future of American finance?

My next pondering is about indexing and might whip a few people up. Pure indexing has not worked in a while. In the last ten years the S&P 500 is down about 30% (yeah, that's right). It is worse if you factor in inflation. What if it continues to not work for the next ten years? The Nikkei 225 peaked around 40,000 in 1990. Let's assume (hope?) we are not 30% lower from here in 2019, but what if where we are at a point for the S&P 500 that is nowhere near where anyone would expect it to be, like 831.95.

A lot of money invests by indexing. How many years of futility would it take before the indexers reinvent what they do? Do any investors in Japan invest in equities via pure indexing? How could they? The market is down 80% in 20 years. I do not assign a high probability to this outcome but would an indexer go an entire 20 years without questioning the method? How can a financial plan that relies on stock market growth possibly succeed with a 20 year period of no growth, very low growth or an outright decline?

Even though we are down 30% over the last ten years there have been times where it made sense to be all in and let it grow and other times where some sort of defense was in order. No matter what happens in the next ten years there will be times to be all in and let grow and other times where some sort of defense will be in order. Pure indexing does not allow for this. Or does it? Can anyone make the case?

Why is is that healthclubs have to hardsell people? When we joined our current gym a few years ago it was like buying a car including that price is only good today and the salesman writing upside down on the paper. Our gym gave us a couple of three month passes to give to friends, Joellyn gave one to one of her dog lady friends and the guy at the gym pounded on her. Anyone own a gym or work at one and know why this is necessary?

Last question, the picture is from Iceland and you will notice a crane in the background. When we went there in 2006 I mentioned on the blog that there were a lot of cranes on the way in from the airport. I wonder how many cranes there are now.
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The Big Picture For The Week Of January 25, 2009

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Discerning & Sophisticated

The Oscar Rogers bit never gets old.

A reader pointed me to this post by Matt Hougan from IndexUniverse about more investment advisors using ETFs for their clients.

Matt opines that the model of relying on actively managed OEFs to generate alpha (so outsourcing alpha) for their clients won't cut it anymore. Matt goes on to say that with ETFs advisors can do a better job for their clients.

This reality of this is multi-faceted. One hand ETFs are merely a tool, a relatively new tool, which create flexibility for all sorts of things. I primarily use narrower ETFs for sector exposure for a couple of sectors usually in conjunction with a stock or two.

For example in the energy sector most clients have a combo of WisdomTree Energy (DKA) and one or two stocks. DKA makes up most of the sector because as the bull market wore on the sector got riskier so it made sense to me to go from all stocks to less single stock risk--so less risk in a possibly played out theme.

Other folks use broad-based ETFs as core holdings and there are countless other ways to use the product.

I can't disagree with Matt I just think there is more to it. One thing that an advisor can do, and from the top down point of view this might be more important that investment selection, is prevent a client from doing something stupid. Many people have done all sorts of research about how normal human thought process works against long term success with investing; behavioral finance. Most people are inclined to do the exact wrong thing which is why different studies show similar results about most actively managed mutual funds lagging the S&P 500 by a couple of percentage points but that the fund holders get about 1/3 the result because they buy and sell at precisely the wrong time and they repeat this behavior.

Simply avoiding stupidity (sorry to be blunt here) is likely more important than how much alpha is generated. Anyone who saves properly and can avoid stupidity has a good chance for having their financial plan work out and if an advisor accomplishes that I would say that is important.

As far as using ETFs to generate alpha in some way that is new, I guess I would say maybe but there are open ended mutual funds that offer many of the same things. The ETF could be a better wrapper (I believe this is generally true) but not always. I use OEFs for absolute return. There have been inverse and levered inverse OEFs trading for ages--again the ETF is a better wrapper but the concept has been available for a while.

More important than adding alpha I think is risk adjusted returns. Beating the market is not necessarily the appropriate goal. To pick an extreme example if your plan on relies on averaging 5% returns to work are you going to take the risk needed to average 20%? You might target more than 5% in that case but targeting 20% would not make sense. As a quick note, averaging 5 or 6 or 7 or whatever percent means you will have a couple of years where you are up 20% give or take because the market will have years where it goes up that much.

The concept of how much risk to take and where to take the risk is crucial to understand and ties in with Taleb's idea of 90% t-bills and taking a lot of risk with the other 10%. If you could get that 10% to double while taking no risk with the other 90% you would be getting all the return you need. Getting that 10% to double is no easy feat but it makes the point.
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30%?

A couple of months ago when we had a couple of days where the market had 8-10% gains many folks pointed out that the biggest up days of all time occurred during bear markets. So what should we infer from the 25-30% gains yesterday in Bank of America, JP Morgan and Citigroup?

It is far more likely that this is not yet over despite how many times it might be asked today on the network.

On an unrelated note it looks like iPath will soon be launching a couple of ETNs tied to the VIX index--more specifically futures contracts on VIX.

It would be great if a product tracking VIX could be used to help hedge a portfolio and maybe these can but the VIX and all things tracking it are very complex.

Whatever you think you know about VIX, you probably need to learn a whole lot more before using the new ETNs. It's not like I am casting a stone, I have a lot more to learn before using these.

Hopefully you will heed me on this--the VIX is more complex than you know (applies to more than 99% of market participants including me). If you want to learn more you should start reading Bill Luby or Adam Warner if you don't already.
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Sectorology

The shots of the crowd at the inauguration were awesome--no real investment implication that I know of but still.

I heard somewhere that before yesterday the worst inauguration decline was 2% when Ronald Reagan took the oath in 1981.

I think the 5.28% decline yesterday was about more than just normal inauguration market activity. It seems like worry about the financial sector has intensified, not saying it isn't justified, after RBS news on Monday and maybe StateStreet (STT) news on Tuesday.

I'm sure this little nugget from Nouriel Roubini didn't help either. I certainly don't have the answers as to how to fix anything, it is a little easier to be skeptical or critical of what has been done thus far of which I am guilty but in terms of investing my entire point through all of this has been that you don't need to have the answers.

At the close yesterday the S&P 500 is down 10.8% for the year (in only three weeks?) but the financial sector as measured buy the Financial Sector SPDR (XLF) is down 35% ($12.52 on Dec 31 to $8.08 yesterday). Since the start of the bear market on October 9, 2007 XLF is down 77% compared to 48% for the S&P 500. Put another way the decline in the financial sector has accounted for a disproportionately large 1/4 of the bear market decline (the sector has dropped from about 22% of the SPX to about 10%--that 12% is 1/4 of the 48% drop in the market).

Forgetting the inverted yield curve as a warning from several years ago, sectors growing to 20% or more of the S&P 500 is warning to be heeded. 30% is a clear danger sign but I'm only aware of that happening twice--tech earlier this decade and energy in the early 1980s. This sort of thing is very important to how I try to look at constructing the portfolio and I why have written about this sort of thing many times in the past. It tends to work but it may require patience as the financials hovered around 20% for a very long time.

I realize there are plenty investors (pros and do-it-yourselfers both) not comfortable with investing at the sector level but I am convinced this will make the task easier over time and contribute to missing some pain in the future.
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Kaboom

Kaboom is what happened in Europe yesterday especially the banks possibly triggered by a 66% decline in Royal Bank of Scotland after announcing the biggest loss ever in the UK.

Just about every European bank has been caught up in this mess including Barclays Bank (BCS). I've disclosed in the past that I used to own BCS but sold it in late 2007 at about $41.80. Generically speaking the banks are a great way to own Europe--they capture what is happening economically and usually have very high yields.

Don't take that as this is a good time to buy European banks, I don't own any now and don't know when I will. But the banks are capturing what is going in Europe, it's just that what is going on now is not good.

The latest news from the UK is a good reminder of a point I have tried to make before about top down portfolio construction. In owning stocks from various countries it is important to stay current on the big picture in those countries. Selling Barclays when I did was more about things I was reading that lead me to believe that the housing market in many European countries (including the UK) was worse than the housing market in the US which made the European banks (including the UK) riskier than the American banks. I don't recall now finding much from the company back then that would have warned me that the drop was just the beginning, even though it was already down 30%

If you read enough things written by people smarter than you, eventually you'll take the hint.

This brings up another point about caring more about where it is going than where it has been. When I sold BCS it was down about 30% from it's peak. That it had been as high as $60 meant nothing. I was concerned about it going down a lot more and doubted that I could quantify how much further it could drop--in fact it is down way more than I would have thought. You can read more about the trade here on the post from December 2007. The stock I bought with the proceeds was a Chilean bank.

To be clear I don't get all of these right. I still have exposure to Australia through a bank that in hindsight has been a bad hold. Australia's economy has puhlenty of problems but I do not believe it is as bad off as Europe or the US--bad housing issues notwithstanding.

Portfolio management is a series of decisions; some will be right and some will be wrong. That is just how it is but you have a chance of adding value over the duration of the stock market cycle if you can be right a little more often.
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Metaphor

There is no hole, this is one of those sidewalk chalk drawings. The one guy appears to be walking around the hole that is not there.

Assuming that is true (and not that he is walking around what he knows is a drawing) there must be an investing metaphor there somewhere.
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Sunday Morning Coffee

All sorts of good stuff in Barron's this week.

First up was a recap of the calls on various stocks by the magazine in 2008. They said their long picks were lousy and their shorts were pretty good. I don't doubt what they say but in case it is not clear long picks not being good and shorts picks being good is exactly what would happen when the market drops 38%. I would add that the call to short Fannie Mae, a very good one, probably skewed the overall result.

This makes an important top down point. In a down 38% world it is difficult to find the few stocks that will go up. If you have a diversified portfolio of individual stocks it is not impossible that you end up with a name or two that would go up but going into the bear I was not concerned in the least with finding stocks that would go up. For my money it is a whole lot easier to simply own less of the thing that is going down; that was stocks. If every stock you own went down the same 40% as the market but you only had half the portfolio in stocks then you'd be in great shape for adding value over the entire stock market cycle.

Next up are a couple of stock lists. One was of companies that should be involved with modernizing the US electrical grid and the other list was stocks tied to reducing greenhouse gases. Both of these themes tie in one way or another with Obama's plans. Each theme has a simple to understand bull case with some risks that could derail how they play out in the stock market. There is no question that money will be spent on each area, the variable is whether the stocks benefit as much as some people think. Should you invest in either or both? The answer must be it depends but there is no question that we should all take the time to learn more than we now know and then make an informed decision based on more information.

Lastly a couple of nuggets from the second installment of the annual Barron's Roundtable.

First this quote from Felix Zulauf;

Investors should keep their powder dry. Sit in fixed income. Buy five-year investment-grade corporate bonds in less-risky industries that service daily necessities, such as telecoms, oil and food, and blend them with medium-term government bonds. Check company balance sheets. I wouldn't buy long-term government bonds, except maybe German bonds. My one recommendation for the longer term is physical gold.

Ouch. He also makes a case for the S&P 500 going to between 400-600. Even if you disagree with the people making this call (as I do) it is still very worthwhile understanding the uber bear argument. Ditto if you do agree with Zulauf, you should learn the bull case. Knowing the other side of the trade will either reinforce your opinion or help you realize that you might be wrong.

Also this week was Abby Joseph Cohen's picks and commentary. She made one point that I would say to watch out for. The US was one of the first countries to get into trouble and so should be one of the first to get out of trouble. A point I have been making for a long time is that many other countries (ex-Western Europe) are probably dealing with more cyclical problems while the US is probably confronting structural/secular problems. This does not mean there won't be bear market rallies or that end times are coming, just a slower recovery process than some other places.

The roundtable convened in the first couple of days in January. One of her picks was Bank Of America priced at $14.33 at the time. It closed at $7.18 on Friday. Double ouch. Disliking big mergers is a truism from way back (don't remember where I picked it up) but it will be the right call more often than not. Just something to file away.
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The Big Picture For The Week Of January 18, 2009

This link is not to the video I mentioned but I thought it was interesting given the subject and the timing.
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Bailouts and Restructurings

The news today about Bank of America (bailout) and Citigroup (restructuring) has both names indicated higher along with the broader market but this entire episode continues to fascinate. The short term implication is probably positive (said with not much conviction) but the longer term implication is...well...what exactly is it?

Regardless of what you thought about Fannie and Freddie they were vital cogs in the machine and now they are gone (not really gone but much different than they were). The biggest banks from two years ago have failed one way or another. The biggest investment banks have either failed or technically are no longer investment banks. This has forced the government to have a large role in fixing things--or more correctly trying to fix things.

If it is correct to say that the US financial system has collapsed (I will let others decide if that description is correct) we should perhaps count ourselves lucky that stocks have not dropped more. Obviously some folks are calling for a much larger decline still to come. I do not think there will be new lows that are meaningful but of course any opinion like that can be wrong. I still believe in a large bear market rally to come and a run down toward the lows after that (maybe the run up to 931 was the rally--smaller than I would have thought-- but I don't think so).

One other reason why I don't think we go dramatically lower than the lows already in is that the shock factor is now gone. Asset prices have plummeted, institutions have failed or been bailed out, foreclosures have gone way up as has unemployment. If the shock factor is gone then there likely would be less of an emotional response which in turn would mean the lows for equities are in even if we churn around the lows for a while to come.

Or not. What do you think?
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Glad To Be Back

Fun visit, long day getting back.

So I'm about 1/3 of the way through Fooled By Randomness. As we landed in Phoenix last night my wife asked if I was enjoying the book and then she corrected herself and asked if I was learning anything. Taleb's books are not exactly fun reads but I learn some things and have some other concepts reinforced.

One concept is about not confusing random with skill. Or worded differently "I'd rather be lucky than good." Here is an example from my days as a beach volleyball player in college. I lived the life of a pro beach volleyball player except for the skill and the income:-0 I did play at a reasonably high level and there were a few parts of my game that were very solid; setting, jump serving effectively which was not done much back then and I was good with shots on offense. I was not good at hitting the ball straight down on offense, my serve reception was mediocre and my ability to control a hard driven ball on defense was borderline lousy.

It is that last one where the example lies. My partner and I were in a tournament in San Diego and we were playing two guys from the San Diego State indoor team. We were competitive but they were clearly better than us and we lost by a few points. On one play my partner was blocking I was back on defense and the guy on the other team, his name was Bill Bailey, sizzled one right at my face. My partner's block was perfect because he forced Bill to hit it right where I was standing. It wasn't exactly at my face but just to the the right of my face. I put up my right hand almost like I was waving hello to someone it hit my hand perfectly went straight up in the air to my partner for him to set me easily, I put the shot down for the point. For people who know beach volleyball very well open hand digs of hard driven balls were kosher by this time.

That I recall one point from one tournament from 22 years ago with such clarity should tell you what kind of impression it made on me. I was lucky with that dig. At the time I played it off of course but it was nothing but luck and I was self-aware enough to realize it. Not confusing luck and skill has important applications in many things especially investing. As I read Taleb, understanding the difference between the two is vital. This sort of self-awareness may be difficult--this is implied in the book anyway. I have no idea when I began to think about being self aware in this regard but certainly this little anecdote from my past was important in my development. Chances are you have something from your past that served the same role for you. Hopefully you realize it but if you had not before, maybe you will think back to that time and realize it now.
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Conference Recap (Part One?)

We'll see if there needs to be a part two.

First let me say I did not attend many sessions, maybe a couple each day and I was not here in time on Sunday to go to the couple of workshops they had that day.

It seemed clear to me (so of course this is just my perception) that the content of the conference was tailored around input received from financial advisors (it was FA Magazine who put it on in conjunction with IndexUniverse) from last year's conference and maybe throughout the year too.

That said most of what I heard was at a lower level of dialogue than I expected, again if this is where advisors are collectively and what the general audience is looking for then that is what the folks running the conference need to provide. On one hand I find it shocking and disappointing that advisors would not be a little more up to speed. On the other hand I cannot imagine how one person could possibly do everything that needs to be done. At our firm we divvy everything up. This allows me to, for example, have heard of Bank Turanalem when it comes up in conversation with a client.

That unresolved snobbishness aside a reader asked how the panel on sector investing that I participated in went. We had a good mix; Joe who builds model portfolios at a regional brokerage firm that uses ETFs, Dan an ETF marketing guy from StateStreet (they have done all sorts of research and he had amazing recall of the info), Phil the moderator works in the rocket science department at an investment bank and one slack-jawed yokel from Arizona.

A large part of the session was Joe and I giving opinions of various things with Dan whipping out some stats that either refuted or supported what was being said. When I spoke I looked at the audience and everyone seemed attentive which I took as a positive.

I talked about all the things I have been talking about on the blog since I started writing. I build portfolios at the sector level, overweighting and underweighting each one based on how markets usually work combined with what I think is going on now to make a forward looking analysis.

I talked about certain sectors being easier to add foreign, like energy, financials and telecom. I also mentioned that some company called EG Shares has filed for emerging market sector funds and went off on a tangent about not knowing who they are or whether their funds will ever list but why I think sector funds in the EM space would play an important role in portfolio construction. One funny thing, after the session was over one of my maybe three blogging friends, Richard Kang, comes up and tells me he is EG Shares and yes they are a real company. That was all he could say but it was a very funny thing.

Also after the session as I was talking to Richard and several people from the audience came up to ask a followup question and the questions were all intelligent questions compared to what some of the content seemed to be targeting.

One thing that I can say confidently is that like you, that adivsors do want to take in more information and bits of process to try to navigate the market more effectively for their clients. That does not have to mean "beat the market." The job of a financial advisor is to give clients their best chance of having enough money when they need it while trying to make the ride between here and there a smooth as possible. That does not mean that every advisor will be able to do that or that the ride will always be smooth but that is the goal.

On a personal note Joellyn and I had a fun time seeing Palm Beach on Monday and then going down to South Beach on Tuesday. The story yesterday about my having played Babe Ruth baseball with one of the industry honchos was just a mind blower.
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One More Thought

Saving for a rainy day is for suckers.

And this from the it's an incredibly small world department; the guy whom I believe to be the head ETF honcho at State Street (I won't publish is name in case that is not kosher) was on my Babe Ruth baseball team 30 years ago and my Pop Warner football team before that.

His older brother actually coached the baseball team we were on together.

I've seen this guy once or twice before but never put it together until today.

We chatted for a few minutes in between sessions. Incredibly small world.
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Dichotomous

The ETF conference I am attending creates a dichotomy that is worth pondering.

The night before our flight I picked up a copy of Fooled By Randomness by Nassim Nicholas Taleb (apparently in its second edition). I am not very far in at all but the gist early on seems to be that chance plays a greater role in outcomes than people realize and financial market participants are far from immune.

At the same time the ETF conference presumably explores ways for advisers to do a better job, whatever that means to each person, managing client assets. Using ETFs can keep costs down, avoid tracking error and whatever else the merits might be which can ultimately deliver a better result for the end user, the client, when compared to traditional, actively managed mutual funds.

I'm going to skip over a couple of things for now that are either reactionary first impressions from the conference or will be the my conclusions of this conference and move to my belief in seeking out the middle ground between chance driving everything (or close to it) and trying to add value with decisions made. In exploring the difference here perhaps you can get a handle on where you fit in.

A few days ago a reader left a comment that no one hires an active manager unless they think that manager can beat the market. The comment completely misses the idea of risk adjusted return which probably comes close to describing what I try to do and so would be what comes through in the blog posts.

The short explanation would be in an up market I hope to go a long for the ride and in a down market miss a chunk of the decline. More specifically taking defensive action when probability of a large decline is greater. The probability of a large decline is greater, in my opinion with a little bit of data to support the idea, when the S&P 500 crosses below its 200 DMA and or when the market rolls over slowly without much pain or worry over several months (2% rule).

If this sort of market action leads to a bear market then value probably gets added as I heed those warnings. If this sort of market action does not lead to a bear market then value probably does not get added. The same can apply at the sector level (the reason I am at this conference) as well. The risk of owning financial stock increases when the yield curve inverts. The risk of owning discretionary stocks increases as the economic cycle gets long in the tooth. The risk of owning utilities and telecom (the Ma Bell kind) increases when interest rates start to go up. There are other examples.

When the risk to being in one area increases it makes sense to take some of that increased risk out of the portfolio. One underlying truth is that while there is logic behind these concepts and they have worked often they cannot be right 100% of the time. It is in this example where randomness and "adding value" can come together giving the chance to put the odds in your favor sometimes. At least this is how I view things even if Taleb would think I'm a fool.

A what took them so long-congratulations to Jim Rice for getting elected to the Baseball Hall of Fame.

The picture is from Palm Beach.
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A Thought From Palm Beach

All that crap about saving, living frugally, living below your means?

Well, forget about it...
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This week's Barrons featured the first part of the annual Barron's roundtable. Included in there were report cards for last year's January roundtable and also the mid year update.

The stock picks were dreadful. Of course in a down 38% they are going to be dreadful. As Meryl Witmer worked through her 2009 picks she shared the logic and process she uses as a value investor and I thought well this is probably similar if not identical to the process she has shared in years past. I can remember past years picks by Witmer being very good with this process but not so for 2008.

So scrap the process? Of course not. The point here is that in a bear market bottom's up stock picking is unlikely to swim against the tide of a 38% decline. This has been the case before and will be the case in future bear markets.

The picture is the entry to the Boca Raton Resort which is where I am for the Inside ETFs Conference. This place is swanky.
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Sunday Morning Coffee

I've been reading a lot and writing a little about retirement stuff in the last few days--401ks and the like. So I plugged my particulars into Yahoo Finance's social security calculator and what you see there was the out put.

According to Yahoo when I turn 76 our combined monthly benefit will be $4494, in today's dollars. Well that is more than our fixed expenses which for now include a second home for which we pay a mortgage on. Without the mortgage our fixed expenses would be about $2100. Of course there are other costs that cannot be easily budgeted like gasoline, dining out (which we do very little of) or clothing (which as covered the other day we are quite cheap). I doubt all of this other stuff works out to exceed $1500. Next are bigger one offs, some of which can be planned for like car insurance, home insurance and dentist visits. Lastly are bigger one offs that cannot be planned for like new tires for the car (written about that one before) or a home repair issue beyond what you can do.

Obviously no run down like that above can cover every circumstance and I specifically left out travel. I view traveling as being lowest on the priority list. If after paying for what has to be paid for and you still have money left over for a trip, great, if not then you don't go (just my view on these things).

In reading about retirement planning you will read about the need to replace X% of your income. 70-80% was a standard target but in some circles this thought has evolved to needing to replace 100% of your pre-retirement income.

Technically speaking I think you need to be more concerned with covering your expenses whatever they are, however you categorize them and with some sense of what your expenses might do in the future. I think the most difficult to forecast for everyone is health costs (insurance and the like). Our health insurance just renewed and it went up by 10%.

So as I try to figure this stuff out for myself I am fortunate enough to need less than what I make. If you care enough about investing to read a stock market blog then you are more likely than the average person to be able to live on less than what you make. If you live on $5000 per month and you make $20,000 I don't think you need to be worried about replacing the $20,000.

Saving the issue of whether social security will go bankrupt for another day, various things like social security, working in some capacity figuring out how to monetize a hobby could to reduce the burden you will put on your portfolio. Maybe one way to think about this is to save like you need $10,000 per month and live like you need $5000 (or whatever numbers make sense for you).

The motivation with this post is not outliving your money, trying to plan for a world where satisfactory long term investment results are harder to come by and the possibility that inflation bumps up to a higher number than we have become used to.

I should note that with these sorts of posts I am sharing my viewpoint which I believe is more conservative than normal.

We are flying to Boca Raton for most of the day so I will not be able to reply to comments.
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The Big Picture For The Week Of January 11, 2009

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50% Returns With No Risk!

Sounds like something Troy McClure might be selling.

The catalyst for this post is an article from the WSJ yesterday about 401ks. No shock, many people are down a lot of money in their 401ks. Being down a lot can cause disillusionment, again no shock.

It has been a while since I have had a 401k (1099 means picking some sort of self employed retirement vehicle) but from what I read, employers still match a portion of what employees contribute (save for a couple of companies that are not matching for 2008).

This might whip a few people up but I am pretty sure I have mentioned this idea before.

If you get a 50% match on your first, say, $8000 or $10,000 or whatever then why put that $8000 or $10,000 or whatever into anything but the money market choice? You are already getting 50%, why mess with that? There is even an argument for getting a 50% match on the first $8000 but putting in more than the amount needed to max out the match and still just putting it into the money market. If you put in $12,000 into a 401k and get $4000 from your employer then you have a 33% return with no investment risk.

If you have a career of normal duration getting 50% a year on your 401K in the manner described above you'd probably be in good shape when retirement comes.

Investing in riskier assets then would come into play with excess savings (maybe not the best term) beyond where you get the maximum benefit from your employer match. If you put $8000 into the 401k (get a $4000 match) and can squeeze out another $8000 into something (max out an IRA of some sort that would be compatible, or even a taxable account if that is the only choice that can work for you) with more choice than a 401k and average 8% per year there over the long term you'd be in even better shape.

At the very least this might get you think before you go hog wild with risk in the 401k. Let me say I do not think it will take anywhere close to ten years for the US stock market to get back to the 2007 high but if that is wrong then people who are 55 today, down a lot and hoping to retire at 65 may have a big problem. If you are younger than 55 you may confront a similar problem when your time does come. If you can get a 50% return (via the match) on a big chunk of your savings for another 20 years how much risk do you need to take?
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Retailers = Dreck

Not sure if that is how dreck is spelled.

I remember in decades past retailers were gold (remember how much Peter Lynch used to write and talk about the group?) but for a while now they have been dreck, longer it seems than for how long the bear market has been unfolding.

I was on CNBC last week and in the pre interview I was talking about a bear market rally and that I'd be looking to see where leadership was coming from to help determine bear market rally or new bull (old leaders bear market rally, new leaders bull market). The producer asked would that include retailers as past leaders? I think there might be a fascination with these stocks that is unwarranted.

I would not minimize the importance of consumer spending trends but the manner in which people shop might have been changing over the last few years. The last pair of jeans I bought were from Costco and I went very cheap. My dress shirts (I wear a couple of times a year only) all come from Ross. My wife considers bargain shopping as a sport. The only thing I don't go cheap on is footwear but there is a catalog we get where I can get my $110 hiking shoes for $60 without fail.

Maybe this is typical or maybe we are an island but I don't think so. If we are not an island then there is an implication for retail stocks.

What say you?
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Not That Alternative

I am a big fan of the buy write index and put write index and have been for a while. I own some shares of the PowerShares S&P 500 Buy Write ETF (PBP) and I use it for some clients where for whatever reason 40 stocks is not the best answer.

Over the years I have many posts about buy write and put write indexes and products. The idea behind both is a smoother ride to a better long term result with the expectation it will lag when the regular S&P 500 goes up a lot. Every back test I have ever looked at and as I have been following them I have to say I am convinced they deliver as advertised. The chart is for one year and shows both PBP and PUT down by quite a bit less than the S&P 500.

PBP has been around a little over a year. It has started slowly but the average volume is now 67,000 shares--not great but not impossible either. For now there is no ETP to track PUT but I hope there will be. In my opinion these indexes offer an easy way to manage volatility with a strategy that might be easier to understand. In the context of building a diversified portfolio that is simple in an increasingly complex world I think there is plenty of meat on this bone.

The reason for the post was an email I received with this link to a recent study on the put write index.

A couple of these types of things carefully selected along with a couple of absolute return products and a couple of hot potato themes might make for an effective portfolio mix.
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ETF Deathwatch

That is the title of an article from someone named Ron Rowland. The article has a spreadsheet of 139 ETFs and ETNs that might be in trouble due to very low dollar volume. Exchange traded products are obviously becoming more and more a part of the portfolio landscape, providers have created over 700 funds so far and I'm not even sure if a third of them are profitable.

It would be reasonable to wonder whether anything from X-shares will be around a year from now but I doubt anything, no matter how obscure, from iShares/iPath is going anywhere. According to the Deathwatch the Barclays Global product with the lowest dollar volume is the iPath Aluminum ETN (JJU) with only $6118 worth of shares traded per day. Anyone thinking they have some particular insight with aluminum can probably buy JJU with confidence about it lasting. That same type of insight about the biofuels ETN from ELEMENTs might not work out as well (in terms of surviving).

I hope all the quirky products can survive, although I know not all of them can. Having 95% of your portfolio in normal broad based products and then allocating 4-5% to quirky things like tin, Norwegian fisheries (so such ETF exists) or anything else they come up with that you know a little something about is perfectly valid; the prices of tantalum and thorium won't go to zero even if they were to go down a lot (I am not aware of any ETPs for tantalum or thorium).

A couple of notes, iShares closed a couple of sub-sector ETFs in 2001 which for the ETF industry was another lifetime ago. Also iPath ETNs are obviously a debt obligation of Barclays Bank and so a failure of the bank would jeopardize the ETNs. The ETNs are part of the BGI division which last I looked was profitable and I believe would be an attractive asset in some sort of fire sale or other restructuring should it ever come to that but you should know the risk in case you decide to step up to a little cocoa.
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As It Was In The Beginning, So Shall It Be In The End

In yesterday's NY Times Paul Lim has a sort of What Should Investors Do Now article. As the title implies, the article questions many, if not all, of the assumptions investors have about how to have long term success investing in the capital markets.

The viewpoint (as I read it) of the article is that it may take a long time for equities to recover and even when they do equities may not be so hot.

There is a huge flaw in the logic, IMO. We are in the middle of the event. As we stand now, the S&P 500 is down thirty something percent from its peak, uncertainties abound and emotion is causing people to reevaluate every financial aspect of their lives. In the middle of the event is not the time where people have the perspective to see such game changing events. How can anyone know the paradigm has shifted until it has shifted (sounds like something Master Po might say)?

As there are more and more articles questioning the death of equities these days there are a couple of facts that no one should lose site of. It is actually possible we are in a bull market right now. The S&P 500 bottomed (for now?) in November around 750 and going into Monday the S&P 500 is at 930. That is 24% in less than two months. I think the probability is greater that 24% in a month and a half is a bear market rally but we can't know the answer until later.

Anyone thinking about giving up on equities should realize where they are emotionally right now in conjunction with where the market is right now. I'll save writing about why giving up on equities is a bad idea for another time and for now just focus on the emotion that is triggering that idea. If you are pondering throwing in the towel it would make more sense to remember how you feel now, then when things recover some more and you no longer are afraid...that would be the time.

Back to the article which, as mentioned above, talks about it taking 16 years to recover from 1966 to 1982 and a similar circumstance in the 1930s. We are of course living through some version of that now. People still working who are smart enough to keep saving and investing are obviously buying at lower prices along the way and would recover much sooner.

Lastly is the ringing endorsement treasuries are given in the article.

AND as this bear has shown, no investment can beat Treasury bonds when it comes to protecting one’s portfolio in a downturn.

How's that for looking in the rearview mirror?

“And the one sector that will do extremely well in such a market will be Treasury bonds.”

How well can they do from here? This seems like the exact same thought process that is lamented at the beginning of the article about equities. Long dated treasuries are up 30% so buy them for their safety? Every one percent increase in ten year yields works out to about an 8% drop in price, at 30 years it is about a 12% drop in price. The lower yield trend could of course continue for a while but buying now is buying after an historic rise in prices.

All of this ties in with extrapolation. The thing that caused people to call for $200 oil when it was at $147 causes them to think equities will never work again and that US treasuries will always be safe (price-wise). This is what causes people to buy high and sell low.
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Sunday Morning Coffee

There is a saying in yoga, stay on your own mat, which means don't worry about how well some else does with the positions, don't worry about how you do with the positions relative to anyone else, just focus on do what you are doing.

This blog shares process. It has been a look over my shoulder for anyone who cares to look. It follows themes I latch onto, the decisions I make on behalf of clients and the things I learn along the way.

Readers share their observations and opinions in the comments which enhances the utility of the site for me and hopefully for readers as well. If you favor a certain approach or whatever and want to make the case for it, cool. However telling me or someone else you should give up on your thing because of whatever is not cool. It would be like me coming into your house and telling you how to raise your kids. As far as telling someone else what they should do here; stay on your own mat.

One thing on my mat that I do not talk about enough is certain types of themes that take years to play out. One theme, for me anyway, in this discussion would be China. As a quick recap I got in a few years ago, out a few months early in June 2007, back in about a month early in late 2008 and am considering adding a little more exposure from here.

I believe China is on a path to being an economic super power (if you think they already are then I am saying more of an economic super power). This ascendancy, both of the country on the world stage and of the quality of life for an emerging middle class, will be slow in coming and be a bumpy ride prone to big cycles (I've been saying the same thing for a while).

There are many ways in to China. I not a big fan of the ETFs because they are heavy in financials (FXI 42% and GXC 32%) and now that the honeymoon might be over for the theme I don't want the risks associated with owning the banks. I prefer non-financial and I'd rather not overly rely on exports out of China which leads me to telecom (I own China Mobile for many clients), maybe utilities (read the Barrons piece about power companies in China) or other things that play more on the ascending middle class.

A better example of a theme that could take years, if it even happens, is higher interest rates in the US. Typically deteriorating economic fundamentals leads to higher interest rates. The fundamentals of the US have been deteriorating for a while and obviously rates have not gone up. I am convinced rates will go up, I have been wrong about the timing for a couple of years now but how could they not go up is my thinking.

In terms of portfolio decisions this has meant not buying low yielding treasuries and having more cash than I'd like. That I think the bond market is a mess, and that I don't want to load up on riskier paper is a subject for another post. If rates ever do go back up then I'll add treasuries in and maybe do so for a longer time. The way I view things treasuries are expensive and have been expensive for a while. A long term theme sometimes means having to wait a long time.

Shortly after I sold out of China in 2007 I figured there would be a big drop and I would wait until then before getting back in. Well that is pretty open ended. Then as China finally did start to decline it seemed to me that cutting in half might be justified, so then an overshoot to down 60% from the peak was likely (so I got back in a little early with this thinking). That happened in the fall of 2008. It could have happened anytime or not at all but I was prepared to wait. Maybe a year and half seems like a long time to you but I've been waiting on US treasuries for longer than that.

The picture is from Hawaii, notice the turtles.
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From Yesterday's Comments

I wrote this Friday morning and somehow is never published. I don't know what happened but whatever....

A discussion broke out in the comments for yesterday's post and I thought some of it would be useful here in case not everyone reads the comments.

The comments were about buy and hold and then drifted into choosing a money manager. The reader asked;

...it is impossible to know what someone's long term performance will be ahead of time.

If investment managers are the "market", how can a manager beat the market ad infinitum? This is a logical contradiction.

My reply;

What is more important to you, beating the market or having enough money when you need (it) and being able to sleep more often than not?

In my answers above I don't think I said competence ties (in with) beating the market.

I would focus on a manager's philosophy, it is either right for you or it isn't, either gives you the sense that they can get you to where you need to be or not. A competent manager will beat the market sometimes, lag it sometimes, have hot streaks along the way and also go cold.

If beating the market is your only criteria you will be disappointed. IMO an investor needs to have enough money when the time comes and need to be able to stomach the ride between here and there.
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The Big Picture For The Week Of January 4, 2009

2007 recap
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Important Public Service Announcement

Coverage of the Dakar Rally starts tomorrow on Versus (the old OLN). It was canceled last year for safety concerns and this year it has been moved to South America.

No idea what that will be like but I'll watching.

On an unrelated note did you see any of the hockey at Wrigley yesterday? Pictures like this one of the ice where you can see the baseball stadium, the buildings and the sky are just wild. Maybe I'm the only one.

And for a little market something check out these stats about 2008 from MarketBeat. Here's a taste;

18

The number of daily 5%+ moves on the S&P 500 in 2008.

17

The number of 5%+ moves on the S&P 500 between 1956 and 2007.

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Happy Double Ought Nine

A couple of recap items from Briefing.com;

• Countrywide: On Jan. 11 it was announced that Countrywide Financial would be acquired by Bank Of America
• Bear Stearns: On March 17 Bear Stearns failed. The stock had been the subject of much speculation prior to its failure, and company management defended the company's standing until the end. The collapse of Bear led to a confidence crisis in other investment banks and financial institutions.
• IndyMac: On July 14 mortgage bank IndyMac was seized by federal regulators
• Fannie & Freddie: On Sept. 8 mortgage GSEs Fannie Mae and Freddie Mac were placed into a conservatorship, effectively wiping out the value of their equity
• Lehman, AIG & Merrill: On Sept. 15, Lehman Brothers filed for bankruptcy, AIG was bailed out by the government and Bank of America bought Merrill Lynch. Lehman represents the biggest bankruptcy in U.S. history.
• WaMu: On Sept. 25, JPMorgan bought the banking assets of Washington Mutual after the bank collapsed and was taken over by the FDIC. WaMu represents the biggest bank failure in history.
• Wachovia: On Sept. 29, it was announced that Citigroup would acquire Wachovia, although Wells Fargo eventually outbid Citigroup.

Region	Symbol	% Change
US	SPX	-38.7%
US	Nasdaq Comp	-40.8%
US	Dow	-33.9%
UK	FTSE 100	-31.3%
France	CAC 40	-42.7%
Germany	DAX	-46.3%
Japan	Nikkei	-42.1%
China	Hang Seng	-48.3%
China	Shanghai	-65.4%
Korea	Kospi	-40.7%
Russia	Micex	-67.2%
Brazil	Bovespa	-41.2%
Iceland	OMX Iceland 15	-90.0%

Holy Crap! It's like that joke "I spent a month in (insert your least favorite city) one night." We did a lot of experiencing in 2008, let's hope 2009 is far less interesting. FWIW I am expecting a very large rally, a run back close to the lows with a mid to low single digit finish around SPX 925.

More important than any prediction is to take whatever comes and react when appropriate and be proactive when that is appropriate.

As far as sector leadership, in other years I've had opinions going in (some right, some wrong) but 2009 is more difficult. If positive leadership comes from the same sectors as during the bull market then I will take that to mean we are still in a bear phase. I would be more trusting (in terms of new bull market) if positive leadership came sectors that lagged in the 2003-2007 bull market.

I believe my expectation of big bear market rally followed by a run toward the low (give or take) netting out to not much of a move is consistent with the notion of stumbling along the bottom.
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