Sunday Morning Coffee

"And if I claim to be a wise man, it surely means that I don't know."

That is a lyric from the 1976 Kansas hit Carry On Wayward Son (the word My is not in the title which I did not know until I looked on Wikipedia). I have this song on my iPod, it is a great workout song (who knew?) and seems to often come on at the most difficult point of my workout; the last 5:30 on the stairmaster.

Anywhoo that one line strikes me being especially poignant. While I am not sure that I claim much wisdom there is plenty I don't know and one thing I really don't know but that I've started to think about more lately is the serious pickle the country is facing.

The chart comes via John Mauldin and tells an important part of the story. While the spread will probably narrow in the next couple of years it is not realistic with what we know today to expect it to revert to any sort of mean.

I am thinking more about the magnitude of the deficits, how much debt needs to be purchased by someone in the future, the percent of revenue that could need to go to interest payments and the $53 trillion (or whatever number you care to insert) entitlement problem and I do not know what the answer is.

To repeat, think about the magnitude of the numbers.

One thing that will happen is that some amount of growth at some point will make the problematic numbers a little smaller. This always happens but whatever the magnitude of the effect it cannot solve the problem, not even close.

As a country we lack the political will and we as citizens collectively lack the will to make truly difficult and painful decisions. We lack political will because politicians who vote for truly difficult things will lose their next election and as far as citizens, try telling someone who relies on social security that their check needs to be cut by 2/3.

This week Mauldin wrote a lot about the book This Time Is Different by Reinhart and Rogoff. In studying just about every crisis in history it is amazing the extent to which past crises had so many things in common with each other and how similar this one has been. The other ones tended to end very badly.

My focus in this regard is not to be the one to come up with a solution to the problem and as noted above I really don't know but instead to focus on what is in our control. We can control our own savings rates, our own balance sheets, how long we work (not universally true) and what we do with our savings.

After such a dour post I'll close on a lighter note. Long time readers who are also sports fans may know my fascination with the blue turf at Boise State. Well Eastern Washington University, about 400 miles north of Boise, is trying to raise money for a red field. The artist rendering is not easy to look at I can only imagine how difficult it will be to watch a game on this stuff but if they do install the field you can bet we will be able to see plenty of it.
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The Big Picture for the Week of January 31, 2010

A few ETP odds and ends.

PowerShares filed for small cap sector ETFs for all ten of the big S&P 500 sectors. The funds will be called PowerShares S&P SmallCap then whatever sector it tracks. For anyone so inclined you can probably glean what the funds might hold by looking at the iShares S&P Small Cap 600 Index Fund (IJR) as the funds will be comprised of stocks from this index.

I think the choice being available is absolutely a plus in terms of, as I have talked about before, being able to manage cap size in a portfolio or just have better diversification for people willing to do the work of building a portfolio at the sector level but would rather not pick individual stocks.

However there are a lot of specialized or thematic ETFs that offer smaller cap exposure to various sectors. As one example mentioned previously is the PowerShares Water Portfolio (PHO) which is a client holding. PHO is 76% industrial stocks and has an average market cap of about $4 billion versus about $45 billion for the mega cap dominated Industrial Sector SPDR (XLI).

Some specialized funds are not so focused into one sector like the iShares Global Infrastructure (IGF) is 40% industrials, 37% utilities and 20% energy. It can still be integrated into a portfolio, I do so with IGF for some clients, but there is a little more to pay attention to with this type of fund. I think it is worth the effort but still it is more work.

Next up is that WisdomTree is closing ten funds including one that I have been using for some accounts, mostly smaller accounts for telecom exposure, that being the International Communications Fund (DGG). The other sector funds being closed are tech, financials, healthcare, staples, discretionary and industrials along with a couple of other funds. The three sectors funds that will survive are utilities, basic materials and energy (the energy fund is a core holding that I combine with a couple of individual stocks).

That so many sector funds are getting cut raises a couple of questions. Does this mean that not that many people are building portfolios at the sector level? What about foreign sectors? The upside could be that the people who do build at the sector level can add real value to their portfolios but I hope this does not lead to a massive contraction in themed funds. They stand to be increasingly more important in the new decade if in fact broad indexes don't quite get the job done as was the case for the decade just ended.

Next up is that iShares filed for four new country funds; Poland, small cap China, Indonesia and New Zealand (finally). The first three are me-too funds, long time readers might know that I would be most curious about the New Zealand fund.

It is likely that New Zealand Telecom (NZT) would be the largest holding but there is one aspect that could make the fund less than ideal which is that quite a few Australian companies have dual listings in New Zealand presumably because they do business in NZ too.

For example Australia & NZ Bank (client holding) and Westpac Banking are also listed in Wellington and the prospectus lists "Australia Risk" as one of the risk factors. Companies from the farming or agricultural groups probably will not have a large weighting (but I hope I am wrong) and if Fonterra ever goes public then it would be one of the largest holdings.

Moving on, UBS has listed an ETN that provides exposure to the S&P 500 priced or hedged in gold. The ticker is SPGH. Candidly I do not know if it is more correct to think of it as hedged in gold or priced in gold but Ron Rowland did a thorough write up where he says to leave it alone. I don't think I'm going to spend a lot of time on it but I would suggest reading Ron's post.

As a housekeeping item I am going to be speaking at the Moneyshow in Vancouver April 6-8. I will be speaking about ETFs so if you are in the neighborhood...

And lastly the cereal boxes; Eddy Elfenbein posted this link on Facebook that had all sorts of breakfast cereals no longer on the market. The two pictured above were my favorite boxes.
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looking-for-a-fix-for-retirement-security

looking-for-a-fix-for-retirement-security

This article is from Yahoo about the ideas President Obama is putting forward.

Here is an idea. To get people to save more how about letting people deduct $2 from their income for every $1 they put into a tax deferred account above some contribution minimum.

So for example the first $3000 (or whatever number) you deduct $1 per and above $3000 you deduct $2 per. Someone putting $10,000 into a 401k would be able to deduct $17,000 ($3000 X $1 plus $7000 X $2) from their income for tax purposes.

Additionally I would make the penalty for non-hardship withdrawals more onerous.

Is this idea crazy?
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Bull Market Bear Market Complicated Market

The idea for this post was my initial and apparently incorrect reading of the Jeremy Grantham letter. On first read I thought he was saying expressly the market is very complicated these days and while he may have have been implying as much I did not find the comment as I remembered it on the second read through. Whether he implied it or not, I will say it; the markets right now are especially complicated and appear to be facing fundamental things that it has either never faced or not faced in modern times.

We as investors need to assess it all and try to navigate through.

The list of risk factors is too long to come up with all of them off the top but things on my mind this week (many of which have been newsworthy this week) have included many countries facing ratings downgrades and having to answer questions about whether they are candidates for default, just about every US state has serious deficit problems, it is possible the GDP growth seen thus far might be all from stimulus, pension funds are looking back at a decade where US stocks dropped a couple of percent per year but they need growth of 7-8% per year, there are conflicting messages coming from Washington (not unique), US budget deficits will be starting for with the letter T for years, creating enough jobs to get the U-6 number down to something decent seems like a mathematical impossibility, it seems like a mathematical certainty that home foreclosures must rise a lot and there are more.

The point of the above the paragraph is not to lay out a bearish argument for why stocks should go down because most of these issues have been around since before the rally started last March. The above paragraph does point out the complexities that we face today. When the market goes up they build the wall of worry for the market to climb and when the market goes down they become fundamental causes for a "big" decline.

That the same factors can be both the wall of worry and a reason to go down is not new but the current events are collectively a little more complicated than I think we are used to.

A big focus of this website from the beginning, and more importantly in the portfolios I manage, has been the expectation of trouble of this sort (with no attempt to assess magnitude or predict specifics) to come along and so to seek out countries that either avoid these issues or do not reasonably face the same magnitude of trouble where the issues might be similar.

There are plenty of countries that have only endured normal cyclical events in the last two years and so are clearly emerging from contraction--some of these places have far fewer employment issues or already raising rates as the economy expands-- or do not have anywhere near the mountain of debt and associated problems or don't have the entitlement program trouble the US has (the biggest number I have seen for social security and medicare is $53 trillion) or their banks are not so fouled up or any combination of the above.

Additionally there are many countries with far fewer moving parts (as a function of being less mature) where demographics are better, growth on the ground (infrastructure to create a modern industrial society) is going to happen as these countries become more globally relevant. Put another way there are less obstacles for these countries to have normal growth or growth that is close to normal.

If you have been reading this site for a while then you know the countries I am talking about but to mention a couple Norway, Chile and Israel and you can dig up Bill Gross' ring of fire that has been moving around the web this week for some ideas about where not to look.

The flip side to this is that every country has its own risk factors and a portfolio heavily invested in any foreign markets will lag when the dollar goes up or go down more during certain types of declines. Think about how much some countries were up during the last decade. Norway was up 121% and Chile was up 194% as the US was dropping 24%. Clearly US based investors were better served holding these markets over the longer term.

However there were periods were they lagged noticeably and perhaps uncomfortably behind the US. From March 1, 2004 to May 10 of that year as the S&P 500 fell 6% Chile fell 10% and Norway fell a more meaningful 14%. During that scare in the second quarter of 2006 (do you even remember that one?) as the S&P 500 fell 6% in a little over a month Chile dropped a little more but Norway fell 17%. In certain types of declines (in these two examples each lasting quite a few weeks) these markets can lag meaningfully but looking at the big picture, that is longer term, they were clearly better to hold.

If this is new to you then going forward it means trying to discern from being wrong and having to endure a market event. All of this adds up to more complicated. We will all have to get used to it.
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Thursday Tidbits

A couple quick items today.

Depending on your level of ETF nerdiness you probably know that First Trust filed for a couple of interesting commodity stock ETFs. Specifically they have filed for a copper ETF and a platinum ETF--note these are stock baskets not commodity trackers. They will track ISE indexes but the ISE Index page did not have info on these two.

If these funds actually list I think the copper stock fund could be a very popular trading vehicle but I think I am more interested, based in initial impression anyway, in the platinum stock fund. It will cover all the platinum metals which are platinum, palladium (knew about that one), rhodium (knew about that one too), iridium, osmium and ruthenium (didn't know about those last three).

At this point there is no indication what will be in either fund so lets not put the cart in front of the horse just yet but while the copper fund will likely be heavy in Freeport (FCX) and Jianxi Copper (JIAXF) and the platinum fund will probably have a couple of South African companies and one or two from Russia but are there any companies that focus on rhodium or ruthenium? I don't know but I guess we'll find out.

The thing here that I think is positive is the specialization. Many people like to make fun of this sort of thing which is unfortunate. Investors can learn about various narrow segments but not be very comfortable picking a stock or two to capture the theme. Even people generally comfortable with stock picking in the context of a narrow portfolio might not want to pick a stock for every single slice of the market they want to own for example I'd rather own the PowerShares Water Portfolio (PHO) than a stock for that segment.

Moving to a similar subject I saw this article on Seeking Alpha about a recent IPO called China Hydroelectric (CHC). This could be a neat one, it ties together two things I am interested in; China and hydroelectricity. The company owns 11 plants outright and has a stake in one more. It will be using the proceeds, which were pretty small, to buy another plant. Based on the literature the company is profitable and has been around for a little while. It looks like the market cap started out at about $700 billion million (originally posted with a typo) based on the $16 offering price but is less now because the stock has dropped a combined 17% on both days of trading thus far. If you click through to the Seeking Alpha you can find a few links with more information of varying utility.

OK, here's the thing if you are interested in buying a stock as a proxy for a country that is more volatile than the US you might want to think long and hard about buying a stock that is likely to be much more volatile than the volatile country. So China in general seems to be a little more volatile than the US, or maybe you think a lot more volatile, and based on the limited trading thus far and the fact that it is a small company that will be transaction oriented CHC is likely to be more volatile than any of the broad Chinese benchmarks.

The opinion thus far doesn't even get into issue of whether the information provided by the company will be accurate which was raised in the comments of the SA post. It is a lot easier to think about stocks in this context that have around for a while and have a decent following that you can more easily find (be it CNBC Asia or websites). I do not assume anything malfeasant with the company but I do assume a whole lot of volatility. Where possible I try to make the task as easy as possible and a stock like CHC probably does the opposite.
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Thematic Investing With ETFs

The folks at SPDR published a report/marketing piece about several macro themes that could be coming down the pike and how SPDR ETFs fit in to those macro themes. The report was called SPDR ETF Guide To Changing Markets. I tweeted the link yesterday but have since removed it in case the report was not meant for widespread distribution. I will, however, recap what was discussed.

The first macro theme discussed was called Opportunities In A Recovering Global Economy. For anyone believing the global economy is recovering SPDR suggests looking at international small cap, international mid cap and emerging small cap. SPDR has funds for all three with the respective symbols being GWX, MDD and EWX. They say that small and mid caps outperform large cap coming off the bottom and foreign outperforms domestic.

If I am reading correctly the data cited for those conclusions go back to 2001 so obviously the last decade greatly favored foreign. I know from other sources that over longer periods of time small outperforms large coming off the bottom in the domestic market. From here conditions may favor foreign still (I think they do) but it is a little short to draw their conclusion about foreign over domestic simply by extrapolating from the period they studied.

GWX has 28% in Japan and 12% in the UK. At the sector level it is heaviest in industrials, discretionary and financials. MDD has 25% in Japan and 14% in the UK and the heaviest sectors are industrials, financials and materials. As much as I dislike Japan the exposure captured in GWX and MDD is not large cap (obviously) and the newly elected DJP party's policies should favor the smaller non-exporting companies that tend to be smaller companies so it is possible that the Japan exposure in these funds won't be a drag. That is the bull case, I want no part of Japan (at least I have not found any exposure I want), you can decide for yourself.

I would note that WisdomTree has funds that capture the same space via dividend weighting so if you are inclined to research the concept there is more than one fund to choose from in each segment. iShares has a small cap fund as well and various providers have narrower ETFs that could also fit in.

The concept behind EWX is interesting but for some reason it is 29% Taiwan so not surprisingly it is heaviest in tech at 21% but the industrial and financial exposures are close behind. The WisdomTree version of this space is also heaviest in Taiwan.

The next theme in the report was Defensive Opportunities During A Market Pullback. It focused on various slices of the bond market; high yield (JNK), intermediate term credit (ITR), long term credit (LWC) and convertible (CWB). This part of the report said something that doesn't seem intuitively correct; it said that spreads widen during market declines (that part makes sense) because investors demand higher yields on lower rated bonds (still with them up to this point), "for that reason, spread products such as high-yield bonds, corporates and other credit bonds, as well as convertible bonds have historically tended to outperform treasuries and equities during market declines." Yeahwhatnow?

Maybe I misread it or maybe there was some context missing about buying during a widening resulting in longer term outperformance once a recovery starts. The implication of widening spreads is usually that yields on lower quality paper goes up (prices down) and yields on higher quality paper goes down (prices up) so I am not sure why you would want to buy lower quality if spreads are going to widen. Be that as it may, if this appeals to you just remember yields are very low right now. Prices could stay high for a very long time but prices are high nonetheless.

Next up on the theme parade is Opportunities For Investors Facing Higher Tax Rates. This one plays on the idea that federal tax rates could be headed higher. If so then tax free income that can be had from municipal bonds could be attractive. Unfortunately something like 48 states have deficits (Montana and South Dakota being the two that don't unless something has changed in the last month or so). Several of the other mountain time zone states have relatively low deficits but there are not a lot of bonds from these states in the indexes underlying the various funds that exist. I posted awhile ago about selling what few California munis we had for clients just so no one would have to even think about the state declaring bankruptcy. We still don't have to think about it.

The last two themes seem to overlap. They are Investments That May Benefit In An Inflationary Environment and Investments To Counteract A Falling Dollar. Both Categories include Gold (GLD) and foreign TIPS (WIP). We own both of those funds. Also included is XLE and several REIT ETFs for the inflation theme and for the dollar falling theme they suggest foreign bond funds.

I have said before I have given up on REITs as diversifiers and both of SPDR's foreign bond funds, symbols BWX and BWZ, are heaviest in Japan which requires an active eye because at some point this exposure could be problematic. We own BWX for some clients and while there is no need to jump out now that could be different in a few years, maybe sooner.

Obviously missing is from the report are currency ETFs because SPDR doesn't have any. If either the inflation theme or the falling dollar theme interest you then you should look at and make a decision (yes or no) about currency funds. There are also plenty of other commodity funds out there beside GLD for actual commodities and XLE for commodity related stocks.

If my post seems critical of the report that is not my intention because there is merit to everything they say but there is also another side of every argument as well as plenty of products from other ETF companies to consider. There is nothing wrong with taking input from someone else and drawing a different conclusion.
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Update On The China Crash Scenario

The FT has this update from Jim Chanos and his opinion that China will crash. It turns out that he was really focusing on the property market.

One part of the call I did not understand was that since Chinese markets are way below where they were a couple of years ago that they would crash seemed like a low probability.

Last night I was looking at some Chinese stocks that are all in a similar business, the names don't matter and so I have removed the tickers from the chart, and as you can see they are all still down a ton from a couple of years ago.

This is not to imply they cannot go down from here but as a rule of thumb buying something that is two years and 60% from its high that has a reasonable fundamental basis for future success is not likely to be the single dumbest thing you ever do.
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Volcker's Rule Could Cause A Crash?

The rhetoric surrounding the so called Volcker Rule kicked up a notch yesterday when Dick Bove put out a lengthy report which you can read here calling for a crash if this gets put into place. He later went on CNBC to recap his thoughts. Basically limiting the growth of banks will, in his opinion, be crash inducing.

As financial stocks were falling and falling for two years the question on CNBC was always about whether now was the time to buy financial stocks. I was on CNBC in March 2008 saying no. I've been saying no for a while and still feel that way.

Part of my thesis, as simplistic as it has been, is that if this was the worst financial crisis in 80 years then we should expect more shoes to drop. I don't know if the Volcker Rule is another shoe or not because it has a long way to go before it can be possibly implemented. Between here and there it could be changed for the better, changed for the worse or simply disappear.

I would not argue with you if you think that the financial system is messed up but heavy handed fixing is going to bring problems because anything that might impede the flow of capital has consequences; how'd that short sale ban work out? I'm not saying things should not be changed or "fixed" just that the initial reaction could be unpleasant. If there is an unpleasant reaction then ok, the market will adjust and then move on. Fiddling with the financial system is different than options expensing (do you even remember that one?).

How complicated do you think this entire topic is? Do you think there are a lot of moving parts? How much of your money do you want to bet on getting this right?

One way to make navigating market cycles easier is avoiding the right things. This is where I am with the US financial system, choosing to avoid it. I was leery of the sector quite a few years ago as it flirted with being 20% of the SPX and then made a big stink later when the yield curve first inverted.

I've owned the same foreign banks for a long time (one from Australia, one from Chile and one from Canada), I also have a publicly traded exchange and just added an index provider. Fundamentally this combo avoids whatever might happen with the Volcker Rule. And if that is not another shoe, ok but I think there will be another one that will come and I don't want to expose the portfolio it.

With a nod to Occam's Razor, more problems ahead seems to be the simpler conclusion. To the extent you agree there are plenty of way to invest in the financial sector while still avoiding US and European banks. There are obviously plenty of stocks, and ETFs that allow access. iShares just launched several financial sector ETFs and one of them fits right in to the conversation. Decide for yourself if any are right for you, but beyond these new iShare funds there will be other products in the future if you are not comfortable picking individual stocks.
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Theory Time

We've been cabin bound riding this storm out for almost a week. Yesterday was the first day in a long time with no new snow fall. The combination of a lot of snow, living in the mountain time zone and not being able to go anywhere lends itself to some interesting theorizing.

I tend to be easily captivated by certain theories from other people, not that I might implement them but because when thought about in the proper context they can teach a lot about risk budgeting and portfolio construction. Not that I can substantiate this but I am convinced my openness to learning about unusual portfolio construction ideas has made me better at my job.

One is from Nassim Nicholas Taleb who has talked many times about putting 90% into t-bills from various countries and be very aggressive, in his case with options, with the other 10%. This is easy to understand. If on January 2, 2009 you put 90% in t-bills from various countries and put 10% into Apple (AAPL) at $90.75 and sold it at $210.73 on December 31, 2009 you'd have made a little over 100% in the stock and so 1000 basis points for the portfolio. In addition to the 1000 basis points from AAPL you'd have gotten some small return from the t-bills. This might all add up to 11% before figuring any currency gains. Do this every year and you have a decent chance of having whatever number you need in the future assuming a proper savings rate.

Picking one stock that will go up 100% is not an easy thing to do obviously but most of us know where to look for stocks with this potential and where not to look. You are not likely to get a double in one year out of a utility stock or a toothpaste company.

There are certain sectors that do have the requisite volatility that allows stocks to double. As hard as picking the few that actually do go up 100% is, options on even middling stocks in these sectors or groups may get enough of a pop for the speculative 10% portion of the portfolio.

Zvi Bodie has written about putting 90% in TIPS and the rest in equities but not with the same volatility characteristics that Taleb seeks. Bodie's idea is less intellectually appealing because collectively we do not save enough to put into a "normal portfolio" so if we went that heavy into TIPS it seems like we would have to save much more than we do now but I concede that for some folks Bodie's theory is perfect and gives them permission to shun risk assets (that is not a sarcastic comment, some people are better off with very little in risk assets).

The 90/10 sort of portfolio is not something I am interested in doing but it teaches some important things, things I've mentioned before. In a diversified portfolio with 40-50 stocks (or mostly stocks) the odds are pretty good that in most years the portfolio will have a couple of stocks that will double (this is more difficult with narrow ETFs). Guessing ahead of time what those couple might be is very difficult but that a couple of them go up a lot is a good bet.

The best example of this from my past is Advanced Auto Parts (AAP) a name we have long since sold. I bought it for most clients in 2004 thinking more people would fix cars than trade up. I thought it would be a fine grower but from October 2004 to August 2005 it doubled. I would have never thought that would be the stock to be one of the best performers in the portfolio but it was.

Point being that you never know where it will come from which is why I prefer to own a lot of stocks in small weightings. If in a year a portfolio is going to be up 10% and 200 basis points come from one 2% holding doubling, another 200 basis points come from dividends then maybe the rest of the portfolio doesn't have to work so hard or be too heavy in volatile names; volatility budgeting. As a clarification I sold AAP a little before it had actually doubled.

The latest theorizing on my part is to wonder whether the larger indexes could be destined for growth that is way below average because of the heavy weighting in financial stocks they all have. One big difference between the financial crisis and the tech wreck is that Internet stocks were allowed to fail but large banks, the ones that dominate the various indexes were not, mostly. The failure of many tech companies helped to cleanse the indexes.

The overweight to financial stocks also applies to quite a few other countries. Take a look at how many country funds are very heaviest in financial stocks. To the extent the crisis was/is global and the folks who believe in Japan-like zombie banks are correct then many of these indexes could be in for a rough road. I'm not talking about every country index imploding but maybe a world where US, Western Europe and Japan are way below normal and other countries are a little below normal.

In that sort of a world it would become crucial to not only invest at the country level but also at the foreign sector level. This would mean picking certain themes and also some individual stocks. in exploring this idea in the past I have explored many things like food related, water related, certain types of alternative energy and various infrastructure projects (like toll roads, airports and the like) but I think I have been looking at them in the wrong way. I've tried to think of them as having a low correlation and low volatility which doesn't necessarily hold water.

A better way to think of them is closer to regular stocks that, if there is anything to the theory being espoused above, would simply outperform the broad indexes. The fact is there are a lot of food and water problems that need to be solved and hopefully they will be solved. I do not know whether these problems can be solved but money is going to be spent in pursuit of solving them. This offers no guarantee of success but it creates a big tailwind.

If the world is getting smaller and emerging countries are in fact becoming more important in the world economic order and more people in emerging countries are ascending to middle class lifestyles then it would seem that traffic of all sorts would increase, not just traffic on the roads but that ports (air and sea) would see more traffic capturing growth of global commerce.

Alternative energy is trickier. I think it will be a long time before solar and wind at peoples houses will become really big--I'm not sure it will ever happen. However the possibility of more and more utilities getting more power to distribute from their own solar or wind farms seems more likely. I think there is more meat on the bone with wind turbine makers than solar companies. I also think companies that clean and filter the air or water could be attractive as well.

You can decide for yourself whether there is anything to this and whether the concept has any place in your portfolio but investing and portfolio construction can evolve. Would the Bogleheads or other hardcore indexers be so entrenched if we had had the same results as Japan for the last 20 years? Obviously some people think we are tracing Japan's trajectory.
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Sunday Morning Coffee

The other day I stumbled across this article on Yahoo Finance originally from MarketWatch called You'll Need More Than You Think which about needing more than you think for retirement. Needless to say I agree with the premise, it is no secret that collectively we do not save anywhere near enough money for our futures.

The secondary headline, or whatever the line under the title is called, promised to offer a savings formula. Ok, I thought, lets see where this goes. The "formula" was to save at least 5% of your income if you are 40 years old but make sure you get it up to 10% per year by the time you are 45.

This struck me as a little light so I decided to run the numbers and see how the idea plays out. In the past I have seen articles estimate the average 401k balance ranging from, if memory serves, $47,000 to $86,000. So I assumed that a 40 year old has accumulated $86,000 which unfortunately is probably a generous assumption. If this person makes $100,000 per year and starts out saving the full 10% and averaged 5% portfolio growth per year, I gave him the unrealistic benefit of putting all $10,000 into the 401k on the first day of the year but did not assume any pay raises (I did not want to make a whole day of this), at age 65 this person would have $792,358.

Another flaw in the numbers is the overly linear assumption of a 5% return every year. Over a 25% year period there would be 2-4 bear markets and a few years like 2009.

Using the 4% rule, the portfolio at that point would generate $31,694 per year. Do you agree that something will have to give? I don't know how difficult it is to start saving 10% but it is difficult to see where relying on the advice in the article will work out. It could work out, the returns could average 10% per year instead of 5% which would make for a much bigger number but relying on saving just 10% and getting 10% returns sounds like a very bad idea.

There are three things that could give but only one has to. If he lives way below his means now he would have a better chance of the $792,000 being enough, of course if he lived way below his means he could probably save more than 10%. If he lives at his means now he could make changes along the lines of downsizing, essentially living a lesser lifestyle upon retirement or he could work, one way or another, past age 65. I suppose a fourth option would be to live in denial, spend the same way and worry about it later. Trust me, trust me, people do this.

With regard to Social Security I usually say I am not planning on it being there. This is a very benign way to not really deal with it but candidly I can't figure how it continues to pay out in the future in any way that looks anything like what we know today. Regardless of when you think it starts to take in less than it pays out or what projected date you think it goes bust it just does not add up to me. This stands to be some harsh reality for a bunch of people, maybe people who today are aged 35-55, especially those folks who have not been able (either for lack of diligence or income) to set aside some money.

In this week's Economic Beat in Barron's Gene Esptein cited a paper by BLS that talked about the supply of job openings increasing dramatically in 2018 as the oldest of the baby boomers turn 72. The article implied that many of these jobs may not be desirable as a big chunk of them will be blue collar-ish jobs but a point I have made often and will continue to make is that this is a problem that requires innovative solutions and a willingness to think about things differently.

I also think that job providers will think differently about how to fill these positions. I'm sure you've read about companies doing this already. It is reasonable that the typical 67 year old would not want or need to work 40 hours per week but if prospective employers realize this, offer 15-25 hour schedules it hopefully creates a win-win. If the labor force evolves the job market will have to evolve with it.

Personally, we save more in a year than we have to spend in a year per our current expenses and I hope to do what I do work wise until the end.

The picture is our neighbor's very old Jeep pickup. We've had quite a bit of snow this week.
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The Big Picture for the Week of January 24, 2010

The week just ended was noteworthy for several reasons most of which seemed to focus on political events. A Republican won the apparently important senate seat, the healthcare bill seems to be struggling (even Nebraska Senator Ben Nelson is having second thoughts), Ben Bernanke's reappointment is a little more in doubt than people might have expected a month or two ago, Paul Volcker has inspired President Obama to try to make some changes to how certain banks do business and quite candidly the President seems to be on very shaky ground.

I guess no one in the Democratic party saw Scott Brown beating Martha Coakley and now the Republicans have filibuster ability which based on Obama's reaction jeopardizes all sorts of things. I have a very conservative and politically opinionated friend on Facebook who has been saying for ages that the Dems are toast in the 2010 election and the desperation I think I saw in Obama's speech from Ohio yesterday made me think that the administration thinks the same thing.

What I have read about the healthcare issue, although I am not an expert, leaves me thinking it stands to create as many problems as it hopes to solve. A few weeks ago when some version of the bill passed in the house a very liberal FB friend said something in praise of congress' action. I pointed out to him Howard Dean's comments, Howard Dean, about being able to charge whatever to someone with a pre-existing condition thus potentially excluding the same group of people and this friend felt it was better to pass a flawed bill that they can fix later. My friend is far from alone in this line of thinking. You know, it is possible to be in favor of healthcare reform without being in favor of wildly flawed legislation.

As far as Bernanke not getting reappointed; I agree with the thought that it will not be the end of the world. He's gotten a few things right and screwed a few things up, no different than whoever might succeed him. If in digesting a change the market goes down some more then so be it but the sun will still rise the next day.

I read a slew of commentary about the bank reforms that were sort of introduced this week. Aside from an initial reaction of "oh, boy" the first thing I thought of that seemed to clearly fall through the cracks was the idea of committing capital to get trades done. When a hedge fund or pension or any other pool of capital needs to execute a trade and they pay up to go trade through certain types of firms these firms will sometimes just execute the trade internally to take care of the client (commit capital so they client can get the their trade complete) and then figure out whether to keep the resulting long position (if the client is a seller) or whether to trade out of it one way or another. Depending on the circumstance this example starts out as servicing a client but could become a proprietary trade which may no longer be kosher. If my example is not clear there are plenty of other people writing about this.

As I heard someone say this has nothing to do with excess leverage and liar loans that are thought to be major causes of the financial crisis. Volcker's name has been attached to the idea but for some reason I don't think that is quite right or maybe someone bastardized his original idea. This is just a guess on my part so pass the salt.

Whatever, we are still a long way from this idea, or some other version of it, being implemented although Meredith Whitney thinks it can get passed. If it does happen I doubt it will have the desired effect but I also doubt it will be the end of the world. It may contribute slightly to making the US a little less attractive of a place to do business and so a little less attractive of an investment destination along with many other things making the US a little less attractive.

One thing that I believe is revealed in how markets around the world performed in the last decade was the gradual move away from US equities. There were a couple of very good years in there to be sure, 2003 and 2009, so it was not a one way trade but I think a lot of people are missing this big macro shift. The 24% decline endured was not the end of the world and was in the same ballpark as some of the big Western European countries and was a lot better than Japan. Looking forward I have said before that I think returns in the US will be positive in the new decade but will lag many foreign markets.

It is not the end of the world just a problem for investor to solve.
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Maybe A Second Cup Of Herbal Tea?

Yesterday's post was a reminder about how volatility tends to work and about letting the market do its thing for your account over longer periods of time. The post made a critical assumption that I'm surprised no one noticed. I didn't even think of it until I was shoveling slush in the pouring rain yesterday.

All the talk about keeping emotions in check and looking at results over a full stock market cycle assumed the correct asset allocation. The extreme volatility of last couple of years has hopefully taught people a thing or two about their own tolerances. Ideally this would have happened ten years ago, the first time in recent memory that the US stock market cut in half.

There have been a couple of times since March, well off the bottom, where I rhetorically asked to think about your mindset back in March. What number did you say if I can only get back to $x then I'm gonna fill in the blank (cut back, get out, whatever). First of all if you had this sort of conversation with yourself then there is a good chance that you have too much in equities or had to much if you have since sold down your exposure.

A useful thought for this discussion which I just mentioned the other day is from Nassim Nicholas Taleb. To paraphrase; if people understood the risks of investing in the stock market they would never do it.

I don't believe this is a practical concept for financial planning but it serves as a bit of a building block for an investing philosophy. Another building block at the other end of the spectrum is that from a numbers standpoint there is an argument to be made for 100% equities all the time. I don't advocate that for several reasons but there is an argument there. Yes the last ten years have been bad for equities, well actually no, the last ten years have been bad for certain equities. The oughts were not the first decade where stocks "did not work" but I do not believe for a moment they are permanently broken.

You all probably know the behavioral finance nugget about negative emotions from losses being far more powerful than the positive emotions that come from stocks going up. People tend to forget about the negative emotions they feel when the market is down a lot or when their picks are not working out.

For those of you that did bargain with themselves as described above, did you remember that you did so before I mentioned it above? I have known people older than me that freak out every time the market goes down some and simply are incapable of remembering that this has happened before. The reason I mention them being older than me is that they have been through more big declines than I have yet they cannot remember what it felt like before and can't reason what happened after. I can promise you that you do not remember every fast decline that you have lived through as an investor.

This line of thinking has influenced me in what I do for clients and what I do in our personal accounts. Getting defensive upon a breach of the 200 DMA is driven off of this subject; that is trying to avoid getting to the point of emotional desperation.

Figuring out the right target for you may not be easy. It is a marriage of how the numbers work with your ability to sleep or in the context of this week's posts not have your day determined by how your portfolio does.
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Anger & Panic!

CNBC is blaming the decline today on the Obama news. Who knows if that is exactly right but anything that impedes liquidity, incentive to trade and the like requires adjusting to.

Who can say what kind of teeth this thing will have but like other similar things in the past (and the future) the market takes a certain amount of time and percentage points to figure things out and then it moves on.

This is not the first time in your life something new has scared the market--if that is even what is really happening.
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Maybe Some Yoga And Then Some Herbal Tea

Yesterday a couple of comments came in that were a little surprising given the context of the blog posts over the last couple of weeks. One reader asked what I do on days like today (meaning yesterday) when things like emerging markets, commodities and foreign in general go down more than the market. He wanted to know if I reexamine assumptions, make any tactical moves because of such a day or watch it like water torture.

Another reader late in the day posted a comment asking what was wrong with Statoil (STO) which is a client holding. At the time this comment came in STO was down something like 3.60% and client holding WisdomTree International Energy ETF (DKA) was down about 3.20%. What's wrong?

Dudes!

I gave brief responses to each comment but thought it would be worthwhile to expand in a full post. For anyone who considers themselves an investor (versus a trader) it is very very unlikely that any thesis you believe in can be invalidated (or validated for that matter) based on the action of one trading day.

Yesterday I was down a few more basis points than the S&P 500 and this was not the first time in my career this has happened. Far from water torture I had a great day. Got my morning reading done, did some trading (implementation of a couple of new clients), shoveled snow for a couple of hours (this is fantastic exercise), took Roscoe for a walk down to get our mail (our box is about a mile away) and then did more reading later in the day capped off with some sports watching. Letting the market or my performance versus the market dictate whether or not I enjoy the day seems crazy to me and no way to live.

A big focus here, with a nod to John Hussman, is to focus on having enough money when it is needed. One way to go about doing this is to think about performance over the course of the entire stock market cycle. A couple of weeks ago I posted a made up example where an active (as opposed to passive) market participant lagged the market every year from 2003-2007, was lucky enough to get defensive on January 2, 2008 and so was 30% ahead of the market for the cycle. I asked rhetorically whether or not this person beat the market.

Themes or assumptions or whatever you want to call them need a long time to be proven right or wrong. Let's say you believe in coal as an investment and you buy your favorite coal stock and it goes up 30% in a couple of months you have made a good trade you have not had the theme validated. The other day day I mentioned that I was considering swapping out of a stock and into a similar ETF. I executed the swap earlier this week selling Monsanto (MON) and buying Market Vectors Agribusiness (MOO). I bought Monsanto on the way up at about $88 and before the trade settled (this is an exaggeration) I was able to sell some at $120. As time went on the stock went down a lot when the market did but lagged its group badly on the way back up. Lately there was some news out that could weigh on the stock a little longer so I made the swap. If I am wrong about MON continuing to lag then its weight in MOO would benefit the fund.

The point with Monsanto is that for me it started out as a good trade but proved out, for now, to not be a great way to access the space. Please note this unfolded over a couple of years not after a bad day.

I've owned Statoil since late 2004. As it was then, it is a proxy for Norway. I bought in around $14, sold some in May 2006 at $41, sold some more in May 2008 at $42 and then bought some back in October 2008 at $16. The prices here belie a certain amount of volatility inherent in the name. That on a given day it went down more than some proxy means nothing. It may not be the best way to own Norway (I think it is you can decide for yourself) but it is a proxy for the country. That did not change yesterday.

It has had a couple of big drops since I first bought it but in that time, even with the volatility it is up about 70% versus flat for the S&P 500. I have no idea if that will repeat over the next five years or not but I believe Norway to be a more attractive investment destination for that time and so will hopefully keep the name for the next five years (assuming they do not do the equivalent of BAC buying Merrill Lynch). This is a multi year theme that has added a lot of value thus far despite the occasional bad day, month or quarter.

I'm not sure what it takes to get investors (not traders) to truly take a long term focus. Hopefully the example above where the guy lagged every year of the bull market but by getting defensive came out way ahead resonates with some people. Between having an objective trigger point for defensive action and being able to see one or two very large macro themes you can add a lot of value to your result over the entire stock market cycle. I would add that adding value does not have to mean outperformance it can also mean value on a risk adjusted basis too.

For some this falls deaf and that is ok. All I can tell you is I do not want any day in the market to be torture of any sort nor have it trigger any sort of negative energy.
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How Gary Shilling Sees Things

Barry Ritholtz posted an article from Gary Shilling called 2010 Investment Strategies: Six Areas to Buy, 11 Areas to Sell. I thought I would weigh in on the six and 11, some of which I agree with and some I do not.

First thing to buy, according to Schilling is long term bonds. For anyone inclined to trade bonds then sure, if you see a trade to make go for it but for investors who do not view their bond portfolios as a place to add volatility then I want no part of long term bonds. Forgetting the economic situation for a moment, rates are very low historically which means prices are very high. Obviously buying high is usually a bad idea. Then layer on the economic situation which screams for higher rates at some point and it seems like a risky proposition.

Number two to buy on his list is income producing securities. This seems to be any type of asset class but he talks most about high yielding stocks. Favoring high yielding stocks is usually a good idea. One point I made ages ago and just made it again to a client the other day is that dividends are not always high on the priority list. In years where the market goes up or down a lot getting an extra 200 basis points in dividends doesn't necessarily help out. But just about every other time it does. After two years in a row with huge moves paying more attention to yield is probably a good idea. Paying attention is not the same as chasing.

Number three was to buy staples stocks. Staples do well on a relative basis in most market environments except up a lot. The sector did well in 2008 and lagged in 2009.

Number four was to buy small luxuries. This appears to mean low priced discretionary items like maybe a tchotchke of some sort but not expensive discretionary items. Is the Franklin Mint a public company (humor attempt)? There are stocks in this space but I have to say I have no interest in this one.

Next up to buy is buy the US dollar. He makes his case, you either agree or you don't. I have said I cannot make a fundamental case for the dollar but I realize that at any time the dollar can go up a lot for any reason or even for no reason. I believe foreign is where it's at and so will lag any time the dollar moves up in a meaningful way.

Last on the buy list is buy eurodollar futures. This is not the euro the way he means it. This is as an interest rate bet. This one is beyond the scope of what I do. If this is within your wheelhouse then presumably you already know how to access this market and have an opinion about doing the trade he talks about.

First up to sell is US stocks in general. He does not give a price target for the S&P 500 but does give a 2010 earnings estimate of $50 for operating earnings. What PE do you think should the SPX should have? If you say 15 then the SPX target would be 750. If you think 20 then the target is 1000. He doesn't say in this post and I am not a fan of this form of targeting because the market can easily appear cheap or expensive for long periods of time. I have said I think the SPX will be down 10% for the year which is down a little, so not something I think needs to be avoided unless it involves a breach of the 200 DMA.

Second to sell is homebuilder stocks. I've never understood the supply and demand dynamics in this space. When I first moved to Phoenix in 1990 I could not understand who was buying all the new homes I was seeing built. This was not predictive of what was to come, we're talking 1990, but I never understood it so I left the group alone. No one can understand every nook of the stock market.

Third to sell is selected big ticket discretionary. This is tough. I think it hinges on whether or not consumers get religion about debt and savings. Just because we should be more frugal does not mean we will be. I'm not willing to go long any big ticket discretionary stocks as individual holdings but we do have an ETF and some Nike which is probably more akin to the small luxury that Shilling would buy.

Next to sell is banks and other financial institutions. I am on board here. We own foreign banks (not from Europe), a publicly traded exchange and last week we bought an index provider to increase our sector exposure but we did so without domestic banks. If this was the worst crisis since...how can there not be another shoe to drop? Clearly there would be more harm to being long and wrong than accessing the sector in other ways.

The fifth thing to sell seems to be the same as the fourth; consumer lenders. Nothing has changed since I wrote that last paragraph.

Next item for sale is Many Low and Old Tech Capital Equipment Producers. I recently added American Tower. In my opinion tech has not been the same since the bubble burst ten years ago. I've said many times that the internet, not the stocks but the net itself, has exceeded the hype. Clearly people have made a lot of money in stocks like Apple and RIMM. We know a lot about the products. There is also a valid argument for buying the commoditized part of the sector like with the iShares Taiwan Fund (EWT)--don't own that one BTW.

Next he advises selling your home right away if you want to sell. He is not saying sell he is saying get cracking now if you want to sell as he expects prices to go down before they go up. In another bullet pointed item for sale should be commercial real estate.

He goes on to say sell junk bonds. We talked about this yesterday, they are up a lot. They could keep going but, again, they are up a lot.

Second to last is to sell most commodities. I would say it depends on how much you have in commodities and why you own them. If you simply speculated on commodities and have made a lot of money then cutting back is probably a good suggestion. If you have a little exposure for diversification then selling may not be a good idea. No matter where gold is today, if something horrible happens tomorrow what do you think gold will do?

The last one is Developing Country Stocks and Bonds. Read what he says, it is a cogent thought, but I disagree. I've written my thoughts on why I believe in this space hundreds of times. I can't imagine you don't have a sense of the bull case for emerging markets. Hopefully what Shilling says is not completely new to you either. There have been and will be times where emerging markets go down fast and hard. It goes with the territory. This is why I don't want 25% in the space but do absolutely believe some exposure will be crucial in this decade as it was in the last decade.
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This Could Be Kind Of Cool

For a short time in the 1990s the Boston Celtics were publicly traded on the NYSE and had ticker BOS. As a devoted fan I bought one share and had it sent to me. Although it was a publicly traded partnership I viewed the purchase as something neat to have not an investment. As a stock it did not do very well and at some point was taken private. I never cared about any of that, I wanted the certificate, still have it and will keep it forever.

In 1998 the Cleveland Indians sold shares to the public with ticker CLEV. It lasted almost a year and half before being bought out. This one did better than the Celtics stock. As best as I can tell from a Google search the shares were originally priced at $15 and the buy out came between $22.25 and $22.75. The actual certificates, one is pictured below, was much neater than the Celtics cert I have.

Manchester United stock used to trade publicly. I say used to because neither Google Finance nor Yahoo Finance know a current ticker symbol. It looks like the ticker in London was MNU and while I know it did trade on the pinks in the US I could not find the ticker symbol.

While Man U's stock appears to be gone the team has recently gone to the capital markets for a bond issue that has a very attractive yield; looking to be 9.25%.

I'm not a Man U fan but a lot of people are and it would not be shocking to see retail interest in the issue be pretty good. However this could turn out to be a bad idea. A site called Covenant Review found some things it did not like about the team being able to sell assets and then borrow more money that could make the bonds unattractive.

If we zoom out a little bit I think there is a more important point to take from this. We have all heard about the possibility of a bond bubble now existing. Let me just say before going on that bubble is a wildly overused word these days. There are a couple of seeds now germinating for a substantial mania. Prices are very high these days, mutual fund flows into bond funds, versus stock funds, have been huge and there is some talk about equities being broken.

There could be one or two things missing from the typical investment mania however, at least for now. In other manias we have seen a huge proliferation of investment products to sate a huge swell of demand. Try to remember how many internet stock IPOs there were and how many companies whose primary valuation was based on eyeballs that grew into $100 billion market caps. This type of behavior is missing from the bond market.

Or maybe not. Maybe the Man U issue is somewhat early in wave yet to come. In other manias new products are sold after most of a big move has occurred that is they are sold at high prices. The 9.25% Man U is looking for might seem attractive but not long ago US treasuries could be had for 7%. If you are someone who does not want to use the fixed income portion of their portfolio as a source of volatility then new product that might be fun or cool should be avoided.

This part of the bond market can move a lot. The SPDR Barclays Capital High Yield Bond Fund (JNK) has gotten a lot of positive attention for going up 56% off of its March 2009 low. The other side of that coin is that it dropped 44% from its listing price. Some folks may want volatility in their bond portfolios but whether you do is an important question to ask yourself especially if we are on the verge of some wave of themed or gimmicky new products. This sort of thing would be a warning sign were it to happen.

So in case it is not clear I do not think the football club's bond issue is cool.
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Storm A Brewin'

We are supposedly going to get dumped on all week; snow every day starting tomorrow through Friday. Someone at fire training yesterday said we're going to get three feet.

The first big storm we had this year was accompanied by winds that were close to 70 mph (no exaggeration) that knocked down trees and subsequently knocked out power and phone service for quite a while.

We were not very well prepared for being without power for that long; no generator and things (cell phones, fire radios, DVD player) not charged fully before the storm arrived. We did have a lantern for light, some batteries (could have used more) and plenty of food and water even though we did have to throw out the food from the freezer. The stuff from the fridge went into a bin and we kept it outside.

Now everything is charged, we have plenty of food and water (again) and more batteries. The biggest help of all is that our friend Bill (he of the you can figure it out now or you can figure it our later but if you can figure it out now you'll be much happier pearl of wisdom) no longer needs his generator because he is living in town and is letting us borrow it. He says it can run for 3-4 hours on one gallon of gas. We can get by on a one gallon per day (the fridge can stay cold for a long time without being on) quite well which will keep the food, let us check in online and watch a little TV. Now that we have prepared better of course the power will not go out.

As a side note how the hell are these things considered portable? Bill bought it on Craigslist and it had no wheels. That I was able to hoist it up into the bed of my pickup was truly a Festivus miracle.

If you have stuck with the post up to now then you probably see the investing parallel I am moving toward which is altering the behavior and or preparedness for our next storm (bear market). We got through the last one just fine but we learned a couple of things that should allow us to endure the next one a little easier.
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Sunday Morning Coffee

This week was the first installment of the Barron's Roundtable. There were three quotes that stuck out to me as being especially useful to ponder.

Felix Zulauf: Many American consumers are back to reality. A fourth of all homeowners with mortgages have negative equity in their homes, and another fourth have less than 10% equity.

In most instances home values will come back to what people spent to buy in. The variable is time and the exceptions will probably be in certain parts of Florida, Las Vegas and maybe Phoenix. More likely those place may just take longer. A point I have made several times with no claim of originality is that if you are living in a home you enjoy and that you can afford then a drop in value doesn't have to adversely effect you. I mean really, if you can afford it and want to stay how much does it matter? And eventually the equity issues will tilt back in your favor, that is if you were even ever underwater.

Bill Gross: When you include government and private net saving after depreciation, we are dis-saving. We are below the trend line for the first time since the Depression. We haven't even started to come to grips with the conservatism required.

Believe it or not I take this comment from Gross as very encouraging. I can't envision how the problems the US has will get solved. There is a lack of will (political and otherwise), an apparent lack of common sense and a structural problem in the government in that the fix needed is likely longer than the typical political cycle--the problems took longer than one political cycle to build.

What is encouraging is the extent to which we can determine our own savings rate, decide (mostly) how long to work, and not leave ourselves overly vulnerable to the future of the current entitlement programs. I realize this may not be the case for the majority of people but I imagine that someone interested enough in investing to visit a site like this one has a better chance at this outcome than does the majority. By saving more, people are able to put more into foreign denominated assets which will protect purchasing power if Fred Hickey is correct and the dollar index drops to 50.

I also think that more people are in a position to live below their means than actually do. The extent to which more people adopt this sort of lifestyle the better off the country will be from the bottom up. From the top down of course the implication is that a drop in consumer spending adversely impacts GDP.

Zulauf: In the past five years, the individual investor has been hit by two bear markets in stocks and a severe bear market in housing. He is just done. You see it in fund-flow statistics. Money is flowing into fixed-income investments that are perceived to be safe.

If you understand the argument that says rates in the US must go up and you buy into it then you know the risk of certain types of bond funds, mostly but not exclusively long dated treasury funds. Of course as is often the case most investors do not understand the full consequence of the risks they take. I am reminded by what Nassim Nicholas Taleb said (paraphrasing here); if people understood the risks they were taking in the stock market they would never invest in it.

I don't think Zulauf's five year reference is quite right, more like ten years. I made a comment in this week's video about many people not having a great experience navigating the market. The oughts was a bad decade, the 1970s was a bad decade as was the 1930s. There will be another bad decade in the future and then another one 30 or 40 years after that. The odds that stocks will work for a while after not working for ten years are pretty good. My own take here is that the S&P 500 will do much better than down 24% for the new decade but still below what is considered normal making foreign markets the place to be.
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The Big Picture for the Week of January 17, 2010

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Odds & Ends

The GlobalX China Materials ETF (CHIM) is now up and running. I had a chance to look under the hood a few days ago and was impressed by the fact that I recognized very few names in the fund.

I made that observation to one of the execs at GlobalX (the one who sent me the index info as a heads up) and he said that the index provider did a good job of populating the fund without overly relying on the mega caps. As a follow up to yesterday's post I would say that materials could be considered as part of the build up and out of the country's infrastructure.

I'm in the process of exploring whether or not to swap a stock out for an ETF of the same theme. There are two ETFs I could choose from. They are both very similar but one's assets are over $1 billion and the other is double digit millions. The respective volumes are lopsided as well. As it turns out the slim differences between the two have not mattered performance wise and the smaller one is a little more expensive.

So if I do the swap I'll buy the bigger fund. In this case the choice of funds is unlikely to matter and an individual investor looking at the same two funds could easily buy 200-500 shares as a position to hold. In order to do the swap I have in mind I would have to buy in the low to mid five figures (share amount) but not enough for a creation unit. It would probably not make sense for me as a small portfolio manager (I mean AUM not my height) to buy the smaller fund.

In concluding this I had a small epiphany; most portfolio managers looking for access to the space will have no choice from a logistics standpoint but to buy the larger fund making it very difficult for the smaller fund to ever gain traction. Yes there is an element of stating the obvious here but a fund forced to rely on getting by 300 shares at a time has a good shot of ending up on Ron Rowland's deathwatch. In this light why would an individual buy the smaller fund? Unfortunately this makes the case for fund providers avoiding me-too specialty funds altogether which I do not view as a positive.

The picture is from the Dakar Rally and is of Robby Gordon's H3 Hummer. If I understand what I am hearing on the video from the Versus website (we have Directv and Versus was pulled) then this year he is running it with a two-wheel drive H3 which is why he had to go through this spot like that. He would have bogged down in the sand had he not gone up the side. Who am I to second guess the two-wheel drive decision (if I even have that right) but it is a neat picture.

Short post today.
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Chanos:China=Bubble

Jim Chanos has caused something of a stir in the last couple of weeks or so by proclaiming that China is a bubble. He called the real estate market Dubai 1000 times over. Here is a link to a video on CNBC and one more link for a further recap.

So is he right? Is he partially right? Is he totally wrong? There is no shortage of opinion and commentary. I tend to come at these things in somewhat of a different way than most of the things I read, hopefully it is useful.

China has almost as many moving parts as whatever the hell is going on with that traffic light pictured below. Typically I prefer simpler investment destinations but China is too important. For anyone new I sold my one China stock, one of the oil majors, in June 2007 which was a few months before the peak. I then bought back in when the Shanghai market had dropped 60% on the way to a 70% decline with China Mobile (CHL). I recently added a little more exposure via a themed ETF. CHL has not been a very good pick thus far but the ETF is working out ok (up a little) so far.

China has plenty of risk and obstacles that anyone who invests there should have some inkling of. There are issues that press now regarding lending growth, empty office towers, concerns over real estate speculation, the government buying goods (artificial demand), some worry about the statistics being fudged, should the yuan be allowed to appreciate it could hurt exports and so the entire economy (job loss and slower growth) and further down the road there will be a demographic problem.

On the plus side the country has clearly become more important in the world economic order, has an enormous cash hoard, is spending on modernizing every aspect of infrastructure which makes the country smaller bringing a middle class lifestyle to the rural, poorer parts of the country. The spending on this stuff is going to happen even if the stock action is not linear. In fact it has been far from linear.

Another part of Chanos' argument is that bubbles are caused by excess credit. Loan growth has been troubling and the South China Morning Post recently reported that upaid credit card debt was up 126% in 2009 (this was reported in the South Morning China Post in late November but is no longer accessible) and we have this from Time Magazine noting that the average household in China saves 25% of disposable income.

This article opines no real estate bubble because down payment requirements are 30% for a primary residence and 50% for a second home. I don't know if there is a real estate bubble or not but a big down payment does not automatically mean people are not speculating. China has a different culture and different rules. If there is a bubble in real estate it would be naive to think it will be exactly like what happened in the US.

I think the use of the word bubble is actually useless. Slapping the correct label on it is less important than avoiding pain if there is to be any. This was the motivation that lead me to sell in June 2007. The Shanghai market peaked around 6100 and is now close to 3200. The Hang Seng topped out at 30,400 and is now around 22,000. And for good measure the Hang Seng Enterprises Index, aka the H share market, hit a high of 19,500 and is now in the twelves. As I have mentioned before the odds of a market going down a lot are less after it has gone down a lot.

The things Chanos worries about could absolutely come home to roost, things could deteriorate and asset values drop but some perspective on where the markets are is in order. I have been very consistent on the exposure I want which the modernization of the country that leads to the middle class lifestyle. This means no banks, no real estate, no exporters and no consumer discretionary. At some point maybe in the middle of the decade or a little later the steam behind the build up and out of the country will wane, this might be around the time that the demographic problems kick in, and I would think owning consumer staples and health providers would make sense at that point and really staples might make sense now but I favor the other part of the theme.

If Chanos turns out to be correct and we are not lucky enough to get out early then how much China you own will matter. If Chinese markets cut in half from here because of the fundamentals he is worried about then a lot of other markets including maybe the US could go down in sympathy but some of those other markets would be on firmer footing and come back quicker than China. I could see topping out around 5-6% of the portfolio in China so that if I am wrong and don't get out it won't ruin clients but if I'm correct then the exposure could add a lot to the overall portfolio.
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Blasphemy!

Did you see the Bill Miller segment on CNBC yesterday morning? If not you can click through and watch it here. He is not on very often, very rarely in fact, but (and here comes the blasphemy) the more I hear or read from him the less impressed I am.

He made a comment yesterday about when he first bought Amazon around $80 in the late 1990s but he said that unfortunately it went down to $6. The way he lamented I took to mean they sold none on the way down to $6. Obviously they bought more, he said the average price now is about $9 so it is up a ton from that average.

We know that from the financial crisis he again held a lot of the wrong names for far too long like Freddie Mac and Citigroup according to this link and AIG, Bear Stearns, Wachovia, Washington Mutual and Countrywide according to this link. I weighed in on Miller a little over a year ago.

In looking at the chart for the last decade it looks as though the decline has more than offset all those years of outperformance however that is not quite right. Adding in the dividends (per Yahoo finance) the fund is down 17.22% over ten years while the S&P 500 was down 21.1%. So for the decade it beat the market by about 0.38% annualized but took anyone who held for the entire ten years on a sickening ride.

If you got in after those first two dividends however then you did much worse over the last nine years losing 18.47% (including the dividends reported by Yahoo) versus losing 13.18% for the SPX. The numbers appear to get worse as you go shorter on the chart. Even after a great 2009 the fund has trailed the S&P by a lot over the last two years.

The second chart (down below) which you can click on to see better is from Morningstar and is for the life of the fund. My understanding is that Morningstar charts show total return, so including dividends. For a little while there right before the bear market started the fund was way, way ahead of the S&P 500 and that outperformance has been almost completely been given back because of how he navigated the recent decline.

Part of the issue that I think he has is summed up in something he said toward the end of his visit to CNBC yesterday in which he cited a fund company called Manning and Napier with an eleven year streak of beating the market. He said he saw a quote from someone there who said it will be a relief when the streak is over. Miller's reaction on Squawk was "so what you're saying is you want to underperform? That doesn't make any sense to me." He said his streak was not important but outperforming and adding value to clients is important.

I have no idea who Manning and Napier are (not a slight) but he does because they have a streak going and he read something about their streak. How is this anything but evidence of a massive ego? Given that he seems to have no sell discipline it would appear that that his massive ego gets in the way of running the fund. Do a search for articles about him for when the stocks mentioned above were only cut in half, so before most of them totally crapped out. See for yourself what he was saying. Essentially the market was wrong. I wonder how many fund holders feel like he has added any value recently.

In my previous post on Miller (linked above) there is a similar story about an interaction he had with Chris Davis. There is a saying about bull markets making geniuses out of people. Does anyone think this might be the case here? It is a reasonable question.
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How Long Has This Stock Been Hiding?

I was trolling around and stumbled across the PowerShares Global Agriculture Fund (PAGG) and one of the holdings is a company called Taiwan Fertilizer which is on the chart in blue.

The red line is iShares Taiwan ETF (EWT) which is about 50% tech stocks and the green line is the Market Vectors Agribusiness ETF (MOO) which a couple of clients own.

I've never heard of the company before now. According to Google Finance the market cap is 119 billion which I take to be Taiwan dollars which would work out to a market cap of US$3.7 billion.

Just kind of interesting.
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Tuesday Tidbits

I've got a few things I've been meaning to comment on that I'm finally getting to today.

First up is this article from a few days ago about covered call writing in the WSJ. It would be worthwhile to read the comments too. I don't think it paid enough attention to the downside of the strategy. Basically when you sell a call you cap your upside but are still exposed to all of the downside, more specifically downside minus call premium taken in.

A good example could be with Murphy Oil (MUR). The stock closed yesterday at $59.10. A call 10% out of the money, so a call struck at $65, with a July expiration was bid at $2.75. I don't know if that was a good price to sell options because only two contracts traded yesterday but can we just say that it was? So how much downside protection is $2.75 for this stock?

The focus here not poor stock picking but if the market dropped a lot which after a sixty whatever percent rally is far from impossible. If the stock dropped to $50 then the premium might turn out to be decent protection. However if you researched the stock before buying then you aren't really worried about $9 dollars for the name. The stock peaked on July 1, 2008 just over $100. It bottomed out November 19, 2008 at $43.58. That 57% drop happened as the S&P 500 was dropping a little over 30%.

While I am sure the premium for the $110 call back when the stock was at its high was bigger than it was yesterday for the July $65 it would not have helped much in the face of a $57 decline. That it fell that much does not make it a bad stock. It is a volatile energy name. If the stock market fell 30% over the next four or five months I am sure Murphy would drop more just as it went up more than the market for the first eleven months of 2009.

Selling covered calls has a lot of devotees and you know their argument, and of course stop orders can be used on the stocks or any other exit strategy but any implication (and people think this) that you can buy a stock take in a handful of percent from a call and be spared in a pukedown is woefully misguided.

On a related note I spoke to the manager of the Collar Fund (COLLX) yesterday. I wrote about this fund the other day. The general idea is that it buys stocks, sells calls and buys puts to reduce the volatility. The track record has been to reduce it a lot, to the point of perhaps being more of an alternative strategy--an idea that the manager agreed with. I think I'm going to write an article about fund for theStreet about the fund. Stay tuned.

The Business Insider had an amusing post called 12 Places To Go If The World Goes To Hell. The choices included Chiang Mai, Thailand where Marc Faber lives, Denver because the ocean will never reach that far, to Tristan da Cunha which is an island chain with only 271 inhabitants because no matter what you'll always be able to fish.

While the post is tongue and cheek the US appears to be on a path to seeing more Americans leave. I read something recently (apologies no link) that said Americans are leaving the country at a growing rate but obviously the numbers are quite small. Ex-pats still get a social security check but if healthcare isn't "the best" anymore and it turns out we end up with a price inflation problem then people will leave.

To repeat myself I find the topic intellectually interesting but would have a difficult time leaving I think and besides if you came to Walker you might think it is a different country (insert kneeslap).

I stumbled across this article ages ago called New Zealand Set For Oil Bonanza. The article quotes a "leading US money manager" who is bullish about oil prospects for NZ. There are comparisons to Norway before oil was discovered in the North Sea. Clearly New Zealand would benefit financially from a huge oil find as would any location that does not now produce a lot of oil. The article seemed to be quite lean on facts but I might be overly skeptical. I will defer to late friend and blogger Greg Newton, a kiwi, who said there is no oil in New Zealand.

Yesterday there was an article in the WSJ about Syria as an investment destination. According to the article there is a stock market there but there are very few stocks and the market is only open ten hours a week. This sort of thing needs to be understood in the proper context similar to what I've talked about before with Kazakhstan and Iran. At some point they might be very viable investment destinations. This article about Syria tells of the need for infrastructure investments, like most countries, and provides a little bit of an introduction.

The article is an introduction to a country that has a lot of obstacles in front of it. There's still a little while to go with this, it's not like anyone has filed for a Syria ETF.
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Big Retirement Planning Bugaboo

One important aspect of retirement planning that gets overlooked too frequently is paying for things that cannot be budgeted for or even planned on. I made references in the past to major house problems like the roof or plumbing, dental bills, vet bills and tires for the car.

If you've been reading this site for a while you know I am a believer in having some sort of job after "retirement," a secondary career or whatever. It occurred to me that maybe in the early retirement years someone could work enough to cover the monthly, budgetable expenses and use savings to cover the unexpected things that come up. I thought it might make sense to quantify the unexpected or at least try (I understand the inherent futility of this).

To do this I looked at our expenses for 2009. I subtracted the things we budget for like various insurances, utilities, taxes and so forth and just kept the things that are one off items like car repairs, the dentist, clothing, Home Depot and gifts. In telling you the gross number some will think we are cheapskates of the highest order and some will think we live like ignorant lottery winners. We are neither.

The gross number was $32,620. The single biggest one time expense in 2009 was $1065 for my wife to get a crown at the dentist. The second biggest one time expense was $877 for tires for the pick up truck, "dude you tires are like practically bald" and they were. So 6% from just two things. Another big one was vet bills which totaled $795.

The gross number includes two things that could be deducted. We don't budget for gas for the cars. We both work from home so our use is very lumpy. Our total for 2009 was $1594 (from eyeballing the Quicken report) so while this needs to be paid for if it is deducted from the one offs then the gross number for one offs drops to $31,026. The other thing that could be removed, maybe, is travel expenses. If I counted correctly the total (personal and business) was $5522. The potential reason to exclude it is that more than anything else travel is very discretionary (most of the time). If removing travel is correct (some will think it is reasonable and some will think not) then we are looking at $25,504 in unexpected items for a randomly chosen year (2008 and 2009 are the only two complete years in my Quicken).

Chances are you have some sort of reaction to the numbers (the $32k, the $25k or anything in between) as being high, low or about right. I would suggest you undertake the same task. I have to imagine that the actual number for you will be higher than you think and I don't think it would be practical to eliminate too many things from your planning either. Occasionally we all need clothes, some younger relative achieves a milestone that will cost you money and you will need more than an oil filter when you get the oil changed.

In circling back to the idea of working in a post retirement job of some sort to cover budgeted expenses and the portfolio to cover the one offs you still can't exceed 4% without running into trouble later, or more correctly increasing the odds of running into trouble later. Taking my $25,504, the portfolio would need to be $637,600 just to cover the one offs and of course next year the one offs could add up to a bigger number (we had no calamity with the house). There are obviously other things that pertain but that are not being mentioned.

Bugaboo!

What is a reasonable number for monthly expenses? Chances are you think that whatever you spend is a reasonable number. The rule of thumb about replacing 75% or 80% of your income is too simplistic but focusing too much on your known expenses is also incomplete.

The extent to which this subject can be complex knows no ends. The variables are unlimited. This is probably why so many people make their living trying to sort this out (writers and planners). Do-it-yourselfers can make a full time endeavor out of trying to get it right and then have their fate decided by random luck like the year they retire.

You most certainly won't find all the answers here but hopefully a couple of good questions. You can mostly control fixed expenses and while you are working you have some control over how much you put away. It most aspects of life it pays to focus on the things you can control as opposed to the thinks you cannot. I also think we have some control over trying to figure out innovative ways to help solve the problem which is why I write about things like my neighbor with his backhoe so often.

Was the Cardinals' win over the Packers about the craziest finish for a playoff game ever? It had to be up there. Just crazy.
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