Sunday Morning Coffee

Yesterday during the Olympics I spent a little time reading about Karl Popper, seriously, and while no one will confuse me for a Popper scholar I am in a slightly more critical (thinking) frame of mind than whatever is normal for me. With that in mind I stumbled across a couple of things that could be worth thinking about, critically or otherwise.

First up was this comment left on the Seeking Alpha version of yesterday's post (sorry if that link doesn't work correctly) about the agriculture theme. A reader asked rhetorically "Why by an ETF, instead by a basket of AG stocks, you will control portfolio, and generally get a better return. I have often looked at various ETFs, but they seem to underperform their parallel markets."

Oh boy.

His comment is a cornucopia of fallacies and other behavioral issues in just a few short words. There are always stocks related to the specialty of an ETF that will outperform the ETF but of course there are always stocks related to the specialty of an ETF that will lag the ETF. Within a fund some portion add to the return of the fund and some are a drag; this should be obvious. Perhaps the reader in question can "generally get a better return" but the implication of how easy it can be is very optimistic.

Similar to the holdings in a fund, in a diversified portfolio whether it uses ETFs, stocks or both there will be holdings that do better than the market and some that lag. I would hope this too would be obvious. The proper expectation whether you pick stocks or use ETFs is that whatever method you choose it cannot always be the best. A good example came up earlier in the week. I disclosed owning Vale (VALE) for most clients and how in 2009 it lagged iShares Brazil (EWZ) but that in most other years since I've owned it it outperformed that ETF. I'm quite pleased with it as a way into Brazil but it will not always be the best way in. Going forward it would be reasonable to expect some years of beating EWZ and some lagging and it would not necessarily be easy to figure ahead of time when that would be.

Embedded in that last sentence is the notion that the market is random and the magnitude of randomness is random and the reader's comment ignores this completely. I believe part of the equation for success in the market (I should probably talk about this more) is a healthy respect for the vagaries that can cause the market to move big in one direction or the other for no reason at all. Taleb has talked about the need that people have to explain why the market or a stock did something or another when often the truth is there is no explanation. "Just because" is often the correct answer.

In a similar vein lately I have been reading posts by Graham Summers as published on Seeking Alpha. Of late, and maybe longer than that I'm not sure, he has seemed to aligned with the deflationists. He has written posts about troubles in the US bond market that I have found insightful. He draws more negative conclusions than I do which is why I read him. It is useful to understand the most bearish of arguments in order to understand what might go wrong and then decide for yourself on the probability of the argument panning out.

His latest post is actually a two-parter titled Is Deflation About To Rear It's Head? He is reasonably down on the extent to which the extreme measures taken created the fuel for the rally that started last March and has quite a few negative things to say about Wall Street as the rally has unfolded, he thinks there are big problems to come and that we are starting to see signs of that trouble now. His past commentaries about recent bond auctions are good reads and are part of his thesis. Then he notes the following;

There are many forces at work in a market, but ultimately the sentiment of its participants is what decides where stocks go in the near-term. With the market being dominated by those expressing the sentiment of desperately wanting to believe that the worst has passed (how many times have we heard this proclamation in the last 18 months?) it is not surprising that the market was dominated by the “inflation trade” with stocks and commodities generally rallying higher and higher, becoming more and more divorced from reality or Market Forces in the process.

This fact is most evident when you compare the performance of a company that believes and lives (literally) based on Government Intervention - Goldman Sachs (GS) - to that of a company with little if any exposure to Government Intervention - Coca-Cola (KO) - and the general market itself - S&P 500 (SPX).

He inserts a chart showing that Goldman Sachs outperforming Coke (KO) over the last year by a mile and the S&P 500 by a little less than a mile. He then concludes;

As you can see, companies influenced by Government Intervention clearly TROUNCED those that did not, as well as the market itself (more on this in a minute).

This is something of a generalization and proves nothing. I left a comment noting that Apple (AAPL) is not "influenced by government intervention" and it blew the doors off of GS in the last year. His example proves nothing and neither does mine. Here is where maybe some Popper applies. I believe Popper was most known for the following (paraphrased); all the positive results in the world can only support a conclusion but it only takes one negative to refute it.

More specifically a high beta stock like GS is a very good bet, but not a guarantee, to outperform a low beta staples stock like KO during a monster rally like we've had. That the firms "influenced by government intervention" benefited unfairly and are a part of the problem (however you care to define the problem) is far from an unreasonable conclusion but GS besting KO means nothing.

Many of the most bearish of bloggers use unquantified phrases like utter collapse or total failure which I think are unnecessary. Peter Schiff, among others, is big on this of thing and I do not know why. A clear, concise and correct analysis arguing for inflation, deflation or any other flation can be written without undefined parameters and hyperbole.

The picture is from Yosemite.
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The Big Picture for the Week of February 28, 2010

Another assist today from Market Folly as they review an agricultural fund from Passport Capital. In the report that Market folly published Passport disclosed being up 10.3% in the period reported versus 66.6% for Market Vectors Agribusiness ETF (MOO). I recently added this ETF to client accounts.

With these sorts of things you can only find out what they are willing to tell you so only a few of the holdings were disclosed. Those holdings were Imperial Sugar (IPSU) 12% of the fund, CF Industries (CF) 10% of the fund, Pilgrim's Pride (PPC) 5% and Makhteshim-Agan Industries (MAIXY) which is an Israeli company at 5%.

Also disclosed were the sub-industry allocations which were Ag processors (sugar, corn, ethanol, and oilseed processors) 21% long exposure, protein processing and production (poultry, beef, and dairy) 21% long exposure and ag inputs (ag equipment, fertilizer, seed and crop protection) 23% long exposure. I've worded it as it was in the report. The fund can go short but I am not sure what portion of the fund is in cash or in short positions but there was mention in the commentary that attributed some (maybe all?) of the lag to the expectation of a big market correction in 2009 that never came (the fund was implemented on March 1, 2009).

There are all sorts of things to learn here. I may be wrong but it seems like the lag was a market call that was wrong not poor stock selection within the theme, indeed although we don't know when things were bought and sold in the fund the holdings disclosed ranged in performance from just fine (relatively) to outstanding (yes there could be window dressing, but I am giving them the benefit of the doubt).

The incorrect market bet cause the fund to not be a proxy for the space in which it invests. If you are inclined to ever seek out a fund like this (it is not a mutual fund that you buy at a brokerage) it is worth making sure who the asset allocator is, you or the fund manager. I've talked about this before in a slightly different context. When a person has a broker (a rep at Merrill or Morgan) place money with active managers those managers need to assume that the asset allocation decision has been made and stay close to fully invested at all time. This creates problems when the client does not realize that the manager won't go on defense but that the broker needs to pull assets back which is a rare thing--at least this is how it was at the start of the decade when I spent about ten minutes working at Morgan Stanley.

For anyone interested in thematic investing either in an undiversified way or closer to what I do in embedding a few themes moderately into the portfolio this raises other questions about just how to add the theme in. Even if the result had been inline with MOO or better than MOO a read of the report tells you there is a lot going on under the hood--far more moving parts than just buying an ETF (MOO is not the only one). At some subjective point an investment product or strategy goes from being sophisticated to overly complex.

Whatever the agriculture theme does in the next few years I would expect that an ETF would easily capture it. A fund like this could certainly add value versus an ETF of course but the nature of the theme in the last couple of years has been to add volatility to the portfolio in both directions and I would note it has a nice fundamental tailwind. If you sniff around the Market Folly site you will find a much more detailed report on the theme (as opposed to the fund) and the research is compelling. In addition to per capita incomes going up in quite a few emerging markets so is protein consumption. Passport notes that the world's population is on pace to grow by 50% in the next 40 years and research from EG Shares notes that a huge portion of the world's births are occurring in emerging markets.

Like with other themes, this is going to happen, diets are going to improve but it will require a lot of things to click and it seems logical that the stocks will benefit from this.

In this context buying fertilizer companies makes sense as do seed companies. They will have to be part of the solution. Certain food producers and farms are interesting and would seem to be logical to include but I am still trying to figure out what to make of them. Some farm stocks that I have mentioned in past posts have had a wide mix of results.

MOO's result for six months has been up 11%, for one year up 60% and down 25% for two years. Black Earth Farms (BLERF) has been down 2% for six months, up 35% for one year and down more than 60% for two years. Trigon Agri (TRGAF) for six months has been down 20%, up 70% for one year and also down more than 60% for two years. New Britain Palm Oil (NBPOF) for six months has been up 30% but does not go farther back than that. Lastly New Zealand Farming Systems (NZFSF) has been down 15% for six months, down 20% for one year and this one too has been down more than 60% for two years.

In looking at the six month chart comparing all of them New Britain looks most like the ETF in terms of volatility, the other stocks all appear to be far more volatile. Perhaps this is attributable to the floats on these being small or just a sign of the times but as interesting as these might be, and if you look you will see they are interesting, they are probably not quite ready for prime time.

As more and more people like Barton Biggs, Marc Faber and Jim Rogers keep telling us to buy farmland I will be curious to see if that benefits stocks like the ones mentioned above.

One thing that hopefully this post conveys is that with themes there can be many ways to build them into a diversified portfolio. I would also add that themes evolve and the best way in today may not be the best way in two or three years from now. Part of the job with buying a theme is staying current and also exploring new ideas within. Similar to what I mentioned the other day I am putting in some time on these farm stocks but still; not quite ready for prime time.
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Digging In To Portfolio Evolution

Long time readers may know my fascination with the evolution of portfolio construction and the exploration of "new" asset classes and market segments. It is worth noting that more time is spent on the exploration than actual implementation but I view a big part of the task as being research and study in the hopes of adding value in the future even if the study simply tells you what not to do. It is truly fascinating.

Embedded in the topic is seeking different ways to construct a portfolio to account for short term events or bigger picture changes in the world and whether the current situation is a short term event or a change in the big picture.

This brings us to the latest recap of the Absolute Macro Fund run by Hugh Hendry from Ececlectica via Market Folly. Hendry is a deflationist these days. I don't necessarily agree with everything he says or run out to copy his trades but he is very insightful and the positions he puts on can convey several messages. Per the Market Folly post Hendry was up 31% in 2008 and down 8% in 2009.

Only the fund's top ten holdings were disclosed. The largest by far is 19.8% of the fund in EUR-LVL. He is short the Latvian lat (LVL) against the euro. LVL is pegged against the euro and the peg is causing all sorts of problems for Latvia as the government won't give up the peg. At some point you would think it would have to be depegged or otherwise adjusted and apparently Hendry thinks the same thing. I first mentioned Latvia's troubles three years ago.

In theory, let me say that again, in theory the trade can't lose other than carrying costs or other slippage. It would seem he is content to wait for the depeg to happen. There is probably something to learn from that even if there is no easy way to access LVL.

The fund has 7.4% and 7.1% respectively in Australian ten year sovereigns and 30 year German sovereigns. Going out that far is a good trade if deflation really happens and both countries are obviously on relatively firm footing. Also featured in the top ten are five different tobacco stocks adding up to about 10% of the fund. I guess that no matter how bad things get people will still smoke, maybe some will start to smoke--clearly this is a bet on stock prices going down.

The top ten add up to 52% and the fund's "gross invested position is 75.5%" which I take to mean there is 24.5% in cash. Only 25% of the fund was in long equities and we know at least 10% was in tobacco stocks. The letter talks about high yielding pharma and utility stocks as well but those were not disclosed. Also mentioned in the commentary were currency positions in USD-HUF (Hungarian forint) and GBP-NZD and a recently added position in USD-ZAR (South African rand). These positions seem to point to betting on risk aversion which also seems consistent with the deflation bet.

The fund is obviously an absolute return vehicle and the literature notes there is no benchmark. It is clear from this post and even more so if you click through and read the report that the fund will go anywhere to seek its result. A 31% return in a year like 2008 is evidence of a great call, no question about that, but not what I would expect from any sort of absolute vehicle. Either "absolute" is not the most accurate description or maybe my interpretation is too narrow.

Reading about these vehicles and then pondering whether or not this is the way to go is intellectually interesting but I would not expect 30% in a year very often, never actually and you will get a couple of those in your lifetime from a normal equity portfolio which would be a big chunk of your lifetime return. Anyone thinking they want to give that up probably needs to plan on saving a whole lot more money.

That said there is room for a little absolute exposure in a diversified portfolio and much to learn from gameplans like Hendry's.
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More Disagreement With Zweig

One more nugget from Jason Zweig that I think misses the mark on portfolio construction. On page two of the Advisor Perspectives interview he talks about emerging market economies likely to grow more than the US but that has not necessarily lead to emerging stock markets outperforming the US and that GDP growth doesn't necessarily correlate to stock market growth.

Zweig again does not cite any time frame. We know that emerging markets dramatically outperformed the US in the decade just ended. We also know that in the middle of the tech bubble (1997) Asian markets got hit hard as did Russia in 1998. From 1995 to year end 1999 the Brazil Bovespa had a more volatile ride to a much larger gain that the S&P 500 (350% to 200%), the data on Yahoo goes back to 1993 but it shows Brazil going up so much in '93 and '94 that I do not think it is right but if it is then all the more to my point. Data on Yahoo Finance goes back to late 1991 for Mexico which was up 400% versus about 275% for the US and there is also data for the Hang Seng index for the entire decade and that market was up 450% versus 300% for the US.

I looked for data for other markets on Yahoo Finance but did not find any. While I do not know the time frame Zweig had in mind but I do know that while my little bit of looking at the 1990s is not comprehensive it might make me second guess the relevance of Zweig's comments about emerging market stock prices. Is he drawing these conclusions from a period that includes the 1960s? If so, is that relevant today?

He goes on to say that "to be overweight something that is so obvious that virtually every investor in America knows about it is a very risky thing to do." Asking the question about emerging markets being crowded is the right question. While that is the correct question I would ask how overcrowded were emerging markets in 2009 when iShares Emerging Markets ETF (EEM) went up 60% versus twenty something percent for the S&P 500.

Missing from the Zweig's comments were any notion of fundamental assessment or forward looking analysis for a particular country. Countries not choking on their debt, having something that other countries need (even if it is just labor) that appear to be getting richer are probably good places to look at closer. There will be risks of course like China and overcapacity and Thailand and political stability but some reasonable tailwinds and a little bit of properly conducted research and you probably will add value to a portfolio versus one without emerging market exposure (it is not clear he is advocating zero exposure but he might be).

On the other side of the argument is Marc Faber who says investors should have 50% in emerging markets because that is where the growth will be (Zweig says this is not a good reason). This is where the growth will be but moderate portfolio exposure is still a good idea as the downside volatility, when it occurs, can be extreme and a 50% weighting could be an emotional deathblow.

Rob Arnott has an article up at IndexUniverse where he lays out the case that "sizable real returns will prove to be difficult for the second 10-year stretch in a row." If this turns out to be correct there will still most assuredly be countries that thrive both economically and stock market-wise. It is likely there will be several countries that are not on anyone's radar now but will become must own destinations later; candidates for this might include Cambodia and Kazakhstan.

I am not sure if Zweig does not believe in doing research (not a shot, it seems like indexers don't do fundamental research) but if there is anything to the notion that investing started morphing into something a little different ten years ago in terms of expected return as has happened a few times before we clearly saw that success in the last decade was about country selection and sector avoidance and this left a lot of people behind. If we see something similar in the new decade then indexers will have been left behind for 20 years which intuitively means that a lot of financial plans (again talking broad indexers) will fail.

I was saddened to hear that long time New England Patriot Mosi Tatupu passed away yesterday at age 54. I remember him being very popular. I used to get a real kick out of how Howard Cosell would say his name; almost as good as the way he said Manu Tuiasosopo.
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Twofer Wednesday

First up is an interview with Jason Zweig at Advisor Perspectives. I tend to read a good bit of his stuff as there is usually an interesting nugget or two but I tend to disagree with his conclusions. Candidly I do not know much about his background other than he's been a prominent writer for quite a while. I have no idea if he has ever been a decision maker in any sort of investment capacity.

In the interview he has some interesting things to say to advisors about making sure they try to understand how risk and volatility work (I have no idea how good his understanding is).

He goes on to say a couple of other things that I think are overly simplistic. He says "The financial advisory community has fallen hook, line, and sinker for the Wall Street propaganda that every investor should have at least 10 percent of their assets in commodities" which he says is unfortunate. He notes that commodities have generally gone down in price over long periods of time so owning them, in that light, is not ideal.

Well I've never been in the 10% camp so I do not quibble with that. The interview does not cite the period of time he is talking about. He made a comment about how long it took to break even in gold for anyone who bought at the high. If part of the reason to own commodities is that they usually have a low correlation to equities and equities had a massive super cycle to the upside from 1982 to 2000 then a poor result in commodities is far from a black swan. Without knowing the time period he had in mind, from a performance standpoint commodities were not important for most of the 1980s or the 1990s.

However during this past decade they were very important as US equities dropped 24% pricewise. Ten years ago gold was around $300 versus a little over $1000 now, Copper was a little less than a dollar versus about $3 now and soy beans more than doubled.

In thinking about commodities for the next decade will they matter or not? To figure that out do you want to rely on what happened in the 1980s or do a forward looking analysis on supply and demand trends around the world? Asset allocation and portfolio construction is not as simple as people like Zweig make it out to be (in his articles anyway, I've never read one of his books).

The other item came from a reader who asked if I've compared returns of stocks I've picked versus ETFs. It is not that simple. Not every stock lends itself to an easy comparison to an ETF. Yesterday I mentioned my Brazil stock, which is Vale (VALE), had lagged EWZ last year but has beaten it in other years. Over five years (I've held it a little longer than that) VALE is about 50% ahead of EWZ. Additionally I sold some in the mid to low $30s in early 2008 so how would I compare the two? I own a Brazilian stock because I do not want to own Brazilian financials and EWZ is heavy in financials.

I've disclosed owning Caterpillar (CAT) which has generally outperformed the Industrial Sector SPDR (XLI) but it doesn't always. However I traded it a couple of times along the way so comparisons are difficult. One name that has not worked out so well is China Mobile (CHL). I bought way below its high but it is down from where I bought it. I'm not sure there is an ETF that makes for an easy comparison. Part of the reason I chose it is that I want to avoid financial companies from China. In the time I've owned it it has done about the same as FXI but even if it had lagged badly I am unwilling to risk client money in Chinese financials.

Up to this point the conversation has ignored the concept of risk adjusted return. In a properly diversified portfolio some stocks could be thought of a volatility dampeners so with those beating something is not necessarily the goal. I recently disclosed swapping Monsanto for MOO. These two probably are more of a direct comparison in the context that the reading is asking. As I disclosed however, MON started out better than MOO and then lagged. MOO went down much more during the worst of the bear and so bounced back a lot more and so while these two might be comparable I am not sure the action taken allows for a comparison.

To repeat it just isn't that simple.
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Are ETFs A Miracle Cure?

By now you know that ETFs provide easy access to the broad market or narrow segments. They are a means to invest or speculate. They also help you regrow hair, lose weight, help with bone density and prevent or cure a lot of diseases. Well it turns out all of these things may not be true; ETFs may not regrow hair.

Ok I'll ease up on the sarcasm now. A few days ago the WSJ had an article about ETF tracking errors for 2009 averaging 125 basis points and noted that 54 ETFs had tracking errors exceeding 300 basis points. This caused Felix Salmon to ask "Is this the beginning of the end of ETFs as an asset class?" I would note that ETFs aren't really an asset class but more like access to asset classes.

So ETFs, the plain vanilla ones, own stocks such that the combo within the fund tracks an index. The creation/redemption process and the arbitrage potential that exists are supposed to prevent the funds from straying meaningfully from their indicative values. In addition to the numbers on this from 2009 I know that in the fall of 2008 bond ETFs came unglued in the immediate aftermath of the Lehman weekend.

Obviously I have been a big believer in the product and I believe it is fair to say I was relatively early in writing about them and doing so a little differently than most folks. However I've also been consistent with several caveats and an important disclosure.

First thing to revisit is that ETFs are investment products. Like all investment products there are pros and cons to using them. Part of assessing the utility of an ETF is to weigh the pros against the cons and make a decision. If you are not aware of any cons for an investment product you are considering then you do not understand the product very well.

Next is that ETFs simply offer access to various things (stocks, bonds, commodities, currencies and complex strategies) that is it. A particular ETF might be the best way to access something or not. Even if an ETF is the best way to access something that does not mean it is perfect.

If you build your portfolio at the sector level, for example, then you are figuring out the best way to build each sector while at the same time you might also be trying to work country decisions into your mix.

An example I have used before is with Brazil. The country hasn't sneaked up on anybody, it has been a popular investment destination for quite a few years. If you want to pure exposure to Brazil you are very likely going to choose a stock (there are plenty of them) or the iShares Brazil ETF (EWZ); you could also choose the Market Vectors Brazil Small Cap ETF or the soon to launch EG Shares Brazil Infrastructure ETF. If you buy an ETF you avoid single stock risk but, in the case of EWZ, you take on a lot of financial exposure. Buy a stock and you take on risk but avoid the financial sector (assuming that matters to you).

The above refer to composition issues. The risks, maybe cons is a better word, addressed in the two links above are more structural. ETFs can stray from their indicated value. Divergences can be short lived or last a long time. There is no way to predict when this will happen or how long it will last when it does. The possibility of such a divergence just goes with the territory just as a stock you buy today could have really bad, unforeseeable news tomorrow.

If the possibility of any tracking error is unacceptable to you then you should not use ETFs at all. From there it might get a little subtler. In 2009 EWZ was up about 100% versus 24 or 25% for the S&P 500. The person above wanting Brazil a year ago made the correct country decision. If they chose EWZ as their way in they added a lot of value to their portfolio. For the sake of discussion let's say that EWZ was up exactly 100%. If the underlying index was up 101% and you got 100% would you be ticked off? There is no wrong answer here, that 1% would either be acceptable or it wouldn't. If the 1% difference is ok then what about 2% or 4%? At what point would it be unacceptable? Again there is no wrong answer but how you answer goes a long way to whether or not ETFs are a good tool for you to use.

If you can't accept the possibility of a tracking error then, where Brazil is concerned, you probably need to pick a stock which is ok. I use a stock for Brazil as opposed to an ETF. Last year my stock lagged and other years it has beaten the ETF. That sometimes the stock does better while at other times the ETF does better is not an argument either way for ETFs.

One other point about tracking error is that the average was 125 basis points. The conversation is not about closed end funds trading 20-30% away from their net asset values. The potential tracking error of ETFs might still be unacceptable but this is not the same as closed end funds--at least not now.

The disclosure I referred to above is that I do not use many ETFs in larger portfolios. In accounts above a certain dollar size we can hold 40 names without giving away too large a percentage to commissions. In those accounts there are maybe half a dozen ETFs and the rest are individual stocks. If I think an ETF, warts and all, is the best way to access something then I use the ETF. I am agnostic about which product I use, I simply have to believe that going forward a thing is the best way to capture the space. Not that I can't be wrong of course but anyone can be wrong with anything they hold.

This is why I've never understood firms that say they only use ETFs. No product can be the single best way to access everything. The notion of limiting your portfolio to just one product makes no sense to me. Today an ETF might be the best way to capture Egypt (the only way really) but if a year from now Arab Cotton Ginning (a real company in the ETF) lists on the NYSE it might be worthwhile deciding if it could be a better way in; it might be (just an example, I know nothing of the company) better than the ETF, the 42% in financials could end up being a drag on the fund for all we know.

If you have been with this site for while then none of this should be new to you. ETFs are a great addition to the tool box but they have never been perfect and to the extent people are surprised tells me that they did not know the product very well. A less that perfect investment product can still be a great way to access a segment of the market.
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Big Changes Whether We Like Them Or Not

A lot of people write about big changes going on in places like China. I've referred to this sort of thing as emergence of a middle class and an ascendancy to an "American lifestyle." To repeat, these represent big changes in how things are done and we are seeing it happen in a very short period of time. This might be analogous to the idea that innovation occurs at an increasingly faster rate.

Just as other countries are making changes toward their perception of an American lifestyle the real American lifestyle is also confronting issues that may result in change that is not for the better and of course we are seeing that happen very quickly.

My father in law worked for the same company from the time he graduated high school until he was 55. In retirement he draws a pension that is certainly less than his final salary but it is sufficient and along with social security can do the job for as long as it needs to (assuming it is properly funded).

His son (my brother in law) is about my age and as best as I can tell is more successful than his father but has had three or four jobs in the 19 years I have known him and at no point has he had to think about a pension. His retirement will boil down to social security (if it is still there) and whether or not he and his wife have been able to save money effectively.

So from one generation to the next (literally) a completely different retirement, transformational really. This example belies an evolution of sorts that could be for the better or worse depending on your viewpoint. The extent to which this is big or important also depends on your viewpoint. We've seen other big changes in recent years including a complete redrawing of the map of Eastern Europe and mass adoption of the internet within 10-15 years of each other.

Anyone thinking these are big changes then needs to be prepared for more big changes. In this context social security and medicare seems like an obvious place to look for big changes in our lifetime. The numbers are massive (perhaps as much as $53 trillion) and no one appears to have the will to actually fix it. Given that no politician will ever vote to pull the plug (my choice) then saving it probably requires some combination of higher taxes, smaller benefits, pushing out the eligibility age and means testing. All four things are "unfair" one way or the other but the program is $53 trillion in the hole.

Once we got over the pain of pulling the plug on social security and medicare and presumably finished swearing in 535 new legislators we could move on to something like a 10-15 year wind down where people above a certain age receive their benefit while the rest of us pay in bitterly (sorry, but the real solution will involve meaningful sacrifice).

From there I think the size of the problem gets much smaller and the government (they are going to be involved no matter what) can then figure out what the one time costs might be, clearly something so radical will cause numerous dislocations, I'm thinking related to housing expense and healthcare expense for people who end up destitute as a result. Welfare may end up being a larger program than it is now but I think much smaller than social security and medicare.

Then a little down the road there would be fewer people newly displaced people in welfare as people realize there is no government check waiting for them when they turn 70. These folks will be forced to do something like work longer, save more or both. Americans will have to adapt, plain and simple and of course we can even if we are ticked off for a few years.

Ok back from fantasy land. I realize nothing like this will ever happen and can see some of the flaws of what is mentioned above. The point of this is not how unviable my thoughts are, the point is that solving the country's financial problems will require us to make big transformational sacrifices to pull off a positive and big change.

Did you watch that hockey game last night? As intense as Olympic hockey is, when was the last time a game was that intense? Have you ever seen an empty net goal like the one Ryan Kessler poked in? Sorry about the picture, it was the best I could get from the NBC video.
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Sunday Morning Coffee

A little help?

I've mentioned a couple of times that I will be speaking at the Moneyshow in Vancouver in April. I found out this week that I will be giving a solo presentation on portfolio construction with ETFs.

In the past I've done a presentation or two like this and written articles in a couple of place on the topic. What I do with this is build an actively managed portfolio going sector by sector using all types of ETFs in an effort to build a practical, diversified portfolio with the weightings I think make sense and embedding themes that I think are useful. The concept lends itself to updating every so often because of the new funds that come to market.

The big idea is not run out and copy this but more like here is a example of how narrow based ETFs allow for building portfolios that can offer much better diversification and avoidance than broad based funds.

One time that I did a presentation on this, two or three years ago, there was feedback from someone who did not understand why I picked what I picked for the portfolio. This person did not know whether the picks were random or what. I spent the whole time talking about the various holdings and why they were there but obviously was not effective in terms of reaching this one person and so I have to believe he was not the only one in the room who felt this way.

If I am going to speak to a crowd (although I can't rule out crickets and tumbleweeds) it would be nice if it were useful to them which is where you, hopefully, come in.

If someone is picking an ETF what do you want to hear from him as to why? If I include iShares Singapore (EWS) as part of the allocation to financial stocks, it is about 50% financials, what would be useful for you to hear presuming you are their to learn something and that I might have something useful to say.

Any input from readers would be much appreciated.
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The Big Picture for the Week of February 21, 2010

In response to my noting the collective $1 trillion hole for the state pension funds a reader asked "Why does a return of 6-8% seem OK for a pension portfolio, while 4% is the expected return for a personal portfolio?"

There are a few things here to address and perhaps clear up. First thing is that the reader might be apples and oranging a couple of numbers. Generically speaking a portfolio might average 8% per year over some long period of time which is different than a safe withdrawal rate. The issue with the state pensions, or any pensions really, is that they have liabilities that must be paid every year in the form of pensioner benefits. If a worker is entitled to $1773 per month then the fund has to pay him that amount every month, period.

In any 10 or 20 year period 8% might be the average annual number like maybe in the 1990s but in another time period like decade just ended it might less, even negative. The problem created by a negative decade is obvious, the fund pays out the benefits as the value of the fund shrinks (or maybe not depending on any funding but you get the idea).

Maybe not, but it seems like the last two decades were very extreme; one very good and one very bad but whether that is true or not one thing that is true is that no matter what the average per year it will rarely hit that average number in a given year. One look at a Stock Trader's Almanac will tell you that.

If a newly retired individual has a $1 million portfolio and plans to take out $55,000 he will be just fine that first year if the stock market goes up 10% and his portfolio goes up 8%. In a simplified world after that type of year he will have $1,025,000. If in his second year the market is up 2%, the investor matches it and takes the same $55,000 he will finish the second year with $990,500. So two up years in the market to start but he has already below where he started.

Lets say that the third year turns out to be 2008 but he does a great job avoiding the full brunt and he only goes down 15% in a down 38% world but thinks he can take out the same $55,000. He would be ending that third year with $786,925 and his $55,000 is now a 7% withdrawal rate Being down 15% is a very generous assumption.

If the third year was not 2008 and the market went up 8% and our investor was up 10% the portfolio would be $1,034,550. Whether the third year is 2008 or not is a matter of luck. Whether an investor ever encounters a 2008 in their retirement is a matter of luck. Clearly this investor starting with a 5.5% withdrawal rate is subject to the vagaries of the market but he is just one person and there are not that many moving parts.

Running a pension has far more moving parts and less flexibility on payouts and investment policies but faces the same varies of the market. Additionally there are pensioners coming and going all the time making it more complicated. While I'm not going to crunch the numbers for this post it has been noted in many places that often a disproportionate amount of the total appreciation in a bull cycle comes from just one year (think about 2003's contribution to the bull ended in October 2007). This means that the typical year might have returns that are less than the average but the state pensions still have the same obligations no matter what.

It is with this sort of thought process as a backdrop why although a portfolio might, I say might, average 8% over some period of time it makes sense to make the withdrawal rate as small as possible keeping in mind a reasonable income need and survivability of the portfolio. I believe most studies find an optimal amount being 4.2% which many people tend to round down to 4.0%.

From there it gets cloudier; 4% and then adjust for inflation every year some would say. I don't get this one. What if after ten years $1 million starting point is still $1 million but inflation works out such that the adjustments for same mean you take out $50,000?

The denial that surrounds this concept will cause an awful lot of misery I am afraid. As I mentioned during the week (albeit with different numbers) it is unlikely that someone who has accumulated $1 million has a lifestyle, even if it is modest, that only requires $3333 per month.

If you think about it there are all sorts of variables at play starting with when you retire that can either make it very easy or very difficult. This is why I believe in living modestly relative to your income and working longer or in other words creating a large margin of safety in your numbers.

One thing not mentioned above but that we have talked about many times before is expensive one off events like expensive home issues or medical events. If you can live comfortably on 4% that is quite commendable but what happens if your roof has to be replaced or you have some sort of foundation issue? Someone with a margin of safety can better navigate these sorts of things than the person who uses his margin of safety to buy a boat. Nothing against boat owners but I heard a guy (over my iPod) bitching about his boat expenses at the gym yesterday--he is underwater and needs to sell it fast.

The easiest way, IMO, to have enough money is to work on getting the overhead down. It is a lot easier to cover your nut if your nut only consists of utilities, insurances and food.

I watched a good chunk of the Czech Republic/Latvia hockey game last night. Nice to see that Latvia was able to put a team together and send them to the tournament (not a sarcastic comment).
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Friday Randoms

First up is the latest with the Chinese being sellers of US debt last month. Well maybe they were not net sellers because as many people have pointed out there was increased buying of US treasuries in the UK which could be a proxy for Chinese buying. A site called EconomPic had a good recap of whatever might be going on with the decrease in the normal TIC data and the increase British buying but to clear the idea of British buying as a proxy for China is in several places around the web.

The nothing to see here folks, let's move it along crowd are telling us that Chinese demand is not waning using the British buying as support for their argument. This could be true but why the change? I posted a question on the EconomPic site; I asked if this is a political game of creating the appearance of less demand, did they really think they would fool anyone? Their previous activity reflected in the indirect bidding was what it was and it seems like it took ten minutes for the world to figure out that they routed their buying another way so what was the purpose if that is what happened?

Of course the conclusions about the UK could be correct but it does not make sense to me. The notion of China buying less in the future or letting what they have mature without rolling it over is something I've mentioned a few times as opposed to some sort of mass dumping which I think is unlikley. Lately it seems like the rhetoric from the Whitehouse has been that they plan to put more pressure on China to let the yuan float freely.

If you want to say that the yuan should have never been pegged I might agree (not sure) but it was pegged and maintaining the peg has required China to buy an awful lot of US debt at a time where the US is issuing increasingly more debt as far as the eye can see. The US needs all sorts of countries to buy its debt. If China actually gives the Whitehouse what it thinks it wants in terms of the exchange rate then it will be buying less US debt (maybe a lot less maybe not much less, I don't know) at exactly the time when the US needs more buyers with deeper pockets.

The table comes from Mike Shedlock. State pensions are in a world of hurt. PEW says the state pensions are collectively in the hole for $1 trillion. The assumed returns remind me of the online calculators people use to plug in 15% returns. I imagine the numbers on the tables come from consultants and the like and while maybe 7.25% might be right over certain long timeframes the per year numbers will be lumpier, that is just how markets work.

The lesson for individuals should be to leave a healthy margin for error in your plan. If you have to get 8% you may be in trouble.

On a lighter note Market Vectors launched the Egypt ETF (EGPT). Market Vectors along with GlobalX seem to really be trying to fill gaps in market coverage which I find encouraging. It should be no secret that I believe portfolio success in the new decade will require accessing "new" segments as was the case last decade. I will probably do a little more of a detailed write up for theStreet but here is a good recap of the story in Egypt (fundamentals of the country not how the fund integrates into a portfolio).

Egypt has plenty of risk factors to consider but not game over risk factors like the US, Western Europe or Japan. It seems pretty clear that life on the ground there will improve even if in fits and starts and I believe the country will become more important in the world economic order. We'll see.

The other bit of new ETF news is from EG Shares and its China Infrastructure ETF (CHXX). I'm turning in an article on that one to theStreet today so without frontrunning that I will say that it is light on things like roads, airports and sea ports (about 4% if I'm counting correctly) and heavier than I expected on solar stocks which looks like about 7.5% of the fund.

Maybe I am wrong but I think my thoughts about avoiding Chinese financials are gaining traction and so funds that offer the chance to do that should be a plus but I think the real estate exposure in CHXX needs to be taken into account and decided on by anyone interested in the concept.
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Market Vectors Egypt (EGPT)

So the Market Vectors Egypt ETF (EGPT) appears to be up an running. It is very heavy in financial stocks but the story on the ground it worth learning (something I've mentioned several times before).

I'll probably do a more thorough write up later but the country has a lot going for it including the fact that it doesn't get talked about much.

Here is a link to more info.
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The Math of Retirement; Not Good

Yesterday Yahoo Finance ran an article called 10 Signs You're Not Ready To Retire and number one on the list made me laugh out loud; You Haven't Done The Math. The math is going to be a nasty surprise for the vast majority of people think they are saving properly. The reason I laughed is because the comment cuts right to the heart of the matter.

There was one brutal statistic in there that I'm not sure if it can be correct but 1/3 of people 55 or older have less than $10,000 saved? True or not most people do not spend a lot of time managing their savings and probably do not know how the math of withdrawals work or the enormity of the entitlement math.

If you are interested enough in the topic to read investment blogs then the ominousness of the math is probably not lost on you but it can be truly unkind. It would be reasonable to conclude that a 60 year old who has accumulated $700,000 or $800,000 (without benefit of a bubble) is in good shape but that may not be true. Chances are this person was somewhat successful professionally and has been making good, not pro athlete, money.

You know where I'm headed, right? Using the 4% rule of thumb for withdrawals the above example should safely generate $28,000-$32,000. I would note that anytime I post this sort of thing one reader always comments that 4% is too much. Anyone agreeing with him would obviously would need to adjust the $28,000-$32,000 down. Maybe I am wrong but I'm thinking the typical guy who socked away that much money has a lifestyle, even if relatively modest, that requires more than $2500 a month.

If social security is still around for this guy and he is married he might collect $3000 per month from that and so obviously be in much better shape but still there might be some cutting back needed. I doubt social security will disappear for someone who is 60 today but I don't see how it can be there for anyone under 50 today. I don't know where the line between yes you get it but you do not will be and frankly since I can't imagine getting a payout I am not spending any time trying to figure out who the last ones in will be.

This brings up a point that will be familiar to long time readers in this regard which is something will have to give. For most of us anyway. Successfully figuring out what has to give is a personal thing. One person might be glad to work longer, someone else might be willing to drive an older car or down size their home or anything else.

I've been writing about this sort of thing for a while because it is interesting and also obvious and it is good to see the concept gaining more traction. This is a challenge to be solved, at least that is my attitude. The idea of my financial fate (assuming no extreme outlying event) being beyond my control is something I am very motivated to prevent.

We can control (to a point) how much we spend, how much we save, where we live and other consumption habits. We cannot control the performance of our investments (although I think we can put some of the odds in our favor) and we cannot control whether social security will last long enough for us. As a matter of personal philosophy I tend to focus more what can be controlled which might sound odd given what I do for a living but if markets across the globe all go down 25% over the next ten years (not my prediction) then getting a positive result in a portfolio would be a long shot.

As far as working some sort of part time job (hopefully one you've planned for and that you really want to do for the fun); it doesn't take a lot of hours for the income to be meaningful if you don't have a mortgage and two $600 car payments.

Did you see the short track relay last night? Wow, I did not remember how chaotic it is. That was nutty.
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And You Thought Roubini and Faber Were Bearish

Paul Farrell from Marketwatch has been getting increasingly apocalyptic over the last couple of years, maybe longer. As best as I can remember he has always been opinionated and I have to tip my hat to the folks at Marketwatch for keeping him on board as blight or more correctly Debt Bomb Explosion might turn off some potential readers. His latest article has the secondary headline of 10 Short Term Tips For Investors Worried About 'Debt Bomb.'

It really is a misery inducing post. After listing ten very dark links he concludes that theyscream: "new meltdown, dead ahead." The ten tips are not necessarily anything you haven't read before but after listing them he goes on to note that "worse yet, 'deleveraging, weak commodity prices, increased government regulation, protectionism and deflation" will also extend the "secular bear market' for years."

He also rails against Wall Street throughout the article which is not new for him either.

I'm not terribly concerned with whether he is right so much as if things do get anywhere near as bad as he thinks what will be the best course of action? What steps can be taken now (or should have already been taken) in case he is directionally correct and even correct on the magnitude.

If the sun stops rising in the United States it will have some effect on many other countries. I would expect, much like in 2008, that effect to be very big--that is not the long term question. To me the long term question becomes 'what next?' There are many countries whose stock markets went down plenty during the bear but came back quicker than the US because despite whatever their connection to the US they were going through more of a cyclical event whereas the US went through more of a secular event which is what I think would happen again in Farrell's scenario (more likely it would all be viewed as one event).

To be clear stock markets from other countries would drop with the US in a debt doomsday but they would not be permanently broken (well some would be) and so would come back and those initial sympathy declines would in hindsight be viewed as great buying opportunities. But there would be some period of extreme nervousness or even panic.

The task of preparing involves figuring out what countries can function without the US, or more correctly get back to some semblance of normal functioning relatively soon after the 'debt bomb' because I promise much of the world will figure out how to function if Farrell's scenario plays out, even if it takes a while.

For what it's worth my opinion all along has been the US as a less attractive investment destination but not a financial apocalypse.
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Are Markets Dumb?

Yesterday Mark Thoma had an interesting look at the efficient market hypothesis (EMH) and cited a couple of papers in an exploration that questions the value of the theory.

One way to think of EMH is that the market prices in all known information. So then the task of beating the market, for those interested in beating the market, becomes trying to figure out what the market does not know.

Based on what we have seen over the last decade or so it seems like maybe the markets know very little. My thoughts have been the same for a while. I do believe that markets price most things correctly most of the time and does provide various types of warnings but things change and the market does get some things wrong, more correctly perhaps it fails to anticipate things.

Markets go through cycles and changes in cycles are often marked by similar things. Additionally the fortunes of companies change. Some company we are not familiar with (maybe it doesn't even exist yet) will come up with a drug that will cure some previously incurable malady and make a lot of money doing so. Along its way it will have various tests and milestones to work through and maybe competitors to beat to the market but it will happen and some folks will successfully navigate all of that in owning the stock.

Another way to view EMH is that it believes markets are rational. Well do you believe in that enough to let your financial future ride on it? The market is made up of its participants which are people and people are from from rational. If markets rationality could be relied upon then I don't think Pets.com and Webvan would have ever IPO'd, the Nasdaq would not have gone above 3000 ten years ago and Johnson Control would not have dropped 75% a year ago.

Additionally, at some point some well regarded mega cap company will do something, like make a huge and peculiarly timed acquisition ala BAC buying MER, that will impair its future prospects for some lengthy period of time and some folks will see that for what it is and get out in a timely fashion.

The notion that no one can pick good stocks or avoid bad ones implies that no one can do analysis which seems like an odd conclusion to draw. This is not to say analysis is easy or that anyone who does analyze companies will always be correct but fundamental attributes change and these changes often influence prices and some of these changes can be observed and navigating them is not impossible.

Looking at the country level from the top down it is simple work to get the statistics for a place in terms of debt levels and GDP and get a sense for what makes the country tick. It is also easy however to view a country as being healthy but draw the wrong conclusion about stock prices in the short term but as we look at the world now countries with low debt and good growth prospects are a likely to treat your money well over the long term regardless of what the market "knows."

A final point here is that a theory that relies on the type assumptions that EMH relies on is a tricky business. Assumptions about efficiency and rational behavior strikes me as a huge leap of faith and while there are people who are clearly comfortable relying on this with their money it is not what I will bet my financial future on.
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The First Real Sign Of Treasury Problems?

Graham Summers posted a detailed account of why last week's 30 year US Treasury auction could be considered to have been a failed auction. The key takeaway for me was that primary dealers (they have to buy) accounted for 47% of auction while indirect bidders (foreign demand is counted in this segment) only accounted for 28% down from 40% in past years.

I am not an expert on the finer points of treasury auctions but much of the foreign demand in the last few years (the kindness of strangers) has essentially been forced in the name of self interest of those strangers. The trend in indirect bidders and what we know about China in the last few months or so plays into a bigger idea that I (along with many others obviously) have been writing about which is that the US is becoming an increasingly unattractive investment destination.

Who knows if this is the big one or not but if you start to think about total indebtedness, budget deficits and the lack of will (political, social and otherwise) to make difficult choices and sacrifices then news like this should not shock you.

A few years ago it was easy to buy shorter term treasuries. Yields were much higher and the fundamental situation was not the same. It was on the path to where we now are (deficits and debt were well known issues) but the housing market had not blown up yet.

If the fundamentals of an investment are not attractive and or the risk of a particular investment is greater than normal then it makes sense to simply avoid the investment, in this case treasuries, altogether. I don't think there is really anything disastrous in buying one or two year treasury paper as some sort of cash substitute but allocating some portion an investment portfolio to regular treasury debt does not seem ideal. The US won't default, the Fed will just print more money which at some point creates a different bad outcome than default.

We have TIP exposure, some exposure to short dated US corporates and some exposure to foreign sovereigns that do not make any news in this regard. Some clients own BWX (23% Japan) which will become a sell at some point if and when Japan starts to deteriorate. We are not there yet though. We also have small exposures to other fixed income things all arranged so that hopefully we are not overly vulnerable to any one thing.

We have very little exposure to muni bonds. This is something I've mentioned a few times but not often. For a while there muni yields were all higher than treasuries which I took as a warning of potential trouble. Since then the news has gotten much worse in terms of budget deficits, insolvent unemployment funds and the possibilities of seemingly drastic things like cutting emergency services at the local level.

I've written quite a few times about the short term foreign sovereigns we own. The influence is from Nassim Taleb although he favors 90% and we are less than 10%. Unfortunately the investment product landscape does not really allow for accessing this market, at least not yet, as many of the funds are heaviest in Japan which, again, is probably ok for now but will need to be addressed at some point.

If you are concerned about some of the things happening in the fixed income market there may be proxies out there that offer the volatility characteristics of traditional bond exposure even if not the traditional yield characteristics. I recently wrote an article for theStreet about the Collar Fund (COLLX). In writing that article I had a chance to talk to the manager of the fund and he brought up the point of his fund acting as a bond proxy in terms of volatility but not yield. To the extent the concept interests you you can do the research and decide for yourself about a given fund but as has been the case for a while the bond market is not quite right.

In a related albeit darkly humorous post Paco Ahlgren discloses that he is "short Treasuries, and long gold, oil, guns, ammunition, potable water, canned goods, pigs, chickens, and toilet paper." What, no beef jerky and TNT? And what about whiskey and Ivory soap?
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Sunday Morning Coffee

This week's interview in Barron's was quite a shock as they interviewed Jim Paulsen from Wells Capital after having just featured him on July 20th. Some of the reader comments on the July article ripped into him for being a broken clock but the comments on the current interview seemed to really let him have it and also ripped into Barron's for interviewing him so soon after the last article and for not asking him any difficult questions.

The interview was pretty ridiculous. The following quote from the introduction says a lot; "He admits to 'blowing it' by failing to sense the ferocity of the 2008-09 economic and stock-market meltdown. Yet he nailed the rebounds after the tech bust and Sept. 11 attacks. Furthermore, he hung tough after the stock-market meltdown last March, with widely ridiculed predictions that both the economy and markets would come thundering back."

As many readers pointed out he is always bullish. Anyone who is always bullish will appear to have "nailed it" at the low because they were bullish all the way down starting from the top. One reader made an interesting observation that I have no way to vouch for but apparently Paulsen was on Lou Rukeyser late in the tech bubble inflation with very bullish things to say, implying that he missed that bear market in addition to the one in 2008, but this reader felt that the look on Paulsen's face said trouble was coming.

So the reader in question is saying that Paulsen is not dumb but that he is dishonest. Kinder commenters noted that it is his job to be bullish. I've picked on this guy before and recently pointed out that Larry Kudlow seems to believe that patriotism and objective analysis are mutually exclusive. Based on his comments when Arianna Huffington was on the show I think Kudlow said he will not warn of trouble coming ahead of time if he actually saw trouble coming.

When Paulsen is interviewed, and the current Barron's piece was no different, he tends to be ready with statistics that seem to support his perpetually bullish case. Ok, statistics can be used to support any conclusion. Further, no matter what is going on the world at any time there are current numbers to make a bullish case and a bearish case. I'm not certain what numbers would have supported a bullish argument back when Paulsen was "blowing it" but you can bet he got interviewed plenty and had plenty of numbers that he was misinterpreting one way or another.

Knowing now, based on the reader comment linked above, that he missed two 50% declines in one decade certainly is not a surprise. As I skimmed the current interview I found myself not knowing whether anything he said is correct or not. As opposed to taking in an idea that might be "different" I instead wonder in what manner is he getting that point wrong. This is not meant to be funny, there is really no way to know if any point he makes is correct because of his remarkable ability to be spectacularly wrong.

One hopefully useful point to make (repeat from past posts actually) being permanently bullish or only relying on commentary from permanently bullish people can hurt you far more than being skeptical or relying on skeptical commentary. Most people get some things right and some things wrong and being wrong does not mean all credibility is lost but some people simply get far too much face time in light of providing truly bad analysis. For the life of me, I do not know why Barron's hitches its wagon to this guy or others like him--very disappointing.
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The Big Picture for the Week of February 14, 2010

Last night during the Olympic coverage there was a commercial for the US Census telling us to fill it out because it will help the town where you live.

How is this possible? There is no money.
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Portfolio Tweak

A few days ago I executed a small tweak in the portfolio. I had held Stryker as an almost across the board holding for many years with the big idea being that boomers would stay active longer than their parents but that activity would require more boomers to need part replacement (knees and such).

From a more bottoms up view, there is no debt, decent cash flow and the rest of the stats look good as well--most of them anyway. In the time I have owned it it has not really distinguished itself as being a good or a bad hold. At times it has outperformed and at times it has lagged in coming out about the same as the broad healthcare sector over the last five plus years.

The reason why I sold it is that it began to dawn on me that there is some aspect of this type of surgery that can be viewed as being discretionary and if the financial crisis has really had the impact on personal finances that the experts say it did then it stands to reason that some procedures won't get done as money needed for the deductible would be harder to part with (all the more so for people who would pay out of pocket for whatever reason). Carrying it a step further it is possible that boomers will have to cut back some on some of the more expensive activities that could necessitate a future replacement.

My thinking may be right or not but I don't want to stick around in the name to find out. In the healthcare sector I would rather avoid any hint of discretionary (or perhaps more precisely, elective) spending which lead me to diabetes. Some of the numbers I dug up doing research were brutal in terms of growth rates for diabetes and once someone learns they have it it has to be treated. Sadly it seems that everything points to more and more people being diagnosed which bodes well for Novo Nordisk (NVO) so the trade was dollar for dollar out of SYK and into NVO.

From the top down the trade slightly increases the foreign exposure of the portfolio (although about 30% of NVO's revenue comes from the US) after a big move up in the greenback, adds a new non-euro country in Denmark but it also increases the average cap size a little (SYK about $20 billion and NVO about $40 billion). Additionally the position provides access to about 25% of Novozymes.

NVO's stats look pretty good as do estimates and the primary business is something that a growing number of people (and their insurance companies) will have to spend money on. Being wrong about this would mean very good things for the health of Americans. NVO is the largest company in the OMX Copenhagen 20 Index and so is featured prominently in a couple of ETFs including the GlobalX FTSE Nordic 30 ETF (GXF).

A couple of things about Denmark; you know from Bill Gross's ring of fire that its debt situation is well under control, unemployment in December was 4.3%, GDP contracted slightly in 2009 but is forecast to go slightly positive this year.

The picture includes a couple of dogs that we are babysitting for the week. The dogs are up for adoption through my wife's rescue. The brown one at the bottom left whom I am calling Brownie and the black one in the middle of the steps whom I am calling Blackie can be found through the United Animal Friends website.
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ETFs and Panic Avoidance

A couple of good articles from this week that I think are related. One is from the WSJ titled Even Pros Have Trouble With Buy And Hold and one from the FT titled Chinese fund fillip for oil and gold ETFs which is about the China's SWF that is now using a lot of ETFs.

Or maybe I'm stretching but either way...

The WSJ article struggled to make its point and maybe I still have it wrong but it seemed to conclude that portfolio managers trade more frequently than they plan to because, like all people, that have emotions that they occasionally give into.

Much of what I write about is geared toward reducing or eliminating the role emotion plays in navigating the market. There is a difference here that is worth exploring. Emotion can come in the form of a complete meltdown where everything is sold in a panic after a big drop and of course this same sort of person might then realize they were wrong and buy back in after a big move up. People lose a lot of ground with that type of action.

Another emotional response I have mentioned quite a few times that is far less damaging is sacrificing one name to the market gods just to make yourself feel better during a market panic. Selling a holding that comprises 2-3% of the portfolio at the low would in hindsight turn out to be a bad trade but it is not ruinous behavior. The consequence of this small sacrifice is reasonably missing out on a couple of hundred basis points so with the rally from the March low it wouldn't really matter whether you bounced 48% or 50%? However anyone riding the market all the way down fully invested who then panicked out completely in March has a big problem.

If the WSJ article even isolated anything interesting or is drawing the correct conclusion it is no doubt obvious the role narrow exposure ETFs can play in helping with this issue. Anyone reading this site for a while know I believe in using mostly individual stocks with a few ETFs but stocks require getting two big things correct; the theme and then the way you access the theme whereas with an ETF you need only be correct about the theme.

Recently I disclosed swapping out of Monsanto (MON) and into Market Vectors Agribusiness (MOO). MON started out as the correct stock in the correct theme and then became the wrong stock in the right theme. Picking the wrong stock now and then goes with the territory. If the wrong one is picked too frequently then maybe the strategy needs to change but picking the correct theme is easier, obviously, and realizing what other segments, if any, also benefit is easy as well. Note that this simply creates a tailwind not a guarantee of success.

A theme usually won't implode unless there is widespread market panic, like a year ago, but a stock can implode at anytime. To the WSJ article when a stock implodes there then is extra work to try to assess whether the stock pick was really an incorrect one or not and after a big drop in that stock the process might be clouded enough by emotion to influence the incorrect action. Under normal market conditions an ETF is likely to be down less than possibly gone-bad stock pick and up less than a home-run stock pick so either way there is less chance of emotion clouding judgment. We are collectively probably wired to better handle a narrow based fund dropping 15% than a stock dropping 25% (obvious statement).

I can appreciate that this entire post may be obvious but if you have been a broad based index investor and are starting to think, as I have for years, that success in the next decade will require going narrower but you do not want to make the leap to individual stocks then ETFs are probably your best shot and the above, obvious or not, might be the right mindset to have.
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The Russia Forum

This link will take you to a 68 minute video of a panel discussion at the Russia Forum moderated by Marc Faber with Nassim Taleb, Hugh Hendry and a couple of other panelists. It is worth the time spent.

Hendry struck me as the most interesting of the lot (he and Faber had some good banter going throughout) and Taleb, quite frankly seemed a little out of his element. The other panelists were more narrowly focused on investment ideas and as broad as the conversation was Taleb was the most vague. This was the panel where he talked about shorting treasuries that Felix Salmon ripped up in this post.

Taleb is, IMO, a great thinker who has added to our (well my anyway) stream of consciousness but at one point during the panel he made a comment about shorting countries based on the number of US educated PHDs. No one else knew what to do with that one.

While there was a lot of meat on the bone throughout I was probably most interested as the discussion moved to China. Taleb noted, vaguely but made a good point, that early in the last century in looked as though Argentina was poised be the global economic leader and of course it never happened. A little more specifically Hendry noted that at some point the country that becomes the big global lender eventually runs into trouble and he cited the US and Japan as examples. His argument seemed to be along the lines of this post from Michael Pettis from a few days ago. Hendry also expressed concern about the massive over capacity in China.

Faber made his usual bull case for China and one of the other panelists was bullish on China but made some odd points as to why. He (sorry I never heard his name mentioned) said, regarding over capacity, that they might build a bridge to nowhere but that soon that bridge will lead to somewhere. He also talked about the demographics being a positive catalyst. That point would have had more credibility if he mentioned the problems they face later this decade or early next about an aging population.

One interesting point about over capacity was made by yet another panelist, this one from South Africa (sorry no name here either). He said that most of the railroad companies from the 1800 went bankrupt but that they still contributed to making the US a great country meaning that the over capacity could be a short run problem not to be underestimated but that China as a long term theme has plenty of legs. Another point made by this fellow was that while the US has its hands full trying to figure out China the "rest of the world" loves China.

I'll finish this short post by saying that China is a theme and all themes go through a maturation process. Earlier on in the theme selectivity matter little. As time goes on selectivity will become increasingly more important. If you've been reading this site for a while you know that I think the most important thing for now is to avoid Chinese financials. My preference is to own where money has to be spent.

Closer to the start of the video there was some interesting comments on farmland with the only memorable nugget being that Canada has 23% of the world's fresh water.
Speaking of Canada, as a reminder I will be at the MoneyShow in Vancouver April 6-8.
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Greece Is Too Small? Really?

We all know much more about sovereign debt solvency than we did a couple of years ago. We now understand some of the dynamics of insuring sovereign debt, we know a lot more about the debt loads of numerous countries than we maybe ever even thought about previously. The most recent concern would seem to be Greece and of course the rest of the PIGS or PIIGS as some prefer to think of, that second I being Italy. The folks at Zero Hedge would also point us to the STUUPID countries as well.

One line of thinking that I have read and heard repeatedly, getting back to Greece, is that it is too small to really threaten the EU. At two point whatever of the EU economy it is hard to argue against that point but it is the incorrect point in my opinion.

People are worried that Greece will default on its debt. It has a large budget deficit around 13% and public sector debt is around 115% of GDP (eyeballing Bill Gross's Ring of Fire Chart). Ken Rogoff has taught us all that 90% is a Mendoza line of sorts (as in Mario Mendoza). Either Greece will default or not and if not it will be because the EU bailed it out or not (please note the phrasing of that last sentence is such that I make no attempt to guess the outcome).

The thing is not the outcome for Greece the thing is what comes next. If Greece is bailed out somehow because it did not have the will to do what it had to then where does that leave Ireland which appears to be taking the difficult steps to heal on its own? If they bail out Greece, what will they do if Portugal and Spain end up needing a bailout? It is possible for members of the EU to default because they cannot print their own currency.

Sweden and Austria had some real trouble for their loan exposure to other countries (talking mostly small countries in Eastern Europe)--a contagion of sorts. Things on the ground in Sweden were never terrible but Latvia almost became a huge problem. So in thinking about Greece we should be thinking not just about what happens there but what could happen elsewhere as a result.

Think about how the financial crisis unfolded in the US. It was one thing after another and then another. Contagion happens and while a default in Greece (a low probability IMO) might not have a domino effect, assuming there would be no domino effect is either an incomplete study or an overly optimistic assessment.
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We Can Be Our Own Worst Enemy

Last week Mike Shedlock made a comment in passing about people being economically and financially illiterate. Collectively we do not know as much as we should and maybe illiterate is the best word.

We should all know how credit card interest works, know enough to only take out a mortgage we understand, know that we have to save money, have some idea what to do with those savings and that our bills should not add up to more than our income. Beyond that some understanding of macro economics to understand some of the basics of what has happened in the last couple of years would be nice and maybe people do have the requisite understanding, I don't know.

I do think that a lot more needs to be done to teach people more about everything. On the investing front the basics need to include, among other things, how markets work, how investment products work and how numbers work. One more that I would add will not be a new concept but the wording might be a little different.

One problem that I see, or at least I think I see, pertains to how people spend their money. Specifically I think that too many people fail to respect whatever it was that they did to accumulate what they have. A common behavior is a willingness to spend in such a way with a belief that it can be made up later (somehow). This sort of thing has been ascribed to the baby boomers and the manner in which they came of age and maybe this is why but either way the lack of regard for the fragility of the nest egg strikes me as a colossal problem looming out there that may be unquantifiable.

Someone like Fidelity or Schwab could probably do a study to figure out what the average nest egg is today and how much the average was three years ago but it seems like it would be difficult to assess how much of the average shrinkage is from the market going down and how much from stupid spending decisions.

How many people do you suppose (this is going to offend some people) spent $200,000 or more on an RV because they were convinced they would love it only to find out they don't? Instead of dipping a toe in the water by renting one for a couple of months (I got quoted a two month summer rental rate from Cruise America of $5600 and I think they would charge for miles on top of that) people like to go out, buy first and ask questions later. Maybe I am wrong but I don't think $200,000 gets you the Cadillac of RVs either. Additionally you could get a lot of two month rentals, that you don't have to maintain, in before you begin to challenge economics of buying an RV. Some folks make the correct decision buying an RV but I doubt that is the case the majority of the time, I'd say not even close.

From my experience this type of example can be applied to countless things people spend money on and I've learned there is no having this conversation with someone. Or at least I have not figured out how to have this type of conversation be productive. Hopefully you have the introspection that I think is needed for an objective analysis before making a huge financial commitment at a point in life that you want to stop working.

Very glad, for several reasons that the Saints won last night. My favorite commercials were the eTrade one after the game had just ended where the tag line was "saved me a pantload" and the Snickers commercial with Betty White and Fish from Barney Miller (or Tessio depending on your reference point).
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Sunday Morning Coffee

Yesterday a reader left this link from DealBook about Burton Malkiel's thoughts on active management along with the other side of the discussion as observed by James Tierney from WP Stewart, and active manager running a very concentrated portfolio with an outstanding track record versus the market going back to the 1970s.

You've heard the basics of Malkiel's argument before; no one can consistently pick winning stocks and no one can consistently time the market. In addition to the difficulty Malkiel also notes the problem of human emotions getting in the way. I imagine the argument in favor of active management is not new to you either. Among other things mentioned the active managers say that there are people who can consistently beat the market.

Malkiel also says the fees are too high but the active managers say a good manager is worth it. Perhaps in defense of the fees it seems as though the active managers were saying that they can tailor a portfolio to the client's needs and do so successfully. The debate in the article finishes up with Malkiel saying things like hedge funds are a better deal for the managers than the clients ("where are the customer's yachts?") and the active guys apply the superior ability to pick stocks into a defense for why exotic products do make sense for some people.

So on the one hand picking stocks that beat the market with consistency cannot be done and on the other hand "we" consistently pick the right stocks and have been doing so for a long time. This is always a good debate. I hate to tell the people who say it cannot be done but if someone has a track record for success of beating the market going back to the 1970s there is a good chance they are on to something. However it is just as true that not everyone can be above average and I am sure there are far more people that lag the market over long periods of time than beat it but I assure you WP Stewart is not the only company to have a stellar track record going back that far.

The above is all well and good and you will read about it again and again but it is completely the wrong context for the vast majority of investors. As I type that thought I know there will be comments from people who are focused on beating the market but again it is completely the wrong priority for most people.

An investor's top priority (repeat theme coming) would seem to be having enough money when they need it. What good is it to have soundly beaten the market for 20 years right up through 2007 with plans to retire in 2009 only, because of hubris from 20 years of beating the market, get hit worse than the market in 2008 and panic out at the low. Obviously an extreme example and you might be thinking about proper asset allocation but often hubris overcomes the logic of a proper asset allocation.

In addition to having enough for whatever the goal is (we're probably talking about retirement) I can tell you that there are all sorts of "one time" events that come up either as a function of an unrealistic understanding of what can be spent or a genuine emergency where money must come from the portfolio. One of these events coming at the wrong time, like last spring, can be impossible to recover from. Impossible that is unless something else gives.

The concept of life events happening makes the argument for smoothing out the ride or as John Serrapere puts it 75/50. To Malkiel's point about emotions getting the better of us; couldn't that be spun into an argument for the exact type of defensive action I talk about so much? After all when is an investor most likely to be overtaken by emotion and do the wrong thing in their portfolio? Wouldn't that point come for many people somewhere between down 30% and 50%? Maybe 20% and 40% but if we can't control our emotions then it seems logical to try to avoid putting ourselves in the position where we might succumb to emotion?

Given the argument I lay out above, I think the thing that matters is smoothing out the ride as much as possible. Avoiding parts of the market where there is obvious trouble, like Western Europe and the US financial sector over the last couple of years and for now we can add financials in China and long dated US treasuries, and favoring areas with some obvious tailwinds (was choosing Brazil really impossible to do five or six years ago?) is a way to do this.

If you don't think you can do this then maybe you shouldn't but it is not impossible to do especially when you realize that all this does, in the context I mean, is put the odds in your favor but there will be times where you are wrong. For normal active investors a career is some combination of correct and incorrect decisions that hopefully add value. Adding value does not have to mean beating the market every year. A month and a half ago I put up a post about a fictitious manager who lagged the market every year of the bull phase but got out in time thus coming out way ahead for the cycle. In that post I asked if lagging for five years but coming out 30% ahead for the entire cycle was a beat or not.

When you realize ahead of time that there will be bear markets, that you will not always be correct and think about the long run success of having enough when you need it you have a much better chance of doing well whatever that means to you. But the idea of picking a bunch of stocks to beat the market this year and then start over again next year makes the task more difficult. Convincing yourself not sell after you've ridden the market down for 40% also makes the task more difficult. I prefer to make the task simpler.
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The Big Picture for the Week of February 7, 2010

On the surface this may seem obvious which is ok to think but it speaks to a bigger point. I've talked before every portfolio being vulnerable to something or a few things. Ever since the low in March it seems that the things that have struggled the most in these various pullbacks have been foreign/emerging equities, certain types of materials stocks and commodity related products.

The logic applied by the media is simple; with yields at zero, money is borrowed in USD and invested in foreign/emerging equities, certain types of materials stocks and commodity related products among other things in a risk seeking trade. Anything causing the dollar to go back up unwinds this effect regardless of what is the chicken and what is the egg and this has been called risk aversion.

Whether this version of the carry trade as spelled out by so many people accurately explains what is going on or not is not so important to me. It is a short term effect and when the dollar goes up foreign/emerging equities, certain types of materials stocks and commodity related products seem to go down more than the broader market. This isn't important for people who are able to think in terms of the entire stock market cycle but it does create short term noise which has the potential for short term stress for people who have not thought about this ahead of time.

Long time readers will know that I am a big believer in exposure to foreign/emerging equities, certain types of materials stocks and commodity related products but not a believer in huge overweights in these areas. Materials are only about 3% of the S&P 500 and while we are overweight we are well within single digits. Our exposure to commodities is mid single digits and our emerging market exposure is in the high single digits.

The idea here is trying to manage volatility. In a year when the market is up a little or down a little a small weighting to "the right" emerging country fund or individual stock could easily go up 50% or more. That can add a lot to the portfolio's overall return. Chances are that the best performer in a portfolio of 40-50 holdings will be up a lot more than 50% in a given year that, again, the market is up a little or down a little even if that return comes from the stock you would least expect. IMO this contributes to the argument for small exposure to many holdings as opposed to large exposures to the things that "should" do well. This is because if you are wrong you will seriously impair your result.

There is an argument to be made that emerging markets "should do well." In the last month, as a microcosm, the iShares Emerging Markets Fund (EEM) is down almost 14% versus just 6% for the S&P 500. Some would advocate 20-25% of an equity portfolio should be allocated to emerging markets. At certain times that will create a lot of the wrong type of volatility. If you work with the numbers a little bit you will see that a little goes a long way.

That the portfolio is vulnerable to something should not be a worry in and of itself it should just be a matter of routine. All portfolios are vulnerable to something and occasionally that something will be exposed and you will lag--this is just how it is and so an emotional response is unnecessary.
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