"You're Spunky! Quirky... I Hate Spunky Quirky"

I actually don't hate quirky, I think quirky is great but I thought of that scene from what I believe was the first episode of the Mary Tyler Moore Show when Mary meets Mr. Grant as I read this article from George Fisher who writes regularly about quirky investment niches.

Quirky areas that I have written about over the years include farmland stocks, airports, Norwegian fisheries and toll roads. George's article provides an overview of timber exports to China from various places and brief introductions to quite a few of the companies in the space.

Of the names he mentions I have owned Plum Creek Timber (PCL) in the past, mentioned Sino Forest (SNOFF) in other blog posts and researched a couple of other names on the list.

Here is an article about rare earth stocks. I read the article and I still don't know what they are but it is another quirky little space in the stock market that someone might want to learn about and of course there are countless others.

While this sort of study and possible inclusion will not be for everyone I continue to believe this is important for several reasons. In the past I have talked stocks like this possibly offering diversification benefits, unique demand elasticity, and also a broader understanding of markets. For example studying the Norwegian fisheries has taught me a couple of things about the Norwegian economy that I might not have picked up just looking at Statoil (STO) which is a client holding.

The new, for me, part of the equation is that one of these quirky things (talking generally, not these specific niches) will be the next really big thing. It would be difficult to find the next really big thing if you never look for the next really big thing. This is one of the great aspects about this job; there are always new things to learn about.

I really don't know what rare earth stocks are.
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Oy Vey

Yesterday was quite a day. The problems in Club Med appear to be worsening, the Goldman Sachs hearings went on longer than I expected (had it on most of the day with only one eye on it), stocks went down a lot and bonds and gold went up.

For purposes of navigating through with a portfolio it doesn't matter whether you can correctly predict what happens with bail outs, austerity, biting of bullets and so on. Euroland and the UK have been unhealthy for a long time now. There was plenty of warning ahead of time for anyone who did some reading. As financial issues were first popping up in the US there were commentaries galore suggesting that it would be bad in the US and worse in Europe.

Before this really started to take shape any foreign investor should have reasonably learned that Europe already had worse unemployment, worse demographics (probably) and visibility for slower growth. We have all since become more knowledgeable about the debt problems.

Whatever the hell is wrong with Euroland it is likely to continue for a while.

As for the Goldman hearings, there was a lot there. Do not take my comments as trying to shed a positive light on GS. I have followed this from the viewpoint of a curious onlooker not as someone interested in trying to solve the caper.

It seemed very obvious to me that most of the Senators don't really understand some very basic things. Carl Levin seemed to not understand being short versus being net short and there is a difference. Goldman could be as evil as some think but getting to what happened, if that is what they actually want, requires that the people asking the questions (or more correctly the people prepping the people asking the questions) have a better understanding of how things work, how one trading desk does not necessarily know what another desk is doing, the general idea of "this is how it is, except when it isn't" and so on.

There was a lot of time wasted when the one Senator who said he is farmer tried to ask Birnbaum about his opinion that the housing market was headed south. The Senator kept including the word "bubble" in his question when Birnbaum never used that word. Birnbaum tried to correct the Senator which resulted in what seemed like a five minute circle.

There was one exchange where the question centered on the quality of the stuff contained within changing. This stuff was always high risk (maybe not disclosed or maybe it was, I don't know) but the reason why buyers wanted it was because it was working which is of course problematic. What changed was not the quality, just that prices started going down--a bit of an understatement.

I don't know how many times I heard the phrase "buy short" or variations on that and candidly I got confused along the way there. The meaning behind the questions was generally whether or not GS was short, whether the buyers of Abacus knew who had shorted the deal, how short they stayed and for how long they stayed short. When I heard "buy short" I had to decipher whether the questioner (the Doctor seemed to be the guiltiest party here) meant closing out a short position which means buying and in some circles is referred to as buying short but I think anyone using this term is being imprecise and potentially causes confusion. The group being questioned seemed to not get too fouled up but we can't know whether they misunderstood a question and gave the wrong answer.

I thought more often than not it looked bad for the people being questioned. Senators Levin and Collins each seemed frustrated with not being able to get direct answers to their questions and while it is clear to me that the people from GS were not really trying to be very helpful many of the questions were being asked in an ineffective way leading to stonewalling and the like.

What I will say is this, based on my couple of years (obviously a short time) spent working at an investment bank (worked at Lehman Brothers but not as an investment banker) I would describe it as follows; despite what you might think these firms are not out to hurt their clients (the occasional 'ripped his face off' story notwithstanding) but, and this important, a hurt client is not the worst possible outcome. The best outcome is that they make a lot of money and the client is not hurt but occasionally the client does get hurt. In this case the market showed signs of cracking but there was still a large audience of people interested in buying and GS continued to package product and sell it and a lot of people got hurt (talking bigger than Abacus and bigger than GS' client roster) just like individual investors in the markets they participate in.

I'm not too focused on GS' guilt or innocence as it is not on my yoga mat, so to speak, but the path to discovery will be slower going than it should be based on what we saw yesterday.
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I Disagree With William Bernstein

IndexUniverse posted an interview with William Bernstein who is known for strong beliefs in index investing and has written several books. In there he made two points that I would strenuously disagree with.

First he reiterated a point that many indexers make that I think is overly academic as he noted that "passive still beats active in the long run because it has to by mathematical certainty." I believe this ignores way too many variables to be useful for most folks.

I have heard versions of this argument that focus on management fees (based on the article this was Bernstein's point) and other versions that focus on there only being so much alpha out there.

It is not clear to me what Bernstein thinks of as long term but most indexers are talking about market cap weighting. If you recall last summer the ALPS Equal Sector Weight ETF (EQL) came out with a ten year back test of beating the regular cap weighted S&P 500. It should be noted that the ten year period backtested for EQL was probably the best possible time for such a thing because of excess and subsequent fallout of the tech sector and then the financial sector. I would also concede that Bernstein probably thinks long run is longer than ten years and I would not disagree with that but ten years of outperformance is a long time.

I believe I have made a reasonably compelling case on this site in the last few years for the importance of correctly avoiding a given sector or country. It does not take a lot of acumen to see that an S&P 500 sector is greater than 20% of that index which is a huge warning sign and easy to heed. Realizing that a country is on shaky ground takes a little more time but most certainly does not require a PHD.

Bernstein's point also ignores the fact that active management is a series of decisions; some right and some wrong. In this light success depends on being right a little more often than you are wrong. If the wrongs can be mitigated one way or another and the rights do well there is a good chance of outperforming. This point is difficult to win the argument with but as a supporting factor a stock I have been writing about for more than five years is Vale (VALE) which is a client holding. Vale as a proxy for materials is up 350% versus about 25% for the Materials Sector SPDR (XLB) in the last five years. This just an example which has flaws of its own but one (mega cap) stock pick combined with one sector avoided (the financials) and an investor would be noticeably ahead of the market for a decent chunk of time, that being five years.

I will say it is very reasonable to question how many people should be making a lot of active decisions in the market. People tend to not understand the volatility they have taken on until after a big decline resulting in panic sales so I am not saying everyone should be actively managing their portfolio but the idea of "has to by mathematical certainty" seems far too simplistic. I won't go into detail on another point here so the at post is not too long but another variable is the occasional buying and selling of stocks or funds that can add value as opposed to what I believe is a static portfolio in Bernstein's comments.

Bernstein also has choice words for levered and inverse ETFs, "But in practice, they’re being used as speculative tools. Some of them are silly, some are dangerous, and some, such as inverse and leveraged ETFs, are downright criminal" noting that they do not "work" over longer periods of time. He adds "what is this concept that an investment can only be used for one day? This is not an investment. Who has the predictive power of knowing which way the market is going to go on one day?" and finally "To the extent that people are using them more for speculation than for long-term investment, it’s a horrible thing."

I would not disagree with an opinion that says many people will misuse a levered fund but speculation plays an important role in the functioning of capital markets. I think this is a rather elementary point actually--markets need liquidity to function and speculators are a source of liquidity. Again any argument that says most people should not be speculating is one I would agree with but the framing that speculation is a bad thing and tools that facilitate speculation are bad things is, again, too simplistic.

To the extent new investors are trying to learn and seek out Bernstein as a source I believe they are learning the wrong thing. There is a difference between a fund being "downright criminal" and a fund simply being unsuitable for many people.
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Generation Y: The Broke Generation

I found this on my brother Larry's blog it is from a site called End Of The American Dream and the title I have for this post is the same title of the original post. I just found this so did not have time to get permission to re-post the whole thing so I am just excerpting it and hope you will take the time to click through and read the whole thing.

No group in America has been hit harder during the current recession than young adults. Millions of Americans are graduating from college with virtually no money, lots of debt and with very dim employment prospects. Those who don't go to college are even worse off. All their lives these young Americans were taught if they studied hard, got an education and worked within the system that good jobs and the American Dream would be waiting for them. But now millions of them are realizing that all of their studying and hard work is not providing them with the rewards that they always thought they would get. This is causing large numbers of young American adults to become depressed and disillusioned. In fact, record numbers of them are moving back in with their parents. But without decent jobs, what are they supposed to do?

There are all sorts of grim stats at the end of the post to underscore the primary point. While statistics can always be skewed, after all of these years where I (and obviously countless others) have talked about working longer it is pretty clear that if people in their 60s are working longer because they have to and the unemployment rate has gone up then gen y will have more obstacles getting out of the starting blocks.

A point I have been making for months, and this too I think is obvious, is that if this was/is the worst financial crisis in 80 years there will be fallout and consequences for many years.
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Sunday Morning Coffee

A couple of quotes to chew on this morning while looking at the Grand Canyon.

Petra Gajdosikova who writes the Money Honey Blog posted the following quote from Thomas Jefferson on Facebook;

I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretense of taking care of them.

And this one is from Thomas Donlan in this week's Barron's editorial;

Ever since the open-air market under the buttonwood tree, a large part of the business of Wall Street has been to introduce people who should not borrow to people who should not lend, and of course to collect fees for it.

What's on your mind this morning?


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The Big Picture for the Week of April 25, 2010

George Soros had a commentary run in the FT late on Thursday and while the main focus was not of great utility there was a comment in passing that got me thinking a little bit. In talking about the Goldman Sachs story and derivatives he noted that "whether or not Goldman is guilty, the transaction in question clearly had no social benefit."

The notion of social benefit is interesting. Does anyone have any obligation to even consider social benefit? Is it better to assume that no one cares about social benefit instead caring only about themselves or their bonus or their clientele or their own account as the case may be?

Everyone needs to answer this sort of thing for themselves as there are plenty of right answers.

For individual investors I cannot imagine why anyone would have social benefit in the context of financial matters as a priority. Between benefiting society and not benefiting society I would prefer the former (I've been a volunteer firefighter for seven years and counting, been giving away content on the internet for five and half years and my wife is a full time volunteer in animal rescue) but where personal finances are concerned the typical individual does not have the opportunity to be an agent for social benefit or the like.

Making a high priority out of social benefit for individuals becomes even less important if the typical social safety nets (entitlements) end up not being there. perhaps a little Ayn Randian looking out for your own makes the most sense--that is making sure you can take care of what benefits you first and foremost and if you have time left over for the other so be it. Let me be clear that I believe in a living a life of service but successfully protecting your finances from dishonest people, overly flawed investment products and your own emotions is what makes the other stuff possible.

I will tie this in to properly understanding what is important financially. For most people it is simply giving yourself the best chance possible for having enough money when you need it. A point I make often is that beating the market in a given year means a whole lot less than having enough when the time comes. The best way to come at this, IMO, is to save a lot and have some strategy to avoid the full brunt of down a lot (smooth out your ride).

My personal priority is our clients for the selfish reason that is is where my bread is buttered. Thanks to a low overhead we save more than we live on and I have no intention of retiring from this which means very little of our savings needs to be exposed to risk assets so doing anything to jeopardize this dynamic would be sheer lunacy. I am acutely aware of our good luck.

To the original point, taking care of your own yoga mat first and then sorting out everything else will help you solve a lot of this for yourself. I can appreciate the extent to which this sounds preachy but I am very personally motivated to eliminate stress and negative energy from my life and I think this happens by figuring out priorities and avoiding certain situations like being down 50% in your portfolio.
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Is China A Bubble?

The chart compares the Shanghai Composite with the Hang Seng Index and the S&P 500. While China clearly has excesses galore and issues to work out is bubble the best way to think of the Chinese equity market given that the Shanghai is 50% below its peak and that the Hang Seng is almost 25% below its peak?

What do you think?
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Sectorology

Yesterday a reader left a comment asking about the dividends from the new PowerShares domestic small cap sector funds. He said he needs more in the way of dividends because he is retired. I gave a quick answer that I want to expand upon today.

So it seems from the question that the reader uses ETFs and either does or is willing to build a portfolio at the sector level. This brings up one of the drawbacks of ETFs that I first brought up before WisdomTree existed which is that it is very difficult to build an ETF portfolio that emphasizes dividend yield. Even with WisdomTree it can be difficult to get a 3% yield especially given that the firm closed most of its sector funds.

You can go to the sites for the various providers and see what the yield has been and Yahoo Finance had gotten better at correctly reflecting the yield based on the trailing 12 months. Do keep in mind that yield going forward will not be the same as the trailing yield. The trailing yield is best thought of as an indication.

There are certain sectors that typically pay higher dividends than the 2% we've come to expect from the S&P 500. The financial sector is one such sector although not so much in the last couple of years. Per the SPDR website the Financial Sector SPDR (XLF) yields 1.17% and the International Financial SPDR (IPF) yields 1.30%.

Some specialty funds might offer a little better yield. The iShares Singapore Fund (EWS) is about 50% financials and yields 2.66%. The WisdomTree Pacific Ex-Japan (DNH) has a similar weighting to financials, is very heavy in Australia and yields 3.45% which is a little better still--some clients own DNH. Even if you put 16% of your portfolio into DNH (about the weight of the financial sector in the S&P 500) there are several sectors that will not provide a lot of yield, at least not at the fund level; sectors like discretionary and tech which are pretty big and some of the high yielders have 3% weights in the index like telecom and utilities making getting a 3% yield for the entire portfolio very difficult. Putting 10% into a sector that only comprises 3% of the index is a pretty big bet and would fall into the realm of yield chasing IMO.

At this point it makes sense to entertain branching out into individual stocks that might yield a little more. With a hat tip to Top Foreign Stocks CorpBanca (BCA) from Chile yields 6.70% and Banco De Chile (BCH) yields 6.30% (to be clear I own a different Chilean bank and am not recommending either of these they are just example) . Something like a quarter of a financial sector allocation into a well researched high yielding stock is obviously an easy way to lift the yield of the entire portfolio while still allowing for exposure to some more growthy holdings.

This can be repeated in most sectors--that is combining something with a very high yield like BCA, something with a slightly above market yield like DNH and depending on the sector something like a specialty ETF where a small yield doesn't have to be a reason to avoid or something with no yield in a sector that typically doesn't pay dividends.

If you think about there being ten sectors, having just one holding for telecom, utilities and materials (high yielding or not) because they only have 3% weights in the index that leaves seven sectors. If each of those seven have three holdings that makes 24 for the entire portfolio with at most seven individual stocks to keep tabs on.

For some folks who have not bought individual stocks before maybe this puts a different perspective on using them in conjunction with funds to build a portfolio. For some other folks picking one breakfast cereal over another amounts to speculation and this would never fly.
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Volcano!

You probably missed this because it has gotten so little attention but apparently a volcano has been erupting in Iceland disrupting all manner of air traffic in and around Europe. Ok no more sarcasm.

For quite a while now I have been writing about things like toll roads and airports as infrastructure investments. Recently I concluded that toll roads are more like utilities than true industrial stocks as they are usually characterized--still being a legitimate form of infrastructure investing.

Investing in publicly traded airports seems like a similar thing. Airports are part of the infrastructure theme and I think a similar type of utility as toll roads. Obviously the volcanic ash has impacted flights and so has impacted airline stocks and to a lesser extent some of the airport stocks I keep tabs on.

The chart captures Copenhagen Airport which has symbol KBHL in Denmark and CPNGF on the US pinks, Aeroports de Paris symbol ADP in Paris and AEOPF on the pinks, Fraport symbol FRA in Frankfurt and FPRUF on the pinks, Auckland Airport AIA in NZ and ACKDF on the pinks, Macquarie Airports MAP in Australia and MGPYF on the pinks and the Claymore Airline ETF (FAA).

The actual chart may not be of much use but anyone interested can take the symbols, make their own charts and draw their own conclusions.

I would expect FAA to be down more than the airports but it looks to me like a couple of the airports are down the same as FAA. MAP is down about as much as FAA and while you might think it odd that an Antipodean airport would be down in line with the airlines, MAP has a lot of exposure in the UK.

It is debatable whether an erupting volcano is a black swan event or not but airport traffic does not get disrupted like this very often so in terms of short term shocks it is possible that this is as bad as it gets. Obviously airports would be vulnerable to fewer commercial flights and fewer cargo flights caused by an economic slowdown or perception of a slowdown which would be more gradual than a volcano.

During the worst of the bear market most of the airports went down more than the S&P 500 except for Fraport which went down the same and Auckland which although did go down a little less had a large portion of its decline before the S&P 500 and did worse than the NZ 50 benchmark index. Interestingly Port of Tauranga (POT in NZ and PTAUF on the pinks), which is a sea port operations company turned out to be a much better place to hide than any airport I've looked at and most toll roads.

I think there can be a place for this sort of thing in a diversified portfolio (toll road or airport but probably not both) but they are very difficult to trade. Many don't trade much in their home markets let alone here on the pinks. Anyone can judge for themselves whether they think there is enough volume to get out of the size they would normally buy. I disclosed a while back owning a Chinese toll road personally and for one client for whom it was suitable but that it would not be a good buy for all clients because I have no faith that I could get out of a full across the board allocation. I own no airports anywhere as I prefer the toll road idea but even then it is very difficult to access for now. Who knows when or if this will change but I do find these to be of interest and so I keep tabs for now.
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Maybe You Can Buy And Hold

Something occurred to me about buying and truly holding that I had not thought of before. In a way this will seem obvious, and I concede that, but still. This is most relevant for people in the accumulation phase.

A couple of years ago I put up a post about my Health Savings Account and the contributions I make to it. To paraphrase that post, an HSA now has $6150 annual contribution limit. If this is your first year and you can put in the max you have $6150 in the account before any investment results.

Assuming the law and your circumstances do not change net year you will put in another $6150 so after year two you have $12,300 before any investment results. As for investment results, whether you made or lost 10% (or any other reasonable number), they are far less important than the second contribution which doubled the size of the account.

Additionally, and this is the different twist, that second year's contribution becomes an allocation device. To pick an extreme example let's say in year one the entire $6150 goes into the Market Vectors Egypt ETF (EGPT). That is clearly an aggressive allocation. If the contribution for year two just goes into cash or some sort of short term debt instrument then the volatility has just been cut in half.

If the contributions that come in every year also go into cash then pretty soon the account's volatility is much different than it was in year one. An account that is 75% cash and 25% in a country fund (remember an S&P 500 index fund is a country fund) looks pretty conservative and gets to a related point I have brought up a couple of times before.

At a past job a coworker was very intrigued (obviously I find it intriguing too) by the concept of a portfolio that went short Nikkei futures with 2% of the account leaving the other 98% in cash. He said the return was the same as the US stock market. The specifics of the trade and whether he was right or not are irrelevant what is intriguing is the idea of a portfolio matching the stock market with only 2% exposed to risk. This is not a feat that many people can pull off but the concept and what it says about risk adjusted returns is fascinating.

So if Egypt were to average 30% per year (nothing is that uniformly distributed, this is a conceptual post) then the 25% exposure during year five offers equity market returns for the entire account with 75% sitting in cash. In that context the need to sell becomes a lot less.

This can be thought of as (sort of) safer leverage. As opposed to a paper put out by Ian Ayres and Barry Nalebuff that avers levering your retirement account if you are young. David Merkel takes a chainsaw to this idea.

While this is more of a theoretical idea of course any implementation remotely close to this would require a large savings rate which means living below your means. As you get older and probably should take the foot off the accelerator some new cash into whatever vehicle becomes an asset allocation device. In addition to over-saving (living below your means) this sort of thing requires some real study of the concept of risk adjusted returns.
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Retirement Planning With Timeshares!

More like timeshare presentations.

We had dinner the other night with a couple of neighbors who are both retired and in their late 60s. They are both very involved in multiple things including his having a part time job which provides medical coverage.

At some point in their life they bought a couple of timeshares and this came up in conversation. More specifically the money they make going to timeshare presentations. My wife and I have done this twice in the past and back when we did it we made $100 per. Our neighbors just collected $300--they said this is now the going rate.

They also made a comment about this being a way that "old" people make money. A big focus on this site has been trying to figure ways to supplement typical income sources in retirement. I don't know anything about how often someone can do this but $300 for 90 minutes is not too shabby.

If this is possible to do once a month it seems like it could be a useful thing. $300 would cover our Directv bill, cell phone bill, land line, and ISP service. This is not insignificant.

The point is not to run out and try to go to timeshare presentations every week but this will fit for some folks like my retired neighbors. Arizona has a lot of these and other places probably not but it is a unique idea and for many people the retirement solution will have to include innovative ideas.

Something like the timeshare scam plus a modest income from even a low paying part time job like maybe $600-$800 (I don't think that low of an income would affect social security benefits but I am not positive) plus social security (for as long as it is there) and a couple with a modest lifestyle only having to pay for utilities, insurances, taxes, food and health coverage will not have to put a huge burden on their savings. In this sort of scenario a $500,000 portfolio could generate another $1000 per month for walking around money and provide money for a big trip (or several smaller trips) while not exceeding the 4% withdrawal rate. Or for people more conservative this leaves a healthy margin for various one-offs like home repairs, new tires, veterinarian bills and the like.

For people who are not wealthy this sort of scenario seems plausible. Of course the cornerstone is living modestly and going into retirement with no debt. As many of the articles about whether home ownership makes sense any more or not seem to mention, it used to be that people bought a house when they were young and got it paid off shortly before retirement. The concepts of trading up and HELOC spending has resulted in more people going into retirement with a mortgage. Obviously an extra $2000-$4000 in fixed expenses in retirement is going to be a deal breaker for many people.

Here is a related post from Kirk Kinder.

This spring (probably May or June) we are going to build an outbuilding that will serve as an office where I will work everyday. A friend, knowing this, sent along a link to an article on Popular Mechanics about this sort of thing. The picture is of one of the sheds from the article. The shed is built upon (and so the jeep is parked between) two cargo containers. I call this shed The Hoarder's Delight. We are going a more conventional route but I really got a kick out this.

While the term Man Cave is out of the question, I do like Secret Volcano Lair (nod to Austin Powers movies) but we are open to suggestion if you have something funny to offer.
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Sunday Morning Coffee

A couple of articles caught my attention this weekend.

The first was a profile of a money manager in Barron's named Stephen Cucchiaro. The article was titled Looking for Black Swans which stemmed from a Black Swan that Cucchiaro endured when he made the 1980 Olympic sailing team which of course never competed.

An Olympic boycott would seem to have a good chance of meeting the definition but even if it doesn't I can believe it came out of the blue for Cucchiaro and has gone on to influence him in his career.

My take is that Black Swans cannot be reasonably predicted so the idea of looking for them would seem to be difficult. Owning a couple of things like gold and a defense contractor would seem to be a way to mitigate against quite a few Black Swan with out of course ever actually predicting one.

One type of black swan-ish event is something unforeseen that is caused by another event. For example could the volcano in Iceland domino into something unforeseen? It is just an example.

The idea of a little protection makes sense to me but I would also say that figuring out what to avoid is also a very important portfolio dynamic. I've been talking about this a lot lately and I think it is crucial.

Cucchiaro made another point that is similar to something I have said in the past. He said that "too many investment professionals equate risk with volatility." I would add that many individual do the same thing. Assuming a proper asset allocation and time horizon and index fund of some sort cutting in half in a year like 2008 is more of an expression about volatility not risk. If you lever up to buy a lottery ticket biotech stock ahead of the FDA you are taking a risk.

Constructing a portfolio and then navigating through a cycle entails assuming proper risk levels and a suitable amount of volatility. In a "normal" diversified portfolio a little risk is suitable. Putting 2% into a lottery ticket of some sort (biotech, junior miner or something else) that does not work out is not a ruinous event.

It is not that difficult to build a portfolio that by design is more volatile or less volatile than the market. If you go the more volatile route, make no changes and the market cuts in half you are going to go down a lot but that doesn't necessarily expose you to undue risk. As a very simplistic example an equity portfolio that is 50% SPY and 50% EEM would have gone down about 46% in 2008 versus 40% for the S&P 500 (the actual dates on Google finance are Jan 4, 2008-Dec 26, 2008). So while this would have been more volatile there was no reasonable risk of either fund going to zero.

Hopefully it is obvious that the wrong asset allocation and or time horizon assumption is a risk. Learning after a big decline that you had too much in equities such that you sell at the bottom is a big problem.

The other article was written by Charles Hugh Smith with a blunt observation about what the loss of home equity means to most people. The money quote;

In effect, there is no inheritable wealth left in most mortgaged homes. Many homes have negative equity--they are worth less than their mortgages--so perhaps the equity in some of the 51 million mortgaged homes is higher than 6%.

Nonetheless, a quick look at the chart reveals the awful truth: inheritable wealth held in household real estate has plummeted from 70% of total value to 38%. In essence, only those households who own valuable homes free and clear have any wealth to pass on to their offspring.

That matters, because most U.S. households hold no appreciable wealth beyond their homes.

Read the whole article.

When asked I always used to say there is no question that investing is preferable to paying off the mortgage (as differentiated from paying a little more every month) but then had to disclose that we paid off our mortgage fairly early in life. It has always been a sleep factor thing, IMO, but it is tough to say now that "no question" applies anymore.

Wildfire season is close to starting.
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The Big Picture for the Week of April 18, 2010

There was an email waiting for me when I got home from the gym yesterday from GlobalX, the ETF provider, with news that they are about to launch an ETF for silver mining companies and one for copper mining companies. The respective symbols are SIL and COPX. You may recall that First Trust recently listed a copper miner ETF with ticket CU and a platinum metals miner ETF with ticker PLTM.

Both the GlobalX funds are heavy in Canada and the copper fund has a lot of overlap with CU. I wrote about both the First Trust ETFs when they launched with the expectation that they will prove to be more volatile than something like the iShares Global Materials ETF (MXI) which is a broad large cap proxy for the sector and also a holding for some clients.

For now it is too soon for the idea of more volatility to be correct or not but I would expect both the new GlobalX funds to also be more volatile.

Candidly I am unlikely to ever need a silver mining ETF, that seems like it would be more of a trading vehicle, but a copper ETF could have utility. Recently the swings in both directions for copper have been bigger than in past cycles, as I recall anyway, but copper and so copper stocks tends to be a good hold earlier in a cycle and the volatility of many of the stocks makes for an easy way to add beta.

As I said the two funds, CU and COPX, seem very similar and I don't necessarily feel the need to spend time picking the better of the two if I am not a buyer right here but I will say that access to copper miners for people who don't want to pick stocks is a good thing.

Also in the ETF news is that Direxion Funds, which amusingly is headquartered five minutes from the house I grew up in, filed for a bunch of funds including 3X Bull Water and 3X Bear Water. Triple short water? I don't know what water index these funds will track but is there really that kind of trading interest in the water theme?

I love this theme, I've held PHO personally and for clients since it first listed and while it has done better than the S&P 500 and the Industrial Sector SPDR (XLI) in that time I've never thought of it, or any water fund, as a trading vehicle. It's just an observation, I'm sure Direxion perceives there is demand to lever up the water theme.
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Goldman Sachs!

The news about Goldman Sachs is still very fresh and we do not know all the details but from 30,000 feet the notion that the worst financial crisis in 80 years could tidily wrap up in a year or two is ludicrous.

All the people who come on liking the recovering fundamentals of the domestic financial stocks; well I've never understood the logic. There will be more shoes of all kinds to drop for a while to come. Anyone looking at these for a trade can clearly do well but a fundamental investment seems like a bad bet.
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Wait, Are We Turning Japanese

With apologies to The Vapors; I don't think so but the quote I posted from Niels Jensen earlier this week is still on the front burner.

The inescapable conclusion is that when you need inflation the most, it is the hardest to engineer whereas, when you don’t want it, you can have it in spades.

The context here is the debate between US debt issuance causing meaningful price inflation versus deleveraging causing a debt spiral, IE deflation. This article from Seeking Alpha delves in with more detail but I had another thought with this. Part of the equation is the reliance on Ben Bernanke and the rest of the crew to know when to start raising rates. While some of the policies that have been enacted have been effective in the short run (we do not know about the long run yet) we must remember that this is the same group who publicly had no idea the financial crisis was coming and so reacted very late.

The reason I say "publicly" is because obviously the Fed Head can't say "hey we got a big big problem coming," that would surely make any bad situation worse. While I do not know how the Fed could have acted preemptively without causing a panic the fact is they did not act preemptively and it is reasonable to conclude that if they did see something bad coming they would have done something.

Given the above quote and the extent to which the country is relying on the guys who previously got it wrong to now get it right is a high expectation.

I'm not in the deflation camp at this point but I am thinking about this side of the debate a little more lately.
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Thursday Tidbits

One idea making the rounds is that retail sales are being supported or lifted by more money left over for consumer spending because they are not paying their mortgages. If we all put on our Shedlock hats for moment if this isn't the stupidest bullish argument I have ever heard I don't know what is. I have never been as negative as Schiff, Shedlock or Denninger (they all seem to take different routes to similar conclusions for equity prices) but if they turn out to be correct in terms of magnitude we will look back on things like this and wonder what the hell were we thinking.

Until then the stock market is apparently going to go up every single day, LOL.

IndexIQ has now joined the pantheon of very innovative ETF providers along with EG Shares, GlobalX and Market Vectors. There is plenty of utility in funds from the big boys too but the smaller companies don't have as deep pockets, are taking a lot of entrepreneurial risk and bringing some great products.

The latest fund from IndexIQ is the South Korea Small Cap ETF (SKOR). I have to say I've never been a fan of South Korea as an investment destination, there are consumer debt problems (probably not as bad as in the US) and companies like Samsung and LG rely in large part on discretionary spending of the US consumer. However it is possible that similar to Japan the story with small caps could be different than the large caps (in Japan DJP policy is supposed to favor domestic companies that are mostly small cap over the big exporters), this is something to learn about. SKOR is 19% financials which could be an issue.

Coming next from IndexIQ is the Taiwan Small Cap ETF (TWON). TWON is 30%, tech which is a lot less than the iShares Taiwan ETF (EWT), 27% industrials and 18% materials. I think the fund is due to come April 28 but whether that is correct or not it is not out yet.

According to IndexUniverse IndexIQ has also filed for small cap ETFs for Thailand, Malaysia, Hong Kong, Singapore and Indonesia. Realistically no one is going to own all these funds but it would be very reasonable to learn a country and draw a conclusion about preferring small over large in one or two of them.

IndexIQ has also filed for a small cap global agribusiness and several other small cap resource industry funds. As I repeat often, more innovation like this allows non-stock pickers to capture very narrow effects which I think is a good thing.

Speaking of sectors iShares has a page on its website titled Explore Sectors. iShares has "over 50" sectors funds. This sort of study is time well spent.
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Go Heavy On Absolute Return?

A little over a month ago I wrote about an article by Niels Jensen from Absolute Return Partners that I found on Credit Writedowns (a must read blog). In that post Jensen wrote an interesting commentary about the accumulation phase being much shorter than many people believe and so the period of 2000-whenever this ends (some believe it is already over) will badly impair a lot of financial plans.

Jensen is back with another commentary that this month comes via Claus Vistesen (never read Claus before but makes a good first impression with this post). Jensen lays out some similar thoughts about why he thinks the equity market will continue to have a bumpy ride to nowhere and why he has changed his mind about higher interest rates, now joining the deflation camp which if correct would mean lower interest rates. The leads him to think a heavy weighting to absolute return products is the way to go; do note the name of his firm.

Jensen in discussing deflation and so lower interest rates mostly makes the same argument that a lot of other folks make and by now you've read about this and you likely lean one way or the other (inflation or deflation) but Jensen adds one other nugget that I found to be very compelling that I have not read anywhere else;

The inescapable conclusion is that when you need inflation the most, it is the hardest to engineer whereas, when you don’t want it, you can have it in spades.

And Japan saga as support for the argument makes the comment all the more interesting. My thought all along here has been that we have clearly had an asset deflation and that deleveraging was never going to wrap up in six months but that longer term the supply of debt that needs to be issued will be inflationary. I can't say I've ever had 100% conviction with this but it is what I believe. The unique spin that Jensen puts on it though is compelling. I am not changing my mind at this point but am maybe more open to the idea of deflation than before.

He also articulates several other reasons why he thinks equities will struggle and then makes the case for allocating "30-40% to uncorrelated asset classes" like absolute return.

The average investor is over-exposed to equities right now. I would consider myself extremely lucky if my equity portfolio were to deliver more than a 5% annualised return over the next 5-10 years.

I've been writing about and using absolute return in client portfolios for a while now but nowhere near 30-40%. At one point we had 5% and now it is more like 2%. When the market was cratering there were quite a few comments wondering whether it made sense to go very heavy into absolute with the idea being that equities are broken. My answer was pretty consistent which was that the time to consider such a thing is not after the market cuts in half.

Now that the market is up 75% it would be more reasonable to consider increasing exposure to absolute return funds. As Jensen notes there were plenty of absolute return funds that "did not work" during the 2008 decline and whatever or whenever the next panic there can be no guarantee that they will work then. So the risk is you go up less than the market but capture too much of the ride down. That sort of outcome would be disastrous.

Having some exposure; yes, go for it. But a huge exposure in the belief that equity markets are broken was a mistake a year ago (I made this point then) and would be a mistake now. I believe the task of capturing a normal equity return requires a willingness to make specific country decisions but of course that was the case last decade too. Absolute could easily help smooth out the ride but too much of anything is risky.
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Big Decline? Well, At Some Point

Daryl Montgomery from The Helicopter Economics Investing Guide has a post up questioning whether a stock market crash could be in the offing. I'm not sure whether crash is right or not but he makes a case for a pullback that will either resonate or not but the idea raises a couple of important talking point.

The S&P 500 has clearly had an awesome rally by any measure in the last 13 months. Some will feel it is fundamentally justified and some not but up seventy whatever percent is a big one. Big rallies after nasty declines is a pattern that has repeated many times in stock market history. While the numbers, on the way down and then back up to this point, may not be in the norm the pattern is normal.

So far in this post I am just talking about market behavior while specifically not discussing the fundamentals.

If you can accept that the pattern (even if not the magnitudes) is normal then you also need to consider what else is normal in the context of large rallies and bull markets (if that is what this is). After big moves, markets correct downward often to the point of scaring the hell out of people. I have felt there would be one more scare the hell out them decline for a while now and have of course been wrong thus far. Be that as it may let this be a reminder of how the market scares people every now and then.

A couple of months ago the market declined a little less than 10% and didn't scare anyone. We can probably conclude that another 9% decline would again not scare anyone, with the context being that enough of a scare would be healthy for the market, so a good cleansing would require more than a 10% decline. Maybe this means 20% or 30% and of course it might not play out that way at all but the occasional scare is a normal thing.

Regardless of whether you are a bull or a bear pullbacks happen and the chance for a "scary" decline is more likely after a big rally that leaves many people feeling pretty good. At various points as the market was going down a lot I commented that a big decline is a lot less likely after a big decline. That sounds quite simplistic of course but it is true. A big rally is also less likely after a big rally.

So here we are today up 70% from the low, volume has been weak for most of it (maybe less participation is part of the new normal if you believe in that theory) and the VIX seems to be expressing some sort of comfort with the current state of the market.

Even if you are wildly bullish a big correction does not have to be disastrous with the Asian Contagion in 1997 and LTCM in 1998 as examples. If you are wildly bearish then you don't believe any of this is real and expect a big decline.

The point here today is one made several times in the past which is to understand/remember that declines are normal and will happen again. As obvious as this sounds many people simply forget or appear to forget about past large declines and go through them like they have never happened before. This was very evident by comments left on this blog and comments left on my posts as they ran on Seeking Alpha along with many other articles by many other people.

In terms of market behavior the only thing that has been different, but not unprecedented, has been the magnitude of the moves. From there people need to then assess the fundamentals to figure out what to do or not do but whatever you conclude about US equities good or bad there will be declines that come along that make us collectively uncomfortable. Losing sight of this is what causes mistakes to be made.
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High Conviction Picks

A few weeks ago Seeking Alpha started a regular feature called High Conviction Pick where someone who is presumably qualified gives a stock pick they believe will do well and they lay out the case for their belief.

The point of this post is not to pick on the concept of the series or anyone participating but point out the difficulty in thinking about anything being the top pick.

If you construct a portfolio for yourself or a bunch of portfolios for clients you will have some number of holdings that you think will be manageable to keep track of. Whatever number of individual stocks you think is right, assuming you use individual stocks, one will be the best performer and one will be the worst. Additionally it is unlikely that every pick in a stock portfolio will work out as hoped for.

To make things more complicated top pick could be absolute or relative. For example if you own a mining stock that goes up 50% it might be the name you own that goes up more than any other stock but if at the same time a mining stock ETF goes up 100% then your 50% riser looks like a bad pick in relative terms.

If you believe in top down management then you place more weight on getting the sector or country correct than the stock pick. One sector must be the best performer and one must be the worst. Over varying periods of time someone with average analytical skills will get some sector calls correct but of course even the best analysts will get sector calls wrong, it simply goes with the territory.

Personally I have very little positive to say about the consumer discretionary sector these days. I generally think the consumer is still in plenty of trouble based on lack of job growth, a belief that the foreclosure rate cannot improve for a while and some of the other things that you no doubt read about in many places.

That being said the sector, as measured by the Discretionary Sector SPDR (XLY), is up a lot more than the S&P 500 YTD. Mentally I have bet against the consumer but clients own plenty of XLY and Nike (NKE). My mental bet, so far, is clearly wrong but who cares, by having at least an underweight position the portfolio captures some of the effect. For me I think XLY and Nike are the best way to build the sector but from the top down I expect the sector to lag.

If anyone asked me on January 1st what my top pick would be I would not have said Nike and I still wouldn't now but it is one of the better performers so far and it is possible it will turn out to be the best performer. For all I know the discretionary sector could turn out to be the top sector this year by a mile regardless of anyone's perception of the fundamentals. Anyone willing to bet against the consumer to the extent of excluding the sector, in the example above, would place a greater burden on the rest of the portfolio.
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Sunday Morning Coffee

Written Saturday afternoon at the Vancouver Airport.

There was a Barron's article about what they expect to be a proliferation of actively managed ETFs. The article stresses the idea that ETF is just a wrapper and that active management can lend itself to the wrapper.

I will not be a fan of these but for a different reason than most other people who end up not liking them. For now and for a while to come the actively managed equity ETFs will be broad based like large cap growth or whatever. The issue with a broad based actively managed fund, regardless of the wrapper is that you don't know what it will do in the future. Today such a fund could be underweight a sector but then be overweight in the future; overweight enough to mean something should be changed elsewhere in the portfolio or the actively managed ETF in question should be sold.

A big positive of ETFs is that you know what it owns now and you have a very good idea what it will own six months from now. This means a portfolio can be constructed to express various opinions that hopefully result from some diligent research. Where active management could be useful with ETFs would be some sort of specialization. If a fund is going to actively manage utility stocks well then it will always be a proxy for utilities. It might be managed well, or not but it will be a proxy for utilities today and a proxy for utilities six months from now.

Ditto for any country fund like if a closed end country fund switched to being an ETF.

My preference is for the ETFs to be somewhat static indexes. I'm not sure who dubbed it this way but the idea of making active decisions with passive products strikes me as a good way to go. You know what you own and they can be easily blended with other holdings.
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The Big Picture for the Week of April 11, 2010

We are on our way home today after a great time in Vancouver. This is a must visit destination.

Yesterday in the FT Gillian Tett had an article about the Government Investment Corp (GIC) of Singapore which is a sovereign wealth fund. The article had a few quotes from GIC officials questioning the Harvard and Yale models for portfolio construction.

Keeping tabs on these makes for fun reading but I believe is also very constructive for learning. My take all along has been that it makes no sense to try to copy what the endowments do but they can influence a portfolio. For example I find it noteworthy when they make changes to how much they have in "real assets." I am not a fan of 25-30% in real assets for any retail type portfolio but when Harvard or Yale, for example, goes from 20% to 30% in real assets (or some other large change) they are clearly expressing an opinion about something. Allowing that to influence you in going from 2% to 4% or some other change that would not involve you betting the house is reasonable.

A few times in the past I've mentioned Jack Meyer's (former HMC CEO) influence on me in keeping Plum Creek Timber (PCL) for quite a few years. Generally it was a good hold most of the time (not 100% of the time of course) and while I did sell it a while back the influence was clear. While I believe in the concept of timberland's low correlation it is very difficult to capture in a stock or ETF I find it useful to keep tabs on this space. Sino Forest (SNOFF) is a popular name from Canada but it seems to go in the same direction as the market but with greater degrees of magnitude.

A different type of example from endowments that can be just as important is what not to do. Harvard and Yale have always allocated large portions to various types of illiquid pools of capital. I've never been a fan of that for several reasons. I know firsthand that people have unexpected things come up that must be paid for. Paying for the unexpected becomes difficult if too much of your assets are tied up in an illiquid investment--even if it is doing well.

Additionally the crisis brought home another point which is that these types of investments don't always do well. There were all sorts of strains placed upon these pools and investors in those pools. It is well known that Harvard was in real trouble for a short while there and could only get absurdly low bids.

In the future it is a very good bet that the endowments will get it right more often than not and they will continue to be a way to learn more about investing but occasionally they will be wrong in a very noteworthy fashion and that will also be a learning opportunity.

The first picture is from the other day driving back from Deep Cove on the Iron Workers Memorial Bridge. The second picture is from Granville Island which some compare to Pike Market Place in Seattle. The food was good and the shopping was not (yippee). The last picture is from the West End.
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Rethinking Asset Allocation

IndexUniverse ran a webinar titled Rethinking Asset Allocation. I looked at the PDF but have not had time to listen to the webinar as we are still out of town enjoying Vancouver. Since I did not listen to the audio I'll talk more generally.

Investing requires introspection to assess your current portfolio and your own ability to navigate market cycles in whatever manner is appropriate for you. To that point it is worthwhile to understand your own asset allocation to make sure you can sleep at night and that it gives you a reasonable chance to have enough money for when you need it. Do not minimize the sleep factor. Chances are insomnia, so to speak, will cause meaningful selling of an asset class at exactly the wrong time.

Assuming you don't do something wildly speculative like putting 25% of your portfolio into a lottery ticket biotech that blows up then the biggest risk comes from panicking after a big decline. I write a lot about trying to avoid big declines for two reasons; it is a way to add value over the entire cycle and you are less likely to panic if you can avoid panic situations that typically occur when a portfolio cuts in half.

Additionally "new" asset classes when used in moderation can help smooth out the ride. Things like currencies, commodities, absolute return and anything else you want to add in are not really new but the ease of accessing them via retail funds is new. Obviously plenty of people will misuse the "new" asset classes but that doesn't have to be you.

Asset allocation requires ongoing study but changes to the practice or if you prefer, the science are probably more evolutionary not revolutionary meaning that one bear market does not mean equities are dead or that half of a portfolio should be in absolute return funds. There will be future "normal" bull markets in equities even if they are easier to find in foreign markets, stocks will go up a lot and you will want to have exposure.

I've mentioned a few times (with no claim to originality) that the biggest lesson learned over the last decade or maybe just the 2008 bear market was about volatility tolerances. People learned the hard way they had too much exposed to risk assets.

The first picture is from Deep Cove. The second picture is from Cleveland Dam and in that last one, someone is overcoming a fear at the Capilano Suspension Bridge.
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ETF Presentation

Yesterday I gave my presentation at the Vancouver MoneyShow on portfolio construction using specialized or narrow based ETFs. I think the general thread went well and I think/hope that I put the context and progression together in a way that made sense.

Below I will lay out the funds used but will avoid percentages in this forum as that could be a compliance issue. The point is not to run out and copy this portfolio. I don't use this mix for anyone and in fact as you will see in the disclosures at the bottom I use a very small number of these funds. The point is to think about how funds can interact with other funds to creates effects, access themes and countries and manage volatility and other portfolio attributes.

Technology

iShares DJ US Technology Sector Index (IYW)
iShares MSCI Taiwan Index (EWT)
First Trust NASDAQ Clean Edge Smart Grid (GRID)

Financials

iShares DJ US Financial Sector Index (IYF)
WisdomTree Pacific ex-Japan Equity Income (DNH)
Claymore/Beacon Global Exchanges (EXB)

Energy

WisdomTree International Energy (DKA)
SPDR S&P Gas Equipment & Services (XES)
GlobalX China Energy (CHIE)

Healthcare

SPDR S&P International HealthCare (IRY)
iShares DJ US Medical Devices (IHI)

Industrials

iShares S&P Global Infrastructure Index (IGF)
PowerShares Water Portfolio (PHO)
First Trust Global Wind Energy (FAN)
iShares DJ US Aerospace & Defense (ITA)

Staples

PowerShares Dynamic Food & Beverage (PBJ)
Consumer Staples Select Sector SPDR (XLP)

Discretionary

Market Vectors Gaming (BJK)
Consumer Discretionary Select Sector SPDR (XLY)

Materials

EG Shares INDXX Brazil Infrastructure (BRXX)
PowerShares Global Ariculture (PAGG)
First Trust ISE Platinum (PLTM)

Telecom

Vanguard Telecom Services (VOX)

Utilities

*iShares S&P Global Infrastructure Index
*First Trust Global Wind Energy

Other

IndexIQ Hedge Macro Tracker (MCRO)
ETFS Physical Gold Shares (SGOL)


*Both part of the industrial sector allocation but are both about 40% utilities and so the utilities from these funds create enough exposure for a modest underweight which could make sense if interest rates go up.

Client or personal holdings to disclose are IYW, IYF, DNH, DKA, IGF, PHO, XLY, BRXX and VOX. So only nine of 25 ETFs are held by clients and no client owns all nine but many clients own five of those funds. For the presentation I talked a little about each of the funds like what they hold, what they avoid and some other characteristics and as I told the audience I would hope that anyone interested in constructing a portfolio in this way would take the time to look under the hood and draw their own conclusions but funds from the same sector can be incorporated into a portfolio but still avoid overlap.

The picture is from a neat little town north of Vancouver called Deep Cove. I had the best doughnut of my life at Honey's, even better than Voodoo Doughnuts in Portland.
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Putting Risk In Proper Perspective

The other day on my way home from fire training I saw some smoke coming up from a neighbor's property. He was burning various logs of different sizes to clean up his property. This sort of cleaning up is not uncommon but depending on the weather conditions this can be very dangerous, in fact this type of burning is banned during the fire season.

Somehow he was able to build his burn pile on top of the little stream that runs from the meltoff meaning water was running under his burn pile. Up one bank from the stream it was covered with snow so no danger there. Up the other bank it was dry-ish pine needles and regular forest litter and this is the slope that lead up to his house.

Don't worry there is no bad ending here but had the wind increased and kicked up a spark or two the risk, the only way this was going to go bad was the dry hillside between the fire and his house. Wildfire "rips uphill" and while he had mitigated several risks the biggest one was not addressed--burning over his house. This guy most certainly doesn't know what I do for a living nor does he reasonably know about this blog but if you are reading this; that fire extinguisher would not have helped a lick.

Anywho investing can obviously be a risky endeavor. I've written many times about every portfolio being vulnerable to something or several somethings. I think my neighbor missed the biggest risk, having a burn pile downhill from his house the stream notwithstanding.

A portfolio with a bunch of mutual funds from one fund company is relying on the same research team so the funds could overlap, a bunch of single country ETFs could leave the portfolio very overweight financial stocks, some folks put too much faith in things like MLPs, people can over commit to a story or theme and so on.

What maybe be an obvious risk to one person could be completely invisible to someone else. This ties in with behavioral quirks. We are often our own worst enemy. Had my neighbor burned down his house (we had that happen about a year and a half ago) clearly it would have been a horrible consequence of his own behavior.

Investors suffer horrible consequences of their behaviors all the time--the people who spend beyond their means, put 25% of their portfolio into a lottery ticket biotech (a reader shared this experience a few years ago); the list of possibilities is endless. Our ability to navigate risks like this will ebb and flow, it is possible to have more blind spots a year from now than you do today.

The first picture is from out on the road between Vancouver and Whistler. The second picture is from Squamish which is where the recent TV show Men In Trees was filmed.
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Live (On Tape Delay) From British Columbia

A little scenery and a little retirement math.
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ETFs and Vancouver

We got to Vancouver yesterday where I will be giving a presentation Wednesday on portfolio construction with specialized ETFs to a couple of crickets chirping and maybe a tumbleweed rolling through the hall.

Without frontrunning the presentation what I generally did was go sector by sector and select funds that capture various themes within each of the sectors. I assembled a spreadsheet that my assistant then put into a powerpoint presentation. I put off giving her the spreadsheet as long as possible because I knew there would be potentially new product out that could contribute to the presentation.

I've mentioned the PowerShares Small Cap Sector funds. They should be out on Wednesday. The symbols will be the same as the SPDR Sector ETFs with an S added at the end. So the PowerShares Small Cap Financial ETF will have the symbol XLFS. Some of them could be sort of similar to existing niche funds. For example I think of the PowerShares Water ETF (PHO), which clients and I own, as capturing small cap industrial stocks. The market cap of PHO may be larger than XLIS but it is certainly much smaller than XLI. Maybe PHO should be mid cap industrial exposure?

Although a long way from listing, GlobalX has filed for Brazilian sector funds as a complement, no doubt, to the China sector funds. Some will think these are useless but if you make the effort to really learn about a country's investment merits you are bound to draw some conclusions about what parts of the economy make more sense to own and which parts are better to avoid.

I seriously doubt too many people are going to conclude I gotta own me some Chinese financials after a detailed study of the country (talking investors as opposed to traders) and so the iShares FTSE China 25 (FXI), which is the most popular, becomes a lot less appealing. And if individual stocks are not right for someone but they know they want to avoid financials they've got to think about narrow ETFs. This applies to all sorts of spaces which is why I think (obvious statement perhaps) there is going to be a place for these funds.

Maybe we will see a Norwegian fishery stock ETF and a Ukrainian farm stock ETF after all. We'll see.

A couple of observations about Vancouver; it is expensive, wow. We are paying out the ying-yang for parking and internet access in the room. Really, wow.

We are a couple of blocks from a popular shopping area (Robson St. for people who know the area) and unlike in the US there is very little that is on sale and stuff is very pricey. All my wife could find was a pair of hiking gloves that were on sale for around $20 (that's it only five more days, LOL). Candidly Joellyn was shocked at how expensive stuff is. Canada has generally fared better than the US but it is far from trouble-free and there are still risks (do a search for what Simon Johnson has to say about the banks) but as expensive as things were, the stores were packed.

The two pictures are from the same area near our hotel. We haven't even done anything or gone anywhere and the scenery is awesome (notice the seaplane taking off in the first picture).
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Vancouver, Eh?

We are rolling down to the airport very early to fly up to Vancouver, BC where I will be speaking about portfolio construction with specialized ETFs. The blogging was light this weekend due to a lot of fire department business that I think you will find interesting when it resolves in a week or so; there is a financial aspect to it.

I hope to get back to normal blogging tomorrow with hopefully some decent pictures, thank you for your patience.
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Sunday Morning Coffee

A couple of related items this morning.

John Mauldin tackled a reader question about what to do for a ten year investment horizon. Mauldin seemed surprised that the person really only had a ten year horizon and offered little hope for that time period but he is more optimistic for anyone with a time horizon of 20 years or longer.

There is a good chance that someone who thinks they only have a ten year time horizon is wrong. Ten years to retirement is not a ten year time horizon. It is possible that in ten years, upon retirement, there would need to be big changes in an investment portfolio but that is not a ten year time horizon.

On a somewhat related note the Barron's cover story was about emerging markets. While not terribly insightful there were a couple of useful nuggets but no mention of Chile which is probably a good thing. If Mauldin is correct about US equity returns then to tie in a point I have been making for years investors have to figure out how to research foreign markets and figure out what is the best way for them to access those markets. I imagine for a growing number of folks that will mean ETFs but even mediocre actively managed funds would probably outperform the US market that Mauldin envisions for the next few years.

There was one little snippet from Mauldin that baffled me;

For most of you, caution is appropriate. Do not plan to make 8% a year from your portfolio, or to spend 7% of your savings. As Ed Easterling has shown, there are historical periods where people taking 5% a year from their portfolios would be left with nothing after 30 years.

Has any part of the industry ever thought an 8% withdrawal rate was appropriate? Ditto 7%. Maybe in the realm of "exclusive investment products" these sorts of withdrawal rates exist but not being privy to those, 7% is crazy let alone 8%. We've covered this ground before about people spending too much and while this problem is not going to go away I would take the opportunity to learn from this mistake that other people will make.

Short post, very busy weekend.
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Holiday Randoms

This interview from Forbes tries to make the case for 50% in emerging markets. One word from me; no.

PowerShares is due to launch domestic small cap sector funds next week. There will be nine funds (in the mold of the SPDR Select Sector ETFs). I hope these gain traction. While we are not at a point where I think the best portfolio can be constructed with no stocks and all ETFs we are moving closer to that point.

Many specialty ETFs have weak volume but IMO this does not have to be priority one, or even priority two if the intention is to hold the fund. Limit orders would be the way to go with one of these funds but if you end up holding something for a couple of years or longer it doesn't really matter if it traded 20,000 shares a day while you held it. Well it wouldn't matter unless you are a 20,000 share buyer.

For those who are unsure if such a fund gets closed you don't lose your investment, you cash out at NAV if you don't sell ahead of the closing.

For the first quarter we lagged the market slightly. Most of the things I favor were up less than the 5ish percent of the S&P 500 so the small lag. But in second quarter we are ahead! Long term is for suckers. [/humor attempt]

Bernie Carbo hit a monumental pinch 3-run homer in game six of the 1975 World Series. This article about him is the latest thing moving around Red Sox Nation and is quite an eye opener.

Have a great long weekend.
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Dividend Investing

This will fall deaf on some ears as the topic often draws passionate comments but I'll give it a try anyway.

Yesterday I read a post on Seeking Alpha called The Four Percent Rule For Dividend Investing In Retirement from an anonymous blogger named Dividend Growth Investor. The post basically lays out a premise for constructing a dividend based portfolio focused on the rule of thumb about not withdrawing more than 4% in retirement.

An important building block of understanding (although probably not new to you) is that over very long periods of time dividends have accounted for about 40% of the total return of equities. Dividends matter in just about every type of the stock market behavior except for up a lot, IMO. The way I look at, with equities up 65 or 70% in the last twelve months whether or not you collected an extra 200 basis points doesn't mean that much but if the market is anywhere from down 10% to up 15% then an extra 200 basis points could be very important.

The Dividend Growth Investor, per the article would split a portfolio into four categories;

1) "The first component would be fixed income securities such as 30 year Treasury Bonds."

2) "The second component would consist of higher yielding stocks with low dividend growth. Likely inclusions in this list include Master Limited Partnerships."

3) "The third component of the portfolio would include mature companies which offer yields similar to average market yields, but which have enjoyed solid dividend growth."

4) "The last component will include companies with low current yields, which have the ability to generate double digit earnings increases. This could generate solid dividend growth in the future."

He did not suggest how to weight the four and did not mention whether this would be the totality of the portfolio.

In averring for the 30 year treasury (he may have been taking generically) he mentions the "stability in the principal and income would provide at least some cushion in certain catastrophic events." There was no mention of the risk of buying a 30 year bond if interest rates rise. I'm not sure if he does not know how the math works out but if rates go up (they are very close to all time lows) then investors who bought 30 year paper with the intention of holding will be down a ton (about 12% in price for each point that rates move up) and then be stuck with a below market yield.

In point number 2 about MLPs, occasionally they get hit very hard as the Canadian ones were back in October 2006 when news of a tax status change came out. There is room in a diversified portfolio for some MLP exposure but to repeat from past posts is you are getting an 6% yield in a 1% (or zero percent) world you are taking risk, you either understand that risk or you don't. In the paragraph he also includes REITs Realy Income (O) 5.6% yield and National Retail Properties (NNN) 6.57% yield and utilities like Consolidated Edison (ED) 5.34% and Dominion Resources (D) 4.45 yield. Utilities tend to not do well if rates go up.

In discussing point number 3 he mentioned Johnson & Johnson (JNJ) 3.01% yield, McDonalds (MCD) 3.30% yield and Kimberly Clark (KMB)4.20% yield.

Companies discussed in point number 4 were Walgreen (WAG) 1.48% yield, Becton Dickinson (BDX) 1.88% yield and Medtronic (MDT) 1.82% yield.

Assuming each of the four groups gets a 25% weighting in the portfolio and giving equal weight within each group to names he mentioned the average yield (assuming 4.72% for the 30 year bond which is where TYX closed yesterday) of the portfolio is 3.91% obviously just shy of the 4% targeted in the title.

The biggest risk to this mix, I realize my assumptions of what is implied could be incorrect, is that half of the portfolio is at serious risk if interest rates rise. I compared the names above to the TYX and found a stretch in 2005 where TYX went up for a few months and most of the names in that second group had noticeable declines during the run up in rates. I should note that the move up in rates was only slight, I picked that period because it lasted for several months.

If rates really move up, and that is the question to be asking at this point, then I think this half of the portfolio would get hit pretty hard.

My idea of a diversified portfolio includes exposure to every big sector of the market with stocks of many different attributes so that there is at least some exposure to whatever is leading the market. Value can be added by overweighting the area that ends up leading the market but if that call is not made correctly at least there is some exposure.

Low vol, high yielding holdings have risks too. In addition to the above, occasionally dividends get cut.

The 4% withdrawal rate is about taking money out at a rate that does not cause the portfolio to blow up. In theory a 2% yield and 4% average price appreciation will more than get the job done (this is a simplification because returns are never that linear). Using (recent) history as a guide the stock market goes up a lot every so often and a reasonably diversified portfolio will capture most of the effect, a gross overweight of dividend payers will not.

Getting a 4% yield for an entire portfolio is very difficult to do, 3% on the other hand is much more approachable. Not mentioned in article is that plenty of foreign stocks with volatility characteristics close to the market (so they could go up a lot if the market does) but aren't necessarily that interest rate sensitive. There are many high yielding foreign oil stocks (so regular equities tied mostly to the price oil as opposed to being income vehicles).

I'll mention long time holding Statoil (STO) which is due to go ex-div in May for its annual dividend. Based on current numbers it yields about 4.3%. A few of those combined with some higher growth names could easily get the portfolio yield up into the high twos or close to 3%. I own plenty of high yielding stocks for clients, as I do believe in trying to kick up the yield ahead of the market, but not at the exclusion of higher growth names.

Even in retirement people need growth. Based on a 3% inflation rate prices/expenses go up 50% in 15 years. A fit 65 year old with good genes could easily go through two fifteen year stretches.

In addition to Statoil, many clients own Johnson & Johnson and some clients own Consolidated Edison.
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