Montier On Portfolio Construction

James Montier, via Barry Ritholtz, knocked it out of the park with a lengthy commentary that explains why benchmarking is the wrong way go, picks apart various strategies including Yale's, offers some interesting numbers and gives an opinion about how to think about portfolio construction.

There are some things he mentions that I agree with, and implement, and other things I don't agree with.

The first idea I wanted to comment on was Montier's belief that benchmarking is a bad way to navigate through with a portfolio. He feels that benchmarking results in "mis-measurement of risk and indifference to valuation." He goes on in great detail why he feels this way and backs it up with some numbers and some logic.

Benchmarking, like anything, has pluses and minuses. The building block here, IMO, is that equities have averaged 9 or 10% in annual returns over long periods of time. A normal and suitable allocation and a healthy savings rate gives people a decent shot of having enough money. This building block is being question after a very long round trip to nowhere for the US equity market and quite a few other major markets.

Of course while we were on a long round trip to nowhere there were many other foreign markets that had very good decades. While I have been consistent in doubting whether the US will have "normal" returns I have been just as consistent in saying there will be plenty of countries that will have "normal" returns and there are ETFs to cover many of them.

A big theme throughout the commentary is that risk and volatility are not the same thing. This is a point I have made often. Part of the mis-measurement he mentions is that many people do not realize the two are different. He notes that volatility, we can see this on a chart of VIX, was lower in 2007 with the SPX above 1500 and it was sky high when the SPX was below 800. If volatility equaled risk then the VIX would have been sky high in late 2007.

Indifference to valuation means buying at any price and then staying fully invested. He was very critical of staying full invested when risk, not volatility, increases. To paraphrase; if risk is greater doesn't it makes sense to reduce exposure?

This resonated with me in how I talk, almost to tedious length, about having some sort of trigger point for defensive action in a portfolio. The way I frame it is that when demand for equities is not healthy it makes sense take defensive action.

One concept I write about a lot in the context of defensive action is avoiding the full brunt of down a lot. He would likely tear into me for believing in going down 15% in a down 30% world is a good result. I don't know if Montier bet big on treasuries and gold in 2008 but narrow bets in a portfolio create the potential for "permanently impairing capital." Gold obviously can be very volatile and volatility when it goes the wrong way on you moves much closer to being risk than the commentary frames it and buying treasuries in 2008 was clearly a good trade, especially at the end of the year, but people buying then were buying high.

Concentrated bets increase risk and potential volatility (the bad kind).

All I'll sale about Yale is that he believes the endowments are mostly chasing heat, you can read the commentary to see why.

The last thing I want to get to here is a point about asset allocation. A few times in the past I have referenced an observation from a past colleague that for some period of time one could have shorted Nikkei futures, kept 98% in cash and about equaled the return of the US stock market. As I always include when mentioning this, the accuracy of the observation is not important. What is important is what the example says about risk adjusted returns and volatility budgeting.

Montier notes that if the 60/40 stocks bonds allocation was built around volatility it would result in 13% in equities and 87% in bonds. I'm not sure what volatility numbers he is using but giving him the benefit of the doubt, the interesting thing is that 13/87 would have averaged 9% per year from 1980-2009 compared to 11% for the 60/40 mix.

That is a fascinating result. Obviously it takes in a colossal 30 year, and counting, bull run in bonds that would seem to be impossible to recreate. Despite that unrepeatable tailwind for bonds it makes an interesting point that a little can go a long way in terms of return.

The big takeaway from Montier seems to be to not worry about what the market is doing. When the risk/reward for an asset class is not attractive then get out of the asset class. It was not clear to me that he was advocating a long term outlook so I will add that in. I've mentioned countless times what markets like Brazil, Chile and Norway did over the entire decade despite occasional big declines.

I would also reiterate the diligence required in saving money. It is likely that in this decade or the next there will be a large run up in equities over a period of quite a few years. If the market ever triples in six or seven years, even if we are talking about foreign markets, then the "extra" savings will obviously result in your having more money. If (global) markets do not have that kind of run then the "extra" savings will have turned out not to be so extra. By the way if the markets do have that kind of run then everyone will love equities, they will always work and of course that will be the time to permanently lighten up.

Congratulations to the Tufts Jumbos for winning the D3 Lacrosse Championship yesterday 9-6 over Salisbury. Look at those unis. Brown with Tar Heel-blue lettering? I am repulsed but I can't look away.
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Sunday Morning Coffee

Ray Dalio was the feature interview in Barron's this week. Below I highlight a few especially useful points made.

The boundaries of the old highs and the boundaries of the lows in the stock market and in the economy will be with us for a long time.

We are entering a period of time in which relations will be more challenging for the U.S. and China. It isn't healthy that the two biggest countries in the world have a very big debtor-creditor relationship. There is going to be a tendency by both countries to blame each other and be antagonistic.

Our portfolio is mostly skewed to Treasury bonds, gold and emerging-market currencies, especially Asian currencies. We also hold commodity assets that are limited in supply and that high-growth emerging countries need. I want to minimize my exposure to the major developed countries' currencies -- the U.S. dollar, the euro, the British pound and the yen.

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The Big Picture for the Week of May 30, 2010

It appears as though things are getting a little dicier in the market. Emotion is clearly elevated as indicated by the now, but probably only temporary, ability of the market to have huge swings in a given day or big moves in one just one direction for a day.

My thought along these lines has been that these exaggerated moves are signs of a fragile market. Fragile does not have to mean that it will implode or even go down in a meaningful way from here, maybe a run down to the low we've hit twice recently will do it but of course we don't know at this point.

For now the 200 DMA still looks important. The huge, I tweeted it was a panic, rally on Thursday stopped about a point under the 200 DMA, one point. Friday was obviously a down day and the S&P 500 is currently about 15 or 16 points below the indicator. From having one eye on CNBC it seems like most of the TV guests view this as a correction in a bull market while more people in print view the rally from a year ago March as a bear market rally or what I like to call a feel good rally.

Throughout I have been saying that the worst financial crisis in 80 years won't wrap up in 18 months and that at some point there would be a another decline that would scare the hell out of people. Whether the low for the current move is in or not, an emotion fueled, fast run back to 1200 will not be the end of it. In my opinion the best thing would be a slow move off of the low with a year or two of single digit gains. Should it play out that way the US may not be a world beating investment destination (I don't think it will be) but the chance for another run to SPX 700 would then be an incredibly remote possibility instead of what I think now is merely a low probability.

Times like now are much easier to navigate with a predetermined and simple strategy.
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Why Do You Have To Use An ETF?

Early in the day yesterday Matt Hougan from IndexUniverse and Paul Justice from Morningstar were on CNBC to talk about ETFs that invest in Europe. Simon Hobbs seemed to ask most of the questions and apparently was feeling feisty. Matt seemed to favor Germany and the Nordics (I am a big fan of the Nordics myself) and (sarcasm alert) shockingly Paul went as broad as possible.

Then Simon asked what's the matter with stock picking, why does anyone need an ETF, why not just buy a stock? Then he asked if this line of questioning was heresy. Matt noted that many investors are not very comfortable picking stocks which is true and he also made a similar argument as I make for country selection which ETFs allow for.

Paul suggested the Vanguard European ETF (VGK) or the iShares EMU ETF (EZU). Paul also made a case for healthcare that seemed out of context to the interview. Matt laced into him for picking VGK and EZU because they take in the good and the bad.

The premise of the conversation seemed off to me. The question is not should people buy ETFs that invest in Europe. From the top down the first thing to decide whether or not to invest in Europe and then depending on that answer what is the best way to do it. If you do want in, are you most interested in a country, a sector or the whole thing? If you want the whole thing, this would make no sense to me but some folks must want something like VGK, you know what to buy; Paul just told you.

Anyone wanting to go narrower than the entire continent needs to figure if they want to add a country or part of a sector. Adding a country is easy for many countries but if you want to go narrower you may need to pick a stock. Some of the foreign sector funds (SPDR and iShares) might be heavy enough in Europe but you'd need to look for yourself. Sticking with the Nordics if you only want exposure to Norway, Finland (uses the euro) or Denmark, and there are reasons to look at these countries, then you need to pick a stock.

Another point from Simon that I have made repeatedly is that many indexes in Europe are very heavily weighted in banks; HELLO! Both VGK and EZU have more than 20% in financials and that is after the sector imploded.

I've been picking on Morningstar from the start of this site for their inability to understand the utility of ETFs and their bottoms up analysis (S&P does bottoms up analysis as well and that too is useless) and it appears that nothing has changed.

I become more and more convinced that the new decade will require narrower exposure in portfolios which is not a bold prediction as this was clearly the case in the last decade. ETFs make this possible up to a point. For those willing to take the step to individual stocks, all the better chance for the long term result you hope for.

Well I didn't start out intending this to be an anti-Morningstar rant but there you go.
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Does The 200 Day Matter This Time?

I disclosed buying shares of ProShares Ultrashort S&P 500 (SDS) late last Friday as it was the second day that the S&P 500 closed below its 200 DMA. I also telegraphed well ahead of time that that is exactly what we would do when and if the time came.

An important thing to remember, and I say this a lot, is that an actively managed portfolio is a series of decisions and some of those decisions will be wrong. What matters more is whether a decision is wrong over some reasonable period of time as opposed to a few days or a week. That being said anytime I place a trade for clients I think about whether the trade will be immediately "wrong." This is more of a personal amusement thing as no trade I have ever placed for clients was done so with the intention of getting out in a week.

The purchase of SDS last week was not immediately wrong but of course the market could go up to take back the 200 DMA and as mentioned when I disclosed the trade I would act in a very tactical manner. To the title of this post a breach of the 200 DMA is sometimes a short lived thing and not a precursor to down a lot.

It does seem that the 200 DMA does matter this time. The behavior since the breach has not been that healthy--panic buying is not healthy-- and as Dennis Gartman might say the chart wants to go from the upper left to the lower right. And again if I am wrong I will simply come out of the position.

If you watch a lot of CNBC, I do because even if you don't like the commentary it is a great way to get news right away, you will hear all sorts of support and resistance numbers thrown around. I don't make a huge priority out of these number but I imagine some of these opinions are correct and some not but they strike me as a more difficult way to navigate the cycle. Deciphering whether SPX 1085 really matters or not is an interpretation not an objective trigger point. Not that an objective trigger point can't turn out to be wrong but the more interpreting one does the more room there is for reacting in the moment as opposed to planning ahead of time when emotion is much less likely to play a role in the thought process.

The chart is similar, in terms of appearance and the line I drew in, to a chart I put in a post called Send In The Bears in December 2007. The chart mattered then and we'll see if it matters now or not shortly.

I am not implying that we need to go back to the March low to get healthy. The market can have the hell scared out of it long before the SPX trades with a six handle. My hope is that after a good scare there would be a slow, tepid move higher. I think another round of panic buying from SPX 900, or whatever, would mean yet another scare coming.
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CNBC Earlier Today

My appearance on CNBC earlier today. My part starts about three minutes in.
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Wednesday Roundup

First up is this interview with Mark Mobius for Hard Assets Investor. Mobius said his four favorite frontier markets are Vietnam, Kazakhstan, Ukraine and Nigeria. The story in Vietnam mostly about demographics, he likes Kazakhstan for resources, Ukraine for farming and Nigeria not for oil but for banking and consumer products.

Accessing Vietnam is pretty easy with the Market Vectors Vietnam ETF (VNM). Interestingly it looks to me like it has had a negative correlation to the iShares Emerging Market ETF (EEM) for the last three months.

I've mentioned Kazakhstan several times over the years as having big corruption problems and also the potential to become incredibly wealthy as a beneficiary for increased resources demand. One way in is through Kazakhmys which has an ADR symbol KZMYY but it looks as though it has not traded since May 5 so that might not be the best symbol to use. The primary listing is in London where it trades plenty of volume.

The Ukraine is very difficult to access directly but there are one stock listed in Sweden that owns farm land in the Ukraine; Trigon Agri (TRAGF) which also has subsidiaries in Estonia, Russia and Cyprus. One oddity is the Black Earth Farming (BLERF) which is also listed in Sweden with most of its farming in Russia also has a subsidiary in Cyprus. Both stocks would be very difficult to trade.

Nigeria is one I haven't studied at all. The Market Vectors Africa Index ETF (AFK) has 18% in Nigeria.

Next up was an interview with Seth Klarman for Advisor Perspectives that covers a lot of ground. One line that made a big impression was when he said "the pressure to be fully invested was the undoing of many managers during the financial crisis." If you are an advisor you want a client who is impatient not scared. If you are a do-it-yourselfer you are far better off being impatient than scared. The difference between the two is very powerful.

Yesterday I was reading something and there was a mention that rhodium was now investable for retail but there was no ticker symbol provided. A rhodium ETF would be a great case study for whether or not investment demand can actually wag the dog or not. So it turns out that there is not an exchange traded product but this was a reference to actually buying some rhodium from Kitco. According to the site you can buy "pure rhodium powder in a convenient, tamper-proof bottle" for $2930 (as of the last time I looked) per ounce.

Lastly, I am scheduled to appear on CNBC today about 30 minutes before the the US close to talk about the energy sector, I hope you can check it out.
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Many People Should Not Make Their Own Investment Decisions

This may whip a few people up but something occurred to me yesterday as I was reading this article at Seeking Alpha that appears to be written by someone who works with annuities but I may have that wrong. He said one thing in particular that I found very provocative and then I happened to find a few other related posts elsewhere.

...because people have a difficult time making good financial decisions for themselves, plans should be designed to “nudge” them, as Richard Thaler and Cass Sunstein of the University of Chicago and Obama’s regulatory brain trust would have it, into making better decisions.

The point I am trying to make with this post is not that subtle but it is succinct. I am all for people taking control of their finances, which can include hiring someone like me or not, and having to live with the consequence good or bad. I would love for there to be a choice of opting out of FICA taxes in lieu of putting the same amount or more if mandated into some private account and, again, owning the consequences good or bad. IMO this is very consistent with the Libertarian viewpoint and I am all for it.

However my belief that these choices should be available does not mean that every person should take advantage of these sorts of things. The premise behind the quote above that many people are simply not equipped to make these sorts of decisions is correct. The idea of people being forced to choose something that is "for their own good" is thoroughly reprehensible to me but as I have said before some sort of privatized social security would be ruinous along the lines what has happened to 401ks over the last ten years.

There is nothing wrong with the concept of allowing people to choose some government plan where decisions are made for them as someone left to choose between to going totally on their own with no safety net or some program where they totally delegate the entire thing is making a choice. People with the introspection to know their short comings could benefit from such a concept.

Note I say concept as I'm not sure how well it would play out in practice but that is a different topic. But if people can choose to totally delegate through a CFP or the like then they can be free to choose something the government might offer. Obviously someone who reads stock market blogs will be unlikely to choose some government plan.

Then there was this very similar article from the NY Times which talked about using technology in a way I had never thought of to, as I read it, scare people straight. There was talk of using software to show the user what they might look like at age 70, or whatever, and then try to dramatize what life would be like for the user based, presumably, on stats about what they had saved and how they might be expected to age, health-wise that I imagine was based on personal habits.

Apologies for being too insensitive but an overweight 50 year old who smokes will be likely to to have much higher health costs than the 50 year old who is fit and trim and my take on the article is that software can let people see this first hand and that it has a powerful impact.

My hope for what the impact would be is to create some understanding about how much money needs to be saved, the benefits of working one way or another later in life and getting people to look at themselves with a critical eye for whether or not they are equipped to manage their finances on their own or get help.

On the idea of going it alone Invest With An Edge did a book review of sorts about The Risk Wise Investor. A great one-liner in the review as follows "Since investors are not robots, we have to remember our human habits, characteristics, and limitations." As I write so often about removing emotion from the equation I am probably advocating that people train themselves to become robots. I guess I would say that the closer you can get to being a robot the better equipped you would be for going it alone but this really is a personal thing of mine and may not carry water with too many people.

The task can be simple; learn a little about how things (like markets and credit) function, learn some basics about saving money, learn some basics about how to build a simple portfolio, learn a little about the types of emotional behaviors that have done people in before and how to avoid those behaviors and then stay current. That will get it done for most people who save properly and live within their means but of course executing that simple task is not easy for many people to execute when emotion and lack of diligence on the above steps results in detrimental behavior.
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The Downside Of Absolute Return

Over the years I've written quite a few posts about absolute return products and strategies. These posts tended to be more popular through much of 2008 as things for the market were looking quite grim. Back then there were more than a few comments from readers who, based on their comments, were considering shifting a very large portion of their portfolio into absolute products.

My general reply was doing so after a 30% decline or 40% decline or 50% decline would be a bad time to make that kind of move. On the way back up, I think when the S&P 500 first got back to 1000, I rhetorically asked what number on the index you were saying "if we only get back to...then I'll..." and suggested that after such a large snap back someone inclined to make a big shift into absolute would be better served after that large snap back not before.

The reason to write about the topic so much is that it is a good way to learn about risk adjusted returns and how to possibly implement a modest exposure. In my experience a little absolute goes a long way toward smoothing out the ride in a normally diversified portfolio (normal meaning an equity target between 50-75%). But for someone who was emotionally desperate a year ago, bargaining with themselves for some level this might be a good time for such an overhaul. The market is way off the low and only a little off the recent high.

That being said this would not be a strategy I would ever recommend for several reasons. First is that too much of anything becomes a lopsided bet that could have some sort of bad consequence as things like this go wrong every so often and very few people seem to see it coming. If you have a modest exposure however you don't have to see it coming.

A more subtle issue is isolated in this chart comparing the S&P 500 to the iShares Diversified Alternatives Trust (ALT) and the Hussman Strategic Growth Fund (HSGFX). The chart goes back to last November when ALT first listed. You can see that by April the S&P 500 had a decent lift that ALT and HSGFX completely missed.

That those two funds completely missed the move does not make them bad funds. It would be nice if the were up a couple of percentage points but this may not be a bad result. The Hussman fund targets a return over an entire stock market cycle. From the low in March 2009 the S&P 500 was up about 75% through mid April but the Hussman fund was only up a little over 1% (I imagine any dividends would need to be added to that result). However from the peak in October 2007 it is only down slightly (if you look for yourself you need to factor in an enormous dividend in November 2008) while the S&P 500 is down about 30% in the same time.

This raises two potential behavioral issues. Looked at over the entire cycle the Hussman fund has behaved as advertised. Anyone who bought in relative size in 2008 is no doubt really kicking themselves. To reiterate the time to give up on stocks is not after they crater. Additionally the people who chased the safe thing at the wrong time also have to grapple with their own ability to be patient. If you buy a fund whose objective is some result over an entire stock market cycle then you need to hold it for the entire stock market cycle unless you have a knack for timing which some folks do but of course some other folks say this sort of timing is impossible.

Psychologically, volatility is not a bad thing on the way up. But how might someone who gave up on stocks at exactly the wrong time likely to react reading, seeing and hearing about all these people who supposedly bought like crazy in March and have made a fortune while he, the person who threw in the towel near the low, is up 3%.

The absolute fund I've written the most about, and still own for clients, has been the Rydex Managed Futures Fund (RYMFX). We target it at a 2-3% weight. It was a home run in terms of smoothing out the ride. About a year after the peak when the S&P 500 was down 48% RYMFX was up 21%. Since that time the fund has drifted slightly lower. At a modest weighting like we have, it is the only absolute fund we hold, the slight drift lower has not been a meaningful drag on the portfolio.

To my way of thinking this is how these funds were meant to be used; to smooth out the ride in a diversified portfolio not be the entire portfolio.
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Sunday Morning Coffee

Barron's had an article titled The Case For European Bank Stocks. My short reply would be "sold to them." The article seemed to base most of the case on valuing the stocks by their book values which is a fine way to value a bank stock when you can rely on the book value but it is not clear to me how book value can be universally relied on as I think there is still a lot we do not know about what the banks will have to do before they are really and finally out of the woods.

iShares recently came out with an ETF that covers the space it is the MSCI Europe Financial Sector Index Fund (EUFN). It has 56% in banks, 21% in insurance and 17% in diversified financials. The UK makes up 28%, France 13%, Switzerland 12%, Spain 12%, Germany 10%, Italy 9%, Sweden 5%, Netherlands 3% and Belgium 2%. The largest holdings are HSBC, Banco Santander, BNP Paribas and Barclays.

Clearly some people made some great trades with all sorts of banks but that does not mean that any of the banks were or are fundamentally sound. The fundamentals of a company don't have to be good for a trade to work out but then the question becomes are you a trader or an investor. It is ok to be a trader but if you are more of an investor than you probably care more about the fundamentals than a trader would in which case I think the case for this group still stinks.

To my way of thinking it makes more sense to simply bypass these stocks until the story is over unless you are more of a trader or don't mind very big swings. Plenty of other banks that are fundamentally removed from the situation went down plenty but they went down less than the ground zero banks. The consequence for being wrong is greater with these banks. Obviously this will be too conservative for some folks but ultimately this is a know thyself question.

The picture is from Molokai.
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The Big Picture for the Week of May 23, 2010

Yesterday the S&P 500 closed below its 200 DMA for the second day in a row which is an important milestone for how we navigate market cycles. A breach of the 200 DMA indicates that demand for equities is not healthy and when demand is not healthy it makes sense to consider defensive action.

The reason I wait until the end of the second day is to try to reduce the chance of getting whipsawed but if we get whipsawed so be it. The priority is not to be correct down to the last basis point it is to avoid the full brunt of down a lot should it happen. The specific trade was to triple up the existing sub-1% position in SDS that many clients had or to buy a suitably sized position for any newer clients who did not own any shares. If we flirt around the 200 DMA then I will be more tactical with the trade this time coming out completely if market circumstances dictate. If it had to be unwound and then it went back below very soon thereafter I would probably use another broad based double short ETF to allow taxable accounts to keep the tax loss.

As far as a read on the market action, I tweeted yesterday that the fact that emerging market stocks and mining stocks were down more than the broader market on Thursday and up more on Friday leads me to believe that the sell off thus far has not been cathartic. It may turn out to be so if it goes back down further of course but not at this point.

David Lutz (he is on Erin's show all the time but I don't recall the firm he works for) said on Thursday that if the SPX did not take back the 200 DMA on Friday then the current breach would be significant. Obviously I'm favorably disposed to the idea as it jibes with the action we took yesterday.

I would tell you at this point to not get caught up in which animal best describes the market or about official corrections (one of the most useless terms ever). The stuff I write about and implement focuses on signs of unhealthy demand which is not perfect but I don't think it has to be. The modern track record for the few occasions where the market does end up going down a lot is to warn very early with the last two important breaches coming in November 2000 and late 2007.

The pictures are from two different places we've been in the last year. Up above is Deep Cove which is maybe half an hour from downtown Vancouver. The ridgeline in the background has a great, and easy, hiking trail that we came back for on a nicer day. The other picture is of course Bryce Canyon which is absolutely worth the time it would take you to get there.
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Normal Market Behavior

Yesterday I received a kind email from a reader noting that I 'nailed' the idea of of one more scare the hell out of them decline. If he by 'nailed' he meant within a ten-12 month window then boo yeah!

Back in late December 2008 I said there would be some sort of very big feel good rally which obviously started in March 2009 and on March 11, 2009 I blogged the following;

While I have no idea whether yesterday (March 10, 2009 when the market went up 6%) will be the start of something really big or a one day wonder I do believe we will have a huge rally at some point that makes people start to feel good again followed by another big decline that scares the hell out the same people who felt good on the way up.

The proper context here is not that anything was predicted, clearly the timing was not helpful in the least, but that I simply regurgitated some rather obvious observations gleaned from past market events. I mentioned in that second post yesterday that people seem to forget what declines actually feel like and at some point these same folks, still with no pre-planning in place, simply react to the selling by doing some selling of their own.

The cycle of feel good rally followed by a scare the hell out of them decline, regardless of the time lines in question, is a very bankable market behavior. I do not know if this is the decline that will scare the hell out of anyone or not--it would need to go lower than this I think in order to be cathartic.

The importance of these sorts of very predictable market movements, to the extent our clients read the blog, is that if you've been reading for the last many months that scare the hell out of them declines are normal and bound to happen at some point you are less likely to be one of the ones who gets the hell scared out of you--you knew this would come at some point so what is there to be scared of?

I think it is actually very comforting to know that while the details now seem to be different and scarier (this is always the case in the current event) the market is behaving in a very similar manner to past events; feel good rally followed by a scare the hell out of them decline (now or maybe later).
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The Market Is Down Today

So this is the chart I've been studying this morning...

For a long time I have been calling for one more scare the hell out of them decline. This may or may not turn out to be it but right here the S&P 500 is only down 11%.

That may not be down a little to you but it is not down a lot either. Somehow people tend to forget what it actually feels like as the market is going down which must be some sort of behavioral thing but if you have a predefined strategy like I write about repeatedly then you are not left trying to interpret this sort of action.

We take defensive action if it looks like the S&P 500 will close below its 200 DMA for a second day, period. Today might be day one or not, we'll see, but it does not matter. Toward the end of a second day we will take defensive action; a plan spelled out years ago and then stuck to along the way.

Having a predefined plan removes emotion from the equation which I believe is the best way to navigate through.
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Wacky Theory Time

For the last few days we've been looking at some of the building blocks of what portfolio construction has been and asking whether or not individual investors need to make changes to how they do things. I also think there are practical applications, at least conversationally, for investment advisors as well.

In that light it might be worth putting forth a wacky-ish theory as a basis for making the conversation a little more interesting. Another motivation for this post is an article from Invest With An Edge that asks Is Modern Portfolio Out Of Date. My general take on MPT is that the assumptions that it relies on work except for the times that they don't, if you take my meaning.

For the concept I will lay out I make a couple of assumptions that you are welcome to disagree with but you can't have a wacky theory without a couple of assumptions. The first assumption is that because of very low interest rates most of the bond market is unattractive and because of the extent to which the crisis is not over fundamentally the risk reward in the high yield market is not so hot. The next assumption is that many investors, including advisors, don't like to pick stocks preferring funds of some sort. Assumption number three is that the broadest of the broad indexes will not offer great results as they are heaviest in the fundamentally least attractive segments of the market.

I made a comment in passing that a tiny allocation to equities, as mentioned by Felix Salmon, is probably not the way to go but that someone ratcheting down to a 50% allocation to equities from 70% might be a reasonable reaction to the previous decade but still the bond market is not very attractive (you're buying high, prices may or may not go down but buying high is buying high).

The chart compares the Index IQ Multi Strategy Tracker ETF (QAI) and the IndexIQ Macro Tracker (MCRO) against the iShares TIP ETF (TIP) and the S&P 500. TIP is a client holding.

When QAI and MCRO came out I was very skeptical but save for the last month they have delivered as advertised, IMO. QAI appears to have rolled over very recently due to exposure in EFA and EEM while MCRO had 32% in emerging market ETFs as of 3/31/10. For the returns for QAI and MCRO you see on the chart you can add 80 or 90 basis points for dividends paid by the funds in December.

In addition to the 5-6% that TIP went up it paid a little over 3% in dividends in the trailing 12 months but that means nothing going forward.

With short term bond yields so low the results of QAI, MCRO and TIP offer real competition for bond exposure. Hopefully it is obvious that there are many other products out there that could fill the role. But so the first part of the wacky theory is putting half the portfolio in things like QAI, MCRO and TIP because so much of the bond market is priced so highly and the fundamentals for so many segments stink.

The second half of the wacky theory is to put the other half of the portfolio into countries that no one talks about or at least don't talk about very often. This could be via country ETFs or thematic ETFs. Research could include South America, Antipodes, much of Asia (not Japan), Scandinavia, Israel, maybe Egypt and Canada. In addition to the most of the large cap country funds, IndexIQ (I do not get paid by them and they do not advertise on my site) has a few small cap country funds with more on the way.

Regarding thematic funds, obviously you need to be on board with the theme but things like wind, smart grid, nuclear--whatever--there are plenty of choices and more on the way. With this sort of approach there would need to be great care taken to watch for sector imbalances and any other type of imbalance. A lopsided portfolio no matter what it owns will come home to roost at some point.

The overall wacky theory addresses what I believe is a lousy environment for bonds and the possibility that broad based indexing will continue to come up short for a while longer. You can decide, and comment, whether these things are addressed well or not or whether they even need addressing.

For the 1+1=11 Brigade this post was theoretical, I'm not doing this, I don't own QAI or MCRO. These posts are about extreme ideas as a means of exploring moderate portfolio tweaks. For example I've written a lot of posts about absolute return funds and strategies but we own one fund in this space with only a 2-3% target allocation.
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Don't Completely Give Up

There was some interesting reading yesterday that I think continues on the conversation we've been having this week about ETF portfolio construction and the extent to which portfolio construction might evolve.

Felix Salmon asked Why People Invest In Stocks now that, in his opinion, there is "no good reason to expect an equity premium going forwards, and if there isn’t an equity premium, then your allocation to stocks should be tiny."

This takes me back to the idea I have repeated from Taleb about 90% t-bills from around the world and 10% going berserk with volatility. Perhaps I am reading Felix incorrectly but I pick up a tone that not only is equity premium gone but that it won't come back. This is an important question that is always worthy of consideration but I believe it is easier to believe that the equity premium might be gone in the immediate wake of one of the worst decades for US stocks in modern times. Meaning stocks are less likely perform badly after they just performed badly.

"Tiny" was not quantified in the article but maybe tiny could mean 25%. Someone to whom this appeals needs to do a couple of things to avoid the consequence of being too conservative. First thing is save more money. If a portfolio has less exposure to risk assets then it has less chance appreciating so the difference needs to come from increased savings. Investing in risk assets takes on the presumed benefit of compounding at a rate greater than 1-2% but 25% in equities changes the dynamic.

In addition to saving more, the fact that the tiny portion would need to do more heavy lifting means that some sort of active action needs to be taken--obviously this is just my opinion and would be in complete disagreement with what Felix appears to be saying. "Some sort of active action" could simply mean an ETF mix that avoids the worst parts of the market like Europe, Japan and the US banks.

The idea of someone realizing that 70% equities was too much for them and making the decision to cut back to something like 50% is a reasonable reaction to the last decade and 2008. Someone taking this more moderate approach should probably save more money (but shouldn't we all?) but they would not be giving up the opportunity for compounded growth at a reasonable rate.

Deciding to shun risk assets after a bad decade for risk assets has the potential for some very bad consequences. I can envision a "whole generation" of investors giving up on equities at precisely the wrong time because they are told the game is rigged and that the stock market does not work. How rigged will people think it is if come May 19, 2020 the S&P 500 is at 4480 (quadrupling in a decade is not unprecedented)? 4480 is not a prediction, I have no idea about 2020 but a fantastic ten year run after a period of years where the market does very poorly would be far from a Black Swan event and I would not want that to happen without me or my clients whenever it might start; 2010, 2015, whenever. The consequence from a fantastic decade happening without people being in would be dreadful.

To be clear my baseline scenario is below average but positive returns for the US market with close to normal returns coming from select foreign markets.

I'll close out with a dog rescue story. This little guy curled up in the picture is Finn. Finn hopped the fence at his foster home on April 24 and had been on the run since yesterday. Joellyn and a few of her colleagues United Animal Friends spent a lot of time looking, they posted fliers where he had been seen and our phone had been ringing off the hook with news of sitings but no one caught him.

"Mike from Groom Creek" agreed to keep a trap at his house for most the time that Finn was on the loose and yesterday he caught Finn, not in the trap but with his hands which is amazing given how skittish Finn was/is. Mike took one for the team (small bite from Finn) but he was none the worse for wear and now we are fostering Finn--we have a six foot fence. Or maybe we are not fostering him if you know what I mean. A dog can last on his own like Finn did for a while but of course anything can happen as we have plenty of wild animals here but Joellyn never gave up hope.
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Model ETF Portfolios

You probably saw on CNBC that Bob Pisani asked Jim Lowell, Matt Hougan and Tom Lydon to construct a series of half a dozen ETF portfolios with each of the six targeting a different expectaion like bull, bear, sideways and so on. For what its worth I consider both Matt and Tom to be blogging friends of mine.

This whole exercise strikes me as a real effort by MSM to produce some ETF 201 content which is unambiguously positive. I thought it would be fun and useful to deconstruct a couple of the portfolios to see what can be learned and whether there can be any improvements offered. Today I'll look at the Global Sideways Market Portfolio and maybe tackle the core portfolio next week for my regular Street.com article.

The reason to look at the sideways portfolio is that it seems almost like a continuation of yesterday's discussion about permanent portfolios. The target weights as follows;

PowerShares Buy Write Portfolio (PBP) 40%
iShares iBoxx Investment Grade Corporate Bond Fund (LQD) 15%
PowerShares G-10 Currency Harvest (DBV) 15% this is the carry trade ETF
iShares iBoxx High Yield Corporate Bond Fund (HYG) 10%
JP Morgan Alerian MLP Index ETN (AMJ) 10%
iShares S&P US Preferred Stock ETF (PFF) 5%
SPDR Barclays Convertible Bond ETF (CWB) 5%

First a couple of bottoms up observations. A few clients own PBP and it is a tough hold for people who are not patient or who cannot think in terms of the entire stock market cycle. I have a lot of faith that over an entire cycle this will look like a very good choice but anyone thinking in three, six or even 12 month increments will be frustrated by this one.

About 1/3 of LDQ is in financial companies, the average maturity is 12 years and the 30 day SEC yield is 4.58%. I think there is something to be said for choosing a few individual corporates that are AA or A rated--obviously it would be prudent to assess the debt load for yourself and get familiar with cash flow numbers and not rely exclusively on the ratings.

The Carry Trade ETF was in the high $20s for a while and then hit a big air pocket to the low $20s and has been creeping up to the mid $20s for a while. One drawback here might be the tendency to overly rely on the back test to the point of not looking under the hood and being in touch with the dynamics of the various currencies.

The junk bond ETFs have of course done well in the rally but I want no part of the space. This might just be my hangup but I do not have faith that capital markets are all better which if true looms as a threat to any space that could be construed as aggressive yield chasing.

AMJ is an ETN and I am not a big fan of that wrapper when there are alternatives. I imagine the ETN wrapper bypasses some of the tax reporting issues with MLPs but if I wanted to go this heavy in MLPs I would rather pick a couple of individual names.

Looking at the top ten holdings of PFF I see Ford and then nine different issues from financial companies--of course it is mostly financial companies that issue preferreds. I have two preferreds stocks that are widely held by clients. I feel more comfortable with individual issues in this space than a fund.

For the convertible space a fund of some sort is going to be the best way to access the space for most people but in an equity market downturn, using 2008 as a proxy, I think the fund could get smacked pretty hard--of course the portfolio is for people who believe the market will be range bound.

From the top down the focus is obviously on yield which if you know the market will be range bound makes plenty of sense. The fund is obviously lacking for foreign exposure, the currency harvest product is billed more as an absolute return vehicle than a proxy for foreign assets, and there doesn't appear to be any counter strategy. I picked up the concept of counter strategies from my brief time at Fisher Investments.

Basically a counter strategy could be thought of something you own so that if your baseline assumptions are wrong you have something that can still go up. The assumption of the portfolio is a sideways market but what if it goes up a lot or down a lot? In an up market this will lag and depending on what would push the market down this portfolio could get hit very hard.

Despite the criticisms I think there is a lot of utility here. I think this type of mix could make for one tranche or bucket of a properly diversified portfolio. The segments chosen make sense and most of the risks isolated above would not be that bad in a normal cyclical downturn. During the 2008 event many of them were crushed beyond what many people would have thought was realistic and any concern that the event is not over and we incur a similar downturn or continuation might want to structure this type of tranche with less reliance of funds and instead favor individual issues for some of the fixed income components.
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ETF Permanent Portfolio?

Long time blogger and active commenter on this site Thomas Smicklas, aka T, had a thought provoking post where he assembled a version of the Permanent Portfolio using exchange traded funds. The original idea, I believe, came from Harry Browne in the 1970s allocating 25% each to gold, long term bonds, stocks and cash. Per Browne the mix should be able to weather anything that might come along. While I think it is difficult to think that a portfolio like this to meet all needs all the time it is intriguing and if there were to be a variation of the idea that could come close to meeting all needs all the time I would want to know about it--no doubt some folks believe the original does just that.

T put forth the following asset allocation as a variation on the original; precious metals 25%, Swiss assets (a mix of stock and currency) 10%, worldwide real estate and real assets (one category per T) 20%, aggressive growth stocks 15% and US treasuries and government bonds of varying maturities 30%. T names names in terms of funds selected so you should click through if you are curious.

There are some things that are of course unique and interesting and some things I would do differently. I should back up for just a moment. Not that T implies that you can buy a dozen funds and never do anything again but rebalance but to be clear I would view any permanent portfolio as something to watch closely, study diligently and change occasionally. For example I do not have as much faith in Switzerland as T does. Obviously the country is known for many positive fundamental attributes, its debt to GDP is around 36% which is pretty good these days, but the banking system is larger than the GDP and the SNB had been trying for months to make the franc more competitive before it finally started to turn down last November. Of course the downturn could not be for anything the SNB has done but just part of a broader market theme.

All of that notwithstanding let's say T is correct about Swiss assets for the next ten years. Well ten years is a long time and it would be reasonable to look down the road and conclude that things may not always be that good for the country. I might prefer Norway in the role that T chose Switzerland. Norway could continue to be "right" until 2020, for example, but if at that point something changes with oil production such that the income deteriorates dramatically the country would then become far less compelling. As great as I think Norway is as an investment destination it should be obvious that anything bad with oil will threaten Norway.

As part of the precious metals allocation T includes a recently listed platinum mining stock ETF. The chart compares the spot price of the metal in red with Anglo Platinum (AGPPY) which is the largest holding in the fund (the fund is too new for a comparison to mean anything). Clearly the stock has been a good hold but it is not clear to me that it is a proxy for the metal. Hopefully stating the obvious; at times the metal will be better to hold and at other times a stock, or fund, will be better. I am not sure where Browne stood on the idea of using a mining stock as a proxy for a precious metal so if anyone knows please leave a comment.

The 20% in aggressive stocks makes sense but I might try to go narrower than the funds that T suggested (he's not actually suggesting anything but for economy of words). I think of the equity allocation in a permanent portfolio being closer to what Taleb advocates, closer but not exactly. So I might want to consider certain higher beta themes like a particular emerging market country or alternative energy; things of that sort but not going berserk with options contracts.

The last thing I will say about the idea from T is that I am no fan of REITs, I have given up on them as diversifiers but I should note that T has forgotten more about real estate than I will ever know. I continue to hold a candle for the idea that some of these funky farm stocks I've mentioned before can offer some diversification benefit but I don't own any of them.

However realistic it is to build a permanent portfolio today with ETFs, it is far more realistic today than it was a year ago. Obviously ETFs can be one tool of several that a do-it-yourselfer could select to build something like this for themselves. Great talking points T, thank you.
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Sunday Morning Coffee

Hopefully you can draw something useful out of this metaphor.

Yesterday we had a fire training where the plan was to pull out a couple of Type 6 trucks (pick up truck with fire equipment like you see pictured to the left) and a water tender (big truck with 2000 or more gallons) with the intention of executing a hose lay (a network of hoses that is usually used to flank a wildfire) with hose packs and spraying some water.

We do this at least once a year for training so that if we need to do it for real it is a little fresher in everyone's mind. One thing about fires is that there is a lot of chaos and invariably at least one or two things will go wrong on an incident, this is unavoidable. Additionally we are all volunteers so it is not like we fight a dozen big fires every summer.

It would be a waste of time to try to prevent something from breaking or otherwise going wrong beyond doing our normal preventative maintenance. Past incidents allows some of the more experienced of our group to quickly figure out a work around that can be effective and safe. This comes from understanding how the equipment works, how the water moves through the plumbing, the nature of fire behavior and so on.

We had two malfunctions during the drill yesterday. The water tender just shut off while it was running. The truck needs to run in order to feed the Type 6s via its pump. This is exactly the type of thing we need to be prepared for. There are two immediate fixes had we been out at an actual fire. One just call out the other tender, hopefully driven to the scene by someone who might be able to diagnose the problem, and the other would be to move the Type 6s to lower ground and feed them via gravity which would be doable in many places in our area.

The other problem we had during the drill was that the plumbing on one of the Type 6s sprung a leak. It was still able to pump water with plenty of pressure so it was ok, usually this is a loose fitting somewhere which turned out to be the case so the engineer just needs to again understand how the truck works when a problem comes as opposed to predict the problem. Another work around for a broken pump on a Type 6 is that a functional water tender can act as the pump. There is a way to bypass the pump on the Type 6 and push water out as needed. This is not preferable but it works.

The key to this stuff is understanding how things work so that there is no panic when things don't go exactly as planned.
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The Big Picture for the Week of May 16, 2010

The crew at ETF Database posted a useful topic yesterday pointing out three country funds that have low correlations to the S&P 500. The three ETFs were iShares Malaysia (EWM) with a 0.76 correlation to the S&P 500, the iShares Thailand (THD) 0.75 and the iShares Chile (ECH) 0.69. If those funds' correlations are lower than other country funds I will take their word for it but they don't seem to be that lowly correlated. BTW a few clients own ECH and I also have a couple of shares.

This is a good reason to revisit something I wrote more about a couple of years ago as things were really hitting the fan. The ETF Database article correctly, IMO, points out that most markets are highly correlated. I would say the funds isolated in the article are merely less highly correlated.

Unfortunately I think many market participants have unrealistic expectations about decoupling. We have seen first hand, a couple of times, in the last few years that most markets go down together even if the magnitudes are different. The context I have been writing about from the start has been that countries with different economic attributes are usually at different points in their respective economic cycles which gives them a chance, I say a chance, of being at different points in their respective stock market cycles.

Of the foreign markets I write about I think this three year chart comparing the IPSA in Chile and the Bovespa in Brazil to the S&P 500 is a good way to show the effect.

Brazil kept going up for months after the US peaked, as did Norway BTW. The Bovespa did drop more than the SPX peak to trough but is currently 11% below its all time high. Chile rolled over in lock step with the US but only went down for about half the time resulting in a much smaller peak to trough decline and the IPSA is higher than where it was before the financial crisis started.

Several times over the last couple of years I have mentioned that for some countries this has been much closer to just being a cyclical event as opposed to secular or structural and while that is obviously the case with Chile I believe it is also the case with Brazil.

While living in the moment is important in life a longer term view with regard to investing probably makes more sense. For the last decade Brazil was up 301%, Chile was up 194% and the S&P 500 was down 24%. First, these countries were worthy of more study for being commodity based. Then it was obvious that they were both on much firmer ground than the US and I believe still are. To revisit a point I make often is it really that difficult to figure out that Europe has some big problems? Of course not. Ditto Japan. And I am telling you it was just as easy to see Europe's problems a couple of years ago too.
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"Cue Talk Of 'Robustness'"

Nassim Taleb has popped up on the radar in the last couple of days as some have opined that a trade for 50,000 options by Universa, a fund that Taleb advises in some capacity, may have contributed to the Crash of 2:45 pm. The WSJ picked this up and FT Alphaville poked some fun at the whole thing, the title for this post came from the Alphaville post.

Barry Ritholtz posted a video from Taleb's recent appearance on Bloomberg, after the Crash of 2:45 pm, that I reposted yesterday. Taleb was asked about whether a trade by Universa was responsible. He sort of denied it and then said that focusing on what caused a blip on a given day is the wrong focus and he is correct. His analogy was to focus on the camel's back not the straw.

Below are a few comments I pulled out of the interview that I wanted to comment on.

He said we've learned nothing from the crisis thus far and that the system is now more fragile; we have increased moral hazard. Have we really increased moral hazard and dumb behavior? Well what do you think will happen the next time financial system faces a meltdown? My take is that they won't bailout banks from a repeat of 2008 but there will never be a repeat of 2008. In the next crisis, and there will be another one at some point, financial institutions will have taken way too much risk because of completely different factors than in 2008 and they will "have to" bail them out. And this of course could be some delayed result from the fix being implemented now. Is there anyone outside of Washington DC who doesn't realize this?

Next up was a comment that black swan events depend on the viewpoint of the person. He said that thanksgiving is a black swan for the turkey (this is a reference from his book) but not the butcher. I would not focus too much on predicting what the next black swan will be (this would seem to be impossible by definition and the term has probably become over used) and instead focus on what the next bad black swan event will do to the market and probably your portfolio. Some sort of lightning fast crash, although it probably won't happen again, is obviously the worst time to sell. I try to have a couple of things that could go up in the face of a longer term panic down, longer than 20 minutes, but the crucial thing is to recognize a panic when it comes. In the last few years that I've had this site I almost always put a post in the middle of it, as I did last Thursday noting the panic hopefully with a little humor.

The other interesting thing to me, but there was more so watch the video, was what he thinks people should hold. He said the stock market is a hoax. He would also avoid long treasuries which is not an off the wall idea by any means. He would hold a collection of metals, he was not specific which is why he used the word collection. If I understood correctly he would also own soft or ag commodities and farmland which he differentiated from real estate.

Comments like the stock market is a hoax are over the top, probably, but can be a catalyst for thinking about asset allocation and the volatility of the asset classes which is always useful even if you disagree with the conclusions that Taleb, or anyone else, draws.
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Taleb Video

Hat tip to Barry Ritholtz. I will do a little write up on this for tomorrow morning.
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Picking Up The Discussion On Stock Picking

Abnormal Returns kicked off a discussion about whether or not now is the time for people to look closer at stock picking, in part because so many market participants seem to have moved away from the practice in favor of funds, both exchange traded and traditional.

Felix Salmon carried on the discussion mostly taking the other side of the argument noting among other things that "active investors, in aggregate, never outperform the stock market" and noting the difficulty in adding trading ability (consistent with part of AR's point) on top of the analysis needed for stock selection which might make it a worse time to try stock picking not a better time.

I was reminded by a humorous quote from Taleb, or not so humorous maybe, where he essentially said that people would never invest in the stock market if they really understood the risk. The Taleb quote covers more ground, that is equity exposure regardless of the wrapper, as opposed to the discussion of stock picking versus some sort of fund strategy debated between AR and Salmon.

I think 'never invest' is a little over the top but the sentiment is very instructive in pointing out that many participants do not understand the risk. Over the last five and half years every time there has been an event of some sort that puts a little scare into people I say something about this having happened before and promising it will happen again.

Rationally, people get this, I think, but many people seem to forget during the heat of the moment. Put another way, they don't understand the risks when they need to. The consequences of risk and volatility lose a lot of importance in the middle of a 75% rally which is of course a very bad way to look at it, foolish really.

If you've been reading this site for a while you know I am a fan of using the best tool available for each part of the portfolio; stock, fund, whatever. Felix' comment about needing to learn how to trade in addition to how to analyze is interesting. Over the years, in an effort to share process, I have talked about stocks that have worked out well and ones that have not. One type of trade I have mentioned several times before is having sold partial positions after a stock had skyrocketed far more than the market or the respective sector in some period of time.

If you have used individual stocks as part of your portfolio for any length of time you have had stocks that have done this. You can't go wrong selling a portion of a position in a stock that is up 80% in an up 20% world and I do not think it takes tremendous acumen to do something like this.

Likewise you have had stocks that have done poorly if you have been using equities for any length of time. A stock that is down 50% when the market is down 50% is not necessarily evidence of a bad stock. In a market that ends up dropping that much the more important thing is the top down decision to reduce exposure a little earlier on like after a breach of the 200 DMA.

A stock that drops 20% in an up 20% world could be a sell (re learn the story and make a decision) but if you are close to either side of mediocre then you have some winners, some losers and some index or sector huggers in your portfolio, in that context you won't go wrong selling the occasional name that you lose confidence in.

The above is not to imply that individual stocks, even just a smattering, are right for everyone because they are not but I do disagree with the idea that using some individual stocks is reckless, this is too broad of an indictment. It is very unlikely that someone putting 5% into Johnson & Johnson (JNJ), we target 3% in that one, is going to ruin themselves financially. It is a good bet that going forward that stock would be ahead of the market sometimes and lag it sometimes all the while inching up the dividend. Even 2% into something like that Intermune from last week that blew up doesn't have to be ruinous. The company didn't get the FDA approval which was unlucky for anyone holding the name, we've never owned this one, but with proper sizing which means understanding the risk and potential volatility it could have just been one that did not work out.

Another concept that I think was missed in both articles was the idea of risk adjusted returns. Not everyone needs to be up 25% in an up 20% world. There is plenty to be said for a strategy that delivers something that is anywhere close to John Serrapere's 75-50 target (75% of the upside and half of the downside). I devote a lot of time trying to explore this sort of thing and try to implement the concept (I refer to it as smoothing out the ride) into client portfolios as I believe it gives a legitimate chance of outperforming over longer periods of time which matter more than some random 90 day or 365 day period that will probably not have any bearing on your financial future.
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An Empty City In China

This is a street in the coal-rich city of Ordos, China where essentially no one lives. This is the sort of thing that bears cite as being the problem.

The WSJ offered up a different take that is worth reading even if you don't draw the same conclusion.

Time has a photo essay that is interesting to look at. It does contribute and add visual context to the modernization theme that I have been writing about for a long time.

So the city is built, will people from more rural areas move there for coal jobs? Bulls would say yes bears would say no. I'm not sure whether Ordos will benefit from the migration or not but the city was built for 1 million people and as I understand it there are 200-300 million rural Chinese.
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ETFs Are Not Perfect

As mentioned in yesterday's post I spoke at an investment conference about ETFs to an audience of investment professionals that we were told were not ETF users and may not know the product. I have no idea whether or not these folks have experience with the product or not but it was a timely event given the attention that ETFs have drawn in the face of last week's market action.

The Crash of 2:45 pm (hat tip Howard Lindzon) or as others are calling it the Flash Crash revealed that they do not always function as they are "supposed" to. Whatever the reason, the market did not function as it should have last week so any product that derives it value from something that is momentarily not functioning cannot be expected to itself function, momentarily. This is similar (completely different circumstances) to when Lehman failed and many bond ETFs did not do what they were "supposed" to for more than the 20 minutes last Thursday.

There have been other instances of market spasm and more importantly there will be future events where the market will not function properly and when that happens you should expect ETFs to again do something that they should not.

Matt Hougan offers up some ideas as to what may have happened to ETFs on Thursday, more specifically plausible explanations for what happened to ETFs. There is nothing wrong with taking the time to learn a little about what happened but it may not be the most important thing because it is a good bet that the next market malfunction will be different than the Crash of 2:45 pm.

From a slightly bigger picture view point things like fast markets, incorrect prints, canceled trades and so on have happened many times before, albeit with a little less attention paid, and to repeat for emphasis will happen again. These things will impact ETFs but that does not mean that ETFs are any better or worse than they were before the Crash of 2:45 pm. They still provide access, they still provide transparency and all of the rest of it. If Proctor & Gamble (PG) can have momentary freak out then so can an ETF.

There are other day to day drawbacks that I think are more important to understand than a freak out that many people think was very important. It was an interesting event but I really doubt it is anything more than a one-off.

Net net I believe ETFs are a very useful tool for portfolio construction, this episode simply underscores a point I have been making for a long time which is that no investment product is perfect. An investor must weigh the positives against the negatives and doing that requires understanding the negatives.
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Tuesday Tidbits

Thank goodness we no longer have to give Europe a second thought now that the EU and IMF (18% of the IMF kitty comes from the US) brought a bazooka to a knife fight in terms of bailouts. The euros involved are huge as the austerity needed was too difficult to implement. The lack of political will to make the sacrifices needed to avoid a bailout were obviously formidable and I had no idea how they thought they could pull it off and it turns out neither did they.

The reaction in the Monday session was truly astounding. Regardless of your take on whether this is the right thing a 4.4% rally in one day is big. We were reminded a couple of years ago that the biggest single day moves come during bear markets. Maybe 4.4% doesn't qualify as big enough but maybe it does. I'm not sure how the consequences can be anything but bad but the rally in the US, that might be over, shows a willingness to buy that is tough to assess.

Last week in the immediate aftermath of the proposed Aussie mining tax I said that iShares should get their filed for New Zealand ETF to the market. Well they came close by listing Ireland (EIRL) and Indonesia (EIDO) . NETS, remember that short lived ETF provider, had an Ireland ETF that was very heavy in financials but now that the banks are down 95% or so that sector only comprises 14% of the fund which is not small but does make for a more rounded fund--at the sector level. The Indonesia fund is 28% financials. There are quite a few interesting materials companies in Indonesia that would be a preferable way in but they are very difficult to access and in some instances very difficult to even follow. Hopefully this improves.

A reader left a comment on the Seeking Alpha version of a recent post that I think was disagreeing with my implication about not enough people living below their means. Of course I could be wrong about this and maybe it is not the problem that I think it is. My view could be skewed by just the people I encounter but I have to say when I think about the increase in foreclosures caused by resets, the mortgage extraction numbers, total indebtedness of this countries, the debt that exists in other countries and combine that with folks I have encountered first hand I have to think this is a massive problem.

Short post today, I am headed down to Phoenix for the day to speak at an investment management conference. The topic of the panel I'm sitting on will be ETFs. I know, I know shocking but it should be fun.
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China and Hong Kong

I read an article yesterday questioning whether or not China will implode. I'm not too concerned with debating that article so much as thinking about the long term prospects or lack thereof. In addition to the article in question there was an analyst of some sort on Asia Squawkbox who believes that the Shanghai Composite will bottom out a few hundred points lower than the current level.

The are concerns about what the various growing pains and mistakes that have been made in managing the Chinese economy and whatever mistakes will be made in the future. Hopefully it is obvious that mistakes will be made in managing the Chinese economy just as in other economies.

I believe the tone of my past posts has been the same for a long time; broad based access is a bad idea. Broad based could be thought of in funds like iShares FTSE Xinhua 25 (FXI), SPDR S&P China ETF (GXC) or the Claymore China All Cap (YAO). Whatever becomes of China as an investment destination in whatever timeframe you care about I think there will be a couple of sectors, especially the banks, that should be avoided and you can't do that with the funds above.

If you buy into this then that leaves narrow based funds, and I would say that GlobalX has the most choices there, or individual stocks. The two stocks that I think I've talked about the most are personal holding Jiangsu Expressway (JEXYY) and Hong Kong Exchanges (HKXCY).

An expressway stock, there are quite a few of them, is a utility of sorts, regardless of the cyclicality of the Chinese economy there are still a couple hundred million people who will move into a city and some portion of those folks will buy cars. There are plenty of people already in the cities who do not yet have a car. There will be more cars per capita and so more people paying tolls. A really bad economy would likely mean this happens at a slower rate.

There are more and more stock listings in Hong Kong to the point of being problematic actually but Hong Kong is becoming more globally relevant for both its role in the development China and for what is happening on the ground there. At some point the massive amount of new listings will decrease, many of those companies will disappear, like during the tech wreck, and HKXCY will lose revenue. It might be able to replace that revenue or not, that is probably down the road some.

If you like a sector fund; the GlobalX China Energy Fund (CHIE) owns a lot of oil stocks, quite a few coal stocks and several solar stocks. By now you've probably heard somewhere that the Chinese use about 2 barrels of oil per capita and that the US uses about 24 barrels. China is going to get closer to 24, and for all I know closer might only mean four barrels but whatever increase on whatever timeline should mean good things for oil in the future and also Chinese energy stocks. Obviously if the economy sputters, or worse then the path to increased consumption and whatever good will come from that will be slower.

In looking at each of the three above there are shorter term risks and longer terms rewards. If you think you could not ride through the consequences of those risks, or the risks to whatever way in is right for you, then you need to be more tactical and take greater heed from arguments making the case for real problems happening now or in the next couple of years. Some folks are long term in such away that they can absorb those consequences.

For anyone thinking the long term for China looks promising, I do albeit selectively, there is need to sort this out, decide how tactical they can be (which might be not tactical at all) and then move forward. If you've been reading this site for a while you know I have come out of China a couple of times on an across the board basis and am out right now with the expectation of getting back in later.

China is similar to a few other countries in that the promise for outstanding long term results seems obvious, more than the US IMO, but the risks are also tangible and the consequences for the full brunt of those risks could be big. One idea for people not confident in their ability to sort this out is to just have some fraction of a full position like maybe 1/3 or 1/2.
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The Big Picture for the Week of May 9, 2010

One interesting element to my job is trying to sort out certain types of investing dilemmas. The positive spin on this is explorations of unique portfolio construction concepts with innovative investment products. The negative spin would be trying to understand the context of being down 24% in a decade and seeing markets not function in the way they are intended as was the case for about 20 minutes on Thursday.

One purpose of this site has been to provide a commentary to clients to do whatever it takes to help them to tune out the short term spasms, understand our approach and placing emphasis on things that are actually relevant to their financial goals. To the extent any reader who is not a client can benefit from this part of the dialogue; great, it feels like I could be offering something constructive to people.

The posts that seek out different theoretical ways to construct a portfolio help clients have some understanding of what I am looking at to try to smooth out the ride and for non-client readers maybe these posts offer a catalyst to think about how different asset classes and market segments interact with each other thus creating a more realistic expectation of how they will hold up during a panic. For example Chile went down puhlenty when things were at their worst but it ended up going down less and coming back sooner and that was the expectation I tried to set as opposed to some market not going down at all which is not realistic in a worldwide panic.

In the instant aftermath from Thursday there have been questions about what the malfunction (or whatever better word you have in mind) means for individual investors. Will this scare them away for good? Simon Hobbs rhetorically asked whether individuals should be in equities at all.

Most of this line of inquiry in more sensational than anything else although my constant pounding that foreign markets will treat money better over the long term could be viewed as contributing to the idea. Going back to 2000, or longer, this has been one event that has lasted for ten years so far. There have been other negative events that have lasted 10-15 years so this isn't necessarily new. Once this event ends then stocks will be viewed more favorably but if it lasts from 2000 until 2020 then a lot of people will have been effectively locked out from compounded growth rates. Anyone worried that this could be their reality needs to save more money. That may not be easy of course but that would be the answer.

Abnormal Returns had a post earlier in the week that was right on point. Another related post came from Felix Salmon responding to the Scott Adams post I mentioned. Felix titled his post Why Invest Retirement Funds In Stocks and keep in mind this was before Thursday's trading.

A ten year period where the US stock market goes down 24% and many other markets go down some similar amount is going to skew a lot of statistics making it seem like equities are not worth the risk or are broken or whatever. I imagine similar discussions in 1981 (what year was the famous Death Of Equities cover? 1979?) would have drawn similar conclusions as are being drawn now. That event ended and this one will too. When it does then equities will work again--I believe money will be treated better in foreign markets however.

Even during that rotten decade some markets did well. From its inception in July 2000 to December 31, 2009 the iShares Brazil (EWZ) was up 295%. Occasionally there were big declines of course and I have no idea if there any days, like Thursday, where it malfunctioned but over a ten year holding period it added a lot of value. The reason to mention the ETF is that many ETFs had pricing problems during the donnybrook on Thursday. At least one ETF we use was down 100% at one point. Obviously this was not real and while I hope anyone would be smart enough to realize this maybe not everyone did, maybe there were panicked phone calls.

Even if a zero print was completely bogus I'm sure there will be some folks that swear off ETFs for good because of it. One market that ETFs serve is individuals, funds are marketed toward being part of the solution for individuals and I believe they are indeed a great tool, albeit with flaws, for access. If a tool in part designed for individuals cannot work for them in a time of need then perhaps individuals are right to ask questions, are right to question the appropriateness of any equity exposure ever. Would a day of "malfunction" be more important than the value added of a ten year holding period? The way you answer that question will determine whether ETFs are right for you or not.

But anyone going down this road will need to save more money. Every choice has a downside. No equities means never worrying about the equity market but it means more money needs to be saved. I have trained myself to realize that the market goes down sometimes; this is guaranteed to happen. Despite the recent experience of 2008 it's as if some people forgot already that markets go down. If you know that markets have dropped before and you know that occasionally it will go down in the future, and you do know this, then there is no need to have an emotional response. In this light the focus should be proper asset allocation and, IMO, some sort of proactive defensive strategy like the one write about so frequently. Layer on top of that the understanding that no one can be correct at every turn and you should be able to navigate through.

And to repeat, if you really conclude that equities and financial markets can never be trusted again then you need to save more money and I would add that you also need to plan on working longer and for some people this will be the best solution.

Perhaps a more realistic hope for individual investors is a better understanding of volatility and asset allocation. This might lead more people to a portfolio that allows them to sleep better, worry less and understand what their numbers can and cannot do for them leading them to the conclusion about saving more and living below their means.
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A Plan And A Trade

Like most late mornings I was watching Barney Miller reruns when Joellyn saw a headline on her Yahoo page about the stock market being down a lot and thought that I might want to check it out. Just kidding--humor attempts are ok.

The other day I said I had mapped out a trade if the market dropped to a certain level and this happened between somewhere around 2:15 EDT; given what was happening I did not take notice of the exact minute but I know I was done trading by 2:30 EDT.

My plan was to increase our tech exposure on a pull back. We're underweight that sector, financials and discretionary. The way I have tech constructed, about 85% of the sector is in a broad tech ETF and the rest is in a stock. The trade was to increase the tech ETF by 25% subject to rounding.

The trade, done in large accounts, does a couple of things but I should note some background here. In 2008 by virtue of some lucky sales and a position in the ProShares Ultra Short S&P 500 (SDS) we were down much less than the market. In 2009 I did not reequitize enough and we lagged the S&P 500 some, but not badly. In 2010 near the high based on what parts of the market were leading we were trailing by a noticeable bit and now the gap has almost gone away during the pullback.

From here if the market goes back up I would hope that the increase in tech will let us stay closer to the market. If the market drifts lower then the position in SDS, which is now a little less microscopic, will grow to hedge more of the portfolio.

If we breach the 200 DMA then I will increase the SDS position. During that crazy 20 minutes Matt Nesto made a point of mentioning that the S&P 500 was below the 200 DMA. The way I have used this is to wait for the second day before taking some sort of defensive action. If near the end of the next day the S&P 500 is below the 200 DMA I will place a trade.

It should be noted that my focus is the result over the entire stock market cycle--however many years that might be. Additionally I am trying to avoid the full brunt of down a lot. While I would love to beat the market every year it is far less important to me than the result for the cycle. The trade placed yesterday will either look like a good one or not a month from now but we are two and half years into this event (longer if you think about financials peaking in June of 2007 or New Century filing for Chapter 11 on April 2, 2007) which means there is a good chance that we are a long way in. A long way in even if it means growth on the other side is not so hot for a while.

One market truthism that mostly held up during the last decade, despite the 24% drop, that I think will hold up this decade is that the stock market has an up year 72% of the time. In the last decade US stocks were up six out of ten years and anyone who heeded the warnings of the 200 DMA and the inverted yield curve probably came out of the decade up on the period versus that 24% decline.

While it is possible that this decade will as bad or worse it is not probable. This means it will make sense to be close to fully invested more often than not (but for god sake have some sort of defensive strategy to protect your portfolio). To be clear I still believe that US will be relatively unattractive and while I plan to have clients close to fully invested more often than not it will be in more foreign countries which is something I have been writing about since I started this site.

I also wanted to respond to a couple of reader comments from yesterday. One reader was kind enough to share his experience of getting whipsawed with stop orders. I have used stop orders occasionally but they have drawbacks and the reader unfortunately experienced probably the biggest one. The market panicked, stop orders were elected and then the market snapped back. I don't have a great answer but I am not a fan of across the board use.

Another reader asked about using the 200 DMA for individual positions. This is not necessarily a bad thing to do but I view things from the top down. If I have reduced net long exposure sufficiently, either by buying SDS or selling stock, then the bottom line of the portfolio should go down less if the SPX ends up going down a lot. To illustrate with an extreme example; if at the peak a few weeks ago you went 95% cash and kept 5% in one stock. Let's say that two weeks from now the S&P 500 is at 1000, down about 20%, but the stock you held onto is down 60%. That 60% hit in the stock would only be 3% of the portfolio, would the drop in the stock in that circumstance matter at all? The more important event in that case was the raising of cash not the drop in the stock, the drop in the stock is practically irrelevant.
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