A Slight Paradigm Shift

It seems like the theme to this weeks posts have been along the lines of realizing that US equities are still not looking so hot but that there is opportunity in certain foreign markets and themes. This is obviously a long running thread here that I believe is becoming increasingly more important.

On one of the posts there was a comment left that reasonably noted the difficulty in beating the market further noting that most people don't have the time that is probably needed for what I'm talking about.

As far as the time needed that is no doubt an issue for many people especially 401k participants. However if you take the time to read stock market blogs then chances are you have more time available than most other people either as a function of circumstance, interest or both. While this assures nothing it is a chance.

To the idea of beating the market, this is maybe where the paradigm needs to shift a little. Forgetting about the notion of beating anything the more important goal should be having enough money when you need it. If someone had the foresight in 2000 to realize that the S&P 500 would go down for the decade then one way or another they would have avoided long exposure and maybe even gone short. Armed with that knowledge the simple act of avoidance, maybe staying in the money market would have "beaten the market." If money market rates averaged 2% for the decade (I don't know what the average over the ten years was) then yes this hypothetical investor would have beaten the market but the next question is if they were where they needed to be, per their plan, in 2000 are they still where they need to be factoring in savings and the compounding of 2% for ten years.

For the sake of discussion what if this hypothetical investor after trouncing the market by virtue of being in cash for ten years is now way behind where his financial plan calls for him to be in 2010? Outperforming in the manner outlined above is better than equaling or lagging the market in that ten years but does not change the more important fact that this investor is now behind where he needs to be.

Conversely an investor could have lagged the 300% lift that the S&P 500 had in the 1990s and still been ahead of plan. Chances are an investor who averages 200% per decade (an absolutely heroic result) will be miles ahead of their plan when they need the money assuming inflation doesn't do anything crazy. The point of both examples is that beating the market is not necessarily the important thing, certainly not compared to having enough money when you need it.

Now, looking forward what are the prospects for the S&P 500? If you think they stink what are you going to do? Simple avoidance could work but money targeted for equity exposure probably needs to go somewhere. Just for the sake of discussion let's say that instead of the US an investor put 25% each into four countries. The countries don't really matter other than, IMO, avoiding Western Europe and Japan. For diversification sake say that of the four two are commodity based and two are fast ascending in terms of the story on the ground. Countries from these two groups might have different enough attributes that they offer some diversification against each other.

In this hypothetical example where on the priority list is beating the market? If it is on the list at all then what market should this person be trying to beat? Benchmarking against the SPX in this case makes sense in that the four countries are being chosen to add value versus investing at home but benchmarking SPX does not make sense because really the example here is changing markets from the home market.

Total avoidance and doing away with the idea of beating the market would be a paradigm shift of sorts. If you are 50 years old in 2010 and have $375,000 today and you need to have $900,000 in 2020 you are going to try to get there by market appreciation and putting away money every month. If in 2020 you have $1.2 million saved it won't matter very much whether you beat the market or not because you will be in decent shape relative to your plan (assuming it was well constructed). If in 2020 you have $760,000 it won't have mattered whether you beat the market because you will be short of what you need and something will have to give somewhere.
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PIMCO:Markets Telling Investors To Drop Dead

Toward the end of Bill Gross' latest is the following;

In the meantime, they are faced with 2.5% yielding bonds and stocks staring straight into new normal real growth rates of 2% or less. There is no 8% there for pension funds. There are no stocks for the long run at 12% returns. And the most likely consequence of stimulative government policies that strain to get us there will be a declining dollar and a lower standard of living. Stan Druckenmiller is leaving, and with good reason. A future of low investment returns, and a heap of trouble for those expecting more, is what lies ahead.

If we were watching television one of the anchors might say "wow, now I'm depressed" which is of course is the completely wrong way to come at this. Market results and market predictions should not trigger any emotional response. Most of the time the market goes up and sometimes it goes down and the thing is the vast majority of market participants realize this (it might make sense to distinguish market participants from 401k participants).

Another reason not to be depressed, besides it being illogical (if you even agree with Gross) is that what he is writing about has already happened. He mentioned 2% growth rates, well for the last ten years stocks have had negative growth rates (so to speak). The first time the SPX touched 1147 (yesterday's close) was in July 1998. As far as 8% pension returns, that obviously is a huge obstacle with very little visibility for 8% being reliable anytime soon--you probably read that pensions cannot reduce their growth assumptions because that would increase the extent to which they are underfunded. As far as bonds yielding 2.5%, yields have been low for a while now even if not this low.

Whether you believe in the new normal, as they coin it, or not it is not that new actually. Crappy results for US stocks is certainly not new yet, repeat stats coming, Brazil managed to go up 300% in the oughts, many others went up more than 100% and some of the "laggards" outperformed the US by 50-75% during that decade. The world in those countries went on without us. Additionally there were plenty of US stocks that are far from obscure that did just fine as well. Deere (DE), a name I've never owned, was up 169% in the decade, Conoco Phillips (COP) was up 123% and obviously Apple was up a bazillion percent.

If the malaise continues for several more years, like another seven, there will be plenty of countries, stocks and themes that do just fine. The solution, same as yesterday, requires more work. A big focus of this site and the way we manage is that over a period of years finding the right countries and themes can add value versus thinking in terms of months where anything goes.

As far as standard of living, this site has been far from alone in pointing out that retirement as it has been thought of before has changed for most people. Less leisure however can hopefully mean a greater sense of purpose for most people.

Short post, tricky medical call with the Fire Department last night that jacked up my normal routine.
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Definitely A Challenging Time To Be An Investor

Yesterday I had an email exchange with someone in another part of the business and he concluded the thread by noting that it is "definitely a challenging time to be an investor." There are challenges but of course that is always the case. The current set of challenges go back before New Century went bust. There were indications of trouble brewing in the US from early in the last decade.

I certainly had no inkling of the magnitude of what was coming but markets and stats warned of some sort of trouble. From the equity market, the financial sector grew larger than 20% of the S&P 500 Index (this is less reliable in smaller foreign markets). Socially there were countless TV shows about house flipping. Stat-wise it was clear banks were taking on more risk, it was clear people were taking more risk buying multiple homes, no down payments, mortgage equity extractions and so on.

Some of the behaviors were repeated from just a few years earlier. I remember a couple of different stock market TV series; I don't remember the names of the shows but there was one on Fox with Giancarlo Esposito. Just as day trading and internet stocks became all encompassing social phenomena so too did house flipping and condo speculation. I don't think this is the case with treasuries and gold but if you think it is the same then you should take some action.

The challenges now are immense. It is far from an original thought to think that no one in charge knows what to do. To paraphrase someone; business don't need more loans they need more customers. I have never been in the Armageddon camp and I am still not, instead my thoughts from the start of this site has been the US will increasingly become a less compelling investment destination and admittedly the cliff was steeper than I imagined it would be.

However where there are challenges there is opportunity however not much in the way of shortcuts in pursuit of opportunity. Obviously there is no way to know what people read as they read this site but I view the opportunities as being immense even if not with many US stocks. To the extent that immense is the correct word then the US' issues notwithstanding there is reason to be very optimistic.

I also think it is pretty easy to know where to look. Between healthier countries and stuff that the world has to have, that should keep most plenty busy. "Plenty busy" is important because I think the task is pretty big. Yesterday I read two articles on rare earth metals and I've read a few other things over the months, probably similar to many other people. If you've done any looking into this niche you know there is an awful lot to go through. There are the actual elements and what they do, I believe there are 17 of them. Then there is the politics, China has the most supply readily available but there are supplies in the ground elsewhere but the companies are speculative of course. This is an important niche but there is a lot to study.

Have you done any serious research into this theme? How many others are out there that you have or have not researched? Countries are a little easier to learn about, learn about the larger companies in the benchmark index for a country, understand what types of stocks best capture the country and commit to a stock or two, or depending on the make up of an ETF, commit to an index fund for the country.

There are probably two ways to come away from the above commentary, assuming you think it holds any water at all. I think the two possible reactions would be to be overwhelmed or to be invigorated by the challenge. Above, where I ask how many themes have you researched and how many have you not, did you come up with a number? Whatever number anyone might come up with they cannot realistically learn about all of them. This might help anyone who might think this is overwhelming.

As a practical matter for portfolios above a certain dollar size I think a large portion of a portfolio can be devoted to smallish allocations to various countries. Something like 8-9 countries at 8-9% can work out to 70% of an equity allocation with the rest maybe going into themes like water, mining of some sort of resource, infrastructure or maybe a defense contractor to name just a few. There are plenty of ETFs to accommodate and while there are no shortcuts there can be some comfort with the products.

Still though, plenty of work. Overwhelming or exciting is up to you but the solution IMO is more about time available to spend than anything else.
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ETFs Are The Worst Idea Ever, No Wait They Are Mankind's Savior

That title sort of sums up some of the current reading about how ETFs are bad versus the only things we should be using and of course both extremes are wrong. I have to say I am astounded that such bi-polarism still exists 17 years after the first US ETF started trading.

From worst idea ever camp is this article from Chuck Jaffe and what I believe was the tipping point for the collapsing ETF theme that a reader was kind enough to link to. Jaffe's article seemed to support both Bogle's idea that they are bad because of the trading they allow (so not the actual product but human behavior) while conceding ETFs might be the better wrapper than traditional funds but he concluded with the suggestion to wait for five or ten years for the "revolution" to actually prove out.

My first response to the collapsing ETF idea was no because in the now famous XRT example it would, IMO, be worthwhile for the fund provider to keep a popular and actively traded ETF seeded with capital if somehow there were to be a run. While I believe it would be worthwhile, folks like IndexUniverse did some sleuthing on the matter and the short answer is that creation/redemption process does not allow for the scenario that Bogan laid out in the original paper.

Just because a collapse as described by Bogan appears to not be plausible some other sort of serious malfunction could be. Part of the case against ETFs stems from how they reacted during the flash crash. I think the narrowness of the argument is a miss because of how short lived the event was and someone who actually thought a fund with an NAV of $50 at noon could all of a sudden be worthless at 2:30 probably needs help with their investing. But looked at from a broader perspective the funds malfunctioned for a short while after many, mostly bond funds, had previously malfunctioned during the Lehman panic days drifting very far from their NAVs.

It would be easy to envision some sort of event where an ETF does not recover from some sort of distortion so quickly. I don't know what this might be but ETFs are investment products that rely on certain things working properly. There can be no assurances that all the things that need to work properly can do so 100% of the time.

From the Mankind's Savior camp is an article from Seeking Alpha that seemed like nothing but a commercial for a website so I'm not going to link to it but it laid out a bunch of different portfolios using broad ETFs from different asset classes (there were no benchmark comparisons). So the entire business is built on broad ETFs and there are plenty of advisory shops who run their practices this way--that is relying solely on the ETF wrapper.

The best use for ETFs is of course in the middle of the two extremes. A point I have been making from the start has been that ETFs are just one of several tools available to all types of market participants. For some they are vehicles to be traded frequently, for some they are core investments and others still (this is where I fit in) they are part of the solution for portfolio construction and cycle navigation.

Yesterday I read an article making the case for uranium as an important investment for quite a few years to come. For anyone for whom this thesis resonates they would probably want to find a way to add uranium to their portfolio. Once that decision has been made the next step should be figuring the best way in and being open to buying whatever this step yields.

Uranium is obviously a play on the nuclear energy theme. GlobalX has filed for a uranium fund but it is not trading now and there can be no guarantee it will ever trade. There are three nuclear energy ETFs that I am aware of each with varying amounts of uranium exposure. The iShares Global Nuclear Energy Index Fund (NUCL) appears to have 18.1% in uranium miners, the PowerShares Global Nuclear Energy Portfolio (PKN) appears to have 13.6% and the Market Vectors Nuclear Energy ETF (NLR) appears to have 39.5%.

If you are convinced uranium is the single most important theme of the decade are the weightings in any of the ETFs enough? If the 39.5% in NLR might be enough, is the 18% in Japan then a problem? If I loved uranium the 39.5% would not be enough but the Japan weighting would not be too big of an issue as the correlation of the fund to Japan looks low enough to me. FWIW the PowerShares Coal ETF (PKOL) has about 11% in uranium and while the fund itself is interesting it is clearly not a pure play for uranium.

So until GlobalX Uranium comes, if it ever does, and an investor thinks uranium is the most important theme what are they going to do? Obviously right here right now they must consider a stock. There are a few stocks out their to choose from mostly from Canada and Australia. It doesn't make sense for an investor to deprive them self of "the most important investment theme" waiting for an ETF that could be several years away or might never come.

Contrast that with something like copper miners where there are at least two ETFs or water where there are I think four ETFs and of course there are others. Here there is more choice for anything else that might be "the most important investment theme" which in a way creates more work; the decision of whether one of the ETFs is better or one of the stocks.

A building block for this post is my belief, that IMO has been playing out, that investors above a certain account size need to learn about and implement narrow investments in their portfolios instead of some combo of SPY/EFA/IWM. My preference is to go sector by sector and a perfectly valid way to do this is with a mix of products (for most people this means individual stocks combined with ETFs). Sticking with the materials sector example a blend of something broad based like the Materials Sector SPDR (XLB) or one of the foreign sector funds that will be heaviest in BHP Billiton (BHP) along with a miner of some specific resource or a fertilizer company can work without taking obscene risk.

This can be applied in all of the sectors and ETFs can be a big part of the solution. For people not wanting too much reliance on ETFs functioning normally I would suggest that a basket of staples stocks with products you have used your entire life that have paid decent dividends for decades would not likely all go to zero at the same time.

The all or none idea with ETFs above a certain account size seems woefully misguided.
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The Big Picture for the Week of September 26, 2010

James Picerno had an interesting post at his site the Capital Spectator. He explored the extent to which investors add value to their portfolios by managing betas, not by trying to add alpha--he even serves up a quote that theorizes "that there are no alphas...only betas we know and betas we have yet to identify."

This is a little fuzzy to me frankly but beta is simply an exposure. Equities are a beta, commodities are a beta as is every asset class that might go into a reasonably diversified portfolio. So "managing betas" means that an investor is adding value by knowing when to underweight equities and overweight commodities and being correct about it (just an example not a forward looking statement). IMO an example of successfully managing betas could be someone taking defensive action in late 2007 by heeding the 2% rule (market averages a 2% decline three months in a row as evidence a bear market has begun).

To the extent that a decision to reduce long exposure for whatever reason and doing so correctly is adding alpha by managing betas then I am on board with that part of it. As far as no alphas well first, I just disagree with that. But the next question to ask is whether or not stocks from other countries comprise a distinct asset class from domestic stocks. This can be in the eye of the beholder but I don't think that Latin American stocks, for example, are a distinct asset class--it is a region not a different asset class. Again though, there can be more than one right answer. Similarly I don't think debt from Thailand is a different asset class from treasuries. Both are fixed income exposure with some different characteristics and variables to be analyzed but it is all debt.

If a country is a different asset class then a correct decision to add Switzerland, just an example, becomes managing betas and if a country is the same asset class then it is a source of alpha. What about sectors? Are they asset classes? I say no but either way a sector is either a beta to be managed or a potential source of alpha. Anyone who decided to avoid tech eleven years ago or avoid financials three years ago added alpha--I can't recall ever reading that those particular trades were not alpha generators but whatever.

Back to no alphas, assuming I understand the comment, and why I disagree; well the points above about countries and sectors rely on them not being separate asset classes. But as a different type of example take a portfolio benchmarked to the S&P 500. Instead of buying SPY an investor chooses a starting point of equalweighting each of the ten big sectors against the index meaning that if energy is 12% of the index then the portfolio buys 12% of XLE. At this point a portfolio like this has merely copied the index expensively and no alpha generation is possible.

As I said though equalweighting with sector funds is just a starting point. Now assuming the builder of this portfolio did not buy XLE at the start of the year but instead bought Ecopetrol (EC). YTD XLE is down 3% and EC is up 62%. That one trade is an alpha generator. The portfolio, with EC in for XLE, would have picked up 7.80% against the S&P 500 (EC would have added 7.44% plus adding back in the 0.36% loss that would have been incurred in XLE).

That example is not particularly subtle. Some subtler examples could include decisons about yield, volatility, style and market cap.

James concludes with an optimistic viewpoint about investment products, mostly ETPs, allowing investors easier access to more betas, errrr asset classes, like currencies, bonds from around the world, commodities, sectors in China and a slew of other things. WisdomTree just launched the Commodity Currency ETF (CCX) which is a way for people to access a lot of world, without equity risk, that I think is important--fair warning I have not looked at the fund yet.

As useful as the ETPs are I would also urge investors to make use of individual issues, stocks and fixed income, too. I feel very confident about country and niche exposure being very important going forward as they were in the recent past. As I have mentioned before I do not think another sector will get bigger than 20% of the S&P 500 for along time after happening twice in the last ten years.

On an unrelated note a reader at Seeking Alpha left the funniest heckle since I started blogging on my post during the week that included a mention of StairMaster machines;

Certainly you could afford to belong to a gym that has more than 2 Stairmasters - is your business that bad?

Maybe the reader really meant it but I thought it was world class funny.
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All Things In Moderation, Even Commodities

This might whip a couple of people up but yesterday I was reminded of point I have made quite a few times in the past and thought it would be worthwhile to revisit again. Yesterday I read an interview with someone generally thought of as an ETF expert that focused on his opinions about various niches in the commodity market. The interviewer also managed to tie in the potential complexities of investing in commodities caused by the structure of the futures curve; contango or backwardation.

From the start I have been very consistent in advocating for a little exposure primarily with gold, which we target at 2-3% of a portfolio, and occasionally a 2-3% exposure to something else and that is it. We owned PowerShares Agriculture Commodity ETF (DBA) for a while but have since sold it. In past posts I have mentioned coffee as having long term potential on the idea that a little penetration into China and India from the current microscopic number up to a slightly less microscopic number could be a big driver for the price (I don't think it will ever come anywhere close to tea consumption). Of course lately coffee has been white hot.

The reason I believe in gold as a core holding is that no matter what the price is today, I would expect it to go up if something bad happened tomorrow. Against that backdrop having one or two things that could go up can help absorb some of the blow that an external shock might cause. If it goes up for other reasons while we hold it, that is ok except that, as I have said before, if gold is the best performing thing you own then chances are the rest of the portfolio is not doing too well.

My reason for believing in a small allocation used to just be about the potential volatility. Commodities are volatile, seemingly more so than equities (subjective comment). When you put 20% of your portfolio into a very volatile asset class you change the volatility characteristic of your portfolio and at some sized allocation the exposure goes from being a portfolio diversifier to being the portfolio.

Another thought that I may have touched on previously but I think is going to become a big deal, if it isn't already, is the extent to which the easy access to commodities from exchange traded products for investors who previously never even considered commodities is or will distort the commodity markets. Do a little digging and it will be clear that many of the markets now available through ETPs are very small. That there could be some sort of unintended consequence from all of that capital should not be a black swan to anyone.

The bullion backed funds (I am not in the camp that says they are a fraud) should not be hurt by something unexpected in the futures market, although this is not impossible, but the futures based ETPs could be hurt--by definition. A 2-4% portfolio exposure in a space that malfunctions is unfortunate but that is all it is; unfortunate. A 20% exposure in a space that malfunctions could be catastrophic.

In addition to a little exposure to commodities it is also valid to have exposure to parts of the stock market that benefit from commodities. I don't view one as a substitute for the other but as a way to capture what some have said is a 17.6 year cycle with quite a few more years to go I would think that the stock of a Colombian coffee plantation (if there is one) or a palm oil plantation stock from Asia (there are quite a few of these but most are very difficult to trade) or an Australia wheat producer or a South African platinum miner all have a decent shot of capturing another seven years of commodity boom time even if the result is not the same as the commodities themselves.

The risk to the commodity ETPs is simple to see. I don't know whether anything bad will happen, I suspect not, but this is something I do not want to have to be correct about with client money on the line. A little exposure, yes, but a lot seems like a bad idea.

Congratulations to Jose Bautista of the Toronto Blue Jays who hit his 50th home run yesterday--I think Bautista's beard hit six of those home runs all by itself.
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Yield Versus Yield

Lately there have been a lot of commentaries making the argument that instead of buying fixed income for yield it makes more sense to buy equities for yield as bond substitutes. Whitney Tilson has used the example of Johnson & Johnson (JNJ), which is a client holding, in pointing out that the company recently issued ten year paper at 2.95% with the common yielding what is now 3.49%. Tilson says it makes much more sense to buy the common for the potential price appreciation and the reasonable likelihood that the company will continue to increase the dividend which the company has done every year since 1752 (slight exaggeration).

Carrying out the thought a little further fixed income yields are at all time lows, or close to it while the S&P 500 is 27% below its 2007 peak and 25% below its March 2000 peak. It would be tough to argue that stocks aren't relatively cheaper than bonds--I've been writing for ages that I think bonds are way overpriced and so have been keeping maturities very short and obviously bonds, or anything for that matter can stay very expensive for a long time and stocks can stay "cheap" for a long time.

So the market is at a point where there are plenty of well run, fundamentally sound companies with high dividend yields such that an investor spending a decent amount of time looking for names could construct a portfolio whose yield was higher than, or at least competitive with a high quality bond portfolio.

Maxim Integrated Products (MXIM) 5.0% yield
Eli Lilly (LLY) 5.50% yield (clients own LLY debt)
AT&T (T) 6.0% yield
Eni (E)4.5% yield
BP Prudhoe Bay (BPT) 8.4% yield
Komercni Banka (KMBNY) 3.0% yield Czech bank mentioned a few weeks ago
Altria (MO) 6.3% yield (clients own this one)

The group covers a lot of ground and depending on how someone might blend them together--note not all of the big SPX sectors are included--the yield could be 5% overall without whoring out to a bunch of companies with lousy stats, IMO, but you can draw your own conclusions.

From the top down I don't think any of these stocks are insanely risky relative to what they are proxies for; meaning that if the Italian market dropped 15% I don't think Eni would drop 40%. Not that this can be overly relied on going forward but the betas of these names, interestingly Komernci Banka has a beta of 0.43, are reasonably tame, the coverage of the dividends is decent and as I said the foundations are pretty solid as equities go of course given the disclosures above I don't really have to worry about being correct.

The above mix actually could be a pretty good start to building an equity portfolio for someone but the key is equity portfolio. MXIM dropped about 60% from peak to trough but that was right in line with the iShares Semiconductor ETF (IGW). LLY did a fair bit worse than the Health Care Sector SPDR (XLV) on the way down, dropping as much as 50%, and at the start the market's snap back but has outperformed by a little in the last year. T has done a little better than the iShares Telecom ETF (IYZ) fairly consistently but it did drop 40% at its trough. Eni dropped almost 60% but that was much better than the iShares Italy (EWI). BPT did much better than the Energy Sector SPDR (XLE) which may not be an apples to apples but from its peak about six months after the SPX' peak BPT dropped 50%. Komercni Banka dropped about 60% from it's peak which sounds bad but the Financial Sector SPDR (XLF) dropped 80% at its worst. Finally MO did a little worse than the Staples Sector SPDR (XLP) dropping slightly more than 30%.

The point of that last tedious paragraph is that there is nothing bond-like about those results. Relative to equities, the results above are not bad and you may agree with that or disagree but again there is nothing bond-like about them. After two 50% declines in ten years another one is unlikely (not impossible of course) but even in a normal bear market, like maybe a 30% decline with no reasonable fear of financial Armageddon, the above stocks would still go down plenty even if it were to be less than the market. Down 25% in a down 30% world is a fine equity market result, or not, but again it is not bond-like. For a little bit of context I am talking about individual bonds not bond funds some of which malfunctioned during the crisis and obviously I am assuming, perhaps unfairly, someone avoided financial sector bonds.

As you read more commentaries along these lines it is crucial to understand there is a big difference between buying stocks that probably won't go down as much as the market and buying bonds. A portfolio that only owns stocks like the above should be expected to go down a lot during a bear market even if they were to go down less, a lack of recognition of this ahead of time would likely cause a lot of anguish.

The picture is of the Bay Bridge taken from Pier 24 in San Francisco by AW, a long time reader of this blog.
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Exploring Risk Adjusted

Eric Falkenstein had a thought provoking post in which he outlined a type of risk adjusted strategy that I had not heard of before. If I understood him correctly this is his idea. The starting point seemed to be that assets with lower volatility tend to have higher returns over time than assets with higher volatility. This then lead to constructing an index comprised of the 100 stocks in the S&P 500 with betas closest to the 1.0 that is the market.

He has data and charts to show how this group outperforms and fills in some detail as to why this might be but that I wasn't specifically interested so much in a fairly broad swath of a major domestic benchmark index so much as taking the opportunity to explore some thoughts about risk adjusted concepts.

The simplest way to think about this is trying smooth out the ride as much as possible during the course of the stock market cycle. John Serappere has taken the concept and created what he calls the 75/50 portfolio which seeks to capture 75% of the market's upside but only 50% of the downside. He used to write about this and publish at IndexUniverse.com but it has been months since he published anything there.

There are many ways to incorporate a little bit of risk-adjustedness into a portfolio that are not particularly complex, many of which I write about and try to implement for clients. One way to think about risk adjusted returns is with an extreme example. Assume an investor seeks a market equaling total return of 10% (presumes the market will have a total return of 10% in a year). If this investor put 10% of the portfolio into a stock that went up 100% and left the other 90% in cash then the doubling of the one stock would result in a 10% return for the portfolio while only putting 10% of the portfolio at risk. The example is not realistic but I think does a good job of explaining the concept.

The simplest practical example is probably with dividends. There are all sorts of statistics floating around about how much of the market's total return comes from dividends with most studies coming up with 40-50% of the market's return coming from dividends. Dividends matter a lot except in years like 2008 where the market goes down a lot or 2009 where the market goes up a lot. Some may disagree with that point but if the market is dropping 38% in a calendar year then an extra 200-300 basis points that might accrue to a fully invested portfolio doesn't mean a whole lot in my opinion.

A point I have made before with dividends is that if the market were to have an average total return of 10% per year over some long period of time with the dividend of the index being 2% (this has been the case for a while now) then one is looking for 8% price appreciation. If the yield of the portfolio can be taken up to 3% then obviously the portfolio would only need price appreciation of 7% to get the total of 10% so the portfolio should not have to take as much risk (really the word volatility is better here) to get a 7% return as it would for an 8% return. Theoretically a safe 10% yield means there would not have to be any price appreciation.

Hopefully it is obvious you can't sellout for the highest yield possible. I seem to remember New Century having a pretty good yield for a long time but of course it eventually went bust. In a well diversified portfolio of individual stocks there would be some names that in normal times would yield 3.5-4.5% but now might yield 5-6% along with names where yield was not a consideration but offer access to some segment of the market believed to be important. The goal then becomes deriving a yield for the whole portfolio. That a portfolio yields 3.2% is more important than one component yielding 1% while another yields 5%.

An important focus on how I seek a good risk adjusted return is by paying attention to the various big picture things I write about so often (SPX above or below its 200 DMA, the yield curve, a sector's weight growing too large in the index). These indicators, IMO, tell when risks to equities are relatively attractive or unattractive. When unattractive then some sort of defense in the portfolio is in order.

Specifically I've talked about avoiding the full brunt of down a lot. I believe the market warns of trouble (add the 2% rule which I believe originated with Ken Fisher to the above) and when it does steps can be taken to make the portfolio look less like the stock market. For me this meant a double short ETF, selling a few things and having an overweight exposure to absolute return funds--all disclosed on the blog as I was implementing. If you can miss the full brunt and go along for the ride on the upside (even if you lag a little on the upside) then the risk adjusted numbers should be pretty good.

Another important aspect to this is to understand how much risk you need to take given the particulars of your situation. If you have been a good saver during your adult years then you probably don't need to be 100% equities with a volatile tilt. With the occasional exception a portfolio should take as little relative risk as possible--relative to your financial situation and volatility tolerances. Some may disagree but the idea of taking unnecessary risk or taking on more volatility than you actually need doesn't make a whole lot of sense. An example that might fit here is United Online (UNTD) which gets attention for having a very high yield. It has three business lines; one is non-highspeed ISP and another is a social networking site you have to pay for. The yield really is good and a cursory look makes me think they can pay it but what really are the prospects? You can decide for yourself but the point is pretty simple.

All facets of risk--analyzing it, building it correctly into a portfolio, everything--is crucial to understand, is very easily misunderstood and often used incorrectly. The amount of time one could spend on it is infinite which makes it such a fascinating topic.
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More Not So Deep Thoughts

Yesterday right before the close Maria asked a guest why the market was up yesterday. Based on his answer I don't think he was expecting the question. This lead me to a new thought on a Talebesque concept brought up in past posts. Taleb has noted that people like there to be explanations for things that happen. This is called fallacies of explanation. I'm sure that this is not new ground for you but we feel better if an event or occurrence can be explained.

The idea behind the fallacy of explanation is that for many things that happen there really is no explanation. This is very true for day to day movements of the stock market. If you look at articles before the open you might see something like futures are down due to growth concerns in Europe. If you look at articles recapping the day from after the close you might see something like equities rose over optimism for earnings.

I buy into the idea about explanations being mostly a psychological thing but the new thought is that one determining factor for success is being able to tell when the explanation actually is important versus the majority of the time when it isn't; more specifically having a good internal filter for sorting out news from noise. Even if most explanations/news doesn't matter some does and being able to understand this could be huge, I think it is anyway.

The best example of this I can come up with might be my experience with Bank Of America (BAC). I bought it years ago with the expectation of holding it forever. Being one of the largest American companies (by market cap) there is a lot of news on it every day most of which is meaningless. For the last few years the market has cared less about analysts raising or lowering estimates or changing ratings than it used to. Sometimes the market does care but in general I believe there is less regard for this sort of news. If you are a long term holder of a stock like Bank Of America it is unlikely that some analyst moving a full year earnings target by ten or 20 cents in either direction would serve as much of a catalyst for action. But the stock is covered by everyone (intentionally vague hyperbole) and it is their job (presumably) to call 'em as they see 'em which creates a lot of noise as opposed to news.

Occasionally news is very important; a ringing bell so to speak as was the case with BAC's announced takeover of Merrill Lynch after Lehman Brothers died but before the market opened and stocks could react (here there was a real explanation). I sold right away at about $29, the stock went to $37 a week or two later and then imploded along with the rest of the sector, well the ones that didn't literally go to zero. This news is as close to a bell ringing as I have ever experienced as an investment manager and candidly I'm not sure I would have known to sell had they waited a few hours and announced they were buying for a third of what they ended up paying so understanding this news for what it was--important and a catalyst for action was about two things; luck and being aware enough to understand that in the noise there is real news now and then.

I would be very surprised if something is ever that obvious to me again; that strikes me as a once in a career type blunder to capitalize on.

Another not so deep thought came to me yesterday afternoon. As some readers may know I go to the gym when the stock market closes for the day (commit yourself to fitness, don't drink soda LOL). The first thing I do at the gym most of the time is a turn on the StairMaster machine. Our gym has two StairMasters and the vast, vast majority of the time one of them is available for me to use. Yesterday I got to the gym and saw only four vehicles in the parking lot. Sweet, the StairMaster won't be an issue! Sure enough both of them were occupied and I felt sort of silly, on the inside, for the assumption I made and immediately tied the behavior in with the complacency that investors often have like forgetting after several up years that markets can go down a lot. That both StairMasters were being used was almost a personal black swan.
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Hussman International Fund

A long time reader asked for my take on the new Hussman Strategic International Equity Fund (HSIEX). Hussman has been managing the fund with only seed money since Dec 31, 2009 and opened it to investors on September 1st. According to the most recent reporting, so it could be different now, the fund had 12.3% in healthcare, 9.1% in staples, tech 9%, telecom 8.9%, discretionary 8.6%, utilities 6.1%, Energy 2.8%, industrials 2.6% and materials 1.3%. There appears to be no exposure to the financial sector. It also has a total of 8.9% in single country ETFs for Belgium, Canada, Netherlands, Sweden and the UK.

The larger country weightings (excluding the ETFs) include 10.5% (of the entire fund) in the UK, 6.5% in Brazil and Switzerland 5.6%. 38.4% of the fund was allocated to Europe out of 60.4% total equity allocation (meaning only 60% in stocks, 2/3rds of which are in Europe). The huge weighting to Europe comes as a surprise to me. There are eleven countries in the fund where the percentage has a one or zero handle.

Also of interest is that out of 53 stocks owned (so excluding the ETFs) 37 of them appear to be ADRs as opposed to ordinary shares. The fund also hedges with put options and index futures. For the period reported the fund was up 0.80% versus a drop of 14.72% (that number comes from the PDF) for the MSCI EAFE Index which is presumably the targeted benchmark.

In looking at the sector make up the fund obviously has taken defensive posture. This is also evident in the result a small increase for the NAV versus a very noticeable drop for the market implies that hedging drove returns over the long exposures. Based on the sector allocation the fund is clearly a long way from index hugging; financials are the largest sector of the EAFE index at 22% and again Hussman appears to be at zero.

While the fund is not really index hugging at the country level either it is much closer than I might have thought given the large exposure to Europe. So much in Europe really surprises me. From the outside looking in Hussman is clearly willing to avoid things that are probably on shaky ground by virtue of no exposure to financial sector stocks. My take on what I have been reading from him is that he would not be favorably disposed to Europe, specifically big Western Europe and the UK. The Scandinavian countries did much better than big Western Europe and the UK and while there is an element of hindsight to that comment I think it is a fair one to make given my position on these countries all along (I don't like them) and more importantly what might have been his take (that is just my read on his comments).

A very workable explanation for this is that the decision to hedge or not to hedge or how much to hedge is more important to Hussman than long composition. Another top down idea that also could be more important long composition is the avoidance of one really unhealthy part of the market. A big part of our return for the last few years can be attributed to an extreme underweight of US financials so if that is the case I am with him on that.
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Sunday Morning Coffee

Fifteen or 16 years ago my wife and I were on vacation and the radio station that we listened to in the car there had a bit where listeners would vote on the most disliked song and whichever one was voted as the worst would get "sledge hammered" off the air forever. Obviously I got a kick out of it as I still remember it today.

The reason to mention that little nugget is that after reading this week's Barron's cover story I have decided to sledge hammer the term emerging markets off of this site in all future posts other than in the proper name of an investment product. The actual cover story was perhaps the weakest cover story I've ever read; I go back to the late 1980s with Barron's. I have a 16 year old nephew who twice has asked me about the stock market. If he ever asked me about emerging markets my answer would be a lot like this cover story. The total lack of depth was shocking. I actually saved the article until the end and could not believe it.

I believe the now sledge hammered term to be obsolete. I have explored this before but am now convinced the term has lost almost all of its usefulness in constructing a portfolio and navigating a market cycle. If you've been reading this site for a while you know my belief in country selection and sector weights for determining a lot of the portfolio's eventual return for whatever the time period in question (reasonably long time period of course).

A focus in country selection is trying to find countries with different attributes than the US and also different attributes from each other. For example Thailand is quite different than South Africa and both are different enough from the US that they probably could zig some when the US zags. Sticking with those two countries as the example, were some to add them to their portfolio they should expect that those two would increase the volatility of the mix. Conversely if someone added Switzerland, this would likely serve to dampen volatility some. If someone wanted to add volatility in the materials sector they could add Peru or if someone wanted materials exposure with a little less volatility then maybe Australia would do the trick.

This process can occur without even thinking about the now banned term. If you want a financial stock from a country that was not part of the financial crisis fundamentally; well there is Australia (although housing prices there are very high now), Canada (concerns that those banks are now over leveraged), Latin America and Asia. Oh and probably Israel and some in Africa. I'm over simplifying some but a country where banks have less leverage, where there is simply less real estate speculation and has some sort of visible growth dynamic that stands to benefit the banks sounds promising. If you then add a well covered and large dividend then where on the priority list are the words emerging or market?

If Japan and Western Europe continue to be poor investment destinations with relatively high correlations to the US market (more so Europe with the correlation) then how much exposure do you want to those places? If you answer that question little to none and are able to spend the time studying individual countries then you will buy into the ones that are both most promising and offer a good shot of real diversification--and again the now banned term becomes much less important.

I will do my best to never use the term again on this site. Seriously.
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The Big Picture for the Week of September 19, 2010

Yesterday Yahoo Finance ran this story from the NY Times about a woman in her early 60s who went to a retirement boot camp. The article also included some information about the concept of a retirement boot camp. Early in the article it was disclosed that the boot camp cost $850 and the admission that at first she felt like she had just blown $850 but it turned out to be a productive experience for her.

At the time I read the article the most recent comment on it was "Yes Maam! You blew $850.00!" Most of the comments, but not all, took the same tone about this sort of thing being a ripoff if it costs money or an investment product pitch if it is free. It is easy to conclude that it was a waste of money but the lady profiled came away feeling like it was money well spent. From the standpoint of staying on your own mat maybe it would be a waste of money for you but not someone else. And if I am not on my own mat then yes this seems like just throwing money away.

If you agree that she threw money away on something that could have probably been found with minimal web-work then retirement boot camps are not your financial blind spot. That is great but then we all need to ask ourselves what type of money-wasters are we blind to? A common one is motor homes. I mentioned motor homes in this context back in February and there were a lot of comments defending the purchase.

Some folks get a lot of use out of RVs but I seriously doubt the majority of buyers do indeed use them enough for the economics to work. In that post I mentioned renting one from Cruise America for a couple of months as either a litmus test or as a once or twice in a lifetime trip. In the February post I dug up a quote of $5600 for a modest RV for two months. Hey go crazy and get a $10,000 two month rental. Doing that twice in a few years would be a whole lot less than buying, registering and insuring an RV.

RVs are just one example of things people love to buy only to end up wasting a lot of money on. Some other examples include boats of all kinds, cars of all kinds, old motorcycles, unnecessary home remodels and I'm sure you can come up with many others. My blind spot is a small one but I love going to sporting events away from home. In the last two years-plus I've been to the Maui Invitational Basketball Tournament twice, Fenway Park and AT&T Park to see the Red Sox. I plan on going to see San Diego State whenever they play their first football game on the smurf turf in Boise.

Life obviously needs to be lived, I am a huge believer in enjoying the journey but a lot of people spend beyond their means on things that no doubt can be rationalized but require large multi year financial commitments. Mistakes get made of course (our Hilo adventure) and that is just how it goes but people need to learn from their mistakes but some people never realize that their blind spot might be a mistake or that it threatens their financial security, well not until it is too late. Like with most things there is a balance to be sought and struck so that life is lived robustly without wasting what turns out to be a lot of money.

As I said have before, with this sort of thing for some people there is no hearing that their thing is really a big waste of money. For anyone who really is wasting a lot of money on something like this the answer doesn't have to be giving it up (which might be difficult if something had to be sold at a large loss) but maybe can be making some changes to make the endeavor cheaper.

This may have seemed a little harsh but most successful financial plans require answering difficult questions and making tough decisions.
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Man Versus Machine?

This week CNBC has been running a relatively in depth series called Man Versus Machine. While I have not seen every installment I tend to get the same message from these things which is that anyone working without algorithms and plugged into the best hardware is at a serious disadvantage. I don't know the magnitude to which people are disadvantaged but the idea that a PHD from MIT has better technology and access to better information than some guy who works outside the industry and is trying to decide whether Microsoft (MSFT) still fits into his portfolio has plenty of merit.

As opposed to fighting this from here in the woods or from wherever you might be I think the solution includes a measure of using the "machine's" weight against it in a manner of speaking as a form of avoidance or deflection. To the extent that "the machine" is looking for beta, index replication, scalping other large traders or anything else they might be trying to game you can simply avoid the most popular ETFs.

SPY averages 198 million shares per day. IVV, the iShares version of the S&P 500 averages a little under three million shares. There is probably more opportunity for the machine in SPY than IVV. iShares Emerging Market ETF (EEM) trades 54 million shares per day while the Schwab Emerging Market ETF (SCHE) trades 110,000. It's not often you read an argument for going with the thinner fund but these two examples are not that thin and to the extent the machine bothers you it is obvious in the numbers that the machines are doing less in these funds.

The better path involves looking yourself in the mirror and figuring out just what type of market participant you are and how much any of this matters to you. If you have owned EEM continuously for the last five years with no plans to sell how much does it matter in the context of you being on the path having enough money in the future that one quant shop is trading this fund every ten seconds or that an HFT shop is trying to pick off some endowment fund's trade?

I would be more interested in the fact that in the last five years EEM is up 57% versus a 9% decline for SPY and my decision to keep it or not would be based on my expectations for the future like maybe the next five years but there is no right answer. Anyone who cannot overcome this issue would be justified in selling and figuring another way to get the exposure.

One word of caution would be that it is often mutual fund companies, as in traditional mutual funds, getting scalped, picked off or whatever they are calling it. You can buy individual stocks that are off the beaten path but Cementos Lima (CEMTY), to pick one example, hasn't traded since August 24 and that was only 500 shares. You could go with Compania de Minas Buenaventura (BVN) which is NYSE traded, averaging 900,000 shares per day, but then you are possibly at the whim of the machine again.

For people looking to trade actively with a goal of something like making $1000 per day, people do do this successfully, then you probably just live with this. Perhaps you resign yourself to the fact that if it takes you 25 trades to know whether you have succeeded or failed for the day that 10 of your trades will not get a very good execution for being beaten to the punch one way or another.

Likewise if you are an investor, as opposed to trader, and you make a dozen trades in a year or two there will be some number where you have to pay a few more cents than you otherwise might have to sell for a few cents less than you otherwise might have, however bad you think that is, a few years ago stocks were quoted in twelve and half cent increments. If someone tried to make that much off of you on trade now you'd think it was a felony.

If you bought PetroBras exactly a year ago and still have it you are down 22%. The last thing on your mind now is whether you paid four cents too much on your trade execution. If you bought the stock yesterday mid day and were out by the close then that four cents matters a lot. Chances are there are not a lot of people reading this post where the four cents does matter but a reminder of that can be useful.

An important thread on this site, and more importantly what I try to do for clients, is to manage a portfolio with an eye toward adding value over the course of the entire stock market cycle with a diversified portfolio. This means some combo of stocks, ETFs and maybe an open end mutual fund or two. Ideally anything purchased would be so correct of a decision that it could be held forever. In the current portfolio there are 15 holdings that have been there five years or more with a couple more on the verge of having been held for five years and a couple more that were temporarily out of the portfolio for a short while in that time. The 15 is a large number versus the total number of holdings.

You understand whether or not any advantage the machine has on you is actually a determining factor in the outcome you seek. If not, then I would not devote a whole lot of time to this. If so, then you'll need to figure a solution that you can live with.
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Serious ETF Drawbacks?

In the last few days there have been quite a few commentaries posted that explore the downside to ETFs. Obviously I have been a big proponent for the wrapper for the access they provide and the democratization of certain strategies. Additionally I have tried to point out various drawbacks as I have seen them, noting that no investment product is perfect and no product can be the best single way to access every part of the market. I have also been clear about how I use ETFs for clients while noting that I use more individual stocks than ETFs.

We are all starting to learn more about their drawbacks and learning about what appears to be new drawbacks as well. One of the big complaints from investors in the last couple of years has been about correlations seeming to go up, some have even quantified this and for now correlations are indeed higher. Some of the blame for this is starting to be attributed to ETFs. It makes sense when you think that for each new creation unit the underlying equities need to be bought either right away or shortly there after for any funds that might use other derivatives as a temporary stopgap to fill the customer order.

This makes a tail-wagging-the-dog argument and while the intent of this post is not to quantify this there is some plausibility here. Let's take Schlumberger (SLB) which based on yesterday's closing price and average daily volume has $522 million in dollar volume. This stock has a 7.5% weight in the Energy Sector SPDR (XLE) and a 12% weight in the Oil Services HOLDR (OIH) and the dollar volume in SLB from those two funds adds up to $81 million or 15% of the dollar volume in the common and that is just two ETFs. While the mathematical process is not airtight it gives some idea of the potentially significant effect that ETPs can have on individual stocks--at least I think it is significant.

If there is anything to this (you can decide for yourself) then it means that ETFs cause a distortion in how markets function and this distortion could be thought of as an unintended consequence for the ease of access and democratization that makes the funds so popular. ETFs are also being heavily criticized for having more clearly erroneous prints during the flash crash than equities meaning a larger percentage of existing ETFs mispriced than with equities.

I don't have much to say about the flash crash because it seemed obvious right away that something was not functioning correctly, I posted as much right in the middle of it with a little humor and added to an ETF position for a lot of clients about ten minutes too early. And as I rarely use stop orders (it has been a while since the last one), a lot of people got hurt by having stop orders elect due to "bogus" prices, I am not too concerned about the event. Not that it wasn't a very bad thing that should be investigated, just that it is not something I have spent any real time on, nor will I.

Ok well there are still some benefits to ETFs. A lot of benefits actually. While I don't think this constitutes talking my book, but you may disagree, the distortions caused by ETFs support my beliefs about top down construction, more foreign exposure and an investment time horizon that looks a little further out than lunch time.

It is a good bet that the long term prospects for Baoviet Holdings, the largest component of the Market Vectors Vietnam ETF, client holding, will not be compromised by high frequency trading, creation unit abuse (I don't think that is a real term) or anything else related. The company will succeed or flounder over the next few years based on the economy where it functions and the quality of the management decisions--another violent panic like the flash crash will not change that even if it were to distort the price for a day or two.

On May 6 Creditcorp (BAP) a big Peruvian financial company opened at $82.46. The low for the day, presumably around 2:40pm was $77.69 for a max drop of 5.7%. It closed the day at $80.62 down 2.2%. If you had been away for the day and BAP was your only holding (intentionally extreme example) you'd have never known there was a problem. The Chilean stock we own for most clients was down even less at its low point that day and both are up a ton since the close that day compared to down a couple of points for the S&P 500.

Four months is not really long enough to make a fundamental argument for those stocks going up but life for them went on and to the extent investors are losing faith in the US market (I don't know how true that is but a lot of people talk about it) things in Peru and Chile seem to be carrying on without us. This is a point I have made countless times, if the US ends up being a less attractive investment destination than other countries the merits of those countries will be recognized in equity prices.

Again, four months is not much time but this can be a microcosm. The US hasn't blown up, it has simply been flat versus up a lot for some other places and ETFs for these countries have been a way for investors to capture those moves despite all of the drawbacks cited above.

One more colorized, depression era photo from the Denver Post. When I first saw this one I thought "it looks a lot like Northern Arizona," turns out to be New Mexico.
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Wednesday Roundup

A bunch of stuff this morning.

Yesterday the gang from Blackrock rang the closing bell to commemorate their recently launched Build America Bond Trust (BBN) which is a closed end fund. There are two ETFs in this segment; PowerShares Build America Bonds Portfolio (BAB) and the SPDR Nuveen Barclays Capital Build America Bond ETF (BABS).

This is a space where the active management could be better than the indexed ETFs. BAB has a lot of exposure to California and Illinois, likewise BABS is heavy there as well. Given the state of the states I would rather be more selective than just picking the biggest issuers of debt. BBN can avoid or underweight the worst states and maybe load up on the healthier states like Montana and the Dakotas, if those states have issued this type of paper. After 37 simple steps to register at the Blackrock site there was no information about the fund posted other than a general description.

We have a couple of new ETFs to mention. The first is the SPDR Global Natural Resources Fund (GNR). Like a few other funds out there this one sort of combines energy and materials into one fund weighted by modified market cap. Not surprisingly Exxon Mobil (XOM) and BHP Billiton (BHP) are the two largest stocks. The utility as I see it is that it gives smaller accounts the chance to do some sector building without necessarily buying ten ETFs. In a similar fashion the now closed WisdomTree International Consumer Fund was sort of combo of staples and health stocks.

The other new ETF is the EG Shares Emerging Markets Consumer ETF (ECON). The heaviest countries in the fund are Mexico, India, Brazil and South Africa. The heaviest industries are automotive, food, beverage and travel & leisure. As you can tell the fund combines staples and discretionary. If the fund does poorly then I think it would be because of the large exposure to Mexico given the near depletion of the Cantarell Oil Field and the escalated violence of late.

From the world is getting flatter file I stumbled across Ncondezi Coal which recently started trading in London with ticker NCCL, no five letter designator for US trading as best as I can tell. This is a coal company from Mozambique. There are a few stocks traded in London from countries not otherwise easily accessible. I don't know anything about Ncondezi but to the extent that places Africa, Sri Lanka, Cambodia, Kazakhstan or Pakistan become more important investment destinations the first access will probably be through stocks like these.

There is probably not much impetus to buy a stock like Ncondezi Coal today but five years from now could be a different story and worthwhile to understand the dynamics of a few places that interest you; Kazakhstan being such a place for me.

A few years ago, before the financial crisis started, I wrote an article for theStreet.com where I tried to have every component of a portfolio of individual stocks properly diversified at the sector level yield 4%. I came close but did not quite get to 4%. I've spent some time revisiting the idea but targeting 5% and am having an easier time finding stocks to include. Yields are obviously higher these days and I think in terms of finding reasonable names to include, 4% a few years ago might be like 6.5% today. I thought it was interesting anyway.

Yesterday a comment was left on a recent post of mine at Seeking Alpha that was about retirement. The reader noted life expectancy rates in the US being high but that they are higher in Canada, France, Austria and Sweden. I can't vouch for the reader's accuracy as I thought Japan and Finland were pretty high as well but the thing I wondered upon reading the comment was "how much soda is consumed in those countries?" There are other dietary issues in the US of course and while I don't know if soda is the most important it seems to me that giving up soda might be the easiest diet improvement one can make--green lettuce instead of white lettuce might have a price barrier for some folks as an example.

Lastly is this link from the Denver Post that is not market related. It has over 60 colorized photos from around the US during the later stages of the Great Depression. There are some truly amazing pictures, the one included in this post possibly being my favorite.
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Tuesday Tidbits

A few things today.

First up is an article over the weekend from Jason Zweig. I usually don't agree with him very often (see this post and this one about emerging markets) but the current article explores an important concept and a clever term. The article talks about the battle between inflation and deflation and what investors should worry about it.

He says that investors should not worry about this and instead understand which outcome hurts them the most and prepare accordingly. He notes that for people in the accumulation phase of their life a little inflation is good because their asset prices generally appreciate, their mortgage gets paid off with cheaper dollars and their pay goes up. He believes a little deflation is good for retired people because their expenses can go down but their social security checks do not so their money goes further. For purposes of this post I'm not too concerned about debating him so much as the bigger picture implication.

He says that investors should worry about meflation; the outcome that threatens them the most. This is a point I've made before but in a slightly different context noting that the typical investor does not need protection against a Kudlowite outcome but they do need protection against a Roubinian outcome. Oh and for what its worth Zweig is still wrong about emerging markets.

Next up is the curious case of Duoyuan Global Water (DGW) which got the stuffing knocked out of it (similar to the beating Dan Doherty took from Captain Turner before turning the tables on the shockingly profane Deadwood) dropping 40% because, as Tate Dwinnell noted, related company Duoyuan Printing (DYP) fired its auditor. DYP dropped by about 50%.

The particulars of the story are less interesting than the psychological litmus test this provides. If this is an out and out fraud then anyone buying right here and holding on will get wiped out, if this is a gross overreaction then anyone buying here stands to make a lot of money very quickly (no guarantee of course).

So with those stakes are you a buyer or do you avoid it? There isn't necessarily a wrong answer in that anyone comfortable buying this type of situation no doubt realizes that sometimes these win and sometimes they lose; this will be one or the other. Anyone leaving this one alone probably does not want the emotional hassle of enduring this. I have used the term know-thyself and this is a fantastic example of how to assess your own tendencies. Oh and BTW; NO POSITION.

Yesterday someone with selective reading heckled me about the "futility" of using the 200 DMA as a triggerpoint for defensive action. I say selective reading because I talk incessantly about the goal being to avoid the full brunt of down a lot. The drag from a small position in a 2X inverse fund on a day that the market is up 1% is microscopic. If the market goes down a lot the hedging effect would be substantial IMO.

Lost on the heckler is that the point has never been do what I do but figure out whether you, in the context of investing not trading, should take any defensive action and if so what is best for you. If ever there was case for staying on your own mat this is it.
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Make Sure You Look Under The Hood

The Wall Street Journal ran an article over the weekend called Beware of Professors Bearing ETFs. It took a reasonably skeptical look at the various funds backed by academic research including Jeremy Siegel's relationship with WisdomTree.

The important quote from the article;

Yet WisdomTree LargeCap Dividend Fund has posted negative average annual returns of 8% over the past three years, compared with 6.7% declines for the SPDR ETF, which tracks the Standard & Poor's 500-stock index, and 6.3% declines for the iShares Russell 3000 Index ETF.

WisdomTree started out with dividend ETFs and then along the way added earnings based ETFs, currency ETFs and recently an emerging market fixed income ETF. I have written a lot about their funds and use a couple for clients. The ones I use were chosen because of my belief that for the segments they capture they are the best way to go. We were impacted when they closed most of their sector funds which was both a disappointment and nuisance.

To the quote above it underscores a crucial point which is understanding what is under the hood of an ETF and so what that ETF is then vulnerable to. Every ETF is vulnerable to something, every thing you have ever invested in is vulnerable to something. The point is not to avoid all vulnerabilities but to understand what you are vulnerable to, assess whether or not this needs to be mitigated and if so, how.

Many of WisdomTree's broader dividend funds were very overweight financials versus various cap weighted benchmarks. As I started to write about these funds when they first listed I almost always included a mention of the weighting to financials. WisdomTree came on to the scene shortly before the financial sector was starting to crack. Here is one example. That last link is to an article about a fund that four years ago was 43% financials. Someone using a fund like that as a broad proxy for US equities did not necessarily have to be able to predict the financial crisis to see that 43% back then compared to about 22% for the S&P 500 at the time and so it should be obvious that if something was going to happen to the sector then this fund would have gotten hit hard.

For a long time I have expressed the same concern about the iShares FTSE/Xinhua China 25 ETF (FXI) because it is 46.7% in financial stocks. BTW this also applies to the newer albeit less popular iShares FTSE China (HK Listed) Index Fund (FCHI) which is 45.3% financials. Financial stocks are the last place I want to be in China. So far the sector has not been a real problem and may never be but clearly some sort of implosion in that sector will hit any fund that is very heavy in financials. You don't have to be a great analyst to realize that sector concentration becomes a risk factor for a fund. If someone buys FCHI and financials never do badly ever again they are still taking the risk of being over exposed to the sector, the risk doesn't go away just because the consequence is never realized.

A problem that seems to repeat over and over is people getting caught with too much in what turns out to be the wrong thing; tech ten years ago or financials three years ago. I would have thought this would have been obvious after the tech wreck ten years ago but many people got caught with too much in the financial sector. That some fund you might own is 60% financials is not bad if that 60% is considered in picking the other funds such that the total financial exposure from all holdings adds up to an acceptable number.

Figuring what sort of number is acceptable can start with comparing to some broad based benchmark and either overweighting, underweighting or equalweighting versus that index. Making this sort of decision requires forward looking analysis which not everyone may want to do but if some index has 15% in financials and you have 38% then maybe you draw a conclusion or two from that.
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The Big Picture for the Week of September 12, 2010

Seeking Alpha included my post during the week called Retirement Realities in a group of posts about retirement featured on their front page. This means the article will get a lot of comments which can provide some insight into many different perspectives which is very useful.

In reading through the comments I had one thought that is almost paradigm shifting. Is the concept of a magic number needed in savings completely useless not for the math but because of the vagaries of human behavior and the frequency of one-off events?

Behavior can include all sorts of things like panic selling, panic buying, denial that is part of the overspending dilemma or anything else you can think of. The notion of one-off events actually happening every month is something I have written about many times and while they are each different they happen all the time and can't easily be budgeted for. This list can include things like new tires, a vet bill, some sort of serious repair on your house, some sort of dental issue or any of the things in your Quicken file from the last 12 months.

If your plan includes retiring at some point and you expect savings to fund some portion of your retirement then you probably have an idea of what portion of your retirement needs to be funded from savings and you can probably put a dollar figure on it. Someone in their mid-40s in 2000 might think of retiring in their mid 60s in 2020. Well if the 17.6 year cycle works this time around (meaning the round trip to nowhere lasts until 2017) then the person now in their mid 50s would appear to be very unlucky compared to the person who will be 45 in 2017 looking to retire in 2037.

If an investor's primetime, so to speak, is during a period like now then they probably won't get they growth they need, they might get sufficient growth but it would be a uphill battle and executing a plan that requires growth becomes very difficult. Then layer on top of that all of the behavioral hangups and other fallacies.

I will say that people who can be patient and get a handle on their own behavioral issues (we all have behavioral issues) can successfully execute a financial plan in any market cycle but as most people struggle with issues like this combined with the current market cycle and it makes the "number" concept much weaker.

While having a target number is a very useful thing the fact is that when the time comes you have what you have and that becomes your reality. If someone needs $2 million and they have $875,000 and they want that pot of money to last then something has to give.

It doesn't matter how much you had ten years ago or how much you were ever making before, an investment portfolio can only generate so much and have a reasonable chances of enduring. We all know that 4% is viewed as the "safe" percentage and whether you think the safe w/d rate is a little more or a little less than 4% I think most can agree 10% is not sustainable.

So if getting the number you think you need can be complicated by a long list of factors, some of which are clearly beyond our control but some that can be addressed, then perhaps the orientation needs to shift toward thinking along the lines "I'd like to have $X but can be prepared for $Y." Prepared can mean ready to work longer, take part time work, downsize or anything that fits in.

For most people the entire concept will need to shift one way or another and it can be completely open ended. The best solution needs to include an introspective look at our own flaws and the willingness to adapt.
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Fixed Income and ETFs

Yesterday I accepted an invitation to speak at the Inside ETFs Conference in February put on by IndexUniverse. They sent along a tentative agenda for the conference for me to pick a panel or two that I'd be interested in. Third or fourth on my list (so I doubt I will be in this one) is one titled Do ETFs Work for Fixed Income?

In past posts I've talked about picking the best (obviously this is subjective) tool to capture whatever it is that is being sought. It does not make sense that any single wrapper can be the best for all segments of all markets. Portfolios that only use ETFs is missing out on all sorts of things.

This point is very true with fixed income investing. There are four wrappers for fixed income, that is without getting in to UITs or other untradedable products; individual issues (including preferreds), ETFs, closed end funds and traditional mutual funds and we have all four in our ownership universe. I think the best path here is an agnostic one. Investors should choose the best product for each exposure they want given the totality of their situation.

From the top down foreign fixed income exposure is important for most folks, IMO. We do a fair bit with individual sovereign issues. Generically speaking this is a great way to go but not right for everyone due in some cases to account size so ETFs and CEFs can work; for some people they are the better way to go.

I have not been a fan of preferred stock ETFs. When they first came out I wrote about them negatively for theStreet. Back then they were obviously very heavy in financial companies because that is who issues most of the preferreds but these funds had a lot of exposure to what I felt were crappy companies. There was a foreign preferred ETF, that might be gone now, that had multiple issues from banks that are no longer with us. The PowerShares Preferred Portfolio (PGX) was issued around $20, bottomed out in the sixes and closed yesterday at $14.54. The two individual preferreds we use the most have each been reasonably close to par for a long time since the meltdown and are now back at par whereas PGX still needs to go up 33% to get back to par--that is if thinking of $20 as par is reasonable.

That is not to say what we use did not go down because it did but it did not take a lot of work to look under the hood, see companies making the most headlines being featured in the funds and deciding to stay away. Here the ETF wrapper was helpful because anyone looking could know exactly what the funds held and could make an informed decision but this is not the case with traditional bond mutual funds. The reported holdings lag by three- six months so buying an actively managed bond fund boils down to a leap of faith that the manager will avoid the sludge. Some managers did and some did not.

Contrast my opinion with any of the many articles out there that look favorably on the preferred stock ETFs. Clearly anyone who bought in the sixes got a fantastic entry point and picked up some yield along the way too. I'm not sure what it is but there is a bullish case for these ETFs now so this boils down to what is sought after in the fixed income portion of the portfolio. Personally I want as little volatility as possible, take in a little yield and have some protection in case the dollar does get away.

What I want is not going to be suitable for everyone. Each person has to understand what they want out their fixed income portfolio and build accordingly using whatever products they feel are most consistent with their intention. This is done by thoroughly understanding the pluses and minuses of each product.
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Calling All ETF Ideas

A few days from now will mark my fifth anniversary with theStreet.com, most of the articles have been about ETFs. As a tie in I am planning to write an article that will look at the evolution of ETFs over the last five years, the good, the bad and maybe a where I'd like to see product development go. I have some ideas about what I would like to see come to market which I will list below and hopefully you will be so motivated share your thoughts on sort of funds would make managing your portfolio easier.

In no particular order...

Cement ETF; I wrote about this a couple of months ago and think it could be a good way to get broad country exposure (many countries have a big cement company) and a narrow slice of the infrastructure theme.

Fishery ETF; This has been one of my favorite ideas to write about. While GlobalX has filed for one I am a little concerned about whether it would have exposure to Japanese fisheries after watching the documentary The Cove. Per the movie there are fish companies selling dolphin meat labeled as whale meat that is loaded with mercury (not intentionally loaded with mercury). This was a huge problem for the country in the 1950s and threatens now. If the fund is heavily weighted to Japan that would be a big risk factor.

Bond ETFs from individual countries; The indexes for these have existed for a long time so a fund provider just needs to license them. Logical choice to me would be Canada and Australia for the stability and diversification but as far as I am concerned the more the merrier.

Chilean peso ETF; As long time readers will know WisdomTree filed for this one ages ago but it is pretty clear they have no plan to list it. The bigger idea here is more choice for the cash portion of the stocks/bonds/cash allocation.

A publicly traded exchanges ETF; Part of the thinking here is that the financial sector is going to be a mess for a long time (look at how many big cap tech stocks are still a fraction of the price they were ten years ago) but there will be some very narrow niches than can still do well and I think this is one of them.

Airports and toll road ETFs; As separate funds, they are considered transportation stocks and so part of the industrial sector but I believe most of them are more like utilities in terms of how they trade and their yields. Like cement above these would create broad country diversification in one industry and deliver pretty specific effects to a portfolio.

Plantation/farmland ETF; This would be expensive as a lot of the stocks are small and thin but if the agriculture/diet story is for real then these stocks would seem poised to benefit. I would note that these stocks have been very cyclical, more so than I would have thought when I first started looking at them. GlobalX has filed for a food ETF but I don't have info on the proposed index and don't know whether the fund will list or not.

More generally for equity funds I would like to continued development of the foreign sector space. EG Shares, GlobalX, SPDR and iShares have done a lot here and PowerShares has a lot of interesting niche funds as does Market Vectors but consistent with my opinion of the importance of foreign investing more choice here will be a plus.

If you are interested in ETFs then you know that many funds don't have much volume or reasonable assets for profitability which makes new fund creation a risk for the issuers. I do believe that individual investors can safely use thinly traded ETFs provided trades are done with limit orders, a few hundred shares coming or going should be easy to execute but I realize this will not be the case with every single fund.

The industry will continue to evolve with new funds offering access to "new" parts of the market. Fund executives to read this sort of content, I'm not sure how much heed they take of the ideas but they do read so hopefully you'll share some ideas you have.
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Retirement Realities

Yesterday during the show Street Signs, CNBC teased a magic number of sorts needed for happiness. The number turned out to be a $75,000 salary. I thought it was going to be a nest-egg number but obviously it wasn't. Would a $75,000 income (in today's dollars) git 'er done for you? Would you need more? Could you get by on less?

If $75,000 (in today's dollars) is the number you would like to have, if you plan on retiring, then you need $1.875 million socked away when you do retire. Of course the further away you are from whatever you consider to be retirement age the bigger the numbers need to be if there is normal inflation. Obviously the $1.875 million relies on the 4% rule which many are now starting to question.

Apologies for being harsh in this post but if you have $350,000 saved, need to get that up to $1.875 million in 12 years and are not on the verge of massive pay raise then something will have to give; either you get by on less than $75,000 in 12 years, wait longer than 12 years or figure a way to save $75,000 per year while getting fantastic returns out the market.

The other part of the dilemma is outlined by Cam Hui at Humble Student of the Markets who dives into the idea of the market being ten years into a 17.6 year (more precise than the 18 years often thrown around) round trip to nowhere. What does it do to your financial plan if in 2017 the S&P 500 is somewhere between 1000 and 1200 and your track record up to this point has been somewhat close to the index? That is not a shot BTW, being somewhat close to the index for most of the 1980s and all of the 1990s was clearly a homerun.

The reaction to the last ten years of round trip to nowhere (actually a little worse than that) is that data has started to suggest that many investors have been retreating from the stock market, giving up on it for being rigged or not working or whatever. Harsh comment alert but to the extent that data is correct who do you suppose is giving up on stocks? Could it be the same people who rode the market all the way down in 2008 and into early 2009? How many of those people also rode the market all the way down (the context here is riding down while fully invested) ten years ago? What are the odds that this group, if it even really exists, is right to shun equity investing now? I'd say pretty low.

To repeat from countless posts this is not a call to buy US markets with both hands, it seems pretty clear that the US equity markets have more obstacles to overcome than many other markets. The investing solution continues to be foreign investing. I've mentioned the results from other countries for the last decade many times as well. There were ample gains in many markets as the S&P 500 went down 24% on a price basis. If that repeats again this decade, or more specifically for the next seven years, there will still be countries that go up plenty.

We've had good luck for a long time with Chile (one of the countries I mention the most). This year that market as represented by the iShares Chile ETF (ECH), which a few clients and I own, is up 27% versus a 2% price decline for the S&P 500. Life in Chile goes on irrespective of the US' economy and while the lift this year is nice the longer term fundamentals have been more promising for years and they continue to be so in my opinion--Chile as one example of many that fit this bill. If you were down on the decade and don't want to be flat for the next seven years then one investing answer is investing in foreign markets but avoiding the ones (big, Western Europe and Japan) with similar issues to the US.

The behavioral answer for many will be figuring out how to get paid for doing something you enjoy past "retiring" (assumes you even want to retire). The goal with this should be having fun and relieving some of the burden off your portfolio as opposed to having to work full time to cover your expenses. This can include things like seasonal work for professional sports teams, seasonal work at some sort of national park, national monument or state park, monetizing a hobby (if you are an expert at some sort of hobby you'll know whether there is a chance to monetize it), sell crap on eBay (this task is waiting for us in a few of decades), work at your gym (free membership plus a few more bucks in your pocket), go to timeshare presentations, answer questions for the KGB texting service (they pay people to do this from their homes, no idea how much money) and one last one that could pertain to me if we need it is our FD pays for patrolling Friday-Monday during fire season. Working two shifts a week for the three months would be about $2400 which would cover a few things at least.

All of the ideas in the above paragraph have been mentioned in previous blog posts.

In addition to some sort of work is "getting right" with whatever amount you do have. If your number needs to be $1.875 million but instead is $960,000 what are you going to do? Chances are the person who accumulates $960,000 did so making more than $38,400 per year (applying 4% logic). A common reaction is denial, to go ahead and take that $75,000 out. Denial can be about future returns, the belief you will cut your spending later our just flat out denial of the entire reality. I'm not joking about any of that; it happens plenty.

Slightly bigger picture there could be some harsh realities headed our way (if they are not already here) in terms of what our markets can offer and the consequences of over-indulgence combined with financial illiteracy. It makes more sense to prepare for harshness that never comes than to be blindsided.

On a much lighter note 63 year old Bill "Spaceman" Lee won his start for the Brockton Rox in the Independent league. The article notes that Lee is believed to be the oldest pitcher to win a start in professional baseball.
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