Happy New Year

Tater and Roscoe playing in the snow. Happy New Year, regular blogging should resume tomorrow.
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An Analogy

Pictured to the left is a batch of chocolate chip cookies I made yesterday. I don't think I've ever mentioned this on the blog before but apparently I bake a hell of a cookie, seriously. This and barbecuing is as far as it goes but by many accounts the cookies are very good.

The key to them turning out, as I will tell anyone who asks, is that I follow the recipe exactly as written, the recipe came from a bag of Ghirardelli chocolate chips from Costco many years ago.

The recipe is simple and has a track record for success. Given the track record I am not inclined to mess with it or think I can outsmart the recipe with a little more sugar or a little less flour or whatever.

I think there is an investing analogy in there somewhere. If you see it, great if not the recipe is on the bag of chips and if I can make them, anyone can.

Happy New Year!
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Are We A Nation Of Wusses?

Yesterday CNBC had a segment about ETFs during its show Power Lunch that started with a snippet from Jack Bogle saying "they've corrupted it (ETFs) into a trading business. You can trade all day long in real time, that's the tag line Tyler (Mathisen), to which I would ask what kind of a nut would want to do that?"

Um, what kind of nut when able to choose, would prefer the more restrictive wrapper, that being traditional mutual funds? Bogle likes VTI and SPY to buy and hold forever but the assertion that ETFs are bad because they can be traded is ludicrous. As mentioned before he is really attacking human behavior not the product. A couple of years ago Dylan Ratigan was going to interview Bogle and of course this same line of thought was coming so I emailed Dylan before the interview and pointed out that this is really about human nature, by coincidence or not Ratigan asked Bogle about this on the air and Bogle sort of conceded the point.

ETFs are just a tool. I promise you that people in the past have misused every single tool in existence and will do so in the future. The rest of yesterday's CNBC segment focused on elementary discussions about potential adverse complexities with commodity based products, funds where the components are thinly traded and so on. It became a reminder (for people somewhat familiar with ETFs) or an introductory point that you need to do homework, look under the hood and understand the dynamics relevant to the fund. So telling people they had to do work.

On a related noted my last few posts about social security have generated a lot of comments at Seeking Alpha. Some comments liked the starting point of self imposed means testing and some were critical which is all fair game but there was one line of comments that popped up in a few instances that was very disappointing and frankly very emblematic of one aspect of the problem.

I noted a couple of times that given how "broken" the US might be financially, any real solution will have to involve sacrifice on everyone's part or if you prefer unfair treatment, punishment or any other word that has a negative connotation. I believe that I set the expectation that anything I might think of would involve everyone taking a bit of a hit somewhere in order to help the country get back on firmer ground.

Even still there were comments along the lines of "why do you want to punish me for being responsible?" Other comments that were similar seem to fail to recognize the magnitude here. The math on several fronts does not work (read Bruce Krasting for detailed content about social security) which threatens our country. Threats like this first require recognition (not quite there yet) and then require an adult response--a sort of tough get going type of thing.

Ed Rendell said we have become a "nation of wusses" because Sunday night's game in Philadelphia got pushed back due to snow. It is possible we are becoming a nation of people who do not want to work hard enough to achieve what we want (like thinking we can get rich buying ETFs we don't understand) and becoming a nation of people who are not willing to sacrifice for the country, in a non-life threatening way mind you, when the country needs that sacrifice.

What's past is past. If you have $2 million saved that is great but it also means you need your social security check a whole lot less than the one of the 54% of Americans who has less than $25,000 saved. Thinking of this as unfair punishment is a bad way to look at it. If you have $2 million then chances are you are at least on firm footing and have a few choices about how your life goes. That sounds fantastic to me and I'm pretty sure the guy with $25,000 would trade places with you. Obviously no one would trade their $2 million portfolio for a $2000/month social security check.

There are of course many complexities and nuances here, I'm not a fan of bailing out reckless behavior as one example, but we all have a vested interest in seeing the country get back on relatively firm footing and should be willing to be involved on some level, especially a noninvasive, non life threatening way.

Who in your life have you respected the most? What would those people have to say about working hard and making certain sacrifices?
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Predictions Gone Awry? So What?

A few days ago Seeking Alpha ran a Q&A about 2011 that I participated in. There were really a lot of negative comments which surprised me in that after six years of doing this I've observed that comments get nastier when the market is doing poorly but then lighten up as the market does better. As 2010 was a pretty good year for the stock market the vitriol was indeed surprising. Please don't take this as a boo hoo comment about me but as more of an anecdotal observation about sentiment--when you write a lot about the stock market you are going to piss people off and six years is enough time to have done that in spades.

One reader seemed to vaguely take me to task about my 2010 predictions, it turns out I was wrong about some unspecified prediction about commodities--not sure if he meant 2010 or some other period. It would be reasonable to expect that anyone who makes market predictions will get some right and some wrong, this is pretty obvious and speaks to the folly of forecasting as I believe Barry Ritholtz has referred to it. As a more practical matter the notion of a given forecast fitting neatly into a calendar year is also difficult.

As an example a reader pointed out that I predicted a 10% decline for the S&P 500 for 2010. Clearly this turned out to be incorrect, 180 degrees so in a manner of speaking. Although at mid year the S&P 500 was down 9% at one point so would it be right to say my timing was off? Probably not but you see the point made.

More directly to prioritizing this sort of thing in the big picture; what is your goal, what is the reason you endeavor? I have made it clear many times over that in the context of my job and my own financial planning the top priority is having the best chance of having enough money when it is needed-- whatever the purpose. Next priority is to smooth out the ride as best as I can so as to minimize the chances of clients (or myself) doing the wrong thing at the wrong time.

As a matter of strategic preference I think it makes more sense to target the entire stock market cycle. Heeding imperfect warnings like when the SPX breaches its 200 DMA helps with avoiding the full brunt of down a lot when it happens. As an example, if a stock market cycle is five years long, if you can go along for the ride in the four bull years and miss a large chunk of the year the market is down a lot (by heeding the 200 DMA or some other indicator) then you should outperform by quite a bit over the entire cycle and smooth out the ride some. If you are lucky you might outperform in one of the up years and really have a good cycle versus the benchmark. We got lucky in 2007 with in this fashion with emerging market stocks.

Clearly this is not for everyone as people have commented here that each year does matter to them, or some folks want to make a killing every year with no regard to volatility. It is silly to say that a given approach is wrong but wrong for you is a different matter altogether. The notion of living quarter to quarter seems to make the task much more difficult in my opinion so I don't do this. In our own personal finances I hope to have enough money whenever we might need it like if one of us needs an experimental toe nail transplant that is not covered and costs $150,000 (trying to make light), I don't want to have to think twice about it. As I want this personally it logical that this philosophy plays into how I choose to manage accounts.

My philosophy probably should mean very little to you other than you should understand your own priorities as well I as understand mine. From there then, for me, the importance of one year predictions is minimal and can rotate back to the thought process behind the conclusions allowing you to take little bits of process from many places and form your own process.

The picture is a screen shot from an episode of Northern Exposure I watched over the long weekend. We own most of the series on DVD, it is one of my two all time favorite shows with the other being the shockingly profane Deadwood.
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Self Imposed Means Testing?

Yesterday on our Sunday hike (pictured to the left) I had an epiphany about social security and medicare that I think can be part of the solution. The idea has a couple of building blocks of understanding that if agreed upon make the idea more plausible. The first building block is that financially, the country has a a lot of problems that must be addressed and second that no solution can be "fair" everyone or give everyone everything they want. An equitable solution should involve everyone giving up something.

You may not like that but it is my starting point.

As we hiked a thought popped into my head; why are there caps on how much money we can put into IRAs, 401ks and the like? I know the answer on a day to day level but conceptually, should there be caps on how much we can put into qualified retirement plans?

My idea is to do away with limits on qualified contributions--sort of. In 2010 we put $5000 into a contributory IRA for Joellyn as a non working spouse (she volunteers more than full time in dog rescue), $6150 into our HSA and 25% of my income (simplified explanation) into my SEP. We also let a fair bit (relative to our circumstances) accumulate in our taxable account. We can write off the first three but obviously not that last one. The idea then would be that we could put much as possible into Joellyn's account and the SEP (HSAs work a little differently) such that anything above the limits is deducted from our future social security and medicare benefits.

This would involve some actuarial/spreadsheet work but maybe we could have put another $25,000 into our IRA in this context. This would have allowed us to reduce our taxes by quite a few thousand dollars while increasing our savings and reducing our social security benefit in the future. Doing this every year the way I am thinking would reduce our benefits to zero in all likelihood but leave us with more saved.

So far this sound like a perk for the wealthy. Here is where everyone has to give up something. People in a position to do this would be saving more, writing off more on their income taxes, phasing out their benefit but would continue to pay the same $16,000 in FICA every year. So they would be paying in the same amount and losing some or all of their future benefit in return for saving more and writing off more. Continuing to pay the full FICA may not seem fair but a real solution should be uncomfortable for everyone (repeated for emphasis). As an incentive for retiring later maybe people could stop paying FICA when they turn 65 or 70.

Given the savings problems the US has there are not a lot of people capable of participating but if something like 10% of the population could do this then it would relieve a substantial portion of the burden on the system as it would like boil down to more than 10% in dollar terms as most people doing this would be likely to otherwise qualify for the maximum benefit. Another element to this that I would add would be to make the penalties for early withdrawals from qualified accounts far more aggressive, bordering on usurious except for medical events.

Making the penalties so stiff would hopefully send a message that this is serious business and that once your money goes in it does not come out except for a medical event for you, your spouse or your kids (I am very forgiving on this issue).

As opposed to just being a perk for the wealthy, people involved are giving up a lot of security (assumes the entitlements survive) but are getting the chance to be more self sufficient. A conceptual drawback to this for me is that I think privatizing social security across the board would be disastrous with 401k results from the last eleven years as exhibit A. A solution here could involve serious education, having to pass a competency exam, a combo of both or any other idea deemed as practical.

This is probably obvious but I personally would jump at the chance to opt out one way or another but I also believe that with the mess we have that no one should get off Scott free. Maybe I am wrong but I think with this idea people still have incentive to work, make as much as they can and save as much as they can with at least an acknowledgment that we do stupid things sometimes with our money.

So, is there a starting point here for contributing to a solution? Obviously I am predisposed that it is a great idea and while blogs lend themselves to negative comments if this can be a starting point, how can it be improved to become something workable? Why not a grassroots solution? If this self imposed means testing makes any sense then maybe we can spread the idea and get it to where it needs to go to be implemented.
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Merry Christmas

James Montier's latest missive talks about reversion to the mean, tails and the folly of forecasting. One great nugget was;

fat tails often create fat pitches

The context was in taking the other side of the new normal argument for lower returns with lower volatility. Montier cited Mandelbrot from the 1960s in noting that fat tails often create the best opportunities.

The post is chock full of jargonny buzzwords that I tend not to use in my thought process or my writing although maybe in how I invest. I think investors can make use of the concept even if they don't use words like covariance, a word I'm pretty sure I've never used before, in daily conversation.

All investors have at least occasional moments of clarity that most people otherwise miss. If you have one or two in a lifetime you are an ordinary person, nothing wrong with that, and if you have a bunch then maybe you are someone like Jeremy Grantham or Marc Faber. You should definitely read the commentary, you can decide for yourself how or if it is useful.

Merry Christmas!
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The Unthinkable

You may have heard about or read about the city in Alabama that has run out of money to pay it's pensioners. Per the article this affects 40 people although the number is larger if you factor in spouses and that a few of them may have family circumstances where they care for a parent or maybe a special needs child.

This may be difficult to remember but a few years ago the idea of a public pension being unable to make payments would have been unthinkable. Fannie and Freddie going under, for all intents and purposes, was also unthinkable. Merrill Lynch is no longer a public company. There is now a debate about how many municipalities will fail. There is also a debate about how many countries in Europe will go down.

Before the financial crisis started I commented several times that Enron and Worldcom showed us that anything can fail; anything. Candidly I did not have municipalities and European countries in mind but they do fit the description of anything.

The last ten years has been a lesson in seeing the unthinkable happen or come much closer to happening than people would have ever thought and the above does not take into account issues in the US at the Federal level (debt and entitlements). It would be very easy to outdebate me on this but I cannot envision a scenario where entitlements as we now know them don't change radically. Or should I say painfully?

The solution (pain) could include means testing, reduced benefits for everyone or something else. In the article linked above the town in Alabama may reduce benefits from $3000 per month to $200 with someone quoted in there that this would not be a haircut but a scalping. Obviously I do not know how this will play out and of course we lack the political will to do anything difficult but something will have to give at some point and people will get caught completely off guard and consequently will be hurt just like anyone in Prichard, AL relying on $3000 per month looking down the barrel of a $2800 pension cut.

The McAdoo card? There was an airline analyst on CNBC yesterday with the same name.
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ETFs Prophesized by Nostradamus To End The World!

That was kind of thought I had yesterday as I read articles from three different and well regarded bloggers. Trader Mark believes they are the tail wagging the dog (in some instances), Phil's Stock World feels that when it comes to going long "we usually know how to pick a good stock for ourselves, thank you very much, that will outperform a whole index" and Barry Ritholtz re-ran a funny post about the next big thing in ETFs being single stock ETFs which will capture 99% of the common but without the dividend.

It makes me wonder who could it have been who came up with this idea...who could it possibly have been....oh, I don't know, Satan?

One big macro point to make is that for better or worse financial services and markets is an industry that evolves. Love 'em or hate 'em ETFs are part of how things are evolving currently. Trader Mark points out that hedge funds used to buy baskets of a few individual stocks to create exposure but now use ETFs which he says means that these dollars are moving the entire index.

The flip side to that might be that the same dollars would potentially be accused of manipulating far fewer stocks without the ETFs.

Phil covered a lot of ground so I will do my best to capture the correct context but he says one thing that, if I am understanding him, is flat out wrong. He notes that the US Oil Fund (USO) is a "poor tracker." Joe Terranova said essentially the same thing on Fast Money one morning (in my time zone) last week. Both say, or imply, that USO does a poor job tracking spot oil and so people should avoid the fund (actually Phil said he sells it short). USO might do a poor job tracking the spot price but, um, well, it is not supposed to track the spot price. USO tracks the front month futures contract. If the market is in contango then it will be a "bad" hold. I have said quite a few times that in addition to being right about the crude oil market you also have to be correct about the roll yield in order to have success with USO--or simply short that fund which has generally worked.

To be clear I have no use for USO as tracking the front month in an ETP has proven out to be worthless IMO but it is functioning the way it is supposed to function--tracking the front month and the consequence (or benefit) of rolling to the next month's contract.

The joke about single stock ETFs makes a point about the proliferation of funds but of course the market place sorts this out with flows into useful (intentionally vague word) funds and little to no flows into funds that for whatever reason lack utility.

The argument about picking stocks and not using ETFs is not much of an argument as an indictment for the wrapper. The idea of doing the work to research the stocks and then buying the best one ignores a lot of variables like just being wrong which happens to everyone or choosing the right stock at the wrong time or choosing the wrong stock but at the right time.

Plenty of people are successful bottoms up stock pickers but ETFs offer access for people who want most of the narrowness of stocks but who do not want single stock risk. While I do not think the Global X Lithium ETF (LIT) will ever look much different than SQM it will be more comfortable for some folks who do the work and conclude yes on lithium to buy the fund over the stock. As another example, in talking about individual stocks people say there is a limit to how many individual stocks an investor can own and maintain proper diligence on. If your number for individual stocks is five are you going to put your entire nest egg into five stocks or will you use other investment products, like maybe ETFs, to round out a diversified portfolio? On a related note ETFs require plenty of work for reasons I have mentioned in other posts but for brevity sake, won't go into here.

I am a huge believer in using whatever you think is the best product for each exposure sought for the portfolio. To repeat myself, it is illogical that any single wrapper can be the best way into every single part of the market for every investor.

As an example, a long time ago we owned BP. We sold it in Q1 2007 and swapped it for WisdomTree International Energy (DKA). Later we sold Sinopec (SNP) and increased our exposure to DKA, which we still own. Going into the bear market it made sense to me, as part of our defensive strategy, to reduce single stock risk and volatility in the sector and by extension, the portfolio. More recently we bought Suncor (SU) to increase the energy exposure and the overall long exposure of the portfolio as adding volatility back in made sense as time moved on from the March 2009 low. Very recently we sold some of the DKA and and bought the Market Vectors Coal ETF (KOL) as increasing the volatility but with the same amount long made sense to me when we did this trade. I have a list now of three or four oil stocks that could replace DKA which I will probably implement in the next couple of months or so. The remaining weight in DKA is such that it would take two or three stocks to replace it out of the four I have isolated as possible candidates.

Don't focus on whether I turn out to be right or wrong with the timing of anything as opposed to the process of ETFs being the better choice for some parts of the stock market cycle versus stocks being better at other times or a combo of the two. At times it makes more sense to take on more volatility and take more single stock risk, relatively speaking, and having multiple products in the context described about makes this easier which is where I think the utility really is.
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Odds and Ends

I meant to get to this earlier but Harvard Management Company's 13F was recently made public, listing the holdings of the small portion of the endowment managed in-house with exchange trade securities. There is rarely upheaval in the holdings but it is constructive to see what's what.

As is always the case the fund is very heavy in emerging markets. The largest holdings appear to be iShares Brazil (EWZ) by a wide margin followed by iShares FTSE/Xinhua China 25 (FXI) with those two adding up to almost one third of the portfolio. Much of the portfolio is a who's who of emerging market ETFs but there are also plenty of individual stocks in the portfolio but those positions seem to be much smaller with largest stock holding appearing to be a REIT called Pebblebrook Hotel Trust (PEB). The market cap is $809 million and HMC's position is worth $46 million. The yield is low and it has underperformed the S&P 500 by a wide margin in the last year (it's time on the market).

On another note Market Vectors has filed for an Andean fund that will focus on small and mid cap stocks. The countries will be Chile, Peru and Colombia. The mention in the filing, and the IU article of small and mid cap might be because the large companies in these markets are mid caps by US standards but that was not clear from my skimming of filing.

There was also a mention in the filing, as there always is, warning of industry concentration which is only a problem when fund holders don't realize the industry or sector concentration of what they own. The way I prefer to do things the more concentrated the better. As an example, the Global X Colombia Fund (GXG) has huge weightings in financials and energy which makes the fund easier to integrate into a portfolio where sector weightings are a concern.

Last night we watched Wall Street: Money Never Sleeps. To paraphrase Ron Burgundy, a few minutes after we bought it I immediately regretted my decision. It was truly awful.
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Interview Preview

I was asked to participate in a 2010 look back/2011 look forward sort of thing with Seeking Alpha. It will run sometime in the next couple of weeks but here is a preview of one of the eleven questions;

5) What are your expectations for commodities, the dollar and precious metals in 2011 and beyond? Will we finally start to see some real inflation in the coming year?

It makes to qualify one thing before trying to address this question which is that, inspired by John Hussman, we are focused on the portfolio result over a longer period of time like an entire stock market cycle. Going back over the last five years things like currencies and commodities have had favorable returns even if they have not done well every single year. Looking forward I can't construct a fundamental case for the US dollar but of course, like in 2008, the dollar can go up. The dollar winning an ugly contest and going up in 2011 is not what I would call a fundamental argument. I do think the euro is worse off and we are avoiding that as much as possible.

We own gold in the belief that no matter the price, if something bad happens today it will go up tomorrow--insurance. Ex-gold our commodity exposure is in the related equities for now. In the past we have had agricultural commodity exposure but for now do not. This could change at any time.

One thing I would add here is that some of the asset allocation suggestions of 20% in commodities is way too much for us. Commodities, among other things, are a source of volatility. Such a large component in such a volatile space invariably causes a lot of anguish during a down turn as people find out the hard way they had too much exposure.

As far as inflation, we already have it--inflation being an increase in the money supply. The question everyone cares about is whether it leads to price inflation. It would be hard for me to peg whether meaningful price inflation starts in 2011. What is more important to me is that the Fed and the Treasury are resorting to desperate measures to try to pump up the economy. Expecting unintended consequences is only logical. Disbelieving that Bernanke can control inflation is only logical. As our debt is not denominated in another currency I do not believe true hyperinflation is in the cards but inflation that is high enough to be a meaningful drag on the economy is easy to visualize as bond yields would have to go up to an uncomfortable (for borrowers) level.

As one anecdotal note, my health insurance premium went up 25% for the New Year.
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The Importance of Pre-Planning

When we are on the way to a wildfire one of the things we do in the truck is prepare for what we might reasonably encounter when we get there in terms of hazards, weather conditions and possible strategy based on what we might know about where we are going. This puts everyone in a more prepared frame of mind which hopefully makes for more effective fire fighting and safer fire fighting. On a related note physical preparation is also important which means drinking a water or sports drink to get in front of hydration issues.

The analogy for investing is hopefully obvious. The catalyst for this post, oddly enough was Nassim Taleb's visit to Squawkbox the other morning. While he didn't seem to have a whole lot to say I was reminded of another appearance he made with Nouriel Roubini where Robin Farzad asked both of them, after they spent ten minutes spinning an economic doomsday scenario, how to invest for a child's college education. I ripped on him pretty good for wasting the opportunity but now I wonder if he wasn't prepared.

We've all had encounters with "important" people and will again occasionally in the future. I once had a five minute conversation with Jeremy Siegel and it was nice to be able to say something more than "hey, your Jeremy Siegel."

Long before the bear market started I wrote a lot of posts about preparing mentally for bear markets because the come along every so often and catch people off guard (not predictions so much as understanding of stock market cycles). Being caught off guard creates a higher likelihood for panic selling.

There are other things to prepare for as well like a meaningful back up in yields (now or later). Another example could be with takeovers, real or rumored. This doesn't happen often but one example was Yahoo from a couple of years ago. We owned it across the board and when I woke up one morning, I flipped on CNBC I saw the name going by in the screen crawl very frequently at a much higher price, found out what was going on (Microsoft was interested) and sold it immediately. As a personal rule of thumb, I expect that any time something like that happens I would be a seller--this assumes there is a large move up in the price. A final example is from the flash crash, I disclosed doing some buying (about 20 minutes too early as it turned out) in the face of what was obviously a malfunction--I prepare for this by maintaining a couple of spreadsheets of what 2% or 3% might be for everyone so that I can react quickly.

The above examples are relevant for me. You should of course explore what would be relevant for you and then be ready. We can't account for everything which is not the point but I think as is the case with working on a wildfire and working on a diversified investment portfolio, there are quite a few reasonable scenarios that we can prepare for.

The truck is not ours obviously but the Black Timber crew helped mop up our Green Fire from a few years ago and I just thought it was a neat rig.
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Sunday Morning Coffee

Long time readers may know my disdain for Chinese banks as investments which means most (probably all) broad based China ETFs seem to me like a lousy way in. While I make no claim of originality on this idea it is nice to hear from other people with similar thoughts. Alan Abelson quoted Harald Malmgren, who among other things advises sovereign wealth funds, extensively on this.

The big challenge confronting China can be found in the nonperforming loan portfolios of its banks and kindred financial institutions. That enormous pile of deadbeat loans is the legacy of late 2008-2009, when exports dried up and the spooked rulers of the command economy ordered the banks to seriously step up their lending -- no ifs, ands or buts. The banks dutifully complied with an awesome $1 trillion in fresh lending.

Much of that huge mountain of loans has fallen into the nonperforming category, which translates from the polite banking parlance into delinquency, big time. To avoid a financial meltdown, Harald expects, Beijing will raise capital-adequacy requirements substantially during the first few months of 2011, conceivably in incremental steps to cushion the pain. Since he anticipates Chinese banks will have trouble raising capital, he expects a large-scale shrinkage in lending.

Chinese banks, he emphasizes, aren't suffering from insufficient liquidity. Rather, he warns, the danger to the country's banking system is insolvency. In the current lineup of problem banks around the world, he would rank Chinese banks as the most troubled, with European banks next, followed by U.S. banks and Japanese banks probably holding down fourth place.

As I mentioned the other day there are plenty of other ways in to China such that a very unhealthy sector (that being financials) is easily bypassed. China is an important investment destination. It has matured some and will continue to do so. For a while there in the last decade it did not matter what you bought, it all went up. This will happen again in other destinations but probably not China. The tone of my comments of course has been the need for selectivity. Personally I want no part of the banks, I also want to avoid companies that rely on US and European consumers (meaning exporters) and I've been no fan of reverse mergers either.

I think things like energy, materials, consumer stock (things Chinese people will spend money on), industrials and utilities are the best places to look, which obviously gives plenty of choices to consider.

The above is not new from me, I tend to believe there is at least some value to repetition. Case in point from yesterday's comments a reader expressed concern about getting "killed" even in short duration fixed income. While I don't know what his idea of getting killed is or what he owns I asked if mutual funds were the problem. I've been repeating the same thing about fixed income for ages now which is that prices have been at all time highs (or thereabouts) for a long time. Buying high is buying high which means there is a threat, an obvious threat, to prices going down and that whenever prices do go down it will hurt long dated paper the most. It will also hurt funds which have no par value to return to. Our largest exposure has been to short dated individual issues and short dated individual foreign sovereign issues. We have a little exposure to things going down during this but that exposure is small for exactly the reasons unfolding now.

I've talked often about not wanting to take a lot of risk in the fixed income portion of the portfolio. To my way of thinking it makes more sense to take on risk, more correctly I mean volatility, in areas like materials stocks or energy stocks as examples, not from bonds.

As I say, I do not know what this one reader is really experiencing but bigger picture a meaningful increase in interest rates is going to hurt a lot of people yet a meaningful increase in interest rates, even if we don't know when, is a very obvious call. The ten year treasury note currently yields about 3.33%. In the summer of 2006 the two year treasury could be had for 5%.
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The Big Picture for the Week of December 19, 2010

Earlier in the week I was interviewed for an article about farmland investing. I'm not sure how I was found for this or when it will run by I first explored this about two and half years ago. Coincidentally this came up in the comments on yesterday's post in terms of my interest in exploring things like farms and fisheries. I am a big believer in blending together holdings with different types of attributes in an effort to deliver a better risk adjusted result, manage the correlation of the portfolio to the broad market and manage the volatility of the portfolio compared to the broad market.

The space, that being farmland, is very difficult to access. There are a couple of US based companies that sort of fit the bill including a bulletin board stock that seems to be popular in this context but the last time I looked there was no information to try to research. I think the potential is as a foreign component to a diversified equity portfolio; a small component. If you click through to that post linked above you will see plenty of names to research some of which are gone due to take over (not aware of any failures but maybe there were), they generally have English versions of their websites and the information is not that difficult to navigate--note that I am giving the benefit of the doubt that none of these are fraudulent companies.

Another coincidence is that Alphaville linked to a post from big picture agriculture that is a great read for doing some learning. Although the post is more about actual farmland than related equities I was struck by this comment; As I stated in my recent post about this subject, I consider investing in land across borders to be very high risk. Our world faces too many insecurities and global risks to assume that new or old foreign farmland ownership contracts would be honored during times of national stress or leadership upheavals.

This is probably less of a risk if you are buying shares of an Indonesian plantation, especially in the proper moderation, but is not impossible depending on where you buy. I isolated some more practical risks in the interview. I noted that most of these names went down plenty during the financial crisis. They may not fit the bill in terms of low correlation although the extreme nature of 2008 might not be a useful test. Additionally these are capital intensive businesses, meaning a lot of them has sizable debt loads.

One of the appeals of this niche is that the businesses are so simple. They own land that is farmed, cattle for dairy and meat or both and generally these are things we understand.

Unfortunately these things are not true in the manner portrayed in that sentence. If you look at a half dozen company sites at random I think will find information about constant buying and selling of land and cattle. Being very transaction oriented, more so with the land, is not simple and most of us are unlikely to understand the nuance here. You will also see information about a lot of science and technology in terms of rotating which parcels get farmed this year versus another year, changing of crops for various reasons beyond just perceived supply and demand and different ideas about increasing efficiency of cattle management.

These things complicate the theme and buying one of these stocks boils down to a faith that the management generally knows what they are doing in this regard. This is not necessarily a bad thing or even a unique thing as I think it applies to just about any individual stock you might buy.

I've been writing about this for a while and studying/following some of them for a while now. They got hit hard in 2008, have done very well since but I have not done anything for clients yet. I find the segment to be fascinating, will continue to study/follow it and it may lead to something for clients. To the extent you can accept that investing is about patience and long term themes, this is a great example of that. It is things like this that make the job so fun.
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The Consensus Says "Up!"

The crew at Bespoke Investment Group posted the following table with 2011 predictions for the S&P 500 by all (or most) of the big Wall Street firms. Looking at these numbers has some utility at the very least in a contrarian way.

With a nod to Ken Fisher this sort of survey tends to get it very wrong and almost always comes to an average of 9-11% expected gain.

From a how markets tend to work standpoint it is difficult to envision that after a two year run for the SPX of 37% (SPX closed at 903 on Dec 31, 2008) that it can go up a lot in 2011 in the manner that some of those folks surveyed think. Obviously the market can do anything for any reason, or no reason, but to paraphrase myself from a couple of years ago--the odds of the market going up a lot after it has gone up a lot are not great.

I also believe down a lot is unlikely because we are so close to down a lot in terms of time (just back to 2008) and the market is still down about 20% from the high. As there are a lot of people in the survey calling for up a little, 5-7%, it would be easy to fade that from a contrarian viewpoint and guess that the market will be down a little. The difficulty there is that the Fed is hellbent on stoking asset prices. Forgetting for a moment the malignancy therein, equity prices are up a couple of percent, give or take, since we learned what QE2 would look like. While that is not a lot, it has not hurt equities and I'm not sure when to expect it to matter--it looks like it matters to the bond market though as yields are up some in that same period.

Circling back to when will this matter, I know that it won't be tomorrow but not sure how soon. I've been working on where in the portfolio to add more foreign exposure at the expense of some domestic exposure. As I've mentioned before things like QE are desperate measures and it makes sense to expect there to be unintended consequences at some point--I think this is only logical based on the last ten years.

An anecdote I have mentioned a few times before; I sat on a panel at a conference a few years ago and one of the other panelists was from Turkey. I asked what a typical allocation to Turkish equities might be for a Turkish investor and he said 15-20%. As time goes on I think the impression this made on me has grown, it was a great lesson about home bias and opens the door to having less and less domestic exposure.

This idea, that being more foreign, mattered a lot in the last decade and as I have been saying I believe will matter in the new decade too. Combine that with the desperate measures that are propping up the US economy and equity market and it would be reasonable to want more foreign.

This thesis made sense in the last decade but there were individual years where US equity returns were somewhat competitive. Maybe 2011 will be one of those years again or not, I don't know but I have unyielding faith that foreign will be much better to hold over the decade than domestic and I care far more about that than I do any single year like 2011.
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Building A Country Exposure

I write a lot of posts about building narrow exposures in portfolios and also about avoiding parts of the market that seem like blatant trouble spots. Obviously with a portfolio of individual stocks it is easy for a do it yourselfer to pick specific names to put in a portfolio in such a way as to avoid whatever he wants to avoid and capture whatever he wants to capture (easy is a reference to the access not the analysis). Obviously not everyone wants stocks only, ETFs are a popular tool that can allow for implementing specific inclusions and exclusions for people who take the time to look under the hood and do a little spreadsheet work.

We can use China as an example. There are broad based funds like the iShares FTSE Xinhua 25 Index Fund (FXI) and several others but they are very heavy in financial stocks which I think are big trouble waiting to happen. Anyone agreeing with me on that but who wants China via funds needs to look at some of the narrower products out there.

Someone ok with energy exposure for example, could buy the Global X China Energy ETF (CHIE) and be done with it. Some portion of the energy allocation could go into this fund and be the total allocation to China. After all China's energy consumption is going to increase. This is one part of the China market, there are others, where the money is going to be spent no matter what (does not make them immune to large declines).

Take a glance under the hood and you'll see the big oil names and big coal names (if you think you want energy exposure in China then you should know these names) which makes plenty of sense. So far so good. But as you make your way down the list you will also see a couple of solar stocks. Actually you will see quite a few solar stocks; about 14% by my rough count. It is possible that money should be spent on solar energy but for now it does not have to be like with oil, coal and natural gas. The solar stocks also seem to have different volatility characteristics. The 14% could be enough to be a drag on the fund versus another way in to the sector.

Energy is not the only way in to China. Anyone who has studied the country could reasonably conclude there might be three or four ways in for them along with one or two they would avoid. For anyone wanting China I think energy is one way in, also infrastructure (think industrials and utilities) and consumer items (things that Chinese people buy with almost inelastic demand).

For a while we have owned the iShares Emerging Market Infrastructure Fund (EMIF) which has a 24% weight to China. Recently we added the Market Vectors Coal ETF (KOL) which has a 20% weight to China. The size of the two funds in the portfolio still leaves us underweight what would be a "normal" allocation to China but you can see where I am going. An increase in either fund obviously increases China's weight as would adding something like the EG Shares Emerging Market Consumer ETF (ECON) which allocates 9% or the Global X China Consumer ETF (CHIQ). ECON would only increase the China exposure a little whereas CHIQ, being 100% China, could really increase the portfolio weight depending on how much was bought.

You may prefer other exposures for China of course, or none at all, but the idea of pulling a country exposure together via several, but different, segments of the market can be a good way to go for someone who is trying to manage their portfolio's volatility.

Finally something very cool on a personal level related to the Fire Department. Every March all of the fire departments in the area have a joint training exercise that we have always participated in but this year we, actually me, are involved with the planning which is either a first for Walker Fire or it has been a very long time since we've been involved at this level. I'm the secretary which puts me in the middle of a lot of the communication that goes into pulling this off. My hope is that this will allow us to integrate a little more into the Prescott fire community; anyway I'm pretty excited about this.
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ETF Argument, This Nerd Weighs In

The fallout and debate from both the Kauffman Report and Bogan Paper continues to flow which is a positive for anyone trying to figure out their best way to construct a portfolio. The latest contribution to the discussion comes from Kendall Anderson in a post called Seven Questions For ETF Investors. Quite candidly it is not crystal clear which side Anderson is taking as after excerpting Matt Hougan from a couple of sources all the article does is ask seven questions. It seems as though he favors individual stocks over ETFs as the tone of the questions is along the lines of how can looking at an entire market or economy be simpler than looking at one individual stock but I am not 100% certain. My post will presume that Anderson is not a fan of ETFs.

Anderson takes Matt to task for saying "the truth of the matter is that most individual investors have no business owing individual stocks as the core of their portfolios.It’s impossible to get truly diversified, and even harder to stay up on the research for more than a handful of securities." Later in the post Anderson circles back and asks rhetorically how many securities does it take to get truly diversified and how many securities is a handful?

Both points of view miss the mark. The notion that most individual investors have no business with individual stocks is a gross generalization. As I have said many times I think portfolio construction will boil down to time available to spend on the task. Someone who is interested enough in investing to spend a couple of hours on Saturday morning and 20 minutes every night during the week could probably handle a couple of stocks integrated into a portfolio of funds (exchange traded or otherwise).

However one builds a portfolio, it will be a series of different exposures that come together to form some combo that is expected to deliver something close to the desired result. For the portfolios I construct, I want a globally diversified portfolio that avoids big bets. Whatever number of exposures you think is ideal, for me the number is between 30 and 40 for accounts above a certain size, you must select something for each of those exposures. In this context I will say you owe it to yourself to seek out the best possible way to capture that exposure, in your opinion, and be agnostic about the wrapper. To repeat from past posts, it makes no sense that any one wrapper can possibly be the best wrapper for all segments of the market.

From the top down an investor wanting to buy Colombia might do some research and find the Global X Colombia ETF (GXG) and Bancolombia (CIB). The two correlate very closely and while I am not sure which one would be "better" it is easy to imagine that someone doing some research would draw some conclusion about which one is better. If you are a fund investor and think the stock would be the better choice are you really going to buy the fund instead?

From the bottom up an investor wanting smartphone exposure might stumble across Apple (AAPL), Research in Motion (RIMM) or an ETF like QQQQ which allocates 19% to AAPL. The best way in is in the eye of the beholder but why would someone put money into what they think is the second best way in? Your own time constraints, assuming ordinary acumen, will dictate how narrow your portfolio should be.

Anderson makes a point about simplicity that I think also misses the mark. He asks "How can it be easier to analyze the S&P 500 Index than it can be to analyze IBM (IBM) or Cisco (CSCO), when IBM and Cisco are just two of the 500 companies included in the index?" and "do you really think it is easier to analyze the Chinese or U.S. economies than it is to analyze an individual company such as IBM or Cisco?" There can be no single, always correct answer to this line of questioning.

To answer the first question if the S&P 500 is below its 200 DMA demand for equities can be thought of as being unhealthy. This analysis can be done as fast as your ISP can load the page. This is of course a top down concept but has served me well thus far. Another example; Ireland's debt to GDP is how big and where might it go? If you have no idea then it would probably take anywhere from two to ten minutes with a search engine.

Figuring out what to avoid can be just as important as figuring out what to buy; this is ground we've covered many times over the years. Sometimes sizing up a country can be pretty simple. Sizing up a stock might be more complicated that that but it might not, again there is no single answer.

Maybe other people need to dig in to defend a position but you do not. Be product agnostic and use whatever tool that best captures each exposure you want in your portfolio.
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Ripped By A Reader

A reader at Seeking Alpha took me to task on several fronts in recent blog post about retirement saving and planning. The reader includes some of his philosophy, some math and appears to make a few assumptions about me personally.

His comment;

I take issue with a comment in the original article. "That people apparently think so highly of $300,000 is a commentary about financial illiteracy. Assuming someone could make it on $12,000 plus social security, they would be blown up after their first five-figure unexpected event "

First, let me tell you that I am far from financially illiterate. In addition to having a good education I believe I am much better in touch with the finances of the common person than the writer of the article and many of the commentators.

I, indeed, will live at least the next couple of years on my social security of $24,000 + another $12,000 for a total of $36,000 as my IRA hopefully continues to increase.The $36,000 is enough to cover the my basic expenses, the healthcare needs I have beyond what is covered by Medicare and a companion plan, plus enough to take one trip a year to visit my children and grandchildren. I have never had and cannot imagine ever having a 5 figure emergency. I can buy a serviceable car for much less than that, I know of no medical expense for which I am not covered which could cost that much. The villa I have in a condo association is covered by the condo maintenance agreement for repairs and insurance against any disaster. I am no longer married so the potential of a financially devistating divorce is not a possibility. I also keep a few months income in a savings account should an unexpected need arise. Many people would envy my situation.

I know of numbers of people who had no opportunity to continue their educations beyond high school, and during their 30's when some suggest they start saving were lucky to be able to put food on the table for their children even with the availability of food stamps, or prior to that program, with government surplus food. Many of these people, with a lot of hard work, made it into the lower middle class at some point in their lives but were pushed back into poverty as the wealth in this country became more unequally distributed to those at the top.

I also take issue with the 4% rule, though from a different perspective. Let us consider a hypothetical situation. Let's assume that a person retired December 31, 2009 at the age of 65 with $300,000. Let's give him a continuing life expectancy of 25 years, to age 90, which is much longer than average. Let's also look at a historically plausible rate of return of 7%, and 3% inflation. He could draw from his $300,000 investment $18,578 in 2010, and the same amount in 2010 dollar equivalent amounts for the rest of his life. Assuming the above 3% rate of inflation this would be $18,525 in 2015, $24,537 in 2015, $24,968 in 2020 and so on with $33,555 in 2030 and a final payment at the beginning of 2034 of $37,766 for a total payout of $677,363 over his 25 year retirement.

Should he or she wish to provide an income until age 95, and if the annual amount earned on investments was only 5.5% and the inflation rate 2.5%, on the same $300,000 the initial payment would be $14,928 which would grow to $19,909 in 10 years, $24,462 in 20 years and $30,500 after 30 years. The total payout would be $655,400 over the 30 years until age 95.

Of course the balance at the end would be zero; this is not an eat your cake and have it too scheme which some of the wealthy have come to expect; it is a plan which with social security would enable a person to have nearly $40,000 a year, in today's dollars, pretty near today's median income, for a long retirement.

Of course, $300,000 will also buy a pretty nice lifetime annuity too.

What you say? You want to retire before you can get full social security benefits or qualify for Medicare? Indeed, why work at all? If your daddy was affluent enough and his daddy too maybe you don't have to and really have no concept of the life of the working man from your priveledged perspective. After all, you're well educated, think anyone can save a million dollars, and the concept of living on $35,000 or $40,000 is foreign to you anyway.

As for those who are lifelong wage slaves, less well educated than you, are not as astute at planning as you and think luxury is a double-wide, $300,000 an unimaginable and huge sum and spent their lives trying to put bread on the table, "Let them eat cake."

My unedited reply;

Lengthy reply with a lot to chew on, thank you.

Your comment "I have never had and cannot imagine ever having a 5 figure emergency." I've never had that type of emergency either but it happens. Not being able to imagine it is not a reason to think it can't happen. Having been in this business for a while, all i can tell you is people get blindsided (whether they should have seen something coming is a different issue) all the time.

Next up "Let's also look at a historically plausible rate of return of 7%." If you get a Stock Trader's Almanac you will quickly see that returns are much lumpier than any average number that might be calculated which makes the rest of the scenario difficult to rely on. Do some more reading about this and you'll see that financial plans blow up all the time for relying on exactly the assumptions you make about returns. This may not resonate with you of course but I have worked in many phases of this business and I am telling you over reliance on this is bad news waiting to happen.

I'm not sure if you're comments about lifestyle, education and wealthy parents is directed at me or not but as I have disclosed countless times we live in an 1100 square foot cabin in the woods that we bought for $87,000 in 1998 that we gutted ourselves and worked on ourselves paying as we went. While I am at one of our cars is a 2000 SUV and the other a 2006 pick up truck. I have a BA from San Diego State University and while that was a fun time no one has ever been too impressed to hear about SDSU. As for retiring early, I don't ever want to retire, I love my work and plan to continue as long as I am mentally capable. And as for wealthy parents, one of my great lessons in life was watching the self inflicted financial mistakes my parents made that made their life much difficult than it had to be (both are alive, not sure the best way to word that part).

I may not be in touch with peoples financial situations beyond our client base, as you say, but I am in touch with how to make a financial plan work, how to increase the odds of failure and the behaviors consistent with both.

Needless to say the collapse of the roof at the Metrodome in Minneapolis due to the weight of snow while tragic for the building was great that no one was in harms way and because no one was hurt can serve as a humorous investment analogy for a long time.
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The Big Picture for the Week of December 12, 2010

Short post due to a jam packed weekend.

As we are starting to see 2011 predictions come out they seem to be awfully bullish. After going up 25% in 2009 and what might be 11% in 2010 against a lousy fundamental background where just about every positive number coming through can be attributed at least in part to some sort of desperate action by the Fed or the government I'm not sure where the bullishness comes from.

Given the totality of the situation I can't construct a bullish fundamental case for the US. Don't confuse that with the fact that the market can go up a lot at any time for no reason at all. There was a reason in 2009 as previous to that there had been a truly violent decline and truly violent declines usually retrace some portion of what was lost and do so quickly--I've made this point before, the market action through all of this has not been something new. The market got scared, dropped a lot and retraced a large portion. This is very normal market behavior.

If you want to tell us that the things causing the market action are not normal, then you are making a different point. It might be a true point (I believe it is) but it is a different point.

In terms of trying to figure out what the market might do in 2011, I obviously don't know but it is a good bet that it will not be down a lot. This opinion should not be taken a a bullish argument for domestic equities as down a little is plausible but the opinion that down a lot is unlikely is more about how markets tend to work than anything else.

At 1240 the S&P 500 is at a level that was first reached in January 1999. We are talking about a 12 year, extremely bumpy ride to nowhere. Markets correct not only in price but also time. There is an argument to be made that much of the crisis started being priced in a long time ago--the market is a forward looking indicator at times. Additionally after dropping 50% recently (this after marginally making a new high from 2000) the market is still down 23% from that high.

Again this is not a bullish argument just a consistent belief that while the details have been different the market reactions have not been.

The picture is the square and courthouse in downtown Prescott last night at Acker Music Night a long time tradition on the second Friday in December.
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Simple Is Usually Better

IndexUniverse posted a blurb about a new FTSE index that will weight "emerging market" countries by investor fund flows subject to some sort of market cap weighting process. I take this to mean that Slovakia could never be 18% of the index like China is of the EEM fund but maybe Slovakia could range from something like 0-4% based on fund flows as a made up example.

It is unlikely that this index is being created purely as an academic exercise. No doubt they hope to see someone create an investable product like an ETF. These markets have been hot so it is plausible that someone would think there would be demand for such a product.

Strategic funds like this are a mixed bag. Some turn out to be pretty good and some stink and there is no way to know ahead of time whether a particular product will be the former or the latter as all of them backtest very well (there would be no fund if the backtest stunk).

There are a lot of strategic funds out there with more on the way ranging from broad exposures that are intended to beat the market like 130/30 funds to what I'll call narrow effect funds like some of the hedge fund strategy replicators from IndexIQ.

While it is impossible to know what people perceive as they read my posts about portfolio construction (some will think it is simple while some might think it complex) but the vast majority of what we own are simple tools, either an individual stock or plain vanilla ETF, to capture just about every desired exposure we have.

During the panel that I moderated the other day at the Superbowl Of Indexing, Scott Burns (panelist from Morningstar) asked me "well, you actually use these what do you do?" So I gave the example of Colombia which is a country we do not own. I said, paraphrasing, being top down that once I decided I wanted in, I would then try to figure the best way in. That might be the Global X Colombia ETF (GXG), Ecopertrol (EC) or the big cement company. If I had thought it was appropriate to elaborate I would have noted GXG's very heavy weighting in financials which would have required a pretty good study of whether I want Colombian financials or not.

The example above would boil down to a plain vanilla ETF versus a couple of stocks. Between the two I would say a stock is a simpler product than an ETF even if would require more work. With a strategically complicated product like a 130/30 or the above fund flow index you run the risk of the strategy not working maybe because of something like things that worked in the last five years not working in the next five years or maybe poor implementation.

A non plain vanilla product, maybe it owns swaps, futures or some other derivatives, runs the risk of malfunctioning or otherwise not doing what investors "expect" during some sort of extreme market event for reasons that may or may not be understandable. Lacking of understanding is something that can lead to panicked reactions at the wrong time. As I said during the flash crash (literally) an individual stock does not go from $50 to a penny in 20 minutes on no news. This sort of thing is a malfunction bigger than any one stock and will be corrected soon enough. This statement is potentially less true with some complex product relying on levered counter parties to function.
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These Numbers Can't Be Correct

Early in the day yesterday CNBC mentioned something about middle class Americans thinking they need $300,000 for retirement but only having 7% of that figure saved so far. My brother sent me the link to a recap of all of this, it is a Wells Fargo study, from Yahoo Finance. There was also a stat in there about the average savings for people ages 50-59 being $29,000.

I find these numbers to be very hard to believe. I seem to remember there being studies from a couple of years ago when the market was much lower that cited averages being in the mid $40,000s an another study with a number closer to $80,000. So the market is up 75% from the low but averages savings has cut in half (or more)? Could people really have taken enough out to pay their bills such that the average balance is that low after the market has gone up so much?

Regardless of the accuracy of the number--there is no way I believe $20,000 is a representative number--none of the above dollar figures are good in terms of thinking about the country's various looming problems. The numbers are bad on multiple levels actually.

The first thing is that the entire framework is defective in that the sample size thinks they only need $300,000 to fund their retirement. Here I am thinking that by "retirement" they mean something pretty close to a life of leisurely pursuits in a conventional sense. In many past posts I've mentioned the 4% rule for portfolio withdrawal, more specifically 1% per quarter, with the context being whatever you got 4%. Generally speaking this is a widely adopted rule of thumb that I can tell you many people have trouble with and to add another layer of futility some in the industry are now questioning whether 4% is too much to be sustainable. It seems like this is gaining traction.

That people apparently think so highly of $300,000 is a commentary about financial illiteracy. Assuming someone could make it on $12,000 plus social security, they would be blown up after their first five figure unexpected event (more on this below).

It is difficult to generalize and say people should save more money but of course for everyone who does not save the way they should there is surely a story behind their lack of savings. You should save more is easy to say but actually doing this requires people taking their own initiative not someone telling them.

To circle back to retirement difficulties I've brought up before; $1 million certainly sounds like a lot of money. Using the 4% rule that would generate $40,000 per year. Unfortunately the typical person who accumulates that much in savings did so while living a lifestyle that was much larger than $40,000. This is a square peg (maybe a $100,000 lifestyle) round hole ($40,000 plus social security) situation. Something will have to give.

There is another point that I have made before that showed up in at least one of the comments on the article as follows;

I retired this year and my largest expense in health insurance that costs me in excess of $1,200 a month. I could go on and on, the facts are unless you have income from multiple sources your screwed. I set a monthly goal and every month I get an unexpected bill. I will probably have to go back to work.

The dreaded one-off expense! I don't know how many times I've written about this and the commenter has one every month. Things like new tires, unexpected dental events, unexpected veterinary events, something with your house and there are plenty more examples. While these things cannot be specifically planned for the prudent course of action might be that whatever monthly number you think you can live on, pad it by $1000. Another $12,000 per year means another $300,000 in the portfolio. I'm sure no one thinks that would be easy.

Clearly some folks who want a conventional retirement will save enough money to do so successfully but that will not be the majority. The sooner everyone looks themselves in the mirror, figures out where they are in relation to where they need to be and accepts that they must live within their means the sooner they can figure out their own solution.

Two things that I would focus on is getting the overhead down and find something you love to do and figure out how to make a little money doing it. Someone who is 55 and wants to "retire" at 65 has ten years to figure out how to do this. A monthly lifestyle of $4000, with another $1000 for one-off and another $5000 a year for a vacation requires $1,625,000 to work as a portfolio-only solution. If social security is still functioning that might be $2500-$3000 per month and if another $1000 can from some sort of enjoyable vocation then the portfolio need drops to $425,000 (although having more than that would be better).

There is nothing about this that will be easy. However much you can save, try to save more. To paraphrase Woody Allen, there is no problem where having more money made it worse.
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Superbowl Follow Up

During the Q&A of the emerging markets panel I sat on at the Superbowl of Indexing an audience member asked a reasonably skeptical question about the valuations of emerging markets. He noted that PE ratios are now generally in the mid teens and he wondered why the panel wasn't more skeptical or maybe more guarded in our outlooks.

While I would note that the context of the panel was long term fundamentals there was not much in the way of caution other than my talking about small weightings to each country. Part of my reply to this question was to note that PE ratios for emerging market stocks used to be in the mid to high single digits and I stressed that this was important for anyone investing here to understand.

After thinking about this some more I think there is a more productive way to address the issue. First, the person asked about emerging market PE ratios. This frames the issue as if all emerging markets are the same thing which of course they are not--early on on the panel I said I thought the term emerging markets is useless and talked a little about looking a the story on the ground, the things to look at in terms of economic stats and demographics.

I'll repeat that the term emerging market has lost most or all of its meaning. Many of the emerging markets had their debt crises years ago and are now far less indebted than the developed markets--in many instances. Every investment destination on the planet has attributes, positives and negatives. This includes stories on the ground, valuations and everything else. There is also the dynamic of how each country, depending on how it is accessed, interacts with the other countries and how they are accessed in the portfolio.

The nature of the current event has been to punish countries with the largest debt problems. As "the worst crisis in 80 years" it stands to last a while longer. If you agree with that line of thinking then it makes sense to avoid or underweight the countries that have the largest debt problems. Taking the largest debtors off the table leaves plenty of destinations with all sorts of attributes to choose from and while plenty of them are emerging or frontier I would say in this context a country being healthier debt-wise is more important than the label of emerging or developed.

From there anyone buying at the country level then needs to analyze each country on the totality of its merits. Someone who places a high priority on PE ratios would not buy something with a high PE ratio. Of course even if a country has a high PE ratio there will be stocks in that market with low PE ratios. The decision to buy or avoid should boil down to how you weigh the various attributes that comprise the story. Long time readers will know I've gone back and forth a few times with China being in, then out, in again, out again and now in but underweight via a couple of thematic (not China specific) ETFs. Decisions along these lines cannot always be correct of course but a reasonable process for country selection is possible for people inclined to put the time in.

The motorcycle is real. I saw one in an add on Facebook and tracked down the website using the search term one wheeled crotch rocket and this showed up on the first page with no pornographic search results.
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Useful ETF Tip (seriously)

One of my duties at the Superbowl of Indexing conference was to moderate a panel of ETF heavyweights to discuss the current state of the industry--I've done a lot of conference gigs now and this was by far largest audience for any segment where I was directly involved.

In the preplanning we all had a conversation about what direction we wanted the conversation to take. One item that came up was about one of the quirks about ETFs that Mariana Bush from Wells Fargo described very succinctly.

In thinking about ETFs being access to various spaces we should expect "problems" to arise when the fund is more liquid than the things that the funds own. The context of the conversation was muni bonds and high yield bonds. If the bonds themselves are not that liquid then pricing of the bonds, which is where the IIV (ETF equivalent of NAV) is derived from, may not be the best reflection of price when compared to an ETF that is always being priced in the equity market, so to speak. This can cause discrepancies between the IIV and the market price which can be magnified during certain market conditions as was the case after the Lehman Brothers collapse.

Short post as I had a hectic weekend. I drove to San Diego to see San Diego State hoops beat Wichita State with some college buddies Saturday night, back to Phoenix for the conference yesterday and that drive take you through Gila Bend which is where yesterday's Space Age Lodge photo came from and today's picture of the Gila Bend Municipal Airport.
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Brite Wite ETF

As I'll be spending most of the day at the Superbowl of Indexing talking about ETFs, a short post about a new fund might be warranted.

On Friday ETF Securities debuted the ETFS Physical White Metal Basket Shares (WITE) which equally weights silver, platinum and palladium. WITE comes on the heels of the recently listed GLTR fund which equally weights the same three plus gold. It seems to me that WITE offers more utility than GLTR despite having less diversification.

The idea here is that gold has far more psychological value with just about no industrial considerations. The other precious metals obviously have industrial uses which makes them less predictable in the face of some sort of external shock. As a reminder my primary motive in owning gold across the board is the expectation that in the face of some sort of external shock it will go up. Obviously it has gone up for other reasons over the last few years as well. A long time ago in this context I said that I don't root for gold to do well because if it is the best performer you own then chances are stocks aren't doing very well which is about right for the last few years.

With GLTR it seems like gold doesn't get enough weight in the fund. I like the idea of access to the other metals without picking between the three but having the opportunity to give gold a larger weight in the portfolio over the white metals. Gold is much easier to buy and keep because it is not any sort of proxy for economic activity.

Zooming out a little there have been a lot of new funds to come out in the last few months (this statement is always true, isn't it?) and I can see working in ETFs into parts of the portfolio that I had not thought of before but this is becoming important for accessing narrow spaces in foreign markets that for now are not very liquid with individual stocks which is obviously a focus of mine.

It is pretty amusing to me that I stumbled onto something good with the Chinese tollroads but frustrating that the volume is not enough to accommodate our rather small client base. There are other names as well where this is the case and the reason to bring this up is that you as an individual do not have the same sort of liquidity constraints and these companies can be understood and analyzed if you can give it adequate time.
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Sunday Morning Coffee

A blogger named Alex Trias had an interesting post the other day about how to invest during retirement. The article gave a detailed portfolio concept in terms of generating income that readers may find of some use. I don't agree with everything but there is plenty of utility to the article and I would also add that people also need to be more open to non-market components to their retirement solution.

Of more interest to me was one of the comments from a reader who called himself Factation and his Seven Rules For Investing In Retirement--although the rules seemed broader than that.

1) Eliminate all debt. Debt is slavery. I've never thought of debt as slavery but obviously am on board with getting out from under. We paid off our mortgage on our Prescott cabin years ago and other than our brief foray into Hilo have been debt free for a while. No debt gives a very big margin for error in terms of dealing with the unexpected.

2) Peace of mind fund. Social Security plus three years of cash or cash equivalency's to live on. Estimate your prospective requirements. I'm not sure how much cash one should keep. We have more than three years worth but our fixed expenses are very low. How much cash do you feel you need in order to ride out something difficult? Whatever your answer, that should be what you have or should be what you are working to accumulate.

3) Invest only in high quality, dividend producing stocks, and only sell if the investment fails to meet requirements. Do not trade. I view this one differently. If you believe in having a diversified portfolio then you would have stocks with varying types of attributes. Yes it may make sense to favor some particular part of the market but owning only one type of investment assumes more risk than I think most people would realize.

4) Only withdraw necessary minimum from tax deferred accounts. I can't argue with that but I would say that getting some help on the best way to pay yourself is a good idea.

5) Own the residence or residences you live in, debt free. From a numbers standpoint, paying off the mortgage with a lump sum was a bad idea but those waters have muddied in the last few years. I have always felt that this was really a sleep factor issue. We paid our place off when I was 38 (the original note was only $57,000) and it does make for peace of mind.

6) Live frugally, and you will have peace of mind and hopefully, good health. I am all for living below your means but good health requires vigorous exercise and while we're at it, elimination of soda. Living below your means could lower stress over money issues too which could also contribute to good health.

7) Do not be envious of any one, or anything else. This is not something I think about or write about so I don't really have anything to add here.

A bigger picture concept to tie all this together might be a quote from our friend Bill here in Walker that I have referenced here many times before; you can figure it out now or you can figure it out later but you'll be much happier if you can figure it out now.

Good stuff Factation, thank you.
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The Big Picture for the Week of December 5, 2010

IndexUniverse posted an interview with Jack Bogle with all sorts of things to talk about. Bogle is obviously one of the biggest proponents of the most passive of index investing, he might be rightly considered the father of indexing. I have noted many times before that when pressed into giving an opinion about nearer term trends he has a track record for pretty good calls. That does not change his mantra of buy and then hold but his insights are useful. The fact that he is very opinionated also makes for good discussion.

Bogle thinks ETFs are great marketing tools but that the 770 (his number) funds that target narrow parts of the market is "problem one." He goes on to say that "these ETFs are basically encouraging you to take market sector risk. I should say it’s not working very well."

Not working well is not defined by Bogle and seems to be impossible to define numerically let alone as vaguely as Bogle seems to do. Many sector funds have a lot of assets and trading volume (more on his thoughts about trading later) so they are successful products. The ones that lack assets and volume are not successful (yet?) and so might close depending on other factors.

As far as end user success this seems particularly impossible to quantify. It is easy to envision some people having success and other folks not. Almost any investment product can be used in the most conservative of investment policies or for the wildest of speculative trading. Obviously a major focus of this site has been blending together narrow exposures to create a particular portfolio effect. There have obviously been countless studies showing that blending together different, but volatile, betas makes for a lower overall volatility.

In talking about who has control of the market Bogle said "There's a place for both (investors and speculators), but in the long run, investors should be driving the market, not speculators."

Should isn't very constructive in building an investment portfolio. Speculators, maybe just for now or not, are liquidity. They are what makes the market function more so than someone like me who has had quite a few positions for more than five years with the hope of holding them literally forever.

If you want a one or two penny spread in the fund or stock that you are looking buy or sell, it is a good bet that you are relying on what Bogle would call speculators to make that market. If you are not a speculator I would suggest focusing more on how to function in a world of speculators more than anything else.

Bogle also feels there should be a "transaction tax." He notes that the regulated commission structure from the 1970s, and earlier, served the same role as what he has in mind by making trading prohibitively expensive. I think quite obviously something like this, although it will obviously never happen, would cause a meaningful disruption in the markets what would adversely affect everyone and then I have to believe the industry would figure a work around and move forward.

Whatever direction the investment world goes in, there will be some that thrive and some that flounder. This is universally correct and so the most important thing becomes figuring your place in the investment world.
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Don't Be A Sucker

Don't be a sucker was essentially Nassim Taleb's answer yesterday when asked on CNBC what people should do with their money. He started to say "that is the problem with CNBC" but he managed to pull himself out of that nose dive and made it a productive discussion, in my estimation anyway.

Long time readers will know that I have been essentially saying the same thing in terms of figuring out what to avoid. Quite the opposite of needing to be one of the world's great thinkers figuring out what to avoid is more than simple it is simplistic, requires no supreme intellect or predilection to use the word robust (that last one was a humor attempt).

This last event was very easy to see trouble coming (although gauging magnitude was more difficult) for all the things I wrote about beforehand; financial's weight in the S&P 500, the inversion of the yield curve and the slow rolling over of the market starting in October 2007 giving plenty of time to get out. This required no intelligence, I did not "invent" any of these things. Anyone smart enough to understand what was happening in the real estate market at the time did all the better in figuring what to avoid.

Look at the world today, what should be avoided? Avoiding Europe might even be an easier call than financials a few years ago. Two countries have received bailouts in a span of six months and the path to contagion is very easy to construct with almost no analysis. This may seem a little assy on my part but market participants are weighing whether the worst crisis in 80 years in the US is finally done and whether the bailouts in the European union will cause the need for more bailouts.

The deeper you can to go the more unanswerable questions there are and while it is certainly possible there will be no more follow through on these issues in terms of equity prices, why take the chance on being "a sucker?" To borrow from yesterday's post; if the above pertained to Paraguay (just an example that is not really an accessible investment destination) it would take you one minute to decide no way.

The list of countries not touched by any of this, fundamentally, is very long; the Scandies, much of Asia, Canada, Antipodes, Latin America should be enough to get you started. There are also companies in the US that bypass the fundamentals of the crisis. This is not to say that there will be no need for defensive action in the future or that correlations won't go to one again but bypassing the heart of the trouble spots means you more likely only have to confront market risk as opposed to business risk. "Market risk" is really more about volatility whereas "business risk" is far more serious as anyone who owns Citigroup above $40 will tell you.
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