October 2009

Showing newest 15 of 27 posts from October 2009. Show older posts

A Better Way to Buy the Stock Market

Do you want to get exposure to the stock market, but are worried about losses, volatility, and picking the wrong time to invest? If you don't want excessive risk, but have access to a margin account, here is an option - synthetic long exposure.

You can:

Buy the inverse S&P 500 ETF with the ticker symbol SH, and

Short the double inverse S&P 500 ETF with the ticker symbol SDS.

If you put an equal dollar amount in both of these trades, this creates an unleveraged long exposure that benefits from the negative compounding effects of leveraged ETFs. Simply put, if you put 1 dollar into each of these securities, it is the same effect of being long 1 dollar of SPY, with guaranteed outperformance over time. Notice, though, that you need to rebalance the holdings at times to maintain an unleveraged exposure.

Here is how the strategy would have done over the past 3 years:

Notice that it is at all time highs, about 12% above the 2007 market highs. By comparison, the S&P 500 is currently about 29% below it's all time high from October 2007.

If you have access to a brokerage account with lower margin interest rates like Interactive Brokers, these are definitely returns above the market with less risk.

NOTE: Do not put your entire account into this trade. Only use it as part of a portfolio, and consult an advisor first. If you don't understand margin accounts, this trade is not for you.

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Understand How the Wall Street Game is Played

Many people claim that Wall Street is a rigged game, where salesmen are more concerned with their profits than yours. Two of the most common examples are mutual funds and stock research.

Numerous studies conclude that mutual funds outperform their ETF cousins, because managers cannot outperform the market after fees. Because markets are efficient. Efficient market research aside, what is the purpose of a mutual fund? Fund companies maintain mutual funds to gain as much revenues as possible, Of course the fund company is more interested in making money than being optimal for your portfolio.

Why Mutual Funds Underperform

Investors display a curious psychology that reviles losses more than it likes profits. A losing fund will shed assets much quicker than a fund that beats the market. True investment greats that have periods of lagging the market but long term outperformance will see money flows into the fund after good runs and out flows in other times. The best way to keep growing assets is to never underperform by more than your peers. So with funds in the same Morningstar style box, you see herding behavior in and out of the same stocks. You won't deviate greatly from the market return, but that is not the point.

If you take away the benchmarks and the herding investors, what happens? Hedge funds have no benchmarks (just an absolute return mandate) and investors generally can only get out quarterly, instead of daily. They beat the market handily on a risk adjusted basis, but a large portion of their aggregate outperformance is gobbled up by high fees. One solution is Alphaclone, which is a service by which you get invest in hedge fund positions without paying the fees. Or you can choose a mutual fund that doesn't have asset gathering as it's main focus. Examples include Hussman Funds and GMO.

Stock Research

Everyone knows that stock analysts have an aversion to sell ratings. The fact is that sell ratings don't make much money. Banks and investment banks want to get other business from the rated companies, including bond and equity issuance deals. The end result is that a firm must be quite bad to get a sell rating. Hold ratings exist for when an analyst is cautious about future stock performance, but doesn't want to issue a sell rating. In my opinion, the best types of ratings systems are the "peer perform/underperform/outperform" systems. But the best system is not to rely on Wall Street stock research at all. Check out the percentage of sell ratings:

Notice that they stayed at 5% throughout the crisis. Analyst ratings are generally a lagging indicator, telling you more about the recent past than the future.

Wall Street has many problems with it, but when you understand that they are in the business of making money more than helping investors, it will help your portfolio.

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Beating Inflation in an ETF

This should be interesting, per Index Universe:

IndexIQ launched a new exchange-traded fund today designed to capitalize on investors’ fear of inflation.
The new IQ CPI Inflation Hedged ETF (NYSEArca: CPI) is designed to provide a “real return” of 2-3 percent above the rolling 12-month Consumer Price Index.
CPI is an ETF of ETFs. Component ETFs are chosen by a rules-based strategy that considers the historical performance of various asset classes during inflationary environments. For instance, as inflation expectations rise, the fund will allocate toward short-term bonds and away from long-term bonds, as one would expect long bonds to decline in an inflationary environment.

Also:

Based on backtested results, CPI would have delivered 4.98 percent returns over the past five years with just 1.90 percent volatility. That is a similar return with much less volatility than the Barclays Capital TIPS Index. Investors often turn to TIPS when they look for inflation protection, despite the somewhat weak correlation between TIPS and the CPI.
Of course, investors will have to determine how much they trust IndexIQ’s backtested results before they adopt the strategy. The prospectus notes that the strategy is based on historical correlations, and there is no guarantee that those correlations will hold in the future.

These are great returns. However, it just states the backtested returns for the previous 5 years. ETFs sound like passive indexes, but this is just an active bond allocation strategy in ETF form. If you don't believe that active strategies can be winners over the long run, look elsewhere.

Get the prospectus for the fund here.

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Stock Profit Margins and Fairy Tales

The current stock market prices are discounting a return to peak corporate profit margins. As you can see from the picture, the margins of the last 15 years have spent most of their time above the normal trend. This exuberance is no indication of what stock prices will do in the next few months, but over the next 30 years, it will be difficult for corporate profit margins to meet current expectations. In an era of rising interest rates, though, this will likely not affect the return premium of stocks over bonds too much.

This is just another indicator that either momentum is ruling this rally, or the prevailing mindset is that the price to earnings ratios of the last 15 years are the normal action, and not the exception.

Once the baby boomers start retiring in force, it may be difficult to keep the earnings multiples as high as they are now.

Chart Source: Hussman Funds

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Protect your Shriveling Assets

Much has been made of gold increasing and dollar declining, both here and on other sites. However, for the majority of investors, this focus on precious metals and commodity plays is shortsighted. Once a person takes notice of the purchasing power of their assets, and how to preserve it, they should move to find ways to diversify and maintain an all-weather portfolio. As the picture above notes, the purchasing power of the S&P 500 has not recovered much in this recent rally. In fact, it has regained barely a third of the decline since the 2007 peak.

If you wonder how investors in other countries have fared, see the following chart. Notice how foreign investors vastly underperformed in '07-early '08, and again in the latest market rally. Their currencies have seen large increases against the dollar, the the point where Australian and Japanese investors are decimated in their US investments. We need to take advantage of unhedged foreign investments to maintain purchasing power.

One bulge bracket research group earlier this week recommended a 50/50 domestic/international allocation to stocks to us this week. Likely in the near future many will recommend weighting assets based on percentage of world GDP for the best diversification. Just remember that rarely does something happen in the market when everyone expects it. Everyone is calling for a dollar decline and a gold bull market. The dollar will decline eventually by a large degree, but with sentiment at such an extreme level, a counter-trend move of dollar strength is more probable than you think. Don't jump all in to international stocks or precious metals, keep your assets at a mix to where if gold falls and the dollar strengthens, you will not lose sleep.

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Linkfest - Emerging Markets, Banking Crises, Gold and Bailouts

There are many great articles this week about possible misdeeds at the highest levels during our banking crisis, and how the end of a financial crisis is not the typical fast recovery. Learn the investment implications for today's market, be it emerging markets, precious metals, or just protecting your portfolio in an overbought market scenario.

Discussing investments in emerging markets and their risk (Steadfast Finances)

The historical aftermath of banking crises - hint: it's not like a typical recession (World Beta)

The CME begins accepting gold for margins, what does this mean? (Money Energy)

This year's top performing mutual fund is in love with Canada (Morningstar)

The stock market has never been this overbought (Hussman Funds)

Four bailouts you didn't know about - (Mental Floss via The Reformed Broker)

Skullduggery by Hank Paulson leading up to the Lehman failure (Felix Salmon)

The Ages of Man - famous writers discuss the stages of life (NYT)

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Economic Indicator Showdown - WSJ Style

In a recent WSJ article, two journal writers face off on whether this is a redux of the 1930's, or whether it's sunshine and roses as far as the eye can see.

First off is Brett Arends, who believes we are in for more tough times for the following reasons:

1. Historically low yielding long-dated Treasuries

2. Slumping dollar and surging gold prices

3. Debt laden households

4. Jobs moving overseas

The rebuttal comes from Dave Kansas, who shows traditional American optimism with his all-American name. He sees a strong recovery because:

1. 10,000 banks failed during the Depression. 125 have failed since 2008.

2. GDP declined 5% in this recession, compared to 30% in the Great Depression.

3. Stock prices only declined 55% this time, compared to almost 90% before.

4. Leading economic indicators, corporate profits, the stock market, and initial unemployment claims are all looking better.

5. Unemployment doesn't look nearly as bad as the 1930's.

To be quite honest, I think both writers have their good points. This isn't the Great Depression, because compared with the tight money supply of the 30's, now money is available for (almost) free. However, with our high spending and unsustainably growing debts, any recovery is just prolonging an inevitable currency devaluation or large-scale debt deleveraging.

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Covered Call Funds - Just like Junk Bonds

You've probably heard of covered calls as a great way to earn extra income in your investment portfolio. They aren't exotic, it just involves selling options on your stock or index to guarantee small, frequent returns while cushioning your downside.

The more gradual the move, the better your relative performance. During steep market moves, your losses will be nearly the same during a crash, and your gains during a fast moving rally will lag by a large margin.

One example covered call fund is PBP. This ETF sells calls on the S&P 500 index. Here is its performance from December 2007, when the bear market was getting underway. PBP predictably outperformed the index through the crash, and underperformed in the recent rally, slightly beating the S&P 500 since the bear market inception.

While covered calls can have a place in your portfolio in range-bound and bear markets, they are not a good substitute for bonds in your portfolio, as was suggested a recent WSJ article. Covered call funds should be seen not as a conservative yield play, but an increased risk exposure play. In fact, covered calls are highly correlated to high yield bonds, as seen here when comparing the covered call funds PBP and BEP with the high yield bond fund HYG:

Covered calls have performed almost identically to high yield bonds. When looking into covered calls, it is best to consider if you want more or less of your portfolio in high yield bonds.

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Dollar Reserve Currency Status Update

Actions speak louder than words. During the last three months, foreign central banks put 63% of their new currency reserves into the yen and euro deposits, and only 37% into US dollars. This is an incredible departure from the past, when up to two-thirds of new reserves went into dollars.

Investors see that the US is stuck between the rock of high inflation and the hard place of deep recession, with no easy exit strategy.

Previously, foreign countries limited their actions to vigorous talk and warnings, but now there is concrete evidence that central banks see the need for currency diversification. Until Bernanke and the Federal Reserve act to raise interest rates, this dollar flight may continue.

Another factor in dollar weakness is the carry trade. The dollar has taken the place of the low interest rate yen, which was sold in order to buy riskier currencies with higher interest rates, like the New Zealand or Australian dollars. Until the US raises rates, this trade will continue.

How do you benefit from this? If you believe this trend will continue, gradually move your US investments to foreign investments. If you are an institution, you can execute a foreign exchange swap to hedge your dollar exposure. However, if you are a CFO reading this blog for currency advice, you have greater problems on your hands.

Source: NY Post

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Investors are Bad Market Timers

Investors in the nation's best mutual fund have performed over 30% worse per year than the fund's advertised return. How could this happen? It's all because of market timing, and how bad investors are at it.

Do you want to see hard evidence? Look at the CGM Focus fund run by the excellent Ken Heebner. This fund has the best returns of any fund out there over the last 10 years. Ken correctly rode the commodity bull for most of this decade, taking his fund to compounded returns of 19.59% for the preceding decade. Did his investors profit? NO.

While his fund went gangbusters, his investors had an annualized LOSS of 13.94% over the last 10 years, putting their returns in the lowest 3% of all mutual funds. Heebner had a volatile fund, and investors piled in after big run ups, and jumped ship during tough times. Morningstar calculates investor profits by dollar weighted returns, meaning CGM focus saw asset growth after rallys, and money outflows during declines.

Remember, if you believe you have picked a good manager, stick with them. Managers that have outperformed over time should continue to do so in the future, unless their fund grows too large. And the time to invest in their funds is during a period of underperformance.

Source: Morningstar

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Competition for Yahoo Finance Stock Data

If you are a fundamental investor, you no doubt have looked for company statistics on Yahoo. It can be difficult to compare the fundamentals of several companies, unless you compare whole sectors and industries. Yahoo shows most of the information you need to know, but it takes a lot of clicking and searching.

Wolfram Alpha makes it easier to look up particular fundamentals, as it shows them on the front page of all the stock data. In addition, it lets you plug in several stock tickers, and it compares them in all of the data points:

The main reason it is viable competition for Yahoo is that the data is all on one page. You don't have to click to other pages or do any looking around.

Consider Wolfram Alpha's optimal portfolio analyzer. Have you ever wondered the best way to allocate your individual stock holdings? What if you hold company stock, or if you did some research and bought stocks on your own? You can input several stocks into Wolfram Alpha, and the system will combine your holdings with stocks, bonds and cash to create the best possible risk/reward for your holdings. This works best from a total portfolio standpoint.

While you may be used to searching for stock data on Yahoo Finance, if you are looking to analyze the stock price history, and the best allocations for your portfolio, then take a look at Wolfram Alpha.

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Bond Fund Outperformance

This just in, bond fund managers do not outperform their indexes after fees. According to Chen, Ferson and Peters via CXO Advisory, there are 9 main factors that influence bond returns. These include interest rates, equity returns, spreads, etc. While managers can outperform significantly before all fees, the fees themselves erase all of the excess returns.

The data shows that (via CXO):

Across all bond mutual funds over the entire sample period, the mean monthly return is 0.62% and the standard deviation of monthly returns is 1.51%.
After controlling for return series non-linearities unrelated to timing, the evidence for market timing ability is on average neutral to weak.
With these controls, 75% of bond funds significantly outperform style-matched benchmarks before fund costs (average expense ratio of each fund plus an assumed round trip trading cost associated with the fund style), but there is no evidence of net outperformance on average after costs.

It would appear from unbiased research that bond index funds are the way to go. A future post will discuss how to pick the best index funds.

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Where Will GDP Growth Come From?

What makes the economy grow? What contributes to a positive GDP? Well, it is corporate profits, and personal savings and investment. What we see now is that corporate America is battered, along with the consumer. The government has done a good job of picking up the slack, but at some point, for any recovery to be real, the private sector must rebound.

The above chart shows the consumer battening down the hatches, wary of making new investments or large purchases. Do you think the government will be able to continue the economic CPR until the patient recovers?

The government averted a mass financial crisis at the cost of future inflation. We avoided outright depression, but it's hard to believe that the recession is completely over. We have a growing economy at the moment, but it will be tough to have a growing economy throughout the next year.

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Going Broke During Retirement is Not an Option!

Yes, of course stocks have higher returns than bonds in the long run. Over a lifetime, there is no question. Stockholders demand a higher return from the corporation in exchange for no claim on the assets if the company goes bankrupt. During a 100 year span, it is fairly certain that stocks will beat bonds by several percentage points.

While this is all true in the long run, what does it mean for the average person investing for retirement? Not much. Like we have seen in the past 10 years, and like Japan has seen for the last 30 years, stock markets can have poor returns for decades. When asked whether stocks or bonds would return more, Buffett replied "Who knows?" People say that stocks have to be better than bonds, but I've pointed out just the opposite: That all depends on the starting price."

From the investors's perspective, this means not to attach oneself to any particular dogma. Buy and hold may not be as good as advertised, but market timing is very hard. Treat your retirement as if your life depended on it with no option for bankruptcy, by contributing more to your retirement than you think you will need. Over-invest in your retirement, because you cannot count on adequate returns.

Remember that the combination of low interest rates and years of bond outperformance mean that fixed income should underperform in the future. Worried investors must understand that future returns may be lower than average. This means recognizing that stocks may return only 2-3% more than inflation over the next 20 years. Bonds may provide 0-1% real returns.

Investment Action Plan

What is your plan in case this happens? You need to max out your 401k to the best of your ability, and open an IRA. If you know nothing about investing, consider making stocks at least 50-60% of your portfolio with equal parts international and domestic, and spreading out the funds among large, mid and small caps. Put the rest in bonds with a sprinkling of other asset classes, including real estate and commodities.

Understand that a secure retirement means possibly giving up spending income now, and putting that money towards retirement. 30 years of leisure at the end of your life is not a God-given right, it is a privilege that must be earned through a lifetime of prudent action.

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