Happy New Year

Just a quick note this morning to wish everyone a healthy, happy and prosperous new year. Also, thank you to everyone for helping to make this site what it is.

I write a lot of content for two big reasons. One is that it helps me do my job by sorting through and articulating the various things I study. This has helped me to rule things in and out. The other reason is I do enjoy trying to help people learn more and think about things differently. To the extent I actually do that, it is very rewarding.
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Sunday Morning Coffee

As my thoughts about things like toll roads and other lowly correlated assets evolve I thought it might make sense to shed a little more light on why I am thinking about this stuff more, what realistically can be expected from these types of assets and more importantly what not to expect.

It's no secret that I think a bear market has already started as a function of excess gone bad in the financial sector.

Regardless of whether a bear market has started or not, the fact is we have had bear markets in the past. The come, the market drops, they go and the market goes back up. This will be the fate of the next one whenever that might be.

It's like going to the dentist. You don't want to have to endure sitting in the chair but you pretty much know what you are going to get.

From this standpoint bear markets do not really threaten you financially (of course bad asset allocation is a different story). You pretty much know what you're gonna get and if you can add any value during a bear market, all the better.

A bigger issue than a bear market that looms is the threat of returns below average after the bear market. Regardless of anyone's emotional state a repeat of the past is not to be feared, it is to be endured. Once endured I think we may be in for a period of returns that are noticeably below normal for an extended period which could be a new thing. This would disrupt a lot of financial plans.

I am thinking something like US markets averaging 5% per year instead of 10%. It might sound benign but it isn't.

Things like toll roads and plane leasing companies, as I mentioned the other day, have complex financial structures. There is a management of leverage and interest rates that is potentially more important that operating the tolls or contracting out the planes. Its kind of like car dealers. I've heard that selling the cars isn't as important as how they manage their interest rate risk. Whether that is true or not crisis, like we have had this summer in the financial sector, creates either real or perceived problems for financially intricate companies like some toll roads and some plane leasing companies.

Since I think the bear market started with financial companies it seems logical to me that the toll roads and plane leasing companies may not offer as much bear market protection as we would like.

But I am not worried about the bear market I am focused on what might come afterwards; returns that are below the historical norm. That is where I think moderate exposure spread over disparate market segments that might yield 6-7% and go up in price 3-4% becomes very important.

To this point all four plane leasing stocks that I am aware of are down 20-26% in the last three months. This does not make them bad stocks, it makes this the wrong time. I don't own any now but will be a buyer at some point (might not be for a couple of years) at a 2% weight. Anyone who bought three months ago at a 2 or 3% weight may not be happy with the purchase but they have not permanently damaged their portfolio either.

I believe the plane leasing space is a valid concept but it can, obviously be cyclical. The last few months have simply been the wrong time in the cycle. Getting the cycle wrong with too much of your portfolio becomes a real danger and all of these themes strike me as having the potential to end up being over owned.

For anyone who cares the context here is my trying to think about what comes after the bear market. If you have been reading this site for the last couple of years, or longer, you know that I was planning a strategy for what I believe is the current bear way back then and I have been making small changes in that direction (buying the double short, making the occasional sale and reducing the size of some bigger winners) for a while now.

The idea of waking up one day and saying a bear market is here I better do something seems crazy to me for anyone employing any sort of active strategy. Similarly waking up one day in 2010 and saying things are different I better do something is just as crazy.

Planning for a bear market that never comes does not seem crazy to me. Planning for a changing investment landscape that never changes doesn't seem crazy either.

The picture is from Kapoho, which is kind of close to us. A few miles further down the road was covered by lava flow. And yes I think I did post this picture before.
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The Big Picture For The Week Of December 30, 2007

Sharpe Ratio Article
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The 10% Solution?

I put up a similar chart on December 13, which was about the last time the S&P 500 turned around at the line drawn in red here.

I've been saying for a while now that I think a bear market has started. I've also been saying that if a bear has in fact started, the way this bear is starting is very typical.

The point of this post is about exploring a different concept than just stocks, bonds, cash for constructing a portfolio. Some people might say that in addition to stocks, bonds and cash that real estate (primarily REITs) and commodities should be included. What about private equity?

What probably makes sense for most people is some sort of a broad category that is perhaps labeled alternative or other (I'll take suggestions on a better name). This could take in the following;

Absolute return ideas (like a long/short fund)

Some strategy funds (like DBV or the Rydex Managed Futures both of which are personal holdings)

Infrastructure

Plane leasing

A Put Write fund (if one ever comes into existence)

One of the merger funds (this probably counts as absolute return but this is the type of thing that gets forgotten about)

Foreign currency (I include this in cash but some may think of it as "other")

All of these categories (if I have left any out please leave a comment) have both positives and drawbacks. There was just an article yesterday in the WSJ about long short funds that have done poorly this year in a market in which I would think they would shine.

Within each segment there are varying characteristics and the context I am going for here is finding a low correlation to US stocks, a little bit of yield and low volatility although that is not as important as the other two.

The title "10% Solution?" of this post is the idea of allocating 10% of a portfolio spread across several of the sub-groups listed above; maybe 2% each in five different categories, whatever. In looking at each of the seven listed they each have a couple of obvious risks but I would want to spread it out for fear of the risks, to steal a page from Nassim Nicholas Taleb, that are not obvious.

I think these segments all live in their own world relative to the others. If you put 2% in a plane leasing company and something unforeseen happens it is likely that the other segments would be untouched. A good example from the last few months might be some of the shipping stocks. Picking a relatively undramatic name, Diana Shipping is down 26% from its high while the market is only down 6% or so from its high. So 2% in DSX bought at the worst time possible, in moderation, is far from a death blow.

The big macro here is that if the chart above does portend a bear market of some sort, where can money go to give a chance of better weathering of a bear. Then, once the next bear is over does it makes sense to keep these types holdings, to perpetually own names with the attributes of low correlation and above market yields.

Don't take 10% as any kind of magic number either. I think a persuasive argument for 3% each allocated to five or six "others" could easily be made. The problem I can see, and this is always the way, is that one or two of them do very well and instead of a moderate allocation of 2-3% in one segment people go with 10-15%, it blows up and they have completely neutralized their bear market protection.

I write these sorts of posts often as I believe that the average 10% return from US markets may be harder to come by in the next few years. If US equities can only average 5% then you either need to own equities in foreign markets that can deliver 10%, or get that 5% with assets that are generally not as risky as US equities or some combo of both. Obviously I vote for the combo.
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Don't Phreak

In case you haven't seen this elsewhere, there is a good chance of a delayed reaction from the Bhutto assassination in some of the emerging markets.

The US market may have sold down more in the last half hour in anticipation of this.

If so, don't freak out. The event is an outlier and if it does cause a fast decline, history says it would snap back quickly.
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Two Cases In Point

Plum Creek Timber (PCL) is a name I have disclosed many times before as a long time holding.

The past three months have been an good microcosm for a couple of points I have tried to make before.

One is that stop orders can be tricky. PCL appears to have bottomed out down 8% which is a magic number for a lot of people. Obviously people have success putting a stop in 8% below where they bought the stock but I think it probably leads to a lot more trading than is necessary for most folks.

The other point is that in a diversified portfolio you never know where leadership might come from. Most of the time PCL doesn't seem to do a whole lot. Occasionally it struggles and occasionally it has a good run and I would say adding 10 or 11% versus the benchmark in a quarter is a good run. And I'm sure that when this run ends the stock will do nothing for a while.

Really I am not sure why the stock has done well. None of the recent news strikes me as market moving. The Timber ETF (CUT) listed during the quarter. It is not clear to me that the listing of the fund or the subsequent volume after listing created too much demand but maybe so.

To say something very obvious; sometimes stocks go up for no real reason just as they go down for no real reason. This creates visibility for trading for no real reason.

Clearly long term success in the stock market requires some degree of patience. The stock named in this post is irrelevant. Obviously I believe in it but there literally thousands of other stocks that could have been substituted in. If you believe in a company, think its prospects going forward are good and it has done a good job of rewarding shareholders in the past you probably just need to be patient when it goes through a stretch where it lags.
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Wish List

Matt Hougan from IndexUniverse has a Christmas wish list of ETFs posted.

It's a great posting and list and I thought I would add a little color to a couple of the items he mentions.

He notes that among the ETFs that should come in 2008 is one pertaining to EU Carbon Allowances from a company called AirShares.

I don't know much about this and your first reaction might be that this has nothing to do with the stock market which is of course exactly why it might be interesting.

If it is more cost effective to buy carbon credits than operate cleaner then businesses will buy carbon credits. The demand for carbon credits could increase independently from whatever is going on in the stock market.

If this becomes an ETF that owns futures with mostly t-bills you might be buying something for which there is demand, has a low correlation to the stock market and kicks of a little yield. If that is how it actually shakes out, well that might be OK.

Another item on Matt's wish list is the coming SPDR Barclays Global TIPS Fund. I too like the concept but....at the recent Super Bowl of ETFs I moseyed on up to the SSGA booth to ask about foreign fixed income ETFs and none of the three guys there knew anything about global TIPS (like they hadn't even heard of it). It has been filed for months but I take this encounter to mean it ain't coming anytime soon. Hopefully I am wrong.

Matt included the potentially coming 130/30 fund filed by ProShares. The constraints on this particular version of the strategy are not ideal. If I wanted 130/30 at all I would not want to be restricted to the S&P starts ranking system. I would want the people running the fund (if that is what I was using) to go short whatever they felt was a short and overweight whatever they thought was a good overweight. The S&P stars system, like any other similar ranking system has biases. At times the biases will be a disadvantage.

Lastly Matt holds out hope for a VIX product of some sort, as I have mentioned once or twice before also. Similar to a post of mine from a week and a half ago Matt wonders if the answer for this issue is an ETN. Matt goes further to offer that a combo of a VIX ETF/ETN/whatever and a bond ETF could be a better hedge for an equity portfolio than gold. I'll have to think on that one for a bit but I agree big picture-wise that new types products will allow for very sophisticated strategies being executed by do-it-yourself investors who are will to take the time to learn.

On an unrelated note but a follow up to the Toll Road post from yesterday a reader left another name for the list. A Canadian company called SNC-Lavalin which trades in Canada under ticker SNC.TO and in the US under ticker SNCAF. The company website can be clicked through to here.
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Toll Roads

I spent a little time this weekend looking for and learning about publicly traded toll roads (these tend to trade on foreign exchanges). This came about from the recent listing of the iShares Infrastructure Fund (IGF) which owns quite a few of them.

The appeal of these stocks is that they should have a low correlation to US stocks, not be very volatile, have some yield and benefit from constant demand; the need to get somewhere.

The drawbacks seem to be low rates of organic growth, some of them have a lot of leverage and some of them do a lot of acquisitions so the idea of one of the acquisitions going badly seems within the realm. What follows is a list from IGF's holdings and the symbol (not all of them have symbols for US trading) linked to Yahoo Finance.

Abertis ABE.MC in Spain or ABFOF on the pinks

Transurban TCL.AX Australia or TRAUF on the pinks

Brisa Auto Estradas BRS.LS in Portugal and BAUEF on the pinks

Cintra BCIN.MC in Spain CCIDF on the pinks

Zhejiang Expressway 0576.HK in Hong Kong ZHEXY might be the pink sheet symbol

Societe Des Autoroutes Paris(aka Paris Rhin Rhone) ARR.PA in Paris no pink sheet symbol

Jiangsu Expressway 0177.HK in Hong Kong JEXYY on the pinks

Autostrada AT.MI in Italy AUOSF might be the pink sheet symbol

Treat all of the pink sheet symbols as best effort and any of them could be wrong. If you know of any other publicly traded toll roads please leave them in the comments. I would add that all of the various Macquarie products traded around the world also have exposure but that can change at any time.

All of the companies have websites where you can learn more about them in addition to what might be on Yahoo Finance.

I bought one of the above personally with a 2% weighting. I have not decided about adding it for clients and so won't disclose it so that I don't front run what I might do for clients. Since there is no commentary about any of the names just a mention that they exist I believe not disclosing the name is kosher.

On a totally unrelated note has any NFL punter had a worse day on the field than Packers punter Jon Ryan had yesterday?
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Sunday Morning Coffee

Arjun Divecha emerging market fund manager at GMO was interviewed in the current issue of Barron's. He had an interesting quote that I sort of touched on conceptually in this week's video.

All the smart clients have been rebalancing. Think about this: If you had 5% of your money in emerging markets in 2003, it has appreciated 450%. You have to be cutting back if you don't want 25% of your overall assets in emerging markets.

A phrase I sorted of stumbled across while writing an article for TheStreet.com is volatility budget or some may prefer to think of it as their risk budget. Each investor can only allocate so much of their portfolio to volatile holdings. That number will vary depending on the person but everyone needs to know how much they can allocate to volatility and then must figure out the best way to access volatility in their account.

The example in the video I gave about allocating 5% to emerging market was just that, an example. I obviously agree with the quote above that 25% in emerging is too much. I would say 20% is too much. I don't believe I have ever allocated more than 10% to emerging, but I think I might have grown into a greater than 10% weight a couple of years ago which I have long since paired back.

Unfortunately there was no mention in the interview about how much emerging market exposure Mr. Divecha thought to be ideal.

Emerging has done so well in the last few years that there are probably quite a few investors (professionals and do-it-yourselfers both) who are confusing a raging bull market with something else. While I do believe the stories behind the price moves are different I would not want to be too exposed to the idea that the stock cycles are different.

Having a moderate allocation means not having to worry. How to define moderate? If your emerging market exposure were have a 50% haircut could you live with the impact on the overall portfolio? So if you have 10% (which is more than what I have) then a 50% hit would take 5% out of your overall account.

Different subject;

I looked at the video I made for 2007 and got a lot of things wrong. My prediction for the stock market will undoubtedly turn out to be wrong; I expected the market to be down a little to 1350-1375. As mentioned in the video I did not expect emerging markets to keep its hot streak going. I thought (maybe I should say hoped?) that the yield curve would have normalized by now with rates going up to something like 6% on the ten year.

I was pretty right, surprisingly, about the Fed cutting rates which was really the only thing I was right about. In the video I said I was right about a few things but, no. I was sort of right about healthcare. I said it would do well and measured by iShares Healthcare ETF (IYH) it was up about 9% YTD through Friday compared to not quite 5% for SPY (neither includes dividends). I say sort of right because even though it did better than the market that 9% pales compared to energy's (XLE) 35% lift, utilities' (XLU) 17% gain and staples' (XLP) 12% gain.

If you think of that as adding all that up to very wrong I could not really out-debate you on the point but, and this is what is important, you will see when I make the video to re-cap the Q4 and full year performance that being this wrong did not hinder results. A point I have been trying to make repeatedly is to not be too levered to your opinion because you could be wrong.

I have been expecting a bear market to start for a while (I think it did start in the last couple of months) but have been plenty invested along the way, though not 100% in, because despite what I thought the market kept going up, until just recently--that is if I turn out to be right about the bear market.

Since BusinessWeek seems to have discontinued it annual survey and replaced with opinions from just eight different strategists (if I missed something here with this someone please let me know) I will have to figure out a different way to make a forecast. For anyone who was not around last year I unoriginally used to take the BusinessWeek annual survey and try to figure whether the consensus was too bullish or too bearish.

The picture is what we used for our holiday card this year; Happy Holidays!

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The Big Picture For The Week Of December 23, 2007

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The Cars That Go Boom?

A reader named rackgen asks if "all investment classes provide good returns during a robust economy? Logically diversification helps only when done during bears."

So this reader likes the boom? Couldn't resist.

He has a point but it is a point that could become a risky concept.

Taken to a ludicrous extreme Trina Solar (TSL) is up 150% YTD so if you put all your eggs in that basket at the start of the year there would have been no need to diversify. The next time the market is down 20%-plus in one year there will be stocks up as much as TSL was this year. Not many but a few.

So to really try to answer his question...I would expect that during boom times all of the big sectors of the market would do well and so in a way the need to diversify could be less.

Of course the next time the S&P 500 is up 20%-plus in a year there will be a few stocks that go down a lot. If you disregard diversification during an up-a-lot year and you buy ten stocks from two sectors and one of the sectors you choose is one of the laggards or a couple of the stocks don't pan out or actually have a bad problem of some sort you will have a problem.

In this decade 2003 has been the only great year with the S&P up 26%. However anyone disregarding diversification and making a bet on the staples sector got pasted as the sector as measured by XLP was only up about 7% or 19% behind the broad market. And if your other sector was Telecom, that one was only up 15% (as measured by IYZ) or 11% behind the market.

In the next boom time there will be haves and have nots as there always are. Guess wrong and you miss out on a big year. Missing out, as opposed to lagging, a huge year is damaging to long term returns. We don't get too many years greater than 25% and in order for most people to make their numbers work they have to be at least relatively close to the market during up a lot.

So to the reader's question, some folks will be comfortable, and successful, betting on some sectors to the exclusion of others so time for some introspection. How much sector risk are you willing to take? How much risk are you qualified to take? There is no right answer for everyone, only a right answer for you.
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Secretly Released

Just as Bobby Petrino left Atlanta under cover of darkness so too did two very interesting ETFs get quietly listed today.

The first is iShares JP Morgan USD Emerging Market Bond Fund (EMB) with a hat tip to 24/7 Wallstreet.

Based on the name I infer that the bonds are dollar denominated like the similar PowerShares product (PCY).

The average coupon is 7.76% but the average price, assuming that means price paid is over $110 so the yield is probably in the sixes and in fact I found an average yield to maturity of 6.29% on the iShares page but can't vouch for that.

EMB is heaviest in Brazil, Russia, Turkey and Venezuela with ten countries in all.

The other fund is the PowerShares S&P 500 Buy Write Portfolio (PBP) with a hat tip to me as I found it on the home page when I went to compare EMB to PCY. I exchanged emails with someone at PowerShares about this fund a week or two ago and was told it is an ETF (as opposed to the ETN from Barclays) and it will pay a dividend.

I am excited (wow I am a nerd) about both of them. I will say easy does it on PBP for a while. While I am sure this is wrong, this strikes me as a candidate for having unintended consequences. I really do hope I am wrong as I would like to use it but it will need to prove itself before I do.
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Diff'rent Strokes

Yesterday I gave a quick second opinion on a portfolio idea for another blogger who is quite successful (it might soon be public but I am not sure) that assembled diversification in a completely different way from the way I do it.

If you have been paying attention to comments from folks like T you have seen the success they are having too. What I know about the way T executes his ideas, it is much different from my approach too.

Last night we were at Barnes & Noble doing some Christmas shopping and I took a quick gander at the investing section and aside from seeing a couple of books that were previously advertised on this site I saw books with different and successful investment ideas still.

In the indexing world there is an ongoing debate about cap weighting and fundamental weighting, again different ideas. Have you ever read or heard someone successful say to sell on weakness? What about someone just as smart saying to sell on strength?

While we all should clearly have a method that we are most comfortable with there are many different ways to succeed. This is one of the things that makes investing and capital markets so fascinating. Additionally there is always more to learn.

However much you know now and however good of an investor your are now you will be better in the future as you experience more and read more. This is true of everyone.

A long time ago an anonymous commenter said he felt my knowledge and understanding of foreign markets was superficial. One thing is very likely, compared to some people my understanding of this area is very weak. Compared to other people it is probably pretty decent. Where ever it stands now it will be better in the future.

By taking the time to read this blog and hopefully other blogs you take in diffr'ent strokes to develop and hone what you do. The manner in which you build a portfolio is going to evolve.

I started writing ages ago about things like blogs and investment products empowering do-it-yourselfers to become more knowledgeable investors. And while that is far from a visionary idea it is true nonetheless so make the most of it.
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Emotional Investing

We all know that emotions get in the way of investing. Sometimes we hold on to a stock too long because we like it so much or we sell too soon because we give up on the thesis if the stock drops a buck or two right after buying in.

Whether due to emotions or not I have obviously sold too soon or too late in the past and will do so in the future. All that can be done is to do your best. I love Starbucks (SBUX), held onto it until this summer. I disclosed selling it in the mid $26s.

I could have sold it earlier in the $30s or I could still be sitting on it at around $20. The point is like most sales it could have been better or worse.

On Tuesday I sold a financial stock that I like and just like Starbucks this new sale could have been better or worse (the stock is obviously way off its high but it has bounced some off of its low too). The sale was not a tactical reduction of exposure, I will be buying a replacement for it today or tomorrow keeping the same net exposure. That the stock is down is not a big problem as most bank stocks are down, the more important decision to be underweight the sector was made ages ago.

The impetus for the sale was more of a top down decision about wanting to reduce, not zero out however, my exposure to this specific country.

I'll disclose the name a little later but for now I'll say that I think very highly of the company and might by it back later but for now the immediate prospects, or more correctly my perception of them, have to be the overriding factor.

It is important to recognize when you have an attachment to a stock, overcome that hang up and be willing to do what is best for the portfolio. There are plenty of reasons why selling at the top is a rare thing and this is just one of them.

As selling at the very top and the very bottom are both unlikely I would say to just focus on having some sort of discipline, analysis or both.
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Detachment

Every once in a while when things are starting to turn a tad uglier I like to post a reminder about how normal market declines are. Corrections and bear markets come along every so often, the market endures it and then works higher. Regardless of what is happening now (my take has been that we are early in a bear market) at some point the market stops going down and will start higher. Over the long term the stock market averages close to 10% per year which includes bear market declines.

Declines followed by recoveries and new highs is just how it works. It may take longer than you would like, but it does happen. Embracing this simple truism should reduce the emotional toll that declines take.

Personally I have unyielding faith that cycles are normal, they tend to end in a similar manner, start in a similar manner and doing a few simple things within a portfolio can help buffer the impact. Obviously there is no guarantee and there people who should not attempt to take defensive action.

I have been writing about some of these basics for months as I have implemented them. One thing that is true, I have tried to make this point countless times, is that if is turning out to be a bear market it is happening slowly. For now the market topped out two months ago, with the decline thus far still in the realm of down a little it is not too late to take defensive action if that is appropriate.

Over the last few months or so I have reduced volatility by selling and reducing a couple names, added a little double short here and there and tilted toward sectors that tend to do better, like staples, in recession or bear market.

I also write often about moderation which applied to being defensive too. I think 100% cash is a very aggressive position. Just as bear markets tend to start the same they also tend to end the same. Whether this is just a dip or really is a bear market there will be a fast and furious rally and if you are 100% cash (or some other extreme number) you are in a situation where you have to correctly guess when that comes which is not a bet I want to make.

Lagging a monster rally while erring on the side of caution is not a problem like missing a monster rally is.

On a much more important note, Prescott (the town where I live) is getting its second pro sports team. Last winter we got minor league hockey and this spring we are getting an indoor football team, the Arizona Adrenaline.
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Reader Question On Diversification

Reader Jimidean left a question yesterday that I answered in the comments but I thought might be worthwhile to answer in a post so more people might see it.

the problem is that commodities, as measured by the Reuters-CRB, for the period 1991-2004, returned less than T-Bills. I can't eat low correlation. Commodity prices are volatile, and if an investment in the asset classs is expected to achieve T-bill rates of return, wouldn't you be better off skipping the asset class (Commodities or whatever) and putting your money in something that rewards you for the risk?

The answer combines philosophy and faith. For me the philosophy is that by allocating to disparate asset classes I'll own the one that has a great year and there is less need to predict which one will be the one to have a great year. So if domestic stocks have a bad year it might be possible to bring up the overall return by getting a lot out of commodities or emerging market bonds or infrastructure or whatever. This has worked in the past and the faith part of the equation is that it will work in the future without having to rely too much on things "going right."

If you have eight different asset classes one of them will be the best performer, that best one may or may not be up a lot but often it is.

The example I used in my reply in the comments was market up 10% a diversified portfolio with 50 stocks being up 9-11% with one stock originally weighted at 2% being up 100% is very plausible. That one stock would account for a disproportionate amount of the total return.

It is is often the case that a disproportionate amount of a portfolio's return will come from just a few things. How is your portfolio YTD? Got any emerging market exposure? What is the weighting of that exposure and how much of your return came from that exposure? Do you have any energy stocks or an energy ETF? The energy sector SPDR is up 25% YTD. An equal weight to energy might be a big chunk of your return too. The Gold ETF (GLD), which is a client holding, is hardly an obscure holding is up 25% also. A 3% allocation from the beginning of the year would have added 75 basis points YTD which in an environment of SPX up 3.4% (plus dividend) seems like a lot.

The dilemma raised in Jimidean's question about commodities having trailed the return of t-bills during the period cited raises two points. One is that obviously that is in the past. The numbers might be a little different if he had picked a different 14 year period and more importantly looking forward are commodities likely to lag t-bills again?

The other point is that if he is worried that commodities will lag t-bills he should underweight the sector. If he is right, great but if he is wrong his portfolio can still get some benefit from an underweight exposure if commodities rocket higher. That is to say the consequence of being wrong could be lessened.

The view expressed in this post is just one of many valid ways to construct a portfolio and manage diversification. No one path can be the best path for all markets. My idea will work well some portion of the time as will more aggressive or more conservative approaches at other times.
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Mistake/Correction/Retraction

I made a mistake with the numbers in my video from Friday by virtue of ANZBY being the first ticker I input into the chart.

Thank you to reader HalM for catching this and bringing to my attention.

The chart here captures the issue. For some reason that probably has to do with a change of ticker symbol YahooCharts only goes up to October 10, you can see the cursor is all the way over and it says October 10.

Not assuming Yahoo would not go all the way through to the current date I never checked. Apologies for the mistake, it just never occurred to me.

ANZBY is up about 5% YTD plus it paid a $2.65 dividend in July and will pay another $3.36 on December 31.

My Norway stock is up about 15% YTD plus a 5.7% (based on the opening print of the year) dividend paid in June.

My Brazil stock is up 120% and the dividend was quite small.

Lastly the Canadian stock is up about 12% plus 3.5% (based on the opening print for the year) in dividends.

FWIW on October 10, the date apparently captured on the chart I was looking at, the S&P 500 closed at 1562 which made it up 10.1% for the year.

Again apologies for the mistake you can decide for yourself what to make of it, all I can do is point it out upon finding out.
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Sunday Morning Coffee

Winters here are great (old picture). I really enjoy having a fire, splitting wood is great exercise and shoveling snow is not so bad when you don't have to do it in the dark trying to get to work.

To take a page from Adam Warner, the Striking Price column in Barron's had an interesting article about volatility as an asset class. This seems like a good follow on to Friday's post.

The article cited a paper by Maria Grant and Krag Gregory from Goldman Sachs. The conclusion of the paper is that enough return can be generated selling volatility that a substantial portion of a portfolio should be allocated to it. Again that is the conclusion from the paper not me.

One interesting observation made in the paper is "that big investors must buy options to hedge their positions." As I only have the article and not the actual paper I will say this statement is sort of strange.

Who is "big" and why can't "big" sell to hedge their positions too?

The paper also notes that "volatility selling tends to outperform long equities in hostile markets, offering diversification benefits." The authors also say "an asset class is defined by expectations that a passive position in it will produce significant returns above cash over time. Additional determinants include long-run returns that don't depend on investment skill, and diversification benefits in unfavorable markets."

I don't believe I have ever read that definition anywhere before and it is intriguing. There are volatility indexes aplenty besides the ones tied to the S&P 500. There would be some obstacles to implementing investment products tied to VIX and the like much as there were problems listing VIX options. The problems that I am aware of have to do with hedging the exposure of the various traders providing liquidity and I remember back when VIX was at 10 puts struck at 9 had no bid. There are also issues with VIX measuring 30 days making the utility of options further out than that questionable.

I don't know if the solution is a managed product that combines volatility of different indexes, a simplistic strategy like selling strangles (as suggested in the research paper) and puts against stocks or indexes not using a volatility index, an ETN that simply gives you the effect or something else.

Fortunately we don't need to be the ones to figure this out. A VIX-like product seems inevitable. It may take trial and error from one or two product providers before a good one comes--I can see a first attempt having an unintended consequence or two.

The topic is very interesting. Clearly there is nothing easy about gaming volatility but it is just as clear that volatility can be uncorrelated to moves in the stock market. Like with the Put Write Index, someone will write a white paper about how to navigate this market and then the products will come. Once the products come we can read the white paper watch the product trade for a bit and then decide whether it makes sense.

An advantage to an exchange traded product over the options is not having to manage expiration. Obviously there are people that are better off with options in this light but that is not the majority of investors.

Conceptually adding return independent of US stocks is appealing. There is no need to be the person who figures out how to deliver the product and there is no need to be the first one in.
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China Forum - Journal of Indexes

China Forum - Journal of Indexes

A few weeks ago I participated, via email, in this discussion (for lack of a better word) about China.

They asked;

1) Is China underweighted in global benchmarks, and should investors increase their exposure?
2) Is the Chinese equity market a bubble ... and will it pop?
3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?

The other participants included Jimmy Rogers, Burton Malkiel, Rob Arnott along with some other folks.

Pretty cool.
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The Big Picture For The Week Of December 16, 2007

Point of clarification: The Australian bank mentioned is up 25% YTD.
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A Whole New Paradigm?

I always say that I don't expect truly bad things to happen. I think a bear market is here but I am expecting a normal bear market that the we have easily survived many times before.

What if the everyone-in-the-shelter crowd turns out to be right? A reader left a link to an article about someone with a very good track record who says a US apocalypse is already here.

Regardless of the fate of the of the US capital markets you still need the X-percent called for in your financial plan. If the US somehow stops growing it is a safe bet that, after the global shock wears off, other countries and asset classes will do just fine (think long term).

Here are some asset classes to think about.

Infrastructure

I am not talking about the road builders that Cramer favors I mean things like publicly traded toll roads (there are a few around the world), parking garages (if there are any that are public), airports (there are some publicly traded airports in foreign markets), some of the Macquarie funds (I have disclosed many times owning MIC going back two years), power grid listings, maybe even publicly traded exchanges (do you think a publicly traded exchange counts as infrastructure?), shipping ports (if there are any), and there are probably a couple of other ideas in the space. I would also ask if you think the plane leasing companies or shipping stocks count in this space.

These tend to have a low correlation to the US market and kick off some yield.

Absolute Return

In the past I have written about certain OEFs that deliver absolute returns, I perceive the carry trade ETF (which I own) to be an absolute strategy. I would expect there to be more products to come. Additionally I have written about (mostly for RealMoney) pairing sector ETFs with inverse sector ETFs (obviously the indexes mimicked by each ETF would need to be different) but of course this would require trades to rebalance.

Usually absolute lives in its own world and while the returns can be high I think high single digits is a better expectation

Currency

If US markets have a permanent breakdown the dollar will get weaker. As a matter of necessity US based investors would need some protection for the cash portion of the stocks/bonds/cash mix. I have been writing about this and some of what I do to monitor the currency markets, and really learning more about this just makes sense even given the more realistic probability that US will not spiral down.

I believe in currency exposure to different types of countries. Betting only on the "strong" currencies is, just that, a bet. At different times different types of currencies lead. You can either bet which ones will lead or maintain a diversified portfolio.

Commodities

I have never been a 20% commodity guy. Commodities are volatile. Volatility is not bad but adding too much will be a problem at some point. Here again diversification matters. I would want some gold, some ag/soft, some industrial metal exposure and maybe some uranium. These markets are not quite as simple as Jimmy Rogers makes them out to be but the basics can be learned.

Individual Countries (not EFA)

Regardless of what ever happens I will never be a fan of a broad-based product like EFA. If this crazy scenario ever plays out, as mentioned above, you still need your X percent and to get it you will probably need to do more work than you do now.

I written about various countries I favor now with the understanding that the list will need to change over time. Pursuing this type of investing will require ongoing study. This may require the most work of any of these themes.

Foreign Fixed Income

The ETFs BWX (which I own for a few clients) and PCY are a start, but PCY owns dollar denominated paper, and there will be more. I would think that if things in our capital markets really deteriorate it would become easier to buy individual issues from other countries--it now needs a minimum of $100,000 to place an order.

This is kind of page from Nassim Nicholas Taleb's playbook.

Stuff

Maybe this part falls under commodities but getting water and food to places that don't have enough seems like it would be a huge opportunity regardless of what happens in the US. All of the countries that are hot emerging or frontier markets are going to continue to modernize. The respective stock markets will go through normal cycles but the infrastructure building out for water, food and anything else that improves life of an ascending economy will continue for quite a while.

Well that's a good start for now. Maybe this whips up some discussion.
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Send In The Bears?

On the drive back from Phoenix yesterday I heard some very bearish sentiment on Fast Money from most of the crew and Dennis Gartman. On Tuesday afternoon, Joellyn and I were out Christmas shopping and I heard Jeff Macke (spelling?) make a comment to the effect he sold a lot of stock as a result of the first bit of Fed news.

Gartman on Wednesday said the he thinks the rest of the year will be down and that he has lost all faith in Bernanke and thinks he should go.

I have been clear for many months that I thought that this market cycle was close to ending and that in fact a bear market has started.

My opinion of course should have no bearing on you and your portfolio. The context here is if you think a bear market or big decline is coming...

I have outlined the general tact I have taken, and why, in past posts. As a matter or normal cyclicality, volatility increases at the end. For anyone interested in trying to avoid some portion of down a lot it makes sense to reduce volatility a little if the chance of it being late cycle is high.

In looking at the chart there are of course different conclusions that can be drawn. I believe the green line will turn out to be the most important but whether that is true or not I do not believe anything changed this week with the Fed news. Bear markets turn slowly, as I have been saying, they do not start with one news item like the Fed did X. The Fed could make things worse however.

Financials have been in trouble for months now and as I have been saying I expect more to come. A stock market is very unlikely to do well without its largest sector. This entire event from the first yield curve inversion through to the present day has been very textbook. Here I am talking about the effect of the crisis as opposed to the details that created the crisis.

The news of the week is simply a part of the equation that either the Fed is behind the curve or there is no real action to solve this other than time. We know that if nothing else time will solve it, we don't know how much time (at least I don't) it will take.

The path I chose (and wrote about) was simple and relied on this time not being different. Inverted yield curve equals trouble for financials and probably for the rest of the market. Expecting trouble meant trying to avoid the full impact of a normal decline.

Looking ahead there is no way to know (we may look back and point to a certain date) whether in fact a bear market has started or whether any action taken to cushion the blow will work if it is a bear but bear markets do come along every now and then and the way they start is pretty similar to what is going on now. I may be adding 1+1 and getting eleven or I may be right but I can build a good case personally that says some defense here makes sense. So far this path has worked very well and we'll see about the future.
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All About The Benjamins

Double entendre.

Reader JackS asks;

Do you think that the Fed's obvious slant towards bailing out Wall Street instead of the dollar will cause further decline for the dollar next year?

While I am not sure bailing out Wall Street is priority one the dollar may not even be the fourth priority.

There are a lot of moving parts to this, some more important than others. Obviously a weak dollar does not matter for Americans buying goods and services in the US. Oof, that is pretty much what Bernanke said to congress and my hunch is he'd like to take that one back.

As far as where the dollar goes, I don't have a trader's answer. I have felt the dollar has been on a clear on obviously path lower for all sorts of reasons having to do with economics and less global demand in the future.

If that turns out to be correct there will be periods where the dollar has big rallies. This was the case for the first few months of 2004 and all of 2005. In 2005 the dollar rallied about 12.5%.

The way client portfolios are structured the weak dollar has been a big help but if the dollar has a counter trend rally the portfolio will lag. If you are heavy foreign, as I am, know that a dollar rally will hurt your performance.

This is not something I am worried about. Every portfolio is threatened by certain outcomes, a strong dollar is one of the threats to what I am doing. Knowing that ahead of time will make it easier for clients should it happen.

Candidly I do not know at what point the dollar decline becomes serious enough to become a topic of conversation for the Fed. The drop in the dollar thus far has not dominoed into a radically different inflation picture or so much faith being lost by our trading partners that it effect trade enough to alter US consumer's access to merchandise.

There are nasty implications for all of these things and more but from where I sit, trying to navigate the stock and bond markets (and that is probably where you sit too), there is no great need to quantify what will happen or when, if anything. What I think matters is understanding the argument for why the dollar may go down, deciding for yourself whether you believe it or not and then structure your portfolio accordingly.

From a portfolio standpoint being right about the magnitude of this sort of thing matters little if the portfolio decisions are wrong. It is easy for people to focus on the wrong thing--in this case correctly guessing the magnitude of some future event which is very complicated. Knowing that you will be better off owning foreign stocks if the dollar declines (picking direction, even if not easy, is easier than picking magnitude) is simpler and more important.

We got six or seven new inches of snow yesterday in about two hours. Roscoe was very pleased.
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REITs

A reader asks;

I am curious about your take on REIT etfs at this stage. It seems to me that as a group they have been overly beat down because of the sub-prime mess and perhaps the coming of the long awaited slow down in the economy. It avoid single stock risk, i have been thinking of putting a toe into this catagory of stocks. Any thoughts? Any best of breed insights?

A lot of people love REITs. You can find recommendations out there suggesting as much as 15 or 20% in REITs. If you do a search for lazy portfolios you will see various suggested weightings there as well.

REITs are an asset class, like most asset classes there are periods where they do very well. I think there is an element of REITs being too adored, people owning too much and the declines being very big when they happen.

The one REIT I own across the board has been hot very hard but not noticeably harder than other REITs. I have 2-3% allocation depending on the client which I consider an underweight.

One of the benefits of REITs is the low correlation to equities. iShares has two domestic REIT ETFs with long track record; IYR and ICF. According to PortfolioScience.com IYR has 0.758 correlation to the S&P 500 and ICF has 0.701 correlation. That isn't that low. There is a closed end fund that invests in Asian real estate with ticker RAP that has a 0.486 correlation which is a little more like it. The one REIT I own has a 0.658 correlation, remember an ETF is likely to have a higher correlation than an individual name.

I am considering taking a tax loss on the one REIT I have and swapping it for something foreign, but not RAP. The logic behind possibly going foreign is the desire for a lower correlation.

The question seems to have a short term element to it. I don't doubt that the decline in REITs is more than what us justified but to the extent they are guilty by association more decline would not be shocking. I said before I am not in a hurry to add financial exposure until the yield curve normalizes and it seems that the abnormal curve may have played a role in the REIT decline too.

Well there certainly appears to be a tight correlation there.

On something like this I think I would need to have a fundamental justification for increasing exposure. Changing it, as I plan to do, is a different matter. It is an asset class and I believe some exposure is warranted in the interest of maintaining a diversified portfolio.

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Ben Stein

As much as he gets pilloried, I enjoy reading commentary from Ben Stein. He usually looks at things from a common sense perspective and while I don't necessarily agree with him all the time I do believe I can learn from him.

In yesterday's NY Times article he made one comment that I don't agree with that might be worth delving into.

He said, and he has said this repeatedly in the past, "unless you are a thorough genius like Warren Buffet, buying individual stocks is tricky."

The implication that I take from this sentiment is that he does not think individuals can or should pick stocks. I won't say stock picking is easy but it is not the sheer alchemy that some folks think it is either. I have long advocated a mix of stocks and products that is manageable and allows for sleeping at night (obviously the right mix will be in the eye of the beholder).

To make up an example where I don't think there is an ETF or other fund and that I am not an investor; stem cell stocks. If there was an ETF, you studied the segment and felt the fund owned companies that would not succeed thus dragging the fund you might think about an individual stock in that case, wouldn't you?

I also think the article makes the case for top down. In the article Stein talks about being wrong about the financial sector over the last few months. The mortgage mess, or whatever we are calling it, had a much bigger impact than he expected.

I have been prattling on about the financials for many months with the same simplistic concern; an inverted curve will be a problem and until the curve normalizes it makes sense to be underweight.

While I have repeated my logic for being underweight I never made any attempt to quantify how big the problem would be other than to say it won't be Armageddon, which I still believe.

The need to be precisely correct becomes less important if you can assess the big picture which is much easier to do than picking stocks. Another aspect of top down is that when you get the asset class right it almost becomes harder to find a stock that goes down.

While that statement is a tad hyperbolic it would not be easy to find a tech stock that was down in 1999 or an emerging market stock that was down in 2006. It would also be hard to find a tech stock that was up in 2001 or a financial stock that was up in the last six months. Obviously if you look hard enough you will find stocks that work against all four examples but you get the idea.

Not everyone can be comfortable buying individual stocks but it is far from Russian roulette. The worst thing a stock can do is go to zero and that does not happen very often. A 2-3% weighting in a stock that goes to zero might set a portfolio back a few weeks, if even. A 25% weighting in a biotech that cuts in half on bad FDA news can set a portfolio back for an entire year.

Moderation.
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Sunday Morning Coffee

There was an interesting post from IndexUniverse that I found on Seeking Alpha by Matt Hougan about six intriguing asset classes available via ETFs.

The six Matt cited are international small cap, China, Japan, bonds, themes (like timber and water) and the last one was more of what might come in the future as opposed to current ETFs and here he cited maybe a 130/30 or a market neutral fund.

I think the investment product evolution we have been witnessing in the last few years is leading to retail investors (whether they are on their own or hire someone) being able to assemble portfolios in the same manner as pensions and endowments.

Currency is an asset class. Infrastructure is an asset class. Absolute return is an asset class. Private equity is an asset class.

I've been writing favorably about using currency and infrastructure for a while, I have written about absolute ideas a few times as more of an exploration but I have not been a fan of private equity products. PowerShares has two private equity ETFs, PSP and PFP. I wrote about both of them for TheStreet.com and concluded that these were more like proxies for the financial sector as opposed to actually capturing private equity.

There is a closed end fund that is kind of in the ball park but I am not sure what to make of the result. You might remember the MVC Capital Fund (MVC). Originally it was an exchange traded product (CEF) that was to provide direct access to a venture capital fund. It floundered for years, had some controversy and now may have righted the ship. So maybe it took six years or so before righting itself. If you look at the holdings it seems like it is more like a pool of capital as opposed to a company that benefits from managing a pool of capital like most of the contents of PSP and PFP. To be clear I don't own MVC nor have I studied it.

The ultimate goal of this sort of study, as I see it, is smoothing out the ride where possible. Invariably if this evolves the way I think it will there will be people who misuse these products and blow themselves up. It happened with tech and based on emails and blog comments people made similar, albeit generally less dire, big bets on emerging markets and Canadian royalty trusts.

I make a point of reiterating moderation with anything and that will go for whatever great thing might be coming.

The picture is not a fire I fought but it is a cool photo.
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The Big Picture For The Week Of December 9, 2007

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Dviersification

This chart captures three stocks and the S&P 500 (as measured by SPY). I removed the other tickers as that is not the point; SPY is in yellow.

The blue line is a growthy stock a bought at the start of the chart (early October), the red line is the one REIT I own across the board and the green line is one of two foreign mining stocks in my ownership universe. The blue line shows up 20%, the red line down 15% and the green line with a wild ride to being down less than 1% in a down 4 plus percent environment for the S&P 500.

One reason for the timing of buying the blue line stock was as a counter strategy to my bearish sentiment--that is if the market rallied I figured this would help me to better keep up.

Going into a period where the market was going to drop 4% in two months I might think the REIT would hold up better than the growthy, albeit with a long term theme I believe in, stock.

The REIT obviously came apart like most REITs due to the financial event we are still working through. Take these three as a microcosm for how a properly diversified portfolio can work. The three are from disparate sectors and make an important point. Leadership will come from somewhere. You may be right or wrong about where leadership comes from but you will have the exposure if you are diversified, meaning you don't have to be right to have a good result.

These are all individual stocks. The stock that is up a lot is ahead of the corresponding narrow themed ETF, the REIT is down more than iShares DJ REIT (IYR) and the mining stock is about even with the iShares Global Materials ETF (MXI), I own MXI for a few accounts. So more risk and more reward with stocks, no shock, than with ETFs but interestingly enough the net result seems to be about the same.

Taking the path of least resistance is important in life and portfolio construction.

One last item, I think this week's video will be interesting. I am going to take a stab at recapping some of the meatier portfolio construction concepts discussed at the Super Bowl of Indexing I attended earlier this week.
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Oy Vey

I am trying to figure out what to make of the Paulson and Hillary ideas for homeowner bailouts.

The first thing is that some sort of government lead thing is going to have unintended consequences. Michael Shedlock had a good post that mentions among other things that anyone who lied to get a loan can't really come back with W-2 that shows a different number meaning that the idea will turn out to be nothing but "lip service."

The entire situation we are in now is an unintended consequence of rates being kept low for too long. Whatever they have in mind now and then whatever it is they actually end up doing will cause problems. I am not going to be the one to figure out what all the issues are ahead of time nor do I know if the problems caused will be worse then the original issue but if they actually execute a plan, watch out.

One aspect of this that also troubles me, especially after hearing what Hillary had to say, was that we need to help people who were the victim of unscrupulous lending practices yada yada. My wife and I each have family who have made catastrophically bad personal finance decisions. Much as I hate to say these family members don't get it and I doubt they ever will.

Lying about income and taking on more mortgage than can obviously be afforded ultimately falls on the borrower no matter what anyone else says along the way.

This is more about individuals making very bad decisions than it is unscrupulous anything and now we are going to bail people out to go on and make more bad decisions in the future.

I realize my stance is particularly unsympathetic.

Speaking of Hillary, I may be wrong but I am convinced she either does not understand how capitalism works or she does not believe in it, except maybe in her commodity trading account.

Just curious, how many jobs are going to be created if people making $50,000-70,000 pay $500 less in taxes and we pay for that by increasing the tax for people who actually make enough to create jobs?

The solace is that if Hillary wins she will not be able to enact a whole lot from the standpoint of very few campaign ideas ever get implemented.
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By Request

Over the weekend T asked for my take on the iShares foreign dividend fund IDV and the First Trust Global Dividend ETF (FGD). In this post I look at IDV and I think I am going to do a write up for TheStreet.com on FGD.

The chart compares IDV to similar funds from PowerShares (PID) and WisdomTree (DTH).

IDV has lagged substantially since inception. The lag, I believe is attributable to a couple of things. It has the heaviest weighting to financials at 41.74% compared to 38.53% for PID and 40.76% for DTH. The difference may not seem to be that much but PID has 10.41% in the big Canadian banks which, luckily for me, has been a good place to have financial exposure during the crunch. The differentiator for DTH has been its 11.56% in energy compared to just 2.09% in energy for IDV.

At some point the financials will obviously provide leadership and at that time (whenever that comes) IDV will probably lead the way up. Some might want to game that sort of thing but that is not my type of trade.

From a diversification standpoint I think IDV is the worst of the three but between PID and DTH I am not sure which is better. DTH excludes Canada as a function of methodology while PID has 20.56% in Canada (according to ETFconnect).

Depending on how PID might be used in a portfolio someone might end up with too much Canada. I have owned one of the banks across the board for quite a while now and have had more exposure in the past (reduced it earlier this year) for some clients. You may have heard they lowered their overnight rate yesterday, and the loonie has given back some of its recent gains. The greenback being too weak is problematic for them and while I have no plans to sell the one bank I would not want too large of a position right now. Also if oil has its usual winter swoon (started a little early this year?) that too could work against Canada and for now I have been trying to reduce volatility for clients.

Trying to look forward for DTH you could take the above paragraph and replace Canada with Great Britain and the 27.88% it has in DTH. Fears of a slow down are gaining traction and so too much GB could also be the wrong place to be. I have a couple of UK stocks as across the board holdings including a bank and some clients own a two year piece of sovereign debt as well.

There have been calls for the pound to generally weaken but I do not think it will weaken against the dollar as a standout unless the dollar surprises everyone and rallies against everything in 2008 which is a possibility. Do not take that as a fundamental opinion but just my being ready for the dollar to rally at exactly the time it shouldn't.

All of the above should illustrate the problems potentially faced with broad-based funds--I do view them as broad-based. I do own PID for a couple of accounts where as a function of circumstance it makes sense but the types of overweights and underweights described above to need to be accounted for, IMO, if they are going to be used.
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Catching Up

As I mentioned over the weekend I went to the Super Bowl of Indexing in Scottsdale yesterday. It was a long day and so as I catch up here and there (I did a 6am interview today which didn't help) if you left a question yesterday I probably won't get to it on that post so you should feel free to re-post it on today's post.

I'll share a couple of observations now and go into a little more detail on the brainier stuff in this weekend's video.

As far as new products that might be coming, I did not get a great feel for the products that might be coming. I asked several people about frontier market products and without saying it exactly it seemed like there are concerns being able to trade enough shares to accommodate potential demand. There were a couple of anecdotes about how thin and small a couple of these markets are.

I spoke to the StateStreet people about more choice in foreign fixed income and I think I got a "I hear you but..." type of answer.

I asked a question in the session that included currency ETFs to Steven Sachs, actually it was more of a request for more product like maybe the Sing dollar. His answer surprised me, he said he'd like to have a product for every currency. There are quantity limitations with many currencies so a product for every currency will never happen but that he was public about wanting to see more is a change from last year and encouraging.

I had a chance to visit with Tom Lydon and Richard Kang for a while. Both of them are on their way to being masters of the universe as I strive to be master of the couch. Both of them are doing a lot of interesting things that I think we will hear more about shortly.

At lunch there were a bunch of awards given out. Paul Samuelson, the guy who wrote your econ 101 textbook, got a life time achievement award and gave a little presentation via satellite that was pretty entertaining. In case your wondering, he's 92.

Jack Bogle was there in person to get his lifetime achievement award but he only spoke for about 90 seconds.

The CBOE S&P Put Write index won the award for most innovative new index (or words to that effect) so maybe it will be coming to an ETN near us soon.

One other point to share now is that in terms of products listed elsewhere someday trading here, this came up in another session. This is important to me as there are some very interesting products on other markets. For this to happen the industry would need to figure out how to "change the wrapper." For example there is an ETF that trades in Norway that tracks the OBX. If you wanted that exposure and there was only one way to get it and that one way was something other than an ETF, would you still buy it (again assuming you want the exposure)?

One funny item. I met one very well known person (well known within the industry), I reached out my hand and said my name and that I write for TheStreet.com (the person introducing us mentioned my blog) assuming that he'd never read any of my stuff (which he hadn't) and he said "Huh, I hear from a lot of other people from there." That was it. Lol, um nice to meet you too?
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Wowsy Wow Wow

If you weren't bearish before you will be after you read this post on IndexUniverse from John Serrapere. I have written about and linked to Serrapere's past work for Index Universe.

John constructs his thesis around several big macros and uses some interesting techniques to reduce volatility as, similar to what I have been writing about, he is playing defense.

He cites a very common issue, one that I have mentioned before, that marks the maturation of the cycle which leadership rotating from, as he calls them, low quality to high quality.

He also notes that when S&P revises earnings downward that is a major sign for caution. He notes "Standard and Poor’s just announced a cut on estimated S&P 500 earnings for 2007 by 7%, which results in a 3.2% year-over-year decline."

He also attributes much of the excess of the last few years to the carry trade which he calls the root of all evil although in the past he has been long the DB Carry Trade ETF (DBV).

In the defensive portfolio profiled in the post he outlined how he reduces volatility with yen (FXY) and swissi (FXF) longs, he shorts EEM, he manages beta with various sector ETFs by analyzing how they react to trends in GDP and how they should react liquidity issues.

He also makes a lot of interesting observations that you might have read about elsewhere but that he really delves into.

Based on what I have read from him (he does not post very often that I am aware) he seems to be very sophisticated, the mixing and matching of volatilities, segments and products is very heady stuff. I believe the things I do are similar but on a much simpler level. I have no idea if he views what he does as simple or complex but my intention is to make things as simple as I can for myself and I try to promote to others that they keep things simple.

Diving into an article like this one that is very complex provides a great learning opportunity for anyone, IMO. Learning about complex, if you do it often enough can go a long way to a better understanding of simple.

This article in particular explores a position's effect on the entire portfolio as opposed to the singular result, something I write about a lot. If a portfolio is diversified there should be always be stocks that are up and others that are down. There are all sorts of technique to change volatility, change the impact of a sector or event on a portfolio to name a few.

This is important stuff to understand.

One last point is that Serrapere's bear case is very compelling, as they always are, and I will lean the same way it is important to remember that capital markets do exactly what they shouldn't all the time. Maybe that could be said about the action we have had thus far but if a bear is here or in the offing you should have plenty of time to get defensive if that is something you would want to do.

Finally thanks to Bill Cara who had a couple of kind mentions for this blog in the last few days.
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Impending Destruction of the US Economy

Impending Destruction of the US Economy

I doubt sorting out the probability of this thesis would be that useful but if it does happen 5% each in 20 other countries or if that is more time than you want to spend 10% each in ten other countries would probably spare a lot of pain.

Hat tip Barry.
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Sunday Morning Coffee

We had our first winter storm Friday night and the dogs are a little out of sorts.

Barry had a link to an article about Goldman Sachs' ten best trades for 2008 and most of them seemed to focus on currencies which can't be accessed very well through brokerage accounts.

There are obviously a few Rydex ETFs and even fewer ETNs from Barclays but they focus on just the biggies and after talking to one of the Rydex guys last year they have no plans to expand the product line, not even the Singapore dollar (SGD) is under consideration. Maybe something has changed?

I believe foreign diversification in currencies is just as important as in equities and fixed income. Perhaps the future of this asset class' accessibility will simply be discount brokerage firms allowing the purchase of foreign currency in brokerage accounts (does this already exist and I don't know about it?).

Some will say its too speculative and that brokerage firms should not offer this. Holding foreign currency ( as opposed to futures contracts) with no leverage is far less risky than somethings brokerage firms have allowed for years. Ever known anyone to blow themselves up owning a huge position, on margin, of a biotech stock that had bad FDA news? The result is negative equity, that means you need to bring money in just to get back to zero. Believe me this has happened many times in the past. This is why a lot of firms were fiddling with margin requirements at the start of the decade.

Ever known anyone to blow themselves up with naked puts? A put sold with a strike of 100 only requires $2500 margin (rule of thumb number). So you'd have to buy $10,000 worth of stock if assigned on one put. Obviously a brokerage firm would let you sell four puts with only $10,000 (subject to minimum account size). So if this blows up very badly the put seller might have to pay $40,000 for $15,000 worth of stock. This happened routinely at the start of the decade.

Buying $10,000 worth of Moldovan leus (MDL), or something a little less off the wall, in a cash account could make for a bumpy ride but won't make for negative equity. And for the this-is-too-dangerous crowd brokerages could implement a suitability screen like they do with options.

For now ETFs, limitations notwithstanding, are the easiest way to add currency exposure--at Schwab anyway. If something better comes along I would have no qualms about bailing on the ETFs. This brings me to a good point to conclude with which is that the product is less important than getting the access you want.
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The Big Picture For The Week Of December 2, 2007

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