The Big Picture for the Week of January 1, 2012

After listening to the umpteenth segment on CNBC where both guests extolled the virtues of some version of dividend stocks, dividend growers or high yielders or the like, it has become clear that we have a very popular theme here. Over the last couple of years I've had some posts where I have tried to isolate the importance of dividends to a portfolio but tried to warn of the risk of a cultish devotion to them hence the term dividend zealot.

Also during the week I read a post at Seeking Alpha with a cautious tone on a dividend stock bubble and all the usual suspects chimed in about why dividend stocks can't be a bubble.

For people not cultishly devoted (read all the comments on dividend articles at SA and tell me there isn't a cultish tone) but still very interested in the topic I thought of a different way to articulate my thoughts on this subject which hopefully is useful. In listening to the aforementioned CNBC segments and the articles that have popped up people seem to think of dividend stocks as an asset class which I don't think is the right way to look at it. People also think of dividends in terms of various strategies like dividend growth and so on and the strategy idea is a correct way to look at it but I don't think it is the only way.

I think of dividends, more precisely yield, as an attribute to be managed in the portfolio. In the trade we executed during the week we added a name that has a pretty easy time paying 6%. I also mentioned that I expect to add a couple of other stocks with similar attributes (higher yield and low volatility) with an idea toward increasing the yield of the portfolio.

Part of my thesis for the decade is equity returns for the US market that are below "normal." The last two years averaged out don't refute the idea. Dividends over extremely long periods of time account for about half of equities' total return and if I am right about the new decade then dividends might account for more than half. While I believe this to be a very plausible scenario it also appears that from the bottom up yields on many stocks are now quite a bit higher than they were in the 1990s or 2000s. It is much easier to find stocks yielding 3% than it was ten years ago.

In years past I wrote many times about targeting a 3% equity yield against the SPX's 2% yield but now it might be possible to get a 4% yield against the SPX's 2% for the next few years or longer. Please note that the context here is a portfolio diversified to include all SPX sectors along with foreign exposure and taking in a full range of attributes into the portfolio.

The reason SPX still yields only 2% is because the financial sector is still a large component and many of the biggest banks pay little or no dividend as ongoing fallout from the crisis--at least this is my opinion as to why SPX only yields 2%.

If my idea of a diversified portfolio (not that you should care about my idea of a diversified portfolio, but this is the process I am working through) can yield 4% (I've not yet come to that conclusion) and if it turns out that domestic equities only average 3-4% per year then that yield does a tremendous amount of heavy lifting for the portfolio. From there a couple of correct country decisions and figuring out one thing to avoid (hint:US and European banks) and there is a good chance of having a "normal" return in a below normal world.

And for anyone doubting their ability to correctly select a couple of countries and correctly avoid something; they can still have that yield to fall back on.

The picture is from the Arizona Sun Dogs hockey game last night. The Sun Dogs are Prescott's minor league hockey team.

Happy New Year!
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Trade Executed

We executed a (mostly) across the board trade for large accounts on Thursday buying ASX Limited (ASXFF) which is the stock exchange in Australia. The trade obviously increases our exposure to financial stocks and takes us back to Australia after having been out for about seven months.

First from the top down I have been concerned that Australia is at risk for some sort of housing problem although with a far less severe magnitude as occurred in the US and so I sold our holding in ANZ Bank (ANZBY) for large accounts and at the same time sold our Aussie ETFs for their large exposure to the banks. ANZBY is down 13% since that sale and the ETFs are down a little more which is nice but I would not call the sale a major transaction.

Going forward I think housing can still be a drag and so I think the banks will underperform but my take overall is that things in Australia look good--drawing this conclusion means you have to believe that China will not stop buying resources and I think Yanzhou's intended purchase of Gloucester Coal supports that belief.

I would also note that the SPX is right at its 200 DMA (give or take) but we have more cash raised than I think is ideal by virtue of selling American Tower. I wanted to buy something with relatively low volatility and higher yield (more on that in a moment) and actually if we have more purchases to make I think most of them, but not all, would be lower vol and higher yield like ASX.

In terms of picking an exchange stock, I think I've been telegraphing this for a while in how much a talk about this group and obviously this adds exposure in the financial sector while still keeping away from US or European banks and Aussie banks for that matter although I would reiterate that I do not think the Aussie banks face anywhere near the magnitude of risk that US and European banks do.

The stock itself is cheap in terms of where it has traded in the last couple of years and while it is a little cheaper valuation wise than where it was a couple of years ago it is not a deep value stock. It has essentially no debt, almost 2/3s of the share price is in cash and yields abut 6% with a pretty reasonable payout ratio.

A little while back ASX was going to merge (be taken over) by the Singapore Exchange (SPXCF) but the deal was nixed. While I think odds of a takeover are low it would not be a black swan event either.

After lagging the US for a couple of years I think Australia can come around again and if that turns out to be correct then I would ASX to do a little better than the broader Aussie market.

As a small logistic item, we bought the stock directly in Australia so it was entered overnight on Wednesday US time which is Thursday in Australia. We bought in this way because it doesn't trade enough volume here for our entire client base but the name is very liquid on the home market. If we buy the name for any new clients for whom it is appropriate I am quite certain the we could get individual trades complete on the US pinks.
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Getting to Know the Future You

A writer named Doug Carey had a post at Seeking Alpha called 3 Pitfalls To Avoid When Retirement Planning. He says don't wait to start saving, don't count on Social Security and make sure you beat inflation. Obviously all three important but as I read through I stumbled across what I think could a huge dilemma.

In talking about starting early he starts out with something like let's say a 25 year old wants to retire at 65 and then he crunches some numbers showing the importance of starting early and he is right but there is a problem here that I have thought of often but could never figure out how to articulate (and maybe I still can't).

Think back to when you were 25. Could you have possibly had any understanding or what it meant to be 65? When I was 25, even 40 seemed to be so far into the future that it would never come (not that I wouldn't make it to 40, but more like it would never come for being so far off in the future). As I got close to 40 I realized that when I was in my 20s I had no concept of what 40 would feel like. At 45 now, from a self-awareness point of view I am quite certain that I don't really know what it will feel like to be 65, it is possible I don't understand 50.

If I am even articulating this in a way that makes any sense it creates a lot of unknowns in trying to plan for retirement. I think it is easy to understand at any age that you need to save money for the future and the more you save the better off you are likely to be. Someone who is 25 can understand this I think because as framed in this sentence there is no need to envision or guess what your life will be like in 40 years. "I know I will need money" is easier than "I will need $3400 month starting out and my health insurance will go up 10-15% per year."

I believe in crunching the numbers. At 40 or 50 you have some piece of money and you have whatever knowledge about yourself that you have accumulated and you need some sort of blueprint. So I guess the point is to have enough self-awareness to know that the 65 year old you might view things much differently than the 50 year old version of you.

To the extent this line of thinking resonates, the solution needs to be keeping as many options open as possible. How each person does this is where personal solutions come into play. I tend to think of options as including not needing every last nickel you make to pay for your lifestyle (as in live below your means) and having some sort of plan B in case the unexpected happens with your primary source of income. In trying to think about post-retirement; what about having a job that you love enough that you don't want to retire or putting in the time to create some sort of ideal job for yourself (monetized hobby) for when you do retire such that it covers a decent chunk of what are hopefully modest expenses?

I believe I walk the walk in this regard in that while I can't envision a scenario where I want to do something besides manage money in the stock market, I realize that anything can happen and between the writing and a small income I could take from the Fire Department (we can be paid for certain patrolling and certain fires) it would cover our fixed expenses by a slim margin. As I have said before I am very motivated to avoid financial stress and having a small monthly nut is probably easier for most people than finding a job that pays a lot of money.

Everyone needs to figure these things out for themselves but everyone can benefit from keeping as many options available as possible.

Yesterday came surprising news that the Red Sox traded Josh Reddick to the A's. Oh, boy. In Theo we trust in Ben we hope.
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It's The End of the World and Paul Farrell Knows It

Paul Farrell had a column up yesterday that detailed ten reasons why 2012 will be a doomsday. Included in the list are failings of US democracy, class warfare and some disturbing prognostications about global warfare.

If you read the paragraphs that Farrell wrote on those points, it is hard to disagree with the nature of the problems he cites. However these are not new issues and Farrell offers no reason as to why 2012 must be a tipping point for any of them. While I apologize for not taking the time to look I would venture to say that these points or similar ones were predicted by him to be tipping points in previous years.

Expectations of torn social fabric, or the breaking down of society were made at the beginning of the crisis and have not panned out and are unlikely to. Some things have gotten worse and will continue to get worse but we collectively can adapt better than most, probably not all, countries. To repeat an idea I have mentioned frequently, the US is the world's most important customer and so other countries have a vested stake in our remaining functional. Remaining functional is not a Jim-Paulsenian argument to be bullish but does argue for the US' ongoing ability to slog through as we have been.

Some of the other reasons cited by Farrell seem totally disconnected from the thesis of doomsday. His number 7 was about market technology whose consequence is that "average investors are no match for Wall Street’s 'high-frequency traders.' " He's probably right here for average investors who actually try to hit bids and lift offers faster than the machines but more practically average investors buy a few shares of broad based ETFs or blue chip stocks with the intention of holding long term not to scalp pennies before lunchtime.

Further, individuals have always been disadvantaged when compared to professionals and they always will be. No argument from me if anyone thinks that is wrong but it is hardly new. It is not plausible that a decades old issue can cause a breakdown in the magnitude he seems to suggest.

Farrell's last reason for doomsday was actually a suggestion of sorts about what to do in the face of doomsday not a cause of it. He cites advice given by Barton Biggs about being able to grow your own food, real everyone into the bunker stuff, except that advice from Biggs came from a book published in 2008. Based on what I have seen of Biggs' TV appearances he appears to have distanced himself from those opinions (please comment if I have that wrong).

We have real and seemingly (almost) unprecedented problems but end of the world arguments like "the next crisis, according to Weiss, 'will destroy the incomes, savings, investments and retirements of millions of Americans.' Yes, destroy. 'It will plunge vast numbers of families into the nightmare of poverty … hunger … and homelessness. Only a minority of investors will survive intact' " have been made for thousands of years, there has always been a big market for selling fear.

It is important to understand the threats but not overreact to them. It is also important to understand the hopium sold by Wall Street and understand how markets and compounding can work. Understanding both sides gives a better chance for successful critical thinking that is required for successful cycle navigation.

Away from investing we need to do our best to be healthy (fit might be a better word) and remain individually adaptive. We can't know how our individual circumstances might evolve. While I hope that my financial situation never relies on my generating an income from being an EMT if it ever does, then I will be grateful that I went through the process.

The need for innovative personal solutions, a long running theme here, will become increasingly more important as time goes on. My neighbor with the backhoe is the best example of this that I know.
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What Do You Think?

From Larry Swedroe's 2012 outlook piece for Seeking Alpha (similar to what I did with them a week or so ago. The following is offered without comment from me (this time), only a question. What do you think of the approach outlined in his answer?

Seeking Alpha: So under specific circumstances such as the current situation in the Eurozone, you don’t lighten up on particular problem areas at all in client portfolios?

Larry Swedroe: That would not make sense. The reason is simple. If we know there are problems, the market surely also knows and that means the problems are already incorporated into prices. And why would you buy when things look safe, and thus valuations are high and thus expected returns are low, only to sell when risks show up, and thus valuations are low and expected returns are now high? That doesn’t seem like a rational strategy, yet it is exactly what most investors do, and it explains why they do so poorly, underperforming the very funds in which they invest.
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Christmas Morning Coffee

Barron's cover story was about the rough ride of Gap Stores (GPS} over the last decade. I was surprised to see that for ten years GPS is up 41% versus 10% for the S&P 500 and for five years GPS is down 6% versus a 10% drop for the index. That all actually sounds pretty good for a supposedly down and out stock which on top of everything else yields 2.4% which is a little more than I would have thought.

I haven't thought about Gap as stock since I don't know when and when I saw the headline of the article I thought I would put up a post about how any must-own or hold-forever stock can have its fortunes change for some reason, either a sensational reason like with Worldcom which was a wildly popular stock that obviously went bust in scandalous fashion or in the case of Gap which seems like a well run company (casual observation only) that has simply become less relevant which of course has happened with fashion companies many times in the past (LA Gear was an amazingly hot stock 20+ years ago).

While the above is an important lesson it doesn't seem to actually apply to GPS. Given the five and ten year results for the name this is probably more of a story about patience. Returning 41% over the course of ten years is still below "normal" but not a catastrophe in an up 10% world.

To be clear I have no interest in Gap Stores but the example is constructive nonetheless.
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The Big Picture for the Week of December 25, 2011

In my 2012 outlook piece for Seeking Alpha and in the upcoming 2012 Roundtable for Bespoke Investments I have some positive things to say about investing in China. As the chart below shows, investing in China has been rough for the last few years. Since the 2007 high for the S&P 500 the Shanghai Composite is down about 60% and the Hang Seng is down about 30%.

One thing that is true in general terms is that markets can correct in time not just price. After four years of going down in fits and spurts it is possible that the China markets are now ready to go up. We can explore this a little further in this post and you can draw your own conclusion but correcting in time is not an outlier phenomenon.

In mid 2007 we sold out of Sinopec (SNP) and a little over a year later went into China Mobile (CHL). SNP was a great hold, I became wary and moved into a less volatile name with CHL but that was a mediocre hold at best and we sold it. After having no China exposure for a while we added an underweight by virtue of China's weight in Market Vectors Coal (KOL) and iShares Emerging Market Infrastructure (EMIF)--our China weighting is about 1% by way of these funds.

The negative argument for investing in China surrounds anything to do with real estate, over capacity, empty cities, debt loads of the banks and debt loads of the municipalities which contributes to questions about whether China will be in for some sort of hard landing. There are also concerns about demographics. GDP growth has been 9-10% for a long time and I have seen several different definitions of what would constitute a hard landing but many believe that if there is a hard landing in China there would be serious social unrest.

The positive argument centers around urban migration, ascending middle class (an "American-ish" lifestyle), China playing an ever increasing role in the world economic order and the country continually becoming wealthier.

I don't think there has been much change to either side of the ledger in quite a while. I think the same threats will continue to threaten for a while longer and the same positives will continue to be the positives for a while longer. I think the decision about what to do with China boils down to a combination of how long the China market has been slogging on and which of the two sides will win out from here.

As you know there has been a lot of commentary about how bad things might get in China because of the various things mentioned above along with other reasons. The reasons are valid but it is also true that the market has fallen by 60% in four years and while it is of course true that it could fall another 60% from here I believe the decline thus far discounts a lot of problems.

China is not facing the systemic threats that the US and Europe are facing yet it is down more than these markets, I looked at Germany, France, Spain, Belgium and Italy (Italy is down about the same as Shanghai) in this context in the last four years. I think this is saying that China is over done, Europe has a lot farther to fall or both.

If you can buy into the idea that China is not facing systemic threats then it is a cyclical event and a cyclical events tend not to last this long. A 60% decline more than prices in a cyclical recession in my opinion. And if a recession of some sort is what is coming then it is plausible that since equities turned down so long ago that they could turn up before a recovery starts and in this instance maybe even before the hard landing. Again, you can agree or disagree.

About that hard landing, although merely anecdotal China is still doing a lot of buying of resources around the world with the latest news being this week that Yanzhou Coal (YZC) is buying Australia's Gloucester Coal (GCRLF).

For many years I have been saying I want no part of the banks or real estate companies, and for that matter I don't want to own companies that rely on discretionary purchases of Chinese trade partners. I'm not changing my opinion on that so this rules out many of the ETFs that exist for investing in China.

For me the story has not changed, it has simply evolved. I don't like the banks and RE companies and haven't for a long time, that has not changed but the story in terms of what appears to be going on with lending and overcapacity continues to play out. Likewise demand for energy, resources (although resources are in part tied to the overcapacity) and something close to the American lifestyle continues to increase. This demand creates a tailwind as I often say, that has not necessarily mattered lately but it is the starting point for an investment thesis.

I think energy can be owned, but not solar, also industrials and utilities. For consumer I would avoid exporters and focus consumer items made in China for Chinese people but to be clear I favor the other sectors mentioned. I will be looking to add a little more Chinese exposure probably with one stock at 2-3% which obviously would take the total exposure to 3-4%.

One point of clarification is I am not talking about reverse mergers or companies that otherwise domicile in China but list primarily in the US.

Obviously you may weigh out the positives and negatives and conclude it is still something to be avoided but if you have ever had some interest in China and think that you might in the future then you do need keep tabs on current events and reassess these various factors every so often because if I am wrong about China in the near term, then it will be a buy at some other point.

Merry Christmas.
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Concessions A Comin'

The other day I found this article about beneficiaries of a public pension (retired police and firefighters) agreeing, by necessity, to a reduction in their payments. While I don't know whether the cuts will be big enough I do know that the idea of of benefits being reduced in a public pension used to be unthinkable.

Over the years I've talked about the importance of not taking anything for granted with things like pensions or social security (probably a good idea in non-financial matters too).

In the news this week was whether or not Congress would extend the payroll tax holiday for two months (so they can then extend it for the full year later) or extend it for the full year all at once. If it is not clear, anything we don't personally pay in FICA during this period is being made up by the treasury which contributes to the ever increasing debt load. This may obviously lead to some bad outcome for social security in the future that ten years ago was equally unthinkable as pension cuts.

For a long time I've been saying that something will have to give with Social Security in terms of benefit cuts one way or another. There have been comments taking the other side noting various data points to the contrary. Things are evolving such that I do not believe it is wise to rely on various assumptions and projections as things have developed over the last ten years in a way that I would submit has been unfathomable and more realistically unanalyzable.

If the last ten years has been reasonably unanalyzable then so too could the next ten years. I am still not in the financial apocalypse camp, I'm not that pessimistic of a person, but do remain in the noticeably uncomfortable camp consistent with my ongoing assertion that the US will still be the world's most important customer but that we will slog through.

A little longer term, as I've said once or twice before, something will have to give with entitlement payments. I think it will be some sort of means testing but either way I think the math being assumed is shaky at best based on assumptions being used, but again I think it is a bad idea to rely on the current assumptions and projections.

As grim as it may sound, prepare for the worst and hope for the best. Preparing for the worst has to mean, in my opinion, expecting nothing from social security especially if you have a high income and did the "right thing" in terms of saving money. Yes, the odds of this being unfair is very high, again, in my opinion.

Obvious statement; it would be better to not be financially done in by a surprise in your social security payment.

The picture; I tried to make a joke on Facebook out of taking it cross country next summer but no one knew I was joking so I'll just say neat motorcycle.
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ETFs in the News

IndexUniverse reported that Global X will be closing several ETFs for lack of AUM. Included in the list are the Fishing ETF (FISN) and the Farming ETF (BARN). Both fisheries (although subtle, I think this would have been a better name than fishing) and farming are themes that I have written about many times and I continue to believe are valid.

However stocks in both, as I mentioned recently in another post, are far more volatile than the underlying demand for protein. Look at the charts for the companies in the funds and you will see they are difficult to own. The combination of being difficult and unlucky timing is what hurt these funds, in my opinion. At some point the stocks within will again catch fire but obviously at that time investors will only have individual stocks to choose from.

The funds got made fun of a lot which I never fully understood. They targeted narrow niches, turned out not to catch on and so they are being closed. Investors were not hurt in any sort of unique or flawed product manner, the funds simply did poorly like any individual stock or narrow fund might.

The other bit of ETF news, also reported by IndexUniverse, is that ProShares has filed for a suite of low volatility ETFs. Broad based, low vol ETFs are being issued left and right and attracting a lot of AUM. The PowerShares S&P 500 Low Vol ETF (SPLV) has attracted $700 million in about ten minutes of trading (hyperbolic comment).

The funds in the filing are targeted to track the Nasdaq 100, Dow 30, Russell 2000, Russell 1000, MSCI EAFE, MSCI Emerging Market and the S&P Mid Cap 400. You can read the IU link for more specifics but basically the strategy will be to increase or decrease equity exposure to the respective index based on realized volatility of that index going above or below 15%.

Obviously I have no idea how well these particular funds will work but SPLV and the EG Shares Low Volatility Emerging Market Dividend ETF (HILO) have both traded as advertised in the short histories.

I think these funds, the ones that end up working as advertised, offer a chance for the core and explore concept to evolve. One aspect of portfolio construction and management for do-it-yourselfers is limited time available to spend on the task. The drawback for using regular cap weighted, broad funds is the lack of portfolio precision and absorbing every bump on the way down.

The low vol funds are obviously designed so that holders do not absorb every bump on the way down (you need to decide for yourself whether they achieve that objective). A broad based fund portfolio capturing various segments (small cap, emerging and so on) could be assembled using low vol fund with some disproportionately large chunk of the portfolio and put the smaller portion into various themes, niches or countries.

This could end up as some combo for the equity portion of four or five low vol funds for the broad portion combined with maybe five individual stocks or narrow ETFs as described above. Keeping track of ten holdings would address the time constraint issue that some folks have. Defensive action could be achieved, at least partly, by selling or reducing exposure in the narrow holdings. The remaining broad, low vol holdings would (or should) be less volatile than straight beta holdings and maybe even have a higher yield.

I am not about to switch to this approach but it can be valid way to go; broad access, some specialty exposure, the chance for more yield and no 40 hour time requirement. For some this would be a very good way to go.
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Small Trade

Yesterday we executed a trade for large accounts selling American Tower (AMT). We bought the stock in October 2009 at about $38.60 and sold it yesterday near $59.35. It was generally a great hold for over the two years and the gain obviously was a nice boost for the portfolio.

The reason for the sell has to do with the story appearing to change. There are several reasons for an outright sale including being wrong about the stock, something wrong at the company, top down reasons and in this case a possible change in the story.

If you know the stock then you know it will be changing to a REIT soon. This doesn't have to be good or bad but it does represent a change. While the company is in process of managing this transition it is also dealing with an SEC inquiry from a few months ago about its accounting. This by itself is not unheard of but the combination of the two simultaneously is unique. I also stumbled across data that insiders had increased their selling of late. As this has been going on the stock price doesn't really seem to be any worse for wear, it made a new yesterday a couple of hours after we sold it.

From the a man has got to know his limitations Harry Callahan school of thought I know I am not the guy to sniff out an accounting scandal. Someone (the SEC) has some questions and the insiders are selling a little more stock. There probably is no meat on this bone but I do not want to take that chance. Where things like this are concerned I would rather have to defend selling too early to a client than selling too late.

I can't recall another sale made where insider activity had much of a seat at the decision table which raises a useful point for narrow based portfolios. I've tried over the years to convey my preference for avoiding slavish devotion to any single indicator or narrow combination of indicators because not everything can work all the time. Sometimes cheap stocks get cheaper, sometimes insiders are wrong, sometimes support fails and so on. I guess I would say to stay flexible my friends.

Speaking of "my friends," a funny Tweet from the most interesting man in the world; He once defended a small village in the amazon basin from ferocious fire ants by using only a pitchfork and a glass of water.

The picture was taken yesterday on a quick hike on the mountain.
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Market to BAC and T; Drop Dead

Or should it be the other way around?

Bank of America (BAC) closed below $5 yesterday during the regular session although traded above the figure after hours. The whole sector was down a lot yesterday; I saw articles blaming Europe and others blaming the new capital requirements. I usually get pushback on this but I will say again that this is not over. The financials will continue to have more shoes drop.

The book value arguments made by Barron's and others over the last few years have not mattered and will not matter for a while longer. I don't know how long this will last I just know we are not done yet. By financials I mean the big banks in the US that dominate the Financial Sector SPDR (XLF) and the big European banks although I would note that that our only US financial exposure is an index provider. Not related but I would also continue to avoid Chinese banks which means avoiding most China ETFs.

The other news of the day was AT&T dropping its bid for DT and so presumably having to fork over the $4 billion break up fee. The worst reaction I can recall to an M&A going bad was when the LBO for UAL unraveled in 1989. It caused a 6.1% drop in the S&P 500 on October 13 of that year.

I don't know whether this news could be that significant (probably not) but it is worth knowing a little market history about this and that deals collapsing can adversely affect the entire market.

The idea that the market volatility would decrease to close out the year as function of towels being thrown in seemed very plausible to me but based on the last couple of hours yesterday's trading seems to be off the table. Volatility; engage.

As I've disclosed in the last few weeks, I've been a little more tactical in the portfolio and mentioned doing a little buying if we dip far enough. No trade yet but I do have one penciled out and ready to implement if this current slide continues, I will keep the blog posted.

A little bit of personal news to share; I am now an EMT. I went to classes twice a week starting in August took the state final two weeks ago, the skills final a little over a week ago and the national final this past Saturday. I was lucky enough to pass all three on the first try; they give multiple chances because, as my instructor said frequently, they really want you to be an EMT.

The process was not fun but the fire department needs more EMTs and since I have responded to almost every medical call since 2003 it only made sense. I've written a lot of posts about volunteerism and finding something along these lines to do but my involvement with the Fire Department sort of found me; I was recruited in by my neighbor with the backhoe. Anyway, I am pretty excited.
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Foreign Markets in 2011? Not So Good

Bespoke Investment Group had a post the other day with the YTD returns of all the stock markets in the world. Of the 78 that they track only ten were positive. Of the ten that were positive, only six were up more than 2%. There are still two weeks left in the year so the numbers could of course change.

There were 13 markets that are down less than 10% which to my way of thinking constitutes down a little. There were 30 markets down between 10-20% and 17 markets down 20-30%. By any reasonable account that is a bad year but that goes with the territory.

Relative to the numbers on Bespoke's table the US had a pretty good year down just a hair. I tend to think the fundamentals are such that the US should not have outperformed quite a few of the countries that it did. Either that assessment is correct in which case 2011 is a good reminder that for a short period of time anything goes regardless of fundamentals.

If I am wrong about the US' fundamentals in relation to other markets then it raises the need for have some sort of counter strategy in a narrow based portfolio for the times you are wrong.

During the last decade there were stretches where the US was a relative solid performer like in 2011 but that did not change the rather long term result for the decade. Along the lines of the market being a short term voting machine versus a long term weighing machine I think it is important to understand what you're investing for and so what is consistent with your real objective.

Long time readers will know I tend to think that for most people the real objective is simply to have enough money when you need it. It would be great if everyone could beat the market every year or maybe go up the same 12% every single year but neither is realistic which, to my way of thinking, shifts the orientation to the longer term--again for most people. There are people who have the emotional makeup and skill for short term trading and there is no reason those folks should not pursue trading in that capacity. But if that isn't you then you need learn that and figure out what type of participant you really are.

The picture is of University of Louisiana Lafayette strength coach Rusty Whitt on the sideline of ULL's bowl game against San Diego State. The coach is very committed, in fact I think he was, once (Rodney Dangerfield line from the movie Old School in reference to the Sam Kinison character). I'm guessing some sort of seemed like a good idea at the time headbutting incident but I'm not sure.
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Sunday Morning Coffee

We all know that the concept of retirement will, by necessity, look much different for many now-working age Americans than what it did for the parents and grandparents of now-working age Americans. Over the years I've tried to explore this inevitability in what I hope is a positive way in that I believe this is a problem/challenge for each of us to solve for ourselves in a way that is right for us.

As long time readers will know, my wife works (volunteers actually) in dog rescue. By virtue of how hard she works and the type of person she is (while I am of course biased she is very innovative one many fronts in her role) she talks to all sorts of people from every conceivable part of the animal rescue world.

She was telling me about a situation that she thinks is coming up at a rescue whereby a rescue will give a free place (one of several houses on the property) to live, utilities included, in exchange for being the onsite manager (not the most accurate word). I believe the circumstance will pay $8/hour for 40 hours but realistically the typical work week would be longer. There are other employees that come and go during the week so the onsite person might better thought of as a coordinator but there is physical work involved.

For the right person, this could be a dream situation. The person would need to be moderately fit first of all but free housing, a $1200/month income, maybe the person doing this has a spouse with a part time job, maybe rental income if this couple owns a house somewhere and maybe a little bit saved to fill in the occasional spending need.

For the right people, how much would be needed per month if there is no mortgage/rent or utilities? A married couple with a modest lifestyle; how much do they need to be comfortable if all they are paying is various insurances (including health), groceries, a car payment and maybe they take one trip per year? While this would be a lot of work, for the right animal person with the right motivation this seems very plausible to me. Again, for some small segment of the population.

It is unlikely that the above would be your ideal solution which is of course not the point. The above is offered as a reminder that whatever it is that you really enjoy doing or otherwise put a lot of time into (or would like to put a lot of time into) can probably be woven into your own personal retirement solution.
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The Big Picture for the Week of December 18, 2011

A reader asks;

Will you comment a little further on deflation, disinflation and inflation? With gold on a slide, the euro approaching parity, world deleveraging, and the US consumer only shopping the "blue light specials" - seems that the economic climate is vastly more complicated than ever before and deflation may be taking hold.

My conclusions here are not very dramatic, no need to load up on whiskey, gun powder, jerky, ivory soap, cans of tuna or, to add a new one to this joke, bacon (see the picture).

The back drop seems to be increasing extremes of long standing patterns. For example we have deflation in asset prices which is the bad kind of deflation. In certain countries and certain sectors here we have what looks to me like a debt deflation which would be very bad depending on how far it ends up going. We have creative destruction in certain consumer goods (we just bought a DVD player at Walmart for $39) which is a good deflation.

As far as inflation, for many years we enjoyed a little inflation (for the most part) which it turns out is a good thing. People have been grappling with serious inflation with education and healthcare costs for quite a while and while I am not sure that it is getting worse it is not improving. I have a post every November griping about how much our health insurance is going up for the next year.

The price of propane to heat our house has gone up a lot but it has been lumpy; one year was a massive increase and it has been the same for the last couple of years (maybe this is because of how they positioned in the market?). Gas at the pump is up a lot over the last few years but it moves up and down such that sometimes we benefit and sometimes we get hit. I know people talk about the cost of groceries and produce having gone up but candidly I am not sensitive to this other than I know blackberries at Costco have gone way up.

The push pull here leads to the search for the right term for the situation. Someone will make a fortune for coining the right term ala stagflation back in the 1970s. Seriously, the push pull is part of the complicated times we live in idea in the reader's question.

One reader noted that now may not be so complicated, he noted what was going on in the 1970s versus now. A point of differentiation between now and the 1970s is the threats that sovereigns are facing. Perhaps that does make things more complicated, perhaps not, that seems like a subjective thing and this part of the conversation opens us up to a discussion of recency bias.

To the question of gold, I don't think is broken in terms of how it should behave but during short stretches I think anything goes. If we have meaningful price inflation for some period of time and/or dollar devaluation then I think gold would do what people would expect but it may not do so with the magnitude that people would hope for; I have to wonder whether the move up in gold over the last ten years was some sort of pricing in of what might be coming.

As for the euro story, it strikes me as a story of relativity in terms of looking at the EURUSD obviously if the euro stays the euro and it goes down then it will provide some consumer benefit for various goods but not for healthcare, education or most items from the grocery store and so I don't think will have a huge an obvious benefit to most Americans.

Lastly as far as deleveraging; it needs to happen. I don't know how painful it will be but I tend to believe that tearing off the band aid is the better way to go. I believe that had we done the hard thing a few years ago we would at this point understand what the end will look like along the lines of Iceland's improvements. At this point, we have not done the difficult things and we have absolutely no idea what the resolution will look like (mostly we just have guesses and opinions about what should be done, not what will be done).

My conclusions have been the same for quite a while which is that GDP growth will be sub-standard but positive. Equity market growth will be sub-standard but positive. Price inflation will be higher than what we have been accustomed to (as measured by CPI) but not ruinous. I still believe yields should go up and be a little higher than what is comfortable but not be ruinous either.

The idea behind the not ruinous meme is that the US is still the richest country (not per capita of course), is still just about everyone's largest customer, is still at the epicenter of the vast majority of global comings and goings all of which adds up to the world having a vested interest in our getting by. Getting by is not the same thing as being wildly prosperous as a country but more like still being a viable customer who is generally able to function. Hence my comments in past posts about slogging through while other countries do prosper wildly.

About the picture, Joellyn saw that at the store, went back to buy it but they were out so she special ordered it. It is Rogue Brewery and Voodoo Doughnuts which of course are both from Oregon. As an amusing note, Rogue was one of my nicknames in college. Even more amusing, a couple of weeks ago I watched the last half an hour of a show on the Travel Channel about doughnut shops. I saw enough of the show to see four shops profiled and we've been to two of them; Voodoo in Portland and Top Pot Doughnuts in Seattle.
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What Happens if Correlations Change?

You probably are aware that gold has gotten taken to the woodshed recently. YTD it is still up 9.8% (as measured by client holding GLD) but it is down over 15% since peaking in August.

The chart is a very near term comparison of the SPDR Gold Trust (GLD) and Bank of America (BAC). For the last couple of weeks the correlation between the two is pretty tight. If you zoom out for just about any other period the correlation is very low and often is negative including for most of 2011.

Obviously there is not much information in a two week chart but it does serve as an example of the extent to which correlations can change. In 2008 there was a stretch from March to October where GLD and the S&P 500 took different paths to the same 25% decline. What has started recently may or may not continue (obvious statement) which makes the point that the various relationships between asset classes can and do change periodically.

The bigger threat looming out there in this regard is the relationship between iShares Barclays 20+ Year Bond ETF (TLT), and other similar products, and domestic equities. TLT did very well in 2008 rising 23% (most of that coming in the last two months of the year) making for another year where the Permanent Portfolio performed quite well on a relative basis.

I think a lot of people are relying on the relationship between long bonds and equities to continue as it has. Predicting that the relationship might change is obviously difficult to do and not really my intention so much as to point out that if interest rates were to go up a lot and stocks were to go down a lot at the same time that it would cause market pandemonium the likes of which not too many of us have seen.

I've made the case numerous times that prices for bonds are very high and I would have thought rates would have started going up by now. While this has obviously been incorrect, the prices are still high and so the risk is still there.

Zooming out a little it is a good idea to understand what assumptions your portfolio is relying on and what the consequence would be if the things you are relying on do not go your way by some magnitude. For a dramatic example all those mutual funds that were grossly overweight financials in 2008 got crushed not just in absolute terms but also relative terms. This year we were right about being underweight financials and having cash raised but were wrong for the year for having a lot of foreign exposure netting out to an incredibly unremarkable result versus the benchmark.

An ongoing part of my process is trying to understand what would happen if the assumptions embedded into the portfolio don't work out for some finite period of time. I believe long term portfolio success comes from not getting blown up on the occasions where you are wrong--staying disciplined to a defensive strategy and avoiding a large chuck of a big decline helps too.
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Process

In the last few days I've made a couple of references to the 2012 Outlook article I've been working on for Seeking Alpha. In the follow up questions that came back on the original submission there was a question that in the context of the article did not call for a blog-length answer but I thought it would still make for a good blog post without front running the article too much (I've only published the answer to one out of 20 questions).

The question had to do with how I decide whether to use an individual stock or an ETF for a particular exposure in the portfolio. The short answer is that in an actively managed portfolio, regardless of what analysis is done a decision needs to be made based on the information taken in and the decision is really a judgement call that hopefully turns out to be correct.

Once the top down decision of what country or theme has been made the next step is sifting through alternatives which requires looking for and then finding alternatives. In reality this is a very long term process of first maybe reading a couple of articles about something like farmland/plantation stocks. Then I might look at a few names and see what other names that might lead to. In June 2008 I did a write up about farmland stocks that would constitute an early step in the process of trying to learn about a theme.

Part of the learning process involves seeing how the various stocks trade and react to various types of news. For example I would think farms would generally not be that volatile because of the nature of the demand for the product but it turns out they are very volatile. I've written many times about this space, and quite a few others, I've spent time on the group but have not bought in for clients (yet?). I've explored and written about far more niches than I've bought for clients and I continue to follow them in case it does make sense at some point to buy an airport, for example.

The chart compares Caterpillar (in green) with a stock I have been following for many years in red. The stock plays into a country exposure and a theme I have been following. The blue line is the benchmark index for the red line stock's country which I am interested in adding to the portfolio.

The volatility of the stock is very low compared to Caterpillar which is a very volatile name. I chose CAT for this because we have owned it more often than not over the last seven years. The chart goes back far enough to give a sense of how a stock will react to all sorts of things. The stock is red, despite being a foreign small cap has a volatility profile that most people could live with, IMO, compared to CAT's volatility which, because of the name, is also a holding many people can be comfortable with.

Knowing how a stock processes news is very important to me as I place emphasis on managing the volatility of the portfolio. I know that if I buy the red-line stock it is unlikely to get crushed on "ordinary" bad news. However the stock must be monitored in case there is bad news that comes that is somehow out of the "ordinary." Obviously a stock, once bought, needs to be monitored for all sorts of typical things like changes in the business, changes in the industry, changes in earnings trends, changes in revenue trends, changes in the balance sheet and any of the other typical things that you might think of.

In terms of selecting a stock, I don't think there is too much that I do bottoms up-wise that is unique. I try to learn about the business, learn about the financials, relative valuations (relative to its own history, relative to the industry and relative to the market) try to understand if any big changes are looming for the company and so on. From the top down I want to understand how it might react to the economic cycle, understand what the stock will be a proxy for, how it plays into various themes, what attributes it will deliver to the portfolio and so on. I choose to believe that more value is added here than with the bottom up work.

For these things I will also look at an ETF if there is one. We have owned the iShares Emerging Market Infrastructure ETF (EMIF) for a while. I've looked at and written about many stocks in this space but the ETF is also appealing because of what it owns and what it doesn't. It has some yield and is easy trade, the stocks are difficult trade, or at least they used to be before we changed custodians. Choosing the ETF was a judgement call as would a switch to an individual stock be a judgement call as would keeping the ETF and increasing the exposure by adding a stock.

If you are going to use an ETF in the above context there is still work to do. EMIF has large weightings to China and Brazil so it makes sense to keep tabs on those countries. If instead of China and Brazil EMIF had 30% in Hungary and 30% in Latvia then the fund would be a sell based on what is going on in those two countries now, as an example. As another example from quite a few years ago I disclosed not wanting to use iShares Sweden (EWD) for exposure to that country because of the then very large weighting in Ericsson (ERIC).

One final point about process. This is my process for doing things and is right for me (and should be right for people who hire us). You probably have your own process for doing things. If you read blog content then you must have some interest in taking in information to refine your own process. As I say often, take little bits of process from various sources to create (or refine) your own process.
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Portfolio Expectations

Over the weekend I spelled out a scenario where I think at some point in 2012 there will be a large, fundamentally unjustified lift in the S&P 500. I also said that I would sell the rally if it happened. I think it is plausible as opposed to the implausible like saying Greece will get its house in order in 2012.

Occasionally over the years I have made these sorts of projections and my track record with them does not suck but the same caveat always needs to go along with such a look forward which is that having opinions about what may happen can be useful but it is far more important to live in the moment with your portfolio.

Right now the SPX appears to be backing off from a one week 7% rally which was itself preceded by a very swift decline. The SPX is below its 200 DMA and the 200 DMA is sloping downward. Long before a big, even if short lived, lift comes in 2012 it will have to break above its 200 DMA so there is no need to abandon the discipline.

We are currently defensively positioned with a large cash position but no SDS. We have been less defensive than we were in 2008 and into 2009 because while I believe another scare has been plausible I have never thought a revisit of the March 2009 low was likely. If this current down move (if you even think it is a down move) takes another 50 or 60 points out of the SPX then I would buy one name to add to the portfolio and may buy the one name sooner than that but we still would have a lot of cash built up in case the timing of this next purchase turns out to be poor.

Tying in to thinking a big lift might be coming in 2012 the influence there might be buying two stocks (or ETFs) when SPX takes back its 200 DMA where I might normally just buy one on a retaking of the 200 DMA. I would describe that as giving the market the benefit of the doubt when the time comes.

In terms of cash levels we probably have room to buy a half dozens names, slowly, into a market that hopefully shows signs of healthy demand soon.

One last point about this type of prediction is that with what my job is, managing portfolios for people who simply hope to have enough when they need it, one part of this is trying to communicate with clients as to the possibility of an outcome that might be difficult to see from here and to convey the extent to which there might be a difficult purchase or two coming soon. If I turn out to be wrong then I think we are well positioned if we have more of the same.

Finally, an update on Pips (whose name was changed from Pep) the dog that Joellyn and I took up to University of Washington in March to go into a program that tracks animals by their scat which requires ball obsessive dogs.

Pips is now working after months of training. Here is one link about Pips from the USGS and another one from the San Diego Union Tribune--Pips was down in San Diego county looking for badgers. This was a very cool thing to be apart of.
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Thinking Long Term

I spent most of the Patriots Redskins game yesterday working on a 2012 outlook article for Seeking Alpha. I had answered one question for Saturday's post and then the other 19 yesterday. This was interesting in terms of comparing how I answered the questions this year to how I answered similar questions last year.

There are two factors here. One is that not much has changed. We are slogging through, there has been some evolution in terms smaller issues but the bigger issues both here and in Europe are not yet resolved even if we know a couple of things now that we did not know before.

As a result, the fundamentals for the things I have been saying stink still stink, the housing market is not started any sort of significant recovery, jobs are still not where they need to be to belie health, treasury yields are still getting what I'd call a panic bid, our political situation has somehow become more dysfunctional and Europe is even worse.

The other factor is the extent to which I try to take a long term view with the portfolio and themes and exposures embedded within. Not everything in a portfolio will work as hoped for of course but assuming something doesn't turn out to be immediately incorrect, then most long term exposures can be given time to do well. That does not mean that each exposure will work for all times but one year means a lot less than five years, at least for us it does.

A perfect example of this might be Vale (VALE). We've owned the stock for almost seven years with a tweak or two along the way. Since we bought in it is up a little less than 200% versus about a 15% lift for the Materials Sector SPDR (XLB). Over the longer term VALE has turned out to be the better hold (the comparison is to the sector exposure of our benchmark, XLB is comprised of the materials stocks in the S&P 500) but it has not been better for every single period. In the second half of 2008 it fell far more than XLB. In the future there will be occasional six or 12 month runs where XLB will be better to hold but I believe over a five year period VALE will have made much more sense.

Again there will be some of these exposures that don't work out as I hope for. There will be a couple of holdings (maybe more) where after a great run the story will change necessitating a sale. The best example there is probably our hold forever position in Bank of America (BAC). The takeover of Merrill Lynch was immediately and obviously unforgivable and an immediate sale despite my previously having thought we would keep it forever. If VALE, another hold forever does something that stupid I would not hesitate to sell that out immediately as well.

There will also be holdings that, to paraphrase Dennis Green, won't be what I think they are and will need to be sold. Fortunately I have not had many of these but this will come every so often (hopefully not too often, knock on wood) and part of managing a portfolio is being on the lookout for something that just proves out as just being flat out wrong.

Something that just meanders either up a little or down a little or moving with the market becomes a risk for losing patience as some themes or countries may take longer to work out than you think.

Obviously I prefer to think longer term as I think it is more consistent with clients objectives which I think of as being having enough when they need it not beating the market this quarter or this year.

A couple of unrelated snippets from the weekend; I got a kick out of the serious argument between Patriots' QB Tom Brady and the Pat's offensive coordinator. I may have this wrong but Brady wins any argument with a non-Belichick coach. University of Cincinnati basketball coach Mick Cronin was very impressive in the aftermath of that hideous fight with Xavier in saying he has to decide who is still on the team and that he made every player take off their game jersey, hopefully he backs up the tough talk. Lastly I watched the movie Step Brothers starring Will Ferrell and John C. Reilly on Saturday afternoon (Saturday was a day of some procrastination). Like all of these movies they are very stupid and very funny. There was a line in the movie that I thought was hysterical and brilliant for how subtle it was, "wait, Dale got Hulk Hands?" It's funny for anyone who saw the movie.
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Sunday Morning Coffee

I am starting to concoct a wacky theory about US equities for 2012. A part of how I think markets work is that price performance can deviate from fundamentals and obviously when this occurs there is not necessarily any reason it just happens. Sometimes there is a reason though and usually the reason is more top down.

A good example is 2009 where domestic stocks skyrocketed despite what I think were lousy fundamentals at the time. After such a vicious decline in 2008, and into Q1 2009, a big rally was very likely (I said as much in a 2009 outlook piece for Seeking Alpha).

As you know when the big firms are surveyed about what the stock market will do in the new year there is almost always a consensus of up 9-10% no matter what year we are talking about, I am very confident that will be the consensus for 2012 and this consensus is almost always wrong. There have been very few years that the market is up 9%, 2010 was actually pretty close at about 12%. This means that the market then is usually up more than consensus or lags consensus (obvious statement).

My wacky idea for 2012 is that there will be a huge, range busting rally sometime during 2012. I will try to explain this but to be clear this is not a bullish call. I still believe the US market, the economic fundamentals and the current political dynamic make for a very unhealthy cocktail but the market can still go up against that backdrop or as I have said in years past; the market can go up a lot for no reason at all.

I have no expectation that if this turns out to be correct that it will fit neatly into a calendar year. If we get a 25% lift from February to September, take it as I could easily see a huge lift then being mostly given back depending on how quickly it were to happen; the more panicked, the lift the more likely it retraces.

There are several ingredients to why I think I am leaning in this direction (I will clarify my opinion in subsequent posts). In no order of importance I believe the main street distrust of the market is immense and has been now for years. More than four years after the peak and the SPX is still about 20% below where it was in late 2007.

Over the last two years the average return is only 5% which is low. The nature of returns often is that most of the positive return for a multi year period comes from just one year which is important because if I am wrong about a big lift coming sometime in 2012, then there will be some other year that has a very big lift. Support this idea is the possibility that 2009 was more about mean reversion than anything else.

While sentiment is always mixed I think there is more pessimism right now, with good reason, so there is an element contrarianism to this thought as well. I don't think too many people are expecting a meaningful lift if you can believe that opinions from people like Binky Chadha are generally ignored then this might be a good ways from consensus and part of this is built on consensus frequently being wrong.

I will spend some time developing this but I will repeat this is not about being bullish or trying to make a correct prediction. Markets make big moves exactly when they shouldn't. I have no fundamental argument to make for why the market could go up a lot right here but it is important for market participants to always be cognizant of the fact that, like in 2009 and in other past years, the market can go up a lot for no reason. Further, if you can buy into the idea of lumpy returns with a disproportionate amount of a cycle's return come from just a narrow slice of the cycle then missing a 2003 or a 2009 becomes very damaging to long term results.

Maybe one way to think of this is that there is so much going against the market that something has to give in a big, range busting way and in such a manner as to be very shocking even if it only lasts for a short while.

I would hope that if this theory plays out that foreign markets with healthier fundamentals would do a little better than the US but of course better fundamentals does not have to result in better returns for such a short period of time.

The picture is of the Buckey O'Neill statue in front of the Prescott courthouse Friday as we went to Acker Night.
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The Big Picture for the Week of December 11, 2011

Every December I am fortunate enough to be asked to participate in various roundtable (ish) panels. The way they work is that a word document goes out and we are asked weigh in on a multitude of topics. One of them is due in a couple of days so I thought I would answer one of the questions for today's blog post.

12) Where are the real growth stories overseas right now?

I would turn this one around a little bit based on the current reality of the investment world. Before figuring out the "growth stories overseas" it is crucial to understand which countries are facing systemic threats that far exceed the threats posed by normal economic and stock market cycles.

For example the Bovespa is down 15% YTD as of this writing up from what was a 25% decline. In looking at the totality of the story it is clear that the country is not wading through different forms of desperate and unprecedented action to try to restore something (growth, jobs, housing market etc). Brazil has had ups and downs and of course that will continue but the nature of the threats are nowhere near what they are in the US, Europe and Japan, not even remotely similar.

We look out longer than one year in building an investment thesis. Part of the country selection process we prefer is, among other things, owning countries where there is a middle class ascendance. The idea here is that the demand for access to (relative) middle class lifestyles is very consistent. This means electricity, potable water, cable TV, telephones (probably wireless), better roads, cars, higher quality personal goods and so on--in short, their perception of an American lifestyle.

The demand is a one way trade but of course the stocks will not be but the demand does create a long term tailwind that is a valid investment thesis. Although not the only form of country selection we use this is one and countries we like and own in this context are Brazil, Chile, Colombia and China (by virtue of that China's weight in two thematic ETFs).

The process for possibly adding more countries in this context is ongoing. I've written many times on my blog about learning about countries and following them for quite a while before buying in, this was the case with Colombia and will be the case with other countries we add in to the portfolio in the future.
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Friday Look In

Quick post to start what will be a very busy day for me.

Yesterday the S&P 500 was down 2.1% and this morning the futures indicate a 14 point upside open about two hours before the open. If this lift sticks throughout the day then we will hear a lot of positive comments about progress with this or progress with that but to repeat a long standing theme here, this sort of thing must be viewed as noise.

The building block should be understanding normal market behavior and the things that drive normal market behavior. This type of volatility is not normal market behavior. The time being spend by various authorities trying to figure out the most effective ways to bail out ailing (ailing is not a strong enough word) countries for the problems of excess and bad policy are not normal market drivers.

The market can churn in either direction in this environment, this is what it has been doing, but it is not normal or healthy and we should expect this will still take a long time to work out. It took more than ten years for the great depression to resolve, it is only logical that the "worst financial crisis in 80 years" will need more than two or three years to resolve.
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What Is Diversification?

Yesterday I found this post by NYU professor Aswath Damodaron that tried to reconcile the divergence between Mark Cuban saying diversification is for idiots and John Bogle's (essentially) saying that diversification is all that matters, advocating owning the entire market. Like with all aspects of investing there is no single correct answer, simply a topic for each investor to explore and sort out for themselves.

Here I offer my approach for you to agree with or disagree with as you sort this out for yourself.

In terms of equities and using individual stocks or narrow ETFs I am a big believer in not letting one position that goes wrong seriously damaging the entire portfolio. As an exaggerated example a 20% position in a stock that then cuts in half could be a serious problem depending on what the rest of the market is doing.

I've disclosed many times that our portfolio typically has 30-35 holdings with most of the positions being targeted at 2-3% of the portfolio. There are several layers to this preference.

From a single holding-risk standpoint if a three-percenter cuts half unexpectedly then the drag obviously is only 150 basis points which can be overcome elsewhere in the portfolio (not necessarily with a 1000 basis point hit from one stock). In a portfolio of 30-35 stocks it is plausible that in a given year one of the stocks held will go up 50-100%. This can be "by accident" but either way it's plausible but realize the one you might think would be up that much won't be the one that ultimately goes up that much. A two-percenter going up 50% adds 100 basis points the portfolio, if you pair that with a 3% yield for the portfolio then you already have a meaningful chunk of your return for an "average" year in the market.

From a smoothing out the ride standpoint I want enough holdings that I can take various types of attributes which potentially creates a zigzag effect in the portfolio. The importance here is that if your base case assumptions turn out to be incorrect then some exposure to things that don't tie into your base case will minimize the consequence for being wrong.

Another element to this is that, as long time readers will know, I think it is very important to build in various themes and countries into the portfolio. The objective in picking themes and countries is to build in what are hopefully some obvious tailwinds into the portfolio. As a totally made up example, if we know trillions must be spent on greasy wool from Laos, then you might want some exposure to greasy wool from Laos.

Going too many holdings makes it difficult for a "winner" to matter and going with too few holdings means a "loser" (and there will be losers) could damage the entire portfolio as mentioned above.
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Europe Is Still Burning

By now you know that S&P put 15 Eurozone countries on credit watch with negative implications. This was of course not a black swan but simply the latest in a long unfolding saga. The point of today's brief post (I have an incredibly hectic week) is to isolate the ongoing thesis that the worst financial crisis in 80 years for both the US and Europe is going to take a long time to fully unwind (unravel?).

While it may no longer correct to say it is early days in this, using the baseball analogy I would say it is the middle innings at most and to take the analogy a little further it is the middle innings of a Red Sox-Yankees game which tend to last 4.5 hours as opposed to the normal three hours.

I have had and continue to have serious doubts about valuation arguments for the most affected market segments. As I have been saying all along there will be trades to be had for those who are nimble--XLF is up 11.7% in the last five days--but a nice lift does not mean things are fixed fundamentally. At some point the valuation argument will turn out to be correct but for now the news continues to be bad without even a vague notion of what a resolution might be.

Yes buying when there is fear and uncertainty is more than valid, there has been fear and uncertainty surrounding this for several years and "opportunistic" purchases has amounted to catching falling knives and it has worked out badly. Whatever positive argument anyone is making today, the same argument was made a year ago and two years ago and three years ago and four years ago and has been consistently wrong fundamentally.
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The Slog Continues

By now you've read a dozen articles ripping into the Friday's jobs data. The big bone of contention of course was the extent to which the decline in the headline rate dropped to 8.6% due to a large contraction in the labor force.

Whether you call it new normal or something else this is the middling, sluggish US economy continuing to unfold. A few years ago there was a mix of complacency that the then credit crunch wouldn't be that big of a deal which then gave way to serious fear, maybe even terror, that this was the end times in terms of the social fabric of the society.

Sluggish and/or middling has been my base case the whole time for several reasons and I expect that will continue. Obviously I am biased to seeing my thesis as playing out over the last few years and continuing to play out. If this turns out to be the case that does not mean some equities won't still do well.

If there is an economic condition where GDP growth is sluggish or perpetually teetering into a recession we know that certain defensive stocks tend to do well; usually staples, healthcare, utilities and ma bell telecom (with those last two be careful when interest rates are going up).

Year to date the S&P 500 is down a little over 1% while long time client holding Philip Morris International (PM) is up about 30%. Going a little broader the Staples Sector SPDR (XLP) is up a little over 8% which combined with XLP's yield is close to an 11% return--pretty good for soda and diapers. The Utility Sector SPDR (XLU) is up almost 11% on a price basis plus then it's 3.8% yield. The Healthcare Sector SPDR (XLV) is only up 6% but 7% ahead of the benchmark is noteworthy and XLV kicks in a little yield too.

Obviously the albatross around the market's neck has been and I believe will continue to be the financial sector. At this point the Financial Sector SPDR (XLF) is down 19% for the year and while I don't think it can drop 20-30% every year forever, I think it will be a long time before there is sustained price appreciation which contributes to the top down idea that the SPX will have a hard time making meaningful progress without the financial sector.

One of the reason's I prefer top down is that I think it makes the job much easier to do. If the above scenario is right then that means finding a domestic financial stock that skyrockets becomes much harder to do than in a year where XLF goes up by 25%.

Sectors like staples and the others mentioned above can be populated in the portfolio with domestic stocks in this scenario. The other sectors, like financials, would be a good place to look for foreign exposure either with individual stocks or ETFs. For example I am favorably disposed to quite a few countries for the long term like Australia (out temporarily as I have been disclosing for months), Chile and Norway.

There are individual stocks from these countries in the sectors that I think should be avoided in the US, like financials, and the ETFs for these countries have decent weighting in financials as a way in.

Going the individual stock route requires bottoms up research and monitoring of course and going the ETF route requires looking under the hood to understand what is in the fund and taking time to monitor the countries themselves and that is a lot of work. However if the US turns in another sub par decade (new decade to date the SPX is up 10.46% so you be the judge) and some of these other markets can again muster close to normal returns then the effort put in will not only have been worth it but could be (financial) life changing or better yet; (financial) life sustaining.
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Sunday Morning Coffee

In the comments of yesterday's post a little discussion broke out about my definition of large accounts and mid sized accounts or more correctly the differences, as I see them, in portfolio construction based on account size.

The relevance could be that many do it yourselfers might be inclined to have fewer holdings not as a function of account size (for our "mid sized" accounts we tend to only have about 20 holdings, most of which are ETFs so that commission expense is not excessive) but as a function of time available to spend on the task. If someone has a full time job then they may not be able to make another full time job out of managing their money which is very reasonable.

I do this going sector by sector same as with large accounts. Decisions need to be made for each sector about overweighting and underweighting and the best proxies (per the person building the portfolio) need to be chosen to fill out the portfolio.

One way to come at this, as we've discussed before, would be one stock and one ETF for each sector which works out to 20 holdings (for someone benchmarking to the SPX). This would not work for everyone of course but it is one way to do it. The idea with one stock one ETF is avoiding over exposure to single stock risk, building in some yield and some precise themes.

I do it a little differently. For the smaller sectors I use just one ETF, again the context is mid sized accounts not large accounts. The three smaller sectors are each only about 3% of the index so even an overweight in those three would still be a small exposure for the portfolio and where commission drag is a concern I think one pick can work.

The financial sector is a tough place for me to find an ETF to use for the way they are constructed. I don't want to own the common of the big US banks, the big European banks, the big UK banks, the big Japanese banks or the big Chinese banks. So for financials I tend use individual stocks that we use for large accounts.

For other sectors we use a mix of an ETF or two and/or a stock or two.

One thing I mentioned yesterday was trying to change the volatility profile of the portfolio with the trade executed. This obviously doable in the context of the type of portfolio we're talking about today. There are a few good compare and contrasts to illustrate the point. In the materials sector you could compare the Global X Fertilizer ETF (SOIL) and the Materials Sector SPDR (XLB); XLB being benchmark beta. The Malthusian argument underpinning SOIL is easy to understand, you may or may not agree with it but it is easy to understand.

Not surprisingly SOIL is quite a bit more volatile than XLB. Someone believing in the argument to own SOIL could keep the fund and switch to XLB at a time where they want to reduce volatility of the portfolio but still maintain exposure to the sector.

There could be a similar dynamic in tech with the eTracs Next Generation Internet ETN (EIPO) Tech Sector SPDR (XLK) although given tech's huge weighting in the SPX, putting that much into EIPO seems very aggressive but you get the idea. With energy maybe this could be illustrated with the Jefferies Wildcatter ETF (WCAT) and the Energy Sector SPDR (XLE).

Before the 1+1=11 brigade comes out, the above symbols are just examples to illustrate a point, we don't own any of them.

The same type of work can be done for yield, cap size, foreign/domestic or anything else you might be interested in trying to capture in your portfolio. More likely there would be several variables being managed at once but again you get the idea.

The picture is from yesterday of Roscoe surveying our second storm of the season.
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The Big Picture for the Week of December 4, 2011

A week ago Thursday I disclosed selling our position in Pro Shares Ultra Short S&P 500 due in part to believing that after a very fast decline in the market, an equally fast snapback was possible. By the time yesterday morning rolled around the SPX was trading near 1250 up a lot for the day, again, perhaps due to the jobs numbers.

So in the face of a 7.7% lift in the SPX in about a week (based on the Friday open which is when we placed our trade) we sold our position in WisdomTree Global Natural Resources (GNAT) for large accounts. GNAT used to be the WisdomTree International Energy Sector ETF (DKA). GNAT is more volatile than DKA used to be. GNAT is still a good proxy for the sector and so we still own shares for mid size accounts that generally own an ETF or two for each sector.

I had this trade in mind for a while if we needed to sell something in this context. Our energy sector exposure in large accounts is pretty volatile and so after selling GNAT at the open I plan on replacing it with something less volatile and with more yield but I will hold off as I think some sort of swing down like from a couple of weeks ago is plausible.

As I said with the SDS sale, the GNAT sale looks good relative to Friday's trading but if the market rockets higher from here (obviously not my expectation) then selling GNAT will have been poorly timed and if the market stalls out or reverses then it will look like a good sale. This is true with every trade but the strategy here is to reduce volatility a little while people are feeling pretty good about the market.

On the post disclosing the SDS sale someone commented that it was pure speculation on my part and maybe they will be back again. Depending on how you define speculation then yes it was or maybe, no it was not, again depending on how you define it. Obviously the portfolios I manage are actively managed. The site is in part a look over my shoulder as I try to navigate cycles. As I have said many times an actively managed portfolio is a series of decisions, some of which will be right and some of which will be wrong.

Not everyone, obviously, who tries to manage an active portfolio will be correct often enough to be successful with it but there are enough examples to show it is very possible to have success with active management. One objective here is sharing process so that you can take little bits of my process (if you're so inclined) and also collect little bits from other people's process to build your own process. My way is right for me and should be right for anyone who hires our firm. You need your own process as that will be right for you or if you choose to hire someone then you need to be sure their process is right for you.
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Our Current Reality

Wednesday's market action had all the music, lighting, choreography and party-like atmosphere of an Earth Wind and Fire concert (I tried to find a picture of the Ohio Players in this context but couldn't find one I liked).

We are in a period where we have very fast moves in both directions that seem to last for a couple of weeks or so. This has been going on for a while and seems like it will continue but who can say for sure. If it does continue then this fast move up will end (maybe near the 200 DMA like the last one?) and then the market will move back down just as quickly. Of course it could be over now, this post was written Wednesday night.

I am not trying to make a prediction with the above possibility merely pointing out (mainly to clients) that another whoosh down is very plausible. We've had all these whooshes with out dramatic changes in the fundamentals in the US. I would say the fundamentals in Europe are changing a little quicker but I think it is correct to say that Europe is the same story and we are living through the deterioration at this point.

Last we I said something very similar while also noting that I think the upper and lower ends of the range are moving up slightly. Where the last one peaked at SPX 1275 maybe this one will peak 10 or 15 points higher as an example and where the intermediate bottom last week was 1158 maybe the next bottom will be something like 1170 as an example. Maybe we churn in that manner up near the May high of 1363 which then becomes the real test for the market to which I would lean bearish. If this plays out I think it would take months and to repeat, sentiment would swing from glee to despair every couple of weeks or so.

One reader has commented a few times about hating this market but going along for the ride, I suspect he would really hate the above scenario.

To be clear this not a description of a healthy market. The market can get healthy again in any number of ways but it appears to be a long way from there now. If this has changed somehow we are decently long such that we should continue to participate which is philosophically where we want to be; smoothing out the ride if possible not being completely out.
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