Rebalance

The WSJ (hat tip The Big Picture) with some faulty numbers:

Advisers, too, have been buying higher and selling lower. Those who use TD Ameritrade had an average of 26% of clients’ assets in bonds and cash on Oct. 9, 2007, the day the Dow Jones Industrial Average hit its all-time high of 14164.53. By March 9, 2009, the day the Dow scraped rock bottom at 6440.08, the advisers had jacked up bonds and cash to 51%.”

Barry piles on:

The simple explanation is that advisers (or at least the bulk of them) are reacting emotionally to market swings. They are over-confident after markets have had big moves up, so that’s when they buy; they dump equity shares in a panic late in a down turn.

Does Ameritrade even provide investment advice? Either way, the numbers shown above don't exactly make the case that these investors were buying high and selling low.

Why?

First take a look at performance of equities and fixed income since that October 9th period.



The relevance?

Ameritrade investors weren't buying high and selling low, they were doing what investors have been told to do... "buying and holding". A passive investor with a 26% allocation to fixed income (i.e. the starting point) would have had a 47% allocation to fixed income on March 9th, 2009 (equities sold off more than fixed income, thus increasing the allocation to fixed income). Very close to the allocation detailed in the WSJ article.



So rather than an article that headlines why investors should be wary of advisers because they are over-confident, perhaps the data shows that investors should simply have advisers that aren't scared to provide advice and can share one of the easiest investment lessons... the power of rebalancing.

Source: Yahoo Finance

Am I Deaf? Gold Up... Inflation Down Edition

Mark Gilbert over at Bloomberg in an article titled Investors are 'Deaf to the Screams of Gold, Cotton':

If you told Rip van Bondtrader that gold had risen to a record during his decade-long slumber, he’d want to know what the inflation outlook was, and how badly he’d gotten killed on his bond investments. He’d be astonished to discover that he’s made a total return of about 8 percent since January on Treasuries maturing in more than a year.

“What makes the gold story so interesting is that bullion has so many different correlations -- with inflation, with the dollar, with interest rates, with political uncertainty,” according to David Rosenberg, chief economist at Gluskin Sheff & Associates in Toronto. “This year, for example, gold has shifted from being a commodity toward being a currency -- the classic role as a monetary metal that is no government’s liability.”

Gold may be screaming more about a general mistrust of the securities markets than about the prospect of rising prices. Rip, though, would be similarly horrified to see cotton trading near a 15-year high at more than $1 a pound, or wheat surging more than 30 percent in the past year, helping to drive a UBS/Bloomberg index of food prices up by about 28 percent. The official figures say inflation is dormant; the phrase “lies, damned lies and statistics” springs to mind.

While his points are interesting, I don't see the paradox that he does (i.e. call me deaf).

Why?

• Tons of liquidity
• A slow(ing) economy
• A deleveraging economy
• Very few remaining places for that liquidity to go

Mark and many others believe this liquidity should have / will lead to an increase in headline inflation. While I think it can (and hopefully will) lead to inflation, it hasn’t for simple reasons. In the actual economy, there has been no excess demand (or liquidity) plowing into goods, services, investments (in fact capacity far outweighs demand) or for hiring (price of labor is a large feed to price levels in the U.S.).

As for the “conundrum” of commodities (including gold) and Treasuries both outperforming, look no further than the above simple reasons... the liquidity in the market has not being used to buy things for actual use / investment. Combined with the fear of putting the money to risk in financial assets (i.e. stocks) and the inability to buy a levered asset (i.e. real estate) and there remains very few places for it to go.


Summary

Money is not going to:

• The economy
• Financial assets
• Levered assets

And is going to:

• Commodities (including gold)
• Paying down debt (which reduces supply of debt outstanding – a benefit similar to demand for debt)
• Fixed income (including Treasuries)
• Cash

For more, please search for gold or Treasuries in the EconomPic search for details of why I have been bullish on both since the inception of this blog back in early 2008 (also please see Investing in a Low Return Environment for more detail of my thoughts on investing in this market environment more broadly).

I am less bullish on both as they have both done quite well on both an absolute and relative basis, I am in not a bear on either now.

Source: BLS

More on Contango

FT Alphaville with a great post "Is ‘cash for commodity’ the biggest trade in town?" explaining why commodity curves are in contango (demand from passive indexers) and the benefit to producers (a cheap source of financing). I have been sitting on the below post explaining how this translates into an investment in a passive commodity strategy (hint... not good) so I thought the time was right to finally post it.

Wikipedia explains roll yield, so I don't have to:

The roll yield is the yield that a futures investor captures when their futures contract converges (or rolls up) to the spot price in a backwardated futures market. The spot price can stay constant, but the investor will still earn returns from buying discounted futures contracts, which continuously roll up to the constant spot price.

Note that in case of a market in contango, the roll yield is negative - since the price of the futures contract trades higher than the spot price, and rolls down to converge towards the spot price.

Said another way, backwardation means the futures price is below the current spot price (i.e. the curve is downward sloping), thus the investor gaining exposure via futures will outperform the underlying spot market (all else equal). Contango means the exact opposite situation (this was explained recently regarding the VIX ETN VXX in the EconomPic post When ETNs Attack). In addition, as explained by FT Alphaville, this negative drag is the "subsidized financing" received by commodity producers "selling" their commodities in the futures market.

How much of an impact does this have? Let's take a look at the impact via the excess roll yield of the S&P GSCI Commodity Index futures vs. spot.



As can be seen above, the futures market has consistently underperformed the spot market since mid-2004. By how much?



A lot...

Betting Does Not Equal Investing

According to Dilbert creator Scott Adams (via an interesting WSJ piece 'Betting on the Bad Guys'):

When I heard that BP was destroying a big portion of Earth, with no serious discussion of cutting their dividend, I had two thoughts: 1) I hate them, and 2) This would be an excellent time to buy their stock. And so I did. Although I should have waited a week.

People ask me how it feels to take the side of moral bankruptcy. Answer: Pretty good! Thanks for asking. How's it feel to be a disgruntled victim?

But the danger of buying out of hatred can be seen with how long people have already "hated" BP (details of the hatred launch date):

On April 20, 2010, a semi-submersible exploratory offshore drilling rig in the Gulf of Mexico exploded after a blowout and sank two days later, killing eleven people and causing a massive oil spill threatening the coast of Louisiana, Mississippi, Alabama, Texas, and Florida.

At the point of the initial explosion, the stock hung in there. Once details of the spill became known... down ~15%. Once details of the spill became even more known... down ~20%. Once details became even more known... ~30%, then ~40%, then ~50%.

This of course is due to the complete lack of transparency. While I know for sure that I truly hate BP, does that mean BP is now (at a 50% discount) a good buy? No clue.

It is very possible they are, but I can also see a situation where things get much worse in the gulf and for BP, which brings me to my next point. Buying purely out of hatred is 100% not an investment decision, but rather (as the title of his article says) betting. I personally love betting, but I keep that to non-investment related matters (anyone think the Celtics are winning the series?).

But don't say Scott didn't warn you:

This would be a good time to remind you not to make investment decisions based on the wisdom of cartoonists.

And this:

Again, I remind you to ignore me.

Source: Yahoo

The Certainty of Uncertainty

Abnormal Returns has a great post about uncertainty and investing; a topic that has been on my mind of late due to the bomb scare, oil spill, natural disaster, and of course sovereign crisis (for anyone interested, I asked for / received help in understanding the potential for a Eurozone breakup back in January '09). To the post:

Alexander Ineichen writes directly to the issue of time diversification and uncertainty:

We believe time amplifies risk. It is true that the annual average rate of return has a smaller standard deviation for a longer time horizon. However, it is also true that the uncertainty compounds over a greater number of years. Unfortunately, this latter effect dominates in the sense that the total return becomes more uncertain the longer the investment horizon.

The logic here is that over the longer term, more bad things can happen and the probability of failure (i.e., non-survival) is higher. The probability, for example, of San Francisco being wiped out by a large earthquake over the next 100 years is much larger than over the next 100 days. If accidents happen in the short term, one might not live long enough to experience the long term. After all, the long term is nothing else than many short term periods adjoined together.

Ineichen uses the recent example of Japan showing that sometimes a market, even a developed one, can go down and stay down. The issue isn’t one of better estimating the equity risk premium or volatility of returns. It stems more from the fact that we really don’t know what the future holds. Recognizing the limitations of our statistical knowledge is a necessary step in facing uncertainty.

And here it is... the chart shows the Nikkei 225 index and the change from its previous peak (note that the chart does not include reinvestment of dividends). 20+ years and the index is still 70% below its peak.



An outlier right?

Well, it took the U.S. Equity market* from 1929 - 1954 (i.e. ~35 years) to re-reach its prior peak post Great Depression.



These "outliers" are important to keep in mind as the global economy has never been more inter-connected or had less "cushion" if an event were to occur (sovereign balance sheets were sucked dry during the crisis making any large bailouts [sovereign or banking] much more difficult going forward).

The result is that any little hiccup (in any part of the world) may have a far greater impact on the entire system than the market is currently pricing in. While it may not happen over the next day, week, month, or even year(s)... it is coming.

* the S&P 500 recreated by Professor Shiller to pre-date its 1957 inception

You Can't Invest in an Average

There is an interesting interview with Howards Marks, Chairman of Oaktree Capital, over at Barron's (hat tip Infectious Greed) explaining how innovation, leverage and risk-taking all lead to the problems the financial community is currently experiencing (bold navy is mine).

So there must be some risks in the overall proposition that are not captured merely by the yield curve. And those risks are that on a bad day, you could be asked to repay your borrowings, or you could be unable to roll over your borrowings. So to repay your borrowings, you have to sell assets. But assets could be either not sellable or only sellable at losses or prices well below what you think they are worth or what they are really worth.

You look at this and say: "OK, I can borrow money short-term at 3%, and I can buy 30-year bonds at 6%. I'm going to make 3% a year forever." That will work in the long run, if you can survive to enjoy the long run. It reminds me of one of the greatest adages in this business:

Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep, on average. It is not sufficient to get through on average. You have to get through every day.

As Howard points out, if you can borrow at 3% and invest in something that year in and year out returns more (equities have returned 8% on average over the past 20 years), you can make an absolute killing. The problem lies when you've borrowed at that 3% and then have a period like we've had over the past twelve months, one in which after dividends has seen the S&P 500 return -36%.