Active Management & Taxes

I have mentioned in the past that I like active management, assuming the proper due diligence is performed.  However, one thing I didn’t mention is the impact of taxes.

Passive management tends to have a lower tax burden than active management.  This is because passive managers follow an index and thus have little turnover (e.g. buying the 500 stocks in the S&P 500 and holding until the index changes).  Active management on the other hand tries to beat the index and may therefore have higher turnover.  Higher turnover = higher capital gains distributions = higher taxes at the end of the year.

Higher taxes mean a lower net return.  When looking at client portfolios, we always manage for after-tax return because that is what the client brings home.  Returns can look great on the surface, only to get dinged by taxes.

Is higher turnover a negative aspect of active management?  Absolutely, but it isn’t a death knell.  First, having the proper manager is still paramount to tax savings.  Keeping your taxes lower is part of the manager discussion, but certainly not the end all be all.     Second, you can still manage for after-tax rate of return and have active managers:

• Keep high turnover funds in tax-deferred accounts
• Tax loss selling to offset your gains
• Utilize active managers that have lower turnover
• Blend in passive managers to go along side your active managers 

Important -

Capital Advisors LTD and Capital Analysts does not provide Tax advice. Contact your tax advisor for review, implications, and applicability of any tax strategy to your situation.  This tax information is provided for educational purposes only and is not a recommendation. Pursuant to recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Chinese Real Estate Bubble?

“Falling home values. Debt-strapped borrowers. Real estate woes dogging the economy.”  Sounds like the US circa 2007, but it is also going on in China right now. 

The LA Times recently wrote an article about China’s property market, highlighting many of the issues it faces.  While it seems certain prices will fall, will it be orderly?  Or will it be more chaotic like the US?  Here are some points on both:

Orderly:

• China’s government has intentionally slowed development
• Lending and purchasing restrictions could be lifted if need be
• Leverage is not nearly as bad as it was in the US ( first-time buyers have a 30% down payment required)
• Hundreds of millions of Chinese are moving into cities
• The drop is not surprising as I can recall this forecast by China bulls and bears alike for some time
• Equity prices in China are down pretty far over the last 12 months (greater than 20% on the Shanghai Composite Index­) indicating some of the pain may be priced in

Chaotic:

• Home prices have fallen for 3 straight months
• Average home prices are down about 40% from their 2009 peak
• Beijing has nearly 2 years worth of inventory
• Sales are plummeting
• Property sector is one-fifth of GDP and a huge employer
• Local governments are highly dependent on sales/appreciation
• Banks have issued a record number of home mortgages
• Home buyers have staged numerous demonstrations (see the personal side in the linked article)
• China has built empty cities

The answer to this question will have broad ramifications for China and the rest of the world, which is hoping that China becomes more of a consumer and/or feeds its demand for commodities. 

I myself can’t say I know how it will ultimately shake out.  On the one hand there are things that certainly don’t pass the smell test (see the Ordos video), on the other hand there seem to be some tangible differences between our housing market and theirs.  

Lowering Your Tax Burden – Tax Loss Selling

At the end of every year it makes sense to take a look at your taxable investment accounts and see if you have any big losses.  If you find some, then it probably makes sense to sell that position (depending on how big the loss is, among other factors) to lock in the loss.  Why?

By selling some securities at a loss, you can offset the gains you have on other items for the year.  Do your losses exceed your gains?  In that case you can deduct up to $3,000 against ordinary income.  Still have more losses?  You can hold on those and do the same thing next year or the year after until you offset the taxable gains in future years.  In short, you can lower your taxable income now and in the future.  Here is an example:

1. I bought XYZ at $100,000.  The position is now worth $80,000 and I sell XYZ for a $20,000 loss.
2. If I have $10,000 in gains, I can use part of the $20,000 to offset that.  I can then deduct $3,000 from ordinary income and save another $7,000 in losses for next year.
3. To make it easy, let’s just say all income is taxed at 15%.  Thus, while you lost $20,000 on the investment, you saved $3,000 in taxes, lowering your net loss to $17,000. 

If you still like the investment, you can still buy it back later after the “Wash Sale Rule” is satisfied (i.e. you can’t purchase the same investment within 30 days or you can’t claim the loss).  During that 30 day window you can purchase something similar to keep your allocation reasonable unchanged. 

The counter argument is that if you buy the same investment back you will now have to pay gains on the appreciation so why tax loss sell in the first place.  Still, I think the benefit goes to selling now:

• A dollar today is worth more than a dollar tomorrow. 
• There is no guarantee the investment will go up.

Important -

Capital Advisors LTD and Capital Analysts does not provide Tax advice. Contact your tax advisor for review, implications, and applicability of any tax strategy to your situation.  This tax information is provided for educational purposes only and is not a recommendation. Pursuant to recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Macro Domination

Here is a graph from EconompicData, which shows ETF performance in September, October, and most of November:

The above graph paints a picture of what most market followers already knew – there has been a “risk on, risk off” trade over the past few months.  Further, the moves each month were pretty sizable.  Take a look for instance at Emerging Market equities – down 18%, up 17%, and then down 11% each in a separate month!

My big takeaways from the graph are these:

• Given how riskier assets are moving in lockstep, it’s pretty evident that macro data is driving the market and however the macro issues (namely Europe) shake out will ultimately determine the fate of the markets. 
• The size of moves and how quickly they change indicate the markets are very uncertain.

Ultimately, even if my conclusions above are off base you can’t argue that markets aren’t very volatile right now.  If you are struggling with the daily moves, reducing your portfolio’s beta might be a viable solution.  

Hedge Funds Look like the Market. So What?

The Wall Street Journal’s MarketBeat just ran an article noting that hedge funds as a whole now exhibit a high correlation to equities and actually have a negative alpha - risk adjusted return relative to the S&P 500.

I don’t think either higher correlation or negative alpha matter, and here’s why:

• The graphs in the article go back to 1995.  Since 1995 I would be willing to wager the total number of hedge funds and the assets hedge funds hold have risen by a large amount. 
• The greater the assets the closer hedge funds will resemble the market.
• More hedge funds means the greater likelihood there will be more underperforming mangers, resulting in lower alpha.
•  I am sure the numbers are similar for the mutual fund universe, but that doesn’t mean quality mutual fund managers don’t exist.
• Hedge funds have various disciplines (e.g. Macro, Convertible Arbitrage, Long/Short, Long Only, etc.) and each discipline probably has different correlation and alpha numbers.

Ultimately at the end of the day picking the right hedge fund manager or any manager that compliments your portfolio is the decision that needs to be made. 

Maybe after doing your due diligence you discover the manger mirrors the market, or the fees are too high, or you don’t like the illiquidity; however, deciding against using a single manager because the universe as a whole isn’t performing up to standards shouldn’t be a large part of this decision.  

Margins are High, Really High. Can they last?

Per Bloomberg, “U.S. companies are the most profitable in more than 40 years”.  In Q3 this year margins of non-financial companies reached 15%, which was the highest level since 1969.  Right now this is a great thing; however, the question the article proposes is whether or not this is sustainable.

To answer that, I think we need to look at why margins are high.  I have ranked the answers below by what I feel is most likely to continue:

1. High unemployment keeps labor costs down
2. Low cost of money
3. Business are investing in technology, increasing productivity
4. Sales to emerging markets help stabilize revenue
5. A surge in government spending 

I think 1, 2, and 3 are in a tie for longevity.  It is hard to see unemployment dropping dramatically, interest rates raising much, and/or improvement in technology not being implemented.  Number 4, I think is trick:  in the short-term there could be some danger here, but in the long-run emerging markets should consume more and more.  Number 5, I think, will evaporate soon given the focus on cutting the deficit.

This leaves me with the following conclusions:

• Margins probably won’t be expanding as costs can’t be cut further, but could stay higher in the near-term given structural issues.
• Longer-term margins are likely to contract given mean reversion and structural issues correcting.
• This could be offset by top-line growth, which will be the most important part of keeping margins elevated.  

Why Residential Building Won’t Recover Quickly

Before I get to the graphs, let me first cover the credit bubble and how it related to home prices rising:

1. Low interest rates, lax lending standards, and credit market innovations helped fuel a boom in credit growth and subsequently home prices.
2. Speculators got more and more involved, further pushing up prices to unsustainable levels by buying more houses. 
3. Builders started building more and more houses because when prices are high so are revenues.
4. At these unsustainable levels, individuals and companies took out more and more loans that were exotic, probably unaffordable, and maybe dependent on homes increasing in value.
5. Given home prices were unsustainable, as soon as credit was removed from  the system market prices started to crash.

So now we have a situation where people who bought homes at a high price can no longer afford or want to pay their mortgage (not to mention high unemployment):

This results in increased foreclosures.  Foreclosures prices are usually pretty low as the bank wants to unload those houses off their balance sheet.  Thus, you have a situation where there is a large supply of existing homes on the market at depressed prices, which new homes can’t compete with:

In short, until forecloses come down more and the overhang of existing housing is cleared, we probably won’t see too many new homes built. 

Go to Calculated Risk for good graphs like the ones above. 

Are Dividend Paying Stocks Bond Substitutes? Yes and No.

I have commented before on how I like dividend paying stocks; however, I like them more for the type of company you tend to get.  Others I presume may like them more for the income stream.

There is nothing wrong with that, especially in this low interest rate environment where investors are looking for yield.  Investors just need to know that just because a stock pays a healthy dividend doesn’t mean it’s high quality. 

Similarly, while the income from stocks might be higher than bonds currently, the volatility of dividend paying stocks is also higher.  In short, if you are using bonds to help lower the volatility of your portfolio then dividend paying stocks are no substitute. 

Vanguard recently wrote an article that shows while bonds yielded less than dividend paying stocks from 1998 through the end of October 2011, they also were less volatile and had a higher return.

None of this is to say that dividend paying stocks aren’t a good place to invest going forward; however, if you are using them as a bond substitute, just be prepared for a bumpier ride.

The Employment Problem

Recently I was alerted to two interesting bits of information:

1. As Italian yields moved higher, so did equities.  The opposite of what you would expect.
2. Despite the rash of headlines on the Eurozone, there appears to be a decent correlation between jobless claims and equities.

Does this mean that markets are being moved` solely by unemployment and are unaffected by Europe?  I have no idea.  I would guess no, but who knows what moves markets, these days? 

What the above links do demonstrate, in my opinion, is how important it is to create jobs for the economy (obviously) and the market.  Take a look at this graph via Calculated Risk:  

Two things standout:  

1. The job loss from the last recession is much larger than any at other time since WWII.
2. The recovery from the lost jobs will no doubt be much longer than any at other time since WWII.

As I have mentioned before, I think it will take time to go through the deleveraging cycle.   This jobs chart is an example of the sluggish growth that we have experienced and probably will experience for the next few years. 

That said, if we can figure out a way to create jobs the great likelihood would be not only a nice economic lift, but also a corresponding bounce in the stock market.

Barron’s Likes Brazil

On last week’s cover of Baron’s is an article highlighting the long-term outlook for Brazil’s economy.

The article lists four big themes that should help the world’s 7^th largest economy: 

1. Growing Middle Class – social mobility gives rise to domestic demand; positive trend in terms population that makes up middle and upper classes; young and growing population
2. Healthy Banking System – high real interest rates curb malinvestment
3. Stable Government – addressing a crumbling infrastructure (6% of roads paved) while preparing for the 2014 FIFA World Cup; large gap between interest rates and inflation rates allows room for rate cutting if need be
4. Globally Focused Companies – a large amount of natural resources that are being exported to other countries (e.g. China)

While the stock market has struggled this year, GDP growth is expected to average 4% over the next three years.  Further, a depressed stock market makes for more compelling valuations.  It should also be noted that Foreign Investment ($60Bb) is 3x the amount 10 years ago.

I do think the article is compelling; however, there are still a few items of which I am wary:

• How dependent on China is Brazil’s economy?  If China has a hard landing, what will the impact be?  Note:  32% of the stock market, but just 3% of the economy is commodity based.
• There are still slums (I recall hearing some of the worst in the world) and a high poverty rate, begs a risk of social unrest?
• Highest corporate taxes in emerging markets (34%).
• An unraveling in Europe could derail the growth story.
• Currency is still volatile.  The Real depreciated 60% versus USD in 2008.  If risk returns to credit markets you could see a large drop as investors flock to the dollar. 

Ultimately I think the risk/reward here makes a compelling reason to like Brazil.  Perhaps the biggest reason for optimism was the quote by Alan Vinson at the end of the article: “The average Brazilian is very optimistic”.  Optimism amongst its citizens provides fuel and lends credence to the abovementioned positive trends.

Europe Summarized

As the Euro crisis deepens and the leaders of Italy and Greece resign, I figured it would be a good time to summarize what is going on.  Luckily, I found this great SNL video that does so nicely (via Big Picture):

Aside from being funny, I think you would be hard pressed to find another three minute video that better captures what is going on overseas:

• It’s hard to convince the masses to cut government spending and lower their standard of living.
• Why were countries like Germany and France lending lots and lots of money to countries like Greece and Italy when the former should have known paying off all that debt would be difficult, if not impossible?
• As such, creditors need to work with debtors to figure out a solution.  The burden isn’t only on the debtor. 
• Leadership from France and Germany has been weak.
• Given the cultural, social, and language barriers, pulling the Eurozone together was an uphill battle from the start.  In times of crisis this will probably prove to be more difficult.  Plus they have been fighting each other since Europe was inhabited and were at it as recently as 60 or so years ago. 

Even the Best are Struggling

Many successful bond managers have had an off year in 2011, the most prominent being   Bill Gross, who recently issued a “Mea Culpa” for his poor performance. 

The same can be said for some equity managers, who have until this year had very good long-term results, for instance John Paulson and Bruce Berkowitz. 

As I already commented, picking a manager based solely on past returns can really get you burned.  It is more important to look at the process, whether or not it’s sustainable, and recognizing AND acting when it’s time to make a change.  (Note:  I am NOT recommending selling any of the above managers, just pointing out their poor returns as of late)

However, the lackluster performance by some of the industy’s best managers who had previously shattered their respective benchmarks points to how hard it has been to invest in the current market environment, due in part to the following:

• Continued consumer deleveraging
• Massive monetary and fiscal stimulus and then the removal of the stimulus
• Credit markets collapsing, then repairing, and now skittish again
• Emerging markets increasing importance and then the subsequent possibility of overheating
• Eurozone struggles  

So if the best are struggling, how can the average investor help weather the storm?  Here are some tips:

• Don’t make big bets , and don’t rely too much on one manager – avoid concentration risk by diversifying
• Develop escape routes before investing
• Take risk off the table when you get queasy
• Avoid drastic moves - if you make moves one way or the other, keep it small
• Hedge when and where it’s appropriate
• Don’t get emotional

“Positive Earnings” are Good, but You Need to Look Deeper

So as of October 21^st about 64% of companies beat Q3 earnings estimates!  On the surface, that seems great; however, take a look at the attached graph.  As you can see, earnings beat rates are always around 64%. 

As Bespoke notes, the earnings beat rates are higher than the last two quarters but still slightly below the average of the current bull market.  Bianco Research, LLC research reaches the same conclusion. 

In short, there appears to be nothing spectacular about 64% of companies beating earnings estimates.  Having said that, the revenue beat rates appear to look a tad better.  Why is that important?

• The first is that corporate margins are at all-time highs or close to that.  Eventually there should be some mean regression and margins will compress.  At that point the only way earnings can continue to impress is if revenue grows.
• Revenue growth is more of an indication of economic health than earnings, especially in this environment.  As the consumer delevers top-line growth would be affected (more savings = less consumption).  If revenue growth strengthens, it would be more of an indication the deleveraging process is becoming manageable and orderly.

So to conclude, just because S&P earnings are “killing” the estimates doesn’t necessarily equate to strong corporate earnings – earnings always kill estimates.  Take a look at historical beat rates and make sure to look at top-line growth estimates too.  

A Good Watch – Ray Dalio on Charlie Rose

Ray Dalio is the founder of Bridgewater Associates, which is ranked as the largest and best- performing hedge fund in the world.  The fund is a global macro hedge fund so it assesses what the world economy is like how various asset classes will change. 

In this video he is being interviewed by Charlie Rose. Given the insight and knowledge base Ray Dalio has, I thought it would be best to provide excerpts on what I thought were the key points, as opposed to commenting on the interview (see Zero Hedge for the transcript):

• “We have to understand the big picture is -- there`s a deleveraging. Three big themes: first there’s a deleveraging; secondly we have a problem with monetary and fiscal policies are running out of ammunition; and thirdly we have an issue in terms of people most importantly who are at each other`s throats politically and globally in terms of having a problem resolving those.”
• “[Deleveraging will] take place over ten years. The key is to spread it out as much as you can. Make sure that it`s not disorderly.”
• On the kicking the can down the road and the deficit:  “I want to say that I`m very concerned not just of that. I do not believe that we will find a political solution. I think that that would not be -- I`m pessimistic about that… We can`t solve the problem easily because we still have too much debt. But we can move forward in being able to make the best of it. We can spread it out, we can keep orderly we have a situation now in which we have a very severe situation, not only because we have a deleveraging going on, but we have a situation in which monetary policy cannot work the way it worked in the past, that fiscal policy will not be simulative.”
• “Yes, so number one is we have a deleveraging. Now that deleveraging means we`re going to have more debt problems. You`re going to see -- no matter what is solved in Europe you will have a deleveraging. Banks will lend less and lending less will mean a contraction. That`s -- that is what I believe is the case, we should talk about whether or not that is the case. Thoughtful people should discuss that.”
• “We have a debt problem in Europe. You can either transfer the money from one rich country to a poor country [or] you can print the money… Or you can write them down. Those are the choices.  Hair cut.”
• “The number one principle at our place is that if something doesn`t make sense to you, you have the right to explore it, to see if it makes sense.”
• “When looking at China, China because they can`t raise interest rates because of their existing monetary policy, is that they can`t control credit growth in the normal ways that we control credit growth. So there`s a credit bubble emerging there and as -- in other words there`s a quality of lending and it`s bypassing the credit system.”
• “We don`t have the ability to have the same effect of monetary policy as we did before because a central bank -- it can buy a bond. It can -- therefore buy the bond. It gives that money to somebody who sold the bond and they were going to buy something like a bond. They`re -- the -- the getting it in the hands of somebody who spends it on cars and houses who really owes probably too much in debt is not an easy thing to do for monetary policy. So monetary policy is not as effective and then we have this social tension.”
• “We should be able to grow at a rate that`s comparable to our income growth if we are -- if we keep orderly and we -- and we work this through and everything is orderly. That means something between like 1.5 percent or 2 percent… The problem with the 2 percent vicinity is that the employment rate remains the same or can trend higher. That produces social pressures, that produces tension which itself means that you can have a situation analogous to that which is existing in Greece and more social pressure you create the more tension that is existing and emerging in various ways, not just a Wall Street piece. But it`s existing in Spain… If we have disruption… and we can`t have fiscal stimulation and you have a problem of what do you do -- you can`t recapitalize the banks. I mean if you should happen to need to recapitalize the banks you can`t have a TARP program again…  Politically not feasible.”
• On being optimistic or pessimistic:  I suppose I`m -- if I was -- I`m concerned. I think it`s a test of us. It`s a test of us in our society. It`s a test of us.

Deficits and Interest Rates.

The following graph (via Business Insider) shows the yield on the 10 Year Treasury (blue) relative to the Total Public Debt (red):

I point this out now as the calls for reigning in government spending are getting louder.  It seems the primary reason why spending hawks do not want any more monetary stimulus is that it could move interest rates higher.  However, as the graph shows, and as the article points out, there is no connection between spending and interest rates.

I have an idea of why this is happening – deleveraging (see here, here, and here).  Basically as people begin to save more and pay off debt they spend less.  The decrease in spending affects the whole economy as individuals, financial institutions, and companies begin to save and hold cash.  Not wanting to take on risk, the cash is invested in Treasuries.  Thus, lower yields.

I have advocated for more fiscal stimulus numerous times.  While I do think longer-term – after the deleveraging cycle winds down – federal spending needs to be cut down, doing so now would make things worse.  In the words of Richard Koo:

“The insistence that fiscal consolidation is necessary in the longer term is like the doctor who, faced with a patient who has just been admitted to the intensive care ward, repeatedly questions the patient about his ability to afford the treatment. This is both lacking in decency and irresponsible.

If the patient loses heart after learning the cost of the treatment, he may end up spending even longer in the hospital, leading to a larger final bill. Completely ignoring the policy duration effect of fiscal policy and constantly insisting on longer-term fiscal consolidation was what prolonged Japan’s recession.”

Spreads and Equities

I commented last week on the value of credit spreads – credit stress, economic conditions, as a possible buy indicator.  This week I came across some graphs that indicate some correlation with the equity market.

The first is the TED spread.  I mentioned this in the last post, but the TED spread is an indicator of credit risk essentially reflecting the difference in yield between short-term corporate borrowers and Treasury Bills.  The higher the spread,  is the greater the risk in the credit markets. 

The graph here (via Infectious Greed) shows the inverted TED spread versus the S&P 500.  If you look at the graph, as the TED spread moves higher equities in general move lower. 

Another graph that caught my eye shows the High Yield spread (High Yield Bonds over Treasuries) versus the S&P 500.  Again, as the spread moves higher equities in general move lower.

Now looking at both graphs you can see the TED and HY spreads are trending wider.  Is this bearish for equities?  Not necessarily as these spreads appear to coincide with stocks (i.e. one is not leading the other). 

Thus, when the spread and stocks diverge from their past correlations (as both of the aforementioned do now) it is a decent indication that one of those markets is due for a correction – one way or the other.  

Commodities No Longer a Diversifier

One graph that caught my eye this week was how commodities are now highly correlated with equities.  You can find that graph here.

The graph in that link indicates that correlation levels have tended to move in cycles since 1970.  While there have been times where commodities have been negatively correlated (stocks move up, commodities move down or vice versa) and non-correlated (stocks move up and commodities may move up or down or vice versa), right now commodities and equities have never had a higher correlation.

This is likely not news to some of you.   Without any sort of data it just seems to me whenever I hear oil moving one way that stocks seem to move that same way.  This creates a problem for those investors who purchased commodities as a way to hedge against equities.  Thus, if commodities are used in that manner, it’s probably time to get a new hedge. 

That said there are still reasons to have a commodity allocation in your portfolio.  They can be used for the following:

• Inflation hedge
• Dollar hedge
• Capitalize on long-term demographic/economic/geological trends

In short, if you have commodities in your portfolio make sure you know why.  If the answer is solely to hedge against an equity allocation it would be sound to re-evaluate that position.  

How the Credit Spread Works

A credit spread is the difference between the yield on one bond and another.  For this post, I am going to focus on the spread between risky bonds and government bonds with similar maturity. 

A widening spread is when the difference in yield between the two bonds (risky bond yield vs. government bond yield) increases.  A narrowing spread is when the difference in yield between the two bonds decreases. 

So what do widening and narrowing spreads tell you?

• Credit Stress:  Certain spreads (TED, German bunds vs. European Peripherals, Treasuries vs. HY, etc.) can indicate there are problems in the credit market.  Widening spreads tend to be a good indicator of this.  On flip side, narrowing spreads indicates the credit market is becoming more functional.
• Economic Conditions:  Widening spreads between Treasuries and Corporates may forecast that an economic slowdown is on the horizon.  On flip side, narrowing spreads may forecast an uptick in the economy is coming.
• Time to Buy?  This gets tricky, but as a spread widens so does the buying opportunity.  Bond yields and prices move in opposite directions.  So if the yield on risky bonds increases relative to the yield on government bonds the price of the risky bonds falls.  The lower the price the better the value.  On the flip side, narrowing spreads might indicate certain bonds are now pricey.

There are some caveats when it comes to buying on a wide spread, namely that spreads can continue to rise and/or the spread can stay the same, but the yields of both bonds rise. 

Regardless of whether or not spreads can provide buy or sell signs, they are certainly a good indicator that deserve attention. 

Occupy Wall Street –Hippies Hipsters, Union Members, Socialists, get all the press attention

By now most have witnessed the large protests, which started on Wall Street have spread around the world.  Hippies, hipsters, union workers, socialists, and other angry people are present to voice their displeasure over the current system.

I have to admit, when first glancing at the videos and pictures I start to think “how fun  it must be to disregard hygiene for weeks and participate in drum circles”.  I also am amused by the irony of those who protest the establishment while Skyping from an iPhone 4 in J. Crew khakis.

 

Having said that, many in the crowd are ordinary, college educated, working Americans.  I would wager a few, maybe many have worked hard their whole lives only to have their savings evaporate and their jobs lost.  The system failed them. 

Just a guess however, but I would think the ratio of wacko people to sensible people is similar to that of a Tea Party rally.  But regardless of who is protesting, isn’t the message more important?  Here is a video from Yahoo’s Aaron Trask:

At the end of the video he makes the following points about “those who mock the protesters, what are they defending”: 

• Crony capitalism
• Bank bailouts
• Rising income inequality
• The slow death of the American dream

Taking a stand against any of those issues doesn’t seem even remotely close to unreasonable, just as those at Tea Party rallies, who are mocked by the left, have valid points on bureaucratic corruption and/or incompetence. 

My non-partisan point is that when it comes to massive protests or rallies the crazies will get all the attention, but they do bring up sensible positions that MUST be addressed if we will continue to prosper as a nation.      

Europe – It’s a Start

Some of my past posts highlight just how important a solution is to the European crisis.  A solution might be on the way.  Recently, French President Sarkozy said “We will recapitalize the banks… in complete agreement with our German friends.” 

A key to such a step appears to be the holders of Greek debt taking a haircut (e.g. a bond has a face value of $100 and the investor accepts $80).  Further, there also seems to be less certainty that Greece will stay in the Euro.  Ultimately, there should be a plan delivered by early November at the latest.  

Just how good last week’s news is will ultimately depend on the goal, strength, and the execution of that plan.  I am unsure how much money is needed for recapitalization, how much Greece leaving the Euro will impact the global economy and markets as a whole, and what the implications of taking these haircuts will be.

However, the success of such a plan will depend on whether or not a PIIGS (Portugal, Ireland, Italy, Greece, Spain) fallout can be contained, if this is a systemic solution (i.e. not the banks), and if the plan can be applied  a timely and effective manner. 

“Contained”  in this instance means preventing the credit markets from freezing up.  As I have outlined before, if such a freeze up happens, it will likely spread to our markets.

In my opinion, this is the central overriding issue facing our markets through at least the end of the year.   Let’s hope the plan is enough to prevent liquidity from drying up and punishes the imprudent while protecting the system.  

Beta Hedging Not Enough? Try Rolling Stop Losses.

So I covered what beta hedging is and how to do it.  I also mentioned that it can’t guarantee your portfolio won’t suffer losses*.  If you absolutely need to stop the bleeding, the easiest and simplest solution is the rolling stop loss. 

Here is how it works:

1. Evaluate various downside points in the market where you want to sell off portions your portfolio.
2. This should be done before the market moves down.  This way you ensure you have a plan and it’s not a panic move.
3. Set up stop losses on stocks and ETFs at those downside price points.  A stop-loss works as an automatic sell trigger.  The price of the stop-loss is set below the current price, once the stock or ETF hits that point it is sold at the next tick. 
4. If you have a diversified portfolio you can set targets on the S&P 500 to sell off a portion of your portfolio.  This way you don’t have the headaches of numerous individual stop-losses to set and re-set.
5. The key is to stay disciplined.  This is where the stop-loss has the advantage over the S&P 500 targets.  The stop-loss is automatic, thus you can’t talk yourself out of selling.
6. You also need to set upside targets.  Why?  This way you can lock in the gains. 
7. At the upside target you reset the stop-loss at a higher price, hence the term “rolling”.  This ensures you keep at least some of that move up.
8. The last thing to do is set a plan for what you will do once the stop-loss triggers.  Do you go back in, and if so when and how?  Again, this makes sure that you have a set plan in place and prevents you from making a rash decision.

As you can probably see, I am not against exiting positions as long as there is a plan in place and it’s not an impulse decision.  If you have everything laid out and stay disciplined then you can liquidate parts of your portfolio in times of market stress without terribly compromising your long-term plan.   

*No investment strategy can guarantee a profit or protect from a loss in a declining market. 

How to Beta Hedge

In my last post I reviewed the strategy of how reducing the beta can help protect if the market begins to move down*.  So how do you do it?

It’s actually quite easy.  You sell assets that have a high beta and buy assets that have a low beta.  This in turn lowers your portfolio’s beta as a whole and makes it less sensitive to market moves. 

High beta assets:

• Small Cap stocks
• Emerging Market stocks
• Real Estate stocks

Low beta assets:

• Large Cap stocks
• Developed Markets stocks
• Macro/Hedged Equity managers

I also mentioned in my last post the problems that selling presents and how beta hedging helps reduce or eliminate those:

• If and when do you get back in?  You are staying in the market, just in assets that are less sensitive to market moves.  Thus, is no decision about when to re-enter.
• Does being in cash compromise your long-term goals?  Not really.  By beta hedging within stocks you are simply just changing the composition of the growth side if the portfolio.  Sure you have a lower upside, but you also have a lower downside. 
• Is this a panic move?  I hate panic moves, but in this case it doesn’t matter.  You aren’t overhauling your portfolio, just lessening its sensitivity to the market.

I will say that lowering your portfolio’s beta is no panacea.  If your beta is .70 and the market is down 20% you are still 14%.  This might not be tolerable.  Thus, in my next post I will cover prudent ways to sell. 

*No investment strategy can guarantee a profit or protect from a loss in a declining market. 

Volatility Bothering You? Try Beta Hedging.

The market has certainly been all over the place the last few months.  Not surprisingly, investors started to liquidate positions.  Is this prudent?  Time will tell, but when an investor does sell it can bring up some issues:

• If and when do you get back in?
• Does being in cash compromise your long-term goals?
• Is this a panic move?

A potential solution that helps eliminate or at the very least reduces the above issues – beta hedging*.

Beta is how an investment or an entire portfolio moves relative to an index.  For this discussion we will use the S&P 500: 

• A beta of 1 indicates the investment(s) should move in line with the S&P 500. 
• Greater than 1 indicates the investment(s) should move more than the S&P 500.
• Less than 1 indicates the investment(s) should move less than the S&P 500.

For example, a stock portfolio has a beta of 1.20.  The S&P 500 goes down 10%.  That investor’s portfolio should be down around 12% given past movements of the investments relative to the S&P 500.  Using the same scenario, if a stock portfolio had a beta of .80 the portfolio should be down roughly 8%.

So by lowering your portfolio’s beta you can help shield it from moves down in the market.  In my next post I will outline how to do this without running into the issues mentioned above. 

*  No investment strategy can guarantee a profit or protect from a loss in a declining market.  Beta  assumes specific time periods being covered. 1 year, 3 year, 10 year.  Behavior of stocks will vary versus the Beta during unexpected shocks to the market