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

Getting Older <> A Crash in Asset Prices

Last week I wrote about trends in emerging markets.  This week I stumbled upon an article from The Economist that discusses the demographic challenges facing developed markets – an aging population.  This is problem facing many developed economies including the US, but Japan, Germany, and Italy in particular.

First it’s best to describe the basic assumption associated with age groups and asset purchasing.  In general, working aged people buy assets and retiring people sell assets.  The former pushes prices up and the latter pushes prices down.  The article has some research that substantiates this:

• A paper by Elod Takats for BIS looked at home prices in 22 advanced economies.  He found that a 1% increase in old-age dependency ration (old people/working age people) was associated with a .66% drop in real home prices.
• The San Francisco Fed found that there has been a high correlation between the ratio of Americans aged 40-49 and those aged 60-69 and the market’s P/E ratio.

To me this indicates there could be some serious problems facing asset markets in developed economies; however, I don’t think it spells certain doom:

• Markets have likely discounted this.
• Elderly people may wind up working longer.
• More liberal immigration laws can help lower the average age.
• Monetary and fiscal policies can help address the problem of an aging a population.

Ultimately I think an aging population will have an effect on asset markets; however, I don’t think it will be severe. 

Where is the US?  In the short-term we appear to be aging; however, by 2025 we should have a strong rebound in working-aged individuals.

Dividends are Good Depending on the Source

Dividend paying stocks are becoming very popular among investors.  The FT notes investors have been moving aggressively into dividend ETFs since July.

There are many reasons to like these kinds of stocks:

• They tend to be bigger companies that have strong balance sheets & diverse revenue streams
• Given the above, those companies should be less volatile than the overall market and provide some stability of the market moves down
• Relative to small cap equities and low yielding government bonds these companies are attractively valued
• From the middle to the end of a cyclical bull market cycle large caps typically perform the best  

The key when buying a dividend paying ETF or stock is that they meet the above criteria.  Just because a company pays a dividend doesn’t mean it’s financially strong.  The same goes when buying a dividend paying ETF; just because it has a high yield doesn’t mean you are getting quality.  Basically, looking only at the yield is a suckers bet.  If an ETF yields 6% but the value falls 20% than you still lose.

You need to know your Dividend ETFs.  What is the composition?  What are the screens?  How many stocks are in there?  What index do it track?  It is imperative you get those answers before you invest. 

Past Returns Can Get You Burned

Hedge fund manager John Paulson is no doubt a smart guy.  He made a lot of money shorting the subprime mortgage market in 2007 and 2008.  His large gains and the bet he made is even chronicled in the book The Greatest Trade Ever Made (and probably a few others).

Recently however, Paulson has not as much success.  His two largest hedge funds are down over 20% this year and he may soon have to start liquidating assets in order to meet the outflows.  If he starts selling the bulk of his investments it could cause the value of his remaining investments to fall, making matters worse.

Did Paulson make a great trade?  Absolutely.  It is also true that he has struggled as of late.  I cannot say for certain whether his initial trade was luck, or if Paulson is an unbelievably skilled trader who will eventually recover.   

The point is judging a manager based on one trade, good or bad, is probably not the best way to pick if you invest with him or her.  Investing money purely on past returns is a fool’s game.  You need to look at the process and whether or not it’s sustainable.