(CC image by Jullen Belli on Flickr)

 

Some say that long-term trends in the financial markets are impossible to predict.  Not so!  Markets follow cycles that, while not precisely predictable to the exact date, time, or price point, can be reasonably well-anticipated in advance.

If you’re a day-trader with a time horizon of minutes or hours, long-term trends won’t have any impact on your results at all.  But if your investing time horizon is multiple days, weeks or months as we recommend, then a good understanding of the long-term trend will enhance profits and reduce drawdowns.

If you have a long-term time horizon and you don’t like to make trades more than a few times a year, these long-term trends will be the single most crucial factor in deciding where to invest your money.

 

Don’t Invest Without a Long-Term Forecast

In my earliest foundational post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post (with the blue circle added to mark today’s focus):

 

For a longer-term investor, someone who can’t or does not want to make trades every week or every month, this simpler framework applies:

In the earlier post, I touched on how I make my long-term forecasts.  When I refer to the “long-term”, I mean cycles that generally last between 4 and 12 years, with an average of 8 years.  In another post, entitled “Want to Conquer the Investment Universe? First, Make a Map!”, I listed the asset classes and subclasses I forecast.  Now, I’ll explain my forecasting methodology in more detail.

 

Begin with a Baseline Trend (The “Very Long-Term”)

First, I make an assumption for what the trend will be across the next few long-term cycles.  This is the baseline trend that would best fit the long-term cycles, if we could knew them in advance.  To develop the baseline trends, I consider several factors:

  • Historical returns, in the form of risk premiums over the risk-free rate (the difference between the annual return and the risk-free interest rate).  This paper, by Aswath Damodaran of the Stern School of Business, explains the concept of equity risk premium in detail.  The author estimates the average annual risk premium for stocks as having been 4.10% (using geometric averages and the long-term risk-free rate) over the period from 1928 to 2010, albeit with a declining trend across that time period.  This means it is ok to make a choice that is slightly different than the longest average, because the risk premium may vary over the course of decades or a century.  Assuming that today’s 10-year US Treasury rate of 2.58% will be representative of the next few decades, the long-term baseline return for US stocks I’d derive from this approach would be 2.58% + 4.10% = 6.68%.
  • Inflation expectations.  In my post titled Inflation, Deflation, and Your Portfolio, I explain what inflation really means, as well as how essential it is to have a good forecast of inflation before making any long-term forecasts.  I expect deflationary pressures to continue to rule the day, up until the point where the massive amounts of unrepayable worldwide debt are either defaulted upon or renegotiated, as explained in my inflation forecast for 2016 and beyond.  Deflation depresses returns across all asset classes, but inflation tends to increase returns as long as there are not sudden shocks.  Because I expect deflation followed by an inflationary shock, it is hard to estimate what the overall impact of the two together will be, but it has to be considered.
  • Fundamental analysis, including political trends, demographics, social patterns, economic indices, and other factors that may impact a single sector or all financial markets over a very long period of time.

Here are the baseline long-term trends I am using as of today:

I also establish a range around each baseline trend value.  I do this by defining and measuring the depth of previous long-term cycles that have occurred in each asset subclass.  For example, the range of possible long-term annual returns I’ve established for gold mining stocks (“PM Stocks”) is -25.9% to +35.0%, but for consumer staples stocks it is only -11.1% to +12.5%.  [Technical note: The positive skew exists so we have symmetry across up and down cycles.  (1+.125) * (1-.111) = 1.000].  I use these ranges later in the process.

 

Determine Trend, Using a Long-Term Chart

Next, I look at a weekly or monthly chart to determine the direction and strength of the current long-term trend.  You can see countless examples of how I gauge trend direction and strength on my YouTube channel.  Recall that the definition of an uptrend is a series of higher lows, and the definition of a downtrend is a series of lower highs.  If there is not a clearly discernable trend, look at the prior trend direction.  Most likely, what is occurring is a flat correction and we would expect the prior trend to resume once the correction is complete.  For example, in the chart below, I have marked the rising yield cycle from 2003 to 2006 which appears as a flat correction when looking at the 30-year yield.

Long-term chart of US Treasury Bond yields, with long-term cycles marked by the blue lines.

 

This example also illustrates how price outweighs time when evaluating long-term cycles.  Often, cycles don’t follow regular lengths, so it is very dangerous to assume that major highs or lows will occur X months from now merely because that happened the last couple times around.  I’ll go more in-depth on this subject in later posts on intermediate-term cycles, another component of my framework for successful investing.

Besides examining the price action in a long-term chart, I also consider the following factors when forecasting the future trend direction:

  • Momentum: The rate at which prices are increasing or decreasing.  Technical indicators that measure momentum include the Stochastic Oscillator, RSI, % rate of change, and deviation from a long-term average.  If prices make a new long-term low or high, but momentum is weaker than another low or high that recently occurred, the odds favor a change in the long-term trend direction.
  • Intermarket analysis: The performance of other asset classes that tend to move in the same direction as, or opposite direction from, the asset class we’re examining.  For instance, the US dollar index and the price of gold (in dollars) tend to move in opposite directions.  When the typical relationship doesn’t hold, it is a warning sign that the trend may be changing.  John Murphy has written several excellent books on the subject, one of which is on my list of essential books for trading and investing.
  • Fundamental factors: shifts in political trends, demographics, social patterns, economic indices, or other factors that may impact a single sector or all financial markets.

Based on the long-term chart, I select an “Actual Long-Term Trend” and a “Forecasted Long-Term Trend” from one of the five choices below:

  • “Up” – representing a clear upward trend
  • “Up (?)” – representing a weak upward trend
  • “Down” – representing a clear downward trend
  • “Down (?)” – representing a weak downward trend
  • “??” – representing a situation where the trend cannot be determined

 

Translate the Trend into a Fearless Forecast

So far, we’ve selected a baseline long-term trend, defined a range within which the long-term forecast can fall, and assessed the current long-term market situation.  Now that we have assembled all the info we need, we can proceed to make our long-term forecasts.

I take the actual and forecasted long-term trends from the prior step and translate them into a percentage between -100% and +100%.  This percentage determines how much my long-term forecast will vary from the baseline trend.  A percentage of -100% represents the most bearish, or negative, stance on from a long-term standpoint, and would produce a long-term forecast at the absolute bottom of the range.  Conversely, a percentage of +100% represents the most bullish, or positive, stance on from a long-term standpoint, and would produce a long-term forecast at the absolute top of the range.  Anything in between will fall within the range, with higher percentages giving higher forecasts and lower ones giving lower forecasts.  A percentage of 0% puts us right in the center of the range.

I have a grid I use to define the percentage for every possible combination of actual and forecasted trend (5 x 5 = 25 combinations in total).  The grid is the same for all asset classes.  The forecasted trend carries much more weight than the actual trend, because the future trend will determine our profit or loss, not the past trend.  As legendary hockey player Wayne Gretzky famously said, “skate to where the puck is going, not to where it has been.”

When I am confident in the forecasted trend, and differs from the actual trend (e.g. actual trend is Down, forecasted trend is Up), the percentage will be positive but not too strongly positive.  We want to start getting on-board the new trend, but not too heavily in case the current trend extends longer.  As the new trend begins to emerge, we become more confident in the forecasted trend so the percentage goes up.  At an actual trend of “Up (?)” and a forecasted trend of “Up”, I am at a percentage of +100% which means I am as bullish on that asset class as I can be, and I’m putting a higher percentage of my assets into it.  In this case, I see the actual trend beginning to turn up, in line with my forecast, so I have more confidence that my forecast is indeed correct.

As another example, let’s continue the earlier case of gold mining stocks.  As of today, my assessment of the actual long-term trend is “Down (?)” and I have chosen “Down (?)” for the forecasted long-term trend.  This is a weak situation, and negative for the gold miners.  However, because both forecasts have low confidence, the percentage is -40% and not any lower.  Applying this percentage to the range we established, -25.9% to +35.0%, and the baseline trend of +6.5%, we get a long-term forecast of -6.5%.  Calculation: -6.5% = 6.5% + (-40%) * (6.5% – (-25.9%)).

This forecast applies to the stage of the long-term cycle that we are in.  For example, if a few months from now the downtrend seems to be exhausting, causing us to change our forecasted trend to “Up (?)”, the percentage would go to +35% (as defined for that combination of actual trend “Down (?)” and forecasted trend “Up (?)”) and the long-term forecast would increase to +16.5%.  This is a big move, but I don’t change my long-term forecasts very often, only when conditions warrant.

To see this in action, including loads of real-life examples, check out our live stream, YouTube channel, and free trading podcast.

Armed with a fearless long-term forecast, we can now take action.

 

Turn Forecasts into Profit

With forecasts on all areas of our investment universe, we are ready to face the market.

Long-term investors can stop here, allocating their wealth to the asset subclasses with the highest projected forecasts.  It’s still important to monitor the risk level of the portfolio to avoid overconcentration.  More about risk levels in Episode 2 and Episode 10 of my investing podcast.

Intermediate-term traders, or swing traders, will want to layer intermediate-term forecasts onto the long-term ones.  Here’s a link to another post with more details, as I continue my series on the Five Components of Successful Investing.

So get started today on your fearless forecasts, and be prepared for the volatile times that lie ahead for financial markets.

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(CC Image by Samantha Marx on Flickr)

(CC Image by Samantha Marx on Flickr)

 

In today’s world, opening up a book may seem like an old-fashioned way to learn.  However, despite the popularity of virtual webinars and other online learning tools (like our free trading podcast, live stream, and YouTube channel), books remain a critical resource for professional traders and investors.  You’d be hard-pressed to find one pro that couldn’t name at least a couple books they read that taught him or her fundamental skills or inspired a new strategy.

For me, books were the first place I turned when I started my investing journey over a decade ago.  Over the years, my collection has expanded through regular purchases as well as inheriting a collection of classic trading books from my uncle.

In the spirit of the holiday shopping season, I’d like to share my list of the ten most essential books for anyone who wants to become a better trader or investor.  Every book on this list is one I personally endorse because it influenced my growth and development as a trader.

These are foundational books that will give you a strong base of knowledge that you’ll be able to apply right away, without overwhelming you with technical mumbo-jumbo.  Many of these books have a practical focus with plenty of examples to illustrate the concepts shown.  That said, I couldn’t resist including one textbook (Derivatives Markets) on the list so those who are mathematically inclined like myself will have something to sink their teeth into.

Without further ado…

Technical Analysis Explained, Fifth Edition: The Successful Investor’s Guide to Spotting Investment Trends and Turning Points, by Martin J. Pring

Pring introduces all the commonly-used technical analysis concepts and indicators in this book.  It’s a great reference book to have on hand and a solid introduction to technical analysis.

The Layman’s Guide to Trading Stocks, by Dave Landry

This accessible and slightly irreverent book is a fun place to start for the beginning trader.  Landry covers several basic yet fundamentally important trading strategies here, along with good coverage of the mental aspects of trading.

Intermarket Analysis: Profiting from Global Market Relationships, by John J. Murphy

John Murphy has written several books on intermarket analysis, all of which are classics that continue to stand the test of time.  Murphy’s excellent analysis of the connections between global stock, bond, currency, and commodity markets had a tremendous influence on the technical strategies I’ve developed.

Tragedy & Hope, by Carroll Quigley

What, a history book?  Yes – a 1300+ page history book, no less.  And I honestly believe it may the most valuable book on this list for investors.  Quigley’s magnum opus, first published in 1966, is an unparalleled study of 20th century history.  Social and political trends have been a major influence on the financial markets since markets were invented, and they always will be.  Reading this book will help you ensure your investments are aligned with these trends.  The book is freely available in PDF form here, although you’ll be missing out on the pride you’d have if this beast was on your bookshelf for all to admire.

Derivatives Markets, by Robert L. McDonald

This comprehensive textbook teaches important theoretical concepts related to the pricing of futures, forwards, swaps, and options.  This textbook is part of the syllabus for the Society of Actuaries’ MFE Exam.  When I took the actuarial exams I learned from a similar book, Financial Economics by Harry H. Panjer.  The Panjer text, published in 1998, is out of print but used copies are still available.

The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets, by Jeff Augen

Every trader must understand the concept of volatility, because trading is all about managing risk.  Augen does a great job of explaining volatility in this book in a way that is understandable for newer investors.  He also introduces strategies to take advantage of mean reversion and other concepts related to volatility.

Harmonic Trading, Volume One: Profiting from the Natural Order of the Financial Markets, by Scott M. Carney

Carney introduces several harmonic patterns which are composed of four price waves each, with all the waves related to each other by Fibonacci ratios.  These patterns don’t appear tremendously often, but they are reliable when they occur.  You’ll want to have harmonic pattern analysis as part of your technical toolbox.

High Probability Trading Strategies: Entry to Exit Tactics for the Forex, Futures, and Stock Markets, by Robert Miner

Miner provides a thorough yet accessible framework for successfully trading all markets and all timeframes.  One of the biggest mistakes I see traders making is having too narrow of a focus.  Miner covers all the bases with his four-part framework consisting of price, pattern, momentum and time.  His writing style can be a little abrasive at times, but it’s clear he knows what he is talking about.

Forecasting Financial Markets: Technical Analysis and the Dynamics of Price, by Tony Plummer

This little-known gem is now out of print, but used copies can still be found.  Plummer’s writing style can be hard to decipher, hence the mixed reviews, but patience is rewarded here.  I have read it several times and unlocked new secrets each time through.  Fibonacci ratios are at the core of Plummer’s ideas.  The 2010 book, linked above, shares the emphasis on theory over practice.   It’s not the place to start for a new trader, but it contains quality insights I’ve yet to find anywhere else.

The Education of a Speculator, by Vic Niederhoffer

This is the most enjoyable book I’ve read about trading, hands-down.  Vic experienced more than his share of ups and downs in the markets, and his writing provides a lot of insight into how he managed through those experiences.  You won’t get charts or trading strategies in this one, just an entertaining glimpse into how the trader’s mind works.

 

I’ve tried to include a mix of easy and challenging books here, with a variety of subject matter, so traders of all experience levels will find something to enjoy.  Now get started!

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(CC image by Hubble ESA on Flickr)

 

Think back to your most successful trades – the ones that made you jump out of your chair and run around the room, high-five your friend, enjoy a celebratory drink, or all of the above.  As traders, we all want more of this kind of trade.  In these moments, we feel like masters of the investment universe!

It takes lots of dedication and practice to achieve mastery, but it is not difficult to get started on the path towards success.  One of the critical first steps is defining what your investment universe will be.  After all, we can’t master something unless we first know what it is we want to master!

I call this mapping your investment universe.  It’s the process of deciding which markets you will follow and analyze, along with making a list of the securities you will trade.

 

Every Winning Plan Includes a Map of the Universe

In my earliest foundational post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post (with the blue circle added to mark today’s focus):

activemgtplan-univ

While the Universe of Securities box sits to the right of the other blue boxes, because it doesn’t need to be updated as often as the other components of successful investing, all the others depend on it.  We can’t make forecasts unless we have first chosen what types of investments (e.g. stocks, commodities, bonds) we want to forecast!  Also, most of us will use technical analysis of chart patterns to inform our trading decisions, which first requires us to select which charts we want to look at.

So, what should your investment universe be?  The answer is: it depends!  It depends on what YOU like to learn about, follow, and trade.  Some traders prefer to follow one industry, such as tech stocks or retailers, and get to know it in great depth.  These type of traders might define their universe as all the stocks in that sector, including small-cap stocks that they feel comfortable trading given their specialized knowledge.  Their universe might also include options or warrants on these stocks, depending on risk tolerance and other factors.

My approach to trading and investing is more broad than this.  It can be best categorized as “macro investing”.  Macro investing is all about trading a wide variety of assets and investment vehicles with the goal of capitalizing on large-scale trends and cycles.  I might buy a small-cap security if I think there is an opportunity there which aligns with a larger trend, but generally I am trading larger ETFs (exchange-traded funds) that hold a basket of securities in any given area.

I believe that macro investing is the optimal approach for most investors.  Here is why:

  • If your universe includes ALL the major asset classes, you’ll be able to take advantage of the best opportunities to bet alongside or against every area when it is becoming underpriced or overpriced, respectively.
  • Having a larger universe requires you to stay current on all the important trends, which makes you a better-informed trader.
  • Using ETFs as your primary investment vehicle, as opposed to individual stocks, provides better diversification within an asset class.

The exception to this would be if you have the time and desire to do lots of research on individual stocks, above and beyond the larger market trends.  In that case, you’d want to select stocks yourself for better returns and lower risk.  The vast majority of traders simply don’t have the kind of time needed in order to select stocks across many different sectors.

In the remainder of this post, I’ll explain how I map out my universe of securities.  This will serve as an example that you can adapt for your own situation.

 

Select Asset Classes

As I mentioned above, I try to include all categories of tradable assets in my investment universe.

First, I group them into major asset classes:

  • Currencies;
  • Precious Metals;
  • Commodities;
  • Bonds;
  • Equities (Stocks); and
  • Pure Derivatives.

Next, I further define “subclasses” within many of the asset classes.  For example, beneath Equities (Stocks) I have the ten market sectors (e.g. energy, utilities, financial services) along with mining stocks.  Beneath Commodities, I have: Soft Commodities, Base Metals, Oil, and Natural Gas.

Now that I’ve defined the scope of my universe, I can choose which securities I’ll trade.

 

Select Securities

To keep it simple, I choose only one preferred investment vehicle within each subclass.  Typically, this will be an ETF that tracks all major components of that subclass.  In some cases, there will be multiple “go-to” choices, as in the Currency Derivatives category where we can use UUP to trade the U.S. dollar, FXE to trade the euro, or FXY to trade the Japanese yen.

My list changes periodically as funds change and new choices become available.  Here is the list as of today:

asset-classes-w-tickers

My investment universe

These are the criteria I use to form the list, in order from highest to lowest priority:

  • Coverage (i.e. low tracking error);
  • High trading volume (i.e. low bid/ask spreads);
  • Low expense ratio;
  • Availability of options;
  • Trading volume in options.

I recommend you use some combination of the above criteria to form your own list, since your priorities might differ from mine.  For example, if you are a very frequent trader of options, the amount of trading volume in options could be your top priority.  In that event, you’d want to entirely remove the ETFs that don’t have high trading volume in options (e.g. DBA, DBB).

 

Follow Your Map, Unless You Are Absolutely Sure Where You’re Going!

Over 75% of my trading activity is in the ticker symbols found in my list.  I only deviate from the list when at least one of the following conditions hold:

  • I am trying to get more exposure outside the United States markets (e.g. I’m bearish on the dollar or U.S. markets have become overbought).  In this case, I’ll choose a fund with more foreign-listed stocks (like RWX instead of VNQ).  I keep a list of favorites.
  • Or, I’m trading a niche that is only a small piece of a subclass.  For instance, while uranium stocks are part of the energy sector they trade quite differently from the rest of the sector, which is dominated by oil and gas companies.
  • Or, I’ve thoroughly researched a company and am confident enough in my view of that firm that I’m willing to take on company-specific risk by trading it.

In the past, when I’ve strayed from my list by trading in different securities without one of these valid reasons, my results have been mediocre to poor.

I learned this lesson in the FactorShares 2x Gold Bull S&P 500 Bear ETF (FSG), an ETF that, mercifully, no longer exists.  From mid-2011 to mid-2012, this fund extracted over $9k from my account before the pain stopped.  I’d been buying it on the thesis that the ratio of the S&P 500 to gold would decrease.  As we see below ….

fsg_2011

… it was a faceplant.  Ouch.  But although the ratio rose instead of falling as I’d expected, I suffered a bigger loss than necessary.  FSG wasn’t in my universe of securities, and I didn’t trade it for any of the three reasons listed above.  I used it because it looked on the surface like it tracked the ratio I wanted to trade.  I’d have been better off creating a synthetic long-short position with GLD and SPY instead of using this ill-contrived fund.

What I discovered later was that FSG was managed terribly.  Factor Capital Management, the managing owner of FSG and 4 similar ETFs, shut down its operations in 2013 and liquidated its funds, but not before:

  • Charging excess expenses above its stated 0.75% fee (already too high) which weren’t clearly disclosed in the fund’s prospectus;
  • Failing to provide required tax forms to investors before March 15 as required by law (I had to amend my taxes in 2012 because of them – what a pain!);
  • Failing to adequately promote its funds, which kept volume low and hurt the fund’s liquidity.

I shared this example because I don’t want to see you fall into the same trap.  Stick to your list of preferred funds only, and don’t deviate unless one of the three conditions in my list is true.

Macro investing can seem like too much to handle.  It can look like the universe is far too vast to navigate.  But make a map, stick to it, and you won’t get lost!  You’ll be ready to pounce on opportunities anywhere they appear, and you’ll be on the path towards mastering your investment universe.

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(CC image by Mario Donati on Flickr)

(CC image by Mario Donati on Flickr)

 

We’ve seen relatively low and stable inflation levels for the last 30 years, so it’s easy to forget that it hasn’t always been this way.  What will the next 30 years bring?  More of the same, a return to the high inflation of the 1970s and early 1980s, or deflation as in the Great Recession of 2009-2010?  Or, could we experience all of the above?  Is your portfolio ready?

My prior post explains the real meaning of the terms “inflation” and “deflation” with several examples.  It also guides you towards making better forecasts of inflation, based on its three main drivers.

When the inflation rate shifts suddenly, it causes major damage to investors who haven’t prepared for these episodes.  Often, it’s the investors with the most conservative approach that are left worst-off once the dust settles.

If my forecast comes to pass, few investors will be spared from the damage.  That’s because the conditions today are ripe for BOTH deflation AND inflation, one after the other.  Only by taking specific steps now, and remaining alert as events unfold, will you emerge with your portfolio intact.

 

Historical Perspective

Prior to 1971, when the United States fully broke all ties between the dollar and gold, consumer prices in the United States underwent phases of high inflation and deflation.  However, when averaging across these cycles, prices maintained stability over the long run.   This happened because the dollar was backed by gold and the supply of gold grew only as quickly as it could be mined and processed.  Overall price levels stayed roughly the same from generation to generation, rather than increasing over time like everyone accepts as normal today.  (Look at how much prices have gone up from 1975 to 2015 – imagine if college was still that cheap today!)

Since 1971, the inflation rate has been less volatile, as the U.S. Federal Reserve has closely managed monetary policy in the United States.  The Fed’s objectives, as defined by the Federal Reserve Act, are to maximize employment, maintain stable prices, and moderate long-term interest rates.  These objectives existed long before 1971, but in the eyes of the Fed’s Board of Governors and the Federal Open Market Committee (FOMC) who are charged with carrying out these goals, “stable prices” now means something very different than it used to.  Today, they say that “stable prices” does not mean actually mean “stable prices” over the long run, but gradually rising prices!  If they really cared about stable prices, you’d still be able to buy a postage stamp for 13 cents or a car for $3,800, as in 1975.

The Fed has managed to keep prices rising gently for most of the last 45 years because it has responded swiftly and dramatically to any threat of falling prices in the economy, whether real or perceived.  By contrast, they react slowly when the economy is booming because they do not want to be blamed for the damage that would occur if they suddenly withdrew stimulus from the economy.  This behavior creates a strong bias towards rising prices rather than stable or falling prices, as we see below.

cpi_graph_70yr

The Fed’s focus has been on using monetary policy to smoothing out the boom-bust cycles that naturally occur in a free market economy.  When the economy starts to contract, the Fed expands the money supply through actions like buying US Treasury bonds (indirectly, because doing so directly would be illegal!), cuts key interest rates, or takes other actions to try to juice up the economy.

On the surface, this seems like a great thing for everyone.  Who cares if prices go up over time, as long as it’s gradual and predictable and there are no major shocks to the system?  If they’ve kept inflation tightly controlled for decades, certainly they can continue to do so?

Not so fast.  This “over-management” of the economy harms us all, especially savers and investors.  It allows bubbles to grow bigger and bigger over a longer period of time, rather than deflating on their own.  We saw massive bubbles burst in currencies (1997), real estate (2008), stocks (1987, 2000, 2008), banks (1980s S&L crisis), junk bonds (1989), and commodities (2008, 2014-15) to name just a few.  These bubbles would likely have still happened without misguided policy from the Fed and the U.S. government, they would just have been smaller and easier to recover from.

In summary, the Fed has kept the inflation rate moderate and positive for decades, but at the cost of pushing more volatility into asset markets.  This is wonderful news for alert traders and active investors, but bad news for savers and passive investors.

 

Current Conditions

Under a “lower-for-longer” interest-rate policy like we observe today, businesses respond by expanding debt, refinancing old debt that they’ll still never be able to pay back, and other financial engineering like massive stock buybacks, all of which are value-destroying in the long run.  They don’t deploy as much capital into real investment that would produce long-run growth and more jobs.  Furthermore, retirees, and savers have to set aside more money when interest rates are low, otherwise they won’t have enough interest and dividends to live on.  Pension funds and insurance companies must set aside more money to meet future obligations.  What does this all mean?  Money sits idle or chases bad investments instead of being invested into job creation, good technologies, or production plants.

We see this most clearly in the velocity of money: the rate at which money, credit, and liquid assets circulate in the economy.  Lower velocity means more money sitting idle instead of being used to purchase goods and services.

A similarly steep drop in velocity happened right before the Great Depression.

A similarly steep drop in velocity happened right before the Great Depression.

 

At the same time, the money supply is rapidly expanding:

m2-60yr

Most measures of credit I monitor are growing too.  Corporate debt, student loans, and auto loans are breaking records month after month.

Yet despite all this credit creation, and consumer prices that are nominally rising, I see deflationary pressures far outweighing any inflationary ones.  Neither government nor the Fed can stop it using their existing tools.

Commodity prices continue to trend downward:

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

 

Gold and gold stocks remain below their 2011 highs:

gold_2006

 

Investors’ inflation expectations keep falling:

infl_exp_5yr_2006

 

Lastly, actual realized inflation continues to fall short of investor expectations:

infl_dev_1_5_2009

 

These charts don’t look anything like what we’d expect to see if inflation were right around the corner.  This is deflation all the way.

 

What’s Next?

When debt builds up in the economy, all is well-and-good until enough borrowers become unable to service their debts.  Debt levels across households, corporations, and governments continue to grow far faster than incomes.  This is unsustainable.  Default rates will reach crisis levels in one area first – state and local governments are a likely starting point, but I cannot be certain which area will tip off the crisis.  It could even be a geopolitical crisis, natural disaster, or any number of events that could set the process in motion.  Timing is even more difficult to predict, but it’s hard to imagine we can go another 3-5 years on the path we’re on.

As default rates rise, the crisis will spread to other sectors of the economy with a speed and severity that will exceed politicians’ and the Fed’s abilities to respond.  Therefore, expect a sudden decrease in virtually all asset prices, with few places to hide.  Gold, income-producing real assets like land and some real estate, will be best protected.  This will be the deflationary phase of the crisis.  (I’d argue the deflationary pressures we see today are a sign that the crisis period has already started!).

But I don’t expect politicians or central bankers to accept this reality for long.  There will be too much pressure on them to act, and to act in ways we have not seen before.

As an example, I believe we are likely to see a large-scale debt forgiveness program for households accompanied by a revaluation of the U.S. dollar at a lower level.  I also think we’ll see a global renegotiation of debts, since a great deal of debt is owed to other governments.   U.S. President-Elect Trump, whether you like him or not, certainly is a man who understands how to renegotiate debt and emerge from bankruptcies.  To make these measures more effective, I also expect governments will initiate capital controls, restricting the movement of money across borders.  We may also see an attempt to introduce regional currencies or a global currency at this time.  These actions will represent the inflationary phase of the crisis.

The length of time we remain in the deflationary and inflationary phases will depend on how effective global policymakers are at achieving consensus during the crisis.  The more rapidly they are able to successfully “reset” the global economy, the faster we’ll move from deflation to inflation and then return to some semblance of normalcy.

 

How To Stay Safe, Or Even Profit, From These Events

If there is one thing all good traders love, it is volatility.  Even in times of crisis, markets remain open (with limited exceptions).  Many of the skills I teach will help you preserve your capital and even make money during both phases of the crisis.  For instance, shorting stocks, buying put options, and trading the VIX in a crisis environment can be immensely profitable!  Keep in mind that these strategies do carry risk, and should be used carefully as your own financial situation permits.

You should also consider owning some hard assets like gold, silver, and income-producing real estate if you are able.  Minimizing your own personal debt will benefit you in a crisis period as well.  Stay tuned for more on all these topics.

Above all else, it goes without saying that you’ll want to take steps to ensure your personal safety, diversify your skillsets, and overall become more self-sufficient.  I highly recommend Jack Spirko’s podcast, The Survival Podcast, for a rational and thoughtful discussion of preparedness topics.  I’ve been a listener and subscriber for many years.

Deflation and inflation don’t have to catch you off-guard.  By sharpening your trading skills, you can use volatility to your advantage.

 

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Currency - (CC image by Taki Steve on Flickr)

(CC image by Taki Steve on Flickr)

 

“Inflation” and “deflation”: These are two of the most commonly used terms in the world of investing, but what do they really mean?

And, why is it so crucial to understand these concepts before making any long-term forecasts?

 

Why Inflation Matters

In an earlier post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post:

activemgtplan

Long-term forecasts, the second component of the plan, are the most impacted by inflationary or deflationary forces in the economy.  The stronger and more persistent the inflation, the higher will be the expected returns across most asset classes.  Of course, the cost of living will rise at the same time, limiting the purchasing power of those investment gains.

The rate at which we expect inflation to expand or moderate in the future will also have a major impact on our preferences for certain asset classes over others.  Assets with a fixed stream of cash flows, like bonds, will be badly hurt by rising inflation, whereas gold will shine.  In mild deflation, when prices are gently falling or nearly constant, cash is king.  In that scenario, a wise investor will maintain a large cash reserve and consider writing options or shorting stocks to generate returns.

For these reasons, all long-term forecasting must start with an assessment of whether we expect inflationary or deflationary forces to be operating, and to what extent.

Before I go further down that path, it’s important to define what “inflation” really means.

What is Inflation?

Most people define inflation as the rate at which prices are increasing in an economy.  This is a good definition, but let’s dig deeper into it to avoid some important pitfalls.

Inflation is controlled by three factors, broadly speaking:

  • The supply and demand for goods and services in an economy;
  • The amount of liquid assets circulating in the economy, and;
  • How rapidly money circulates in the economy.

I’ll refer back to these towards the end of this post.

Goods and services are anything that is produced and available for sale to consumers.  This includes physical products, digital goods, and all kinds of services.  It even includes the underground economy or “black market”.  For simplicity, we’ll assume a closed economy, like a country that does not trade with other nations, so we can ignore the impact of cross-border flows of goods, services, and currency.

The second factor includes money, defined as any item that is serves as both a store of value and a medium of exchange.  Today, the vast majority of money in circulation is in the form of bank notes issued by central banks (paper currency, notes, and digital entries), but this category also includes gold, silver, and digital currencies like bitcoin.  A follower of the Austrian school of economics would simply define inflation as the rate of growth of the money supply, but this ignores all forms of credit and other liquid assets besides money.  It also ignores the rate at which money circulates in the economy.  Thus, the money supply by itself is useless for measuring inflation.

By “liquid assets”, I mean anything that can be converted to money in a reasonably efficient and fast way.  This includes far more than the supply of money and credit in the economy, and rightfully so.  For instance, let’s say you are considering the purchase of a new car for $30,000.  If you have $30,000 in your checking account, clearly this is money.  But if you instead have $30,000 of stocks in your online trading account, and all you have to do to get that money into your checking account is to: (1) click “Sell” and (2) request a check from your broker, how is this any different than money?

I’ve also included credit in my definition of “liquid assets”.  There are many types of credit.  As a simple illustration, let’s stay with the car-buying scenario.  Instead of using any money at all for the car, you could get a zero-down loan from your local bank.  That bank will then create the money out of “thin air” and use it to purchase the car on your behalf.  This puts new money into circulation, which will be taken out of circulation as you repay your loan.

The third factor, often forgotten, is arguably the most critical one when trying to predict future inflation rates.  It is the velocity of money – the rate at which all that money, credit, and liquid assets are circulating.  It generally follows a well-defined trend over long periods of time:

Prior to the start of this graph, money velocity also exhibited stable trends (down 1900-1932, up 1932-1960), when removing the impact of the two world wars.

Prior to the start of this graph, money velocity also exhibited stable trends (down 1900-1932, up 1932-1960), when removing the impact of the two world wars.

 

In the extreme case, the Treasury could print warehouses full of cash and drop it by helicopter, but if everyone stuffs it under their mattresses then it will have no impact on prices today.  Yet we can be certain that as soon as velocity begins to rise again, pent-up inflation will be released.   It is just a matter of time until it occurs.  We’re seeing this same phenomenon today in all the world’s leading economies, just not to such a dramatic level.  Central banks continue to stimulate growth by pumping money into the banking system, but its effect remains limited because it is not being deployed into the broader economy.

Now that we’ve defined inflation, let’s consider the factors that cause the inflation rate to go up or down (all other factors held equal).

Inflation increases when:

  • The supply of goods contracts (e.g. production quotas or natural disasters);
  • The supply of liquid assets increases (e.g. growth in money supply, financial asset values);
  • Liquid assets begin to circulate more rapidly.  For instance, when people expect rapid inflation, they spend their money more quickly.

Inflation decreases when:

  • The supply of goods expands;
  • The supply of liquid assets decreases (e.g. banks pull back on lending);
  • Liquid assets begin to circulate more slowly.  For instance, when people worry about the economy, they tend to hold onto their money longer.

(Which scenario fits today’s economy?  More the second scenario than the first, I’d say!  We see this in the inability of inflation to hit the Federal Reserve’s 2% target level, despite massive money-printing.)

If the rate of inflation is negative, i.e. price levels are dropping, we say that “deflation” is happening.

 

How is Inflation Measured?

It’s easy to measure inflation if you’re only interested in past or present values of the inflation rate.  Government agencies regularly publish inflation data, often labeled as a Consumer Price Index (CPI).  These series measure the rate at which prices are increasing for consumers in the economy.  Price levels at the producer level, like commodities and raw materials used by manufacturers to produce consumer goods, are measured by a Producer Price Index (PPI).  A more obscure measure of price levels, yet one that is arguably more valuable for investors, is the GDP (Gross Domestic Product) deflator.  The GDP deflator is the inflation series used to convert the GDP of a nation (a measure of its annual production of goods and services) into today’s prices.  I prefer to use the GDP deflator when running analyses because it aggregates all transactions in the economy, including those at the consumer and producer levels.

PriceStats and State Street have collaborated to develop their own inflation series, giving an alternate view that in many ways is more comprehensive than official series.

The tougher task is determining how much inflation to expect in the future.  The prices of gold and silver offer some insight into how much inflation investors are expecting, but these markets are small and subject to many forces beyond just inflation expectations.  Tracking gold and silver prices isn’t enough.

Without a good forecast of inflation, all our long-term forecasts will be too high or too low, and we won’t be adequately protected against distastrous outcomes.

 

Forecasting Inflation

It’s a whole lot easier to predict future inflation once you break it down into the three factors that I listed earlier.  Here is each one, with a list of questions to ask yourself when assessing each:

Supply vs. demand of goods & services

  1. How rapidly will technology advance?
  2. Will energy become more abundant, or more scarce?
  3. How rapidly will governments increase their spending?  Will some pull back?
  4. Will the population expand rapidly, or level off?

Amount of liquid assets circulating in the economy

  1. Will central banks follow loose (expansionary) or tight (contractionary) policies?
  2. Will government policies cause banks to hold on to reserves, or incentivize them to lend to the public?
  3. How will investors preferences change between non-liquid assets, like privately owned businesses, and liquid ones, like publicly traded companies?

The velocity of money

  1. Which will be stronger, fear or greed?
  2. How likely is it that a major war will break out, pulling money off the sidelines into the war effort?
  3. Has velocity been trending downward or upward, and for how long?  Is it due for a reversal?

 

After reflecting on these questions, you’ll be able to make more confident long-term forecasts.

Think of a swimmer going along with the current, or fighting against it – this is the difference between a forecast that starts with a good understanding of inflation, and one that does not.  Whether you’re a long-term investor or a frequent trader, you’ll want the current on your side.

 

 

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(CC image by Jim Linwood on Flickr)

(CC image by Jim Linwood on Flickr)

 

Have you ever been to one of the world’s financial centers – London, New York, Hong Kong, Chicago, to name a few – and seen the huge glass-walled towers full of luxury offices?

When you hear about the massive salaries and bonuses being paid to the high-ranking people inside those offices, which house companies like Goldman Sachs, JP Morgan, Morgan Stanley, Lehman Brothers (rest in peace), Bear Stearns (another RIP, maybe they’re not so smart after all?), PIMCO, Wellington, Edward Jones, and so many more – how does it make you feel?

Certainly, these firms perform many useful functions for large institutional investors, who must maintain portfolios full of thousands of individual securities and file tons of paperwork.

But what about the office down the street in your town?  The branch office that handles the accounts of high net-worth individuals, corporate middle managers, hard-working entrepreneurs and diligent savers from all walks of life.  They work in the brand-new building, drive around luxury cars, and advertise constantly on TV.  They must be doing something really hard to earn all that money, right?

What if I told you that they’re not doing a single thing you can’t do, if you have only:

  • A computer or tablet,
  • The ability to listen to podcasts (a shameless plug for our podcast!) at some point during your week, like during your commute,
  • A minimum of 1-2 hours per week to review your investments (or only per quarter, if you prefer a more “hands-off” approach).

The more time and dedication you’re willing to put in to building these skills, the better your results will be, of course.  But even with just the basics, you can do most of what the “professional” advisors down the block are doing, and you can do it for a much cheaper price.

Even if your portfolio is as high as $10 million, this is within your reach.  You can learn it, and you don’t need to be a math whiz to do so.

Let me illustrate.

 

The Five Components of Successful Investing

This is the approach I developed to manage my own assets, which I accumulated across 10+ years of working in the corporate world.  Although I’ve developed advanced analytical tools to perform  each one of these steps, this is the overall process I follow.  You can do it too.

 

activemgtplan

Each step will be the foundation for lots and lots of future podcasts and posts.  For now, I’ll introduce the topic by giving just a brief outline of each step.

 

1. Determine why you’re investing.

Is your goal to have a secure retirement?  To save for your kids’ college?  To leave a legacy for future generations?  To become filthy rich and own 5 Lamborghinis?  No matter how ordinary or ambitious the goals, you need to know what they are.

Your goals impact your risk tolerance as well.  I like to distill the concept of risk tolerance to one sentence to make it easier to think about.  “If my net worth went down by [X%] in a short period of time, I would get very worried about my investments.”  Fill in the [X%] for yourself, it is a personal choice.  Yours might be as low as 2%, or as high as 100%!

Lastly, figure out your liquidity reserve.  That is, how much money you must keep safe and secure because you might need it in the not-too-distant future.  This is an emergency fund for job loss or, if you’re self-employed, a downturn in your business.  Three months, six months, or a year of expenses are common amounts.  Add on any big expenses you know are coming up soon, like a car purchase or down payment on a house.  The total is your liquidity reserve, or how much you absolutely must keep away from potential risk.

2. Develop long-term forecasts.

When it comes to forecasting, you can do all of the work yourself, rely on outside resources like Torpedo Trading, or fall somewhere in between the two extremes.  If you want to develop your own forecasts, you could mimic my comprehensive approach.  I developed my forecasts using: historical returns adjusted for long-term cycles, volatility assumptions, and correlation matrices.  If not, it’s much simpler to tune in to the podcast and follow the blog since you will find the results of all this hard work there, for free!  Alternatively, you could make your own forecasts based on independent research, talking with other investors, your favorite advisory services, astronomical cycles, or whatever you heard on CNBC yesterday.  (OK, not the last two examples.)

I re-evaluate my forecasts about once per quarter, sometimes sooner if there is a major shift in market conditions for a particular asset class.  Trends I define as long-term usually last 10 years or more, so they will not change much.

I chose about 25 asset classes in total, including: the 11 stock sectors, gold, oil, corporate bonds, Treasury bonds, and others.  You could use as few as 6 to 8 and get decent coverage of the investing spectrum.

Once you have a forecasted return and volatility level for each asset class, just put all your money into the one with the highest forecasted return.

JUST KIDDING!  That’s NEVER a good idea because of something called correlation.  Quite simply, correlation is the tendency for two asset classes to move up or down at the same time.  Even if you think bonds will have a lower return than stocks, you still want to include some bonds because they offer you diversification.  During a year in which stocks drop 25%, bonds may lose only 5% or even go up in value.  You might not have sufficient risk tolerance to take a 25% loss, but could absorb a smaller loss.

If you don’t want to be checking your portfolio or trading weekly or monthly, stop here!  Your plan looks like this instead, a shortened version of the one from earlier in this post:

activemgtplan-simple

Simply keeping your asset allocation in line with the long-term targets will put you in good position for long-term gains.  Once you’re confident in steps 1 and 2, it’s also enough to feel comfortable putting your advisor out of a job!

On the other hand, if you like to trade and you want the best plan, read on!

 

3. Develop intermediate-term forecasts.

By intermediate-term, I mean around 6 to 14 months.  I find that to be the typical trend length in most markets.

Intermediate-term cycles operate within longer-term trends, which last from several years to decades.  Aligning yourself with intermediate-term cycles takes more work and involves more risk than simply tracking the slow-moving long-term trends, but offers tremendously higher rewards.

I use a form of intermarket analysis that I developed with inspiration from an acclaimed book by John Murphy.  I also use a few other advanced technical tools to identify likely turning points.  More info on my approach can be found in this blog post.

You’ll use these intermediate-term forecasts to flex your asset allocations up or down from their long-term targets.  For example, you might have set a long-term allocation target of 50% for stocks, but your risk tolerance and goals permit you to vary that percentage in a range between 30% and 70%.  If you’re forecasting an intermediate-term rise in stocks, you would increase your stock holdings towards 70%.  When your forecast changes, anticipating a drop in stocks, you would begin selling stocks down to 30% of your total portfolio.

 

My current intermediate-term targets. I'm not bullish on stocks or bonds right now.

My current intermediate-term targets (some asset classes have been grouped together here, like all the stock sectors). I’m not bullish on stocks or bonds right now.

 

4. Be aware of short-term market moves.

Notice I don’t say “develop short-term forecasts” or “watch charts every single day” here.  This would be a full time job by itself.  We’ve all got a life to live!

I’m not opposed to day trading, but it’s foolish to be playing tiny moves in an hourly or shorter chart unless you’ve already got extremely sound intermediate-term and long-term forecasts.  Those moves will always dwarf the short-term oscillations.

If you’re under- or over-weighted in an asset class based on the intermediate term forecast, you’ll be trying to increase or reduce your position in that asset class.  Simply be aware of whether the last few days have trended down or up so you’re buying on a dip or selling on a pop.

I use my live stream and YouTube channel, both of which are free to watch, to keep viewers up-to-date on the latest developments in the financial markets.  Please consider subscribing to be updated when I release new content on those platforms.

 

5. Choose what you’ll buy and sell from each asset class.

I call this step “mapping your investment universe”.  Learn how it works and see an example here.

I usually recommend the major ETFs because they’re liquid and cost-effective.

It’s certainly appropriate to pick individual securities instead of ETFs here, wherever you feel comfortable doing so.  For example, maybe you work in the health care sector so you keep up on the trends in that area.  Or perhaps you love the latest tech products, and you’ve got a good lead on what will be hot and what won’t.

As part of this step, you’ll also want to consider whether options (calls or puts) are appropriate for you or not.

At Torpedo Trading, we maintain a list of preferred ETFs for each asset class.  The list changes from time to time as the fund companies make changes or add new funds.  This list will be provided to members once our membership program goes live.

 

More to Come

Stay tuned for future podcasts and posts that will dive much deeper into each of the steps above.  I hope this post will serve as a helpful reference for the overall process and how it works.

I’m here to help you take control of your investments, and avoid being gouged by expensive advisors.  This framework will set you on the path towards success.

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(CC image by Core Media Product Demo on Flickr)

(CC image by Core Media Product Demo on Flickr)

 

If you trade stocks, you’ve heard it before.  We all have.  From a colleague, family member, friend, or a mainstream investment advisor.

“You can’t beat the market.”  “Picking stocks is a fool’s game.”  “Stick to low-cost index funds.”  “Buy and hold for the long run.”

The list of prominent names who advocate for passive investing over active investing includes, to name just a few:

  • Jack Bogle, founder & former CEO of Vanguard Group;
  • Warren Buffett, founder & CEO of Berkshire Hathaway, who bet $1 million that a basket of 5 hedge funds would not beat an index fund;
  • Burton Malkiel, Princeton economist and author of Random Walk Down Wall Street;
  • Dave Ramsey, radio host and author of personal finance books including The Total Money Makeover. (Dave seems to be OK with actively managed funds, as long as you don’t do anything besides buy-and-hold the fund)

These folks would have us believe that the recipe for building wealth through investments is the following:

  1. Shovel money into low-cost indexed mutual funds and exchange-traded funds (ETFs) that mimic a broad market index, such as the S&P 500, FTSE 100, Euronext 100, DAX, or the S&P/ASX 200.  Or better yet, a global fund that includes all of them.
  2. Sit and wait for many years, while trying really hard not to look at your broker or retirement provider’s statements, lest you be tempted to sell.
  3. Retire rich.

Sounds simple, right?  It is!  Being somewhere between “mediocre” and “below average” isn’t too tough, if that’s your goal.

Why “below average”, not average?  If you hold a broad market index, aren’t you achieving the same return as the average market participant?

No.

 

Why holding index funds puts you at a disadvantage

Some companies perform better financially than other companies.  (Duh!)

There are exceptionally well-run companies, terribly-run companies, and many in between.  As a passive investor, you’re the last to discover which are the good ones and which are the bad ones.  Active investors are constantly researching these firms to separate the wheat from the chaff.  Accordingly, they bid up the prices of the stronger ones and sell the shares of the weaker ones, so that over time their market values move in the right directions.  This process generally happens over a period of time, with the first movers getting the rewards for their work and the late movers stuck on sinking ships or chasing trendy companies that have already reached stratospheric levels.

Some companies are a disaster waiting to happen – a powder keg that will blow a hole in the value of your portfolio.  What if you could avoid them?

As an example, let’s examine the performance of the Energy Select SPDR Fund (XLE) starting with the major peak that occurred on July 24, 2014.  This fund is the largest ETF tracking the energy sector.

The chart below illustrates the XLE (the black line) and ten of its largest holdings (the colored lines) in 2014, all indexed to a starting value of 100 for clearer comparisons.  The XLE fell by over 40% to a low in January 2016, followed by a recovery of about half its losses.  However, all energy stocks are not created equal.  A sharp investor could have avoided the pain, or even experienced gains during this tumultuous period.

xle-2014-16

After initially being sold off alongside the rest of the sector, independent refiner Valero Energy (VLO) had vaulted to a gain of over 50% by the end of 2015, thanks to strong refining margins, low debt, and productive capital investments.  Refiners like Valero actually benefit from declines in the price of oil, the raw material for its refineries, as long as profit margins hold steady.

Other components of the XLE fared better than the index, including Exxon Mobil (XOL) (10% decline) and EOG Resources, Inc. (EOG) (15% decline) compared to a 29% decline in the XLE as a whole.

On the flip side, Chesapeake Energy (CHK) collapsed, shedding 90% of its value and dragging down the energy ETF along with it.  The natural gas producer suffered steep drops in the value of its shale assets, many of which could not produce at a profit as oil and gas prices plunged.  It continues to suffer under the burden of substantial debt.

You didn’t need to be a professional investor to see the potential for huge differences in how these companies would perform.  Two tools – (1) a simple stock screener filtering on debt levels and (2) an understanding of the basic differences between a refiner, pipeline company, an explorer, and a producer – would have helped you hang on to 15 or 20 percent of your investment that would otherwise have been lost in XLE.

But because index funds have all the stocks, and there tend to be more winners than losers, it all works out in the long run, right?  Wrong, because…

Most indexes are capitalization-weighted

What does this mean?  Each stock’s share in the fund is proportional to its market capitalization (the price per share multiplied by the number of shares outstanding) relative to the market capitalization of the index.  So, the stocks that make up the highest weight in the index are the ones that have already been bid up by the market to the point where they are worth more than the others.  By investing in a fund that mirrors one of these index, you’re piling into the stocks that already have reached celebrity status.  You don’t own tomorrow’s Amazon or Facebook, or enough of it to matter, because they are too small today to get much (or any) weight within the large ETFs.

For some companies with strong cash flows and well-established business models (think: Exxon Mobil, Wal-Mart, Boeing), high valuations can make sense.  But for every one of those, there is an overvalued dud.  Remember Enron, Eastman Kodak, Woolworth’s, Trans World Airlines, Pan Am, WorldCom, RCA, Compaq, or Pets.com?   At one time, each of these was a hot stock with a very high market capitalization, but now they are all confined to the history books.  Which of today’s high flyers will join that infamous list one day?  Apple?  Volkswagen?  BP?   All of the above?

The “illusion of diversification”.

It is easy to be lulled into a false sense of security by thinking you are diversified because you hold 20 or 30 of the biggest publicly traded companies in a sector instead of just one.  But, it’s typical for the largest 4 or 5 to comprise over half of the weight in a sector ETF.

What about holding all the sectors?  If you own many retailers, chemical companies, oil refiners, banks, wireless providers, technology firms, and mining companies, surely that is enough diversification?.  In 2008 and 2009, that didn’t work so well.

S&P 500 Index, from 2006 to 2009

S&P 500 Index, from 2006 to 2009

 

Correlations between different stocks and sectors always increase during times of financial stress – which are precisely the times when you need true diversification the most.

Another way of saying this is that when the markets are panicked, everything gets sold – the baby, the bathwater, the tub, the copper pipes in the bathroom, the house itself, and the land it rests on.  Imagine if you had just retired in 2007 with a “diversified portfolio” full of stocks.  By 2009, half your assets had vaporized.

True diversification requires owning multiple asset classes, including alternative assets, in proportions that are optimal for today’s investing environment.  I also encourage investors to consider using options to manage portfolio risk.  This will be a topic for future posts.

 

ETFs are more popular than ever, creating opportunity for active investors

Hedge funds are closing at an increasing pace.  Institutional money managers and individual investors are flocking to ETFs in record numbers.  Since gaining mainstream status in the 1990s, index funds have captured a larger share of overall stock assets nearly every year since 2000, according to CNN Money.  There are over 1,000 ETFs today, with new ones released every week.  They track a mind-boggling number of indexes, with tongue-twisting names like the “Dow Jones FEAS Titans 50 Equal Weighted Index” and the “Dow Jones Europe Developed Markets Select Real Estate Securities Index.”

This article, from Julia La Roche at Yahoo Finance, is a reminder of how dangerous this phenomenon can be for buy-and-hold index fund investors.  In it, independent researcher Steven Bregman warns of an “indexation vortex that’s distorted clearing prices in every type of asset in every corner of the globe.”  He emphasizes the systemic risk that ETFs pose, an argument that has become more mainstream lately as ETF “flash crashes” become a more common occurrence.  But I’d like to focus on what I feel is the critical point here – the tremendous opportunity the ETF boom provides to active investors.  That is, the “golden age of active management.”

Every dollar that moves OUT of an active fund (e.g. hedge fund or actively managed mutual fund) or an active strategy-based approach INTO a passive, indexing plan puts you and I one step closer to being one of the “first movers” I mentioned earlier.  It’s as if you own a home improvement store in your city, you’ve just watched Home Depot close its doors, and Lowe’s has announced a going-out-of-business sale.  Fewer investors identifying mispriced stocks leaves more money on the table for savvy active investors.

It’s a fantastic time to manage your own investments!

 

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