How to Deal With a Correction: Give me an E, Give me a T, Give me an F

The broad market has yet to go really parabolic which makes me think this rally hasn’t fully run out of steam, but it’s also no prerequisite to get a good 5%+ correction going.  We don’t want to be reactive when a sell-off takes hold, so let’s mentally prepare to deal with this eventuality. 

Now let’s begin with some fun ETF education.  There is so much to know and so much fantastic information out there.  You may be wondering where to get started and what ETFs make sense for you.  Start here:  Then read on:

  1. Use Yahoo’s ETF tool to see funds in various categories:
  2. Popular sector and US index ETF creator:
  3. Popular Global/foreign ETF creator:
  4. Leveraged ETF firm:
  5. List of leveraged ETFs created by different firms with different levels of leverage:
  6. Very cool firm creating equal weighted ETFs which are a great complement to any portfolio (this is how you can remove the Apple effect from your Nasdaq/Technology sector investments):

Whether you’re up 10% or 25% so far this year, it’s now time to play defense for a bit to protect those gains.  Please eliminate any and all leverage.  Maintain exposure to core broad market ETFs like SPY, RSP, IWM, and EFA.  If you have extreme exposure to a single sector ETF like QQQ, XLF or XLE, tone it down.  Emerging markets bets like VWO or EEM can remain, but take them down to a maximum total of 10% of your portfolio.  Raise 5-15% cash if you feel the need now and we will add exposure to some leveraged ETFs like UPRO, TQQQ and EDC as opportunities present themselves during any correction.  Once a correction is underway, we will discuss how investors with higher risk profiles can use a very small short-term volatility ETF position in TVIX to enhance returns.

My ETF portfolio is up 18.4% year-to-date thanks to some well-timed leverage, exposure to the tech-heavy Nasdaq 100 Index and emerging markets bets.  Sure individual stocks like Bank of America, Caterpillar and Apple have posted 20-45% returns, but don’t get green with envy.  They come with stock specific risk trumped by the diversification most ETFs offer.  Want to analyze your performance year-to-date like the pros?  Comparing your % return to the S&P 500 Index or your next door neighbor is a good start, but you should learn to measure your risk-adjusted return like an institutional investor. 

Let’s start with the basic Sharpe Ratio: (rp – rf ) / sp::  In this equation, rp = the average return on the portfolio; rf = the risk-free rate; and sp = the standard deviation of portfolio return.  The Sharpe measure is found by dividing the portfolio risk premium, or the return on the portfolio minus the risk-free rate, by the standard deviation of the portfolio.  Compare that to the market’s ratio or those of your friends.  You will need daily values for your portfolio to do this in excel – it’s very simple, just make one of your financier or engineer friends dinner and force them to help you with the calculations.  Once you figure out Sharpe ratios, look up Treynor and Jensen ratios – these are other ways to measure risk-adjusted returns.  Big returns aren’t very useful if they fall flat on a risk-adjusted basis.

Enjoy the long weekend and remember to protect the hard-earned gains achieved during this wonderful rally.

The Economics of Luxury: Apples and Googles

I have a wealthy friend who asked the following question today:  What are the odds of Google and Apple hitting $1,000/share, respectively, in the coming 18-30 months?

I don’t have a clue, but it doesn’t seem too far fetched.  Which stock will get there first?  No idea.  This is a great topic to remind ourselves about luxury goods from Econ 101.  Between Google’s IPO in 2004 until 2007, investors couldn’t get enough – it outpaced the tech-heavy NASDAQ 100 index by 3-4x over that period.  The higher the price went, the more investors demanded shares of GOOG. 

This price action was no different than what you see with Louis Vuitton purses, Rolex watches, Ferraris, and trendy art.  But in 2008, GOOG changed its behavior and began trading like a technology stock rather than a sought-after purse.  Over the past three years, AAPL has traded in similar fashion with similar results.  This week even as Eurozone worries returned to the forefront of market action, AAPL seemed to defy gravity.

High net worth folks (politicians call them the 1%) around the globe flaunt their Apple shares at parties like a gold Rolex or red Ferrari.  Look at me, look at me.  The more AAPL stock makes up of your liquid net worth, the cooler you feel now.  This has nothing to do with ratios or earnings or any fundamentals at all since these folks could care less about them – this is about being cool and envied.  I don’t know how to time when AAPL stops acting like a luxury good, but I bet it will someday sooner than later.  Sadly, there just isn’t any reason to bet against it for now.  When it stops acting special, you will know.

Meanwhile, I take the road less traveled.  So long as the bull market is in place for 2012, I choose to own QLD or TQQQ which offer 2x or 3x the daily return of the tech-heavy QQQ ETF, respectively.  Because AAPL is the single most influential stock inside the QQQ ETF now, these leveraged ETFs will better mimic its potential for continued ascent.  If it loses its luxury luster along the way, even better.

3 Bull Market Buys – Asset Management

If you’re optimistic that stocks will rise this year like I am and you believe some money will FINALLY rotate out of bonds into stocks to boot, buy asset management stocks.  It’s a great way to play the financials sector if you dislike banks for what they did to your fellow Americans and still feel gun-shy about a real estate comeback over the next 1-3 years. 

These businesses directly benefit from a rising stock market and the more it goes up, the more fees they earn, the more their client list grows.  Plus they benefit from compounding just like you and I, which is amazing.  These are pure, simple stock market plays – they are not brokers, they don’t fund private equity, and they are not venture capitalists.  The following businesses have been beaten down 60-80% over the past 10 years, all have quality investment professionals and they deserve a good look from investors like you and I:

1. AllianceBernstein Holding LP (NYSE: AB).  This is a great way to play a unque, independent asset manager that might get gobbled up by a big firm like Morgan Stanley or UBS as markets improve.  This is also a baby boomer play since their market is older, high net worth individuals.  The stock is down 82% in five years to a market capitalization of $1.7 billion with a very cheap P/E of 11.

2. Legg Mason, Inc. (NYSE: LM).  This company provides services through a number of asset managers, each of which generally markets its products and services under its own brand name and, in many cases, distributes retail products and services through a centralized retail distribution network. They employ great people and manage tons of retail and institutional money.  The stock trades at 19x earnings and has lost 74% over the past five years down to market capitalization of $3.8 billion.

3. Janus Capital Group Inc. (NYSE:JNS).   Janus is a household name born out of the technology bubble.  The firm survived and now thrives with a market cap of $1.6 billion even after a 59% haircut over the past five years.  It trades at an attractive P/E of 11.

Buy all three proportionally for your portfolio’s financials exposure or pick one or two.  I left the nitty gritty details out so you can do your own reading about them online and see if you find one more attractive than the other.  It’s best to diversify within a specific sector in my view, but you make your own call.

Portfolio Checkup and Facebook Musings

It’s February and the weather in Southern California is reminiscent of spring.  Birds are singing, the ocean is glassy, and the sky is blue – it’s a nice feeling.  This is appropriate given the spring awakening stocks enjoyed so far in 2012.  Luckily there remain many negative headlines and bearish doubters out there, so we may have some room to run with this rally before an inevitable correction a.k.a gut check. 

My timing isn’t always great, so if you’re just now diving into stocks, it may be wise to hold off for a meaningful correction.  The fears that caused me to reduce equity exposure last fall perfectly coincided with the bottom in global equities so I still feel a little pain from that error.  But I followed my gut that if things didn’t play out as I expected by the end of 2011, I had to admit error and return to a more bullish positioning.  Now 2011’s tiny gain in the S&P 500 Index is followed up so far year-to-date with a 7% pop , but beaten-down European shares are up a few extra percentage points over US stocks, the tech-heavy Nasdaq 100 is up 11% along with small cap US stocks (Russell 2000 Index), and risky emerging markets are up over 15% (MSCI Emerging Markets Index).  Gold is mostly keeping up with the broad stock indices much to my chagrin.

The news is chalk full of headlines about individual investors sitting on the sidelines, waiting.  I love that.  If you wait for your neighbor to tell you how great his portfolio is doing, you missed the boat or at least part of it.  I also enjoy reading about how February is a bad month for stocks over 50% of the time.  Pay no mind – this is no different than the sucker bet on black in a game of roulette after three or four red bets pay off.  Summer of 2011 is starting to fade into history much like the summer of 2010’s 20% drop.  That one took six months to fade from memory and make new highs.  This time shouldn’t be much different from the smell of it. 
Is a Eurozone financial panic and debt default still a risk?  Sure and it’s enough to keep my nose mostly out of their stock market.  But the economic picture is getting brighter in the US with steadily rising output and employment.  A slowdown in corporate earnings may well be in effect, but the powerful leverage achieved via massive layoffs during the recession can only last so long. 
Stay the course with your equity investments.  When meaningful pullbacks occur, I use leveraged ETFs (exchange traded funds) to add a little pop to the portfolio.  I like TQQQ (3x leveraged daily Nasdaq 100) and EDC (3x leveraged daily Emerging Markets).  These 3x ETFs should not be used as the basis of a portfolio, but rather to add some juice to returns after a 4-5%+ pullback occurs at any given time.  When this happens you can swap out a 10-15% position in a boring index fund like SPY or IWM for one of these little rockets and see how you do.  Don’t hold them over 30-60 days as leverage can be very painful when the index moves in the opposite direction of where you need it to go.  These ETFs even have inverse brethren so you can profit when markets slide.  I am a terrible short seller and I avoid these like the plague.  Use them at your own risk.
Republican primary coverage is constantly on television.  Obama was smiling during the debates, but now has reason to giggle a little.  The financial wizards at the Fed are helping make sure he wins a fresh 48 months in the White House.  The Fed is helping Europe push off implosion to never or at least 2013 with quasi-QE3.  Don’t worry about what that means, just know they are pumping tons of liquidity to European banks.  Employment and GDP numbers smell like roses and Bernanke promised Wall Street near-zero interest rates through 2014.  Love or hate Newt and Mitt, their whining about the economy may start to sound like a broken record in a little bit.  Is all this action artificially inflating stock prices?  Let’s not worry about that and enjoy the ride.  We can revisit this issue at year-end. 
Obama’s dinner buddy Mark Zuckerberg (Facebook CEO worth $20+ billion) is about to make thousands of new millionaires via their IPO.  They will buy toys, homes and pay taxes on their very public earnings.  That’s great.  Should you buy the stock when it finally trades?  Sure, why not, just don’t go crazy with the actual amount of stock you buy relative to your net worth.  A more interesting play is to figure out what public firms Facebook will buy after it gets that multi-billion-dollar cash infusion. Zynga is an obvious choice and its stock is already shooting higher.  I like LinkedIn (LNKD) as a takeover idea.  I’m not crazy about the site and its business model, but I have an account and I don’t belong to the cult of Facebook.  Mark will have to buy me and my ilk to earn our eye balls and dollars.  And I think he will do just that.