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: http://en.wikipedia.org/wiki/Exchange-traded_fund.  Then read on:

  1. Use Yahoo’s ETF tool to see funds in various categories: finance.yahoo.com/etf/browser/mkt
  2. Popular sector and US index ETF creator: www.spdrs.com/
  3. Popular Global/foreign ETF creator: www.ishares.com
  4. Leveraged ETF firm: www.direxionshares.com/etfs
  5. List of leveraged ETFs created by different firms with different levels of leverage: http://etf.stock-encyclopedia.com/category/leveraged-etfs.html
  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):  http://www.rydex-sgi.com/products/etfs/content/equalweight.shtml

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.

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.

Necessary Pep Talk; Aside on Skyrocketing Home Builders

All that glittered before darkness hit last August is shining again in the new year.  Technology stocks up 6%, emerging markets up over 8%, even gold up over 6%.  All the hot stuff from the rally off the 2009 bear market bottom is sizzling and that gives off a warm and fuzzy feeling like the sun is out and flowers are in bloom.  Don’t get sell-trigger happy.  The volatility of 2011 makes you want to sell this rally and that would be a mistake.  As we move higher, any material pullback that could make 2012’s chart look like a V or W on renewed European default or earnings concerns is a buying opportunity.  Reread our 2012 outlook below for more ammo on staying invested.

I wish our small gold short position would drop some more, but we remain confident this will break our way as 2012 develops and the dollar gains traction along with the broad US stock market.  Foreign developed markets are lagging US stocks which is a positive for our US-centric portfolio at the moment.  Our small emerging markets position added a little juice to year-to-date performance, which is a nice bonus. 

Despite so much negative punditry on the topic, Eurozone stocks are positive for the year so far and climbing a wall of worry as tall as the empire state building.  I am not a buyer yet to be clear, but it’s a good sign for the global stock market looking forward.  If you have a lot of time on your hands to watch CNBC or read WSJ, you probably see home builders rocketing higher with no remorse.  Wow, what a move!  Toll Brothers (NYSE: TOL) up 15%, Lennar (NYSE: LEN) up 17% and Pulte Homes (NYSE: PHM) up almost 26%.  That doesn’t even cover the fact that most of these stocks were up over 50% from October through the end of 2011.  Our instinct as humans is to jump on this bandwagon.  Some of you want to dive head first with all your money.  Dip your toe to the tune of 3-5% of your portfolio if you can’t help yourself, but know that the reversal may be very fast and very violent… you will feel immense pain that will make you forget the ride to the top. 

D.R. Horton, Inc. (NYSE: DRI) is the largest home builder in the US with a market capitalization of over $4 billion.  It has a trailing P/E ratio of 62.  The hedge funds that got in early on this rally have now shared some profits with news reporters and TV talking heads who carried the torch to you, the individual investor.  Who will get stuck holding the bag after buying high and selling low?  I am going to guess it’s not SAC Capital, but rather average Joe investor.  Act accordingly.  Accredited, seasoned investors with a strong risk appetite can start looking at long-term puts on some of the biggest gainers.

Q4 2011 Summary and 2012 Outlook

I know, I know, I have been quiet.  But for good reason.  The market is behaving like a roller coaster and investors have indigestion from the volatility.  Talking heads only add to it.  My September 12, 2011 call for a significant easing off the investment accelerator pedal has felt right, wrong and anywhere in-between so many times I should feel dizzy.  That day I said “The market may be giving a signal that a sharp drop is ahead and risky assets could drop 1.5-3x more than the broad market.”  We have had three valleys, two peaks and lots of up and down in little more than three months.  Europe and the global banks underperformed at first, but are now outperforming other sectors and countries.  One bright spot has been my gold call: “Another theory is that gold is reflecting future relative dollar strength to a basket of global currencies.  Either way, it probably makes sense to get out of its way.”  Avoiding it or being short one of the gold ETFs has been profitable and offset pain elsewhere.  The issue at hand is what to do now and we shall get to that.

While the broad US stock market will end 2011 darn near flat to up a little, most investments that outperformed in the bounce since the bear market bottom performed poorly.  Emerging markets and developed markets outside the US fell 15-20%. Europe and its euro currency were the worst offenders.  Technology stocks lagged the broad market.  The volatility since August has been so potent I heard a man in his sixties complain about it to a clerk at my local grocery store.  Buy and hold investors with a mostly US-focused portfolio have done just fine so far, but the traders among us are just about ready to throw up.  Hedge funds are feeling the pain the most as they are whipsawed from low to high, to subsequent low, to the next high.  They are at the mercy of psychology and trend-following no less than the average investor/trader.

If you followed my advice, you should have ~25% cash to burn at this point.  Stop day trading (you know who you are) and add a bit to those broad, large and small cap US index funds you own and keep your now reduced exposure to emerging markets and non-US developed markets in case a bounce happens.  As I said in September, “Poor stock market performance in the fourth year of a President’s term is rare as can be.”  Please don’t think for a second the volatility is over.  A plausible scenario for 2012 is a W shaped year with one or two shocks causing steep drops in the first and second quarters, followed by a nice rally into the election and an overall 10-20% S&P 500 return.  I expect the market to trick us into believing 2012 is like awful 2008, an anomaly for a fourth year in the election cycle, at least a few times in the near future.  But 2012 will buck the trend because stocks hate the uncertainty that goes along with legislation which creates winners and losers.  Losers hate losing more than winners like winning – this keeps stocks from rising when the prospect of big legislative change is at hand.  Election years like 2012 yield little in the way of change and President Obama has no real competition at this point.  Regardless of your political leanings, Romney is no more a contender for President than John Kerry two elections ago. Fourth years for lame ducks are even better historically.  There is good reason to believe Obama is essentially a  lame duck to his own second term, especially if you watched the Republican debates so far.

Europe could throw a monkey wrench into our plans for a good year and help create a W chart, but the US should continue to do better than foreign markets if for no other reason than the strength of the US Dollar.  Our economy is also recovering nicely from the recession, but not fantastically.  Beating expectations is a win even if your wallet doesn’t feel as high and mighty as it did in 2005-06.  Hedge funders like SAC Capital are even betting on a real estate stock rebound in 2012 which seems a tad premature.  Tech stocks should gain leadership once again as risk appetites return, but don’t bet on that in the first half of next year.  A strengthening USD should keep gold prices falling as speculators exit their long-held positions to lock in profits.  If some brainy solution to European banks’ sovereign debt problems arises out of the blue, we could see things reverse with the US lagging again and gold moving up.  Until then, maintain an 80-90% allocation to stocks with the remainder short gold or in cash.

Good Luck and Happy New Year!!!

Jobs Jobs Jobs

No, not Steve Jobs.  I know you love to hear about your favorite stock Apple Inc. (NASDAQ: AAPL).  It sure has defied gravity and the market as a whole, despite news of Amazon’s tablet competitor and global demand worries.  I like AAPL, but I wouldn’t build my portfolio around it solely based on the fact that it’s your grandma’s, uncle’s and next door neighbor’s favorite stock too.  That means any stumble on its path to even greater global domination could be exaggerated.  On to more important things… Congress and Obama want to fix the dismal US JOBS picture.  But how?  Probably not the way they want to do it and not the way they will try to do it.

Ben Bernanke is going around telling people unemployment is a national crisis.  He is also saying he doesn’t have the tools to help.  Congress wants to create government programs to “retool” or retrain the labor pool.  They also want to give businesses a tax break.  Sounds good on the surface.  But how does that help get demand going for the products and services businesses provide?  What about hiring – will these measures actually cause hiring?  I will speculate a little.

As a small business owner, I know what it takes to get me to hire a new employee.  Promises of more demand from the government won’t do it.  Now if the phone starts ringing and old clients start asking about new programs, that’s a different story.  How about a lower payroll tax?  I think this is a waste.  Small business owners aren’t making the kind of profits they would like these days, so that little extra money will go right into the S Corp owner’s pocket.  What about big business?  Giving them tax breaks right now is pure nonsense.  They have the cash to hire if they want.  So if Uncle Sam focuses on small businesses, how can he help?  Money, that’s how!  Congress should pick up the tab for new workers and IT CAN. 

Let’s work through a reasonable scenario:  Congress can spend $48 billion over the next 24 months to create one million new jobs.  So we add to the national debt – it’s $14 trillion already.  This money is peanuts compared to what we spend fighting the Taliban and securing Iraq and the bailout we gave big banks a few years ago.  The math is easy.  Start with $2 billion a month.  That’s 20,000 salaried employees making $50,000 a year for two years.  Since Congress won’t agree to foot the entire bill for a new employee, let’s cover 50% of each new employee’s wages for two years.  Now we created 40,000 long-term positions in a month.  Let’s do this for 24 straight months and we only spent $48 billion to generate 960,000 jobs.  We can probably double that easily and spend $100 billion to put 2 million people to work.

Let’s open this program only to businesses with under $100 million in revenue to make sure it hits its intended target.  Put a cap in place on the number of employees a business can hire under the program and you have something raw, but relatively viable.  I can tell you with certainty that small business owners will start hiring if they know a 50% tax credit is coming for their new employee for two straight years.  Call your congressman :)

The Market Speaks… Listen Up

Watching stocks daily is a loser’s game, but as we come to the end of September, it’s high time to pay attention.  Study after study shows individual investors time their buy and sell decisions poorly, buying high and selling low.  There are, however, those moments when a decision can change the long-term course of portfolios.  

Equities and commodities may be sending a signal not to be ignored for the rest of 2011.  Recession fears are the wrong reason to sell any portfolio holding now – this is the oldest news around.  The US was somewhat insulated from declines in Europe and emerging markets so far this month, but we are retesting August’s lows.  Even gold is making new lows.  The market may be giving a signal that a sharp drop is ahead and risky assets could drop 1.5-3x more than the broad market. 

US stocks, especially our favorite technology names, enjoyed some level of insulation this month from worries over the health of the Euro currency and the survival of European banks.  Investors may be concerned about US banks now too after the Fed shared its innermost thoughts with us common folk today.  Bernanke’s crew fears it has no more tools left to fix the economy aside from long-term bond purchases.  Such purchases mean lower long-term bond yields and that can mean a heap of trouble for banks.  Banks make money by borrowing near zero now at the short end of the yield curve and lending at the long end.  When the long end falls, so do banks’ profit margins.  Meanwhile, Republicans and Democrats are very publicly fighting over tax increases and markets hate that regardless of the eventual outcome.  Whether taxes on millionaires and government program cuts matter or not, nobody wants to go out and spend while their income and benefits sit on a giant chopping block. 

Should’t gold be going up now?  Investors who profited from gold’s rise may be freeing up cash to meet future potential margin calls or make quick investments as a rare opportunity presents itself at some point in the intermediate future.  Another theory is that gold is reflecting future relative dollar strength to a basket of global currencies.  Either way, it probably makes sense ot get out of its way.

Poor stock market performance in the fourth year of a President’s term is rare as can be.  And there is no reason to panic over 2012 just yet.  But it’s time to make prudent decisions about the remainder of 2011.  Taking 25-50% of your risky assets (financials sector, non-US equities, gold, commodities) off the table is probably wise.  This may be accomplished with inverse ETFs that go up when markets drop, index put options, or simply holding more cash.

Economic Anxiety Ferris Wheel

As the market figures out a direction this week, let’s examine three headlines; each worrisome for different reasons:

Some very bright men opine on the Euro’s future here:  http://www.bloomberg.com/news/2011-08-21/el-erian-joining-feldstein-fels-on-prospect-of-euro-evolving-into-new-core.html.  If you want to be part of a union, strong partners must support weaker partners in times of need.  Partners in a union also work out compromises when they disagree.  Kicking the PIIGS (Portugal, Italy, Ireland, Greece, Spain) off the Euro currency presents a real potential shock to global markets and at this time the EU will likely sidestep this immense policy blunder.  To put this issue in perspective, most US citizens would love to be rid of “housing bubble and illegal immigration” states like Florida, Arizona and Nevada.  I leave out California because it’s simply too darn big and important to the US as a whole.  You could argue the “parasite” sates are dragging the dollar down with big budgets, falling tax revenue, and localized economic problems the folks in Illinois and Virginia just don’t care about.  You can see how this argument can quickly turn to political civil war and roil markets.

Warren Buffett’s tax rhetoric gains supporters: http://economix.blogs.nytimes.com/2011/08/23/what-the-rich-can-afford-in-income-tax/.  Bruce Bartlett is a conservative guy when it comes to economics.  Why is he talking about tax increases for the rich at a time when populist headlines are all the rage?  I won’t discuss the specific merits of his argument, but opening yet another pitch fork stand for angry villagers doesn’t seem like a great idea.  It is important to note that changes in the tax code represent a shift in the distribution of wealth–markets get depressed when this happens, no matter the direction of the shift.  Losers hate losing more than winners like winning: that’s basic behavioral economics. 

So ridiculous, it’s worrisome: http://www.marketwatch.com/Story/story/print?guid=CF3F1872-CCE9-11E0-BE2D-00212803FAD6.  The future is always scary, I agree.  Human civilization will successfully deal with the challenges a more populous planet Earth presents.  We are capable of immense innovation at an exponential rate relative to what we believe is possible today.  Gloom and doom stories like this about post-apocalyptic investment ideas are about as useful as umbrellas at Chernobyl.  if you feel inspired, don’t log into your Schwab account.  Go out and buy a Nissan Leaf with some roof-mounted solar panels.

Put Economic Growth Fears in Perspective

Volatility is back in equity markets today and headlines point to slowing economic growth across the globe.  First, the market is a discounter of known information.  If you understand that, you know GDP revisions by analysts and the same old stories about high unemployment don’t move stocks.  Second, volatility is normal; it’s why stocks earn a premium over other asset classes over time.  But guessing why stocks do what they do any given day is best left to fortune tellers.  Let’s take our eyes off today’s bleeding ticker and focus on economic data from the World Bank and IMF. 

Apparently European economic growth slowing may be contagious to the rest of the world.  The 27 nations of the European Union (EU) are no poster child for growth and haven’t been for a very long time.  2001-2010 EU real GDP growth was a “massive” 1.18% on average.  The trend doesn’t look good when you look at prior decades: 2.14% on average during the 1990s, 2.38% during the 1980s and 3.03% during the 1970s.   To provide some perspective, Asia ex-Japan and Emerging Markets GDP expanded 7.06% and 5.75% 2001-2010, respectively.  The US posted consistent showings in the low 3% range during the 70s, 80s and 90s.  US real GDP grew just 1.64% on average 2001-2010.

Economies can slow during expansions just like a stock can take a step back before heading to new highs.  Worries over the European Union’s economy are not new and add little credibility to global recession/depression fears.  Equity investors should build portfolios with powerful global exporters in mind.  This will help minimize exposure to structurally slowing economies and maximize exposure to the new engines of economic growth.

Real Clear Markets

http://www.realclearmarkets.com/ is an excellent site reposting the day’s headlines relevant to global markets from a variety of media outlets.  From time to time, I will repost articles I believe to be particularly relevant, impactful and/or ridiculous with my own commentary.  Here are a few: 

  1. Richard Salsman’s dog and pony show for a return to the gold standard: http://www.forbes.com/sites/richardsalsman/2011/08/16/gold-reagan-and-the-reds-from-degraded-dollar-to-downgraded-debt/3/.  Life is immitating art:  remember the movie “Lord of War,” where the African dictator asks the arms dealer character played by Nicholas Cage for a solid gold machine gun?  The 007 series also comes to mind with a shadowy New World Order set to control the globe’s currencies and natural resources.  I say ask the Treasury Department to hold endangered species as collateral for currency.  I think the dollar is worth its weight in black rhinos, giant pandas, and beluga sturgeons.  Caviar is the new black gold. 
  2. http://www.realclearmarkets.com/articles/2011/08/17/gov_rick_perrys_red-hot_bernanke_slam_99198.html.  A blurry picture is forming of the 2012 competition for leader of the free world.  Governor Perry says “Printing more money to play politics at this particular time in American history is almost treacherous, or treasonous, in my opinion.”  Mr. Perry is certainly no economist.  And Mitt Romney reminds me of John Kerry with a more obscure religious profile.  Doesn’t look like Barak and Michelle need to worry about packing up just yet.  Whether you approve of the President’s performance or not, Mr. Obama is more camera shy than he was during his first year.  What has he accomplished so far?  I recall something about healthcare reform and a promise to pull back from global conflicts; and oh yeah, he said he would fix the economy and create jobs.
  3. http://www.nytimes.com/2011/08/17/opinion/why-we-should-end-homeownership-subsidies.html?_r=2&ref=opinion.  The NYT proposes we kill GSEs Fannie and Freddie currently financing the vast majority of US home purchases at a time when private investors want to sit on the sidelines.  Let’s assume these are good ideas.  Unfortunately, stories like this are used by nasty politicians to argue for crazy notions like removing mortgage interest as a tax deduction.  This article says GSEs cost $700 billion in lost revenue over five years, whatever that statistical mumbo jumbo means.  That is the tiniest of fractions in relation to our aggregate spending on the military industrial complex.  Where would you rather cut?
  4. http://www.nakedcapitalism.com/2011/08/bank-of-america-death-watch-unloading-non-core-assets-aggressively.html.  This story would not be worth discussing were it not for what transpired in the US financial sector over 2008 and 2009.  Words sometimes equate to Chinese water torture.  Each word holds little weight, but add them up over time and Bank of America could end up in the hands of a competitor for pennies on the dollar.  There are only seven and a half dollars left as of this writing, so caveat emptor.  This is not some gloom and doom prediction, but confidence is key to market stability.  Just remember that Wall Street is even better at spreading rumors and manipulating feelings than making money and political contributions.

 

US vs Japan Continued

August 10 I wrote the topic of Japan has died down in the media of late: http://www.cardiffassetmanagement.com/blog/2011/08/10/japan-part-deux/.  It’s back with a vengeance.  Here’s a good article about structural issues faced by the Japanese economy relative to the US economy:  http://the-diplomat.com/2011/08/17/no-the-us-isn’t-japan/.  Please ignore all rhetoric on US financial regulation.