Tag Archives: financial advice

More Market Mayhem On Its’ Way

My Comments: History does typically repeat itself. Whether its human frailty or the laws of physics, the past is usually a glimpse into the future. Cries of ‘this time it’s different’ usually prove to be false. It’s not what happens that has a critical effect on your financial future, it’s how you manage the inevitable. I’ve been at this for almost 40 years now, and while I’m far from perfect, there are ways to mitigate the risk.

26 Sep 2015 Richard Dyson

Earthquakes and volcanoes rarely strike once only to vanish. A number of smaller episodes precede and follow the main event.

The same appears true of market routs, where a series of dramatic falls cluster within a period of several weeks, or more often months, sometimes signalling an entire change in the market’s direction.

Black vertical lines in the chart, above, show the number of days per month in which the FTSE 100 index has fallen by more than 3% – from opening to close – in the past 20 years.

While falls of that magnitude often capture front-page headlines, they are relatively uncommon.

If all such falls over the past two decades were spread out evenly, they would occur on average every 78 trading days, or once a quarter, according to broker AJ Bell which processed the data for Telegraph Money.

But they rarely occur in isolation.

On only 12 occasions since 1995 has there been just a single day within a calendar month where the market fell by more than 3%. Instead the bad days clump around wider market events, usually global in origin.

The first cluster of lines marks the crises in the late 1990s beginning in Thailand and spreading across Asia and from there to Western markets.

The two biggest concentrations of falls – including single months where there were six and seven days in which the FTSE fell by more than 3% – came in the desperate years of 2003 and 2009.

The first marked the final end of the protracted sell-off of the technology bubble. The 2009 cluster marked the trough at the end of the financial crisis.

By contrast the correction suffered since last month’s “Black Monday” (August 24) has been comparatively minor.

If the past patterns of the data are to be repeated, further days of sharp sell-offs are to be expected in coming weeks.

Russ Mould, investment director at AJ Bell, said: “If anything, the story here is the comparative absence of turmoil in the past 18 months up to August.”

He points out that downward market movements are more abrupt. This means days of 3% falls far outnumber those where the market gained 3% or more. “Markets tend to rise serenely and lose ground quickly, which again is what can make bear markets such a shock.”

Preparing for opportunities

With further falls likely, investors are eyeing sectors where the greatest value is likely to emerge – and building cash reserve in preparation.

Based on a number of measures of value including price to earnings ratio, yield, and “Cape” – the cyclically adjusted p/e – Telegraph Money identifies European and emerging markets as “prepare to buy” areas, with commercial property, bonds and gold as sectors to trim back as a way of raising cash ahead of future falls.

5 Reasons the Fed Shouldn’t Raise Rates

080519_USEconomy1My Comments: You’ve already read my comments about the significance of interest rates. They are going to start going up; when is the big unknown.

By Akin Oyedele, September 9, 2015

Larry Summers is convinced the Federal Reserve will make a huge mistake if it raises interest rates next week.

Two weeks ago, Summers wrote in the Financial Times that a rate hike risked “tipping some part of the financial system into crisis.”

And in a blog post on Wednesday, the economist, who withdrew as a candidate for chair of the Federal Reserve Board, a job now held by Janet Yellen, followed up on this thinking, giving five reasons his argument against a rate hike was even stronger than it used to be.

Summers’ main points are:

  • The stock market chaos two weeks ago tightened financial conditions and created the equivalent of 25 basis points of a hike (this is the amount by which most think the Fed will raise rates if it does this month).
  • Employment growth has slowed down, and commodity prices have fallen. The Atlanta Fed’s gross-domestic-product tracking model, which nailed first- and second-quarter growth, is forecasting only 1.5% growth in Q3.
  • The Fed has argued that low inflation is transitory. But inflation will most likely stay low, and the Fed’s preferred measure — personal consumption expenditures — is expected to be below the 2% target, according to market-based expectations.
  • It would be pointless, as some have suggested, for the Fed to raise its benchmark rate by 25 basis points and then say there will not be more hikes for some time. “If as some suggest a 25-BP increase won’t affect the economy much at all, what is the case for an increase?”
  • If the Fed does nothing, the “risks” are a rise in inflation and less volatility in markets. But there could be a “catastrophic error” if it tightens policy now. And according to Summers, the consensus views on the economy are understating its real risks.

At next week’s meeting, the Federal Open Market Committee will decide whether to raise its benchmark rate for the first time in nine years. But markets think it’s a remote possibility and are pricing in a 30% chance that the Fed will hike.

Summers joins the World Bank, the International Monetary Fund, and others in calling on the Fed to not raise rates just yet.

5 Events of Significance

flag USMy Comments: Students are back in school, the morning air is fresher, a stray dog showed up yesterday, I have no doctors appointments this week, and we’re having a garage sale on the 19th. Not significant enough you say?

Well, here are five more that confirm my faith in my fellow countrymen. Yes, there are those who’d rather recapture the glories of the past and I’ve pretty much given up on them. I’d rather spend time and energy and control some of the present and pretend to influence the future. The following five events are nothing to sneeze at and are reasons to be more optimistic about the future.

September 7, 2015

What will you remember about the summer of 2015?

Will it be the GOP tying its fate to the most divisive, thin-skinned and clownish Republican frontrunner/birther in American history? Will it be an amorphous Benghazi investigation that has been impaneled longer than the investigation into Iran-Contra — an actual Constitutional crisis that saw a sitting vice president/candidate for president refuse to release relevant diary entries that may have implicated him in the crime — yielding nothing but questions about administrative vagaries of classified email? Will we remember how the right and a complicit media machine that invented Whitewater, summoned a ridiculous impeachment, and misled us into war deployed every argument at its disposal to destroy the strongest non-incumbent and first female frontrunner for president in American history?

Or will these daffy distractions go the way of the media’s illusory concern for Ebola, the missing plane, and President Obama’s tan suit?
Who knows? But what we can say for sure is that truly historic things have unfolded this summer, and been only glanced at by a media transfixed on conflict and personality. Here are five events that history will definitely have to reckon with, even if the media would rather not.

1. The Iran deal.
On Sunday, Colin Powell joined Richard Lugar and Brent Scowcroft to support the deal the U.S., its European allies, China, and Russia reached with Iran to bring the nation under compliance with the Nuclear Non-Proliferation Treaty. These three former high-ranking Republicans represent the last remaining rinds of right-wing realism, and they join with 38 Democratic senators who have vowed to support the president’s veto on any attempt to undermine the agreement. Legitimate fears and concerns about Iran’s conduct have been overwhelmed by a calculus that assumes the rogue state is both canny enough to evade the laws of physics and suicidal enough to secretly build a bomb, knowing that would invite the world to destroy its economy and possibly the entire existence of the regime. This deal could be the first successful attempt in history to use diplomacy to dissuade a nation that has defied the world to swear off the pursuit of a nuclear weapon. It does not eliminate Iran’s ability to fund terrorism any more than our long relationship with Saudi Arabia prevented that nation and its citizens from funding terrorism, including the seeds of al Qaeda and ISIS. But it does stand in sharp contrast to the way America approached Iraq’s alleged nuclear program. This caution and realignment of strategies makes sense given the incredible humanitarian disaster that was fueled by the failures of the neoconservative approach to Iraq. If America were to suddenly shift back to the chauvinism of the recent past, either by choice or force, history would distinctly note how profoundly disappointing the collapse of this noble effort was.

2. Syrian refugee crisis.
No disaster has gone more ignored by the American media than the ongoing refugee crisis in the countries surrounding Syria. And that probably would have continued forever if a small percentage of those fleeing the war-torn nation had not begun to seep into Europe, and the world had not been shocked by the image of a dead toddler on a beach. Predictably, the right has advanced fantasies that more western interventionism could have fixed a problem ignited by western interventionism. There’s no doubt that the nations that have done the most to fuel the catastrophe—which include the United States, Iran, Russia and Saudi Arabia—have done little to nothing to take responsibility for the brunt of this humanitarian crisis. From Europe, we’ve seen both images that conjure the vile specter of how Jews were treated in the 1930s and incredible acts of enlightened graciousness. Both will play a role in the European perception of the costs of a belief that the west can reshape the Middle East by force. But for America, the agony is still distant. And, for many, so are the lessons.

3. Climate change.
We joke that President Obama has done more to fight climate change than all other U.S. presidents combined because it’s impossible to multiply by zero. His stimulus was a ginormous green-energy bonanza that manifested an American renewables industry from almost nothing, leading us to a revolution that has now seen clean energy become cheaper in some instances than its dirty competitors. The president’s deal with China, the world’s largest carbon polluter, to limit emissions neutered the strongest argument against persistent climate action. This summer, the president presented his finalized plan for demanding power producers reduce their carbon output by 32 percent from what it was a decade ago, by 2032. This new rule is tougher on the states that have been the most recalcitrant in pursuing limitations on emissions, and arrives as we have increasing evidence that fighting climate change is actually helping the economy. This rule still needs to survive legal challenges, which seems likely given the current makeup of the Supreme Court, which rejected a Bush administration attack on regulating CO2 under the Clean Air Act in 2007. So like much of Obama’s legacy, this will truly be decided by the outcome of the 2016 election.

4. Record job growth.
We’ve finally recovered all the full-time jobs lost in the Great Recession and it only took a record 66 months of private-sector job growth. That Obama has gone from the president who prevented a greater depression to the steward of a genuine boom is too much to handle for many Republicans. They argue that his unemployment rate is only lower than anything ever achieved by Reagan because so many people have left the job market out of fear of contracting a bad case of Obama’s Muslim atheism. To make this argument, they have to ignore trends that have been going on for decades or reveal that they’re really upset that Baby Boomers are actually getting to retire. This isn’t to say the economy is perfect, at all. Wage growth is far too slow and too much of the recovery is going to the richest Americans, and this is a problem that Marco Rubio, for instance, wants to solve by cutting Mitt Romney’s taxes to zero. The economy is definitely not as good as we should demand. It’s just better than it’s been all century, and it’s showing great resilience despite persistent claims it would be destroyed by inflation, food stamps and — of course — Obamacare.

5. Obamacare wins.
Perhaps the most underreported story of the summer of 2015 is that Obamacare won again.

This wasn’t proven by the uninsured rate dropping below 10 percent for the first time in decades. Though that’s impressive. And it wasn’t proven by Obamacare spending its first two straight months receiving higher favorable than unfavorable ratings in the Kaiser Foundation’s tracking poll. That’s good, but nope.

This was proven by Scott Walker — the Koch brothers’ mascot — actually producing an Obamacare alternative that resembles… OBAMACARE. “At the talking-point level, Governor Walker’s plan sounds an awful lot like Obamacare,” said Larry Levitt, a senior vice president of Kaiser Family Foundation.

The big difference? It protects way fewer people, and the people it does protect aren’t those who need it the most. This isn’t surprising, but it’s proof that after a half-decade of vowing the destruction of Obamacare, even the most right-wing Republicans recognize that the American public will refuse to give up much of what the law offers. You can see why Republicans aren’t eager to have that story get out.

Major Bond Warning

moneyMy Comments: A recent letter to the editor of the Gainesville Sun suggested there was a conspiracy afoot, run by the US Government, to whit “How was it possible for anyone to survive when banks were only paying 1% on Certificates of Deposit.” While the question itself is legitimate, the context implies a vast ignorance of how money works.

I’ve talked in this blog about how interest rates are due to start rising. I’ve talked about how the economy is doing well these days. I’ve talked about the need to position your money so it will have a chance to grow instead of shrink the next time we have a crash.

The following came from a newsletter to which I subscribe. It might or might not help if you have little knowledge about how money works. Here’s what the author said:

In May 2013, I (Porter) gave my first warning.

I told subscribers this was “the single greatest threat to your wealth you will ever face.” Longtime readers might recall I was warning about the bond markets. In particular, I was pointing to the part of the market that provides financing to smaller, faster-growing firms – bonds known as “high yield,” or “junk.”

I know most of my subscribers don’t buy bonds. Most don’t really understand how bonds work – at least, not in any real detail. And when most readers think about interest rates, they probably focus on mortgage interest rates or municipal-bond interest rates.

Here’s the thing, though: If you want to see the next bear market in stocks coming ahead of time, you ought to focus on the corporate-bond market. The corporate-bond market shows how much most companies pay for the capital needed to grow. For some industries, access to such financing is vital. Without a healthy corporate-bond market, some companies would drop to zero almost overnight. And that makes the cost of capital a crucial variable…

Another thing that most investors don’t understand about the bond markets: Interest rates (set by the bond markets) influence how stocks are priced relative to their earnings, their “valuations.” Starting in 2009, the Federal Reserve intervened in the bond markets, driving interest rates lower. That has pushed stock valuations higher, and it has been a powerful driver of this bull market. Higher interest rates, on the other hand, will drive valuations lower. I believe that’s likely to cause our next bear market.

Here’s what I wrote back in May 2013…

The U.S. bond market – particularly the junk-bond market – is going to crash. When this crash occurs, it will be the largest destruction of wealth in history. There has never been a bigger bubble in U.S. bonds. How do I know? It’s simple. Junk bonds (aka high-yield bonds issued by less creditworthy companies) have never yielded less than 5% annually. But they do today. Likewise, the difference between the yields on junk bonds and the yields on investment-grade bonds has almost never been smaller. That means credit is more available today than almost ever before for small, less-than-investment-grade firms. The last time credit was this widely available – and at such low costs – was in 2007. And you know how that turned out…

The coming collapse in the bond market will be far worse than it was last time, too. This time, the Federal Reserve’s actions have driven forward the huge bull market in bonds. The Fed is printing up almost $100 billion per month and buying bonds. That has forced the other buyers of bonds to buy riskier debt that, historically, offered much higher yields.

Today, those yields have been incredibly “compressed.” You can imagine the high-yield segment of the bond market to be like a spring whose coils have been driven together by the force of the Federal Reserve’s market manipulation. As soon as the Fed’s buying stops (and it must stop one day, or else it will trigger hyperinflation), the yields on those riskier bonds will soar again. As bond yields rise, the prices of bonds will fall sharply.

One of the best ways to follow the corporate high-yield bond market is to watch the leading exchange-traded funds that buy huge amounts of corporate bonds, like the iShares iBoxx High Yield Corporate Bond Fund (HYG).

Here’s how HYG has performed since my warning in early May 2013…
15-08 HiYldBonds

As you can see, shortly after my warning, these bonds fell sharply. The funds’ shares dropped from $95 to $89 in a matter of days. They rallied back, though, and roughly a year later (June 2014), they nearly hit a new high. We repeated our warnings in several Digests in 2014 (on May 29, June 4, and June 12).

Here’s what we wrote in the May 29, 2014 Digest…

There’s probably no larger sign of the top than what’s currently happening in the high-yield (aka “junk”) bond market… Investors are lending money to the riskiest corporate credits for near-record-low interest rates – currently a little more than 5%. And these companies literally cannot meet the demand for their paper. According to the Wall Street Journal, of the 10 largest U.S. bond funds at the end of 2013, the four with the fastest growth in assets since 2008 held an average 20% of their portfolios in junk bonds.

That outlook led us to close our high-yield bond newsletter, True Income. There was nothing we wanted to recommend in the entire market.

Still, as interest rates raced for record lows and bond prices shot to record highs, investors decided they had to own junk bonds. While we were shuttering our high-yield bond research, the individual investor began buying junk bonds like never before… many for the first time ever. As former Digest editor Sean Goldsmith wisely noted, “Nobody ever heralded the individual investor for his timing.”

Today, high-yield bonds are trading near their lows of the last three years. HYG is trading around $88 a share. I still believe all the things I’ve written over the last two years: A collapse in the high-yield market will kill the current bull market and wipe out billions of dollars of investors’ savings.

It’s interesting to note that the rising defaults and distress in the bond market are causing the decline in bond prices today, not inflation. In particular, the two fastest-growing parts of the high-yield market for the last decade have been bonds tied to oil and gas companies (some of which have already filed for bankruptcy, many of which are now distressed) and bonds tied to subprime auto lending (which now makes up roughly 25% of all car loans).

I don’t need to tell you that oil and gas prices are way down. As a result, a lot of the investments made into the oil patch over the last decade aren’t going to produce anything like what was expected. As oil and gas companies’ “hedges” expire this year, revenues at most of America’s oil and gas companies are going to go way, way down. A lot of bonds will end up in default.

Likewise, the default rates on newly issued subprime auto loans have been setting new highs, rates much like those in 2008. Specifically, 8.4% of the subprime borrowers who bought a car in first-quarter 2014 missed at least one payment before the end of the year. The early default rate on subprime car loans last peaked in 2008 at 9%. Given that the job market remains strong, this suggest a huge problem in subprime auto underwriting and larger-than-expected losses in securitized auto loan bonds.

Now… consider this. Outside of student loans, auto lending is the only form of consumer lending to grow in the U.S. since 2009. And something like 30% of all the jobs that have been created in the U.S. since 2010 are tied directly to the oil and gas industry. Take the credit weakness in these industries as a significant warning sign. Perhaps all the cars they sold in 2014 (a record for U.S. car sales) can’t actually be paid for… And perhaps all of those oil wells they drilled can’t, either. If that’s the case… no matter how many bonds the Fed buys, defaults are likely going to rise… and bonds are going to fall.

What should you do about this? First and foremost, check your accounts and make sure you don’t own any high-yield bonds. As for other strategies… be aware that a bear market this fall is, in my opinion, likely. Watch your trailing stops. Consider shorting a stock or two as a hedge. And most of all, avoid companies that use large amounts of debt. Their costs are going up

Reverse Mortgages

home mortgageI follow an internet magazine that can be described politically as progressive. Early last month a summary of articles appeared in my email inbox that included one entitled Reverse Mortgages: The Final Blow Killing Middle Class Wealth by Egberto Willies. The date it first appeared was August 18, 2013.

The author claims that reverse mortgages are yet another ripoff, promoted by greedy bankers intent on removing money from our pockets. While I understand and share the basic sentiment about ripoffs, it’s clear the author didn’t and may not yet have a clue what he’s talking about. He says that reverse mortgages are “nothing but a no-risk gift to the bankers, a wealth transfer engine from the masses to a select few.”

He goes on to make more than a few factual mistakes, with little or no understanding of the positive role a reverse mortgage can make in someone’s life. Take me, for example.

I am a financial planner, first earning professional credentials in 1981, have owned my own Registered Investment Advisory firm, and have embraced a fiduciary standard from day one. While far from wealthy, I’ve enjoyed a solid professional career and been part of the social and professional fabric of my community for over 50 years. I can be described today as partially retired, though still very engaged with clients and prospective clients.

The 2008-09 crash made like difficult for many people, for many reasons. I had planned to retire and play golf. All the necessary pieces were properly lined up and ready to go. With the crash, however, many of the critical pieces of the puzzle came unglued. Part of me thinks, as a financial planner, I should have known better, but the another part realizes there were forces at work that were simply bad timing. Our story is not dissimilar from millions of other people across the country.

In my judgement, the writer of the DailyKos article makes assumptions that are far removed from reality. He suggests that banks are ripping off those wanting to leave assets for their children. In my case, I have a substantial life insurance policy in place to provide financial security for those I leave behind. There are many who will argue that life insurance is a ripoff, and it can be, but not in the hands of a professional adviser. The same has to be said about a reverse mortgage. If you are willing to be duped, then it’s very possible you will be. This observation is valid about dozens of other financial products.

My reasons for using a reverse mortgage arise from our downsizing to a home that is more realistic in terms of what we can look after and what we need to feel comfortable. Without a mortgage payment, it allows us the ability to continue our lives with a degree of financial freedom and peace of mind that we cherish.

To get here, we initiated what is known as a Reverse Purchase. We purchased a new house, paid for in full with our money and a reverse mortgage. This amount came from a lender willing to advance roughly 50% with the debt accruing behind the scenes. The property title is in our names, and the note is known as a non-recourse note. This means that if the debt somehow exceeds the value of the home and land at our respective deaths, our heirs will not be responsible. To achieve this, an amount is added to the accruing total that pays for mortgage insurance.

A downside to a reverse mortgage is upfront cost. For anyone who has purchased a home with traditional mortgage financing, you are very aware of how much it costs to initiate and record the debt. The same thing happens with a reverse mortgage, and just as with a traditional mortgage, the cost can be added to the obligation. In our case, the total will grow in the background and when the lights finally go out and the debt paid, what’s left will pass to our children. Meanwhile, we get to live our lives as best we can without having to make monthly payments to one of those pesky banks.

A Painful but Healthy Adjustment

money mazeMy Comments: Reassuring comments here from a trusted thinker on the markets. No guarantees but if you have at least a 5 year time horizon, we will be OK. Just don’t get caught up in the media rhetoric and the pointing of fingers. Almost all of it is stupid, ill informed, and self-serving. Life happens, and this is normal. Which is not to say there are no ways to continue making money.

August 24, 2015 by Scott Minerd

The recent global equity market selloff reflects a long-awaited—and I believe ultimately healthy—market correction. A number of commentators speculated that after Monday morning’s sharp decline in U.S. stocks, the intra-day reversal indicated that we reached a bottom. In the very short run, I would agree. However, longer term, neither fundamental nor technical data support that we have reached the levels of capitulation associated with the end of a market correction.

One example is the Chicago Board Options Exchange SPX Volatility Index (VIX), often referred to as the “fear” index. While it spiked significantly higher, the VIX still failed to stay at the levels normally associated with capitulation like those experienced in 2011. Over the coming days I expect the market will try to find some short-term footing, but I doubt we have found a bottom yet. Buying risk assets now would be like catching a falling knife—if you do so you are likely to get quite bloody in the short run.

The market rout has spawned numerous news stories attempting to explain the source of the sharp declines in global equities. Many have highlighted the decline in emerging markets, which, on balance, have now officially reached bear market territory, given the over 20 percent decline in the MSCI emerging markets index since April.
Some markets have done much worse, especially when measured in U.S. dollars. Brazil is the poster child for the ravages of a full-fledged bear market. Even with the devastating declines, emerging markets have yet to show any signs of bottoming based on either economic fundamentals or market technical indicators.

While in the U.S. fundamentals remain supportive of continued economic growth, technical indicators point to lower prices in U.S. risk assets. Looking at the S&P 500, the sudden collapse in prices should provide near-term support, but after some consolidation I would expect us to revisit the lows and ultimately test the 1,820 level. A decline to 1,820 on the S&P 500 would represent a 15 percent drop from the peak, which would be a healthy correction in a long-term bull market. As this correction plays out, I would expect yields on below-investment-grade energy credits to widen by another 200 to 300 basis points. Other equity markets and higher quality credit assets are likely to sell off in sympathy as well.

So what is causing all of this turbulence? The source is the massive misalignment of exchange rates, which finds its roots in quantitative easing. Case in point, consider Japan, which has weakened its currency by over 50 percent against the U.S. dollar, while China, Japan’s largest trading partner, has basically pegged the renminbi (RMB) to the dollar.

Strains on the terms of trade between countries that have devalued and those that have not have built to the point that perpetuating these disparities is destabilizing to the countries that have staunchly fought devaluation. Witness China’s recent move to devalue the RMB versus the dollar, proving that artificial equilibrium is not only impossible to maintain, but ultimately disruptive to markets and economic growth.

Now we are facing the turbulent path to a new equilibrium. The coming weeks will be difficult and it is hard to hazard a guess as to when and how this will all end. Nevertheless, I place great faith in governments’ willingness to use the printing press. It is a handy tool to prop up asset prices and temporarily spur economic growth. For that reason I don’t see recession on the horizon for the G-7 nations or China either.

In time, policymakers will react. I would assume that the reaction time is fairly short. No one seems inclined to test the limits of how far asset prices can fall. Yet, given the current bias by the U.S. Federal Reserve to raise rates and the Peoples’ Bank of China to support the RMB, some more time will need to pass before more dramatic action is taken.

I would suspect that this will all climax by late October, but only time will tell. For the time being more downside risks remain. As I have mentioned before, cash is king, treasuries will outperform, and patience is a virtue. I don’t believe we have reason for panic, but complacency is dangerous too. Look for opportunities and more signs of capitulation.

Get Ready For A Bear Market

moneyMy Comments: This person may be right, or not. Yesterdays sell-off sure was ominous but you never “know” until it’s too late. One way to profit from the downturn is with alternative investments. Only very few investment managers use them as a matter of course when promoting their skill set to the public.

Those of you who know me may know about a company called Portfolio Strategies. My associate Alan Hagopian and I use them almost exclusively when positioning our clients money for the very same reasons described in this article from Axel Merk. We don’t try to hit any home runs, but being able to make money when everyone else is losing theirs is very helpful.

Axel Merk, Merk Investments Aug. 4, 2015

Increasingly concerned about the markets, I’ve taken more aggressive action than in 2007, the last time I soured on the equity markets. Let me explain why and what I’m doing to try to profit from what may lie ahead.

I started to get concerned about the markets in 2014, when I heard of a couple of investment advisers that increased their allocation to the stock market because they were losing clients for not keeping up with the averages.

Earlier this year, as the market kept marching upward, I decided that buying put options on equities wouldn’t give me the kind of protection I was looking for. So I liquidated most of my equity holdings. We also shut down our equity strategy for the firm.

Of late, I’ve taken it a step further, starting to build an outright short position on the market. In the long-run, this may be losing proposition, but right now, I am rather concerned about traditional asset allocation.

Fallacy of traditional asset allocation
The media has touted quotes of me saying things like, “Investors may want to allocate at least 20% of their portfolio to alternatives [to have a meaningful impact on their portfolio].” The context of this quote is that because many (certainly not all!) alternative investments have a lower volatility than equities, they won’t make much of a dent on investors’ portfolios unless they represent a substantial portion of one’s investment. Sure, I said that. And I believe in what I said. Yet, I’m also embarrassed by it. I’m embarrassed because while this is a perfectly fine statement in a normal market, it may be hogwash when a crash is looming. If you have a theoretical traditional “60/40” portfolio (60% stocks, 40% bonds), and we suppose stocks plunge 20% while bonds rise 2%, you have a theoretical return of -11.2%.

Now let’s suppose you add a 20% allocation of alternatives to the theoretical mix (48% stocks, 32% bonds, 20% alternatives) and let’s suppose alternatives rise by 5%: you reduce your losses to -7.96%. But what if you don’t really feel great about losing less than others; think the stock market will plunge by more than 20%; and that bonds won’t provide the refuge you are looking for? What about 100% alternatives? Part of the challenge is, of course, that alternatives provide no assurance of providing 5% return or any positive return when the market crashes; in fact, many alternative investments faired poorly in 2008, as low liquidity made it difficult for investors to execute some strategies.

Scholars and pundits alike say diversification pays off in the long-run, so why should one deviate from a traditional asset allocation. So why even suggest to deviate and look for alternatives? The reason is that modern portfolio theory, the theory traditional asset allocation is based on, relies on the fact that market prices reflect rational expectations. In the opinion of your humble observer, market prices have increasingly been reflecting the perceived next move of policy makers, most notably those of central bankers. And it’s one thing for central bankers to buy assets, in the process pushing prices higher; it’s an entirely different story for central bankers trying to extricate themselves from what they have created, which is what we believe they may be attempting. The common theme of central bank action around the world is that risk premia have been compressed, meaning risky assets don’t trade at much of a discount versus “risk-free” assets, notably:

Junk bonds and peripheral government bonds (bonds of Spain, Portugal, Italy, etc.) trade at a low discount versus US or German bonds; and
Stocks have been climbing relentlessly on the backdrop of low volatility.

When volatility is low and asset prices rise, buyers are attracted that don’t fully appreciate the underlying risks. Should volatility rise, these investors might flee their investments, saying they didn’t sign up for this. Differently said, central banks have fostered complacency, but fear may well be coming back. At least as importantly, these assets are still risky, but have not suddenly become safe. When investors realize this, they might react violently. This can be seen most easily when darlings on Wall Street miss earnings, but might also happen when central banks change course or any currently unforeseen event changes risk appetite in the market.