July 2011 Asset Allocation Model Update

As has been the case for well over a year now, the asset allocation model that I built and have been tracking for quite some time indicates that a split of 80/20 stocks vs. bonds is still called for in these circumstances.

Though valuations on an absolute basis are not as attractive as they were at this time last year, the slope of the yield curve, combined with very low interest rates continue to provide a strong case for equities. If you look at the past year and a couple of months since we inaugurated it, I think it has been generally correct, though it has been limited to recommending an 80% equity asset allocation:

Since the beginning of the tracking period, the S&P 500 has outperformed long-term bonds by about 1500 basis points. There was a stretch in the summer of last year that I regretted that the model could only go to 80% stocks since the readings were off the charts recommending buying equities. Part of the reason the model has been stuck at 80% in stocks for so long is that it shot so far above the threshold that even though it has since come down somewhat, it is still over the line for 80% in stocks. I may refine the model somewhat to allow for rare cases where you should go "all in" because there are a number of times in the history of the financial markets where that is called for. Conversely, there are times where having just about no equities also makes sense. This, however, is not one of them.

The bottom line is that the comparative case for allocating your money to equities and away from fixed income instruments is very very strong right now.

The Municipal Bond Rout

One thing I've always marveled at is just how quickly a bond market panic can materialize. Case in point, the municipal bond market rout over the past several trading days.

My favorite proxy for munis, MUB, has sold off in spectacular fashion, but this rout has not been entirely confined to munis. Treasuries have sold off too, as shown in this comparison with TLT.

Still, when you consider the generally narrower bounds in which MUB trades due to not only being long term securities, it is clear that this sell-off is more than just a turn away from government bonds generally. Now, as to the proximate cause of this panic, it is hard to say. There isn't a general financial panic like there was when muni bonds did this back in 2008.

That sell-off was caused by hedge funds desperately raising cash from whatever they could and they liquidated municipal bonds without mercy. This sell-off has been partially blamed on a large issue by California  coming to the market. I'm not so sure about that. I have a hard time buying that a $12 billion issue by California is enough to cause this mayhem. It is true that with Republicans now controlling one house of Congress that federal aid to state and local governments is unlikely to aid them as they attempt to bridge their budget gaps. Still, the election outcome was not a surprise and usually bond markets price things like that in.

The PIMCO California Municipal Income Fund (PCQ) might be making a bit of a fool of me, though. It has shown a sharper rout than munis in general and because California is such a large segment of the muni market this may make sense. However, with California now having the ability to pass budgets more easily, I'm not sure that questions about California's solvency are quite as pertinent as they used to be. Regardless, California munis have been obliterated.

Very oddly, this has been accompanied by a sell-off, not a rally, in gold. If there's one asset I would expect would do well in a rout of safe assets, it would be gold.

This bears watching and there's easy money to be made in munis if the sell-off gets out of control. Don't be so foolish as to pick up individual issues since if you happen to buy a special district's issues without understanding what revenue stream backs its payments, you can end up in a world of hurt. Those can and do default.

The crazy(?) bond rally

Over the past four weeks or so, the bond rally has become truly epic. I have been truly stunned by the magnitude of it.

Here is the oft-mentioned TLT, which tracks the 20 and 30 year US Treasuries.

It's charted against SPY (the S&P 500 proxy) and EEM (the emerging markets proxy). To show that the bond rally has some breadth, let's look at municipal bonds as well. Now, the MUB is not just a long maturity municipal bond fund but rather a larger aggregate so its moves aren't as dramatic, but it tells a similar tale.

The same had also held with corporates, as represented by LQD, which tracks long term investment grade corporate debt.

Now, the question that many are asking is "Is this a bond market bubble?" Well, current interest rates do seem absurdly low. In terms of the stock market, it would be the equivalent of paying 40x earnings for a company's stock (the equivalent of a 2.5% earnings yield). However, with inflation also at historic lows, the bubble might not be as big as some are claiming. If you are of the view that inflation will soon accelerate to 4%+, then yes, bonds are dramatically overvalued. If you believe instead that inflation will be between 0% and 1.5%, the overvaluation of bonds ranges between not much and only marginally overvalued. I do happen to think that, when you look at comparative stock market measures, bonds are at least moderately overpriced. That holds true so long as corporations will be increasing their earnings even at a moderate pace over the next several years.

With the Fed possibly embarking on more quantitative easing (the direct purchase of treasuries to increase the money supply), one might wonder if interest rates will be capped at these low levels or even drop further. The last time the Fed did a similar action, interest rates rose anyway because market expectations of an economic recovery picked up. At this juncture, it's hard to say which way they will go, but I think that past performance might be a decent indication. Quantitative easing is a powerful stimulative tool and if the Fed is zealous in its application, it actually might actually have the net effect of increasing interest rates through market expectations of higher growth. All of this remains to be seen, however.

The Peculiar Allure of Gold: Part 1.1

Some time recently, we discussed here some of what seems to drive the price of gold.While all of the other arguments for owning gold are generally a pile of crap, I had noted that over time there did seem to be an inverse relationship with the value of the dollar under most circumstances. However, I would note of late that it seems that even this relationship has broken down.

This is a simple picture (click on it to enlarge):

What you are seeing there is a 3-month chart of the ProShares US Dollar Bullish Fund (UUP), which has leveraged bullish bets on the US dollar vs the SPDR Gold Trust (GLD) which tracks the price of gold. You might note that there is a positive correlation between the dollar and the price of gold. Wait... what?

Well, maybe for the past three months gold has been a bet against the Euro while over the long run it is a bet against the dollar while also being an inflation hedge while also being a crisis hedge while not doing a particularly good job reflecting any of those relationships! I think there is a simpler reason for the decline of gold recently and that is that as it is clear that there is no risk of accelerating inflation, probably the number one reason scared little Glenn Beck listeners have been hoarding gold has been undercut severely. By the way, bashing on Glenn Beck is not in violation of this blog's no political discussions rule since Glenn Beck's insanity transcends ideology. He gives investment advice and it is damn bad advice at that.

For instance, while things have gotten rough over the past few months and U.S. deficits are in the stratosphere, surely you wouldn't want to invest in worthless pieces of paper like U.S. Treasuries and instead would want the safety of gold, right? Wrong. Very wrong. Stupidly wrong.

TLT, our long term treasury proxy, kicked the hell out of GLD over the past three months while stocks, represented by SPY here, suffered as we all know. It is interesting to note that some gold bulls had maintained that stocks and gold must necessarily rise together because... um... well because they said so, that's why. Never mind that this is a relationship that has never really held except for brief periods when it seems to out of pure coincidence. Recently stocks have rebounded more sharply than many give them credit for while gold has been in a trudging decline.

Gold currently is trading in such a peculiar way that it is helpful to think about the following. Currently, gold is not trading in accordance with any clear rational relationship to, well, anything. If the rationale for investing in an asset is not clear, then you should not invest in it. I can easily spell out why equities are good buys at present levels based on well accepted empirically derived relationships. Gold, it is not so easy unless you truly believe that we are about to undergo a period of 10%+ inflation, which I do not and the markets do not either except for the gold bugs who are always and everywhere trapped in a particularly pernicious insanity.

It may well be that gold gets foisted to new highs by irrational markets, but I would wager that in the next five years gold will be beaten by just about everything, including housing.

Strategy: How to manage future transaction costs in a small portfolio

As I am not a wealthy man, nor will I likely be working for my state's government, I, like many others, must pay a great deal of attention to transaction costs when executing trades. In what follows, I try to provide a few examples, all reasonably straightforward, of how to reduce the potential for ruinous costs.

Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.

Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.

Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.

Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.

Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.

Threading Strategies Together

Several different strategies have been discussed here on Finance Monitor along with numerous individual investments and I thought I would provide some context on how to view the discussions in the context of your own investments. The fundamental goal of this post is to weave several different posts on different subjects together. I will try to provide links so that you can quickly look up the prior discussions.

I guess the proper way to start this conversation was with the prior post on risk reduction in portfolio construction. This is one way of looking at your macro strategy, though there are many potential variations on this broader strategy. Within the core portfolio, either use equity index funds or balanced funds and basically just try to keep your overall allocation right, unless you want to be a little more active here. Then, you can engage in what was discussed on the post on dynamic asset allocation.

To do this, use the SPY and TLT ETFs at a basic level. If you have less than $2,000, I strongly encourage you to only re-balance when interest rates suggest you make a large reallocation from stocks to bonds or bonds to stocks. If you re-balance with every twinge, you'll get eaten alive by commissions. For example, let's say the model changes each month and you re-balance with $7 commissions each time (on both purchase and sale) with a $2,000 balance. You will incur $14 a transaction 12 times for a total of $168 in commissions. That would be 8.4% of your portfolio or greater than your average annual gain. With $20,000, it's 0.84%, which is bad, but not ruinous. If you are so fortunate to get up to $100,000, the fees are very low indeed. The ETF fees for TLT and SPY are also very low. In the case of SPY they are 0.09% per year and 0.15% on TLT.

A Brief Note on Financial Crises and Safe Harbors

One of the great new contrarian pieces of "knowledge" has been that you can hide from a developed market financial crisis in emerging markets. This was said in 2007 and 2008 when we went into the soup and it was said again this time during the ongoing European financial crisis. Just to show how silly that idea is, here is a chart from June 1, 2008 through March 1, 2009:

The green candlestick line is the S&P 500, the olive line is the FXI from yesterday, the purple line is the iShares MSCI Emerging Markets Index Fund (EEM) and the light blue line is the iShares Brazilian Index Fund (EWZ). As you can see, over this period, the U.S. outperformed all of those markets for the duration of the worst of the crisis.

Similarly, in the current crisis the pattern has been continued:

The pattern is repeated, to varying degrees. So, what is the safe harbor? U.S. Treasuries have been, are, and will likely continue to be the last best hope for investors in the midst of a crisis. I could show the chart from 2008, but that's just beating a dead horse. Here's the most recent performance with the iShares Barclay's 20+ Year Treasury Bond Fund (TLT) represented by the.... I guess that's salmon colored line:

As you can see, long-duration U.S. Treasuries are a good safe harbor for assets in short term financial crises, regardless of whether they are here in the U.S. or if they are in Greece, China, Japan, or wherever else there might be a crisis. That being said, as a long term prospect, I am not thrilled with the outlook for Treasuries at the moment as I have indicated previously. As interest rates rise in the future, you will get slaughtered for a large position in them. In the short run they might be appealing, though even here I'm not sure how much more upside they have. I think we are probably within a couple weeks of the worst of the European crisis being behind us, though it will get ugly before it is over.

Someone may ask "What about gold?". In response I say, "Treasuries > gold" in a crisis. It was true in 2008. It is true now. Gold is only superior in a time of hyperinflation.

Anyway, those are my thoughts.

Today's Ridiculous Performance and Lessons From It

I had the misfortune of being at a very boring series of presentations when all hell broke loose today, but I've read enough about it now to make some comments on it.

Whenever you are going through a period of market stress like we are, the market is vulnerable to truly massive daily swings. It's similar to setting off a firecracker behind someone suffering a panic attack. Today, there were some, to put it bluntly, bullshit trades that rapidly sold off major issues such as Procter and Gamble by ridiculous amounts. Just in case you don't know, P&G at one point today fell from $62 a share to $39 a share on absolutely no news whatsoever. On a stock with 2.9 billion shares, that erases $67 billion in market value in an instant. When a stalwart like P&G drops that much, many programmed trades will be slated to sell as well largely because that big of a drop in P&G leads to a major decline in the DJIA and S&P 500.

Additionally, those not engaging in program trading will get extremely afraid and they will liquidate. Of course, at those discounts people will rapidly come in and snap them up. Accenture(ACN) getting knocked down to a penny a share will trigger buying, for instance.

Now, what should you do in periods of market stress, such as when we are worried about a rolling series of European sovereign debt defaults? The answer is that if you have some stocks that you are looking at and want them at lower prices, keep some long term limit orders out there at 10-15% discounts. If the panic trades don't occur, no skin off your nose. If they do, you make out pretty big. The trick is just to make sure that you don't commit more than your brokerage balance.

Because we have had a fairly sharp decline in the past several days, there is the possibility of margin calls tomorrow or early next week so there is the possibility of a less dramatic, but longer lasting repeat of today. The European debt crisis is going to come to a head in a hurry. Right now if you have a cash position, such as myself, start looking at some stocks that you have been eyeballing, but have not been enamored with the prices. Put out some low limit orders (though don't do 30-45% discounts) on your favorites. 5, 10, 15% discounts are probably good ideas right about now.

If you don't want to be as adventurous, there is the possibility that there may be some modest gains left in treasuries, for which you can buy TLT. This, in my opinion, is not the end of this Euro-induced panic yet, but the worst of today was, well, bullshit.