happy memorial day

No post this weekend b/c I was at the beach with the fam.

real interest rates (part 3)

Just to round out the thoughts on real interest rates, I've run a simplistic multi-variable linear regression in Excel to try isolating the effect of real interest rates on the S&P 500. The idea is to re-test the association between real interest rates and the S&P while controlling for the aforementioned effects of inflation on those real interest rates. The reason I say it's a simplistic analysis is because there is some obvious multi-collinearity involved whereby our two explanatory variables (real interest rates and inflation) are not totally independent of each other. Therefore, you can't trust the co-efficients derived by the analysis (i.e. "how much"), but I think perhaps it's at least helpful to suggest whether or not the S&P tends to go up or down when real rates increase. I'm sure there are more sophisticated statistical techniques capable of overcoming this multi-collinearity amongst the explanatory variables, but if so, they are beyond my knowledge.

As shown in the charts above, the results suggest there is in fact an inverse relationship between real interest rates and the S&P 500. The co-efficient for inflation is -5.98, meaning when inflation increases 1%, the S&P tends to decrease on average -5.98% that year. The co-efficient for real interest rates is -4.25, meaning when real interest rates increase 1%, the S&P tends to decrease on average -4.25% that year. Like I said, you can't trust the exact value of these co-efficients, but I believe at least the signs are correct, such that increasing real interest rates are associated with a decreasing S&P 500.

Considering that inflation is currently low by historical standards, one might reasonably conclude the probability of an increase in inflation is greater than the probability of a decrease. By extension, one might reasonably conclude the probability of a decrease in the S&P 500 is greater than the probability of an increase. On the other hand, since real rates are not low by historical standards, one could reasonably expect an increase in inflation to be accompanied by a decrease in real interest rates, which would counteract some of the negative influence upon the S&P.

real interest rates (part 2)

To follow-up on the post last week, I subscribed to and downloaded some data from http://www.economagic.com/, which I think is a great source of data at a very reasonable price.

In looking at corporate bond rates (Moody's Baa index) and the S&P 500 since 1950, I think the reason for observing a positive relationship between changes in real interest rates and changes in the S&P 500 is mainly due to the underlying inverse relationship between real interest rates and inflation (which is inverse by definition because Real Baa Interest Rates = Baa Interest Rates - Inflation). In other words, decreasing inflation is associated with increasing real interest rates by definition. However, decreasing inflation tends to be associated with a rising S&P 500 as well.

What I'm Reading

New Trading Systems and Methods

Model Portfolio Performance Update

The low beta aspects of the model portfolio have paid off during the last couple weeks' market downturn. Outperformance vs. the S&P 500 ETF (ticker: SPY) has widened to ~4.5%. In regard to our primary benchmark, outperformance vs. the Vanguard Total World Stock ETF (ticker: VT) has widened to ~12.0% as calculated by folioinvesting.com since the model portfolio was established 9/4/09.

Real Interest Rates

I started out this day mowing the lawn and thinking about a nice recent post at Crossingwallstreet.com that has to do with the outlook for gold prices and asserts that a main driver thereof is real interest rates (i.e. nominal interest rates minus inflation). Naturally, I wondered about the relationship (if any) between real interest rates and the stock market. My hypothesis was that an inverse relationship exists such that the stock market suffers when companies' cost of capital (real interest rate) increases. I'm interested in this potential relationship because I tend to think real interest rates will generally trend higher in the intermediate term as the Federal Reserve is forced to eventually confront inflation pressures by raising short-term rates / soaking up some of the base money supply. I'm not saying inflation pressures exist at present, I'm just inclined to think they are poised to increase over time as lenders and borrowers each become healthy enough to lend and borrow again, thus increasing the velocity of money (i.e. effective money supply).

As shown in the charts above, my hypothesis was not validated. If there is any relationship between real interest rates and stock market returns, it is positive. In other words, when real interest rates increase, the stock market tends to perform better (but the relationship is very tenuous with an R-squared of only about 7%). I think perhaps this is because the causation flows somewhat 'backwards'. When the stock market suffers, investors flock to treasuries for safety thereby driving down real interest rates. Perhaps the problem is how I'm effectively using treasury rates as a proxy for the changing 'cost of capital' for companies in the S&P 500. At a later date, I'll test the stock market returns against corporate bond rates (adjusted for inflation), rather than treasury rates, which is almost certainly a better proxy for changes in the companies' cost of capital.

In the meantime, since the value of treasury bonds tend to increase when the stock market declines, I'll have to give some thought and further analysis to potentially exchanging some stock exposure for exposure to short-term inflation protected treasury securities (TIPS) as a means of smoothing out the model portfolio returns. Or perhaps I'll save that move solely for those times I think the stock market is especially prone to a decline based on my favorite economic indicator, retail sales.

Quote for the Week: "There's nothing wrong with living on the first floor until you've spent time in the penthouse". - William Irvine, author of A Guide to the Good Life.

model portfolio refinement 2

In a further effort to decrease correlation with the S&P 500, I've decided to allocate 1/3 of the model portfolio to foreign stocks with low betas. The new holdings will be 'acquired' tommorow via commission free trades and are shown in the chart above (32 stocks and 2 ETFs). Note: click the charts twice to enlarge them further for easier viewing.

The first ETF (ticker: DFJ) provides exposure to small cap stocks in Japan and its holdings are shown here. The beauty of a small cap focus is that it tends to exclude banks while still providing exposure to foreign stocks that don't trade in the U.S.

The second ETF (ticker EWM) provides exposure to Malaysia and its holdings are shown here. If you follow the link, you'll notice the Malaysia ETF is 31% financials, but I decided to let that slide because (i) it works out to only 1% of the model portfolio, (ii) it provides exposure to foreign stocks that don't trade in the U.S., and (iii) the ETF has a low beta (.74).

Separately, let me say a few more words about Exchange Traded Funds (ETFs). First, I think ETFs are superior to your typical mutual fund primarily because they tend to have lower annual fees. This is because ETFs are typically managed passively with low overhead (simply trying to mimic an index), whereas mutual funds are typically managed actively. Active management requires more overhead associated with hiring folks to research and trade securities. Since 90% of mutual funds don't keep up with stock indexes after accounting for overhead every year, I don't think the cost differential is worth it. So by default I think ETFs are better investment vehicles.

However, ETFs are still blunt instruments. For example, if you're like me and want exposure to foreign stocks but are averse to banks, oil companies, gold miners, and high beta, then there are hardly any ETFs out there for you. If your savings are in a brokerage account that charges a commission for every trade, then you can't finely tune your account because it would be cost prohibitive to buy and sell a large number of securities (unless your account is very large). However, if your brokerage account is at folioinvesting.com where there are no trading commissions, then you can afford to finely tune your investments as I've shown above.

Quote of the Week: "Always to seek to conquer myself rather than fortune, to change my desires rather than the established order, and generally to believe that nothing except our thoughts is wholly under our control, so that after we have done our best in external matters, what remains to be done is absolutely impossible, at least as far as we are concerned." - René Descartes (1596 - 1650)

model portfolio refinement

I've decided to reduce the average Beta of the model portfolio. Although the model portfolio has been keeping ahead of our primary benchmark of Vanguard Total World Stock Index (ticker: VT), I'd prefer a little less correlation. Therefore, I've drastically cut down the number of stocks in the portfolio from 665 to 138 by selling all the higher beta stocks and redeploying the proceeds to the lowest beta stocks (all without incurring any trading commissions). My expectation is this reallocation will provide for less volatility going forward without any diminished returns in the long-run. However, in the short-run, if the S&P and/or VT spurt upwards, the model portfolio will most likely show some temporary underperformance, which is fine. Based on the stats shown in the chart above (calculated by folioinvesting.com), the Beta of our model portfolio is now 0.43 (relative to the S&P). Note, the Beta of the model portfolio was already 'low' at ~0.78 prior to these changes. Unfortunately, folio doesn't calculate the same stats relative to VT.

Quote for the Week: "I must die. If forthwith, I die; and if a little later, I will take lunch now, since the hour for lunch has come, and afterwards I will die at the appointed time". - Epictetus (AD 55 - AD 135) [In other words, it's counterproductive to worry about uncontrollable outcomes]