new ETFs on the way

This is a step in the right direction since heretofore if you wanted to invest in an international stock ETF, you most often had to accept econonic sector exposure corresponding to the economy of the country or continent in question. Now, these ETFs allow you a bit of fine tuning of economic sectors, but less choice with respect to specific countries. Also, from just peeking at the top ten holdings of the ETF for Consumer Staples ex US, it appears that most of the exposure is related to large cap companies, the stocks for which one could purchase individually now on the US exchanges. In other words, it's not like the Malaysia ETF held in our model portfolio that provides access to a bunch of stocks you just can't buy here.

model portfolio performance update

Quote from the Sunday Richmond Times-Dispatch

From an article related to the Lebron James saga:

"We are engaged in the age-old struggle between order and chaos. For all their limitations, the games we play nonetheless represent something of our attempt to organize the world in which we live.

Perhaps the growing fear that the world is only chance explains the current rage for order. But life is neither wholly determined nor wholly arbitrary. Men are neither completely free nor completely enslaved. We must contend with both contingencies and necessities. For all our striving, we shall never impose our will upon creation. We will never eliminate chance." - Mark Malvasi; teacher at Randolph-Macon College in Ashland, VA.

roth conversion (part 2)

Not a real post this weekend b/c was too busy catching up at the office. However, geekonwheels recovered my files this week, so I've posted the charts above pertaining to the roth conversion analysis.

roth conversion

Lately I've been meaning to convert my Regular-IRA account over to a Roth-IRA account and pay the associated income taxes (that would be levied this year on the amount converted) by pulling funds from my regular (taxable) brokerage account. The reason such a move would be beneficial under current tax law is because I wouldn't have to pay taxes on any withdrawals from the Roth account when I retire (unlike a regular IRA where the entire amount of the withdrawals are taxed at ordinary income rates). Thus, converting to a Roth now would increase my after-tax retirement nut assuming (i) the market provides a positive return between now and my retirement date and (ii) my income tax rate in retirement is equal to or higher than my current income tax rate. If I weren't comfortable with the first assumption then I wouldn't be in the market at all and the entire analysis would be mute. I'm pretty comfortable with the second assumption given the fiscal dynamics of our government and the fact that I probably won't have a mortgage interest deduction when I retire (house will be paid off).

I was going to upload a few charts I put together, but my laptop crashed just as I was going to, so you'll have to take my word for it. For these charts, I assumed the market provides a 5% annual return (pre-tax), I can retire in 20 years, the capital gains rate on my regular brokerage account will still be 20% when I retire, and my marginal income tax rate will still be 35% when I retire.

First, I calculated the after-tax retirement nut on my retirement date under two scenarios. Scenario 1: "As-Is" & Scenario 2: "Convert to Roth", with the difference between the two scenarios stated in terms of annual after-tax returns. I was a little surprised at how small the benefit is of a Roth conversion - only 0.2% per year. Of course this small difference still compounds handsomely if we're assuming it will be 20-30 years until I retire.

Next, I calculated the after-tax retirement nut under Scenario 3: "Convert to Roth and Government Renegs", which calculated what happens if congress renegs at some point and decides to levy a 7% tax on the gains accrued in the Roth account post conversion. The result of this scenario is there is exactly no benefit to the Roth conversion (the difference in annual returns is 0%). I chose the 7% gains tax assumption for purposes of illustration because it's the exact capital gains tax rate that results in 0% benefit (i.e. I would be indifferent to doing a Roth conversion or leaving things As-Is. If the hypothetical new capital gains tax is greater than 7%, then I would be better off not converting to a Roth.

model portfolio performance update

Timing of recent moves to trim the portfolio Beta down to ~0.0x was fortuitous insofar as the market moved downward almost immediately thereafter. The model is now up ~15% since inception vs. ~0% for the benchmark Vanguard Total World Stock fund (ticker: VT).

Essentially, the portfolio is now 66% long of low beta stocks diversified across economic sectors and national geographies, except for my own esoteric bias against banks and gold miners, and 33% short of the S&P 500 (i.e. Large-cap, U.S. stocks).

Since I think the economy has reached an intermediate term headwind, I don't expect to go net long again anytime this year. The market will probably have a few huge up days here and there as the Fed makes announcements concerning liquidity supports, but overall I think the downside risk is too much for being long anytime soon. I wish I saw it differently, and was correct in seeing it that way, but that's not the case and only time will tell. It's frightening to see the recent flight to treasuries and away from stocks and high-yield bonds; reminds me of darker days. At the least, it doesn't portend good things for folks seeking work. If only this were to prove true, the import-substitution effect and associated multiplier would be a huge game changer and brighten the future of profits and jobs (ht: andrew).

Theory of Runs

A trading book I was reading a few weeks ago had a chapter on Martingales and Anti-Martingales. I already knew the pitfalls of a Martingale strategy based on an unfortunate occurrence in Vegas a few years ago when I had but 15 minutes before needing to catch a cab to catch a red eye back to home. I sat down at a $10 black jack table with a couple friends and proceeded to double my bet every time I lost hoping the ever present risk of a run of bad hands wouldn't be realized. I was $800 lighter in the pocket when I caught that cab.

Anyhow, when reading of the Anti-Martingales strategy whereby one increases their bet after a win and decreases the bet after a loss, I was reminded of the book Bringing Down the House wherein this type of strategy was used for risk management purposes. So the combination of these two experiences created a desire to back-test the strategy against historical stock market data (SURPRISE!).

Using Dow Jones Index data from yahoo! finance going back to 1929, I ran the following test:

1. If the prior day was a down day, then don't invest.
2. If the prior day was an up day, then invest 100%.
3. If the prior two days were up, then invest 200%.
4. If the prior three or more days were up, then invest 300%.

Historically speaking, this strategy would have needed to use margin (i.e. borrowed money) to purchase stocks equal to 200% or 300% of ones bankroll or 'stake'. However, today such leverage can be effectuated via ETFs such as UPRO and SDS.

The results of the test are displayed in the charts above. Some interesting take-aways:

1. The Anti-martingales strategy produced higher returns than the Buy&Hold strategy whilst its Beta (relative to the Buy&Hold strategy) typically ranged over time from 0.5x to 1.0x, thus producing a considerable amount of Alpha when measured over the entire 80 years.
2. There were a couple time periods, such as the 1930s and 2000s, when the Anti-martingales strategy would have cost someone ~90% of their stake.
3. All the outperformance of the Anti-martingales strategy came from the period 1940-1974. From 1974 to 2000ish, the returns of Anti-martingales essentially matched those of the Buy&Hold strategy.
4. Around 1974, the average 'run' of either positive or negative days in the market experienced a sudden drop from ~2.3 days down to ~1.9 days. Although I'm not sure why the average 'run' suddenly decreased then (widespread use of computers for trading?), the fact that it did obviously impacted the performance of the Anti-martingales strategy.

Conclusion: I wouldn't try this Anti-martingales strategy since it hasn't worked since 1974. However, the last time this strategy experienced a 90% decline (1930s), it really outperformed over the subsequent 35 years. Perhaps since this strategy experienced a 90% decline in the 2000s it could be poised for some outperformance.

market timing (part 1.2)

Since I basically changed the model portfolio to be market-neutral last week based on the most recent retail and employment stats, I thought it worthwhile to update my prior post on market timing based on retail sales. Last week, I did what no trader should do, which is to take action based on quantitative data before back-testing the decision. In other words, my prior back-testing was based on a rule whereby the trailing-2-month average retail sales were compared to the trailing-12-month average retail sales. So, just to get squared away, this week I've back-tested what it would looks like if one were to have traded based on the criteria I implicitly cited last week, which was:

1. If the year-over-year retail sales growth has weakened for two consecutive months, then sell.
2. If the year-over-year retail sales growth has strengthened for two consecutive months, then buy.
3. Otherwise, hold your position (either in or out of the market as the case may be) the same as the previous month.

The results are shown in the chart above, and the story is essentially the same as it was. Lower variability of returns (standard deviation), much lower Beta, and positive Alpha, which you'll recall is simply the amount of 'excess' return after adjusting for what you 'should' have received after adjusting for the lower Beta of the market-timing strategy. As you can see, this is a long-term strategy that will under-perform in bull markets and outperform in bear markets, but over the entire cycle does fairly well after accounting for the lower volatility risk.

Note: retail sales data is only available in electronic format back to 1994.

Quote for the Week: "Anger is an acid that can do more harm to the vessel in which it is stored than to anything on which it is poured." - Mark Twain

happy fathers day!

I attended this class back in October, the week before my second son was born, and won a door prize for being the expectant father with the nearest due date. It's a great, informative, positive program that I'd recommend to any expectant fathers you may know. I've since been back a couple times as a 'veteran' together with my son to share my own experience with the new 'recruits'. Anyhow, the program hosted a big event today in honor of fathers day and I thought I'd share a couple poinant quotes:

"Slow down and live today like you're dying. Because you are. You just don't know the rate at which you're dying or the expiration date."

Advice to your child when they stop thinking you know everything: "The older you get, the smarter I'll get".

Quotes from Reminiscences of a Stock Operator

REMINISCENCES OF A STOCK OPERATOR by Edwin LeFevre The Sun Dial Press,Inc. Garden City, New York Copyright 1923, by George H. Doran Company

"The public ought always to keep in mind the elementals of stock trading. When a stock is going up no elaborate explanation is needed as to why it is going up. It takes continuous buying to make a stock keep on going up. As long as it does so, with only small and natural reactions from time to time, it is a pretty safe proposition to trail along with it. But if after a long steady rise a stock turns and gradually begins to go down, with only occasional small rallies, it is obvious that the line of least resistance has changed from upward to downward. Such being the case why should any one ask for explanations? There are probably very good reasons why it should go down, but these reasons are known only to a few people who either keep those reasons to themselves, or else actually tell the public that the stock is cheap. The nature of the game as it is played is such that the public should realise that the truth cannot be told by the few who know."

"Speculation in stocks will never disappear. It isn't desirable that it should. It cannot be checked by warnings as to its dangers. You cannot prevent people from guessing wrong no matter how able or how experienced they may be. Carefully laid plans will miscarry because the unexpected and even the unexpectable will happen. Disaster may come from a convulsion of nature or from the weather, from your own greed or from some man's vanity; from fear or from uncontrolled hope."

"On the other hand there is profit in studying the human factors the ease with which human beings believe what it pleases them to believe; and how they allow themselves - indeed, urge themselves -to be influenced by their cupidity or by the dollar-cost of the average man's carelessness. Fear and hope remain the same; therefore the study of the psychology of speculators is as valuable as it ever was. Weapons change, but strategy remains strategy, on the New York Stock Exchange as on the battlefield. I think the clearest summing up of the whole thing was expressed by Thomas F. Woodlock when he declared: "The principles of successful stock speculation are based on the supposition that people will continue in the future to make the mistakes that they have made in the past.""

houston, we have a problem

Yesterday, I received an email from my friend and first boss post college, to which I replied:

"i've been thinking hard lately about taking my model portfolio beta down from ~0.50 to 0.25 by allocating 10% to 2x inverse S&P. but the gubmint releases retail sales tomorrow at 8:30am, which if they come in near expected 0.4% month over month growth (seasonally adjusted), will still show a decent y/y figure (which is my personal favorite indicator). overall, i think i'd rather leave something on the table than get trigger happy - so will likely wait for more confirmation. when i think about potential future scenarios, i just don't see the S&P going back to 666 simply b/c i don't see liquidity getting squeezed like it was back then. also, i think the FED can buy a lot of treasuries to finance govt spending via seniorage without creating inflation pressures, especially if the proposed higher banking reserve ratios keep a permanent lid on lending / velocity of money."

The retail sales figures released this morning were not good. Down 1.2% (month/month), rather than the consensus estimate of up 0.4%. More importantly in my view, this marks the second month in a row where the year/year increase has weakened (see chart above - click it twice).

So what do I do? I go look at other indicators to confirm and I find that the employment sitch isn't any better. Everyone was talking last week about how something like 90% of the new jobs were due to census hiring. Furthermore, calculated risk shows that temp hiring (which tends to lead payrolls) has pulled back. As icing on the cake, the small business hiring that usually isn't picked up by government payroll stats during economic recoveries (which tends to cause people to call them 'jobless' when they really aren't) apparently isn't there.

Separately, and perhaps most ominous, the TED spread has begun to widen. This is particularly worrisome to me because of all the zombie commercial real estate loans out there for which the only sustenance is low LIBOR. This is b/c their interest expense charged to borrowers is most often a spread over LIBOR, which if it's low, can be covered by cash flow generated by the property.

I think the writing is on the wall now. No use in waiting for the trumpets to sound. Trade early or not at all. [feel free to insert your own favorite cliche here]. I'm going to offset the model portfolio's exposure to the stock market by allocating ~33% to the Proshares ETF that is short the S&P 500 (ticker: SH). That will take the beta down to ~0.0x [33%*(-1.0) + (1-33%)*0.5 = 0.0]. I chose the ETF that's 1x inverse of the S&P 500, rather than the version that's 2x inverse b/c I don't like leverage (long or short).

I stand by my views expressed in the email to my friend, but I think we now have confirmation. I don't think the S&P will return to 666, but rather will swing back and forth between 800-1,200 for a few years until P/E ratios (i.e. valuations) bottom out and we begin with a new secular bull market. In the meantime, I think it's worth trying to avoid some of the downswings. At the very least, decreased exposure now will reduce volatility in my account and thereby help preserve clear judgement.

My only hesitation is that I don't know anyone who is bullish on the market right now, but I'm just going to chalk that up to being a function of my friend selection. Nevertheless, when you're a contrarian investor at heart (it's intuitively appealing), it's always bothersome to find someone who agrees with you. I take solace from the fact that wall street sell-side shops are still ostensibly bullish. In any case, I want to make decisions based on intermediate-term drivers like economic stats, without regard to short-term drivers like sentiment. [UPDATE: I hope these guys are both representative of the market consensus and overly optimistic]

P.S. Looking to the bright side, if you choose not to reduce your exposure to stocks at this time and this downswing I've described actually plays out, it will provide a nice chance to convert regular IRA accounts over to Roth IRAs while minimizing the amount of income taxes triggered (which are based on the value of your account at the time of conversion).

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]

good link

No post this weekend. Had to work a full day at my day job.

I did however follow a great link provided by Falkenblog. Has to do with low volatility stocks providing returns in line with overall equities (contradicting Modern Portfolio Theory), so that your return per unit of heartburn is maximized. Not only heartburn, but 'risk' insofar as (i) big drawdowns to your account have the potential to cause panic and lead you to sell at the worst possible time or (ii) you may have an unexpected use for that money you previously thought was 'long-term' and end up needing to sell at relatively low prices.

Quote for the Week: "He that cleaves to wealth had better cast it away than allow his heart to be poisoned by it: but he who does not cleave to wealth, and possessing riches, uses them rightly, will be a blessing unto his fellows." - Siddhartha Gautama Buddha (c. 563 BC - 483 BC).