bonds

I'm not a bond guy, but if I were allocating part of my portfolio to bonds, this is how I'd do it. Whatever you do, DO NOT allocate more than 2-3% of your portfolio to a single bond. Doesn't matter if it's rated investment grade. You can buy it investment grade and the next week it can be non-investment grade. Trust me, I know from personal experience.

recent reading

In the past month, I've read a few well written books about investing, all of which advocate value investing:

Bull's Eye Investing - Not only an interesting read, but the author was writing in 2004 and got a lot of things right about the subsequent six years.

The Little Book that Still Beats the Market - Starts off really hokey, but the second half makes a compelling case for buying quality stocks with cheap prices based on an objective formula that adjusts for varying tax rates and debt loads of companies, so you won't miss some good buys just because they have depressed earnings.

The Little Book of Sideways Markets - Explains why the overall stock market will continue to tread water with high volatility over the next decade and recommends a means of outperforming in such an environment. I thought this book might have been banal, but it actually makes a lot of smart, nuanced observations and is well written.

buying foreign small caps; decreasing exposure to Yen and China

I'm generally of the opinion that it makes sense to avoid mutual funds and exchange traded funds with their embedded management fees that act as a drag on a portfolio's returns. I feel this way due to the advent of platforms such as folioinvesting.com where individual investors can construct a portfolio containing a large number of stocks without incurring commissions for each trade. However, with foreign stocks, pretty much the only ones that trade on U.S. exchanges are large-cap companies, many of which happen to be energy companies and banks. Since I wish to obtain exposure to other sectors, I've purchased the following exchange traded funds geared to foreign small caps (within the model portfolio - 1% allocation to each): BRF, SCIF, and DGS.

To make room, I've sold the three Japanese stocks - WACLY, NTT, and DCM - which is in keeping with concerns about the future direction of the Yen. Basically, I'm trading out of a country with poor demographics and high debt and into countries with with favorable demographics and low debt, which I believe will provide for some long-term currency appreciation to go along with the investment returns from economic growth.

Separately, I sold the two Chinese stocks - HNP and SNDA. I don't have a rigorous reason; I'm just worried about the Chinese economy being unbalanced and the potential turbulence in Chinese stocks that would likely result from a recession over there. As replacements, I bought VE and TM (1% allocation to each).

Wait, didn't I just say I was worried about the Yen? Yes, but actually TM should benefit from a declining Yen as 70% of its revenues are derived from outside Japan and 58% of its expenses are incurred inside Japan. Furthermore, the stock is cheap based on price/book, price/cash flow, and price/sales, all of which is in keeping with my re-born value investing fetish.

happy holidays

coleman 100 portfolio

The charts above are created by morningstar.com as a feature of their premium membership offering. As you can see, the 100 stocks provide for a well diversified portfolio by economic sector, market cap, and geography. In fact, I would go so far as to say this equal-weighted porfolio is more diversified than the S&P500, which is market-cap weighted.

The average beta of this portfolio is 0.69x, which means in any short run time period, it should zig and zag with a magnitude about equal to 69% of the S&P500. In the long run, as the small short-run deviations accumulate, I'm expecting the portfolio to out-perform the S&P500 and also out-perform my true benchmark, which is the Vanguard Global Stock ETF (ticker: VT).

The portfolio is tilted towards stocks with valuation ratios (price/earnings, etc) lower than the S&P500 and growth prospects (earnings growth projections) greater than the S&P500. The benefit of investing in companies with decent growth prospects, rather than solely low valuation ratios is that it helps one avoid companies that are cheap for a reason that have increased risk of bankruptcy. It's a nod to the value investors' philosophy of buying companies with decent business prospects at a cheap price.

Lastly, the first chart above is a back-test showing how this portfolio would have performed against the S&P500 over the past five years. This is only an indication and isn't definitive because some of the 100 stocks haven't been around five years, which is indicated by the dotted line for the first portion of the time period.

Note: In order to view the chart above showing the 100 stock holdings, or any of the other charts, click the image twice for a larger version.

portfolio overhaul

It has now been exactly 15 months since I established the model portfolio 9/4/09. There have been changes along the way, as I tried my hand at a little market timing from June-November with a market-neutral portfolio. Although the hedge used was the ETF that moves inversely to the S&P500, which left the portfolio somewhat exposed to foreign currency movements vis-a-vis the dollar and small cap stocks vis-a-vis large cap stocks. The portfolio has also evolved as I've continually pruned it from roughly 700 stocks down to 169 stocks. This was mainly done by eliminating all but the lowest beta stocks. This week I've culled the portfolio down to 100 stocks by eliminating some of the pricier names, thereby increasing the tilt towards value stocks.

My intention is to hold these 100 stocks throughout 2011. Furthermore, I'm going to fund my account at folioinvesting.com and henceforth report the results from my real portfolio, rather than a model (paper) portfolio.

The next post will provide a summary of the 100 stocks, but before getting to that, I've posted for the record the results of the model portfolio over the past 15 months (see charts above). Nothing stellar, but not bad. Essentially, total return was in line with the overall market, but the pathway of getting there was less stomach-churning than the overall market, so if you had been invested like the model, there was less chance you would panic and sell out at the bottom. I mention this because most investors fall short of matching the overall market for this very reason, which is why in some ways, I think the volatility of one's portfolio is an important determinant of realized returns.

value investing

I've been listening to the siren song of the value investing philosophy lately. It started with attending a lunch sponsored by the local CFA chapter where the speaker was Pat Dorsey from Morningstar. Then I bought his book and read it. Now I've signed up for the premium membership tools (stock screeners, research reports, etc) over at morningstar.com.

Sometimes I wonder if the main near-term benefit of writing this blog and managing a model portfolio is that it absorbs my free time devoted to the investing hobby such that I end up leaving my own portfolio alone without a bunch of excessive trading.

Anyhow, I wondered whether or not low beta stocks may provide superior returns in part because they overlap with morningstar's notion of economic moats. In short, there seems to be a little connection, but it's not overwhelming. In the chart above, you can see how the 169 stocks in the model portfolio are rated by morningstar in terms of having economic moats (not all 169 stocks are covered). It appears as though the wide moat stocks do indeed exhibit less volatility as measured by standard deviation of returns (beta isn't yet available as a field to screen). Also, it appears the wide moat stocks in the model portfolio are considered by morningstar to trade at a discount to their assessment of fair value. However, this could potentially be caused by morningstar calculating higher fair values for stocks they deem to have wide moats.

At the risk of being rash, I decided to go ahead and tweak the model portfolio just a bit to provide a slight value tilt. I sold nine stocks with no or narrow moats that were deemed to be overvalued 1.5x or more and I bought nine stocks with wide moats that were deemed to be 0.86x or less of fair value (which puts them in top quartile of morningstar's database).

Sales: CHD, EW, BJ, ORLY, ILMN, INFA, PNY, RYAAY, LFL
Purchases: EXC, GE, MDT, NVS, RHHBY, ZMH, WU, AMAT, CSCO

esoteric rambling hand waver (yours truly)

I'm on the verge of transitioning the model portfolio back to being net long stocks for two somewhat related reasons. Most importantly, when adjusting for last year's cash-for-clunkers program (i.e. excluding auto sales), retail sales growth seems to have stabilized with a slight up trend.

Secondly, I just think the forces of inflation will eventually overwhelm deflation. I know there is plenty of slack in the labor market right now which is generally where higher inflation expectations originate, but the problem is that much of this slack is comprised of folks tied to the housing/finance industry who don't have the skills to immediately switch to more productive sectors of the economy. So I think in those more productive sectors, we actually could see some wage inflation. Meanwhile, in housing/finance, the blood has been let and folks left with jobs probably won't see a steady drop in their nominal incomes.

Then of course you have the 'currency wars' whereby sovereign states with inverted age demographic pyramids (e.g. Japan, E.U.) or even just age columns (e.g. U.S.) are pursuing Quantitative Easing in order to monetize their high levels of external debt. Of course the party line is they are only trying to ward off deflation, but call me cynical, I don't think the general public has the stomach for another Paul Volker to come in and disinflate when banks start lending again (which they are now by the way) thereby increasing credit, which I believe is the largest driver of the total money supply.

So who wins with inflation in the long run? If you have a mortgage loan or large amount of other debt, you might break even because that gets repaid with less valuable dollars, but you still have to cope with higher costs throughout the rest of your budget (food, energy, consumer goods, healthcare). Who loses with inflation? Anyone without a mortgage, especially retirees who are trying to live off their savings. Ultimately, if it really gets out of hand and transitions to hyperinflation, everyone loses because exchanging goods and services for currency could become undesirable, which is the basis for the specialization of labor that underlies modern society. I realize that last point could qualify for tin-foil hat club membership, but I do believe most things sound crazy until they don't.

As an aside, I suspect the reason bonds and stocks have rallied together of late is due to the strong bid from the FED underlying bond prices. As institutions understandably sell treasuries at incredibly low yields to the FED, they redeploy the proceeds into riskier assets like corporate bonds. The sellers of the corporate bonds redeploy their proceeds into preferred equity and the sellers of preferred equity redeploy into common equity. Thus, the FED can increase asset prices across the entire risk spectrum. Now there is a seller for every buyer in each of these asset classes, but as the prices get bid up, you have more companies raising capital via bond issuances or stock offerings. If the companies invest that money to create new productive assets (machines, software, etc), then it will drive economic growth, at least in nominal terms before adjusting for inflation. In real terms, since the world's population growth is declining, we don't need as much real growth in production of goods and services. But of course real growth would still be desirable insofar as it would necessarily increase material wealth per capita. I think that is a good thing for everyone out there making less than say ~$70m per year, but above that level, I subscribe to the view that material wealth doesn't correlate with happiness.

So, back to where I started, the only question is when I increase exposure to stocks and how much. I've been thinking there would be a pull-back coming this week on news of Republican gains in congress and the putative quantitative easing announcement. You know, the old "buy the rumor, sell the news" bit. Unfortunately, that seems to be a popular bit of advice, so if there are enough market participants out there of this persuasion, we may actually see the market rise again this week.

Conclusion: I'm going to sell the 1/3 allocation to the ETF that moves inversely with the S&P on Monday and sit with the proceeds in cash until next week when I may redeploy the cash into the low beta stock holdings.

time to short Yen?

According to this persuasive article, it may be time to short Yen, which can be done by purchasing the Exchange Traded Fund that moves 2x the inverse of the Yen; ticker YCS.

model portfolio 10/10/10

Although I decided to go 'market neutral' back in June based on weakened retail sales data, the instrument I used to hedge the stock exposure is the ETF that is short the S&P 500 (ticker: SH). Since the model portfolio's long positions are roughly 1/3 foreign stocks, I essentially hedged out the stock exposure while leaving some foreign currency exposure. Sometimes, it's better to be lucky than good (in the short run). So while the market has been fairly volatile and the model portfolio has been fairly stable (providing for a superior risk-adjusted profile), the model portfolio has only maintained its return lead over the indexes due to the declining dollar alluded to above.

real estate (part 4)

I wondered what it might look like if one were to trade the top-25 cities based on momentum. Again this is based on OFHEO data, which pertains to single-family residential.

The Test:
1. Rank the 25 cities based on price appreciation over the prior three quarters.
2. Invest 10% of the portfolio into each of the top-10 ranked cities.
3. Whenever a city falls out of the top-10, sell the investment (with 6% transaction cost) and buy whatever city has moved up to the top-10. These trades are modeled using a two-quarter lag, so as not to incorporate any hindsight bias. Two quarters is probably the minimum amount of time necessary to receive the price appreciation data from the government pertaining to the prior quarter and then make the trades.

Results:
1. With transaction costs, the momentum trading strategy results pretty much match the results achieved by simply buying and holding all 25 cities. The benchmark of buying and holding all 25 cities is without any re-balancing and the associated transaction costs.
2. Without transaction costs, the momentum trading strategy is far superior, generating much higher returns with approximately the same volatility.

Conclusion:
As with many quantitative strategies, transaction costs become the limiting factor. However, the insight is useful if one is deploying new money and would have to incur the transaction costs in any event.

One day I'd like to see how closely the OFHEO data tracks the appreciation of apartment properties and other commercial property types. Since those larger transaction sizes typically have much lower transaction costs (say 1.5%), I'd like to see if this would be a viable investment strategy, or at least a helpful augmentation.

great minds

think alike as crossingwallstreet makes the same point articulated in this space not two weeks ago.

making money in a random market (part 2)

It occurred to me that i should know what the returns and volatility are if one simply holds SPY overnight, every night - regardless of whether or not the market was up intra-day. Interestingly enough, it appears that the positive attributes of the aforementioned strategy whereby one holds overnight when the market was up that day are unrelated to whether or not the market was up that day. In fact, if one simply holds the SPY overnight (every night), then the average daily return is .036%, whereas if one only holds overnight after the market was up intra-day, then the average daily return is only .030%. Furthermore, simply holding overnight, every night, provides for an overall return since 1993 in line with a buy-and-hold strategy with much less volatility.

If I were to fabricate a theory to explain this phenomenon, I'd say it has to do with a liquidity premium related to the idea that many market players (e.g. day traders) are only active during the day and liquidate their positions prior to the market close so as not to have exposure over night. So the strategy of only holding stocks overnight means that one is selling at the open (when others are bidding up the prices) and buying at the close (when others are selling down the prices).

If one wanted an apples-to-apples comparison of the hold-overnight strategy against the buy-and-hold strategy, then one could leverage their investment overnight (via margin borrowing). This means one would be holding more stock in comparison to the amount of their investment and therefore the changing price of that stock in proportion to their investment would be more volatile. Given the data set I'm working with here (i.e. ticker SPY since 1993), if one were to have consistently financed 47.9% of their overnight holdings via margin, then the annualized volatility (standard deviation of returns) would have been 19.8%, precisely the same as for the buy-and-hold strategy. However, the returns from this leveraged hold-overnight strategy would have been 12.88% (annualized), which compares favorably to the 7.33% annualized return provided by the buy-and-hold strategy. For this analysis, I've just assumed the interest rate associated with the margin borrowing was a constant 10%.

Aside from higher returns with equivalent volatility (if leveraged) or equivalent returns with lower volatility (if unleveraged), there is the conceptual risk reduction associated with the fact that one would only be exposed to stock price fluctuations for ~16 hours per day, rather than 24 hours per day. So if something bad happens in the world that triggers a market crash, one would theoretically have a 1 in 3 shot at side stepping the carnage to their portfolio.

So what's the catch? Transaction costs. If one bought everyday at the market close and sold the next morning at the market open, one would lose their entire investment over time to brokerage commissions. This is the case even if one started with $100, 000 and could complete trades for only $10 per 1,000 shares traded.

Nonetheless, this overnight holding phenomenon could be marginally useful information even if one has to incur transaction costs, because if one is using some other system that generates daily trade decisions, one could enter those buy orders at the market close and enter those sell orders at the market open and perhaps realize some additional return over time.

making money in a random market

i was googling for articles on suggested ways to make money in a random market and i came across an interesting site that articulates the theory of the screw, which is a belief i myself hold and recommend this article to you as worthwhile reading. but aside from that, the author writes in another article about momentum investing. Soooo, i decided to do a simple backtest on the system whereby one buys and holds overnight if the market closed that day higher than it opened. For the test, i pulled historical quotes for the ETF that tracks the S&P500 (ticker: SPY), which has been trading since 2/1993.

what i found is an annualized return of 3.59% with annualized standard deviation of 7.36% over this 17.6-year time period. now, this isn't very compelling if you consider one could obtain an annualized return of 3.50% with annualized standard deviation of only 0.57% over that period by holding 3-mo. t-bills. however, if the stock market would have performed better over that period, this system would have undoubtedly performed better, whereas the same upside potential doesn't exist with t-bills. so perhaps the correct benchmark is the s&p500 itself, which provided a return of 5.36% (annualized) with standard deviation of 15.26% (annualized) over that 17.6-year time period. so for this trading system, the return/volatility was 0.49, which compares favorably to the return/volatility provided by the s&p of 0.35.

now to get a truer picture, i'll have to go back later and model in transaction costs, but the purpose of this test was simply to get a feel for whether or not this system even has any potential. i may have to test this system a bit more, but at first blush, it doesn't appear half bad. i mean look at the chart above since 2001; sure it hasn't made any money, but compare that to the crazy volatility and low returns of the s&p 500.


Technical Notes:
1. if you want to buy and hold overnight, you must buy prior to the close (unless you buy in the after-market), but i'm just assuming one can buy a few minutes prior to the close and almost always hit a bid very close to the closing price assuming there are no huge moves during the last few minutes.

2. i did not take the time to model in transaction costs, which would dilute the returns of this system.

no free lunch here

I was wondering if folks who ordinarily have some portion of their portfolio allocated to bonds might be better off to instead utilize a mix of stocks and cash. The idea is the stocks and cash would be proportioned so as to achieve the same volatility as bonds while potentially achieving a higher return.

To investigate, I pulled historical data from yahoo! finance going back to the early 1960s for 3-month treasury bills (proxy for cash returns), 10-year treasury notes (proxy for bond returns), and the S&P 500 (proxy for stock returns). Then I solved for the stock/cash proportions (54.7% / 45.3% with monthly rebalancing) that would provide for the same volatility (8.3% annualized standard deviation in returns) provided by the 10-year treasury notes.

What I found is that the stock/cash portfolio provides a slightly lower return than the 10-year treasury notes. Perhaps next week I'll try to get my hands on some corporate bond data and see if the idea pans out better there.

congrats to jmu dukes

Money Quote: "It was the first time Virginia Tech Coach Frank Beamer has lost to a division I-AA opponent since taking over the program in 1987. It also was only the second time a division I-AA team defeated a ranked division I-A team, the first being when Appalachian State shocked No. 5 Michigan in 2007." Full story here.

Also, intriguing bit of motivation here: "Asked during the week about Saturday' s matchup with No. 13, Virginia Tech, Matthews [JMU coach] had a simple summation for his team's chances against a major-college, in-state school located a couple of hours south off I-81 from his Harrisonburg campus:

"When you get right down to it, they didn't want any of our guys. It's kind of comical to think you're going to go down there and beat them."

poignant post

complements of crossingwallstreet.

model portfolio (1-year in)

Between reading loan documents for work and preparing for my fantasy football draft on Monday, I won't be doing a real post this weekend. However, the charts above show the model portfolio performance after the completion of one full year of history.

As a recap, from 9/2009 thru 4/2010, the model portfolio slowly but steadily got out to a lead over the benchmarks, in my opinion due mainly to the low beta stock selection, economic sector diversification, and minimization of financial sector exposure. From 4/2010 thru 6/2010 I pruned the portfolio to lower the beta even more and allocated 1/3 to low beta foreign stocks in an effort to further lower the covariance with the S&P 500. In 6/2010, I turned bearish based on the weakening economic fundamentals, mainly retail sales, and allocated 1/3 of the portfolio to the ETF that moves inversely to the S&P 500 (ticker: SH). Since then, the portfolio volatility has been very low while the equity markets as a whole have essentially been unchanged from then to now, but with a lot more volatility along the way.

Overall, I am pleased with the results, while realizing this could well be 100% luck. The markets are so volatile in comparison to the magnitude of the model portfolio outperformance, that one could reasonably attribute this outperformance to statistical noise. As I told my son last month while explaining the basics of investing to him, one should try to select an advisor that can demonstrate this type of outperformance consistently over say 10 years. Further, even such a track record of outperforming 9 of 10 years would be insufficient if the one year of underperformance is so awful as to make the cumulative return lag the market benchmark. Still, if an advisor is found who can truly meet this standard, it could still be luck, but intuitively I believe such a track record would provide for a better chance of outperformance in coming years as compared to an advisor without such a record.

Otherwise, if one can only find advisors for whom the prospect of outperformance is essentially a gamble, why not save the management expense and gamble on your own? I don't mean go crazy and put 100% of your savings into the latest hot stock, but I do think most folks would do well to (i) minimize their management expenses via a low cost platform like folioinvesting.com and (ii) minimize portfolio volatility via sector diversification, geographic diversification, and low beta stock selection. For the technically inclined, disciplined market timing strategies based on quantitative rules can help minimize portfolio volatility as well.

Inflation Expectations Bet

I was thinking about the disconnect between gold prices and government bond prices as they pertain to inflation expectations. Gold prices are high presumably due to expectations of increased inflation. However, government bond prices are high (i.e. interest rates are low) presumably due to expectations of low inflation if not outright deflation. The first chart above illustrates this disconnect as represented by the ETF that tracks the inverse of the 30-year Treasury bond (ticker: RYJUX) and the ETF that tracks gold prices (ticker: GLD). As you can see, the spread between the two is relatively wide now. In the simplest terms, if I want to try profiting from this disconnect, I might consider (i) buying the ETF that moves inversely to the price of gold (ticker: DGZ) and (ii) buying RYJUX.

Such a combination would reflect my personal expectation that inflation reality will play out somewhere in between the two aforementioned sets of expectations. Helicopter Ben Bernanke will neuter deflation by increasing the base money supply via quantitative easing, thereby sufficiently offsetting the decline in credit / velocity of money. The resulting increased inflation (or lack of deflation) will raise nominal interest rates, thereby decreasing bond prices and increasing the price of RYJUX. However, since inflation probably will not get out of hand and I think this outlook will eventually become widespread, it will cause the price of gold to decline, thereby increasing the price of DGZ. If I'm wrong and inflation gets out of hand, then losses from DGZ should be more than offset by gains from RYJUX.

So there are three scenarios:
1. If there is moderate inflation (my expectation), then this trading setup should do well.
2. If there is hyperinflation, this trading setup should do just OK.
3. If there is deflation, this setup is most likely a looser.

I might consider solely buying RYJUX, but then it's possible that increased inflation expectations could be offset by lower real interest rates, thus leaving nominal interest rates unchanged, thus leaving the price of RYJUX unchanged. Meanwhile I would miss out on the likely rise in DGZ resulting from the moderate (not hyper) inflation.

UPDATE: The fly in the ointment here could be the method of quantitative easing. For instance, if the Fed keeps the treasury bond prices artificially high by purchasing them with newly created money, then you could in fact end up with the counterintuitive scenario of continued low interest rates on treasury bonds and high inflation, in which case the trade outlined above would be a bust until the quantitative easing abates. In other words, the Fed could seriously distort the connections between market expectations of inflation and treasury interest rates. However, the Fed could implement quantitative easing by purchasing financial assets other than treasuries, such as mortgage bonds, in which case the trade would likely work out well.

Technical notes:
1. The charts only go back to the start of 2008 because that's when the DGZ ETF was originated.
2. The allocations between RYJUX and DGZ are 75% and 25%, respectively, because DGZ is more volatile and those proportions help minimize the overall volatility of the setup.
3. To be precise, 30-year government bond prices may be high primarily due to technical factors such as 'flight to safety', rather than expectations of low inflation or deflation and the associated low short-term interest rates during the foreseeable future, but the distinction shouldn't impact the above analysis.

Quote for the Week: "Envy reflects our values by showing us not just what we want, but also what we would do to get what we want...because we're envious only of people who make their money in ways that we condone. We envy people for getting what we want in ways we can imagine. The more distant the possibility of achieving a certain kind of success, the weaker the envy. How can you control your envy? The same way you control all your emotions: by changing your beliefs. Convince yourself...that your life will not be essentially improved by a new patio, and you'll no longer envy your neighbor's new addition to his house. When you change your values, you change your emotions...success depends in part on understanding how our evaluations direct our emotions. To gain that understanding, we need to do a bit of philosophical analysis. -Joshua Halberstam, author of Everyday Ethics, copyright 1993.

model portfolio backtest

One of the cool things about folioinvesting.com is the ability to quickly see a backtest of how your current portfolio would have done in the past versus a benchmark. As shown in the chart above, our model portfolio with roughly 2/3 invested in low beta stocks and 1/3 invested in the short-S&P 500 ETF (ticker: SH) would have done pretty well over the past 4 years as compared to being 100% long the S&P 500.

Note: the time period selected (i.e. 4 years) was chosen solely because the short-S&P ETF wasn't originated until 6/2006.