Consider this figure:

Correlations among global securities

The first 14 securities are indexes and ETFs of various segments of the USA equity market. These are followed by a European and a Chinese equity ETF. The last  five are currency, fixed income or anti-inflation securities.

Note how the equity indexes are very highly correlated with each other (with most correlations over 0.8 and thus green in the matrix), but very uncorelated with the non-equity securities. GLD, the gold ETF, is truly uncorrelated with both equity and the 30 year T-Bond ^TYX.  Interestingly, GLD  and TIP (the anti-inflation US treasury security) are moderately correlated at 0.4. We would expect this since they both are used to protect against inflation, but are not equivalent in their structure.

The two rows above the matrix show the returns and volatility of each security. Note that the highest volatility is for VGK (41%/yr) and the lowest is for TIP at 5%/YR. On the other hand, only 7 of 21 securities measured have positive returns for the last 45 days. The highest return was China (FXI at 50%/YR) and the lowest was Dow Jones US Industrials (IYJ at -38%/YR).

We say this matrix, derived from the last 45 days of price action, indicates securities can best be picked based upon estimates of returns, assuming most securities will continue their very high correlations. Only asset classes, broadly categorized as equity/fixed income/anti-inflation, have negative or zero correlations for diversification.

Thus, we see yet again how the asset allocation task requires the asset class be picked before individual securities.

Budgeting skills are as important as what your portfolio is doing—probably, more important really, because budgeting is an everyday issue. If a person can scale back appropriately so that they can actually survive on a 4 percent withdrawal rate, they’re good. Any reasonably designed retirement portfolio will last with a 4 percent withdrawal rate. Eight percent? You’re going to have to get really lucky in your investments.

We love reading his work and he’s a very sharp, knowledgeable finance maven. But his claim about the 4 percent withdrawal rate seems a tad glib–there are many assumptions built-in to this claim that need explanation. Would you really like to bet on such a simple number for your retirement? We think not.

Intuitively, at 4% withdrawal rate,  if your return is 4%/YR and inflation is nil, then in fact you can simply withdraw the gain each year and never deplete the principal. But if, for example, inflation is 2%/YR and your return is 4%/YR, then we can show 4% withdrawal rate would last you 34 years. Not bad. But if your return is 3%/YR and inflation is 4%/YR, then this account will deplete after 22 years if withdrawals are at 4%/YR.  That’s probably a big difference. We show you how to handle all these “What Ifs”.

This post introduces the idea of the Safe Withdrawal Rate (SWR), a concept that has recently captured the attention of many investment advisors and publications. We introduce our own focus on this topic now. We announce two initiatives. First, we published a descriptive piece in Advisor Perspectives, a highly respected and popular website for investment professionals. This piece explains SWR ideas without math for the average investor. Second, we published our full research results in detail here, in our permanent pages (see Investing Tools drop-menu above, or click this link):

Investing Tools> Safe Withdrawal Rate

This page introduces our technical analysis and methodology to determinine your own, personal SWR. Our innovation: we capture each individual’s beliefs about his own future returns and inflation to find the expected value of his SWR, irrespective of market history. Ultimately, your personal beliefs about how future returns and inflation evolve is all that matters for your planning purposes.

We set forth a somewhat formal answer in our post on the three main economic scenarios, deflation, neutral and inflation. We want to present a more intuitive answer below.

First, we need to set the stage.

As we have discussed, the Efficient Markets Hypothesis (EMH) is an idea fiercely defended by a variety of senior finance professors, in spite of massive evidence to the contrary. Our post here gives a good summary of what the EMH is, why it is wrong and how it leads to mistakes.

The issue revolves around the implication of EMH that active management is a waste of time and money, since no amount of work can produce more insight than everyone else in market has or can get, and so an investor can get only the market ROI overall over the long run. Thus, according to the EMH, one should just invest in index funds.

OK, let’s stipulate EMH is useless. Now what? How should we invest? Before answering this question, let’s also stipulate, for obvious reasons, we cannot avoid this question.

One answer could be, just give our money to an advisor and let him invest for us. But of course, that raises the question as to how one chooses an advisor who if not sufficiently skilled, is sufficiently lucky. So we need to define an investment strategy.

In spite of all the confusion and uncertainties, one can still make some rational investments, while staying emotionally calm. Let’s define assumptions for a strategy:

The goal is to maximize our ROI, subject to a level of risk we can tolerate. Clearly, the ROI and the risk level are both subjective. We are willing to take more risk to get larger ROI. But the relationship between those two large factors is not known in advance.

We believe the current economic condition is mainly deflationary (prices are dropping and being a creditor is good).

We want to hold securities in such a way that when we discern inflation signs, we can switch easily from the current deflationary position to an inflation stance.

In our case, we want to preserve capital, but have growth reasonably better than that of money market rates (which are now ~0%/YR). This is the risk avoidance component of the strategy. Additionally, we want exposure to some upside to growth. The allocation between our risk avoidance securities and the upside-capture securities is where emotion enters the framework.

Our specific recommendation: account for deflation buy owning a variety of bonds and bond funds. Position the portfolio for upside by owning equities in companies in sectors which we believe are especially promising in the current political-economic environment. This idea, of course, is a standard approach, but modified by a strong emphasis on a small amount of very high risk/high payoff equities. The portion devoted to capturing future innovations or even disasters through equities can of course be enhanced by using various combinations of long dated puts and calls.

Using this broad approach, we can manage risk simply through the allocation between fixed income and equities, and focus on higher risk equities to be exposed to upsides from innovation.

This is not what is called well-diversified….rather, it’s a bet on specific beliefs. Remember, if you diversify enough, you effectively index everything.

Finally, some examples: First, the online, medical records sector, which will be quite actively converting old medical records to electronic format, as well as creating new records electronically, and the semiconductor industry, which continues to grow and also acts as a leading indicator of economic revival.

As the magazine says in the article:

In selecting this year’s winners, Global Finance’s editorial team considered objective and subjective factors. Objective criteria included growth in assets, profitability, geographic reach, strategic relationships, new business development and product innovation. Subjective criteria included the opinions of equity and credit-rating analysts, banking consultants and others in the industry, as well as corporate financial executives. The winners are not always the biggest banks but, rather, the best banks – those with the qualities that corporations should look for when choosing a ban

You can read the article and the winners  here.

We draw your attention to very useful and well established type of security, the Structured Note (SN). (We emphasize SNs are not the Structured Investment Vehicle of recent ill repute.)  Their fundamental purpose is to provide an investment that focuses on a specific set of investment goals, market beliefs and risk preferences of the investor. These notes can provide diversification for all kinds of portfolios. They can deliver a chosen combination of bond, equity and options behavior, and they are customized and offered by financial institutions. Even better, you can design and implement many of the characteristics of these notes for yourself…or your RIA can do so.

The main characteristics of structured notes are:

1. A defined maturity date, upon which the note expires and the positions are closed.
2. Specified amounts of principal can be placed at risk, from 0% (“Principal Protected”) to over 100% (“Principal at Risk”)

These SNs are effectively a hedge fund style investment, without the fund. They are unlike ETFs and mutual funds for the two reasons above.

Simple Example of a Structured Note Designed at Home

Here’s a very simple example to get you started conceptually: A Principal Protected Note. (The numbers are intended to illustrate the concepts. Scales and other details are readily accounted for in practice).

Suppose you believe the S&P500 will appreciate in a year, but you are worried about Black Swans flying into your portfolio. You want to invest, but you are a bit anxious. How can you gain some upside and not risk much downside?

The idea is to build the note based on existing securities with required properties to get the desired behavior. Suppose you buy a zero coupon bond (ZCB) from the US Treasury and the ZCB has 1 year maturity and $10000 par value. Let’s say you pay $9800 now and the UST will pay you $10000 one year from from now for a 2% ZCB.  In 1 year, you will get your principal paid back with a $200 profit. What if you invested that $200 due to you in one year, now? In effect, you will spend your future guaranteed profit on the possibility you can make more money in a year through investing.

For example, do this: put the $200 in a money market account. Then buy an out-of-the-money call option on the S&P500 Index. In one year, there are two possibilities:  the option will be worth nothing, in which case you have only the money market remainder if any, or the option will have some profit in addition to any money market remainder.

Worst case, you lose the full $200. But you get the $10000 payoff, $200 of which matches what you risked on the option initially. So your $9800 principal is repaid.

Extensions of the Basic C0ncept to More Complex Structured Notes

You can extend the maturity of the ZCB and the type of option or stock position (purchases, spreads and straddles,…). You can choose other types of very high quality bonds. For example, if the ZCB above had a maturity of 20 years and paid 4%, then the initial purchase would be $4564 and you would get back $10000 at 20 years. So you would have $5436 to invest in some other position. Again, you could lose the entire $5436 and still regain your initial capital in 20 years.

Of course, this form of principal protection is simplistic since the time value of the money is lost. But the main idea holds.

These basic concepts can be developed by your investment advisor to target your specific investment beliefs, and they offer good diversification possibilities.

Live it up, be a hedge fund manager!

(Please keep in mind all information and ideas presented on this web site are subject to our Terms of Use. We also remind you that nothing written here can be a recommendation for any particular person to invest. Please consult your own financial or investment advisor before you make any investments.)

Can the Fed Control the Money Supply?

The problem is this: Given the enormous amount of money Bernanke’s Fed has “printed” to restart the credit markets, there now is a substantial danger the Fed will not successfully retrieve that money. Bernanke needs to use all the Fed’s tools to raise interest rates sufficiently for banks to place money on deposit with the Fed, and out of the economy. The Fed must start, at a crucial time we’ll label TIME, a control policy of raising rates fast enough and high enough to attract money. This is a tricky balancing act. When the Fed pays interest, the amount and timing must not be so high or fast as to slow the economy into recession again and deflation, or be so low and slow as to enable inflationary expectations to squirt loose. There are thus three huge unknowns in this problem and all of them are beyond investor influence: TIME, interest rate level, and speed of change in interest rates. Perfection happens when Ben gets it exactly right, and the economy washes the excess money supply back with minimal impact on prices. But being wrong will launch deflation or inflation.

Under these conditions, how best to invest? We take a scenario approach. There are three main future economic conditions (Deflation, Perfection, Inflation) and four main investable asset classes to choose from. We need to pick the amount to invest from each class, depending on our beliefs about the future.

Main Investable Asset Classes

The main asset classes are roughly described this way, considering the variations within each class. First, cash. This ranges from cash in mattress, to money market funds and extremely short term T-Bills. Second, Fixed Income comprises all forms of bonds and ETFs/Mutual Funds based on bonds, both corporate and municipal, and various Treasury offerings, most particularly Treasury Inflation Protected Securities (TIPS). Third are corporate equities and ETFs/Mutual Funds based on them. Finally, we have hard assets. These consist of commodities (metals, precious metals, food products, animal products,…) and real estate (land, buildings, and Real Estate Investment Trusts (REITs)). REITs enable liquidity in real estate purchases, since one trades shares of corporations whose assets are interests in real property. Note that more esoteric asset classes, such as hedge funds and derivatives all can be fit into these categories, if you are willing to sit on top of the bag to close the zipper.

Model Portfolios

Let’s look at a straightforward way to invest for each scenario. Consider this table, which shows the amount of your investable assets to invest in each class, given the scenario.

These amounts were intuitively chosen. By applying the Markowitz portfolio optimation algorithm, one can create an optimal portfolio for all three cases based on one’s own specific ROI and risk assumptions.

Perfection

Under the Perfection scenario, the economy percolates along without undue influence of the money supply, and is what we call “normal”. Our nominal portfolio for Perfection consists of equal amounts of equity and fixed income, with lesser equal amounts of cash and real assets. Again, we note the specific assets in each class are chosen by the individual investor.

Inflation

With inflation, one wants to hold hard assets and inflation protected securities. The two most often named are gold and TIPS. Commodities generally gain in price with overall inflation. Stocks vary with inflation. Empirically, the equities evidence is mixed. Some firms win due to having price increases masked by inflation, while others lose since their purhases also rise with inflation. Surprisingly, cash tends to track inflation. So, compared to Perfection, the model portfolio has more cash and fixed income, with an increased dose of TIPS, less equities, and much more Real Assets.

Deflation

Under deflation, cash is king, and the model portfolio shows this bias compared to the Perfection condition.

Combination

Of course, these scenarios are mutually exclusive, and we can build only one portfolio of all our assets. To build the final portfolio, we have to assign a probability to each scenario, and then combine the asset classes according to the scenario weights.

Bernanke Article in WSJ, 7-21-09

He concludes by saying:

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

The only problem with all this is what he failed to address: how to get the timing right. All his tools are good ones, but the entire challenge is to start using them at best time. He can err by starting too soon, and slow growth, or too late, and enable inflation to squirt loose.

How can he get it right?

No answer. So in self-defense, take anti-inflation positions, while their prices are relatively low.

See Original Research Paper

Here are important conlusions, In Our Humble Opinion:

1–”Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth.”

2–”The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president’s Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3.”

3–”The combination of an extremely overleveraged economy, ineffectual monetary policy and misdirected fiscal policy initiatives suggests that the U.S. economy faces a long difficult struggle. While depleted inventories and the buildup of pent-up demand may produce intermittent spurts of growth, these brief episodes are not likely to be sustained. In several years, real GDP may be no higher than its current levels. However, since the population will continue to grow, per capita GDP will decline; thus, the standard of living will diminish as unemployment rises. These conditions will produce a deflationary environment similar to the Japanese condition.

4–”In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios. However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event. The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.”

We find (2) above especially surreal, since Dr. Romer fully understands what president Obama is doing and that his actions deny reality as revealed by her own empirical research!

The prospects for job creation are equally distressing. The likelihood is that when economic activity picks up, employers will first choose to increase hours for existing workers and bring part-time workers back to full time. Many unemployed workers looking for jobs once the recovery begins will discover that jobs as good as the ones they lost are almost impossible to find because many layoffs have been permanent. Instead of shrinking operations, companies have shut down whole business units or made sweeping structural changes in the way they conduct business. General Motors and Chrysler, closed hundreds of dealerships and reduced brands. Citigroup and Bank of America cut tens of thousands of positions and exited many parts of the world of finance.

In this Op-Ed he explains 10 major reasons in detail all pointing to a sustained recession and slow recovery. This will affect corporate earnings and credit ratings.

His key point:

This process is nowhere near complete and, until it is, the economy will barely grow if it does at all, and it may well oscillate between sluggish growth and modest decline for the next several years until the rebalancing of excessive debt has been completed. Until then, the economy will be deprived of adequate profits and cash flow, and businesses will not start to hire nor race to make capital expenditures when they have vast idle capacity.

Think about it for your investing.

Read entire article in Wall St. Journal.

In his latest work, Ted Wong digs deeper into the drawdowns and shows (again) that MAC beats BAH on a risk-adjusted basis as well.

Being passive will not help you, especially when markets deeply drawdown, as they have in last twelve months.

MAC beats BAH

MAC beats BAH on a Risk-Adjusted Basis