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.

Not really. Consider this excerpt from the article:

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.

Remember the 1970s-era price ceiling on gasoline? By causing prices at the pump to lie about the scarcity of oil, that price ceiling led Americans to waste untold hours waiting in lines to fuel their cars. Similar wastes occur when corporate assets are mispriced.

Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme’s managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme’s share price will be too high. Investors will buy Acme shares at prices that conceal the company’s imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme’s employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

Eventually, of course, those misled investors, creditors and workers will suffer financial losses. But the economy as a whole loses, too. Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme’s deceitfully high share price, those better-run firms don’t enhance their efficiencies as much. They don’t expand their operations as much. They don’t create as many good jobs. Consumers don’t enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

In short, overall economic efficiency is reduced.

You can read the whole article here.

Almost every page of the health care bill HR3200 from the House of Representatives has at least one statement that can alter your life. When those 1017 pages interact, they will produce effects not imagined by the bureaucrats and politicians who wrote this thing. The odds those unpredictable Black Swans are good for you are nil. They will hurt you.

As an example, consider this from the New York Times of 1 OCT 09 in regard to the current Medicare:

Medicare is putting in place a new policy that may sharply curtail the use of the cancer drug Avastin as a treatment for eye diseases.

But the way the bureaucratic gears mesh in this case, the move could end up costing Medicare itself hundreds of millions of dollars a year, and individual patients thousands of dollars.

What happened is that Medicare added a new reimbursement category for doctors to use for very small doses of an existing expensive drug. As the Times writes:

But Medicare has now introduced a special reimbursement code just for the smaller doses of Avastin. And starting Thursday, the reimbursement of Avastin dropped to about $7.20 for the dose typically used in the eye.

That would mean eye doctors — who purchase Avastin and then are reimbursed when using it on patients — would lose money administering the drug.

The new policy would give eye doctors a financial incentive to switch to Lucentis, for which they would be fully reimbursed even though that drug is significantly more expensive.

If doctors do shift to Lucentis, “this will have a huge economic impact on Medicare, in the range of hundreds of millions of dollars,” said Dr. David W. Parke II, chief executive of the American Academy of Ophthalmology. “Members view this as a bureaucratic decision that is maybe necessary, based on statutes, but highly short-sighted.”

This illustrates the obscenity the Congress is creating by rushing to a new, vast bureaucratic system with enormous perverse incentives and deep complexities that can only make life worse for everyone.

Read Full Article

Here’s the answer, in beautiful brevity:

Professor Bolster stated his overall conclusion: “He has an alpha of 0; he could do worse. He’s harmless.”

This means you would have gained nothing and lost nothing for the risk level of Cramer’s recommendations over the time horizon analyzed (July 2005 to the end of 2007). For details, see the full results described here:

Paul J. Bolster and Emery A. Trahan, “Investing in Mad Money: Price and Style Effects,” Financial Services Review, Vol.18 (2009), pp. 69–86.

You also can read a summary here.

“There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it “just right.” The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week’s Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.”

See full text here

Of course, we have written about this looming disaster, and proposed some specific ways investors can prepare for it. See, for example:

http://www.rocketcap.com/portfolios-for-deflation-inflation-and-good-luck/

Watch Milton Friedman Video

(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.

In the first, The Economist lead editorial sets the stage:

What went wrong with economics

It says:

“In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled. Though economists are still at the centre of the policy debate—think of Ben Bernanke or Larry Summers in America or Mervyn King in Britain—their pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.” “

We almost always find Krugman’s assessment of anything remotely political off-base or wacky, but he definitely gets it right, here!

Two other articles analyze the failures of economists to detect or clearly recover from the calamity. These two focus on various aspects of economic theory itself.

The other-worldly philosophers

Efficiency and beyond

The latter article has a nice discussion of the famous Efficient Markets Hypothesis, which is obviously bogus. I love the EMH! It says. all information that could affect the price of a stock is already incorporated into the price, so over time, no one can profit from investing. Don’t you love it?

The EMH is the source of the old joke about two economist walking together down the street. One sees a $20 bill on the ground and reaches to pick it up. Then the other economist stops him, and says “Hey, don’t bother-if that was a REAL $20 bill, someone would already have picked it up!”

One of themes coursing through these articles is that economists have used some important simplifying assumptions, such as EMH, to build their models. These models have worked fairly well. But just as in engineering, one has to consider the “corner cases” before accepting a model. Clearly, economists failed to consider a variety of corner cases, any one of which would have set off alarms about calamity. (A corner case is a situation in which an assumption takes an extreme value. For example, an economic corner case: credit stops flowing completely.)

OK, here is our addition to the post-mortem about economists: Economists need to learn that just because model building is very hard, it’s not a reason to avoid numerous, dirty details. Engineers build elegant, and sometimes ugly, theories. They strive to be elegant and as simple as feasible. They like to avoid complexity. But the engineering mission is to design and build stuff that works according to spec and costs no more than spec. Thus, they do whatever it takes to handle the details of reality.

We acknowledge up front that in the real world, engineers get real feedback, so they know how well their models work. But they also know how to use computers for some of the most beastly models. Just consider the modeling required to predict tomorrow’s weather (Al Gore pay attention). Major mainframe-level facilities are commonly used. Same thing for understanding airflow over a wing design, and how to connect 2 billion transistors to make a speedy CPU.

So, the message to the economics profession is: Life is tough, deal with it! Make models of really messy reality. Just because some social systems can be much more difficult to understand than various physical systems is not an excuse to choose simplicity when brute force of simulation of ugly factors would give better results.

In the fall of 2008, the political, economic, business and investing worlds as we knew them changed forever. It happened when Hank Paulson dramatically announced the emergent need for what became the Troubled Asset Relief Program (TARP),

We no longer can choose stock or bond investments based primarily on company, sector or even macro economy understandings. Those understandings are being seriously challenged by events. Every economic or business issue sustains major argument, and of course politics strides over reality, whether correctly perceived or not. The root of this excessive contentiousness is the catastrophic state of the banking system, which state drives more uncertainty than usual in the economic system.

Now, in self defense, we strive to understand the effects of pure fear permeating the market participants, regulators and politicians.

The fear, lack of basic understanding of what to do to “stabilize” the banking system, and ongoing political interventions and power grabs all combine to form a toxic stew. Our economy, businesses and markets now operate in a New World Order (NWO), politically driven, whose true nature is only dimly emerging. But those who see through the haze can profit from NWO and defend their futures from its likely depredations. We will try to enlighten the quest.

What Can we Dimly See?

In the movie “Master and Commander”, one of the early scenes shows glimpses of a feared battleship emerging from the mist, with the watchman on the good guys’ ship straining to discern the threat to warn his crewmates. The watchman isn’t sure but he’s very afraid. Finally, the Master looks through the telescope and instantly sees the rapidly emerging enemy ship. We are the watchman, but unfortunately we cannot claim to be the Master!

What we see are some really large facts:

• On the demand side, huge job losses and fear drive consumer demand lower, and fear-drives savings increases.
• Production and sales outlooks have naturally been reduced to levels more closely matched to perceived lower consumer demand.
• Government prints of trillions of dollars for a variety of “bailouts” and guarantees to save the banking system, even as the policy      within which government operates is not articulated.
• Political shock and awe lead to massive additional “stimulus” spending to increase government control of the economy through bureaucratic and regulatory action and through financial support to institutions, such as unions, that help the current regime keep power.

Likely Macro Results

The short term demand reduction is keeping prices down and helping to absorb the massive spending. Thus there are deflationary forces at work. However, the massive cash bolus into the banking system will eventually work its way out into the economy and start inflationary pressure, which usually results from too much money relative to the amount of goods out there. While inflation seems unlikely to spring forth soon, it probably will emerge in roughly two years.

How to Profit?

Here is a collection of securities chosen to profit from this NWO. The operating theme is that the NWO will be a deflationary economy transitioning to an inflationary one, with regulatory burdens increasing with unclear effectiveness on risk reduction.

The collection isn’t a portfolio since we wouldn’t own all of these securities. Rather, these instruments serve various purposes quite pertinent to our beliefs about the future. Also, we aim to test ideas.

We chose seven broad categories of instrument, and by no means do we claim these are all inclusive. Rather, they are particularly pertinent for aspects of the NWO that matter.

• Fixed Income Securities-Buy long
• Fixed Income Securities-buy bond proxies with ROI designed to respond short
• Equities – buy Long
• Equities – buy proxies for Short
• Long equities in sectors favored by OBAMA’s stimulus package (health care, clean energy, infrastructure)
• Inflation and currency hedges (gold and dollar/euro exchange rate)
• Jim Cramer’s “survival” portfolio (This designed by the CNBC entertainer and market maven as his idea of an equity portfolio that   gains even during a severe recession)

Given the list of 21 asset classes shown below for these categories (click on the thumbnail), we computed the annualized ROI and annualized standard deviation of daily ROI for each security. We also computed the cross-correlation among all the securities and show all these measurements in the matrix (click on the thumbnail for the matrix).  Naturally, based on these correlations we provide our Portfolio Diversification X-Ray (PDX) that tracks the amount of diversification in this particular combination.

Description of NWO Assets

Matrix of NWO Collection

We’ll focus on a few specific observations and leave the rest to you, dear reader.

This combination had a low value of PDX of 9% based on the measured 45 day period ending 3-13-09. So this is an undiversified combination, but that’s OK as long as it’s not your portfolio!

Notice that Cramer’s set of five stocks had very poor ROI and very high volatilities, and were also highly undiversified. The exception was AEM, the gold mining firm, which is very uncorrelated from his other four choices, and had a positive but highly volatile return.

On the other hand, RRPIX, RYJUX, TBT were all very big winners but also quite volatile. (Note: S&P500 index ^GSPC  ”normally” has volatility of about 20%, so we call anything over 30% high for any security). These ETFs are quite interesting for our approach to making money in the NWO and we’ll pay attention to them as we track this NWO combination going forward.

We then compute the ROI and standard deviation of ROI for weach of these securities, based on the trailing 45 business days ending 3-13-09. Of course we compute the PDX for the matrix as well as the ROI and STD of the whole set. You can see the matrix and the individual performace by clicking on this thumbnail.