(also posted at: http://watchingtheherd.blogspot.com/2008/09/portfolio-strate... )The number and size of the recent failures in the financial industry (from Bear Stearns, IndyMac, Fannie and Freddie and now, apparently, Lehman Brothers and Merrill Lynch) are causing millions of investors to review their investments and try to find a way to protect their assets from future turmoil and losses. A lot of the thinking likely began during the first credit freeze-up in August of 2007 but the worldwide nature of the problem requires rethinking many truisms of portfolio management that might have been useful in the past but may have limited value in the current situation.A Triangle Model of InvestmentsTraditional strategies for investing are based upon long-observed patterns of performance with assets in three key categories. Each category can exhibit movement (and hence, provide opportunity for making / losing money) independently of what happens in the others but they also frequently move in patterns related to each other which have encouraged certain strategies by investors based upon their goals (growth versus safety) and horizon (long term versus near term).Stocks -- Investments in stocks are based upon obtaining mid- to long-term gains in the price of the stocks based upon long term growth in a company's earnings or based upon speculation of short-term mistakes in other investors' current valuation of the company. The truism with stocks is that over a long term period (NOT just one or two business cycles), a well-diversified portfolio managed to proactively cull out losers will outperform virtually any other category of investment. Another truism is that stocks should be avoided by investors with capital preservation goals over a short time horizon, especially when economic growth slows or declines outright since slow/no growth cuts earnings and drives stock prices down.Bonds -- Investments in bonds produce profit directly for the bondholder by interest paid back to the bondholder by the issuer at maturity. Because the actual value of promises of future, fixed payments of principle and interest are DIRECTLY dependent upon changes in real (or imagined) interest rates, the price of bonds at any given moment not only reflect the credit worthiness of the borrower but reflect larger estimates of changes in interest rates over the life of the bonds. One key truism with bonds is that accurately rated bonds pose significantly less risk over short periods than stocks and are therefore a more suitable investment vehicle for investors with short term horizons whose tolerance for risk is lower than those investing with a 15-20 year horizon.Commodities -- Commodities act as the raw materials to higher level products and services and provide two avenues by which investors can profit. By their nature, many commodities such as wheat, rice, pork bellies, oil, natural gas, etc. can have regular, seasonal fluctuations in their supply, demand or both, requiring producers and consumers to constantly make bets on those numbers and their impact on their ability to fill next week's orders of widgets. This short term speculation is virtually required in a modern economy and has profit potential for those with nerves of steel. Because of commodities' perceived role as required inputs for an economy (albeit with some seasonal fluctuation), investors often use commodity investments as a hedge against currency concerns. The idea behind this is that no matter what a government may do to devalue its currency through monetary policy, a barrel of oil or a bushel of wheat is "worth" what we get out of a barrel of oil or bushel of wheat and therefore, in theory, if a currency declines in value by half, any commodity position denominated in that currency will double, protecting the investment. The key truism for commodities is that overall demand for commodities may fluctuate week to week or month to month but is predictable and steady over many months / years. In other words, demand for commodities is nearly independent of the long term performance of one or both of the other investment categories.Trade-offs In the TriangleMuch of the established wisdom of portfolio management for individuals and institutions revolves around correctly understanding why each of these corners of the triangle traditionally behaves the way it does and how problems with one corner affect the other two. For example,1) fears in the stock market will lead many short-term investors to shift funds to lower-yield but higher-safety bonds, raising prices in the bond market, lowering interest rates2) fears of weak economic growth or actual reductions in economic output often lead the Federal Reserve to lower interest rates to reduce the cost of borrowing to spur the economy, raising bond prices3) signs of stable earnings growth increase valuations on stocks, attracting more investors into stocks and lowering demand for bonds, reducing their price and causing borrowers who DO need to borrow money to pay higher interest rates to attract lenders4) volatility in credit markets combined with weak growth or losses in equities can trigger increases in commodities prices as investors assume steady demand for commodities will protect against currency declines resulting from inflationThe obvious assumption behind this financial triangle concept is that the primary source of uncertainty in the system is the inability of the players involved to correctly forecast performance of the system down to the nearest billion (mere rounding errors in a multi-trillion economy) in the immediate term. These short term errors cause the system to go through the normal undershoot / overshoot oscillations of the business cycle but they are systematically identified by properly functioning accounting and risk management systems and acted upon. The events since August 2007 prove this assumption is absolutely no longer holding true. Banks have been caught holding commercial paper rated AAA until the day they sold at 25 percent of face value. Banks not even on the FDIC watch list have capsized and disappeared under the water with little notice.The larger but more subtle problem with the triangle model is the assumption that at least one investment segment --- equities, bonds or commodities --- would retain a negative correlation to the others and provide a mechanism for hedging risk due to financial / monetary problems within an economy is likely untrue. The theory doesn't account for a global economy in which systemic failures in one economy produce systemic failures in other economies at the same time. Global trade requires currencies in different economies to become a commodity for other economies to facilitate trade OR requires many economies to consciously hold a subset of currencies as a de facto world currency for transactions. Regardless of which approach is chosen, either one immediately links the "triangles" at not only the commodity corner but the bond / credit corner as well. If a systemic problem is encountered in the bond / credit sector of one of the economies, it can immediately affect the bond / credit sector of other economies. That in turn violates the assumption of larger world markets for commodities remaining stable / predictable over the long term as economic growth in multiple economies slows due to "contagion" in the financial sector. The net result is that the interconnected financial markets create POSITIVE correlations between all three corners of a particular economy and can create POSITIVE correlations BETWEEN economies. This might be good when things are going well in the short term but poses tremendous concerns when trouble arises.Stated in the simplest terms, the triangle concept works as long as at least ONE corner of the triangle has a strong negative correlation to the performance of the other two corners. If the stocks and bonds corners are performing poorly, an investor can still shift money to commodities and ride that up as the other two corners go down until they stabilize. If larger problems crop up in all the triangles and reduce economic growth and demand for commodities, suddenly ALL THREE corners have a positive correlation to each other, leaving investors with no where to flee to protect their investments.The concern facing all investors now is that this is precisely the situation we face. Gross mismanagement and outright fraud in the American housing market and financial industry have propagated trillions of dollars worth of bad debt to banks throughout the world. Any economy in the global system that attempts to shun more of the bad paper at the root of the problem will trigger a collapse in its local credit markets which already carry vast amounts of that bad paper. Any such credit meltdown will likely shrink economic output, weakening its equities and reduce demand for commodities, further increasing the positive correlation in all of the economic triangles.So what's the best strategy for protecting one's portfolio? In a global economy linked by credit systems which have poisoned the fiat money of nearly all the players at the same time, it isn't clear there IS a winning strategy. The only way to win is to not play and that option doesn't exist.WTH
... The only way to win is to not play and that option doesn't exist. Unless you are a mutual fund, the option to stand aside does exist, at least temporarily. I traded the crash of 87 (not stocks or stock index futures) and what happened is that bonds soared (flight to safety) and commodities got crushed too - all of them, because of general panic and mostly forced margin call liquidation. Volatility was extremely high as you can imagine and none of the above, nor stock prices were permanent "trends." So, why get hurt in the crossfire? Don't want to sell at the "wrong" time, go market neutral - hedge.Good trading/investing,Russ
wth: "So what's the best strategy for protecting one's portfolio? In a global economy linked by credit systems which have poisoned the fiat money of nearly all the players at the same time, it isn't clear there IS a winning strategy. The only way to win is to not play and that option doesn't exist."As some of you know, I started shifting money into savings in August of 2007 because I no longer had a clue whether stocks, bonds or commodities were safe investments and I couldn't risk throwing it all away in the downdraft like I did in 2000. Now you are telling me NOBODY has a clue?
eryep!Now you are telling me NOBODY has a clue? KBM (not with any degree of certainty)
An excellent anaylsis, as usual.One important factor that you left out:Many of the large institutional investors are leveraged. Some of them are heavily leveraged. The "shadow banking system" involves trillions of dollars of borrowed money.As the price of assets (bonds, stocks, commodities) drop, leveraged players may get margin calls. They may be forced to sell good assets to cover bad. The shadow money evaporates.Less money = less bids on assets. This will cause the price of all leveraged assets to fall.What is the only asset that isn't leveraged? CASH.Real money, not borrowed money.That is why the majority of my holdings are in cash or cash equivalents (FDIC insured CDs), and in TIPS and I-Bonds.Wendy
wendy:They may be forced to sell good assets to cover bad.*************************************This is the essence of the deflation case, and also the reason the markets have seemed crazy, and will seem crazier. Really good stuff will go on sale as investors and especially institutions are FORCED (shrieking in agony) to cough up good assets to pay bad debts. The unknown is the interplay between this aspect of deflation and Helicopter Ben's flight plans, providing one half of the inflation case (other half being already massive U.S. indebtedness).david fb
What is the only asset that isn't leveraged? CASH.The U.S. has leveraged the dollar up quite a bit, though.
Less money = less bids on assets. This will cause the price of all leveraged assets to fall.What is the only asset that isn't leveraged? CASH.Real money, not borrowed money.That is why the majority of my holdings are in cash or cash equivalents (FDIC insured CDs), and in TIPS and I-Bonds.============================I'm currently at 38% in near-cash equivalents so I'm with you but here's my concern. Looking at one's portfolio in one's home currency overlooks how that currency is doing and will do in the future against other currencies. True, keeping stuff in cash instead of bonds (which can take if interest rates spike) or in equities (which can tank if earnings tank) can preserve capital as measured in dollars. But what if foreign Treasury holders get spooked by our financial health and demand higher interest rates to keep buying T-Bills? If the Fed floods the banks with cheap money (essentially "printing money"), the value of the dollar can decline, eating into your nest egg.I'm not knowledgeable enough about investing in foriegn currencies to make a big swing in that direction and I have as little faith in the soundness of financial reporting in foreign countries as I do with American countries so there aren't many easy, obvious, attractive alternatives.WTH
I don't think you need to do that WTH for exactly the reasons you state.....tho, my way may be just as obtuse.....If the Fed floods the banks with cheap money (essentially "printing money"), the value of the dollar can decline, eating into your nest egg.I'm not knowledgeable enough about investing in foreign currencies to make a big swing in that direction and I have as little faith in the soundness of financial reporting I prefer to hedge the currency risks by indirect investments in "dirt&grease" companies producing commodities, and direct investment in PM's [either the miners or the physical]. The goal for me being to hedge against my own currency via a commodity with a supply demand pattern that I both understand and is somewhat "predictable. Add to this approach a desire [big time] for high yield divi's distributions and you get a pretty good hedge without much risk especially when commodities are under stress like the rest of the markets currently.YOMMVThat's the way I do it. I'll not get into any specifics tho I do use CEF and GLD for direct physical metals hedges apart from direct ownership....for the rest [companies], anything I'd say would sound to much like a pump&dump scheme and that ain't me.Good trading...and don't be afraid to experiment a bit. Just keep it small scale.KBM (grease&dirt been verdy good to me)
As some of you know, I started shifting money into savings in August of 2007 because I no longer had a clue whether stocks, bonds or commodities were safe investments and I couldn't risk throwing it all away in the downdraft like I did in 2000. Now you are telling me NOBODY has a clue?Congratulations! You have won the exploding cigar!By savings do you mean a savings account at the corner bank? TIPS? MMF? GNMAs? or the bank of Sealy?
<If the Fed floods the banks with cheap money (essentially "printing money"), the value of the dollar can decline, eating into your nest egg.I'm not knowledgeable enough about investing in foriegn currencies to make a big swing in that direction and I have as little faith in the soundness of financial reporting in foreign countries as I do with American countries so there aren't many easy, obvious, attractive alternatives.>I agree with you completely. The doomsday scenario investment, as we have heard so many times, is gold. However, gold is just another commodity, with no yield and a high cost of converting into cash that can actually be spent.As you say, no easy answers.Wendy
I'm cash heavy. I just (painfully) moved about half my equities into more Vanguard GNMA fund. (It's not volitile, is gov't backed and pays 5.5%). I'm now about 13% equity, 6% Vanguard PM (OUCH), 10% Swiss franc, 30% cash/equivalents, 40% bonds (mostly GNMA, NY tax free, some short Treasury - sold long bonds and high yield corporate bonds today).I should have stuck to the plan and not even entered back into the market until October, but got bored around March (idle hands are the devil's workshop - now trying to sit on hands as much as possible).I figure that we have not seen the bottom of the stock market (and despite anopther drop that I have scheduled for OCtober, won't see the bottom until next March/April time frame.I intend to accumulate bargains as I see them in specific divdend aristocrat equities, rather tthn invest in the averages.If I can pick up stacks paying 5-6% yields at the bottom, I should be able to ride them up for quite a few years until we have to rinse and repeat again.Of course theirs always the chance that the FEDD will screw up to plan :-)Of course I could be wrong <G>Jeff
I should have stuck to the plan ... If I can pick up stacks paying 5-6% yields at the bottom, I should be able to ride them up for quite a few years until we have to rinse and repeat again.My plan, such as it is, is to keep a big chunk of my money in Vanguard's GNMA Admiral Shares (VFIJX) @ ~5.10% until Oct/Nov when I expect the stock market to stumble over its own untied shoelaces. At that point, with a click or a phone call, I can transfer it in an instant to my Vanguard Treasury Money Market Fund (VMPXX) account which funds my stock purchases through Vanguard. VMPXX pays a penurious compound yield of 1.66% so I don't want to make that transfer until the last minute.Failing that, I'm expecting the other shoe to fall in March/April '09 when the majority of Alt-A and Option ARMs are scheduled to reset.Though those events are generally expected by knowledgeable persons, I'm not basing my investment strategy solely on them. I'm buying in (averaging down) as the stock market slides down the slippery slope of hope that blinds it to the realities it has created for itself (and unfortunately for the rest of us too) with its irresponsible behavior. Using new investment money, I bought 266 shares of GE @ $24.93 this morning. That's a dividend yield of almost 5%!I plan to buy into the downward spiral (with "new" money) until the DJIA dips below 9000 or the S&P 500 is below 1000. I'll consider that a bottom and commit my Vanguard GNMA Admiral Fund (VFIJX) Shares then.
My strategy for the down draft has been simplicity itself, at least in my 401K, which is about 1/2 of my liquid assets and where my options are fairly limited -- I am 100% in a cash-like instrument that Fidelity offers, a "fixed principal annuity" that pays about 4%, since May 2007, except that I briefly went to mostly small cap funds from March to May 2008. So today I watched the carnage with interest as my account gained some insignificant percentage, though ytd it is up 11%. Admittedly this only beats inflation a little, but it has beaten the hell out of the S&P.I basically have two pools of investment funds. In one I am extremely risk averse. In the other I take a lot of risk and concentrate my bets into a few sectors or areas, that is, I really diversify - I buy both gold AND silver (bada boom! <ggg>). I won't go into the details of my trading activity (again) except to say that I follow macro trends (that stuff we used to talk about on here a lot), trying to buy when nobody wants stuff and selling or shorting when people start saying things like "oil is going to $200!!!." This board and guys like Mish and Sitka and Suissebear and Plunger and Rien and too many others to name have really helped me figure a lot of this stuff out and become fairly successful in trading macro trends. But unfortunately, where the conversation was once led by these mavericks and contrarians, I hate to say that it, but now there is this incessant drone of herd followers, whose opinions mostly just add to the confusion if you don't know to tune them out. (Wow, did I digress or what??? <gg>)...anyway, I just finished entering PMs last week and I'm also 30% SKF and QID in my trading accounts, so I had an ok day today, considering - just barely green. YTD still very green.
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