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MODERN PORTFOLIO THEORY IS HARMING YOUR PORTFOLIO

SmartStops comment:  an excellent article that every investor should read as MPT continues to be deeply entrenched in our systems.  Its shortcomings are proven.  The article concludes with:

The advice that most investment advisors give their clients – At its core, the message is usually something similar to this: “The markets are random and unpredictable, so the best way to invest is to properly diversify and wait for the averages to play out.”

However, what most investors seem to be unaware of is that this whole theory of random movement of market prices was proven false over 50 years ago by one of the most influential mathematicians of the 20th century, Benoit Mandelbrot. The random motion of market prices was a very nice theory, but it just doesn’t match what actually happens in the real world.

Some excerpts from JJ Abodeely, CFA’s article :   Modern Portfolio Theory Is Harming Your Portfolio

              1. MPT and the quantification of investing has further (mis)informed the debate by seeking a easy way to label and quantify “risk.” In 1952, Harry Markowitz chose variance or volatility of prices or returns to define risk. He did so because it was mathematically elegant and computationally simple. However, this idea has serious limitations (most of which Markowitz has since acknowledged).

              On the individual stock level, Vincent notes

Risk is often in the eye of the beholder. While “quants” (who rely heavily on MPT) might view a stock that has fallen in value by   50 percent over a short period of time as quite risky (i.e. it has a high beta), others might view the investment as extremely safe,   offering an almost guaranteed return. Perhaps the stock trades well below the cash on its books and the company is likely to         generate cash going forward. This latter group of investors might even view volatility as a positive; not something that they need to be paid more to accept. On the other hand, a stock that has climbed slowly and steadily for years and accordingly has a       relatively low beta might sell at an astronomical multiple to revenue or earnings. A risk-averse, beta-focused investor is happy to add the stock to his diversified portfolio, while demanding relatively small expected upside, because of the stock’s consistent track record and low volatility. But a fundamentally-inclined investor might consider the stock a high risk investment, even in a diversified portfolio, due to its valuation. There’s a tradeoff between risk and return, but volatility and return shouldn’t necessarily have this same relationship.

2.  After all, if you buy and hold the market you can earn the long-term returns right? Unfortunately, the answer to that is no. The long-term “average” returns are rarely available. In fact, depending on where you are standing, the returns are either much higher, or much lower. Consider this chart from Crestmont Research which shows that even for periods as long as 10 years, average rarely occurs:

10_yr_Rolling_Stock_Market_Return

3. Consider this chart which you’ve probably seen in one form or another. It shows expected risk and return of various mixes of asset classes and the typical approach to asset allocation which Modern Portfolio Theory has spawned:

Sample_Asset_Allocation_Risk_Expected_Returns

So what’s wrong with this picture? Lots of things.

The first is the inputs– namely expected returns and volatilities of various asset classes– most investment programs are built on logic like this:

  • Bonds will return 5% on average over the long-term but be between 0-10% in any given year
  • Stocks will return 10% on average over the long-term but be between -10% and +20% in any given year
  • Some might include other nuance regarding different types of bonds like High Yield or different types of stocks like Emerging Markets
  • Some might include different types of assets like real estate, commodities, or “alternatives”

The problem of course is this is an incomplete description of investment returns:

  • The math contends that returns are randomly and unpredictably distributed around the average
  • This “normal distribution” of returns contends that larger market movements outside of the ranges above will be relatively rare
  • “Average” returns ignore the role of valuation and the importance of when you start investing (buy) and when you finish (sell) even over multi-decade time horizons

The traditional approach to asset allocation is built on false axioms. The phenomenal secular bull market in stocks and bonds from 1982-1999 created the perfect conditions for the nearly religious acceptance of MPT. In a recent post, Expensive Markets Mean Low (or Negative) Prospective Returns, I made the case that valuation matters greatly and currently portend disappointing returns for both stocks and bonds. Traditional asset allocation has no way of dealing with this in a way that successfully protects portfolios from experiencing meaningful and unnecessary drawdowns.

Read JJ Abodeely, CFA’s article :   Modern Portfolio Theory Is Harming Your Portfolio in its entirety.

European Default Inevitable — Sell Your Gold?

By Christopher Georgopoulos

 What if, hypothetically, fear of a Greek default cannot be contained? What will be the aftermath to the markets? To gold?

 In the prequel to this article (European Default Inevitable — Sell Your Gold?), I discussed the fact that safe-haven-seeking investors could be in for a surprise when they run to buy gold after a Greek default and find huge sellers in the form of European sovereign nations. That article focused on events that would occur if a Greek default could be contained and the contagion that’s brought so much fear to the global system could be defeated. But what if, hypothetically, that fear cannot be contained? How will it happen, and what will be the aftermath to the markets? To gold?

The first signs of a detrimental contagion will be surprise losses, initially centered within the European banks and financial institutions. Articles such as, “European Stress Tests Underestimated Greek Exposure” will catch front-page attention. Quickly after, multiple small banks will become insolvent and the names of those banks — which many Americans have never heard of — will become as well-known as Citibank (C). Those defaults will spread to the larger European institutions that many of us know, and emergency midnight conferences will be highlighted on CNBC wherein the global financial community will be assured that all is sound. Sooner than later, a major default of one of these institutions will be revealed, and the bomb will be detonated.

This is when a 2008-type Lehman event reemerges, but this time on steroids. The fear driven from individual financial institutions will quickly morph into a fear for the nations of Europe. This fear will be derived from the recent questions concerning the lack of growth to combat their immense debt-to-revenues ratios. Anyone holding the bonds of these debt-ridden countries (i.e. Ireland, Portugal, Spain, and Italy) will panic and sell, driving their yields even higher and their credit-worthiness even lower. Those countries will find that trying to fund their needs through bond markets has become even harder and more expensive, and their risk of default will skyrocket. Deep recessions will set in as they will impose even deeper austerity plans, and unemployment — already high — will grow. Because these country’s economies are co-dependent upon each other as trading partners and consumers, even the more financially stable countries will be adversely affected. The viability of the entire Union will be questioned, their currency devalued, and talk of secession will be popular. Even worse, the spread of these losses will not be restricted by their coastal boundaries. Many American and global banks still have exposure to their European counterparts as well as money market and mutual funds. New losses, which could include massive losses on European credit default swaps, must be accounted for, which could cause a new round of credit freezes. Just like a repeat of the 2008 financial crisis, the foundation of the rapidly spreading fear will be a lack of confidence. Although this time around the solution won’t be as easy: Who will have the money to back-stop the back-stoppers?

If this were the scenario, the panic that the markets around the world would experience would be historic. The first wave of heavy selling (besides the aforementioned European bonds and stocks) would be centered in your most risky investments — the high-yielding and high-return emerging markets. Equities of the most stable markets would quickly follow. Money would flow from there to the “safest” of investments, such as US treasuries, US currency, and gold. As mentioned in my previous article, the price of gold would initially fall as Germany and the ECB try to contain the Greek default, but if the world’s confidence erodes and the defaults spread, the gold markets would once again be one of the few safe alternatives and could offer substantial upside.

The coming volatility of the markets could be unprecedented and swift. My firm has highlighted that the risks of serious market deprecation are likely with its SmartStops Risk Barometer Indicator.

SmartStops Risk Barometer Indicator (SRBI)

You need to monitor the SPDR gold Trust (GLD), SPDR S&P 500 (SPY), Rydex Currency Shares Euro Trust (FXE) and the Vanguard MSCI Europe ETF (VGK).

Know when to Hold ‘em, Know when to Fold ‘em

SmartStops comment:   Its why this service was brought to fruition.  Follow SmartStops and you can be protected before you lose it all. 

Unprecedented Monthly Volume Sell-Off Suggests Now’s the Time to Take Shelter – published at Minyanville by Kevin A. Tuttle

Do not concern yourself if the market goes up today, tomorrow, or a month from now. The risk of entering is not worth the reward.

Over the weekend I had the pleasure of speaking with a very prominent European money manager – overseeing hundreds of billions – about the “across-the-pond” financial crisis unwind and looming hazard of a potential domino-effect coming to fruition. Without rehashing the entire conversation, the consensus is not “if,” it’s “when” will the developing pressure finally blow. He actually went so far as to say it could truly begin unraveling within the next few weeks considering the catalysts currently in play.

The intent of providing the conversation synopsis is not for sake of fear, but understanding the potential ramifications. About three years ago, in one of my firm’s quarterly reports, we opined on a unique situation in regard to the GDP measurements of Global Nations. It stated the unprecedented growth statistics from the 56 nations tracked. “History is currently being made in the sense that all the globally tracked economic growth nations (56), every one… 100%…, are showing expansion.” This lead to my next comment… “If the economic cycle pendulum swings in both directions what would happen if the inverse occurred?” Are 2011/2012 the years we are about to find out? Maybe that’s somewhat extreme, but yet… is it possible?

We at my firm do not pretend to be intelligent enough to figure out all the nuances, catalysts, causes and reasons why the markets could fall apart; we’ll leave it to the team of economists and officials to attempt to sort that out. What we do instead is try to determine when the storm is coming and how to take shelter, which brings me to my point: Now is the time. Take shelter! Do not concern yourself if the market goes up today, tomorrow or a month from now. Clarity is key! Would you sail your boat into rocky waters with a potential hurricane looming because of your love of sailing? Is the risk worth the reward? For some, maybe; but for most, probably not.

S&P 500 Index

Since the “2011 Channel of Indecision” broke on August 4, the seas have picked up dramatically and have begun swallowing ships. The markets have never seen this type of monthly volume sell-off – 47% above average (unprecedented), as seen in the monthly chart above. As Kenny Rogers put it so eloquently… “Know when to hold em’ and know when to fold em’, know when to walk away, know when to run!”

Bill Gross: Prepare for ‘disharmony’

By Bill Gross – Originally published at Investment News:  The following is the commentary of Bill Gross, managing director and co-CIO at Pimco, for the month of September. For a complete archive of his commentaries, click here.

“Just an old-fashioned love song, comin’ down in three-part harmony.” –Three Dog Night

In many ways the global economic crisis is like a marriage gone bad. As the Three Dog Night sang years ago, global economies have functioned harmoniously for many years, but suddenly the love songs have become strident and cacophonous, the policy coordination morphing into a war of the roses as opposed to a giving of them. Instead of three-part harmony we are now experiencing, at a minimum, tri-party disharmony, teetering on the brink of “divorce,” which in economic parlance means a possible “developed economy” recession – a downturn from which reconciliation may be difficult due to a lack of policy options and cooperation. But I get ahead of myself. Let’s first ring the wedding bells, then take you through an explanation of three separate global marriages and how each of the partners have grown apart.

Europe Unites!

Oh those feisty Europeans! Always fighting like a dating couple and then finally resolving their differences by saying “I do” sometime in the 1950s with the creation of the Common Market and the European Economic Community (EEC). In doing so, France and Germany said “never again,” and even though they didn’t like each other (read “hate”) they decided to make economic lurv in the hopes that they wouldn’t destroy the continent again. It later turned into a formal union, a European Community (EC), where they invited lots of witnesses to the ceremony and created instant family members, if that’s metaphorically possible. Twenty-seven of them, including Italy, Spain and the U.K. were now relatives despite some liking pasta and others preferring horrid cuisines featuring Shepherd’s Pie or fish and chips. The marriage progressed to the point of a smaller monetary union sometime in 1999, but critically, without a common budget. Husband and Wife – Germany and Greece – decided to have a joint bank account, but with separate allowances and no oversight. Greece could issue bonds at nearly the same yield as could its Northern hard-working neighbors, but were free to spend it any way they chose. This was an economic version of an open marriage where one party gets to have all the fun and the other worked nine-to-five and came home too exhausted for whoopee. Well sometime last year, global lenders said enough is enough and soon the whole cheating European Union (EU) was at each other’s throats, hiring lawyers and threatening to break up. Calmer heads prevailed when the ECB decided to make nice and use its checkbook. Last week Angela Merkel and France’s Sarkozy sort of got engaged for at least the second time, nixing expanded funding for their Southern neighbors and placing the burden even more on the ECB. Who knows where it goes now, but let’s put it this way – Germany and France are sleeping in a king-size bed while the rest of its EU family are sleeping in separate bedrooms. As a result Euroland faces economic contraction.

California Dreamin’

This impending divorce in America is not about sex or sleeping around, but more about romancing the now stone-cold notion that anyone could be a millionaire in the good old U.S. of A. if only they worked hard enough. Our Statue of Liberty proclaimed “give us your tired, your poor…” and sent many of them West to build a little house on the prairie or strike it rich in the goldfields of Sacramento, California or Skagway, Alaska. Many of them did and a century later, the option-laden fields of Silicon Valley provided modern-day examples of rags to riches fairytales come true. But this odd couple marriage of rich (and poor hoping to be rich), now seems on rather shaky ground. Instead of boundless opportunity, the nursery rhyme describing Jack Sprat – who could eat no fat – and his wife – who could eat no lean – appears to be the starker of the two realities. There are the poor and there are the very rich, with the shrinking middle class resembling Mr. Sprat rather than his wife.

During this country’s recent economic “recovery,” real corporate profits increased by four times the amount of working wages in dollar terms, and, as the chart below shows, are 50% higher than at the turn of the century while wages remain relatively unchanged, something that has not occurred since this country’s nuptials were concluded over three centuries ago. Is it any wonder that preliminary battlefield skirmishes in Wisconsin and Ohio between labor and capital promise to spread across every state of this land? (Not Texas!) Is it any wonder that Republican orthodoxies favoring tax cuts for the rich and Democratic orthodoxies promoting entitlements for the poor threaten to hamstring any constructive efforts to reduce unemployment over the foreseeable future? We are witnessing romantic love turning into a spiteful, bitter clash between partners in name only.

Alimony Anyone?

The Asian Miracle

Confucius say, “Can there be a love which does not make demands on its object?” While not a marriage, there has definitely been a love affair between Western consumers and their Chinese producer “objects” for several decades now. Read More…

Swiss Franc Remains the Safest Currency as Long as Europe’s Debt Problems Continue

by Rani Chopra, SmartStops.net contributor

The market has experienced unprecedented volatility and investors are getting more risk averse than ever before with equity fund outflows exceeding $61 billion since the start of May. The CBOE Market Volatility Index, (VIX) considered to be the markets fear indicator, continued to fall yesterday and is now down 12%.
Investors did not care whether they were invested in stocks, bonds, mutual funds or ETFs. Fear and uncertainty caused outflows across the board and gold became a safe haven, with gold prices rising over 24%.
In the midst of all the market turmoil, with the downgrade of the US debt and the continual downtrend of the US dollar, investors have turned to the Swiss Franc as a safe haven. The Swiss Franc is up more than 37% against the dollar compared to a year ago and has managed to rise against all major currencies amidst the fiscal problems of the Eurozone. The currency is also up 20% against the Euro from the start of the year.
Read the rest at: http://seekingalpha.com/article/287876-swiss-franc-remains-the-safest-currency-as-long-as-europe-s-debt-problems-continue

SmartStops.net Introduces New Market Risk Barometer Indicator

 

PALO ALTO, Calif., Aug. 5, 2011 (SEND2PRESS NEWSWIRE) — SmartStops (www.SmartStops.net) announced today the launch of the SmartStops Risk Barometer Index™ or SRBI™. The SRBI is an easy to use metric that helps investors quickly gauge the relative level and direction of risk posed by a specific group of equities such as a particular market or sector.

Derived from the SmartStops individual equity short term risk signal which identifies equities as being in a normal or above normal risk state on any given day, the SRBI compares the current risk state ratio for a group of equities to the group’s 100 average. Unlike the VIX which uses volatility as a proxy for risk and rises when equities experience big moves in either a positive or negative direction, the SRBI leverages the SmartStop Above Normal Risk State which focuses only on abnormal price movements to the down side.

An SRBI greater than 1 indicates that the number of equities in the group experiencing above normal risk is higher than the average over the last 100 trading days.

An SRBI below 1 indicates that the number of equities in the group experiencing above normal risk is lower than the average over the last 100 trading days.

The SRBI can be used in conjunction with traditional market risk indicators such as the VIX to help investors gain visibility and better manage their risk exposure.

“Investors make purchase decisions based on risk/reward analysis. Unfortunately, risk does not remain constant through time,” explains Chris Conway, SmartStops’ Director of Product Management. “The SRBI can help investors quickly gauge a market or sector’s risk profile relative to its recent history, allowing for more informed and timely decisions. We expect the SRBI to be particularly helpful in strategies employing sector or market rotation.”

Financial Advisor Akber Zaidi welcomes this new risk metric. “Managing risk is fundamental to successful investing. I am always on the lookout for innovative and effective ways to quantify and track risk exposure and I look forward to adding the SmartStops Risk Barometer Index to my risk management toolbox.”

Currently SmartStops is publishing SRBI numbers for the S&P 500 and the Dow 30 as well as for ten market sectors including Basic Materials, Consumer Goods, Consumer Services, Energy, Financials, Healthcare, Industrials, Technology, Telecommunications and Utilities.

To learn more about the SRBI and to view today’s SRBI values, visit http://www.SmartStops.net/PublicPages/MarketRiskBarometer.aspx .

SRBI from SmartStops for SPY , August 04, 2011

About SmartStops:
SmartStops.net is dedicated to helping investors of all levels be more aware of changes in their risk exposure enabling timely decisions that protect assets, improve returns and provide peace of mind. SmartStops’ portfolio monitoring and risk alert services start at just $9.95 per month. For more information visit us at http://SmartStops.net or contact us at info@SmartStops.net.

NEWS SOURCE: SmartStops
This story was issued by Send2Press® Newswire on behalf of the news source and is Copyright © 2011 Neotrope® News Network – all rights reserved.

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