Sell in May and Go Away?? This Week’s Must Read Article #3

family:arial;font-size:85%;" >size:100%;">From Prieur du Plessis of Investment Postcards from Capetown, he studies the popular axiom ‘Sell in May and Go Away”. The mixed results below:

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family:arial;font-size:85%;" >Where is the stock market heading? Has the rally that started in early March been exhausted? These are the key questions on all investors’ minds as financial markets remain caught between the frantic actions of central banks to get the cogs of the credit system and economy turning again on the one hand, and a still shaky economic and corporate outlook on the other.

family:arial;font-size:85%;" >It is therefore no wonder that even so-called “pop analysis”, including some legendary axioms, is resorted to in a quest for direction. And besides “buy low and sell high” few other axioms are more widely propagated than “sell in May and go away”. A Google search revealed an astounding 127,000 items featuring this phrase.

family:arial;font-size:85%;" >As equities have seen a particularly strong six-week rally, followed by what looks like the start of a consolidation/retracement of some of the recent gains, investors are justifiably questioning the market’s next move. And they nervously wonder whether this May will not only herald longer days in the Northern Hemisphere, but also live up to its reputation as the advent of a corrective phase in the markets.

family:arial;font-size:85%;" >The important issue, however, is whether this axiom actually has any scientific basis at all. Analyzing historical returns, the figures vary from market to market, but long-term statistics seem to show that the best time to be invested in equities is the six months from early November through to the end of April of the next year (”good” periods), while the “bad” periods normally occur over the six months from May to October.

family:arial;font-size:85%;" >A study of the MSCI World Index, a commonly used benchmark for global equity markets, reveals that since 1969 “good” periods returned +6.5% per annum while investors were actually in the red by -1.0% per annum during the “bad” periods.

family:arial;font-size:85%;" >“Sell in May and go away” also holds true for the US stock markets. An updated study by Plexus Asset Management of the S&P 500 Index shows that the returns of the “good” six-month periods from January 1950 to March 2009 were 7.9% per annum whereas those of the “bad” periods were 2.5% per annum.

family:arial;font-size:85%;" >A study of the pattern in monthly returns reveals that the “bad” periods of the S&P 500 Index are quite distinct, with five of the six months from May to October having lower average monthly returns than the six months of the good periods. Interestingly, May – the first month of the bad patch – is the only exception.


family:arial;font-size:85%;" >Historical average returns from May to October in emerging markets also tended to be weaker than those from November to April, as shown in the graph below (hat tip: US Global Funds).


family:arial;font-size:85%;" >But what exactly does this mean for the investor who contemplates timing the market by selling in May and reinvesting in November? Further analysis shows that had one kept the investment in the S&P 500 Index only during the “good” six-month periods, and reinvested the proceeds in the money market during the “bad” six-month periods, the total return would have been 10.5% per annum.

family:arial;font-size:85%;" >These calculations do not take tax into account. And, of course, every time one switches out of and back into the stock market there are costs involved, which would also reduce the returns for the market timer.

family:arial;font-size:85%;" >How did the good and bad periods stack up during the past two years? The results are as follows.

family:arial;font-size:85%;" >• May 2007 – October 2007: +4.52%
• November 2007 – April 2008: -9.62%
• May 2008 – October 2008: -30.1%
• November 2008 – April 2009: -5.1%

family:arial;font-size:85%;" >Some you win, some you don’t! It seems that the axiom “sell in May and go away” in itself is a rather doubtful basis for timing equity investments. However, it may serve a useful purpose as input, together with other factors, to otherwise rational decision making.

More on this topic (What's this?) Read more on Sell at Wikinvest

Must Read Article for This Week #2 – Hussman

I am a regular reader of John Hussman’s Weekly Market Comment. Below are excerpt’s from this weeks letter (emphasis mine):

That’s not to say that stocks have to decline here, but having failed so far to recruit much in the way of strong volume sponsorship, there is not much speculative merit to market risk, and only a modest amount of investment merit on the basis of valuations. Even if profit margins sustainably recover to above-average levels in the years ahead, stocks are priced to deliver probable total returns of about 10% annually over the coming decade. The idea that stocks are “once in a lifetime bargains” ignores the fact that this bear market began at strenuously overvalued levels on record profit margins – conditions that are not likely to return naturally in a deleveraging economy. Investors are taking the depth of the decline as a measure of the probable subsequent gain, but historically, the market doesn’t work that way. There is little relation between the depth of a bear market and the strength of the subsequent bull.

...In order for U.S. financial institutions to earn their way out of the losses, they will have to accrue and retain an amount on the order of 25% to 35% of GDP. From where will they reallocate that amount? Well, prior to the recent earnings downturn, corporate profits were running at about 8% of GDP, a figure that was already based on unusually high profit margins (the sustainable norm is less than 6%). The personal savings rate was about zero, but has increased to about 4% as consumers have scaled back consumption. If banks were able to sustainably charge high interest rates on loans and pay low interest rates on deposits, the earnings of the banks would come at a cost to what would otherwise have been retained: corporate earnings and private savings. Essentially, savers will earn less, and corporate borrowers will pay more. To accrue 25-35% of GDP to cover the debt losses (which is a mainstream estimate, not a worst-case by any means), you would have to persistently depress non-financial corporate profits and personal savings by about 25% for well over a decade.

So yes, we can indeed abuse the U.S. public in order to make the bondholders of U.S. financial institutions whole and protect them from any losses. This was the policy of the Bush Administration, and has tragically become the policy of the Obama Administration as well. By doing so, we will commit our future production to foreign hands, or we will commit about a quarter of U.S. non-financial profits and personal savings to these bondholders for at least the next decade….

What we cannot do is create all of this out of thin air. Understand that the money that the government is throwing around represents a transfer of wealth from an unwitting public to the bondholders of mismanaged financial corporations, even while foreclosures continue. Even if the Fed buys up the Treasuries being issued, and thereby “monetizes” the debt, that increase in government liabilities will mean a long-term erosion in the purchasing power of people on relatively fixed incomes.

To a large extent, the funds to defend these bondholders will come by allowing U.S. businesses and our future production to be controlled by foreigners. You’ll watch the analysts on the financial news channels celebrate the acquisition of U.S. businesses by foreign buyers as if it represents something good. It’s frustrating, but we are wasting trillions of dollars that could bring enormous relief of suffering, knowledge, productivity, and innovation in order to defend bondholders of mismanaged financials, and nobody cares because hey, at least the stock market is rallying. If one thing is clear from the last decade, it is that investors have no concern about the ultimate cost of the wreckage as long as they can get a rally going over the short run.

For my part, I remain convinced that without serious efforts at foreclosure abatement (ideally via property appreciation rights), mortgage losses will begin to creep higher later this year, surging in mid-2010, remaining high through 2011, and peaking in early 2012. To believe that we are through with this crisis or the associated losses is to completely ignore the overhang of mortgage resets that still remain from the final years of the housing bubble.

Must Read Article for This Week #1 – Paul Merriman

I have run across some great articles in recent days and still have a few on my to-read list. Below is the first article I would recommend reading this week:

The first article
if actually an updated version of an older article by Paul Merriman of Merriman summarizes the article by saying “The Ultimate Buy-and-Hold Strategy uses no-load mutual funds to create a sophisticated asset allocation model with worldwide equity diversification by adding value stocks, small company stocks and real estate funds to a traditional large-cap growth stock portfolio.” This may not be anything new to experienced investors, but it is worth revisting.

I have 4 issues with Merriman’s article. First, while his company and he practices quite a bit of market timing basaed on long term moving average strategies, he does not discuss this in the article. I think this could even further increase the risk-adjusted returns of his portfolio. Second, commodities are not included in the portfolio and recent research has shown the diversification benefit of including commodities in a portfolio. Third, the bond portion of the portfolio is sparce on details – I think further diversification could be gained if the bond portion was further categorized (long term treasuries, TIPS, 10 year treasuries, corporate bonds, etc.) Finally, he only discusses using the strategy with mutual funds and not ETFs. I think ETFs, especially if the portfolio was combined with a moving average strategy, could serve as a viable alternative to holding mutual funds (although for those with 401ks, mutual funds may be the only option). Having said all of this, this is an article worth reading, especially for new investors. For more information on ‘market timing’, I would *highly* suggest readers follow up this article by reading an article by Merriman and Mebane Faber on different timing strategies, which one could combine with this portfolio.

[as an aside, here is a good audio mp3 clip of Paul Merriman discussing market timing vs. buy and hold]

The article in full:

The Ultimate Buy-and-Hold Strategy – 2009 Update

In this update to one of the most important items in our article library, Paul Merriman shows how a series of simple but powerful concepts can benefit patient, thoughtful investors. This 2009 revision updates all reported returns to include the year 2008.

If you are a serious investor, this article could be one of the most important things you’ll ever read. I’m going to show you the strategy that’s behind the way we manage the majority of the money we invest for clients.

This strategy is best understood with a brief history lesson. When I founded the company that’s now Merriman in 1983 (it was then Paul A. Merriman & Associates), millions of investors had just suffered large market losses over a period of almost 20 years. In fact, from 1966 through 1982, the Standard & Poor’s 500 Index had produced negative returns after accounting for inflation.

We initially offered only strategies that used market timing systems to actively manage risk. The systems were designed to give investors a chance to participate in the equity market without the high risks of buying and holding through thick and thin.

In 1992, as we began helping clients with more and more of their money, it became increasingly clear that much of that money was invested without timing. We sought – and found – a buy-and-hold strategy that we believed would be worth recommending.

After all these years, we like this strategy so much that we call it the Ultimate Buy-and-Hold Strategy, as the title of this article indicates.

We don’t use that word “ultimate” casually. I don’t claim this is the best investment strategy in the world – but it’s the best I have found. I believe almost every long-term investor can use it to advantage.

As we shall see, compared with the U.S. stock market as measured by the Standard & Poor’s 500 Index, the Ultimate Buy-and-Hold Strategy has historically increased returns and reduced risk.

However good it is, this strategy is not a cure-all for the inevitable challenges of investing money. This strategy is built on massive diversification. Almost always, at least some part of it performs relatively well. But in 2008, a year most investors would rather forget, it was nearly impossible to escape losses in the equity markets. I believe those losses, which continue as I write this update, will prove in the long run to be temporary. And when the market turns upward once again, I believe this strategy will help investors take advantage of that recovery.

The strategy I’m going to describe is suitable for do-it-yourself investors as well as those who use professional investment advisors. It works in small portfolios (although not tiny ones) as well as large portfolios. It’s easy to understand and easy to apply using low-cost no-load mutual funds.

You should know that we did not invent this strategy. It has evolved from the work of many people over a long period, including some winners and nominees for the Nobel Prize in economics.


In theory, a perfect investment strategy would be cheap, easy and risk-free. It would make you fabulously rich in about a week. Tax-free, of course. We haven’t found that combination, and we don’t expect to find it. But in the real world, this is the best substitute we know.

Over the long run, the Ultimate Buy-and-Hold Strategy has produced higher returns than the investments that many people hold. It did so at lower risk, with minimal transaction costs. It’s mechanical, so it doesn’t require you to pore over newsletters, pick stocks, find a guru or understand the economy.


Even though this strategy is based on academic research, it’s really fairly simple. If I had to reduce it to just one sentence, here’s what I would say: The Ultimate Buy-and-Hold Strategy uses no-load mutual funds to create a sophisticated asset allocation model with worldwide equity diversification by adding value stocks, small company stocks and real estate funds to a traditional large-cap growth stock portfolio.

If you think you already know what that means and you’re tempted to skip the rest of this article, I hope you’ll resist that temptation. I have some compelling evidence to show you. If you apply this diligently, doing so could make a big difference in your future and your family’s future.

If there is a “catch” to this strategy, it’s availability. You cannot buy it in a single mutual fund. You can put together most of it using Vanguard’s low-cost index funds; but Vanguard doesn’t offer every piece of it. If you use more than one fund family and include ETFs, you can get each individual piece; but in order to do that you may have to open more than a single account and you might have to pay more in expenses than I would regard as ideal.

In my view, the ultimate way to implement this ultimate strategy is to hire a professional money manager who has access to the institutional asset-class funds offered by Dimensional Fund Advisors. (More on that later.)


The Ultimate Buy-and-Hold Strategy is based on more than 50 years of research into a deceptively simple question: What really makes a difference to investment results?

Some of the answers may surprise you. The people behind this research include Harry Markowitz, a 1990 Nobel laureate; Rex A. Sinquefield, who started the first index fund; and Eugene F. Fama, Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago graduate school of business.

Their expertise is pooled in a company that Sinquefield started in 1981 in order to give institutional investors a practical way to take advantage of their research. Today, that company, Dimensional Fund Advisors, manages more than $100 billion of investments for pension funds, large corporations and a family of terrific mutual funds that are available to the public through a select group of investment advisors.


Before we get into the meat of this strategy, there are a few things you should know. Every investment and every investment strategy involves risks, both short-term and long-term. That means investors can always lose money. The Ultimate Buy-and-Hold Strategy is not suitable for every investment need. It won’t necessarily do well in every week, every month, quarter or year. As 2008 pointed out dramatically, there will be times when it loses money. You have been warned.

Like most worthwhile ways to invest, this strategy requires investors to make a commitment. If you are the sort of investor who dabbles in a strategy to check it out for a quarter or two, don’t even bother with this. You will be disappointed, and you’ll be relying entirely on luck for such short-term results.

I am often asked how this strategy did last year or how it’s doing so far this year. Some people tell me they think investors should be in some particular asset over the next few months or the next year. Almost always, this is the result of something they have read or heard without checking it out thoroughly on their own. These people aren’t likely to succeed with this ultimate strategy because they are focused on the short term.

The Ultimate Buy-and-Hold Strategy is not based on anything that happened last year or last quarter. It’s not based on anything that is expected to happen next quarter or next year. It makes absolutely no attempt to identify what investments will be “hot” in the near future. If that’s what you want, you should look elsewhere, because you won’t find it here.

This strategy is designed to produce very-long-term results without requiring much maintenance once the pieces are in place. If that is what you want, I hope you’ll keep reading.


The most important building block of this strategy is your choice of assets. Many investors think success lies in buying and selling at exactly the right times, in finding the right gurus or managers, the right stocks or mutual funds. In short, they believe in being at the right place at the right time. Those are elements of luck, and they can work against you just as much as they can work for you.

Here’s the truth: Your choice of asset classes has far more impact on your results than any other investment decision you will make. I know this flies in the face of a lot of conventional wisdom and almost all the marketing hype on Wall Street, so I want to repeat it. Your choice of the right assets is far more important than exactly when you buy or sell those assets. And it’s much more important than finding the very “best” stocks, bonds or mutual funds.

Dimensional Fund Advisors studied the returns of 44 institutional pension funds with about $450 billion in assets over various time periods averaging nine years. The study concluded that more than 96 percent of the variation in returns could be attributed to the kinds of assets in the portfolios. Most of the remaining 4 percent was attributable to stock picking and the timing of purchases and sales.


So how do you choose the right asset classes? I’ll show you how, illustrating the process with a series of pie charts. We’ll start with Portfolio 1, a very basic investment mix. Assume the whole pie represents all the money you have invested. This version of the pie has only two slices, one for bonds (labeled the Lehman Govt. Credit Index) and one for equities (labeled the Standard & Poor’s 500 Index).

(The returns cited throughout this article are not those of our managed strategy and do not reflect any potential transaction costs, fees or expenses that investors must inevitably pay. These figures represent the returns of asset classes, not specific investments.)

Portfolio 1’s 60/40 split between equities and bonds is the way that pension funds, insurance companies and other large institutional investors have traditionally allocated their assets. The equities provide long-term growth while the bonds provide stability and income.

Let me say up front that we don’t believe 60 percent equity and 40 percent fixed-income is the right balance for all investors. Many young investors don’t need any bonds in their portfolios. And many older folks may want 70 percent or more of their portfolios in bonds. However, the 60/40 ratio of Portfolio 1 is a good long-term investment mix. It’s an industry standard, and I’ll use it throughout this article to illustrate my points.

For 39 years, from January 1970 through December 2008, this portfolio produced a compound annual return of 9.3 percent. That’s not bad, especially considering this period included four major bear markets. I believe that long-term return should be more than enough to let most investors achieve their long-term goals.

Therefore, for this discussion I will use a long-term annual return of 9.3 percent as a standard or benchmark against which to measure the strategy I’m presenting. You’ll see this strategy unfold in a series of pie charts as we split the pie into thinner and thinner slices by adding asset classes.

Remember that we also must look at risk. Adding return while also increasing riskis certainly possible, but it’s not what we’re after here. We want risk to remain the same – or ideally, to decline. Therefore, another measure I’ll use to gauge this strategy is standard deviation.

Standard deviation is a statistical way to measure risk. (If you want to understand this statistically, there are plenty of resources online that will tell you how it’s defined and applied.) In order to understand the attractiveness of the Ultimate Buy-and-Hold Strategy, what you need to know is that a lower standard deviation is better, indicating a portfolio that is more predictable and less volatile. The standard deviation of Portfolio 1 is 12.1 percent, so we’ll use that as the benchmark.

Hundreds of thousands of investors would be better off with Portfolio 1 than they are with their current portfolios, which offer too little diversification and too much risk. If those investors did nothing more than adopt this simple mix of assets – which is easily duplicated using a couple of no-load index funds, they would be more likely to achieve their long-term investment goals.

Because of that, and because it is used by institutional investors who cannot have much tolerance for getting things wrong, I believe Portfolio 1 is a relatively high standard from which to start. In my view, anything worthy of being called an “ultimate” strategy must beat Portfolio 1 in two ways. It must be worthy of a reasonable expectation that it will produce a return higher than 9.3 percent and at the same time have a standard deviation lower than 12.1 percent.

Most of the Ultimate Buy-and-Hold Strategy is concerned with the 60 percent equity side of the pie. That’s where the main focus will be in this article. But it’s very important to get the fixed-income part of this strategy right.

Most people include bond funds in a portfolio to provide stability, which can be measured by standard deviation. Many investors also expect bond funds to produce income, which of course is part of any investor’s total return. The higher the percentage of bonds that make up a total portfolio, the more stability that portfolio is likely to have – and the less long-term growth it is likely to produce.


Whether your portfolio is heavy or light on bonds, it matters what kind of bonds you own. In general, longer bond maturities go together with higher yields and higher volatility (higher standard deviation, in other words). However as you extend maturities beyond intermediate-term bonds, the added volatility (risk) rises much faster than the additional return.

In the past, we recommended short-term bond funds for this part of the portfolio. After more study, we refined our approach two ways. First, the fixed-income portfolio now is exclusively in government fixed-income funds. Second, this segment of the portfolio is now made up of 50 percent intermediate-term funds, 30 percent short-term funds and 20 percent in TIPS funds for inflation protection. (TIPS funds invest in U.S. Treasury inflation-protected securities, which automatically adjust their interest payments and their value to changes in the Consumer Price Index.)

For a variety of reasons, we expect this combination to produce slightly higher returns with a little bit of additional risk. In an all-fixed-income portfolio, this would leave us with that higher risk. But because the additional risk comes from the longer term of the bonds (instead of from the possibility of a corporate default), this extra risk is non-correlated with the risk of the stock market. That means that when we combine this fixed-income mix with a diversified equity portfolio, the volatility of the entire portfolio goes down.

I know it’s counter-intuitive to think you can reduce risk by adding risk. But in this case, as the result of a lot of careful thought and study, we believe you can do just that. This is what I call “smart diversification” at work, and we’ll encounter it again when we examine the equity side of the portfolio.

Why do we exclude corporate fixed-income funds? In a nutshell, because they entail some risk of default – a risk that tends to increase when times are tough, just when we want stability the most. We believe in taking calculated risks on the equity side of the portfolio and being very conservative on the fixed-income side. U.S. Treasury securities are the safest in the world and virtually eliminate the risk of default.

Making these changes gives us Portfolio 2. From 1970 through 2008, this combination had an annualized return of 9.3 percent and a standard deviation of 11.5 percent. This change gives the portfolio more stability (less risk) at the same return.

This refinement from Portfolio 1 is modest. But there’s much more to come as we tackle the 60 percent of the portfolio devoted to equities.


Virtually all serious investors are familiar with the long-term attraction of owning real estate. When this asset class is owned through professionally managed real estate investment trusts known as REITs, it can reduce risk and increase return.

From 1975 through 2008, REITs compounded at 13.2 percent, outpacing the Standard & Poor’s 500 Index (which returned 11.3 percent over that same period). This was an unusually productive period for REITs, and academic researchers expect the future returns of real estate and of the S&P 500 Index to be similar to each other – though not as high as they were during this period.

As you will see, when REITs make up one-fifth of the equity part of this portfolio (in Portfolio 3), the annual return rose slightly to 9.6 percent; more important for our purposes, the standard deviation (risk) fell to 10.9 percent. At this point we have accomplished our objective of adding return and reducing risk. Over this long period, the bottom line is an additional $319,377 in cumulative return. This is an excellent start, but the best is yet to come.


The standard pension fund’s equity portfolio, shown here in Portfolios 1 and 2, consists mostly of the stocks of the 500 largest U.S. companies. These include many familiar names like ExxonMobil, General Electric, Johnson & Johnson, Microsoft, Pfizer and Proctor & Gamble. Each of these was once a small company going through rapid growth that paid off in a big way for early investors. Microsoft was a classic case in the 1980s and 1990s.

Because small companies can grow much faster than huge ones, a fundamental way to diversify a stock portfolio is to invest some of your money in stocks of small companies.

To accomplish this, the next step in building the Ultimate Buy-and-Hold Strategy is to add small-cap stocks to the equity part of the portfolio. To represent small-cap stocks, we have used the returns of the Dimensional Fund Advisors U.S. Micro Cap Fund, which invests in the smallest 20 percent of U.S. companies.

The result is Portfolio 4, a pie that now has four slices and which from 1970 through 2008 produced an annualized return of 9.8 percent, with a standard deviation of 11.2 percent. With these three changes, we added more than $600,000 to the cumulative return, an increase of 19.1 percent.

I think that is very impressive, and I’d like you to pause for a moment and think about that. The additional return is more than six times the entire initial investment of $100,000. How much work did it take to capture that extra return? I’m betting you could set this up with less than 20 hours of your time. But let’s be very conservative and say that it took you 40 hours, a full standard work week. Divide the extra return by those hours and the payoff amounts to about $15,500 per hour. I don’t know anywhere else you can get paid that much for your time. If you do, I hope you’ll let me know! Could I now interest you in doubling that extra return, and doing so within the same allotted 40 hours of the calculation above?


The next step is to differentiate between what are known as growth stocks and value stocks. Typical growth investors look for companies with rising sales and profits, companies that either dominate their markets or seem to be on the brink of doing so. These companies are typical of those in the S&P 500 Index of Portfolio 1.

Value investors, on the other hand, look for companies that for one reason or another may be temporary bargains. They may be out of favor with big investors because of things like poor management, weak finances, new competition or problems with unions, government agencies and defective products.

Value stocks are regarded as bargains that are expected to return to their supposedly “normal” levels when the market perceives their prospects more positively. Some prominent examples, taken from the largest holdings of the Vanguard Value Index Fund in early 2009, include J.P. Morgan Chase, Wells Fargo, Intel and Verizon. Identifying such companies can take a lot of analysis, based on many assumptions that might or might not prove out.

The Ultimate Buy-and-Hold Strategy uses a different approach, a purely mechanical one, to identify value companies. We start by identifying the largest 50 percent of stocks traded on the New York Stock Exchange and then including all other public companies of similar size. These companies are then sorted by the ratio of their price per share to their book value per share. The top 30 percent of this list, the companies with the highest price-to-book ratios, are classified as growth companies. The bottom 30 percent are classified as value companies.

Although the most popular stocks are growth stocks, much research shows that historically, unpopular (value) stocks outperform popular (growth) stocks. This is true of large-cap stocks and small-cap stocks, and it’s true of international stocks as well. From 1927 through 2008, an index of large U.S. growth stocks produced an annualized return of 8.6 percent; large U.S. value stocks, by contrast, had a comparable return of 10 percent. Among small-cap stocks over the same period, growth stocks returned 8.4 percent, and value stocks returned 13 percent.

Therefore, we create Portfolio 5 by adding equal slices (each shown in the pie chart as 12 percent of the entire portfolio) of large-cap value and small-cap value. At this point, the equity side of the portfolio is divided equally five ways.

This boosts the portfolio’s return to 10.7 percent, still with a lower standard deviation than Portfolio 1. And notice how much this adds to the 38-year cumulative return: nearly $2 million. That is more than three times the “added value” that came from Portfolio 4.

To recap where we are at this point, we started with a standard industry portfolio mix, refined the fixed-income portion and added real estate, small and value stocks to the equity portion. The result is an increase of 15 percent in annualized return (and of nearly 60 percent in cumulative return) at essentially the same level of risk.

Now there is one more very important step in creating the Ultimate Buy-and-Hold Strategy.


The final step toward Portfolio 6 is to go beyond the borders of the United States to invest in international stocks. U.S. and international stocks both go up and down, but often they do so at different times and different velocities. Because of this, international stocks are diversifiers to reduce volatility.

Like U.S. stocks, international stocks have a long-term upward bias. Yet when the shorter-term movements of U.S. and international stock markets offset each other, as they often do, the combination has a smoother long-term upward curve than either one by itself.

There are two major reasons international stocks have low correlation to U.S. ones. First, they trade and operate in different economic environments with different growth rates and monetary policies. Second, currency fluctuations affect their prices when translated into U.S. dollars.

The virtues of small-cap stocks and value stocks apply equally to international stocks as to U.S. stocks. Portfolio 6 slices the equity portion equally 10 ways, adding international large, international large value, international small, international small value and emerging markets. We haven’t discussed emerging markets, and this isn’t the place for a full discussion, but let me say that emerging markets represent great long-term growth opportunities. That’s why they deserve a place here.

As you’ll see, the annualized return of Portfolio 6 jumps to 11.7 percent and the standard deviation remains at 12 percent. Cumulatively over 39 years, this portfolio produced a gain of $7.4 million, more than twice as much as Portfolio 1. If you go back to my premise that you could implement this strategy in a total of 40 hours, the added-value return works out to $105,197 per hour for your time. (Too bad you can’t do that for a whole career!)

This completes the basic makeup of the Ultimate Buy-and-Hold Strategy, which over this time period increased annualized return by more than 25 percent while reducing volatility slightly. This is not complicated, and it’s based on solid research, not hocus-pocus. It doesn’t require a guru. It doesn’t require investors to figure out the economic landscape or make predictions about the future.

With 2008 fresh in our minds, let me say a few things about risk. While the standard deviation of Portfolio 6 fell by only 0.1 percent, as compared with that of Portfolio 1, I think the real risk fell much further. Consider that Portfolio 1 contained only about 500 stocks. There’s always a default risk when companies implode unexpectedly. (Washington Mutual is a recent example.)

Now consider all the stocks held by all the funds in Portfolio 6. At the end of 2008, according to Dimensional Fund Advisors, those funds owned a total of 16,118 stocks. Even if you figure that some part of that number represents duplications, Portfolio 6 entails ownership in many thousands of stocks, not just 500. To my way of thinking, that much diversification is very worthwhile in terms of peace of mind.


The trickiest part of the Ultimate Buy-and-Hold Strategy is getting the level of risk right for each individual investor. The most important asset-class decision an investor makes is how much to have in fixed-income and how much in equities. In these illustrations we have used a 60/40 mix. That is an industry standard, and I believe that over a long period of time many investors can use it to accomplish their goals at reasonable levels of risk.

But this may not be right for you. For help in applying risk-vs.-reward to your own situation, I suggest you read one of our most important articles, “Fine tuning your asset allocation.”

As I mentioned earlier, there’s no single mutual fund that puts all the pieces of this together under one roof. For help in finding funds, I recommend another article, “The best mutual funds: DFA or Vanguard?” For an excellent discussion of the value of non-correlated assets, I recommend a fine article by my son, Jeff Merriman-Cohen, called “The perfect portfolio.”


We’re often asked why we don’t include mid-cap funds in our recommendations. We believe it’s possible to have a great portfolio without mid-cap funds, rebalancing large-cap and small-cap funds to gain some of what we call “smart diversification.” This involves putting together assets that typically behave differently from each other; large-cap and small-cap funds is one excellent example of that.

For our clients, we use funds that include mid-cap stocks. But we don’t use specifically mid-cap funds. Mid-cap funds often produce attractive returns. But we don’t think investors need them.


This combination of asset classes works best in tax-sheltered accounts such as IRAs and company retirement plans. In taxable accounts, we recommend leaving out the REIT fund and dividing that portion of the portfolio equally among the other four U.S. equity classes. I say this because real estate funds produce most of their total return in the form of income dividends that may not qualify for the favorable tax treatment afforded to most other dividends.

Many investors implement this strategy in taxable accounts to supplement their employee retirement plans in order to capture asset classes not available in those plans. Investors who take this approach, which we favor, should hold REIT funds in their tax-sheltered accounts.


Even though this is the best buy-and-hold strategy that I know for serious long-term investors, it isn’t flawless. Investment markets are not highly predictable, and this strategy might not work as well in the future as well as it did in the past.

The equity side of this portfolio is slightly overweighted to value stocks. Yet it is quite possible that value stocks will underperform growth stocks over the next five, 10, 15 or 20 years. The portfolio contains a large dose of small-cap stocks. But it’s possible that large-cap stocks will do better than small ones in the future. This portfolio contains an above-average exposure to international stocks, which could underperform U.S. stocks in the future. Likewise, it’s possible that fixed-income funds, which make up the minority of this portfolio, could do better than equities in the future.

All this uncertainty is simply inevitable. Still, I believe the Ultimate Buy-and-Hold Strategy deals very well with it. If you own this portfolio, you aren’t dependent on any particular asset class. You have them all. And no matter which ones are doing well, you will own them.

To my mind, this is the best an investor can do. And when you have done your best, it’s time to turn your attention to something else. A very good “something else” is to make sure you are living your life the way you want to.

Paul Merriman is founder of Merriman.


Directors and officers of DFA Investment Dimensions Group Inc. include:
• David G. Booth, co-founder, director, CEO, president and chief investment officer; trustee, University of Chicago
• George M. Constantinides, Leo Melamed Professor of Finance, Graduate School of Business, University of Chicago
• John P. Gould, Steven G. Rothmeier Distinguished Service Professor of Economics, Graduate School of Business, University of Chicago
• Roger G. Ibbotson, Professor in the Practice of Finance, School of Management, Yale University
• Robert C. Merton, Nobel laureate, John and Natty McArthur University Professor, Harvard University
• Myron S. Scholes, Nobel laureate, Frank E. Buck Professor Emeritus of Finance and Law, Stanford University
• Rex A. Sinquefield, co-founder and director; trustee, St. Louis University; life trustee, DePaul University
• Abbie J. Smith, Boris and Irene Stern Professor of Accounting, Graduate School of Business, University of Chicago.

This document contains hypothetical results. Although we have done our best to present this information fairly, hypothetical performance is still potentially misleading. Hypothetical data does not represent actual performance and should not be interpreted as an indication of actual performance. This data is based on transactions that were not made. Instead, the trades were simulated, based on knowledge that was available only after the fact and thus with the benefit of hindsight. Results do not include the impact of taxes, if any. Past returns are not indicative of future results.

Data Sources: The following data sources were used to develop the tables and figures in this workshop. Note that many of our return series rely on academic simulations gathered and developed by Dimensional Fund Advisors (DFA). All performance data are total returns including interest and dividends. Simulated data subtracts the current expense ratio for the comparable fund, except for the S&P 500 Index.


Emerging Markets DFEMX to May 1994, DFA simulation back to Jan 1987.

Emerging Market Core DFCEX from May 2005.

Emerging Market Small Cap DEMSX back to 1999, DFA simulation back to Jan. 1987.

Emerging Market Value DFEVX back to 1999, DFA simulation back to Jan. 1987.

International Large Cap DFALX back to 1992, MSCI EAFE back to 1970.

International Large Cap Value DFIVX back to Mar 1994, DFA simulation back to 1975.

International Small Cap DFISX back to Oct. 1996, DFA simulation back to 1970.

International Small Value DISVX back to 1995.

Large Cap DFLCX back to 1991, S&P 500 back to 1970.

Large Value DFLVX back to 1994, simulation back to 1927.

Micro Cap (or Small Cap) DFSCX back to 1983, Dimensional US Micro Cap Index to 1970.

Real Estate Investment Trusts DFREX back to Jan. 1993, Don Keim REIT Index 1975-1992, NAREIT 1972-1974.

S&P 500 1926 – 1989. Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Chicago (annually updated); 1990 – Present S&P 500 Index, provided by Standard & Poor’s Index Services Group, through DFA.

Small Value DFSVX back to 1994, DFA simulation back to 1927.


Barclays Government Credit. Index 50% long-term corp., 50% long-term government for 1970-1972 (from DFA Matrix 2004), Barclays Government/Credit Bond Index from 1973 to present.


DFA Intermediate Government Bonds DFIGX, Morningstar

Vanguard Short-Term Treasuries VFISX, Morningstar.

Vanguard Intermediate-Term Treasuries VFIIX, Morningstar.

Vanguard Inflation Protected Securities VIPSX, Morningstar.

Portfolios 1-6:

• Yearly rebalancing
• Short/ Intermediate Bond Allocation: 50% in Intermediate Term Government, 30% in Short-term Treasuries and 20% in TIPs
• U.S. Equity Allocation: 20% each in LC, LCV, SC, SCV, and REITs
• International Allocations:
1970-1974: 50% Int. LC, 50% Int. SC
1975-1986: 25% Int. LC, 25% Int. LCV, 50% Int. SC
1987-1994: 20% Int. LC, 20% Int. LCV, 10% EM, 5% EMS, 5% EMV, 40% Int. SC
1995-2005: 20% Int. LC, 20% Int. LCV, 10% EM, 5% EMS, 5% EMV, 20% Int. SC, 20% Int. SCV
2006 – 2007: 20% each in Int. LC, Int. LCV, Int. SC, Int. SCV, and EM Core

Donald Coxe’s Investment Recommendations

From Investment Postcards from Capetown, a summary of Donald Coxe’s Basic Points April research report which include several investment ideas/themes:

family:arial;font-size:85%;">The April edition of Donald Coxe’s Basic Points research report (subtitled “Where will America go to grow”) has just been published. His investment recommendations, as summarized in this document, are listed in the paragraphs below, but I do recommend you also read the full report at the bottom of the post. (Also note that Donald’s weekly webcasts can be accessed from the sidebar of the Investment Postcards site.)

family:arial;font-size:85%;">1. F. Scott Fitzgerald had it wrong, at least for American stocks: you do get a second, and even a third chance. Stocks leading that six-week rally looked down, couldn’t see the bottom anymore, and promptly retreated to lower levels. Think about what you’ll most want to own when The Real Thing arrives, and accumulate them at leisure, while the market tries to decide whether the economic recovery is a month, a quarter, or a year away.

family:arial;font-size:85%;">2. Larry Summers adroitly brushed off a question about future levels of unemployment by saying, “Economic forecasters are divided between those who know they don’t know, and those who don’t know they don’t know”. Galbraith said the function of economic forecasting has been to make astrology look respectable. We know we don’t know, but we know we didn’t feel comfortable with the speed of optimism’s return. Those last two deep Mama Bear recessions didn’t end with such alacrity – nor did optimism return so speedily.

family:arial;font-size:85%;">3. We do believe that the stock market is giving the correct signals that techs and commodities will lead the next recovery.

family:arial;font-size:85%;">4. The other winner will be (sound of trumpets) commodity stocks. They were heavily outperforming the S&P until the late stages of the recent rally. We think they’ll move back to #1 slot – at least on relative strength.

family:arial;font-size:85%;">5. Gold has been a bitter disappointment to its boosters in recent weeks. Bullion is down 4.6% this year, and most of the leading stocks are down far more than that. These setbacks came at a time when gold was getting more publicity as a haven investment than it has received in decades. Gold has been hurt by two rallies – first the dollar, then the bank stocks. More recently, investors have been spooked by the deal for the IMF to sell 403 tonnes of gold, at a time Indians, traditionally the most reliable buyers, are on strike. That 500 tonnes of scrap gold has come to the markets this year is a bad news/good news story: it’s a huge amount for markets to absorb, but it proves anew that gold is a precious asset in tough times. Gold stocks remain core investments within equity portfolios, reducing overall portfolio volatility. They will be superstars when the dollar finally falls, and people begin to get genuinely worried about inflation’s return. The stocks will outperform bullion on the upside.

family:arial;font-size:85%;">6. Copper’s remarkable performance (up 48% in three months) worries us. Yes, China is coming back, but the industrial world is looking as bleak as a group of paid mourners at a funeral. We do not recommend adding to base metal exposure.

family:arial;font-size:85%;">7. Within the energy group, we believe the bookends – refiners and oil sands – are most attractive. Why refiners? (1) Most oil analysts despise them; (2) They have to continue to refit their refineries to provide for greater percentage usage of that great nuisance, ethanol; (3) Americans are driving less; however (4) Refiners should hold up better than other oil sectors if there’s one last oil shakeout coming. Oil sands: You just possibly may never be able to buy oil for the 2020s as cheaply as you can today by buying the oilsands stocks. These are cornerstone investments for long-term oriented investors.

family:arial;font-size:85%;">8. It’s planting season as we write, and the snow is largely gone. Low corn prices are discouraging farmers from planting as much corn as last year. Higher soybean prices (and cold wet weather) are encouraging them to plant more beans. Both these crucial crops are priced profitably for farmers, so don’t believe the talk that they’ll be cutting back dramatically on fertilizers. However, the extra emphasis on beans is bad news for the nitrogen fertilizer companies. (Beans don’t need nitrogen.) Overall, we still think the agricultural stocks have the best risk/reward profile.

family:arial;font-size:85%;">9. The steep yield curve entices investors to buy long-term bonds and enriches all those bankers who have any wiggle room for making real loans after succumbing to the allure of all those fascinating, sophisticated ways to make ghastly bets. However, what the market giveth, the market taketh away once the economy begins to recover and inflation begins to return. Stay below your duration benchmark: give up yield now for performance later.

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John Mauldin on MV=PQ and Modeling ‘Garbage’

In John Mauldin’s most recent Frontline Thoughts letter, he discusses the importance of money velocity when discussing inflation/deflation and the Fed’s policy of ‘quantitative easing’. Also discussed is the role of the recent destruction of markets for CDOs, SIVS and other securitization products in decreasing the velocity of money. He anticipates slow growth to start in 2010 with the possibility that we may then reenter a recession as tax increases take effect. Perhaps his most important points are at the end of the article when he discusses that ‘ideas have consequences’ and that we have been teaching the wrong ideas to an entire generation of finance students. The whole article is pasted below, but for individual investors I think the quote immediately below of Mauldin’s thought on Modern Portfolio Theory is highly relevant:

What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes – see what happens? You get long-term positive results.”

And they would project that into the future. But they didn’t project crises, when
correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

Well, we can go back to the 19th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we’ve wiped out a generation of retirement income.
I could go on and on, but it’s nonsense.

The entire article:

family:Arial, Helvetica, sans-serif;color:#000000;">This week we look at the second half of my speech from a few weeks ago at my annual Strategic Investment Conference in La Jolla. If you have not read the first part, you can review it here. The first few paragraphs are a repeat from last week, to give us some context. Please note that this is somewhat edited from the original, and I have added a few ideas. You can also go there to sign up to get this letter sent to you free each week.

family:Arial, Helvetica, sans-serif;color:#000000;">MV=PQ

family:Arial, Helvetica, sans-serif;color:#000000;">Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever genetically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: deflation, we can’t have it.

family:Arial, Helvetica, sans-serif;color:#000000;">MV=PQ. This is an important equation, right up there with E=MC2. M (money or the supply of money) times V (velocity — which is how fast the money goes through the system — if you have seven kids it goes faster than if you have one) is equal to P (the price of money in terms of inflation or deflation) times Q (roughly standing for the Quantity of production, or GDP)

family:Arial, Helvetica, sans-serif;color:#000000;">So what happens is, if we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we’ll have inflation, because this equation always balances. But if you reduce velocity (which is happening today) and if you don’t increase the supply of money, you are going to see deflation. We are watching, for reasons we’ll get into in a minute, the velocity of money slow. People are getting nervous, they are not borrowing as much, either because they can’t or the animal spirits that Keynes talked about are not quite there.

family:Arial, Helvetica, sans-serif;color:#000000;">To fight this deflation (which we saw in this week’s Producer and Consumer Price Indexes) the Fed is going to print money. A few thoughts on that. The Fed has announced they intend to print $300 billion (quantitative easing, they call it). That is different than buying mortgages and securitized credit card debt — that money (credit) already exists.

family:Arial, Helvetica, sans-serif;color:#000000;">When they just print the money and buy Treasuries, as with the $300 billion announced, they can sop that up pretty easily if they find themselves facing inflation down the road. But that problem is a long way off.

family:Arial, Helvetica, sans-serif;color:#000000;">Sports fans, $300 billion is just a down payment on the “quantitative easing” they will eventually need to do. They can’t announce what they are really going to do or the market would throw up. But we are going to get quarterly or semi-annual announcements, saying, we are going to do another $300 billion here, another $500 billion there. Pretty soon it will be a really large total number.

family:Arial, Helvetica, sans-serif;color:#000000;">When we first started out with TALF and everything, it was a couple hundred billion, and now we just throw the word trillions around and it just drips off of our tongues and we don’t even think about it. A trillion is a lot. It’s a big number. And the total guarantees and backups and all this stuff we are into — I saw an estimate of $10-12 trillion. That’s a lot of money.

family:Arial, Helvetica, sans-serif;color:#000000;">Understand, the Fed is going to keep pumping money until we get inflation. You can count on it. I don’t know what that number is; I’m guessing maybe as much as $2 trillion. I’ve seen various studies. Ray Dalio of Bridgewater thinks it’s about $1.5 trillion. It’s some very big number way beyond $300 billion, and they are going to keep at it until we get inflation.

family:Arial, Helvetica, sans-serif;color:#000000;">Side point: what happens if the $300 billion they put in the system comes back to the Fed’s books because banks don’t put it into the Libor market because they are worried about credit risks? It does absolutely nothing for the money supply. Okay? It’s like, goes here, goes back there — it doesn’t help us. The Fed has somehow got to get it into the financial system. They’ve got to figure out how to create some movement.

family:Arial, Helvetica, sans-serif;color:#000000;">Will it create an asset bubble in stocks again? I don’t know, it could. Dennis [Gartman] talked about being nervous yesterday. I would be nervous about stock markets both on the long side, as I think we are in a bear market rally, but also there is real risk in being short. Bill Fleckenstein will be here tonight. He is a very famous short trader. He closed a short fund a couple of months ago. He says he doesn’t have as many good opportunities, and basically he’s scared of being short with so much stimulus coming in. So it’s going to work, at least in terms of reflation, but the question is, when? A year? Two years?

family:Arial, Helvetica, sans-serif;color:#000000;">Financial Innovation: The Round Trip

family:Arial, Helvetica, sans-serif;color:#000000;">Financial innovation is one of the drivers of the velocity of money. We started in approximately 1991 creating the first securitizations and CDOs. It was done at Merrill Lynch, if I remember right. But they started getting copied, and then we went into warp speed, creating all kinds of new CDOs and SIVs that invested in loans, securitized mortgage debt — most of which was rated AAA — banks loans, credit card debt, etc. Without thinking about it, we created a shadow banking system that funded a huge chunk of our total credit markets. It was outside the bailiwick of the normal regulatory authorities.

family:Arial, Helvetica, sans-serif;color:#000000;">Then in 2007 we began to destroy the shadow banking system. If it was working so well, why did we do that? Because they mismatched their liabilities and assets. They were borrowing short-term and lending long-term, and doing it highly leveraged. They were buying up long-term assets at 4-5-6%, some (or most) of them rated AAA. Then they were selling commercial paper at 1% or 2% — so you get a 2-3% profit spread.

family:Arial, Helvetica, sans-serif;color:#000000;">A 2-3% spread doesn’t really make you anything, you’re not really excited about that; so since we’re dealing with AAA investments that everyone believes to be absolutely safe, let’s leverage it up 6-7-8 times. Now you’re talking a 20% return. Now you’re talking about making money, real money. And I should note that we were also talking real commissions and monster bonuses.

family:Arial, Helvetica, sans-serif;color:#000000;">I think one other side note needs to be made here. In hindsight, we can now look back and wonder what the investment banks were thinking. They “must” have known they were pushing bad paper into the system.

family:Arial, Helvetica, sans-serif;color:#000000;">But their behavior tells us they didn’t know. If they really believed they were, there would not have been so much of the toxic debt left on their books. Bear Stearns launched very large funds to buy this debt at obscene leverages and sold it to their best customers. At least some people in management thought there was real value in these securities, which just goes to show how lax or ignored the risk managers were in all parts of the financial industry.

family:Arial, Helvetica, sans-serif;color:#000000;">Then it all began to implode, because people started paying attention to some of the assets on the balance sheets of the various SIVs and CDOs and suspected they might not be worth what they had originally thought. You have subprime mortgages in your Special Investment Vehicle? Hey, I’m not going to buy your commercial paper. Suddenly, the commercial paper market simply imploded. This was the start of the banking crisis.

family:Arial, Helvetica, sans-serif;color:#000000;">So we started taking the innovation of securitizations off the table. The innovation that had driven the velocity to new highs was now slowly being pulled off. So, velocity slows down, and it’s continuing to slow down with each passing month.

family:Arial, Helvetica, sans-serif;color:#000000;">Let’s survey the economic landscape. We have an unstable economy. Housing doesn’t bottom until 2011 or 2012, unless, as I wrote the other day, we give immigrants a green card to come here. We need the immigrants anyway. We need smart immigrants. By the way, I’ve never had as much response to my letter, both positive and negative. It ran about 60/40 for. Many of the “against” were people outside of the US, saying why are you trying to take our best, we need them. I suppose there is a certain logic to that, but if we could pull a million homes off the market, it would solve a big part of the US credit crisis right now, not to mention, we would have people putting money into our system and it wouldn’t cost taxpayers anything.

family:Arial, Helvetica, sans-serif;color:#000000;">But back to the current scene. Consumer spending is slowing, and it’s going to slow for years as savings increase. At one time we were savings 7-8-10% of our incomes, back in the early ’80s. We grew from 63% of the economy being consumer spending, to 71% in 2006. We are going back to the mid –to low 60s in terms of the percentage of consumer spending in GDP. We are not doing it all at once, it’s going to take years; but, gentle reader, it’s the blue screen of death! We are hitting the reset button.

family:Arial, Helvetica, sans-serif;color:#000000;">Economists have a term for this process. It’s called rationalization. We have too many stores to sell “stuff,” all sorts of stuff. Too many malls. We have too many factories to build too many cars, too many plants to build too many widgets for an economy where 65% of GDP is consumer spending. When we built all that capacity it was for an economy in which consumer spending was 71%; and because we were enthusiastic and believed we would grow at 3% forever, we probably built it for 73% or 74%.

family:Arial, Helvetica, sans-serif;color:#000000;">We are watching capacity utilization fall off the table. It is down to 67%, fully 15% below normal. What happens when you see that? You start closing factories. It’s just what you have to do. We are going to have fewer restaurants, fewer clothing stores. The survivors will get bigger market shares; that’s just what happens. Schumpeter called it creative destruction.

family:Arial, Helvetica, sans-serif;color:#000000;">And this being a different type of recession — because we are hitting the full credit-cycle reset, it’s going to take longer. I think the recession — the actual, honest, mark-to-market numbers –will be negative through 2009. Then we’ll start to improve. This current first quarter is going to be ugly again, then it will be a little better in the third quarter. The second quarter — I don’t know how bad it’s going to be, but it’s not looking good.

family:Arial, Helvetica, sans-serif;color:#000000;">But in 2010 we could start seeing slow growth again, maybe Muddle Through. There might be a sluggish recovery in 2010, but we have to put an asterisk on that possibility because the Democrats are going to push through the largest tax increase in history.

family:Arial, Helvetica, sans-serif;color:#000000;">First of all, the tax increase is the Republicans’ fault. They didn’t make the tax cuts permanent when they had the chance, so consequently they go away in 2010. US taxes are going to go way up, whether there is no compromise, so that we go back to the pre-Bush years, or there is some compromise because the Obama Administration realizes that putting in that type of a tax increase will throw us back into recession. Remember Roosevelt? What did he try to do? He raised taxes in the middle of a recession (1937), when unemployment was 14%, driving it back up to 20%. Unemployment will be 10% or 11% by this time next year, and maybe by the fourth quarter.

family:Arial, Helvetica, sans-serif;color:#000000;">If you count those who are working part-time but want full-time employment, the unemployment number is closer to 15%. Yesterday, my taxi driver was a mechanical engineer who lost his job, but had kids and had to do whatever he could to put food on the table. He said there are a lot of people like him here in California.

family:Arial, Helvetica, sans-serif;color:#000000;">The deficit is going to explode way past $2 trillion unless somebody can show some sense. Let’s look at the carbon credit problem. Obama wants to impose this new carbon credits program, which sounds benign. We call it a credit and not a tax. Here’s the issue. It gives us two bad possibilities, one of which is going to happen. Number one, he is assuming there is something like $800 billion coming in over the next decade from these carbon credits, and he’s put that as income in his proposed budget, like it’s going to get passed into the system. He is assuming that revenue. If he doesn’t get it, deficits are much higher in the near term.

family:Arial, Helvetica, sans-serif;color:#000000;">But if he gets it, it’s even worse, as US industry becomes uncompetitive with Third World industries that don’t have the same carbon credits and energy costs. Do you think China or India will pass the same legislation? They are building more coal-fired plants every month than we build in a year.

family:Arial, Helvetica, sans-serif;color:#000000;">We are going to be seeing factory after factory shut down and moved off-shore, because they simply won’t be able to compete. Either way, we go back to that economics technical term I used earlier: we’re screwed. The carbon credits program is just a massively bad idea. There are things that we should do to cut down energy usage, but this is not the way to go about it. We can talk about other ways to do it if you want to.

family:Arial, Helvetica, sans-serif;color:#000000;">2010-11: Back to the Future Recession

family:Arial, Helvetica, sans-serif;color:#000000;">I think the country could re-enter a recession in 2010 and 2011; we would go right back into it when those tax hikes start to hit. What do tax increases do? They take money out of consumers’ pockets — and the consumers that actually spend. Plus, 75% of those who will see their taxes rise are small businesses that employ people, so we deflate ourselves.

family:Arial, Helvetica, sans-serif;color:#000000;">Liberal economists are going to argue, “Wait a minute, John. We are taking it from these [rich] guys, but we are giving it to lower-income families, so it will get spent.” But it’s going through the government — we don’t get the same bang for our buck. We don’t get new employment. We’re simply transferring and creating a new welfare state; plus, we have a number of recent studies which show that the propensity now is not to spend the new money but to use it to pay down debt. This is not a pro-growth policy, and growth is what we need. Not wealth transfers and a new welfare state.

family:Arial, Helvetica, sans-serif;color:#000000;">At some point inflation starts to show up again, because when you start running two-trillion-dollar deficits and you start trying to borrow it, at the same time the Fed is printing money, at some point in this process the bond markets (and the currency markets) are going to rebel. An unsustainable trend will keep going until it stops. I don’t know when that day is, but the current policies mandate that we will hit the proverbial wall. One day it will be just like August 2007. Someone is going to ring a bell and the Treasury bond market is going to look the deficits and wonder how they will fund them, and they are going to let out a huge gasp and then throw up. Because you can’t run two- to three-trillion-dollar deficits as far as the eye can see.

family:Arial, Helvetica, sans-serif;color:#000000;">As Woody Brock so capably points out, the key to watch is the debt-to-GDP ratio. You can grow debt fast; but at some point you start to have to grow the economy faster than you are growing debt, or you become an economic basket case, where the dollar is devalued and interest rates go up fast. At that point, the Fed will have lost control. The key item to watch now is the budget debates. Are we going to build in $2 trillion deficits, or we will show some fiscal restraint?

family:Arial, Helvetica, sans-serif;color:#000000;">The Fed at the Crossroads

family:Arial, Helvetica, sans-serif;color:#000000;">And, are we going to try and do this when unemployment is at 10% or more? The Fed at some point is going to come to a crossroads. They can allow inflation, like the ’70s. (And some of us are old enough to have lived through the ’70s, though I really didn’t notice much — I actually made money on inflation during the ’70s. I was in the printing business before I went into the investment publishing business. I would buy traincar loads of paper on credit and put it on warehouse floors; and because I was the only guy who could get paper and I had it at a good price, I got a lot of business. So I made money off of that inflation cycle.

family:Arial, Helvetica, sans-serif;color:#000000;">We figure out how to Muddle Through, even during periods like the ’70s. So the Fed can bring that back — which they all swear they won’t do — or they can withdraw liquidity. What happens if they withdraw liquidity? It slows the economy down, because we are pulling money out of the system. Just as higher interest rates begin to take a toll on the economy, they will have to start pulling money out of the system to avoid higher inflation. By the way, if rates are rising that means the interest payments on the federal debt are rising, because we have a lot of short-term federal debt. Frankly, as a government, we should be buying all the 30-year bonds we can possibly buy. But we are not, because that would increase the pressure on the current debt. We have the long-term forecasting ability of a mongoose.

family:Arial, Helvetica, sans-serif;color:#000000;">We are in the middle of a Great Experiment, the one truly great experiment of this time; so the economists are fascinated. We have Keynes versus von Mises versus Irving Fisher versus Friedman, and they all have theories about what you should do after depressions and what works. Someone commenting on Keynes said, “In a world organized in accordance with Keynesian specifications there would be a constant race between the printing press and the business agents of the trade unions. With the problem of unemployment largely solved, the printing press could maintain a constant lead.”

family:Arial, Helvetica, sans-serif;color:#000000;">Printing money. That’s what the current Fed is doing. Just as aside, here is a great quote I came across. It really doesn’t have anything to do with anything, but it’s fun. John Ehrlichman told us about a conversation between Richard Nixon and Arthur Burns, who was Nixon’s nomination to be Chairman. Nixon said, “I know there is the myth of the autonomous Fed [short laugh]. When you go up for confirmation some Senator may ask you about your friendship with the President. Appearances are going to be important, so you can call Ehrlichman to get messages to me, and he’ll call you.” I’m sure that’s not done today.

family:Arial, Helvetica, sans-serif;color:#000000;">Seriously, the independence of the Fed is critical, Nixon notwithstanding. Given the recent revelations about Bernanke and Paulson supposedly telling Ken Lewis at Bank of America not to tell the public about how bad the Merrill situation was — do you think there might possibly be some pressure on Bernanke? His term is up early next year. It is quite possible we get a Fed chairman who would be more accommodative of a left-wing agenda than Bernanke, who I believe really will pull back from allowing inflation to get too high.

family:Arial, Helvetica, sans-serif;color:#000000;">This would force budgetary discipline on Congress, which the left will not like. I can see some real issues in the upcoming nominating process if Bernanke is not left at the helm. Do we really want Larry Summers?

family:Arial, Helvetica, sans-serif;color:#000000;">Let’s get back to our discussion of the Great Experiment. Von Mises said there is nothing you can do about a deleveraging cycle, you basically just let it all go to hell and then pick up the pieces. The hair-shirt economists, I call the Austrians: just let it drop, take your medicine, take your 15-20% unemployment, and just deal with it, because you’ll be able to come back faster from the lower base. By the way, to von Mises, the velocity of money was a meaningless concept. Gold was where you should have had your money to begin with.

family:Arial, Helvetica, sans-serif;color:#000000;">Then there is Friedman, who produced his great work that says inflation is always and everywhere a monetary phenomenon. He had his studies to prove it. But when he did his studies, in the 30 years that he analyzed, the velocity of money was remarkably stable. So of course, inflation had a 1-to-1 correlation with money supply.

family:Arial, Helvetica, sans-serif;color:#000000;">Fisher says, “The velocity of money is important.” For Fisher, debt deflation controlled all other economic variables. It was the driving economic force. You’re going to have to rationalize all your debts. There’s nothing you can do about it; but what you do is, do as much as you can to provide a soft landing for the people who lose their jobs. Do whatever you can to get them along and to keep the system working, but you are still going to have to go through a credit reorganization. We are going to find out in 5-6 years who was right. That is the experiment we are living through. My bet’s on Fisher, just for the record.

family:Arial, Helvetica, sans-serif;color:#000000;">How Did We Get It So Wrong?

family:Arial, Helvetica, sans-serif;color:#000000;">So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.

family:Arial, Helvetica, sans-serif;color:#000000;">We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the whole concept of correlation and assets. Correlations change.”

family:Arial, Helvetica, sans-serif;color:#000000;">And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

family:Arial, Helvetica, sans-serif;color:#000000;">What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”

family:Arial, Helvetica, sans-serif;color:#000000;">And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

family:Arial, Helvetica, sans-serif;color:#000000;">Well, we can go back to the 19th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we’ve wiped out a generation of retirement income. I could go on and on, but it’s nonsense.

family:Arial, Helvetica, sans-serif;color:#000000;">We let the rating agencies become way too important. They were supposed to be the adults supervising the sandbox, and they weren’t. They started out perfectly acceptably, but then they decided they wanted to rate multiple-obligor securities like real estate mortgage bonds using the same ratings they used for corporate bonds. They sold their business souls and didn’t even realize it.

family:Arial, Helvetica, sans-serif;color:#000000;">Remember, we trained a generation of people to think they could model this stuff. So they modeled what potential defaults would be, based on past performance, and not even past performance that looked like the assets in the investments they were rating. But it was scientific and looked like the models they learned in school.

family:Arial, Helvetica, sans-serif;color:#000000;">Every time you get a letter from me, there is a page and a half down there at the bottom, full of disclosures. At least twice in those disclosures I say past performance is not indicative of future results. It’s like, “coffee is too hot, don’t spill it.” We don’t pay attention to it, but it’s the most important thing, because past performance has nothing to do with future history.

family:Arial, Helvetica, sans-serif;color:#000000;">The future is going to look different, yet we think we can model it. The models are bullshit. (That’s a technical economics term that requires advanced degrees to use.) They just are. Now you can take some comfort from them, and you have to try and figure stuff out, and you look for correlations. That’s what I do, and we all do that. I confess I use models every day.

family:Arial, Helvetica, sans-serif;color:#000000;">But you have to recognize that the model has a huge asterisk beside it. You just can’t bet the farm on it. And God, have I learned that the hard way. I’ve got bruises on my back from making assumptions. That’s why I don’t go around half-naked, because it would just look ugly.

family:Arial, Helvetica, sans-serif;color:#000000;">We let the rating agencies use a corporate bond-rating system — AAA, AAB — for multi-obligor bonds that had nothing to do with reality, and they rated them up on the way up and now they are rating them down on the way down, and they are screwing us both ways. Because if you lose 1% on a triple-A bond, it immediately goes to junk. That means the banks have to write it off their capital and sell it for 50 cents on the dollar.

family:Arial, Helvetica, sans-serif;color:#000000;">When did this problem start? July of 2007, when we introduced mark-to-market accounting. When did AIG have a problem? When they had to start writing their AAA’s down. Now we should never have let it get to that place to begin with, but now we have to deal with reality. You can’t just sit there and say, “Tsk, tsk, we need to let these guys go bankrupt.”

family:Arial, Helvetica, sans-serif;color:#000000;">No, you can’t, not unless you want 25% unemployment again. We have “X” amount of pain to go through to get back to whatever the “new normal” will be. Think of this as a big tube of pain, OK? We can do it in one year or in seven or eight years. I vote for seven or eight. I don’t want 20-25% unemployment. I would rather have 10% unemployment for seven years. Now, that’s just me, because I know when my neighbor is unemployed, when my kid is unemployed, that it hurts.

family:Arial, Helvetica, sans-serif;color:#000000;">The Trend Is Not Your Friend When It Ends

family:Arial, Helvetica, sans-serif;color:#000000;">So, the establishment is now saying, “Let’s keep the system going.” Now, are we going to have problems when the Fed starts trying to pull the extra cash they are printing out of the economy? Yes. Is that going to create a different form of future history than we have experienced in the past? Yes. Therefore, trying to model the future based upon that past, will not work.

family:Arial, Helvetica, sans-serif;color:#000000;">We believed the trend. The trend is not your friend when it ends. OK? It just isn’t. Now, I’m the guiltiest person in the world. I live on what one of my friends calls “psychic income.” That is the income you get when you take a current business model, the current business you are in, and you say, if I could grow these assets to “Y” I would make “Z”. That “Z” charges me up. I haven’t earned it yet and the train probably won’t go there, but it gets me up in the morning. That’s my psychic income. We all do that. But we rarely realize that it’s just psychic income; it’s not real income until the cash is there.

family:Arial, Helvetica, sans-serif;color:#000000;">Given all that I have said, I still contend I am not a pessimist, at least not in the long term. Stocks go from high valuations to low valuations to high valuations. They’ve done it in US markets and world markets, and we are halfway through the trip in a secular bear market. We haven’t gotten to low valuations yet, I don’t care what they say. The P to E at the end of July was something like 289 on the S&P. You can go to the S&P website and you can see that. Now you smooth it with five-year curves and performance, and it goes to 20. 20 is not cheap. But it’s going to get cheap — at least that’s what history tells us.

family:Arial, Helvetica, sans-serif;color:#000000;">Now maybe history is wrong, because past performance is not indicative of future results; and I could be wrong, but sometimes you just have to set an anchor and say this is what I’m believing. I think we are going to lower valuations, and when that happens we will have compressed price to earnings ratios just like we did in 1982. The world will be coming to an end and we’ll be moaning and groaning. We haven’t gotten as bad as we were in ’82 — whoever pointed that out is correct.

family:Arial, Helvetica, sans-serif;color:#000000;">But what will happen? The stock market will be a coiled spring and we’ll have a bull market and we’ll get to have fun in the stock market again. Until then, be careful.

family:Arial, Helvetica, sans-serif;color:#000000;">Orlando, Naples, Cleveland, and Grandkids

family:Arial, Helvetica, sans-serif;color:#000000;">I am writing today’s letter at the St. Regis Hotel in Laguna Beach, California. I am going to hit the send button a little early so I can get out and walk around, as it looks to be too beautiful a place to be in my room writing. This weekend I join Rob Arnott and his friends (Mohammed El-Erian, Harry Markowitz, Jack Treynor, and Peter Bernstein, among others) at his annual conference. It is one of the few conferences I attend where I just go just to absorb as much as I can, and don’t speak. This one looks to be special.

family:Arial, Helvetica, sans-serif;color:#000000;">On Monday I fly out to Orlando to speak at the Chartered Financial Analyst’s national conference on the “state of the union” of the alternative investment industry. I think my talk will garner mixed reviews, and is certain to be controversial in a few circles. I hope I get invited back some time.

family:Arial, Helvetica, sans-serif;color:#000000;">Then I am back home for most of the next two months. I will make a quick trip to Naples to be with my friends at Jyske Global Asset Management for their conference the 29-31 of May ( And I am going to schedule a quick trip to Cleveland to get a full physical at the Cleveland Clinic with my good friend and best-selling author Dr. Mike Roizen. I have put it off too long. I will tell you more about the really interesting program they have, where you can get a three-day, thorough physical in one long day. I think it is a real value.

family:Arial, Helvetica, sans-serif;color:#000000;">And then there was a call from Tiffani last Saturday. She was in Kentucky visiting friends. One of my standing rules is that when I get back from Europe I am not to be disturbed before 10 at the earliest the next morning. But I got a call from her, and I groggily took it, worried that something was wrong.

family:Arial, Helvetica, sans-serif;color:#000000;">“Dad, I’m pregnant. It’s going to be a Christmas baby. What do you think?” Didn’t she just tell me January 23 or so that they were going to try? That didn’t take long. Not long at all.

family:Arial, Helvetica, sans-serif;color:#000000;">Henry and Angel are due in June. Chad and his SO Dominique are due in October. I will go from no grandkids to three in the space of a few months. And Amanda is getting married in August. Lots of things happening in the Mauldin clan. And it’s all good.

family:Arial, Helvetica, sans-serif;color:#000000;">I need to wrap it up. Tiffani will be here in a few hours, and then the meetings start. Have yourself a great week; and if you are at the CFA conference, be sure and look me up.

family:Arial, Helvetica, sans-serif;color:#000000;">Your almost ready to be a grandfather analyst,

John Mauldin">

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Bonds: Why Bother?

A great article from Rob Arnott in the Journal of Indexes May/June issue. It is fairly lengthy, so I just pasted the conclusion below. In a nutshell, bonds are generally–and incorrectly– underloved by the investment community. I’ve added this article to my ‘interesting article vault’ at the very bottom right of my blog (a high honor!):


We manage assets in an equity-centric world. In the pages of the Wall Street Journal, Financial Times and other financial presses, we see endless comparisons of the best equity funds, value funds, growth funds, large-cap funds, mid-cap funds, small-cap funds, international equity funds, sector funds, international regional funds and so forth. Balanced funds get some grudging acknowledgment. Bond funds are treated almost as the dull cousin, hidden in the attic.

This is no indictment of the financial press. They deliver the information that their readers demand, and bonds are—at first blush—less interesting. The same holds true for 401(k) offerings, which are overwhelmingly equity-centric. If 80–90 percent of the offerings provided to our employees are equity market strategies, is it any surprise that 80–90 percent of their assets are invested in stocks? And is it any surprise that they now feel angry and misled?

Many cherished myths drive our industry’s equity-centric worldview. The events of 2008 are shining a spotlight, for professionals and retail investors alike, on the folly of relying on false dogma.

  • For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don’t. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market.
  • For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite—long periods of disappointment, interrupted by some wonderful gains—appears to be more accurate.
  • For the long-term investor, mainstream bonds are supposed to reduce our risk and provide useful diversification, which can improve our long-term risk-adjusted returns. While they clearly reduce our risk, there are far more powerful ways to achieve true diversification—and many of them are out-of-mainstream segments of the bond market.
  • Capitalization weighting is supposed to be the best way to construct a portfolio, whether for stocks or for bonds. The historical evidence is pretty solidly to the contrary.

As investors become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend, there will be growing demand for new ideas, and for more choices.

Why are there so many equity market mutual funds, diving into the smallest niche of the world’s stock markets, and so few specialty bond products, commodity products or other alternative market products? Today, investors are still reeling from the devastation of 2008, and the bleak equity results of this entire decade. They have already begun to notice that there were opportunities to earn gains, sometimes handsome gains, in a whole panoply of markets in the past decade—most of which are still difficult for the retail investor to access.

We’re in the early stages of a revolution in the index community, now fast extending into the bond arena. In the pages of this special issue of the Journal of Indexes, we see several elements of that revolution. In the months and years ahead, we will see the division between active and passive management become ever more blurred. We will see the introduction of innovative new products. The spectrum of bond and alternative product for the retail investor will quickly expand. We will shake off our overreliance on dogma. And our industry will be healthier for it.

Mish on Stress Tests and Mortage Delinquencies

Mike ‘Mish’ Shedlock on the ‘Stress’ Test (1st article) and the second article is a note on the soaring number of delinquencies at Fannie and Freddie:

The results of the Geithner’s stress test cake walk are going to be announced debated by the general public the stress test participants on Friday.

Please consider Stress-Test Briefings for Lenders to Begin Friday.

Regulators will begin briefing banks Friday about how they fared in government-performed “stress tests,” giving lenders an opportunity to debate the findings before they’re made public a week later, according to government officials.

The discussions will signal to some banks whether they’ll need to seek additional capital, either from private investors or the Treasury Department.

On Tuesday, Treasury Secretary Timothy Geithner said “the vast majority” of banks could be considered well-capitalized. But he also said the impact of the government’s efforts to ease the financial crisis so far had been “mixed.”

In the stress tests, regulators used some estimates of likely losses on loans that were tougher than observers had expected.

Under a more adverse scenario, which assumes a 10.3% unemployment rate at the end of 2010, banks would have to calculate two-year losses of up to 8.5% on their first-lien mortgage portfolios, 11% on home-equity lines of credit, 8% on commercial and industrial loans, 12% on commercial real-estate loans and 20% on credit-card portfolios, according to a confidential document the Federal Reserve gave banks in February that was viewed by The Wall Street Journal. Regulators are expected to have used other assumptions as well when measuring a bank’s strength.

Cake-Walk Scenarios

Note that the adverse scenario assumes a 10.3% unemployment rate at the end of 2010. Hells bells, it’s highly likely unemployment far exceeds 10.3% before the end of 2009.

Let’s take a look at a table from Jobs Contract 15th Straight Month; Unemployment Rate Soars to 8.5%.

Table A-12

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Let’s ignore line U-6, a number I believe is close to the true rate of unemployment and simply look at line U-3, the “official” measure of unemployment.

In December of 2008, unemployment was 7.2. In March it was 8.5. Three or four months from now unemployment will be 9.8, assuming the same pace. However, the pace has been escalating. Add a few more months assuming no escalation in pace and the unemployment rate will be approaching 11% by the end of this year.

In other words, the Treasury’s adverse scenario is a complete joke. Moreover, instead of disclosing the results immediately, the results are going to be debated rigged for a week while the Treasury has a week to figure out exactly what they can get away with.

Is this supposed to be believable?

Sobering Stress Test Analysis

The New York Times is commenting on Sobering Numbers Ahead of Stress Test Results.

In a market note Wednesday called “Leaking (and Reeking) of Stress,” two managing directors at Westwood Capital used those figures to run some numbers. They concluded that the government’s worst-case assumptions — what is known as the stress test’s “more adverse” scenario — could imply losses of more than 50 percent in the banks’ Tier 1 capital.

That’s a sobering thought, because Tier 1 capital is one of the most closely watched measures of a financial institution’s ability to weather a storm.

Citing a “confidential document the Federal Reserve gave banks in February,” The Journal reported Wednesday that the government’s more-adverse scenario will assume up to 20 percent losses in banks’ credit-card portfolios, 12 percent losses in their commercial real estate holdings and 11 percent losses on home-equity credit lines.

Using the percentages from the story, Daniel Alpert and Jon Messersmith of Westwood did some number crunching of their own.

They pulled together year-end figures from the Federal Deposit Insurance Corporation for 13 banks undergoing stress tests, including Citigroup and Bank of America, and applied the assumed losses to the assets in question.

The result: A combined haircut of about $240 billion among the 13 banks — or about 56 percent of their reported Tier 1 capital as of Dec. 31.

Sobering Indeed

Using cake-walk assumptions, Westwood Capital still came to the conclusion 56% of Tier 1 capital is going to be annihilated. If that doesn’t reek, what does?

Geithner’s Meaningless Statement

On Tuesday, Treasury Secretary Timothy Geithner said “the vast majority” of banks could be considered well-capitalized.

Geithner’s statement is meaningless. If Citigroup, Bank of America, Wells Fargo and a few others in the Stress Test 19 are all insolvent (they are but it will never be reported that way), it will not matter much if every other bank in the country is solvent. Giethner’s statement would have meaning if every bank was the same size. They are not.

Week of Leaks

So no, we can prepare for a “week of leaks” starting Friday, where good news lies are spoon fed to the public in a hopeless attempt by the biggest liars on the planet to gain credibility.

Mike “Mish” Shedlock

On Tuesday, Fannie Mae and Freddie Mac reported Mortgage Delinquencies Rose 50% in a Month.

Fannie Mae and Freddie Mac mortgage delinquencies among the most creditworthy homeowners rose 50 percent in a month as borrowers said drops in income or too much debt caused them to fall behind, according to data from federal regulators.

The number of so-called prime borrowers at least 60 days behind on mortgages owned or guaranteed by the companies rose to 743,686 in January, from 497,131 in December, and is almost double the total for October, the Federal Housing Finance Agency said in a report to Congress today.

Of all borrowers who ended up in default, 34 percent told Fannie and Freddie they were earning less money, about 20 percent cited excessive debt as a reason for missing mortgage payments, and 8.1 percent blamed unemployment, FHFA said.

Those are pretty nasty numbers.

Mark Hanson (aka Mr. Mortgage) at The Field Check Group said “We saw this coming well in advance by watching notices of default (NODs).”

GSE Notices Of Default Rate of Change

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Fannie and Freddie data is woefully late. The GSEs are just now reporting January delinquencies.

In the meantime, Mark is tracking actual notice of default data (90-120 days late) for March. If defaults are soaring, it stands to reason that delinquencies will be soaring as well. In this way, someone watching Notices of Default (NODs) is able to know in advance whether or not an upcoming GSE report is going to be bad.

Mark is also tracking California specifically. Please consider the following chart.

Notices Of Default Rate of Change Total Universe (Not just GSEs)

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A key point for the above charts is that Fannie and Freddie loans are now blowing up at a faster rate than the entire universe of loans!

Mark’s data is for the west coast, primarily California. However, his assumption is that if his west coast data is bad, the overall numbers for the GSEs will be bad as well.

SB1137 Effect

Note the effect of SB1137, a ridiculous foreclosure prevention act that gave give delinquent payers 30 days grace period before the actual foreclosure process begins. All that bill did was add red tape and delay the inevitable.

CA Foreclosure Prevention Act Coming Up

A new CA law dubbed the CA Foreclosure Prevention Act comes into effect in July that will essentially do the same thing. It’s primary purpose is to delay the time between the Notice-of-Default (foreclosure stage 1) to the Notice-of-Trustee Sale (stage 2) by 90-days further delaying the foreclosure process and ultimate end of the foreclosure and housing crisis.

Hanson says, “It is likely we are already seeing unintended consequences of the new law. A certain percentage of the last few month’s surge of new loan notice-of-defaults was likely servicers gaming the calendar in order to get borrowers into the foreclosure process prior to the July enactment of the new law.”

FHFA Expands Reporting On Homeowner Assistance

Inquiring minds are digging into news that FHFA Expands Reporting On Homeowner Assistance

Since late November, the Enterprises had suspended foreclosure sales and evictions on owner-occupied properties. The suspensions, which ended on March 31, 2009, allowed servicers additional time to work with borrowers in foreclosure who were eligible for the Streamlined Modification Program (SMP). The impact of the suspensions caused completed foreclosure sales and third-party sales to decline 77 percent from the prior three-month average of 16,342 to 3,711 in December, and 79 percent to 3,391 in January. At the same time, loans that were 60+ and 90+ days delinquent increased. All loans 60+ days delinquent increased from 834,831 as of November 30 to 1,229,051 as of January 31, representing an increase of 47 percent over the period. However, prime loans 60+ days delinquent increased by 69.6 percent while nonprime loans increased by 23 percent.

Total Delinquencies

The reported 743,686 in the first widely read article was only Prime loans. The total 60-day and worse delinquent/defaulted loans stood at 1.229 million as of Jan 31st from 834k in November, up 47%. This represents 4.1% of their entire portfolio. This was led by prime that was up 70% while Subprime was up 23%.

Successful loss mitigation is increasing BUT in January only 9k loans were successfully modified. That would have to increase 10 fold to make a dent in the upcoming foreclosure wave.

The multi-month foreclosure suspension that ended on March 31st came at the same time as the new GSE loss mitigation initiative — but with a 400k increase in distressed loans over the past 2 months and a recent record of 9k mods per month, the broken dam has a lot of water coming over it.

It’s no wonder why the Fed is buying Agency MBS. Foreigners are likely a tad worried about now about this trash they were peddled by the trillions carries no explicit guaranty.

Fannie Mae Certificate

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MBS Purchase Program

Please consider the MBS Purchase Program.

On Wednesday, March 18, the FOMC announced the expansion of the Federal Reserve’s program to purchase agency MBS to a total of $1.25 trillion by the end of the year.

Does the agency MBS program expose the Federal Reserve to increased risk of losses?

Assets purchased under this program are fully guaranteed as to principal and interest by Fannie Mae, Freddie Mac, and Ginnie Mae, so the Federal Reserve’s exposure to the credit risk of the underlying mortgages is minimal. The market valuation of agency MBS can fluctuate over time based on the interest rate environment; however, the Federal Reserve’s exposure to interest rate risk is mitigated by the conservative, buy and hold investment strategy of the agency MBS purchase program.

When did the purchases begin?
Purchases began in early January, 2009 and will continue until the end of 2009.

Defaults and delinquencies are soaring an the Fed has the gall to say there is no risk because the principle is guaranteed by Fannie Mae and Freddie Mac.

Pardon me for asking, but I have two questions:

1. Exactly who is guaranteeing Fannie and Freddie?
2. How the hell does the Fed think it can get away with such a blatant lie about the risks?

Those who think that lie would be hard to top need to think again. Please consider the GSE MORTGAGE BACKED SECURITIES PURCHASE PROGRAM FACT SHEET

Risk. Treasury is committed to protecting taxpayers and will ensure that measures are in place to reduce the potential for investment loss.

Under most likely scenarios, taxpayers will benefit from this program – both indirectly through the increased availability and lower cost of mortgage financing, and directly through potential returns on Treasury’s portfolio of MBS.

Any idea that taxpayers will benefit from gains on the MBS portfolio is complete nonsense and the Fed and Treasury both know it.

An Explanation of the DMI/ADX Indicator

For anyone interested in using indicators in your trading/investing, the DMI/ADX is an indicator I’ve recently been looking at to help identify trends. It’s primary purpose is to measure directional trends and more importantly the strength of the trend. Keep in mind any indicator is secondary to price, which is the only leading indicator. provides a great explanation school:technical_indicators:average_directional_">here. Also, one of the better articles I’ve read explaining DMI/ADX and how to trade it is from the site FX Instructor, pasted below:

The DMI/ADX is one of the most effective and yet underused indicators. If used with the correct parameters, it can be a very effective trading system on its own.

It consists of two components:

  • The Directional Movement Indicator (DMI) is a trend-following system developed by Welles Wilder.
  • The Average Directional Movement Index (ADX), is part of the DMI and determines the market trend.

When used with the up and down Directional Indicator (DI) values: Plus DI and Minus DI – the Directional Movement Indicator is considered a trading system.

The rules for using the Directional Movement Indicator are:

  • You establish a long position whenever the Plus DI crosses above the Minus DI.
  • You establish a short position, when the Minus DI crosses above the Plus DI.

A simple DI+/DI- crossover is an entry and exit system. However, used that way it produces frequent whipsaws.

Hence we combine this with the ADX to reduce these whipsaws.

The ADX is the integral part of this system, as it gives a warning for a market about to change direction. It gives precise interpretations of the price action as follows:

  • It tells you if there is a trend present or not.
  • It also informs you if it is early or late in a trend.
  • It informs of a de-trending, of a reversal and renewal.
  • If the ADX line is trading above 20, then the market is in a trend.
  • If the ADX line is below 20, it means the trend is not a strong one.
  • As long as the ADX line is above 20, you should still consider a trend to be in effect.

The ADX however does not indicate the direction of the trend, only the strength of the trend.

Once we have these basics clear, let us add some filters to these indicators, which will enhance the characteristics.

Now in our chart here, we have the red line as the minus DI, the blue line as the plus DI, and the green line is the ADX. I have drawn a line at the 20 level for the ADX, since the rise of the ADX above 20 signifies an emerging of a trend.

Overall, if we observe only the two DMI lines (the blue and the red) it does give a correct picture of the trend, and keeps us in the correct side of the market.

Simply put, at the area marked with the red line, the –DMI line, is above the +DMI line, signifying a downtrend.

And at the area marked with the blue line, the +DMI line is above the –DMI line, signifying an uptrend.

But what about the areas, where the DMI lines have frequent crossings?

This is the kind of situation which will whipsaw out any position and this where the ADX is used in tandem. For these kinds of situations we define certain parameters, which will help us make a correct decision.

For the effective use of this indicator, the rules for a trade should be:

  • The ADX must have 3 consecutive higher readings above 20 to confirm that we are entering into a trend.
  • The ADX should be pointed up at all times when entry is being considered
  • If at this time, the plus DMI (the blue line) is above the minus DMI (the red line), which indicates an uptrend, then the ADX should have also crossed the minus DMI (the red line). This is a very important confirming factor.

On this ADX/DI crossover, the trend is very frequently confirmed and is a good place to add a position. Or if you failed to take the original DMI crossover entry signal, then this is a good position to enter.

  • We place our stops at the low of the bar, where the DMI lines have the crossover.
  • We look to exit the trade only when the ADX line starts to fall down.

This use of the ADX for the exits is called the “turning-point” concept.

  • First, the ADX must be above both DI lines.
  • When the ADX turns lower, the market often reverses the current trend.
  • The turning points in markets are often heralded by turns in the DI+/DI- at upper and lower extremes shortly followed by a down turn in the ADX which is above both DI lines.

This sign is near coincident with major turning points. So the reversal of the ADX at these high levels is a good place to take profits and STAND ASIDE.
These rules will help keep us out of a whipsaw trade, give us a safe stop point, and a proper exit to protect our profits.
If we apply our rules to our example here:

We will consider an entry only at this point marked ‘A’, when the ADX has had 3 higher readings.

At this point the ADX has already crossed the minus DMI line, so we have an added confirmation to the trade.

We have our stop level clearly defined, and we place it beneath the low of the bar where the DMI lines have crossed.

We consider exiting the trade, only when the plus DMI has reached an extreme level, and the ADX is turning down at this point.

This keeps us in the trade till the end of the trend.

If you notice at the area marked with red dot, the price had a retracement to the downside. But since the ADX was still rising, the -DMI had not crossed above the +DMI line, and the +DMI had not yet reached the overbought level, we could decide to stay with the trend.

And as we can see, price found support at the 21 EMA and resumed its uptrend.

A Contrarian Take on Inflation and Treasuries

From John Mauldin’s Outside the Box newsletter, an outstanding contrarian piece from Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management Company on why deflation, and not inflation, is going to be our biggest problem. Their conclusion is that Treasuries still remain the premier asset class. Some excerpts:

The bottom line, however, is that it is totally incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.

The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.

Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging…

…Since the 1870s, three extended deflations have occurred–two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of “extreme over indebtedness,” a term originally used by Irving Fisher in his famous 1933 article, “The Debt-Deflation Theory of Great Depressions.” Fisher argued that debt deflation controlled all, or nearly all, other economic variables. Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per annum more than Treasury bonds, but in deflations the risk premium was negative. In the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9% and 7% per annum, respectively, more than common stocks. In Japan’s recession from 1988-2008, Treasury bond returns exceeded those on common stocks by an even greater 8.4%. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond…

Therefore on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows and slow growth.

John Hussman Weekly Market Comment: Wishful Thinking

John Hussman’s Weekly Market Comment (which has become can’t miss reading for me) for April 20th, Wishful Thinking casts a very skeptical eye on the recent market surge:

Over the past several weeks, the stock market has enjoyed a strong but low-sponsorship advance from deeply oversold conditions. Not surprisingly, this advance has prompted hope that the market is “looking over the valley” toward an economic recovery. This confusion between economic information and an oversold bounce is typical of strong bear-market rallies, as we saw during the 2000-2002 decline, as well as the surge off of the November lows. It immediately strikes me that investors don’t understand that a near-term economic recovery would require a major and immediate resumption of the housing boom…

…In short, we should be careful to make distinctions between what constitutes improvement, and what only constitutes a backing off from extreme risk aversion. Put bluntly, the economy is not improving, and it is not likely to improve within a few months, because we have far more defaults, foreclosures, and credit excesses to work through. It is simply not true that the stock market heads higher 6 months before the economy bottoms. That simplification was true of 1970 and 1975, but not much else. Rather, there is enormous variation, and about the only reliable tendency is that stocks are usually advancing strongly within about 3 months of a recession’s end. That said, in the 2000-2002 plunge, the market didn’t bottom until about a year after the recovery started.

It is wishful thinking to believe that the stock market is forecasting the economy here just because we’ve observed a sharp advance off of an oversold trough. Yes, the stock market will probably bottom before the economy does, but lacking any credible approach to foreclosure abatement, the economic pain could easily extend well into 2010. We are likely to see a very wide and extended trading range, more deep selloffs, more short squeezes, and eventually disillusionment and revulsion from investors.

As the Wall Street Journal made clear in last Wednesday’s front-page headline (“Banks Ramp Up Foreclosures”), much of the relief in the recent pace of the deterioration has been the result of “internal moratoriums which temporarily halted foreclosures.” The Journal also noted “the resulting increase in the supply of foreclosed homes could further depress home prices and put additional pressure on bank earnings as troubled loans are written off.”

At present, the advance we’ve seen over the past several weeks is looking increasingly speculative. We certainly cannot rule out a further advance, but the basis for expecting one is currently weak. Better internals, higher quality leadership, broader sponsorship, and needless to say, a credible foreclosure abatement plan, would all be helpful “legs” if this advance is to be durable. For now, we don’t observe enough of that evidence…