Sunday Night Reads

Harvard Risked Its Cash (from The Big Picture):

The Boston Globe’s Beth Healy writes what looks like another Lawrence Summers bashing Harvard Endowment story–with an extra helping of unnamed Robert Rubin-kicking on the side–when she reveals that Summer fought with Harvard Endowment head Jack Meyers over his decision to add the University’s operating cash account to the general endowment pool. Meyer, and his successor Mohammed El-Erian, both warned that the university’s president was doubling down on the endowment and creating excessive risk. The warnings proved true when the school lost $1.8 billion from that cash account last year.

Will Increased Capital Requirements Kill a Recovery? Morgan Stanley Wants You to Think So (Simon Johnson):

size:85%;">The bottom line, translated: Let us adjust our balance sheets (downwards to some degree) and continue with our existing business models (including unconstrained bonuses), and we will bring you back to growth eventually. If you mess with us, unemployment will stay high for a long time. And any future crises that may befall us are just a cost of doing business, and making us whole is just what you have to do.

size:85%;">But this is all wrong. The essential premise of the Morgan Stanley reasoning (heard much more widely on Wall Street) is that the size of our biggest banks cannot be constrained–because it would raise the cost of equity for these smaller units. This misses three points:

size:85%;">1) If you are sufficiently small, you can take more risk without jeopardizing the system. So the expected risk/return combination can attract investors and be fine for society. Most successful venture capital funds, hedge funds, and private equity funds are in the right size range from this perspectives and don’t have trouble attracting capital–except when the big banks blow up. As long as you are small enough to fail, go for it.

size:85%;">2) Morgan Stanley’s pricing of risk model implicitly assumes that big banks still exist as a comparison point and an alternative for investors. But if you put a size cap on the largest banks (e.g., assets cannot exceed 1% of GDP), this defines the asset class available–so investors don’t choose small vs. medium vs. large; they choose small vs. medium. Yes, this removes a choice for investors, but we routinely constrain investors ability to put money into activities that are potentially dangerous for society (e.g., try proposing a “new” high risk/high return approach to nuclear power).

size:85%;">3) There will always be financial shocks, but these do not always need to have such devastating effects. Our financial system worked fine in the post-World War II period, with a great deal of risk-taking and much nonfinancial innovation–our biggest banks were much smaller, in absolute terms and relative to the economy. The notion of “let us take any risks we want and, if it all goes bad, bail us out so we can make it up to you later” is simply preposterous and completely at odds with the historical record of U.S. economic development.

size:85%;">The big banks’ bonuses undermine their legitimacy. Every time these banks CEOs speak or write in public, they just underline their hubris and the danger this poses to financial system stability. And their own research strengthens the case for breaking up the megabanks.

Why I am an Optimist – pdf (John Mauldin – most of the article is on optimism despite the excerpt below):


size:85%;">When anything as relatively small as Dubai spooks the market, it should serve as a warning sign. The world has priced in 5% GDP growth for the US and much of the developed world in the equity and commodity markets. Either we have to get that or the markets are going to have to come back to the reality of what I think is going to be a much lower growth figure.

But in any event, one of the lessons to be learned is that investors should pay attention to where the leverage is. Unsustainable debt trends end in tears. They always do. Spain, Greece, Italy, the UK, and Japan will all have to face major restructuring in the next decade due to leverage. And we in the US will also find that we cannot grow debt at our current levels. Will we pare our debt willingly or be forced to by the market? Either way, it will make for a less than optimal economy over the coming years. Muddle Through, indeed.

McClellan: Why US Debt Is Good for Equities

I recently heard an interview on Andrew Horowitz’s Disciplined Investor podcast with Tom McClellan (of McClellan indicator fame) who seems like an incredibly intelligent analyst. He mentioned in the interview how high US federal debt, while bad for many reasons, has historically been very good for equity investors. McClellan runs which has some pay content but also some interesting free content (I have no affiliation with his site). As an aside, in the interview McClellan was still bullish on equities but saw a cyclical low (in other words, the bottom of a consolidation or pullback) on or around December 11th 2009.

This week’s free McClellan Chart in Focus shows the historical return of the S&P 500 alongside the annual federal deficit as a percentage of GDP. The obvious implication is that high federal deficits have historically fueled high equity returns. Thus, we should not be surprised that this year has been very good to equity investors. As citizens, the high deficits should concern us. As equity investors, we should understand the implications of high deficits on our portfolios and plan accordingly.

The chart, however, also made me question how much of our country’s marketplace–when reflected in equity returns–is ‘free market’ and how much is dependent on government spending. Black and white dualistic terms like ‘free market’ and ‘socialism’ often fail to capture full macroeconomic realities. While many of us in the United States (at least prior to 2008/09) would proudly proclaim our country a ‘free market, the US, like most countries, fall somewhere in between free market and socialism, an economic shade of gray.

Below is a copy of McClellan’s chart:

e) {}" href="">

Portfolio Updates

There was a data issue with the Global Sector ETF portfolio for a previous month that has been corrected. However, I’m finding that Google Finance quotes doesn’t always work, so from time to time you may see a ‘N/A’ for some ETF prices.

For those of you new to the site, please check out the ETF portfolios on the right hand side of the page. They are updated around the 1st of every month so new updates will be coming this week.

Dubai, the Dollar, and Equities

If you have followed the news the past few days, you are already aware of Dubai’s inability to make their debt payments on schedule. The market sold off hard (albeit on low volume) on Friday in what is typically a sleepy day after Thanksgiving. It seems that US firms have little exposure to Dubai debt, with most of the direct exposure in the Middle East and Europe. Cumberland Advisors stated yesterday that they don’t see a long term impact on the US or the dollar.

In the short-term, the dollar could rally on the Dubai news as overseas institutional investors seek safety. This is significant for equity investors because the dollar and equity markets have been negatively correlated for much of the past two years. A rising dollar has meant a falling market and vice versa (see first chart comparing $USD and $SPX). This is most likely a result of the ‘dollar carry-trade’ in which institutional investors are short the low-yielding dollar and long virtually everything else. So long as the dollar continues to fall, those who are short the dollar can continue to pour funds into every corner of the market; a rising dollar could mean quick liquidations of leveraged investment positions. Hence, we have seen the market rally in the face of seemingly bad news and porous fundamentals for much of 2009. Long term the fundamentals for the dollar are not encouraging and the Fed has shown no signs of raising rates (which would damper the dollar carry-trade).

For investors who want to continue to hold equity positions, one potential short-term hedge opportunity would be to enter a long dollar position via the ETF UUP (free UUP trend analysis here). The dollar is still in a downward channel (see chart 2), so one could wait for confirmation on any short-term rally by looking for a breakout above the top of the channel (on UUP this would be around $22.50-$22.65). The higher lows on some of the indicators coupled with lower lows on the dollar could also be a sign of a pending short-term dollar rally.

e) {}" href="">

e) {}" href="">

no positions

Finding the Trend in Forex

Here is the fastest and easiest way to tell the trend in the foreign exchange markets.

In today’s video Adam Hewison of MarketClub (30 day risk free trial available) shares with you a wonderful way to look at the forex markets and determine which way they are headed in a matter of seconds. We’ll be looking at three different cross rates and how they all correlate together in a way that I think may surprise you.

The forex markets are the biggest markets in the world and MarketClub not only covers all of them, but also covers them in real-time with pricing and charts. I hope you learn from this video and take the time to explore the forex market

As always there is no charge and no registration required to watch this 6-minute educational trading video.

Jim Jubak: How to Profit in the Upcoming Lost Decade (!)

Jim Jubak wrote a helpful, albeit depressing, article recently on MSN, Another lost decade for investors?

In the article he thinks that the next decade could be just as grim as the last decade for US equity investors. However, he argues for allocating assets to non-US equities so that your portfolio better reflects the realities and allocations of the global markets. Logically, this makes sense to me:

“You should gradually work to increase your allocation toward this)" href="">overseas stocks, with an emphasis on the equities of the world’s this)" href="">fastest-growing economies, toward something like the actual weighting of global capital markets.

There are lots of reasons that feels hard. I’ve been working for the past five years or so in my own portfolio to achieve an allocation like that, and I’m not there yet. Let me tell you from experience why it feels so hard, and I’ll tell you about the strategies I’m using to get past those difficulties.

Obstacle No. 1: It feels like I’ve missed the boat. The iShares FTSE/Xinhua China 25 (FXI, news, msgs) exchange-traded fund is up 55% this year (as of Nov. 18) and 103% in the past year. The iShares MSCI Brazil Index (EWZ, news, msgs) ETF is up 120% in 2009 (as of Nov. 18) and 97% in the past year.

Solution No. 1: Remind yourself that it’s early in the ballgame. Deciding not to invest in China or Brazil now is like a 19th-century investor saying he doesn’t want to buy into the future of the United States in 1875 because he missed the this)" href="">post-Civil War boom. Wait for corrections and busts. The iShares Brazil ETF was down 54% in 2008, let’s not forget. And realize that a long enough holding period and a strong enough performance will wipe out a lot of timing mistakes.

Obstacle No. 2: Who knows anything about Chinese solar companies or Indonesian cell phone operators or Indian banks? McDonald’s (MCD, news, msgs) and General Electric (GE, news, msgs) and Apple (AAPL, news, msgs) are names I know. I can go out and visit a store. I buy their products. And when I need information, I can get it from Standard & Poor’s or my online broker or on the Internet. But just try to find decent information on Telkom Indonesia (TLK, news, msgs).

Solution No. 2: Take it slow. You don’t have to become an expert on any of these companies to invest in them, thanks to the growth of actively managed this)" href="">mutual funds and this)" href="">ETFs that follow single-country indexes. Buying iShares MSCI Brazil is a great way to add Brazil to your portfolio. Owning it will — if you poke around in the lists of the fund’s holdings you can find online — give you an entry point into learning more about individual companies.

In some cases — and Brazil is one — you’ve even got a choice of ETFs that will give you an exposure to different pieces of an emerging market. For example, in my Jubak’s Picks portfolio, I own the Market Vectors Brazil Small Cap (BRF, news, msgs) ETF to get exposure to more of the domestic consumer economy. (For more on that buy, see my blog post on my this)" href="">original buy in September at About 30% of my Jubak’s Picks portfolio is now in true overseas stocks, and I plan to increase that percentage over time.)

Obstacle No. 3: I feel like everybody is chasing the same handful of stocks and the same two or three markets. I’m worried that I’m buying just in time to be the fool of last resort so that the early, smart money can sell.

Solution No. 3: Recognize that emerging markets are a constantly changing new-world pecking order. If China is the next United States and India is the next China and Brazil is the next India (whew!), then who’s the next Brazil? At the moment, I’d say Indonesia. The country shows signs of moving down the same path that Brazil started down 15 years ago. There is already an ETF, Market Vectors Indonesia (IDX, news, msgs), but it’s less than a year old. Another emerging economy to watch is Turkey’s. The iShares MSCI Turkey (TUR, news, msgs) ETF goes all the way back to 2008. In the case of both Indonesia and Turkey, you can also buy an older closed-end mutual fund, such as Turkish Investment (TKF) or Indonesia Fund (IF).”

John Hussman is on Alert for Financial Tanks

One of my favorite investment reads is John Hussman’s Weekly Market Comment, available for free at Below are some excerpt’s from last Monday’s letter, Alert for Tanks:

“In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn’t a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place.”

“The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has � aside from the recent collapse � maintained a well-behaved growth channel for the better part of a century.

From my perspective, we are again at the point where we should be alert for tanks. We already know that stocks are priced to deliver a 10-year total return in the area of 6.1% annually – among the lowest levels observed in history except for the period since the late-1990’s (which despite periodic advances has ultimately not worked out well for investors). We are already observing evidence of weak sponsorship from a volume perspective and growing non-confirmations of recent highs from the standpoint of market internals. The cumulative tally of surprises in economic reports (a metric we credit to Bridgewater, which Bill Hester adapted here), has also turned down decidedly. Though the historical correlation is not always as strong as it has been during the recent downturn, shifts in economic surprises have tended to lead market turns in recent years.

Still, with market internals mixed but not clearly collapsing, prices strenuously overbought but still achieving marginal new highs, and valuations unfavorable but not as extreme as they were in 2000 or 2007, investors may be convinced that there is still a little bit of punch in the bowl. We can’t argue with that too strongly, and have been trading in (on market weakness) and out (on market strength) of a modest positive market exposure in recent weeks (to diversify our position and allow for two very different potential states of the world). We’re just keeping our risk very close to the vest.

In short, we have to allow for the potential for further speculation, and we can’t ignore the day-to-day charts showing several market indices near 52-week highs. But we are also at the point where we can look right over the top of the monitor, and see the tanks a-coming.”

GMO 7 Year Asset Class Forecasts

GMO released their November 7 year asset class forecasts on 11/25. Below is a summary:

Real return forecasts before any extra returns gained from active management (estimated returns with active management listed in parenthesis):

Large Cap US: 2.4% (4.2%)
Small Cap US: 2.3% (4.1%)
US High Quality: 8.7% (10.5%)
Large International: 5.7% (8%)
Small International: 5.6% (7.9%)
Emerging: 4.9% (8.6%)

US Govt: 1% (1.9%)
Intl Govt: .4% (1.3%)
Emerging: 2.7% (5.6%)
Inflation Indexed: .9% (1.8%)
US Treasury (30 days to 2yrs): -.3% (1.1%)

Managed Timber: 6% (7.5%)

Gift Ideas for Your Favorite Investor

Being that the holiday shopping season officially starts Friday, below are some book ideas for the investor in your life (I have not read all of these, but they are either on my wish list or I have read and enjoyed):

A Look at the Dollar Index.

Today we’re looking at the dollar index and some important elements Adam Hewison sees building in this market and wants to bring to your attention. In this short video he outlines the key areas to watch for and one important component that you may not have seen. I think this factor could, in fact, be a short term game changer for this market.

As always the MarketClub videos are free to watch and there is no need to register.