Tag Archives: diversification

The term “Fiscal Cliff” is being tossed around everywhere since last week’s election. You know it’s a big deal when it hits the New Yorker, known to make political satire out of just about any government-induced malaise.

I came across the article today on NewYorker.com, “The Absolute Moron’s Guide to the Fiscal Cliff,” and it spurred me to write this post. What I think few Americans understand is what the looming doom of the Fiscal Cliff means to our economy and how radically it can change. Some say it will be more like a waterslides, slow and loopy but an eventual drop. Others say it will be more like a cliff, a big drop fast. Regardless of what you believe will happen, the fact is that you need to educate yourself of the basics of what the “Fiscal Cliff” means as there’s an important deadline of January 1, 2013 coming up that could change everything.

First, we need to take a ride in the way back machine to the year of 2001, when, according to the New Yorker post,

“George W. Bush signed a massive round of tax cuts that were supposed to expire ten years later, in 2011. President Obama later extended the expiration date to January 1, 2013. After that, your rates will go back up to the rates you paid in 2001. A bunch of other tax changes, like the expiration of a “payroll tax holiday” and the elimination of some tax credits, will also hit on January 1, meaning that no matter how much you pay now, you’ll probably pay more after the new year unless there's a deal.”

So, your question after reading this might be, “Who the heck do I blame for this crazy freakenomics?” The answer is unclear. Do you blame the Republicans for setting a round of tax cuts in the first place? Or do you blame the Democrats for prolonging the decision on said tax cuts to buy time? Regardless of who you blame, if we don’t have a plan and a deal before the expiration date, experts warn of spending cuts and potentially a recession.

Could this fiscal stalemate be Obama’s way to get what he wants in terms of tax hikes? In the words of Voltare, “A long dispute means that both parties are wrong.” Both parties are wrong because no one is right – that’s what compromise, meeting halfway, and making unbiased decisions for the greater good is about.” Let’s see if the leaders of our countries can turn a fiscal cliff into a fiscal decision that keeps our economy from taking a nosedive.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Modern Portfolio Theory remains a major part of many investment portfolio allocation processes. Basically, the idea of MPT is that one can combine a collection of securities into a portfolio which offers comparable return prospects with reduced risk. This is done by mixing together stocks and other assets which are not well correlated, or perhaps are negatively correlated.

Sounds good, right?

The problem is, as has been discussed, that individual stocks have become extremely highly correlated to the market in recent years. This, by definition, means they have become increasingly correlated to each other as well, reducing the opportunity for diversification in portfolios using the old methods.

Another issue with MPT-based portfolio development is the fact that correlations change over time and in different time frames. The chart below from Oanda shows a recent set of correlations between EUR/USD and other currency pairs (as well as gold and silver).

Notice in the AUD/USD column how the correlations to EUR/USD are strongly positive (darkest red) in the hour, day, and week time frames, but then are uncorrelated in the longer time frames, and even negatively correlated at 3 months. In the case of USD/JPY we can see the correlations are very time frame depended, running the full spectrum over the time frames. Even with silver and gold (XAG/USD and XAU/USD) the correlations aren’t consistently strongly positive.

All this correlation variation creates considerable challenges to standard asset allocation and portfolio development methods and approaches. Imagine creating a portfolio of stocks that have been properly minimally correlated only to have them all become highly correlated? It would totally change the portfolio’s risk dynamics, and likely at the worst possible time.

This is where the importance of considering diversification not just in terms of markets and securities, but also in terms of trading/investing approach becomes clear. This is the approach of fund-of-fund investors. They seek out uncorrelated money managers, exactly the same sort of thing you can do by taking part in the Trade Leaders program.

It’s always reassuring when an industry leader releases information shedding positive light on the future of an alternative investment. Today, it was derivatives marketplace Chicago Mercantile Exchange, or CME Group, discussing the promising outlook of foreign currency futures.

Since the CME is arguably the biggest futures exchange out there, is it any surprise they’re touting FX futures contracts? No, not really, but the whole concept of currency futures is still pretty interesting nonetheless. I decided this fit as a nice follow-up to a post I wrote the other day on managed futures and risk mitigation in general, since these particular investments can get a little complex.

For anyone who’s unfamiliar with them, currency futures allow investors to exchange one currency for another on a future date at a specified price that is set at the time of the agreement.  This allows investors the ability to make a purchase that will be executed sometime in the future for the price it would cost them today. In turn, they’re granted protection against exchange rate fluctuations, which could end up working for or against them depending on where the currency pair moves.

Derek Sammann, global head of foreign exchange and interest rates at CME Group, explains how, due to rapid economic globalization, cross-boarder asset flows show no sign of slowing down anytime soon. This provides both a growing opportunity for potential prosperity, as well as risk, for investors interested in tapping the $4 trillion a day foreign currency market.

As Forex continues to become a more mainstream alternative investment option, the need for a supplementary vehicle for hedging risk will inevitably rise. Currency futures are just one avenue investors can take to fill that need. Others come in the form of continuously developing advanced software controls within the realm of spot Forex trading. As various up and coming forms of alternative investments popularize, it is interesting to note what types of risk controls they will inspire and bring with them.

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Have you been paying attention to the changing markets?

Once upon a time all the talk was about how stocks and the dollar traded in opposing directions. The chart below with weekly bars shows how that was definitely the case until the latter part of 2011 (S&P 500 left scale, blue plot; USD Index right scale, black plot). Since then, though, with the exception of a few months earlier this year, the two markets have been trending higher roughly in tandem.

That’s a bit of an illusion, though.

You see, the USD Index is very heavily weighted toward the euro. That means it trades very close to how EUR/USD trades. As a result, it doesn’t always provide a comprehensive view the way we’d normally expect from an index.

Here’s something a bit more representative. It’s the same weekly chart, but swaps out the USD Index and replaces it with AUD/USD. Here you can see a VERY close correlation between the two markets.

So why the difference?

Well, AUD/USD is a good proxy for the so-called commodity currencies. Other commodity-oriented pairs are NZD/USD, USD/CAD, and many of the emerging market pairs like USD/MXN and USD/BRL. These are economically sensitive currencies, so they have a strong link to the stock market. Thus the strong correlation.

The euro, on the other hand, has all sorts of stuff going on which influences its exchange rate. It’s not just a function of economic growth but also of monetary policy and general confidence. The same can be said about both the yen and the pound. Further, since the Swiss National Bank effectively has the franc pegged to the euro (it’s really a floor on EUR/CHF, but is acting like a peg), the CHF is basically trading the same as the EUR.

What this all means is that we can no longer just look at “the dollar” and its relationship to stocks, commodities, and interest rates. We have to account for the variance in the performance of different currencies depending on the influencing factors if our analysis can have any validity. We may get back to the point where EUR/USD and the S&P 500 close correlate as they have done in the past, but for now we need to focus on the likes of AUD/USD and USD/CAD in our inter-market analysis of stocks, commodities, and the greenback.

Stock prices have been held back for at least the last two years, as the continued turbulence in the euro-zone – alongside the stop/go nature of America’s recovery from the ‘Great Recession’ – has weighed heavily on investor sentiment.

The bulls argue that the incessant focus on the well-known macroeconomic travails in both Europe and the US has seen investors ignore the stellar improvement in the corporate sector’s fundamentals since the profits cycle reached its nadir more than three years ago; the positive spin contends that the virtual sideways movement in the major stock market averages since the spring of 2010 has pushed equity valuations to the most attractive levels in more than a generation.  Is the optimism justified?

It is beyond dispute that the corporate sector’s recovery from the ‘Great Recession’ has been nothing short of impressive.  After-tax corporate profits, as reported by the Bureau of Economic Analysis, dropped by more than a third between the autumn of 2006 and the winter of 2008 – the steepest decline since quarterly data was first collected in 1947, and almost double the average of the previous ten contractions.

Record earnings seemed a long way off as stock prices plummeted towards their crisis lows during the spring of 2009, but somewhat surprisingly to say the least, corporate profits recovered their pre-recession peak by the end of the very same year.  The robust uptrend was sustained in subsequent quarters, and return on net worth reached the highest level since the late-1990s in recent times, while the corporate sector captured a record share of GDP.

The bulls’ frustration with the stock market’s refusal to move higher seems justified in light of the headline numbers concerning trends in corporate profitability.  However, a more probing analysis demonstrates that there are valid reasons behind investors’ unwillingness to attach a higher multiple to current earnings.

S&P earnings data reveals that cost-containment and the accompanying margin improvement accounts for almost three-quarters of the cumulative increase in per-share profits over the last three years, with top-line growth accounting for the remainder.  The relatively minor contribution from revenue gains has seen per-share sales fail to exceed their pre-recession peak.

By way of comparison, profit gains during the previous earnings expansion that extended from the end of 2001 to the summer of 2007, were shared relatively evenly between margin improvement and revenue growth.  Further, the quarterly year-on-year growth in sales-per-share averaged almost four per cent back then, as against just two per cent today.

It is important to appreciate that the magnitude of the economic downturn that accompanied the global financial crisis saw the corporate sector trim their cost structures to the bone.  Troubling, the subsequent lukewarm recovery has seen little let-up in this regard, and though this may well have pushed both corporate profits and cash flow generation to all-time highs, but the reluctance to reinvest the gains in either human capital or productive assets has created a negative feedback loop that threatens not only to hold economic growth below trend, but also to lower the economy’s potential future growth rate.

It is fair to say that the ‘Great Recession’ sparked serious erosion in labour’s bargaining power that is likely to persist for the indefinite future.  The unemployment rate surged to a peak of ten per cent in the autumn of 2009, as the corporate sector responded forcefully to reverse the sharp drop in profitability.  However, the high rate of joblessness combined with unsustainable household debt levels to virtually assure nothing more than a modest rebound in final demand, which in turn, has led to a relatively jobless recovery.

Subdued job growth has seen the unemployment rate persist above eight per cent for more than forty months, and the downward pressure on real wages has seen the labour share of GDP drop to the lowest levels on record.  The stagnation in household incomes means that final demand is sure to remain lacklustre, which in turn, means the unemployment rate will remain elevated.  All told, high rates of long-term unemployment and the resulting erosion of human capital could well result in a loss of productivity and lower potential future growth.

The economic downturn had a pronounced negative effect not only on the labour market, but also on net new investment in the productive capital stock.  Business investment dropped by than a fifth through the downturn, and though corporate cash flows have surged to the highest level on record, capital expenditures remain below their pre-recession peak, and have not recovered to their long-term average relative to GDP.

The current high return on corporate assets alongside historically low interest rates has not proved sufficient to generate a robust investment cycle, as high levels of macroeconomic uncertainty have kept most companies on the sidelines.  In a nutshell, the relatively low investment rate could well lead to a decline in labour productivity with a corresponding fall in the economy’s sustainable growth rate.

The upturn in corporate profitability in recent years is undoubtedly impressive, but persistently high unemployment alongside a relatively low investment rate means that the economy’s sustainable long-term growth rate is in jeopardy.  Investors are right to attach a low multiple to current earnings.

 

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The forex market continues to make some folks nervous. While there are certainly reasons to be cautious when playing exchange rates, a considerable amount of the nervousness of the average person on the street comes from misinformation. Most notably, they all too often think of the forex market as being highly volatile. I addressed this issue before in Looking at Volatility Across Markets, but I think it’s worth revisiting.

I’ve collected 5 years of weekly values for a number of markets to look at just how volatile they are. Let me first look at the US Dollar Index. Between July 2007 and July 2012 the average weekly range for the USD Index was just 2%. I derived that by taking the distance between each week’s high and low and dividing it by the midpoint for that week [( High – Low)/( (High+Low)/2) ]. At the same time, the standard deviation of weekly closing prices (which gives us an idea of how choppy the market is) was only 4.9% (relative to the average close for the study period).

As you will see, that’s not a lot of volatility.

Let’s start by comparing the USD Index values to those from the major US stock indices.

DJIA: 4.0% average weekly range, 15.0% standard deviation
S&P 500: 4.4% average weekly range, 16.0% standard deviation
NASDAQ 100: 4.7% average weekly range, 20.2% standard deviation
Russell 2000: 5.6% average weekly range, 17.3% standard deviation

As you can see, the major stock indices show considerably more volatility than does the USD Index.

How about individual stocks?

JPM: 9.4% average weekly range, 15.0% standard deviation
IBM: 4.8% average weekly range, 24.6% standard deviation
GE: 7.4% average weekly range, 39.9% standard deviation
XOM: 5.1% average weekly range, 12.0% standard deviation
KO: 4.0% average weekly range, 15.3% standard deviation
AAPL: 7.2% average weekly range, 53.5% standard deviation
KO: 6.2% average weekly range, 18.0% standard deviation

No real surprise to see that individual stocks are pretty volatile by comparison.

Looking at commodities:

CRB Index: 3.9% average weekly range, 18.2% standard deviation
Gold: 4.6% average weekly range, 28.1% standard deviation
Crude Oil: 8.4% average weekly range, 24.2% standard deviation

Here again we see markets with a great deal more volatility than the USD Index. The one place where there is something of a contest is the bond market. The long-date Treasury note/bond ETF is TLT. Looking at its weekly figures I come up with a 3.2% average range and 10.6% standard deviation. That’s considerably less volatility than the other markets and securities shown above, but still not at low as what we have seen the last five years in the USD Index. We would likely have to move down to short-term Treasury securities (like 2yr Notes and T-Bills) to find lower values.

The point of all this is that anyone avoiding the currency market because of the perception that it’s super volatile is operating on a false belief. The figures just don’t back that up.

 

The financial markets are in disagreement.  The yields available on high-quality corporate bonds have dropped to generational lows, as fixed income investors embrace the idea that the US economy is caught in a deflationary trap.  Meanwhile, stock markets are priced for perfection, as equity investors remain optimistic that the life-support operations provided by the Federal Reserve will ultimately reflate the economy and restore price stability.

Investors need to determine which view will ultimately win out and allocate their assets accordingly.  All else equal, the deflationary argument calls for a highly-defensive asset allocation with minimal exposure to risk assets, while the reflationary case prescribes an aggressive allocation with little investment in high-quality bonds.  A reasoned analysis on which way the dice will ultimately fall requires a comprehensive understanding of secular investment cycles through time.

Investors need to appreciate that the economy rotates around price stability or the rate of inflation that maximises the non-inflationary rate of economic growth, and at any given point in time, the economy is either moving closer to or further away from this Holy Grail.  Meanwhile, secular trends in both bond and stock valuations are determined by the stage of the cycle in which the economy currently lies.

The stages of the secular investment cycle can be classified under four general headings – disinflation, deflation, reflation, and inflation.  A disinflationary regime is characterised by falling inflation and robust growth, a deflationary regime is characterised by low and falling inflation alongside poor growth, a reflationary regime is characterised by rising inflation and strong growth, and finally, an inflationary regime is characterised by high and rising inflation alongside disappointing growth.

The historical evidence reveals that recessions are fewer and less severe in both disinflationary and reflationary regimes, while real economic growth is stronger.  During the reflationary period between 1949 and 1968 for example, the economy spent just one month in eight in recession, while the annual rate of economic growth was 4.3 per cent.  Meanwhile, during the inflationary period between 1968 and 1982, the economy spent almost 30 per cent of the time in recession, while real growth was just 2.5 per cent.

It is important to appreciate that the secular investment cycle should be employed as an important input to asset allocation, given its influence on asset prices and valuations.  Both bonds and stocks perform well in a disinflationary environment as valuations rise with the latter outpacing the former over the period.  Bonds excel in a deflationary environment as yields decline, while stocks perform miserably as valuations contract.  Stocks exhibit robust performance in a reflationary regime as valuation multiples expand, while bonds do poorly as yields rise, and finally, both fare badly in an inflationary period as valuations fall, with stocks outpacing bonds.

As an input to asset allocation decisions, it is important to identify transition points in the secular cycle.  In this regard, it is instructive to note that high-quality corporate bonds have led stocks, as the cycle transitioned from deflation to reflation, and once again, when the underlying regime switched from inflation to disinflation.

The historical record of the past one hundred years provides clear evidence of the corporate bond market’s ability to signal an impending regime shift ahead of time in 1920, 1947, and 1981.  The yield on high-quality corporate bonds peaked in June 1920 at 6.4 per cent, and registered a lower high six months later, which signalled the end of the two-decade long bear market.  The stock market’s inflationary bear market drew to a conclusion eight months later.

The yield on high-quality corporate bonds bottomed in April 1946 at 2.5 per cent, and registered a higher low thirteen months later, which signalled the end of a secular bull market that spanned almost three decades.  The stock market’s twenty-year deflationary bear market came to an end two years later, and even though the ‘buy’ signal seems quite premature, the high dividend yield available on stocks alongside the modest decline in the major market averages in the intervening period, meant that equity investors who acted upon the call earned a positive real return.

The yield on high-quality corporate bonds peaked in September 1981 at 15.5 per cent, and registered a lower high the following February, six months before the stock market’s inflationary bear market hit bottom.  Equity investors subsequently went on to enjoy the strongest secular bull market in stock market history.

The financial markets are currently enduring a tug-of-war between the deflationary fixed income view, and the stock market’s reflationary optimism.  Unfortunately for equity investors, the weight of historical evidence indicates that the bond market leads the stock market at important turning points in the secular investment cycle.

The fresh generational lows in the yields available on high-quality corporate bonds suggest the stock market’s more than decade long deflationary bear is not over.

 

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

This past Thursday, we had the exciting opportunity to host a webinar with Currensee Trade Leader JCB FX Trading. Javier Colon, principal trader of JCB FX, conducted the presentation entirely in Spanish, his native language. The main incentive of his talk was to educate investors on the advantages of diversifying in alternative investments as a means of combating market volatility. Colon operates as a professional Forex trader out of Madrid, Spain; the epicenter of what could easily be considered the eye of the economic storm.

On the day of Colon’s webinar about the growing significance of alternative investments, an influential financial survey just so happened to be released simultaneously. The results shown were in perfect confluence with Colon’s insight. In a Business Wire press release, findings generated in the Elite Access Alternative Investment Survey conducted by Jackson National Life Insurance Company showed information gathered from the responses of over 2,000 financial advisers.

In an attempt to determine adviser’s current use of alternative asset classes and their needs from financial product providers, the survey uncovered a huge increase in their expected use of alternatives. The driving factors behind their interest in tapping this resource were to help negate potential market volatility and try to improve upon client portfolio diversification.

The survey found that within the next year, nine out of 10 advisers plan to increase allocations into alternative investments – with over half looking to do so by 15% or more, and a third aiming for 20+ percent.

The rest of the release details insight from Jackson executive vice president, Clifford Jack, who explains how over the last decade markets have seen record volatility. This has spawned an evolution in investment breakdown, which renders traditional 60/40 portfolio composites somewhat obsolete. A portfolio broken into thirds, with the inclusion of alternatives, is now becoming the norm.

One of the most prevalent themes the survey demonstrated was an obvious need amongst advisers for guided strategies in devising the alternative portion of client portfolios. Up towards 80 percent of advisors expressed they would be more likely to use alternatives if they were able to be to have some guidance in strategizing.

Being in the alternative sector of the investment industry, I sometimes take for granted the seeming “simplicity” of alternative investments and their related financial products. This survey demonstrated that despite their rapidly growing popularity, investments of these kinds are still emerging and thus require far more transparency. It is, however, very exciting to be right in the middle of the “traditional” investment portfolio makeup evolution. From the old 60/40, equities/fixed income breakdown, to the now evolving versions that include alternatives as an increasingly permanent fixture.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

For a long time there’s been an argument in the retail foreign exchange trading community about whether it is better to trade futures or spot. It’s something which comes up so often that I included “Is it better to trade spot forex or currency futures?” as one of the questions addressed by contributors to my Trading FAQs book. One of the key elements long seen as being in favor of futures is the regulation, transparency, and security of the futures market.

Then we had MF Global go under.

In one shocking moment the accounts of thousands of futures traders were at best frozen and at worst completely gone. This was a stunning development. After all, customer funds with brokers are supposed to be sacrosanct. Even if a broker goes belly-up it’s not supposed to impact customer accounts. The MF Global fiasco shook that confidence in the system very hard.

Now we get PFG Best.

No doubt it will take a while to get things all cleared up, but early indications are that a lot of customer money has vanished. This is another blow to the previously nearly unassailable integrity and stability of the futures markets and brokerage industry.

I am personally on record as having favored spot trading over futures for some time now,  primarily on the basis of flexibility and lower capital requirements. Those on my side of the debate may very well use the MF Global and PFG collapses as arguments in favor of the spot market, especially since none of the big brokers in the retail forex space have suffered anything like this kind of failure (though they have had issues of their own). This, to my mind, is a dangerous case to make.

What the implosion of these two futures brokers does is highlight the need to manage risk not just on the level of your trades and/or portfolio, but also in the security of your accounts. We may feel comfortable working with highly capitalized firms, but as MF and PFG have shown, there are flaws in the regulatory and oversight structure.

And on top of all that, whenever things aren’t going well in society there is an increased effort to find someone to blame (notice how few market scandals there are during bull markets?) and to look for lawbreaking behavior. The banks and other financial institutions are facing that now from many different angles, as the current LIBOR scandal demonstrates. What impact would there be on your broker or bank if a regulator or court slapped it with a huge fine or judgement?

The point is that diversification of assets isn’t the only thing you want to be doing. You should be diversifying your exposure to financial institutions as well.