If you invest in listed securities, it is critical that you have a good broker working for you. Some readers have written in to ask which brokers to use so today I will share some of the considerations we take into account in choosing a broker and our experience with some of the brokers that we have used. As a self-directed investor, I only expect my broker to handle my transactions for me and not to provide me with investment advice. Hence an online broker is an obvious choice for self-directed investors like me as the brokerage fees are normally much lower when compared with a full-service broker. When comparing online brokers, most people tend to focus on brokerage fees and functionality of the broker’s trading platform. While these two items are important, many people neglect the most important consideration, which is, how safe is the broker?

On 23 June 2010, over 3000 of Sonray Capital’s clients found out the hard way when their brokerage accounts were frozen because Sonray had gone into voluntary administration. Sonray’s clients are considered as unsecured creditors and their money could be used to pay other creditors. Sonray’s collapse is the latest in a string of financial service firms to go under. During the global financial crisis, Opes Prime, Chimaera Capital’s Primebroker and Lift Capital all failed, hitting client accounts worth more than $1 billion. Although brokers are regulated by ASIC, brokerage clients do not get very much protection in Australia.

We have chosen to use CommSec as our broker for Australian listed securities mainly because of the safety aspect even though their trading platform is pretty basic and their brokerage fees are not that cheap. I like holding our stocks under our own separate Holder ID Number (HIN) and holding any cash meant for investing in a bank account in our own name, rather than in a pooled account with the broker. A few years ago, I contemplated switching to Spectrum Live, a broker who was highly recommended by one of the local options gurus because it had a much more sophisticated trading platform that allows you to trade 21 markets around the world, including stocks, options, CFDs, futures and foreign currencies from one account! As we invest in both stocks and options in the US and Australian markets, the ideal broker for us would be one who can allow us to trade seamlessly in both markets so I was keen to try this broker out. After completing the initial account opening paperwork, I noticed I had to fund my account by sending a cheque to Tricom Equities. I remembered reading something negative about Tricom Equities so I quickly googled them and found out that Tricom Equities has been fined a record $1.35 million by the Australian Securities Exchange for 10 breaches of the rules spanning three years including “blatant market manipulation”. That was enough to put me off using a broker like Spectrum Live, even if they have the best trading platform in the world. It turned out that they also use the Saxo Bank platform, which is the same platform as the one used by Sonray Capital.

Last year I opened an account with Interactive Brokers (IB) which is a US broker who actively operates in Australia. They also touted a sophisticated platform that allows you to trade different types of securities in multiple markets. As a US broker, IB easily passed the safety requirement as all US brokerage clients are protected by the Securities Investor Protection Corporation (SIPS), which will ensure clients get their money back if their broker goes bankrupt. Their trading commissions were also very attractive when compared with Australian online brokers but they do charge all kinds of other fees for services that are normally provided free of charge by other brokers. For example, you have to pay extra for live market data and it costs around AUD 30 per month to get real time prices for ASX listed securities. Their trading platforms are robust but not that user friendly and it was a lot more complex to complete an international transaction that I expected. I set my base currency to AUD and funded my account in Aussie dollars. I then decided to buy UUP, an Exchange Traded Fund which is listed in the US. The transaction seemed pretty straight forward. With a few keystrokes, I managed to buy UUP shares and I assumed they would simply take money out of my account to pay for the shares. When I looked at my statement at the end of the month, I was shocked to find out that I had been hit with interest charges, even though I had more than enough money in my account to cover the purchase of the UUP shares. I later found out that if I want to buy US shares, I have to do a Forex transaction first to buy the required amount of US dollars. If I do not do that, IB would loan me the US dollars to complete the transaction but would charge me interest for it. I found their statements and their margin calculations confusing compared with other brokers, and I had to pay a lot of hidden fees which I did not expect. After a few months, I finally gave up on the idea of using one broker for all our investments and decided to close my account with them.

For now we use two brokers – Commsec for our Australian investments and Thinkorswim (TOS) for our US investments. Although you can buy international shares like US listed shares and ETFs through Commsec, the commissions charged are very high compared to buying them through a US broker. It may okay to use Commsec if you plan to buy and hold a few international shares but it would be very costly if you plan to trade actively. As a US broker, all TOS client accounts are protected by SIPS. TOS has a high functionality trading platform with more features and functions than you will probably ever need and they provide some really great tools for the options trader. One of  my favourite tool is the Risk Profile tool which shows you the profit and loss and the probabilities of any trade you currently have on or are planning to put on. A sample screen is shown below (left click on the picture to enlarge image). You can change various parameters and forward the calendar to see what your position will look like in the future.

After you have used their trading platform, you will find other broker’s platforms clumsy and limited in comparison. TOS has been voted the best broker for options and best overall online broker in four out of the past five years by Barrons. As we mainly invest in stocks and options, TOS meets most of our needs well but it still has some drawbacks. One drawback of TOS is that you can only trade US listed securities and you have to fund your account in US dollars which currently does not earn any interest. Ideally, I would prefer to keep any uninvested cash in my account in Australian dollars but this is not an option with TOS. Another drawback of TOS is that its platform is not so robust. Their trading platform stopped working for about an hour during the Flash Crash in May 2010, which can be a big problem if you urgently need to close a position to limit losses.

Some other brokers that we have tried include E*trade and Optionsxpress. Compared to CommSec, E*trade has a slightly superior option trading platform but their brokerage fees are more expensive. For trading options in the US market, TOS definitely has a superior trading platform compared to Optionsxpress. For now, CommSec and TOS are the brokers that best meet our needs. For anyone looking for a good US broker, check out this Barrons report. I have no hesitation in recommending TOS as their trading platform is a joy to use and their commissions are very cheap when compared to what Australian brokers charge.

The Hindenburg Omen is another technical indicator that has been talked about a lot in the media recently. This indicator looks at data from the New York Stock Exchange so it may be more relevant for the US markets. More information on how this indicator is calculated can be found in Wikipedia.

This indicator has a scary name as it is named after the Hindenburg disaster and has historically warned of an impending stock market crash. The Hindenburg Omen has a roughly 25% accuracy rate in predicting big market upheaval since 1987, meaning it’s far from infallible but isn’t inconsequential either. The Hindenburg Omen was sighted on  Aug 12, 2010 and has been reconfirmed at least twice since then. If you would like to follow this indicator, the Zerohedge blog tracks and reports each sighting.

Jim Miekka, the blind mathematician who created this technical indicator over a decade ago himself is already out of the stock market. In the latest issue of Miekka’s Sudbury Bull & Bear Report, the headline is, “Our traffic light has changed to red, so you should exit the market.”

September is also statistically the worst month of the market and with the Hindenburg Omen as supporting evidence for a correction; it is probably safer to be out of the markets, unless you have positions that can profit from a falling market. In September 2008, the Lehman Brothers collapse triggered one of the worst stock market sell-offs in history. What could possibly trigger another September crash in 2010? Some possibilities could be a lower than expected revised second quarter GDP or jobs number in the US. Or perhaps it could be the European debt crisis rearing its ugly head again. S&P downgraded Ireland’s debt recently indicating that things are getting worse there despite having adopted very severe austerity measures. Bond yield spreads between safe and risky debt is widening again.

My bet is that the trigger for a major sell-off would probably come from a unexpected source which no one is watching closely, like what is happening in the middle east. Iran just went nuclear on Saturday, the same day Aussies went to the polls. Although most Australian investors are more pre-occupied about who will win the elections, this new development could have far more important consequences than whether Tony or Julia becomes our next Prime Minister. According to Frank Gaffney, President of the Center for Security Policy and a former Assistant Secretary for Defense, we could be at the cusp of war. This story has not hit the major headlines yet, but I suspect it may in the coming days. Do watch the video below if you would like to know more. I am no expert on the situation in the middle east but I am worried by the deadly serious look on Gaffney’s face when he says it is not IF, but WHEN war will break out there. Israel is already preparing for war and September is only a week away, so stay safe….

I have covered a number of my favourite sources of fundamental information in the first three posts in this series so today I would like to cover sources of “non-fundamental” information which include technical and sentiment analysis. Technical analysis involves looking at price charts, technical indicators like volume, moving averages, Fibonacci retracement levels, and Moving Average Convergence / Divergence (MACD). Recently, a few interesting technical patterns have showed up on the charts and you may have read about the “Death Cross” pattern observed on the SPX 500 chart in early July 2010 or about the “Head and Shoulders” pattern that appears to be forming on the chart of this widely followed index.

Technical analysis is not very popular in Australia and I know many stock investors do not even look at charts and rely purely on the fundamentals. The chart patterns discussed above for the S&P 500 can also be observed on the price chart of the major Australian stock indexes but I do not recall anyone talking about it in the local financial media. As I consider myself reasonably competent in technical analysis and have talked about the Head and Shoulders pattern and Using Fibonacci to identify potential turning points in earlier posts, I thought perhaps I should talk about the Death Cross and MACD divergence using the All Ords in today’s post.

Above is a daily chart of the All Ords. The Death Cross occurs when a shorter term moving average crosses below a longer term moving average. The commonly used moving averages are the 50 day (blue line) and the 200 day (red line). As you can see, we got our Death Cross in early June 2010, about a month before the S&P 500. This is a lagging indicator that confirms that a downtrend has already started. The opposite of the Death Cross is the Golden Cross. As you can see on the above chart, we got one on the All Ords in mid June 2009, about three months after the rally started.

The other pattern that can be observed on the above chart is the MACD divergence. MACD is a momentum indicator that measures how strong a trend is. When the All Ords came close to 5000 in Jan 2010, the MACD indicator was around 25 but when the index hit a new high in April 2010, the MACD indicator was a lot lower than 25 which showed that the rally has lost momentum and we got a 15 percent correction soon after. We can see another MACD divergence from June to August 2010. When the index was at 4600 in June 2010, the MACD indicator was well over 25 but when we touched the same level again in August 2010, the MACD indicator was well below 25 which again indicates a loss in momentum and therefore we can expect the rally to end soon.

Advanced technical analysis includes using Elliott Waves and market cycles to forecast market direction. Those who understand Elliott Waves well were able to forecast a rally in February 2009, just before the huge rally started in March 2009.  Correctly interpreting Elliott Wave patterns is not easy and there is a lot of work involved in studying market cycles. This is too hard for me so I pay to get this analysis by subscribing to companies that have the resources to do this like Elliott Wave International (EWI).

EWI does not just do technical analysis. They also study socionomics which involves social moods which have a big impact on market movements. For example, the sovereign debt problem has been there for years and no one worried about it. Suddenly social mood changes and the same problem which investors could happily live with one day, becomes something that causes them to panic the next day.

EWI also tracks investor sentiment and uses it as a contrarian indicator. When 98 percent of investors are bearish on something, then it is very likely that the price will go up as there are no sellers left. This was clearly the case last year when everyone hated the US dollar so EWI correctly predicted that it would go up. We see the same extreme sentiment on treasury bonds as 99 percent of investors are currently bullish on bonds, so they are predicting a correction soon.

Although I have classified EWI as a technical information source, it is more than that. Robert Prechter’s best selling book “Conquer the Crash” gives a lot of fundamental reasoning why he believes there is going to be a deflationary depression in the coming years. You can also get a lot of free information on Elliott Waves and Technical Analysis on the Elliott Wave page on this blog.

This is one of those off-message rants that marks, I guess, one of the real differences between “blogs” and “old media,” and if you’re only here for the investment strategy stuff, you can skip this post.

As someone who has never been that interested in the political processes, I was really surprised that after Saturday’s election, there is no winner just because no party managed to win at least 76 seats in parliament. In Julia Gillard’s post election speech, she quoted a former US president in saying “The people have spoken, but we are not quite sure what they said”. I disagree with her on that. Over half a million more voters have chosen the Coalition over the ALP. With only 14 million voters in total, it is quite clear what the people have said. It is only the peculiar election rules in Australia that prevents the people from getting what they asked for. Unfortunately, the key to the decision on who will govern now falls in the hands of a few independents and they will probably choose which party to support based on their own personal agendas.

The hung parliament outcome was the topic of debate in our household during our family dinner on Sunday. Isn’t the election supposed to be for the people of Australia to choose their leaders? I feel the election process is flawed if it does not allow the people’s vote to be the final deciding factor in a true democracy. Another silly rule is the mandatory voting for citizens. Why force someone who doesn’t care who governs their country to vote? If they don’t care, they probably will not have bothered to find out much about what each party stands for and may inadvertently vote for a party for the wrong reasons. In our house, we had a first time voter. My 19 year old daughter was voting for the first time and she had no idea who to vote for. Her views of the parties were formed from watching their election advertisements on TV.  Luckily she had parents who could counter some of the election ads with real facts. She also thought about voting for the Greens because the name “Greens” implied “good for the environment”. Of course she does not realise that voting Greens could imply a carbon tax that would make everything cost more for her in the future because if she knew that, I don’t think she will be voting for the Greens. I hope she did make an informed decision on Aug 21.

Another silly rule is not allowing permanent residents to vote. Permanent residents who work and pay their taxes in Australia should have a right to have a say on how their taxes gets spent. It frustrates me that permanent residents like myself who do care about who gets into power are not allowed to vote. Government policies have a big impact on our lives as well, not just the lives of the citizens. Sure you could say if you care so much, why don’t you become a citizen? Kingsley and I have discussed many times about whether or not I should change my citizenship. We are currently living in Australia because Kingsley made a decision to come back to Australia to help to look after his aging parents. I have aging parents in Malaysia and he has a daughter there as well so we are hesitant to make any decision that could prevent us from living there for an extended period of time if needed. We have decided to keep our options open by having me hang on to my Malaysian citizenship, at least for now. I would not be surprised if there are a lot of immigrants who are in a similar position as us. I wish I could vote and I wonder how the elections would have turned out if all the permanent residents were allowed to vote.

Anyway, that’s my rant for today – thanks for reading. Feel free to drop a comment with your thoughts, however, I would appreciate if we can keep the debate friendly and avoid personal attacks on anyone.

“Of course , there is a place for judgment, and sometimes there is a place for furious denunciation, but I think Australians would be better off without the feral quality which so often contaminates our public lives.” Tony Abbott, Aug 2010.

Looking at the chart above, it quite obvious that bonds have outperformed stocks in 2010. The S&P 500 (red line) is down 2 percent while TLT, the ETF for long-term bonds (blue line) has rallied 17 percent since the start of this year. The spectacular bond rally in recent weeks has become the hottest topic in the financial headlines. Bond yields which move inversely to bond prices have fallen to record lows.  The yield for the US 10 year bond fell as low as 2.58 percent this week and many financial experts are scratching their heads and cannot understand why investors would be happy to accept such low returns and think this rally is just a bubble which will soon burst. In my humble opinion, I don’t think the bond rally is a bubble as there is a huge demand for bonds for some time to come.

Baby boomers, the largest group of investors are reaching the age where their risk tolerance is low. Their financial advisers would be advising them to change their portfolio allocation to a more conservative one which has a higher allocation to fixed income. From mutual fund data, money has been flowing out of equity funds and into bond funds. The amount of money entering bond funds even exceed money leaving equity funds, meaning that new savings are going into bond funds. The US savings rate has gone up to 6 percent and I would argue that a lot of the savings are coming from the “empty nesters” i.e. baby boomers who are still working and earning good income but have reduced expenses. From a US investor’s perspective, there are few better investment alternatives to bonds. Property prices have fallen since 2006 and are still continuing to fall so there is little reason to invest in property. The stock market is still 30 percent below it’s value in 2000 and investors in this age group would have endured two stock market crashes where their stock portfolio have fallen by up to 50 percent each time so I don’t think many people approaching their retirement would want to risk putting their nest egg in an asset class that is so volatile. Bank interest rates in the US are near zero so cash is not an attractive investment option either. With over 100 bank failures in 2010, the FDIC which guarantees bank deposits is almost broke so keeping money in the bank is also not as safe as owning treasury bonds which are guaranteed by the US government. While a 2-4 percent return may not seem like much, it sure beats a negative return!

While the bond rally is a relatively new phenomenon in the Western economies, this has been happening for years in Japan whose citizens are on average 10 years older. Bond yields have continued to fall over the years and are still falling. The 10 year Japanese bond yield recently fell below 1 percent, making the 2.5 percent yield of its US counterpart look rich in comparison. Property and stock prices have also been falling since 1989 so even at 1 percent yield, bonds are still more attractive than other asset classes. If the US follows in the footsteps of Japan, bond yields still have a long way more to fall which means that the bond rally should continue for some time to come.

Individual investors are not the only ones who want to buy bonds. Banks who can borrow at interest rates of close to zero percent are also buying truckloads of bonds as the yields are very attractive especially when you can buy them using leverage. If you can buy $1 million worth of bonds using $100K of your own money and borrowing the rest at zero percent, a 4 percent yield would equate to a 40 percent return on your $100K. This type of trade has been responsible for the fat profits reported by banks. Banks prefer to buy treasuries rather than to lend money to people to buy risky assets like property or businesses.

On top of all this demand from investors and banks, the Federal Reserve Bank has also announced that it plans to buy bonds as well as part of its quantitative easing program. The Fed has deep pockets and can buy big – they bought over a trillion dollars worth of mortgage backed securities last year. On hearing this announcement, speculators like hedge funds are also jumping in to buy bonds as part of “front running the Fed”.

US treasury bears have always argued that the US will not be like Japan because unlike Japan most of the US government debt is owned by foreigners like China who will one day dump their US treasury investments when they get freaked out by the ballooning US debt. When this happens, they expect bond yields to go up just as they did in Greece and the other European countries with sovereign debt problems. Well, this scenario actually happened recently as China sold off over 21 billion dollars worth of US long term bonds in June 2010 and guess what happened? They were snapped up by domestic buyers and bond yields continued to fall!

I think the penny is finally starting to drop on what happens when there is deflation – quality bonds are still the best investments. Even Alan Kohler who for a long time has poo-poohed the “deflationeers” has advised his Eureka report subscribers this week to buy some bonds, just in case. Does Australia have a problem with deflation as well? The stock market is about 25 percent below its 2007 peak and like the US S&P 500, has gone nowhere in 2010. Since the new restrictions for foreign property investors were announced in April 2010, property prices seem to have plateaued and sales have slowed. I don’t know about you but it looks to me like deflation is coming, if not already here.

Although APRA’s Annual Superannuation Bulletin for June 2010 will not be available until Feb 2011, some preliminary reports have claimed that the average professionally managed super fund should be able to report a low double digit performance for FY2010. This is seen as a very remarkable recovery from the negative returns in the previous financial year, however, when I did a more detailed analysis, I found some worrying trends.

The most common super fund is the balanced fund with 60-76% exposure to stocks, so the performance of these funds is highly dependent on the performance of the stock market. When I look at the price chart of the Australian All Ordinaries (see chart below) for 30 June 2009 to 30 June 2010, I see a stock market that went up from June to October 2009 and then sideways after that. In fact, the chart looks pretty bearish from April to June 2010. On 30 June 2010, the All Ords was back at the same level as where it was at the end of August 2009 which means other than a big rally in July 2009, stock prices did not really go anywhere in the last financial year. I have also drawn in the Fibonacci retracement levels from the stock market top in October 2007 and you can see that even at the height of the rally, prices have only retraced 50% of the fall from Oct 2007 to March 2009.

When I look at the ASX 200 performance on a quarterly basis (see the red line in chart below), there was only one great quarter of growth which was the first quarter of FY2010 and growth got progressively weaker after that. The last quarter was quite a disaster with a growth of -12 percent which wiped out all the gains in the second and third quarters. Although you may see a good annual result, most of this growth would have come from the first quarter and the quarterly performance trend is negative, which does not bode well for FY 2011.

The green line on the chart above is the quarterly performance of our fund’s USD investments. I wanted to do a quarterly performance of our combined assets but it was too hard to track our AUD investment performance with new monthly contributions and assets being held in a number of different places. A combined performance would also include gains/losses due to currency exchange rate fluctuations which could obscure the true performance of our investment strategies. As all our US assets are held in one brokerage account, it was easy to get the balance at the end of each quarter. We only made one new “contribution” in August 2009 so I have added this to the previous quarter’s balance so I do not get artificially large first quarter growth.

Although we had a -1.6 percent annual growth in our US investments, most of the losses were in the second quarter which were mainly from some new bear market strategies which did not work out, and we were perhaps a little too early with some of our bearish investments. By adopting good risk management practices, I have managed to keep those losses small. The quarterly trend however is up and I am pretty optimistic that FY 2011 will be a better year for SLI Super Fund. FY 2010 was a “transition year” as we tried out new strategies to help us position our fund better for deflation and an extended bear market.

Our AUD investments which were mainly in defensive assets have generated a positive annual return of about 7.3 percent, giving an overall return of 5-6 percent if we do not include currency exchange gains/losses. Based on an estimated 10 percent return from the average balanced fund, we would have underperformed the APRA regulated funds in FY2010 but we are not too far below our own target of 5 percent after inflation, as set out in our investment strategy. As our outlook at the beginning of FY2010 was that the global financial crisis which began in 2007 is far from over, we were more concerned with the preservation of capital over returns on capital. We are pretty comfortable with our defensive asset allocation and are content with our small positive return for the year.

As I believed that the major downtrend in the stock market that started in October 2007 would resume after the counter trend rally ends, I started to try out strategies that would enable us to profit in a falling market. Due to the unlimited risk in shorting stocks, SMSFs are not allowed to short stocks. I identified two potential strategies that I could use which would comply with the restrictions for SMSFs. The first strategy is to buy put options and the second strategy is to buy inverse ETFs.

Put options

Put options can be used for two purposes i.e. for protection of stock positions or for speculation to profit from falling prices.

a) Protective puts
I bought a few of these to protect some stock positions. Some of them did help to offset some losses in our stocks but overall I lost a few hundred dollars which I am happy to pay as a form of insurance to help me sleep at night during times of market uncertainty.

b) Speculative puts
I made only a few small trades and one terrible trade that cost us dearly. If I had to pick the dumbest trade that I did for the year, it would be buying a RIO put in July 2009 after the stock had fallen 40% as shown in the chart below. Volatility was sky high so the puts were really expensive but for some reason which I now cannot remember, I was certain that prices would fall further. RIO’s price shot up a few days after I bought the put and volatility collapsed causing the put option to lose most of its value very quickly.

It was one of those really bad decision that I regret which will NOT happen again. As options are a decaying asset with an expiry date, they are best used for very short term trades. I don’t plan to do many more speculative trades using put options but if I do, I will definitely do more careful analysis and manage the risk a lot better.

Inverse ETFs

Inverse ETFs are designed to mirror the performance of an index on a daily basis. For example, if the index goes up by 3 percent in a day, the corresponding ETF should go down by 3 percent on the same day. The result is achieved by the use of derivatives. I was aware of some of the risks involved with using these products but I still wanted to try them as the only way to really understand an investment is to try it, but apply strict risk management rules to avoid big losses while you learn. For example, I can limit the amount of money I invest to no more than ten percent of the portfolio and set a pre-determined stop loss or buy a put option to limit my loss to 20 percent on that investment. This way I can limit my maximum loss to 2 percent of my portfolio.

The first inverse ETF that I bought was FXP which mirrors FXI, an index of 25 large cap Chinese stocks. I thought this index would be a good proxy for the Shanghai index, in the same way as the 30 stocks in the Dow Jones Industrial index are for the broader S&P 500 index. I bought this ETF in August 2009, after the Shanghai index started to fall sharply. I opened this position together with a 3 month put option to limit my losses. After a few weeks, the position started to make money so I decided to sell the protective put but as soon as I sold our protection, the Shanghai index started to rise which was not good for the position. I also noticed that FXP did not mirror the Shanghai index very closely at all and found out that the 25 Chinese stocks are actually listed on the Hongkong, and not the Shanghai stock exchange. I decided to close the FXP position because it obviously did not track the Shanghai index which was what I was trying to “short” as shown in the chart below.

I learned a couple of lessons from this investment. The first lesson is to make sure you know exactly what the inverse ETFs mirrors. Check the Product Disclosure Statement if you are not sure. The second lesson is to hold on to your protective puts as they are meant to limit your losses to a pre-determined amount.

The second inverse ETF that I bought was SH which mirrors the S&P 500 index. From the chart below, you can see it tracked the S&P 500 index quite closely for a while but when volatility increased in April 2010, the “tracking error” became a lot worse. One of the known risks of inverse ETFs is the “correlation and compounding” risk which can cause a “tracking error” if the ETF is held for longer than one day. While the ETF does provide a one-to-one inverse correlation in one day, this may not be true if the shares are held for longer periods. Depending on how the market moves, the performance of an inverse ETF may be greater or less than the corresponding index performance. Inverse ETFs do not perform well when the market moves up and down a lot as it has since April 2010.

Because inverse ETFs do not have expiry dates like put options, I was hoping to use them as a long-term bear market investment strategy, in the same way you would buy and hold stocks as a long-term bull market strategy. However, inverse ETFs have not worked out very well, especially when held over longer periods. Even though they do not have an expiry dates, the “tracking error” and fees affect their performance over time. I will no longer pursue this as a long-term bear market investment strategy.

As neither of the above bear market strategies had worked out very well, I continued to look for better strategies to make money in a bear market. In April 2010, I tried the “put revolver” strategy which involves a complex set of options spreads. However, due to the flash crash on May 6, these trades lost money but I was able to recover all the losses by July 2010. This strategy shows promise but I plan to practice doing it in my personal account before using it in our SMSF account.

Precious metals

We started the year with holdings in SLV, an exchange traded commodity fund for silver. In 2008 we bought gold and silver to in a bid to diversify our assets to reduce our portfolio risk. This diversification strategy did not help us as the price of precious metals fell together with stocks and commodities in 2008. I sold off our gold positions in May 2009 when I had a chance to get out at break even but decided to keep our silver position because at that time I was still undecided whether inflation or deflation would be a problem in the next few years. As precious metals are supposed to be the ultimate hedge for inflation, I thought we should still hold small position in this asset class while I continued my research on inflation vs. deflation. The more I understood about this topic, the more convinced I became that there is little risk of inflation in the near future and deflation was the bigger threat so I decided to sell our silver investments in October 2009 at a small loss. The price of gold and silver was still going up at the time as many big investors including some very clever fund managers like John Paulson and George Soros were piling into gold. However, I trusted my own research and once I was convinced of the threat of deflation, I adjusted our asset allocation accordingly.

It looks like the consensus for deflation is growing and in recent weeks there are many headline stories like these in the financial news:

Aug 2, 2010 – Big investors wary of deflation risk
Aug 4, 2010 – Defending yourself against deflation
Aug 4, 2010 – With deflation looming, even the top guys are flummoxed right now

If you are confused about how to invest if there is deflation, you are not alone – even the top investors are flummoxed right now! Most of us who are born after the Great Depression will have no idea what to do to prepare for deflation because inflation is something we have lived with all of our lives. If you want to learn more about deflation, I would highly recommend you learn from deflation experts like Robert Prechter who wrote about it in his best selling book Conquer the Crash which was first published in 2002. This book was republished with updates in 2009 and it gives a very detailed case for deflation and tells you how to protect yourself and maybe even profit from deflation. Do also read Deflation: First Step, Understand It, a recent article published by Elliott Wave International, Prechter’s investment advisory company.

With deflation, cash and cash equivalents are the best investments because cash becomes more valuable when prices of assets fall. Quality bonds are the best types of investments for deflation and US treasury bonds is one of the recommended investments. Investment advisers from the deflation camp like Gary Shilling and Yves Lamoureux have been advising their clients to buy the 30 year treasury bonds. David Rosenberg has been advising his clients to buy quality corporate bonds. Recently, Bill Gross who runs PIMCO’s $US239 billion Total Return Fund increased his allocation to treasuries to about 51 per cent of the portfolio, up from less than 33 per cent at the end of March 2010.

Treasury bonds

With some fear and trepidation, I proceeded to make our first investment in US treasury bonds last year. Even though my research tells me this is the right investment, the thought of buying bonds from a country with trillions of dollars of debt was still a little uncomfortable for me. Based on simple logic, it is hard to imagine why something like bonds that can be freely created from thin air can be more valuable than tangible assets like gold or property, but once you understand what causes deflation, you will understand why they can.

As usual, I looked to get our exposure to bonds through Exchange Traded Funds. In August 2009, I bought some shares in IEF, a US 7-10 year bond ETF together with protective put options, just in case. The bond yield for 10 year bonds was just over 3 percent at the time. The bond market remained pretty flat for a while but when the US stock market started to fall sharply in April 2010, bond ETFs shot up in price as investors rushed into bonds as part of the flight to safety. By June 30, we managed to get an unrealised gain of nearly 7 percent on our IEF position, giving us a total annual return of ten percent. Our bond investments have outperformed our Australian term deposit investments even though the interest rates for the term deposits were a lot higher.

Term Deposits

When interest rates went above 6 percent in Australia, I decided to lock in some of our excess Australian cash into term deposits. I managed to get some pretty good rates from Ubank at 6.26 percent for a 24 month term and 6.81 percent for a 12 month term around late 2009. As interest is only paid on an annual or semi-annual basis, some of the income from these investment will not be included in the FY2010 returns.

More information about our fixed income investments can be found on my earlier post Term deposits vs. treasury bonds.

Australian Stocks

We started the year with no stock positions in the Australian market. We decided to do off market transfers of some stocks that were held in Kingsley’s personal name to the SMSF so he could use the capital losses from these stocks to offset other capital gains. This turned out to be a very good decision as the price of one of the stocks doubled in 2009 and capital gains are taxed at a much lower rate in the super fund compared with Kingsley’s marginal tax rate.

We continued our strategy of selling puts to get into stock positions at a discount and selling covered calls to generate additional income on top of dividends. We started using this strategy in FY2009 and we were happy with the results and it continues to meet our expectation last year as well. We set aside about AUD100K in our CommSec high interest account to buy stocks that we would be happy to own long term. As we did not have very bullish expectations of the stock market, we decided to stick with fundamentally sound stocks in defensive sectors like consumer staples and healthcare, that held up well in the last stock market downturn. As we planned to sell options over these stocks, another of our requirements was that the stocks have to be optionable, and there has to be sufficient liquidity in the options for those stocks. As the options market on the ASX is pretty small, we were limited to ASX 20 stocks like Telstra, CSL and Woolworth which have reasonably liquid options.

We used some of the money to buy Telstra shares which we used as collateral for selling put options. It was a lot less troublesome than using cash as CommSec calculates margin required on a daily basis and this generates a lot of meaningless transactions in our bank account which confused our accountants in the previous year. We generated an additional income of $10,060 from selling options on top of the $2,106 of dividend income from these shares, giving us a total income of $12,166. The cost of our shares was AUD90K and even after we deduct the unrealised capital loss of $3669 on our stocks, we still get an annual return of 9.4 percent from this strategy. While waiting to buy stocks at the price that we wanted, we also received interest income from the cash which was reserved for paying for the stocks should any of our put options get assigned. If we include this interest income and franking credits from dividend income, we would have an even higher rate of return from this strategy.

We also bought an XJO put in as a partial hedge for our Australian portfolio but did not find it to be a very effective hedge for our portfolio as our stocks did not have a high correlation to the ASX 200 which comprise of mainly mining and finance stocks. Because we hold defensive stocks, they held up well when the market corrected 15 percent in April 2010, so we do not see any need to buy protective puts in future.

US Stocks / Exchange Traded Funds

We started the year with only one long positions in XLF, a financial ETF. This position was showing an unrealised loss as it was purchased in 2008 when I thought banks were oversold after the Lehman Brothers collapse. XLF recovered most of the losses during the 2009 stock market rally. Because we believed the rally was only a bear market rally which would end sooner or later, I decided to sell our positions at the end of July 2009 after a big rally in financial stocks that month. In hindsight I probably sold too early as the rally continued until April 2010 and I could have recovered all our losses and even make a small profit if I waited to sell. The lesson learned here is that it normally takes time for market tops to form after a strong rally so there is no need to rush into selling at the first sign of market weakness. As I still saw lots of uncertainties ahead in the banking sector, XLF was not an investment I wanted to keep for the long term so I was happy to sell it even at a loss.

As our outlook for the US economy is deflationary, we expect prices of assets including stocks not to do well in the next few years so I avoided buying any more stocks. Many years ago I read an amusing book about dealing with change called “Who moved my cheese?”. In the book there were two mice (Sniff and Scurry) and two Littlepeople (Hem and Haw) who used to get their cheese from a place called Cheese Station C. For a long time there was plenty of cheese to meet their daily needs but one day they found that there was no longer any cheese at Cheese Station C. The mice quickly moved on to find new cheese but the Littlepeople kept going back to the Cheese Station C to look for their old cheese and complained when they could not find any. Like many thought leaders, we believe that we are living in a period of significant change where old beliefs like “the stock market will outperform in the long term” may no longer hold true in the future. The Japanese stock market has been declining in the past 20 years and the US stock market seems to be headed the same way as well. Good stock pickers and market timers can probably still make money in the stock market, but it will be increasingly harder to get a good return on stock investments.

As we recognise that we are not particularly good at picking stocks, we decided to be like Sniff and Scurry and go out to look for new cheese. We decided to put some of our capital into new investments like treasury bonds which we believe would do better in a deflationary environment. We also used some of our capital to try some new bear market strategies using products that were only available in the US market such as inverse ETFs and complex option strategies. I will discuss the performance of theses new investments / strategies in other posts in the coming weeks so stay tuned…

I started pulling together the information for our annual review of our investment performance last week. As we have been pretty defensive in our investment strategy last financial year, I was only expecting a small positive single digit return for the year.

Despite having positive earnings, I was slightly disappointed that in terms of net asset value, our returns were pretty flat due to the strong Australian dollar. The US to AUD exchange rate set by the ATO for FY2010 is about 18% higher than FY2009 and that meant that our entire USD denominated assets would be worth 18% less this year compared to last year. If they were valued at the same exchange rate as last year, then we should have achieved a 5.5% annual return, according to my simple calculations. Accounting for currency gains/loss is a bit beyond my abilities so I will leave it to our capable accountants to do the correct valuations. We are not too worried if our performance this year is lower due to currency fluctuations, as we are comfortable with holding a large part of SMSF assets in US dollars. We actually increased our US dollar holding last year because we expected the US dollar to go up, which it did against the Euro but unfortunately not against the Aussie dollar.

What is more important in our review is how well each of our investment strategies worked out and what lessons we have learned, and that is what we will focus on in our review. The following is a summary of investments and strategies we used last year:

The first three types of investments were familiar ones which we had used before in previous years. The next three were new to our SMSF. As we are among those who believed that the 2009 stock market rally is simply a counter trend rally, we expect the major downtrend which started in October 2007 to resume after this rally ends. In the first leg down from October 2007 to March 2009, we were not prepared for a bear market and all we did was move out of stocks into the safety of cash. For the next leg down, we would like our SMSF to be able to profit from a falling market so I started to look for strategies that would enable us to do that. Due to the unlimited risk in shorting stocks, SMSFs are not allowed to short stocks. I identified two potential strategies that we could use which would comply with the restrictions for SMSFs. The first strategy is to buy put options and the second strategy is to buy inverse ETFs. In April 2010, I added a third strategy which is proprietary options strategy I learned from San Jose Options called put revolvers, which are a type of complex option spread. I will be sharing how each of our investments worked out in a series of blog posts over the next couple of weeks.

Stay tuned…