Asset Allocation Insights & Major Investment Trends

Protect Your Life Insurance from Unfair Taxation

2008-11-28T18:59:00.002-05:00

We hear of many individuals obtaining life insurance policies to benefit their families in the event of their deaths, but only a fraction of these people realize that their life insurance proceeds are taxed heavily upon their death, drastically reducing the resources of their heirs.

To remedy this, establish a life insurance trust that contains your policies. You'll pay premiums out of the trust, and the proceeds upon your death will be paid into the trust. Consult an appropriate lawyer to set up the trust for you.

There are many useful links by searching "life insurance trust." A very brief further explanation is here. (We have no connection with the author of the linked blurb.)

China Impacts Your Allocation More Than Ever

2008-11-27T23:07:00.005-05:00

What China does is far more important now to our personal finances than even during the '00s boom. If it fails to strongly stimulate its domestic demand, the U.S. and world could remain mired in recession for a decade or longer. If it rolls out a much stronger internal investment program, we'll raise our equity allocation much more quickly. That's why we're watching China's actions more closely than ever.

The crucial article on China is here. A crux of the long-term global problem now is the huge imbalance caused by China keeping the yuan artificially weak in order to export its way to prosperity. But that system can't work any longer because global demand is slumping and the U.S.'s deficits are becoming too huge to service. Now, China's efforts to export its way to prosperity will bring about continued over-capacity in the world, worsening deflation, sharpening U.S. debt-service problems, and intensifying trade protectionism.

So China needs to quickly develop its domestic economy.

What is so little talked about, but explained so well by the linked article above, is that the U.S. today should NOT be learning lessons from the U.S. in the 1930s; instead, China should.

China now, as the U.S. heading into the Great Depression, is heavily export-dependent, has large current account surplus, is highly vulnerable to the global demand implosion, is at risk of trying to export its way out of the current downturn, and is desperately in need of stimulating internal consumption by establishing a social safety net and other large fiscal investments that will give people the courage to spend.

The problem is even more acute when one realizes that China is far MORE export-dependent than ten years ago, and its consumers won't spend more as long as they have to pay cash up-front for hospital care, don't receive real unemployment insurance (or even back-wages) if they're fired, etc etc. And China's apparent unwillingness to face its domestic consumption shortfall puts the entire global economy at bigger risk of a decade-long depression. A Chinese New Deal would help elevate China's internal consumption to balance its export dependency, and establish a more stable society for the long-term health of its economy and the world. U.S. export markets would also grow more quickly, helping it to offset the economic impact of less Chinese investment in its U.S. securities.

Before allocating any capital to "risk-assets" anywhere in the world in the next few years, consider whether China is truly accelerating domestic investment and consumption.

The longer China takes to address the problem of its artificially-weakened currency, the more likely it is that investors will have to muddle through the next decade seeking secure cash yields in an environment of rising trade protectionism and a stagnant global economy.

Preparing for Fallout (from U.S. debt)

2008-11-26T11:30:00.007-05:00

We continue to expect the U.S. dollar to weaken and long-rates to skyrocket (as the virtual U.S. sovereign default becomes clearer) once the current flight to "quality"/liquidity dissipates. That could happen as investors begin to see a light at the end of the current deep recession, and shift money out of treasuries. Tremendous additional U.S. and global stimulus packages could start this process.

We may invest in this trend by buying gold (such as ETF: DGL) and the Rydex Inverse Government Long Bond fund (RYJUX), which rises as long-dated U.S. treasuries decline.

There are strong counter-arguments, one of which which goes like this: Non-U.S. economies such as China are slowing down even faster than the U.S. economy, with the hope for recovery even further away than for the U.S. If indeed this is the case, then the U.S. dollar will probably not crater versus foreign currencies, and U.S. rates would not rise sharply in a predictable time frame. Another counter-argument to the long-gold & short treasuries idea is that global economic weakness will continue to overwhelm policy stimulus for a long time, which could result in heavy losses for our trading strategy before seeing any gains.

Considerations like these make us rather frozen with U.S. equities in our long-term accounts, and cash holdings for our 0-5 year horizon. We'll argue this is prudence, and say that we'll commit to non-cash investments once a trend becomes clearer.

Preparations for Trading Allocation

2008-11-24T23:56:00.004-05:00

We recently raised our trading allocation given our expectation of continued bear markets (over the next 0-10 years) across a wide range of asset classes. Specifically, we're waiting to a take short US dollar position. Any sign of future economic stabilization will cause us to initiate this position, because we'd then expect investors to flee "safe" Treasuries in favor of "everything else." The underlying view for this position is the same as the view underlying our purchase of an ETF that rises as long-dated US Treasuries fall. We think the U.S. will have significant trouble paying for its accumulated debts, after its "mitigate recession and financial crisis at all costs" policy.

Separately, within our commodities allocation, which has been at zero for most of this year, we expect to buy an agriculture ETN.

Established Long-Term Bearish Bet on U.S. Treasury Bonds

2008-11-12T20:59:00.007-05:00

Within our Trading allocation, which we eventually target for 10% of our asset allocation, we established a small, long-term bearish bet on U.S. Treasury bonds. This is consistent with our writings on this blog that the U.S. government is badly undermining its creditworthiness with all manner of stimulus plans, at a time when we think big foreign investors will increasingly look to diversify their holdings away from the U.S. We also think that the massive "flight to safety" of the past year, which has significantly boosted long bonds, will increasingly shift toward shorter-dated U.S. treasuries, which would take away from demand for long bonds. A small datapoint along these lines came this week when demand for a treasury bond auction was weak. We used the Rydex Inverse Government Long Bond fund (RYJUX).

Deflation vs Inflation, and Our Changed Long-Run "Policy Allocation"

2008-11-12T19:01:00.011-05:00

The mother of all questions: will deflation or inflation be the major U.S. and global trend in the next 5, 10 and 20 years? Having the right calls will lead some investors to drastically outperform others, save their investments from ruin, and live far more comfortably. (For example, investors who saw the '00s inflationary trend coming multiplied their net-worth many times over, while deflationary worry-worts saw their investments decrease in value. Investors who saw the declines in inflation coming this year made money in treasuries instead of losing enormous sums in equities.)

The question of deflation-or-inflation has become super-heated. The world's central banks and government treasuries fear economic crisis and deflation and thus are putting trillions of currency units into circulation. Meanwhile, a growing contingent of economists and investors see the money-printing binge as massively inflationary within the next couple of years, despite the global deleveraging that is taking money out of the economy. One of the more successful (and famous) investors with the latter view is Jim Rogers; a quick summary of his views is here.

We think the answer is worse than the question: We expect moderate deflation for the next year or two, and then a shift toward inflation as the lag-effect of the current monetary stimulus (which is likely to remain policy for too long) takes hold. In actuality, we see the market worrying most now about deflation while worrying a little bit now about inflation, and over the next year or two we expect the proportion of worry to shift toward inflation. There will be be many "watershed" moments along the way when inflation fears crystallize and U.S. government bonds sell off significantly owing to the inflation fears and concern about the implications of the $12 trillion U.S. debt, which could rise at about $1 trillion per year. We believe the resulting rise in interest rates as potentially the ultimate end to the U.S. consumer's power and its role in "global imbalances," which are today enabled by emerging economies' artificially low currencies.

What We're Doing:
(1) Adopting value investing disciplines that have been out of style since the early-mid-'80s. Compare dividend yields on asset classes and within asset classes, and gauge value in relation to long-run historical ratios. For instance, equities are still expensive around 3% yields, versus buying opportunities of 5-6% yields earlier in the 20th century. Trading equity momentum and P/E multiples will be difficult in the rolling bear/value market we expect for the next 5+ years.
(2) Raising long-run "policy allocation" of secure yield & cash equivalents to 30% from 10%.
(3) Raising trading allocation from traditional 5% of allocation to 10%. Use trading allocation to favor short positions.

Our long-run "policy allocation" now looks like this:
30% secure yield and cash equivalents
25% real estate (projected equity in our residence)
15% U.S. equities
15% emerging equities
5% treasuries
10% trading -- favoring short positions

Bear Market to Continue; No "Diving Saves" Occurring

2008-11-12T09:18:00.009-05:00

We continue to wait for a set of emerging market currency collapses and debt defaults before we consider increasing our equity allocations to our "policy allocation" levels.

But we're always on the lookout for potential "diving saves" that could prevent this disaster scenario. For instance, if investors develop increasing confidence that developed market consumers will start to spend again, a floor would set in many financial markets. After all developed market consumer spending is a hallmark of the "global imbalances" that are unwinding today: artificially low emerging market currencies are supporting over-investment in those countries, lower-than-natural interest rates in developed countries, and ballooned credit and purchasing habits in developed countries.

This "system" of global imbalances has a long way to unwind. But if this unwinding process slows down -- say, if developed market mortgage rates were to decline (allowing a pickup in the housing markets and consumer confidence) -- then markets would rise significantly on the hope that the painful global deleveraging could reverse.

The problem is, banks and bank financing providers show no sign of creating an environment for declining mortgage rates. We're presenting a chart from economists at ISI. It shows that mortgage rates (top, dotted line) are still in an UPtrend, even as Treasury rates (bottom line) continue to slide. When deep recessions were avoided in the past, mortgage rates fell as treasury rates fell.

This situation reflects many aspects of the ongoing credit crisis, which is essentially a plunge in confidence among lenders that buyers will be able to pay them back.

It's worth pointing otu that we don't think certain other "bullish indicators" for consumers will help much this time around. For instance, some economists believe that decline gasoline prices can save the consumer; we don't. Falling oil and gas prices are producing a negative feedback loop for the world's producers of these, many of whom are already the world's most vulnerable credits, such as Russia and, increasingly, the Middle East. Further commodity price reductions would trigger other major negative credit events that would further dampen global credit and demand. What's needed are improving credit conditions within the global financial system, such as with respect to mortgages -- we don't see it happening yet.

U.S. Dollar Still in Terminal Bear Move

2008-11-03T00:31:00.007-05:00

We realize more than ever that we'd better reduce our long-term "policy allocation" for U.S. assets, and increase our developing markets policy allocation. Our policy allocation had been 60% equities, consisting of 40% U.S. and 20% rest of world. We'll be reversing that gradually, as opportunities present themselves.

The link (and comments) that give us the raw material for coming to this conclusion are here.

Despite the recent rally in the U.S. dollar, we think it's still in a terminal bear market that will make itself evident in the next few months or couple of years. The U.S. is losing its creditworthiness as a result of its skyrocketing debt, particularly given its response to the current economic crisis, the Iraq war, and political failures. The current "flight to safety" that is boosting the dollar will end as soon as China shows it can weather the current economic slowdown without collapsing. When that becomes apparent, assets will leave dollars for yuan so rapidly that the dollar will plunge, and anyone holding U.S. dollar assets will feel poor compared to yuan holders.

Maybe China isn't the only major nation whose currency will become the world's fiat currency. We could enter a multi-polar fiat....the Brazilian real, the euro, perhaps the rupee could be included. Actually, we'll need to find nations that are thriving and that do not have a ton of exposure to U.S. dollars! China is less attractive by this standard. The point is, we want to get positioned for the bursting of the treasury bond and dollar bubbles.

The biggest risk to our bearish U.S. view is that the government will take decisive action over the next 5-10 years and beyond to dramatically reduce spending relative to revenue. We doubt this is politically possible, because the public won't accept the cost of suffering fewer handouts, as it won't understand that the system is in peril.

Boosting Emerging Markets Equities Weighting Further

2008-10-30T06:24:00.004-04:00

We've been taking baby steps, and are increasing our Emerging Markets Equities weighting now to 3% from 2% (with an ultimate goal of roughly 15%). We went into the financial crisis with a 0% weighting.

We continue to think a series of emerging economy crises is about to happen, but we've been boosting our weighting because we see the bear case as slightly less likely. In the past several days, China has guaranteed Russia $25b in financing (a move to protect China's energy interests, but something that China could repeat across many emerging economies), the IMF has significantly increased its loan availability to emerging markets (and has lent Ukraine 8x its normal loan limit), the Fed has opened $30b swap lines with several emerging economies, and interbank lending rates have pulled back slightly further worldwide. Investing in emerging markets satisfies the William Bernstein criteria of feeling like you're "throwing money down a rat hole" (investing near potential market bottoms).

The Closet of Shoes is About to Drop

2008-10-26T13:36:00.002-04:00

This article ("Currency Crisis is Gathering Storm" -- click on this link and scroll down) perfectly summarizes why we'll continue to wait for major emerging markets to experience financial collapses before we'll consider raising our equity allocation back to our "policy allocation." We probably won't be waiting long.

Kudos to the blogger Yves Smith for also pointing out a few ways that catastrophe can be postponed -- China could prop up collapsing currencies, and international agreements could help too. Postponing disaster increases the chances of a softer landing, but we expect more downside to risk assets in the near term, and tough battles beyond that.

Boosted Equity Allocations Slightly

2008-10-24T08:52:00.007-04:00

Given today's sharp worldwide equity selloff and a slightly lower probability of emerging economy collapses (due to chatter about an IMF plan to consider loans up to 5 times quotas to emerging economies), we're slightly boosting our allocation to U.S. and emerging market equities.

We're still underweight -- at only about 2/3 of our target U.S. Equities allocation, and at a mere 1/7 of our target emerging market equities allocations -- because we think the IMF probably can't head off the crisis we're anticipating. Recall, we've been waiting for widespread emerging economic collapses before raising our equity exposure to our "policy allocation." But IMF flexibility could buy the world more time to re-balance the accumulated "global imbalances" in leverage, currencies and current accounts.

A bit more background: In addition to above-mentioned imbalances, discussed at length here, emerging markets are seeing capital flight to the developed markets, which the U.S. has afforded access to vast quantities of dollars, and where governments have been quicker to announce bigger bailout plans. Global capital flight is taking out the weakest link in the global financial chain ..... currently, the weakest link is emerging markets; if this link is strengthened by the IMF and other efforts, capital flight will probably find another weak link in the global finance chain. So we're not turning bullish, but are instead preparing to be fully-weighted in equities closer to an ultimate market bottom, which we won't be able to time perfectly.

House Sales Jump -- Blip in a Longer Bear Market

2008-10-24T01:55:00.004-04:00

News has traveled fast in the real estate agent community that California home sales have jumped by about 2/3 in the latest period owing to low, foreclosure-induced market-clearing prices, as Bloomberg reports.

But your home could remain a depreciating part of your asset allocation for some time to come.

That's why we say caveat emptor.

A major new wave of job losses will probably flood the market with new homes, which will drop the market-clearing prices further.
Mortgage rates could stay high as the credit crisis rolls further around the world, further shrinking the number ultimate buyers for U.S. mortgage paper.
And, after the current "flight to safety" in U.S. treasuries passes, interest rates in the U.S. could rise broadly as huge buyers of U.S. securities -- emerging foreign economies -- hit deep crises of their own.

Allocation for Short Selling

2008-10-24T01:20:00.002-04:00

Something which could become a game-changer for asset allocation worldwide, as investors pick up the pieces of the current financial catastrophe: We believe that many more asset allocators will initiate an allocation for shorting -- bets that a security class will drop. This is not common today, but a natural extension of the recent trend to add market-neutral hedge funds to one's asset allocation. It has occurred to us more than once as we held 0% in emerging market equities this year (because of our avidly bearish case, as discussed in this blog), that we should have had a negative allocation here all year long. (And it's not too late, as our last post argues.) The case for shorting would fit many asset allocators' small allotment for a "trading allocation," but we think negative bets could become a more enshrined piece of asset allocation, particularly as we may be staring into several more years of sideways markets.

Collapse of Some Emerging Markets is Probably Very Near

2008-10-24T01:00:00.006-04:00

Interbank borrowing rates are again across many of the emerging markets, after a several day lull. And today, three-month LIBOR (the London interbank borrowing rate -- widely used worldwide) rates fell by the smallest margin in nine days, according to this Bloomberg article. The credit freeze is getting colder again, which is plunging many emerging markets toward deeper recession and ultimately defaults. This shock will provide the next leg-down in global risk markets, including the U.S. equity market, we believe. We thought that recognition of this pending "day of reckoning" would send U.S. equities plunging yesterday (Thursday). It might be today. It might be in the next few weeks, but it's coming real soon. When it happens, we're going to raise our U.S. and emerging market equity weightings closer toward our long-run "policy allocation." How much we invest depends on how badly equity markets crater.

The BIG Risk is Becoming Real -- Collapse of "Global Imbalances"

2008-10-22T16:16:00.002-04:00

This powerful article by economist Brad Setser (which I located via Yves Smith), explains that the global current account imbalances are collapsing. There is a lot more pain to come before the current bear market ends. To fund their purchasing binges, U.S. consumers were using artificially cheap debt provided by the U.S. financial system, which was given artificially cheap capital by the likes of China and other "emerging economies" that were buying U.S. dollars to keep their own currencies artificially low to boost exports. Now that the U.S. consumer "leg" of the stool has been kicked out, the U.S. financial system and thus emerging economies who have lent so much to the U.S. are now in BIG trouble because they bought way too much U.S. debt at low prices that will cause them formidable losses. Equity investors are only now beginning to understand that there will probably be a resulting collapse of numerous emerging economies. This disaster scenario is becoming more of a certainty with every passing day, and today's 10% declines in some emerging economy stock markets is representative of that. So we maintain our determination to stay underweight equities until we see more emerging economies collapse -- Hungary, Russia, others. We wish we'd been more underweight all this time, but must keep looking forward. We're preserving capital fairly well now (despite wishing we were preserving all of it), and hope to be at our full equity "policy allocation" near the bottom and end of the current bear market. '09 is our hope, but '10 or beyond is perfectly conceivable.

Detail on Two Pending Disasters, And Why We're Underweight Equities

2008-10-22T10:24:00.008-04:00

Though we recently boosted our equity weighting, we're still not yet 2/3 of our "policy allocation" because we think additional tsunami waves of crisis are on the way. Last week we let this post sum-up our cautions. (And did you see Nouriel Roubini on CNBC this morning, reiterating all these points?) Today we are linking to two further elaborations on just how bad and likely these tsunami waves are:

CDOs. Banks, especially foreign banks, are only just starting to reveal the holes [scroll down that page for article] in their balance sheets left by Collatoralized Default Obligations (CDOs), which are bundles structured credit products (the kind that has been blowing up recently). Buyers of CDOs were doing so on faith in the credit ratings; they lacked the personnel to evaluate the garbage they were buying unwittingly. The gaping new holes in bank balance sheets that we're seeing could lead two another shock wave of asset-selling and illiquidity, and gaps down in public markets.
Emerging Markets. Global de-leveraging, bursting investment bubbles within emerging market economies, and tumbling commodity prices, are creating a rush for liquidity (namely, dollars). Many emerging economies can't get the dollars they need [scroll down that page for article] to finance their economies, so asset prices are dropping even faster in those places. We continue to wait for several major financial crises in emerging economies before raising our allocation from 1% currently toward our long-run allocation of roughly 10%.

Inner Peace and the Path to Wealth

2008-10-22T00:31:00.003-04:00

We recently received simple satisfaction in successfully encouraging a friend to shift equity assets from a high-churn retail broker with a poor track record (even before taxes!) to a Vanguard equity index fund. Here's to hoping that the current bear market will shake loose many more "investors" from retail brokers who masquerade as friendly advisors.

Deeper Developing Markets Crunch Likely; We Started Nibbling Anyway

2008-10-22T00:12:00.003-04:00

A deeper crisis in several major developing markets is on the way, we think. Securities prices in these financial systems -- which are so fragile and untested in crisis -- can go a lot lower since we're still not finding many articles about the risks (but here's a very good one indeed). As we've said many times, we're not going to raise our equity allocation to our long-run "policy allocation" until we see financial panic take down a few big developing markets players.. That's why we'd been 0% developing markets this year, and happy, even though we slashed our allocation about a year too early.

All that said, we've now raised our developing markets allocation from 0% to a mighty 1%. It makes little sense to deal in numbers so small, but we wanted to "break the ice." We expect to average down.

Timeless Words to Invest By

2008-10-19T17:58:00.003-04:00

William Bernstein's The Intelligent Asset Allocator is growing into a classic of the genre. It offers far more than hard evidence that smart diversification and rebalancing ar e the ways to enhance your lifetime wealth. It also says what you're up against -- yourself -- and helps readers gain conviction in the discipline of asset allocation:

An important assumption underlies all of the portfolio discussions thus far: that at the end of each year the investor rebalances the portfolio back to the target compositions [% U.S. equities, % treasuries, etc]. If a particular asset has done extraordinarily well, its portfolio weighting will increase; consequently, enough of it must be sold and reinvested in the poorly performing assets, to return to the target composition. This target composition is often referred to as the "policy allocation." You cannot underestimate the amount of discipline and patience required for this process, because it means doing exactly the opposite of what most of the investment world, almost all of whom are professionals and experts, is doing. A psychologist friend points out that this is an effective way of becoming a "contrarian," always moving in the opposite direction of the crowd. You will of necessity be selling what everybody loves and buying what they hate. You have only to remember that the great buying opportunities in U.S. stocks in 1974 and Japanese stocks in 1970, to name a few, followed several years of grinding bear markets. But be forewarned: investment during market bottoms has the distinct feel of throwing money down a rat hole.

We strive to asset allocate decisively instead of programmatically; meaning, we want to make judgements about how and when to rebalance toward the weakened performers. We'll be comparing our performance to a programmatic rebalance, and to other "classic" asset allocations. Berstein's book is a treasure trove for us in this endeavor, and for all kinds of investors.

Grantham's 3Q Market Letter

2008-10-18T22:31:00.009-04:00

Jeremy Grantham is about the best at providing accurate long-run returns expectations for asset classes. His 3Q investor letter is here.

Reading it, we realize that our 40% equity weighting may be right for someone with a several year time horizon. But it's likely too low for someone with a 10-year (or more) time horizon and a strong stomach such as we think we have, despite the systemic risks we highlighted in recent posts. Equity valuations based on dividend yields may be too reasonable, and too much of the global crisis may be "in the market" for someone with a 10-year horizon to be only 40% in equities. (Register for and log into www.gmo.com to see Grantham's long-run return forecasts, which are based on dividend discount models and the expectation for mean reversion.) To quote from Grantham's October letter:

"Rounds I and II – the asset bubbles breaking and the credit crisis – will soon be mostly behind us, but the effect on the real world of economic output lies, unfortunately for all of us, almost entirely ahead." [The question for us is, how deep & long will the economic recession be, and will it lead to other asset and credit crises?]

We're cognizant that you pay a terrible price for being underweight equities, if you're wrong. Putting it all together, we'll be keen to raise our 40% equity weighting further if sentiment worsens or we gain conviction when the market isn't. Also, how could anyone with a long-term horizon ignore the Warren Buffet op-ed piece this week? There's more math behind his thinking than the article tells.

Why We're Still Underweight Equities (Just Less So)

2008-10-14T00:14:00.002-04:00

We believe that economist Nouriel Roubini, whose dead-on predictions regarding the financial crisis have saved people fortunes, has done us another service by listing reasons why investors will get more opportunities (at lower price points than today's close) to raise their equity allocations. We've been citing several reasons for remaining underweight (just less so) that make Roubini's list. But his list packs a real punch, so here goes (from Naked Capitalism):

details of these [recapitalization] plans are still very fuzzy and ambiguous and with uncertain effects on various assets classes (common shares, preferred shares, unsecured debt of financial institutions, etc.);
macro news will surprise on the downside as the economies sharply weaken and contract while fiscal policy stimulus is lagging;
earnings news for financial and non financial firms will surprise on the downside;
the damage done to confidence and to levered investment is already severe and the process of deleveraging of the shadow financial system will continue;
major sources of future stress in the financial system remain; these include the risk of a CDS market blowout, the collapse of hundreds of hedge funds, the rising troubles of many insurance companies, the risk that other systemically important financial institutions are insolvent and in need of expensive rescue programs, the risk that some significant emerging market economies and some advanced ones too (Iceland) will experience a severe financial crisis, the ongoing process of deleveraging in illiquid financial markets that will continue the vicious circle of falling asset prices, margin calls, further deleveraging and further sales in illiquid markets that continues the cascading fall in asset prices, further downside risks to housing and to home prices.

Seeing risks like these play out (or be surmounted) will give us more willingness to further narrow our underweight stance in equities.

Raised Equity Allocation at 10am

2008-10-13T18:54:00.005-04:00

Based on the rapid string of positives that emerged in the last several days, we raised our equity allocation this morning from roughly 35% to 40%. When the market rallied another 6% this afternoon, we were happy to be getting such rapid payback for a long-term decision.

But more importantly, we need to continue to strategize how we'll get back to our full long-run equity allocation target while equities are still close to their lows ... or making new lows. We'll watch for the triggers and fundamentals we've discussed in our last few posts. When buying this morning, we thought there would be at least two more opportunities to raise our equity allocation in coming months or quarters. We'll be on the lookout for those opportunities.

Two More Positives? Time To Slightly Boost Equity Allocation If You're Far Below Target

2008-10-12T10:11:00.008-04:00

(1) European countries may be close to agreeing to recapitalizing some of their banks.

(2) Exposure on credit default swaps may not be as bad as "$55 trillion."

One of the major reasons banks won't lend to one another, is that they're hoarding cash to prepare to make big payouts for the bond insurance (CDS) they've written, and they don't trust that other banks haven't written the same type of insurance. But "$55 trillion" in outstanding CDS may be far more than the amount of actual liability. A NakedCapitalism post this afternoon explains:

Reader Tim sent us a link to a press release from The Depository Trust and Clearing Corporation which says that the net payout on Lehman credit default swaps will be comparatively minor, a mere $6 billion, versus the gross exposure, which has been widely reported as in excess of $400 billion. If this proves correct, that will be the best news we have heard for some time, since one of the unknowns hanging over the market has been the prospect of further bank failures resulting from Lehman payouts.
DTCC's report, if accurate, is consistent with the industry's claim that protection writers hedged their exposures, and in this market, the only effective way to do so was by entering into an offsetting swap).
The problem is that even if many of the trades were hedged, for any dealer, the quality of its hedges depends on the quality of its counterparties. Even though CDS protection-writing was concentrated among a short list of names (all big suspects), hedge funds were also writing protection. So way BigBank had $30 billion of Lehman CDS exposures, $15 billion each way. Let's say 15% of the protection was written by hedge funds that can't make good. That leaves a $2.25 billion failure, which multiplied by the payout, is a $2 billion loss. In this environment, any meaningful losses would be a source of worry.

Why only make a slight boost to equity allocations, and then only because we're way underweight? Because the tsunami of crisis has yet to roll across most U.S. and European banks, and the Asian and the Middle Eastern banks and economies. Also, there will be fresh opportunities for the banking system to freeze up further; for example, payment on Lehman CDS paper aren't due until October 21.

After the Dam Breaks...

2008-10-11T18:49:00.002-04:00

....we'll be more free to swim.

As people pick up the pieces of their portfolios -- which they'd thought were diversified effectively to avoid losing as much money as they did -- we expect to see waves of new product offerings for individual investors: more "market neutral" equity funds (which rise only when fund managers' longs do better than their shorts), more portfolios that promise to have uncorrelated components based on recent history, more "bear market" equity funds, even more "hard assets" funds, and so on.

The choices will be bewildering to many individual investors, but there will be a few new offerings that will make us better off, too.

Pack of Bears

2008-10-11T18:34:00.002-04:00

The NY Times posted an excellent graphic on how the current U.S. bear market compares to previous bear markets since 1929 in terms of severity and duration.

You can't draw any conclusions from the graph because it's entirely "historical," but you can consider whether the severity of the risks faced today -- relative to the recently-ended boom -- are as serious as they were in the past.

We think the balance of risks today are a bit more severe now than during past bear markets, so that the rapid, sharp declines in equities in the past few months are justified. That's why we're not rushing to raise our equity allocation to our strategic target of 65%, though we became more positively inclined in the past couple of days. The prospect of an unwinding of the dollar as a reserve currency, the potential breakdown of the European Monetary Union, and other threats -- alongside the "good" news that some governments are starting to recapitalize their nations' banks -- means we think there's an "even" chance of earning better-than-cash returns in the next 3-5 years.

We're still waiting for some emerging markets to face a severe financial crisis, and for more bank failures, before we're comfortable raising our equity weighting to our long-term strategic target.