Wednesday, December 22, 2010

Gold is Mighty Expensive Inflation Insurance

Generally the price of insurance rises after an event occurs.  Hurricane insurance increased dramatically after Hurricanes Ivan and Katrina.  Terrorism insurance experienced exponential price increases after the 9-11 World Trade Center attacks.  However, if we consider gold as insurance against inflation, it contradicts this notion and appears mighty expensive.  The chart below shows how much commodities (CRB Index) one unit of gold will buy--4.24 now and 4.75 at its 2010 high.  At its extreme in the most recent previous gold bubble in January 1980, the  price of gold moved to 2.84 units of CRB after an entire decade of 5-15% US CPI increases stimulated huge demand for inflation insurance.  Gold is now 60-70% more expensive versus the CRB than at the end of the previous bubble.

GOLD priced in CRB


Inflation insurance at Gold Insurance Company is ridiculously expensive, or the inverse, inflation insurance through the CRB Insurance Company is extremely cheap.  If we get inflation, an investor will do much better with the CRB.  Gold might move higher but not nearly as much as all other commodities.


45 minutes

Tuesday, December 21, 2010

Hedge Fund Boom Nothing Like Mutual Fund Explosion

As I thought about my post on hedge fund popularity, I realized that lacked a relative comparison, so I reran the Google Ngram with mutual fund.  Hedge funds have a long way to go to catch their less exciting older sibling.

Monday, December 20, 2010

Wow on Hedge Funds, But What Does It Mean?

I spent way too much time today on Google’s new ngram tool which graphs the use of a word or phrase in its set of books.  I was absolutely amazed when I typed “hedge fund”  and found this Google Ngram on Hedge Funds

I thought the bubble burst in 2007, but evidently the trend based on the use of the term in books is still very clearly intact.  With a more narrow timeframe but more comprehensive dataset,  Google Trends shows a different picture.

Generally, I like to follow the money to tell me the truth, but assets show both withdrawals and drawdowns.




From these I have to conclude that the trend towards hedge funds is still alive and kicking.


40 minutes

Friday, December 17, 2010

Well Written and Obviously Understood but Poor Recommendation provides one of the best written pieces that I have read on the dangers of bonds.  However, I believe the recommendation completely opposes the wonderful explanation.

Fighting bond risk with bonds does not solve the problem.  The suggestions of high-yield and emerging markets might outperform other bonds through extra spread for currency and credit risk, but they still get clobbered by a big upward shift in interest rates, so risk still exceeds returns.  All bonds are priced to US Treasuries, and US Treasuries are artificially low, so inflation, the core risk and biggest enemy of bonds, is not priced.

Return to bonds = Return for Credit Risk + Return for Currency Risk + Return for Illiquidity + Real Return – Inflation

so in my mind

Return to Bonds = (2% to 6% for Credit, Currency, and Illiquidity) + (0 to –10%) + (-2% to –10%) = 4% to –22% with what we already know.

With 4% to –22% best case real return over the next 10 years, risk clearly exceeds return.  If the potential losses to bonds in a bad environment approach –20 to -50%, then the risk is the same as those “risky” asset classes of stocks and commodities, but these just might be the beneficiaries of a little inflation.

This poor recommendation explains why journalists might not make good money managers and why investors depending on tv and media for investment advice can make such bad decisions.  I intend to be a good money manager that can also write.  I would love to achieve this level of writing without impairing my ability to manage portfolios.  I started writing to help me think.  Paul Tudor Jones in his Foreword to Reminiscences of a Stock Operator Annotated Edition says

“While attending the University of Virginia, I took some summer courses at Memphis State in journalism and at the same time worked editing my father’s small business paper.  Looking back at my education, I would say that journalism was the single most important element of my development as a trader and as a businessman, more so than any of the economics and business classes I took at the University of Virginia….Learning to report and communicate in this fashion is far and away the best training any businessman, investor, or trader can have.  It’s a vital yet surprisingly underestimated skill that really enhances one’s ability to frame, analyze, and solve problems in the most expeditious fashion.”

This is a very powerful statement from one of the most successful money managers ever, and I listened.

If I cannot beat bonds over the next ten years, I need a new career if I have not had to find one already.  I guess by then maybe writing might be an option.



Criticize me, so I can write better.

1.25 hours

Thursday, December 16, 2010

Interesting New Words from CFA Society of Alabama Lunch with Dr. Robert Brooks

Dr. Brooks of the University of Alabama gave a wonderful presentation at the CFA Society of Alabama lunch on financial derivatives and ethics (not often heard together) in Birmingham, Alabama.  I learned two new words that I hope to research, understand, and incorporate (of course probably the subject of additional more detailed blog posts):

performativity and counterperformativity—“Practical use of an aspect of economics makes economic processes more like their depiction by economics.” and the opposite “Practical use of an aspect of economics makes economic processes less like their depiction by economics.”, p. 17

risk-take instead of mistake—risk-take I define as “the rational pursuit of return after careful consideration of the risks involved “ versus a mistake, which I do not think I need to define.

Unfortunately I now realize that I did myself a disservice by not figuring out how to take Dr. Brooks derivatives course while I was pursuing accounting at the University of Alabama.  His presentation validates my opinion on the quality of education I received at U of A, and I’m proud to say “My Home’s in Alabama.”

Monday, December 13, 2010

Global Imbalances all the Fed (Bernanke) and US Treasury (Geithner) Fault?

Are the US Federal Reserve and Treasury at fault for the imbalances caused by the US Dollar reserve system?  The answer is probably the same as your answer to “Is the alcoholic to blame or the person that knowingly gives the alcoholic a drink more at fault?” or “Is the subprime borrower to blame or the bank that lends money to the subprime borrower more at fault?” I do not think Bernanke and Geithner can bear the burden of imbalances stemming from a US dollar reserve system that has evolved over the last 15 years; however, through improper exploitation of the imbalanced system, they certainly might be very responsible for its demise.

Bloomberg reports $3 trillion in US Dollar Reserve Assets as of June 30, 2010, so the world has added $2.1 trillion in reserves since March 1999.

Emerging currencies are undervalued by 20 to 100%.  Hard to fault the Fed for joining in the world’s buying efforts.  The world has engaged quantitative easing since March 1999.  If they pursue it for their benefit, then why can’t we?

Plan to update soon but time is up for now.


2.25 hours

Saturday, December 11, 2010

Opinions Not Backed with Money are Not That Believable

If the world really is overly bullish on stocks as some suggest, I would think money would flow visibly in that direction.  Reuven Brenner in Gambling and Speculation offers some reasons for gambling or risk-taking in pursuit of wealth improvement:  entertainment,  overconfidence, rational action given competent assessment of probability, and desperation or relative underperformance.

Entertainment can be eliminated in the case of investing, since entertainment prevails primarily when the stakes are low.

The other three reasons for risk-taking however would in the current environment of supposedly strong bullishness all very readily apply.  However, analysis of a chart that I have surprisingly not seen in the press, reveals an interesting result.  Mutual fund flows as measured by ICI show an exodus from equities precipitated by the financial panic of 2007-2008 but extended throughout the supposedly “bubble bull market” since March 2009 driven by lingering effects of fear due to the severity of the crisis.  When we compare the 2009-current period to the most recent bull markets of 1987 (start of the ICI series)-2000 and 2003-2007, equity mutual fund flows are markedly different and do not exhibit any real correlation to the often cited sentiment survey of the AAII- The American Association of Individual Investors.  The survey displays varying degrees of bullishness and bearishness, but opinion has not affected the outflow from equity mutual funds.  Whether the bullishness is justified by overconfidence or rational assessment of probability, it has not been strong enough to convince investors to pursue a potential opportunity to improve wealth.


If this bullishness through reasons 2 and 3 combined with the fourth reason of desperation has not driven money to opportunity, then fear dominates. If fear dominates, then opportunity will be squandered, and the increasing, but already record income/wealth disparity in the United States and dramatic underperformance of everyone’s savings disproportionately invested in bonds will incite even more desperation.  Eventually if for some reason 2 and 3 do not kick in first, this desperation will become so severe that it will force investors to take risk.  Its exact manifestation is unknown, but it will appear somewhere other than bonds.  Overconfident and desperate risk-taking causes bubbles and since we have not seen any real risk-taking, no bubbles currently exist in stocks.


1.5 hours

Thursday, December 9, 2010

Preparing for the Best

Thorough study of investment success has convinced me that investors must prepare for the worst but also must prepare for the best.  Recent volatility from the financial panic of 2007-2009 and the recent mini-crisis of the Flash Crash and PIIGS has led everyone to prepare for the worst.  Unfortunately, if good things happen, most investors do not have the exposure to benefit from economic/financial stabilization and expansion.  Opportunity is potentially being squandered and long term goals are being forgotten.  No one can forecast at a rate of even 70%, so if you are wrong, what are you sacrificing?  I think the long term consequences of risk avoidance could be severe .

13 minutes

Wednesday, December 8, 2010

Bonds Tumble and Questions Start Getting Asked

As bonds tumble, questions start getting asked, but the one most appropriate is “Am I getting compensated for the risk I am taking?'”  When risk exceeds returns, generally the outcome is not favorable over the long term.  Unfortunately after 30 years of outstanding excess bond returns with no real drawdowns, bonds seem riskless, and investors have chosen to aggressively pursue this perceived risklessness.  Basic analysis reveals that this decision is reckless not riskless.

Since December 1982 bonds as measured by the Barclays Aggregate Index have gained 8.5% per year with a maximum drawdown of 6% in 1994 and 4% after 1994.  This performance rivals or exceeds even the most successful hedge fund managers, dwarfs Warren Buffett, and has to offer one of the highest asset class Calmar ratios (annualized return divided by drawdown) of investing history.  In the chart below, Calmar ratio over 3 year periods never goes below 1 after 1982 and approaches 2 for the entire period 1982-2010.  Bond performance has been so good, your bond portfolio should be treated like winning a lottery.  After winning a lottery, the wise action is to recognize your good fortune and not use your winnings to buy more tickets.


source:Barclays Capital and thanks to the fine contributors to R and PerformanceAnalytics

So as you decide to cash in and reap your good fortune or to buy more bond tickets, please keep in mind:

1) Bonds will not perform well enough to achieve return targets, so long term outcome is guaranteed failure.

2) Bonds will incur significantly more volatility (generally the definition of risk) as yield is too low to sufficiently offset potential losses.

3) Bonds will not fit their intended purpose in a portfolio to protect principal first while providing income second and potentially offering real return third.  At current levels, bonds will not reach any of these goals.

And the real question to investors is “Where do I go next/now?”  Much more to come…

40 minutes


I am determined to play not spectate.  After 20 years of voracious reading, I have decided to write, and this blog represents my commitment.  More than likely it will be a reflection of me, so a lot about my work/passion money management and markets but also hopefully some worthwhile thoughts and observations.  I will be the writer and possibly the only reader ultimately but I know that I will benefit immensely from this project.  Any benefit to others will be extremely gratifying and help resolve my debt to all the wonderful authors that have entertained and enlightened me over the years.