Saturday, March 31, 2012

Beware Those VIX Plays

Beware Those VIX Plays

Good article in the WSJ this morning about the risk of some of the ETN VIX products, like the one that lost something like 60% this month.  These are not buy and hold products by any means but they can be powerful if used correctly.  Correctly means holding them for short term periods to hedge a portfolio of stocks or stock based ETFs or funds.  The three key components of making this strategy work are which VIX product to buy, how much of the VIX to hold, and when to buy and sell.

1.  Which VIX product to buy?  Stay away from the levered versions, the VIX is already very leveraged, getting 2x leverage on a leveraged product is a license for disaster.

2. How much to hold?  This is best done using a risk parity approach so that the risk of your VIX product is balanced with the risk of the rest of your portfolio.  The riskier your portfolio the more of the VIX you need.

3. When to buy and sell?  You need to use a tactical approach and you need to be nimble.  Trying to buy the VIX during a market uptrend is another license for disaster.

Is It Time to Dial Back the Risk

It's Time To Dial Back The Risk

There was an article in the WSJ today suggesting that investors should dial back the risk.  If you look at the numbers this might actually be a decent idea.  For the first part of the year "riskier" areas of the market outperformed----International developed stocks, emerging markets, and small caps---for example.  Last month the S&P 500 did well but those areas lagged quite a bit.

Saturday, March 24, 2012

Why Treasuries Won't Crater

Why Treasuries Won't Crater

Article in the WSJ today about investors tweaking their bond holdings vs. overhauling them.  Since Treasury yields have backed up there has been a debate about whether the long anticipated bear market in Treasury bonds is here.  At the end of the day it doesn't matter if you just stay in harmony with bond market trends.  Last year Treasuries were in an uptrend so you should have owned them (and made a ton of money in the process).  This year other areas of the bond market are stronger-----investment grade corporates, high yield, emerging markets, and even dividend paying stocks.  As long as that trend continues those are the types of areas bond holders should focus on.  If Treasury bond prices resume an uptrend then you can shift back there.

Monday, March 19, 2012

Head For The Hills?

This from the Wall Street Journal Today:

Head for the hills—at least if you put much stock in the dark art of technical analysis. Three influential market-timers believe the end is nigh for the stock-market rally.

Joe Granville, who single-handedly sparked a large drop in the Dow industrials in 1981 with his "sell everything" warning, sees a potential drop to 8,000 in the Dow this year. Granted, his calls since that big one have been a bit more miss than hit.

Elliott Wave theorist Robert Prechter, also known for incredible prescience but premature bearishness, is even more pessimistic, seeing a drop below 2009 lows.

Last but not least is Charles Nenner, who advised Goldman Sachs for years and now provides services privately to hedge funds. Some of his recent calls have been eerily accurate, and his coming ones are the most specific. He advises selling stocks after the S&P 500 hits 1,449 or by April 19, whichever comes first. If stocks then fail to break back above that level, it would confirm a multiyear bear market with the Dow eventually hitting 5,000.

Predictions make for great fun but nobody can predict the market.  Sometimes it appears they can as you have a 50/50 chance of getting it right, the market will either be up or it will be down.  Instead us trying to predict where the market is going  investors would be better served just staying in harmony with market trends.

Monday, March 12, 2012

Why Stocks Are Riskier Than You Think

Why Stocks Are Riskier Than You Think
Great article in the WSJ this morning about the problems with buy and hold and normal asset allocation.   The only part I don't agree with is the using TIPS and some of the risk reduction strategies, this will protect from large losses but it will also protect from gains.  Stocks are a great place to invest, just not all of the time.  The answer is a tactical portfolio filled with non correlated tactical strategies weighted by a risk parity approach.

Thursday, March 8, 2012

Should You Be Buying Dividend Paying Stocks?

There has been a lot of press lately about the merits of buying dividend paying stocks.  The so called experts have decided that the next few years in the market are likely to be mediocre so why not get a return from dividends?  Setting aside the fact that nobody knows what the market is likely to do this post will compare a couple of different strategies:

1.       Buying a dividend stock ETF,  iShares Dow Jones Select Dividend Index (DVY)

2.       A relative strength strategy that rotates among a group of dividend paying stocks

3.       A relative strength strategy that rotates among asset classes—US Stocks, International, REITs, commodities, and bonds

I did a comparison of each of these strategies over the past 5 years ending 3/7/12.  The comparison does not include any fees, commissions, or taxes.  For the DVY I just assume you buy and hold it.  For the relative strength dividend stock strategy we start with a basket of 10 high yielding stocks---Verizon, AT&T, Merck, Pfizer, GE, Intel, Johnson & Johnson, Dupont, and JP Morgan.  Each month we use our proprietary relative strength analysis to buy the top five stocks in equal weights.  For the relative strength asset class strategy we have a basket that includes bonds, US stocks, international developed stocks, emerging market stocks, REITs, and commodities.  Each month we use our proprietary relative strength analysis to buy the top four asset classes in equal weights. 

Results are below:

5 yr   Avg Annual Return
5 yr Sharpe Ratio
2008 Performance
Buy and hold DVY
Relative Strength Dividend stocks
Relative Strength Asset Classes

Buying and holding the DVY was the worst of the three strategies, mostly because of the awful performance in 2008.  While the dividend stocks didn’t do as poorly as the S&P 500, losing over 32% still stinks.  The relative strength strategy did a little better but still lost a bunch in 2008.  The best by far was the strategy that rotated among asset classes.  The key take away from this simple study is that every asset class---dividend stocks, gold, bonds, etc--- has merit at different times.  A strategy of buying and holding any asset class can be extremely dangerous.  Instead, investors should stay in harmony with market trends and buy the asset classes that are in an uptrend and sell the ones that aren’t. 

Tuesday, March 6, 2012

Designing Portfolios-How to Allocate Among Asset Classes or Models

In the old days deciding how to allocate a portfolio came down to a decision on stocks vs. bonds.  With all the new ETFs and other investments out there it is becoming more and more difficult.  Now investors have access to commodities, currencies, alternative strategies, etc.  There a number of ways to decide how to allocate among these different areas, including but not limited to:

1.      Traditional Modern Portfolio Theory (MPT)—Here an investor uses some sort of optimizer that either has past returns, correlations, and volatility of a number of asset classes or some prediction of future ranges for these variables.  The optimizer then creates the “optimal” portfolio mix.  The drawbacks of this approach are apparent to anyone who suffered through 2002 and 2008 as asset classes that weren’t that correlated or volatile, became correlated and volatile.  MPT works in an up market (along with everything else) but suffers horribly in a down market.

2.      Core and Satellite- This approach typically has a fixed core of around 80% that is in an index fund or a mix of index funds to get market returns.  It will then have around 20% that will be used to be opportunistic or defensive.  If the investor has a solid strategy for the satellite portion then this can be better than MPT but the large index exposure will still suffer horribly in a down market.

3.      Balanced portfolio—This is the simplistic 60% stocks/40% bonds approach.  The idea is that stocks and bonds are uncorrelated so the bonds can cushion the portfolio in a down market.  While bonds can provide some cushion the inherent problem with this design is that stocks are much more volatile than bonds.  So bonds may go up in a down market but stocks will go down much more than bonds will go up.

4.      Risk Parity---This is an approach that is gaining a lot of favor in the institutional marketplace because it typically needs to use leverage.  In a risk parity approach, asset classes, or in our case tactical models, are weighted by risk so that each asset class or model contributes equally to portfolio risk.  When done using uncorrelated assets or tactical models this can significantly smooth out returns.

5.      Equity Curve Feedback—In this approach you monitor the returns of each asset class, or in our case each tactical model, money is then taken away from the asset classes or models doing the worst and moved towards the ones doing the best.  This is in contrast to the rebalancing done with MPT portfolios where you sell your winners to buy more of your losers.

6.      Leveraged Space---This is something new we are working on so expect to see more in the future.  Basically this is the Optimal F approach that specifies how much should be allocated to one asset class or strategy taken to the portfolio level.  So far this looks like a very promising way to reduce risk while still generating attractive returns.