Evidence Investing

Add Italy to the list of "In Trouble."  And, while the overall cost is still low, look at the year to date percentage change for France and Germany.   AND CHINA!  Not defaluting, but maybe in trouble.  Keep your fingers crossed....hard!

I wanted to add one more paper to my ‘Basics of Momentum’ series.  I hope that by now you are beginning to admit that momentum truly exists as a unique phenomenon.  As I have said, we are going to get into how to maximize it and practically use it on a daily basis to invest more profitably.

#8:  Review of  “Relative Strength Strategies for Investing”.   In this excellent paper by one of the giants in the relative strength/TAA arena, Mebane Faber (check out his blog here) looks at the basics of momentum as well as  a few strategies to maximize its employment in an investing strategy.  We are going to be looking at this paper again when we start getting into combinations and practical applications of this style of trading, so here I am just going to pick and choose what I highlight…and believe me, I am saving the best for later.

Abstract:      The purpose of this paper is to present simple quantitative methods that improve risk-adjusted returns for investing in US equity sectors and global asset class portfolios. A relative strength model is tested on the French-Fama US equity sector data back to the 1920s that results in increased absolute returns with equity-like risk. The relative strength portfolios outperform the buy and hold benchmark in approximately 70% of all years and returns are persistent across time. The addition of a trend-following parameter to dynamically hedge the portfolio decreases both volatility and drawdown. The relative strength model is then tested across a portfolio of global asset classes with supporting results.

In this paper he looks at over 80 years of data from 10 sectors of US equities versus the returns of the S&P for the same period.  Individually, any one of the sectors showed little/no advantage over the market or over a equally weighted portfolio of all the ten sectors, either in absolute returns or with risk adjusted returns (Sharpe ratios).

Then he employs a simple trading rule…which is the essence of momentum: on a monthly basis, rank the sectors based on recent monthly returns (either 1, 3, 6, 9, 12 month returns, depending which ranking period he was testing).  Then he constructed an equally weighted portfolio of the Top 1 performing sectors (top sector only), Top 2 (top two sectors only) performing sectors, and so on up to the top 10 (all sectors, which IS the Equally Weighted portfolio). 

Here’s what he found:   

This shows an amazing 3.25% to over 5.5% out performance!  WITH improved drawdowns, significantly better Sharpe ratios in every case!  It out performs buy and hold about 70% of the time, as well.  This is a superbly elegant way to show how powerful momentum/relative strength and asset allocation really is.

Now, turnover is an issue, and trading frictions as well, but I will get to those soon enough.

Everyone is raving about the national debt...and with good reason.  I truly believe we are spending our kids money at not only a record pace, but also to such an extent as to have a real and significant negative affect on the standard of living and security of future generations.

Look at this:

And here is another veiw:

Now, everyone has seen graphs like this and their viewing is usually accompanied by much 'tsk-tsk'ing' and wringing of hands.  But we need to look a little deeper in to this to see what it really means.   What I want to look at in this post is the interest that must be paid on the rising debt, the portion of the graphs above that represent more debt being issued to finance the intrest (aka debt service), and the affect of interest rates on the debt.

From CNN:
"More than half of the $9 trillion in debt that Uncle Sam is expected to build up over the next decade will be interest"...$4.8 trillion to be exact.  "In 2015 alone, the estimated interest due - $533 billion - is equal to a third of the federal income taxes expected to be paid that year."

So if we look at the first chart above, at the year 2015, the Obama budget puts the debt at about 77% of a GDP of about $15 tillion which equals about about $11.5 trillion in debt.  $533 billion divided by $11.5 trillion equals about 4.5% of our total debt is interest for that year alone AND about 3.5% of our TOTAL GDP will BE SPENT ON DEBT SERVICE.

The key to this is to realize that debt service provides no increase in our utility...in other words, we don't get better roads out of it, or a stronger army or anything which makes our standard of living better.  Its THE definition of a 'drag on the economy.' 

Now this equals about 1/3 of projected federal income taxes.  Do you think government will decrease expenditures by 1/3 so it can pay the debt service on this debt every year?  Not a chance!  SO, it will have to borrow more, and use the proceeds of that borrowing to pay the interest...and, it good government form, increase the debt and ADD to the yearly burden of debt service. 

This is all calculated with "reasonable" rate increases...on the order of a few percent higher than where we are right now....RECORD low rates.

Debt is being sold at record low rates, which is great.  The average interest rate on treasuries is about 2%.
 
"A Treasury borrowing advisory committee reported that approximately 40 percent of the debt will need to be refinanced in less than one year."

Ok, in light of that, lets say we have some inflation...say 8% (which I feel is still conservative).  Our debt service begins to drift upwards as we refinance the debt (and issue new debt to pay for our rising interest payments).  That $533 billion in 2015 could EASILY become $2 trillion before ya know it. Which is all of a sudden about 12% of our GDP.  Which means that we would have to borrow even more to pay off that interest...  Do you see the danger here, folks?  Yes, absolute catasrophy.

Even Paul Krugman (Nobel Prize Winner in Economics) agrees: “My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.” Now he was writing in 2003, when a different president was in office, but he was also warning about the possibility of a ten-year deficit of $3 trillion.

Here's how:  (hint = feta cheese)
Currently, Greece has a budget deficit of 13.6 percent. We’re not in that league — ours is only 10.6 percent, the highest level since 1945.  Greece has a public debt of 113 percent of GDP.  Under President Obama’s budget, by 2020 our debt will be$20.3 trillion  or 90% of GDP. If we consider the $100+ trillion unfunded entitlement liability, not to mention that the government is incapable of controlling spending, we could see the debt at 215% of GDP in 30 years.

Welcome to Greece...and we all know whats happening there right now. 

Get ready folks...Hopfully we are all wrong about this.  Vote with this stuff in mind.


Thanks to these papers for insight on this post.  1, 2, 3

A few days ago Fed Chairman Bernanke said this:

"The Federal Open Market Committee has stated clearly that they currently anticipate that very low, extremely low rates will be needed for an extended period." (source: Yahoo)

Well, talk is cheap, as we know.  Lets take a quick look at the evidence of how the Fed has acted on rate hikes in the past:

So, if the past is any guide (as I would argue it is), and if the recent signs of a decrease in unemployment are true, "an extended period" may actually be something more along the lines of "right around the corner."  

It’s been said over and over again…mostly by financial advisors:

You must be in the market all the time to see your portfolio grow to its potential….If you miss the 10 best days, your returns will suffer greatly!

They usually show you something that looks like this:

This quote from Charles Schwab and Company show what I mean: On "importance of being invested…just a few trading days each year…for the ten-year period from 1994 though 2003, only 10 days accounted for almost half of the gain during the period. That's 10 days out of about 2,600."

This is one of the biggest, if not THE all-time biggest, fallacy foisted on unsuspecting unsophisticated small-time investors.

This subject has been address else where on the net, but I really feel like it cant be said enough and it deserves a little more air time.

Let me ask you this:  if you missed your “10 best” job interviews, where would you be?  Not as well off, I would guess.  What if you missed your “10 best” dates?  Not married to the women of your dreams …or at least not as many memories, right?  What about your “10 best” investing plays?  Lower account balance now, maybe?  

Its not rocket science, right?  You miss the best, 10 best, or 50 best of anything and you will be less ‘well off.’  Yet another expensive useless piece of advice from and expert.

In reality, if we look at missing the 10 best days, we also have to look at missing the 10 worst days.   Unless you have some kind of system that makes you miss all the best and keeps you in for all the worst days…  And that means you have much bigger problems. J

In fact with no system at all, you have an equal probability of missing the best days and missing the worst days, right?  And with any kind of worthwhile system, you just tip those odds in your favor and miss a few more bad days than you do good days.
So we need to look at what happens if you miss both best and worst days.

But first a little DETOUR:  Lets just quickly clarify a basic idea in investing and finance ->  participating in percentage gains are not as valuable as avoiding equal percentage losses. [to a degree, of course…we all know you can’t make money without percentage gains]

Here is an illustration:

So you can see that as you gain and loss and equal percentage, your portfolio value slips away.

Now let’s see what percentage we have to gain to stay even after a 25% loss

So from this, we can see that equal losses have a much larger effect on your portfolio than do gains!  This is a basic risk management concept which becomes even more interesting when linked with the “10 Best/10 Worst” concept.

REMEMBER ->  participating in percentage gains are not as valuable as avoiding equal percentage losses, generally speaking.

Ok, keeping this in mind, back to our “10 Best/10 Worst” discussion.

Look at what happens if you miss both best and worst days.   Below are the results from essentially three studies each using different holding periods, for your viewing pleasure.

Note that the return from “Both” is about 3% points HIGHER than the Buy and Hold return.

Here’s another example. During the period analyzed below, the S&P 500 Index yielded annualized return of 7.06% (buy and hold) over the same period of time: 

Note that the return from “Missed Both” is about 1.5% points HIGHER than the Buy and Hold return.

Now look at this:

This looks at a shorter period.  Note that missing the 10 Worst gives you more gain (+1.43% above buy and hold) than the loss you sustain if you miss the 10 Best (-0.84%).  This ties back in to my “Detour concept” above:  you need even MORE of a gain to offset an equal percentage loss…and here, you have LESS of a gain (i.e. even if the 10 Best days were worth +1.43% (instead of +0.84%), that STILL would not be enough to offset the 1.43% savings that occurs when you avoid the 10 Worst days.

I hope that’s clear.   If not, just remember that missing both the 10 Best and 10 Worst days beats buy and hold (as shown above).

Read these few pages for “in other words” look at it.

AND what’s more, I’ve just been looking at the return numbers here.  I haven’t taken into account the affect on psychology that missing some highly volatile days can have on an investor; neither have I addressed the chance that high volatility can totally wipe out your portfolio OR the fact that there are several systems (TAA) that can tilt the ‘missed days’ in your favor!

Keep reading folks, lots more to come!

I'm slammed today, but I just wanted to check in real quick...a little more 'op-ed-ish' than I like for this site, but I think its useful anyway...

I'm going to reach back a few weeks to tie something together for you:

First take a quick look at this post from a few weeks ago about the bubble in Chinese real-estate .  I'm going to repost the graph here:

Now, check out this article from Bloomburg (which I have summarized):

China is in the midst of “the greatest bubble in history,” said James Rickards, former general counsel of hedge fund Long-Term Capital Management. 

The Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan, he said.  “[It] is the greatest bubble in history with the most massive misallocation of wealth.” China “is a bubble waiting to burst.”   Rickards joins hedge fund manager Jim Chanos, Gloom, Boom & Doom publisher Marc Faber and Harvard University professor Kenneth Rogoff in warning of a potential crash in China’s economy.

The Shanghai Composite Index of stocks jumped 80% last year and property prices rose at the fastest pace in almost two years in February, helped by a record 9.59 trillion yuan ($1.4 trillion) of new loans in 2009. The Index is valued at 32 times reported earnings, compared with 52 times at its peak in October 2007. The U.S. benchmark Standard & Poor’s 500 Index trades at 19 times earnings. China’s economic growth quickened to 10.7 percent last quarter. Property prices in 70 cities rose 10.7 percent from a year earlier in February. 

REFER TO ABOVE GRAPH!!!  J

The nation’s “massive monetary stimulus” risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, says the World Bank. 

Harvard’s Rogoff said Feb. 23 that a debt-fueled bubble in China may trigger a regional recession within a decade, while Chanos, founder of New York-based Kynikos Associates Ltd., predicted a slump after excessive property investments. 

Now, there are some economic heavies on the other side, for sure, all of them saying that the Chinese central bankers will raise rates high enough and quick enough.
 
The banking industry has “very low impairment charges compared to what you’d expect this time in the cycle,” HSBC’s Geoghegan said. “I wouldn’t be surprised if there’s a gradual increase in impairments, but long term I’m confident that the structure of the banking industry is very, very sound.” 

I guess we will see, Mr. Geoghegan…but that chart up there is pretty convincing J