Today looks like one of those mini-panic days, with investors hyper-ventilating for reasons not entirely clear to them if they paused and thought about it for a few seconds. If I was going to breathe into a paper bag today, it would be due to the report this morning that both China and Japan trimmed their holdings of U.S. assets in April. WSJ.com So who is going to pay for our extravagances? It is almost mind boggling that the Democrats may soon pass another social program which will ultimately cost far more than the "trillion or so" currently predicted while at the same time failing to come to grips with the gigantically underfunded social security and medicare programs. Yes, the politicians plan to kick the can by appointing yet another commission to examine that problem. I thought the "trillion or so" for the soon to be enacted federal health insurance program was an interesting number, when I saw a politician use it over the weekend. As if a few hundred billion here and there was really no big deal when the U.S. plans to run a 1.8 trillion dollar deficit this fiscal year. And, why exactly is the dollar gaining strength today? Maybe the Asians will grow weary of financing our irresponsibility.
1. Boeing: At the Paris Air Show, Boeing predicted a recovery in the commercial plane market by mid 2010. R Cramer's prediction of the world seeing the Boeing 787 Dreamliner in flight at the Paris air show proved to be one of his more illusory forecasts, as the company said the maiden flight would be sometime before the end of this quarter.
2. NY Manufacturing Survey: The New York Fed released its June Empire State Manufacturing Survey this morning which showed continued contraction, with the general business conditions index sliding to -9.4, down five from the May reading. Empire State Manufacturing Survey (overview) - Federal Reserve Bank of New York However, the six-month outlook improved to its highest level in nearly two years.
3. Examples of Dynamic Asset Allocation over the Past Two Years: In dynamic asset allocation, the investor needs to make changes in their asset allocation based on conditions, risks, and opportunities in the market. Those changes would be made regardless of considerations that dictate allocations in a static allocation model such as age. In this blog, I have given several examples of the changes that I have made and will just briefly summarize a few of them now:
(a) VIX Asset Allocation Model Signaling Reduction in Stock Allocation in 2007: I have discussed at length how the VIX Asset Allocation Model signaled in August 2007 a need to reduce one's exposure to stocks based on a breakdown in the Stable Vix Pattern prevalent from October 2003 to August 2007. This would have to be done under that model regardless of a person's age or risk tolerance, though a larger reduction may be advisable for those facing serious short or intermediate term situational risks.
The change from a long standing stable pattern (lower than 20 on the VIX) to an unstable volatility pattern indicates that stocks have become riskier, with elevated levels of volatility indicating a significant risk of lower prices to come. Vix Asset Allocation Model Explained Simply With as Few Words as Possible Thus, the model suggests a shift out of stocks when a Trigger Event occurs into a non-correlated asset class, with the amount of the shift determined by each individual investor based on a realistic assessment of their situational risks and other unique circumstances. But, some shift would be done irrespective of risk tolerance or age. Once stability in the VIX is reestablished, which may take several years, then an investor could shift some funds back into stocks from the non-correlated holding pond. Target funds, in their mechanical glide path, would do none of those kind of shifts, which is one reason for their many failures. More on Failures of Standard Asset Allocation Models and Target Funds/Use of Volatility in an Asset Class to Make Adjustments to an Asset Allocation
(b) Shift into investment grade corporate bonds in the Fall of 2008: During the fall of 2008, investment grade corporate bonds fell significantly in price and the spread in yields between investment grade corporate bonds and treasuries widened to unprecedented levels.
Investment Grade Corporate Bond Spreads/ CPI FLOATER: OSM
This dysfunction rose to extreme levels in October and November, as I noted in my posts back then.
This dysfunction rose to extreme levels in October and November, as I noted in my posts back then.
This presented an opportunity to increase one's allocation to investment grade corporate bonds. This shift into corporate bonds would be due solely to the opportunity created by the market, and would most likely be a long term shift into that asset class, lasting two or more years, until other considerations like an increase in inflation rates would cause a re-examination. I found at the time that the best opportunities for buying corporate bonds at the time were in the securities that I call Trust Certificates, and I documented many of my buys in these posts as they occurred during the 4th quarter of 2008 and into 2009. Trust Certificate Links in One Post
This topic was recently discussed in greater detail in this post: Examples of Dynamic Asset Allocation Other Than Using the Vix as Timing Tool for Shifts into and out of Stocks
(c) TIP: If an investor was considering adding Treasury Inflation Protected securities to their portfolio, an opportune time to make an investment in the TIP is when the market does not charge much if anything for the inflation protection. This is likely to occur during a deflation type scare. At that point in time, an evaluation needs to be made about the likelihood of deflation occurring over a long period of time. During the 4th quarter of 2008, there were several opportunities to buy the TIP without paying much for the inflation protection. In other words, the break-even point was close to zero.
(d) Equity Preferred Stocks: Generally, my allocation to traditional preferred stocks would be close to nil. I have discussed their many disadvantages, including a lack of a maturity date, non-cumulative dividends for most but not all of them, and low priority in the event of a bankruptcy.
Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock
Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock
However, even for a conservative investor, an asset class can be priced at a level than can no longer be ignored, which was the case with traditional preferred stocks, particularly in the 4th quarter of 2008 and the 1st quarter of 2009. The equity preferred floating rate securities that pay the greater of a guarantee or a percentage above a short term rate like three month LIBOR became especially attractive due to their large discounts to par value during those earlier periods.
(e) Shift out of T Bills into Bank Certificates of Deposit: Starting last October, when the T Bill rate started its slide to near a zero yield, I locked in some longer term Bank CDs and refused to roll over my treasury bills then coming due.
(f) Emerging Market Stock and Natural Resource Stocks Virtual Elimination in 2007: While I have said that the VIX Asset Allocation Model applies to U.S. stocks, I give myself the latitude of using it as a signal also to eliminate or pare an asset class that was highly correlated with U.S. stocks during the U.S. stock market's bull move, with a higher beta in the same direction, which was the case for both emerging market and natural resource stocks in 2007.
Thus, a Trigger Event in the Model, which is tied to the volatility of the S & P 500 index, may cause me to sell an asset unrelated to, or distinct from that asset class, provided it has had a high positive correlation and a high beta during the S & P's bull move.
I would add a few caveats. There are certainly no guarantees. For example, it was certainly conceivable that the world could have fallen into another Great Depression after the Lehman failure, which would have caused a large increase in corporate defaults and elimination of non-cumulative preferred dividends. So a shift into corporate bonds and equity preferred securities in the 4th quarter would have been ill-advised with another Great Depression coming to pass. There was a reason for the market event that caused the opportunity to arise. And, it is incumbent on each individual to assess whether the market has rationally priced the likelihood of the event causing the significant dysfunction in pricing. Another caveat is the tension between the VIX model and other more traditional allocation techniques, especially when you have a situation like the one which existed in early March 2009: More Of Less Safe After Averages Fall-Tension with Vix Model
Sometimes I hear an individual ask is this security safe, or express a desire for safety and an unusually high potential return at the same time. I always wonder about those kind of questions. Once I venture beyond 3 month treasury bills and bank certificates of deposit or savings accounts, I quit asking myself whether a security is safe, and start focusing on the risks and weighing the potential risks against the rewards. John Bogle considers a purchase by an individual of any individual security, bond or stock, to be a form of gambling. CNBC.com It is, without a doubt, and I have always viewed it as such. I assume lack of safety when I buy a stock or a bond. All that I am doing with all of my models is trying to improve my odds of winning, since I was born a gambler and will always be one (sort of like a blackjack player learning to count cards and memorizing the basic strategy, just to improve their chances of winning) So, in my VIX Model, as an example, I have a requirement that the VIX has to return to below 20 and stay below 20 for 3 months before I recommit the 30% of my investable assets currently in cash raised prior to 2008 back into stocks. Is it safe then? No is the short answer, it is just safer than it was when the VIX was meandering in the Unstable VIX pattern as it is now, so it is still relative even with a return to the Stable VIX pattern, and we are not close to that happening yet : Vix Asset Allocation Model is Obvious
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