Thursday, December 18, 2008

Jane Quinn's Problem with Static Asset Allocation/Hedge on Long Bond/ WALL STREET Bonuses

In Jane Quinn's column in the current Newsweek, she expressed both anxiety and frustration with what I call static asset allocation, which worked in the 1982 to 2000 period but is not working very well now.  TipSheet : There Goes The 401(K)  She notes that it worked for her through three market cycles between 1980 to 2000.  I would suggest to Jane that the period from 1982 to 2000 was one market cycle in a long term secular bull market for the two major asset classes of stocks and bonds.  There were some relatively short and nasty down periods in stocks during that period where a re-balancing to bonds and to minor asset classes would have proved beneficial.  My point, made in several earlier posts, is that a static asset allocation model will not work in the current market, starting in 2000 or the period from about 1966 to 1982 or several earlier periods lasting a decade or longer.  We are currently in a period that requires a dynamic asset allocation model which may give way to a more appropriate static model in a few years.  
On the positive side, we are not yet in an extended period where the bond asset class fails.  For those who advocate the static model, I am not sure how it would work in a period of stagflation similar to the experience in the 1970s which would be tough on the bond asset class. Stagflation - Wikipedia, the free encyclopedia I have at least found a positive return in my dynamic asset allocation with my individual bond selections and bond ETFs, along with my large cash position. 

I mentioned in a post from last night that I was going to hedge my long term corporate bond portfolio with an inverse ETF for long term treasury bonds.  I described this as a hedge.  It is partly psychological tailored for my own peculiar personality traits.  Many of these long bonds recently purchased will provide me with a greater return, year in and year out, than I could ever hope to achieve with stocks over a twenty year period. As I discussed, I know this as an intellectual matter.  Knowing myself, however, I also realize that there will be one or more inflation scares during the next twenty to twenty five years. That is where the hedge comes into play.  The hedge might keep me anchored to a longer term over-weight position in long term investment grade corporate bonds, now extending for the likely remaining years of my life.
The hedge may also need to be managed some, more than the long term bond position which may become a static allocation percentage due to the favorable prices of the large number of issues purchased during the corporate bond market meltdown.   Why an inverse ETF for Treasury bonds?  There are two reasons.  I could not find an inverse ETF for corporate bonds.  I bought LQD and would not want to short it.  I did not look too hard because the double short for a long treasury bond makes more sense to me based on my current opinion of the likely course of events over the next several years.  It is possible that I will make money on both the long corporate bond position and the double short long treasury position.  This would be possible because of the unusually large spread in yields between the two categories of long bond.  Both positions could become profitable simply by a return to normal spreads, with the long corporates continuing to rally and the long treasury bonds falling in price and rising in yield.   There is never any certainty when talking about the future. I simply have to act based on my own judgment.   My judgment  is all that I have and that is all that I would pay attention to anyways which is fine as long as I constantly question each decision as if some stranger had made it as new information is digested and never filtered through an ideological filter.   

Possibly, I need to quit reading the excellent articles in the Reckoning series by the NYT.  The last one about bonuses doled out at Merrill Lynch just put me a foul mood this morning.   While there was certainly bad judgments exercised by a large segment of average Americans in managing their credit, it was Wall Street that provided the lubricant and temptation.  I am a firm believer in individual responsibility.  Bad decisions by consumers in taking on credit need to have bad consequences.  This is for the most part happening now.  On the other hand, incredibly stupid decisions and actions by a few thousand ridiculously compensated investment "professionals" have had no consequences for them.  To the contrary, their bonuses- ultimately paid for losing hundreds of billions of dollars- frequently ran into the tens of millions and those monies are kept by them, along with their homes in Palm Beach and the Hamptons, their small yacht and villa in the south of Spain.   What were they really worth?  I would give them as a class a NEGATIVE 4 trillion dollar figure.  If there was any justice, the first dib in cleaning up their mess would come from liquidation of all their assets before the taxpayers forked over a dime in bailout money.  

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