Monday, March 30, 2009

Long Term Stock Risks and Situational Risk/Managing Lost Opportunity Risk in a Long Term Secular Bull and Bear Markets/ Novartis or Sanofi

1. Bayesian Long Term Risk Analysis for Stocks: The article that I previously discussed in Sunday's NYT relating to the use of Bayesian techniques to analyse the long term risk of stocks is also discussed in this article, A Yahoo! Finance and in these blogs, Is it time to rethink how much stock you own? | Kevin Hoffberg's Blog Stocks for The Long Run — Riskier than Stocks for The Short Run? « The Guru Investor

If stocks are more risky than previously thought for a long term investor, as suggested by this analysis, then consideration needs to be given to reducing their weight, at least where an investor faces significant situational risk, that is, a need for capital unique to the individual investor based on their personal situation.

In the example that I gave in a previous post, I postulated what would happen to me if I lived another 35 years to the ripe old age of 92 and my stock portfolio suffered a horrendous meltdown at age 88, followed by a relentlessly long bear market lasting several years. What if that was accompanied by stagflation that reduced the value of my bonds, and I had to sell them at a loss?  Duality of Long Term Risks

Or,  what happens when I am depending on stocks to finance my retirement, and they fall 50 to 70% quickly soon after I retire? Another example would be having a heavy weight in stocks in a 529 plan with the child starting to enter college right now. There are countless situational risks where new thinking needs to be done to weigh the long term risk of stocks with the applicable situational risk even with a five year or longer time frame.  And, the end result of that analysis may be less weighting to stocks as an asset class than you would normally see in a target funds glide path.   

2.  Long Corporate Bond Purchases and Inflation Risk-Use of Floaters: One thing that I have done over the past two years is to buy bonds with maturity dates 20 to 30 years into the future that provide a steady flow of income, with many of the purchases made a deep discounts to par value.  So, I have been using the fear and volatility since October of last year to buy investment grade bonds that provide a high level of current income for two or even three decades.  I am going to continue looking for similar opportunities in the future, and I will try to hedge the inflation risk by a combination of tools.  These tools include the use of floaters, double short ETFs like PST and TBT, and inflation protected bonds.  Some of my purchases over the past six months are floaters that will pay a higher rate when short term rates rise, which provides a measure of inflation protection.

I have only become a bond investor during the past two years so this is still a work in progress for me.  

3. Critique of Siegel's Failure to Account for a Typical Investors Situational Risk:  I have been critical in the past about Siegel's views of stocks for the long run in light of situational risks and the often long periods associated with secular bear markets for stocks.

Stocks for the Long Run?/End to Irrational Exuberance for Now 
Part of my analysis was Bayesian without knowing anything about Bayesian techniques. It is obvious, a common sense observation, when one examines history since I have been alive, that there are prolonged periods when ownership of stocks is just painful.  In my life, those periods have included two long spans, from about 1968 to 1982 and 2000 to 2009 and counting.  

4: No More Bond Mutual Funds For Me-Awful Experience with Loomis Sayles in 2008: Are bond mutual funds the answer for me? I just had an extremely bad experience with Loomis Sayles last year.  I do not think that I will ever buy a bond mutual fund again under any circumstances.  I have enough funds to achieve diversity in a portfolio of individual securities, and I can always hold the bond to maturity if need be.

A bond mutual fund has no maturity.  Its net asset value fluctuates with changes in the values of its bond positions.  Even in periods where bonds have performed well, it is not unusual to find bond funds that continue to decline in their NAV. Even when you add the dividends back, you may easily realize a total return once the shares are sold in an amount less than the total dividends paid out (loss on shares subtracts from the dividend return).

It will get a lot worse when the long term secular bull market in bonds comes to an end, which will happen, and this major asset class starts to fail.  This will happen when inflation becomes a problem again, as in the 1970s and early 1980s over a long period of time and periodically thereafter. Then the decline in the NAV will far exceed the dividends paid out and the option of recovering your principle at maturity does not not exist in that ownership structure.

So I have elected to buy individual bonds and to supplement my individual securities with four bond ETFs: TIP, WIP, BWX and LQD.  I will trade the ETFs but the first three are in areas of the bond market where I will most likely never buy an individual security. TIP is U.S. Treasury Inflation Protected Bonds; WIP includes International Government Inflation Protected Bonds; and BWX contains International Government Bonds. 

5.  Do Not Assume Bonds Will Always Rise in Value: I would not take for granted the safety of bonds as an asset class. In the 1970s, there was in my opinion a failure of both bonds and stocks in an asset allocation scheme over about a fifteen year period.  Yes, stocks may have presented a trading opportunity here and there, but you had to be nimble. The best investment was probably treasury bills from about 1968 to 1982.   

 It is hard to see how treasury bonds will provide decent income or appreciation at the current price and yield levels.  High yield bonds are notorious for their volatility and unreliability.  If inflation becomes a big problem, investors will find out that bonds will lose value and result in negative returns even after interest payments.  

6.  Meaning of Opportunity Risk: I have received a comment about my use of the phrase "opportunity risk" to describe the risk that shares might be purchased at a lower price, and any capital used to purchase at a higher price will not be available to acquire shares at the lower cost.

This risk postulates that every investor only has a limited amount of capital to deploy, the amount is not relevant. The query is whether the phrase would be appropriate to describe the risk of the price rising so much that the opportunity is lost.

I would say it could be used both ways but the more appropriate description for a bear market would be to use opportunity risk to describe the risk to the downside and the consequences of buying too early.  In a secular bull market, the risk would not be buying at all and/or waiting too long.  

So, in a clearly defined long term secular bull market, the risk of lost opportunity can be best described as not taking a full position in the security all at once. The reverse is true in the current market, where risk is managed by slicing and dicing orders into several parts, selling some securities on spikes, and repurchasing at lower prices on downdrafts using volatility to gradually build up positions at the lowest possible prices in preparation for the next bull market.  So, my use of the phrase, and the way I manage opportunity risk, will depend on whether the market is characterized as a long term secular bull market or bear market.  

7. Cash Allocation and My Vix Asset Allocation Model: My investable capital on the sidelines currently in cash will not be deployed until I am confident that a secular bull market has started, using primarily my VIX signal and other indicators, along with common sense and experience.  It would also be best to wait at least a year into the bear market before doing what I am attempting to do now in the consumer staples sector. The failure of the S & P 500 index to close above 815 for the month of March will also keep my cash flow from dividends and interest in cash until at least until May 1st for the reasons discussed in prior posts.  This is building up and I keep a log of the amounts so I know precisely how much to invest in common stocks when and if the S & P 500 index closes a month above 815. 

8. Recent Shift out of Short Term Bonds into Stocks in Violation of the Vix Model: I made a decision earlier this month to raise almost 30 grand  by selling several short term bonds (from GE, CAT, HIG, International Lease, BAC and one bond ETF-TFI),  and to allocate most of that capital slowly to consumer staple stocks for the most part (with some used to buy DD, NYX, IR, AA, DIS and a few lottery tickets).   I  am still  deploying that capital.  I picked consumer staples as my first major foray into stock purchases since 2007  due to their dividend yields, financial stability, and favorable prices for a long term hold.  My acquisition of them is being done under what I refer to as managing the risk of lost opportunity in a bear market. I also mentioned that I wanted to add one pharmaceutical company.  I have only a small position in Bristol Myers.   The only thing that I did today was to narrow my choice to either the Swiss firm Novartis (NVS) or the French firm Sanofi-Aventis (SNY).  Since both firms pay good dividends that would be subject to a foreign withholding tax, I will not buy one of them in a retirement account where the foreign tax paid can not be recouped.  

9.  Life Insurance Stocks: My decision to stay away from life insurance common stocks is being confirmed almost weekly.  I sold at a profit a small position in Lincoln National earlier this year, which was the last common stock position owned.  Lincoln fell almost 40% today after it withdrew its application to issue debt under the government's Temporary Liquidity Guarantee Program. MarketWatch   I was concerned enough about this sector that I also reduced my senior bond exposure by eliminating my Hartford financial senior bonds at a small loss.  For the U.S. insurance companies, my current exposure is small, consisting of some senior bonds issued by Prudential, a MET LIFE floating rate preferred stock and a small position in a Phoenix insurance company senior bond.  

10 Aegon Preferred Stocks & AEB: I recently sold one my Aegon preferred stocks in an IRA.  Give the AIG Masters of Disaster my New Medal of Chutzpah/Sold AEV in Risk Reduction Move   I am going to shift some of the risk of the Aegon floating rate preferred, AEB, out of my taxable account into my retirement account.  On  additional weakness below $5, I intend to add up to 100 of AEB to the 100 owned in the retirement account and then at some point sell 100 of the 250 owned in the taxable account. 

Some individuals do not realize that the interest on a preferred stock or a bond is calculated on its par value, not the market price or your cost.  The Aegon floater, which has been discussed many times, pays the greater of 4% or 7/8% over 3 month LIBOR.  It has a $25 par value.  At the 4% guarantee, the dividend would be .04% x 25= $1 per year for 1 share.  If you bought those shares at $5, you would receive that $1.  If you bought a share at par value you would receive $1.  If you bought a share at $10, you will receive $1.  Where you buy does not effect the dividend paid but it does impact your yield.  So at the 4% guarantee and a $25 price, the yield would be 4%.  At $5 which is where AEB traded today, the yield would be 20%.  Then I have shown how the yield is impacted in the event the float provision is greater than the guarantee.  The problem with this security, as I have said many times, is that it has no maturity, which is always a bad thing; Aegon is a life insurance company;  and it is senior only to common stock. The 7/8% over 3 month LIBOR float provision does provide some inflation protection. At a 5 1/8% 3 month LIBOR, the yield on the $25 par would be 6% but that translates to a yield of  30% at a $5 cost.

This is a link to the prospectus:

These are links to some of my prior discussions:

Since I am concerned about inflation in the future, and the impact it will have on my large fixed rate bond investments, floaters have a coveted spot in my portfolio so I will place more emphasis on AEB than other Aegon preferred fixed rate securities due to its float provision. Similarly, in the J P Morgan floater that I have discussed, GJN, the 3% guarantee is worth 6.25% at a purchase cost of $ 12 since the guarantee is calculated on a $25 par value. 

11.  Forbes Article on Floaters and Canadian Energy Trusts: I received my issue of Forbes today in the mail and I noticed that Richard Lehmann  had an article recommending several floaters for their inflation protection, along with several Canadian energy trusts that I own.

  I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. I have never worked for a financial institution and never will.  In these posts, I am acting as an unpaid financial journalist and an occasional political commentator.  I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine. Any discussion made by me of particular securities  is not a recommendation to buy or to sell.  Trade at your own risk.  Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons.  The sale may before or after the post.  Before buying or selling any stock, even one recommended by a trusted financial advisor,  please research it and make up your own mind which is what I always try to do.  Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news.  In this post, and all others by me, I am merely describing my reasons for purchasing  or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale. The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile.  By way of example, it is unlikely that I will ever need the funds contained in my retirement accounts. Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments.  Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed.  These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities.  All content in these posts is provided for informational and entertainment purposes only, and it is a form of entertainment for me. 

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