Hyman Minsky & the Economic Profession/Savings Bonds/Correlation of Asset Classes/Sold CYB

1. Hyman Minsky: Minsky and Robert Schiller are two of the very few economists worth reading. The rest are consumed with mathematical models and absurd, even laughable constructs based on the "Rational Man" The Death of 'Rational Mans- washingtonpost.com Rational man | The Economist

For those unfamiliar with Minsky, here is a link to an introductory article in Wikipedia. A ten page paper written by Minsky titled "The Financial Instability Hypothesis" is worth a read: www.levy.org/pubs/wp74.pdf The stark failure of mainstream economists is due in part to ignoring Minsky, a point recently made by Floyd Norris in his NYT column. This is a link to Pimco's Paul McCulley discussing Minsky and his relevance to understanding the recent financial crisis: pimco-global.com/pdfs For the most part, I would have the same reverence for economists as I do the Masters of Disaster, and I would wholeheartedly agree with Hayek's remark that economists have "made a mess of things". Friedrich August von Hayek - Nobel Prize Lecture Unfortunately, nothing has changed since that remark by Hayek many moons ago.

2. Savings Bonds: For anyone interested in determining the value of their savings bonds, the treasury department has a calculator: Calculate the Value of Your Paper Savings Bond(s) Some might say that this is a staid investment. In 1992, the treasury sold some EE with a guarantee of 7.5% until the bond reached its face or par value, and 4% thereafter until maturity. The maximum face amount was $10,000, bought for $5000. A $10,000 face amount savings bond bought in 1992 for $5,000 would now be worth $12,392. It would currently be accruing interest at a rate higher than the 10 year Treasury bond. This is a link to the table of that shows the current rates by issue data: www.treasurydirect..pdf The current rate for newly issued bonds is just 1.2%: Individual - EE/E Savings Bonds If I had to buy a savings bond today, it would be the "I" series: Individual - I Savings Bonds & Individual - I Savings Bonds Rates & Terms (the last link shows how the treasury calculates interest for its inflation linked I Savings Bonds)

On tax issues for I bond holders, see IRS publication 550 at the bottom of page 7: www.irs.gov/pub/irs-pdf/p550.pdf The coupon rate for the I bonds is very low now at .3%. But, there is always the option after five years to redeem the bond without penalty and then invest in an new one. Since the investor can redeem after 5 years, receive their principal and accrued interest at that time, I view them as comparable to the 5 year TIP bond. Bloomberg reports that the current coupon yield on the 5 year TIP as of 12/24/09 is .41%. There are no penalties for redemption after a five year holding period: Individual - I Savings Bonds

If the coupon payable on the I Bond moved up substantially from its current low rate, it might make sense to redeem the old one with say a .3% coupon for a new one with a 3% coupon, for example, both having the same inflation adjustment component. But this kind of investment is not the path many will choose, because the upside is so limited, even when the coupon was over 3% from 9/1/98 to 5/1/2001. Individual - I Savings Bonds Rates & Terms The last link contains the historic coupon rates of the I savings bond, and illustrates a point that I have made several times about TIPs. The coupon rate will fluctuate with changes in inflation and inflation expectations.

3. Asset Correlation: I occasionally will look at historical charts that contain information on how one asset class correlates with another. Positive correlation simply means the asset classes move in the same direction, both up and down. If positive correlation is stated at 1, the correlation is perfect. I would view anything over .7 to be a high positive correlation. Negative correlation indicates that the asset classes move in different directions. A recent example of negative correlation was the movement of the S & P 500 and treasury bond prices between September 2008 and early March 2009.

For historical data, I turn to the charts contained in David Darst's book "Mastering the Art of Asset Allocation". This book contains data up to 2004. I am most interested in the rolling 10 year periods. Looking at the data starting in 1970 showing correlations with the S & P 500, I see very high positive correlations with the Wishire 5000 index. The positive correlations are mostly .99 or .98. The asset classes with negative correlations with the S & P 500, or small positive correlations, for significant periods of time were gold, silver, REITs and TIPs. The 10 year treasury note had positive correlation in every ten year rolling period starting in 1970 and ending in 2004, with a large number of low or modest positive correlation. I would call 1 to 30 a low positive correlation, 31 to 69 modest, and over 70 as high. Generally, for the purposes of evaluating diversity, I would want some assets with low positive correlations and some that would historically be negative, more often than not. (see the comments of Gary Gordon in this article: ETF Trends )

And it always needs to be emphasized that correlations between asset classes can be volatile. This article shows how the commodity index was negatively correlated with the DJIA for most of the 1970s and early 1980s, and then turned toward more positive correlation numbers in rolling five year periods after 1985 with only one negative correlation five year period: Seeking Alpha But even that picture can be a little deceiving by arbitrarily focusing on specific five year periods, rather than rolling five year periods, and comparing stocks to the broad commodity index which is weighted in energy. So oil prices were rising in the 1970s and stocks were going nowhere for the decade. I would expect a negative correlation between oil and stocks in the 1970s, but I expected positive correlation between that broad commodity index and stocks in 2008. So, the analysis has to be specific for the particular time at issue. The broad commodity index is running with stocks now. The Ishares ETF for the GSCI Commodity index was at 23.1 in early March and has risen to $31.11 as of 12/24: GSG Fund Charts - iShares S&P GSCI Commodity Indexed Trust Fund Charts You can also see looking at that one year chart the positive correlation in the first quarter of 2009 between GSG and stocks, both moving down.

For agricultural commodities, 2009 has not been exactly been stellar. Just compare DBA, a ETF for agricultural commodities to the S & P 500.S&P 500 INDEX,RTH Index Chart DBA is flat. But if I include a chart with data from last year's stock debacle, DBA would have suffered less in losses than the S & P 500.

Some of the more detailed posts on this subject include the following:

instability & volatility in asset correlations

Emerging Market Currencies and Bonds as Non-Correlated Asset Classes

Treasury Inflation Protected Securities as a Non-Correlated Asset

Total Bond Market Index (BND) and IEF as Non-Correlated Assets to Stocks

More on International Bonds as a Non-correlated Asset

Examples of Dynamic Asset Allocation over the Past Two Years

Static v. Dynamic Asset Allocation

4. Lions Gate (LGF) (owned LT category): Precious is still playing in 1003 theatres. Over the past 7 weeks, the film has an estimated gross of about 40 million. Another LGF release, Brothers, is up to 22.349 million in 3 weeks. top films

5. Dividends and Interest: One of the securities that I own, PFK, goes ex interest on Tuesday for its monthly interest payment. PFK is a senior bond whose interest rate is calculated based on a 2.4% spread to CPI. The calculation is explained in earlier posts. / CPI and CPI Floaters OSM and PFK The rate for the January payment is $.0231. I expect that rate to increase over the coming months (see the calculations below).

Two of the Trust Certificates (TCs) containing a junior Aon trust preferred (TP), KTN and KVW, go ex interest for their semi-annual payment also on the 29th of December. I own both of those, with KTN bought at $14 or less per share, now trading over $25. Other securities that go ex dividend or interest that I own and have discussed in this blog include Winstream; the U.S. Bancorp equity preferred floater ( USB.PRH); two synthetic floaters-GJT & GJN; Sysco; a BDC, Prospect Capital (PSEC); PMA Capital Senior note (PMK); Wilshire Bancorp; two Odyssey Re equity preferred stocks, one a floater and the other a fixed coupon; IDG an ING hybrid; IAE, IGD, GCS, CSQ, PSY- Closed End Investment funds (CEFs); GRT & GRTPRF (a cumulative REIT preferred stock); EHL, A FIRST MORTGAGE BOND issued by Entergy Louisiana; Enerplus, a Canadian energy trust; LXPPRD (cumulative equity REIT preferred stock); SIVBO (a TP from SVB Financial); & CVB Financial. So, that is a diverse lot of securities. The income orientation is clear.

I will summarize the method used to calculate the interest payment for the Prudential CPI floater (a senior bond maturing in 2018 at a $25 par value) which goes ex tomorrow with a payment in January. The CPI calculation covers a 12 month period with a 3 month lag. The non-seasonally adjusted CPI is used:

Pricing Supplement No. 122 dated March 31, 2006

NSA CPI September 2009: 215.969

NSA CPI September 2008: 218.783

Difference: -2.814

Divided by 218.783= -.01286

Add Spread: .024= .0111 x $25 par value= $.2775

Divide by 12 months= .0231 cents which is what is shown on the WSJ dividend page.

As shown, this rate for January 2010 is still being adversely impacted by the negative CPI numbers from 4th quarter of 2008.

This is the calculation for the payment in February 2010, as one negative CPI number from 2008 is eliminated:

NSA CPI October 2009: 216.177

NSA CPI October 2008: 216.573

Difference: -.395

Divide -.395 by 216.573= -.0018

Add Spread .024 to -0018238= .0222 x. $25 par value= $.555

Divide by 12= $.04625

And for the March 2010 payment, another 2008 negative CPI number is eliminated, and I can now calculate the penny rate:

NSA CPI November 2009 216.330

NSA CPI November 2008 212.425

Difference 3.905

Divide by 212.425= + .0184

Add Spread .024= .0424 x. $25=$1.06

Divide by 12 months= $.0883

I can not do the April 2010 payment until the December CPI number is released in mid January 2010. But let's make an assumption of an increase from 216.330 to say just 216.5 in that December CPI number. I calculated the penny rate based on that assumption at $.1121.

This is the data series that has to be used: http://research.stlouisfed.org/fred2/data/CPIAUCNS.txt As the negative numbers from 2008 are eliminated Bureau of Labor Statistics Data, the penny rate moves up. LB had a deer in the headlights look when PFK was at $12.5, unable to push the buy button, then hit the buy button several times in the $17.83 to $18.94 range.

6. Inflation Adjusted Stock Market Returns: While the rally in 2009 has taken the DJIA to 1999 levels, an article in the WSJ highlights the obvious, the inflation adjusted number is worse. For the DJIA to return to return to the 1999 highs adjusted for inflation, the DJIA would now have to be at 13460. This does not take into account dividends, but dividends are not what they use to be either.

The moneychimp site has a calculator that lets you adjust stock returns for any period of time: S&P 500 I did a calculation of the S & P 500 return with dividends and adjusted for inflation, starting on 1/1/99 to 12/31/2008. The annualized return was a -3.89. I tried another bad period, with inflation, between 1/1/1969 to 12/31/1981, and the annualized return was -2.07. But if I take a longer period, starting on 1/1/1982 to 12/31/2008, the return is positive at 7.43% annualized.

7. Sold 100 CYB for a Small Loss ( see disclaimer): I went to the Wisdomtree website this morning, and checked to see whether CYB paid an annual dividend in 2009. No dividend was paid. WisdomTree - WisdomTree Dreyfus Chinese Yuan Fund (CYB) I also read a story this morning, where the Chinese premier insisted that China would not be presurred to unpeg the yuan to the dollar. CNBC Those two new facts caused me to reconsider holding the currency ETF for the Chinese Yuan, and I decided to sell my position this morning. Instead of owning the Yuan in a very indirect through this ETF, I will increase my holdings in Canadian dollars which will be used to buy high yielding Canadian stocks. The position was bought at $25.36 in November: BOUGHT 100 CYB at $25.36

8. Australian Dollars: I mentioned in an earlier post that I would be buying some Australian dollars at some point, rather than buying back the currency ETF for the Australian dollar, FXA. I have changed my mind on that one. The only reason for me to convert my U.S. dollars in the Aussie currency directly is to buy stocks on the Australian exchange. I have decided to refrain from doing that due to the brokerage commission being too high at 32 Australian dollars (currently about $28 U.S.Currency Converter ). If the Australian dollar falls significantly, say to $20 U.S., I may choose to buy a stock on the Australian exchange and convert my dollars then. In the meantime, I may buy back my shares in FXA: Sold FXA My trades in FXA, and other currency ETFs, in 2008 were one of the few positive events from that year.

9. RB Receives a Reward While LB Is Given Awards: Headknocker is generous to a fault, which goes without saying. While the RB in this operation is frequently maligned by the Nerd LB, HK recognizes that the vision thing can sometimes play a role in advancing the HK's capital position. So, to show his generosity, HK will allow the RB to buy five Lottery Tickets today and tomorrow on the condition that any loss be realized before it turns into a long term loss next year.

For LB, HK will thank the NERD for preserving HK's capital during the trying times in 2008. To show HK's gratitude, HK hereby grants to LB the follow awards: Best Macro Economic Analysis in 2009 at HQ; Best Market Historian in 2009 at HQ; Best Stock Researcher in 2009 at HQ; Best Numbers Cruncher in 2009 at HQ; and Best Technician in 2009 at HQ. Of course, LB is the only candidate for those awards here at HQ.

Instability & Volatility in Asset Correlations

In a prior post, I mentioned that I was going to focus some attention on the unstable nature of the relationship between asset classes. This post assumes some familiarity with my VIX Asset Allocation Model. USING THE VIX MODEL AS A TIMING INDICATOR FOR LONGER TERM STOCK ALLOCATIONS

For anyone interested in that topic, this is a link to a starter post: Vix Asset Allocation Model Explained Simply With as Few Words as Possible

In addition, it is important to understand the meaning of positive and negative correlation. 

I have just started to dig into this subject more thoroughly. I understand that the relationship between many asset classes is unstable, so that permanent conclusions can not be drawn based solely on historical experience. One asset class may have a low positive correlation or even a negative correlation with the S & P 500 Index during one period and then exhibit a high positive correlation during a severe bear market which would be a negative of course. I discovered this paper written by Willaim Coaker that documents the instability of the correlations between asset classes, and suggests a need for dynamism in constructing an asset allocation scheme, similar to what I have been preaching in this blog which requires a dynamic approach based on conditions in the market and the real world. This is a link to the Pdf of his paper:

http://spwfe.fpanet.org:10005.pdf

One of the most stable negative correlations was between intermediate bonds and the S & P 500 average in years when that stock average declined. In all 8 years since 1970 to the date of Coaker's paper, intermediate bonds gained in value when the S & P 500 declined. This is what you want in an asset allocation. When the Trigger Event happened in the VIX Asset Allocation Model in 2007, the proceeds raised by my reduction in exposure in stocks had to find a temporary home in what would then be viewed as the most likely candidates for negative correlation with stocks. There were several alternatives considered at the time. The alternatives chosen were money market funds, bond ETFs (TFI, BND, BSV, GVI, SHY, TIP, BWX, etc), a municipal bond fund with Tennessee issues, and short term individual investment grade bonds.

Then, in 2008, I did a shift out of some bond ETFs into individual bond or bond like securities such as floating rate securities with a guarantee, trust certificates, trust preferred, fixed coupon equity preferred, and some individual long term bond names, with my buying of those issues documented for the most part day by day after I started this blog in October 2008. I then started a shift in 2/09 of the overweight short term bond positions and used the proceeds to buy stocks in early March 2009, also discussed in this blog.

This was basically a good response to the signal given by the Vix Asset Allocation model in August 2007, but none of those responses were based on any study of historical correlation patterns. It was based on a intuitive understanding of those historical relationships between asset classes based on many years of investing experience. I am now starting to examine in more depth the volatility of correlations among asset classes to better prepare myself for the next bull and bear markets.

An assumption can not be made that an asset class which was negatively correlated in past downturns would necessarily have the same correlation in the next one. Each downturn has to be assessed at its inception or as soon as possible once the investor realizes that a bear market in stocks is underway. In Coaker's study, natural resource stocks earned positive returns in 6 of the 8 down years for the S & P 500.

In August 2007, it would have been foolish to draw any conclusion about the future correlation of natural resource stocks with the S & P 500 based just on that historical negative correlation at the start of a bear market in stocks. In other words, the odds were not 75% in favor of adding to, or keeping the natural resource stocks in August 2007 after the Trigger Event.

The historical probability has to be assessed under the circumstances then prevalent. I would suggest that two factors would have militated against using the past historical correlation when entering the current bear market for the S & P 500: (1) the alternative asset has itself had a high positive correlation with the bull move in stocks and (2) the correlation is more than highly positive, the beta of the other asset is higher, so that the move in the other asset class is stronger in the same direction as the S & P 500 during that indexes bull move.

In fact, several alternative asset classes slid badly in the current downturn. This would include such assets as commodities, natural resource stocks, REITs, and emerging market stocks. My reasoning for jettisoning natural resource mutual funds had to do with the parabolic rise in oil and other commodity prices. The parabolic nature of the rise, plus the additional and obvious problems inherent in demand reduction caused by an economic downturn, would cause a change in the historical negative correlation pattern between those two asset classes and consequently require an reduction or elimination of the natural resource asset class. I have not studied yet the positive correlation statistics for these alternative asset classes during the 2003 to 2008 period, but I lived that history. All of them were moving up with the S & P 500, and moving stronger in the same direction.

This is a link to a prior discussion of beta and positive correlation for emerging market stocks and bonds. Emerging Market Currencies and Bonds as Non-Correlated Asset Classes/Links to Performance Data on Target Funds & More on Their Many Failures

This positive correlation with high beta in the same direction prior to the downturn in the S & P 500 would militate against assuming low or negative correlation in the current bear market. The more reasonable prediction would be a continuation of the the positive correlation with a high beta continuing in the same direction, except the direction would be down during this bear market.

Maybe the negative correlation in an asset class like commodities and natural resource stocks will hold up better in a period (1) where commodity prices had not had a parabolic rise until something happens that causes them to rise quickly while jolting the stock market into a decline (e.g. the first Iraq war in 1990-1991; the 1973 Arab Oil Embargo, 1973 oil crisis - Wikipedia, the free encyclopedia) and/or (2) a real shortage in oil and/or other commodities causes prices to skyrocket which precipitates a decline in the S & P 500 index while natural resource stocks rise in value. Those situations are different than the events which preceded the current bear market. Natural resource stocks had enjoyed several stellar years of large percentage gains. I remember one natural resource mutual fund that I sold in 2007 that had a five year gain of over 400%. You can not make an assumption of negative correlation in a stock bear market after those kinds of gains for natural resource stocks and oil hitting $140 going into a recession. The correlation with the S & P 500 was both positive and at a high beta.

So, after the Trigger Event, all alternative asset categories have to be independently examined and a prediction then made whether or not those assets will have a negative correlation with stocks at that point in time. A high positive correlation and beta before the Trigger Event with stocks would militate against using the alternative asset class. There may even be strong factors present militating against the use of certain bond asset classes, such as a period of stagflation causing both a downturn in stock and bonds. Also, it is important to keep in mind that the VIX Asset Allocation Model does not provided guidance on the severity or length of the downturn in stocks. So when doing the asset allocation, I have to gauge how serious are the events which caused the disruption in the Stable Vix Pattern, causing the formation of the Unstable Vix Pattern, at higher and more dangerous volatility levels. The answer to that question will also impact my allocation decisions in the future. This topic is generally discussed in these posts:

More on the Vix Model: What it Does not Predict is as Important as What it Does/Parallels to VXO 1987-1988

There is one caveat. The formation of another Phase 2 Unstable VIX Pattern in the future will be dealt with immediately by a number of shifts in asset allocation: SEPTEMBER 2008: FORMATION OF THE DEADLY PHASE 2 OF THE UNSTABLE VIX

I am actually starting to work on those potential responses now, realizing that my response in late September 2008 was inadequate in many respects.

I am just writing in this post some very preliminary thoughts on this subject, immediately after waking up this Saturday morning, with no beverage jolt to the mind to help the process, before the thoughts escape me. I will come back to the topics discussed in this post after more study and thought.

Emerging Market Currencies and Bonds as Non-Correlated Asset Classes/Links to Performance Data on Target Funds & More on Their Many Failures

1. Emerging Market Bonds and Currencies as a Sub-Asset Class: Recently I bought some shares in a new ETF offering by Wisdomtree that will attempt to match the movement of a basket of emerging market currencies. Bought 50 Currency ETF for Emerging Markets-CEW/ Bought GYC: Synthetic Floating Rate Bond Wisdomtree provides a chart of the correlation of emerging market currencies with other asset classes. The correlations were all positive with the correlation to U.S. stocks at .68% and to international stocks at .8%. This would suggest that this ETF would add diversity but would not be a hedge for those other asset classes.  here is a lower positive correlation with alternative asset classes such as gold and commodities. CEW-570.pdf  In that PDF, there is another chart that shows that adding a 10% allocation to emerging market currencies to a balanced portfolio of stocks and bonds, which I would never consider doing, would increase returns and lower volatility, always a desirable objective from my viewpoint. That is always my objective, to outperform the S & P 500 with less volatility, though I would add the goal of outperforming that stock index while realizing over twice as much current income than 100% exposure to that index would produce in dividends. 

This is a link to a chart showing the correlation of an ETF for emerging market bonds and the S & P 500. Features That chart shows a low positive correlation over an extended period which suggests that emerging market bonds can offer diversity to a holder of U.S. stocks, with some potential of equity like returns. There does appear to be a high positive correlation when stocks started their meltdown in 2008, which would indicate to me that emerging market debt may need to be eliminated or substantially trimmed when the VIX Allocation Model flashes red for U.S. stocks.  You do not want an asset class that has a very high positive correlation with U.S. stocks in a stock bear market.  This is just another reason why so many static allocations fail-an unwillingness to adjust to the market in their mechanical glide paths to mediocrity.

The need to eliminate a sub-asset class at times would also be true for emerging market stocks. Those stocks are not only positively correlated with the U.S. stock market, but have a very high beta. This article shows that when the S & P moves 1%, an emerging market ETF would amplify that move to 1.83%. Seeking Alpha See also, Do Emerging Market ETFs Help You Diversify? | ETF Trends This is the kind of data that would justify my decision to dump emerging market stocks prior to 2008. A target fund would just keep that kind of asset in the allocation irrespective of market conditions and signals. I would also generally expect all stocks to fall in a bear market led by the U.S. The emerging market stocks most likely would only serve to amplify the down move in U.S. stocks, and would be counter-productive as an asset class in those circumstances. Another article has a chart showing, for example, a high positive correlation between emerging market stocks and the S & P 500 during the 2000 to 2002 bear market. Seeking Alpha

2. The Many Failures of Mechanical Glide Paths in Target Funds:

I just briefly discussed my general observations about the failures of Target Funds over the past decade as an asset allocation model. The Failure of Target Funds for Retirement:

I do not even view this point to be debatable.

The MSN Money web site is one of the best for analyzing mutual funds. This is a link to the performance data for the Fidelity 2020 fund. FFFDX - Fund returns - MSN Money Over the past 10 years, the annualized return is shown as .94%. That return is listed as #1 in the category.  This is the link for the same date on the Fidelity 2010 fund. FFFCX - Fund returns - MSN Money  

So, what is the problem?  In a nutshell, a workable asset allocation can not be based on a static glide path model.  The problem with such a static approach is discussed by me in the many posts linked in my main Gateway Post on Dynamic Asset Allocation. Time for a Paradigm Shift in Asset Allocation Theory: Need Dynamism, Better Assessment of All Forms of Risk, and Due Regard to Volatility Patterns

To summarize, some adjustments need to be made in asset allocation based solely on an assessment of volatility of an asset class. As shown in my Vix Asset Allocation Model, it would have been foolish to maintain the same allocation to stocks after the first Trigger Event in August 2007. VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern When volatility becomes more elevated out of a long term stable pattern, the risk has increased substantially for stocks as an asset class.  Along with that increased risk, there is a substantial likelihood of lower prices.  This would require some shift out of a fixed stock allocation required by some brain dead glide path model to an asset class likely to show negative correlation with stocks.  This would need to be done regardless of a person's age. Since all stocks would likely have strong positive correlation in a bear market, this would require a lightening up in all stock classes, not just U.S. stocks, but all international stock classes and sub-classes, particularly emerging market stocks that will likely swing harder in the same downward direction. So one of the major failures of these glide path funds is a unwillingness to make adjustments tied to increased risks signaled by a movement into elevated volatility ranges.

The books that I am have listed on my profile page are just the ones that I am reading now. In one of them, written by David Swenson who runs Yale's endowment, he spends a great deal of time discussing the many failures of mutual funds.  I did not need much convincing. Most of us are already aware that the stock mutual funds as a class underperform dumb index funds. And that is another problem with these target funds.

Recently, however, one of the more serious problems is the failure of the bond components of these funds to match the dumb index from Vanguard for the total bond market.  In a really serious bear market for stocks, this is a time for bond funds to shine, to prove their worth as an asset class with a low positive correlation with stocks or a much needed negative correlation during a stock bear market.  Some bond funds, like the Loomis Sayles retail bond fund, showed a very unhelpful positive correlation with stocks in 2008 falling 22.1% according to the MSN data. LSBRX - Fund returns - MSN Money

The Fidelity Strategic Real Return fund, a component of Fidelity's target funds, was one of the funds used by Fidelity in the bond allocation. This is the MSN link to the component funds of Fidelity's 2010 fund. FFFCX - Fund Top 25 holdings, Fund top twenty-five holdings - MSN Money The Strategic Return fund was down 23.4% in 2008 according to the MSN data.  FSRRX - Fund returns - MSN Money   That fund made up 6.88% of the Fidelity Freedom 2010 target fund.  The Fidelity Short Term bond fund made up 4.97% and it fell in 2008 too. FSHBX - Fund returns - MSN Money  The dumb index fund, the Vanguard Total Bond Market, was up over 5% in 2008.  VBMFX - Fund returns - MSN Money

Another critical failure is the inability to recognize prolonged periods where major asset classes fail.  The S & P 500 is now back to where it was in May 1997 as shown in this chart. S&P 500 INDEX,RTH Index Chart - Yahoo! Finance  This is not the first time stocks went nowhere for 10 to 15 years.  This is a similar chart for the S & P from early 1965 to the summer of 1982, S&P 500 INDEX,RTH Index Chart - Yahoo! Finance  If you had a target fund during those years, what would you expect. When the professors and pundits start talking about how well something may work since 1871 or over 60 yearsTo Professor Siegel: Time for a Re-Think, I would just suggest that 15 years is an awful long period of time in an individual's life for any asset allocation model to fail.  

At least back in the 60s and 70s, dividends would have provided some overall upward movement in the stock allocation. I found this chart this morning showing the rates of returns for stocks, t bills and treasury bonds: Historical Returns  This chart starts in 1928.  I am going to look at it more closely later today but it appears that all three of these asset classes are started at a constant 100 value in 1928. This is the kind of chart Professor Siegel would use to show the long term value of stocks. Since I am a stock jock, I agree with him on that point, as long as you look at very, very long periods of time.  

What I wanted to highlight now is the period staring in 1965 and compare the lowly T Bill with the Treasury Bond:

T Bill 1965           $179.28                           T Bill 1981  $512.73

       T Bond 1965        $ 274.49                             T Bond  1981  $484.91

To me this illustrates the failure of the bond asset class over a 16 year period.  This did set up the bond class for a period where in retrospect it would outperform stocks. (page 3: Barrons.com)

Duality of Long Term Risks/Stocks Under $5: Per Se Lottery Tickets
Buy of 50 CUZPRB in Regular IRA/Bonds vs. Stocks: 1968 to 2009/ABBOTT/UBS & Tax Evasion by the Rich/NRA: AK47s for Everybody

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

When you start to have failures in a major asset class lasting 15 years,  or have bonds and stocks going basically nowhere for 15 years,  that may be find in academia or with a professor, or a person who says just give it some more time and it will come around. In the real world, where human beings have limited life spans and real situational risks, 15 years is a long time. Just ask that retiree who has had to go back to work because their portfolio has just been smashed, or someone who will have to postpone retirement for five or more years for the same reason. Or someone who had their college fund decimated at the time a kid is about ready to start college. Or countless other situational risks. I would submit that all of those risks need to be managed including the very important risk of volatility of asset classes particularly as it relates to situational risks. While proponents of the glide path target funds may look good again for a few years, when a bull cycle starts again in stocks, I would just remind people to come back and look at what has happened in the past twelve years or in earlier periods. Is that target fund going to make the same mistake again down the road?  

Total Bond Market Index (BND) and IEF as Non-Correlated Assets to Stocks

Even if I am satisfied that an asset shows very low positive correlation with stocks, or even  negative correlation at times, I may not invest in it because I view my downside risk to be significant, whereas my potential upside is limited.  I have not lost anything other than a small dividend by selling BND last year. (BND is the Vanguard ETF for the Total Bond Market Index: Vanguard - Vanguard Total Bond Market ETF Overview) I had to ask myself.  Is the risk to the downside for BND significant and more than a possibility, even a probability if assessed in terms of a year or two rather than in a more limited time of months?  I am responsible to myself and have no choice but to act based on my personal assessment.  With the current expansionary monetary and fiscal stimulus, it is hard to envision that a security like BND has much left in upside stock appreciation, and a real possibility of losing value. And, I personally do not believe that the downside risk is being compensated with a 4% dividend. Others may disagree and advocate a total bond market index as part of an asset allocation now.  

A separate issue is whether the total bond market index  is a low positive correlation or sometimes negatively correlated, with stocks.    

The correlation between bonds and stocks depends to some degree on whether the stock market is in a bear or bull mode. Starting in October 2007, I would expect a strong negative correlation between BND and the S & P 500, and a small positive or negative correlation during many stock bull market phases, a conclusion recently confirmed in an academic study summarized in this blog. Stock and Bond Returns Correlation Variability

Easy monetary policy as now would most likely contribute to a negative correlation period. This would suggest by itself, without taking into account other relevant factors, a shift of some assets out of bonds and into another non-correlated asset class at or soon after the start of a bull market phase. The purpose would be to find another asset that would be a better hedge than bonds during such a period, even though bonds would still provide diversity to the allocation. 

The academic study referenced above used the Vanguard Total Bond Market Index, which has a lot of GSE debt in it. If you had the misfortune of being in one of a large number of bond funds which substantially underperformed that dumb index in 2008, then your returns between those bond funds and stocks would be a positive correlation, and a fairly strong one, at a time when you needed assets going in the opposite direction to your stock portfolio. I will never buy a bond fund again, and will simply stick with the one that I have now devoted to Tennessee Municipal bonds, more due to the fact that I do not want to fool with buying individual Tennessee municipal bonds, at least for now, maybe later.      

Similarly to BND, the Ishares ETF for the 7 to 10 year treasury bonds (IEF), iShares Barclays 7-10 Year Treasury Bond Fund (IEF): Overview, would have shown strong negative correlation statistics to the S & P 500 since the onset of this bear market. However, the current yield on this ETF is just 3.67%. MarketWatch.com Quote

While I made a small mistake in not including IEF with my other bond ETF buys made at the start of this bear market, I can not make a case for it now anywhere in my asset allocation. So, under static allocation, this kind of security would have a permanent home. I, however, can not ignore the risks associated with owning this security at the current time, including the risk of lost opportunity and the risk of a negative real rate of return after inflation and taxes. Since it is my personal view that I am not being compensated to assume those risks with a yield at 3.67%, and also based on my view that the downside risk in price is more prominent than further upside gains, I have no place for IEF in my portfolio at the current time, possibly that may change by 2011 or 2012.    

Then, there is a question at least in my mind of how good the negative or low correlation is between stocks and a 5 year treasury. This is a link to a chart showing the positive and negative correlation between stocks and the 5 year treasury over rolling ten year periods since 1938. Portfolio Solutions While the negative correlation has been strong during the recent bear market, as you would expect, most of time the correlation is positive, sometimes hitting the .25 to .50 range, particularly during a bull market in stocks. That actually makes intuitive sense if interest rates are falling causing investors to afford richer P/E ratios to stocks, so that a bull move would be occurring in both markets. This would suggest at a minimum a change in static allocation theory, requiring a move more into bonds soon after the start of a bear move (confirmed by the formation of an Unstable Vix Pattern), moving more when situational risk is more prominent, and then a move out of bonds, to some meaningful degree, upon the formation of a Stable VIX Pattern. Then, some of those proceeds from bonds sales could then find a home in an asset class with less positive correlation than bonds with stocks. In other words, a shift in asset allocation caused by market factors rather than any consideration unique to the individual.

There is also a product from Ishares for the 3 to 7 year treasury that could also be used in an asset allocation, but it has the same problem as IEF from my perspective. iShares Barclays 3-7 Year Treasury Bond Fund (IEI): Overview  The current yield on this ETF, IEI, is just 2%. MarketWatch.com Quote

ADDED 6:47 P.M. 5/25/2009:  One of the many failures of the static asset allocation approach, which puts an individual on some kind of mechanical "glide" path, is an unwillingness to adapt and respond to the market when some kind of response is the only prudent action.   Many of my posts mention one tool that I use in implementing a Dynamic Asset Allocation called the VIX Asset Allocation Model.   An understanding of that model is critical to understanding points being made even in a Post such as this one.  Some of the posts summarizing this model include the following:

Vix Asset Allocation Model Explained Simply With as Few Words as Possible

VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern

VIX and S & P Compared 1990 to 1997

Vix Charts from 2004 2005 2006 Stable VIX Patterns Phase 1 and Phase 2

This model would have required a shift out of stocks in the fall of 2007 caused by a Trigger Event in August 2007, with the money raised shifted into bonds, which would be viewed a likely candidate for negative correlation with stocks at that time. The model would also cause a shift back into stocks when a Stable Vix Pattern is formed lasting 3 months.  The major shifts into and out of stocks signaled by the Model have lasted for several years when the model was backtested to 1990 using the VIX data from the CBOE. So even when I am discussing the ETF BND as a non-correlated asset to stocks, I am integrating that discussion as it relates to my Dynamic Asset Allocation approach using the VIX model. It was in the fall of 2007- after the first Trigger Event- that I would expect to increase my holding in BND from the proceeds raised from stock sales. The same would have been true in the 1997 and 1998 Trigger Events. This would be done irrespective of my glide path or my age.  Although I face no situational risk personally, the interruption in the so called glide path, to make a course correction in the allocation to stocks particularly for those facing significant situational risks, is deemed critical by me when the VIX model starts to flash the red signals, as it did with three separate Trigger Events between August 2007 to February 2008.   

Treasury Inflation Protected Securities as a Non-Correlated Asset

added 6/3 & 7/2009: A few more recent discussions of the TIP are in these later posts:

Advantages and Disadvantages of Treasury Inflation Protected Securities:

item #3 in Morning Notes 6/3/2009: More on TIP Pricing/Sold PST/Record Spreads in 2 and 10 Year Treasuries/Australia GDP

item # 6: Bond Asset class in danger of failing?/Moody's Comments on U.S Debt Rating/BAC Equity Capital Raise Good for Preferred shareholders?

I also have a Gateway Post that collects links to all of my discussions on Bond ETFs:

Bond ETFs: Links in One Post

*************original post:

Before starting this discussion, I would like to link a chart that shows correlations among various asset classes.

Asset Correlations

I currently own TIP, an ETF containing U.S. Treasury Inflation Protected securities, with a very modest .2% expense ratio. iShares Barclays TIPS Bond Fund (TIP): Overview State Street also has an ETF with these securities in it, IPE, with a .18% expense ratio. SPDR Barclays Capital TIPS ETF The TIP has a high positive correlation with U.S. bonds. 

So, if I am seeking an asset to diversify my U.S. bond assets, this would not be my choice. For that, I would look at international bond ETFs like WIP and BWX, and emerging market bonds. The TIP can have a strong negative correlation with U.S. stocks, particularly during a stock bear market, which is why it has a place in an asset allocation. The negative correlation varies according to the particular stock category, and time period, with one author noting wide swings over longer periods of time including some periods with positive correlation. (p. 163: Google Book Search)

(I just ordered that book from Amazon, authored by David Durst. I want to know more myself about non-correlated assets.) I would not be surprised by the strong negative correlation between the TIP and stocks over the past year given the direction stocks have taken particularly since September 2008.

In a static asset allocation approach, an asset like TIP would remain in the allocation, never eliminated, and possibly trimmed some in periodic rebalancings (Rebalancing (investment) and possibly given more weight in the allocation as the individual ages.

What I am about to say is worse than sacrilege among static allocation enthusiasts. I will at times eliminate the TIP entirely from my portfolio based on a number of considerations, and then add it back when the market is pricing the inflation protection inappropriately in my view. This would be called foolish by practitioners of static allocation, and is only for those individuals with a lot of free time on their hands. It probably helps to have a mind set that efficient market theory is garbage.

I have eliminated TIP entirely, with the last elimination occurring last year when it rose to around 105-106. At the time, I thought the price for the inflation protection was too high, which results in the spread in yield between the TIP and the comparable fixed rate treasury becoming too large in my opinion. 

As it turned out, the large spread soon evaporated, and the two securities narrowed to almost an identical yield. The market made a mistake on both occasions. As that spread starts to widen, I would expect the TIP to be rising in value compared to the fixed rate coupon treasury. This is a link to a web site with a good explanation in both written and video form with some charts too. Inflation with the TIPS Spread | Intermarket Analysis | Stocks

Then, when the spread narrows to a point when I am paying virtually nothing for the inflation protection, I will consider buying the TIP back, since I am generally not willing to assume that deflation will be norm for very long and that is what a non-existent spread is basically forecasting for an extended period of time, at least when the TIP and the comparable treasury are both 10 year maturities. This narrowing happened in the 4th quarter of 2008, and I was then buying the TIP back in the low 90s. TREASURY INFLATION PROTECTED BONDS (TIP)

My prior discussions of the TIP are linked under the category TIP in this Gateway Post: Bond ETFs: Links in One Post

This movement in and out of TIP may not occur again for months or even years. It really requires me to exercise some judgment about whether the market has swung too far in one direction or another when pricing the TIP. I would understand an "expert's" criticism of an individual investor trying to make those sort of judgments. I would even echo those criticisms for most individuals who do not have the time and experience to form judgments about such matters. But, LB is 1/2 trader and it has to give it a go-so far so good on the TIP.

Another problem with the TIP is that both it and the comparable maturity fixed coupon treasury both may be priced incorrectly on their base yields (e.g. assume both have a base of 2% and the fixed coupon has a 1% advantage over the TIP over that base rate (REAL YIELD), is that reasonable under the market conditions then existing or should both have a higher base with at least a 2% inflation expectation built into the TIP price). I am concerned about that issue right now. This is how I summed up the problem in a prior post:

"One of the negative points that I made about TIP is that it will be adversely impacted when comparable non-inflation treasuries take a hit. The TIP may not have much of a premium to non-inflation protected securities but the yield on both may be out of line (i.e. what happens to a TIP if the comparable treasury moves from a 2% to a 5% yield?). TIP pricing The ETF TLT (20 year treasury) is down 2.16% in early trading and the TIP is down 1% and the 7 to 10 year treasury ETF has fallen .63% in early trading. IEF 

This is just my opinion but I believe TIP can go down when the comparable treasuries rise in yield since the basic yield of both securities may be too low. Thus, I just look at TIP at the current prices being more favorable to own than the comparable treasuries without any inflation protection. If I had to choose one over the other I would pick TIP. This does not mean that either will be good investments at the current prices when and if treasuries as an asset class start to fall in price and rise in yield. MORE ON TIP PRICING

See also,  TIP pricing

So I might trim TIP when I develop a strong opinion that both the TIP and the comparable treasury are priced to yield too low. That will be far more difficult than making a judgment on the spread being too great or narrow. I can look at a chart and make a good "guess" on that later issue. For now, I am just open to making small adds to TIP, maybe in 30 share increments, though I have not even done that this year yet. Basically, I am not enthusiastic one way or the other.

I am not particularly enthused about any of the bond ETFs now, due to their low yields. The Vanguard Total Bond Market ETF ( BND) is hovering around 4%. 

The international bond ETFs that I currently own have lower yields. I have lived through enough interest rate cycles to know that a 4% yield can get wiped out pretty quick in the devaluation of a bond's price, when bonds start to fall in value based on a change in inflation expectations or the actual rate of inflation. 

 I am not one to assume that the current bull run in bonds is going to run for several more years. I am in a month to month evaluation of a potential shift from a bull to a bear market in bonds. The current time may easily turn out to be an inopportune time for new purchases of bonds at such historically low yields and high prices. 

In Dynamic Asset Allocation, I have to be mindful of what is happening in the market and in the real world.David Swenson's comments on Inflation/ TIP-WIP-Floaters/ how will the dollar react?/Summers-Tarp-Bank stocks/alcoa 

Consequently, I have already eliminated BND, BSV, GVI, and SHY from my portfolio. I am in an active management mode on BWX. I have already re-allocated money raised from the bond ETF sales into floating rate securities and higher yielding corporate debt, bought mostly on an opportunistic basis. The point is simply this. TIP has a place but not a permanent place in my application of Dynamic Asset Allocation for an experienced individual investor managing his own portfolio and solely responsible for every decision made. All individual investors need to recognize that personal responsibility for their own decisions, and prepare to make them with that attitude in mind.