June 2012

Obama has his Healthcare Law passed by SCOTUS.

In his landmark majority opinion Thursday, Chief Justice John Roberts ruled that U.S. citizens can be forced to pay a tax as a consequence of not buying health insurance.

The chief justice came to the conclusion that the mandate was constitutional as a tax after finding that it was not, in fact, a legal “command” to buy health insurance.
“Rather, it makes going without insurance just another thing the government taxes, like buying gasoline or earning income,” he wrote.

When I get some spare time, I’m going to read the 195 pages of the opinion. The Supreme Court, has once again arrogated the lawmaking power that should inhere with Congress. In the meantime, some Rousseau.

So let’s take a look.

Rule #1: Don’t lose money.

Rule #2: See rule #1.

Those were the first two things I was taught by David Geller on my first day as a trader at Geller Capital.

For some of you that may seem obvious. Don’t lose money, of course, who the hell would think otherwise.

For those mentioned above, you most likely already know that when we actually look at the universe of market participants, you’re in the minority, the very very small minority.

Fact is, most market participants engage in relative return strategies where losing money is part of the game. Why? Because somewhere along the way, in order to make huge assets under management fees, large asset managers realized that it was easier to make people believe that their job was to beat an arbitrary benchmark than actually make money for their clients. By doing this, they were able to trade around the margins, and collect their fees whether they did well or not.

In the Mutual Fund world, where “long only” strategies predominate, they still operate on creating wealth over longer periods of time, simply that if you are long only, and holding large cash positions is against the rules, you will have periods of ‘losing money.” The idea [relative returns] is that you lose less [and gain more] than some arbitrary index, due to a superior selection of investments. This is not unreasonable. Involved in this strategy must be buying and selling, which incorporates either: timing, valuation, or both. Only through buying and selling, can you compound returns at a greater [relative] rate than your arbitrary index. The arbitrary index holds investments without any changes, thus provides a measure, albeit imperfect.

Absolute returns takes the buying/selling idea one step further stating that in any market condition, buying/selling decisions can add value as, the “long only” condition is dispensed with, and, selling short can be added to the strategy, which, allows value [wealth] to be created in bear markets and falling asset prices. If it can be done, then, yes, absolute returns will [should] outperform a buy/sell “long only” strategy. Again however, the arbitrary index is a useful measure of these absolute returns.

How did this happen? Well, it came about via the efficient market theory, which we now know to be complete garbage. Yes, it won a Nobel Prize, so did Obama (that’s not a political jab, you get the point). The asset managers took this defunct theory and used to to make people believe that your goal should be to outperform some average of assets in the same universe (stocks in an index). Their marketing machines went into overdrive when Americans got a bit wealthy and wanted a piece. And it worked for a while, because it’s easy to push this way of thinking when the economy and or the market are surging year after year.

While EMT may well have some serious issues, EMT on some level, vis-a-vis diversification, has some sensible observations. Holding companies on a fundamental basis requires a lot of work, the more you hold, the harder it is. Holding on a fundamental basis also creates real understanding issues, so much so that holding a truly diversified list is hard. Diversification provides exposure to randomness and “luck” two very important elements in investing, which, are most easily gained via holding an index, say SPY, of all 500 S&P companies. You can hold all the micro-caps via another ETF.

Until it doesn’t.

I agree with all the literature that says the average guy should not be investing in long only mutual funds that attempt to beat their benchmarks. The evidence is pretty irrefutable, after fees it’s almost always a bad deal.

What I definitely do not agree with, is the idea that instead, the average guy should be investing in an index.

The index via an ETF behaves like a stock. As such, you have only macro-economic issues to deal with, not the additional micro-economic issues. Second, now you only have “timing” as a variable in buy/sell decisions. True it is unlikely that you will hold a stock that gains 12,000% like a CSCO, but who actually held 100% of their portfolio in CSCO, and sold at the top?

Where on gods green earth was it every written that relative return investing, putting yourself at the mercy of an index of assets was the default investment strategy? Who thought this up?

Relative return is relative on your definition. As we have seen, relative does not mean passively buying and holding until the funds are required, it means, with some effort, buy/sell decisions are made to take advantage of market conditions, to create out-performance and wealth, using the index as a measure. The ultimate measure the wealth that you create. At times, if you are “long only” there will be losses. Are the losses greater than or less than your index? This is information that can improve your buy/sell decisions.

What is this really? This is praying that the average of the price of a bunch of assets will appreciate over time. This is gambling.

If you simply buy and hold, there is a certain amount of passive acceptance. However relative return investing does not actually necessarily mean this at all.

When someone says that a long/short strategy is riskier than investing long term in an index, I laugh. I laugh really hard, because they haven’t given any real thought to that belief in a logical way.

It would seem that you are guilty of your own critique.

If you are investing to beat a benchmark, and not to make money, or better, not to not lose money, I would take a long hard look at why that is. And don’t come back and tell me that you don’t have access to really good absolute return managers so therefore you are left only with relative return or indicies. The absence of a good solution is no excuse for sticking with a bad one, that is not a valid argument. You do not have to be in the market, no one is forcing you, you’re being brainwashed by the TV into thinking you do, it’s their job to do that, to take your money.

Relative return strategies do seek to make money. They gauge their success relative to an arbitrary index. If you are by law required to be 65%+ invested, and long only, then in a down market, a good relative return manager will be down less than his benchmark. Let’s take a look at an excellent stock-picking manager:

Last Week 2.43%
Last Month 2.98%
Last 3 Months 1.82%
Last 6 Months 43.38%
Last 12 Months 27.60%
Last 2 Years 104.51%
Last 3 Years 122.14%
Last 5 Years 175.25%
Since Inception 1833.60%
(Annualized) 34.79%

Last Week -0.56%
Last Month 1.41%
Last 3 Months -3.92%
Last 6 Months 6.64%
Last 12 Months 6.33%
Last 2 Years 27.47%
Last 3 Years 58.72%
Last 5 Years -0.89%
Since Inception 94.22%
(Annualized) 6.92%

Now I know that you can actually buy an inverse ETF, so that you can actually “short” the market, but generally this is a “long only” portfolio. It may be argued that this is an “absolute return” strategy, but it is still measured relative to an index.

Take a look at my “relative return” strategy, which is really “long only” I won’t use inverse ETF’s to short the market, I will rely on market “timing” only to generate absolute returns on a relative basis.

Last Week -0.30%
Last Month 0.34%
Last 3 Months -2.74%
Last 6 Months 2.06%
Last 12 Months N/A
Last 2 Years N/A
Last 3 Years N/A
Last 5 Years N/A
Since Inception 2.96%
(Annualized) 5.92%

Last Week -0.56%
Last Month 1.41%
Last 3 Months -3.92%
Last 6 Months 6.64%
Last 12 Months N/A
Last 2 Years N/A
Last 3 Years N/A
Last 5 Years N/A
Since Inception 8.52%
(Annualized) 17.50%

On a relative basis I lag the market currently. I am holding 50% cash currently. This means should we have one or more deep plunges that I will out-perform on a relative basis and have capital to deploy at lower prices, that will again improve my relative performance. However, over time, of regular out-performance on a relative basis, I will actually generate absolute out-performance. This black & white definition or separation of the two strategies is silly.

Asset allocation is nothing but a suped up way for them to take your money and be able to say it wasn’t our fault you lost it when the market goes down. They give you all these stats on how active management doesn’t beat the indices, and they are right, but no one every explained why you are competing against some index did they? Is that the word of god that this is how everyone is measured.

Blah, blah. Think about it.

I don’t run money for other people under Surfview Capital anymore, I’m focused on building Estimize, but here’s what I used to say to my clients and perspective clients.

We are going to shoot for a return of 10-12% a year, after fees.Based on our strategy we should be able to do this in any kind of market, straight up, straight down, or sideways. And because we have a natural long bias, when the market is really good, we should be able to make a good deal more that 10%. But we’ll always be focused on not losing money, because god forbid we lose 30% right before you decide to retire, or want to buy that yacht, what the hell did the other 5 years of good returns matter for? We’re going to go completely to cash in markets we have no edge in, and we’re going to trade on margin in markets that we are extremely confident in. We’re going to stick to our strategy and focus on making money, not some random benchmark. You’re hiring me to make you money, you are not hiring me to beat an arbitrary number.

Which is excellent if you can deliver year in year out. Two years means nothing.

And some people didn’t like that, and they did not become clients. And for the ones who did, we went out and crushed those expectations during the two years I ran Surfview, at 30+% returns both years, with low volatility. We never had a draw down more than 4%.

There is no way, after 2yrs, to differentiate between genuine skill, and just random luck. Stretch it out to 10yrs and the luck element gets smaller and smaller, while the skill element grows larger.

My case against passive index investing is not that you won’t likely make money over time. The average returns of various asset classes are likely to revert to their means over the course of 30-40 years. But there in lies the rub. For most people who don’t have any real money to invest until their 30′s, that gives about 30 years to let the averages work. And if you are not actively managing risk, you could end up having to exit that passive investment at the end of a huge draw down, as was the case in ’08. And I’m not even factoring in long stretches which could coincide with the latter half of your investing period where those averages are well below their mean, as equity has been for the past two decades. You might be willing to leave that all up to chance, but thank you very much I will not.

On a 40yr holding period, has anyone ever lost? Over 10yrs, just a buy and hold, like currently, would have a disappointing return, but 40yrs, even buying at the top in 1929 would have seen you ok after 40yrs. There are reasons for this obviously.

Just remember, relative return is a construct of a business model, there is nothing that says you must engage in it. In some cases you will want to be directly correlated to an index, or group of indices, but that has to be an active decision as part of a broader risk management strategy. If an index loses 15% in any year, and you lost 12%, you didn’t win, you lost a lot of money for your clients, and you broke rule #1.

Think about it.

The story line seems to be getting a little thin.

The COT Index calculation uses a 3yr rolling min/max to provide as the baseline in the calculation. This changed this week. The previous reading was from the March lows in 2009. Those numbers have now expired. The resultant calculation this week is different, but not I think significantly enough to alter the positions, I’ll see.

Again this week, like the last two weeks, the COT Index is positive, indicating that Long positions likely hold the edge in trading any index, and hence equity positions [in the aggregate].

The perceptual ambiguity of wine helps explain why contextual influences—say, the look of a label, or the price tag on the bottle—can profoundly influence expert judgment. This was nicely demonstrated in a mischievous 2001 experiment led by Frédéric Brochet at the University of Bordeaux. In the first test, Brochet invited fifty-seven wine experts and asked them to give their impressions of what looked like two glasses of red and white wine. The wines were actually the same white wine, one of which had been tinted red with food coloring. But that didn’t stop the experts from describing the “red” wine in language typically used to describe red wines. One expert praised its “jamminess,” while another enjoyed its “crushed red fruit.”

The second test Brochet conducted was even more damning. He took a middling Bordeaux and served it in two different bottles. One bottle bore the label of a fancy grand cru, the other of an ordinary vin de table. Although they were being served the exact same wine, the experts gave the bottles nearly opposite descriptions. The grand cru was summarized as being “agreeable,” “woody,” “complex,” “balanced,” and “rounded,” while the most popular adjectives for the vin de table included “weak,” “short,” “light,” “flat,” and “faulty.”

Nothing really need be said. These types of errors crop up so frequently, in so many areas of life, it is truly amazing that we get anything done.

Commodities as an investment asset class, and as a trading vehicle have come under discussion all over blogoland recently as the drop in commodity prices, particularly oil, have created an intense debate between the two sides.

June has been the month of major bottoms. Stocks and gold have already formed major yearly cycle lows. Now it’s the CRB’s turn to put in a major three year cycle bottom. This bottom will almost certainly form well above the 2009 low, establishing a pattern of higher lows and setting up for what I believe will be an extreme inflationary scenario over the next two years, culminating in a parabolic spike much higher than the one in 2008.

The argument is essentially this: that money and credit creation [inflation] have driven commodity prices higher. If we take a look at a much longer time frame, this becomes more apparent.

Here, the bull market in nominal prices is clearly visible. The question is: is the bull market over? Is the “top” now in? To answer that question, again, we have to identify our argument as to causation. The premise is that “inflation” is responsible, in part, for the rise in nominal prices.

If we look at “real” prices, we see that the current “highs” are not all-time highs, they are a trend off of the lows. The “in part” assertion with relation to nominal prices ignores supply/demand variables, which clearly cannot be done in reality.

It has been said that the “cure for high prices, are high prices.” Obviously that with higher prices, come higher profit margins, which creates new supply, thus lowering prices. With oil, the argument then takes a further twist in that new supply is not feasible going forward, that “Peak Oil” has arrived, and that increasing supply to match demand, simply cannot be sustained, thus increasingly higher prices will be the result.

On the broad question however in relation to inflation, will this variable: increase/decrease going forward? Clearly, empirical evidence would suggest a continuation of inflationary monetary and fiscal policies. The inflation component will therefore remain. Supply/demand variables will fluctuate, providing market fluctuations in nominal prices.

The question will revolve around will/can supply/demand variables overwhelm the pricing component attributable to the inflation component? Particularly in an economic climate of stagflation and debt destruction deflation, with the concurrent drop in money velocity?

Not easy questions to answer. How you answer it will determine your stance vis-a-vis commodities going forward.

So the crisis is getting ever deeper. Tensions in financial markets have risen to new highs as shown by the historic low yield on Bunds. Even more telling is the fact that the yield on British 10 year bonds has never been lower in its 300 year history while the risk premium on Spanish bonds is at a new high.

Agreed, the crisis is deepening. It is becoming increasingly obvious to all that the debtor nations: PIIGS, simply cannot repay the debt that their economies labour under.

The real economy of the eurozone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.

I would disagree that Germany is booming. Germany is also experiencing an export slowdown. In addition Germany has put itself in a position through the assumption of its creditor status and the assumption of European liabilities, of massive capital destruction.

In my judgment the authorities have a three months’ window during which they could still correct their mistakes and reverse the current trends. By the authorities I mean mainly the German government and the Bundesbank because in a crisis the creditors are in the driver’s seat and nothing can be done without German support.

There is pretty much nothing Germany can do. The answer is that the PIIGS have to create production of goods and services in their own economies. Simply going further into debt is no answer at all.

I expect that the Greek public will be sufficiently frightened by the prospect of expulsion from the European Union that it will give a narrow majority of seats to a coalition that is ready to abide by the current agreement.

Which is exactly how it played out.

But no government can meet the conditions so that the Greek crisis is liable to come to a climax in the fall. By that time the German economy will also be weakening so that Chancellor Merkel will find it even more difficult than today to persuade the German public to accept any additional European responsibilities. That is what creates a three months’ window.

The German public it seems, has had enough.

With the market selling off currently there are all manner of opinions out there following the extension into QE4.

Technically, currently, the pattern remains bullish. A retest of the last lows is a standard technical pattern. You would buy long [if you didn’t already buy the low] the retest low, which might be a little higher, or lower, than the low of a couple of weeks ago. Technically then you have a pretty low risk [setting stops] entry, that should it fail, exits you from the market without too much damage.

Fundamentally, based on valuations [of any stripe] and macro-economic analysis, you would have to be cautious entering the market here. If you were to, a partial position. I still hold the 50% position entered last September/October, which was entered on a pullback test of the August lows. That position is still in profit. I have done nothing save generate income from selling covered calls/puts on the position. This will add about 10% to the existing dividend yield of circa 3.2%

The point is, if you are investing, the price action today, is pretty irrelevant, it is just noise. Trading noise is the preserve of day-traders and swing traders, don’t get sucked into the wrong time frame: conversely, if you are trading, don’t start trying to justify a position based on macro-economics or valuations, you’ll need something else, technicals, quant, something.

It is always fascinating to see interpretations of facts. Almost a Hume guillotine scenario. So let’s get into it.

Here is the hypothesis that the article will seek to prove.

The FOMC meeting began yesterday and will announce a decision today. As I and NDD have noted, the underlying data of the US economy for the last few months has been weakening. As such, it seems appropriate to think the Fed may act in some capacity, probably with some type of asset purchase program. Some will argue this is not warranted, or, more importantly, that this is going to lead to an inflationary spike. Nothing could be further from the truth, as I explain below.

One of the primary complaints about the Fed’s action of increasing their balance sheet is that the increase in money will lead to inflation. In essence, an increase in the supply of money inherently devalues it (increased supply = lower value).

So simple arithmetic should suffice. If you start with $1. That $1 dollar will purchase 100% of an available supply, adding a second $1 does what? It cannot purchase anything additional, $1 already purchases 100% of available production. You simply have $2. Money per se, is not wealth. Production is. We will gradually move to “valuation.”

However, this theory runs into two problems. First, the money has to get into circulation and then, second, be exchanged. Put another way, if the Fed prints the money and then the banks don’t lend it and consumers don’t spend it, the devaluation of the currency can’t occur. That lack of transmission of the Fed’s policy is exactly what is occurring right now.

But of course the money is getting into the circulation. Government expenditures are higher than their revenues, yet, the government continues to spend. How is that possible? Well the government can create more money, or borrow more money. The Federal Reserve currently monetizes the government debt. Therefore “new money” most certainly is entering the economy.

Of course further examination provides the reasons as to why this tremendous fiscal expansion has not yet resulted in an inflation that is far higher than the current inflation. So let’s look at the aggregate outcomes:

The results are starker within the PPI than CPI. The deflation + current level provide a measure of the distortion in prices created via the money & credit expansion. That is to say the rate of inflation is positive in that it exceeds the rate of asset [money & credit] destruction currently taking place, for example in the residential housing market: it is occurring however throughout the economy.

The three charts show the year over year percentage change in M1, MZM and M2, respectively. All three show that money is flooding the system: M1 is increasing at about a 15% YOY clip, MZM at 8.5% and M2 at about 9.3%; So — why has there been no commensurate increase in inflation?

There are two answers to that. First, the “money printing” is getting stopped at the banks. The Fed is purchasing assets from financial intermediaries and giving them money in return. But lending has been very weak during this expansion.

The charts are simply monetary aggregates. Our chappie simply considers monetary policy. He totally ignores fiscal policy. The banks, largely, are still capital restrained. They still hold impaired assets from previous loan cycles and lax credit standards.

Above is a chart of total loans and leases at commercial banks. Notice that the figure is right at pre-recession heights — and this is after almost two years of quantitative easing. And while we’ve seen an increase over the last few years, it is hardly a strong rise. Let’s look at the chart in logarithmic scale, which further highlights the situation:

Like a terrier, hanging onto the one explanation that explains his hypothesis and provides some empirical evidence. Unfortunately, simply incorrect.

The slope of the curve for the latest expansion (rise/run) is very low. It’s slightly above the level seen after the 1990 recession and the 2000 recession, but below that seen over the last 40 years. Put another way, loans just aren’t being made, meaning the “money printing” is not being transmitted through the financial intermediary system.

And the multi-decade low in velocity tells us that consumers aren’t spending what money is getting into the economy, but instead hoarding cash:

We now come to “Velocity” of money. I will reproduce this chart.

First, a definition of velocity: simply the number of times that money exchanges against goods and services. So as the chart depicts, individuals are in point of fact “holding” higher cash balances.

This “holding” is a valuation. The valuation on an ordinal, diminishing marginal utility scale, raises the value of holding cash, higher than the goods or services that could be exchanged for it. This higher valuation of money definitely offsets the loss of value that an inflation creates. Thus, the dilution of the money supply via inflation is offset to the current rate of inflation by the continued asset [value] destruction, and credit contraction, and the increased value of holding higher cash balances.

The velocity of M1 (top chart), MZM (middle chart) and M2 (bottom chart) all show that the speed at which money moves through the economy is at or near multi-decade lows.

True. See above.

Let’s put these two pieces of data together. First, while the Fed is technically flooding the system with money, this is not leading to inflation as there has been no respective increase in lending. As such, inflation cannot be transmitted into the system. And what money is getting into the system is being hoarded by consumers rather than being spent.

But there has:

Government debt has exploded higher. The debt is simply in a different sector.

So, the complaints that “money printing will lead to inflation and devaluation of the dollar (read: Ron Paul acolytes) are unfounded.

Well your argument does not come within a country mile of proving your hypothesis.

The Federal Reserve monetary policy announcement is out.

Rather than go on with full on QE3 (more bond buying), the Federal Reserve is extending what’s known as “Operation Twist” which means that the Fed will buy long dated Treasuries and finance that with sales of short-dated government bonds.

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