Reader Hedge Question

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Reader John had this to say about his experience with the SimpleHedge Strategy:

Having read your ‘SimpleHedge’ Strategy document, I set up my own account in late March. Yesterday, my total gain went above 5%.

If I remember your approach to investment correctly, you generally recommend investing another third of one’s account once a 5% gain has been achieved. Since your Domestic TTI has also generated a Buy signal a few weeks ago, should I simply drop my short position from my ‘SimpleHedge’ Strategy account and put additional funds into the long positions? Your inputs into this transition would be greatly appreciated.

Let me clarify some items, since we are dealing with several issues. When I establish an outright long position, after a buy signal has been generated, I usually add to it once a gain of 5% has been achieved.

However, I do not use the same approach with hedges, although I suppose you could. Since you set up your hedge back in March, chances are that the original 50/50 ratio has become lopsided due to market activity. It is important that you rebalance back to the 50/50 ratio as soon as the hedge reaches an imbalance of 61%, as described in the e-book.

This will accomplish two things:

1. It will lock in some of your profits and

2. It will reduce your risk when the markets head south again. How? If you are in a 61% long position (and 39% short) you will lose more during a correction than if you are balanced in a 50/50 ratio.

If you wish to increase your hedge to make it a larger part of your portfolio, you can do that at anytime. I have done something similar with the hedge tracking portfolio featured in section 7 of the StatSheet.

If you are an aggressive investor, and believe the current bull market has more stamina, you can drop the short position altogether. I have done this for some clients whose risk profile fit the aggressive mode. Actually, it’s really not that aggressive, since we still work with a trailing 7% sell stop, which limits downside risk.

It all depends on you, there is no right or wrong. As you can see, starting with a hedge during times of uncertainty gives you more options later on to either increase the value of the hedge or become outright long.

Whatever you do, you always want to have an exit strategy in place to protect your portfolio from the next downturn. It’s not a question of “if” a trend reversal will happen, but “when.”

Sunday Musings: Monetary Madness

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Reader Robert emailed me an interesting story written by Bill Bonner of Vancouver, Canada (sorry, no link available) with the title “Romulus, Remus, Stimulus: A Brief History of Monetary Madness.”

It puts the current monetary madness in historical perspective, and gives you something to think about.

Those whom the gods would destroy are first granted stimulus. When a man wins the lottery, for example, it has a stimulating effect on everyone around him. He usually spends the money quickly – often even before he gets it. But no matter how much he wins, he is usually broke within a few years…often, even broker than he was before he bought the winning ticket.

A recent example from the British press: One of the first lottery millionaires punched a plumber and ended up in court, says The Telegraph. Michael Antonucci won 2.8 million pounds in 1995. But he “blew his entire fortune,” reported the paper last month. Now he’s reduced to stiffing tradesmen. The amount in dispute was just 400 pounds, what he was billed for a “gigantic ceiling mirror fitted above a whirlpool Jacuzzi.” He had the mirror installed when he was still flush. Now that he’s broke, he can’t pay…hence the altercation.

The phenomenon is little different when it happens on a national or even imperial scale. Any money that you don’t earn is stimulus. Without the sweat of honest toil on it, money seems to play a pernicious role in history. There are no examples – none – where it produced genuine prosperity. Instead, when a nation suddenly runs into some easy cash, it is soon spending more than it can afford…and getting into trouble.

The Roman Empire is in some measure a stimulus story. It conquered. It grew. Each conquest brought more booty…gold, silver, land and slaves. And each led to more conquests, which brought forth more booty. But the stimulus of this booty stimulated only the need for more stimulus. It did not stimulate real prosperity. Instead, it undermined it. First, slaves bought by rich landowners destroyed the free labor market and ruined small farmers. And then, imported wheat from the provinces – paid as tribute – put the large-scale farmers out of business too. Italy was then dependent on foreigners for its food.

In the first century AD, Roman conquests reached the point of diminishing returns; the stimulus came to an end. But borders still had to be protected. And Roman mobs, made up of displaced small landowners and out-of-work laborers, needed bread and circuses which drained the Treasury.

The first financial crisis of the imperial period came early. Caesar Augustus tried to solve it…with more stimulus. Neither paper money nor the printing press had yet been invented. So, Augustus increased the money supply in the only way he could; he ordered slaves in the silver mines in Spain and France to work around the clock! This extra money did not bring prosperity; it caused price inflation. In a period of about three decades, Rome’s consumer price index almost doubled. Then, when output from the mines could be increased no further, Augustus’s great nephew, Nero, found a new source of stimulus; he reduced the silver content of the coins. This source of stimulus proved ineffective, but enduring. By the time barbarians took over, the silver denarius contained almost no silver at all. Of course, Rome itself was played out too.

Another early and dramatic example of stimulus-in-action came in Spain in the 16th century. The conquistadors increased their supply of money in the time-honored fashion – by stealing it. Galleons brought treasure from the Americas; increasing the Spanish money supply substantially and fatally. The Spaniards had so much stimulus that they laid down their tools. Why should they work? They could buy things.

The discovery of a whole mountain of silver – Potosi – in the middle of the 16th century insured a supply of stimulus that would last for nearly a century. Results? Predictable. Inflation. In the “price revolution” from 1540 to 1640 the cost of living went up throughout Europe. In England, for which we have the most reliable data, prices went up 700%. And Spain, though it covered 40% of its state budget with this easy cash, still defaulted on its debts about once every 15-20 years, from 1557 for the next 10 decades. Spain, like Rome, welcomed stimulus; it never recovered from it.

Now we turn to the biggest misadventure in stimulus ever – the period after the United States ‘closed the gold window’ in 1971. In the 150 years before then, nations could stimulate their own economies with cash and credit, but only to a point. They could overspend; but they had to settle up in gold. After 1971, on the other hand, the sky was the limit – especially in the United States of America. The US could settle its bills in paper, which was then used by foreign central banks as monetary reserves. Since foreign banks were eager to add to their supplies of reserves, there was no effective limit on the amount of stimulus available. The Fed’s adjusted monetary base grew 900% since 1985, and more than doubled this year alone. Total US debt tripled – as percent of GDP.

As it did with Rome and Spain, more and more stimulus stimulated spending and speculation, but not real output. During the 2001-2007 period, for example, credit in the United States increased by $22 trillion. The nation’s GDP increased only by $4 trillion. For every extra dollar of output, Americans took on $5.50 of debt.

But now the bubble has blown up; the feds are on the case. What do they offer? More stimulus! Cometh a report this week that $23 trillion has already been put at risk in the various bailouts and credit guarantees. As for the US public debt, it is expected to increase until the country goes broke.

Future economic historians will look at these staggering efforts with awe and they will wonder what the Hell we were thinking.

Using The Benefit Of Hindsight

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Our International Trend Tracking Index (TTI) signaled a buy on 5/11/09, which was followed by the Domestic TTI’s move into buy mode effective 6/3/09.

As is often the case, just because long-term trend lines are crossed to the upside, it does not mean all is smooth sailing from there. The markets had a 4-week sell off before resuming their respective up trends. Many sell stops were triggered as the major indexes retreated and then recovered.

Yes, that constitutes a whip-saw signal, which is the price we pay from time to time in order not to go down with the masses when the markets head south. It appears that, at least for the time being, the uptrend is back intact. With that comes the potential decision as to whether you want to jump back in or simply keep those positions that were not affected by the sell stop.

There is no right or wrong, it simply depends on your personal preference along with your risk tolerance. I added some positions earlier in the week by selecting funds/ETFs that have held up well during the recent sell off.

How?

Now that I have the benefit of hindsight, I went back to the beginning of the domestic Buy cycle date and analyzed which funds/ETFs were not affected by the recent pullback. The tool I use is my own indicator, which is referred to in the StatSheet Glossary of Terms as MaxDD% (Maximum DrawDown percentage)

Here’s the definition:

If you were to go the beginning of a buy cycle and measure DD% (shown in the StatSheet table) for a given fund every trading day, and then select the worst (largest) DrawDown number, you would have the information that I call MaxDD% (Maximum DrawDown Percentage).

This allows me to look back at anytime and see which funds have held up best and never hit our 7% sell stop. Those are the ones with a low MaxDD% (low volatility) number and may be among my primary selections for the next Buy cycle.

To be clear, this does not guarantee that, during the next downturn, these funds will not trigger their sell stops. However, I believe that my chances are enhanced, by using funds with a little less volatility, to possibly avoid another whipsaw.

The list below features those domestic ETFs, whose sell stop point of 7% never got triggered during the recent market downturn:



In the following table, I have mixed in mutual funds and ETFs with a MaxDD% of less than 7% since 6/3/09:

[Click on tables to enlarge]

As I have noticed in the past, and recent market behavior confirmed this again, there are far more mutual funds than ETFs that that have better resisted market corrections such as the last one. My guess is that sometimes active management does pay off.

No Load Fund/ETF Tracker updated through 7/23/2009

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My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Decent earnings kept the rally going with all major indexes gaining over 4% for the week.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +4.79% keeping the current buy signal intact. The effective date was June 3, 2009.



The international index has now broken above its long-term trend line by +14.09%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.



[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

What Recovery?

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I have always liked contrarian thinking, especially if it goes against the usual sound bites dispensed by the government or even Wall Street.

Forbes had this to say in “What recovery? This Bond Investor Says It’s A Hoax:

The markets may be saying a recovery is imminent but a famed bond investor with a record of prescient calls thinks that’s bunk–and is sticking with a big bet the slump is here to stay.

A sort of gunslinger of the fixed-income set, Van R. Hoisington of Austin, Texas, says he won’t budge from his risky strategy of letting nearly half of the $4 billion he manages ride on long-dated, zero-coupon government bonds. Those can tank on even a whiff of recovery.

It’s a bet that has worked out wonderfully for his eponymous money management firm–until recently. In the last three years a mutual fund run by Hoisington Investment Management has returned 10% annually vs. 6.4% for the broad bond market. But the fund has fallen 19% so far this year as signs emerge the economy may be bottoming.

On Friday came more bad news, so to speak, for the 68-year-old investor.

The Commerce Department reported that housing starts unexpectedly rose 3.6% in June. Investors saw that as yet another sign the economy is reviving and dumped Treasuries, including Hoisington’s zeroes, in favor of other assets. That in turn pushed the yield on the benchmark 10-year note to 3.64%, the highest in nearly a month.

Ever the contrarian, Hoisington, along with his partner, Lacy H. Hunt, believe the market’s got it wrong. The yield will shift direction and fall, they say, eventually hitting 1.5% or so.

Now that’s low. Even during the depths of the credit crisis, when many investors feared capitalism itself was in peril, the 10-year yield never sunk that far–hitting 2.06% after Lehman Brothers failed.

In the summer of 2007, when economists from Goldman Sachs and Merrill Lynch were pulling back from their forecast of a slowing economy, Hoisington predicted a recession in a year and a 10-year yield of 3.5% within two. He turned out right on both counts.

Now the markets are suggesting the economy is on the mend again and inflation, that scourge of fixed-income investors, is around the corner.

Hoisington advice? Forget what most investors think and focus on the only two things that matter for inflation: demand and supply. And right now, he says, there’s too little demand and too much supply for prices to rise.

In fact he thinks inflation’s opposite will prevail–deflation, or a sustained fall in prices. He points to a litany of depressing figures of late, including factories running at their lowest levels in six decades, unemployment broadly defined at all-time highs and people lucky enough to have jobs working the fewest hours per week on record.

And if that isn’t bad enough, Hoisington argues all the new government spending eventually will slow the economy, not speed it up. He says bigger federal outlays mean bigger federal debt, crowding out private investment to devastating effect.

[Emphasis added]

While I don’t necessarily agree with Hoisington’s investment approach, I do agree with him on the state of the economy and the effect of government spending.

Sooner or later, even Wall Street with its infinite wisdom will have to realize that the alleged recovery is not on track as hoped for. Once that happens, you will see the current trend reverse and head the other way. I am not sure when that will happen, but I suggest for you to be prepared to deal with it.

Illusionary Profits

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When I heard of strong earnings released by Goldman Sachs last week, I had to shake my head in disbelief wondering if anybody saw through the charade of bank earnings.

Apparently others saw it too, as the WSJ featured in “The Bank Profits That Weren’t:”

Most investors and analysts saw through the first wave of bank earnings for what they were – pretty poor quarters. Bank of America and Citigroup would have posted billions in losses had they not booked gains from asset sales and Goldman Sachs Group made its trading gains in a market void of real competition.

Tuesday’s Writing on the Wall column in MarketWatch takes a look at the artificial means the financial industry used to make the second quarter look better than it really was.

“It’s hard not to be skeptical after the financial community made the choices it did last week. Rather than come clean with the brutal truth that the banking business stinks and the investment banking business isn’t much better, the biggest firms chose to obfuscate, be dim, mislead and camouflage what in reality was the kind of crummy quarter one would expect in the middle of the worst recession since World War II.”

Here’s how:

“Wall Street’s best client was Uncle Sam. Forget the government-mandated business. Washington continues to keep the financial system afloat with $242 billion in commercial paper guarantees, $1 trillion committed to the Term Asset-Backed Secured Loan Facility, $455 billion committed through the Term Auction Facility and billions more in other programs.

Even with the government greasing the gears, the nation’s two biggest banks, B. of A. and Citi, still would have shown billions in losses had they not sold a combined $16 billion in pre-tax assets, and these are banks that have taken a combined $102 billion in taxpayer cash.”

The column underscores a point made by the WSJ’s Dan Fitzpatrick and David Enrich on Monday that not only was business tough for banks in the second quarter, the chief executives of those firms believe the second half of the year will be worse. One problem, according to a story Monday by Lingling Wei and Maurice Tammen, is commercial loans that are defaulting at the fastest rate in two decades.

There is Wall Street reality and then there is Main Street reality. Sooner or later the two will clash, most likely in favor of Main Street reality. Wall Street will have to adjust its lofty views and come face to face with how things really are.

While you and I will have no control if and when this event is this taking place, there is one thing we all can do: Keep our sell stops in place and act when they are triggered.