Unrest in the middle-east and a horrible series of disasters in Japan, among other things, have investors on edge. However, despite these events, there has been very little panic selling outside of the individual markets/regions that were directly affected. In fact, the VIX Index, which measures the equity market's expectation of near-term volatility (or risk), is trading near its 52-week lows (see chart at right).
The VIX is a little like the flying in an airplane. Any spike higher in the VIX is similar to the fasten seat belt sign going on—99.99% of the time everything is fine. Even so, that little sign and the accompanying bumps raise your heart rate; fear levels go up. A spike above 30 or so is like the oxygen masks dropping down—the plane is not necessarily crashing but something frightening is happening; everything is not ok. Finally, any reading consistently above 35 or higher for more than several weeks is a sign that there is something systemically wrong—it is time to put the parachute on and exit the plane.
The reason I point this out is because many investors I have recently spoken with have expressed concern over the market. And, given recent events, some concern is warranted; however, the fasten seat belt came on only briefly over the last several months. Surprisingly the markets have shrugged off a series of horrible news and appear to want to go higher. (As explained in last month’s commentary, we believe this is in large part due to easy monetary policies in most developed countries.)
Regardless, given how unpredictable and uncertain the first three months of this year have been, the rest of this month’s commentary is dedicated to explaining our risk management process (i.e. when we strap on our parachutes).
There are two core components to our risk management strategy—strategic asset allocations and dynamic risk management. The combination of the two results in a portfolio with positively skewed monthly returns and significantly fewer negative months (see chart below).
Strategic Asset Allocation forms the “broad strokes” of our models and is based on our 3-5 Year Investment Outlook, as well as mean-variance optimization. Mean-variance optimization attempts to maximize portfolio return for a given amount of portfolio risk. The product of the two is a policy portfolio that balances investment opportunities across geographies and asset classes, and that serves as the reference portfolio off which we structure all of our models.
In theory, a well thought-out mixture of uncorrelated assets (equities, fixed income, commodities, currencies) should reduce overall risk and protect your portfolio against wild swings—when one asset zigs, the other zags—however, in practice, in times of severe disruption, all markets tend to move in the same direction at the same time.
Therefore, we have an added layer of risk management, Dynamic Risk Management, that acts as the “fine tuning” for our models and your portfolios. We follow a purely mechanical logic based on the current price level for any given security relative to its N-period simple moving average (SMA)—where N varies depending on certain preset parameters. Although, our process is slightly more complicated, at the most basic level when the monthly closing price for a security is above its SMA, we are invested; when it is below its SMA, we are in cash.
While not fail-safe, this mechanical system allows us to rapidly adjust our models to the prevailing trading environment and avoid making unwise investment decisions based solely on emotion. This in turn dramatically reduces the risk inherent in our clients’ portfolios (which is one of the key reasons many of our clients rely on us).
To receive a PDF presentation on our Portfolio Construction Process and Dynamic Risk Management please contact us.
Bottom Line: Despite the horrible toll on life, the recent events only temporarily raised the level of fear in the financial markets.
Tokyo Electric Power Co.’s nuclear power plant experienced two explosions today that significantly increase the chance of more radiation leaks. These leaks are not expected to be on the same level as Chernobyl however given recurring aftershocks it seems hard to rule anything out at this time.
This has direct implications on Japanese stock markets, of which we have little to no exposure to; it has indirect implications on global markets due to the size of Japan’s economy and the threat that a significant slowdown there could spread to other economies. Most non-Asian markets are down 1.5% to 2% (at the time of this writing), which does not qualify as an extreme move, but still warrants caution. The USD, CHF and JPY, as well as US Treasuries, are up on a flight to safety. Most commodities are down on global slowdown concerns; natural gas is up as this catastrophe represents a significant setback for nuclear power.
First and foremost, our hearts go out to everyone that has family or friends in Japan, or that is in anyway affected by the events in Japan. With that said, we are weighing our long-term investment philosophy versus the extremely unique and highly unpredictable nature of the current situation, and may decide to temporarily reduce our higher beta equities allocations, such-as emerging markets, as well as other allocations should the situation deteriorate further. As of this writing no action has been taken.
To be clear, we are invested for the long-term and do not let day-to-day or even month-to-month swings strongly influence our decisions (and neither should you). However given the unpredictable nature of this event, combined with the unprecedented (and possibly escalating) unrest in the Middle East, we may err on the side of being overly cautious, reduce some of our exposure and wait for more clarity on the global outlook.
If you have any questions/comments please do not hesitate to contact us.
To monitor the events in Japan in near real-time: http://live.reuters.com/Event/Japan_earthquake2
Sincerely,
James & Adam
For all US taxpayers that have an unreported offshore account (or that have a friend with one), the IRS has re-implemented a program to repatriate hidden offshore assets. It appears that the IRS is turning up the heat and progressively making it more difficult, if not impossible, to hide assets offshore.
“U.S. taxpayers with hidden offshore accounts have until Aug. 31 to decide whether to disclose their holdings to the government without being criminally prosecuted, the Internal Revenue Service said.” To read more see “IRS Giving Partial Amnesty to U.S. Taxpayers With Hidden Overseas Accounts”.
While we do not provide tax advice nor any tax-related services, we are here to help anyone that would like to learn more about their options or be put in touch with a tax specialist. Please do not hesitate to contact us.
Despite the S&P 500 equities index setting a new 52-week high and finishing up nearly 3.5% for the month, February was a nerve-racking and at times sleepless month. But things could have been a lot worse.
Last month we spoke about how unrest in Egypt and Tunisia could spread to more strategically important oil producing countries and produce 1979-like inflation. Well the unrest spread and commodities prices rose– WTI crude oil topped $100; gold, cotton and food indices made all-time highs; silver multi-decade highs, etc., etc. (see CRB commodity index chart at right ). Despite widespread unrest and rapidly increasing energy prices, it appears that extraordinarily loose monetary policy led by Quantitative Easing in the US, but implemented by most developed countries’ Central Banks, has helped mitigate any negative impact on developed equity markets.
However, loose monetary policy is proving to be a double-edged sword and inflation is on the precipice of spiraling out of control. Not necessarily because central bankers have pushed it too far or because the US dollar is in a downward death-spiral as many doomsayers predict, but because of wildly unpredictable factors beyond the control of central bankers and government officials alike.
Which makes me think of Jurassic Park. Bear with me...
Jurassic Park, a novel by Michael Crichton and movie by Steven Spielberg, is “often considered a cautionary tale on unconsidered biological tinkering. [Jurassic Park] uses the mathematical concept of chaos theory and its philosophical implications to explain the collapse of an amusement park showcasing genetically recreated dinosaurs.” (http://en.wikipedia.org/wiki/Jurassic_Park)
Rearrange some of the characters and you could be talking about our current predicament: inflation (the dinosaurs), quantitative easing (biological—read economic—tinkering) and unrest in the Middle East (chaos). Central bankers have successfully engineered inflation designed to stimulate growth, reduce unemployment and increase consumption. However, now that they have succeeded, their creation appears to have taken on a life of its own; chaos has set in; the beast has escaped from the park!
With that said, our portfolios are now firmly biased toward inflation risk. As recently as mid to late-2010 we were on the fence between deflation/inflation and our portfolios reflected our lack of conviction. Starting in late 2010, we progressively began adding and/or increasing allocations to securities that should outperform in an inflationary environment (and the resulting rising interest rates)—TIPS, precious metals, energy, agriculture, infrastructure, and floating rate bank loans.
Furthermore, we are closely watching the USD index for a clear break below its long-term resistance (see chart below). While we already have significant non-USD exposure through non-US equities, should the dollar index make a significant move lower we will move excess cash and cash-equivalents into a basket of non-USD currencies.
Bottom Line: Inflation is a major and growing risk. The rapid accent of energy prices has the potential to reverse economic progress made since ‘08/09, which will be negative for equities, however positive for most real assets as long as the rise is orderly.
Rising US Interest Rates - BVI Property Guide
by Adam Stauffer, CFA, Chief Investment Officer at Offshore Investment Advisor
In the last months of 2010, US Treasury rates—or the interest on US government debt—started to climb from near historic lows.
The combination of a second round of quantitative easing by the Federal Reserve and an extension of former US President George W. Bush-era tax cuts sparked a rally in 10-year Treasury rates from a low of 2.45% in early October to around 3.5% at the time of this writing.
While the prospect of rising rates is welcome news for investors in CDs, many of whom have realised negative real rates of return over the last several years due to near zero percent interest rates, the impact on short-term CDs will be muted. In fact, the benchmark three-month CD rate only increased to 0.29% from 0.27%. Instead, the primary impact will be felt in mortgage rates and more generally across an investor’s portfolio.
When you are a rapper named 50 Cent and you use Twitter to promote stocks in your portfolio: “Sales of the penny stock [ticker: HNHI] increased by 290 percent following the endorsement [by 50 Cent], resulting in a paper profit of almost $5.2 million for the rapper, who owns 7.5 million shares in the company...” To read the full article see “Is 50 Cent Using Twitter to 'Pump and Dump' Stock?”
Maybe James and I should hire 50 Cent to write this commentary …
In some ways it sure seems like it. Equities appear to be unstoppable and some names like YOKU and DANG have had IPOs that have skyrocketed in their first several days of trading similar to dot-coms in ‘99. In reality, 1979 may be more like it. But let’s hope it is neither!
What is happening in Egypt has some similarities to Iran in the late 70’s. In 1979, amid massive protests in Iran, the Shah fled and the anti-western Ayatollah Khomeini took over leadership. This set up the Arab oil embargo of the US and its western allies and set off an inflationary cycle in everything oil-related, from gasoline to food. The price of Saudi crude more than doubled to around $34 a barrel at the end of 1980 from $14 two years earlier. A similar disruption in the Middle East could send WTI crude oil, which currently trades around $90, well above its previous high of $145 in 2008 (see chart).
However, it is unlikely that Egypt will be the cause of a massive spike (at least directly), since the country does not produce much oil. Egypt does control the Suez Canal, which sees more than 5% of the world's oil pass through it, however even this is unlikely to set off an inflationary spike.
In my opinion, the bigger concern is how quickly these disturbances are spreading from country to country. According to Business Insider, what started in Tunisia “partially due to food price inflation and unemployment, but also because of WikiLeaks,” has spread to Egypt, Morocco, and Algeria, among other countries. If a serious disruption were to spread to a significant producer of oil then runaway inflation—starting in oil-related products then spreading to other commodities—could be an issue.
Coincidently, if you have been reading our past couple of Commentaries there is a scary, albeit loose and lucky, similarity between what we spoke about and what is going on. Specifically, in November, we mentioned:
“To cap off the negative tone for the month, Wikileaks has thrown a wrench into closed door politics and, in my opinion, has turned a nearly impossible situation in the Middle East into an impossible one…” Read more here.
Then in December we spoke tongue in cheek about Armageddon and commodities inflation:
“I am not an “Armageddon is coming” type person, but It is easy to let your mind get carried away when you think of how much food, energy, water, etc. 7 billion people need…” Read more here.
Bottom line: The current turmoil in the Egypt is not Armageddon (although if you live in the region then it may feel like it). However, food prices have been rising dramatically in the Middle East, as well as other parts of the world. According to the UN, the food price index is at the highest level ever recorded. This food inflation has the possibility of creating global social unrest (particularly developing markets), which generally speaking will have negative implications for stocks which tend to decrease in value during times of uncertainty and positive implications for supply constrained things like commodities. Furthermore, it appears that risks are starting skew in favor of holding developed equities vs. developing.
For more information on the linkages between the Mid-East unrest and Wikileaks and Food Inflation see here and here.
