A quick update on the situation in Greece

It seems I am writing these intra-month notes more often than hoped for.  However, I want to update you on the situation in Greece and reiterate our sentiment from last month's commentary that the current market activity, while volatile, still appears to be well within the normal range for a temporary market correction.  It is also important to note that our portfolios have little to no direct exposure to European equities and debt. 

The situation in Greece and periphery Europe has deteriorated over the past several days, and credit markets are pricing in a high likelihood of a Greek default.  With that said, we think there will be a last minute deal (as suggested yesterday by the EU Commissioner: Rehn Sees Markets Misreading EU Resolve).  If this does not happen, then Greece could default within the next several weeks.  While this will be a painful event, particularly for EUR denominated assets and EU banks, we maintain that it will not spread systemic risk as happened in 2007/08 (see Greece is Not Lehman).  If our thesis proves wrong over the next several days/weeks/months, then we have several options to ride out the storm.

(1) We can stay invested in equities, (2) we can exit or hedge (via options) our current positions and wait for calmer markets, or (3) we can go short and profit if the market enters a prolonged downturn.  As of today, despite weak performance, we have not seen outright sell signs that warrant exiting our long-term positions:

• The VIX Index, which is a measure of investor fear, has flashed the “fasten seatbelt” sign but investors are still far away from “jumping out of the plane”.
• Furthermore, by many metrics the market is oversold.  If/when any of the current issues are resolved (and all should be resolved within the next several months) markets should move higher as happened last year.

Additionally, while we do not think we will witness a widespread crisis, now is a good time to make sure your financial house is in order and double-check that your checking, saving/CD and brokerage accounts are insured against bank insolvency (i.e. provide the equivalent of FDIC/SIPC insurance).  This is particularly important for assets held at select European banks.

Finally, it is important to remember that as a long-term investor the current market volatility, while disconcerting, is just noise in the longer-term context of your portfolio’s returns.

IRS Loosens Aug. 31 Deadline for Offshore Tax Disclosures - Bloomberg

The Internal Revenue Service will let taxpayers with undeclared offshore accounts apply for a 90-day extension of the Aug. 31 deadline for coming forward.

The change, announced on the IRS website today, would let taxpayers seek the extension in writing by showing that they have made a “good-faith attempt” to meet the deadline and explain what information they are missing.

To read more please see: IRS Loosens Aug. 31 Deadline for Offshore Tax Disclosures - Bloomberg

How do you say Deja Vu in Greek?

The end of the search for Bin Laden and relatively dovish statements from Bernanke (meaning interest rates are going to stay low) should have provided a good start to May. However, negative headlines quickly outweighed positive ones and May 2011 turned into a near identical repeat of May 2010, which similarly witnessed concerns of over Greek debt and double-digit intra-month market swings. 

The euro’s slide and resulting USD strength, combined with what should have been a normal correction in an overheated commodities market, to form a wave of selling of across all markets several times greater than any single newsbyte warranted—a rogue wave of sorts. However, as mentioned last month we expect some positive swings in the USD over the short-term; over a longer-term horizon, however, we still maintain that the USD will remain relatively weak until interest rate differentials narrow. This should be positive for most commodities and non-USD assets.

As such, for new accounts, we used the corrections as buying opportunities in select markets that benefit from a weaker dollar and continued loose monetary policy in the US. For example:

After an initial sell-off in gold in USD terms, gold rallied to new highs in EUR terms and has provided relative stability against violent currency fluctuations. Gold remains a buy on pullbacks (more on this in a future article).

Furthermore, US Treasuries have proved their safe-haven characteristics, defying simple logic, and have rallied despite the imminent end of QE2. In fact, using history as our guide (see Figure 1 below), we think there is high likelihood that US rates will move lower (and bond prices higher), despite prevailing opinion that the end of the Fed’s buying will push rates higher (again more on this in a future article). 

Figure 1: With the Fed buying bonds in QE1 and QE2, one would expect rates to decrease. Instead the opposite occurred. Likewise, with the end of QE1 and QE2, one would expect rates to rise. QE1 proved differently. Will this be the same for the end of QE2?

Data Source: Federal Reserve

Bottom Line: Currently market activity, while volatile, appears to be well within the norm. For the most part, corrections are buying opportunities in select markets, rather than a reason to sell. Should this change and the markets show signs of prolonged deterioration, we will reduce exposure and then get re-invested as opportunities arise again in the future.

Greece is Not Lehman

Recently, there have been quite a few comparisons between a Greek default and the Lehman Brothers bankruptcy -- “Is Greece the 'next Lehman Brothers'?”, “Greek Restructuring Would Be 'Lehman Moment,' MIT's Johnson Says” and "Could Greece be the next Lehman Brothers? Yes - and potentially even worse" to cite a few. The comparisons, while tempting, are exaggerated and overstate Greece’s role in the European Union and more importantly in the global financial system. In short, it is our opinion that Greece’s debt issues alone do not pose the same threat that Lehman Brothers did in 2008. 

As such, while a Greek default would be extremely disruptive, the disruptive effect is not as much due to contagion and the spread of systemic risk, but more due to the disruption of the status quo—USD down / risk on. A Greek default will obviously be hugely painful, placing stress on EU relations, reducing confidence in the euro and generally decreasing risk appetite; however an all out freeze of the global financial system and movement of capital as experienced before, during and after Lehman’s collapse seems out of the question at this time. This is best illustrated by the Ted Spread, which still remains well within normal levels. See Figure 1 below.

Figure 1: The Ted Spread “represents the change between the three-month LIBOR rate and the three-month rate for U.S. Treasury bills. It is used to measure the amount of pressure on the credit markets. Generally, the spread has stayed under 50 basis points. The bigger the difference between the two, the more worry there is about the credit markets. Economists will look at this to determine how risk-averse banks and investors really are.” Source: Investopedia; Data Source: Federal Reserve

Lehman Brothers and the other now reincarnated investment banks were the pistons, gears and engine of the financial system. All were interlinked and as we ultimately learned the failure of one meant the virtual shutdown of all. The crisis of 2007/08, which I unfortunately had a front seat for as an ETF trader at Lehman, was a solvency crisis for investment banks and many commercial banks; it was a bubble bursting; it was a crisis of confidence; and importantly it was a liquidity crisis on a worldwide scale—money literally stopped moving. The spike in the TED Spread in 2007-2009 shows how capital movement virtually froze.

On the other hand, Greece and most of the periphery European countries, even the larger ones, are merely passengers of the financial system. They are not integral components to the continued viability and fluidity of the financial system. Spreads on Greek and some periphery European country debt have exploded relative to German Bunds, and yet we are not seeing the same general distrust amongst global banks that was so pervasive during the credit crisis.

Bottom Line: In some ways Greece’s relationship to Europe is like a tangled ball of yarn. Untangling the mess without serious disruption is possible but it will be difficult and at times painful. On the other hand, Lehman Brother’s relationship to the global financial system was somewhere between tangled yarn and a scrambled egg—maybe a tangled yarn dipped in egg. Untangling it was nearly impossible without serious blood, sweat and tears and despite best efforts by all everyone was left with a horrible mess on their hands. With that said, given the fragility of the global economic system, the possibility of a severe market downturn cannot completely be ruled out. As such, we are watching for warning signs that the above thesis is wrong—TED Spreads, Bund/Treasuries spreads, equity market volatility and credit spreads, among other things. So far all appear to be well within normal expectations.

Prepare for volatility and downward corrections but not outright collapse.

Rotary Club Sunrise welcomes presentation on personal finance « Virgin Islands News Online

ROAD TOWN, Tortola, VI- The Rotary Club Sunrise of Road Town welcomed James Bridgewater and Adam Stauffer of Offshore Investment Advisor, a Wealth Manager based on Tortola, on April 26, 2011.

According to Public Relations Director of the club Edwin Adams, James and Adam delivered an educational presentation on personal finance, including the effects that inflation, a declining US dollar and compounding returns have on an investor’s ability to save for retirement.

To read more: Rotary Club Sunrise welcomes presentation on personal finance « Virgin Islands News Online 

Dollar, Yuan, CDs and Silver

While the first several months of 2011 were dominated by non-market related events—the Middle-East uprising and the Japan catastrophes—April provided a month of nearly pure macroeconomic news. Despite the lack of sensational and heartbreaking headlines, these macroeconomic events will undoubtedly have implications on your money whether held in CDs or some of today’s favorite trades like gold and silver. Some of the more noteworthy news items include:

• The European Central Bank raised rates to 1.25% to tame inflation and despite struggling peripheral member countries. 
• Similarly, China increased banks’ reserve requirements to a record 20.5% less than two weeks after they raised interest rates; both desperate attempts to lock up cash and cool inflation. 
• Meanwhile, the US maintained QE2 and signaled prolonged loose monetary policy. 

The divergence in policies, which was confirmed in a late-April speech by Bernanke, means that the interest rate spreads between US Treasuries and other governments’ bonds are likely to continue to widen before they start to narrow—the forces driving the USD lower and gold/silver higher are going to get stronger before they get weaker. According to Bloomberg, “yields on Treasuries due in one to three years are 1 percentage point below that of government debt with similar maturities in the rest of the world on average, Bank of America Merrill Lynch indexes show. A year ago, there was no difference” (see here)

Bernanke’s speech combined with the technical breakdown in the USD solidified our convictions. We already had a substantial short USD position indirectly through international equities, which make up 50% of our total equities holdings, and international local currency bonds, as well as commodities like gold and silver, which historically have had a high negative correlation to the USD. However, in April we maxed out our non-USD holdings by initiating direct shorts against the USD—we moved excess cash in our clients’ portfolios to (1) a long position in the Chinese Yuan, which has been a “no brainer” trade that has gone nowhere for a long time, and (2) a basket of non-USD currencies.

Some may say we are late (and we are … by over three decades) and that everyone is already so bearish on the USD that now is the time to be a contrarian (which may prove true), but given Bernanke’s actions and the opposing actions of the world’s central bankers we are comfortable that over the medium-term the dollar will continue its slide.

Chinese Yuan - The Chinese have been very disciplined (or stubborn) in allowing the Yuan to appreciate relative to the USD. However, over the last several months it has become clear that China has an inflation problem and a wage inflation problem as well as possibly even a housing bubble. They have used rates and reserve requirement increases to try to alleviate their issues with relatively little success; now Governor Hu Xiaolian suggested on the central bank's website that The People's Bank of China plans to increase the Yuan's flexibility to cut the cost of imports and counter inflation. Yuan forwards traded at the biggest premium to the spot rate in more than five months, confirming speculation the central bank will allow faster currency gains (see here). Furthermore, the Yuan is making new multi-year highs—the Yuan strengthened beyond 6.5 per dollar for the first time since 1993 (see here)

The end result, we feel, is that the opportunity for a significant one-time jump in the Yuan is not only probable but could finally happen relatively soon.

Silver - On a different note, I spent much of Easter weekend looking at old Silver charts (get a life)—one of the more impressive ones is shown at right (March ’80).

Most of our clients hold silver, as well as gold, which have been great investments/trades recently. However now the concern becomes: when does it end?

Silver has a long history of making losers out of winners—rapid appreciation followed by extremely violent reversals means that most silver holdings fall back to cost or lower before the trader even knows what hit him. In the commodities market, and in particular silver, sentiment can shift very quickly with supply/demand dynamics changing over a matter of days or weeks rather than months or years.

With that said, we feel that silver likely still has some upside left given anticipated USD weakness. However, we are not initiating new positions until there is a significant pullback. It should be noted that given how volatile most commodities are, we follow a much quicker Risk Management process (see March 2011 Commentary) for commodities. This in theory should get us out of silver faster than most other investors. (Since the time of this writing margin requirements for silver have been raised twice by the CME which has had a deleterious effect on silver prices – see here)

To receive a PDF presentation on our Portfolio Construction Process and Dynamic Risk Management please contact us.

Bottom Line: On a daily/weekly basis the USD may correct upwards; however in the medium-term the USD will slide well beyond its 35+ year inflation-adjusted lows until the disparity across interest rates is eliminated and there is clarity on the US deficits and economic recovery. This means that already struggling savings and CDs accounts, will be doubly penalized—first by near-zero interest rates and second, and more importantly, by a weak and declining dollar combined with inflation. Cash held “safely” in USD-denominated savings and CD accounts are, and will continue to lose value. Which begs the question how do you define safe?

Dynamic Risk Management

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.